1. Introduction & Financial Analysis Objectives for a firm? Quick Review of Financial Statements Financial Analysis

2. The firm's objectives? -To maximize profits? - To act in an ethical manner? - To increase market share? - To maximize shareholder wealth? -To maximize managers’ wealth? What are agency problems? Interests of managers & shareholders can be aligned by: - compensation plans - appointment & review by board of directors and auditors - the threat of takeover - scrutiny by banks & other specialists

3. Flow of cash between capital markets and firm's operations Financial manager Firm's operations Capital markets (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors (1)(2) (3) (4a) (4b)

4. 3 Basic Financial Statements Income Statement (I/S) Balance Sheet (B/S) Statement of Cash Flows (CFs)

5. Income Statement An Income Statement shows profitability Sales - Cost of Goods Sold (COGS) = Gross Profit (GP) GP - Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI) EBIT - Interest = Earnings Before Taxes (EBT) EBT - Taxes = Earnings After Taxes (EAT) or Net Income (NI)

7. Limitations of the Income Statement Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period. Inflation can impact reported profits (FIFO, LIFO) Backward looking…

8. Balance Sheet Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest – Delineates the firm’s holdings and obligations – Items are stated on an original cost basis rather than at current market value

10. Limitations of the Balance Sheet Most of the values are based on historical/original cost price – Troublesome when it comes to plant and equipment inventory FASB ruling on disclosure of inflation adjustments no longer in force – It is purely a voluntary act on the part of the company

11. Limitations of the Balance Sheet (cont’d) Differences between per share values may be due to: – Asset valuation – Industry outlook – Growth prospects – Quality of management – Risk-return expectations

12. Comparison of Market Value to Book Value per Share

13. Accrual Method of Accounting Is used most often by corporations Revenues and expenses are recognized when they occur, rather than when cash changes hands For example, a credit sale in December 2009 is shown as revenue in that year (2009), even though payment is not received until March 2010

14. Statement of Cash Flows Emphasizes critical nature of cash flow to the operations of the firm – It represents cash/cash equivalents items easily convertible to cash within 90 days Cash flow analysis helps in combating discrepancies faced through accrual method of accounting

15. Illustration of concepts behind the statement of cash flows

16. Steps in computing net cash flows from operating activities using the indirect method

18. Free Cash Flow 2-18 Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends – Capital expenditures Maintain productive capacity of firm – Dividends Maintain necessary payout on common stock and to cover any preferred stock obligations Free cash flow can be used for special financing activities – Example leverage buyouts – Excess Free cash flow can lead to agency costs.

19. Financial Analysis and Ratios What is financial analysis? Evaluating a firm’s financial performance Analyzing ratios or numerical calculations Comparing a company to its industry

20. There are many potential ratios, with some variation in applications. Below are some of the most common financial ratios: A. Profitability Ratios. 1. Profit margin. 2. Return on assets. 3. Return on equity. B. Activity (Asset utilization) ratios. 4. Receivable turnover. 5. Average collection period. 6. Inventory turnover. 7. Fixed asset turnover. 8. Total asset turnover. C. Leverage (Debt utilization) ratios. 9. Debt to total assets. 10. Times interest earned. 11. Fixed charge coverage. D. Liquidity ratios. 12. Current ratio. 13. Quick ratio.

21. Financial statements for sample ratio analysis

22. Profitability Ratios Show how profitable a company is. The ratios express: — Profit Margin or Return on Sales (%) — Return on Assets or Return on Investment (%) — Return on Equity (%)

23. Profitability Ratios Saxton Company Industry Average 1. Profit margin = = 5% 6.7% 2. Return on assets = a. = 12.5% 10% b. 5%  2.5 = 12.5% 6.7%  1.5 = 10% 3. Return on equity = a. = 20% 15% b. = 12.5% x 1.6 15% = 20% Net income sales $200,000 $4,000,000 Net income Total assets Net income Sales Total assets  $200,000 $1,600,000 Net income Stockholders’ equity $200,000 $1,000,000 Net income Total Assets  equity

24. Return of Wal-Mart versus Macy’s using the Du Pont method of analysis, 2007

25. Activity (Asset Utilization) Ratios Show how effectively a company uses its assets. The ratios express: — Receivables Turnover (times) — Average Collection Period (days) — Inventory Turnover (times) — Fixed Asset Turnover (times) — Total Asset Turnover (times)

26. Saxton Company Industry Average 4. Receivables turnover = = 11.410 times 5. Average collection period = = 32 36 days 6. Inventory turnover = = 10.87 times Sales (credit) Receivables $4,000,000 $350,000 Accounts receivable Average daily credit sales $350,000 $10,959 Sales Inventory $4,000,000 $370,000 Activity (Asset Utilization) Ratios

27. Asset Utilization Ratios Saxton Company Industry Average 7. Fixed asset turnover = = 55.4 times 8. Total asset turnover = = 2.5 1.5 times Sales Fixed assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000

28. Leverage (Debt Utilization) Ratios Show how well a company is managing or using debt. The ratios express: —Debt-to-Total Assets (%) —Times Interest Earned (times) —Fixed Charge Coverage (times) (Fixed Charges = lease payments, i expense)

29. Leverage (Debt Utilization) Ratios Saxton Company Industry Average 9. Debt to total asets = = 37.5%33% 10. Times interest earned = = 11 7 times 11. Fixed charge coverage = = 65.5 times Total debt Total assets $600,000 $1,600,000 Income before interest and taxes Interest $550,000 $50,000 Income before fixed charges and taxes Fixed charges $600,000 $100,000

30. Liquidity Ratios Show how liquid a company is or how much $ it has to meet S/T needs. The ratios express: —Current Ratio (times) —Quick Ratio or Acid-Test Ratio (times)

31. Liquidity Ratios Saxton Company Industry Average 12. Current ratio = = 2.672.1 13. Quick ratio = = 1.43 1.0 Current assets Current liabilities $800,000 $300,000 Current assets − Inventory Current liabilities $430,000 $300,000

32. Ratio analysis

33. Trend analysis

34. 1-34 Trend Analysis in the Computer Industry

35. Cash Conversion Cycle Is the length of time from the payment for the purchases of raw materials to the collection of accounts receivable that were generated by the sale of the finished product, (i.e., the time between paying out cash and receiving cash). Cash Conversion Cycle = Inventory Conversion Period + Receivables Collection Period (DSO) - Payable Deferral Period = Inventory/ Sales per Day + Receivables / Sales per day – Payables / Credit purchases per day

36. Leverage (Debt) Ratios

37. Efficiency (Utilization) Ratios - Show how effectively a company uses its assets.

38. Profitability Ratios - Show how profitable a company is.

39. Profitability Ratios

40. P/E Ratio P/E Ratio = Price/Earnings Ratio P/E Ratio = Market Price of Stock / Earnings per share (EPS)

41. Market Value Ratios - PE ratio is one way of measuring desirability of a stock - Indicates expectations about future of a company

42. Market Value Ratios

43. Price-earnings Ratios for Selected US Companies

44. Which ratio is most important? It depends on your perspective. Suppliers and banks (lenders) are most interested in liquidity ratios. Stockholders are most interested in profitability ratios. A long-run trend analysis over a 5-10 year period is usually performed by an analyst.

45. Growth and External Financing Basic sources and uses relationships show us: External capital required = Investment in net working capital PLUS Investment in Fixed Assets PLUS Dividends LESS Operating cash flow

46. Percent-of-Sales Method A short-cut, less exact, easier method of determining financing needs (The “quick and dirty” approach) Assumes that B/S accounts will maintain a constant percentage relationship to sales Assets / Current Sales = % of Sales

47. Percent-of-Sales Method RNF = A/S (change S) – L/S (change S) – PS 2 (1-D) Where: A/S = % relationship of assets to sales change S = Change in Sales (forecast – prior sales) P = Profit margin S 2 = Forecasted Sales D = Dividend Payout Ratio. (1-D) is retention rate.

48. Internal & Sustainable Growth Rates The growth rate that a company can achieve without external funds is known as the internal growth rate: Internal growth rate = retained earnings/net assets = Retained earnings/net income x net income/equity x equity/net assets = plowback ratio x ROE x equity/net assets =.40 x.1822 x.5455 = 3.98% The growth rate that a company can achieve without increasing its debt ratio is known as the sustainable growth rate: Sustainable growth rate = plowback ratio x return on equity =.40 x.1822 = 7.29%

49. Importance of Ratios Which ratio is most important? It depends on your perspective. Suppliers and banks (lenders) are most interested in liquidity ratios. Stockholders are most interested in profitability ratios. A long-run trend analysis over a 5-10 year period is usually performed by an analyst.

50. Development of pro forma statements

51. Percent-of-Sales Method A short-cut, less exact, easier method of determining financing needs (The “quick and dirty” approach) Assumes that B/S accounts will maintain a constant percentage relationship to sales Assets / Current Sales = % of Sales

52. Percent-of-Sales Method RNF = A/S (change S) – L/S (change S) – PS 2 (1-D) Where: A/S = % relationship of assets to sales change S = Change in Sales (forecast – prior sales) P = Profit margin S 2 = Forecasted Sales D = Dividend Payout Ratio. (1-D) is retention rate.

53. Development of a pro forma balance sheet