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Chapter 3 Cash Flows and Financial Analysis © 2000 South-Western College Publishing FINANCIAL INFORMATION Results of operations in money terms Basis for projecting future results Responsibility of management

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chapter 3
Chapter 3

Cash Flows and

Financial Analysis

© 2000 South-Western College Publishing

financial information
FINANCIAL INFORMATION

Results of operations in money terms

Basis for projecting future results

Responsibility of management

USERS OF FINANCIAL INFORMATION

Investors

Make judgments about the firm's securities

Financial Analysts report to investment community

Vendors

Sell to the firm on credit

Management

Highlight areas in which attention will improve performance

TM 3-1 Slide 1 of 3

sources of financial information
SOURCES OF FINANCIAL INFORMATION

Annual Report

Management's report card to

stockholders on its own

performance

Tends to be favorably biased

Other Sources

Brokerage firms, credit bureaus

TM 3-1 Slide 2 of 3

orientation of financial analysts
ORIENTATION OF FINANCIAL ANALYSTS

Critical and investigative

Looking for current or potential problems

Looking for the physical reasons behind financial results

TM 3-1 Slide 3 of 3

cash flow
CASH FLOW

Businesses run on cash, not on accounting profits.

It's possible to go out of business while making a profit.

THE STATEMENT OF CASH FLOWS

Shows where money actually comes from and goes to

Developed from the basic income statement and balance sheet

Other Terminology

Funds flow

Sources and uses (applications) of cash or funds

Statement of changes in financial position

TM 3-2 Slide 1 of 2

basic approach
BASIC APPROACH

Adjust net income for non cash items

Analyze changes in balance sheet accounts between beginning and end of year as sources or uses of cash

Organize and sum

Free Cash Flows

Available after reinvestments needed for growth

and to replace worn-out equipment

TM 3-2 Slide 2 of 2

cash flow rules
CASH FLOW RULES

Asset Increase = Use

Asset Decrease = Source

LiabilityIncrease = Source

Liability Decrease = Use

TM 3-3

cash flows in a business
CASH FLOWS IN A BUSINESS

Organized into three activities

Operating Activities

Routine running of the company

Sales, collections, inventories, wages, etc.

Paying interest on debt

TM 3-4 Slide 1 of 2

investing activities
Investing Activities

Commitment of long term capital

Usually buying or selling fixed assets

Investing Activities

Equity and long term debt transactions

Selling stock and paying dividends

Borrowing and repaying loans

(Note: Interest payment in operating activities)

TM 3-4 Slide 2 of 2

slide10
Operating

Activities

Investing

Activities

Buy Inventory

A GRAPHIC PORTRAYAL OF BUSINESS CASH FLOWS

Figure 3.1 Business Cash Flows

Cash to vendors

Cash to

vendors

Cash to

employees

Stock

Cash price Cash from

from/to customers

stockholders

Cash

Cash to IRS

to/from Repayment

lenders

TM 3-5

Payable

Purchase

Fixed

Assets

Pay Wages

Accrual

CASH

Product

Financing

Activities

Sale

Stock Equity

Receivable

Divs

Loan

Bonds Debt

Intrst

Pay Taxes

another visual representation the cash conversion cycle racetrack diagram
ANOTHER VISUAL REPRESENTATION THE CASH CONVERSION CYCLE(RACETRACK DIAGRAM)

A/R

Figure 3-2 The Cash Conversion Cycle: The Racetrack Diagram

TM 3-6

Cash

Sale

Inventory

Labor

Assets, Taxes, Profits...

building the statement of cash flows
Belfry Company

Balance Sheet

For the Period Ended 12/31/00

ASSETS

12/31/99 12/31/00

Cash $1,000 $1,400

Accts. Receivable 3,000 2,900

Inventory 2,0003,200

CURRENT

ASSETS $6,000 $7,500

Fixed Assets

Gross $4,000 $6,000

Accum. Depr. (1,000) (1,500)

Net $3,000 $4,500

TOTAL ASSETS $9,000 $12,000

LIABILITIES

Accts. Payable $1,500 $2,100

Accruals 500 400

CURRENT LIABIL. $2,000 $2,500

Long-term debt $5,000 $6,200

Equity 2,0003,300

TOTAL CAPITAL $7,000 $9,500

TOTAL LIABILITIES

AND EQUITY $9,000 $12,000

Belfry Company

Balance Sheet

For the Period Ended 12/31/00

Sales $10,000

COGS 6,000

Gross Margin $ 4,000

Expense $ 1,600

Depreciation 500

EBIT $ 1,900

Interest 400

EBT $ 1,500

Tax 500

Net Income $ 1,000

BUILDING THE STATEMENT OF CASH FLOWS

TM 3-7

operating activities
OPERATING ACTIVITIES

Net income $1,000

Depreciation 500

Net changes in

current accounts (600)

Cash from operating

activities $ 900

Detail of Changes in Current Accounts

AccountSource/(Use)

Receivables $ 100

Inventory (1,000)

Payables 600

Accruals (100)

$ (600)

INVESTING ACTIVITIES

Purchase of fixed assets ($2,000)

(Note: excludes cash)

TM 3-8 Slide 1 of 2

financing activities
FINANCING ACTIVITIES

Increase in long-term debt $1,200

Sale of stock 800

Dividend paid (500)

Cash from financing activities $1,500

UNDERSTANDING THE EQUITY ACCOUNT

Amount Activity

Net income $1,000 Operating

Stock sale 800 Financing

Dividend (500) Financing

Change in equity $1,300

TM 3-8 Slide 2 of 2

ratio analysis
RATIO ANALYSIS

Pairs of numbers from the financial statements formed into ratios

Each ratio high-lights a particular aspect of running the business

Example:

The current ratio measures liquidity, the ability to pay bills in the short run

Current Assets: Money coming in within a year

Current Liabilities: Money going out within a year

For solvency need: Current ratio >> 1.0

TM 3-9 Slide 1 of 3

comparisons
COMPARISONS

Ratios are most meaningful when compared with similar figures

History

Prior performance - look for trends

Competitors

Identify strong or weak spots relative to similar businesses

Plan

Is performance better or worse than expected?

AVERAGE OR ENDING BALANCES

Ending when measuring a status

Average when measuring an activity

Distinction important when growth is rapid

TM 3-9 Slide 2 of 3

categories of ratios
CATEGORIES OF RATIOS
  • Liquidity
  • Asset Management
  • Debt Management
  • Profitability
  • Market Value

Ratios Don't Provide Answers

They Help You Ask The Right Questions

TM 3-9 Slide 3 of 3

common size statements
COMMON SIZE STATEMENTS

Ratios of income statement line items

to sales revenue

Facilitates operating comparisons

over time and between

companies of different sizes

TM 3-10 Slide 1 of 2

common size statements19
COMMON SIZE STATEMENTS

Example:

Alpha Beta

$ %$ %

Sales Revenue $2,187,460 100.0 $150,845 100.0

Cost of Sales 1,203,10355.072,40648.0 *

Gross Margin $ 984,357 45.0 $ 78,439 52.0

Expenses 505,30323.139,974 26.5 *

EBIT $ 479,054 21.9 $ 38,465 25.5

Interest 131,2486.015,38610.2 *

EBT $ 347,806 15.9 $ 23,079 15.3

Tax 118,2545.4 3,462 2.3 *

Net Income $ 229,552 10.5 $ 19,617 13.0

* Operating differences worth investigating

TM 3-10 Slide 2 of 2

liquidity ratios
LIQUIDITY RATIOS

Measure the ability to meet short term obligations

(Use ending balances)

(Examples from Belfry Company)

Current Ratio

TM 3-11 Slide 1 of 2

quick ratio acid test
Quick Ratio (Acid Test)

Removes inventory which may be problematic in

generating cash

TM 3-11 Slide 2 of 2

asset management ratios use average balances
ASSET MANAGEMENT RATIOS(Use average balances)

AVERAGE COLLECTION PERIOD (ACP)

How long does it take to collect on credit sales?

Interpretation:All customers paying slow or there are old receivables which may never be collected.

TM 3-12 Slide 1 of 2

inventory turnover
INVENTORY TURNOVER

Measures inventory used to support production and operations

(COGS)

(Sales)

Interpretation: Too much inventory is expensive to carry. Too little causes stockouts: inefficient production and lost sales.

TM 3-12 Slide 2 of 2

fixed asset turnover and total asset turnover
FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER

Measures effectiveness of assets in generating sales

Interpretation: Are there idle or inefficient assets?

Are promotional efforts effective?

TM 3-13

debt management ratios
DEBT MANAGEMENT RATIOS

Measures the firm's debt level relative to assets, equity, and income (Use ending balances)

DEBT RATIO

TM 3-14 Slide 1 of 2

debt to equity ratio
DEBT TO EQUITY RATIO

Debt to Equity Ratio = Long Term Debt : Equity

Debt to Equity = $6,200 : $3,300

= 1.9 : 1

(Stated as 1.9 to 1, since $6,200/$3,300 = 1.9)

Interpretation: Too much debt as a percentage of assets or

equity is an indication that financial risk may

be making the firm unstable.

TM 3-14 Slide 2 of 2

debt management coverage ratios
DEBT MANAGEMENT (COVERAGE) RATIOS

Measure the firm's ability to service debt with operating

income and cash flows

TIMES INTEREST EARNED (TIE)

Measures the interest burden relative to the ability to pay it

TM 3-15 Slide 1 of 3

cash coverage
CASH COVERAGE

A variation on TIE to better get at cash flow

TM 3-15 Slide 2 of 3

fixed charge coverage
FIXED CHARGE COVERAGE

A variation on TIE to include lease payments asfixed financial charges equivalent to interest

Interpretation: Failure from excessive debt is due to the inability to pay interest (fixed) charges which depend on the amount of debt and the interest rate. Coverage ratios measure financial charges relative to available income.

TM 3-15 Slide 3 of 3

profitability ratios
PROFITABILITY RATIOS

Measure profitability relative to sales, assets, and the owners' investment (equity) (Use average balances)

RETURN ON SALES (ROS)

Interpretation: Measures control of pricing, costs, and expenses

TM 3-16 Slide 1 of 3

return on assets roa
RETURN ON ASSETS (ROA)

Interpretation:Measures control of pricing, costs, and expenses

and asset utilization

TM 3-16 Slide 2 of 3

return on equity roe
RETURN ON EQUITY (ROE)

Interpretation:Measures control of pricing, costs, and expenses and asset utilization, and the use of leverage

TM 3-16 Slide 3 of 3

market value ratios
MARKET VALUE RATIOS

Measure the market's opinion of the stock as an investment based on its price (Use ending balances)

PRICE/EARNINGS RATIO (P/E)

Interpretation:The amount investors will pay for each dollar of earnings

Based primarily on expected growth

TM 3-17 Slide 1 of 2

market to book value ratio
MARKET TO BOOK VALUE RATIO

Interpretation:Identifies the going concern value of the firm as perceived by investors

TM 3-17 Slide 2 of 2

du pont equations
DU PONT EQUATIONS

Identify relationships between ratios

TM 3-18 Slide 1 of 3

extended du pont equation
Extended Du Pont Equation

TM 3-18 Slide 2 of 3

using the du pont equations to analyze problems
Using the Du Pont Equations to Analyze Problems

ROA = ROS´Total Asset Turnover

Pillbox Inc. 12% 6% 2 ´

Industry 15% 5% 3 ´

Focus attention on revenue or assets rather

than on cost or expense

TM 3-18 Slide 3 of 3

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