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FIN355-Corporate Finance Chapter 3

Working with Financial Statements

Siqi Wei, Ph.D.†

† Department of Finance, Financial Planning, and Insurance David Nazarian College of Business and Economics

California State University, Northridge

[B [email protected]]

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Learning Objectives

Key Concepts Understand sources and uses of cash, and the Statement of Cash Flows. Know how to standardize financial statements for comparison purposes. — Common size stmnts Know how to compute and interpret important financial ratios Understand the limitations of ratio analysis.

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Cash Flows and Financial Statements: A Closer Look

Sources of cash Cash inflow – occurs when we “sell” something and we add to the cash account Decrease in asset account

Accounts receivable, inventory, and net fixed assets (-) Increase in liability or equity account

Accounts payable, other current liabilities, and common stock (+)

Uses of cash Cash outflow – occurs when we “buy” something Increase in asset account

Cash and other current assets Decrease in liability or equity account

Notes payable and long-term debt

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Statement of Cash Flows

Changes divided into three major categories: Operating Activity – includes net income and changes in most current accounts Investment Activity – includes changes in fixed assets Financing Activity – includes changes in notes payable, long-term debt, and equity accounts, as well as dividends

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Sample Statement of Cash Flows

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Standardized Financial Statements

Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry

Common-Size Balance Sheets Compute all accounts as a percent of total assets

Common-Size Income Statements Compute all line items as a percent of sales

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Example: Common Size Balance Sheet

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Example: Common Size Income Statement

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Ratio Analysis

Goal The goal of ratio analysis is to take the numerous lines from both the income statement and balance sheet and to interpret this information in a meaningful way. There is simply too much information to grasp at one time.

Ratio Ratios are simply the construction of a Numerator and a Denominator using data from a balance sheet and/or an income statement.

Ratio = Numerator Denominator

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Categories of Financial Ratios

Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

Ratios allow for better comparison through time or between companies

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Sample Balance Sheet

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Computing Liquidity Ratios

Current Ratio = CA/CL = 2,256/1,995 = 1.13 times (1)

Quick Ratio = (CA− Inventory)/CL = (2,256−301)/1,995 = .98 times (2)

Cash Ratio = Cash/CL = 696/1,995 = .35 times (3)

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Sample Income Statement

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Computing Liquidity Ratios

NWC to Total Assets =NWC/TA = (2,256−1,995)/5,394 = .05 (4)

Interval Measure = CA

average daily operating costs = 2,256/((2,006+1,740)/365) = 219.8days

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Sample Balance Sheet

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Computing Long-term Solvency Ratios

Total Debt Ratio = (TA−TE)/TA = (5,394−2,556)/5,394 = 52.6% (5)

Debt/Equity =TD/TE = (5,394−2,556)/2,556 = 1.11 times (6)

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Sample Balance Sheet

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Computing Long-term Solvency Ratios

Equity Multiplier = EM =TA/TE = 1+D/E = 1+1.11 = 2.11 (7)

Long − term debt ratio = LTD/(LTD+TE) = 843/(843+2,556) = 24.80% (8)

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Sample Income Statement

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Computing Coverage Ratios

Times Interest Earned = EBIT /Interest = 1,138/7 = 162.57 times (9)

Cash Coverage = (EBIT + Depreciation) / Interest =(1,138 + 116) / 7 = 179.14 times

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Computing Inventory Ratios

Inventory Turnover = Cost of Goods Sold / Inventory =2,006 / 301 = 6.66 times Days’ Sales in Inventory = 365 / Inventory Turnover= 365 / 6.66 = 55 days

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Computing Receivables Ratios

Receivables Turnover = Sales/AR = 5,000/956 = 5.23times (10)

Days’ Sales in Receivables (Average collection period) = 365 / Receivables Turnover= 365 / 5.23 = 70 days

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Computing Total Asset Turnover

Total Asset Turnover =TAT = Sales/Total Assets = 5,000/5,394 = .93 (11)

NWC Turnover = Sales/NWC = 5,000/(2,256−1,995) = 19.16times (12)

Fixed Asset Turnover = Sales/NFA = 5,000/3,138 = 1.59times (13)

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Computing Profitability Measures

Profit Margin = PM =Net Income/Sales = 689/5,000 = 13.78% (14)

Return on Assets (ROA)=Net Income/Total Assets = 689/5,394= 12.77% (15)

Return on Equity (ROE)=Net Income/Total Equity =689/2,556=26.96% (16)

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Computing Market Value Measures

Market − to−bookratio = Market value per share book value per share

(17)

Ecample: If the Market Price = $87.65 per share and If the number of shares of common stock outstanding is: 190.9 million, and the book value of the equity is $2,556, Then the Market-to-book ratio = 87.65 / 3.61 = 24.28 times

*“does a market-to-book ratio below one indicate a good investment?” It may be an indication of undervaluation; however, such a ratio may also indicate negative consensus regarding the future viability of the firm.

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Computing Market Value Measures, cont’d

The Enterprise Value The Enterprise Value: An estimation of the market value of the company’s operating asset

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

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Computing Market Value Measures, cont’d

The Price/Earnings (P/E) ratio focuses on the market price of a share of stock and compares it to the Net Earnings of a company The EBITDA ratio compares the market value of all the operating assets (the enterprise value) to the operating cash flow generated by those assets (EBITDA).

EBITDA ratio = the Enterprise Value EBITDA

(18)

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Du Pont Identity

THE DU PONT IDENTITY

ROE=[ NI Sales

]× [

Sales TA

]× [

TA TE

] = PM ×TAT ×EM where

[

NI Sales

]× [

Sales TA

] = ROA

Profit margin (PM) is a measure of the firm’s operating efficiency – how well it controls costs. Total asset turnover (TAT) is a measure of the firm’s asset use efficiency – how well it manages its assets. Equity multiplier (EM) is a measure of the firm’s financial leverage.

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Extended Du Pont Chart (Figure 3.1 on Text p.p.71)

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Using Financial Statements

Time Trend Analysis Used to see how the firm’s performance is changing through time

Peer Group Analysis How does our firm compare to other firms in the same industry? Peer firms often identified using SIC (Standard Industrial Classification) codes.

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Potential Problems

There is no underlying theory, so there is no way to know which ratios are most relevant. Benchmarking is difficult for diversified firms. Globalization and international competition makes comparison more difficult because of differences in accounting regulations. Firms use varying accounting procedures. Firms have different fiscal years. Extraordinary, or one-time events.

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End-chapter Questions

Try to think about... How do you standardize balance sheets and income statements and why is standardization useful? Use of fund v.s. Source of fund What are the major categories of ratios and how do you compute specific ratios within each category? What is Dupont? -The DuPont identity puts ratios into an organizational format to demonstrate the relationship of some of the key ratios

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Q & A

Questions ?

* Read the Textbook

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