Chapter 3 - 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

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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

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Orientation of Financial Analysts

Critical and investigative

Looking for current or potential problems

Looking for the physical reasons behind financial results

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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

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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

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Table 3-1 Cash Flow Rules

Asset Increase = UseLiability Increase = SourceAsset Decrease = Source

Liability Decrease = Use

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Buying a Car on CreditJoe Jones and His New Car

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Buying and Selling Cars -Sally Smith and Her Two Cars

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Buying and Selling Cars -Sally Smith and Her Two Cars

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Business Cash Flows

Three sources of cash flows:

Operating Activities – day-to-day activities

Investing Activities – firm buys or sells ( or invests in) fixed assets that enable it to do business.

Financing Activities – borrow money, pay off loans, sell stock, pay dividends.

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Figure 3.2 BUSINESS CASH FLOWS

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Example 3-1 Business Cash Flows

Belfry also sold new stock during the year receiving a total of $800 and paid its shareholders dividends of $500.

Additional Information

Operating Activities

Net Income $ 1,000

Depreciation 500Net Change in Current Accts

(600)Cash from Operating Activities $ 900

Detail of Changes in Current Accounts Account Begin End Source/(Use)Receivables $3,000 $2,900 $ 100Inventory 2,000 3,200 (1,200)Payables 1,500 2,100 600

Accruals 500 400 (100) $

(600)

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 of Stock 800

Dividends Paid (500)

Cash from Financing Activities $ 1,500

Free Cash Flows (FCF)

Used to estimate whether a company will provide or require cash in futureCash generated by operations that’s available for distribution to investors.If negative, owners must borrow or sell equity just to keep going as before

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Calculating Free Cash Flow

NOPAT is net operating profit.T = tax rate

NOPAT = EBIT – (T)(EBIT) = EBIT (1 – T)

Note: If there is no debt, NOPAT equals net income

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Calculating Free Cash Flow

Depreciation is subtracted from revenue when calculating EBIT.

Depreciation is a noncash 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

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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

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Calculating Free Cash Flow to Equity (FCFE)

If a company is able to distribute cash to stockholders, then the equation becomes:

FCFE = Operating Cash Flow

– Increase in Gross Fixed Assets

– Increase in Current Accounts

– (1-T)Interest – Principal Reduction

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The Cash Conversion CycleRacetrack Diagram

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RATIO ANALYSIS

COMPARISONS

Ratios are most meaningful when compared with similar figures

Three comparisons:– History– Competitors– Budget

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Common Size Statements - Example

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CATEGORIES OF RATIOS

Five Classifications

Liquidity

Asset Management

Debt Management

Profitability

Market Value

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LIQUIDITY RATIOS

Liquidity ratios measure the company’s ability to meet short-term financial obligations

Current Ratio – primary measurement of a company’s

liquidity

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sliabilitiecurrent assetscurrent

= RatioCurrent

LIQUIDITY RATIOS

Quick Ratio (acid test) – A liquidity measure that does not depend on inventory

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sliabilitie currentinventory - assets current

Ratio Quick

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

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360 sales

receivable accounts = ACP

salesdaily averagereceivable accounts = ACP

Interpretation: Customers pay slowly OR there are a few very old accounts that will probably never be collected.

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INVENTORY TURNOVER

Inventory turnover ratio measures whether the firm has excess funds tied up in inventory.

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

inventorysold goodsof cost turnoverInventory =

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FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER

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

assets fixedsales turnover asset Fixed

assets totalsales turnover asset Total

DEBT MANAGEMENT RATIOS

Measures the firm’s debt level relative to assets, equity, and income

DEBT RATIOUses a broad concept of debt including current liabilities

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assets total

sliabilitiecurrent +debt term-long = ratioDebt

DEBT TO EQUITY RATIO

Measures the mix of debt and equity within total capital.

Debt to Equity Ratio = Long Term Debt : Equity

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TIMES INTEREST EARNED (TIE)

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

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interest

EBIT = TIE

CASH COVERAGE

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

interest.

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interest

ondepreciati + EBIT = coverage Cash

FIXED CHARGE COVERAGE

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

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payments lease +interest

payments lease + EBIT = coverage charge Fixed

DEBT MANAGEMENT RATIOS

Compares fixed (obligatory) payments with the cash available to pay (cover) them.

repayments principalpayments leaseinterestpayments leaseEBITDA

ecoveragEBITDA

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PROFITABILITY RATIOS

Relative measures of the firm’s money-makingsuccess, also called profit margin.

RETURN ON SALES (ROS)

sales

incomenet = ROS

RETURN ON ASSETS (ROA)

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

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assets total

incomenet = ROA

RETURN ON EQUITY (ROE)

The most fundamental profitability ratio

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

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equity

incomenet = ROE

MARKET VALUE RATIOS

PRICE / EARNINGS RATIO (P/E)

Measures 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.

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EPS

price stock = Ratio P/E

MARKET TO BOOK VALUE RATIO

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shareper value book

price stock = ratio value book toMarket

DU PONT EQUATIONS

Equations show relationships between ratios

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turnoverasset total ROS = ROA

assets total

sales

sales

incomenet = ROA

sales

sales

assets total

incomenet = ROA

Extended Du Pont Equation

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multiplier equity ROA = ROE

multiplier equity turnoverasset total ROS = ROE

equityassets total

assets totalsales

salesincomenet

= ROE

assets totalassets total

salessales

equityincomenet

= ROE

Using the Du Pont Equations

Focus attention on revenue or assets rather than on cost or expense

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ROA = ROS X Total Asset Turnover

Sampson Inc. 12% 6% 2x

Industry 15% 5% 3x

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

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