Ch2 - Financial Management Chapter 2 PDF

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Financial Management Chapter 3...

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Chapter 3 Working With Financial Statements

1

Key Concepts and Skills • Understand sources and uses of cash and the Statement of Cash Flows • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Be able to compute and interpret the DuPont Identity • Understand the problems and pitfalls in financial statement analysis 2

Chapter Outline

•Cash Flow and Financial Statements: A Closer Look •Standardized Financial Statements •Ratio Analysis •The DuPont Identity •Using Financial Statement Information

Sample Balance Sheet

Sample Income Statement

Sources and Uses of Cash Sources : Activities that bring cash in (Cash inflow) are sources. Firms raise cash by selling assets, borrowing money or selling securities. – Cash inflow – occurs when we “sell” something – Decrease in asset account • Accounts receivable, inventory, and net fixed assets

– Increase in liability or equity account • Accounts payable, other current liabilities, and common stock

• Uses: Firms use cash to buy assets, pay off debt, repurchase stock or pay dividends. – Cash outflow – occurs when we “buy” something – Increase in asset account • Cash and other current assets

– Decrease in liability or equity account • Notes payable and long-term debt

Sources and Uses of Cash

Statement of Cash Flows • Statement that summarizes the sources and uses of cash over a specified period. • Changes divided into three major categories – Operating Activity – includes net income and changes in most current accounts – Investment Activity – includes changes in fixed assets – Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends

Statement of Cash Flows – A general Statement of Cash Flows 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) Investment Activities » + Ending net fixed assets » - Beginning net fixed assets » + Depreciation

Statement of Cash Flows » » » » »

Financing Activities  Change in notes payable  Change in long-term debt  Change in common stock - Dividends 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

Sample Statement of Cash Flows

Statment Sources and Uses of Cash

Sample Statement of Cash Flows

Standardized Financial Statements • Common-Size Balance Sheets: ฀ Compute all accounts as a percent of total assets. • Common-Size Income Statements: ฀ Compute all line items as a percent of sales • Standardized statements make it easier to compare financial information, particularly as the company grows. -Also, They are also useful for comparing companies of different sizes, particularly within the same industry. • Common-Base Year Financial Statements: (Trend Analysis) Select a base year and then express each item or account as a percent of the base-year value of that item. This is useful for picking up trends through time. Combined Common-Size and Base-Year Analysis

Common-Size Balance Sheet

Common-Size Balance Sheet • Notice that total change has to be zero because the beginning and ending numbers must add up to 100 percent. • Also notice that the statement is relatively easy to read and compare (for example: CA increased from 19.1 to 19.7%, CL decreased from 15.7 to 12.7%)

Common-Size Income Statements

Common-Size Income Statements • Common-Size Income Statement tells us what happens to each dollar in sales (for example: we pay taxes $.061 of each $1 in sales) • Notice that the percentages are useful in comparisons, such as cost control.

Common-Base Year Financial Statements • Common-Base Year Financial Statements (Trend Analysis): Select a base year and then express each item or account as a percent of the base-year value of that item. This is useful for picking up trends through time. • 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 common-size percent to the base-year percent (abstracts from the growth in assets and sales).

Summary of Standardized Financial Statements

Ratio Analysis • Financial ratios: Relationships determined from a firms financial information and used for comparison purposes. • 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 is important • Ratios are used both internally and externally

Categories of Financial Ratios 1. Short-term solvency, or liquidity, ratios: The ability to pay bills in the short-run 2. Long-term solvency, or financial leverage, ratios: The ability to meet long-term obligations 3. Asset management, or turnover, ratios: Efficiency of asset use 4. Profitability ratios: Efficiency of operations and how that translates to the “bottom line” 5. Market value of ratios: How the market values the firm relative to the book values

Computing Liquidity Ratios • Current Ratio = current assets / current liabilities – 708/540= 1.31 times – Current ratio measures short term liquidity, it mean that the company has 1.31 in CA for every 1$ in CL.

• Quick Ratio = (current assets – inventory) / current liabilities – (708 – 422) / 540 = .53 times – Because inventory i the least liquid CA, so it omit inventory from CA, it mean that the company has .53 in CA except the inventory for every 1$ in CL.

Computing Liquidity Ratios • Cash Ratio = cash / current liabilities – 98 / 540 = .18 times – Normally a very short term creditor interested in this ratio.

• NWC to TA = (current assets – current liabilities) / total assets – (708-540) / 3588 = 4.7% – As NWC is viewed as the amount of short term liquidity we use this ratio, a relatively low value indicate a low levels of liquidity.

Computing Liquidity Ratios • Interval Measure = current assets / average daily operating costs – 708 / (1344/365) = 192 days – It give an indicator for how long could the company business keep running in case of strike. – Note that average daily operating costs generally exclude depreciation expense since it is not a cash expense and interest since it is not an operating expense

2. Computing Long-term Solvency Ratios • Total debt ratio = (total assets – total equity) / total assets – (3588-2591) / 3588 = .28 times – It accounts the % of (all debt of all maturities to all creditors) to the assets, it mean that the company has a .28$ in debt for every 1$ in assets. – .28 in debt and (1-.28= .72 ) in equity

• debt/equity ratio = (total assets – total equity) / total equity – (3588-2591) / 2591 = .38 times – Or = Total Debt / Total Equity = .28/.72 = .38

Computing Long-term Solvency Ratios • equity multiplier = 1 + debt/equity ratio – 1 + .38 = 1.38 times – Or = total assets / total equity = 3588/2591 = 1.38

• Long-term debt ratio = long-term debt / (long-term debt + total equity) – 457 / (457+2591) = .15 times – We use this ratio as analysts are more interested in the L-T debt than S-T debt as the S-T debt will constantly be changed, and AP reflect trade practice more than debt management policy. – It mean that the company has a .15$ in L-T debt for every 1$ in assets.

Computing Coverage Ratios • Times Interest Earned = EBIT / Interest – 691/141 = 4.9 times – It measure how well a company has its interest obligations covered ( also called interest coverage ratio)

• Cash Coverage = (EBIT + Depreciation) / Interest – (691+276) / 141 = 6.9 times – It measure company cash flow available to meet financial obligations (we add depreciation because it’s noncash expenses)

3. Asset management ratios 3.1. Inventory Ratios 3.2. Receivables Ratios

3.3. Total Asset Turnover

Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory – 1344/422 = 3.2 times – As long as we are not running out of stock and thereby forgoing sales, the higher ratio is, the more efficiently we are managing inventory.

• Days’ Sales in Inventory = 365 / Inventory Turnover – 365 / 3.2 = 114 days – This mean that inventory sits 114 days on average before it sold.

Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable – 2311/188 = 12.3 times – The company collect its outstanding credit accounts and reloaned the money 12.3 times during the year.

• Days’ Sales in Receivables = 365 / Receivables Turnover – 365 / 12.3 = 30 days – This ratio may also be called “average collection period” or “days’ sales outstanding.” – It mean that the company collects on its credit sales in 30 days on average.

Computing Total Asset Turnover • NWC Turnover = Sales / NWC – 2311 / (708-540) = 13.8 times – It measure how much work we get out of our working capital, the higher value is preferred.

• Fixed Asset Turnover = Sales / net fixed assets – 2311/2880= .80 times – For every $1 in fixed assets, company generate $.80 in sales.

• Total Asset Turnover = Sales / Total Assets – 2311/3588 = .64 times – For every $1 in assets, company generate $.64 in sales – It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

4. Computing Profitability Measures • Profit Margin = Net Income / Sales – 363/2311 = 15.7% – The company generate around 16 cents in profit for every dollar in sales, the higher percentage is preferred.

• Return on Assets (ROA) = Net Income / Total Assets – 363/3588 = 10.12% – Measure of profit per dollar of assets. – The company generate around 10 cents in profit for every dollar of assets.

• Return on Equity (ROE) = Net Income / Total Equity – 363/2591 = 14% – For every dollar in equity, the company generate 14 cents in profit.

5. Computing Market Value Measures • Market Price = $88 per share • Shares outstanding = 33 million • Earnings per share = net income / shares outstanding – 363/33 = $11

• Price-earnings ratio = Price per share / Earnings per share – 88/11 = 8 times – The company shares sell for eight times earning, or have PE multiple of 8. – It measure how much investors are willing to pay per dollar of current earnings. – Higher PEs often take to mean the firm has significant prospectus for future growth

Computing Market Value Measures • Price-Sales Ratio = Price per share / Sales per share – 88/(2311/33) = 1.26

• Market-to-book ratio = market value per share / book value per share – 88 / (2591/33) = 1.12 times – It compares the market value of firm’s investment to their cost. – A value less than 1 could mean that the firm has not been successful overall in creating value for its stockholders.

Computing Market Value Measures • Tobin’s Q = Market value of firm’s assets / Replacement cost of firm’s assets • = Market value of firm’s debt and equity / Replacement cost of firm’s assets – It focuses on what the firm is worth today relative to what it would cost to replace it today. – High ratio tend to be those with attractive investment opportunities or significant competitive advantages. – But it is difficult to estimate the replacement cost.

Deriving the DuPont Identity • The DuPont Identity provides analysts with a way to break down ROE and investigate what areas of the firm need improvement. – ROE = (NI / total equity)

multiply by one (assets / assets) and rearrange – ROE = (NI / assets) (assets / total equity) = ROA*EM

multiply by one (sales / sales) and rearrange – ROE = (NI / sales) (sales / assets) (assets / total equity) – ROE = PM*TAT*EM

Using the DuPont Identity • ROE = PM * TAT * EM – Profit margin is a measure of the firm’s operating efficiency – how well does it control costs – Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets – Equity multiplier is a measure of the firm’s financial leverage

Expanded DuPont Analysis – Aeropostale Data • Balance Sheet Data Cash = 138,356 Inventory = 61,807 Other CA = 12,284 Fixed Assets = 94,601 – EM = 1.654

– – – –

• Computations – TA = 307,048 – TAT = 2.393

• Income Statement Data – – – – –

Sales = 734,868 COGS = 505,152 SG&A = 141,520 Interest = (760) Taxes = 34,702

• Computations – – – –

NI = 54,254 PM = 7.383% ROA = 17.668% ROE = 29.223%

ROE = 29.223%

ROA = 17.668%

EM = 1.654

PM = 7.383%

NI = 54,254

Total Costs = - 680,614

TAT = 2.393

Sales = 734,868

Sales = 734,868

Sales = 734,868

TA = 307,048

Fixed Assets = 94,601

COGS = - 505,152

SG&A = - 141,520

Cash = 138,356

Interest = - (760)

Taxes = - 34,702

Other CA = 12,284

Current Assets = 212,447

Inventory = 61,807

Why Evaluate Financial Statements? • Internal uses – Performance evaluation – compensation and comparison between divisions – Planning for the future – guide in estimating future cash flows • External uses - making credit decisions, evaluating competitors, assessing acquisitions – Creditors – Suppliers – Customers – Stockholders

Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something

• Time-Trend Analysis – Used to see how the firm’s performance is changing through time – Internal and external uses

• Peer Group Analysis – Compare to similar companies or within industries, use SIC or NAICS codes to determine the industry comparison figures. – SIC codes: A US government code used to classify a firm by its type of business operations.

Real World Example - I • Ratios are figured using financial data from the 2003 Annual Report for Home Depot • Compare the ratios to the industry ratios in Table 3.12 in the book • Home Depot’s fiscal year ends Feb. 1 • Be sure to note how the ratios are computed in the table so that you can compute comparable numbers. • Home Depot sales = $64,816 MM

Real World Example - II • Liquidity ratios – Current ratio = 1.40x; Industry = 1.8x – Quick ratio = .45x; Industry = .5x

• Long-term solvency ratio – Debt/Equity ratio (Debt / Worth) = .54x; Industry = 2.2x.

• Coverage ratio • Times Interest Earned = 2282x; Industry = 3.2x

Real World Example - III • Asset management ratios: – Inventory turnover = 4.9x; Industry = 3.5x – Receivables turnover = 59.1x (6 days); Industry = 24.5x (15 days) – Total asset turnover = 1.9x; Industry = 2.3x

• Profitability ratios – Profit margin before taxes = 10.6%; Industry = 2.7% – ROA (profit before taxes / total assets) = 19.9%; Industry = 4.9% – ROE = (profit before taxes / tangible net worth) = 34.6%; Industry = 23.7%

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 (finding comparable firms) • Globalization and international competition makes comparison more difficult because of differences in accounting regulations • what to do with conglomerates, multidivisional firms • Varying accounting procedures, i.e. FIFO vs. LIFO • Different fiscal years • differences in capital structure • Extraordinary events (seasonal variations, one-time events )

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 www.investor.reuters.com – Choose a company and enter its ticker symbol – Click on Ratios and then Financial Condition and see what information is available

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?

End of Chapter...