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Chapter 3

Chapter 3 Cash Flows and Financial Analysis © 2000 South-Western College Publishing FINANCIAL INFORMATION Results of operations in money terms Basis for projecting future results Responsibility of management

RoyLauris
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Chapter 3

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  1. Chapter 3 Cash Flows and Financial Analysis © 2000 South-Western College Publishing

  2. FINANCIAL INFORMATION Results of operations in money terms Basis for projecting future results Responsibility of management 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 TM 3-1 Slide 1 of 3

  3. SOURCES OF FINANCIAL INFORMATION Annual Report Management's report card to stockholders on its own performance Tends to be favorably biased Other Sources Brokerage firms, credit bureaus TM 3-1 Slide 2 of 3

  4. ORIENTATION OF FINANCIAL ANALYSTS Critical and investigative Looking for current or potential problems Looking for the physical reasons behind financial results TM 3-1 Slide 3 of 3

  5. CASH FLOW Businesses run on cash, not on accounting profits. It's possible to go out of business while making a profit. THE STATEMENT OF CASH FLOWS Shows where money actually comes from and goes to Developed from the basic income statement and balance sheet Other Terminology Funds flow Sources and uses (applications) of cash or funds Statement of changes in financial position TM 3-2 Slide 1 of 2

  6. BASIC APPROACH Adjust net income for non cash items Analyze changes in balance sheet accounts between beginning and end of year as sources or uses of cash Organize and sum Free Cash Flows Available after reinvestments needed for growth and to replace worn-out equipment TM 3-2 Slide 2 of 2

  7. CASH FLOW RULES Asset Increase = Use Asset Decrease = Source LiabilityIncrease = Source Liability Decrease = Use TM 3-3

  8. CASH FLOWS IN A BUSINESS Organized into three activities Operating Activities Routine running of the company Sales, collections, inventories, wages, etc. Paying interest on debt TM 3-4 Slide 1 of 2

  9. Investing Activities Commitment of long term capital Usually buying or selling fixed assets Investing Activities Equity and long term debt transactions Selling stock and paying dividends Borrowing and repaying loans (Note: Interest payment in operating activities) TM 3-4 Slide 2 of 2

  10. Operating Activities Investing Activities Buy Inventory A GRAPHIC PORTRAYAL OF BUSINESS CASH FLOWS Figure 3.1 Business Cash Flows Cash to vendors Cash to vendors Cash to employees Stock Cash price Cash from from/to customers stockholders Cash Cash to IRS to/from Repayment lenders TM 3-5 Payable Purchase Fixed Assets Pay Wages Accrual CASH Product Financing Activities Sale Stock Equity Receivable Divs Loan Bonds Debt Intrst Pay Taxes

  11. ANOTHER VISUAL REPRESENTATION THE CASH CONVERSION CYCLE(RACETRACK DIAGRAM) A/R Figure 3-2 The Cash Conversion Cycle: The Racetrack Diagram TM 3-6 Cash Sale Inventory Labor Assets, Taxes, Profits...

  12. Belfry Company Balance Sheet For the Period Ended 12/31/00 ASSETS 12/31/99 12/31/00 Cash $1,000 $1,400 Accts. Receivable 3,000 2,900 Inventory 2,0003,200 CURRENT ASSETS $6,000 $7,500 Fixed Assets Gross $4,000 $6,000 Accum. Depr. (1,000) (1,500) Net $3,000 $4,500 TOTAL ASSETS $9,000 $12,000 LIABILITIES Accts. Payable $1,500 $2,100 Accruals 500 400 CURRENT LIABIL. $2,000 $2,500 Long-term debt $5,000 $6,200 Equity 2,0003,300 TOTAL CAPITAL $7,000 $9,500 TOTAL LIABILITIES AND EQUITY $9,000 $12,000 Belfry Company Balance Sheet For the Period Ended 12/31/00 Sales $10,000 COGS 6,000 Gross Margin $ 4,000 Expense $ 1,600 Depreciation 500 EBIT $ 1,900 Interest 400 EBT $ 1,500 Tax 500 Net Income $ 1,000 BUILDING THE STATEMENT OF CASH FLOWS TM 3-7

  13. OPERATING ACTIVITIES Net income $1,000 Depreciation 500 Net changes in current accounts (600) Cash from operating activities $ 900 Detail of Changes in Current Accounts AccountSource/(Use) Receivables $ 100 Inventory (1,000) Payables 600 Accruals (100) $ (600) INVESTING ACTIVITIES Purchase of fixed assets ($2,000) (Note: excludes cash) TM 3-8 Slide 1 of 2

  14. FINANCING ACTIVITIES Increase in long-term debt $1,200 Sale of stock 800 Dividend paid (500) Cash from financing activities $1,500 UNDERSTANDING THE EQUITY ACCOUNT Amount Activity Net income $1,000 Operating Stock sale 800 Financing Dividend (500) Financing Change in equity $1,300 TM 3-8 Slide 2 of 2

  15. RATIO ANALYSIS Pairs of numbers from the financial statements formed into ratios Each ratio high-lights a particular aspect of running the business Example: The current ratio measures liquidity, the ability to pay bills in the short run Current Assets: Money coming in within a year Current Liabilities: Money going out within a year For solvency need: Current ratio >> 1.0 TM 3-9 Slide 1 of 3

  16. COMPARISONS Ratios are most meaningful when compared with similar figures History Prior performance - look for trends Competitors Identify strong or weak spots relative to similar businesses Plan Is performance better or worse than expected? AVERAGE OR ENDING BALANCES Ending when measuring a status Average when measuring an activity Distinction important when growth is rapid TM 3-9 Slide 2 of 3

  17. CATEGORIES OF RATIOS • Liquidity • Asset Management • Debt Management • Profitability • Market Value Ratios Don't Provide Answers They Help You Ask The Right Questions TM 3-9 Slide 3 of 3

  18. COMMON SIZE STATEMENTS Ratios of income statement line items to sales revenue Facilitates operating comparisons over time and between companies of different sizes TM 3-10 Slide 1 of 2

  19. COMMON SIZE STATEMENTS Example: Alpha Beta $ %$ % Sales Revenue $2,187,460 100.0 $150,845 100.0 Cost of Sales 1,203,10355.072,40648.0 * Gross Margin $ 984,357 45.0 $ 78,439 52.0 Expenses 505,30323.139,974 26.5 * EBIT $ 479,054 21.9 $ 38,465 25.5 Interest 131,2486.015,38610.2 * EBT $ 347,806 15.9 $ 23,079 15.3 Tax 118,2545.4 3,462 2.3 * Net Income $ 229,552 10.5 $ 19,617 13.0 * Operating differences worth investigating TM 3-10 Slide 2 of 2

  20. LIQUIDITY RATIOS Measure the ability to meet short term obligations (Use ending balances) (Examples from Belfry Company) Current Ratio TM 3-11 Slide 1 of 2

  21. Quick Ratio (Acid Test) Removes inventory which may be problematic in generating cash TM 3-11 Slide 2 of 2

  22. ASSET MANAGEMENT RATIOS(Use average balances) AVERAGE COLLECTION PERIOD (ACP) How long does it take to collect on credit sales? Interpretation:All customers paying slow or there are old receivables which may never be collected. TM 3-12 Slide 1 of 2

  23. INVENTORY TURNOVER Measures inventory used to support production and operations (COGS) (Sales) Interpretation: Too much inventory is expensive to carry. Too little causes stockouts: inefficient production and lost sales. TM 3-12 Slide 2 of 2

  24. FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER Measures effectiveness of assets in generating sales Interpretation: Are there idle or inefficient assets? Are promotional efforts effective? TM 3-13

  25. DEBT MANAGEMENT RATIOS Measures the firm's debt level relative to assets, equity, and income (Use ending balances) DEBT RATIO TM 3-14 Slide 1 of 2

  26. DEBT TO EQUITY RATIO 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) Interpretation: Too much debt as a percentage of assets or equity is an indication that financial risk may be making the firm unstable. TM 3-14 Slide 2 of 2

  27. DEBT MANAGEMENT (COVERAGE) RATIOS Measure the firm's ability to service debt with operating income and cash flows TIMES INTEREST EARNED (TIE) Measures the interest burden relative to the ability to pay it TM 3-15 Slide 1 of 3

  28. CASH COVERAGE A variation on TIE to better get at cash flow TM 3-15 Slide 2 of 3

  29. FIXED CHARGE COVERAGE A variation on TIE to include lease payments asfixed financial charges equivalent to interest Interpretation: Failure from excessive debt is due to the inability to pay interest (fixed) charges which depend on the amount of debt and the interest rate. Coverage ratios measure financial charges relative to available income. TM 3-15 Slide 3 of 3

  30. PROFITABILITY RATIOS Measure profitability relative to sales, assets, and the owners' investment (equity) (Use average balances) RETURN ON SALES (ROS) Interpretation: Measures control of pricing, costs, and expenses TM 3-16 Slide 1 of 3

  31. RETURN ON ASSETS (ROA) Interpretation:Measures control of pricing, costs, and expenses and asset utilization TM 3-16 Slide 2 of 3

  32. RETURN ON EQUITY (ROE) Interpretation:Measures control of pricing, costs, and expenses and asset utilization, and the use of leverage TM 3-16 Slide 3 of 3

  33. MARKET VALUE RATIOS Measure the market's opinion of the stock as an investment based on its price (Use ending balances) PRICE/EARNINGS RATIO (P/E) Interpretation:The amount investors will pay for each dollar of earnings Based primarily on expected growth TM 3-17 Slide 1 of 2

  34. MARKET TO BOOK VALUE RATIO Interpretation:Identifies the going concern value of the firm as perceived by investors TM 3-17 Slide 2 of 2

  35. DU PONT EQUATIONS Identify relationships between ratios TM 3-18 Slide 1 of 3

  36. Extended Du Pont Equation TM 3-18 Slide 2 of 3

  37. Using the Du Pont Equations to Analyze Problems ROA = ROS´Total Asset Turnover Pillbox Inc. 12% 6% 2 ´ Industry 15% 5% 3 ´ Focus attention on revenue or assets rather than on cost or expense TM 3-18 Slide 3 of 3

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