Chapter 3 - Cash Flows And Financial Analysis
Users of Financial Information
Investors
– Make judgments about the firm's securities
– Financial Analysts report to investment community
Vendors
– Sell to the firm on credit
Management
– Highlight areas in which attention will improve
performance
2
Sources of Financial Information
Annual Report
– Management's report
card to stockholders on
own performance
– The primary source of
financial information
– Required of publicly
traded companies
Other Sources
– Reports from
brokerage firms
and advisory
services
– Value Line
– Credit reports
– Must be audited
– GAAP
3
Orientation of Financial Analysts
Critical and investigative
Looking for current or potential
problems
Looking for the physical reasons behind
financial results
4
Statement of Cash Flows
Businesses run on cash, not accounting
profits
It is possible for a business to go out of
business while making a profit
Statement of Cash Flows
– Reports inflows and outflows of money
– Developed from the income statement and
balance sheet
5
Building the Statement of Cash
Flows – Basic Approach
Build a Statement of Cash Flows from two
balance sheets and an income statement
Analyze where money has come from and
gone to
Begin with some personal examples
6
Table 3-1 Cash Flow Rules
Asset Increase = Use
Liability Increase = Source
Asset Decrease = Source
Liability Decrease = Use
7
Buying a Car on Credit
Joe Jones and His New Car
8
Buying and Selling Cars Sally Smith and Her Two Cars
9
Buying and Selling Cars Sally Smith and Her Two Cars
10
Business Cash Flows
Three sources of cash flows:
Operating Activities – day-to-day activities
Investing Activities – firm buys or sells ( or invests
in) fixed assets that enable it to do business.
Financing Activities – borrow money, pay off loans,
sell stock, pay dividends.
12
Figure 3.2 BUSINESS CASH FLOWS
13
Example 3-1 Business Cash Flows
Additional Information
Belfry also sold new stock during
the year receiving a total of $800
and paid its shareholders dividends
of $500.
Operating Activities
Net Income
Depreciation
Net Change in Current Accts
Cash from Operating Activities
$ 1,000
500
(600)
$ 900
Detail of Changes in Current Accounts
Account
Begin
End
Source/(Use)
Receivables
$3,000 $2,900
$ 100
Inventory
2,000
3,200
(1,200)
Payables
1,500
2,100
600
Accruals
500
400
(100)
$ (600)
Investing Activities
Purchase of Fixed Assets $(2,000)
Use Change in Gross Fixed Asset
Account
Financing Activities
Increase in Long Term Debt
Sale of Stock
Dividends Paid
Cash from Financing Activities
$ 1,200
800
(500)
$ 1,500
Free Cash Flows (FCF)
Used to estimate whether a company
will provide or require cash in future
Cash generated by operations that’s
available for distribution to investors.
If negative, owners must borrow or sell
equity just to keep going as before
21
Calculating Free Cash Flow
NOPAT is net operating profit.
T = tax rate
NOPAT = EBIT – (T)(EBIT) = EBIT (1 – T)
Note: If there is no debt, NOPAT equals net
income
22
Calculating Free Cash Flow
Depreciation is subtracted from revenue when
calculating EBIT.
Depreciation is a noncash charge, so EBIT
understates cash flow by at least that amount.
Adding back depreciation gives a figure that’s
closer to cash flow called operating cash flow.
Operating Cash Flow = NOPAT + Depreciation
23
Calculating Free Cash Flow
Money available to investors can be written
as:
FCF = Operating Cash Flow
– Increase in Gross Fixed Assets
– Increase in Current Accounts
24
Calculating Free Cash Flow to Equity (FCFE)
If a company is able to distribute cash to
stockholders, then the equation becomes:
FCFE = Operating Cash Flow
– Increase in Gross Fixed Assets
– Increase in Current Accounts
– (1-T)Interest – Principal Reduction
25
The Cash Conversion Cycle
Racetrack Diagram
26
RATIO ANALYSIS
27
COMPARISONS
Ratios are most meaningful when
compared with similar figures
Three comparisons:
– History
– Competitors
– Budget
28
Common Size Statements - Example
29
CATEGORIES OF RATIOS
Five Classifications
Liquidity
Asset Management
Debt Management
Profitability
Market Value
30
LIQUIDITY RATIOS
Liquidity ratios measure the company’s ability
to meet short-term financial obligations
Current Ratio – primary measurement of a company’s
liquidity
current assets
Current Ratio =
current liabilities
31
LIQUIDITY RATIOS
Quick Ratio (acid test) – A liquidity measure that
does not depend on inventory
current assets - inventory
Quick Ratio 
current liabilities
32
ASSET MANAGEMENT RATIOS
The fundamental efficiency with which a
company is run
Average Collection Period (ACP) – the time it
takes to collect on credit sales
ACP =
accounts receivable
average daily sales
ACP =
accounts receivable
 360
sales
Interpretation:
Customers pay slowly
OR there are a few
very old accounts that
will probably never be
collected.
33
INVENTORY TURNOVER
Inventory turnover ratio measures whether
the firm has excess funds tied up in inventory.
cost of goods sold
Inventory turnover =
inventory
Interpretation: Too much inventory is expensive to carry. Too
little causes stockouts which lead to inefficient production
and lost sales
34
FIXED ASSET TURNOVER AND TOTAL ASSET
TURNOVER
Measures the relationship of the firm’s assets to
a year’s sales
sales
fixed assets
sales
Total asset turnover
total assets
Fixed asset turnover 
35
DEBT MANAGEMENT RATIOS
Measures the firm’s debt level
relative to assets, equity, and income
DEBT RATIO
Uses a broad concept of debt including current liabilities
Debt ratio =
long - term debt + current liabilities
total assets
36
DEBT TO EQUITY RATIO
Measures the mix of debt and equity
within total capital.
Debt to Equity Ratio = Long Term Debt : Equity
37
TIMES INTEREST EARNED (TIE)
Measures the number of times interest can be paid
out of earnings before interest and taxes (EBIT)
EBIT
TIE =
interest
38
CASH COVERAGE
A variation on TIE. Adds depreciation to EBIT to
better approximate the cash available to cover
interest.
EBIT + depreciation
Cash coverage =
interest
39
FIXED CHARGE COVERAGE
A variation on TIE to include lease payments as
fixed financial charges equivalent to interest
Fixed charge coverage =
EBIT + lease payments
interest + lease payments
40
DEBT MANAGEMENT RATIOS
Compares fixed (obligatory) payments with
the cash available to pay (cover) them.
EBITDA coverage
EBITDA  lease payments

interest  lease payments  principal repayments
PROFITABILITY RATIOS
Relative measures of the firm’s money-making
success, also called profit margin.
RETURN ON SALES (ROS)
ROS =
net income
sales
42
RETURN ON ASSETS (ROA)
Measures the overall ability of the firm to utilize
the assets in which it has invested to earn a profit
net income
ROA =
total assets
43
RETURN ON EQUITY (ROE)
The most fundamental profitability ratio
Measures the firm’s ability to earn a
return on the owners’ invested capital.
net income
ROE =
equity
44
MARKET VALUE RATIOS
PRICE / EARNINGS RATIO (P/E)
Measures market’s opinion of the stock as an investment
P/E Ratio =
stock price
EPS
Interpretation: The amount investors will pay for each
dollar of earnings. Based primarily on expected growth.
45
MARKET TO BOOK VALUE RATIO
Market to book value ratio =
stock price
book value per share
46
DU PONT EQUATIONS
Equations show relationships between ratios
net income sales
ROA =

total assets sales
net income
sales
ROA =

sales
total assets
ROA = ROS  total asset turnover
47
Extended Du Pont Equation
net income sales total assets
ROE =


equity
sales total assets
net income
sales
total assets
ROE =


sales
total assets
equity
ROE = ROS  total asset turnover  equity multiplier
ROE = ROA  equity multiplier
48
Using the Du Pont Equations
ROA
= ROS
X
Total Asset Turnover
Sampson Inc.
12%
6%
2x
Industry
15%
5%
3x
Focus attention on revenue or assets
rather than on cost or expense
49
Limitations and Weaknesses
of Ratio Analysis
Diversified Companies
– Analysis of consolidated results is confused
Window Dressing
– Year end tricks can artificially improve ratios
Accounting Principles
– Allow latitude in reporting
Inflation Can Distort Financial Results
Interpretation of Ratios is Often Unclear
Ratio Analysis Doesn’t Give Us Answers, It Helps Us
Ask the Right Questions
50