Financial Statements
and Cash Flows
Financial Statements
Financial Statements
 Balance sheet
 Income statement
 Statement of cash flows
Balance Sheet
 Statement of financial position.
 The balance sheet is a financial statement that
shows the firm’s assets, liabilities and equity at a
given point in time.
 Balance Sheet Identity
 Assets = Liabilities + Shareholders’ Equity (Owner’s
Equity)
Assets and Liquidity
 The speed and ease with which an asset can be
converted to cash.
 Ease of conversion to cash.
 Without significant loss in value.
 Trade-off between the advantages of liquidity and
foregone potential profits.
 The more liquid a firm is, the less likely it is to
experience financial distress.
 The return on liquid assets is low.
Debt versus Equity
 Shareholder’s equity = Assets – Liabilities
 Shareholder’s equity is the residual portion and equity
owners are entitled to only the residual value.
 The use of debt in a firm’s capital is called financial
leverage. The more debt a firm has, the greater of
financial leverage.
Net Working Capital
 Net Working Capital = Current Assets – Current Liabilities
 Positive when current assets exceed current liabilities.
 Positive when the cash that will become available over
the next 12 months exceeds the cash that will be paid
over the next 12 months.
 Usually positive in a healthy firm.
Market Value versus Book Value
 Book value – the balance sheet
 Assets at historical costs.
 Market value - the price at which an item could be
bought or sold
 Stockholder wealth maximization is to maximize the
market value of the stock, not the book value.
Income Statement
 Profit and loss statement.
 Statement of financial performance.
 The income statement shows the revenue and
expenses of a firm during a period of time.
 Revenue – Expenses = Income
 Accounting net income is not the same as cash flow.
 Depreciation, a noncash expense, is deducted when net
income is calculated.
Sources and Uses of Cash
 Sources of cash
 Cash inflows
 Decrease in assets other than cash
 Increase in liabilities or equity
 Uses of cash
 Cash outflows
 Increase in assets other than cash
 Decrease in liabilities or equity
Statement of Cash Flows
 The statement which summarizes the sources and
uses of cash.
 Three categories
 Operating activities
 Investment activities
 Financing activities
Cash Flows
Cash Flow
 The difference between the number of money that
came in and the number that went out.
 The actual net cash, as opposed to accounting net
income, that flows into or out of a firm during a
certain period.
 Free cash flow refers to the cash that the firm is free to
distribute to creditors or stockholders because it is not
needed for working capital or fixed asset investment.
Cash Flow Identity
 Cash Flow From Assets (CFFA) = Cash Flow to Creditors +
Cash Flow to Stockholders
 Cash Flow From Assets = Operating Cash Flow – Net Capital
Spending – Change in NWC



Operating cash flow = Earnings before interest and equity (EBIT) +
Depreciation – Taxes
Net capital spending = Ending net fixed assets – Beginning net fixed
assets + Depreciation
Change in NWC = Ending NWC – Beginning NWC
 Cash Flow to Creditors = Interest paid – Net new borrowing
 Cash Flow to Stockholders = Dividends paid – Net new equity
raised
Example
 Current assets
 2011: Current assets = 8,800
 2010: Current assets = 7,000
 Current liabilities
 2011: Current liabilities = 3,000
 2010: Current liabilities = 2,400
 Fixed assets
 2011: Net fixed assets = 6,800; 2010: Net fixed assets = 6,200
 Depreciation Expense = 800
 Long-term debt and Equity
 2011: Long-term debt = 8,000; Common stock = 800
 2010: Long-term debt = 7,900; Common stock = 800
 Income Statement
 EBIT = 4,000; Taxes = 600
 Interest expense = 700; Dividends = 1000
 Calculate the CFFA
Solution
 OCF = $4,000 + 800 – 600 = $4,200
 Net capital spending = $ 6,800 – 6,200 + 800 = $1,400
 Change in NWC = ($8,800 – 3,000) – ($7,000 – 2,400)
= $1,200
 CFFA = $4,200 – 1,400 - 1,200 = $1,600
 CF to Creditors = $700 – ($8,000 – 7,900) = $600
 CF to Stockholders = $1,000
 CFFA = $600 + 1,000 = $1,600
Working with
Financial Statements
Standardized Financial Statements
 Common-size balance sheets
 Express each item as a percent of total assets
 Common-size income statements
 Express each item as a percent of sales
 Common-size statements of cash flows
 Express each item as a percent of total sources or
uses
 Standardized financial statements are useful for
comparing companies of different sizes.
Trend Analysis
 Common base-year statements
 Choose a base year and express each item relative to the base
amount.
 Combined common-size base-year analysis
 As the assets grow, most of the other accounts must
grow as well.
 By forming the common-size statements, the effect of
the overall growth would be eliminated.
Ratio Analysis
 Ratio analysis are useful for comparing through time or
between companies.
 Categories of financial ratios
 Short-term solvency or liquidity ratios
 Long-term solvency or financial leverage ratios
 Asset management or turnover ratios
 Profitability ratios
 Market value ratios
Short-Term Solvency Ratios
 Current ratio = Current assets / Current liabilities
 Quick ratio = (Current assets – Inventory) /
Current liabilities
 Cash ratio = Cash / Current liabilities
 Net working capital to total assets = Net working
capital / Total assets
 Interval measure = Current assets / average daily
operating costs
Long-Term Solvency Ratios
 Total debt ratio = (Total assets – Total equity) /
Total assets
 Debt-equity ratio = Total debt / Total equity
 Equity multiplier = Total assets / Total equity
= 1 + Debt-equity ratio
 Long-term debt ratio = Long-term debt / (Long-
term debt + Total equity)
 Times interest earned ratio = EBIT / Interest
 Cash coverage ratio = (EBIT + Depreciation) / Interest
Asset Management Ratios
 Inventory turnover = Cost of goods sold / Inventory
 Days’ sales in inventory = 365 / Inventory turnover
 Receivables turnover = Sales / Accounts receivable
 Days’ sales in receivables = 365 / Receivables
turnover
 NWC Turnover = Sales / NWC
 Fixed asset turnover = Sales / Net fixed assets
 Total asset turnover = Sales / Total assets
Profitability Ratios
 Profit margin = Net income / Sales
 Return on assets (ROA) = Net income / Total assets
 Return on equity (ROE) = Net income / Total equity
Market Value Ratios
 Price-earnings ratio = Price per share / Earnings per
share
 Price-sales ratio = Price per share / Sales per share
 Market-to-book ratio = Market value per share / Book
value per share
 Tobin’s Q = Market value of the firm’s assets /
Replacement cost of the firm’ s assets = Market value
of the firm’s debt and equity / Replacement cost of the
firm’ s debt and equity
The Du Pont Identity
 ROE = Net income / Total equity
 ROE = (Sales / Sales)(Net income/ Total
assets)(Total assets / Total equity)
 ROE = (Net income / Sales)(Sales / Total
assets)(Total assets / Total equity)
 ROE = (ROA)(Equity multiplier)
 ROE = (Profit margin)(Total asset
turnover )(Equity multiplier)
The Du Pont Identity
 ROE = (Profit margin)(Total asset turnover)(Equity
multiplier)
 Profit margin – profitability ratio, operating
efficiency
 Total asset turnover – asset management ratio, asset
use efficiency
 Equity multiplier – long-term solvency ratio,
financial leverage
Why Evaluate Financial Statements?
 Internal uses
 Performance evaluation
 Planning for the future
 External uses
 Creditors
 Suppliers
 Customers
 Credit-rating agencies
Choosing a Benchmark
 Time-trend analysis
 Compared to history
 Peer group analysis
 Compare to the peer group
Limitations
 The results of ratio analysis depend on the quality of
financial statements.
 It is difficult for diversified firms to find a benchmark.
 Factors such as inflation, different operating and
accounting practices, seasonal factors can distort
comparisons.
 It is difficult to judge whether a particular ratio is
“good” or “bad”.
 It is difficult to judge whether a firm is “good” or “bad”
if some ratios look “good” and some ratios look “bad”.