Chapter 3 Cash Flows and Financial Analysis Sources of financial information (BIASED)

What is Financial Information?  Annual report for stockholders (several years of

 Results of business operations in money financial info)
terms  Must be audited, level of assurance in
 Not only a document accordance with GAAP
 Used by stakeholders in and out for  Minimize or ignore failures, exaggerate success,
decisions and relationships. build opportunities unrealistically.
 It is created by accountants and auditors; Brokerage firms offer free financial information.
they review it to guarantee correctness.
 Preparing financial information is the Investment advisory services might ask for a fee
responsibility of management. Advertisements use flowery words, marketing, and
strategic information.
Who are the users of financial information? Finance uses financial statements to evaluate
1. Investors and financial analysts – must be business and their future prospects.
interested in buying stocks or might be  Look for problems
asked to lend money.  Why do we borrow money? What does it
 Lenders – concerned with the firms' mean? Can the firm pay? Will we need
stability and cash flow (will they more?
lend you)
 Stockholders – prospects for growth In finance, attitude is critical and investigative.

They may also analyze financial statements and Statement of Cash Flows – the movement of cash
may rely on the reports of financial analysts (work in and out the company.
in large brokerage firms or other financial
 Statement of changes in financial position
institutions.
 In (+) where it came (sold); and out (-) are
what we bought shown in parentheses as
negative numbers.
 Financial analysts – study the company and  Constructed from balance sheet and income
predict the firm’s performance. statement; NOT CLOSED.
They are the main audience for
investor oriented information 2 balance sheets 1 income statement
They present financial statements Beginning and end; the From the period
(relate to the past) beginning is the end of
the previous; it carries
2. Vendors or Creditors – advancing funds in on
the form of product and services. They are
invested like lenders. Does the firm have 1. Net income and adjust it
cash available to pay its debts in the 2. Two consecutive balance sheets and analyze
immediate future? the changes and how it affect the cash
balance.
3. Management – final group interested. They
study the successes and failures to pinpoint Cash Flow notes:
strengths and weaknesses. They know where Asset Increase Use -
to put effort to correct problems and Liability Decrease Use -
improve performance. Asset Decrease Source +
 Liability Increase Source +  Cash is generated by operations available for
Income is represented by adjusting net income distributions to investors
 Operating cash flow plus assumption that
Operating – day2day basis
firm will remain competitive
Investing – buys or sells that return more than its
Earnings before interest and taxes (EBIT)
cost
 Cost – Expenses (except interest and tax)
Financing – borrow money, pay loan, sell stock, pay
 Not influenced by how the company is
dividend. Raise money
financed
Operating  Operating profit (EBIT) exclude financing
Operating Activities – cash generated from Net Operating Profit After Tax (NOPAT)
operations; produce net income
 EBIT – (T) (EBIT) = EBIT (1-T)
Operating Income – net income with non-cash  Equals net income (if no debt)
(depreciation)
Operating Cash Flow
Operating transactions = current balance sheet
 NOPAT + Depreciation
Current Accounts:  Fixed assets must exceed depreciation
(Depreciation is noncash)
Accounts receivable Accounts Payable
Inventories Accruals FCF = Operating Cash Flow – Increase in Gross
Fixed Assets – Increase in Current Accounts
Depreciation is non-cash that is why you add it to Money available to investors is operating cash flow
Net Income. less funds to support asset growth.
Investing Positive operating cash flow provides enough cash
for asset growth
Investing includes (gross) fixed assets. It is NOT
net because “net” includes reduction for Negative, investors have to makeup shortfall
accumulated depreciation which was already
It helps the investor decide whether they buy a
included in the operating section.
company or not. Will it generate cash? Or will it
Financing require cash?
1. Increase in long-term debt.  Increase fixed assets
2. Sale of stock results in increase in source of  Increase working capital or current accounts
equity (liability)
There is a principal payment if there is a long-term
3. Dividend payment is the use of money
debt, there is NO principal payment.
which decreases equity (liability)
Free Cash Flow + Equity (FCFE)
Investors buy whole companies with a history of
steady growth. Can it generate cash? Company can distribute cash to stockholders while
continuing to perform as it has if company is
Free Cash Flow (FCF) – will a company provide
acquired subject to existing debt.
cash or require it in the future?
FCFE = Operating cash flow – increase in gross
 Positive business operations fund their own
fixed assets – increase in current accounts – (1-
growth, upkeep, money is available to pay
T)Interest (after tax) - Principal reduction
interest and dividends.
 Negative require cash contributions outside
The result will either show whether company can Competition – Other company’s performance is a
support own performance or is in need of new good yardstick for evaluating a firm’s performance.
funds. Find out why. Industry average data.
Cash conversion cycle (racetrack diagram) Budget – plan involves a projected set of financial
statements from which ratios can be developed.
Product is converted into cash, which is transformed
into more product, creating cash conversion cycle. 1. Common size statements
 First step, calculation of a set of ratios
Cash – Product – Cash
 Each line item as a percentage of revenue
Ratio Analysis  Frequently used.

 Is the general technique they use in Cost ratio – cost of sales/sales revenue
analyzing transformation.
Expense ratio – expense as percentage of revenue
 Financial ratios are formed from sets of
financial statement figures. Return on sales – net income of percentage of
 Ratios highlight different aspect of sales.
performance.
2. Ratio for balance sheet
Current Ratio  Ratios don’t provide answers they help you
ask the right questions
 Ratio that gives a quick indication of
 Depends on what the ratio is measuring
whether the company will have the means to
(beginning, ending or average) WE WILL
pay its bills during the next year.
USE ENDING.
 “current” – cash will be generated or
 Beginning values are never appropriate
required within a year
 If the firm is shrinking rapidly, average and
 To be solvent, a company must have at least
ending values are important
as much money coming in as it has going
out. Liquidity management – the firm’s ability to
 Current ratio = current assets / current pay its bills in the short-run
liabilities (both end)
Asset management – how the company uses its
 In every assets, there is a liability. 1:1
resources to generate revenue and profit and to
 Measures liquidity (company’s ability to pay
avoid cost
its bills in the short-run)
Debt management – how effectively the firm
Financial Ratio
uses other people’s money and whether its using
 Are formed from sets of financial statement too much borrowed money.
figures. Ratios highlight different aspects of
Profitability – gives us several measures by
performance.
which to assess the success of the whole venture
 Comparisons are made with respect to
in making money.
history, the competition and the budget.
 Liquidity is the ability to pay its bills in the Market value – give an indication of how
short-run. investors feel about the company’s financial
future.
History – looking at ratio next to the same figure
calculated for the same organization in one or more Liquidity ratio – measures the ability to meet
immediately preceding accounting periods. The short-term obligations
idea is to look for trends.
Current Ratio
 Primary measure of company liquidity
  Current ratio = current assets/current  Measure the relationship of the firms asset
liabilities to a year’s sale. Relationship between assets
and sales
Quick ratio or Acid test
 Fixed asset turnover = sales/fixed asset
 Inventory cannot be immediately converted  Total assets turnover = sales/total assets
to cash  Better is generate more sales with a given
 Also deduct prepaid expenses and other level of assets
assets that never become cash  Not if generate few sales with same assets
 Quick ratio is nearest to cash, easy to avail  Stated in times, x
cash
Debt Management Ratio
 Quick ratio = current assets – inventory/
current liabilities  Any source of money other than equity
 Important to creditors and stockholders, how
Asset Management Ratio – fundamental efficiency
the firm uses other people’s money to its
with which a company is run
own advantage
Average Collection Period (ACP)  Firms should not use this as much
(borrowing, trade credit)
 Average number of days the firm takes to  Total debt figure = current liabilities + long-
collect its receivables term debt
 How long does it take to get paid on credit
sales Debt Ratio
 Also DSO or days sales outstanding,
 Total debt concept and measures the
receivable cycle
relationship between total debt and equity in
 Stated in days (units of measure)
supporting a firms assets
 ACP = accounts receivable/average daily
 Debt ratio = long-term + current liabilities
sales (360)
total/ current assets
 ACP = accounts receivable /average daily
sales x 100 Debt to Equity Ratio
 The longer to collect money, the worse
 Uses long-term debt
 Most credit business runs on 30 days
 Debt to equity ratio : long-term debt : equity
 Discounts offered to encourage early
 Interest is fixed and must be paid regardless
payment
of whether revenue is healthy or not.
 Old receivables should be written off
 Financial risk is the risk associated with debt
without delay or reserved through allowance
and interest
for doubtful accounts. The value of
receivables balance net of ADA should be Time Interest Earned (TIE)
used in calculation.
 ACP = (end) ar/sales x 360  Burdening the income statement with
interest more directly. Measures the number
Inventory turnover ratio of times interest can be paid out earnings
before interest and taxes (EBIT)
 Measure excess funds tied up in inventory
 TIE = EBIT /Interest
 Gives an indication of the quality of
inventory as well as how well it is managed. Cash coverage
 Inventory turnover = COGS/inventory
 High turnover is better because holding  interest is cash payment but EBIT is not
inventory causes costs. exactly a source of cash. It is income
 Inventory turnover = Sales/inventory statement subtotal. More or less cash than
EBIT may be available in any given year to
Fixed Asset and Total Asset Turnover pay interest.
  Depreciation- subtracted as part of cost and  ROA adds the effectiveness of asset
expense in the calculation of EBIT management ROS
 Cash coverage – depreciation added to EBIT  ROA = net income/total assets
in numerator
Return on Equity (ROE)
 Cash coverage = EBIT + depreciation/
interest.  Most fundamental profitability ratio. Net
income as percentage of equity
Fixed charge coverage
 Measures the firm’s ability to earn a return
 leased equipment is necessary to stay in on the owner’s invested capital.
business or if noncancellable  ROE = net income/ equity
 To come to EBIT, lease payments are
Market value ratios- not controlled by management,
subtracted along other costs and expenses
but can influence. Market value of a company is
 It needs to be added back in the numerator
reflected in its stocks.
to arrive at the cash figure available to pay
all fixed charges. Price or Earning Ratio
 Fixed coverage charge = EBIT + lease
payments/ interest + lease payments  Compares market price of stock to the EPS
 Other fixed charges can be added to calculated from the latest income statement
numerator and denominator  EPS = net income/number of shares of
common stock
Earning before Interest, Tax, Depreciation and  PE ratio = stock price/EPS
Amortization (EBITDA)
Market to Book value ratio
 EBITDA = EBITDA + lease payments/
interest+ lease payment+ principal payment  a book value is the total value of the equity
on its balance sheet.
Profitability Ratio  =A-L.
 A healthy company is expected to have
 Fundamental measure of a business success
market value in excess of book value.
is profit
 Market to book value ratio = stock
 No profit, no dividends
price/book value per share
 No dividends, no expectation
 Give relative measures of the firm’s money- Du Point Equations – express the relationship
making success between ratios that gives insights into successful
 Percentages operations.
Return on Sales (ROS) 1. ROA = net income/total assets x sales/sales
2. ROA = net income/sales x sales/total assets
 Also called profit margin or net profit
3. ROA = ROS x total asset turnover
margin. Net income as percentage of sales.
 ROS = net income/sales Roa is a fundamental measure of performance, how
 Measures the control of the income a company uses its assets to generate profits
statement: revenue, expense, cost
 Overall indication of business profitability 1. ROE = net income/equity x sales/sales x
total assets/total assets
Return on Assets (ROA) 2. ROE = net income/sales x sales/total assets
x total assets/equity
 Uses assets and the skills of its people to
earn a profit. ROA quantifies the success of Economic Value Added (EVA) – subtract cost of
that effort with respect to assets by stating debt and equity. Cost of capital average “interest
net income as a percentage of total assets.
rate” that reflects the rate of return the business
pays to suppliers
EVA = EBIT (1-T) – (debt+equity) (cost of
%capital)