Ch. 3: Working with Financial Statements

Sources and Uses of Cash

• Cash Inflow (Increase in Current Assets) requires either:
  • Decrease in LHS (selling something)
    • Accounts Receivable
    • Inventory
    • Net Fixed Assets
  • Increase in RHS (issue securities)
    • Debt (Liabilities)
    • Equity
• Cash Outflow (Decrease in Current Assets) requires either:
  • Increase in LHS (buying something)
  • Decrease in RHS (pay down debt)

Statement of Cash Flows

• Operating Activity: net income and changes in most current accounts
• Investment Activity: changes in fixed assets
• Financing Activity: dividends and changes in debt or equity issuance (not interest)

Comparing Financial Statements

• Scaling
  • Levels (Balance Sheet): divide by total assets
  • Flows (Income Statement): divide by sales
• Ratio Analysis
  1. Short-term solvency or liquidity
     • Current Ratio = Current Assets / Current Liabilities
     • Quick Ratio = (Current Assets - Inventory) / Current Liabilities
     • Cash Ratio = Cash / Current Liabilities
     • Net Working Capital / Total Assets
     • Interval Measure = Current Assets / Avg. Daily Operating Costs
  2. Long-term solvency or liquidity
     • Total Debt Ratio = (Total Assets - Total Equity) / Total Assets
     • Total Debt / Total Equity = Total Debt Ratio / (1 - Total Debt Ratio)
     • Equity Multiplier = Total Assets / Total Equity = 1 + Debt / Equity
     • Long-term Debt Ratio = Long-term Debt / (Long-term Debt + Total Equity)
     • Times Interest Earned Ratio = EBIT / Interest
     • Cash Coverage Ratio = (EBIT + Depreciation) / Interest
  3. Asset management or turnover
     • Inventory Turnover = COGS / Inventory
     • Days’ Sales in Inventory = 365 days / Inventory turnover
     • Receivables Turnover = Sales / Accounts Receivable
     • Days’ Sales in Receivables = 365 days / Receivables turnover
     • NWC Turnover = Sales / NWC
     • Fixed Asset Turnover = Sales / Net Fixed Assets
     • Total Asset Turnover = Sales / Total Assets
  4. Profitability
     • Profit Margin = Net Income / Sales
     • Return on Assets = Net Income / Total Assets
     • Return on Equity = Net Income / Total Equity
  5. Market Value
     • PE Ratio (Multiple) = Price per Share / Earnings per Share
     • Market to Book Ratio = Market Value per Share / Book Value per Share
• Dupont Identity
  • ROE = ROA * EM = PM * TAT * EM
  • Links ROE to three factors:
    1. Operating efficiency - how well are costs controlled
    2. Asset use efficiency - how well are assets managed
    3. Financial leverage

Using Financial Statements

• External Uses
  • Creditors
  • Suppliers
  • Customers
  • Stockholders
• Internal Uses
  • Evaluate performance
  • Financial planning
• Benchmarks
  • Time-trend analysis
  • Peer group analysis (SIC and NAICS codes)