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Cash Flows and Financial Analysis Chapter 3 Our main coverage for this chapter is financial ratios Financial Information—Where Does It Come From, etc . Financial information is the responsibility of management Created by within-firm accountants

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cash flows and financial analysis

Cash Flows and Financial Analysis

Chapter 3

Our main coverage for this chapter is financial ratios

financial information where does it come from etc
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
users of financial information
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
sources of financial information
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
slide5
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
the orientation of financial analysis
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
ratio analysis
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
comparisons
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
common size statements
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
ratios
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

In this class we usually cheat and

just use the ending balance sheet.

Often it is the only one given.

ratios12
Ratios
  • 5 Categories of Ratios
  • Liquidity: indicates firm’s ability to pay its bills in the short run
  • Asset Management: Right amount of assets vs. sales?
  • Debt Management: Right mix of debt and equity?
  • Profitability— Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
  • Market Value— Do investors like what they see as reflected in P/E and M/B ratios?
liquidity ratios
Liquidity Ratios
  • Current Ratio
  • 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
liquidity ratios14
Liquidity Ratios
  • Quick Ratio (or Acid-Test Ratio)
  • Measures liquidity without considering inventory (often the firm’s least liquid current asset)
  • Not a good ratio for grain farms
asset management ratios
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
asset management ratios16
Asset Management Ratios
  • Inventory Turnover
  • 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
asset management ratios17
Asset Management Ratios
  • Inventory conversion period -- Days of sales in inventory
  • An alternate measure of inventory size
  • Has the same information as ITO
  • Inventory/COGS/360
  • 360/ITO
  • Used in cash conversion cycle (CCC) calculation
asset management ratios18
Asset Management Ratios
  • Fixed Asset Turnover
  • Appropriate in industries where significant equipment is required to do business
  • Long-term measure of performance
  • Average balance sheet values are appropriate
asset management ratios19
Asset Management Ratios
  • Total Asset Turnover
  • More widely used than Fixed Asset Turnover
  • Long-term measure of performance
  • Average balance sheet values are appropriate
debt management ratios
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
debt management ratios21
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
slide22

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.

debt management ratios23
Debt Management Ratios
  • Times Interest Earned
  • TIE is a coverage ratio
    • Reflects how much EBIT covers interest expense
    • A high level of interest coverage implies safety
debt management ratios24
Debt Management Ratios
  • Cash Coverage1
  • 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

1EBITDA or “earnings before interest taxes depreciation and

amortization” is a commonly used measure of cash flow.

debt management ratios25
Debt Management Ratios
  • Fixed Charge Coverage
  • 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
debt management ratios26
Debt Management Ratios
  • Days of sales in accounts payable
  • Accounts Payable deferrals
  • Accounts Payable/(COGS/360)
  • A measure of how large accounts payable are in comparison to COGS (sales)
  • Used in CCC calculation
profitability ratios
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
profitability ratios28
Profitability Ratios
  • Return on 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
profitability ratios29
Profitability Ratios
  • Return on 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
profitability ratios30
Profitability Ratios
  • Basic earnings power
  • BEP = EBIT/Total Assets
  • Compare to the pre-tax interest rate
  • Return on capital employed
  • ROCE = EBIT(1-T)/Total Assets
  • Compare to after tax interest rate
market value ratios
Market Value Ratios
  • Price/Earnings Ratio (PE Ratio)
  • 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
market value ratios32
Market Value Ratios
  • Market-to-Book Value Ratio
  • 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
du pont equations
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
du pont equations34
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.

extended du pont equation
Extended Du Pont Equation
  • Designed to explain ROE
  • Not Designed to Calculate ROE
  • Can get EM from:
du pont equations36
Du Pont Equations
  • Extended Du Pont equation states that the operation of a business is reflected in its ROA
    • 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
operations cash conversion cycle
Operations—Cash Conversion Cycle
  • A firm begins with cash which then “becomes” inventory
    • Which then becomes a product which is sold
    • Eventually this will turn into cash again
  • The firm’s operating cycle is the time from the acquisition of inventory until cash is collected from product sales
cash conversion cycle
Cash Conversion Cycle
  • CCC = ICP + DSO – AP Deferral
  • The shorter the CCC the less interest bearing and/or equity capital is needed to fund operations.
  • This can be very significant for businesses with high working capital
sources of comparative information
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 Lineprovides industry profiles and individual company reports
    • Go to MEL page for AGEC 424
limitations weaknesses of ratio analysis
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