Chapter 3

Cash Flows and Financial

Analysis

Our main coverage for this chapter is financial ratios

Financial Information—Where Does
It Come From, etc.

 Financial information is the

responsibility of management
 Created by within-firm accountants
 Creates a conflict of interest because
management wants to portray firm in a
positive light
 Published to a variety of audiences

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Users of Financial Information
 Investors and Financial Analysts
 Financial analysts interpret information about
companies and make recommendations to investors
 Major part of analyst’s job is to make a careful study of
recent financial statements
 Vendors/Creditors
 Use financial info to determine if the firm is expected to
make good on loans
 Management
 Use financial info to pinpoint strengths and weaknesses
in operations

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Sources of Financial Information

 Annual Report
 Required of all publicly traded firms
 Tend to portray firm in a positive light
 Also publish a less glossy, more
businesslike document called a 10K with
the SEC
 Brokerage firms and investment
advisory services

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 Data sources for term project
 See the course links page for link to MEL
page
 http://www.lib.purdue.edu/mel/inst/agec_424

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The Orientation of Financial
Analysis
 Accounting is concerned with creating
financial statements
 Finance is concerned with using the
data contained within financial
statements to make decisions
 The orientation of financial analysis is
critical and investigative

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Ratio Analysis
 Used to highlight different areas of
performance
 Generate hypotheses regarding
things going well and things to
improve
 Involves taking sets of numbers from
the financial statement and forming
ratios with them

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Comparisons
 A ratio when examined alone doesn’t
convey much information – but..
 History—examine trends (how the value
has changed over time)
 Competition—compare with other firms
in the same industry
 Budget—compare actual values with
expected or desired values

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Common Size Statements
 First step in a financial analysis is
usually the calculation of a common
size statement
 Common size income statement
 Presents each line as a percent of revenue
 Common size balance sheet
 Presents each line as a percent of total
assets

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Common Size Statements
Alpha Beta
$ % $ %
Sales $ 2,187,460 100.0% $ 150,845 100.0%
COGS $ 1,203,103 55.0% $ 72,406 48.0%
Gross margin $ 984,357 45.0% $ 78,439 52.0%

Expenses $ 505,303 23.1% $ 39,974 26.5%

EBIT $ 479,054 21.9% $ 38,465 25.5%
Interest $ 131,248 6.0% $ 15,386 10.2%
EBT $ 347,806 15.9% $ 23,079 15.3%
Tax $ 118,254 5.4% $ 3,462 2.3%
Net Income $ 229,552 10.5% $ 19,617 13.0%

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Look at ANF income statement

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Ratios
 Designed to illuminate some aspect of how
the business is doing
 Average Versus Ending Values
 When a ratio calls for a balance sheet item, may
need to use average values (of the beginning
and ending value for the item) or ending values
 If an income or cash flow figure is combined
with a balance sheet figure in a ratio—use
average value for balance sheet figure
 If a ratio compares two balance sheet figures—
use ending value

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Ratios

 5 Categories of Ratios
1. Liquidity: indicates firm’s ability to pay its
bills in the short run
2. Asset Management: Right amount of assets
vs. sales?
3. Debt Management: Right mix of debt and
equity?
4. Profitability— Do sales prices exceed unit
costs, and are sales high enough as reflected
in PM, ROE, and ROA?
5. Market Value— Do investors like what they
see as reflected in P/E and M/B ratios?
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Liquidity Ratios
Current Ratio


Current Assets
Current Ratio =
Current Liabilities

 To ensure solvency the current ratio

has to exceed 1.0
 Generally a value greater than 1.5 or 2.0
is required for comfort
 As always, compare to the industry

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Liquidity Ratios
 Quick Ratio (or Acid-Test Ratio)
current assets - inventory
Quick Ratio =
current liabilities
 Measures liquidity without considering
inventory (the firm’s least liquid current
asset)
 Not a good ratio for grain farms

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Asset Management Ratios
 Average Collection
Period (ACP)
accounts receivable
ACP = DSO =
sales per day
 Measures the time it takes to collect on
credit sales
 AKA days sales outstanding (DSO)
 Should use an average Accounts
Receivable balance, net of the allowance
for doubtful accounts
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Asset Management Ratios
 Inventory Turnover
cost o f g o od s sold
=r
In v e n to ry T urn o ve
in ve n to ry
 Gives an indication of the quality of
inventory, as well as, how it is managed
 Measures how many times a year the
firm uses up an average stock of goods
 A higher turnover implies doing business
with less tied up in inventory
 Should use average inventory balance
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Asset Management Ratios
 Fixed Asset Turnover
Sales (Total)
Fixed Asset Turnover =
Fixed Assets (Net)

 Appropriate in industries where

significant equipment is required to do
business
 Long-term measure of performance
 Average balance sheet values are
appropriate

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Asset Management Ratios
 Total Asset Turnover
Sales (Total)
Total Asset Turnover =
Total Assets
 More widely used than Fixed Asset
Turnover
 Long-term measure of performance
 Average balance sheet values are
appropriate

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Debt Management Ratios
 Need to determine if the company is using so much debt that it is
assuming excessive risk
 Debt could mean long-term debt and current liabilities
 Or it could mean just interest-bearing obligations—often sources just
use long-term debt
 Debt Ratio
TL
Debt Ratio =
TA
 A high debt ratio is viewed as risky by investors
 Usually stated as percentages

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Debt Management Ratios
 Debt-to-equity ratio
 Can be stated several ways (as a percentage, or
as a x:y value)
Total Liabilities TL
Debt − to − Equity = =
Common Equity E
 Many sources use long term debt instead
of total liabilities
 Measures the mix of debt and equity
within the firm’s total capital
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Debt Management Ratios
 Times Interest Earned
EBIT
TIE =
Interest Expense
 TIE is a coverage ratio
 Reflects how much EBIT covers interest
expense
 A high level of interest coverage implies
safety

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Debt Management Ratios
 Cash Coverage
EBIT + depreciation
Cash coverage =
Interest Expense
 TIE ratio has problems
 Interest is a cash payment but EBIT is not
exactly a source of cash
 By adding depreciation back into the
numerator we have a more representative
measure of cash

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Debt Management Ratios
 Fixed Charge Coverage
EBIT + Lease Payments
Fixed Charge Coverage =
Interest Expense + Lease Payments
 Interest payments are not the only fixed
charges
 Lease payments are fixed financial
charges similar to interest
 They must be paid regardless of business
conditions
 If they are contractually non-cancelable

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Profitability Ratios
 Return on Sales (AKA:Profit Margin (PM), Net
Profit Margin)

Net Income
PM = ROS =
Sales
 Measures control of the income
statement: revenue, cost and expense
 Represents a fundamental indication of
the overall profitability of the business

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Profitability Ratios
 Return on Assets
Net Income
ROA =
Total Assets
 Adds the effectiveness of asset
management to Return on Sales
 Measures the overall ability of the firm to
utilize the assets in which it has invested
to earn a profit

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Profitability Ratios
 Return on Equity
Net Income
ROE =
Stockholders' Equity
 Adds the effect of borrowing to ROA
 Measures the firm’s ability to earn a
return on the owners’ invested capital
 If the firm has substantial debt, ROE
tends to be higher than ROA in good
times and lower in bad times

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Market Value Ratios
 Price/Earnings Ratio (PE Ratio)
Current stock price
PE Ratio =
Earnings per share (EPS)
 An indication of the value the stock
market places on a company
 Tells how much investors are willing to
pay for a dollar of the firm’s earnings
 A firm’s P/E is primarily a function of its
expected growth
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Market Value Ratios
 Market-to-Book Value Ratio
Current stock price
Market-to-Book-Value =
book value per share (of equity)
 A healthy company is expected to have a market
value greater than its book value
 Known as the going concern value of the firm
 Idea is that the combination of assets and human
resources will create an company able to generate
future earnings worth more than the assets alone
today
 A value less than 1.0 indicates a poor outlook for
the company’s future
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Du Pont Equations
 Ratio measures are not entirely
independent
 Performance on one is sometimes
tied to performance on others
 Du Pont equations express
relationships between ratios that give
insights into successful operation

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Du Pont Equations
 Du Pont equation involves ROE, which
can be written several ways:
Net Income sales States that to
ROA = × run a business
Total Assets sales
well, a firm must
or
manage costs
Net Income sales and expenses
ROA = × as well as
sales Total Assets
generate lots of
or
sales per dollar
ROE = ROS × total asset turnover of assets.

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Du Pont Equations
 Extended Du Pont equation states
ROE in terms of other ratios
Net Income sales total assets
ROE = × ×
Stockholders' Equity sales total assets
Related to the
or
proportion to
Net Income sales total assets which the firm
ROE = × ×
sales total assets Stockholders' Equity is financed by
1 4 4 44 2 4 4 4 43
Equity Multiplier other people’s
or money as
opposed to
1 4 4×4Total
ROE = ROS Asse
4 44 2 4 4t 4 4 4 43 × Equity Multiplier
Turnover
owner’s
ROA
money.
or EM = [1/(1-L)];
ROE = ROA × Equity Multiplier where L = TL/TA 32
Du Pont Equations
 Extended Du Pont equation states
that the operation of a business is
reflected in its ROE
 However, this result—good or bad—can
be multiplied by borrowing
 The way you finance a business can
exaggerate the results from operations
 The Du Pont equations can be used to
isolate problems
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Sources of Comparative
Information
 Generally compare a firm to an industry
average
 Dun and Bradstreet publishes Industry Norms
and Key Business Ratios
 Robert Morris Associates publishes Statement
Studies
 U.S. Commerce Department publishes Quarterly
Financial Report
 Value Line provides industry profiles and
individual company reports

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 Limitations/Weaknesses of Ratio
Analysis

 Ratio analysis is not an exact science and requires

judgment and experienced interpretation
 Examples of significant problems
 Diversified companies—because the interpretation of
ratios is dependent upon industry norms, comparing
conglomerates can be problematic
 Window dressing—companies attempt to make balance
sheet items look better than they would otherwise
through improvements that don’t last
 Accounting principles differ—similar companies may
report the same thing differently, making their financial
results artificially dissimilar
 Inflation may distort numbers

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