cash flows and financial analysis

Slides developed by:Pamela L. Hall, Western Washington University

Cash Flows and Financial Analysis

Chapter 3

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 (Value Line Investment Survey)

5

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

6

The Statement of Cash Flows

Income doesn’t represent cash in the firm’s 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

7

How the Statement of Cash Flows Works—Preliminary 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

8


Q: Suppose Joe Jones has after-tax income of $50,000 and spends $40,000 on normal living expenses during the year. Also assume that at the beginning of the year he had a bank balance of $10,000 and no other assets or liabilities. Further, assume that during the year he bought a new car costing $30,000, financing $25,000 at the bank with a car loan. At the end of the year he has $15,000 in the bank. Generate a Statement of Cash Flows for Joe.

A: Inflows of cash are known as sources and outflows are known as uses. The Statement of Cash Flows will show how Joe ended up with $15,000 in his bank account.

Joe generated a net source of cash of $10,000, or the difference between his income and normal living expenses. He also experienced an inflow of $25,000 from the car loan and used $30,000 to buy the car. Thus, Joe’s Statement of Cash Flows is:

Exa

mpl

e

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Exa

mpl

e

$15,000 Ending cash balance

$5,000 Net cash flow

$10,000 Beginning cash balance

$5,000Net inflow/(outflow) of cash

($30,000)Use of cash to buy auto

(40,000)

$50,000

$25,000Source of cash from loan

$10,000Net source of cash from income

Cash used on living expenses

Cash income

10

Business Cash Flows

Cash Flows Rules The following rules can be applied to any

business’s financial statements• Asset increase use of cash• Asset decrease source of cash• Liability increase source of cash• Liability decrease use of cash

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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

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Figure 3.2: Business Cash Flows

A successful business has to withdraw cash to

finance growth and replace worn out assets, pay taxes

and for profit.

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Figure 3.3: The Cash Conversion Cycle

Product is converted into cash, which is

transformed into more product,

creating the cash conversion cycle.

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Belfry Company Belfry CompanyBalance Sheet Income StatementFor the period ended 12/31/X2 For the period ended 12/31/X2

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 2,900Inventory 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$

Accounts payable 1,500 2,100Accruals 500 400CURRENT LIABILITIES 2,000 2,500Long-term debt 5,000 6,200Equity 2,000 3,300TOTAL CAPITAL 7,000 9,500

TOTAL LIABILITIES AND EQUITY 9,000 12,000

Assets

Liabilities

Constructing the Statement of Cash Flows

Also assume firm paid a $500 dividend and sold stock for $800

during the year.

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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• Producing and selling product• Paying expenses and taxes• Collecting credit sales

Focus of activitiesis generating net

income—the beginning of a

cash flowstatement.

Money from operating transactions runs through current balance sheet accounts

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Constructing the Statement of Cash Flows Thus, for Belfry the cash from Operating

Activities isNet Income $1,000

+ Depreciation $500

= Operating Income $1,500

+ increase in Receivables $100

- increase in Inventory ($1,200)

+ increase in Payables $600

- decrease in Accruals ($100)

Cash from operating activities $900

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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)

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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

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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 isn’t considered

because the sum of cash flows from operations, financing activities and investing activities must equal the change in the cash account

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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

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Constructing the Statement of Cash Flows

While the firm was profitable it still had to

borrow money and sale stock to finance the

increase in Fixed Assets.

Belfry CompanyStatement of Cash FlowsFor the period ended 12/31/X2CASH FROM OPERATING ACTIVITIESNet income 1,000$ Depreciation 500$ Net changes in current accounts (600)$ Cash from operating activities 900$ CASH FROM INVESTING ACTIVITIESPurchase of fixed assets (2,000)$ CASH FROM FINANCING ACTIVITIESIncrease in long-term debt 1,200$ Sale of stock 800$ Dividend paid (500)$ Cash from financing activities 1,500$ NET CASH FLOW 400$

Beginning cash balance 1,000$ Net cash flow 400$ Ending cash balance 1,400$

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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

23

Ratio Analysis

Used to highlight different areas of performance

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

24

Comparisons

Ratios when examined separately don’t convey much information 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

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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

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Common Size Statements

$ % $ %Sales 2,187,460$ 100.0% 150,845$ 100.0%COGS 1,203,103$ 55.0% 72,406$ 48.0%Gross margin 984,357$ 45.0% 78,439$ 52.0%

Expenses 505,303$ 23.1% 39,974$ 26.5%EBIT 479,054$ 21.9% 38,465$ 25.5%Interest 131,248$ 6.0% 15,386$ 10.2%EBT 347,806$ 15.9% 23,079$ 15.3%Tax 118,254$ 5.4% 3,462$ 2.3%Net Income 229,552$ 10.5% 19,617$ 13.0%

Alpha Beta

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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

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Ratios

Categories of Ratios Liquidity—indicate firm’s ability to pay its bills in the

short run Asset Management—show how the company uses its

resources to generate revenue, profit and to avoid cost

Debt Management—show how effectively the firm has used borrowed funds and whether or not it has a high amount of leverage

Profitability—allow assessment of the company’s ability to make money

Market Value—give an indication of how investors feel about the company’s financial future

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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

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Liquidity Ratios

Quick Ratio (or Acid-Test Ratio)

current assets - inventoryQuick Ratio

current liabilities

Measures liquidity without considering inventory (the firm’s least liquid current asset)

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Asset Management Ratios

Average Collection Period (ACP)

accounts receivableACP

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

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Inventory Turnovercost 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

33


Fixed Asset TurnoverSales (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

34


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

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Debt Management Ratios

Need to determine if the company isn’t 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 obligations—generally

long-term debt

Debt Ratio

Long-term debt Current LiabilitiesDebt Ratio

Total Assets

A high debt ratio is viewed as risky by investors Usually stated as percentages

36


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 DebtDebt-to-Equity

Common Equity

Measures the mix of debt and equity within the firm’s total capital

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Times Interest EarnedEBIT

TIE Interest Expense

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

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Cash CoverageEBIT 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

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Fixed Charge Coverage

EBIT Lease PaymentsFixed 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

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Profitability Ratios

Return on Sales (AKA: Profit Margin, Net Profit Margin)

Net IncomeROS

Sales

Measures control of the income statement: revenue, cost and expense

Represents a fundamental indication of the overall profitability of the business

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Return on AssetsNet 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

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Return on EquityNet Income

ROE Stockholders' 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 higher than ROA in good times and lower in bad times

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Market Value Ratios

Price/Earnings Ratio (PE Ratio)

Current stock pricePE 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 firm’s earnings

A firm’s P/E is primarily a function of its expected growth

44

Market Value Ratios

Market-to-Book Value RatioCurrent 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 company’s future

45

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

46

Du Pont Equations

Du Pont equation involves ROE, which can be written several ways:

Net Income salesROA

Total Assets salesor

Net Income salesROA

sales Total Assetsor

ROE = ROS total 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.

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Du Pont Equations

Extended Du Pont equation states ROE in terms of other ratios

Equity Multiplier

Net Income sales total assetsROE

Stockholders' Equity sales total assets

or

Net Income sales total assetsROE

sales total assets Stockholders' Equity

or

ROE = ROS Total Asse

ROA

t Turnover Equity Multiplier

or

ROE = ROA Equity Multiplier

Related to the proportion to

which the firm is financed by other people’s

money as opposed to

owner’s money.

48

Du Pont Equations

Extended Du Pont equation states that the operation of a business is reflected in its ROE 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

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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

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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

cash flows and financial analysis

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