Cash Flows and Financial

Analysis
Chapter 3

2003 South-Western/Thomson Learning

Financial InformationWhere
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

2
Users of Financial Information

Investors and Financial Analysts

Financial analysts interpret information about
companies and make recommendations to investors
Major part of analysts 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
3
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 (Value Line Investment Survey)

4
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

5
The Statement of Cash Flows

Income doesnt represent cash in the firms

pocket
The Statement of Cash Flows (AKA:
Statement of Changes in Financial Position)
provides info on the actual movement of cash
in and out of the company
Constructed from the Balance Sheet and
Income Statement

6
How the Statement of Cash Flows
WorksPreliminary Examples
Requires two consecutive balance sheets
and one income statement from which
the statement of cash flows is generated
Takes net income for the period and
makes adjustments
Then takes the balance sheet items and
examines the changes

7
Business Cash Flows

Cash Flows Rules

The following rules can be applied to any
businesss financial statements
Asset increase use of cash
Asset decrease source of cash
Liability increase source of cash
Liability decrease use of cash

8
Business Cash Flows

Standard Presentation
Statement of Cash Flows organized to show
Operating activities
Running business on day-to-day basis
Investing activities
When firm buys or sells things to do business
Includes long-term purchases and sales of financial
assets
Financing activities
When firm borrows money, pays off loans, sells stock or
pays dividends

9
Constructing the Statement of
Cash Flows
Belfry Company Belfry Company
Balance Sheet Income Statement
For the period ended 12/31/X2 For the period ended 12/31/X2
Assets Sales $ 10,000
12/31/X1 12/31/X2 COGS $ 6,000
Cash 1,000 1,400 Gross margin $ 4,000
Accounts receivable 3,000 2,900
Inventory 2,000 3,200 Expense $ 1,600
CURRENT ASSETS 6,000 7,500 Depreciation $ 500
Fixed assets EBIT $ 1,900
Gross 4,000 6,000 Interest $ 400
Accumulated deprec. (1,000) (1,500) EBT $ 1,500
Net 3,000 4,500 Tax $ 500
TOTAL ASSETS 9,000 12,000 Net Income $ 1,000
Liabilities
Accounts payable 1,500 2,100
Accruals 500 400 Also assume firm paid
CURRENT LIABILITIES
Long-term debt
2,000
5,000
2,500
6,200
a $500 dividend and
Equity
TOTAL CAPITAL
2,000
7,000
3,300
9,500
sold stock for $800
TOTAL LIABILITIES AND EQUITY 9,000 12,000
during the year.
10
Constructing the Statement of
Cash Flows
Operating Activities
Involve the Income Statement and current
Balance Sheet accounts
Involves activities firm does on a day-to-day
basis such as
Buying inventory Focus of activities
is generating net
Producing and selling product incomethe
Paying expenses and taxes beginning of a
cash flow
Collecting credit sales statement.

Money from operating transactions runs

through current balance sheet accounts 11
Constructing the Statement of
Cash Flows
Thus, for Belfry the cash from Operating
Activities is
Net Income $1,000
+ Depreciation $500
= Operating Income $1,500
+ decrease in Receivables $100
- increase in Inventory ($1,200)
+ increase in Payables $600
- decrease in Accruals ($100)
Cash from operating activities $900

12
Constructing the Statement of
Cash Flows
Investing Activities
Typically include purchasing Fixed Assets
Examine the change in GROSS Fixed Assets, not
net
Because the net value includes an adjustment for
depreciation
Depreciation has already been included under operating
activities
Thus, for Belfry the cash from investing activities is
Purchase of Fixed Assets ($2,000)

13
Constructing the Statement of
Cash Flows
Financing Activities
Deal with the capital accounts, long-term
debt and equity
Thus, for Belfry the cash from financing
activities is
Increase in long-term debt $1,200
Sale of stock $800
Dividend paid ($500)
Cash from financing activities $1,500

14
Constructing the Statement of
Cash Flows
The Equity and Cash Accounts
The change in equity is not included because the
changes are reflected elsewhere in the Statement of
Cash Flows
Net Income is included in Cash Flows from Operations
Sale of stock and dividends are considered under financing
activities
The change in the cash account isnt considered
because the sum of cash flows from operations,
financing activities and investing activities must
equal the change in the cash account

15
Constructing the Statement of
Cash Flows
Thus, for Belfry, the final portion of the
Statement is
Beginning Cash Balance $1,000
Net cash flow 400
Ending Cash Balance $1,400

16
Constructing the Statement of
Cash Flows
Belfry Company
Statement of Cash Flows
For the period ended 12/31/X2
CASH FROM OPERATING ACTIVITIES
Net income $ 1,000
Depreciation $ 500
Net changes in current accounts $ (600)
Cash from operating activities $ 900
CASH FROM INVESTING ACTIVITIES
Purchase of fixed assets $ (2,000) While the firm was
CASH FROM FINANCING ACTIVITIES profitable, it still had to
Increase in long-term debt $ 1,200
borrow money and sell
Sale of stock $ 800
Dividend paid $ (500) stock to finance the
Cash from financing activities $ 1,500 increase in Fixed Assets.
NET CASH FLOW $ 400

Beginning cash balance $ 1,000

Net cash flow $ 400
Ending cash balance $ 1,400 17
Free Cash Flows

Refers to cash generated beyond

reinvestment needs
Under normal conditions most firms
generate positive cash flow from
operations
Some of these funds are used to maintain
long-run competitive position
Replace worn-out fixed assets
Pay dividends on Preferred Stock

18
Ratio Analysis

Used to highlight different areas of

performance
Involves taking sets of numbers from the
financial statement and forming ratios
with them

19
Comparisons

Ratios when examined separately dont

convey much information
Historyexamine trends (how the value has
changed over time)
Competitioncompare with other firms in
the same industry
Budgetcompare actual values with
expected or desired values

20
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

21
Ratios

Designed to illuminate some aspect of how the

business is doing
Average Value
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 ratiouse average value for balance sheet
figure
If a ratio compares two balance sheet figuresuse ending
value

22
Ratios

Categories of Ratios
Liquidityindicate firms ability to pay its bills in the
short run
Asset Managementshow how the company uses
its resources to generate revenue, profit and to
avoid cost
Debt Managementshow how effectively the firm
has used borrowed funds and whether or not it has
a high amount of leverage
Profitabilityallow assessment of the companys
ability to make money
Market Valuegive an indication of how investors
feel about the companys financial future 23
Liquidity Ratios

Current Ratio
Current Assets
Current Ratio
Current Liabilities

To ensure solvency the current ratio has

to exceed 1.0
Generally a value greater than 1.5 or 2.0 is
required for comfort

24
Liquidity Ratios

Quick Ratio (or Acid-Test Ratio)

current assets - inventory
Quick Ratio
current liabilities
Measures liquidity without considering
inventory (the firms least liquid current
asset)

25
Asset Management Ratios

Average Collection Period (ACP)

accounts receivable
ACP
average daily (credit) sales
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
26
Asset Management Ratios

Inventory Turnover
cost of goods sold
Inventory Turnover
inventory
Gives an indication of the quality of inventory
as well as how it is managed
Measures how many times a year the firm
uses up an average stock of goods
A higher turnover implies doing business
with less tied up in inventory
Should use average inventory balance
27
Asset Management Ratios

Fixed Asset Turnover

Sales (Total)
Fixed Asset Turnover
Fixed Assets (Net)

Appropriate in industries where significant

equipment is required to do business
Long-term measure of performance

Average balance sheet values are

appropriate

28
Asset Management Ratios

Total Asset Turnover

Sales (Total)
Total Asset Turnover
Total Assets
More widely used than Fixed Asset Turnover
Long-term measure of performance

Average balance sheet values are

appropriate

29
Debt Management Ratios

Need to determine if the company isnt using so much

debt that it is assuming excessive risk
Debt could mean long-term debt and current liabilities
Or it could mean just interest-bearing obligationsgenerally
long-term debt
Debt Ratio
Long-term debt Current Liabilities
Debt Ratio
Total Assets
A high debt ratio is viewed as risky by investors
Ending balance sheet items are appropriate
Usually stated as percentages

30
Debt Management Ratios

Debt-to-equity ratio
Can be stated several ways (as a
percentage, or as a x:y value)
Debt-to-Equity LT debt : Common Equity
or
LT Debt
Debt-to-Equity
Common Equity

Measures the mix of debt and equity within

the firms total capital

31
Debt Management Ratios

Times Interest Earned

EBIT
TIE
Interest Expense
TIE is a coverage ratio
Reflects how much EBIT covers interest expense
A high level of interest coverage implies safety

32
Debt Management Ratios

Cash Coverage
EBIT depreciation
Cash coverage
Interest Expense
TIE ratio has problems
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

33
Debt Management Ratios

Fixed Charge Coverage

EBIT Lease Payments
Fixed Charge Coverage
Interest Expense Lease Payments
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
34
Profitability Ratios

Return on Sales (AKA: Profit Margin, Net

Profit Margin)
Net Income
ROS
Sales

Measures control of the income statement:

revenue, cost and expense
Represents a fundamental indication of the
overall profitability of the business

35
Profitability Ratios

Return on Assets
Net Income
ROA
Total 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

36
Profitability Ratios

Return on Equity
Net Income
ROE
Stockholders' Equity

Adds the effect of borrowing to ROA

Measures the firms ability to earn a return
on the owners invested capital
If the firm has substantial debt, ROE tends to
be higher than ROA in good times and lower
in bad times
37
Market Value Ratios

Price/Earnings Ratio (PE Ratio)

Current stock price
PE Ratio
Earnings per share (EPS)
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 firms earnings
A firms P/E is primarily a function of its
expected growth
38
Market Value Ratios

Market-to-Book Value Ratio

Current stock price
Market-to-Book-Value
book value per share (of equity)
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
companys future 39
Du Pont Equations

Ratio measures are not entirely

independent
Performance on one is sometimes tied to
performance on others
Du Pont equations express relationships
between ratios that give insights into
successful operation

40
Du Pont Equations

Du Pont equation involves ROE, which

can be written several ways:
Net Income sales States that to
ROA run a business
Total Assets sales
well, a firm must
or manage costs
Net Income sales and expenses
ROA as well as
sales Total Assets
generate lots of
or sales per dollar
ROE = ROS total asset turnover of assets.

41
Du Pont Equations

Extended Du Pont equation states ROE

in terms of other ratios
Net Income sales total assets
ROE
Stockholders' Equity sales total assets
Related to the
or
proportion to
Net Income sales total assets which the firm
ROE
sales total assets Stockholders' Equity is financed by
Equity Multiplier other peoples
or money as
opposed to
ROE = ROS Total Asset Turnover Equity Multiplier
ROA
owners
money.
or
ROE = ROA Equity Multiplier
42
Du Pont Equations

Extended Du Pont equation states that

the operation of a business is reflected in
its ROE
However, this resultgood or badcan 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

43
Sources of Comparative
Information
Generally compare a firm to an industry
average
Dun and Bradstreet publishes Industry Norms and
Key Business Ratios
Robert Morris Associates publishes Statement
Studies
U.S. Commerce Department publishes Quarterly
Financial Report
Value Line provides industry profiles and individual
company reports

44
Limitations/Weaknesses of Ratio
Analysis
Ratio analysis is not an exact science and
requires judgment and experienced
interpretation
Examples of significant problems
Diversified companiesbecause the interpretation of ratios
is dependent upon industry norms, comparing
conglomerates can be problematic
Window dressingcompanies attempt to make balance
sheet items look better than they would otherwise through
improvements that dont last
Accounting principles differsimilar companies may report
the same thing differently, making their financial results
artificially dissimilar
Inflation may distort numbers
45