Understanding Financial Statements and Cash Flows &

Evaluating a Firms Financial Performance

Income Statement Revenue

Cost of Goods Sold Operating Expenses
(marketing, administrative)

SALES - EXPENSES = PROFIT

Financing Costs Taxes

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SALES - Cost of Goods Sold GROSS PROFIT - Operating Expenses

Income Statement

SALES - Cost of Goods Sold GROSS PROFIT - Operating Expenses

Income Statement

OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
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OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
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Balance Sheet
Outstanding Debt + Shareholders Equity

Balance Sheet
Assets Current Assets
Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses

Liabilities (Debt) & Equity Current Liabilities

Accounts Payable Accrued Expenses Short-term notes

Total Assets =

Long-Term Liabilities
Long-term notes Mortgages

Fixed Assets
Machinery & Equipment Buildings and Land

Equity
Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings
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Other Assets
Investments & patents
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Assets
Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.
Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Assets
Fixed Assets: machinery and equipment, buildings, and land.

Other Assets: any asset that is not a current asset or fixed asset. Intangible assets, such as patents and copyrights.
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Financing
Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.
Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Financing
Equity Capital: shareholders investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.
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Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

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Historical Accounting Statements

They do not provide information about future income and cash flows. Assets and liabilities as reported do not reflect current market values. Thus, the total value of the firm, as well as the value of the shareholders equity, is historical.
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Accounting Net Income Versus Cash Flow

Net income is not an accurate measure of cash flow since it contains noncash items such as depreciation.
Certain cash flows occur before the item is recorded. Example: depreciation expenses Certain cash flows occur after the item is recorded: Example: accrued wages and taxes, sale of merchandise on credit
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Market versus Book Values of Assets

The market value of an asset can differ from its book value for the following reasons:
Accounting depreciation differs from economic depreciation. Book values ignore the effects of inflation. Book values ignore the assets liquidity. Intangible assets are highly illiquid.
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Market versus Book Values of Liabilities

The market value of a liability can differ from its book value for the following reasons:
Book values do not reflect current and expected future economic conditions affecting the liabilitys market value. Book values do not reflect the firms current and expected future financial health.
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Market versus Book Values of Equity

Stockholders Equity = Assets Liabilities Since the market and book values of assets (and liabilities) are not equal, the book value of shareholders equity does not reflect its market value.

Financial Ratio Analysis

Are our decisions maximizing shareholder wealth?

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Why are ratios useful?

Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight weaknesses and strengths.

Financial Ratios
Tools that help us determine the financial health of a company. We can compare a companys financial ratios with its ratios in previous years (trend analysis). We can compare a companys financial ratios with those of its industry.
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We will want to answer questions about the firms

Liquidity Efficient use of Assets Leverage (financing) Profitability

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The key steps of financial ratio analysis

Identify users and their information needs

Example: CyberDragon Limited

Select and calculate appropriate ratios

Interpret and evaluate the results

We will use the data in the following financial statements for CyberDragon Ltd. to illustrate the process.
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CyberDragons Balance Sheet

Assets: Cash Marketable securities Accounts receivable Inventories Total current assets Plant and equipment less accum deprec. Net plant & equip. Total assets

CyberDragons
($000)

$2,540 1,800 18,320 27,530 50,190 43,100 11,400 31,700 81,890

Liabilities & Equity: Accounts payable 9,721 Notes payable 8,500 Accrued taxes payable 3,200 Other current liabilities 4,102 Total current liabilities 25,523 Long-term debt (bonds) 22,000 Total liabilities 47,523 Common stock ($10 par) 13,000 Paid in capital 10,000 Retained earnings 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890

Sales (all credit) Income Statement Cost of Goods Sold Gross Profit Operating Expenses: Selling (6,540) General & Administrative (9,400) Total Operating Expenses Earnings before interest and taxes (EBIT) Interest charges: Interest on bank notes: (850) Interest on bonds: (2,310) Total Interest charges Earnings before taxes (EBT) Taxes (assume 40%)

$112,760 (85,300) 27,460

(15,940) 11,520

(3,160) 8,360 (3,344)

Net Income
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5,016
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CyberDragon:

Other Information

1. Liquidity Ratios Do we have enough liquid assets to meet approaching obligations?

Dividends paid on common stock Earnings retained in the firm Shares outstanding (000) Market price per share Book value per share Earnings per share Dividends per share

$2,800 2,216 1,300 20 26.44 3.86 2.15

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What is CyberDragons Current Ratio?

What is the firms Acid Test Ratio?

current assets current liabilities 50,190 25,523 = 1.97

If the average current ratio for the industry is 2.4, is this good or not?
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current assets - inventories current liabilities

50,190 - 27,530 = .89 25,523

Suppose the industry average is .92. What does this tell us?
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What is the firms Average Collection Period?

2. Operating Efficiency Ratios Measure how efficiently the firms assets generate operating profits.

accounts receivable daily credit sales 18,320

112,760/365

= 59.3 days

If the industry average is 47 days, what does this tell us?

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What is the firms Operating Income Return on Investment (OIROI)?

What is their Operating Profit Margin?

operating income total assets 11,520 81,890 = 14.07%

operating income sales 11,520 112,760 = 10.22%

Slightly below the industry average of 15%. The OIROI reflects product pricing and the firms ability to keep costs down.
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This is below the industry average of 12%.

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What is their Total Asset Turnover?

What is the firms Accounts Receivable Turnover?

sales total assets 112,760 = 1.38 times 81,890

The industry average is 1.82 times. The firm needs to figure out how to squeeze more sales dollars out of its assets.
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credit sales accounts receivable 112,760 18,320 = 6.16 times

CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?
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What is the firms Inventory Turnover?

Low inventory turnover: The firm may have too much inventory, which is expensive because: Inventory takes up costly warehouse space. Some items may become spoiled or obsolete.
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cost of goods sold inventory 85,300 27,530 = 3.10 times

CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient?
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What is the firms Fixed Asset Turnover?

3. Leverage Ratios (financing decisions)

Measure the impact of using debt capital to finance assets. Firms use debt to lever (increase) returns on common equity.

sales fixed assets 112,760 31,700 = 3.56 times

If the industry average is 4.6 times, what does this tell us about CyberDragon?
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How does Leverage work?

Suppose we have an all equityfinanced firm worth $100,000. Its earnings this year total $15,000.

How does Leverage work?

Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.

ROE =

15,000 100,000

= 15%

ROE =

15,000 - 4,000 = 50,000

22%

(ignore taxes for this example)

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What is CyberDragons Debt Ratio?

What is the firms Times Interest Earned Ratio?

total debt total assets 47,523 = 58% 81,890

If the industry average is 47%, what does this tell us? Can leverage make the firm more profitable? Can leverage make the firm riskier?
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operating income interest expense 11,520 3,160 = 3.65 times

The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average.
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4. Return on Equity

What is CyberDragons Return on Equity (ROE)?

net income common equity

5,016 34,367 = 14.6%

How well are the firms managers maximizing shareholder wealth?
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The industry average is 17.54%. Is this what we would expect, given the firms leverage?
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Conclusion:

The DuPont Model Brings together: Profitability Efficiency Leverage

Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.

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The relationship between profitability and efficiency

Net Profit Margin (profitability)
Net profit before interest and taxation Sales multiplied by

The DuPont Model

ROE =
Net Profit Margin

Total Asset Turnover

/ (1-

Debt Ratio

) )

= =

Net Income Sales x Total Assets Sales

/(1-

Total Debt Total Assets

Net Asset Turnover (efficiency)

Sales______ Long-term capital employed equals

5,016 112,760

112,760 81,890

/ (1 -

47,523 81,890

)
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Return on capital employed

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= 14.6%

Potential problems and limitations of financial ratio analysis

Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Average performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better.
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More issues regarding ratios

Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is good or bad. Difficult to tell whether a company is, on balance, in strong or weak position.

Qualitative factors to be considered when evaluating a companys future financial performance Are the firms revenues tied to 1 key customer, product, or supplier? What percentage of the firms business is generated overseas? Competition Future prospects Legal and regulatory environment
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A Word of Caution
Ratios are only as reliable as the accounting data on which they are based Firms that compile industry norms often do not report information about the dispersion of the individual values around the mean ratio Comparative analysis depends on availability of data Financial ratios provide historic record

Quality and Financial Analysis

The quality of a firms earnings is positively related to the proportion of cash earnings to total earnings and to the proportion of recurring income to total income. The quality of a firms balance sheet is positively related to the ratio of the market value of the firms assets to book value of the assets and inversely related to the amount of its hidden liabilities.
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Problems Caused by Inflation

Inventory profit as a result of timing of price increases Inventory valuation methods
(LIFO) (FIFO)

Rising interest rates causing a decline in the value of long-term debt Differences in the reporting of earnings Recognition of sales
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Practice Problems
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Example #1 Assume you are given the following relationships for the Brauer Corporation:
Sales / Total Assets 1.5x Return on Assets (ROA) 3% Return on Equity (ROE) 5%

Example #1
ROA = Profit margin Total assets turnover 3% = Profit margin x 1.5 Profit margin = 3% / 1.5 = 2% ROE = ROA TA/E 5% = 3% TA/E TA/E = 5% / 3% E/TA = 3/5 = 60% therefore, D/TA = 1 - 0.60 = 0.40 = 40%
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Calculate Brauers profit margin and debt ratio.

Team Assignment
Complete the balance sheet and sales information in the table that follows for Hoffmeister Industries using the following financial data (all sales are on credit):
Debt Ratio: 50% Current Ratio: 1.8x Total assets turnover: 1.5x Accounts receivable turnover: 10x Gross profit margin on sales: 25% Inventory turnover ratio: 5x
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Team Assignment
BALANCE SHEET Cash Accounts receivable Inventories Fixed assets Total assets Sales $300,000 Accounts payable Long-term debt Common stock Retained earnings Total liabilities & equity Cost of goods sold
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60,000

97,500

Team Assignment
1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000. 2. Accounts payable = Debt Long-term debt = $150,000 - $60,000 = $90,000. 3. Common stock = Total liabilities & equity - Debt Retained earnings = $300,000 - $150,000 - $97,500 = $52,500. 4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000. 5. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500 6. Inventories = Cost of goods sold /5 = $337,500/5 = $67,500.
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Team Assignment
7. Accounts receivable = Credit Sales / Accounts receivable turnover = ($450,000/10) = $45,000. 8. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable) Cash + $45,000 + $67,500 = (1.8)($90,000) Cash + $112,500 = $162,000 Cash = $49,500. 9. Fixed assets = Total assets - (Cash + Accts rec. + Inventories) Fixed assets = $300,000 - ($49,500 + $45,000 + $67,500) = $138,000.

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