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Chapter 3 lecture slides.


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  • 1. Cash Flows and Financial Analysis Chapter 3 Our main coverage for this chapter is financial ratios
  • 2. 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
  • 3. 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
  • 4. 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
  • 5.
    • Data sources for term project
      • See the course links page for link to MEL page
  • 6. 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
  • 7. 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
  • 8. 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
  • 9. 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
  • 10. Common Size Statements
  • 11. 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
  • 12. Ratios
    • 5 Categories of Ratios
    • Liquidity: indicates firm’s ability to pay its bills in the short run
    • Asset Management: Right amount of assets vs. sales?
    • Debt Management: Right mix of debt and equity?
    • Profitability— Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
    • Market Value— Do investors like what they see as reflected in P/E and M/B ratios?
  • 13. Liquidity Ratios
    • Current Ratio
    • To ensure solvency the current ratio should exceed 1.0
      • Generally a value greater than 1.5 or 2.0 is required for comfort
      • As always, compare to the industry
  • 14. Liquidity Ratios
    • Quick Ratio (or Acid-Test Ratio)
      • Measures liquidity without considering inventory (often the firm’s least liquid current asset)
      • Not a good ratio for grain farms
  • 15. Asset Management Ratios
    • Average Collection Period (ACP)
      • 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
  • 16. Asset Management Ratios
    • Inventory Turnover
      • 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
  • 17. Asset Management Ratios
    • Fixed Asset Turnover
      • Appropriate in industries where significant equipment is required to do business
      • Long-term measure of performance
      • Average balance sheet values are appropriate
  • 18. Asset Management Ratios
    • Total Asset Turnover
      • More widely used than Fixed Asset Turnover
      • Long-term measure of performance
      • Average balance sheet values are appropriate
  • 19. 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
      • A high debt ratio is viewed as risky by investors
      • Usually stated as percentages
  • 20. Debt Management Ratios
    • Debt-to-equity ratio
      • Can be stated several ways (as a percentage, or as a x:y value)
      • Many sources use long term debt instead of total liabilities
      • Measures the mix of debt and equity within the firm’s total capital
  • 21.
    • Sometimes you are given the debt-equity ratio (TL/E) or you may find it in a source for industry ratios. In AGEC 424, I normally want you to use TL/TA. So you need to convert the debt-equity ratio into the TL/TA ratio. The conversion is according to the equation:
    • Steps in derivation:
    • First use TA = TL+E, to replace TA in the denominator.
    • Second divide numerator and denominator by TL.
    • Third multiply numerator and denominator by TL/E.
  • 22. Debt Management Ratios
    • Times Interest Earned
      • TIE is a coverage ratio
        • Reflects how much EBIT covers interest expense
        • A high level of interest coverage implies safety
  • 23. Debt Management Ratios
    • Cash Coverage 1
      • 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
    1 EBITDA or “earnings before interest taxes depreciation and amortization” is a commonly used measure of cash flow.
  • 24. Debt Management Ratios
    • Fixed Charge Coverage
      • 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
  • 25. Profitability Ratios
    • Return on Sales (AKA:Profit Margin (PM), Net Profit Margin)
      • Measures control of the income statement: revenue, cost and expense
      • Represents a fundamental indication of the overall profitability of the business
  • 26. Profitability Ratios
    • Return on 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
  • 27. Profitability Ratios
    • Return on 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
  • 28. Market Value Ratios
    • Price/Earnings Ratio (PE Ratio)
      • 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
  • 29. Market Value Ratios
    • Market-to-Book Value Ratio
      • 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
  • 30. 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
  • 31. Du Pont Equations
    • Du Pont equations start with expressing ROA in terms of ROS and asset turnover:
    States that to run a business well, a firm must manage costs and expenses as well as generate lots of sales per dollar of assets .
  • 32. Du Pont Equations
    • Extended Du Pont equation states ROE in terms of other ratios
    EM = [1/(1-L)]; where L = TL/TA Related to the proportion to which the firm is financed by other people’s money as opposed to owner’s money.
  • 33. 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
  • 34. 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
      • Go to MEL page for AGEC 424
  • 35. 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