How to derive statement of CF from income
statement and balance sheet (indirect method for
year 2005)
CF from operations = A - B, A – from income statement,
B – from balance sheet



A = Net Income + Depreciation + Other non-cash items (e.g.
deferred taxes) = 2 + 1.2 + 0.2 = 3.4
B = Changes in NWC, except items related to financing activities
= ΔAR + ΔInventory + ΔOther CA - ΔAP - ΔOther CL = 5.3 + 1 +
1 – 4.7 + 2 = 4.6
Hence, OCF = 3.4 – 4.6 = -1.2
CF from investing = -(ΔTotal long-term assets +
depreciation) = -41
CF from financing = new debt issues – retirement of debt
+ new equity issues – dividends – repurchase of equity =
ΔTotal debt + ΔNotes payable + ΔCurrent maturities of
LT debt + ΔStockholders’ equity – Net Income = 43.6 +
0.3 + 1 + 1 – 2 = 43.9
Note on statement of CF
Interest expense is classified as operating cash flow,
though it’s clearly a financing cash flow.
Sometimes (but not in our case) ΔShort term borrowing
is included in operating CF calculation
Increase in inventory does not affect Net Income, but still
included in operating CF calculation
Interest income and dividends received are classified as
operating cash flows, though they result from investment
activities
Income taxes are classified as operating cash flows,
though taxes are affected by financing (e.g., deduction
for interest expense) and investment activities (e.g.
reduction of taxes from tax credits on investment
activities)
How much actually goes to investors?
CF to investors (CF from assets) = -CF from financing
activities + interest = - 43.9 + 7.7 = - 36.2

Another way to compute it: CF to investors = CF from operations
– CF from investment – ΔCash + interest
Cash flow to creditors = interest + retirement of debt –
new debt issues = interest – Δshort term borrowing –
Δlong term borrowing = 7.7 – 1.3 – 43.6 = -37.2
(Δshort term borrowing = ΔNotes payable + ΔCurent
maturities of LTD; Δlong term borrowing = Δlong term
debt)
Cash flow to shareholders = dividends + repurchase of
stock – new equity issues = ΔStockholders’ equity – Net
Income = 1.0
Cash flow patterns
Wal-Mart (mature, healthy company)
Cash flow patterns
Amazon (successful fast-growing company)
Cash flow patterns
Weirton steel. Went bankrupt in 2003.
Quality of financial info.
Example: Earnings management
Stock prices are sensitive to earnings
Hence managers that want to inflate stock
price (or sustain it high) use techniques to
“manage” earnings (usually increase but
sometimes smooth)
Not all techniques are illegal (hence
difference between “earnings
manipulation” and “earnings management”
in general)
Correlation between earnings and stock value for GE
How do managers manage earnings?
Discretionary use of accounting accruals
Revenue and expense recognition
Inventory accounting
Moving expenses to capital expenditures
etc …
Enron’s earnings and cash flows from
operations
WorldCom earnings management
Financial Ratio Analysis
Aggregates info from financial statements
by forming indicators of the firm’s financial
condition (ratios)
Trend Analysis
Cross-Sectional Analysis
Types of ratios:
Liquidity (short-term solvency) ratios
Activity ratios
Leverage ratios
Profitability ratios
Market value ratios
Liquidity ratios
Measuring short-term liquidity:
Current Ratio = Current Assets / Current Liabilities


Too low CR may be a sign of financial trouble
Too high CR may mean poor operating practices
Quick Ratio
= (Current Assets – Inventories) / Current Liabilities
Activity ratios
How well the company uses its productive resources
Total Asset Turnover = Sales / Average Total Assets

Effectiveness in using the total assets
Accounts Receivable Turnover
= Credit Sales / Average Accounts Receivable
Average Collection Period
= 365 / Accounts Receivable Turnover


Too long ACP may mean lenient credit policy, failure to collect on
time, bad quality of receivables
Too short ACP may mean too stringent credit policy ( missed
sales)
Inventory Turnover
= Cost of Goods Sold / Average Inventory
Days in Inventory = 365 / Inventory Turnover


Too many days is a bad thing if products become obsolete
Too few days may mean lost sales due to items being out of
stock
Financial leverage ratios
Debt Ratio = Total Debt / Total Assets
Debt-to-Equity Ratio
= Total Debt / Total Equity

Higher these ratios imply higher risk of
financial distress
Interest Coverage = EBIT / Interest

Meeting interest payments out of EBIT (can
be modified to be based on cash flows
instead of earnings – Cash Flow Coverage)
Debt Ratio & Debt-Equity Ratio:
Spectrum Manufacturing
1999
Total Liabilities
Total Assets
Stockholder’s Equity
Debt Ratio
Debt-Equity Ratio
$8,456
13,396
4,940
0.63
1.71
1998
1997
$7,609
12,117
4,508
0.63
1.69
$3,695
7,794
4,099
0.47
0.90
Industry Average (Debt Ratio)
Industry Average (Debt-Equity Ratio)
=
=
0.55
1.22
Creditors are exposed to “more risk” than the industry average
The risk is growing over time, impairing the firm’s ability to borrow
Times Interest Earned:
Spectrum Manufacturing
Net Operating Income (EBIT)
Interest Expense
Interest Coverage
1999
1998
$1,265
389
3.3X
$1,775
363
4.9X
Industry Average
=
1997
$1,915
142
13.5X
5.4X
Although the ratio is going down, it’s still OK to provide
security to creditors
Profitability ratios
Help evaluate managerial performance
Gross Profit Margin = EBIT / Sales
Net Profit Margin = Net Income / Sales

Profit margins measure the ability to generate and market
profitable products and control expenses
Gross Return on Assets (ROA) = EBIT / Total Assets
Net Return on Assets (ROA) = Net Income / Total Assets

Measure profitability of the overall firm
Return on Equity (ROE) = Net Income / Equity

Measures profitability from the perspective of the equity investors
Note: here book values of assets and equity are used
Payout Ratio = Cash Dividends / Net Income
The DuPont Analysis
Net Income
ROE 

Sales

Net Profit Margin
Sales
Assets


Total Asset Turnover

Assets
Equity

Equity Multiplier
ROA
Gives an understanding of what is causing changes in
ROE and through which variables it can be improved
E.g., if it is hard to change Net Profit Margin, a firm can
play with Total Asset Turnover and Equity Multiplier. But
should be careful with EM since it increases risk
Du Pont Analysis:
Spectrum Manufacturing
1997-1999
Year
Net Profit
Margin (%)
1997
1998
1999
4.3
3.0
2.6
x
Total Asset
Turnover
2.8
2.3
1.6
x
Equity =
Multiplier
1.9
2.7
2.7
ROE (%)
22.9
18.6
11.2
The firm is following a dangerous path: increasing leverage does not help
revert the trend of decreasing ROE, while at the same time raises financial
risk.
ROA for Winn-Dixie
What was responsible for the fall of Winn-Dixie’s ROA?
Market Value Ratios
Measures of the firm’s prospects:
Price-to-Earnings = Share Price / EPS =
= Market Cap / Net Income
Dividend Yield = DPS / Share Price
Market-to-Book Ratio
= Market Cap / Book Equity Value
Tobin’s Q
= Market Value of Debt + Equity / Replacement
Value of Assets
Book value and market value of
equity compared
Coca-Cola