Practical financial manaegment lasher 7th ed chapter 03

Statement of Cash FlowsBusinesses run on cash , not accounting profits It is possible for a business to go out of business while making a profit Statement of Cash Flows – Reports inflow

Chapter 3 - Cash Flows And Financial Analysis

Users of Financial Information

Investors

– Make judgments about the firm's securities

– Financial Analysts report to investment community

Sources of Financial Information

– Value Line – Credit reports

3

Orientation of Financial Analysts

Critical and investigative

Looking for current or potential problems

Looking for the physical reasons behind financial results

4

Statement of Cash Flows

Businesses run on cash , not accounting profits

It is possible for a business to go out of business while making a profit

Statement of Cash Flows

– Reports inflows and outflows of money

– Developed from the income statement and

balance sheet

5

Building the Statement of Cash

Flows – Basic Approach

Build a Statement of Cash Flows from two balance sheets and an income statement

Analyze where money has come from and gone to

Begin with some personal examples

6

Table 3-1 Cash Flow Rules

Asset Increase = Use

Liability Increase = Source Asset Decrease = Source Liability Decrease = Use

7

Buying a Car on Credit

Joe Jones and His New Car

8

Buying and Selling Cars

-Sally Smith and Her Two Cars

9

Buying and Selling Cars

-Sally Smith and Her Two Cars

10

Business Cash Flows

Three sources of cash flows:

Operating Activities – day-to-day activities

Investing Activities – firm buys or sells ( or invests in) fixed assets that enable it to do business.

Financing Activities – borrow money, pay off loans, sell stock, pay dividends

12

Figure 3.2 BUSINESS CASH FLOWS

13

Example 3-1 Business Cash Flows

Belfry also sold new stock during

the year receiving a total of $800

and paid its shareholders dividends

of $500.

Additional Information

Operating Activities

Net Income$ 1,000

Depreciation 500

Net Change in Current Accts (600)

Cash from Operating Activities $ 900

Detail of Changes in Current Accounts

Account Begin EndSource/(Use)

Receivables $3,000 $2,900 $ 100

Inventory 2,000 3,200 (1,200)

Payables 1,500 2,100 600

Accruals 500 400 (100) $ (600)

Investing Activities

Purchase of Fixed Assets $(2,000) Use Change in Gross Fixed Asset Account

Free Cash Flows (FCF)

Used to estimate whether a company will provide or require cash in future

Cash generated by operations that’s

available for distribution to investors.

If negative, owners must borrow or sell equity just to keep going as before

21

Calculating Free Cash Flow

NOPAT is net operating profit.

T = tax rate

NOPAT = EBIT – (T)(EBIT) = EBIT (1 – T)

Note: If there is no debt, NOPAT equals net income

22

Calculating Free Cash Flow

Depreciation is subtracted from revenue when calculating EBIT

Depreciation is a noncash charge, so EBIT

understates cash flow by at least that amount Adding back depreciation gives a figure that’s

closer to cash flow called operating cash flow.

Operating Cash Flow = NOPAT + Depreciation

23

Calculating Free Cash Flow

Money available to investors can be written as:

FCF = Operating Cash Flow

– Increase in Gross Fixed Assets – Increase in Current Accounts

24

Calculating Free Cash Flow to Equity (FCFE)

If a company is able to distribute cash to

stockholders, then the equation becomes:

FCFE = Operating Cash Flow

– Increase in Gross Fixed Assets

– Increase in Current Accounts

– (1-T)Interest – Principal Reduction

25

The Cash Conversion Cycle

Racetrack Diagram

26

RATIO ANALYSIS

27

Ratios are most meaningful when

compared with similar figures

Common Size Statements - Example

29

LIQUIDITY RATIOS

Liquidity ratios measure the company’s ability

to meet short-term financial obligations

assets

current

= Ratio

LIQUIDITY RATIOS

Quick Ratio (acid test) – A liquidity measure that

does not depend on inventory

32

s liabilitie

current

inventory -

assets

current Ratio

ASSET MANAGEMENT RATIOS

The fundamental efficiency with which a company is run

Average Collection Period (ACP) – the time it takes to collect on credit

Customers pay slowly

OR there are a few

very old accounts that will probably never be collected.

360 sales

receivable accounts

=

ACP

sales daily

average

receivable accounts

=

ACP

×

INVENTORY TURNOVER

Inventory turnover ratio measures whether

the firm has excess funds tied up in inventory.

Interpretation: Too much inventory is expensive to carry Too little causes stockouts which lead to inefficient production and lost sales

34

inventory

sold goods

of

cost turnover

FIXED ASSET TURNOVER AND TOTAL ASSET

turnover asset

assets total sales

turnover asset

DEBT MANAGEMENT RATIOS

Measures the firm’s debt level relative to assets, equity, and income

total

s liabilitie current

+ debt

term -

long

= ratio Debt

DEBT TO EQUITY RATIO

Measures the mix of debt and equity

within total capital

Debt to Equity Ratio = Long Term Debt : Equity

37

TIMES INTEREST EARNED (TIE)

Measures the number of times interest can be paid out of earnings before interest and taxes (EBIT)

38

interest

EBIT

= TIE

= coverage Cash

FIXED CHARGE COVERAGE

A variation on TIE to include lease payments as fixed financial charges equivalent to interest

40

payments

lease +

interest

payments

lease +

EBIT

= coverage

charge

Fixed

DEBT MANAGEMENT RATIOS

Compares fixed (obligatory) payments with

repayments principal

payments lease

interest

payments lease

EBITDA

e coverag EBITDA

+ +

+

=

PROFITABILITY RATIOS

Relative measures of the firm’s money-making

success, also called profit margin.

RETURN ON SALES (ROS)

RETURN ON ASSETS (ROA)

Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit

43

assets total

income

net

= ROA

RETURN ON EQUITY (ROE)

The most fundamental profitability ratio

Measures the firm’s ability to earn a

return on the owners’ invested capital

MARKET VALUE RATIOS

PRICE / EARNINGS RATIO (P/E)

Measures market’s opinion of the stock as an investment

Interpretation: The amount investors will pay for each dollar of earnings Based primarily on expected growth.

45

EPS

price

stock

= Ratio P/E

MARKET TO BOOK VALUE RATIO

46

share per

value

book

price

stock

= ratio

value

book

to Market

total

ROS

= ROA

assets

total

sales sales

income

net

= ROA

sales

sales assets

total

income

net

= ROA

×

×

×

Extended Du Pont Equation

48

multiplier

equity ROA

=

ROE

multiplier

equity

turnover asset

total

total assets

total

sales sales

total

assets

total sales

sales equity

Using the Du Pont Equations

Limitations and Weaknesses

– Allow latitude in reporting

Inflation Can Distort Financial Results

Interpretation of Ratios is Often Unclear

Ratio Analysis Doesn’t Give Us Answers, It Helps Us Ask the Right Questions

50