1. Financial Statements
Balance Sheet
Income Statement
Managers and Analysts Use Financial Statement to Conduct:
- Cash Flow Analysis
- Performance (Ratio) Analysis
2. The Link Between the Balance Sheets and the Income
Statement.
1999 2000 2000
3. Accounting Profits and
Cash Flows
•Are Accounting Profits and cash Flows same?
• Why Accounting Profits and Cash Flows
Differ
– Revenue Recognition
– The Matching Principle
– Depreciation
4. Translating Accounting Profits into
Cash Flows
• The statement is based on three cash flow
categories:
Cash flow from operations is net income
adjusted for depreciation and changes in
receivables, payables, and inventories.
5. Translating Accounting Profits into
Cash Flows
Cash flow from investing activities arise from
the purchase and sale of marketable securities
and productive assets such as machinery.
Cash flow from financing activities include the
repayment of debt, the payment of dividends,
and the issuance of new securities.
6. Sources And Uses Of Cash
• Sources of cash
– Operations—customers pay invoices
– Investing—firm sells assets
– Financing—firm borrows or issues new shares
• Uses of cash
– Operations—pay its suppliers
– Investing—capital expenditures
– Financing—interest and dividend payments
8. The Sources and Uses of Corporate
Cash
Sources Uses
• Decrease in any asset • Increase in any asset
• Increase in any liability • Decrease in any liability
• Net profits after taxes • Net loss
• Depreciation and other • Dividends paid
non-cash charges • Repurchase or retirement
• Sale of stock of stock
9. Key Measures of Cash Flow
Cash Flow
from • Total Cash Generated
Operations
Operating • Cash Flow Before Repaying
Cash Flow Lenders
Free Cash • Cash Flow Firm Could
Flow Distribute to Investors
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11. Objectives of Analysis
• The adequacy or otherwise of the profits
earned
• The adequacy or otherwise of the financial
strength
• Its ability to generate enough cash and cash
equivalents, their timing and certainty
• The future growth outlook
12. 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, Analysts
13. The Tool Kit
• Multi – Step Income Statement
• Horizontal Analysis
• Common-Sized Analysis
• Trend Analysis
• Analytical Balance Sheet
• Ratio Analysis
• Cash flow Analysis
17. RoI Ratios
• RoNW = PAT – Preferred dividend /
Networth (%)
• EPS (Rs)
• CEPS = PAT – Preferred dividend + non-
cash charges / no. of equity shares o/s (Rs)
18. Solvency Ratios
• NAV / NWPS / BVPS (Rs)
• DER
• Interest cover = PAT + Int (LTD) + non-
cash charges / int (LTD) – Times
• DSCR = PAT + Int (LTD) + non-cash
charges / int (LTD) + principal repayment –
Times
19. Liquidity ratios
• CR = CAs, loans and advances + ST Inv / CLs +
provisions + ST debt
• QR
• CP allowed to customers = receivables x 365 /
credit sales
• Supplier’s credit = payables x 365 / credit
purchases
• Inventory holding period = inventory x 365 /
COGS
20. Turnover Ratios
• FATO = Net sales / fixed assets
• NWTO = Net sales / NW
• Debtor turnover
• Inventory turnover
21. Profitability Ratios
• Multi-step profit margins
• Ratios of individual costs and expenses to
sales
• Ratios of other income, extraordinary items
and prior year adjustments to PBT and/or
net sales
23. Deriving the Du Pont Identity
• ROE = NI / TE
• Multiply by 1 and then rearrange
– ROE = (NI / TE) (TA / TA)
– ROE = (NI / TA) (TA / TE) = ROA * EM
• Multiply by 1 again and then rearrange
– ROE = (NI / TA) (TA / TE) (Sales / Sales)
– ROE = (NI / Sales) (Sales / TA) (TA / TE)
– ROE = PM * TAT * EM
24. Du Pont Analysis
Net Income Sales Assets
Return on equity =
Sales Asset Shareholder’s Equity
Net Total Equity
Profit Asset Multiplier
Margin Turnover
25. Using the Du Pont Identity
• ROE = PM * TAT * EM
– Profit margin is a measure of the firm’s
operating efficiency – how well does it control
costs
– Total asset turnover is a measure of the firm’s
asset use efficiency – how well does it manage
its assets
– Equity multiplier is a measure of the firm’s
financial leverage
26. Potential Problems
• There is no underlying theory, so there is no way
to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes
comparison more difficult because of differences
in accounting regulations
• Varying accounting procedures, i.e. FIFO vs.
LIFO
• Different fiscal years
• Extraordinary events
27. • Comparison with industry averages is difficult if
the firm operates many different divisions.
• “Average” performance is not necessarily good.
• Seasonal factors can distort ratios.
(More…)
28. • Window dressing techniques can make
statements and ratios look better.
• Sometimes it is difficult to tell if a ratio value
is “good” or “bad.”
• Often, different ratios give different signals, so
it is difficult to tell, on balance, whether a
company is in a strong or weak financial
condition.
29. What are some qualitative factors
analysts should consider when
evaluating a company’s likely future
financial performance?
• Are the company’s revenues tied to a single
customer?
• To what extent are the company’s revenues tied to
a single product?
• To what extent does the company rely on a single
supplier?
(More…)
30. • What percentage of the company’s
business is generated overseas?
• What is the competitive situation?
• What does the future have in store?
• What is the company’s legal and
regulatory environment?
31. Non-Financial Measures of Operating
Effectiveness
• Innovation
• Customer Service
• Product Quality
• Reputation
• Good Employee Relations
32. Balanced Scorecard
• Organisational Learning and Growth
(Employee Training & Education, Innovation,
Opportunities for Improvement, New Product
Dev. Time)
• Business and Production Process Efficiency
(Quality, Productivity, Cycle time)
• Customer Value (Customer Satisfaction and
Loyalty)
• Financial Performance
Editor's Notes
Value of any financial asset is the PV of future cash flows Bonds: PV of promised interest & principal payments Stocks: PV of all future dividends Patents, trademarks: PV of future royalties Valuation is the process linking risk & return Output of process is asset’s expected market price A key input is the required [expected] return on an asset Defined as the return an arms-length investor would require for an asset of equivalent risk Debt securities: risk-free rate plus risk premium(s) Required return for stocks found using CAPM or other asset pricing model Beta determines risk premium: higher beta, higher reqd return
Improving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong then we can look at fixed asset turnover and cash management. We can also improve our ROE by increasing our leverage – up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilize our interest tax credit effectively, but we don’t want to overdo it. The choice of leverage is discussed in more detail in chapter 13.
