Cash Flows and Financial Analysis Chapter 3 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 management wants to portray firm in a positive light • Published to a variety of audiences
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
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
Data sources for term project • See the course links page for link to MEL page • http://www.lib.purdue.edu/mel/inst/agec_424.html
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
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
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
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
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 In this class we usually cheat and just use the ending balance sheet. Often it is the only one given.
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?
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
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
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
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
Asset Management Ratios • Inventory conversion period -- Days of sales in inventory • An alternate measure of inventory size • Has the same information as ITO • Inventory/COGS/360 • 360/ITO • Used in cash conversion cycle (CCC) calculation
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
Asset Management Ratios • Total Asset Turnover • More widely used than Fixed Asset Turnover • Long-term measure of performance • Average balance sheet values are appropriate
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
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
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.
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
Debt Management Ratios • Cash Coverage1 • 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 1EBITDA or “earnings before interest taxes depreciation and amortization” is a commonly used measure of cash flow.
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
Debt Management Ratios • Days of sales in accounts payable • Accounts Payable deferrals • Accounts Payable/(COGS/360) • A measure of how large accounts payable are in comparison to COGS (sales) • Used in CCC calculation
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
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
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
Profitability Ratios • Basic earnings power • BEP = EBIT/Total Assets • Compare to the pre-tax interest rate • Return on capital employed • ROCE = EBIT(1-T)/Total Assets • Compare to after tax interest rate
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
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
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
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.
Extended Du Pont Equation • Designed to explain ROE • Not Designed to Calculate ROE • Can get EM from:
Du Pont Equations • Extended Du Pont equation states that the operation of a business is reflected in its ROA • 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
Operations—Cash Conversion Cycle • A firm begins with cash which then “becomes” inventory • Which then becomes a product which is sold • Eventually this will turn into cash again • The firm’s operating cycle is the time from the acquisition of inventory until cash is collected from product sales
Figure 15.2: Time Line Representation of the Cash Conversion Cycle
Cash Conversion Cycle • CCC = ICP + DSO – AP Deferral • The shorter the CCC the less interest bearing and/or equity capital is needed to fund operations. • This can be very significant for businesses with high working capital
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 Lineprovides industry profiles and individual company reports • Go to MEL page for AGEC 424
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