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Learning objectives
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 Identify the ways that firms obtain and use cash as reported in the Cash Flow Statement.
 Calculate and interpret key financial ratios.
 Discuss the Du Pont identity as a method of financial analysis.
 Understand the use of financial information for comparative purposes.
 Outline the problems associated with using financial ratios.

Cash
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 Cash is generated by selling a product or service, asset or security.
 Cash is spent by paying for materials and labor to produce a product or service and by purchasing assets.
 Recall :
Cash flow from assets = Cash flow to debtholders + Cash flow to shareholders

Sources and Uses of Cash
 At the most fundamental level, firms do two things: generate cash and spend cash.
 Activities that bring in cash are called sources of cash .
 Activities that involve spending cash are called uses (or applications) of cash .
 An increase in an asset account or a decrease in a liability or equity account is a use of cash .
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 A decrease in an asset account or an increase in a liability or equity account is a source of cash .

Financial Statements

A firm’s financial statement that summarizes its sources and uses of cash over a specified period.
 The presentation of cash flows in annual reports is determined by an Accounting Standard .
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 Changes are divided into three main categories:
 Operating activities —includes net profit and changes in most current accounts.
 Investment activities —includes changes in noncurrent assets.
 Financing activities —includes changes in notes payable, long-term debt and equity accounts, as well as dividends.

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Cash Flow Statement
 Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
– Any increase in current assets (except cash)
– Decrease in accounts payable

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Cash Flow Statement
 Investment activities
+ Ending non-current assets
– Beginning non-current assets
+ Depreciation

Cash Flow Statement
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 Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
– Dividends paid

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Assets ($’000s) 2006 2007
Current assets
Cash
Accounts receivable
Inventory
Total
Non-current assets
Net plant and equipment
TOTAL ASSETS
$ 90
520
640
$ 1 250
1 970
$3 220
$ 100
620
770
$ 1 490
2 200
$3 690

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Liabilities and equity ($’000s)
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Shareholders’ equity
Ordinary shares
Retained earnings
Total
TOTAL LIABILITIES AND EQUITY
2006
$ 420
220
$ 640
$ 410
580
1 590
$2 170
$3 220
2007
$ 520
350
$ 870
$ 450
580
1 790
$2 370
$3 690

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Sales
Cost of goods sold
Depreciation
EBIT
$1 420.00
960.00
60.00
$400.00
Interest
Taxable income
Tax
40.00
360.00
108.00
Net profit
Dividends
$252.00
52.00
Addition to retained earnings $200.00

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Example: Cash Flow Statement
 Operating activities
(+) Net profit
(+) Depreciation
(+) Increase in payables
( –) Increase in receivables
( –) Increase in inventory
$ 252
60
100
(100)
(130)
$ 182

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Example: Cash Flow Statement
 Investment activities
(+) Ending non-current assets $2 200
( –) Beginning non-current assets (1 970)
(+) Depreciation 60
( $ 290)

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Example: Cash Flow Statement
 Financing activities
(+) Increase in notes payable $ 130
(+) Increase in long-term debt
( –) Dividends
40
(52)
$ 118
Putting it all together, the net addition to cash for the period is:
$182 – 290 + 118 = $10

Financial Ratio Analysis
 A Financial ratios is an index that relates two accounting numbers and is obtained by dividing one number by the other .
 Used to compare and investigate relationships between different pieces of financial information, either over time or between companies. Types of Comparisons: Internal
Comparisons and External Comparisons
 Ratios eliminate the size problem.
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Ratio Analysis: Questions to Consider for Each Ratio
 How is it computed?
 What is it intended to measure, and why might we be interested?
 What is the unit of measurement?
 What might a high or low value be telling us? How might such values be misleading?
 How could this measure be improved?

Categories of Financial
Ratios





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Liquidity Ratios
 Current Ratio
 Quick Ratio
 Profit before depreciation and amortization to current liabilities (PDACL)
 Operating cash flow to current liabilities
(OCFCL)
 Cash balance to total liabilities (CBTL)
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Liquidity Ratios
 Current Ratio: The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).
Current ratio

Current
Current assets liabilitie s
Example:
6-19 in 2006 = 1250/640 = 1.15

Liquidity Ratios
 Quick Ratio: The quick ratio measures the dollar amount of liquid assets available for each dollar of current liabilities.
Quick Ratio =
Cash in hand + Cash at Bank + Receivables +
Marketable Securities
Current Liabilities
= (current assets – inventory)/ liabilities
Example: in 2006 quick ratio = 1.50
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Liquidity Ratios
 Profit before depreciation and amortization to current liabilities (PDACL): Measures how many times company’s profit covers liabilities before non-cash items.
PDACL

Profit before depreciati on and amortizati on
Current Liabilitie s
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Example: in 2006 PDACL = 0.40

Liquidity Ratios
 Operating cash flow to current liabilities
(OCFCL): Refers to the cash generated from the operations of a company
(revenues less all operating expenses, plus depreciation), in relation to short-term debt obligations. .
OCFCL

Operating Cash Flow
Current Liabilitie s
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Example: In 2006 PDACL = 0.40

Liquidity Ratios
 Cash balance to total liabilities (CBTL):
Refers to the company’s cash balance in relation to its total liabilities.
CBTL

Cash Balance
Current Liabilitie s
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Example:
In 2006 CBTL = 0.40

Leverage (Capital
Structure) Ratios
 Debt to equity ratio (DE ratio)
 Total liabilities to total tangible assets
(TLTAI)
 Interest cover ratio
 Net debt to equity ratio
 Equity multiplier
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Leverage (Capital
Structure) Ratios
 Debt to equity ratio (DE ratio): It refers a company’s capital structure and whether the company is more reliant on borrowings (debt) or shareholder capital (equity) to fund assets and activities.
Debt/equit y ratio

Total
Total debt equity
 Example: Debt/Equity ratio = 1.14
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Leverage (Capital
Structure) Ratios
 Total liabilities to total tangible assets
(TLTAI): This ratio provides the relationship between a company’s liabilities and tangible assets.
Tangible assets are defined as physical assets, such as property, cash, inventory and receivables.
TLTAI

Total liabilitie s
Total tangible assets

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Example: TLTAI = 1.60

Leverage (Capital
Structure) Ratios
 Interest cover ratio: measures company’s ability to meet interest expenses on debt using profits.
Interest cover ratio

EBIT (Earnings before interest and taxes)
Interest
 Example: ICR = 3
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Leverage (Capital
Structure) Ratios
 Net debt to equity ratio: This represents the level of risk associated with the company’s funding source. It is a useful internal measure to review the balance between interest bearing debt and shareholders’ equity for the purpose of improving company capacity to meet debt repayments and/or return on equity.
Net debt/equit y ratio

Interest bearing
Net ordinary debt

Cash share equity
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Leverage (Capital
Structure) Ratios
 Equity multiplier: It is a measurement of a company's financial leverage. It measures the amount of a firm's assets that are financed either through equity or debt .
Equity multiplier

Total
Total assets equity
 Example: EM = 1.11
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Profitability Ratios
 Earnings per share (EPS )
 Gross profit margin
 Net profit margin
 Return on assets (ROA )
 Return on equity (ROE )
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Profitability Ratios
 Earnings per share (EPS): It shows the portion of a company’s profit that is allocated to each outstanding share of common stock. EPS figure is very important for shareholders because the payment of dividend and increase in the value of stock in future largely depends on it. EPS is the most widely quoted and relied figure by investors.
EPS

Net income
Total outstandin g shares
Example: EPS = $1.60
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Profitability Ratios
 Gross profit margin: Gross profit margin tells us what percentage of a company’s sales revenue would remain after deducting the cost of goods sold.
Gross Profit Margin

Sales

Cost of goods sold (direct cost)
Sales
X 100
 Example: Gross profit margin = 50%
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Profitability Ratios
 Net profit margin: Net profit margin meanwhile indicates what percentage of a company’s sales revenue would remain after all costs have been taken into account.
Net Profit Margin

Net Income
Sales
X 100
 Example: Net profit margin = 20%
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Profitability Ratios
 Return on assets (ROA): It is a measurement of management performance. ROA tells the investor how well a company uses its assets to generate income. A higher ROA denotes a higher level of management performance.
Return on assets (ROA)

Net Income
Average Total Assets

100%
 Example: ROA = 13.3%
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Profitability Ratios
 Return on equity (ROE): It is another measurement of management performance.
ROE tells the investor how well a company has used the capital from its shareholders to generate profits. A higher ROE denotes a higher level of management performance.
Return on equity (ROE)

Net Income
Average Total Equity

100 %
Example: ROE = 22.22%

Valuation Ratios
 Price to earnings ratio (PE)
 Price/earnings to growth ratio (PEG)
 Dividend yield
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Valuation Ratios
 Price to earnings ratio (PE) : It assess a company’s value. It measures company’s current share price relative to its per-share earnings.
PE

Price per share
Earnings per share
 Example: PE = 10
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Valuation Ratios
 Price/earnings to growth ratio (PEG): The
PEG ratio acts as a measure of company’s value that takes into account future growth.
PEG

EPS
PE growth rate
 Example: PEG = 0.625
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Valuation Ratios
 Dividend yield: It shows what percentage of the market price of a share a company annually pays to its stockholders in the form of dividends.
Dividend yield ratio

Dividend per share
Market val ue per share

100 %
 Example: Dividend yield ratio = 1
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Turnover Ratios
 Inventory turnover
 Fixed asset turnover
 Total asset turnover

Day’s sales in inventory
 Receivables turnover

Day’s sales in receivable
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Turnover Ratios
 Inventory turnover:
Inventory turnover

Cost of goods sold
Average Inventory
 Example: Inventory turnover = 0.29 times
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Turnover Ratios
 Fixed asset turnover: It
Fixed asset turn over

Net revenue
Average Fixed Assets
 Example: Fixed asset turnover = $6.44
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Turnover Ratios
 Total asset turnover: It measures a company's ability to generate sales from its assets by comparing net sales with average total assets. In other words, this ratio shows how efficiently a company can use its assets to generate sales.
Total Asset Turnover

Net Sales
Average Total Assets
Example: Total Assets Turnover = 0.33
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Turnover Ratios

Day’s sales in inventory:
It measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a company's current stock of inventory will last.
Days' sales in inventory

Ending Inventory
Cost of goods sold
X 3 65
Example: Day’s sales inventory = 122 days
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Turnover Ratios
 Receivables turnover: It measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year.
Receivable s turnover

Net Credit Sales
Average Accounts Receivable

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Example: Receivable Turnover: 3.33

Turnover Ratios

Day’s sales in receivable:
It measures the number of days it takes a company to collect cash from its credit sales. In other words, it shows how well a company can collect cash from its customers.
Days' sales in receivable s

Accounts Receivable
Net credit sales
X 365
 Example : Days’ sales in receivables = 31
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 Breaks ROE into three parts:
 operating efficiency (as measured by Net profit margin)
 asset use efficiency (as measured by total asset turnover)
 financial leverage (as measured by the equity multiplier)
ROE

Net profit (income)
Sales

Sales
Total assets

Total assets
Total equity

Net profit margin

Total asset turn over

Equity multiplier

ROA

Equity multiplier


ROE

Net profit
Sales

Sales
Assets

Assets
Equity

250
7000

7000

3500
3500
1900

3.57%

2.00

1.84

13.14%
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 Internal uses:
 performance evaluation
 planning for the future
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 External uses:
 evaluation by outside parties
 evaluation of main competitors
 identifying potential takeover targets

 Ratios are most useful when compared to a benchmark.

—examine how a particular ratio(s) has performed historically.

—using similar firms (competitors) for comparison of results.
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 One common way of identifying potential peers is based on the Global Industry
Classification Standard (GICS) used by the
Australian Stock Exchange (ASX).
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 GICS is a code used globally to classify a firm by its type of business operations.
 GICS consists of 23 industry groups, 59 industries, and 122 sub-industries; covering over 12 000 companies globally.
 The basis of classification is the area from which most revenue is generated.

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 No underlying theory to identify correct ratios to use or appropriate benchmarks.
 Benchmarking is difficult for diversified firms.
 Firms may use different accounting procedures.
 Firms may have different recording periods.
 One-off events can severely affect financial performance.


Activities that bring in cash are called ‘ sources of cash’, and activities that involve spending cash are called ‘uses of cash’.
 A Cash Flow Statement summarises sources and uses of cash over a specified period.
 Financial ratios are grouped together into five main categories: Liquidity, Capital Structure, Valuation,
Profitability, and Turnover.
 Ratios are most useful when compared to a benchmark (e.g. time-trend and peer group analysis).
 Problems can arise in using financial statements.
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