Ch3. Working With Financial Statements

1. Ch3. Working With Financial Statements

2. Using Financial Statement • Our goal in this chapter is to expand our understanding of the uses of financial statement information. • Keep in mind we have different users of financial statement. • Although market value information is more important to financial managers, they rely more on accounting numbers because they are unable to obtain all the market information they want. • Accounting numbers are just pale reflection of economic reality but they are the best availableinformation.

3. 3.1 Cash Flow and Financial Statements Cash flow from the assets= Cash flow tocreditors +Cash flow to shareholders • The previous formula simply means that firms do two things: • Generate cash ( Source of cash) • Spend cash ( Use of cash ) • Source of Cash: A firm’s activity that generate cash. • Examples: selling a product, selling an asset, selling a security (by selling bonds to borrow money or by selling a share of stock) • Uses of Cash: A firm’s activity in which cash is spent. • Examples: paying for materials and labor to produce a product, purchasing assets, payment for creditors and owners.

4. 3.1 Sources and Uses of Cash

5. cash.

6. Analyzing the Results • You might ask, how did we get the +$14 increase in cash in the previous balance sheet • The answer is : All sources of cash – All uses of cash • In Our example: sources of cash (increase 32 in account payable + +$50 increase in common stock + $242 increase retained earnings = $324) • uses of cash ( $23 increase in account receivable + $29 increase in inventory + $35 decrease in note payable + $74 decrease in long term debt + $149 increase in fixed assets acquisition = $310) • $324 - $310 = $14 in cash.

7. The Statement of Cash Flow Statement of Cash flow: A firm’s financial statement that summarizes its sources and uses of cash flow over a specified period Steps to prepare the statement of cash flow: 1. To prepare the statement of cash flow, we need to use both the income statement and the balance sheet. 2. Find the difference (changes) between the end of the year and the beginning of the year in the balance sheet. 3. Start the cash flow statement by (cash at the beginning of the year ), then, Divide the statement of cash flow to three categories: • Operating Activity: includes net income + depreciation, and changes in current accounts (current assets or account payable, add them if they are sources and subtract them if they are uses). • Investment Activity: includes changes in fixed assets+ depreciation. • Financing Activity: includes changes in notes payable, long-term debt, equity accounts, and dividend. 4. To find (cash at the end of the year), add all (sources of cash) together and subtract them from all (uses of cash) ↑Assets or ↓ Liabilities or owner’s equity = use of cash ↓Assets or ↑ Liabilities or Owner’s equity = Source of cash

8. Statement of Cash Flow • The following is the income statement since we will use it in making the statement of cash flow.

9. Building a Statement of Cash Flow

10. 3.2 Standardized Financial Statements • It will be impossible to compare financial statement of one company to other financial statements of similar companies who do the same business. WHY? Because they have different sizes so we can not compare dollar amounts. • It is also hard to compare the financial statements of the same company but in different periods of time because the size has changed. • To start making comparisons, we need to standardized the financial statements by using percentages instead of total dollars. • Three ways to standardize financial statements: • Common Size statements • Common Base year financial statements (Trend Analysis) • Combined Common Size and Base year Analysis

11. Standardized Financial Statements 1.Common Size Statements: • Is a standardized financial statement presenting all items in percentage terms. • Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales and cash flow items as a percentage of total sources or total uses of cash. • Next slides is a common size balance sheet and common size income statement.

12. cash.

13. Common size income statement

14. Standardized Financial Statements 2. Common Base year Financial Statement Is a standardized financial statement presenting all items relative to a certain base year amount. • Choosing a base year and then express each item relative to the base amount. • Used to compare the performance of the company during the years to see the pattern of the firm operations: • Ex. Does the firm use more or less debt? Has the firm grown more or less liquid? • The following slide is a common base year balance sheet.

15. Common Base Year Financial Statement .

16. Standardized Financial Statements 3. Combined common size and base year analysis: (see table in the following slide)

17. cash.

18. 3.3 Ratio Analysis • Financial Ratios: Relationships determined from a firm’s financial information and used for comparison purposes. • We will learn the most important ratios and we consider several questions when finding them: • How is it computed? • What is it intended to measure? • What is the unit of measurement? • What might a high or low value tell us? • How could this measure be improved?

19. 3.3 Ratio Analysis • Financial ratios are grouped into four categories: • Short term solvency, or liquidity ratios. • Long term solvency, or financial leverage ratios. • Asset management or turnover measures. • Profitability ratios • Market value ratios.

20. 1. Short Time Solvency OR Liquidity Ratios • 1. Short Term Solvency Ratios, or Liquidity Measures • Current ratio • Quick ratio (Acid test) • Cash ratio • Net working capital to total assets • Inventory measure • The primary concern of these ratios is To measure the firm’s ability to pay its bills over the short run. Or, a measure of a short term liquidity. • Who is interested in knowing these ratios the most? Creditors (banks, suppliers).

21. 1. Short Time Solvency OR Liquidity Ratios Current ratio = Current Assets /Current Liabilities 1.A. Current ratio (From the previous table) Current assets = $708/540 = 1.31 times. Or we can say, the company has $1.31 in current assets for every $1 in current liabilities. • What does this number mean to the firm’s creditors? The higher the current ratio, the better. • What does this number mean to the firm itself? A higher current ratio indicates liquidity, but it also means inefficient use of cash and other short term assets. (it shouldn’t be less than 1 ) • See example 3.1 in the textbook

22. 1.Short Time Solvency OR Liquidity Ratios The Quick Ratio=( Current assets-inventory)/Current liabilities • 1.B The Quick Ratio or (Acid test): • Because inventory is the least liquid current assets item and some of it get damaged or lost, we want to find the current ratio excluding the inventory. • Quick ratio = ($708- $422)/$540 = 0.53 times. • NOTEthat using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio • 1.C Cash Ratio: • Some short term creditors might be just interested in cash ratio. Cash Ratio = Cash / Current Liabilities

23. 1.Short Time Solvency OR Liquidity Ratios • 1. D. Net working capital to total assets = (708-540)/3588 = 4.7% • 1.E Interval measure • This ratio is used when the firm is facing a strike and cash inflows start to dry up, how long could the business be running (cover the operating costs)? • Average daily operating cost = cost of good sold (from the income statement) / 365 • 708/3.68= 192 days. Net working capital = NWC/Total Assets • Interval measure= Current𝑡 assets/Average daily operating costs

24. 2. Long Term Solvency Measures • it measures the firm’s financial leverage or the firm’s ability to pay its debt or meet its obligations. • 2.A Total Debt Ratio From the balance sheet in page55: = ($3,588 – 2,591)/$3,588 = 0.28 times • which means that the firm uses 28% debt. Or we say the company has $0.28 in debt for every $1 in assets. • Assets = Liability + Owners Equity $1 = $0.28 + $0.72 • Total Debt Ratio =( total assets-total equity)/total assets

25. 2. Long Term Solvency Measures • from this ratio we can come up with two related ratios: • 2.B Debt Equity Ratio = 0.28/ 0.72 = 0.39 times 2.C Equity multiplier OR OR = $1/$0.72 = 1.39 1+0.3 • NOTE If we have any one of the previous three ratios, we can find the other two ratios. debt-equity ratio = total debt/total equity 1 + debt-equity ratio Equity multiplier = total assets/total equity

26. 2. Long Term Solvency Measures Long term debt ratio =Long term debt/(Long term debt+total equity) • 2.D Long term debt ratio: • Financial analyst are more concerned with the firm long term debt more than its short term debt because they want to know the firms debt management policy and the short term debt is constantly changing. • Long-term debt and equity are called firm’s total capitalization.

27. 2. Long Term Solvency Measures Times interest earned (TIE)= EBIT/ Interest • 2.E. Times interest earned (TIE) = $691/141 = 4.9 times • Means how well the company has its interest obligation covered. • The problem with TIE is that its based o EBIT that has a non cash item (depreciation), which is not a measure of cash available to pay interest. • 2.F. Cash coverage Ratio = (691+267)/141 = 6.9 times. Cash coverage ratio =( EBIT+ Depreciation)/ Interest

28. 3. Asset Management or Turnover, Measures • These ratios are also called utilization ratios. • They describe how efficiently a firm uses its assets to generate sales. A. Inventory Turnover: A.1 Inventory turnover • This ratio means how fast we can sell our inventory. = $1,344/$422 = 3.2 times • The higher the ratio, the more efficiently we are managing inventory. A.2. Days’ sales in inventory • This ratio shows how long or (how many days) does it take to turn it over on average. = 365/3.2 = 114 days • Inventory sits 114 days on average before it is sold. Inventory Turnover= cost of good sold / Inventory Days’ sales in inventory= 365 days/Inventory turnover

29. 3. Asset Management or Turnover, Measures Receivables Turnover =Sales/ Account receivable B. Receivables Turnover B.1 Receivables Turnover = $2,311/$188 = 12.3 times = $2,311/$188 = 12.3 Times • It means that the firm collected credit accounts and reloaned the money 12.3 times during the year. • We are assuming here that all sales are credit sales. B.2 Days’ sales in Receivables = 365/12.3 = 30 days • When the firm increases the days it gives the firm a competitive advantage and when the days are reduced, the company is reducing its financing cost significantly. • Its is also called average collected period. B.3 Payable turnover • Assuming the firm purchase everything on credit, how often the firm pays the money it owes to the creditors (suppliers). Days’ sales in Receivables = 365 days/Receivable turnover Payable turnover= Cost of good sold/Account payable

30. 3. Asset Management or Turnover, Measures NWC Ratio = Sales/ NWC C. Asset Turnover Ratios C.1 NWC Ratio =$2311/(708-540) = 13.8 times • This provides some useful information as to how effectively a company is using its working capital to generate sales. • The higher the better. C.2 Fixed Assets Turnover = $2,311/$2880 = 0.80 times • it means that for every dollar in fixed assets, the company got $0.80 in sales. C.3 Total asset turnover = $2,311/$3588 = 0.64 times • for every dollar in assets, the firm generated $0.64 in sales. Fixed assets turnover= Sales/Net Fixed Assets Turn asset turnover = sales /total assets

31. 4. Profitability Ratios Profitability Ratios • It measures how the efficiently the firm uses its assets and manages its operations. • A.1 Profit Margin = 363/2311 = 15.7% • it means for every dollar in sales the firm generates 0.157 in profit. • A.2 Return on Assets = $363/3,588 = 10.12% • How efficient the company is in using its assets to get earnings. • Measure of profit per dollar of assets. Profit Margin = Net Income / Sales Return on Assets = Net income / total Assets

32. 4. Profitability Ratios Return on Equity (ROE)= Net Income Total Equity A.3 Return on Equity = 363/ 2591 = 14% • How much profit a company generates with the money shareholders have invested. • Sometimes its called return on net worth. • Looking at ROA = 10% AND ROE 14%, the difference shows the amount of financial leverage. • we usually take the average when we calculate ROA,ROE. (ex 3.4).

33. 5. Market Value Ratios • for publicly traded companies • These types of ratios are not included in the financial statements like the (market price per share of stock) is not in the financial statement. • EX. If the company has 33 million shares and from the financial statement the net income was $363 million A. Earning per Share = $363/33 =$11 B. Price earning ratio = $88/$11 = 8 times • Which means that the company’s shares sell for 8 times earnings. • It measures how much investors are willing to pay per dollar of current earnings. • Higher PE s means that the firm has a significant prospects for future growth. • Dividing the PE/ future earning growth rate 100 , results in PEG ratio that shows weather PE ratio is high or low depending EPS= Net Income/ # of shares outstanding • PE = Price per share/Earning per share

34. 5. Market Value Ratios Price sales ratio= price per share/sales per share C. Price sales ratio = $88/ ($2,311/33) = 1.26 • This ratio was created because some starts up companies have negative earnings for some period of time so we replace the net income by sales D. Market to Book Ratio = $88/ (2,591/33) = 1.12 times E. book value per share • This ratio compares the market value of the firm’s investments to their cost. • Book value is a historical cost. • Market value per share/Book value per share • Book value per share= total equity / number of shares outstanding

35. THE DU PONT IDENTITY • ROE = Net Income/ Total Equity • ROE = Net Income/ Total Equity × Assets /Assets ROE = Net Income/ Assets×Assets/Total Equity ROE = ROA × (1 + Debt-Equity ratio) ROE = Sales Sales×Net Income/ Assets×Assets /Total Equity ROE = ROA× Equity Multiplier ROE = (Net Income/ Sales)×(Sales / Assets)×(Assets Total Equity) ROE = Profit margin × Total assets turnover × Equity multiplier

36. THE DU PONT IDENTITY • Du Pont identity tells us that ROE is effected by three things: • Operating activity and its measured by the profit margin. • Asset use efficiency as measured by the total assets turnover. • Financial leverage as measured by the equity multiplier. • If ROE is unsatisfactory , then Du pont tells you where to start looking for the reasons.

37. 3.5 Using Financial Statement Information • The primary reason for looking at accounting information is that we don’t have and cant expect to get market information. • Internal Uses • Performance evaluation • Financial manager insures the financial safety of the company. • Are we liquid enough to cover our current liabilities with our current assets • Can we pay our supplier on time? • Is our level of debt good to minimize our cost of capital? • Do we generate enough income? ..etc • Financial ratios documents a company’s operational and financial strengths and weaknesses and highlight areas that require reaction by the financial management. • Planning for the future.

38. 3.5 Using Financial Statement Information External Uses • financial statements are useful for parties outside the firm, including, short term and long term creditors, and potential investors. • Large customers use this information as well. • Credit rating agencies rely on financial statements in assessing a firm creditworthiness.

39. Choosing a Benchmark Time trend Analysis By looking at the company’s history and compare the result. Peer Group Analysis The second way of establishing a benchmark is by identifying firms similar to our firm (compete in the same market, have similar assets, and operate in similar way). In other words, we need to identify a peer group. • Potential peers is based on Standard Industrial Classification SIC: • Which is a U.S four digit code used to classify a firm by its type of business operation.

40. Review Questions • 1. Which one of the following is a source of cash? A. Increase in accounts receivableB. decrease in notes payableC. decrease in common stockD. increase in accounts payableE. increase in inventory • 2. Which one of the following is a source of cash? A. increase in accounts receivableB. decrease in common stockC. decrease in long-term debtD. decrease in accounts payableE. decrease in inventory • 3. On a common-size balance sheet all accounts are expressed as a percentage of: A. sales for the period.B. the base year sales.C. total equity for the base year.D. total assets for the current year.E. total assets for the base year.

41. Review Questions • 6. A firm has sales of $2,190, net income of $174, net fixed assets of $1,600, and current assets of $720. The firm has $310 in inventory. What is the common-size statement value of inventory? A. 13.36 percentB. 14.16 percentC. 19.38 percentD. 30.42 percentE. 43.06 percent • 5. Over the past year, the quick ratio for a firm increased while the current ratio remained constant. Given this information, which one of the following must have occurred? Assume all ratios have positive values. A. current assets increasedB. current assets decreasedC. inventory increasedD. inventory decreasedE. accounts payable increased • 7. Russell's Deli has cash of $136, accounts receivable of $87, accounts payable of $215, and inventory of $409. What is the value of the quick ratio?