Chapters 3 and 13 Financial Statement and Cash Flow Analysis

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1 Chapters 3 and 13 Financial Statement and Cash Flow Analysis Balance Sheet Assets Cash Inventory Accounts Receivable Property Plant Equipment Total Assets Liabilities and Shareholder s Equity Accounts Payable Notes Payable Accrued Wages Bank Loans Bonds Common Stock Retained Earnings Total Liabilities and Shareholder s Equity Income Statement Used to figure out how much money we are earning for: (a) (b) (c) (d) vendors, employees, etc - Cost of Goods Sold, Operating Expenses lenders, bondholders - Interest, government - Taxes, owners/stockholders - Dividends/Retained Earnings Sales revenues (-) Cost of Goods Sold cost to manufacture product (-) Operating Expenses general expenses (-) Depreciation expensing fixed assets EBIT earnings before int. and taxes (-) Interest to bondholders EBT earnings before taxes (-) Taxes rate set by government Net Income (-) Dividends payout Additions to R/E payout or retain retain

2 Statement of Cash Flows Cash Flow from Operations: Net income (I/S) + depreciation (I/S) - increases in current assets (B/S) + increases in current liabilities (B/S) Cash Flow from Investments: - investments in PPE (B/S) + sale of assets (B/S) Cash Flow from Financing: + proceeds from issues of common stock or debt (B/S) - payment of dividends (I/S) - repurchase of common stock (B/S) - repayment of debt (B/S) Net increase/decrease in Cash Account MicroDrive, Inc: Balance Sheet (millions of dollars) Assets Liabilities and Equity Cash and equivalents $10 $15 Accounts payable $60 $30 ST investments 0 65 Notes payable Accounts receivable Accruals Inventories Total current liabilities $310 $220 Total current assets $1,000 $810 Long-term bonds Gross plant and equip 1,400 1,230 Total liabilities $1,064 $800 Accumulate Depr Preferred stock (400k shr) Net plant and equip $1,000 $870 Common stock (50m shr) Retained earnings Total common equity $896 $840 Total assets $2,000 $1,680 Liabilities and Equity $2,000 $1,680 footnote - lease payments for 2007 were $42,000,000, and for 2008 were $45,000,000

3 MicroDrive, Inc: Income Statement (millions of dollars) Net sales $3,000.0 $2,850.0 Cost of goods sold 1, ,211.6 Administration expenses 1, ,285.4 Earnings before int., taxes, depr., amort., (EBITDA) $383.8 $353.0 Depreciation Amortization Earnings before int. and taxes (EBIT) $283.8 $263.0 Less: Interest Earnings before taxes (EBT) $195.8 $203.0 Taxes (40%) Net income before preferred dividends $117.5 $121.8 Preferred dividends Net income $113.5 $117.8 Common dividends $57.5 $53.0 Additions to retained earnings $56.0 $64.8 Calculations of EPS, DPS, BVPS, and CFPS for 2008 (based on 50,000 shares outstanding) Earnings per share = EPS = Net income = $113,500,000 = $2.27 Common shares O/S 50,000,000 Dividends per share = DPS = Dividends to C/S = $57,500,000 = $1.15 Common shares O/S 50,000,000 Book value per share = BVPS = Total common equity = $896,000,000 = $17.92 Common shares O/S 50,000,000 Cash Flow per share = CFPS = NI + Depr + Amort = $213,500,000 = $4.27 Common shares O/S 50,000,000 Stock Price = $23.80 Average analysts expected growth forecast for EPS is 7% per year

4 MicroDrive, Inc: Statement of Retained Earnings (millions of dollars) Balance of retained earnings, 12/31/07 $710.0 Add: Net income, Less: Dividends to common stockholders (57.5) Balance of retained earnings, 12/31/08 $766.0 MicroDrive, Inc: Statement of Cash Flows (millions of dollars) Operating Activities Cash provided or uses Net income before preferred dividends $117.5 Adjustments Noncash adjustments Depreciation Due to changes in working capital Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in accurals (60.0) (200.0) Net cash provided by operating activities ($2.5) Long-Term Investing Activities Cash used to acquire fixed assets ($230.0) Financing Activities Sale of short-term investments Increase in notes payable Increase in bonds outstanding Payment of P/S and C/S dividends $ (61.5) Net cash provided by financing activities $227.5 Summary Net change in cash ($5.0) Cash at beginning of year 15.0 Cash at end of year $10.0

5 Cash Flow Analysis Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) Cash Flow available to bondholders, to pay government, and to fund asset purchase. Adds back in noncash items. Net Operating Working Capital = Operating Current Assets - Operating Current Liabilities Operating = those flows from normal operations Operating Current Assets = Cash, A/R, Inv Operating Current Liabilities = A/P, Accruals Net Operating Profit after Taxes (NOPAT) = EBIT ( 1 - tax rate ) Free Cash Flow (FCF) = NOPAT - Net investment in operating capital Net investment in operating capital = - change in current assets (operating) + change in current liabilities (operating) - change in net capital assets Current asset increase represents an investment Current liability increase represents borrowing Net capital assets = Increase in PPE - Depreciation Market Value Added (MVA) Consistent with shareholder wealth maximization MVA = market value of common stock - initial value of equity capital example: Google, Inc. Google went public (IPO) on August 19, 2004 at $85 per share Google stock value on June 16, 2008 was $ Shares Outstanding = 1.2B MVA GOOG = $439.2B - $102B = $337.2B

6 Economic Value Added (EVA) EVA = NOPAT - (After-tax dollar cost of capital used to support operations) After-tax dollar cost of capital used to support operations = (net operating working capital + net plant and equipment) * WACC = (amount spent on B/S) * (cost of raising money) EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise EVA is the actual return from the company s assets in place less the cost of raising the money to purchase those assets. In other words, the actual net dollar return from the assets reported on the balance sheet Michael Sullivan

7 Analyzing Financial Performance using Ratio Analysis Five major areas to analyze. (1) Liquidity Position (2) Management of Assets (3) Management of Debt (4) Company's Profitability (5) Market's View of Company (1) Liquidity Ratios - use to investigate the relationship between a firm's current (shortterm) assets and current (short-term) liabilities. (a) Current Ratio = Current Assets = 1,000 = 3.23x Current Liabilities 310 (b) Quick Ratio = Current Assets - Inventory = 1, = 1.24x Current Liabilities 310 (2) Asset Management Ratios - Use to evaluate how efficiently management employs assets. (a) Inventory = Cost of Goods Sold = 1,284.5 = 2.09x Turnover Inventory 615 (b) Days Sales = Accounts Receivable = 375 = 45 days Outstanding Credit Sales/day 3,000/360 (c) Fixed Asset = Net Sales = 3,000 = 3.0x Turnover Net Fixed Assets 1,000 (d) Total Asset = Net Sales = 3,000 = 1.5x Turnover Total Assets 2,000

8 (3) Debt Management Ratios - use to evaluate riskiness of company (remember higher risk equates to higher required return) (a) Debt Ratio = Total Liabilities = 1,064 = 53.2% Total Assets 2,000 (b) Times-Interest-Earned = EBIT = = 3.23x (TIE) Interest 88 (c) EBITDA = EBITDA + Lease Payments Coverage Interest + Principal + Lease Payments = = 3.22x (4) Company's Profitability - Are the owner's earning an adequate return on their investment. (a) Profit Margin = Net Income = = 3.78% Net Sales 3,000 (b) Return on Assets = Net Income = = 5.68% (ROA) Total Assets 2,000 (c) Return on Equity = Net Income = = 12.66% (ROE) Shareholder's Equity 896 (5) Market Value Ratios - use to determine how market views company (a) PE Ratio = Price per share = = EPS 2.27 (b) PEG Ratio = PE Ratio = = 1.50 e(g ) 7.0 EPS (c) Market to Book = Price = = 1.33 Ratio Book Value 17.92

9 Du Pont Analysis The DuPont equation provides us a method to evaluate the components that make up ROE. ROE = Net Income = = 12.66% Shareholder's Equity 896 ROE = (ROA)*(Equity Multiplier) remember: ROA = Net Income = = 5.68% Total Assets 2,000 Equity Multiplier = Total Assets = 2,000 = 2.23 Shareholder s Equity 896 shows the asset base supported by common equity; high equity multiplier shows a lot of risk or may be due to low market value relative to book value. ROE = (ROA) * (Equity Multiplier) ROE = Net Income * Total Assets Total Assets S/E 12.66% = 5.68% * 2.23 ROA = (profit margin)*(total asset turnover), where: Profit Margin = Net Income = = 3.78% Net Sales 3,000 Total Asset = Net Sales = 3,000 = 1.5 Turnover Total Assets 2,000

10 may be most beneficial to use as analysis tool. Extended DuPont Equation ROE = PROFIT * TOTAL * EQUITY MARGIN ASSET MULTIPLIER TURNOVER ROE = Net Income * Net Sales * Total Assets Net Sales Total Assets S/E 12.66% = 3.78% * 1.5 * 2.23 ROE is separated into profitability of each $ of sales (profit margin), efficiency of asset management (total asset turnover), and company risk (equity multiplier). Can now get insight into whether company's return is due to high profitability, good management, or compensation for risk. Keys to using Ratio Analysis (1) Compare ratios to industry (2) Look at trend of ratios over time (3) Be aware of the limitations in using ratio analysis LIMITATIONS TO RATIO ANALYSIS (1) Difficult to fit conglomerate into specific industry - or company make-up may change over time. (2) Focus on some 'important' ratios may adversely effect overall firm performance. (3) Timing of cash flows affect balances in accounts. (4) Window Dressing Techniques - make ratios appear better than they are to improve appearance of the company (fool investors). (5) Different Accounting Methods (6) No absolutes - high/low does not always mean good/bad or bad/good. (7) Industry averages may be distorted if all company's in industry very good or very bad.

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