chap003_DW.ppt

• 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

• • • selling assets, borrowing money or selling securities.

• • • USES: Activities that involve cash outflows

• • • buying assets, paying off debt, repurchasing stock or paying dividends.

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:

• • operating activities

• • investing activities

• • 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

• • Compare companies of different sizes

• • Compare a company as it grows through time.

• CommonSize Statements: Useful in comparison of firms of unequal size.

• • Common-Size Balance Sheet express each account as a percent of total assets

• • Common-Size Income Statement express each item as a percent of sales

• CommonBase Year Financial Statements: Trend Analysis

• • Select a base year, then express each item or account as a percent of the baseyear value of that item

• • 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

• • Current Ratio= current assets / current liabilities

• • Quick Ratio= (current assets inventory) / current liabilities

• • Cash Ratio= cash / current liabilities

16. Solvency (continued)

• LongTerm Solvency: ability to meet long-term obligations

• • Total debt ratio= (total assets total equity) / total assets

• • • Variations:

• • • • Debt/equity ratio = (total assets total equity) / total equity

• • • • Equity multiplier = 1 + debt/equity ratio

• • Times interest earned ratio= EBIT / interest

• • 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

• • Ratio also called"average collection period" or "days' sales outstanding

• Total asset turnover= sales / total assets

18. Profitability Measures

• Note

• • 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

• • its operating efficiency (profit margin)

• • its asset use efficiency (total asset turnover)

• • 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

• • Compare to other companies in the same industry

• • 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

• • Cash inflow occurs when we sell something

• • Decrease in asset account ( Sample B/S )

• • • Cash & equivalents is the only source

• • Increase in liability or equity account

• • • Everything except accounts payable is a source

• Uses

• • Cash outflow occurs when we buy something

• • Increase in asset account

• • • Everything except cash & equivalents is a use

• • Decrease in liability or equity account

• • • Accounts payable is the only use

29. Statement of Cash Flows

• Statement that summarizes the sources and uses of cash

• 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

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

• • 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

• 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

• • 1,801,690 / 1,780,785 = 1.01 times

• Quick Ratio = (CA Inventory) / CL

• • (1,801,690 314,454) / 1,780,785 = .835 times

• Cash Ratio = Cash / CL

• • 3,171 / 1,780,785 = .002 times

35. Computing Long-term Solvency Ratios

• Total Debt Ratio = (TA TE) / TA

• • (4,931,444 1,761,044) / 4,931,444 = .6429 times or 64.29%

• • The firm finances a little over 64% of its assets with debt.

• Debt/Equity = TD / TE

• • (4,931,444 1,761,044) / 1, 761,044 = 1.800 times

• Equity Multiplier = TA / TE = 1 + D/E

• • 1 + 1.800 = 2.800

36. Computing Coverage Ratios

• Times Interest Earned = EBIT / Interest

• • 820,183 / 52,841 = 15.5 times

• Cash Coverage = (EBIT + Depreciation) / Interest

• • (820,183 + 362,325) / 52,841 = 22.38 times

37. Computing Inventory Ratios

• Inventory Turnover = Cost of Goods Sold / Inventory

• • 1,762,721 / 388,947 = 4.53 times

• Days Sales in Inventory = 365 / Inventory Turnover

• • 365 / 4.53 = 81 days

38. Computing Receivables Ratios

• Receivables Turnover = Sales / Accounts Receivable

• • 4,335,491 / 1,095,118 = 3.96 times

• Days Sales in Receivables = 365 / Receivables Turnover

• • 365 / 3.96 = 92 days

39. Computing Total Asset Turnover

• Total Asset Turnover = Sales / Total Assets

• • 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

• • 471,916 / 4,335,491 = .1088 times or 10.88%

• Return on Assets (ROA) = Net Income / Total Assets

• • 471,916 / 4,931,444 = . 0957 times or 9.57%

• Return on Equity (ROE) = Net Income / Total Equity

• • 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

• • 60.98 / 2.41 = 25.3 times

• Market-to-book ratio = market value per share / book value per share

• • 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

• • ROE = (NI / TE) (TA / TA)

• • ROE = (NI / TA) (TA / TE) = ROA * EM

• Multiply by 1 again and then rearrange

• • ROE = (NI / TA) (TA / TE) (Sales / Sales)

• • ROE = (NI / Sales) (Sales / TA) (TA / TE)

• • ROE = PM * TAT * EM

43. Using the Du Pont Identity

• ROE = PM * TAT * EM

• • Profit margin is a measure of the firms operating efficiency how well does it control costs

• • Total asset turnover is a measure of the firms asset use efficiency how well does it manage its assets

• • Equity multiplier is a measure of the firms financial leverage

44. 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

• • Creditors

• • Suppliers

• • Customers

• • Stockholders

45. Benchmarking

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

• Time-Trend Analysis

• • Used to see how the firms performance is changing through time

• • Internal and external uses

• Peer Group Analysis

• • Compare to similar companies or within industries

• • 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

• • Current ratio = 2.433x; Industry = 1.4x

• • Quick ratio = .763x; Industry = .6x

• Long-term solvency ratio

• • Debt/Equity ratio (Debt / Worth) = .371x; Industry = 1.9x.

• Coverage ratio

• • Times Interest Earned = 70.6x; Industry = 3.4x

48. Real World Example - III

• Asset management ratios:

• • Inventory turnover = 2.8x; Industry = 3.6x

• • Receivables turnover = 22.2x (16 days); Industry = 17.7x (21 days)

• • Total asset turnover = 1.6x; Industry = 2.2x

• Profitability ratios

• • Profit margin before taxes = 17.4%; Industry = 3.1%

• • ROA (profit before taxes / total assets) = 27.6%; Industry = 5.8%

• • 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

• • Choose a company and enter its ticker symbol

• • 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?