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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

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

- 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

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

- 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

- 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

- 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

- 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

- 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.

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

- 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 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

- 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 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 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 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 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

- 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 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

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 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 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 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 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

- 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 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 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 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

- 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 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

- 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 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

- Designed to explain ROE
- Not Designed to Calculate ROE
- Can get EM from:

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

- 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

Figure 15.2: Time Line Representation of the 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

- 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

- 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

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