Chapter 3 Working with Financial Statements

1. Chapter 3Working withFinancial Statements • Homework: 13-17

2. Topics • Sources and Uses of Cash • Financial Ratio Analysis • The Du Pont Identity • Using Financial Statement Information

3. Sources and Uses of Cash • Sources of cash include: • Decrease in assets • Increase in liabilities • Increase in common stock • Increase in retained earnings • Uses of cash include: • Increase in assets • Decrease in liabilities • Decrease in common stock • Decrease in retained earnings

4. Organizes cash flows into 3 main categories • Operating Activities • Revenues from sales of goods and services • Costs associated with productions • Investment Activities • Acquisition of a new production plan • Proceeds from selling equipment • Financing Activities • Issuing long-term debt • Payments associated with retiring long-term debt • Proceeds from issuing equity • Cash Dividends paid to shareholders

5. Statement of Cash Flows • Operating activities • + Net income • + Depreciation • + Any decrease in current assets (except cash) • + Increase in accounts payable • – Any increase in current assets (except cash) • – Decrease in accounts payable • Investment activities • + Ending fixed assets • – Beginning fixed assets • + Depreciation

6. Statement of Cash Flows (concluded) • Financing activities • – Decrease in notes payable • + Increase in notes payable • – Decrease in long-term debt • + Increase in long-term debt • + Increase in common stock • – Dividends paid

7. Example: Hermetic, Inc., Balance Sheet Hermetic, Inc. Balance Sheet as of December 31 ($ in thousands) Assets 1999 2000 Current Assets Cash $ 45 $ 50 Accounts receivable 260 310 Inventory 320 385 Total $ 625 $ 745 Fixed assets Net plant and equipment 985 1100 Total assets $1610 $1845

8. Hermetic, Inc., Balance Sheet (concluded) Liabilities and equity 1999 2000 Current liabilities Accounts payable $ 210 $ 260 Notes payable 110 175 Total $ 320 $ 435 Long-term debt 205 225 Stockholders’ equity Common stock and paid-in surplus 290 290 Retained earnings 795 895 Total 1085 1185 Total liabilities and equity $1610 $1845

9. Hermetic, Inc., Income Statement ($ in thousands) Net sales $710.00 Cost of goods sold 480.00 Depreciation 30.00 Earnings before interest and taxes $200.00 Interest 20.00 Taxable income 180.00 Taxes 53.45 Net income $126.55 Retained earnings $100.00 Dividends 26.55

10. Hermetic, Inc., Statement of Cash Flows • Operating activities • + Net income + 126.55 • + Depreciation + 30.00 • + Increase in payables + 50.00 • – Increase in receivables – 50.00 • – Increase in inventory – 65.00 91.55 • Investment activities • + Ending fixed assets +1,100.00 • – Beginning fixed assets – 985.00 • + Depreciation + 30.00 (145.00)

11. Hermetic, Inc., Statement of Cash Flows (concluded) • Financing activities • + Increase in notes payable + 65.00 • + Increase in long-term debt + 20.00 • – Dividends – 26.55 58.45 Putting it all together 91.55 – 145.00 + 58.45 = 5.00

12. Financial Ratios • Short-Term Solvency or Liquidity • Ability to pay bills in the short-run • Long-Term Solvency • Ability to meet long-term obligations • Asset Management • Intensity and efficiency of asset use • Profitability • Market Value • Going beyond financial statements

13. Short-Term Liquidity Ratios The Current Ratio Current Assets Current Ratio = Current Liabilities • Indicates a firm's ability to meet its short-term obligations • What Does This Number Mean? • Question: If you are a short-term creditor, the higher the current ratio the better?

14. Current Ratio Notes of Caution • Changes in the trend are difficult to interpret • Equal increases and decreases in current assets and current liabilities have different effects on the current ratio. • Depends on whether the current ratio is greater or less than one.

15. Quick Ratio Includes only current assets that can be converted quickly to cash. Current Assets - Inventory Quick Ratio = Current Liabilities

16. Short-term Solvency Ratios: The Bottom Line • Use both measures when assessing a firm's short-term liquidity • Using only the current ratio will overstate a firm's liquidity in the short-term. • By using both measures, we can see why the firm's current assets are increasing over time.

17. Long-Term Solvency Ratios The Total Debt Ratio Takes into account all debt of all maturities of all creditors Total Assets - Total Equity Total Debt Ratio = Total Assets

18. Long-Term Solvency Ratios Debt/Equity Ratio • Variation of the total debt ratio. • Measures total debt as a multiple of total equity. Total Debt Debt/Equity Ratio = Total Equity

19. Long-Term Solvency Ratios Long-Term Debt Ratio • Most popular leverage ratio • Omits short-term liabilities which are changing often. • Account payables: more a reflection of trade practices than of debt management Tot. Long-term Debt Long-Term Debt Ratio = Tot. L.T. Debt + Tot. Equity

20. Long-Term Solvency Ratios Times Interest Earned Ratio • Also called interest coverage ratio. • Measures the multiple of interest expense that a firm could support given its current level of earnings. EBIT Times Interest Earned Ratio = Interest expense The Lower this ratio, the more levered the firm.

21. Long-Term Solvency Ratios Cash Coverage Ratio • EBIT includes depreciation • Measures the multiple of interest expense that a firm could support given its level of cash. EBIT + depreciation Cash Coverage Ratio = Interest Expense The Lower this ratio, the more levered the firm.

22. Long-term Solvency Ratios • Measure a firm's ability to meet its long-term financial obligations. • Three Debt Ratios: The higher the ratios the more levered the firm. • Times Interest Earned and Cash Coverage Ratios: The lower the ratio the more levered the firm. • What is a good ratio? • Analysts vary the standard in direct relation to the stability of the firm's earnings and cash flows. • Different standards for different industries.

23. Asset Management Ratios Inventory Turnover Ratio Measures how many times a firm sold off its inventory Cost of Goods Sold Inventory Turnover Ratio = Inventory

24. Asset Management Ratios Days' Sale in Inventory Ratio Measures how long it took a firm to sell inventory 365 Days' Sales in Inventory = Inventory Turnover

25. Inventory Management Ratios • Measure how quickly a firm can convert inventory into cash. • Important in industries where inventory becomes obsolete relatively quickly. • Fashion industry • Inventory becomes obsolete and can't be converted into cash. • liquidate below costs => losses for the firm

26. Asset Management Ratios Receivables Turnover Ratio Measures how fast a firm collects on the credit sales of inventory Sales Receivables Turnover Ratio = Accounts Receivable

27. Asset Management Ratios Days' Sale in Receivables Ratio Measures how long it took a firm to collect on its credit sales 365 Days' Sales in Receivables = Receivables Turnover

28. Receivables Management Ratios • Measure how quickly a firm can convert receivables into cash. • If we observe an increase in days' sales in receivables, what does it indicate? • Loan officers will ask for a list of top customers and percentage of sales accounted by these customers. • Assess credit quality of the firm's main sources of revenues

29. Asset Management Ratios NWC Turnover Ratio Measures the efficiency of a firm's NWC Sales NWC Turnover Ratio = NWC

30. Asset Management Ratios Total Asset Turnover Ratio Measures the efficiency of a firm's Total Assets Sales Total Asset Turnover Ratio = Total Assets

31. Profitability Ratios Profit Margin Measures how well a firm is managing its costs relative to its sales Net Income Profit Margin = Sales

32. Profitability Ratios Return of Assets (ROA) Measures how hard a firm's assets are working Net Income ROA = Total Assets

33. Profitability Ratios Return of Equity (ROE) Measures how efficient a firm's equity is being employed to generate profit Net Income ROE = Total Equity

34. Market Value Measures Price/Earnings (P/E) Ratio Measures what investors are willing to pay per $1 of current earnings Price Per Share P/E Ratio = Earnings Per Share

35. Market Value Measures Market-to-Book Ratio Measures the market value of the firm's investments to their historical costs. Market Value Per Share Mkt-to-Book = Book Value Per Share

36. Example The Cross Companies 45 Million Shares Outstanding Stock sells for $80 per share at fiscal year-end Net Income = $675 million Total Equity = $3,375 million

37. The Du Pont Identity ROE Can be Decomposed into 3 Components: ROE = Net income/Sales x Sales/Assets x Assets/Equity ROE = Profit Margin x Asset Turnover x Equity Multiplier Operating Efficiency Financial Leverage Asset Use Efficiency

38. Standardized Financial Statements Common Size Balance Sheet All items are presented as a percentage of total assets => Divided all items by total assets Common Size Income Statement: All items are presented as percentage of total sales => Divide all items by total sales Common-Base Year Financial Statement => Present relative to a certain base year.

39. Things to Consider When Using Financial Ratios • What goes into a particular ratio? • Historical cost? Market values? Accounting conventions? • What is the unit of measurement? • Dollars? Days? Turns? • What would a desirable ratio value be? What is the benchmark? • Time-series analysis? Cross-sectional analysis?

40. Problems with Financial Analysis • Very little underlying financial theory • Differences in accounting practices • Finding comparable firms is difficult • Differences in fiscal-year ends • One-time events • Seasonal variations • Conglomerates • Choosing Benchmark: Which industry?