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 firm’s future cash flows.
 Outline

• The Balance Sheet

• The Income Statement
• The Statement of Cash Flows
• On ratio analysis
 Balance Sheet

Financial Statement showing a firm’s accounting value on a particular date.

 Balance Sheet

1994 1995 LIABILITIES & EQUITY 1994 1995

ASSETS
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 firm’s cash
Other statements

Free Cash Flows

Read chapter 12
 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 = NWC t - 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 firm’s ability to pay its bills over the short run without undue stress.

Financial leverage:
Describe a firm’s 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/(Long-term debt + Total equity)

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

Day’s sales inventory = 365/Inventory turnover

Day’s sales inventory =(365)Inventory/Cost of goods sold

Receivables turnover = Sales/Accounts receivable

Day’s sales in receivables = 365/Receivables turnover
Day’s 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

Day’s sales inventory = 365/3.2 = 114 days of sales in inventory
Receivables turnover = $2,311/$188 = 12.3 times
Day’s 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

 Market ratios

Price/Earnings ratios = Price per share/Earnings per share

Market-to-book ratio = Market value per share/Book value per share

Tobin’s Q
Q = (Mkt. value of debt + Mkt. value of equity)/Replacement value of assets
Higher Q’s 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