CHAPTER 17
1
CHAPTER 7, THIRD EDITION
Projecting Cash Flow and Earnings
Financial Statements and Ratio Analysis, Chapter 7, Third Edition
Chapter Sections:
Sources of Financial Information
Financial Statements
Financial Statement Forecasting
Starbucks Company Case Study (Adolph Coors, Chapter 7, Third Edition)
Chapter 17 of the fourth edition and Chapter 7 of the third edition
deal mainly with financial statements and ratio analysis. It is
important enough to warrant our attention. We will look at all the
ratios but only compute a few. We will skip the forecasting.
2
Financial Statements

Balance Sheet
 A financial summary of a firm’s assets, liabilities,
and shareholders’ equity at a given point in time

Income Statement
 A financial summary of the operating results of firm
covering a specified period of time, usually 3
months (quarterly results) and 1 year (annual results)

Cash Flow Statement
 A financial summary of a firm’s cash flow and other
events that caused changes in the company’s
cash position (again, quarterly & annually)
3
Financial Statements

(continued)
Balance Sheet
 Assets
 Anything a company owns that has value
 Liabilities
 A firm’s financial obligations
 Equity
 An ownership interest in the company

Assets = Liabilities + Equity
 Assets – Liabilities = Equity

Current versus Long-term
Balance Sheet Example
4
Financial Statements

(continued)
Income Statement
 Income
 The difference between a company’s revenues
and expenses, used to pay dividends to
stockholders or kept as retained earnings within
the company to finance future growth
 Net Income = Revenue – Expenses
 But some income and expenses are not always
received or paid in cash
 That’s why there is the Cash Flow Statement…
Income Statement Example
5
Financial Statements

(continued)
Cash Flow Statement
 a.k.a. Statement of Cash Flows
 Cash Flow – Income realized in cash form
 Non-cash Item – Income and expense items not
realized in cash form
 Operating Cash Flow – Cash generated by a firm’s
normal business operations
 Investment Cash Flow – Cash flow resulting from
purchases and sales of fixed assets and investments
 Financing Cash Flow – Cash flow originating from the
issuance or repurchase of securities and payment of
dividends
Cash Flow Statement Example
6
Sources of Financial Statements

SEC EDGAR
 Annual Report – 10K
 Quarterly Update – 10Q
 Regulation FD (Fair Disclosure)
 Requires companies to make public disclosures of
material information fairly
 An “Earnings Call” is scheduled for a set date & time

Countless Other Sources
I have heard many investors opine that nowadays there is
simply too much information.
“Wisdom Sold Separately.” – Nick Murray
7
Financial Ratios

Financial Ratios
 The relation between two financial quantities
expressed as the quotient of one divided by the
other

Ratio Analysis
 The study of the relationships between financial
statement accounts
Recall that there is no one ratio that can accurately sum up the overall general
state of a company. Each ratio must be considered in the context of all the
information gathered. Plus you must consider any ratio in the context of the
industry the company exists within. (We will see an example soon.)
8
Financial Ratios – Common Stock

Common Stock Ratios – a.k.a. Market Ratios
 Financial ratios that convert key information about







a firm to a per-share basis
Price/Earnings Ratio – P/E
Price/Earnings to Growth Ratio – PEG
Dividends per Share
Dividend Yield
Dividend Payout Ratio
Book Value per Share
Price-to-Book-Value, Price-to-Cash Flow, Price-toSales
These ratios use data from the Balance Sheet or the Income Statement or both.
9
Financial Ratios – Common Stock
(continued)

Price / Earnings Ratio – a.k.a. P/E
 Market Price divided by Earnings per Share
Market Price of Common Stock
Price / Earnings Ratio = –––––––––––––––––––––––––––––
Earnings per Share
REVIEW: The most popular stock market statistic. Historically, P/E ratios
were in the 5 to 12 range for mature companies and 14 to 20 range for
growing companies. Greater than 20 was unusual. Today, it is commonplace.
The P/E ratio also tells you how long it will take in years (assuming no
changes in earnings) for the company to earn back its price. A P/E of 3 will
take three years; a P/E of 20 will take twenty years.
10
P/E Ratios and Specific Industries
Exxon –
Chevron –
CononoPhillips –
BP –
10.79
9.84
11.61
5.11
Google –
Yahoo –
Sohu –
Baidu –
Amgen –
Life Technologies –
Biogen Idec –
Illumina –
18.91
31.01
36.12
94.35
J.P. Morgan –
8.67
Citigroup –
15.47
Wells Fargo – 11.18
US Bank –
12.32
General Mills –
Hormel –
Kellogg’s –
Kraft –
17.85
22.59
22.53
17.15
!
!!
!!!
25.27
9.08
32.44
31.95
Merck –
28.54
Pfizer –
7.98
Eli Lilly –
11.36
Bristol Myers – 56.74
?
?
As of 30 September 2013
!
P/E Ratios and Specific Industries
11
(continued)

How can we account for the wide P/E
disparity between different industries and
different companies within industries?
 Again, it is the expectation of future earnings and
dividend growth by investors
“Take a nice little company that has been making shoelaces for 40 years and sells at a
respectable six times earning ratio. Change the name from Shoelaces, Inc. to Electronics
and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are
worth 15 times earnings. However, the real play comes from the word “furth-burners”
which no one understands. A word that no one understands entitles you to double your
entire score. Therefore, we have six times earnings for the shoelace business and 15
earnings for electronics and silicon, or a total of 21 times earnings. Multiply this by two
for furth-burners and we now have a score of 42 times earnings for the new company” –
Jack Dreyfus, Founder, Dreyfus Funds
A Random Walk Down Wall Street
Today, replace furth-burners with nanotechnology or 3-D printing and replace
electronics and silicon with social networking and China.
12
Financial Ratios – Common Stock
(continued)

Price/Earnings to Growth Ratio – a.k.a. PEG
 Compares the P/E ratio to the rate of growth
Stock’s P/E Ratio
PEG Ratio = ––––––––––––––––––––––––––––––––––––
3- or 5-Year Growth Rate in Earnings
A PEG Ratio of 1.0 means that P/E Ratio matches its growth rate.
Historically, a PEG Ratio of 1.0 was desirable since it meant that the P/E
Ratio equaled the growth rate. Anything above 1.0 was considered high.
Now, greater than 1.0 is common.
13
Financial Ratios – Common Stock
(continued)

Dividends per Share
 Measure of how much dividends each share of
stock will receive
Dividends
Annual Dividends Paid to Stockholders
per
= –––––––––––––––––––––––––––––––––––––––
Share
Number of Shares Outstanding
REVIEW: As we discussed, dividends became taboo during the 1990’s. Since
the 2000-2002 bear market, investors have changed their minds about
dividends. Dividends can be discussed in polite company again!
14
Financial Ratios – Common Stock
(continued)

Dividend Yield
 Measure of how much dividends are as a
percentage of the stock price
Dividend
Yield
Dividends per Share
= ––––––––––––––––––––––––––––
Market Price per Share
REVIEW: This important statistic allows an investor to compare a company to
other forms of investments that pay income (such as savings accounts or bonds).
Traditionally, 4% to 6% was considered good. Currently, the S&P 500 is yielding
just over 2% (while 10-year Treasury bonds are yielding around 2½% and
savings accounts are yielding far less than 1%.) Some stocks are paying much
more while many growth stocks are paying no dividends.
15
Financial Ratios – Common Stock
(continued)

Dividend Payout Ratio
 Measures of how much of a company earnings are
being paid out to shareholders in the form of
dividends
Dividends per Share
Payout Ratio = ––––––––––––––––––––––
Earnings per Share
REVIEW: More mature companies often pay out almost all their earnings in
the form of dividends. Growing companies retain their earnings (called
Retained Earnings) to support the growth of the company.
16
Financial Ratios – Common Stock
(continued)

Book Value per Share
 Measure of the net worth of a company on a per
share basis
Book Value
Common Stockholders’ Equity
per
= ––––––––––––––––––––––––––––––––
Share
Number of Shares Outstanding
REVIEW: Book Value per Share tells an investor how much assets are
behind each share of stock. In other words, if all the assets of the company
were liquidated, how much would each shareholder receive? It is common
for the actual market price of a share to be above the book value per share
since the company is worth more intact than if it were dissolved. Today, it is
common for the market price to be far above the book value.
17
Financial Ratios – Common Stock
(continued)

Price-to-Book-Value per Share
 Ratio of the market price to the book value per
share
Price-toMarket Price per Share
Book-Value = ––––––––––––––––––––––––
per Share
Book Value per Share
REVIEW: Given that the Book Value per Share is often less than the market
price, the Price-to-Book-Value Per Share tells an investor how far above
the book value the market value is. If the Price-to-Book-Value per Share =
1.0, they are the same. Today, Price-to-Book-Value per Shares of 3 to 4 are
not uncommon and some are much higher.
18
Financial Ratios – Common Stock
(continued)
 Price-to-Cash Flow Ratio
Current price divided by current cash flow per share
Cash flow often differs from earnings per share
For several reasons, but the most common reason is…
Depreciation is not an actual cash expenditure
 But there are many reasons cash flow & earnings differ
“Good quality” versus “poor quality” earnings
Current Price
Price-Cash Flow Ratio = ––––––––––––––––––––––––––––
Cash Flow per Share
REVIEW: During the Internet mania, many companies were reporting record
earnings. At the same time, their cash flow was negative. How could that be?
19
Financial Ratios – Common Stock
(continued)

Price-to-Sales Ratio
 Current price divided by annual sales per share
 Historically, a higher Price-to-Sales Ratio suggested
a higher sales growth
 And a lower Price-to-Sales Ratio suggested a lower
sales growth
Current Price
Price-to-Sales Ratio = –––––––––––––––––––––––––––––
Annual Sales per Share
REVIEW: During the Internet mania, many analysts used Price-to-Sales
instead of Price-to-Earnings since most all of the new companies never
generated any earnings!
20
Financial Ratios – Profitability

Profitability Ratios
 Financial ratios that measure a firm’s returns by





relating profits to sales, assets, or equity
Net Profit Margin – a.k.a. After-Tax Profit Margin
Gross Margin
Operating Margin
Return on Assets
Return on Equity – a.k.a. Return on Investment
Profitability Ratios allow one to measure the ability of a firm to earn an
adequate return on sales, total assets and invested capital.
21
Financial Ratios – Profitability
(continued)

Net Profit Margin – a.k.a. After-Tax Profit
Margin
 The rate of profit being earned from earnings after
expenses and taxes
Net Income
Net Profit Margin = ––––––––––––––––––
Total Revenue
The higher, the better. It varies greatly from industry to industry.
22
Financial Ratios – Profitability
(continued)

Gross Margin
 The rate of profit being earned from gross profit
Gross Profit
Gross Margin = –––––––––––––––––––––
Total Revenue
Again, the higher, the better. And again, it varies greatly from industry
to industry.
23
Financial Ratios – Profitability
(continued)

Operating Margin
 The rate of profit being earned from net income
adjusting for non-cash items
Operating Income
Operating Margin = –––––––––––––––––––––––
Total Revenue
Yep, you guessed it. The higher, the better. And it varies greatly from
industry to industry. So when we are looking at a specific company, we
always need to look at its competitors within the industry. When we find a
company that is atypical of its competitors in an industry, it is a signal that
we have more investigative work to do.
24
Financial Ratios – Profitability
(continued)

Return on Assets (ROA)
 Measures how profitable a company is relative to
its total assets
Net Income
Return on Assets = ––––––––––––––––––––––
Total Assets
Return on Assets looks at the amount of resources a company needs to
support operations. It reveals how effective the company is in generating
profits from the assets it has available. The higher, the better.
Very popular ratio.
25
Financial Ratios – Profitability
(continued)

Return on Equity (ROE) – a.k.a. Return on Investment
 Measure of the overall profitability of a company in
relation to the shareholders’ equity
Net Income
Return on Equity = ––––––––––––––––––––––––––––
Total Stockholders’ Equity
Because Return on Equity uses Stockholders’ Equity instead of Total Assets
for the denominator, Return on Equity is sensitive to the amount of debt a
company is carrying. Specifically, if a company carries a great amount of
debt, ROE will be much larger than ROA. “You are using other people’s
money to make your money.” Some investors think this is good; others are
worried about the possible negative consequences of too much debt.
26
Financial Ratios – Liquidity

Liquidity Ratios
 Financial ratios concerned with a firm’s ability to
meet its day-to-day operating expenses and
satisfy its short-term obligations as they come due
 Current Ratio
 Ratio of current assets to current liabilities
 Net Working Capital
 Current assets – current liabilities
 Acid Test Ratio – a.k.a. Quick Ratio
 These ratios use data from the Balance Sheet
27
Financial Ratios – Liquidity
(continued)

Current Ratio
 One of the more popular financial measures
Current Assets
Current Ratio = –––––––––––––––––––
Current Liabilities
The Current Ratio is a good indicator of how stable a company is.
Anything over 1.0 is normally considered acceptable. If your current assets
equal or exceed your current liabilities, you should be able to satisfy your
short-term obligations without any problems. Obviously, the greater the
number is, the better.
28
Financial Ratios – Liquidity
(continued)

Net Working Capital
 Absolute dollar measure of liquidity
Net Working Capital = Current Assets – Current Liabilities
Net Working Capital is the Current Ratio in dollar terms. If the Current
Ratio is greater than 1.0, then Net Working Capital will be positive. If the
Current Ratio is less than 1.0, then Net Working Capital will be negative.
The higher the Net Working Capital, the better. (This statistic is less
popular than the Current Ratio. It really is not a ratio but is often discussed
when discussing the Current Ratio and other liquidity ratios.)
29
Financial Ratios – Liquidity
(continued)

Acid Test Ratio – a.k.a. Quick Ratio
 A more stringent version of the Current Ratio
Acid Cash + Accts recv + Short-term investments + Other current assets
Test = ––––––––––––––––––––––––––––––––––––––––––
Ratio
Current Liabilities
Unlike the Current Ratio, the Acid Test Ratio excludes inventory. This ratio
measures the ability of the company to meet its short-term obligations even
if its current inventory becomes obsolete or undesirable and hence, difficult
or impossible to be turned into cash. Anything greater than 1.0 is
considered adequate.
30
Financial Ratios – Activity

Activity Ratios
 Financial ratios that are used to measure how well




a firm is managing its assets
Accounts Receivable Turnover
Inventory Turnover
Total Asset Turnover
These ratios use data from the Balance Sheet and
the Income Statement
Activity ratios measure a firm’s ability to convert different accounts within
their balance sheets into cash or sales. Companies will try to turn their
production into cash or sales as fast as possible because this will generally
lead to higher revenues.
31
Financial Ratios – Activity
(continued)

Accounts Receivable Turnover
 Measure of how accounts receivable are managed
Total Revenue
Accounts Receivable Turnover = –––––––––––––––––––––
Accounts Receivable
The higher the number, the better. It indicates the return a company is
getting from its investment in accounts receivable. By maintaining accounts
receivable, firms are indirectly extending interest free loans to their clients. A
high ratio implies that the company operates either on a cash basis, or its
extension of credit and collection of accounts receivable is efficient. A low
ratio implies that the company should re-assess its credit policies in order to
ensure the timely collection of imparted credit not earning interest for the
firm. (Or that may just be how that industry operates. Example: Defense.)
32
Financial Ratios – Activity
(continued)

Inventory Turnover
 Measure of how inventory is managed
Total Revenue
Inventory Turnover = ––––––––––––––––––
Inventory
The higher the number, the less time an item spends in inventory and the
better the return the company is able to earn from funds tied up in inventory.
As with all ratios, this ratio must be compared against industry averages.
A low turnover implies poor sales and, therefore, excess inventory. A high
ratio implies either strong sales or ineffective inventory buying /
maintenance. High inventory levels are unhealthy because they represent an
investment with a rate of return of zero. It also opens the company up to
trouble in the case of falling prices or obsolete products.
33
Financial Ratios – Activity
(continued)

Total Asset Turnover
 Measure of how total assets are managed
Total Revenue
Total Asset Turnover = ––––––––––––––––––––
Total Assets
The Total Asset Turnover Ratio measures the firm’s efficiency at using
assets to support sales and revenue, the higher the number the better.
Companies with low profit margins tend to have high asset turnover, those
with high profit margins have low asset turnover.
34
Financial Ratios – Leverage

Leverage Ratios
 Financial ratios that are used to measure the




amount of debt being used to support operations
and the ability of the firm to service its debt
Debt-Equity Ratio – a.k.a. Debt-to-Equity Ratio
Times Interest Earned
Total Debt to Total Assets
These ratios use data from the Balance Sheet or
the Income Statement
Debt is often referred to as leverage. The idea is that you are using other
people’s money to make money. You are using the borrowed money as a
“lever” to increase your earnings. When one firm buys another firm using
borrowed money, it is often referred to as a “leveraged buyout.”
35
Financial Ratios – Leverage
(continued)

Debt-Equity Ratio
 A measure of a company's financial leverage
calculated by dividing long-term debt by
shareholders’ equity. It indicates what proportion of
equity and debt the company is using to finance its
assets
Long-term Debt
Debt-Equity Ratio = –––––––––––––––––––––––––––
Total Stockholder’s Equity
A higher Debt-Equity Ratio generally means that a company has been
aggressive in financing its growth with debt. This can result in lower
earnings as a result of the additional interest expense. Sometimes investors
only use interest bearing long-term debt instead of total liabilities. The
lower, the better.
36
Financial Ratios – Leverage
(continued)

Times Interest Earned (TIE)
 Measures the ability of a company to meet its fixed
interest payments
Times
Earnings before Interest & Taxes
Interest = –––––––––––––––––––––––––––––––––
Earned
Interest Expense
Times Interest Earned is used to determine how frequently interest payments
are earned by the company during a year. The higher, the better. Normally,
3 or 4 is considered adequate.
37
Financial Ratios – Leverage
(continued)

Total Debt to Total Assets
 Measure of how much of the company’s total
assets have been financed by debt
Total Liabilities
Total Debts to Total Assets = –––––––––––––––––––
Total Assets
Total Debt to Total Assets includes both short-term and long-term debt and
assets. If it varies substantially from the Debt-Equity Ratio, the company
may be relying heavily on short-term debt. A heavy reliance on short-term
debt can denote more risk.
CHAPTER 17 – REVIEW
38
Financial Statements and Ratio Analysis
Chapter Sections:
Sources of Financial Information
Financial Statements
Financial Statement Forecasting
Adolph Coors Company Case Study
Next week: Chapter 7, Stock Price Behavior and
Market Efficiency