Financial statements and ratios

1
Financial statements and ratios
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Preamble

• The overview of Financial Statements reveals
  information about past and current performance of
  the firm.
• When combining this information with other
  sources, we might be able to form expectations
  about the firms future cash flows.

3
Outline

• The Balance Sheet
• The Income Statement
• The Statement of Cash Flows
• On ratio analysis

4
Balance Sheet

• Financial Statement showing a firms accounting
  value on a particular date.

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Balance Sheet
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Reminder

• Assets are listed in the order of decreasing 
  liquidity
• Liquidity the degree of ease to which an asset
  can be converted to cash without a substantial
  loss or price reduction.
• The balance sheet does not reflect the real value
  of firm's assets.
• The balance sheet reflects the historical cost of
  firm's assets.

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The Income Statement

• Reveals how profitable the firm is over a certain
  period of time.

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The Income Statement
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Statement of cash flows

• Integrates the Balance Sheet and the Income
  Statement
• CF from operating activities CF from investing
  Cf from financing
• Interpretation
• Net increase or decrease in the firms cash

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Cash flows identities

• In any given year
• Cash flow from assets CF to creditors CF to
  shareholders
• where
• CF to creditors Interest paid - Net new debt
  raised
• CF to shareholders Dividends paid - Net new
  equity raised
• Cash flow from assets OCF - NCS - Additions to
  NWC
• where
• Operating CF EBIT Depr. - Taxes
• NCS Ending Fixed Assets - (Beginning Fixed
  Assets - Depr.)
• Additions to NWC NWCt - NWCt-1

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Cash flows identities

• In our example
• CF to creditors 70 - (454-408) 24
• CF to shareholders 65 - (640-600) 25
• Operating CF 694 65 - 250 509
• Net capital spending 1,709 - (1,644 - 65)
  130
• Additions to NWC (1,403-389) - (1,112-428)
  330
• Cash flow from assets (24 25) (509 -
  130- 330) 49

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Sources of cash

•  
• Increase in accounts payable
• Increase in common stock
• Increase in retained earnings

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Uses of cash

•  
• Increase in accounts receivable
• Increase in inventory
• Decrease in notes payable
• Decrease in long-term debt
• Net fixed asset acquisitions

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Ratio analysis

• When analyzing a firm, we want to know
• if the firm is able to meet its short-term
  financial obligations (is it solvent?)
• if the firm is able to meet its long-term
  financial obligations (going bankrupt in the
  future?)
• how well the assets of the firm are managed
• how well the overall operations of the firm are
  managed (is it profitable?)
• how the market interprets accounting data and
  what expectations are factored in.

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Ratio analysis

• Short-term solvency and liquidity ratios
• Indicate the firms ability to pay its bills over
  the short run without undue stress.
• Financial leverage
• Describe a firms long-term ability to meet its
  financial obligations
• Asset utilization turnover ratios
• Describe how efficiently (intensively) a firm
  uses its assets to generate sales.
• Profitability ratios
• Describes how efficiently the firm manages its
  overall operations (the higher, the better !!!!!)
  
• Market ratios
• Describe how the market values the firm.

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Short-term solvency and liquidity ratios

• Current ratio Current assets/Current
  liabilities
• Quick ratio (Current assets-Inventory)/Current
  liabilities
• Cash ratio Cash/Current liabilities
• NWC to total assets (Current assets - Current
  liabilities)/Total assets
• Interval measure Current assets/Avg. daily op.
  costs

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Short-term solvency and liquidity ratios

• Current ratio 708/540 1.31
• Quick ratio (708-422)/540 0.53
• Cash ratio 98/540 0.1815
• NWC to total assets (708 - 540)/3,588 0.047
  
• Interval measure 708/1,344/365 192 days

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Financial leverage

• Total debt ratio (Total assets-Total
  equity)/Total assets
• Debt/equity ratio Total debt/total equity
• Equity multiplier Total assets/Total equity 1
  Debt/Equity
• Long-term debt ratio Long-term debt/(Total
  assets)
• Times interest earned EBIT/Interest
• Cash coverage ratio (EBIT Depreciation)/Intere
  st

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Financial leverage

• Total debt ratio (3,588 - 2,591)/3,588
  0.28
• Debt/equity ratio 997/2,591 0.28/0.72
  0.39
• Equity multiplier 1 0.39
• Long-term debt ratio 457/457 2,591
  0.15
• Times interest earned 691/141 4.9 times
• Cash coverage ratio (691 276)/141 6.9

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Asset utilization turnover ratios

• Inventory turnover Cost of goods sold/Inventory
  
• Days sales inventory 365/Inventory turnover
• Days sales inventory (365)Inventory/Cost of
  goods sold
• Receivables turnover Sales/Accounts receivable
• Days sales in receivables 365/Receivables
  turnover
• Days sales in receivables (365)Accounts
  receivables/Sales
• NWC turnover Sales/(Current assets - Current
  liabilities)
• Fixed asset turnover Sales/Net fixed assets
• Total asset turnover Sales/Total assets

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Asset utilization turnover ratios

• Inventory turnover 1,344/422 turned out the
  inventory 3.2 times
• Days sales inventory 365/3.2 114 days of
  sales in inventory
• Receivables turnover 2,311/188 12.3 times
• Days sales in receivables 365/12.3 30
• The average collection period (ACP) is 30 days
• NWC turnover 2,311/(708 - 540) 13.8
• Fixed asset turnover 2,311/2,880 0.8
• Total asset turnover 2,311/3,588 0.64

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Profitability ratios

• Profit margin Net income/Sales
• Return on assets (ROA) Net income/Total assets
• Return on equity (ROE) Net income/Total equity

23
Profitability ratios

• Profit margin 363/2,311 0.157
• Return on assets (ROA) 363/3,588 0.1012
• Return on equity (ROE) 363/2,591 0.14
• ROE is the ultimate accounting measure for
  profitability

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Du Pont identity

• Shows which variables account for profitability
• ROE Net income/Total Equity
• ROE (Net income/Sales)(Sales/Total Assets)(Total
  Assets/Total Equity)?
• ROE (Profit margin)(Total asset
  turnover)(Equity multiplier)
• ROE (0.157)(0.64)(1.39) 0.14

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Extended DuPont Equality

• ROE NI/E (EBT/TA)(TA/E)(NI/EBT)
• ROE EBIT/TA I/TA(TA/E)(EBT/EBT Tax/EBT)?
• ROE (EBIT/S)(S/TA) I/TA(TA/E)(1- Tax/EBT)?
• ROE (Operating margin) (TAT) Interest
  expense rate
• (Equity multiplier)
• (Tax retention rate)?

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Market ratios

• Price/Earnings ratios Price per share/Earnings
  per share
• Market-to-book ratio Market value per
  share/Book value per share
• Tobins Q
• Q (Mkt. value of debt Mkt. value of
  equity)/Replacement value of assets
• Higher Qs indicate higher investment
  opportunities and/or comparative advantage)

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Market ratios

• Assume
• There are 33,000 shares outstanding and P 88
• P/E 88/11 8
• Market-to-book ratio 88/(2,591/33) 1.12
• P/E and Market-to-book are also measures of
  cheapness