1. Cash Flows and Financial Analysis and Cash Conversion Cycle
Chapter 3
Plus CCC part of Ch. 15
Cash Flows and Financial Analysis and Cash Conversion Cycle
Our main coverage for this chapter is financial ratios – the chapter in the book covers more than that

2. Financial Information—Where Does It Come From, etc.
Financial information is the responsibility of management
Created by within-firm accountants
Creates a conflict of interest because management wants to portray firm in a positive light
Published to a variety of audiences

3. Users of Financial Information
Investors and Financial Analysts
Financial analysts interpret information about companies and make recommendations to investors
Major part of analyst’s job is to make a careful study of recent financial statements
Vendors/Creditors
Use financial info to determine if the firm is expected to make good on loans
Management
Use financial info to pinpoint strengths and weaknesses in operations

4. Sources of Financial Information
Annual Report
Required of all publicly traded firms
Tend to portray firm in a positive light
Also publish a less glossy, more businesslike document called a 10K with the SEC
Brokerage firms and investment advisory services

5. Data sources for term project
See the course links page for link to MEL page

6. The Orientation of Financial Analysis
Accounting is concerned with creating financial statements
Finance is concerned with using the data contained within financial statements to make decisions
The orientation of financial analysis is critical and investigative

7. Ratio Analysis Used to highlight different areas of performance
Generate hypotheses regarding things going well and things to improve
Involves taking sets of numbers from the financial statement and forming ratios with them

8. Comparisons
A ratio when examined alone doesn’t convey much information – but..
History—examine trends (how the value has changed over time)
Competition—compare with other firms in the same industry
Budget—compare actual values with expected or desired values

9. Common Size Statements
First step in a financial analysis is usually the calculation of a common size statement
Common size income statement
Presents each line as a percent of revenue
Common size balance sheet
Presents each line as a percent of total assets

10. Common Size Statements

11. Ratios Designed to illuminate some aspect of how the business is doing
Average Versus Ending Values
When a ratio calls for a balance sheet item, may need to use average values (of the beginning and ending value for the item) or ending values
If an income or cash flow figure is combined with a balance sheet figure in a ratio—use average value for balance sheet figure
If a ratio compares two balance sheet figures—use ending value
In this class we sometimes cheat and just use the ending balance sheet. Often it is the only one given.

12. Ratios – get insights into the company just by looking at financial statements
5 Categories of Ratios
Liquidity: indicates firm’s ability to pay its bills in the short run
Asset Management: Right amount of assets vs. sales?
Debt Management: Right mix of debt and equity?
Profitability— Do sales exceed costs, and are sales high enough as reflected in PM, ROA, and ROE?
Market Ratios— Do investors like what they see as reflected in P/E and M/B ratios?

13. Liquidity Ratios Current Ratio
To ensure solvency the current ratio should exceed 1.0
Generally a value greater than 1.5 or 2.0 is required for comfort
As always, compare to the industry
A low current ratio suggests the company must give serious attention to cash management

14. Current ratio
If a company is able to operate with a low current ratio,
It may just mean that the company is more efficient about using its capital.
Therefore, a low current ratio can lead to higher return of assets.
Sometimes the current ratio is more an indicator of the resources a company devotes to cash management than liquidity per se.

15. Liquidity Ratios Quick Ratio (or Acid-Test Ratio)
Measures liquidity without counting inventory (often the firm’s least liquid current asset)
Not a good ratio for companies with very liquid inventory (e.g., grain farms)
If liquidity ratios are low, a company needs to do careful cash budgets and stay on top of cash management.

16. Asset Management Ratios
Total Asset Turnover
Cash (no ratio per se)
Receivables
Inventory
Fixed Assets

17. Asset Management Ratios
Total Asset Turnover, TAT
Does the company get high enough sales out of its assets?
“Bottom line” of asset management
One of the Du Pont equation ratios
Large effect on ROE
Average balance sheet values are appropriate

18. Asset Management Ratios
Average Collection Period (ACP): receivables management
Measures the time it takes to collect on credit sales
AKA days sales outstanding (DSO)
Should use an average Accounts Receivable balance, net of the allowance for doubtful accounts

19. Asset Management Ratios
Inventory Turnover
Measures how many times a year the firm uses up an average stock of goods
A higher turnover implies creating sales with less money tied up in inventory
Gives an indication of the quality of inventory, as well as, how it is managed
Should use average inventory balance

20. Asset Management Ratios
Inventory conversion period (ICP) -- Days of sales in inventory
Has the same information as ITO
Inventory/(COGS/360) = 360/ITO
Used in cash conversion cycle (CCC) calculation

21. Asset Management Ratios
Fixed Asset Turnover
Appropriate in industries where significant equipment is required to do business
“Fixed Assets” usually limited to net PP&E
Long-term measure of performance
Average balance sheet values are appropriate
Some companies have excess fixed assets outside of PP&E

22. Debt Management Ratios
Need to determine if the company is using so much debt that it is assuming excessive risk (or using too little debt)
“Debt” could mean:
Long-term debt and current liabilities = total liabilities
Or it could mean just interest-bearing obligations
Or often data sources just use long-term debt
Debt Ratio preferred in this class
A high debt ratio is viewed as risky by investors
Usually stated as percentage

23. Equity Multiplier (EM)
Assets as a multiple of equity
Same information in EM, debt ratio, and debt-equity ratio
Equity multiplier used in the Du Pont Model
One of the BIG 3

24. Debt Management Ratios
Debt-to-equity ratio
Can be stated as a percentage or times
Many sources of data use long term debt instead of total liabilities
Measures the mix of debt and equity within the firm’s total capital

25. Sometimes you are given the debt-equity ratio (TL/E) or you may find it in a source for industry ratios. In AGEC 424, I normally want you to use TL/TA. So you need to convert the debt-equity ratio into the TL/TA ratio. The conversion is according to the equation:
Steps in derivation:
First use TA = TL+E, to replace TA in the denominator.
Second divide numerator and denominator by TL.
Third multiply numerator and denominator by TL/E.

26. relationships 𝐴 𝐸 = 𝑇𝐿+𝐸 𝐸 = 𝑇𝐿 𝐸 + 𝐸 𝐸 = 𝑇𝐿 𝐸 +1
EM=debt to equity ratio plus 1.0

27. Debt Management Ratios
Times Interest Earned
TIE is a coverage ratio
Reflects how well EBIT “covers” interest expense
A high level of interest coverage implies safety
Some sources of data combine interest income and interest expense, giving you net interest expense, making the ratio bigger than it should be.
Some analysts consider 1.5 a minimum level

28. Debt Management Ratios
Cash Coverage1
TIE ratio has Issues
Interest is a cash payment but EBIT is not exactly a source of cash
By adding depreciation back into the numerator we have a more representative measure of cash
The numerator is EBITDA
1 EBITDA or “earnings before interest taxes depreciation and
amortization” is a commonly used measure of cash flow.

29. Debt Management Ratios
Fixed Charge Coverage
Interest payments are not the only fixed charges
Lease payments are fixed financial charges similar to interest
They must be paid regardless of business conditions
If they are contractually non-cancelable

30. Debt Management Ratios
Days of sales financed by accounts payable (Accounts Payable deferral)
Accounts Payable/(COGS/360)
A measure of how large accounts payable are in comparison to COGS (sales)
Used in CCC calculation

31. Profitability Ratios
Return on Sales (AKA:Profit Margin (PM), Net Profit Margin)
Measures control of the income statement: revenue, cost and expense
Represents a fundamental indication of the overall profitability of the business

32. Profitability Ratios Return on Assets
Adds the effectiveness of asset management to Return on Sales
Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit

33. Profitability Ratios Return on Equity
Adds the effect of borrowing to ROA
Measures the firm’s ability to earn a return on the owners’ invested capital
If the firm has substantial debt, ROE tends to be high in good times and low in bad times

34. Profitability Ratios Basic earnings power Return on capital employed
BEP = EBIT/Total Assets
Compare to the pre-tax interest rate
Return on capital employed
ROCE = EBIT(1-T)/Total Assets
Compare to after tax interest rate
ROCE = BEP(1-T)

35. Market Value Ratios Price/Earnings Ratio (P/E Ratio)
An indication of the value the stock market places on a company
Tells how much investors are willing to pay for a dollar of the firm’s current earnings
A firm’s P/E is primarily a function of its expected growth and risk

36. Market Value Ratios Market-to-Book Value Ratio
A healthy company is expected to have a market value greater than its book value
Known as the going concern value of the firm
Idea is that the combination of assets and human resources will create an company able to generate future earnings worth more than the assets alone today
A value less than 1.0 indicates a poor outlook for the company’s future

37. Du Pont Equations Ratio measures are not entirely independent
Brings ratios from different areas together
Du Pont equations express relationships between ratios that give insights into successful operation

38. Du Pont Equation (2 component)
Du Pont equations start with expressing ROA in terms of ROS and asset turnover:
States that to run a business well, a firm must manage costs and expenses as well as generate lots of sales per dollar of assets.

39. Extended Du Pont Equation
Designed to explain ROE (expense mgt., asset mgt., debt mgt.)
Not Designed to Calculate ROE
Can also get EM from:

40. Du Pont Equations
Extended Du Pont equation states that the operation of a business is reflected in its ROA
However, this result—good or bad—can be multiplied by borrowing
The way you finance a business can exaggerate the results from operations
The Du Pont equations can be used to isolate problems

41. Operations—Cash Conversion Cycle (from ch. 15)
A firm begins with cash which then “becomes” inventory
Which then becomes a product which is sold
Eventually this will turn into cash again
The firm’s operating cycle is the time from the acquisition of inventory until cash is collected from product sales

42. Figure 15.2: Time Line Representation of the Cash Conversion Cycle

43. Cash Conversion Cycle CCC = ICP + DSO – AP Deferral
The shorter the CCC the less interest bearing and/or equity capital is needed to fund operations.
This can be very significant for businesses with high working capital

44. Wal Mart CCC WAL MART STORES INC sales per day 1126.69 COGS per day
850.44
RECEIVABLES
3905
INVENTORIES
34511
ACCOUNTS PAYABLE
47638

45. Wally World CCC – 2010 data from Yahoo finance
ICP
40.6
DSO
+3.47
AP deferrals
-55.65
CCC
-11.58

46. Sources of Comparative Information
Generally compare a firm to an industry average
Go to MEL page for AGEC 424
Three sources
BizMiner
eStatements
D&B
Based on SIC or NAICS codes

47. Limitations/Weaknesses of Ratio Analysis
Ratio analysis is not an exact science and requires judgment and experienced interpretation
Examples of significant problems
Diversified companies—because the interpretation of ratios is dependent upon industry norms, comparing conglomerates can be problematic
Window dressing—companies attempt to make balance sheet items look better than they would otherwise through improvements that don’t last
Accounting principles differ—similar companies may report the same thing differently, making their financial results artificially dissimilar
Inflation may distort numbers