Chapter 3

Cash Flows and Financial Analysis

Our main coverage for this chapter is financial ratios
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 manage
ment wants to portray firm in a positive light
Published to a variety of audiences
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Users of Financial Information
Investors and Financial Analysts
Financial analysts interpret information about companies and make recommendation
s to investors Major part of analyst’s job is to make a careful study of recent fi
nancial 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
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Sources of Financial Information
Annual Report
Required of all publicly traded firms Tend to portray firm in a positive light A
lso publish a less glossy, more businesslike document called a 10K with the SEC
Brokerage firms and investment advisory services
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 Data sources for term project
See the course links page for link to MEL page http://www.lib.purdue.edu/mel/ins
t/agec_424
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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
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Ratio Analysis
Used to highlight different areas of performance Generate hypotheses regarding t
hings going well and things to improve Involves taking sets of numbers from the
financial statement and forming ratios with them
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Comparisons
A ratio when examined alone doesn’t convey much information – but..
History—examine trends (how the value has changed over time) Competition—compare wit
h other firms in the same industry Budget—compare actual values with expected or d
esired values
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Common Size Statements
First step in a financial analysis is usually the calculation of a common size s
tatement
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
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Common Size Statements
Alpha
$ % Sales $ 2,187,460 100.0% COGS $ 1,203,103 55.0% Gross margin $ 984,357 45.0%
Expenses EBIT Interest EBT Tax Net Income $ $ $ $ $ $ 505,303 479,054 131,248 3
47,806 118,254 229,552 23.1% 21.9% 6.0% 15.9% 5.4% 10.5%
Beta
$ % $ 150,845 100.0% $ 72,406 48.0% $ 78,439 52.0% $ $ $ $ $ $ 39,974 38,465 15,
386 23,079 3,462 19,617 26.5% 25.5% 10.2% 15.3% 2.3% 13.0%
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Look at ANF income statement
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Ratios
Designed to illuminate some aspect of how the business is doing Average Versus E
nding 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 ca
sh flow figure is combined with a balance sheet figure in a ratio—use average valu
e for balance sheet figure If a ratio compares two balance sheet figures— use endi
ng value
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Ratios
5 Categories of Ratios 1. Liquidity: indicates firm’s ability to pay its bills in
the short run 2. Asset Management: Right amount of assets vs. sales? 3. Debt Man
agement: Right mix of debt and equity? 4. Profitability— Do sales prices exceed un
it costs, and are sales high enough as reflected in PM, ROE, and ROA? 5. Market
Value— Do investors like what they see as reflected in P/E and M/B ratios?
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Liquidity Ratios
Current Ratio
Current Ratio =
Current Assets Current Liabilities
To ensure solvency the current ratio has to exceed 1.0
Generally a value greater than 1.5 or 2.0 is required for comfort As always, com
pare to the industry
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Liquidity Ratios
Quick Ratio (or Acid-Test Ratio)
current assets - inventory Quick Ratio = current liabilities Measures liquidity
without considering inventory (the firm’s least liquid current asset) Not a good r
atio for grain farms
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Asset Management Ratios
Average Collection Period (ACP)
accounts receivable ACP = DSO = sales per day
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 f
or doubtful accounts
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Asset Management Ratios
Inventory Turnover
cost o f g o od s sold In v e n to ry T urn o ve r = in ve n to ry Gives an indi
cation of the quality of inventory, as well as, how it is managed Measures how m
any times a year the firm uses up an average stock of goods A higher turnover im
plies doing business with less tied up in inventory Should use average inventory
balance
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Asset Management Ratios
Fixed Asset Turnover
Fixed Asset Turnover = Sales (Total) Fixed Assets (Net)
Appropriate in industries where significant equipment is required to do business
Long-term measure of performance Average balance sheet values are appropriate
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Asset Management Ratios
Total Asset Turnover
Sales (Total) Total Asset Turnover = Total Assets
More widely used than Fixed Asset Turnover Long-term measure of performance Aver
age balance sheet values are appropriate
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Debt Management Ratios
Need to determine if the company is using so much debt that it is assuming exces
sive risk Debt could mean long-term debt and current liabilities
Or it could mean just interest-bearing obligations—often sources just use long-ter
m debt

Debt Ratio
TL Debt Ratio = TA
A high debt ratio is viewed as risky by investors Usually stated as percentages
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Debt Management Ratios
Debt-to-equity ratio
Can be stated several ways (as a percentage, or as a x:y value)
Total Liabilities TL Debt − to − Equity = = Common Equity E
Many sources use long term debt instead of total liabilities Measures the mix of
debt and equity within the firm’s total capital
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Debt Management Ratios
Times Interest Earned
EBIT TIE = Interest Expense
TIE is a coverage ratio
Reflects how much EBIT covers interest expense A high level of interest coverage
implies safety
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Debt Management Ratios
Cash Coverage
Cash coverage = EBIT + depreciation Interest Expense
TIE ratio has problems
Interest is a cash payment but EBIT is not exactly a source of cash By adding de
preciation back into the numerator we have a more representative measure of cash
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Debt Management Ratios
Fixed Charge Coverage
EBIT + Lease Payments Fixed Charge Coverage = Interest Expense + Lease Payments
Interest payments are not the only fixed charges Lease payments are fixed financ
ial charges similar to interest
They must be paid regardless of business conditions
If they are contractually non cancelable
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Profitability Ratios
Return on Sales (AKA:Profit Margin (PM), Net Profit Margin)
Net Income PM = ROS = Sales
Measures control of the income statement: revenue, cost and expense Represents a
fundamental indication of the overall profitability of the business
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Profitability Ratios
Return on Assets
Net Income ROA = Total Assets
Adds the effectiveness of asset management to Return on Sales Measures the overa
ll ability of the firm to utilize the assets in which it has invested to earn a
profit
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Profitability Ratios
Return on Equity

ROE = Net Income Stockholders Equity
Adds the effect of borrowing to ROA Measures the firm’s ability to earn a return o
n the owners’ invested capital If the firm has substantial debt, ROE tends to be h
igher than ROA in good times and lower in bad times
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Market Value Ratios
Price/Earnings Ratio (PE Ratio)
Current stock price PE Ratio = Earnings per share (EPS)
An indication of the value the stock market places on a company Tells how much i
nvestors are willing to pay for a dollar of the firm’s earnings A firm’s P/E is prim
arily a function of its expected growth
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Market Value Ratios
Market to Book Value Ratio
Current stock price Market to Book Value = book value per share (of equity) A he
althy 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 compan
y able to generate future earnings worth more than the assets alone today A valu
e less than 1.0 indicates a poor outlook for the company’s future
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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
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Du Pont Equations
Du Pont equation involves ROE, which can be written several ways:
Net Income sales ROA = × Total Assets sales or Net Income sales ROA = × sales Total
Assets or ROE = ROS × total asset turnover
States that to run a business well, a firm must manage costs and expenses as wel
l as generate lots of sales per dollar of assets.
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Du Pont Equations
Extended Du Pont equation states ROE in terms of other ratios
ROE = or ROE = or ROE = ROS4×4Total 2 4 4 4 4 4 4 × Equity Multiplier 14 4 4 Asset T
urnover 4 3
ROA


Net Income sales total assets × × Stockholders Equity sales

total assets Net Income
sales total assets × × sales total assets Stockholders Equity 1444 24444 4 3
Equity Multiplier
or ROE = ROA × Equity Multiplier
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.
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Du Pont Equations
Extended Du Pont equation states that the operation of a business is reflected i
n 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
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Sources of Comparative Information
Generally compare a firm to an industry average
Dun and Bradstreet publishes Industry Norms and Key Business Ratios Robert Morri
s Associates publishes Statement Studies U.S. Commerce Department publishes Quar
terly Financial Report Value Line provides industry profiles and individual comp
any reports
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Limitations/Weaknesses of Ratio Analysis
Ratio analysis is not an exact science and requires judgment and experienced int
erpretation
Examples of significant problems Diversified companies—because the interpretation
of ratios is dependent upon industry norms, comparing conglomerates can be probl
ematic Window dressing—companies attempt to make balance sheet items look better t
han they would otherwise through improvements that don’t last Accounting principle
s differ—similar companies may report the same thing differently, making their fin
ancial results artificially dissimilar Inflation may distort numbers
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