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Financial Statements, Taxes and Cash Flow


Chapter 2 Intro to Financial Statements Analysis The Concept of Cash Flow Cash flow is one of the most important pieces of information that a financial manager can ... – PowerPoint PPT presentation

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Title: Financial Statements, Taxes and Cash Flow

Intro to Financial Statements Analysis
Key Concepts and Skills
  • Know the difference between book value and market
  • Know the difference between accounting income and
    cash flow
  • Know the difference between average and marginal
    tax rates
  • Know how to determine a firms cash flow from its
    financial statements

Key Concepts and Skills
  • Know how to standardize financial statements for
    comparison purposes
  • Know how to compute and interpret important
    financial ratios
  • Know the determinants of a firms profitability
    and growth
  • Understand the problems and pitfalls in financial
    statement analysis

Chapter Outline
  • The Balance Sheet
  • The Income Statement
  • Taxes
  • Cash Flow

Balance Sheet
  • The balance sheet is a snapshot of the firms
    assets and liabilities at a given point in time
  • Assets are listed in order of liquidity
  • Ease of conversion to cash
  • Without significant loss of value
  • Balance Sheet Identity
  • Assets Liabilities Stockholders Equity

Balance Sheet
  • Assets Liabilities Owners

Market Vs. Book Value
  • The balance sheet provides the book value of the
    assets, liabilities and equity.
  • Market value is the price at which the assets,
    liabilities or equity can actually be bought or
  • Market value and book value are often very
    different. Why?
  • Which is more important to the decision-making

Income Statement
Income Statement
  • The income statement is more like a video of the
    firms operations for a specified period of time.
  • You generally report revenues first and then
    deduct any expenses for the period
  • Matching principle GAAP say to show revenue
    when it accrues and match the expenses required
    to generate the revenue

Ratio Analysis
  • Ratios also allow for better comparison through
    time or between companies
  • As we look at each ratio, ask yourself what the
    ratio is trying to measure and why is that
    information important
  • Ratios are used both internally and externally

Standardized Financial Statements
  • Common-Size Balance Sheet
  • Compute all accts as of Tot. Assets
  • Common-Size Income Statements
  • Compute all accts as of Sales
  • Standardized stmts make it easier to compare
    financial info, particularly as firm grows
  • Also useful for comparing co.s of different
    sizes, particularly in same industry

Categories of Financial Ratios
  • Short-term solvency or liquidity ratios
  • Long-term solvency or financial leverage ratios
  • Asset management or turnover ratios
  • Profitability ratios
  • Market value ratios

Sample Balance Sheet
Cash 6,489 A/P 340,220
A/R 1,052,606 N/P 86,631
Inventory 295,255 Other CL 1,098,602
Other CA 199,375 Total CL 1,525,453
Total CA 1,553,725 LT Debt 871,851
Net FA 2,535,072 C/E 1,691,493
Total Assets 4,088,797 Total Liab. Equity 4,088,797
Numbers in thousands
Sample Income Statement
Revenues 3,991,997
Cost of Goods Sold 1,738,125
Gross Profit 2,253,872
Expenses 1,269,479
Depreciation 308,355
EBIT 739,987
Interest Expense 42,013
Taxable Income 697,974
Taxes 272,210
Net Income 425,764
Shs outstanding 205,838.594
EPS 2.17
Dividends per share 0.86
Numbers in thousands, except EPS DPS
Computing Liquidity Ratios
  • Current Ratio CA / CL

  • 1.02 times
  • Quick Ratio (CA Inventory) / CL

  • .825 times
  • Cash Ratio Cash / CL

  • .004 times
  • Net Working Capital CA-CL

Long-term Solvency Measures
  • Total Debt Ratio (TA TE) / TA

  • .5863 times or 58.63
  • The firm finances almost 59 of their assets with
  • Debt/Equity TD / TE

  • 1.417 times
  • Equity Multiplier TA / TE 1 D/E

  • 2.417

Computing Coverage Ratios
  • Times Interest Earned EBIT / Interest

  • 17.6 times
  • Cash Coverage (EBIT Depreciation) / Interest

  • 24.95 times

ASSET MGMT RATIOSComputing Inventory Ratios
  • Inventory Turnover Sales / Inventory

  • 13.52 times
  • Days Sales in Inventory 365 / Inventory

  • 27 days

Computing Receivables Ratios
  • Receivables Turnover Sales / Accounts

  • 3.79 times
  • Days Sales in Receivables 365 / Receivables

  • 96 days

Computing Total Asset Turnover
  • Total Asset Turnover Sales / Total Assets

  • .98 times
  • Measure of asset use efficiency
  • Not unusual for TAT lt 1, especially if a firm has
    a large amount of fixed assets

Computing Profitability Measures
  • Profit Margin Net Income / Sales

  • .1067 times or 10.67
  • Return on Assets (ROA) Net Income / Total

  • .1041 times or 10.41
  • Return on Equity (ROE) Net Income / Total

  • .2517 times or 25.17

Computing Market Value Measures
  • Market Price 61.625 per share
  • Shares outstanding 205,838,594
  • PE Ratio Price per share / Earnings per share

  • 28.4 times
  • Market-to-book ratio market value per share /
    book value per share

  • 7.5 times

Market Value Measures
  • Value Stocks Firms w/ low Mrkt to Book ratios
  • Growth Stocks Firms w/ high Mrkt to Book ratios
  • Market Capitalization Mrkt Value of Common
  • Enterprise Value MV equity MV debt Cash
    mrktbl securities. Measures value of firms
    underlying business

Using the Du Pont Identity
  • Profit margin is a measure of the firms
    operating efficiency how well does it control
  • Total asset turnover is a measure of the firms
    asset use efficiency how well does it manage
    its assets
  • Equity multiplier is a measure of the firms
    financial leverage

Payout and Retention Ratios
  • Dividend payout ratio Cash dividends / Net

  • .3963 or 39.63
  • Retention ratio Additions to retained earnings
    / Net income 1 payout ratio

  • .6037 60.37
  • Or
    .6037 60.37

The Internal Growth Rate
  • The internal growth rate tells us how much the
    firm can grow assets using retained earnings as
    the only source of financing.

The Sustainable Growth Rate
  • The sustainable growth rate tells us how much the
    firm can grow by using internally generated funds
    and issuing debt to maintain a constant debt

Determinants of Growth
  • Profit margin operating efficiency
  • Total asset turnover asset use efficiency
  • Financial leverage choice of optimal debt ratio
  • Dividend policy choice of how much to pay to
    shareholders versus reinvesting in the firm

Why Evaluate Financial Statements?
  • Internal uses
  • Performance evaluation compensation and
    comparison between divisions
  • Planning for the future guide in estimating
    future cash flows
  • External uses
  • Creditors
  • Suppliers
  • Customers
  • Stockholders

  • Ratios are not very helpful by themselves they
    need to be compared to something
  • Time-Trend Analysis
  • Used to see how the firms performance is
    changing through time
  • Internal and external uses
  • Peer Group Analysis
  • Compare to similar companies or within industries
  • SIC and NAICS codes

Quick Quiz
  • How do you standardize balance sheets and income
    statements and why is standardization useful?
  • What are the major categories of ratios and how
    do you compute specific ratios within each
  • What are the major determinants of a firms
    growth potential?
  • What are some of the problems associated with
    financial statement analysis?

  • The one thing we can rely on with taxes is that
    they are always changing
  • Marginal vs. average tax rates
  • Marginal the percentage paid on the next dollar
  • Average the tax bill / taxable income
  • Other taxes

Example Marginal Vs. Average Rates
  • Suppose your firm earns 4 million in taxable
  • What is the firms tax liability?
  • What is the average tax rate?
  • What is the marginal tax rate?
  • If you are considering a project that will
    increase the firms taxable income by 1 million,
    what tax rate should you use in your analysis?

The Concept of Cash Flow
  • Cash flow is one of the most important pieces of
    information that a financial manager can derive
    from financial statements
  • The statement of cash flows does not provide us
    with the same information that we are looking at
  • We will look at how cash is generated from
    utilizing assets and how it is paid to those that
    finance the purchase of the assets

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Cash Flow Problem 2-19
  • Belyk Paving has sales of 2,000,000. COGS, SGA,
    and depreciation expenses were 1,200,000,
    300,000, 400,000 respectively. It also had
    interest expense of 150,000, a 35 tax rate.
    Ignore any tax loss carry back or forward
  • What is the Net Income?
  • What is the Operating Cash Flow?

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Quick Quiz
  • What is the difference between book value and
    market value? Which should we use for decision
    making purposes?
  • What is the difference between accounting income
    and cash flow? Which do we need to use when
    making decisions?
  • What is the difference between average and
    marginal tax rates? Which should we use when
    making financial decisions?
  • How do we determine a firms cash flows? What
    are the equations and where do we find the
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