Cash Flows and Financial Analysis

Chapter 3

Our main coverage for this chapter is financial ratios

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

5

Data sources for term project See the course links page for link to MEL

page http://www.lib.purdue.edu/mel/inst/agec_424.html

6

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

7

Ratio Analysis

Used to highlight different areas of performance

Generate hypotheses regarding things going well and things to improve

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

8

Comparisons

A ratio when examined alone doesn’t convey much information – but.. 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

9

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

10

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

11

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

12

Ratios

5 Categories of Ratios2. Liquidity: indicates firm’s ability to pay its

bills in the short run3. Asset Management: Right amount of assets

vs. sales?4. Debt Management: Right mix of debt and

equity?5. Profitability— Do sales prices exceed unit

costs, and are sales high enough as reflected in PM, ROE, and ROA?

6. Market Value— Do investors like what they see as reflected in P/E and M/B ratios?

13

Liquidity Ratios

Current Ratio

= Current AssetsCurrent Ratio

Current Liabilities

To ensure solvency the current ratio should exceed 1.0 Generally a value greater than 1.5 or 2.0

is required for comfort As always, compare to the industry

14

Liquidity Ratios

Quick Ratio (or Acid-Test Ratio)

current assets - inventoryQuick Ratio

current liabilities=

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

Not a good ratio for grain farms

15

Asset Management Ratios

Average Collection Period (ACP)

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

daypersales

receivableaccountsDSOACP ==

16

Asset Management Ratios

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

17

Asset Management Ratios

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

18

Asset Management Ratios

Total Asset TurnoverSales (Total)

Total Asset Turnover Total Assets

=

More widely used than Fixed Asset Turnover

Long-term measure of performance Average balance sheet values are

appropriate

19

Debt Management Ratios

Need to determine if the company is 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—

often sources just use long-term debt Debt Ratio

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

TA

TLRatioDebt =

20

Debt Management Ratios

Debt-to-equity ratio Can be stated several ways (as a percentage, or

as a x:y value)

Many sources use long term debt instead of total liabilities

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

E

TL

EquityCommon

sLiabilitieTotalEquitytoDebt ==−−

21

Sometimes you are given the debt-equity ratio (TL/E) or you may find it in a source for industry ratios. In AGEC 424, I normally want you to use TL/TA. So you need to convert the debt-equity ratio into the TL/TA ratio. The conversion is according to the equation:

Steps in derivation: First use TA = TL+E, to replace TA in the denominator. Second divide numerator and denominator by TL. Third multiply numerator and denominator by TL/E.

22

Debt Management Ratios

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

23

Debt Management Ratios

Cash Coverage1

EBIT depreciationCash 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

1 EBITDA or “earnings before interest taxes depreciation and amortization” is a commonly used measure of cash flow.

24

Debt Management Ratios

Fixed Charge CoverageEBIT 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

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Profitability Ratios

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

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

Represents a fundamental indication of the overall profitability of the business

Sales

IncomeNetROSPM ==

26

Profitability Ratios

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

27

Profitability Ratios

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

28

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 firm’s earnings

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

29

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

30

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

31

Du Pont Equations

Du Pont equations start with expressing ROA in terms of ROS and 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.TurnoverAssetTotalxROSROA

AssetsTotal

Salesx

Sales

IncomeNetROA

Sales

Salesx

AssetsTotal

IncomeNetROA

=

=

=

or

Rearrange

Du Pont Equations• Extended Du Pont equation states ROE in

terms of other ratios

32

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

= × ×

= × ×

×

14444244443

ROA

t Turnover Equity Multiplier

or

ROE = ROA Equity Multiplier

×

×

144444424444443

Related to the proportion to

which the firm is financed by other people’s

money as opposed to

owner’s money.

EM = [1/(1-L)]; where L = TL/TA

33

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

34

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 Go to MEL page for AGEC 424

35

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