Analyzing Financial Statements: Cash Flow, Ratio Analysis, and Du Pont Identity - Prof. Pi, Study notes of Financial Management

Download Analyzing Financial Statements: Cash Flow, Ratio Analysis, and Du Pont Identity - Prof. Pi and more Study notes Financial Management in PDF only on Docsity! Chapter 3 Working With Financial Statements McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills • Understand sources and uses of cash and the Statement of Cash Flows • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Be able to compute and interpret the Du Pont Identity • Understand the problems and pitfalls in financial statement analysis 3-2 Sample Income Statement Revenues 5,000 Cost of Goods Sold (2,006) Expenses (1,740) Depreciation (116) EBIT 1,138 Interest Expense (7) Taxable Income 1,131 Taxes (442) Net Income 689 EPS 3.61 Dividends per share 1.08 Numbers in millions of dollars, except EPS & DPS 3-5 Sources and Uses • Sources – Cash inflow – occurs when we “sell” something – Decrease in asset account (Sample B/S) • Accounts receivable, inventory, and net fixed assets – Increase in liability or equity account • Accounts payable, other current liabilities, and common stock • Uses – 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 3-6 Statement of Cash Flows • Statement that summarizes the sources and uses of cash • 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 3-7 Ratio Analysis • 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 3-10 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 3-11 Computing Liquidity Ratios • Current Ratio = CA / CL – 2,256 / 1,995 = 1.13 times • Quick Ratio = (CA – Inventory) / CL – (2,256 – 301) / 1,995 = .98 times • Cash Ratio = Cash / CL – 696 / 1,995 = .35 times • NWC to Total Assets = NWC / TA – (2,256 – 1,995) / 5,394 = .05 • Interval Measure = CA / average daily operating costs – 2,256 / ((2,006 + 1,740)/365) = 219.8 days B/S I/S 3-12 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 B/S I/S 3-15 Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable – 5,000 / 956 = 5.23 times • Days’ Sales in Receivables = 365 / Receivables Turnover – 365 / 5.23 = 70 days B/S I/S 3-16 Computing Total Asset Turnover • Total Asset Turnover = Sales / Total Assets – 5,000 / 5,394 = .93 – It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets • NWC Turnover = Sales / NWC – 5,000 / (2,256 – 1,995) = 19.16 times • Fixed Asset Turnover = Sales / NFA – 5,000 / 3,138 = 1.59 times B/S I/S 3-17 Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 (TA/TA) and then rearrange – ROE = (NI / TE) (TA / TA) – ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 (Sales/Sales) again and then rearrange – ROE = (NI / TA) (TA / TE) (Sales / Sales) – ROE = (NI / Sales) (Sales / TA) (TA / TE) – ROE = PM * TAT * EM 3-20 Using the Du Pont Identity • ROE = PM * TAT * EM – Profit margin is a measure of the firm’s operating efficiency – how well it controls costs – Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets – Equity multiplier is a measure of the firm’s financial leverage 3-21 Expanded Du Pont Analysis — Du Pont Data TABLE 3.9 FINANCIAL STATEMENTS FOR DU PONT 12 months ending December 31, 2007 (All numbers are in millions) | Income Statement Balance Sheet Sales $30,454 Current assets Current liabilities CoGS 20,318 Cash $ 1,436 Accounts payable $ 2,723 Gross profit $10,136 Accounts receivable 5,683 Notes payable 1,346 SG&A expense 4,547 Inventory 6,041 ‘Other _4A72 Depreciation 1,371 Total $13,160 Total $ 8,541 EBIT $ 4,218 Interest 482 Fixed assets $20,971 Total long-term debt $14,454 EBT $ 3,736 Taxes 748 Total equity $11,136 Total liabilities and Net income $ 2,988 Total assets $34,131 equity $34,131 3-22 Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis – Used to see how the firm’s performance is changing through time – Internal and external uses • Peer Group Analysis – Compare to similar companies or within industries – SIC and NAICS codes 3-25 Real World Example - I • Ratios are figured using financial data from the 2007 Annual Report for Home Depot • Compare the ratios to the industry as they are reported in Tables 3.11 and 3.12 in the book • Home Depot’s fiscal year ends Feb. 3 • Be sure to note how the ratios are computed in the table so you can compute comparable numbers • Home Depot sales = $77,349 MM 3-26 Real World Example - II • Liquidity ratios – Current ratio = 1.15x; Industry = 1.7x – Quick ratio = .23x; Industry = .4x • Long-term solvency ratio – Debt/Equity ratio (Debt / Worth) = 1.5x; Industry = 1.1x. • Coverage ratio – Times Interest Earned = 11.6x; Industry = 4.5x 3-27 Work the Web Example • The Internet makes ratio analysis much easier than it has been in the past • Click on the web surfer to go to www.reuters.com – Click on Stocks, then choose a company and enter its ticker symbol – Click on Ratios to see what information is available 3-30 Quick Quiz • What is the Statement of Cash Flows and how do you determine sources and uses of cash? • How do you standardize balance sheets and income statements and why is standardization useful? • What are the major categories of ratios and how do you compute specific ratios within each category? • What are some of the problems associated with financial statement analysis? 3-31 Ethics Issues • Should financial analysts be held liable for their opinions regarding the financial health of firms? • How closely should ratings agencies work with the firms they are reviewing? I.e., what level of independence is appropriate? 3-32