Chapter 3: Working with Financial Statements

Cash Flow and Financial Statements: A Closer Look

Cash is generated by selling a product, an asset, or a security. o Selling a security involves either borrowing or selling an equity interest (shares of stock) in the firm. o Cash flow from assets = Cash flow to creditors + Cash flow to owners Sources of cash: a firms activities that generate cash. o A decrease in an asset account or an increase in a liability (or equity) account is a source of cash. Uses of cash: a firms activities in which cash is spent. Also called applications of cash. o An increase in a left-side (asset) account or a decrease in a right-side (liability or equity) account is a use of cash.

Statement of cash flows: a firms financial statement that summarizes its sources and uses of cash over a specified period. o Group three categories: operating activities, financing activities, and investment activities. o Interest is deducted as an expense when net income is computed.

o Only earnings per share are to be reported because accountants feel that cash flow is not an alternative to accounting income.

Standard Financial Statements

Almost impossible to directly compare the financial statements for two companies because of differences in size. o Standardize the financial statement by working with percentages instead of total dollars. Common-size statement: a standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales. o Total change has to be zero because the beginning and ending numbers must add up to 100% o Common-size income statements express each item as a percentage of total sales. o Common-size statements of cash flows can be interpreted as the percentage of total sources of cash supplied or as the percentage of total uses of cash for a particular item. Common-base year statement: a standardized financial statement presenting all items relative to a certain base year amount. Combined common-size and base year analysis o As total assets grow, most of the other accounts must grow as well.

Eliminate the effect of this overall growth by first forming the common-size statement.

Ratio Analysis
Financial ratios: relationships determined from a firms financial information and used for comparison purposes. o Way of comparing and investigating the relationships between different pieces of financial information. o Eliminates the size problem. Traditionally grouped into the following categories: o Short-term solvency, or liquidity, ratios. Provide information about a firms liquidity liquidity measures Current Ratio = Is a measure of short-term liquidity. Unit of measurement is either dollars or times. To a creditor, the higher the ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. A current ration of at least 1 is expected because having less than 1 means that net working capital is negative. Affected by various types of transactions. An apparently low current ratio may not be a bad sing for a company with a large reserve of untapped borrowing power. Quick (or Acid-Test) Ratio Inventory is often the least liquid current asset o Large inventory are often a sign of short-term trouble Omits inventory Quick Ratio =

Cash Ratio = Net working capital to total assets = A low value may indicate relatively low levels of liquidity.

Interval measure =

Useful for newly founded or start-up companies that often have little in the way of revenues. The average daily operating cost for start-up companies is often called the burn rate (the rate at which cash is burned in the race to become profitable). o Long-term solvency, or financial leverage, ratios Intended to address the firms long-term ability to meet its obligations, or its financial leverage. Total debt ratio takes into account all debts of all maturities to all creditors. Total debt ratio = o Two Variations: Debt-equity ratio = Equity multiplier =

Total Capitalization vs. Total Assets A firms accounts payable may reflect trade practice more than debt management policy. o Long-term debt ratio = o Total long-term debt and equity is sometimes called the firms total capitalization. Times Interest Earned (TIE) Measure of long-term solvency Times interest earned ratio = This ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. Problem = based on EBIT, which is not really a measure of cash available to pay interest. Cash coverage Cash coverage ratio = EBIT = earnings before interest, taxes, and depreciation EBITDA o A = amortization refers to a noncash deduction similar conceptually to depreciation, except it applies to an intangible asset.

o Asset management, or turnover, ratios. o Profitability ratios. o Market value ratios