1. 6-1 Financial Statements Analysis and Long- Term Planning

2. 6-2 Learning objectives u Identify the ways that firms obtain and use cash as reported in the Cash Flow Statement. u Calculate and interpret key financial ratios. u Discuss the Du Pont identity as a method of financial analysis. u Understand the use of financial information for comparative purposes. u Outline the problems associated with using financial ratios. u Identify the ways that firms obtain and use cash as reported in the Cash Flow Statement. u Calculate and interpret key financial ratios. u Discuss the Du Pont identity as a method of financial analysis. u Understand the use of financial information for comparative purposes. u Outline the problems associated with using financial ratios.

3. 6-3 CashCash u Cash is generated by selling a product or service, asset or security. u Cash is spent by paying for materials and labor to produce a product or service and by purchasing assets. u Recall: Cash flow from assets = Cash flow to debt- holders + Cash flow to shareholders

4. 6-4 Sources and Uses of Cash u At the most fundamental level, firms do two things: generate cash and spend cash. u Activities that bring in cash are called sources of cash. u Activities that involve spending cash are called uses (or applications) of cash. u An increase in an asset account or a decrease in a liability or equity account is a use of cash. u A decrease in an asset account or an increase in a liability or equity account is a source of cash.

5. 6-5 Financial Statements u A firm’s financial statement that summarizes its sources and uses of cash over a specified period. u The presentation of cash flows in annual reports is determined by an Accounting Standard. u Changes are divided into three main categories: u Operating activities—includes net profit and changes in most current accounts. u Investment activities—includes changes in non- current assets. u Financing activities—includes changes in notes payable, long-term debt and equity accounts, as well as dividends. u A firm’s financial statement that summarizes its sources and uses of cash over a specified period. u The presentation of cash flows in annual reports is determined by an Accounting Standard. u Changes are divided into three main categories: u Operating activities—includes net profit and changes in most current accounts. u Investment activities—includes changes in non- current assets. u Financing activities—includes changes in notes payable, long-term debt and equity accounts, as well as dividends.

6. 6-6 u Operating activities + Net profit + Depreciation + Any decrease in current assets (except cash) + Increase in accounts payable – Any increase in current assets (except cash) – Decrease in accounts payable Cash Flow Statement

7. 6-7 u Investment activities + Ending non-current assets – Beginning non-current assets + Depreciation Cash Flow Statement

8. 6-8 u Financing activities – Decrease in notes payable + Increase in notes payable – Decrease in long-term debt + Increase in long-term debt + Increase in ordinary shares – Dividends paid Cash Flow Statement

9. 6-9 Example―Balance Sheet Assets ($’000s)20062007 Current assets Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment TOTAL ASSETS $ 90 520 640 $ 1 250 1 970 $3 220 $ 100 620 770 $ 1 490 2 200 $3 690

10. 6-10 Example―Balance Sheet Liabilities and equity ($’000s)20062007 Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY $ 420 220 $ 640 $ 410 580 1 590 $2 170 $3 220 $ 520 350 $ 870 $ 450 580 1 790 $2 370 $3 690

11. 6-11 Example―Income Statement ($000s) Sales $1 420.00 Cost of goods sold 960.00 Depreciation 60.00 EBIT $400.00 Interest 40.00 Taxable income 360.00 Tax 108.00 Net profit$252.00 Dividends 52.00 Addition to retained earnings $200.00

12. 6-12 Example: Cash Flow Statement u Operating activities (+) Net profit $ 252 (+) Depreciation60 (+) Increase in payables 100 (–) Increase in receivables (100) (–) Increase in inventory (130) $ 182

13. 6-13 Example: Cash Flow Statement u Investment activities (+) Ending non-current assets $2 200 (–) Beginning non-current assets (1 970) (+) Depreciation 60 ( $ 290)

14. 6-14 u Financing activities (+) Increase in notes payable $ 130 (+) Increase in long-term debt 40 (–) Dividends (52) $ 118 Putting it all together, the net addition to cash for the period is: $182 – 290 + 118 = $10 Example: Cash Flow Statement

15. 6-15 Financial Ratio Analysis u A Financial ratios is an index that relates two accounting numbers and is obtained by dividing one number by the other. Types of Comparisons: Internal Comparisons and External Comparisons u Used to compare and investigate relationships between different pieces of financial information, either over time or between companies. Types of Comparisons: Internal Comparisons and External Comparisons u Ratios eliminate the size problem.

16. 6-16 Ratio Analysis: Questions to Consider for Each Ratio u How is it computed? u What is it intended to measure, and why might we be interested? u What is the unit of measurement? u What might a high or low value be telling us? How might such values be misleading? u How could this measure be improved?

17. 6-17 u Liquidity Ratios u Leverage ratios (Capital Structure Ratios) u Profitability ratios u Valuation ratios u Turnover Ratios Categories of Financial Ratios

18. 6-18 Liquidity Ratios u Current Ratio u Quick Ratio u Profit before depreciation and amortization to current liabilities (PDACL) u Operating cash flow to current liabilities (OCFCL) u Cash balance to total liabilities (CBTL)

19. 6-19 u Current Ratio: The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). in 2006 = 1250/640 = 1.15 Liquidity Ratios Example:

20. 6-20 u Quick Ratio: The quick ratio measures the dollar amount of liquid assets available for each dollar of current liabilities. = (current assets – inventory)/ liabilities in 2006 quick ratio = 1.50 Liquidity Ratios Example: Quick Ratio= Cash in hand + Cash at Bank + Receivables + Marketable Securities Current Liabilities

21. 6-21 u Profit before depreciation and amortization to current liabilities (PDACL): Measures how many times company’s profit covers liabilities before non-cash items. in 2006 PDACL = 0.40 Liquidity Ratios Example:

22. 6-22 u Operating cash flow to current liabilities (OCFCL): Refers to the cash generated from the operations of a company (revenues less all operating expenses, plus depreciation), in relation to short-term debt obligations.. In 2006 PDACL = 0.40 Liquidity Ratios Example:

23. 6-23 u Cash balance to total liabilities (CBTL): Refers to the company’s cash balance in relation to its total liabilities. In 2006 CBTL = 0.40 Liquidity Ratios Example:

24. 6-24 Leverage (Capital Structure) Ratios u Debt to equity ratio (DE ratio) u Total liabilities to total tangible assets (TLTAI) u Interest cover ratio u Net debt to equity ratio u Equity multiplier

25. 6-25 Leverage (Capital Structure) Ratios u Debt to equity ratio (DE ratio): It refers a company’s capital structure and whether the company is more reliant on borrowings (debt) or shareholder capital (equity) to fund assets and activities. u Example: Debt/Equity ratio = 1.14

26. 6-26 Leverage (Capital Structure) Ratios u Total liabilities to total tangible assets (TLTAI): This ratio provides the relationship between a company’s liabilities and tangible assets. Tangible assets are defined as physical assets, such as property, cash, inventory and receivables. u Example: TLTAI = 1.60

27. 6-27 Leverage (Capital Structure) Ratios u Interest cover ratio: measures company’s ability to meet interest expenses on debt using profits. u Example: ICR = 3

28. 6-28 Leverage (Capital Structure) Ratios u Net debt to equity ratio: This represents the level of risk associated with the company’s funding source. It is a useful internal measure to review the balance between interest bearing debt and shareholders’ equity for the purpose of improving company capacity to meet debt repayments and/or return on equity.

29. 6-29 Leverage (Capital Structure) Ratios u Equity multiplier: It is a measurement of a company's financial leverage. It measures the amount of a firm's assets that are financed either through equity or debt. u Example: EM = 1.11

30. 6-30 Profitability Ratios u Earnings per share (EPS ) u Gross profit margin u Net profit margin u Return on assets (ROA ) u Return on equity (ROE )

31. 6-31 Profitability Ratios u Earnings per share (EPS): It shows the portion of a company’s profit that is allocated to each outstanding share of common stock. EPS figure is very important for shareholders because the payment of dividend and increase in the value of stock in future largely depends on it. EPS is the most widely quoted and relied figure by investors. Example: EPS = $1.60

32. 6-32 Profitability Ratios u Gross profit margin: Gross profit margin tells us what percentage of a company’s sales revenue would remain after deducting the cost of goods sold. u Example: Gross profit margin = 50%

33. 6-33 Profitability Ratios u Net profit margin: Net profit margin meanwhile indicates what percentage of a company’s sales revenue would remain after all costs have been taken into account. u Example: Net profit margin = 20%

34. 6-34 Profitability Ratios u Return on assets (ROA): It is a measurement of management performance. ROA tells the investor how well a company uses its assets to generate income. A higher ROA denotes a higher level of management performance. u Example: ROA = 13.3%

35. 6-35 Profitability Ratios u Return on equity (ROE): It is another measurement of management performance. ROE tells the investor how well a company has used the capital from its shareholders to generate profits. A higher ROE denotes a higher level of management performance. u Example: ROE = 22.22%

36. 6-36 Valuation Ratios u Price to earnings ratio (PE) u Price/earnings to growth ratio (PEG) u Dividend yield

37. 6-37 Valuation Ratios u Price to earnings ratio (PE): It assess a company’s value. It measures company’s current share price relative to its per-share earnings. u Example: PE = 10

38. 6-38 Valuation Ratios u Price/earnings to growth ratio (PEG): The PEG ratio acts as a measure of company’s value that takes into account future growth. u Example: PEG = 0.625

39. 6-39 Valuation Ratios u Dividend yield: It shows what percentage of the market price of a share a company annually pays to its stockholders in the form of dividends. u Example: Dividend yield ratio = 1

40. 6-40 Turnover Ratios u Inventory turnover u Fixed asset turnover u Total asset turnover u Day’s sales in inventory u Receivables turnover u Day’s sales in receivable

41. 6-41 Turnover Ratios u Inventory turnover: It is a measure of the number of times inventory is sold or used in a time period such as a year u Example: Inventory turnover = 0.29 times

42. 6-42 Turnover Ratios u Fixed asset turnover: It measures how successfully a company is utilizing its fixed assets in generating revenue. u Example: Fixed asset turnover = $6.44

43. 6-43 Turnover Ratios u Total asset turnover: It measures a company's ability to generate sales from its assets by comparing net sales with average total assets. In other words, this ratio shows how efficiently a company can use its assets to generate sales. Example: Total Assets Turnover = 0.33

44. 6-44 Turnover Ratios u Day’s sales in inventory: It measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a company's current stock of inventory will last. Example: Day’s sales inventory = 122 days

45. 6-45 Turnover Ratios u Receivables turnover: It measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year. u Example: Receivable Turnover: 3.33

46. 6-46 Turnover Ratios u Day’s sales in receivable: It measures the number of days it takes a company to collect cash from its credit sales. In other words, it shows how well a company can collect cash from its customers. u Example: Days’ sales in receivables = 31

47. 6-47 The Du Pont Identity u Breaks ROE into three parts: u operating efficiency (as measured by Net profit margin) u asset use efficiency (as measured by total asset turnover) u financial leverage (as measured by the equity multiplier)

48. 6-48 Ex ample: The Du Pont Identity u Sales are $7 000, net profit is $250, total assets are $3 500 and equity is $1 900.

49. 6-49 Why Evaluate Financial Statements? u Internal uses: u performance evaluation u planning for the future u External uses: u evaluation by outside parties u evaluation of main competitors u identifying potential takeover targets

50. 6-50 Benchmarks for Comparison u Ratios are most useful when compared to a benchmark. u Time-trend analysis—examine how a particular ratio(s) has performed historically. u Peer group analysis—using similar firms (competitors) for comparison of results.

51. 6-51 Benchmarks for Comparison u One common way of identifying potential peers is based on the Global Industry Classification Standard (GICS) used by the Australian Stock Exchange (ASX).  GICS is a code used globally to classify a firm by its type of business operations.  GICS consists of 23 industry groups, 59 industries, and 122 sub-industries; covering over 12 000 companies globally.  The basis of classification is the area from which most revenue is generated.

52. 6-52 Problems with Financial Statement Analysis u No underlying theory to identify correct ratios to use or appropriate benchmarks. u Benchmarking is difficult for diversified firms. u Firms may use different accounting procedures. u Firms may have different recording periods. u One-off events can severely affect financial performance.

53. 6-53 Summary and Conclusions u Activities that bring in cash are called ‘sources of cash’, and activities that involve spending cash are called ‘uses of cash’. u A Cash Flow Statement summarises sources and uses of cash over a specified period. u Financial ratios are grouped together into five main categories: Liquidity, Capital Structure, Valuation, Profitability, and Turnover. u Ratios are most useful when compared to a benchmark (e.g. time-trend and peer group analysis). u Problems can arise in using financial statements.