Cash Flow and Financial Statements in Finance

+ Working With Financial Statements ch 3

+Using Financial Statement Our goal in this chapter is to expand our understanding of the uses of financial statement information. Keep in mind we have different users of financial statement. Although market value information is more important to financial managers, they rely more on accounting numbers because they are unable to obtain all the market information they want. Accounting numbers are just pale reflection of economic reality but they are the best available information.

+3.1 Cash Flow and Financial Statements Cash flow from the assets= Cash flow to creditors +Cash flow to shareholders The previous formula simply means that firms do two things: Generate cash ( Source of cash) Spend cash ( Use of cash ) Source of Cash: A firm s activity that generate cash. Examples: selling a product, selling an asset, selling a security (by selling bonds to borrow money or by selling a share of stock) Uses of Cash: A firm s activity in which cash is spent. Examples: paying for materials and labor to produce a product, purchasing assets, payment for creditors and owners.

+Sources and Uses of Cash ^ v Liabilities v Assets ^ Liabilities Assets ^ MONEY v MONEY Source of Cash Use of Cash

2008 2009 change cash. + Current Assets Assets Cash $84 $94 +$14 Account Receivable $165 $188 +$23 USE Inventory $393 $422 + $29 USE Total $642 $708 +$66 Fixed Assets Net plant and Equipment $2,731 $2,880 +$149 USE Total Assets $3,373 $3,588 +$215 Liabilities and Owner s Equity Current liabilities Account payable $312 $344 + $32 Source Notes Payable $231 $196 - $35 Use Total $543 $540 -$3 Long term debt $531 $457 -$74 Use Owner s Equity Common stock $500 $550 +$50 Source Retained earning $1,799 $2,041 +242 Source Total $2,299 $2,591 +$292 $3,373 $3,588 +$215 Total liabilities and owner s equity

+Analyzing the Results You might ask, how did we get the +$14 increase in cash in the previous balance sheet The answer is : All sources of cash All uses of cash In Our example: sources of cash (increase 32 in account payable + $50 increase in common stock + $242 increase retained earnings= $324) uses of cash ( $23 increase in account receivable + $29 increase in inventory + $35 decrease in note payable + $74 decrease in long term debt + $149 increase in fixed assets acquisition = $310) $324 - $310 = $14 in cash.

+The Statement of Cash Flow Statement of Cash flow: A firm s financial statement that summarizes its sources and uses of cash flow over a specified period Steps to prepare the statement of cash flow: 1. To prepare the statement of cash flow, we need to use both the income statement and the balance sheet. 2. Find the difference (changes) between the end of the year and the beginning of the year in the balance sheet. Assets or Liabilities or owner s equity = use of cash Assets or Liabilities or Owner s equity = Source of cash 3. Start the cash flow statement by (cash at the beginning of the year ), then, Divide the statement of cash flow to three categories: Operating Activity: includes net income + depreciation, and changes in current accounts (current assets or account payable, add them if they are sources and subtract them if they are uses). Investment Activity: includes changes in fixed assets+ depreciation. Financing Activity: includes changes in notes payable, long-term debt, equity accounts, and dividend. 4. To find (cash at the end of the year), add all (sources of cash) together and subtract them from all (uses of cash)

+Statement of Cash Flow The following is the income statement since we will use it in making the statement of cash flow. 2009 Income Statement of Prufrock Corporation Sales Cost of Good Sold Depreciation Earning before Interest and taxes Interest paid Taxable Income Taxes (34%) Net Income Dividends Addition to retained earnings $2,311 $1,344 $ 276 $691 $141 $550 $187 $363 $121 $242

+Building a Statement of Cash Flow 2009 statement of cash flow $84 Cash, beginning of the year Operating Activity Net income $363 +Depreciation $276 Increase in account payable (source) $32 Increase in account receivable (use) - $23 Increase in inventory (use) - $29 Net cash from operating activity $619 Investment Activity Fixed asset acquisition (use) - $149 + Depreciation assets) (added because it was subtracted from the fixed - $276 Net cash from investment activity - $425 Financing Activity Decrease in note payable (use) -$35 Decrease in long term debt (use ) -$74 Dividend Paid (use) - $121 Increase in common stock (source) $50 Net cash from financing activity -$180 Net increase in cash $14 Cash end of the year (84+14) $98

+3.2 Standardized Financial Statements It will be impossible to compare financial statement of one company to other financial statements of similar companies who do the same business. WHY? Because they have different sizes so we can not compare dollar amounts. It is also hard to compare the financial statements of the same company but in different periods of time because the size has changed. To start making comparisons, we need to standardized the financial statements by using percentages instead of total dollars. Three ways to standardize financial statements: Common Size statements Common Base year financial statements (Trend Analysis) Combined Common Size and Base year Analysis

+Standardized Financial Statements 1.Common Size Statements: Is a standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales and cash flow items as a percentage of total sources or total uses of cash. Next slides is a common size balance sheet and common size income statement.

cash. 2008 2009 2008 ratio 2009 ratio + Current Assets Assets 84/3373 = 2.5% 2.7% Cash $84 $94 165/3373= 4.9% 11.7% 5.2% Account Receivable $165 $188 11.8% Inventory $393 $422 19.1% 19.7% Total $642 $708 Fixed Assets 80.9% 80.3% Net plant and Equip. $2,731 $2,880 100% 100% Total Assets $3,373 $3,588 Liabilities and Owner s Equity Current liabilities 9.2% 9.6% Account payable $312 $344 6.8% 5.5% Notes Payable $231 $196 16% 15.1% Total $543 $540 15.7% 12.7% Long term debt $531 $457 Owner s Equity 14.8 15.3% Common stock $500 `550 53.3% 56.9% Retained earning $1,799 $2,041 68.1% 72.2% Total $2,299 $2,591 100% 100% Total liabilities and owner s equity $3,373 $3,588

+Common size income statement 2009 Income Statement of Prufrock Corporation Ratios% $2,311 $1,344 $ 276 $691 100% 58.2% 11.9% 29.9% Sales Cost of Good Sold Depreciation Earning before Interest and taxes Interest paid $141 $550 $187 $363 $121 $242 6.1% 23.8% 8.1% 15.7% 5.2% 10.5% Taxable Income Taxes (34%) Net Income Dividends Addition to retained earnings

+Standardized Financial Statements 2. Common Base year Financial Statement Is a standardized financial statement presenting all items relative to a certain base year amount. Choosing a base year and then express each item relative to the base amount. Used to compare the performance of the company during the years to see the pattern of the firm operations: Ex. Does the firm use more or less debt? Has the firm grown more or less liquid? The following slide is a common base year balance sheet.

Common Base Year Financial Statement . + 2008 2009 Common base year Assets Current assets 98/84 = 1.17% Cash $84 $94 1.14% Account Receivable $165 $188 1.07% Inventory $393 $422 1.10% Total $642 $708 Fixed Assets Net plant and Equip. $2,731 $2,880 1.05% 1.06% Total Assets $3,373 $3,588 Liabilities and Owner s Equity Current liabilities 1.10% Account payable $312 $344 0.84% Notes Payable $231 $196 0.99% Total $543 $540 0.86% Long term debt $531 $457 Owner s Equity 1.1% Common stock $500 550 1.13% Retained earning $1,799 $2,041 1.13% Total $2,299 $2,591 1.06% Total liabilities and owner s equity $3,373 $3,588

+Standardized Financial Statements 3. Combined common size and base year analysis: (see table in the following slide)

2008 2009 2008 common size ratio 2009commo n size ratio combin ed cash. + Assets Current Assets 84/3373 = 2.5% 2.7% 2.7/2.5= 1.08% 1.06% Cash $84 $94 165/3373= 4.9% 11.7% 5.2% Account Receivable $165 $188 11.8% 1.01% Inventory $393 $422 19.1% 19.7% 1.03% Total $642 $708 Fixed Assets 80.9% 80.3% 0.99% Net plant and Equip. $2,731 $2,880 100% 100% 1.00% Total Assets $3,373 $3,588 Liabilities and Owner s Equity Current liabilities 9.2% 9.6% 1.04% Account payable $312 $344 6.8% 5.5% 0.80% Notes Payable $231 $196 16% 15.1% 0.94% Total $543 $540 15.7% 12.7% 0.80% Long term debt $531 $457 Owner s Equity 14.8 15.3% 1.03% Common stock $500 `550 53.3% 56.9% 1.06% Retained earning $1,799 $2,041 68.1% 72.2% 1.06% Total $2,299 $2,591 100% 100% 1.00% Total liabilities and owner s equity $3,373 $3,588

+3.3 Ratio Analysis Financial Ratios: Relationships determined from a firm s financial information and used for comparison purposes. We will learn the most important ratios and we consider several questions when finding them: How is it computed? What is it intended to measure? What is the unit of measurement? What might a high or low value tell us? How could this measure be improved?

+3.3 Ratio Analysis Financial ratios are grouped into four categories: Short term solvency, or liquidity ratios. 1) Long term solvency, or financial leverage ratios. 2) Asset management or turnover measures. 3) Profitability ratios 4) Market value ratios. 5)

+1. Short Time Solvency OR Liquidity Ratios 1. Short Term Solvency Ratios, or Liquidity Measures Current ratio A. Quick ratio (Acid test) B. Cash ratio C. Net working capital to total assets D. Inventory measure E. The primary concern of these ratios is To measure the firm s ability to pay its bills over the short run. Or, a measure of a short term liquidity. Who is interested in knowing these ratios the most? Creditors (banks, suppliers).

+1. Short Time Solvency OR Liquidity Ratios 1.A. Current ratio Current ratio = Current Assets /Current Liabilities (From the previous table) Current assets = $708/540 = 1.31 times. Or we can say, the company has $1.31 in current assets for every $1 in current liabilities. What does this number mean to the firm s creditors? The higher the current ratio, the better. What does this number mean to the firm itself? A higher current ratio indicates liquidity, but it also means inefficient use of cash and other short term assets. (it shouldn t be less than 1 ) See example 3.1 in the textbook

+1.Short Time Solvency OR Liquidity Ratios 1.B The Quick Ratio or (Acid test): The Quick Ratio=( Current assets-inventory)/Current liabilities Because inventory is the least liquid current assets item and some of it get damaged or lost, we want to find the current ratio excluding the inventory. Quick ratio = ($708- $422)/$540 = 0.53 times. NOTE that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio 1.C Cash Ratio: Cash Ratio = Cash / Current Liabilities Some short term creditors might be just interested in cash ratio.

+1.Short Time Solvency OR Liquidity Ratios 1. D. Net working capital to total assets Net working capital = NWC/Total Assets = (708-540)/3588 = 4.7% 1.E Interval measure Interval measure= Current? assets/Average daily operating costs This ratio is used when the firm is facing a strike and cash inflows start to dry up, how long could the business be running (cover the operating costs)? Average daily operating cost = cost of good sold (from the income statement) / 365 708/3.68= 192 days.

+2. Long Term Solvency Measures it measures the firm s financial leverage or the firm s ability to pay its debt or meet its obligations. 2.A Total Debt Ratio Total Debt Ratio =( total assets-total equity)/total assets From the balance sheet in page55: = ($3,588 2,591)/$3,588 = 0.28 times which means that the firm uses 28% debt. Or we say the company has $0.28 in debt for every $1 in assets. Assets = Liability + Owners Equity $1 = $0.28 + $0.72

+2. Long Term Solvency Measures from this ratio we can come up with two related ratios: 2.B Debt Equity Ratio debt-equity ratio = total debt/total equity = 0.28/ 0.72 = 0.39 times 2.C Equity multiplier 1 + debt-equity ratio OR OR Equity multiplier = total assets/total equity = $1/$0.72 = 1.39 1+0.3 NOTE If we have any one of the previous three ratios, we can find the other two ratios.

+2. Long Term Solvency Measures 2.D Long term debt ratio: Long term debt ratio = Long term debt(/Long term debt+ total equity) Financial analyst are more concerned with the firm long term debt more than its short term debt because they want to know the firms debt management policy and the short term debt is constantly changing. Long-term debt and equity are called firm s total capitalization.

+2. Long Term Solvency Measures 2.E. Times interest earned (TIE) Times interest earned (TIE) =EBIT/ Interest = $691/141 = 4.9 times Means how well the company has its interest obligation covered. The problem with TIE is that its based o EBIT that has a non cash item (depreciation), which is not a measure of cash available to pay interest. 2.F. Cash coverage Ratio Cash coverage ratio =( EBIT+ Depreciation)/ Interest = (691+267)/141 = 6.9 times.

+3. Asset Management or Turnover, Measures These ratios are also called utilization ratios. They describe how efficiently a firm uses its assets to generate sales. A. Inventory Turnover: A.1 Inventory turnover Inventory Turnover= cost of good sold / Inventory This ratio means how fast we can sell our inventory. = $1,344/$422 = 3.2 times The higher the ratio, the more efficiently we are managing inventory. A.2. Days sales in inventory Days sales in inventory= 365 days/Inventory turnover This ratio shows how long or (how many days) does it take to turn it over on average. = 365/3.2 = 114 days Inventory sits 114 days on average before it is sold.

+3. Asset Management or Turnover, Measures B. Receivables Turnover B.1 Receivables Turnover = $2,311/$188 = 12.3 times Receivables Turnover =Sales/ Account receivable = $2,311/$188 = 12.3 Times It means that the firm collected credit accounts and reloaned the money 12.3 times during the year. We are assuming here that all sales are credit sales. B.2 Days sales in Receivables Days sales in Receivables = 365 days/Receivable turnover = 365/12.3 = 30 days When the firm increases the days it gives the firm a competitive advantage and when the days are reduced, the company is reducing its financing cost significantly. Its is also called average collected period. B.3 Payable turnover Payable turnover= Cost of good sold/Account payable Assuming the firm purchase everything on credit, how often the firm pays the money it owes to the creditors (suppliers).

+3. Asset Management or Turnover, Measures C. Asset Turnover Ratios NWC Ratio = Sales/ NWC C.1 NWC Ratio =$2311/(708-540) = 13.8 times This provides some useful information as to how effectively a company is using its working capital to generate sales. The higher the better. Fixed assets turnover= Sales/Net Fixed Assets C.2 Fixed Assets Turnover = $2,311/$2880 = 0.80 times it means that for every dollar in fixed assets, the company got $0.80 in sales. Turn asset turnover = sales /total assets C.3 Total asset turnover = $2,311/$3588 = 0.64 times for every dollar in assets, the firm generated $0.64 in sales.

+4. Profitability Ratios Profitability Ratios It measures how the efficiently the firm uses its assets and manages its operations. Profit Margin = Net Income / Sales A.1 Profit Margin = 363/2311 = 15.7% it means for every dollar in sales the firm generates 0.157 in profit. A.2 Return on Assets Return on Assets = Net income / total Assets = $363/3,588 = 10.12% How efficient the company is in using its assets to get earnings. Measure of profit per dollar of assets.

+4. Profitability Ratios A.3 Return on Equity Return on Equity (ROE)= Net Income Total Equity = 363/ 2591 = 14% How much profit a company generates with the money shareholders have invested. Sometimes its called return on net worth. Looking at ROA = 10% AND ROE 14%, the difference shows the amount of financial leverage. we usually take the average when we calculate ROA,ROE. (ex 3.4).

+5. Market Value Ratios for publicly traded companies These types of ratios are not included in the financial statements like the (market price per share of stock) is not in the financial statement. EX. If the company has 33 million shares and from the financial statement the net income was $363 million A. Earning per Share EPS= Net Income/ # of shares outstanding = $363/33 =$11 B. Price earning ratio PE = Price per share/Earning per share = $88/$11 = 8 times Which means that the company s shares sell for 8 times earnings. It measures how much investors are willing to pay per dollar of current earnings. Higher PE s means that the firm has a significant prospects for future growth. Dividing the PE/ future earning growth rate 100 , results in PEG ratio that shows weather PE ratio is high or low depending

+5. Market Value Ratios C. Price sales ratio Price sales ratio= price per share/sales per share = $88/ ($2,311/33) = 1.26 This ratio was created because some starts up companies have negative earnings for some period of time so we replace the net income by sales D. Market to Book Ratio Market value per share/Book value per share = $88/ (2,591/33) = 1.12 times E. book value per share Book value per share= total equity / number of shares outstanding This ratio compares the market value of the firm s investments to their cost. Book value is a historical cost.

+THE DU PONT IDENTITY ROE = Net Income/ Total Equity ROE = Net Income/ Total Equity Assets /Assets ROE = Net Income/ Assets Assets /Total Equity ROE = ROA Equity Multiplier ROE = ROA (1 + Debt-Equity ratio) ROE = Sales Sales Net Income/ Assets Assets /Total Equity ROE = (Net Income/ Sales) (Sales / Assets) (Assets Total Equity) ROE = Profit margin Total assets turnover Equity multiplier

+THE DU PONT IDENTITY Du Pont identity tells us that ROE is effected by three things: Operating activity and its measured by the profit margin. 1. Asset use efficiency as measured by the total assets turnover. 2. Financial leverage as measured by the equity multiplier. 3. If ROE is unsatisfactory , then Du point tells you where to start looking for the reasons.

+3.5 Using Financial Statement Information The primary reason for looking at accounting information is that we don t have and cant expect to get market information. Internal Uses Performance evaluation Financial manager insures the financial safety of the company. Are we liquid enough to cover our current liabilities with our current assets Can we pay our supplier on time? Is our level of debt good to minimize our cost of capital? Do we generate enough income? ..etc Financial ratios documents a company s operational and financial strengths and weaknesses and highlight areas that require reaction by the financial management. Planning for the future.

+3.5 Using Financial Statement Information External Uses financial statements are useful for parties outside the firm, including, short term and long term creditors, and potential investors. Large customers use this information as well. Credit rating agencies rely on financial statements in assessing a firm creditworthiness.

+Choosing a Benchmark Time trend Analysis By looking at the company s history and compare the result. Peer Group Analysis The second way of establishing a benchmark is by identifying firms similar to our firm (compete in the same market, have similar assets, and operate in similar way). In other words, we need to identify a peer group. Potential peers is based on Standard Industrial Classification SIC: Which is a U.S four digit code used to classify a firm by its type of business operation.

+Review 1. Which one of the following is a source of cash? A. Increase in accounts receivable B. decrease in notes payable C. decrease in common stock D. increase in accounts payable E. increase in inventory 2. Which one of the following is a source of cash? A. increase in accounts receivable B. decrease in common stock C. decrease in long-term debt D. decrease in accounts payable E. decrease in inventory 3. On a common-size balance sheet all accounts are expressed as a percentage of: A. sales for the period. B. the base year sales. C. total equity for the base year. D. total assets for the current year. E. total assets for the base year.

+Review 6. A firm has sales of $2,190, net income of $174, net fixed assets of $1,600, and current assets of $720. The firm has $310 in inventory. What is the common-size statement value of inventory? A. 13.36 percent B. 14.16 percent C. 19.38 percent D. 30.42 percent E. 43.06 percent 5. Over the past year, the quick ratio for a firm increased while the current ratio remained constant. Given this information, which one of the following must have occurred? Assume all ratios have positive values. A. current assets increased B. current assets decreased C. inventory increased D. inventory decreased E. accounts payable increased 7. Russell's Deli has cash of $136, accounts receivable of $87, accounts payable of $215, and inventory of $409. What is the value of the quick ratio?