Financial Statements, the Statement of

Cash Flow & Cash Flow Valuation

Income Statement

Records the flow of resources over a specific time

interval, from the beginning to the end - a year.

Accrual Accounting

Recognition of revenues occurs when the efforts needed

to generate the sale have been “substantially” completed

and title to the goods has passed from the seller to the

buyer.

The expenses required to generate the revenues are then

"matched" to the revenues following the accounting

protocol of "accrual“

Accrual = matching expenses to revenues.

Depreciation

The spreading of the cost of a machine/facility over its expected life

To determine three estimates are required:

The asset’s useful life

Its salvage value

Method of allocation to be employed

Straight line

Accelerated depreciation – used to minimize current taxes

Taxes

Tax payable

Short term liability

Deferred taxes

Long term liability

Tax obligations incurred in past periods but not yet paid

Can be used to finance the business

The Balance Sheet

The balance sheet is a "snapshot" at a point in time

of everything the firm owns, and everybody to whom

it owes, i.e., creditors and stockholders.

Assets

Referred to as the "left-hand side" of the balance sheet.

The current assets are listed in one section in the order of

their liquidity.

Inventory is considered a current asset if it will be sold,

converted to account receivables, and then transformed

to cash within a year's period.

Assets also are divided into "tangible" and "intangible.“

Tangible assets

Current assets plus fixed assets that you can "touch."

Intangible assets are ephemeral, i.e., they are difficult to

quantify. Examples of intangible assets include goodwill,

trademarks, patents, and the human capital of employees.

While estimating the value of intangible assets is difficult, or even

impossible, these assets can have a huge impact on the market

value of a firm.

A firm may have very little in the way of fixed assets, but may have a

team of software engineers that are the real basis for the value of

the firm's common stock.

Good example of why the market value of a firm’s equity typically bears

little resemblance to the accounting (or book) value (assets - liabilities) of

“owner’s equity.”

Liabilities

Divided between current and long-term.

Preferred stock

A hybrid security that has some of the properties of debt

and some of the properties of equity.

It falls into a “gray area” and, depending upon the

purpose of the analysis, can either be classified as debt

or equity.

If you are a debt holder analyzing the firm, preferred stock has

an inferior, or "junior," claim to your position. You probably

would consider the preferred stock as equity.

From a common stockholders position, preferred stock has a

superior, or "senior," claim to the cash flows of the firm.

Equity

Accountants typically list a variety of accounts under

the equity section. Standard “sub”-accounts are:

capital (or common) stock,

capital surplus (or capital in-excess of par),

and

retained earnings.

The equity accounts are called the net worth (or

book value) of the firm, or the difference between

the total assets and the total liabilities.

Statement of Retained Earnings

Expresses the relationship between the retained

earnings (R.E.) at the start of the accounting period

and the ending retained earnings balance.

𝐸𝑛𝑑𝑖𝑛𝑔 𝑅. 𝐸.= 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑅. 𝐸. +𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

± 𝐴𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡𝑠

Note: accountants do not generally approve of

making direct adjustments to retained earnings so

the last portion of the equation may be ignored.

Statement of Cash Flow (SCF) Basics

SCF is a summary of a company’s transactions for a given period that affect the cash account. Statement of where the company gets its cash and

how it spends it. Income statement can’t do this because:

It includes accruals that are not cash flows Lists only cash flows associated with the sale of goods or services

during the accounting period

It is derived from the income statement for the period and (at least) the two balance sheets surrounding the period. Put two balance sheets for different dates together and

calculate all the changes in accounts that occurred over the period.

Can be an important diagnostic tool and provide insight into which financial ratios should be calculated to assess the strengths and weaknesses of the firm.

Cash flow information is increasingly viewed as a (the) crucial piece of information for assessing the firm and its financial health by outside audiences.

SCF

The generic structure of the SCF is: Cash provided (used) by operating activities.

Basic running of the business, how fast cash comes in versus how fast it goes out. Tells us about how past investments are generating cash.

Cash provided (used) by investing activities.

Acquisition/sale of new assets.

Cash provided (used) by financing activities.

Raising new capital/retiring old, significant sources/uses of cash.

Increase (decrease) in cash.

Cash – beginning of the period.

Cash – end of the period.

SCF

Operating Activities:

Start with: Net Income (from Operations)

Add: Depreciation & Amortization

Add: Change in Deferred Income Tax

Subtract: Change in NWC (exclude Cash

and interest bearing liabilities)

Total to find: Total Cash from Operations

SCF

Investing Activities:

Acquisitions of fixed assets are (generally) cash outflows.

Sales of fixed assets (net of any tax implications) are (generally)

cash inflows.

Acquisitions of financial assets are outflows.

Sales/maturities of financial assets are inflows.

= Cash Flow from Investing Activities.

SCF

Financing Activities: Subtract the amount of long-term or short-term debt retired.

Add the amounts of newly issued long-term or short-term debt.

Subtract total amount of dividends paid.

Subtract the amount of stock repurchases.

Add the amount of new stock issues.

= Cash Flow from Financing Activities.

Cash Flows and Free Cash Flows

Definitions of Cash Flow

Cash flow

The movement of money into or out of a cash account

over a period of time.

Known as cash earnings

Measures the cash a business generates

Assumes a business’ current assets and liabilities are

either unrelated to operations or do not change over time.

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝐼𝑡𝑒𝑚𝑠

Cash flow from operating activities

A more inclusive measure of cash generation

Cash flow from operating activities = Net Cash Flow

± 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑛𝑑 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Discounted Cash Flow

A family of technique for analyzing investment opportunities

that take into account the time value of money.

Discounted Cash Flow = A sum of money today having the samevalue as a future stream of cash receipts and disbursements

Free Cash Flow

Extends cash flow from operating activities by recognizing that some of the cash a business generates must be plowed back into the business, in the form of capital expenditure, to support growth.

Cash flow from operating activities less capital expenditure.

A fundamental determinant of the value of a business.

𝐹𝐶𝐹= 𝑇𝑜𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑜𝑤𝑛𝑒𝑟𝑠 𝑎𝑛𝑑 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠

𝑎𝑓𝑡𝑒𝑟 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 𝑎𝑙𝑙 𝑤𝑜𝑟𝑡ℎ𝑤ℎ𝑖𝑙𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑎𝑐𝑡𝑖𝑣𝑡𝑖𝑒𝑠

Valuation (Free) Cash Flow

While the SCF is a good diagnostic tool, it does not present cash flow information in a form useful for valuation purposes. Here we do not focus on the change in the cash account as on the

SCF.

Cash itself is really just another asset.

The basic valuation equation.

....4)1(

43)1(

32)1(

2

)1(

10

r

C

r

C

r

C

r

CCV

Valuation (Free) Cash Flow

Need forecasts of all future cash flow generated by current ownership of a firm (asset).

Free Cash Flow (FCF). The cash flow that would be generated by a firm and be available

to be dispersed to its claimants if the firm were all equity financed.

It is important to note that free cash flow is on an enterprise level and is used to value a firm.

Free Cash Flow (FCF)

The most theoretically correct cash flow figure to

use in DCF valuation is labeled Free Cash Flow.

FCF:

Start with: Net Income (from Operations)

Add back: Depreciation & Amortization

Subtract: Change in NWC

Add: Change in deferred income tax – often

ignored

Subtract: Net Capital Expenditures

Add: After tax interest = (1-Tc)Interest

Note: this is really free cash flow from operations, we are ignoring any non-operating

cash flows not contained in Net Cap Ex.

Free Cash Flow (FCF)

Alternatively, FCF can be estimated as:

Start with: EBIT less tcEBIT = EBIT(1-tc) – “unlevered net income”

Add: Depreciation & Amortization Subtract: Net Capital Expenditures Subtract: Change in NWC Add: Change in Deferred Income Taxes

Why Cash Flow and NOT Net Income

Net income is not a measure of cash flow so an adjustment must be made. Accrual accounting.

Off income statement expenses.

Interest.

Net income is, however, a reasonable place to start. It captures, in an accounting sense, what existing assets are generating.

Free Cash Flows and Accrual Accounting

The most obvious problem with using net income to

understand cash flow is that non-cash expenses are

deducted.

The largest and most commonly deducted are

depreciation and amortization.

In order to help turn net income into free cash flow

we have to add these expenses back into net

income.

Revenues Revenue is booked when sales are made. This is true

regardless of whether the sale is for cash or credit. Cash flow must reflect any and only cash flows. If only cash sales are considered, what would that miss?

The timing of credit sales. This problem is corrected by subtracting the change in accounts

receivable.

Expenses Expenses work the same way.

Expenses are booked even if only an accounts payable is recorded rather than an actual cash outflow.

This is correct by adding the change in accounts payable.

The shortcut used to deal with lots of these corrections at once is to subtract the change in NWC.

Free Cash Flows and Tax Accruals There are three tax accrual accounts that tells what is the

difference between “allowance for income taxes” in the public books and actual cash taxes on the tax books. Prepaid taxes is a short term asset account, Taxes payable is a short term liability, and Deferred taxes is a long term liability.

“Book” taxes can be changed to “cash” taxes by adding the change in the asset account and subtracting the changes in the liability accounts to “allowance for income taxes.”

However, in most instances taxes paid is not the goal, rather it is free cash flow. The two short term accounts are dealt with when we look at the

change in NWC so we only have to add the change in deferred taxes to net income.

FCF and Off Income Statement Outflows

An expense that must be taken out of free cash flow that isn’t reflected on the income statement is net capital expenses (CAPEX).

This can be estimated by the change in gross fixed assets over the period (or the change in net fixed assets plus the period’s depreciation).

Free Cash Flows and Interest

A final thing taken out of net income that should

not be taken out of free cash flow is interest

payments.

Should not be removed from free cash flow

because interest is a cash flow that has been

generated and actually paid to contributors of

capital by the firm.

Therefore, add interest back into net income.

Taxes For The All Equity Firm The big difference between the taxes paid by an

all equity firm and a firm that uses debt is that the firm that uses debt pays interest.

The payment of interest generates a tax deduction.

For each dollar of interest paid the firm saves $Interest × tc, where tc is the firm’s tax rate.

Thus the total savings that an all equity firm would not have received is $Interest × tc.

Therefore, subtract $Interest × tc from net income to find free cash flow.

After Tax Interest

A shortcut commonly used in calculating free cash flow is to add after tax interest.

This takes care of “putting interest back” into net income and “adjusting taxes” for the “what if” part of the exercise all at once.

In other words, adding back interest and subtracting the interest tax shield sequentially from net income effectively adds after tax interest to net income: +$Interest – tc×$Interest = +(1-tc)$Interest

Evaluating Financial Performance

Financial Analysis and Planning

Financial Analysis is the selection, evaluation, and

interpretation of financial data, along with other pertinent

information, to assist in investment and financial

decision-making.

May be used internally to evaluate issues such as employee

performance, the efficiency of operations, and credit policies.

May be used externally to evaluate potential investments and

the credit-worthiness of borrowers, among other things.

The financial analyst must select the pertinent

information, analyze it, and interpret the analysis,

enabling judgments on the current and future financial

condition and operating performance of the firm.

Financial Ratios

Combine information from the financial statements to

help us understand and analyze the firm

Example: turnover ratio ( 𝐶𝐺𝑆𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦), the numerator is an

amount from an annual income statement (CGS), while the

denominator is a balance sheet amount (Inventory)

Problem: the balance sheet amount is a snapshot and reflects

only an instant or moment, there is an inconsistency between

the numerator and the denominator.

Solution: Use average of balance sheet amount

The appropriate ratio to use would depend on what the

analyzer is trying to understand about the company

Could be seen as a tool to test a hypothesis about the

firm

Financial Ratios

Financial ratios are used to compare actual financial results with various benchmarks of performance, such as

a firm’s own historical financial ratios to identify improving and deteriorating trends,

comparable ratios from other firms in the same industry, or

comparison of actual ratios versus a previously developed financial plan.

Financial ratios have two primary uses:

Financial control (or analysis)

The activity of comparing ratios to any of these benchmarks

Financial planning

The use of financial ratios to project a firm’s future financial position.

Ratio Analysis

In financial ratio analysis one must select the relevant information – primarily the financial statement data – and evaluate it. Some things to keep in mind are that:

A financial ratio is a comparison between one bit of financial information and another. A single ratio will not provide an all encompassing view of the corporation.

There is no correct value – the appropriate value depends on the analyst and strategy of the corporation.

The best performance benchmark to determine whether the company is doing well is to do a trend analysis; that is, calculate the ratios for a company over several years and see how they change over time.

Classification of Ratios

Ratios can be classified according to the way they are constructed and their general characteristics. By construction, ratios can be classified as:

Coverage Ratio

a measure of a firm’s ability to satisfy (meet) particular obligations

Return Ratio

a measure of the net benefit, relative to the resources expended

Turnover Ratio

a measure of the gross benefit, relative to the resource expended

Component percentage

the ratio of a component of an item to the item

Ratios to measure financial performance can be

divided into three major categories.

Profit Margin or Profitability Ratios

compare components of income with sales

Asset Turnover

measure a company's efficiency in using its assets

it measures the sales generated per dollar of assets

Financial Leverage

Profit Margin or Profitability Ratios

Provide an idea of what makes up a firm’s income

and are usually expressed as a portion of each dollar

of sales.

In simpler terms these ratios:

Measure the portion of each dollar of sales that ends up

as profit.

Helps managers determine the company’s pricing

strategy.

Helps determine the company’s ability to control operating

cost.

Return on Assets The ratio of net income (net profit) to assets.

It measures how efficiently a company manages and allocates resources; i.e., how many dollars of earnings they derive from each dollar of assets they control.

Measures profits considering the money provided by both owners and creditors.

𝑅𝑂𝐴 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑥 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝐴𝑠𝑠𝑒𝑡𝑠

Note that there exist an inverse relationship between profit margin and asset turnover. High profits require lots of assets and this in turn creates lower asset turnover. Good: High profit margin and low asset turnover or high profit margin and

high asset turnover

Bad: Low profit margin and low asset return

Gross Margin

The ratio of gross income or profit to sales.

The percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company.

It indicates how much of every dollar of sales is left after costs of goods sold (variable in nature).

It establishes the percentage of sales dollars (or cents per dollar) that pays for fixed costs and adds to profits.

𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛 =𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡

𝑆𝑎𝑙𝑒𝑠

Operating Expenses to Sales

Gives an indication of the ability of a business to convert

income into profit.

Generally, businesses with low ratios will generate more

profit than others.

Operating margin

A measurement of what proportion of a company's

revenue is left over after paying for variable costs of

production such as wages, raw materials, etc.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 =𝐸𝐵𝐼𝑇

𝑆𝑎𝑙𝑒𝑠

Zero Profit Sales Volume

Used to estimate the breakeven sales volume (in $

amount) of a corporation.

Company loses money when sales are below zero-profit

sales volume and makes money if above.

𝑍𝑒𝑟𝑜 − 𝑝𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑉𝑜𝑙𝑢𝑚𝑒 =𝑇𝑜𝑡𝑎𝑙 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛

Asset Turnover

Asset turnover is meant to measure a company's

efficiency in using its assets.

Measures the sales generated per dollar of assets.

The higher the number, the better.

A high turnover equates to a corporation that is not asset-

intensive.

The higher a company's asset turnover, the lower its

profit margin tends to be (and vice-versa).

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =𝑆𝑎𝑙𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Inventory Turnover

A ratio showing how many times a company's inventory is sold and replaced over a period.

COGS (cost of goods sold) is used because sales are recorded at market value, while inventories are usually recorded at cost.

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =𝐶𝑂𝐺𝑆

𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

# 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑡𝑒𝑚 𝑖𝑠 𝑠𝑜𝑙𝑑 =365

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑂𝐺𝑆/365

Collection Period

The approximate amount of time (days) that it takes for a

business to receive payments owed, in terms of

receivables, from its customers and clients.

A short period is desirable because the firm obtains cash

more quickly for reinvestment or for paying its own bills.

Net sales, instead of credit sales, give a close solution

when the amount of credit sales is not available.

𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =𝐴/𝑅

𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑟 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦

𝐷𝑎𝑦𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 =𝐴/𝑅

𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑟 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠/365

Receivables Turnover

Used to quantify a firm's effectiveness in extending credit

as well as collecting debts.

Is an activity ratio, measuring how efficiently a firm uses

its assets.

𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

=𝑁𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

Day’s Sales in Cash

It indicates the effectiveness of the firm's credit and

collection policies, and the amount of cash and

marketable securities required as buffer for unexpected

delays in cash collection.

Measure of liquidity.

It is the inverse of cash turnover ratio.

𝐷𝑎𝑦′𝑠 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐶𝑎𝑠ℎ

=𝑐𝑎𝑠ℎ 𝑎𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠

𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦

Fixed Asset Turnover

The ratio of sales to fixed assets.

Indicated the ability of the firm’s management to put the

fixed assets to work to generate sales.

Measures a company's ability to generate net sales from

fixed-asset investments - specifically property, plant and

equipment (PP&E) - net of depreciation.

A higher fixed-asset turnover ratio shows that the

company has been more effective in using the investment

in fixed assets to generate revenues.

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑁𝑃𝑃𝐸

Payables Period

Control ratio for a liability rather than asset as those

described before.

An indicator of how long a company is taking to pay its

trade creditors.

Determines how long it takes a firm, on average, to go

from creating a payable (buying on credit) to paying for it

in cash.

𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑃𝑒𝑟𝑖𝑜𝑑 =𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑/365

Cash-to-Cash Cycle (Cash Conversion Cycle) Used to calculate how long cash is tied up in the main cash

producing and cash consuming areas: receivables, payables and inventory.

The lower the number the better.

Steps: Step 1 - Calculate Sales per day and Cost of Goods Sold (CGS)

per day

𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑜𝑛 𝑎𝑛 𝑎𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑏𝑎𝑠𝑖𝑠 =𝑆𝑎𝑙𝑒𝑠

365𝑜𝑟

𝑄𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦 𝑆𝑎𝑙𝑒𝑠 𝑋 4

365

𝐶𝐺𝑆 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑜𝑛 𝑎𝑛 𝑎𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑏𝑎𝑠𝑖𝑠 =𝐶𝐺𝑆

365𝑜𝑟

𝑄𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦 𝐶𝐺𝑆 𝑋 4

365

Step 2 - Calculate Component Days

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 =𝐴/𝑅

𝑆𝑎𝑙𝑒𝑠/365𝑜𝑟

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑄𝑢𝑎𝑟𝑡𝑒𝑟

𝑆𝑎𝑙𝑒𝑠/365

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠 =𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝐺𝑆/365𝑜𝑟

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑄𝑢𝑎𝑟𝑡𝑒𝑟

𝐶𝐺𝑆/365

𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 =𝐴/𝑃

𝐶𝐺𝑆/365𝑜𝑟

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑄𝑢𝑎𝑟𝑡𝑒𝑟

𝐶𝐺𝑆/365

The results are show as whole numbers

Step 3 - Calculate the Cash to Cash Cycle

𝐶𝑎𝑠ℎ 𝑡𝑜 𝐶𝑎𝑠ℎ = 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠

+ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠− 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠

Financial Leverage

Balance Sheet Ratios

Debt to Assets Ratio

Debt to Equity Ratio

Coverage Ratios

Times Interest Earned

Times Burden Covered

Market Value Leverage Ratios

Liquidity Ratios

Current Ratio

Acid Test Ratio

Debt to Assets Ratio

The portion of assets that are financed with debt (both short-term and long-term debt).

The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load.

𝐷𝑒𝑏𝑡 𝑡𝑜 𝑎𝑠𝑠𝑒𝑡 𝑅𝑎𝑡𝑖𝑜 =𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

A debt ratio of greater than 1 or 100% indicates that a company has more debt than assets, meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt.

Debt to Equity Ratio Indicates the relative uses of debt and equity as sources of capital

to finance the firm’s assets, evaluated using book values of the capital sources.

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity.

It indicates what proportion of equity and debt the company is using to finance its assets.

𝐷𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

Times Interest Earned or Interest Coverage Ratio

Used to measure a company's ability to meet its debt

obligations.

It is calculated by taking a company's earnings

before interest and taxes (EBIT) and dividing it by the

total interest payable on bonds and other

contractual debt.

Failing to meet interest obligations could force a

company into bankruptcy.

𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 𝑇𝐼𝐸 =𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

Times Burden Covered

Shows the coverage of the total debt obligations of the firm, old and new.

Measures the burden of debt on the firm.

Coverage should increase as Business Risk increases.

Weakness: assumes the company will pay its existing loans to zero.

𝑇𝑖𝑚𝑒𝑠 𝐵𝑢𝑟𝑑𝑜𝑛 𝐶𝑜𝑣𝑒𝑟𝑒𝑑 =𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡

1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

𝑇𝑎𝑥 𝑟𝑎𝑡𝑒 =𝑝𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛 𝑓𝑜𝑟 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥𝑒𝑠

𝑖𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥𝑒𝑠

Market Value Leverage Ratios

These ratios are more relevant than Book Value ratios.

Book Value does not generally give a true picture of the investment of shareholders in the firm because: Earnings are recorded according to accounting principles

which may not reflect the true economics of transactions, and

Due to inflation, the dollar from earnings and proceeds from stock issued in the past do not reflect today’s values (i.e., it is stated in historical terms)

Market Value is the value of equity as perceived by investors. These are based on investor’s expectations about future cash flows.

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

=𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

# 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠 𝑥 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠=

𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 + 𝑒𝑞𝑢𝑖𝑡𝑦

Market value of debt = total liabilities

Equity = number of share of Stocks x price per share

Current Ratio

The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The higher the current ratio, the more capable the company is of paying its obligations.

A ratio under 1 or 100% suggests that the company would be unable to pay off its obligations if they came due at that point.

Acid Test Ratio

A stringent test that indicates whether a firm has enough

short-term assets to cover its immediate liabilities without

selling inventory.

The acid-test ratio is far more strenuous than the current

ratio, primarily because the working capital ratio allows for

the inclusion of inventory assets.

This ratio is similar to the current ratio except that the

acid-test ratio does not include inventory and prepaids as

assets that can be liquidated.

𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 −𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Companies with ratios of less than 1 cannot pay their

current liabilities and should be looked at with extreme

caution.

If the acid-test ratio is much lower than the working capital

ratio, it means current assets are highly dependent on

inventory. Retail stores are examples of this type of

business.

Return on Equity

Most popular ratio when examining the financial performance of a corporation.

The amount of net income returned as a percentage of shareholders equity.

Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

How much value was created by capital employed

Combines stock (balance sheet) and flow (income statement) accounting information.

ROE is expressed as a percentage.

Determinants of ROE

𝑅𝑂𝐸 =𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑆𝑎𝑙𝑒𝑠𝑥

𝑆𝑎𝑙𝑒𝑠

𝐴𝑠𝑠𝑠𝑒𝑡𝑠𝑥

𝐴𝑠𝑠𝑒𝑡𝑠

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

𝑅𝑂𝐸= 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆𝑎𝑙𝑒𝑠𝑥 𝐴𝑠𝑠𝑒𝑡 𝑈𝑡𝑖𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛𝑥𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 =𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑠 𝑟𝑒𝑝𝑜𝑟𝑡𝑒𝑑 𝑜𝑟 𝑎𝑣𝑒𝑟𝑎𝑔𝑒

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

ROE or Market Price

The role of the financial manager is to maximize shareholder’s value – maximize the price of the stock –rather than maximize ROE. But which one should be used when measuring financial performance? Neither because of they both have problems.

Problems with ROE

Timing

It is backward looking and only considers the short-term.

Fails to capture the full impact of multi-period decisions because it only uses earnings from a single year.

Risk

ROE does not take risk into consideration.

Solution: Use Return on Invested Capital.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑂𝐼𝐶

=𝐸𝐵𝐼𝑇(1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑑𝑒𝑏𝑡 + 𝑒𝑞𝑢𝑖𝑡𝑦

Interest bearing debt = long-term debt due in one year + long

term debt

A calculation used to assess a company's efficiency at

allocating the capital under its control to profitable investments.

The return on invested capital measure gives a sense of how

well a company is using its money to generate returns.

Comparing a company's return on capital (ROIC) with its cost of

capital (WACC) reveals whether invested capital was used

effectively.

Value

ROE uses book value rather than market value

Solution: Use P/E Ratio not the Earnings Yield ratio because

this last one suffers from a severe timing problem.

𝑃 𝐸 𝑟𝑎𝑡𝑖𝑜 =𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

A high P/E suggests that investors are expecting higher

earnings growth in the future compared to companies with

a lower P/E.

Problems with Market Price

Difficulty specifying how operating decisions affect the

price of the stock.

Managers know more than outside investors and should

not consider the assessment of less informed investors.

Depends on factors outside the company’s control.

Possible Problems with Using Financial Ratios

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.

Firms use varying accounting procedures.

Firms have different fiscal years.

Extraordinary, or one-time, events.

EVA

Instead the financial manager should use the

Economic Value Added (EVA).

Measures the value added to shareholders by

management during a given year.

True economic profit over a year.

ACC)Capital)(W (Operating - tax)-(1 EBIT

capital) of cost percentagetax fterCapital)(A (Operating

- tax)-(1 EBIT =EVA

Case of the Unidentified Industries-2006

Background Information Advertising agency

Revenue commissions equal to 15% of media purchases $1.00 of revenue creates $6.67 of account receivable (i.e., $1.00/0.15)

Firms which transact with customers In cash on a face-to-face basis will have a zero day accounts

receivable.

On a credit card basis will receive payment from the credit card issuing bank within a week or two of the charge and not when the customer pays the credit card bill.

Business transaction on open account usually have credit term of 30 days or longer

Department stores with own credit card may have a collection period greater than 30 days

Most will be retailers

Loans of commercial banks are classified as

accounts receivable and deposits as accounts

payable.

Electric and gas utility

The gas portion of the utility is a tangible product that is

carried as inventory

Firm Students Should be …

Advertising Agency

Airline

Bookstore Chain

Commercial Bank

Computer Software Developer

Department Store Chain

Electric and Gas Utility

Family Restaurant Chain

Health Maintenance

Organization

Online Bookseller

Online Computer Vendor

Pharmaceutical Manufacturer

Retail Drug Chain

Retail Grocery Chain

Service Providers – no inventory

Advertising Agency

Airline

Commercial bank

Health maintenance organization (HMO)

Which would match with: E, G, M, N

So what do we know about each industry

Advertising Agency

Low fixed assets and long accounts receivable collection

period ($6.67 for every $1 as mentioned above)

Accounts payable are high because the agency does not

usually pay for its media purchases until after the agency

has collected from its client the funds needed to pay the

media.

E

Airline

High level of property, plant and equipment (airplanes,

ground equipment, reservation system)

M

Commercial bank

Assets are mostly financial in nature

Cash, accounts receivable (loans), accounts payable

(deposits)

N

Health maintenance organization (HMO)

Liquid assets, high accounts receivable, no inventory,

accounts payable (to service providers)

G

Firms with account receivable collection

periods of under 30 days – i.e., those with

business transactions

Accounts

Receivables

Collection Period

Inventory Turnover Plant &

Equipment/Ass

ets

H 2 days 22.3 x 81%

I 4 days 10.2 x 55%

B 7 days 2.7 x 25%

A 12 days 11.4 x 9%

K 16 days 5.7 x 41%

Retailers with account receivable collection

periods of under 30 days

Bookstore

Slowest inventory turnover

B

Family restaurants Fast inventory turnover, mostly cash business

H

Online booksellers

Low property and equipment/assets

A

Drug stores

K

Grocery chains Faster inventory turnover because of produce

I

Left overs…

Inventory

Turnover

(P+E)/Asset

s

Inventory/

Assets %

A/R

Collection

Period

Net

Profits/

Revenue

C 79.8 x 9 2 36 0.064

D 1.6 x 14 5 68 0.158

F 5.2 x 4 2 77 0.285

J 2.3 x 36 22 41 0.063

L 19.8 x 69 2 40 0.068

Matches… Electric and gas utility

Large amount of assets committed to net plant and equipment

Low inventory

L

Online vendor of office computer

High inventory turnover

C

Department store

High plant and equipment (stores0 and inventory

J

Computer software developer

Lower investment in plant and equipment than a

pharmaceutical manufacturer

F

Pharmaceutical manufacturing

D

Balance Sheet

Line Balance Sheet Percentages A Β C D Ε F G H I J Κ L M Ν

1. Cash and marketable securities 54 12 39 19 8 49 11 1 3 1 8 0 18 2

2. Accounts receivable 7 3 24 8 37 13 51 1 3 8 12 5 2 90

3. Inventories 15 42 2 5 0 2 0 7 22 17 35 2 0 0

4. Other current assets 2 2 11 8 5 6 0 3 3 5 2 6 6 0

5. Plant & equipment (net) 9 25 9 14 4 4 7 81 55 36 41 69 66 0

6. Other assets 11 16 15 46 46 25 32 6 13 33 3 18 8 9

7. Total assetsᵃ 100 100 100 100 100 100 100 100 100 100 100 100 100 100

8. Notes payable 0 0 0 10 6 0 8 6 3 4 0 3 4 73

9. Accounts payable 37 26 43 2 39 4 46 7 17 16 24 5 4 5

10. Accrued items 15 22 26 1 1 3 2 8 4 0 5 0 0 0

11 Other current liabilities 0 0 0 11 9 25 0 13 9 3 5 5 19 0

12. Long-term debt 41 0 2 5 15 0 7 16 33 27 0 30 10 15

13. Other liabilities 0 17 11 14 6 10 0 9 13 10 7 26 15 0

14. Preferred stock 0 0 0 0 0 0 0 0 0 0 0 1 0 0

15. Common stock 7 35 18 56 25 58 37 41 21 41 59 29 48 7

16. Total liabilities and net wortha

100 100 100 100 100 100 100 100 100 100 100 100 100 100

Financial Data

A Β C D Ε F G H I J Κ L M Ν

17. Current

assets/current

liabilities

1.52 1.23 1.11 1.65 0.92 2.18 1.10 0.37 0.96 1.34 1.69 0.95 0.94 1.17

18. Cash, MS, and

ARs/current liabilities

1.18 0.31 0.91 1.12 0.82 1.94 1.10 0.08 0.21 0.36 0.59 0.37 0.72 1.17

19. Inventory turnover

(X)

11.4 2.7 79.8 1.6 NA 5.2 NA 22.3 10.2 2.3 5.7 19.8 NA NA

20. Receivables

collection period

(days)

12 7 36 68 201 77 89 2 4 41 16 40 12 4,071

21. Total debt/total

assets

0.41 0.00 0.02 0.15 0.21 0.00 0.16 0.23 0.35 0.31 0.00 0.33 0.14 0.88

22. Long-term

debt/capitalization

0.86 0.00 0.11 0.08 0.33 0.00 0.14 0.26 0.57 0.37 0.00 0.47 0.16 0.15

23. Revenue/total assets 2.297 1.613 2.419 0.439 0.675 0.636 2.079 1.90 2.956 0.675 2.767 0.423 0.542 0.081

24. Net profit/revenue 0.042 0.029 0.064 0.158 0.074 0.285 0.022 0.059 0.016 0.063 0.037 0.068 0.072 0.204

25. Net profit/total assets 0.097 0.046 0.155 0.069 0.050 0.181 0.045 0.112 0.047 0.042 0.102 0.029 0.039 0.016

26. Total assets/net

worth

15.020 2.840 5.600 1.780 4.030 1.740 2.740 2.450 4.670 2.450 1.690 3.30 2.10 13.28

27. Net profit/net worth 1.459 0.131 0.865 0.123 0.200 0.314 0.123 0.275 0.218 0.104 0.173 0.096 0.082 0.218