Goal of the Lecture:
Understand how to construct
a cash flow statement, a cash
budget, and pro-forma
financial statements.
Financial Analysis and Planning
I.
Analyze Financial Health of Companies
a. Ratio Analysis
b. Common Size Statements
c. Dupont System
II.
Cash Flow Analysis – Cash Flow Statement
III.
Financial Planning
a. Cash Budgeting
b. Pro Forma Financial Statements
I. Ratio Analysis - Five Types
a. Liquidity Ratios
1. Current Ratio = Current Assets/Current Liabilities
2. Quick Ratio = (Current Assets -Inventory)
Current Liabilities
b. Asset Management
1. Total Asset Turnover = Sales/Total Assets
2. Fixed Asset Turnover = Sales/Fixed Assets
3. Inventory Turnover = COGS/Inventory
4. Average Collection Period= Accounts Receivable
(Sales/365)
c. Debt Management
1. Total Debt to Total Assets = Total Debt
Total Assets
2. Times Interest Earned = EBIT/Interest Expense
3. Fixed Charges Coverage =
(EBIT + Lease Expense)
(Interest + Lease Expense)
d. Profitability
1. Return on Equity =
Net Income
Stockholders Equity
2. Operating Margin = Operating income(EBIT)
Sales
3. Basic Earning Power = EBIT/Total Assets
3. Return on Total Assets = Net Income
Total Assets
4. Net Profit Margin = Net Income/Sales
e. Market
1. Price/Earnings Ratio = Market Price per Share
Earnings Per Share
2. Dividend Yield = Dividends Per Share
Share Price
3. Dividend Payout = Dividend Per Share
Earnings Per Share
Example: Ratio Analysis
Ratios
General Mills
Kellogg
Current
.85
.89
Total Asset TO
.81
1.1
Debt to Equity
117
259
EBITD Margin
21.2
18.5
ROA
8.8
10.1
ROE
28
50.3
Kellogg is slightly more liquid.
Kellogg has the best asset management.
Kellogg has the most leverage (financial risk).
Kellogg seems most profitable.
For liquidity, asset management and leverage, one ratio can
often be used to make comparisons. But for profitability,
looking at more than one ratio is often helpful. In this case,
the large write-offs and high leverage makes Kellogg seem
profitable but this could be misleading. Why? Hint: Compare
betas.
II.
Criticisms of Ratio Analysis
a. Uses Historical Information Distorted by Inflation
b. Need to Look Beyond the Numbers
c. Accounting Numbers can be Manipulated
d. Ratio Complexity Related to International and
Multi-diversified Firms
e. Difficult to Determine a Comparison Industry
for some Firms
For Examples: See reuters.com
III. Dupont System
a. Components of ROE (Return on Equity)
ROE = Net Income/Equity
= (Net Income/Pre-tax Income) x (Pre-tax Income/EBIT) x
(EBIT/Sales) x (Sales/Total Assets) x (Total Assets/Equity)
= (Tax Burden) x (Interest Burden) x (Return on Sales)
(Total Asset Turnover) x (Financial Leverage)
b. To show the relationship between ROE and ROA
ROE= (1-Tax Rate)[ROA + (ROA-Interest Rate)Debt/Equity]
Note: The leverage effect can be positive or negative.
IV.
Financial (Cash Flow) Planning
A. Importance of Cash Flow
1. Cash Budgeting - need cash to pay bills
2. Used in Evaluating Investments – NPV
3. Avoid Accounting Ambiguity - unique cash amount
4. Cash Flow Statement
V. Cash Flow Statement Analysis
1. Three Parts
a. Operating Activities
b. Investment Activities
c. Financing Activities
2. Cash Flow Statement - Advantages
a. Breakdown by activities
b. Removes accrual effects and restates on a cash basis
c. Breaks out gross figures instead of net figures on debt
and other transactions.
3.Cash Flow Statement - Disadvantages
a. Confusion with the Indirect Approach (Starts
with Net Income)
b. Does Not Reconcile Taxes Reported on Income
Statement and Actual Taxes Paid
c. Does Not Require Separate Disclosure of Cash
Flows Associated with Discontinuing
Operations and Extraordinary Items
d. Non-Cash Investing and Financing Reported
in the Notes
e. Interest is an Operating Expense, But Dividends
are Reported as Financing Expense (Misleading)
Cash Flow Statement - Inflows and Outflows
“Accounting statement that reports the flow of cash into and
out of the firm in terms of operating, investing, and
financing activities.”
I.
Cash Flow Statement
Illustration of Inflows and Outflows
II.
Inflows
Outflows
Operations
Operations
Cash Sales
Payment for Materials
Collection of A/R
Wages, Rent, Tax, etc.
Investments
Investments
Sell Securities
Working Capital
From Subsidiaries
Capital Investments
Sell Assets
Financing
Issue Securities
Obtain Loan
Financing
Pay Interest & Dividends
Repay Loans and Bonds
Retire Equity
For Examples: reuters.com, 10kwizard.com
VI. Cash Budget
1. A Detailed Statement of Cash Inflows and Outflows
(Short-Term Financing)
a. Predict Economy and Business Future
b. Estimate Sales - historical, industry trend, sales force
c. Determine Cash Inflows From Operations – seasonals
d. Determine Cash Outflows From Operations - cash cost
e. Determine Other Extra Cash Inflows/Outflows dividends, asset sales, capital investments, loans
f. Subtract Total Outflows From Total Inflows
g. Determine Financing Needed -> > Maximum Outflow
Examples: See handout.
Pro Forma Financial Statements
“Projection of Expected Future Financial Statements and
Longer-Term Financing Needs”
XII.
Pro Forma Financial Statements
a. Long-Term
b. Two Approaches
1. Take Cash Budget Numbers and Adjust for GAAP
2. Percentage of Sales Method - More Common
- Project sales
- Project costs, assets and liabilities as
fixed percentages of projected sales
- Some accounts will not vary with sales leave fixed, - debt, dividends, common
For Examples: See handout
XIII. External Financing
1. Calculate pro forma retained earnings from
income statement and pro forma change in assets
and liabilities from the balance sheet.
External Financing = Assets - Liabilities +
Refinancing - Retained Earnings + Replacement
Investment