Financial Statement and Cash Flow Analysis

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 (-) Cost of Goods Sold (-) Operating Expenses (-) Depreciation EBIT (-) Interest EBT (-) Taxes Net Income (-) Dividends Additions to R/E revenues cost to manufacture product general expenses expensing fixed assets earnings before int. and taxes to bondholders earnings before taxes rate set by government payout or retain payout retain

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 Cash and equivalents ST investments Accounts receivable Inventories Total current assets Gross plant and equip Accumulate Depr Net plant and equip 2008 $10 0 375 615 $1,000 1,400 -400 $1,000 2007 $15 65 315 415 $810 1,230 Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term bonds Total liabilities 2008 $60 110 140 $310 754 $1,064 40 130 766 $896 $2,000 2007 $30 60 130 $220 580 $800 40 130 710 $840 $1,680

MicroDrive, Inc: Income Statement (millions of dollars)
2008 Net sales Cost of goods sold Administration expenses Earnings before int., taxes, depr., amort., (EBITDA) Depreciation Amortization Earnings before int. and taxes (EBIT) Less: Interest Earnings before taxes (EBT) Taxes (40%) Net income before preferred dividends Preferred dividends Net income Common dividends Additions to retained earnings Calculations of EPS, DPS, BVPS, and CFPS for 2008 (based on 50,000 shares outstanding) Earnings per share = EPS = Net income Common shares O/S = $113,500,000 50,000,000 $57,500,000 50,000,000 = = = = $2.27 $1.15 $17.92 $4.27 $3,000.0 1,284.5 1,331.7 $383.8 100.0 0.0 $283.8 88.0 $195.8 78.3 $117.5 4.0 $113.5 $57.5 $56.0 2007 $2,850.0 1,211.6 1,285.4 $353.0 90.0 0.0 $263.0 60.0 $203.0 81.2 $121.8 4.0 $117.8 $53.0 $64.8

Dividends per share = DPS = Book value per share = BVPS = Cash Flow per share = CFPS =

Dividends to C/S = Common shares O/S Total common equity Common shares O/S NI + Depr + Amort Common shares O/S

$896,000,000 = 50,000,000 $213,500,000 = 50,000,000

Stock Price = $23.80 Average analysts expected growth forecast for EPS is 7% per year

MicroDrive, Inc: Statement of Retained Earnings (millions of dollars) Balance of retained earnings, 12/31/07 Add: Net income, 2008 Less: Dividends to common stockholders Balance of retained earnings, 12/31/08 MicroDrive, Inc: Statement of Cash Flows (millions of dollars) Cash provided or uses Operating Activities Net income before preferred dividends Adjustments Noncash adjustments Depreciation Due to changes in working capital Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in accurals Net cash provided by operating activities Long-Term Investing Activities Cash used to acquire fixed assets Financing Activities Sale of short-term investments Increase in notes payable Increase in bonds outstanding Payment of P/S and C/S dividends Net cash provided by financing activities $65.0 50.0 174.0 (61.5) $227.5 ($230.0) (60.0) (200.0) 30.0 10.0 ($2.5) $117.5 100.0 $710.0 113.5 (57.5) $766.0

Summary Net change in cash Cash at beginning of year Cash at end of year ($5.0) 15.0 $10.0

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 $366.00 Shares Outstanding = 1.2B MVAGOOG = $439.2B – $102B = $337.2B

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” http://www.sternstewart.com/ “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

Analyzing Financial Performance using Ratio Analysis
Five major areas to analyze. (1) (2) (3) (4) (5) Liquidity Position Management of Assets Management of Debt Company’s Profitability Market’s View of Company

(1) (a)

Liquidity Ratios – use to investigate the relationship between a firm’s current (shortterm) assets and current (short-term) liabilities. Current Ratio = Current Assets Current Liabilities = 1,000 = 310 3.23x

Quick Ratio = Current Assets – Inventory Current Liabilities = 1,000 – 615 = 310

3.23x

(2) (a) (b)

Asset Management Ratios – Use to evaluate how efficiently management employs assets. Inventory = Turnover Days Sales Outstanding Fixed Asset = Turnover Total Asset = Turnover = Cost of Goods Sold Inventory = 1,284.5 = 2.09x 615 375 = 45 days 3,000/360 3,000 = 3.0x 1,000 3,000 = 1.5x 2,000

Accounts Receivable = Credit Sales/day Net Sales Net Fixed Assets Net Sales Total Assets = =

(c) (d)

(3) (a)

Debt Management Ratios – use to evaluate riskiness of company (remember higher risk equates to higher required return) Debt Ratio = Total Liabilities Total Assets EBIT Interest = 1,064 = 53.2% 2,000 283.8 = 3.23x 88

Times-Interest-Earned = (TIE)

EBITDA Coverage

EBITDA + Lease Payments Interest + Principal + Lease Payments 383.8 + 45 88 + 0 + 45 = 3.22x

(4) (a)

Company’s Profitability – Are the owner’s earning an adequate return on their investment. Profit Margin = Net Income Net Sales = 113.5 3,000 = 3.78%

(b)

Return on Assets = (ROA)

Net Income Total Assets

113.5 2,000 = 5.68%

Return on Equity = (ROE)

Net Income = Shareholder’s Equity

113.5 896 = 12.66%

(5) (a)

Market Value Ratios – use to determine how market views company PE Ratio = Price per share EPS = 23.80 = 10.48 2.27

(b)

PEG Ratio =

PE Ratio e(gEPS) Price Book Value

10.48 = 1.50 7.0 23.80 = 1.33 17.92

Market to Book = Ratio

Du Pont Analysis
The DuPont equation provides us a method to evaluate the components that make up ROE. ROE = Net Income = Shareholder’s Equity 113.5 = 12.66% 896

ROE = (ROA)*(Equity Multiplier) remember: ROA = Net Income Total Assets = 113.5 2,000 = = 5.68%

Equity Multiplier = Total Assets Shareholder’s Equity

2,000 896 = 2.23

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 = ROE = 12.66% =

(ROA) Net Income Total Assets 5.68%

(Equity Multiplier) Total Assets S/E 2.23

ROA = (profit margin)*(total asset turnover), where: Profit Margin = Net Income Net Sales Net Sales Total Assets = 113.5 = 3.78% 3,000 3,000 2,000 = 1.5

Total Asset Turnover

Extended DuPont Equation may be most beneficial to use as analysis tool. ROE = PROFIT * MARGIN TOTAL * ASSET TURNOVER * * EQUITY MULTIPLIER Total Assets S/E 2.23

ROE = 12.66% =

Net Income * Net Sales Net Sales Total Assets 3.78% * 1.5

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) (2) (3) Compare ratios to industry Look at trend of ratios over time Be aware of the limitations in using ratio analysis

LIMITATIONS TO RATIO ANALYSIS (1) (2) (3) (4) (5) (6) (7) Difficult to fit conglomerate into specific industry – or company make-up may change over time. Focus on some ‘important’ ratios may adversely effect overall firm performance. Timing of cash flows affect balances in accounts. Window Dressing Techniques – make ratios appear better than they are to improve appearance of the company (fool investors). Different Accounting Methods No absolutes – high/low does not always mean good/bad or bad/good. Industry averages may be distorted if all company’s in industry very good or very bad.