Fundamentals of corproate finance 3e chapter 03

Chapter Three Working with Financial Statements Copyright  2004 McGraw-Hill Australia Pty Ltd 3-1 Chapter Organisation 3.1 Cash Flow and Financial Statements: A Closer Look 3.2 Financial Statements of Publicly Listed Firms 3.3 The Du Pont Identity 3.4 Using Financial Statement Information 3.5 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd 3-2 Chapter Objectives • Identify the ways that firms obtain and use cash as • • • • reported in the Statement of Cash Flows Calculate and interpret key financial ratios Discuss the Du Pont identity as a method of financial analysis Understand the use of financial information for comparative purposes Outline the problems associated with using financial ratios Copyright  2004 McGraw-Hill Australia Pty Ltd 3-3 Cash • Cash is generated by selling a product or service, asset or security • Cash is spent by paying for materials and labour to produce a product or service and by purchasing assets • Recall: Cash flow from assets = Cash flow to debtholders + Cash flow to shareholders Copyright  2004 McGraw-Hill Australia Pty Ltd 3-4 Cash Flow • Sources of cash are those activities that bring in cash • Uses of cash are those activities that involve spending cash • The firm’s statement of cash flows is the firm’s financial statement that summarises its sources and uses of cash over a specified period Copyright  2004 McGraw-Hill Australia Pty Ltd 3-5 Statement of Financial Position ('000s) Assets (‘000s) Current assets Cash Accounts receivable Inventory Total Fixed assets Net plant and equipment 2003 2004 $ 45 260 320 $ 625 $ 50 310 385 $ 745 985 100 $1 610 $1 845 Copyright  2004 McGraw-Hill Australia Pty Ltd 3-6 TOTAL ASSETS Statement of Financial Position ('000s) Liabilities and equity (‘000s) Current liabilities Accounts payable Notes payable Total 2003 2004 $ 210 110 $ 320 $ Long-term debt $ 205 $ 225 Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY 290 795 $1 085 $1 610 290 895 $1 185 $1 845 Copyright  2004 McGraw-Hill Australia Pty Ltd 260 175 $ 435 3-7 Statement of Financial Performance ('000s) Net sales Cost of goods sold Depreciation EBIT Interest Taxable income Tax Net profit Dividends Addition to retained earnings $710.00 480.00 30.00 $200.00 20.00 180.00 53.45 $126.55 26.55 $100.00 Copyright  2004 McGraw-Hill Australia Pty Ltd 3-8 Statement of Cash Flows • A statement that summarises the sources and uses of cash • Changes are divided into three main categories: – – – Operating activities—includes net profit and changes in most current accounts Investment activities—includes changes in fixed assets Financing activities—includes changes in notes payable, long-term debt and equity accounts as well as dividends Copyright  2004 McGraw-Hill Australia Pty Ltd 3-9 Statement of Cash Flows • Operating activities + Net profit + Depreciation + Any decrease in current assets (except cash) + Increase in accounts payable – Any increase in current assets (except cash) – Decrease in accounts payable • Investment activities + Ending fixed assets – Beginning fixed assets + Depreciation Copyright  2004 McGraw-Hill Australia Pty Ltd 3-10 Statement of Cash Flows • Operating activities + Net profit + $ 126.55 + Depreciation + 30.00 + Increase in payables + – Increase in receivables – – Increase in inventory – $ 91.55 50.00 50.00 65.00 • Investment activities + Ending fixed assets +$1 100.00 – Beginning fixed assets – 985.00 + Depreciation + 30.00 ( $ 145.00) Copyright  2004 McGraw-Hill Australia Pty Ltd 3-12 Statement of Cash Flows • Financing activities – – – + Increase in notes payable + Increase in long-term debt – Dividends – 26.55 $ 58.45 + $ 65.00 + 20.00 Putting it all together, the net addition to cash for the period is: $91.55 – 145.00 + 58.45 = $5.00 Copyright  2004 McGraw-Hill Australia Pty Ltd 3-13 ‘Players’ in Accounting Standards • Accountants • Government • Regulators • Other users Copyright  2004 McGraw-Hill Australia Pty Ltd 3-14 Ratio Analysis • Financial ratios are relationships determined from a firm’s financial information • Used to compare and investigate relationships between different pieces of financial information, either over time or between companies • Ratios eliminate the size problem Copyright  2004 McGraw-Hill Australia Pty Ltd 3-15 Categories of Financial Ratios • Liquidity—measures the firm’s short-term solvency • Capital structure—measures the firm’s ability to meet long-run obligations (financial leverage) • Asset management (turnover)—measures the efficiency of asset usage to generate sales • Profitability—measures the firm’s ability to control expenses • Market value—per-share ratios Copyright  2004 McGraw-Hill Australia Pty Ltd 3-16 Liquidity Ratios Current assets Current ratio = Current liabilities Current assets − Inventory Quick ratio = Current liabilities − Bank overdraft Copyright  2004 McGraw-Hill Australia Pty Ltd 3-17 Capital Structure Ratios Total financial debt − Cash Total equity − Intangibles Total debt Debt/equity ratio = Total equity Total assets Equity multiplier = Total equity EBIT Net interest cover = Interest + finance charges Interest - bearing debt Debt to gross cash flow = Net profit after tax + depreciation + amortisation Net debt/equity ratio = Copyright  2004 McGraw-Hill Australia Pty Ltd 3-18 Turnover Ratios Cost of goods sold Inventory turnover = Inventory 365 days Days' sales in inventory = Inventory turnover Sales Receivables turnover = Accounts receivable Copyright  2004 McGraw-Hill Australia Pty Ltd 3-19 Turnover Ratios (continued) 365 days Days' sales in receivables = Receivables turnover Sales Fixed asset turnover = Non - current assets Sales Total asset turnover = Total assets Copyright  2004 McGraw-Hill Australia Pty Ltd 3-20 Profitability Ratios Profit margin = Net profit Sales Net profit Return on assets (ROA) = × 100% Total assets EBIT Return on investment = ×100% Total assets Return on equity (ROE) = Net profit ×100% Total equity Copyright  2004 McGraw-Hill Australia Pty Ltd 3-21 Market Value Ratios Price per share Price/earning ratio = Earnings per share Market value per share Market - to - book ratio = Book value per share Copyright  2004 McGraw-Hill Australia Pty Ltd 3-22 The Du Pont Identity • Breaks ROE into three parts: – – – operating efficiency asset use efficiency financial leverage Net profit Sales Assets ROE = × × Sales Assets Equity = Profit margin × Total asset turnover × Equity multiplier = ROA × Equity multiplier Copyright  2004 McGraw-Hill Australia Pty Ltd 3-23 Uses for Financial Statement Information • Internal uses: – – performance evaluation planning for the future • External uses: – – – evaluation by outside parties evaluation of main competitors identifying potential takeover targets Copyright  2004 McGraw-Hill Australia Pty Ltd 3-24 Benchmarks for Comparison • Ratios are most useful when compared to a benchmark • Time-trend analysis—examine how a particular ratio(s) has performed historically • Peer group analysis—using similar firms (competitors) for comparison of results • Global Industry Classification Standard (GICS) used by ASX is a useful way to find a peer company Copyright  2004 McGraw-Hill Australia Pty Ltd 3-25 Problems with Ratio Analysis • No underlying theory to identify correct ratios to • • • • use or appropriate benchmarks Benchmarking is difficult for diversified firms Firms may use different accounting procedures Firms may have different recording periods One-off events can severely affect financial performance Copyright  2004 McGraw-Hill Australia Pty Ltd 3-26 ... Profitability Ratios Profit margin = Net profit Sales Net profit Return on assets (ROA) = × 100% Total assets EBIT Return on investment = ×100% Total assets Return on equity (ROE) = Net profit... Australia Pty Ltd 260 175 $ 435 3-7 Statement of Financial Performance ('000s) Net sales Cost of goods sold Depreciation EBIT Interest Taxable income Tax Net profit Dividends Addition to retained earnings... 3-8 Statement of Cash Flows • A statement that summarises the sources and uses of cash • Changes are divided into three main categories: – – – Operating activities—includes net profit and changes