Introduction & Financial Analysis Objectives for a firm? Quick Review of Financial Statements...
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Transcript of Introduction & Financial Analysis Objectives for a firm? Quick Review of Financial Statements...
Introduction & Financial Analysis
• Objectives for a firm?• Quick Review of Financial Statements• Financial Analysis
The firm's objectives?-To maximize profits?
- To act in an ethical manner?
- To increase market share?
- To maximize shareholder wealth?
-To maximize managers’ wealth?
What are agency problems?
Interests of managers & shareholders can be aligned by:
- compensation plans
- appointment & review by board of directors and auditors
- the threat of takeover
- scrutiny by banks & other specialists
Flow of cash between capital marketsand firm's operations
Financial
manager
Firm's
operations
Capital
markets
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
(1)(2)
(3)
(4a)
(4b)
3 Basic Financial Statements
• Income Statement (I/S)• Balance Sheet (B/S)• Statement of Cash Flows (CFs)
Income Statement
An Income Statement shows profitability
Sales - Cost of Goods Sold (COGS) = Gross Profit (GP)
GP - Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)
EBIT - Interest = Earnings Before Taxes (EBT)
EBT - Taxes = Earnings After Taxes (EAT) or Net Income (NI)
Limitations of the Income Statement
• Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period.
• Inflation can impact reported profits (FIFO, LIFO)
• Backward looking…
Balance Sheet
• Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest– Delineates the firm’s holdings and obligations– Items are stated on an original cost basis rather
than at current market value
Limitations of the Balance Sheet
• Most of the values are based on historical/original cost price– Troublesome when it comes to plant and equipment
inventory
• FASB ruling on disclosure of inflation adjustments no longer in force – It is purely a voluntary act on the part of the
company
Limitations of the Balance Sheet (cont’d)
• Differences between per share values may be due to:– Asset valuation– Industry outlook– Growth prospects– Quality of management– Risk-return expectations
Comparison of Market Valueto Book Value per Share
Accrual Method of Accounting
• Is used most often by corporations
• Revenues and expenses are recognized when they occur, rather than when cash changes hands
• For example, a credit sale in December 2009 is shown as revenue in that year (2009), even though payment is not received until March 2010
Statement of Cash Flows
• Emphasizes critical nature of cash flow to the operations of the firm– It represents cash/cash equivalents items easily
convertible to cash within 90 days
• Cash flow analysis helps in combating discrepancies faced through accrual method of accounting
Illustration ofconceptsbehind thestatement ofcash flows
Steps in computing netcash flows fromoperating activitiesusing the indirectmethod
Free Cash Flow
2-18
Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends
– Capital expenditures• Maintain productive capacity of firm
– Dividends• Maintain necessary payout on common stock and to
cover any preferred stock obligations• Free cash flow can be used for special financing activities
– Example leverage buyouts
– Excess Free cash flow can lead to agency costs.
Financial Analysis and Ratios
What is financial analysis?
• Evaluating a firm’s financial performance• Analyzing ratios or numerical calculations• Comparing a company to its industry
There are many potential ratios, with some variation in
applications. Below are some of the most common financial ratios: A. Profitability Ratios.
1. Profit margin.
2. Return on assets.
3. Return on equity.
B. Activity (Asset utilization) ratios.4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.
C. Leverage (Debt utilization) ratios.9. Debt to total assets.
10. Times interest earned.
11. Fixed charge coverage.
D. Liquidity ratios.12. Current ratio.
13. Quick ratio.
Financial statementsfor sample ratio analysis
Profitability Ratios
Show how profitable a company is.
The ratios express:— Profit Margin or Return on Sales (%)— Return on Assets or Return on Investment
(%)— Return on Equity (%)
Profitability RatiosSaxton Company Industry Average
1. Profit margin = = 5% 6.7%
2. Return on assets =
a. = 12.5% 10%
b. 5% 2.5 = 12.5% 6.7% 1.5 = 10%3. Return on equity =
a. = 20% 15%
b. = 12.5% x 1.6 15% = 20%
Net incomesales
$200,000$4,000,000
Net incomeTotal assets
Net incomeSales
SalesTotal assets
$200,000$1,600,000
Net incomeStockholders’ equity
$200,000$1,000,000
Net incomeTotal Assets
Total Assetsequity
Return of Wal-Mart versus Macy’s using the Du Pont method of analysis, 2007
Activity (Asset Utilization) Ratios
Show how effectively a company uses its assets.
The ratios express:— Receivables Turnover (times)— Average Collection Period (days)— Inventory Turnover (times)— Fixed Asset Turnover (times)— Total Asset Turnover (times)
Saxton Company Industry Average
4. Receivables turnover =
= 11.410 times
5. Average collection period =
= 32 36 days
6. Inventory turnover =
= 10.8 7 times
Sales (credit)Receivables
$4,000,000$350,000
Accounts receivableAverage daily credit sales
$350,000$10,959
SalesInventory
$4,000,000$370,000
Activity (Asset Utilization) Ratios
Asset Utilization RatiosSaxton Company Industry
Average
7. Fixed asset turnover =
= 5 5.4 times
8. Total asset turnover =
= 2.5 1.5 times
SalesFixed assets
$4,000,000$800,000
SalesTotal assets
$4,000,000$1,600,000
Leverage (Debt Utilization) Ratios
Show how well a company is managing or using debt.
The ratios express:—Debt-to-Total Assets (%)—Times Interest Earned (times)—Fixed Charge Coverage (times)
(Fixed Charges = lease payments, i expense)
Leverage (Debt Utilization) RatiosSaxton Company Industry
Average
9. Debt to total asets =
= 37.5% 33%
10. Times interest earned =
= 11 7 times
11. Fixed charge coverage =
= 6 5.5 times
Total debtTotal assets
$600,000$1,600,000
Income before interest and taxes
Interest$550,000$50,000
Income before fixed charges and taxes
Fixed charges$600,000$100,000
Liquidity Ratios
Show how liquid a company is or how much $ it has to meet S/T needs.
The ratios express:—Current Ratio (times)—Quick Ratio or Acid-Test Ratio (times)
Liquidity Ratios Saxton Company Industry Average
12. Current ratio =
= 2.67 2.1
13. Quick ratio =
= 1.43 1.0
Current assetsCurrent liabilities
$800,000$300,000
Current assets − InventoryCurrent liabilities
$430,000$300,000
Ratio analysis
Trend analysis
1-34
Trend Analysis in the Computer Industry
Cash Conversion Cycle
Is the length of time from the payment for the purchases of raw materials to the collection of accounts receivable that were generated by the sale of the finished product, (i.e., the time between paying out cash and receiving cash).
Cash Conversion Cycle = Inventory Conversion Period +Receivables Collection Period (DSO) -Payable Deferral Period
= Inventory/ Sales per Day +Receivables / Sales per day – Payables / Credit purchases per day
Leverage (Debt) Ratios
interest
ondepreciati+EBIT=Ratio EarnedInterest Times
equity
leases of value+debt termlong=ratioequity Debt
Efficiency (Utilization) Ratios - Show how effectively a company uses its assets.
assets totalAverage
Sales=ratioover Asset turn
sold/365 goods ofcost
inventory average=inventoryin salesDays'
salesdaily average
sreceivable average=period collection Average
Profitability Ratios - Show how profitable a company is.
assets totalaverage
tax-EBIT=assetson Return
sales
tax-EBIT=marginprofit Net
equity average
stockcommon for available earnings=equityon Return
Profitability Ratios
ratiopayout -1=
earnings
dividends-earnings=ratioPlowback
earnings
dividends=ratioPayout
earnings
dividends-earnings=plowback fromequity in Growth
P/E Ratio
• P/E Ratio = Price/Earnings Ratio
• P/E Ratio = Market Price of Stock / Earnings per share (EPS)
Market Value Ratios
g-r
1
aveEPS
P=ratio PE Forecasted
1
1
1
0 xEPS
Div
shareper earnings
pricestock =Ratio PE
pricestock
shareper dividend=yield Dividend
- PE ratio is one way of measuring desirability of a stock
- Indicates expectations about future of a company
Market Value Ratios
shareper book value
pricestock =ratiobook Market to
cost replcement estimated
assets of uemarket val=Q Tobins
Price-earnings Ratios for Selected US Companies
Which ratio is most important?
It depends on your perspective.• Suppliers and banks (lenders) are most interested
in liquidity ratios.• Stockholders are most interested in profitability
ratios.• A long-run trend analysis over a 5-10 year period
is usually performed by an analyst.
Growth and External Financing
Basic sources and uses relationships show us:
External capital required =
Investment in net working capital PLUS
Investment in Fixed Assets PLUS
Dividends LESS
Operating cash flow
Percent-of-Sales Method
A short-cut, less exact, easier method of determining financing needs (The “quick and dirty” approach)
Assumes that B/S accounts will maintain a constant percentage relationship to sales
Assets / Current Sales = % of Sales
Percent-of-Sales Method
RNF = A/S (change S) – L/S (change S) – PS2(1-D)
Where:A/S = % relationship of assets to saleschange S = Change in Sales (forecast – prior sales)P = Profit marginS2 = Forecasted SalesD = Dividend Payout Ratio. (1-D) is retention rate.
Internal & Sustainable Growth Rates
The growth rate that a company can achieve without external funds is known as the internal growth rate:
Internal growth rate = retained earnings/net assets = Retained earnings/net income x net income/equity x equity/net assets =plowback ratio x ROE x equity/net assets =.40 x .1822 x .5455 = 3.98%
The growth rate that a company can achieve without increasing its debt ratio is known as the sustainable growth rate:
Sustainable growth rate = plowback ratio x return on equity =.40 x .1822 = 7.29%
Importance of Ratios
Which ratio is most important?It depends on your perspective.• Suppliers and banks (lenders) are most
interested in liquidity ratios.• Stockholders are most interested in profitability
ratios.• A long-run trend analysis over a 5-10 year
period is usually performed by an analyst.
Developmentof pro formastatements
Percent-of-Sales Method
A short-cut, less exact, easier method of determining financing needs (The “quick and dirty” approach)
Assumes that B/S accounts will maintain a constant percentage relationship to sales
Assets / Current Sales = % of Sales
Percent-of-Sales Method
RNF = A/S (change S) – L/S (change S) – PS2(1-D)
Where:A/S = % relationship of assets to saleschange S = Change in Sales (forecast – prior sales)P = Profit marginS2 = Forecasted SalesD = Dividend Payout Ratio. (1-D) is retention rate.
Development of a pro formabalance sheet