FIN 311 Financial Management

Ch.3 Financial Statement

Analysis

In

chapter 2, we learned some basics of financial

statements and how to estimate cash flow from
assets(CFFA) using the financial statements
Cash flow from assets: total cash result of all
transactions a firm engage in during the year
Cash flow from assets
=OCF- Net capital spending-Chg.in NWC
= Cash flow to creditors + cash flow to stockholders
(cash flow identity)

In

chapter 3, we will study a statement of cash

flow (detailed look of cash sources and uses)
and how to use financial statement information
more effectively
Ratio analysis and standardize financial statement for
comparison purposes
2

Key Concepts and Skills

Understand

sources and uses of cash

and the Statement of Cash Flows
Know how to standardize financial
statements for comparison purposes
Know how to compute and interpret
important financial ratios
Be able to compute and interpret the
Du Pont Identity
Understand the problems and pitfalls
in financial statement analysis
3

Sources and Uses

Sources

of cash

Activities

that bring in cash

Cash inflow occurs when we sell
something or borrow money
Need to trace B/S
Decrease in asset account
A firm sold some assets => cash inflow

Increase in liability or equity account

A firm borrowed money (raise money using
debt or stock securities)=> cash inflow

Sources and Uses Continued

Uses

of cash

Activities that involve spending cash

Cash outflow occurs when we buy
something or pay back the money we
borrowed

Need to trace B/S

Increase in asset account
A firm bought some assets

Decrease in liability or equity account

A firm paid off some debts/stocks

SC

Sample Balance Sheet

(B/S)

L2

Sample Balance sheet

2011
Current Assets (CA)
Cash

2012

$84

Accounts
receivable

Chg.

2011
Current Liabilities(CL)

$98 +$14 Accounts Payable

2012

Chg.

$312

$344

+$32

$165

$188 +$23 Notes Payable

$231

$196

-$35

Intentory

$393

$422 +$29 Total CL

$543

$540

-$3

Total CA

$642

$708 +$66 Long-term debt

$531

$457

-$74

$1,074

$997

-$77

Total liabilities

Fixed assets

$2,880 +$149 Common stock

Retained

earnings

Total
assets

Stockholders' equity
$2,731

Net equipment

$3,373

Total equity
Total liab. &
$3,588 +$215 equity

Numbers in millions of dollars

$500

$550

+$50

$1,799

$2,041 +$242

$2,299

$2,591 +$292

$3,373

$3,588 +$215

Source of cash:
Increase in accounts payable
Increase in common stock
Chg in RE
= Net income
- Dividends
=363-121

Increase in retained earnings

Total sources

$32
50
242
$324

Use of cash:

Chg in NFA
= FA
acquisition
costDeprecation
= acquisition
cost-276

Acquisition
cost=425

Increase in accounts
receivable

$23

Increase in inventory

29

Decrease in notes payable

35

Decrease in long-term debt

74

Net fixed asset acquisitions

149

Total uses

=Total sources-total uses=324-310

Net addition to cash

$310
$14

Same as the change in Cash from 2011 to

2012 in B/S= $14 (=$98-$84)
7

Sample Income
Statement (I/S)
Sales

$2,311

Cost of Goods Sold

(1,344)

Depreciation

(276)

EBIT

$691

Interest Expense

(141)

Taxable Income
Taxes

$550
(187)

Net Income

$363

Dividend
Addition to retained
earnings

Numbers in millions of dollars

$121
$242
Addition to RE=Net
income-dividend
=>Increase in RE in B/S

Question
Which

one of the following is a

source of cash?

A.
B.
C.
D.
E.

repurchase of common stock

acquisition of debt
purchase of inventory
payment to a supplier
granting credit to a customer

10

Statement of Cash Flows

A

statement of cash flows summarizes the

sources and uses of cash over a specified
period
It reflects a firms liquidity

mandatory statements together with the

balance sheet and the income statement
under GAAP since 1994
Purposes:
provide information on a firm'sliquidityandsolvencyand
its ability to changecash flowsin future circumstances
improve the comparability of different firms' operating
performance by eliminating the effects of
differentaccounting methods
10

Statement of Cash Flows

(Continued)
Operating

Activity

Include most of chg. in CA, CL(e.g. accounts payable)

Include net income part of chg. in addition to RE
Include depreciation part of chg in NFA(=net asset
acquisitions-depreciation)
Investment

Activity

Include asset acquisitions part of chg. in net fixed

assets(NFA)
Financing

Activity

Includes chg. in some current liabilities such as notes

payable
Include chg. in long-term liabilities
Include chg. in common stocks
Include dividends part of chg. In addition to RE

11

Statement of Cash Flows

(Continued)
Operating

Activity

Calculated as net income+ depreciation-chg.in

CA+chg.in CL
Interest paid belongs to operating activity here in Ch.3
since net income is computed after deducting interest
expense
It is different from OCF (=EBIT-Taxes+depreciation) in
ch.2

Investment

Activity

Calculated as (chg. in NFA+ depreciation)

Financing

Activity

Calculated as in chg. in notes payable + chg. in

LT debts + chg. in common stocks dividends
12

B/S

Sample Statement of Cash Flows

(2012)
$84
Cash, beginning of year
Financing Activity
Operating Activity

Decrease in Notes
Payable

Net Income

363

Decrease in LT Debt

Plus: Depreciation

276

Dividend paid

Increase in accounts
payable
Less: Increase in accounts
receivable
Increase in inventory
Net Cash from Operations

Investment Activity

32
(23)

Increase in common
stock
Net Cash from
Financing

(35)
(74)
(121)
50
($180)

(29)
$619

Net Increase in Cash

$14

Cash End of Year

$98

Acquisitions
Assets
(425)
Investment activity:
-(changeofinFixed
net fixed
assets + depreciation)
= -(149+276)
= -425
Net Cash from
Investments

Numbers in millions of dollars

($42
5) mil worth of fixed assets
acquire $425

13

Question
A

firm generated net income of $878. The

depreciation expense was $47 and dividends
were paid in the amount of $25. Accounts
payables decreased by $13, accounts receivables
increased by $22, inventory decreased by $14,
and net fixed assets decreased by $8. There was
no interest expense. What was the net cash flow
from operating activity?
A.$876
B.$902
C.$904
D.$922
E.$930
14

Question
On

the Statement of Cash Flows, which of the

following are considered financing activities?
I. increase in long-term debt
II. decrease in accounts payable
III. interest paid
IV. dividends paid

A.
B.
C.
D.
E.

I and IV only
III and IV only
II and III only
I, III, and IV only
I, II, III, and IV
15

Question
According

to the Statement of
Cash Flows, an increase in
interest expense will _____ the
cash flow from _____ activities.
A.
B.
C.
D.
E.

decrease; operating
decrease; financing
increase; operating
increase; financing
increase; investment
16

Standardized Financial
Statements

Standardized

statements are useful for

comparing companies of different sizes or
currency, particularly within the same
industry (cross-section analysis)
Cf. Ford vs. GM , Toyota vs. GM

Standardized

statements also make

it easier to compare financial
information, particularly as the
company grows (time series/trend
analysis)
17

Standardizing financial
statements
Common-size

financial statements

Common size Balance Sheets

Compute all accounts as a percent of total assets

Common size Income Statements

Compute all line items as a percent of sales

Common size statement of cash flows not common

No obvious denominator such as total assets or total sales

Common-base

year financial statements

Expression offinancialinformation in a given year as a

percentage of an amount in an base year.
Cf. Net income in 2009 is 20% higher than that in the base year 2008
=> Net income is recorded as 1.20 or 120% in the 2009 common-base year
financial statements

Combined

common-size and base year analysis

Form the common-size statements first and compute each item in

common-size statements as a percentage of the item in an base
year
Why?
Eliminate the effect of overall growth

18

Simple Example of Standardized

Balance Sheet

All items in B/S are expressed as percents of total

assets
* Source: Investopedia
19

Simple Example of Standardized

Income Statement

All items in I/S are expressed as percents of sales

* Source: Investopedia
20

CASH: 1.17=$98/$84 (17% increase)

Cash: 1.08= 2.7%/2.5% (8% increase)

21

Question
A

firm uses 2008 as the base year for its

financial statements. The common-size, baseyear statement for 2009 has an inventory
value of 1.08. This is interpreted to mean that
the 2009 inventory is equal to 108 percent of
which one of the following?
A.
B.
C.
D.

2008 inventory
2008 total assets
2009 total assets
2008 inventory expressed as a percent of 2008
total assets
E. 2009 inventory expressed as a percent of 2009
total assets
22

Ratio Analysis
Another

way of avoiding the problems

involved in comparing companies of
different sizes

Ratios

allow for better comparison

through time or between companies
by eliminating the size problem

As

we look at each ratio, ask yourself

what the ratio is trying to measure
and why that information is important
23

Five Categories of Financial

Ratios
Short-term

solvency or liquidity ratios

Measure a firms ability to pay its bills over the short

run without financial stress
Long-term

solvency or financial leverage ratios

Measure a firms long-term ability to meet its

obligations
Asset

management or turnover ratios

Measure how efficiently a firm uses its assets to

generate sales
Profitability

ratios

Another way to measure how efficiently a firm uses its

assets and manages its operations
Market

value ratios

Only applicable for publicly traded companies

24

B/S

Liquidity Ratios (using the

sample B/S & I/S in 2012)
Current Ratio = CA / CL

1.

Current
To a creditor, the higher
the ratio>1=>
currentPositive
ratio, NWC
the
better.

To the firm, a higher current ratio indicates high

liquidity. Think of the trade-off of liquidity.

Inefficient use of current assets vs. high liquidity

Quick Ratio = (CA Inventory) / CL

2.

Cash Ratio = Cash / CL

3.

& 3: More conservative ways of measuring

short-term solvency than 1
25

B/S

Long-term Solvency Ratios

1.
2.
3.

Total Debt ratio = TD/ TA

Debt/Equity (or D/E) ratio = TD / TE
Equity Multiplier = TA / TE
( =(TE+TD)/TE = 1+ TD/TE = 1+
D/E )

26

Long-term Solvency Ratios

4.

Times interest earned ratio=EBIT/Interest

Or called interest coverage ratio
How well a company has its interest obligation
covered

5.

Cash coverage ratio

=(EBIT + Depreciation) / Interest
Depreciation is non-cash expenses. Add back
depreciation to EBIT to measure a real cash available
to pay interest.
A measure of cash flow available to meet financial
obligations.
The higher the cash coverage ratio, the better the
firms ability to meet its obligations to creditors
27

Question
If

a firm has a debt-equity ratio of

1.0, then its total debt ratio must
be which one of the following?

A.
B.
C.
D.
E.

0.0
0.5
1.0
1.5
2.0

28

Question
An

increase in current liabilities will

have which one of the following
effects, all else held constant? Assume
all ratios have positive values.

A. increase in the cash ratio

B. increase in the net working capital to total
assets ratio
C. decrease in the quick ratio
D. decrease in the cash coverage ratio
E. increase in the current ratio
29

Asset Management Ratio or

Turnover Ratios
1.

Inventory Turnover
= Cost of Goods Sold / Inventory
A low turnover is usually a bad sign
because the products tend to deteriorate
as they sit in warehouse
Firms with perishable items tend to have
high turnover

2.

Days Sales in Inventory

= 365 / Inventory Turnover
30

Asset Management Ratio or

Turnover Ratios
3.

Receivables Turnover

=Sales (or Net credit sales)/ Accounts

Receivable
How effectively the company uses its credit policy
A high ratio implies either that a company
operates on a cash basis or that its extension of
credit and collection of accounts receivable is
efficient

Days Sales in Receivables

= 365 / Receivables Turnover
4.

It is also called the average collection period

31

Asset Management Ratio or

Turnover Ratios
5.

Total Asset Turnover = Sales / Total

Assets
It is not unusual for TAT < 1, especially if a
firm has a large amount of fixed assets.

6.

NWC Turnover = Sales / NWC

It measures how much the company get
out of its working capital.

7.

Fixed Asset Turnover = Sales / NFA

32

Profitability Measures
1.

Profit Margin = Net Income / Sales

It measures operating efficiency and one of the
component of the Du Pont identity.

2.

Return on Assets (ROA) = Net Income /

Total Assets
A measure of profit per dollar of assets

3.

Return on Equity (ROE) = Net Income / Total

Equity
A measure of profit per dollar of equity
Always higher than ROA as long as the firm has
debt.

33

Market Value Measures

Additional

information is required
to compute the market value ratios.
1. EPS =Net Income/Shares
outstanding
2. PE Ratio = Price per share / EPS
3. Market-to-book ratio = market
value (of equity) per share / book
value (of equity) per share
overvalued or high expected future
growth
34

PE ratio
Generally

a high P/E ratio means that

investors are anticipating higher growth
in the future.
Amazon

The

average market P/E ratio is 20-25

times earnings.
P/E of US large company in the US: 15-20

Companies

that are losing money do not

have a P/E ratio.
E.g. Blackberry
35

The

point of the ratio analysis

is not simply the ability to
compute the ratios, but
rather the ability to interpret
them.

36

Question
That

Wich Corp. had additions to retained

earnings for the year just ended of $375,000.
The firm paid out $175,000 in cash dividends,
and it has ending total equity of $4.8 million.
The company currently has 145,000 shares of
common stock outstanding.

Q1) What are earnings per share(EPS)?

Q2) What are dividends per share?
Q3) What are book value per share?
Q4) If the stock currently sells for $79 per share,
what are the market-to-book ratio and PE
ratio?
37

Du Pont Identity
Du

Pont Identity is an expression

which breaks ROE into three parts.
ROE = Profit Margin(PM)* Total
Asset Turnover(TAT) * Equity
Multiplier(EM)

The

names comes from the

Dupont Corporation which started
using this formula in the 1920s
38

The

Du Pont identity (ROE= PM*TAT*EM) tells

us how ROE is affected by three things:
Operating efficiency : measured by profit
margin(PM)
Asset use efficiency: measured by total asset
turnover(TAT)
Financial leverage: measured by equity
multiplier(EM)

Operating

efficiency (PM) or asset use

efficiency(TAT) can improve the ROE
Also, ROE can be improved by increasing
leverage(EM)
39

Deriving the Du Pont

Identity

Start

from ROE ratio (= NI / TE).

Multiply

by 1 (=TA/TA) and then rearrange

ROE = (NI / TE) (TA / TA)

= (NI / TA) (TA/TE) = ROA * Equity Multiplier
Multiply

by I(=Sales/Sales) again and then

rearrange
ROE = (NI / TA) (TA/ TE) (Sales / Sales)
= (NI/Sales) (Sales /TA) (TA / TE)
= Profit Margin*Total Asset
Turnover*EquityMultiplier
40

Problem Du Pont Identity

Kindle

Fire Prevention Corp. has a

profit margin of 5.1 percent, total
asset turnover of 2.0, and ROE of
24 percent. What is the firms
debt-equity ratio?

41

Why Evaluate Financial

Statements?
Internal

uses

Performance evaluation compensation

and comparison between divisions
Planning for the future guide in
estimating future cash flows
External

uses

Creditors
Suppliers
Customers
Stockholders

42

Benchmarking
Ratios

are not very helpful by

themselves; they need to be
compared to something (choose a
benchmark)

Standard

benchmarking

Time-Trend Analysis
Used to see how the firms performance is
changing through time
Internal and external uses

Peer Group Analysis

Compare to similar companies or within
industries
Common way of identifying potential peers: Use

43

Potential Problems
There

is no underlying theory, so there is no

way to know which ratios are most relevant
Benchmarking is difficult for diversified firms
E.g. amazon (sic code: 5961, Retail-Catalog & MailOrder Houses)
Globalization

and international competition

makes comparison more difficult because of
differences in accounting regulations
Varying accounting procedures, i.e. FIFO vs.
LIFO
Different fiscal years
Extraordinary events
3-44

44

Work the Web Example

The

Internet makes ratio analysis

much easier than it has been in the
past
Click www.reuters.com
Click on Markets-> Stocks, then enter its
ticker symbol (if you already now it) or just
company name

45

enter Netflix and click NFLX.O

To see more financial ratios, click Financials

46

Summary
We

discussed how to identify the uses

/sources of cash.
Standardized financial statements make
it easier to compare financial statements
of the companies of different sizes.
Evaluating ratios of accounting numbers
is another way of comparing financial
statement information.
We discussed how to establish
benchmarks for comparison in financial
statement analysis and also examined
47
potential problems.