Financial Management Chapter 3

Bill Baddorf BDBaddorf@ngu.edu 915915-3654
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Key Concepts and Skills    

Know the difference between book value and market value Know the difference between accounting income and cash flow Know the difference between average and marginal tax rates Know how to determine a firm¶s cash flow from its financial statements
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The Balance Sheet  

The balance sheet is a snapshot of the firm¶s assets and liabilities at a given point in time Assets are listed in order of liquidity
‡ Ease of conversion to cash ‡ Without significant loss of value 

Balance Sheet Identity
‡ Assets = Liabilities + Stockholders¶ Equity
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Net Working Capital (NWC)

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Test Worksheet
Financial Management Test Worksheet 1: Corporate Tax Rate Table Taxable Income Tax Rate $ 0 - 50,000 15% 50,001 - 75,000 25% 75,001 - 100,000 34% 100,001 - 335,000 39% 335,001 - 10,000,000 34% 10,000,00110,000,001-15,000,000 35% 15,000,00115,000,001-18,333,333 38% 18,333,334+ 35% Bill Baddorf

_________ _________ _________ _________ _________ _________ _________ _________

@ @ @ @ @ @ @ @

15% 25% 34% 39% 34% 35% 38% 35%

__________ __________ __________ __________ __________ __________ __________ __________ __________

Total Tax Paid

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Cash Flow From Assets: (Look at equation in Appendix B) 

Operating CF:
EBIT + Depreciation ________ +_______

Net Capital Spending:
Current Year net fixed asset - Previous ³ ³ ³ ³ _______ -______ 



- Taxes = Operating CF

- _______ =_______

+ Depreciation +____ = Net investment in fixed assets=_____ 

  

Change in NWC: Current Year net working capital - Previous ³ ³ ³ ³ = Change in NWC

________ - _______ =_______ 

    

Cash Flow From Assets: Operating CF - Net Capital Spending - Change in NWC = CF from Assets

***Identity Check: _______ CF from Assets = CF to Creditors - ______ CF to Stockholders - ______ =______ 

    

Cash Flow to Creditors: Interest Paid ________ - Net New Borrowing - _______ (Current L/T Debt ± Previous L/T debt) = CF to Creditors =_______

Cash Flow to Stockholders: Dividends Paid - Net New Equity Raised (Current Stock ± Previous Stock) = CF to Stockholders

______ -_____

=_____

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Homework 
      

Now Chapter 2 SelfSelf-Test: 2.1 Concepts: 2.1, 2.2, 2.4, 2.5, 2.7 Problems: 1, 2, 3, 4, 6, 7, 14, 21 Read Chap 3 Chap Review/Self-Test 1, 2 Review/SelfCritical Thinking: 1, 2, 4, 5, 10, Questions: 1-6, 9, 16, 23, 25, 34 1Financial Management 7

Chapter 3
Working With Financial Statements

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Key Concepts and Skills    

Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios Know the determinants of a firm¶s profitability and growth Understand the problems and pitfalls in financial statement analysis
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Standardized Financial Statements 

CommonCommon-Size Balance Sheets
‡ Compute all accounts as a percent of total assets 

CommonCommon-Size Income Statements
‡ Compute all line items as a percent of sales  

Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry
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Ratio Analysis   

Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important Ratios are used both internally and externally
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Categories of Financial Ratios    



ShortShort-term solvency or liquidity ratios LongLong-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios
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Standard Balance Sheet
Numbers in thousands
Cash A/R Inventory Other CA Total CA Net FA Total Assets 680,623 A/P 1,051,438 N/P 300,459 Other CL 415,310 Total CL 2,447,830 LT Debt 3,415,159 S/E 5,862,989 Total Liab. & Equity 318,301 4,613 1,645,748 1,968,662 909,814 2,984,513 5,862,989

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CommonCommon-Size Balance Sheet
Cash A/R Inventory Other CA Total CA Net FA Total Assets 680,623 11.61% A/P 318,301 1,051,438 17.93 N/P 4,613 300,459 Other CL 1,645,748 415,310 Total CL 1,968,662 2,447,830 LT Debt 909,814 3,415,159 S/E 2,984,513 5,862,989 Total Liab. & Equity 5,862,989

The book only shows %, but it is much more common to see $ & % together. % = Item as a % of Total Assets Fill in the rest of the % on the board If the preceding year is shown, then a % of change would also be shown on the far right of each column
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Standard Income Statement
Numbers in thousands, except EPS & DPS
Revenues Cost of Goods Sold Expenses Depreciation & Amortization EBIT Interest Expense Taxable Income Taxes Net Income EPS Dividends per share
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5,250,538 2,046,645 1,904,556 124,647 1,174,690 5,785 1,168,905 412,495 756,410 3.92 1.20
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CommonCommon-Size Income Statement
Revenues Cost of Goods Sold Expenses Depreciation & Amort. EBIT Interest Expense Taxable Income Taxes Net Income EPS 3.92 Dividends per share 1.20 Express each item as a % 5,250,538 2,046,645 1,904,556 124,647 1,174,690 5,785 1,168,905 412,495 756,410 100% 38.98%

of Sales. Fill in on the board.
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Computing Liquidity Ratios (Appendix B ± must be laminated!) 

Current Ratio = CA / CL
‡ 2,447,830 / 1,968,662 = 1.24 times 

Quick Ratio (also Acid Test) = (CA ± Inventory) / CL
‡ (2,447,830 ± 300,459) / 1,968,662 = 1.09 times 

Cash Ratio = Cash / CL
‡ 680,623 / 1,968,662 = .346 times
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Computing Leverage Ratios 

Total Debt Ratio = (TA ± TE) / TA
‡ (5,862,989 ± 2,984,513) / 5,862,989 = .491 times or 49.1% ‡ The firm finances slightly over 49% of their assets with debt. 

Debt/Equity = TD / TE
‡ (5,862,989 ± 2,984,513) / 2,984,513 = .964 times 1 + .964 = 1.964
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Equity Multiplier = TA / TE = 1 + D/E
‡

Computing Coverage Ratios 

Times Interest Earned = EBIT / Interest
‡ 1,174,900 / 5,785 = 203 times 

Cash Coverage = (EBIT + Depr.) / Interest
‡ (1,174,900 + 124,647) / 5,785 = 225 times

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Computing Inventory Ratios 

Inventory Turnover = Cost of Goods Sold / Inventory
‡ 2,046,645 / 300,459 = 6.81 times 

Days¶ Sales in Inventory = 365 / Inventory Turnover
‡ 365 / 6.81 = 54 days

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Computing Receivables Ratios 

Receivables Turnover = Sales / Accounts Receivable
‡ 5,250,538 / 1,051,438 = 4.99 times 

Days¶ Sales in Receivables = 365 / Receivables Turnover
‡ 365 / 4.99 = 73 days

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Computing Total Asset Turnover 

Total Asset Turnover = Sales / Total Assets
‡ 5,250,538 / 5,862,989 = .896 times 



Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
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Computing Profitability Measures 

Profit Margin = Net Income / Sales
‡ 756,410 / 5,250,538 = .1441 times or 14.41% 

Return on Assets (ROA) = Net Income / Total Assets
‡ 756,410 / 5,862,989 = .1290 times or 12.90% 

Return on Equity (ROE) = Net Income / Total Equity
‡ 756,410 / 2,984,513 = .2534 times or 25.34% Financial Management
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Computing Market Value Measures 
 

Market Price (12/31/04) = $91.54 per share Shares outstanding = 189,813,459 PE Ratio = Price per share / Earnings per share
‡ 91.54 / 3.99 = 22.94 times 

Market-toMarket-to-book ratio = market value per share / book value per share
‡ 91.54 / (2,984,513,000 / 189,813,459) = 5.82 times
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Memorize (or Appendix B)

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Payout and Retention Ratios 

Dividend payout ratio (³b´) = Cash dividends / Net income
‡ 1.20 / 3.92 = .3061 or 30.61% 

Retention ratio = Addn. to R/E / Net income
‡ (3.92 ± 1.20) / 3.92 = .6939 = 69.39% 

Or: Retention ratio = 1 ± Dividend Payout Ratio
‡ 1 - .3061 = .6939 = 69.39%
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Why Evaluate Financial Statements? 

Internal uses
‡ Performance evaluation ± compensation and comparison between divisions ‡ Planning for the future ± guide in estimating future cash flows 

External uses
‡ ‡ ‡ ‡ Creditors Suppliers Customers Stockholders
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Benchmarking  

Ratios are not very helpful by themselves; they need to be compared to something TimeTime-Trend Analysis
‡ Used to see how the firm¶s performance is changing through time ‡ Internal and external uses 

Peer Group Analysis
‡ Compare to similar companies or within industries ‡ SIC and NAICS codes Financial Management

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Real World Example - I    

Ratios are figured using financial data from the 1/31/05 Annual Report for Hughes Supply, Inc. Hughes is in SIC 507, which is a component of NAICS 444130 (pg 70) Compare the ratios to the median industry ratios in Table 3.9 in the book (pp. 70 - 72) Hughes¶ sales for the year ended January 5, 2005 were 4.42 billion, so we compare it to the right-most rightcolumn.
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Real World Example - II 

Liquidity ratios
‡ Current ratio = 2.36x; Industry = 1.8x ‡ Quick ratio = 1.42x; Industry = .6x 

LongLong-term solvency ratio
‡ Debt/Equity ratio (Debt / Worth) = 1.02x; Industry = 1.4x. 

Coverage ratio
‡ Times Interest Earned = 7.22x; Industry = 4.8x
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Real World Example - III 

Asset management ratios:
‡ Inventory turnover = 5.34x; Industry = 4.2x ‡ Total asset turnover = 1.75x; Industry = 2.8x 

Profitability ratios
‡ ROE = (profit before taxes / tangible net worth) = 15.81%; Industry = 16.8% ‡ ROA (profit before taxes / total assets) = 7.84%; Industry = 7.3%
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Quick Quiz   

How do you standardize balance sheets and income statements and why is standardization useful? What are the major categories of ratios and how do you compute specific ratios within each category? What are some of the problems associated with financial statement analysis?

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Hang in there!
Outdoor BBQ  Don¶t let your homework pull your weekend out of whack!

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Must have a financial calculator for next week!  

The book teaches the use of HP-10B HP& TI BA II Plus Financial Calculators I¶ll be using the HP 10B II (from Walmart) Better FedEx it

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Homework
Chap 3  Chap Review/Self-Test 1, 2 Review/Self Critical Thinking: 1, 2, 4, 5, 10,  Questions: 1-6, 9, 16, 23, 25, 34 1 TEST Chapters 1-3 Tuesday 9/12 1 For 9/14: Read Chap 4  Self Test: 1-4 1 Thinking & Concepts: 1-3, 6, 7, 9 1 Questions: 1-6, 9, 14, 17, 18 1Financial Management 35

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