TOPIC 2: FINANCIAL STATEMENT AND CASH FLOW ANALYSIS Topic Learning Outcomes After this topic, you should be able to: 1. Define financial statement analysis. 2. Understand the need to analyze the broader business environment. 3. Know the basics of profitability analysis. 4. Realize the limitations of financial statements analysis. 5. Analyze a business firm’s short-term financial position, asset liquidity and management, longterm financial position and profitability using financial ratios. 6. Apply DuPont Disaggregation Analysis. 7. Understand the usefulness of the statement of cash flows as far as decision making is concerned. 8. Calculate and interpret the free cash flow Be Engaged Analyze: The financial statements of Company A and Company B shows the Net Income and its Total Assets below: Company A Company B Net Income β± 400,000.00 β± 90,000.00 Total Assets β± 1,250,000.00 β± 130,000.00 Think: 1. Which company shows a greater result of operation? 2. If you are an investor, which of the company above will you chose to invest in? Why? Will your answer in this question change if you found out that Company B is allegedly involved in a law suitcase? 3. If you are a manager of a company, what will you do to attract investors to invest in your company? 1 Let’s Discuss 1. Vertical analysis (common-size financial statements) 2. Horizontal analysis (trend percentages and index analysis) 3. Financial ratios 3.1 Liquidity, 3.2 Solvency, 3.3 Activity, 3.4 Profitability, 3.5 Growth and other ratios, 3.6 Du Pont technique 4. Cautions About Using Ratio Analysis 5. Cash flow analysis 5.1 Interpreting Statement of Cash Flow 5.2 Operating Cash Flow 5.3 Free Cash Flow Financial Statement Analysis Sample Income Statement and Balance Sheet This will be used for the application of different financial analysis tools. INCOME STATEMENT 2019 900,000 450,000 75,000 375,000 75,000 300,000 90,000 210,000 Sales Cost of Goods sold Other expenses (includes depreciation 20%) EBIT Interest Expense EBT Taxes (30%) Net Income 2018 600,000 300,000 90,000 210,000 60,000 150,000 45,000 105,000 BALANCE SHEET Assets Cash Accounts receivable Inventories Total Current Assets Non-Current Assets Less: Accumulated Depreciation Net Non-Current Assets Total Assets 2019 2018 200,000 300,000 500,000 1,000,000 150,000 20,000 130,000 1,130,000 150,000 150,000 300,000 600,000 100,000 10,000 90,000 690,000 2 Liabilities and Equity Accounts payable Notes payable Accruals Total Current Liabilities Long-term debt Total Non-current Liabilities Common Stocks Retained Earnings Total equity Total Liabilities and Equity 200,000 20,000 10,000 230,000 80,000 100,000 40,000 10,000 150,000 120,000 80,000 300,000 520,000 820,000 1,130,000 120,000 250,000 170,000 420,000 690,000 For PROFITABILITY RATIOS AS TO SHAREHOLDERS’ INTEREST and MARKET VALUE RATIOS, use this sample problem: Financially Company’s Statement of comprehensive income in 2019 reflects a total Net Income of 2,000,000. Financially Company has a total of 500,00 outstanding common stocks which can be sold at a market price of 40 per share. It is a policy of the company to pay an annual cash dividend of P1 per share to common stock. The financial Statement shows a book value per share of P2. Trend Analysis • • • • • • Also Known as the horizontal analysis Trends should be established to determine the most likely direction of the company and to help assessing the financial performance of the company Analyzes a firm’s financial ratios over time Can be used to estimate the likelihood of improvement or deterioration in financial condition. Financial Statement line item is compared and get its change from a year to another Example: Increase/ 2019 2018 Decrease Sales 900,000 600,000 50% Cost of Goods sold 450,000 300,000 50% Other expenses (includes depreciation 75,000 90,000 -17% 20%) EBIT 375,000 210,000 79% Interest Expense 75,000 60,000 25% EBT 300,000 150,000 100% Taxes (30%) 90,000 45,000 100% Net Income 210,000 105,000 100% 3 Common Size Financial Statement • • • Also Known as Vertical Analysis Financial Statement line item is presented as a percentage of a certain significant aggregate • Balance sheet items as percentage of total assets • Income statement items as percentage of sales Example: 2019 Assets Cash 200,000 17.70% Accounts receivable 300,000 26.55% Inventories 500,000 44.25% Total Current Assets 1,000,000 88.50% Non-Current Assets 150,000 13.27% Less: Accumulated Depreciation 20,000 1.77% Net Non-Current Assets 130,000 11.50% Total Assets 1,130,000 100.00% Financial Ratios • • • • • Show the financial health and stability Useful tools in verifying management’s targets, level of commitment, and consistency in implementing policies. Useful in forecasting Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths. Categories of Financial Ratios LIQUIDITY RATIOS Measure the ability of the company to pay short term obligation Current Ratio Quick Ratio πππ‘ππ πΆπ’πππππ‘ π΄π π ππ‘π πππ‘ππ πΆπ’πππππ‘ πΏπππππππ‘πππ πππ‘ππ ππ’πππ π΄π π ππ‘π πππ‘ππ πΆπ’πππππ‘ πΏπππππππ‘πππ Quick Asset = Total Current Assets - Inventories – Prepaid Assets Example: 2019 1,000,000 = 4.35 230,000 Example: 2019 1,000,000 − 500,000 = 2.17 230,000 4 Cash Ratio Working Capital to Total Asset Ratio πΆππ β + ππππππ‘ππππ ππππ’πππ‘πππ πππ‘ππ πΆπ’πππππ‘ πΏπππππππ‘πππ Example: 2019 πΆπ’πππππ‘ π΄π π ππ‘π − πΆπ’πππππ‘ πΏπππππππ‘πππ πππ‘ππ π΄π π ππ‘π Example: 2019 200,00 = 0.87 230,000 1,000,000 − 230,000 = 0.68 1,130,000 LEVERAGE RATIOS Measures the ability of the company to meet long term obligation when they due fall Debt Ratio Equity Ratio πππ‘ππ πΏπππππππ‘πππ πππ‘ππ π΄π π ππ‘π πππ‘ππ πβπππβππππππ ′ πΈππ’ππ‘π¦ πππ‘ππ π΄π π ππ‘π It tells how much of the assets is financed by debt or creditors Example: 2019 It tells how much of the assets is financed by equity or owners Example: 2019 310,000 = 0.27 ππ 27% 1,130,000 820,000 = 0.73 ππ 73% 1,130,000 Debt to Equity Ratio πππ‘ππ πΏπππππππ‘πππ πππ‘ππ πβπππβππππππ ′ πΈππ’ππ‘π¦ Show the relativity of creditors’ claims to shareholders’ claim Example: 2019 310,000 = 0.38 820,000 Times Interest Earned Ratio or Interest Coverage Ratio πΈπππππππ π΅πππππ πΌππ‘ππππ π‘ πππ πππ₯ππ (EBIT) πΌππ‘ππππ π‘ πΈπ₯ππππ π Shows the degree on how many times the earnings before interest and taxes can cover the interest expense Example: 2019 375,000 = 5π₯ 75,000 Cash Coverage Ratio πΈπ΅πΌπ + π·ππππππππ‘πππ + π΄ππππ‘ππ§ππ‘πππ πΌππ‘ππππ π‘ πΈπ₯ππππ π The extent to which interest expense are covered by cash generated from operation 5 Example: 2019 375,000 + (75,000 ∗ 20%) = 5.2π₯ 75,000 ACTIVITY RATIOS Measures how the company productively uses or manages its assets Asset Turnover Ratio (ATO) Cash Conversion Cycle (CCC): the length of time required to convert cash invested in operations to cash received πππ‘ πππππ as a result of operations. πΆπΆπΆ = π·ππ + π·ππΌ − π·ππ π΄π£πππππ π΄π π ππ‘π The peso generated per unit of asset Example: 2019 900,000 = 0.99 (1,130,000 + 690,000)/2 Accounts Receivable Turnover Ratio (ARTO) πππ‘ πΆπππππ‘ πππππ π΄π£πππππ π΄ππππ’ππ‘π π πππππ£ππππ Tells how many times Accounts receivable is being collected during a year. Normal Operating Cycle (NOC): time from the start of the production to collection of cash from the sale of the finished product πππΆ = π·ππ + π·ππΌ Example: 2019 πππΆ = 90 + 320 = 410 πππ¦π πΆπΆπΆ = 90 + 320 − 180 = 230 πππ¦π Days’ Sales Outstanding (DSO) π΄π£πππππ π΄ππππ’ππ‘π π πππππ£ππππ 360∗ ππ π΄π£πππππ π·ππππ¦ πΆπππππ‘ πππππ π΄π ππ The average amount of time needed to collect accounts receivable. *Mostly, 360 days is used unless stated in the problem Example: 2019 Example: 2019 900,000 =4 (300,000 + 150,000)/2 Inventory Turnover Ratio (ITO) πΆππ π‘ ππ πππππ ∗ π΄π£πππππ πΌππ£πππ‘πππ¦ *if data not available, use net credit sale Tells how many times Inventory is being sold during a year. 360 = 90 πππ¦π 4 Days’ Sales in Inventory (DSI) π΄π£πππππ πΌππ£πππ‘πππ¦ 360 ππ π΄π£πππππ π·ππππ¦ πΆππ π‘ ππ πππππ πΌππ Average number of days’ sales in inventory. *Mostly, 360 days is used unless stated in the problem 6 Example: 2019 Example: 2019 360 = 320 πππ¦π 1.125 450,000 = 1.125 (500,000 + 300,000)/2 Accounts Payable Turnover Ratio (APTO) Days’ Payable Outstanding (DPO) πππ‘ ππ’ππβππ ππ π΄π£πππππ π΄ππππ’ππ‘π πππ¦ππππ π΄π£πππππ π΄ππππ’ππ‘π πππ¦ππππ 360 ππ π΄π£πππππ π·ππππ¦ ππ’ππβππ ππ π΄πππ Tells how many time Accounts payable is being paid during a year. The average amount of time needed to pay accounts payable. *Mostly, 360 days is used unless stated in the problem Example: 2019, assuming purchases is 300,000 Example: 2019 300,000 =2 (200,000 + 100,000) 360 = 180 πππ¦π 2 PROFITABILITY RATIOS Measures the overall financial performance of the firm and its return on investment AS TO MARGINS Gross Profit Margin (GPM) Operating Profit Margin (OPM) Net Profit Margin (NPM) πΊπππ π ππππππ‘ πππ‘ πππππ Example: 2019 450,000 = 50 900,000 AS TO RETURNS Return on Sales (ROS) πππ‘ πΌπππππ πππ‘ πππππ Example: 2019 210,000 = 23.33% 900,000 ππππππ‘πππ ππππππ‘ (πΈπ΅πΌπ) πππ‘ πππππ Example: 2019 375,000 = 41.67% 900,000 Return on Assets (ROA) πππ‘ πΌπππππ π΄π£πππππ πππ‘ππ π΄π π ππ‘π Example: 2019 πππ‘ ππππππ‘ (ππ πππ‘ ππππππ) πππ‘ πππππ Example: 2019 210,000 = 23.33% 900,000 Return on Equity (ROE) πππ‘ πΌπππππ π΄π£πππππ πβπππβππππππ ′ πΈππ’ππ‘π¦ Example: 2019 210,000 (820,000 + 420,000)/2 = 33.87% 7 210,000 (1,130,000 + 690,000) /2 = 23.08% AS TO SHAREHOLDERS’ INTEREST Earnings per Share (EPS) Pay-out Ratio (POR) πππ‘ πΌπππππ − πππππππππ π·ππ£ππππππ ππ. ππ ππ’π‘π π‘ππππππ ππππππππ¦ πβππππ π·ππ£πππππ πππ π βπππ πΈππ Portion of the earning paid out to shareholders Example: 2,000,000 = 4/π βπππ 500,000 Dividend Yield (DY) Example: 1 = 25% 4 Plow Back Ratio (PBR) or retention ratio π·ππ£πππππ πππ π βπππ ππππππ‘ πππππ πππ πβπππ πΈππ − π·ππ£πππππ πππ π βπππ ππ 1 − πππ πΈππ Tells how much the investor will receive as dividend for every peso invested in the shares Show how much portion of the earnings is retain or invested by the firm Example: Example: 4−1 = 75% 4 1 = 2.5% 40 MARKET VALUE RATIOS Ratios that relate the company’s stock price to its earnings and book value per share Price-Earnings Ratio (PER) Market/Book Value Ratio ππππππ‘ πππππ πππ πβπππ πΈππ ππππππ‘ πππππ πππ πβπππ π΅πππ ππππ’π πππ πβπππ Assess the ability of the company to sustain growth and generate cash flow in the future The higher this ratio is the lower the risk and higher growth, and vice versa. Example: Example: 8 40 = 10 4 40 = 20 2 Dupont Technique A tool used to analyze the return on asset and equity by breaking down its components. π ππ΄ = π ππ ∗ π΄ππ π ππΈ = πΏππ£πππππ πΉπππ‘ππ ∗ ∗ π ππ ∗ π΄ππ πΏππ£πππππ πΉπππ‘ππ = • π΄π£πππππ π΄π π ππ‘ π΄π£πππππ πΈππ’ππ‘π¦ Focuses on: a. Expense control b. Asset utilization Example: 2019 π ππ΄ = 210,000 900,000 210,000 ∗ = = 23.08% 900,000 1,130,000 + 690,000 (1,130,000 + 690,000) 2 /2 1,130,000 + 690,000 210,000 900,000 210,000 2 π ππΈ = ∗ ∗ = (820,000 + 420,000)/2 900,000 1,130,000 + 690,000 (820,000 + 420,000)/2 2 = 33.87% Potential Problems And Limitations Of Financial Ratio Analysis • • • • • • • Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. “Average” performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better. Inflation Factor Different accounting practices and policies (e.g. leasing improves turnover and debt ratio) Generalization about “good” or “bad” ratios 9 Cash Flow Analysis Statement of Cash Flows • summarizes the firm’s cash flow over a given period. • reports the impact of a firm’s activities on cash flows over a period. • when assessing the firm’s liquidity financial managers typically combines cash and marketable securities since both represent a reservoir of liquidity. • Financial managers strive to maximize the cash flows available to investors to maximize the price of the firm’s stock since its valuation is based on the cash flow prospective. Major activities of the firm that generates cash a. Operating Activities – directly related to the principal revenue producing activity of the firm such as the sale and production of the firm’s products and services. b. Investing Activities – associated with purchase and sale of both fixed assets and equity investments of other companies. c. Financing Activities – associated with debt and equity financing transactions. These includes but not limited to incurrence and repayment of debt, cash inflow from the sale of shares, and cash outflows to repurchase shares or pay cash dividends. Non-cash activities • A firms’ activities that does not involve cash inflow or outflow. • Examples of significant non-cash activities: o Depreciation o Amortization o Depletion Interpreting The Statement Of Cash Flows a. A financial manager should analyze both the major categories of cash flow activities and the individual items of cash flow to assess whether such activities are in compliance or contrary to the firm’s financial policies. b. The cash flow statement can be used in evaluating progress toward company goals or identifying inefficiencies in cash flow activities. c. Financial manager also can prepare a projected statement of cash flows in conjunction with projected financial statements to identify whether planned activities reflected in the income statement and balance sheet are favorable in terms of its resulting cash flows. Operating Cash Flow (OCF) • The cash flow generated from the normal operations of the firm. • computed as net operating profits after taxes (NOPAT) plus depreciation. Net Operating Profit After Taxes (NOPAT) • The profit a firm would generate if it had no debt and held only operating assets. Formula of NOPAT and OCF ππππ΄π = πΈπ΅πΌπ ∗ (1 − π) 10 ππΆπΉ = ππππ΄π + π·ππππππππ‘πππ ππΆπΉ = πΈπ΅πΌπ ∗ (1 − π) + π·ππππππππ‘πππ Free Cash Flow (FCF) • • • The amount of cash that could be withdrawn without harming a firm’s ability to operate and to produce future cash flows. The amount of cash flow available to investors i.e., creditors and owners, after the firm has met all operating needs and paid for investments in net fixed assets and net current assets. Alternative Formulas πΉπΆπΉ = ππΆπΉ − πππ‘ πππ₯ππ ππ π ππ‘ πππ£ππ π‘ππππ‘ (ππΉπ΄πΌ) − πππ‘ ππ’πππππ‘ ππ π ππ‘ πππ£ππ π‘ππππ‘ (ππΆπ΄πΌ) πΉπΆπΉ = [πΈπ΅πΌπ ∗ (1 − π) + π·ππππππππ‘πππ & π΄ππππ‘ππ§ππ‘πππ] − [πΆππππ‘ππ πΈπ₯ππππππ‘π’πππ + ο πππ‘ ππππππ‘πππ π€ππππππ πππππ‘ππ] πΉπΆπΉ = ππΆπΉ – πΊπππ π πππππ‘ππ πππ£ππ π‘ππππ‘ πΉπΆπΉ = ππππ΄π – πππ‘ πππππ‘ππ πππ£ππ π‘ππππ‘ • • A positive FCF o Firm is generating more than enough cash to finance current investments in fixed assets and working capital. A negative FCF o Firm does not have sufficient internal funds to finance investments in fixed assets and working capital. o Need to raise new money in the capital markets to pay for prospective investments. Net fixed asset investment (NFAI) • net investment that the firm makes in fixed assets • pertains to purchases of fixed assets less sales of fixed assets • also equal to the change in gross fixed assets from prior year to the current year • Formula ππΉπ΄πΌ = πΆβππππ ππ πππ‘ πππ₯ππ ππ π ππ‘π + π·ππππππππ‘πππ • A negative amount of NFAI show a net cash inflow attributable to the firm selling more assets than it purchased or acquired during the year. Net current asset investment (NCAI) • net investment made by the firm in its current or operating assets 11 • • The account notes payable is not included in the NCAI computation since it represents a negotiated creditor claim on the firm’s free cash flow Formula ππΆπ΄πΌ = πΆβππππ ππ ππ’πππππ‘ ππ π ππ‘π − πΆβππππ ππ (πππππ’ππ‘π πππ¦ππππ + πππππ’πππ ) Net Operating Working Capital (NOWC) • Formula ππππΆ = πΆπ’πππππ‘ ππ π ππ‘π − ππππππ‘ππππ π‘ πππππππ ππ’πππππ‘ ππππππππ‘πππ (π. π. πππππ’ππ‘π πππ¦ππππ + πππππ’πππ ) Illustration for Cash Flow Analysis A. CBA has operating income of P2,500,000. The company’s depreciation expense is P500,000 and it has no amortization expense. The company is 100% equity financed. The company has a 40% tax rate, and the net operating working capital increased by P1,000,000. 1. What is CBA’s net income? 2. What is CBA’s net operating profit after taxes (NOPAT)? 3. What is CBA’s free cash flow? Solution: 1. EBIT Interest EBT Taxes (40%) NI P2,500,000 0 2,500,000 1,000,000 P1,500,000 2. ππππ΄π = πΈπ΅πΌπ ∗ (1 – π) = π2,500,000 (1 – 40%) = π·π, πππ, πππ 3. πΉπΆπΉ = [πΈπ΅πΌπ (1 – π) + π·ππππππππ‘πππ]– ο πππ‘ ππππππ‘πππ π€ππππππ πππππ‘ππ πΉπΆπΉ = [π2,500,000 ∗ (1 – 40%) + π500,000] − π1,000,000 = π·π, πππ, πππ B. Refer to the additional supplemental material for TOPIC 2 12 References Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited. Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege. Roque, R. S. (2013). Reviewer in Management Advisory Services. Other online resources https://www.accountingtools.com/articles/2017/5/14/financial-statement-analysis https://corporatefinanceinstitute.com/resources/knowledge/finance/analysis-of-financial-statements/ https://www.youtube.com/watch?v=lBBXmim527A 13
