chapter 3 lecture slides
TRANSCRIPT
Cash Flows and Financial Analysis
Chapter 3
Our main coverage for this chapter is financial ratios
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Financial Information—Where Does It Come From, etc.
Financial information is the responsibility of management Created by within-firm accountants Creates a conflict of interest because
management wants to portray firm in a positive light
Published to a variety of audiences
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Users of Financial Information
Investors and Financial Analysts Financial analysts interpret information about
companies and make recommendations to investors
Major part of analyst’s job is to make a careful study of recent financial statements
Vendors/Creditors Use financial info to determine if the firm is
expected to make good on loans
Management Use financial info to pinpoint strengths and
weaknesses in operations
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Sources of Financial Information
Annual Report Required of all publicly traded firms Tend to portray firm in a positive light Also publish a less glossy, more
businesslike document called a 10K with the SEC
Brokerage firms and investment advisory services
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Data sources for term project See the course links page for link to MEL
page http://www.lib.purdue.edu/mel/inst/agec_424.html
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The Orientation of Financial Analysis
Accounting is concerned with creating financial statements
Finance is concerned with using the data contained within financial statements to make decisions The orientation of financial analysis is
critical and investigative
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Ratio Analysis
Used to highlight different areas of performance
Generate hypotheses regarding things going well and things to improve
Involves taking sets of numbers from the financial statement and forming ratios with them
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Comparisons
A ratio when examined alone doesn’t convey much information – but.. History—examine trends (how the value
has changed over time) Competition—compare with other firms
in the same industry Budget—compare actual values with
expected or desired values
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Common Size Statements
First step in a financial analysis is usually the calculation of a common size statement Common size income statement
Presents each line as a percent of revenue
Common size balance sheet Presents each line as a percent of total
assets
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Common Size Statements
$ % $ %Sales 2,187,460$ 100.0% 150,845$ 100.0%COGS 1,203,103$ 55.0% 72,406$ 48.0%Gross margin 984,357$ 45.0% 78,439$ 52.0%Expenses 505,303$ 23.1% 39,974$ 26.5%EBIT 479,054$ 21.9% 38,465$ 25.5%Interest 131,248$ 6.0% 15,386$ 10.2%EBT 347,806$ 15.9% 23,079$ 15.3%Tax 118,254$ 5.4% 3,462$ 2.3%Net Income 229,552$ 10.5% 19,617$ 13.0%
Alpha Beta
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Ratios Designed to illuminate some aspect of how
the business is doing Average Versus Ending Values
When a ratio calls for a balance sheet item, may need to use average values (of the beginning and ending value for the item) or ending values If an income or cash flow figure is combined
with a balance sheet figure in a ratio—use average value for balance sheet figure
If a ratio compares two balance sheet figures—use ending value
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Ratios
5 Categories of Ratios2. Liquidity: indicates firm’s ability to pay its
bills in the short run3. Asset Management: Right amount of assets
vs. sales?4. Debt Management: Right mix of debt and
equity?5. Profitability— Do sales prices exceed unit
costs, and are sales high enough as reflected in PM, ROE, and ROA?
6. Market Value— Do investors like what they see as reflected in P/E and M/B ratios?
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Liquidity Ratios
Current Ratio
= Current AssetsCurrent Ratio
Current Liabilities
To ensure solvency the current ratio should exceed 1.0 Generally a value greater than 1.5 or 2.0
is required for comfort As always, compare to the industry
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Liquidity Ratios
Quick Ratio (or Acid-Test Ratio)
current assets - inventoryQuick Ratio
current liabilities=
Measures liquidity without considering inventory (often the firm’s least liquid current asset)
Not a good ratio for grain farms
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Asset Management Ratios
Average Collection Period (ACP)
Measures the time it takes to collect on credit sales
AKA days sales outstanding (DSO) Should use an average Accounts
Receivable balance, net of the allowance for doubtful accounts
daypersales
receivableaccountsDSOACP ==
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Asset Management Ratios
Inventory Turnovercost of goods sold
Inventory Turnover inventory
=
Gives an indication of the quality of inventory, as well as, how it is managed
Measures how many times a year the firm uses up an average stock of goods
A higher turnover implies doing business with less tied up in inventory
Should use average inventory balance
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Asset Management Ratios
Fixed Asset TurnoverSales (Total)
Fixed Asset Turnover Fixed Assets (Net)
=
Appropriate in industries where significant equipment is required to do business
Long-term measure of performance Average balance sheet values are
appropriate
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Asset Management Ratios
Total Asset TurnoverSales (Total)
Total Asset Turnover Total Assets
=
More widely used than Fixed Asset Turnover
Long-term measure of performance Average balance sheet values are
appropriate
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Debt Management Ratios
Need to determine if the company is using so much debt that it is assuming excessive risk
Debt could mean long-term debt and current liabilities Or it could mean just interest-bearing obligations—
often sources just use long-term debt Debt Ratio
A high debt ratio is viewed as risky by investors Usually stated as percentages
TA
TLRatioDebt =
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Debt Management Ratios
Debt-to-equity ratio Can be stated several ways (as a percentage, or
as a x:y value)
Many sources use long term debt instead of total liabilities
Measures the mix of debt and equity within the firm’s total capital
E
TL
EquityCommon
sLiabilitieTotalEquitytoDebt ==−−
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Sometimes you are given the debt-equity ratio (TL/E) or you may find it in a source for industry ratios. In AGEC 424, I normally want you to use TL/TA. So you need to convert the debt-equity ratio into the TL/TA ratio. The conversion is according to the equation:
Steps in derivation: First use TA = TL+E, to replace TA in the denominator. Second divide numerator and denominator by TL. Third multiply numerator and denominator by TL/E.
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Debt Management Ratios
Times Interest EarnedEBIT
TIE Interest Expense
=
TIE is a coverage ratio Reflects how much EBIT covers interest
expense A high level of interest coverage implies
safety
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Debt Management Ratios
Cash Coverage1
EBIT depreciationCash coverage
Interest Expense
+=
TIE ratio has problems Interest is a cash payment but EBIT is not
exactly a source of cash By adding depreciation back into the
numerator we have a more representative measure of cash
1 EBITDA or “earnings before interest taxes depreciation and amortization” is a commonly used measure of cash flow.
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Debt Management Ratios
Fixed Charge CoverageEBIT Lease Payments
Fixed Charge Coverage Interest Expense Lease Payments
+=+
Interest payments are not the only fixed charges
Lease payments are fixed financial charges similar to interest They must be paid regardless of business
conditions If they are contractually non-cancelable
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Profitability Ratios
Return on Sales (AKA:Profit Margin (PM), Net Profit Margin)
Measures control of the income statement: revenue, cost and expense
Represents a fundamental indication of the overall profitability of the business
Sales
IncomeNetROSPM ==
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Profitability Ratios
Return on AssetsNet Income
ROA Total Assets
=
Adds the effectiveness of asset management to Return on Sales
Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit
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Profitability Ratios
Return on EquityNet Income
ROE Stockholders' Equity
=
Adds the effect of borrowing to ROA Measures the firm’s ability to earn a
return on the owners’ invested capital If the firm has substantial debt, ROE
tends to be higher than ROA in good times and lower in bad times
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Market Value Ratios
Price/Earnings Ratio (PE Ratio)Current stock price
PE Ratio Earnings per share (EPS)
=
An indication of the value the stock market places on a company
Tells how much investors are willing to pay for a dollar of the firm’s earnings
A firm’s P/E is primarily a function of its expected growth
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Market Value Ratios
Market-to-Book Value RatioCurrent stock price
Market-to-Book-Value book value per share (of equity)
=
A healthy company is expected to have a market value greater than its book value Known as the going concern value of the firm
Idea is that the combination of assets and human resources will create an company able to generate future earnings worth more than the assets alone today
A value less than 1.0 indicates a poor outlook for the company’s future
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Du Pont Equations
Ratio measures are not entirely independent
Performance on one is sometimes tied to performance on others
Du Pont equations express relationships between ratios that give insights into successful operation
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Du Pont Equations
Du Pont equations start with expressing ROA in terms of ROS and asset turnover:
States that to run a business
well, a firm must manage costs and expenses
as well as generate lots of sales per dollar
of assets.TurnoverAssetTotalxROSROA
AssetsTotal
Salesx
Sales
IncomeNetROA
Sales
Salesx
AssetsTotal
IncomeNetROA
=
=
=
or
Rearrange
Du Pont Equations• Extended Du Pont equation states ROE in
terms of other ratios
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Equity Multiplier
Net Income sales total assetsROE
Stockholders' Equity sales total assets
or
Net Income sales total assetsROE
sales total assets Stockholders' Equity
or
ROE = ROS Total Asse
= × ×
= × ×
×
14444244443
ROA
t Turnover Equity Multiplier
or
ROE = ROA Equity Multiplier
×
×
144444424444443
Related to the proportion to
which the firm is financed by other people’s
money as opposed to
owner’s money.
EM = [1/(1-L)]; where L = TL/TA
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Du Pont Equations
Extended Du Pont equation states that the operation of a business is reflected in its ROE However, this result—good or bad—can
be multiplied by borrowing The way you finance a business can
exaggerate the results from operations
The Du Pont equations can be used to isolate problems
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Sources of Comparative Information
Generally compare a firm to an industry average Dun and Bradstreet publishes Industry Norms
and Key Business Ratios Robert Morris Associates publishes Statement
Studies U.S. Commerce Department publishes Quarterly
Financial Report Value Line provides industry profiles and
individual company reports Go to MEL page for AGEC 424
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Limitations/Weaknesses of Ratio Analysis
Ratio analysis is not an exact science and requires judgment and experienced interpretation Examples of significant problems
Diversified companies—because the interpretation of ratios is dependent upon industry norms, comparing conglomerates can be problematic
Window dressing—companies attempt to make balance sheet items look better than they would otherwise through improvements that don’t last
Accounting principles differ—similar companies may report the same thing differently, making their financial results artificially dissimilar
Inflation may distort numbers