Chapter 3 lecture slides.


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Chapter 3 lecture slides.

  1. 1. Cash Flows and Financial Analysis Chapter 3 Our main coverage for this chapter is financial ratios
  2. 2. Financial Information—Where Does It Come From, etc . <ul><li>Financial information is the responsibility of management </li></ul><ul><ul><li>Created by within-firm accountants </li></ul></ul><ul><ul><li>Creates a conflict of interest because management wants to portray firm in a positive light </li></ul></ul><ul><li>Published to a variety of audiences </li></ul>
  3. 3. Users of Financial Information <ul><li>Investors and Financial Analysts </li></ul><ul><ul><li>Financial analysts interpret information about companies and make recommendations to investors </li></ul></ul><ul><ul><li>Major part of analyst’s job is to make a careful study of recent financial statements </li></ul></ul><ul><li>Vendors/Creditors </li></ul><ul><ul><li>Use financial info to determine if the firm is expected to make good on loans </li></ul></ul><ul><li>Management </li></ul><ul><ul><li>Use financial info to pinpoint strengths and weaknesses in operations </li></ul></ul>
  4. 4. Sources of Financial Information <ul><li>Annual Report </li></ul><ul><ul><li>Required of all publicly traded firms </li></ul></ul><ul><ul><li>Tend to portray firm in a positive light </li></ul></ul><ul><ul><li>Also publish a less glossy, more businesslike document called a 10K with the SEC </li></ul></ul><ul><li>Brokerage firms and investment advisory services </li></ul>
  5. 5. <ul><li>Data sources for term project </li></ul><ul><ul><li>See the course links page for link to MEL page </li></ul></ul><ul><ul><li> </li></ul></ul>
  6. 6. The Orientation of Financial Analysis <ul><li>Accounting is concerned with creating financial statements </li></ul><ul><li>Finance is concerned with using the data contained within financial statements to make decisions </li></ul><ul><ul><li>The orientation of financial analysis is critical and investigative </li></ul></ul>
  7. 7. Ratio Analysis <ul><li>Used to highlight different areas of performance </li></ul><ul><li>Generate hypotheses regarding things going well and things to improve </li></ul><ul><li>Involves taking sets of numbers from the financial statement and forming ratios with them </li></ul>
  8. 8. Comparisons <ul><li>A ratio when examined alone doesn’t convey much information – but.. </li></ul><ul><ul><li>History—examine trends (how the value has changed over time) </li></ul></ul><ul><ul><li>Competition—compare with other firms in the same industry </li></ul></ul><ul><ul><li>Budget—compare actual values with expected or desired values </li></ul></ul>
  9. 9. Common Size Statements <ul><li>First step in a financial analysis is usually the calculation of a common size statement </li></ul><ul><ul><li>Common size income statement </li></ul></ul><ul><ul><ul><li>Presents each line as a percent of revenue </li></ul></ul></ul><ul><ul><li>Common size balance sheet </li></ul></ul><ul><ul><ul><li>Presents each line as a percent of total assets </li></ul></ul></ul>
  10. 10. Common Size Statements
  11. 11. Ratios <ul><li>Designed to illuminate some aspect of how the business is doing </li></ul><ul><li>Average Versus Ending Values </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><ul><li>If an income or cash flow figure is combined with a balance sheet figure in a ratio—use average value for balance sheet figure </li></ul></ul></ul><ul><ul><ul><li>If a ratio compares two balance sheet figures—use ending value </li></ul></ul></ul>
  12. 12. Ratios <ul><li>5 Categories of Ratios </li></ul><ul><li>Liquidity: indicates firm’s ability to pay its bills in the short run </li></ul><ul><li>Asset Management: Right amount of assets vs. sales? </li></ul><ul><li>Debt Management: Right mix of debt and equity? </li></ul><ul><li>Profitability— Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? </li></ul><ul><li>Market Value— Do investors like what they see as reflected in P/E and M/B ratios? </li></ul>
  13. 13. Liquidity Ratios <ul><li>Current Ratio </li></ul><ul><li>To ensure solvency the current ratio should exceed 1.0 </li></ul><ul><ul><li>Generally a value greater than 1.5 or 2.0 is required for comfort </li></ul></ul><ul><ul><li>As always, compare to the industry </li></ul></ul>
  14. 14. Liquidity Ratios <ul><li>Quick Ratio (or Acid-Test Ratio) </li></ul><ul><ul><li>Measures liquidity without considering inventory (often the firm’s least liquid current asset) </li></ul></ul><ul><ul><li>Not a good ratio for grain farms </li></ul></ul>
  15. 15. Asset Management Ratios <ul><li>Average Collection Period (ACP) </li></ul><ul><ul><li>Measures the time it takes to collect on credit sales </li></ul></ul><ul><ul><li>AKA days sales outstanding (DSO) </li></ul></ul><ul><ul><li>Should use an average Accounts Receivable balance, net of the allowance for doubtful accounts </li></ul></ul>
  16. 16. Asset Management Ratios <ul><li>Inventory Turnover </li></ul><ul><ul><li>Gives an indication of the quality of inventory, as well as, how it is managed </li></ul></ul><ul><ul><li>Measures how many times a year the firm uses up an average stock of goods </li></ul></ul><ul><ul><li>A higher turnover implies doing business with less tied up in inventory </li></ul></ul><ul><ul><li>Should use average inventory balance </li></ul></ul>
  17. 17. Asset Management Ratios <ul><li>Fixed Asset Turnover </li></ul><ul><ul><li>Appropriate in industries where significant equipment is required to do business </li></ul></ul><ul><ul><li>Long-term measure of performance </li></ul></ul><ul><ul><li>Average balance sheet values are appropriate </li></ul></ul>
  18. 18. Asset Management Ratios <ul><li>Total Asset Turnover </li></ul><ul><ul><li>More widely used than Fixed Asset Turnover </li></ul></ul><ul><ul><li>Long-term measure of performance </li></ul></ul><ul><ul><li>Average balance sheet values are appropriate </li></ul></ul>
  19. 19. Debt Management Ratios <ul><li>Need to determine if the company is using so much debt that it is assuming excessive risk </li></ul><ul><li>Debt could mean long-term debt and current liabilities </li></ul><ul><ul><li>Or it could mean just interest-bearing obligations—often sources just use long-term debt </li></ul></ul><ul><li>Debt Ratio </li></ul><ul><ul><li>A high debt ratio is viewed as risky by investors </li></ul></ul><ul><ul><li>Usually stated as percentages </li></ul></ul>
  20. 20. Debt Management Ratios <ul><li>Debt-to-equity ratio </li></ul><ul><ul><li>Can be stated several ways (as a percentage, or as a x:y value) </li></ul></ul><ul><ul><li>Many sources use long term debt instead of total liabilities </li></ul></ul><ul><ul><li>Measures the mix of debt and equity within the firm’s total capital </li></ul></ul>
  21. 21. <ul><li>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: </li></ul><ul><li>Steps in derivation: </li></ul><ul><li>First use TA = TL+E, to replace TA in the denominator. </li></ul><ul><li>Second divide numerator and denominator by TL. </li></ul><ul><li>Third multiply numerator and denominator by TL/E. </li></ul>
  22. 22. Debt Management Ratios <ul><li>Times Interest Earned </li></ul><ul><ul><li>TIE is a coverage ratio </li></ul></ul><ul><ul><ul><li>Reflects how much EBIT covers interest expense </li></ul></ul></ul><ul><ul><ul><li>A high level of interest coverage implies safety </li></ul></ul></ul>
  23. 23. Debt Management Ratios <ul><li>Cash Coverage 1 </li></ul><ul><ul><li>TIE ratio has problems </li></ul></ul><ul><ul><ul><li>Interest is a cash payment but EBIT is not exactly a source of cash </li></ul></ul></ul><ul><ul><ul><li>By adding depreciation back into the numerator we have a more representative measure of cash </li></ul></ul></ul>1 EBITDA or “earnings before interest taxes depreciation and amortization” is a commonly used measure of cash flow.
  24. 24. Debt Management Ratios <ul><li>Fixed Charge Coverage </li></ul><ul><ul><li>Interest payments are not the only fixed charges </li></ul></ul><ul><ul><li>Lease payments are fixed financial charges similar to interest </li></ul></ul><ul><ul><ul><li>They must be paid regardless of business conditions </li></ul></ul></ul><ul><ul><ul><ul><li>If they are contractually non-cancelable </li></ul></ul></ul></ul>
  25. 25. Profitability Ratios <ul><li>Return on Sales (AKA:Profit Margin (PM), Net Profit Margin) </li></ul><ul><ul><li>Measures control of the income statement: revenue, cost and expense </li></ul></ul><ul><ul><li>Represents a fundamental indication of the overall profitability of the business </li></ul></ul>
  26. 26. Profitability Ratios <ul><li>Return on Assets </li></ul><ul><ul><li>Adds the effectiveness of asset management to Return on Sales </li></ul></ul><ul><ul><li>Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit </li></ul></ul>
  27. 27. Profitability Ratios <ul><li>Return on Equity </li></ul><ul><ul><li>Adds the effect of borrowing to ROA </li></ul></ul><ul><ul><li>Measures the firm’s ability to earn a return on the owners’ invested capital </li></ul></ul><ul><ul><li>If the firm has substantial debt, ROE tends to be higher than ROA in good times and lower in bad times </li></ul></ul>
  28. 28. Market Value Ratios <ul><li>Price/Earnings Ratio (PE Ratio) </li></ul><ul><ul><li>An indication of the value the stock market places on a company </li></ul></ul><ul><ul><li>Tells how much investors are willing to pay for a dollar of the firm’s earnings </li></ul></ul><ul><ul><li>A firm’s P/E is primarily a function of its expected growth </li></ul></ul>
  29. 29. Market Value Ratios <ul><li>Market-to-Book Value Ratio </li></ul><ul><ul><li>A healthy company is expected to have a market value greater than its book value </li></ul></ul><ul><ul><ul><li>Known as the going concern value of the firm </li></ul></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>A value less than 1.0 indicates a poor outlook for the company’s future </li></ul></ul>
  30. 30. Du Pont Equations <ul><li>Ratio measures are not entirely independent </li></ul><ul><li>Performance on one is sometimes tied to performance on others </li></ul><ul><li>Du Pont equations express relationships between ratios that give insights into successful operation </li></ul>
  31. 31. Du Pont Equations <ul><li>Du Pont equations start with expressing ROA in terms of ROS and asset turnover: </li></ul>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. 32. Du Pont Equations <ul><li>Extended Du Pont equation states ROE in terms of other ratios </li></ul>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. 33. Du Pont Equations <ul><li>Extended Du Pont equation states that the operation of a business is reflected in its ROE </li></ul><ul><ul><li>However, this result—good or bad—can be multiplied by borrowing </li></ul></ul><ul><ul><li>The way you finance a business can exaggerate the results from operations </li></ul></ul><ul><li>The Du Pont equations can be used to isolate problems </li></ul>
  34. 34. Sources of Comparative Information <ul><li>Generally compare a firm to an industry average </li></ul><ul><ul><li>Dun and Bradstreet publishes Industry Norms and Key Business Ratios </li></ul></ul><ul><ul><li>Robert Morris Associates publishes Statement Studies </li></ul></ul><ul><ul><li>U.S. Commerce Department publishes Quarterly Financial Report </li></ul></ul><ul><ul><li>Value Line provides industry profiles and individual company reports </li></ul></ul><ul><ul><li>Go to MEL page for AGEC 424 </li></ul></ul>
  35. 35. Limitations/Weaknesses of Ratio Analysis <ul><li>Ratio analysis is not an exact science and requires judgment and experienced interpretation </li></ul><ul><ul><li>Examples of significant problems </li></ul></ul><ul><ul><ul><li>Diversified companies—because the interpretation of ratios is dependent upon industry norms, comparing conglomerates can be problematic </li></ul></ul></ul><ul><ul><ul><li>Window dressing—companies attempt to make balance sheet items look better than they would otherwise through improvements that don’t last </li></ul></ul></ul><ul><ul><ul><li>Accounting principles differ—similar companies may report the same thing differently, making their financial results artificially dissimilar </li></ul></ul></ul><ul><ul><ul><li>Inflation may distort numbers </li></ul></ul></ul>