Financial statements and ratios

Preamble

The overview of Financial Statements reveals information about past and
current performance of the firm.

When combining this information with other sources, we might be able to
form expectations about the firms future cash flows.
Outline


The Balance Sheet
The Income Statement
The Statement of Cash Flows
On ratio analysis

Balance Sheet



Financial Statement showing a firms accounting value on a particular date.

Balance Sheet
ASSETS
1994 1995
Cash
Accounts recei vable
Inventory
Total current assets:
$114
$445
$553
$1,112
$160
$688
$555
$1,403
Net, plant and equipment
Fixed assets
$1,644
$1,664
$1,709
$1,709
TOTAL ASSETS $2,756 $3,112
LIABILITIES & EQUITY
1994 1995
Accounts payable
Notes payable
Total current liabilities:
$232
$196
$428
$266
$123
$389
Long-term debt $408 $454
Common shares
Retai ned earnings
Total owners equity
$600
$1,320
$1,920
$640
$1,629
$2,269
TOTAL LIABILITIES & EQUITY $2,756 $3,112
Reminder
Assets are listed in the order of decreasing liquidity
Liquidity = the degree of ease to which an asset can be converted to cash without a
substantial loss or price reduction.

The balance sheet does not reflect the real value of firm's assets.


The balance sheet reflects the historical cost of firm's assets.
The Income Statement

Reveals how profitable the firm is over a certain period of time.
The Income Statement
Net sales $1,509
Cost of goods sold ($750)
Depreciation ($65)
EBIT $694
Interest paid ($70)
Taxable i ncome $624
Taxes paid ($250)
Net income (Earnings) $374
Addition to retained earni ngs $309
Di vi dends pai d $65
Statement of cash flows

Integrates the Balance Sheet and the Income Statement

CF from operating activities + CF from investing + Cf from financing

Interpretation
Net increase or decrease in the firms cash
Cash flows identities
In any given year:

Cash flow from assets = CF to creditors + CF to shareholders
where:
CF to creditors = Interest paid - Net new debt raised
CF to shareholders = Dividends paid - Net new equity raised

Cash flow from assets = OCF - NCS - Additions to NWC
where:
Operating CF = EBIT + Depr. - Taxes
NCS = Ending Fixed Assets - (Beginning Fixed Assets - Depr.)
Additions to NWC = NWC
t
- NWC
t-1


Cash flows identities
In our example:
CF to creditors = $70 - ($454-$408) = $24
CF to shareholders = $65 - ($640-$600) = $25
Operating CF = $694 + $65 - $250 = $509
Net capital spending = $1,709 - (1,644 - $65) = $130
Additions to NWC = ($1,403-$389) - ($1,112-$428) = $330

Cash flow from assets= ($24 + $25) = ($509 - $130- $330) = $49

Sources of cash:


Increase in accounts payable
Increase in common stock
Increase in retained earnings

Uses of cash:


Increase in accounts receivable
Increase in inventory
Decrease in notes payable
Decrease in long-term debt
Net fixed asset acquisitions
Ratio analysis
When analyzing a firm, we want to know:

if the firm is able to meet its short-term financial obligations (is it
solvent?);
if the firm is able to meet its long-term financial obligations (going
bankrupt in the future?);
how well the assets of the firm are managed;
how well the overall operations of the firm are managed (is it
profitable?);
how the market interprets accounting data and what expectations are
factored in.

Ratio analysis
Short-term solvency and liquidity ratios:
Indicate the firms ability to pay its bills over the short run without undue stress.

Financial leverage:
Describe a firms long-term ability to meet its financial obligations

Asset utilization turnover ratios:
Describe how efficiently (intensively) a firm uses its assets to generate sales.

Profitability ratios:
Describes how efficiently the firm manages its overall operations (the higher, the better !!!!!)

Market ratios
Describe how the market values the firm.
Short-term solvency and liquidity ratios
Current ratio = Current assets/Current liabilities

Quick ratio = (Current assets-Inventory)/Current liabilities

Cash ratio = Cash/Current liabilities

NWC to total assets = (Current assets - Current liabilities)/Total assets

Interval measure = Current assets/Avg. daily op. costs

Short-term solvency and liquidity ratios
Current ratio = $708/540 = 1.31

Quick ratio =($708-$422)/$540 = 0.53

Cash ratio = $98/$540 = 0.1815

NWC to total assets = ($708 - 540)/$3,588 = 0.047

Interval measure = $708/[$1,344/365] = 192 days
Financial leverage
Total debt ratio = (Total assets-Total equity)/Total assets

Debt/equity ratio = Total debt/total equity

Equity multiplier = Total assets/Total equity = 1 + Debt/Equity

Long-term debt ratio = Long-term debt/(Total assets)

Times interest earned = EBIT/Interest

Cash coverage ratio = (EBIT + Depreciation)/Interest
Financial leverage
Total debt ratio = ($3,588 - $2,591)/$3,588 = 0.28

Debt/equity ratio = $997/$2,591 = 0.28/0.72 = 0.39

Equity multiplier = 1 + 0.39

Long-term debt ratio = $457/[$457 + $2,591] = 0.15

Times interest earned = $691/$141 = 4.9 times

Cash coverage ratio = ($691 +$276)/$141 = 6.9
Asset utilization turnover ratios
Inventory turnover = Cost of goods sold/Inventory

Days sales inventory = 365/Inventory turnover
Days sales inventory =(365)Inventory/Cost of goods sold

Receivables turnover = Sales/Accounts receivable
Days sales in receivables = 365/Receivables turnover
Days sales in receivables = (365)Accounts receivables/Sales

NWC turnover = Sales/(Current assets - Current liabilities)
Fixed asset turnover = Sales/Net fixed assets
Total asset turnover = Sales/Total assets


Asset utilization turnover ratios
Inventory turnover =$1,344/$422 = turned out the inventory 3.2 times
Days sales inventory = 365/3.2 = 114 days of sales in inventory
Receivables turnover = $2,311/$188 = 12.3 times
Days sales in receivables = 365/12.3 = 30
The average collection period (ACP) is 30 days

NWC turnover = $2,311/($708 - $540) = 13.8
Fixed asset turnover = $2,311/$2,880 = 0.8
Total asset turnover = $ 2,311/$3,588 = 0.64

Profitability ratios

Profit margin = Net income/Sales

Return on assets (ROA) = Net income/Total assets

Return on equity (ROE) = Net income/Total equity
Profitability ratios
Profit margin = $363/$2,311 = 0.157

Return on assets (ROA) = $363/$3,588 = 0.1012

Return on equity (ROE) = $363/$2,591 = 0.14

ROE is the ultimate accounting measure for profitability
Du Pont identity
Shows which variables account for profitability

ROE = Net income/Total Equity

ROE= (Net income/Sales)(Sales/Total Assets)(Total Assets/Total Equity)

ROE = (Profit margin)(Total asset turnover)(Equity multiplier)

ROE = (0.157)(0.64)(1.39) = 0.14
Market ratios
Price/Earnings ratios = Price per share/Earnings per share

Market-to-book ratio = Market value per share/Book value per share

Tobins Q
Q = (Mkt. value of debt + Mkt. value of equity)/Replacement value of assets
Higher Qs indicate higher investment opportunities and/or comparative
advantage)

Market ratios
Assume:
There are 33,000 shares outstanding and P = $88

P/E = $88/$11 = 8
Market-to-book ratio = $88/($2,591/33) = 1.12

P/E and Market-to-book are also measures of cheapness