How to derive statement of CF from income How to derive statement of CF from income statement and balance sheet (indirect method for statement and balance sheet (indirect method for

year 2005)year 2005)

CF from operations = A - B, A – from income statement, CF from operations = A - B, A – from income statement, B – from balance sheetB – from balance sheet

A = Net Income + Depreciation + Other non-cash items (e.g. A = Net Income + Depreciation + Other non-cash items (e.g. deferred taxes) = 2 + 1.2 + 0.2 = 3.4deferred taxes) = 2 + 1.2 + 0.2 = 3.4

B = Changes in NWC, except items related to financing activities B = Changes in NWC, except items related to financing activities = = ΔΔAR + AR + ΔΔInventory + Inventory + ΔΔOther CA - Other CA - ΔΔAP - AP - ΔΔOther CL = 5.3 + 1 + Other CL = 5.3 + 1 + 1 – 4.7 + 2 = 4.61 – 4.7 + 2 = 4.6

Hence, OCF = 3.4 – 4.6 = -1.2Hence, OCF = 3.4 – 4.6 = -1.2

CF from investing = -(CF from investing = -(ΔΔTotal long-term assets + Total long-term assets + depreciation) = -41depreciation) = -41CF from financing = new debt issues – retirement of debt CF from financing = new debt issues – retirement of debt + new equity issues – dividends – repurchase of equity = + new equity issues – dividends – repurchase of equity = ΔΔTotal debt + Total debt + ΔΔNotes payable + Notes payable + ΔΔCurrent maturities of Current maturities of LT debt + LT debt + ΔΔStockholders’ equity – Net Income = 43.6 + Stockholders’ equity – Net Income = 43.6 + 0.3 + 1 + 1 – 2 = 43.90.3 + 1 + 1 – 2 = 43.9

Note on statement of CFNote on statement of CF

Interest expense is classified as Interest expense is classified as operating operating cash flow, cash flow, though it’s clearly a financing cash flow.though it’s clearly a financing cash flow.Sometimes (but not in our case) Sometimes (but not in our case) ΔΔShort term borrowing Short term borrowing is included in operating CF calculationis included in operating CF calculationIncrease in inventory does not affect Net Income, but still Increase in inventory does not affect Net Income, but still included in operating CF calculationincluded in operating CF calculationInterest income and dividends received are classified as Interest income and dividends received are classified as operatingoperating cash flows, though they result from investment cash flows, though they result from investment activitiesactivitiesIncome taxes are classified as Income taxes are classified as operatingoperating cash flows, cash flows, though taxes are affected by financing (e.g., deduction though taxes are affected by financing (e.g., deduction for interest expense) and investment activities (e.g. for interest expense) and investment activities (e.g. reduction of taxes from tax credits on investment reduction of taxes from tax credits on investment activities)activities)

How much actually goes to investors?How much actually goes to investors?

CF to investors (CF from assets) = -CF from financing CF to investors (CF from assets) = -CF from financing activities + interest = - 43.9 + 7.7 = - 36.2activities + interest = - 43.9 + 7.7 = - 36.2

Another way to compute it: CF to investors = CF from operations Another way to compute it: CF to investors = CF from operations – CF from investment – – CF from investment – ΔΔCash + interestCash + interest

Cash flow to creditors = interest + retirement of debt – Cash flow to creditors = interest + retirement of debt – new debt issues = interest – new debt issues = interest – ΔΔshort term borrowing – short term borrowing – ΔΔlong term borrowing = 7.7 – 1.3 – 43.6 = -37.2long term borrowing = 7.7 – 1.3 – 43.6 = -37.2((ΔΔshort term borrowing = short term borrowing = ΔΔNotes payable + Notes payable + ΔΔCurent Curent maturities of LTD; maturities of LTD; ΔΔlong term borrowing = long term borrowing = ΔΔlong term long term debt)debt)

Cash flow to shareholders = dividends + repurchase of Cash flow to shareholders = dividends + repurchase of stock – new equity issues = stock – new equity issues = ΔΔStockholders’ equity – Net Stockholders’ equity – Net Income = 1.0Income = 1.0

Cash flow patternsCash flow patternsWal-Mart (mature, healthy company)Wal-Mart (mature, healthy company)

Cash flow patternsCash flow patternsAmazon (successful fast-growing company)Amazon (successful fast-growing company)

Cash flow patternsCash flow patternsWeirton steel. Went bankrupt in 2003.Weirton steel. Went bankrupt in 2003.

Quality of financial info.Quality of financial info.Example: Earnings managementExample: Earnings management

Stock prices are sensitive to earningsStock prices are sensitive to earningsHence managers that want to inflate stock Hence managers that want to inflate stock price (or sustain it high) use techniques to price (or sustain it high) use techniques to “manage” earnings (usually increase but “manage” earnings (usually increase but sometimes smooth)sometimes smooth)Not all techniques are illegal (hence Not all techniques are illegal (hence difference between “earnings difference between “earnings manipulation” and “earnings management” manipulation” and “earnings management” in general)in general)

Correlation between earnings and stock value for GECorrelation between earnings and stock value for GE

How do managers manage earnings?How do managers manage earnings?

Discretionary use of accounting accrualsDiscretionary use of accounting accruals

Revenue and expense recognitionRevenue and expense recognition

Inventory accountingInventory accounting

Moving expenses to capital expendituresMoving expenses to capital expenditures

etc …etc …

Enron’s earnings and cash flows from Enron’s earnings and cash flows from operationsoperations

WorldCom earnings managementWorldCom earnings management

Financial Ratio AnalysisFinancial Ratio Analysis

Aggregates info from financial statements Aggregates info from financial statements by forming indicators of the firm’s financial by forming indicators of the firm’s financial condition (ratios)condition (ratios)

Trend AnalysisTrend Analysis

Cross-Sectional AnalysisCross-Sectional Analysis

Types of ratios:Types of ratios:

Liquidity (short-term solvency) ratiosLiquidity (short-term solvency) ratios

Activity ratiosActivity ratios

Leverage ratiosLeverage ratios

Profitability ratiosProfitability ratios

Market value ratiosMarket value ratios

Liquidity ratiosLiquidity ratios

Measuring short-term liquidity:Measuring short-term liquidity:

Current Ratio = Current Assets / Current LiabilitiesCurrent Ratio = Current Assets / Current Liabilities Too low CR may be a sign of financial troubleToo low CR may be a sign of financial trouble Too high CR may mean poor operating practicesToo high CR may mean poor operating practices

Quick RatioQuick Ratio

= (Current Assets – Inventories) / Current Liabilities= (Current Assets – Inventories) / Current Liabilities

Activity ratiosActivity ratiosHow well the company uses its productive resourcesHow well the company uses its productive resources

Total Asset Turnover = Sales / Average Total AssetsTotal Asset Turnover = Sales / Average Total Assets Effectiveness in using the total assetsEffectiveness in using the total assets

Accounts Receivable TurnoverAccounts Receivable Turnover= Credit Sales / Average Accounts Receivable= Credit Sales / Average Accounts Receivable

Average Collection PeriodAverage Collection Period= 365 / Accounts Receivable Turnover= 365 / Accounts Receivable Turnover

Too long ACP may mean lenient credit policy, failure to collect Too long ACP may mean lenient credit policy, failure to collect on time, bad quality of receivableson time, bad quality of receivables

Too short ACP may mean too stringent credit policy (Too short ACP may mean too stringent credit policy ( missed missed sales)sales)

Inventory TurnoverInventory Turnover= Cost of Goods Sold / Average Inventory= Cost of Goods Sold / Average Inventory

Days in Inventory = 365 / Inventory TurnoverDays in Inventory = 365 / Inventory Turnover Too many days is a bad thing if products become obsoleteToo many days is a bad thing if products become obsolete Too few days may mean lost sales due to items being out of Too few days may mean lost sales due to items being out of

stockstock

Financial leverage ratiosFinancial leverage ratios

Debt Ratio = Total Debt / Total AssetsDebt Ratio = Total Debt / Total AssetsDebt-to-Equity RatioDebt-to-Equity Ratio

= Total Debt / Total Equity= Total Debt / Total Equity Higher these ratios imply higher risk of Higher these ratios imply higher risk of

financial distressfinancial distress

Interest Coverage = EBIT / InterestInterest Coverage = EBIT / Interest Meeting interest payments out of EBIT (can Meeting interest payments out of EBIT (can

be modified to be based on cash flows be modified to be based on cash flows instead of earnings – Cash Flow Coverage)instead of earnings – Cash Flow Coverage)

Debt Ratio & Debt-Equity Ratio:Debt Ratio & Debt-Equity Ratio:Spectrum ManufacturingSpectrum Manufacturing

1999 1998 19971999 1998 1997

Total Liabilities Total Liabilities $8,456 $7,609 $3,695$8,456 $7,609 $3,695 Total Assets Total Assets 13,396 12,117 7,79413,396 12,117 7,794 Stockholder’s Equity Stockholder’s Equity 4,940 4,508 4,099 4,940 4,508 4,099 Debt Ratio Debt Ratio 0.63 0.63 0.47 0.63 0.63 0.47 Debt-Equity Ratio 1.71 1.69 0.90Debt-Equity Ratio 1.71 1.69 0.90

Industry Average (Debt Ratio) = 0.55Industry Average (Debt Ratio) = 0.55 Industry Average (Debt-Equity Ratio) = 1.22Industry Average (Debt-Equity Ratio) = 1.22

Creditors are exposed to “more risk” than the industry averageCreditors are exposed to “more risk” than the industry averageThe risk is growing over time, impairing the firm’s ability to borrowThe risk is growing over time, impairing the firm’s ability to borrow

Times Interest Earned:Times Interest Earned:Spectrum ManufacturingSpectrum Manufacturing

1999 1998 19971999 1998 1997

Net Operating Income (EBIT) $1,265 $1,775 $1,915Net Operating Income (EBIT) $1,265 $1,775 $1,915

Interest Expense Interest Expense 389 363 389 363 142 142

Interest Coverage 3.3X 4.9X 13.5X Interest Coverage 3.3X 4.9X 13.5X

Industry Average = 5.4XIndustry Average = 5.4X

Although the ratio is going down, it’s still OK to provide Although the ratio is going down, it’s still OK to provide security to creditorssecurity to creditors

Profitability ratiosProfitability ratiosHelp evaluate managerial performanceHelp evaluate managerial performance

Gross Profit Margin = EBIT / SalesGross Profit Margin = EBIT / SalesNet Profit Margin = Net Income / SalesNet Profit Margin = Net Income / Sales

Profit margins measure the ability to generate and market Profit margins measure the ability to generate and market profitable products and control expensesprofitable products and control expenses

Gross Return on Assets (ROA) = EBIT / Total AssetsGross Return on Assets (ROA) = EBIT / Total AssetsNet Return on Assets (ROA) = Net Income / Total AssetsNet Return on Assets (ROA) = Net Income / Total Assets

Measure profitability of the overall firmMeasure profitability of the overall firm

Return on Equity (ROE) = Net Income / EquityReturn on Equity (ROE) = Net Income / Equity Measures profitability from the perspective of the equity investorsMeasures profitability from the perspective of the equity investors

Note: here book values of assets and equity are usedNote: here book values of assets and equity are used

Payout Ratio = Cash Dividends / Net IncomePayout Ratio = Cash Dividends / Net Income

The DuPont AnalysisThe DuPont Analysis

Gives an understanding of what is causing changes in Gives an understanding of what is causing changes in ROE and through which variables it can be improvedROE and through which variables it can be improved

E.g., if it is hard to change Net Profit Margin, a firm can E.g., if it is hard to change Net Profit Margin, a firm can play with Total Asset Turnover and Equity Multiplier. But play with Total Asset Turnover and Equity Multiplier. But should be careful with EM since it increases riskshould be careful with EM since it increases risk

Multiplier EquityTurnover

Asset

Total MarginNet Profit

Equity

Assets

Assets

Sales

Sales

IncomeNet ROE

ROA

Du Pont Analysis:Du Pont Analysis:Spectrum ManufacturingSpectrum Manufacturing

1997-19991997-1999

Year Year Net Profit Net Profit x Total Asset x Total Asset x x Equity = Equity = ROE (%)ROE (%)

Margin (%)Margin (%) Turnover Turnover Multiplier Multiplier

1997 4.3 2.8 1.9 22.91997 4.3 2.8 1.9 22.9

1998 3.0 2.3 2.7 18.61998 3.0 2.3 2.7 18.6

1999 2.6 1.6 2.7 11.21999 2.6 1.6 2.7 11.2

The firm is following a dangerous path: increasing leverage does not help The firm is following a dangerous path: increasing leverage does not help revert the trend of decreasing ROE, while at the same time raises financial revert the trend of decreasing ROE, while at the same time raises financial risk.risk.

ROA for Winn-DixieROA for Winn-Dixie

What was responsible for the fall of Winn-Dixie’s ROA?What was responsible for the fall of Winn-Dixie’s ROA?

Market Value RatiosMarket Value Ratios

Measures of the firm’s prospects:Measures of the firm’s prospects:

Price-to-Earnings = Share Price / EPS =Price-to-Earnings = Share Price / EPS == Market Cap / Net Income= Market Cap / Net IncomeDividend Yield = DPS / Share PriceDividend Yield = DPS / Share PriceMarket-to-Book RatioMarket-to-Book Ratio

= Market Cap / Book Equity Value= Market Cap / Book Equity ValueTobin’s QTobin’s Q= Market Value of Debt + Equity / Replacement = Market Value of Debt + Equity / Replacement Value of AssetsValue of Assets

Book value and market value of Book value and market value of equity comparedequity compared

Coca-ColaCoca-Cola