Chapter - Cash Flows And Financial Analysis Users of Financial Information Investors – Make judgments about the firm's securities – Financial Analysts report to investment community Vendors – Sell to the firm on credit Management – Highlight areas in which attention will improve performance Sources of Financial Information Annual Report Management's report card to stockholders on own performance – – The primary source of financial information – Required of publicly traded companies – – Must be audited GAAP Other Sources Reports from brokerage firms and advisory services – – – Value Line Credit reports Orientation of Financial Analysts Critical and investigative Looking for current or potential problems Looking for the physical reasons behind financial results Statement of Cash Flows Businesses run on cash, not accounting profits It is possible for a business to go out of business while making a profit Statement of Cash Flows – – Reports inflows and outflows of money Developed from the income statement and balance sheet Building the Statement of Cash Flows – Basic Approach Build a Statement of Cash Flows from two balance sheets and an income statement Analyze where money has come from and gone to Begin with some personal examples Table 3-1 Cash Flow Rules Asset Increase = Use Liability Increase = Source Asset Decrease = Source Liability Decrease = Use Buying a Car on Credit Joe Jones and His New Car Buying and Selling Cars Sally Smith and Her Two Cars Buying and Selling Cars Sally Smith and Her Two Cars 10 DEBT MANAGEMENT RATIOS Measures the firm’s debt level relative to assets, equity, and income DEBT RATIO Uses a broad concept of debt including current liabilities Debt ratio = long - term debt + current liabilities total assets 36 DEBT TO EQUITY RATIO Measures the mix of debt and equity within total capital Debt to Equity Ratio = Long Term Debt : Equity 37 TIMES INTEREST EARNED (TIE) Measures the number of times interest can be paid out of earnings before interest and taxes (EBIT) EBIT TIE = interest 38 CASH COVERAGE A variation on TIE Adds depreciation to EBIT to better approximate the cash available to cover interest EBIT + depreciation Cash coverage = interest 39 FIXED CHARGE COVERAGE A variation on TIE to include lease payments as fixed financial charges equivalent to interest Fixed charge coverage = EBIT + lease payments interest + lease payments 40 DEBT MANAGEMENT RATIOS Compares fixed (obligatory) payments with the cash available to pay (cover) them EBITDA coverage EBITDA + lease payments = interest + lease payments + principal repayments PROFITABILITY RATIOS Relative measures of the firm’s money-making success, also called profit margin RETURN ON SALES (ROS) ROS = net income sales 42 RETURN ON ASSETS (ROA) Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit net income ROA = total assets 43 RETURN ON EQUITY (ROE) The most fundamental profitability ratio Measures the firm’s ability to earn a return on the owners’ invested capital net income ROE = equity 44 MARKET VALUE RATIOS PRICE / EARNINGS RATIO (P/E) Measures market’s opinion of the stock as an investment stock price Interpretation: The amount investors will pay for each dollar of earnings Based primarily on EPS expected growth P/E Ratio = 45 MARKET TO BOOK VALUE RATIO Market to book value ratio = stock price book value per share 46 DU PONT EQUATIONS Equations show relationships between ratios net income sales ROA = × total assets sales net income sales ROA = × sales total assets ROA = ROS × total asset turnover 47 Extended Du Pont Equation ROE = net income sales total assets × × equity sales total assets ROE = net income sales total assets × × sales total assets equity ROE = ROS × total asset turnover × equity multiplier ROE = ROA × equity multiplier 48 Using the Du Pont Equations ROA = ROS X Total Asset Turnover Sampson Inc 12% 6% 2x Industry 15% 5% 3x Focus attention on revenue or assets rather than on cost or expense 49 Limitations and Weaknesses of Ratio Analysis Diversified Companies – Analysis of consolidated results is confused Window Dressing – Year end tricks can artificially improve ratios Accounting Principles – Allow latitude in reporting Inflation Can Distort Financial Results Interpretation of Ratios is Often Unclear Ratio Analysis Doesn’t Give Us Answers, It Helps Us Ask the Right Questions 50 [...]... Figure 3. 2 BUSINESS CASH FLOWS 13 Example 3- 1 Business Cash Flows Additional Information Belfry also sold new stock during the year receiving a total of $800 and paid its shareholders dividends of $500 Operating Activities Net Income $ 1,000 Depreciation 500 Net Change in Current Accts (600) Cash from Operating Activities $ 900 Detail of Changes in Current Accounts Account Receivables Begin End $3, 000... Market Value 30 LIQUIDITY RATIOS Liquidity ratios measure the company’s ability to meet short-term financial obligations Current Ratio – primary measurement of a company’s liquidity current assets Current Ratio = current liabilities 31 LIQUIDITY RATIOS Quick Ratio (acid test) – A liquidity measure that does not depend on inventory current assets - inventory Quick Ratio = current liabilities 32 ASSET MANAGEMENT... never be collected ACP = accounts receivable × 36 0 sales 33 INVENTORY TURNOVER Inventory turnover ratio measures whether the firm has excess funds tied up in inventory cost of goods sold Inventory turnover = inventory Interpretation: Too much inventory is expensive to carry Too little causes stockouts which lead to inefficient production and lost sales 34 FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER... sales sales fixed assets sales Total asset turnover = total assets Fixed asset turnover = 35 DEBT MANAGEMENT RATIOS Measures the firm’s debt level relative to assets, equity, and income DEBT RATIO Uses a broad concept of debt including current liabilities Debt ratio = long - term debt + current liabilities total assets 36 ... charge, so EBIT understates cash flow by at least that amount Adding back depreciation gives a figure that’s closer to cash flow called operating cash flow Operating Cash Flow = NOPAT + Depreciation 23 Calculating Free Cash Flow Money available to investors can be written as: FCF = Operating Cash Flow – Increase in Gross Fixed Assets – Increase in Current Accounts 24 Calculating Free Cash Flow to Equity... in Current Accts (600) Cash from Operating Activities $ 900 Detail of Changes in Current Accounts Account Receivables Begin End $3, 000 $2,900 Inventory 2,000 Payables 1,500 2,100 Accruals 500 400 (600) 3, 200 Source/(Use) $ 100 (1,200) 600 (100) $ Investing Activities Purchase of Fixed Assets $(2,000) Use Change in Gross Fixed Asset Account Financing Activities Increase in Long Term Debt $ 1,200 Sale ... Activities – borrow money, pay off loans, sell stock, pay dividends 12 Figure 3. 2 BUSINESS CASH FLOWS 13 Example 3- 1 Business Cash Flows Additional Information Belfry also sold new stock during... will improve performance Sources of Financial Information Annual Report Management's report card to stockholders on own performance – – The primary source of financial information – Required of... Line Credit reports Orientation of Financial Analysts Critical and investigative Looking for current or potential problems Looking for the physical reasons behind financial results Statement of Cash