Cash Flows and Financial
Analysis
Chapter 3
© 2003 South-Western/Thomson Learning
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
2
Users of Financial Information

Investors and Financial Analysts



Vendors/Creditors


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
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
3
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 (Value Line Investment Survey)
4
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
5
The Statement of Cash Flows



Income doesn’t represent cash in the firm’s
pocket
The Statement of Cash Flows (AKA:
Statement of Changes in Financial Position)
provides info on the actual movement of cash
in and out of the company
Constructed from the Balance Sheet and
Income Statement
6
How the Statement of Cash Flows
Works—Preliminary Examples
Requires two consecutive balance sheets
and one income statement from which
the statement of cash flows is generated
 Takes net income for the period and
makes adjustments
 Then takes the balance sheet items and
examines the changes

7
Business Cash Flows

Cash Flows Rules

The following rules can be applied to any
business’s financial statements
•
•
•
•
Asset increase  use of cash
Asset decrease  source of cash
Liability increase  source of cash
Liability decrease  use of cash
8
Business Cash Flows

Standard Presentation

Statement of Cash Flows organized to show
• Operating activities
• Running business on day-to-day basis
• Investing activities
• When firm buys or sells things to do business
• Includes long-term purchases and sales of financial
assets
• Financing activities
• When firm borrows money, pays off loans, sells stock or
pays dividends
9
Constructing the Statement of
Cash Flows
Belfry Company
Belfry Company
Balance Sheet
For the period ended 12/31/X2
Assets
Income Statement
For the period ended 12/31/X2
Sales
COGS
Gross margin
$
$
$
10,000
6,000
4,000
Expense
Depreciation
EBIT
Interest
EBT
Tax
Net Income
$
$
$
$
$
$
$
1,600
500
1,900
400
1,500
500
1,000
12/31/X1
12/31/X2
1,000
1,400
3,000
2,900
2,000
3,200
6,000
7,500
Cash
Accounts receivable
Inventory
CURRENT ASSETS
Fixed assets
Gross
Accumulated deprec.
Net
TOTAL ASSETS
4,000
(1,000)
3,000
9,000
6,000
(1,500)
4,500
12,000
Accounts payable
Accruals
CURRENT LIABILITIES
Long-term debt
Equity
TOTAL CAPITAL
1,500
500
2,000
5,000
2,000
7,000
2,100
400
2,500
6,200
3,300
9,500
TOTAL LIABILITIES AND EQUITY
9,000
12,000
Liabilities
Also assume firm paid
a $500 dividend and
sold stock for $800
during the year.
10
Constructing the Statement of
Cash Flows

Operating Activities
Involve the Income Statement and current
Balance Sheet accounts
 Involves activities firm does on a day-to-day
basis such as

•
•
•
•

Buying inventory
Producing and selling product
Paying expenses and taxes
Collecting credit sales
Focus of activities
is generating net
income—the
beginning of a
cash flow
statement.
Money from operating transactions runs
through current balance sheet accounts
11
Constructing the Statement of
Cash Flows

Thus, for Belfry the cash from Operating
Activities is
Net Income
+ Depreciation
= Operating Income
+ decrease in Receivables
$1,000
$500
$1,500
$100
- increase in Inventory
($1,200)
+ increase in Payables
$600
- decrease in Accruals
($100)
Cash from operating activities
$900
12
Constructing the Statement of
Cash Flows

Investing Activities


Typically include purchasing Fixed Assets
Examine the change in GROSS Fixed Assets, not
net
• Because the net value includes an adjustment for
depreciation
• Depreciation has already been included under operating
activities

Thus, for Belfry the cash from investing activities is
• Purchase of Fixed Assets ($2,000)
13
Constructing the Statement of
Cash Flows

Financing Activities
Deal with the capital accounts, long-term
debt and equity
 Thus, for Belfry the cash from financing
activities is

Increase in long-term debt
Sale of stock
$1,200
$800
Dividend paid
($500)
Cash from financing activities
$1,500
14
Constructing the Statement of
Cash Flows

The Equity and Cash Accounts

The change in equity is not included because the
changes are reflected elsewhere in the Statement of
Cash Flows
• Net Income is included in Cash Flows from Operations
• Sale of stock and dividends are considered under financing
activities

The change in the cash account isn’t considered
because the sum of cash flows from operations,
financing activities and investing activities must
equal the change in the cash account
15
Constructing the Statement of
Cash Flows

Thus, for Belfry, the final portion of the
Statement is
Beginning Cash Balance
Net cash flow
Ending Cash Balance
$1,000
400
$1,400
16
Constructing the Statement of
Cash Flows
Belfry Company
Statement of Cash Flows
For the period ended 12/31/X2
CASH FROM OPERATING ACTIVITIES
Net income
Depreciation
Net changes in current accounts
Cash from operating activities
CASH FROM INVESTING ACTIVITIES
Purchase of fixed assets
CASH FROM FINANCING ACTIVITIES
Increase in long-term debt
Sale of stock
Dividend paid
Cash from financing activities
NET CASH FLOW
Beginning cash balance
Net cash flow
Ending cash balance
$
$
$
$
1,000
500
(600)
900
$
(2,000)
$
$
$
$
$
1,200
800
(500)
1,500
400
$
$
$
1,000
400
1,400
While the firm was
profitable, it still had to
borrow money and sell
stock to finance the
increase in Fixed Assets.
17
Free Cash Flows
Refers to cash generated beyond
reinvestment needs
 Under normal conditions most firms
generate positive cash flow from
operations


Some of these funds are used to maintain
long-run competitive position
• Replace worn-out fixed assets
• Pay dividends on Preferred Stock
18
Ratio Analysis
Used to highlight different areas of
performance
 Involves taking sets of numbers from the
financial statement and forming ratios
with them

19
Comparisons

Ratios when examined separately don’t
convey much information
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

20
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
21
Ratios


Designed to illuminate some aspect of how the
business is doing
Average Value

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
22
Ratios

Categories of Ratios





Liquidity—indicate firm’s ability to pay its bills in the
short run
Asset Management—show how the company uses
its resources to generate revenue, profit and to
avoid cost
Debt Management—show how effectively the firm
has used borrowed funds and whether or not it has
a high amount of leverage
Profitability—allow assessment of the company’s
ability to make money
Market Value—give an indication of how investors
feel about the company’s financial future
23
Liquidity Ratios

Current Ratio
Current Ratio 

Current Assets
Current Liabilities
To ensure solvency the current ratio has
to exceed 1.0

Generally a value greater than 1.5 or 2.0 is
required for comfort
24
Liquidity Ratios

Quick Ratio (or Acid-Test Ratio)
current assets - inventory
Quick Ratio 
current liabilities

Measures liquidity without considering
inventory (the firm’s least liquid current
asset)
25
Asset Management Ratios

Average Collection Period (ACP)
accounts receivable
ACP 
average daily (credit) sales
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

26
Asset Management Ratios

Inventory Turnover
cost of goods sold
Inventory Turnover 
inventory
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
27

Asset Management Ratios

Fixed Asset Turnover
Fixed Asset Turnover 
Sales (Total)
Fixed Assets (Net)
Appropriate in industries where significant
equipment is required to do business
 Long-term measure of performance
 Average balance sheet values are
appropriate

28
Asset Management Ratios

Total Asset Turnover
Sales (Total)
Total Asset Turnover 
Total Assets
More widely used than Fixed Asset Turnover
 Long-term measure of performance
 Average balance sheet values are
appropriate

29
Debt Management Ratios


Need to determine if the company isn’t 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—generally
long-term debt
Debt Ratio
Debt Ratio 



Long-term debt  Current Liabilities
Total Assets
A high debt ratio is viewed as risky by investors
Ending balance sheet items are appropriate
Usually stated as percentages
30
Debt Management Ratios

Debt-to-equity ratio

Can be stated several ways (as a
percentage, or as a x:y value)
Debt-to-Equity  LT debt : Common Equity
or
Debt-to-Equity 

LT Debt
Common Equity
Measures the mix of debt and equity within
the firm’s total capital
31
Debt Management Ratios

Times Interest Earned
EBIT
TIE 
Interest Expense

TIE is a coverage ratio
• Reflects how much EBIT covers interest expense
• A high level of interest coverage implies safety
32
Debt Management Ratios

Cash Coverage
EBIT  depreciation
Cash coverage 
Interest Expense

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
33
Debt Management Ratios

Fixed Charge Coverage
EBIT  Lease Payments
Fixed Charge Coverage 
Interest Expense  Lease Payments
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
34
Profitability Ratios

Return on Sales (AKA: Profit Margin, Net
Profit Margin)
ROS 
Net Income
Sales
Measures control of the income statement:
revenue, cost and expense
 Represents a fundamental indication of the
overall profitability of the business

35
Profitability Ratios

Return on Assets
Net Income
ROA 
Total 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

36
Profitability Ratios

Return on Equity
ROE 
Net Income
Stockholders' 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

37
Market Value Ratios

Price/Earnings Ratio (PE Ratio)
Current stock price
PE Ratio 
Earnings per share (EPS)
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

38
Market Value Ratios

Market-to-Book Value Ratio
Market-to-Book-Value 

Current stock price
book value per share (of equity)
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
39
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

40
Du Pont Equations

Du Pont equation involves ROE, which
can be written several ways:
Net Income
sales
ROA 

Total Assets sales
or
Net Income
sales
ROA 

sales
Total Assets
or
ROE = ROS  total 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.
41
Du Pont Equations

Extended Du Pont equation states ROE
in terms of other ratios
ROE 
Net Income
sales total assets


Stockholders' Equity sales total assets
or
ROE 
Net Income
sales
total assets


sales
total assets Stockholders' Equity
Equity Multiplier
or
ROE = ROS  Total Asset Turnover  Equity Multiplier
ROA
or
ROE = ROA  Equity Multiplier
Related to the
proportion to
which the firm
is financed by
other people’s
money as
opposed to
owner’s
money.
42
Du Pont Equations

Extended Du Pont equation states that
the operation of a business is reflected in
its ROE
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
43
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 Line provides industry profiles and individual
company reports
44
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
45