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MGMT 31000

Financial Management

CHAPTER 3: Working with Financial Statements

Agenda

1. Cash Flow and Financial Statements: A Closer Look

 Understand sources and uses of cash

2. Ratio Analysis

 Know how to compute and interpret important financial ratios

3. The Du Pont Identity

 Be able to compute and interpret the Du Pont Identity

MGMT 31000 - Financial Management

Sources and Uses of Cash

Sources

1. Cash inflow – occurs when we “sell” something

2. Decrease in asset account

 Accounts receivable, inventory, and net fixed assets

3. Increase in liability or equity account

 Accounts payable, other current liabilities, and common stock

Uses

1. Cash outflow – occurs when we “buy” something

2. Increase in asset account

 Cash and other current assets

3. Decrease in liability or equity account

 Notes payable and long-term debt

MGMT 31000 - Financial Management

Source vs. Use?

Source Use

Increase in accounts payable √

Increase in accounts receivable √

Decrease in notes payable √

Increase in retained earnings √

Increase in common stock √

Net fixed assets acquisitions √

Decrease in inventory √

Decrease in long-term debt √

MGMT 31000 - Financial Management

2. Ratio Analysis

 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.

 Ratios allow for better comparison through time or between companies

 As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important

 Ratios are used both internally and externally

MGMT 31000 - Financial Management

Categories of Ratios

 Short-term solvency or liquidity ratios

 The ability to pay bills in the short-run

 Long-term solvency or financial leverage ratios

 The ability to meet long-term obligations

 Asset management or turnover ratios

 Efficiency of asset use

 Profitability ratios

 Efficiency of operations and how that translates to profit

 Valuation ratios

 The MV of the firm relative to the BV

MGMT 31000 - Financial Management

Categories of Financial Ratios

3-9

Short-term Solvency Ratios

 Current Ratio: Ability to pay current liabilities

 Quick Ratio: Ability to pay current liabilities without converting inventory to sales

 Cash Ratio: Ability to pay current liabilities with cash on hand

sLiabilitieCurrent

AssetsCurrent RatioCurrent 

sLiabilitieCurrent

Inventory)-Assets(Current RatioQuick 

sLiabilitieCurrent

Cash RatioCash 

10 MGMT 31000 - Financial Management

Long-term Solvency Ratios

 Total Debt Ratio: Measure of all debts and maturities

 Debt-Equity Ratio: Use of debt and equity in capital structure

 Equity Multiplier: A company’s total assets per dollar of equity

Total Debt Total Debt Ratio 1

Total Assets

A   

Total Debt Debt-Equity Ratio

Total Equity 

Total Assets Equity Multiplier 1

Total Equity

E   

11 MGMT 31000 - Financial Management

Long-term Solvency Ratios (cont’d)

 Times Interest Earned: Ability to pay its interest expense

MGMT 31000 - Financial Management

EBIT Times Interest Earned Ratio

Interst Expenses 

Turnover Ratios

 Inventory Turnover: Number of times each year inventory is turned.

 Days’ Sales in Inventory: How long inventory sits before being turned.

 Total Asset Turnover: How many sales are generated per

dollar of assets.

Assets Total

Sales TurnoverAsset 

Inventory

Sold Goods ofCost TurnoverInventory 

365 days Days' Sales in Inventory

Inventory Turnover 

13 MGMT 31000 - Financial Management

Turnover Ratios (cont’d)

 Receivables Turnover: How fast receivables are collected.

 Days’ sales in Receivables: How long it takes to collect on credit sales.

MGMT 31000 - Financial Management

Sales Receivables Turnover

Account Receivable 

365 days Days' Sales in Receivables

Receivables Turnover 

Profitability Ratios

 Profit Margin: Profit for every dollar in sales

 Return on Assets (ROA): Profit per dollar of assets.

 Return on Equity (ROE): Profit per dollar of stockholders’ equity.

MGMT 31000 - Financial Management

Assets Total

Income Net ROA 

Equity of ValueBook Total

Income Net ROE 

Net Income Profit Margin

Sales 

Market Value Ratios

 Earnings Per Share (EPS): Profitability available to each share

 Price-Earnings (P/E) Ratio: How much investors are willing to pay per dollar of current earnings.

 Market-to-Book Ratio: Compare how investors value the stock to the financial statement value.

gOutstandin Shares #

IncomeNet EPS 

EPS

PriceShare

IncomeNet

tionCapitalizaM arket RatioP/E 

Equity of ValueBook

Equity of ValueM arket RatioBook -to-M arket 

16 MGMT 31000 - Financial Management

Market Value Ratios (cont’d)

 EBITDA

 Earnings Before Interest, Taxes, Depreciation, and Amortization.

 A rough measure of the cash a firm has ‘earned’ from its operations (i.e. a rough measure of operating cash flows).

 Enterprise Value: Estimate how much it would cost to take over the business (i.e. purchase all of the equity and repay the debt).

 EV-EBITDA ratio

EV Market Value of Equity Book Value of Liabilities - Cash 

EV Enterprise Value - EBITDA Ratio =

EBITDA

17 MGMT 31000 - Financial Management

Exercise..

 Current Ratio = 57.0/48.0=1.19

 Quick Ratio = (57.0-15.3)/48.0=0.87

 Cash Ratio = 21.2/48.0=0.44

MGMT 31000 - Financial Management

Global’s 2012 B/S (Excerpted)

Current Assets Current liabilities

Cash 21.2 Accounts payable 29.2

Accounts Receivable 18.5 Notes payable/short-term debt 3.5

Inventories 15.3 Current maturities of long-term debt 13.3

Other Current Assets 2.0 Other current liabilities 2.0

Total Current Assets 57.0 Total current liabilities 48.0

Exercise…

 Total Debt Ratio = (177.7-22.2)/177.7 =0.88

 Debt-Equity Ratio = (3.5+13.3+99.9) /22.2 = 5.26

 Equity Multiplier = 177.7/22.2= 8.00

MGMT 31000 - Financial Management

Assets 2009 Liabilities and Stockholders' Equity 2009

Current Assets Current liabilities

Cash 21.2 Accounts payable 29.2

Accounts Receivable 18.5 Notes payable/short-term debt 3.5

Inventories 15.3 Current maturities of long-term debt 13.3

Other Current Assets 2.0 Other current liabilities 2.0

Total Current Assets 57.0 Total current liabilities 48.0

Long-Term Assets Long-Term Liabilities

Land 22.2 Long-term debt 99.9

Buildings 36.5 Capital lease obligations 0.0

Equipment 39.7 Total debt 99.9

Less Accumulated Depreciation (18.7) Deferred taxes 7.6

Net Property, plant, and equipment 79.7 Other long-term liabilities 0.0

Goodwill and intangible assets 20.0 Total long-term liabilities 107.5

Other Long-term assets 21.0 Total Liabilities 155.5

Total long-term assets 120.7 Stockhoders' Equity 22.2

Total assets 177.7 Total Liabilities and Stockholders' Equity 177.7

Global’s 2012 B/S

Exercise…

 Times Interest Earned = 10.4/7.7= 1.35

MGMT 31000 - Financial Management

2009

Total Sales 186.7

Cost of Sales (153.4)

Gross Profit 33.3

Selling, general, and administrative expense (13.5)

Research and development (8.2)

Depreciation and amortization (1.2)

Operating Income 10.4

Other income 0.0

Earnings before interest and taxes (EBIT) 10.4

Interest income (expense) (7.7)

Pretax income 2.7

Taxes (0.7)

Net Income 2.0

Global’s 2012 I/S

Exercises..

 Asset Turnover =186.7/177.7=1.05

 Inventory Turnover =153.4/15.3=10.03

 Days’ sales in inventory = 365/10.03 =36.40

 Receivables Turnover = 186.7/18.5=10.09

 Days’ sales in receivables = 365/10.09=36.17

MGMT 31000 - Financial Management

Assets 2009

Current Assets

Cash 21.2

Accounts Receivable 18.5

Inventories 15.3

Other Current Assets 2.0

Total Current Assets 57.0

Long-Term Assets

Total long-term assets 120.7

Total assets 177.7

2009

Total Sales 186.7

Cost of Sales (153.4)

Gross Profit 33.3

Global’s 2009 I/S (Excerpted)

Global’s 2012 B/S (Excerpted)

Exercises..

 Profit Margin=2.0/186.7=0.01

 EBITDA= EBIT + Depreciation & Amortization = 10.4+1.2=11.6

 ROA=2.0/177.7=0.01

 ROE=2.0/22.2=0.09

MGMT 31000 - Financial Management

Global’s 2012 I/S (Excerpted)

2009

Total Sales 186.7

Cost of Sales (153.4)

Gross Profit 33.3

SG&A (13.5)

Research and development (8.2)

Depreciation and amortization (1.2)

Operating Income 10.4

Other income 0.0

Earnings before interest and taxes (EBIT) 10.4

Interest income (expense) (7.7)

Pretax income 2.7

Taxes (0.7)

Net Income 2.0

• Book Assets = 177.7 • Book Equity = 22.2

3. The Du Pont Identity

ROE = NI / TE

ROE = (NI / Sales) (Sales / TA) (TA / TE)

ROE = PM * TAT * EM

 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 does it manage its assets

 Equity multiplier (EM) is a measure of the firm’s financial leverage

MGMT 31000 - Financial Management

Using the Du Pont Identity

XYZ Corporation has the following financial information for

the previous year:

 Sales: $8M

 Profit Margin (PM) = 8%

 Current Assets (CA) = $2M

 Fixed Assets (FA) = $6M

 Net Working Capital (NWC) = $1M

 Long Term Debt (LTD) = $3M

MGMT 31000 - Financial Management

Using the Du Pont Identity

Compute the ROE using the DuPont Analysis.

1. Total assets = CA + FA = $2M + $6M = $8M

2. TAT = Sales / TA = $8M / $8M = 1

3. NWC = CA – CL CL = CA – NWC = $2M - $1M = $1M

4. Total liabs. = CL + LTD = $1M + $3M = $4M

5. Total equity = total assets – total liabs. = $8M - $4M = $4M

6. EM = assets / equity = $8M / $4M = 2

7. ROE = PM x TAT x EM = 8% x 1 x 2 = 16%

8. Without DuPont, ROE = NI / TE = PM * Sales / TE = 8% x $8M /

4M = 16%

MGMT 31000 - Financial Management

Potential Problems

1. There is no underlying theory, so there is no way to know which ratios are most relevant

2. Benchmarking is difficult for diversified firms

3. Globalization and international competition makes comparison more difficult because of differences in accounting regulations

4. Varying accounting procedures, i.e. FIFO vs. LIFO

5. Different fiscal years

MGMT 31000 - Financial Management

Example: Determinants of ROE

 Problem:

 For the year ended November 2012, Wal-Mart Stores and Target had the following accounting measures:

 Compare the two firms’ profitability, asset turnover, equity multiplier, and ROE during this period.

 If Target had been able to match Wal-Mart’s asset turnover in 2012, what would its ROE have been?

MGMT 31000 - Financial Management

(in $ billion) Wal-Mart Target

Sales 403.9 65.3

Net Income 13.7 2.6

Total Assets 167.8 47.0

Book Equity 65.5 13.6

Example: (cont’d)

 Solution:

 Mainly due to its lower asset turnover, Target had a lower ROE than Wal-Mart.

 If Target had been able to match Wal-Mart’s asset turnover, its ROE would have been 3.98%× 2.41× 3.46=33.2%

MGMT 31000 - Financial Management

Wal-Mart Target

Net profit margin 13.7/403.9=3.39% 2.6/65.3=3.98%

Asset turnover 403.9/167.8=2.41 65.3/47.0=1.39

Equity multiplier 167.8/65.5=2.56 47.0/13.6=3.46

ROE 13.7/65.5=20.91% 2.6/13.6=19.1%

Example: Computing EV

 Problem:

 In January 2009, H.J. Heinz Co. (HNZ) had

 A share price of $36.95

 314.44 million shares outstanding

 A market-to-book ratio of 7.99

 A book debt-equity ratio of 3.7

 Cash of $0.93 billion.

 What was Heinz’s enterprise value?

MGMT 31000 - Financial Management

Example: (cont’d)

 Solution:

 Heinz’s market cap = $36.95 × 314.44 million shares = $11.62 billion.

 Heinz’s book value of equity =11.62/7.99=$1.45 billion.

 Given a book debt-equity ratio of 3.7, Heinz had total debt of 1.45 X 3.7 = $5.37 billion.

 Thus, Heinz’s EV was 11.62+5.37–0.93 = $16.06 billion.

MGMT 31000 - Financial Management

More Exercises on EV..

 Problem

 In January 2009, Rylan Corporation had a market capitalization of 110 million, a market-to-book ratio of 2.2, a book debt to equity ratio of 1.4, and cash of $6.3 million. What was Rylan’s enterprise value?

 Solution:

 Rylan’s book value of equity is 11/2.2=$50 million.

 Given a book debt-equity ratio of 1.4, Rylan had total debt of 1.4 X 50 = $70 million.

 Thus, Rylan’s EV was 110+70–6.3 = $173.7 million.

MGMT 31000 - Financial

Management 31

Quick Quiz

1. How do you determine sources and uses of cash?

2. What are the major categories of ratios and how do you interpret them?

• You do not need to memorize the formulas for any of the ratios studied. They will be provided to you during exams.

3. What are some of the problems associated with financial statement analysis?

MGMT 31000 - Financial Management

Practice Question 9. (p 85)

 Sources and Uses of Cash [LO4] Based only on the following information for Shinoda Corp., did cash go up or down? By how much? Classify each event as a source or use of cash.

MGMT 31000 - Financial Management

Practice Question 18. (p 86)

 Using the DuPont Identity [LO3] Y3K, Inc., has sales of $6,189, total assets of $2,805, and a debt–equity ratio of 1.40. If its return on equity is 13 percent, what is its net income?

MGMT 31000 - Financial Management

Practice Question 22. (p 86)

 Return on Equity [LO2] Firm A and firm B have debt–total asset ratios of 45% and 35% and returns on total assets of 9% and 12%, respectively. Which firm has a greater return on equity?

MGMT 31000 - Financial Management

Practice Question 24. (p 86)

 Cost of Goods Sold [LO2] Saunders Corp. has current liabilities of $435,000, a quick ratio of .95, inventory turnover of 6.2, and a current ratio of 1.6. What is the cost of goods sold for the company?

MGMT 31000 - Financial Management