Ch. 3 Working with financial statements 1. The statement of cash flows: a firm’s financial statement that summarizes its sources and uses of cash over a specific period. In order to evaluate cash flows, we have to understand the sources of cash (cash in) and uses of cash (cash out). In the balance sheet, the increase (decrease) in assets means cash out (cash in) whereas increase (decrease) in liabilities and equities means cash in (cash out). Another form of cash flow statement Cash, beginning of the year Source of Cash Operation Net Income Depreciation Working capital: Increase in accounts payable Long term financing: Increase in common stock Total sources of cash Uses of Cash Working capital: Increase in accounts receivable Increase in inventory Decrease in notes payable Long term financing: Decrease in long term debt Fixed asset acquisition Dividends paid Total uses of cash Net addition to cash Cash, end of year • 2. Standardized financial statements • In order to compare companies’ financial statements without size or scale issues. • Also standardized financial statements can be used for trend analysis. • 1) Common size statement. • Items in balance sheet are expressed by the percentage of asset. • Items in income statement are expressed by the percentage of sale. • Items in cash flow statement are expressed by the percentage of total sources of cash supplied or as the percentage of total uses of cash for a particular item. • 2) Common-base year financial statement: trend analysis • A standardized financial statement presenting all items relative to a certain base year amount. • 3) Combined common-size and base year analysis. Common-base year financial statement is influenced by size of asset. • 3. Ratio analysis: Here ratios commonly used are introduced. • 5 categories of ratios: • - short term solvency or liquidity ratios • - long term solvency or financial leverage ratios • - asset management ratios or turnover • - profitability ratios • - market value ratios 3-1) Short term solvency or Liquidity ratio Information regarding firm’s ability to pay its bills over the short run without undue stress. • Current ratio = current assets/current liabilities • Quick (Acid test) ratio = (current asset –inventory)/ current liabilities. • Cash ratio = cash/current liabilities • Net working capital to total assets = net working capital / total assets • Interval measure (how long business could keep running) = current assets/average daily operating costs • 3-2) long term solvency or financial leverage Information regarding firm’s long term ability to meet its financial obligations. • Total debt ratio =(total assets – total equity)/total assets • Debt to equity ratio = total debts /total equity • Equity multiplier = total assets/total equity • Time interest earned = EBIT/interest • Cash coverage = (EBIT + depreciation)/ Interest • 3-3) Asset management • How effectively and intensively the firm use assets to generate sales. • Inventory turnover = Cost of goods sold/ inventory • - how many times inventory was filled and empty? • Days’ sales in inventory = 365/Inventory turn over • - how many days it takes to reload inventory? • Receivable turnover =sale/account receivable • - how many times firm collected its outstanding credit and reloaned it? • Days’ sales in receivables = 365/ Receivable turnover • - how many days it takes to collect account receivable • Net working capital turnover = sales/ NWC • Fixed asset turnover = sales/fixed assets • Total asset turnover = sales/total asset turnover 3-4) Profitability measures • Profit margin = net income/sales • Return on assets = net income/total assets • Return on equity = net income/total equity 3-5) Market value measures Information regarding market value • Earnings per share = Net income / shares outstanding • Price –Earnings per share (PE ratio) = price per share/ Earnings per share. It relates to growth potential of the firm. • Price –sales ratio = price per share /sales per share. It is used when EPS is negative. • Market to book ratio = market value per share / book value per share. Here book value = total equity. • 4. Du Pont Identity • Decomposing ROE into three components. • • • • • ROE = net income/total equity = net income / total asset * total asset/total equity = net income/total asset * Equity multiplier = net income / total asset * (1+ debt to equity ratio) = net income/sales * sales/total asset * equity multiplier • = profit margin * asset turnover * equity multiplier • 5. Why evaluate financial statements? • Internal uses: performance evaluation and planning for future. • External uses: information for deciding whether to grant credit to a new customer, Evaluating major competitors, and information for evaluating potential target firms in merger attempts. 6. Choosing benchmarks. • 1) Time trend analysis: evaluate its own historical ratios in order to understand whether they improve. • 2) Peer group analysis: SIC (standard industry classification) code. But SIC code is not perfect due to firms with various sub-businesses. Table 3.10. NAICS (North American Industry Classification System) is intended to replace SIC. • 3) Problems with Financial Statement Analysis • - no guideline for value and risk • - consolidated financial statements do not fit any neat industry category. • - peer group or major competitors from foreign markets. • - different accounting and fiscal times for each firm.