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1

© 2008 Thomson South
-
Western

Chapter 3

Cash Flows and

Financial Analysis


2

Users of Financial Information






Investors and Financial Analysts


Make judgments about the firm’s securities


Financial Analysts report to investment
community






Vendors


Sell to the firm on credit


Management


Hi
-
light areas in which attention will improve
performance

3

SOURCES OF FINANCIAL
INFORMATION

Annual Report


Management's report
card to stockholders
on own performance



Positively biased



The primary source of
financial information



Required of publicly
traded companies



Must be audited



Other Sources


Reports from
brokerage firms
and advisory
services



Value Line

4


STATEMENT of CASH FLOWS


Businesses
run on cash
, not accounting
profits

Statement of Cash Flows


Also called or Sources and Uses of Cash or
Statement of Changes in Financial Position


Shows where money comes from
-

goes to


Developed from the Income



Statement and Balance Sheet


5

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
by
:


Adjusting net income for non
-
cash items


Analyzing changes between beginning


and ending Balance Sheets


Classify as sources or uses of cash


Begin with a personal example



6

Buying a Car on Credit

Joe Jones and His New Car

7

Cash Flow Rules


Asset
Increase


=

Use

Asset
Decrease


=

Source

Liability
Increase
=

Source

Liability
Decrease
=

Use




8

Buying and Selling Cars
-

Sally Smith and Her Two Cars

9

Business Cash Flows


Three sources of cash flows
:


Operating Activities



day
-
to
-
day activities


Investing Activities



firm buys or sells fixed

assets that enable it to do business, long
-
term

purchases, and sales of financial assets.


Financing Activities



borrow money, pay off
loans, sell stock, pay dividends
.


10

BUSINESS CASH FLOWS









Figure 3.2


11

Free Cash Flows

Cash generated beyond reinvestment needs
is free cash flow


Net cash flow less non
-
operating cash
requirements (such as worn out fixed assets)


If negative, then borrow




or sell equity


12


RATIO ANALYSIS

Pairs of financial statement numbers formed into ratios

Ratios highlight different aspects of performance



The
current ratio

measures liquidity
-

ability to pay bills in the short run


Current Assets:

Money coming in within a year

Current Liabilities:

Money going out within a year

Needed for solvency:

Current ratio >> 1.0



s
liabilitie
current
assets
current

=

ratio
Current
13

CATEGORIES OF RATIOS



Five Classifications

Liquidity

Asset Management

Debt Management

Profitability

Market Value


Ratios Don’t Provide Answers
-



They Help You Ask the Right Questions






14

LIQUIDITY RATIOS





Measure the ability to meet short term financial
obligations





Current Ratio


primary measurement of a
company’s liquidity















s
liabilitie
current
assets
current
=

ratio
current

current ra
tio
=

$7,500
$2,500

=
3.0
(Examples from Belfry Company)

15

LIQUIDITY RATIOS


Quick Ratio (Acid Test)


A liquidity measure that does
not depend on inventory









1.72

=

$2,500
$3,200

-

$7,500

=

Ratio

Quick

s
liabilitie
current
inventory

-

assests
current

=

Ratio

Quick
16

ASSET MANAGEMENT RATIOS



The fundamental efficiency with which a
company is run



AVERAGE COLLECTION PERIOD (ACP)


the time it
takes to collect on credit sales



















days

104.4

=

360


$10,000
$2,900

=

ACP
360


sales
receivable

accounts

=

ACP
sales

daily

average
receivable

accounts

=

ACP


Interpretation
:
Customers pay slowly
OR

there are a few
very old accounts that
will probably never be
collected.

17

ASSET MANAGEMENT RATIOS


INVENTORY TURNOVER



Measures efficiency of inventory use























Interpretation
: Too much inventory is expensive to carry. Too little
causes stockouts which lead to inefficient production and lost sales






3.1

=

$3,200
$10,000

=
turnover

Inventory
1.9

=

$3,200
$6,000

=
turnover

Inventory
inventory
sales

=
turnover

Inventory
OR




inventory
sold

goods

of
cost

=
turnover

Inventory
18

ASSET MANAGEMENT RATIOS

FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER


Measure the relationship of the firm’s assets to a year’s sales















Interpretation
: Are there idle or inefficient assets?

.83

=

$12,000
$10,000

=
turnover
asset

Total
2.2

=

$4,500
$10,000

=
turnover
asset

Fixed
assets

total
sales

=
turnover
asset

Total
assets

fixed
sales

=
turnover
asset

Fixed
19

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








A high debt ratio is viewed as risky by investors




Debt ratio

=

long
-
term debt
+
current l
iabilities
total asse
ts
Debt ratio

=

$6,200
+
$2,500
$12,000

=
72.5%
20

DEBT MANAGEMENT RATIOS


DEBT TO EQUITY RATIO


Measures the mix of debt and equity within total capital.

An important risk measurement
-

a high debt level burdens the
income statement with excessive interest making failure
more likely.


Debt to Equity Ratio = Long Term Debt : Equity


Debt to Equity = $6,200 : $3,300 = 1.9 : 1


(Stated as 1.9 to 1, since $6,200/$3,300 = 1.9)



21

DEBT MANAGEMENT RATIOS



TIMES INTEREST EARNED (TIE)


Measures the number of times interest can be paid out of earnings
before interest and taxes (EBIT)










TIE
=

EBIT
interest
TIE
=

$1,900
$400

=
4.8
22

DEBT MANAGEMENT RATIOS

Cash Coverage

A variation on TIE. Adds depreciation to EBIT to better
approximate the cash available to interest.












Cash cover
age
=

EBIT
+
depreciat
ion
interest
Cash cover
age
=

$1,900
+
$500
$400

=
6.0
23

DEBT MANAGEMENT RATIOS


FIXED CHARGE COVERAGE



A variation on TIE to include lease payments as fixed
financial charges equivalent to interest










Interpretation
: Business failure is often a result of the inability to
pay interest. Coverage ratios measure the interest burden
relative to the ability to pay.



Fixed char
ge coverag
e
=

EBIT
+
lease pay
ments
interest
+
lease pay
ments
Fixed char
ge coverag
e
=

$1,900
+
$700
$400
+
$700

=
2.4
24

PROFITABILITY RATIOS

Relative measures of the firm’s money
-
making
success


RETURN ON SALES (ROS)












ROS
=

net income
sales
ROS
=

$1,000
$10,000

=
10%
25

PROFITABILITY RATIOS


RETURN ON ASSETS (ROA)

Measures the overall ability of the firm to utilize the
assets in which it has invested to earn a profit













8.3%

=

$12,000
$1,000

=

ROA
assets

total
income
net

=

ROA
26

PROFITABILITY RATIOS

RETURN ON EQUITY (ROE)

The most fundamental profitability ratio

Measures the firm’s ability to earn a return on the
owners’ invested capital.


30.3%

=

$3,300
$1,000

=

ROE
equity
income
net

=

ROE
27

MARKET VALUE RATIOS

PRICE / EARNINGS RATIO (P/E)

Measures the market’s opinion of the stock as an
investment











Interpretation
:

The amount investors will pay for each dollar of
earnings. Based primarily on expected growth
.

11.4

=

$3.33
$38

=

P/E
$3.33

=

300
$1,000

=

EPS
EPS
price

stock

=

Ratio

P/E
28

MARKET VALUE RATIOS

MARKET TO BOOK VALUE RATIO

Total value of the equity on the balance sheet










Market to
book value
ratio
=

stock pric
e
book value
per share
Market to
book value
ratio
=

$38
$11

=
3.5
29

Financial Ratios

30

Financial Ratios

31

Financial Ratios

32

Limitations and Weaknesses of
Ratio Analysis

Diversified Companies


Analysis of consolidated results generally
offers limited insight

Window Dressing


Yearend efforts to make ratios look good

Accounting Principles


Allow a great deal of reporting latitude