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- 1. Working With Financial Statements Chapter Three
2. Chapter Outline
- Cash Flow and Financial Statements: A Closer Look
- Standardized Financial Statements
- Ratio Analysis
- The Du Pont Identity
- Using Financial Statement Information
3. Cash Flow and Financial Statements: A Closer Look
- Sources and Uses of Cash
- SOURCES: Activities that bring in cash
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- selling assets, borrowing money or selling securities.
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- USES: Activities that involve cash outflows
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- buying assets, paying off debt, repurchasing stock or paying dividends.
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4. Mechanical Rules for determining Sources and Uses:
- Sources: Decrease in asset account Increase in liabilities or equity account
- Uses: Increase in asset account Decrease in liabilities or equity account
5. The Statement of Cash Flows
- Group cash flows into one of three categories:
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- operating activities
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- investing activities
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- financing activities.
- Note:some considerable simplification in chapter especially with respect to treatment of gains and losses
6. Operating Activities
- + Net Income
- + Depreciation
- + Decrease in current asset accounts (except cash)
- + Increase in current liability accounts (except notes payable)
- Increase in current asset accounts (except cash)
- Decrease in current liability accounts (except notes payable)
7. Investing Activities
- + Ending net fixed assets
- -Beginning net fixed assets
- + Depreciation
8. Financing Activities
- +/- change in notes payable
- +/- change in longterm debt
- +/- change in common stock
- Dividends
9. Putting it all together:
- +/- Net cash flow from operating activities
- +/- Fixed asset acquisition
- +/- Net cash flow from financing activities
- =Net increase (decrease) in cash over the period
10. Standardized Financial Statements:
- Allow users to
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- Compare companies of different sizes
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- Compare a company as it grows through time.
- CommonSize Statements: Useful in comparison of firms of unequal size.
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- Common-Size Balance Sheet express each account as a percent of total assets
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- Common-Size Income Statement express each item as a percent of sales
- CommonBase Year Financial Statements: Trend Analysis
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- Select a base year, then express each item or account as a percent of the baseyear value of that item
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- Useful for picking up trends through time.
11. Combined Common-Size and Base-Year Analysis
- Express each item in base year as a percent of either total assets or sales.
- Then, compare each subsequent year's commonsize percent to the baseyear percent
- Abstracts from the growth in assets and sales.
12. Ratio Analysis
- Considerations
- Categories
13. Things to consider with financial ratios:
- What aspects of the firm are we attempting to analyze?
- What information goes into computing a particular ratio and how does that information relate to the aspect of the firm being analyzed?
- What is the unit of measurement (times, days, percent)?
- What are the benchmarks used for comparison? What makes a ratio "good" or "bad?
14. Categories of Financial Ratios:
- Solvency
- Asset Management
- Profitability
- Market Measures
15. Solvency
- Shortterm Solvency, or Liquidity:ability to pay bills in the short-run
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- Current Ratio= current assets / current liabilities
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- Quick Ratio= (current assets inventory) / current liabilities
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- Cash Ratio= cash / current liabilities
16. Solvency (continued)
- LongTerm Solvency: ability to meet long-term obligations
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- Total debt ratio= (total assets total equity) / total assets
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- Variations:
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- Debt/equity ratio = (total assets total equity) / total equity
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- Equity multiplier = 1 + debt/equity ratio
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- Times interest earned ratio= EBIT / interest
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- Cash coverage ratio= (EBIT +depreciation) / interest
17. Asset Management, or Turnover, Measures: efficiency of asset use
- Inventory turnover= cost of goods sold / inventory
- Days' sales in inventory= 365 days / inventory turnover
- Receivables turnover= sales / accounts receivable
- Days' sales in receivables= 365 days / receivables turnover
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- Ratio also called"average collection period" or "days' sales outstanding
- Total asset turnover= sales / total assets
18. Profitability Measures
- Note
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- These measures are based on book values, so they are not comparable with returns that you see on publicly traded assets.
- General Form:Net Income / Some Base
- Profit margin= net income / sales
- Return on assets= net income / total assets
- Return on equity= net income / total equity
19. Market Value Measures
- How the market values the firm relative to the book values
- Priceearnings ratio= price per share / earnings per share
- Markettobook ratio= market value per share / book value per share
20. The DuPont Identity
- Provides a way to breakdown ROE and investigate what areas of the firm need improvement.
21. DuPont Formulas
- ROE = (NI / total equity)
- Multiply by one:(assets / assets) & Rearrange
- ROE = (NI / assets) (assets / total equity)
- Multiply by one: (sales / sales) & rearrange
- ROE = (NI / sales) (sales / assets) (assets / total equity)
- ROE = profit margin x total asset turnover x equity multiplier
22. Interpretation
- Three ratios indicate that a firm's return on equity depends
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- its operating efficiency (profit margin)
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- its asset use efficiency (total asset turnover)
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- its financial leverage (equity multiplier).
23. Using Financial Statement Information
- Why
- Benchmarks
- Problems/Limitations
24. Why Evaluate Financial Statements
- Internal Uses evaluate performance, look for trouble spots, generate projections
- External Uses making credit decisions, evaluating competitors, assessing acquisitions
25. Choosing a Benchmark
- TimeTrend Analysis look for significant changes from one period to the next
- Peer Group Analysis
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- Compare to other companies in the same industry
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- Use SIC or NAICS codes to determine the industry comparison figures
26. Problems with Financial Statement Analysis
- Lack of Theory: No underlying financial theory
- Finding comparable firms
- What to do with conglomerates, multidivisional firms
- Differences in accounting practices
- Differences in capital structure
- Seasonal variations, onetime events
27. 28. Sources and Uses
- Sources
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- Cash inflow occurs when we sell something
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- Decrease in asset account ( Sample B/S )
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- Cash & equivalents is the only source
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- Increase in liability or equity account
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- Everything except accounts payable is a source
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- Uses
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- Cash outflow occurs when we buy something
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- Increase in asset account
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- Everything except cash & equivalents is a use
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- Decrease in liability or equity account
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- Accounts payable is the only use
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29. Statement of Cash Flows
- Statement that summarizes the sources and uses of cash
- Changes divided into three major categories
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- Operating Activity includes net income and changes in most current accounts
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- Investment Activity includes changes in fixed assets
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- Financing Activity includes changes in notes payable, long-term debt and equity accounts as well as dividends
30. Sample Statement of Cash Flows Numbers in thousands 3,170* -3,319 227,301 -395,521 -36,159 517,764 141,217 *Difference due to rounding of dividends Cash End of Year Net Decrease in Cash Net Cash from Financing Dividends Paid Decrease in C/S Increase in LT Debt Increase in Notes Payable Financing Activity -957,007 Net Cash from Investments -957,007 Fixed Asset Acquisition Investment Activity 726,387 Net Cash from Operations -26,934 Decrease in A/P -82,150 Increase in Other CA -93,692 Increase in Inventory -46,127 Less: Increase in A/R 141,049 Increase in Other CL 362,325 Plus: Depreciation 471,916 Net Income Operating Activity 6,489 Cash, beginning of year 31. Standardized Financial Statements
- Common-Size Balance Sheets
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- Compute all accounts as a percent of total assets
- Common-Size Income Statements
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- Compute all line items as a percent of sales
- Standardized statements make it easier to compare financial information, particularly as the company grows
- They are also useful for comparing companies of different sizes, particularly within the same industry
32. Ratio Analysis
- Ratios also allow for better comparison through time or between companies
- As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important
- Ratios are used both internally and externally
33. Categories of Financial Ratios
- Short-term solvency or liquidity ratios
- Long-term solvency or financial leverage ratios
- Asset management or turnover ratios
- Profitability ratios
- Market value ratios
34. Computing Liquidity Ratios
- Current Ratio = CA / CL
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- 1,801,690 / 1,780,785 = 1.01 times
- Quick Ratio = (CA Inventory) / CL
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- (1,801,690 314,454) / 1,780,785 = .835 times
- Cash Ratio = Cash / CL
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- 3,171 / 1,780,785 = .002 times
35. Computing Long-term Solvency Ratios
- Total Debt Ratio = (TA TE) / TA
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- (4,931,444 1,761,044) / 4,931,444 = .6429 times or 64.29%
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- The firm finances a little over 64% of its assets with debt.
- Debt/Equity = TD / TE
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- (4,931,444 1,761,044) / 1, 761,044 = 1.800 times
- Equity Multiplier = TA / TE = 1 + D/E
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- 1 + 1.800 = 2.800
36. Computing Coverage Ratios
- Times Interest Earned = EBIT / Interest
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- 820,183 / 52,841 = 15.5 times
- Cash Coverage = (EBIT + Depreciation) / Interest
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- (820,183 + 362,325) / 52,841 = 22.38 times
37. Computing Inventory Ratios
- Inventory Turnover = Cost of Goods Sold / Inventory
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- 1,762,721 / 388,947 = 4.53 times
- Days Sales in Inventory = 365 / Inventory Turnover
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- 365 / 4.53 = 81 days
38. Computing Receivables Ratios
- Receivables Turnover = Sales / Accounts Receivable
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- 4,335,491 / 1,095,118 = 3.96 times
- Days Sales in Receivables = 365 / Receivables Turnover
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- 365 / 3.96 = 92 days
39. Computing Total Asset Turnover
- Total Asset Turnover = Sales / Total Assets
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- 4,335,491 / 4,931,444 = .88 times
- Measure of asset use efficiency
- Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
40. Computing Profitability Measures
- Profit Margin = Net Income / Sales
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- 471,916 / 4,335,491 = .1088 times or 10.88%
- Return on Assets (ROA) = Net Income / Total Assets
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- 471,916 / 4,931,444 = . 0957 times or 9.57%
- Return on Equity (ROE) = Net Income / Total Equity
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- 471,916 / 1,761,044 = .2680 times or 26.8%
41. Computing Market Value Measures
- Market Price = $60.98 per share
- Shares outstanding = 205,838,910
- PE Ratio = Price per share / Earnings per share
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- 60.98 / 2.41 = 25.3 times
- Market-to-book ratio = market value per share / book value per share
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- 60.98 / (1,761,044,000 / 205,838,910) = 7.1 times
42. Deriving the Du Pont Identity
- ROE = NI / TE
- Multiply by 1 and then rearrange
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- ROE = (NI / TE) (TA / TA)
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- ROE = (NI / TA) (TA / TE) = ROA * EM
- Multiply by 1 again and then rearrange
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- ROE = (NI / TA) (TA / TE) (Sales / Sales)
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- ROE = (NI / Sales) (Sales / TA) (TA / TE)
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- ROE = PM * TAT * EM
43. Using the Du Pont Identity
- ROE = PM * TAT * EM
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- Profit margin is a measure of the firms operating efficiency how well does it control costs
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- Total asset turnover is a measure of the firms asset use efficiency how well does it manage its assets
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- Equity multiplier is a measure of the firms financial leverage
44. Why Evaluate Financial Statements?
- Internal uses
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- Performance evaluation compensation and comparison between divisions
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- Planning for the future guide in estimating future cash flows
- External uses
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- Creditors
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- Suppliers
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- Customers
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- Stockholders
45. Benchmarking
- Ratios are not very helpful by themselves; they need to be compared to something
- Time-Trend Analysis
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- Used to see how the firms performance is changing through time
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- Internal and external uses
- Peer Group Analysis
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- Compare to similar companies or within industries
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- SIC and NAICS codes
46. Real World Example - I
- Ratios are figured using financial data from the 1999 Annual Report for Ethan Allen
- Compare the ratios to the industry ratios in Table 3.9 in the book
- Ethan Allens fiscal year end is June 30.
- Be sure to note how the ratios are computed in the table so that you can compute comparable numbers.
- Ethan Allan sales = $762 MM
47. Real World Example - II
- Liquidity ratios
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- Current ratio = 2.433x; Industry = 1.4x
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- Quick ratio = .763x; Industry = .6x
- Long-term solvency ratio
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- Debt/Equity ratio (Debt / Worth) = .371x; Industry = 1.9x.
- Coverage ratio
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- Times Interest Earned = 70.6x; Industry = 3.4x
48. Real World Example - III
- Asset management ratios:
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- Inventory turnover = 2.8x; Industry = 3.6x
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- Receivables turnover = 22.2x (16 days); Industry = 17.7x (21 days)
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- Total asset turnover = 1.6x; Industry = 2.2x
- Profitability ratios
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- Profit margin before taxes = 17.4%; Industry = 3.1%
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- ROA (profit before taxes / total assets) = 27.6%; Industry = 5.8%
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- ROE = (profit before taxes / tangible net worth) = 37.9%; Industry = 17.6%
49. 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
- 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
50. Work the Web Example
- The Internet makes ratio analysis much easier than it has been in the past
- Click on the web surfer to go to Multex Investor
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- Choose a company and enter its ticker symbol
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- Click on comparison and see what information is available
51. Quick Quiz
- What is the Statement of Cash Flows and how do you determine sources and uses of cash?
- How do you standardize balance sheets and income statements and why is standardization useful?
- What are the major categories of ratios and how do you compute specific ratios within each category?
- What are some of the problems associated with financial statement analysis?