Cash Flows and Financial Analysis

Users of Financial Information

Investors and Financial Analysts
Make judgments about the firms securities Financial Analysts report to investment community

Vendors
Sell to the firm on credit

Management
Hi-light areas in which attention will improve performance

SOURCES OF FINANCIAL INFORMATION

Annual Report
Management's report card to stockholders on own performance Positively biased The primary source of financial information Required of publicly traded companies Must be audited
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Other Sources
Reports from brokerage firms and advisory services Value Line

STATEMENT of CASH FLOWS

Businesses run on cash, not accounting profits Statement of Cash Flows
Also called or Sources and Uses of Cash or Statement of Changes in Financial Position Shows where money comes from - goes to Developed from the Income Statement and Balance Sheet
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Building the Statement of Cash Flows Basic Approach

Build a Statement of Cash Flows from two balance sheets and an income statement Analyze where money has come from and gone to by:
Adjusting net income for non-cash items Analyzing changes between beginning and ending Balance Sheets
Classify as sources or uses of cash

Begin with a personal example

Buying a Car on Credit Joe Jones and His New Car

Cash Flow Rules Asset Increase = Use Asset Decrease = Source Liability Increase = Source Liability Decrease = Use

Buying and Selling Cars Sally Smith and Her Two Cars

Business Cash Flows

Three sources of cash flows: Operating Activities day-to-day activities Investing Activities firm buys or sells fixed
assets that enable it to do business, long-term purchases, and sales of financial assets.

Financing Activities borrow money, pay off loans, sell stock, pay dividends.
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BUSINESS CASH FLOWS

Figure 3.2

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Free Cash Flows

Cash generated beyond reinvestment needs is free cash flow Net cash flow less non-operating cash requirements (such as worn out fixed assets) If negative, then borrow equity or sell

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RATIO ANALYSIS
Pairs of financial statement numbers formed into ratios Ratios highlight different aspects of performance

The current ratio measures liquidity - ability to pay bills in the short run

Current ratio = current assets current liabilitie s

Current Assets: Money coming in within a year Current Liabilities: Money going out within a year Needed for solvency: Current ratio >> 1.0
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CATEGORIES OF RATIOS

Five Classifications Liquidity Asset Management Debt Management Profitability Market Value Ratios Dont Provide Answers They Help You Ask the Right Questions
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LIQUIDITY RATIOS
Measure the ability to meet short term financial obligations Current Ratio primary measurement of a companys liquidity

current ratio =

current assets current liabilitie s

$77 7 7 , current ra tio = = 77 . $77 7 7 ,

(Examples from Belfry Company)
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LIQUIDITY RATIOS
Quick Ratio (Acid Test) A liquidity measure that does not depend on inventory

current assests - inventory Quick Ratio = current liabilitie s Quick Ratio = $7 - $7 ,777 ,777 =77 .7 $2 ,222

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ASSET MANAGEMENT RATIOS

The fundamental efficiency with which a company is run
AVERAGE COLLECTION PERIOD (ACP) the time it takes to collect on credit sales
ACP =
Interpretation: Customers pay slowly OR there are a few very accounts receivable ACP = 77 old accounts that will 7 sales probably never be collected. $7 ,777

accounts receivable average daily sales

ACP =

77 77 days 7 = 7.7 $77 ,777

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INVENTORY TURNOVER Measures efficiency of inventory use

cost of goods sold inventory OR sales Inventory turnover = inventory Inventory turnover = Inventory turnover = Inventory turnover = $7 ,77 7 =2 .2 $7 ,77 7 $7 ,7 7 77 =7 .7 $7 7 7 ,7

ASSET MANAGEMENT RATIOS

Interpretation: Too much inventory is expensive to carry. Too little causes stockouts which lead to inefficient production and lost sales
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ASSET MANAGEMENT RATIOS

FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER Measure the relationship of the firms assets to a years sales

F e ix d T ta o l F e ix d T ta o l

as t se as t se as t se as t se

tu n v r r oe tu n v r r oe tu n v r r oe tu n v r r oe

= =

s le a s fix d a s ts e se s le a s to l a s ts ta se

,7 7 7 = $7 7 = 7 7 . $7 7 ,7 7 ,7 7 7 = $7 7 = .7 7 $7 7 ,7 7 7

Interpretation: Are there idle or inefficient assets?

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DEBT MANAGEMENT RATIOS

Measures the firms debt level relative to assets, equity, and income DEBT RATIO
Uses a broad concept of debt including current liabilities long- term debt + current liabilities Debt ratio = total assets $7 7 7 2 2 2 ,7 + $ ,2 Debt ratio = = 7 .7 7 % $7 ,7 7 7 7

A high debt ratio is viewed as risky by investors

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DEBT MANAGEMENT RATIOS

DEBT TO EQUITY RATIO
Measures the mix of debt and equity within total capital. An important risk measurement - a high debt level burdens the income statement with excessive interest making failure more likely.

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)

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DEBT MANAGEMENT RATIOS

TIMES INTEREST EARNED (TIE)
Measures the number of times interest can be paid out of earnings before interest and taxes (EBIT)

TIE =

EBIT interest

$7 ,777 TIE = = 2 .2 $777

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DEBT MANAGEMENT RATIOS Cash Coverage

A variation on TIE. Adds depreciation to EBIT to better approximate the cash available to interest.

EBIT + depreciat ion Cash cover = age interest $77 7 7 7 7 , + $7 Cash cover = age = 77 . $7 7 7

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DEBT MANAGEMENT RATIOS

FIXED CHARGE COVERAGE
A variation on TIE to include lease payments as fixed financial charges equivalent to interest
Fixed charge coverage = EBIT + lease payments interest + lease payments $7 ,777 + $777 = 7 .7 $777 + $777

Fixed charge coverage =

Interpretation: Business failure is often a result of the inability to pay interest. Coverage ratios measure the interest burden relative to the ability to pay.
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PROFITABILITY RATIOS
Relative measures of the firms money-making success

RETURN ON SALES (ROS)

net income ROS = sales $7 7 7 ,7 ROS = = 7% 7 $7 ,7 7 7 7

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PROFITABILITY RATIOS
RETURN ON ASSETS (ROA)
Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit

ROA = ROA =

net income total assets $7 ,777 =7% .7 $77 ,777

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PROFITABILITY RATIOS
RETURN ON EQUITY (ROE)
The most fundamental profitability ratio Measures the firms ability to earn a return on the owners invested capital.

net income ROE = equity ROE = $7 ,777 = 7.7 7% $7 ,777

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MARKET VALUE RATIOS

PRICE / EARNINGS RATIO (P/E)
Measures the markets opinion of the stock as an investment
P/E Ratio = EPS = P/E = stock price EPS

$7 ,777 = $7 . 77 22 2

$22 = 7.7 7 $7 . 77

Interpretation: The amount investors will pay for each dollar of earnings. Based primarily on expected growth.

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MARKET VALUE RATIOS

MARKET TO BOOK VALUE RATIO
Total value of the equity on the balance sheet

stock pric e Market tobook valueratio = book valueper share $7 7 Market tobook valueratio = = 22 . $7 7

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Financial Ratios

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Financial Ratios

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Financial Ratios

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Limitations and Weaknesses of Ratio Analysis

Diversified Companies
Analysis of consolidated results generally offers limited insight

Window Dressing
Yearend efforts to make ratios look good

Accounting Principles
Allow a great deal of reporting latitude
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