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

LIABILITIES & EQUITY

1994

1995

Cash

$114

$160

Accounts payable

$232

$266

Accounts receivable

$445

$688

Notes payable

$196

$123

Inventory

$553

$555

Total current liabilities:

$428

$389

Total current assets:

$1,112

$1,403

Long-term debt

$408

$454

Net, plant and equipment

$1,644

$1,709

Common shares

$600

$640

Fixed assets

$1,664

$1,709

Retained earnings

$1,320

$1,629

TOTAL ASSETS

$2,756

$3,112

Total owners equity

$1,920

$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 income

$624

Taxes paid

($250)

Net income (Earnings)

$374

Addition to retained earnings

$309

Dividends paid

$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 = NWCt - NWCt-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

Extended DuPont Equality

ROE = NI/E = (EBT/TA)(TA/E)(NI/EBT)

ROE = [EBIT/TA I/TA](TA/E)(EBT/EBT Tax/EBT)
ROE = [(EBIT/S)(S/TA) I/TA](TA/E)(1- Tax/EBT)
ROE = [(Operating margin) (TAT) Interest expense rate]
(Equity multiplier)
(Tax retention rate)

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