Chapter 3 Financial Management

Working With Financial Statements

Sources of cash

activities that bring in cash; decrease in asset or increase in liability or equity

Uses of cash

activities that involve spending; increase in asset or decrease in liability

True or False:

After finding the sources and uses, you find the net addition to cash which is the difference between sources and cash

True

Examples of Current Assets

Cash, Accounts Receivable, Inventory

Example of Fixed Assets

Net plant & equipment

Examples of current liabilities

Accounts payable, Notes payable (can be current or long term), accrued expenses

Stockholders Equity

=Common Stock + Paid-in surplus + Retained Earnings

How do you calculate the EBIT?

=Sales - COGS - Depreciation

How do you calculate taxable income?

=EBIT - Interest Paid

How do you calculate net income?

=Taxable income - Taxes

How do you calculate the addition to retained earnings?

=Net income - dividends

What is statement of cashflows what is it split up into?

Summarizes its sources and uses of cash over a specified period. Operating, Financing and Investment activities

Why is it almost impossible to directly compare financial statements of 2 companies?

Because of different company sizes

Key Performance Indicators (KPIs)

measurable value that shows how effectively a company is achieving business objectives

Common size statement/vertical analysis

presents all items in percentage terms. Balance sheet items are shown as a percentage of asset, income statement as a percentage of sales.

How do you use common-size statement of cashflows?

You would want to express each item as percentage of total uses or total sources

Common-base year statements/horizontal analysis

when comparing given balance sheets for previous years you would standardize by choosing a base year and the express each item relative to base amount

How do you use common-base year statements?

Divide the current value amount by the base year amount, plot it, and compare for each year

What is ratio analysis used for?

Compare’s financial ratios to compare companies of difference sizes because it divides out and leaves with percentages

Current Ratio

=Current Assets / Current Liabilities

Represented as Times (x)

Whether company has enough current assets to cover current liabilities

The company has $$$ in currents assets for every $1 in Current liabiltiies

What would a current ratio of less than 1 mean?

That means they has a negative net working capital; the higher the ratio the better in most cases

Quick Ratio

=Current Assets - inventory / Current Liabilities

Represented as times (x)

Measures companies ability to pay current liabilities without needing to sell inventory (inventory least liquid asset)

The company has $0.80 in quick assets for every $1 in current liabilities

What does the quick ratio show?

Large inventories are often sign of short-term trouble, which means there could be overestimated sales, or be overproduced. This means firms have a lot of liquidity ties up in slow moving inventory.

Cash Ratio

=Cash / Current Liabilities

Represented as times (x)

Whether company can cover current liabilities with cash

The company has $0.25 of cash for every $1 of current liabilitiies

Net Working Capital to Total Assets

=NWC / Total Assets

Low level might indicate low liquidity

Total Debt Ratio

=Total Assets - Total Equity / Total Assets

Represented as %

Shows how much of company’s assets are financed through debt

The company has $0.40 cents in debt for every $1.00 in assets

Debt-Equity Ratio

=Total Debt/Total Equity

Represented as times (x)

Compares creditor financing with shareholder financing

The company has $0.60 of debt for every $1.00 in equity

Equity Multiplier

=Total Assets / Total Equity

Represented as times (x)

Shows amount of assets supported by each dollar of equity, measure of leverage

Company has $1.60 of assets for every $1 of equity

What are the 3 equity multiplier equations that are interchangeable?

= Total Assets / Total Liabilities

= (Total Equity + Total Debt) / Total Equity

= 1 + Debt-Equity Ratio

Times interest earned ratio (TIE)

=EBIT / Interest

Represented as times (x)

How well company has its interest obligations covered

Company’s EBIT covers its interest expense … times

Cash Coverage Ratio

= EBITDA / Interest

Represented as times (x)

Basic measure of firm’s ability to generate cash from operations; measure of cashflow used to meet financial obligations

The companies operating cash flow covers its interest expense approximately … times

Inventory Turnover

= COGS / Inventory (should be average)

Represented as times (x)

how many times company sells/turns over inventory during the year

The company turns over inventory approximately … times

Days’ sales in inventory

=365 days / Inventory turnover Ratio

Represented as days

How long it took on average to turnover.

Inventory sits for approximately … days before being sold

Receivable’s Turnover

= Sales / Accounts Receivable (should be average)

Represented as times per year (x)

How efficiently company collects receivables payments

The company collects outstanding receivables … times per year

Days’ sales in receivables

= 365 / Receivables turnover

Average collection period

Takes company … days to collect credit sales

Net Working Capital Turnover

= Sales / Net Working Capital

How much work we get out of our working capital; assuming we are not missing out on sales higher is better

Company generates … sales for every $1 of NWC

Total Assets Turnover

= Sales / Total Assets (should be an average)

Fore every dollar in assets, … generated … in sales

Company generates … sales for every $1 invested in total assets

Profit Margin

= Net income / Sales

Generates … in profit for every dollar in sales

Return on Assets

= Net income / Total Assets (should be average)

Profit per dollar of assets

Return on Equity

= Net income / total equity (should be average)

How stockholders did during the year

For every dollar in equity, … generated … in profit

Earnings Per Share (EPS)

= Net income / shares outstanding

PE Ratio

= Price per share / EPS

… sells for almost … times earnings

Measures how much investors are willing to pay per dollar of earnings

Higher means the firm has signficiant prospects for high future growth

PEG Ratio

= PE / Future Earnings Growth Rates

High PEG suggest PE is too high relative to growth & vice versa

Price - Sales Ratio

= Price Per Share / Sales per Share

Market - to - book ratio

= Market Value Per Share / Book value per share

Value less than 1 could mean firm has not been successful in creating value for stockholders

Book Value

= total equity / # of shares outstanding

Enterprise value

= Total Market Value of stock + Book value of all liabilities - Cash

When calculating enterprise value, why is book value used for all liabilities?

You use book value because you can’t usually get market value for all of them

EBITDA Multiple

= Enterprise Value / EBITDA

Relates value of operating assets to a measure of the operating cashflow generated by those assets

Dupont Identity

ROE = Net Income / Total Equity

= Net Income / Sales X Sales / Assets X Assets / Total Equity

= Profit Margin X Total Asset Turnover X Equity Multiplier

What does the Dupont identity tell us?

Tells use ROE is affected by 3 things:

1. Operating Efficiency (measured by profit margin)

2. Asset use efficiency (measured by total asset turnover)

3. Financial Leverage (measured by equity multiplier)

What will a weakness in either operating or asset use efficiency effect?

Will show up in diminished return on assets

What happens when there is a increasing in the amount of debt in the Dupont Identity?

The ROE will be leveraged up but this also increases interest expense which reduces profit margins and ROE

Time trend analysis benchmark

specific ratio over a specific period of time

Peer group analysis

identify firms similar to them (same market, similar assets, operate similarly)

What are the short-term solvency / liquidity ratios?

Current ratio, quick ratio, cash ratio

What are the long-term solvency, or financial leverage ratios?

Total debt ratio, debt-equity ratio, equity multiplier, cash coverage ratio

What are the asset management or turnover ratios?

Inventory turnover, days’ sales in inventory, A/P turnover, Receivables turnover, days’ sales in receivables turnover, NWC turnover, Total asset turnover

What are the Profitability Ratios?

profit margin, ROE, ROA,

What are the market value ratios?

EPS, PE ratio, PEG ratio, Price-sales ratio, Market-to-book ratio, enterprise value, EBITDA multiple