Introduction to Finance, Part 2: Cash Flow Statement & Financial Statement Analysis

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1 1 Introduction to Finance, Part 2: Cash Flow Statement & Financial Statement Analysis CHRIS GASTON AND JENNIFER DEBOER Review & Roadmap Balance Sheet: a summary of a company s financial position at a specific point in time (e.g. a snapshot); total assets = total liabilities + owner s equity Income Statement: a summary of a company s revenues and expenses over a specific period of time; determines net income or loss for the period considered Cash Flow Statement: a summary of the flows of cash in and out of the company; the statement reveals where a company spends its money (cash outflows) and where a company receives its money (cash inflows). Trend Analysis & Financial Ratios: analyzes the financial health of a company or compare the financial health of companies Dragon's Den expectations 2 Please note all three financial statements as well as four types of financial statements will be required in your final report. 1

2 Balance sheet 3 How much debt the business has relative to its equity How quickly customers are paying their bills. Whether short-term cash is declining or increasing. The percentage of assets that are tangible (factories, plants, machinery) and how much comes from accounting transactions. Whether products are being returned at higher-than-average historical rates. How many days it takes, on average, to sell the inventory the business keeps on hand. Whether the research and development budget is producing good results. Whether the interest coverage ratio on the bonds is declining. The average interest rate a company is paying on its debt. Where profits are being spent or reinvested. Source: Income statement 4 The primary purpose of any income statement is to report a company's earnings Also known as a "Profit and Loss Statement Provides important insights into how effectively management is controlling expenses, the amount of interest income and expense, and the taxes paid. Can be used to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets (in other words, how well they are investing the money under their control). Can also compare a company's profits to its competitors by examining various profit margins such as the gross profit margin, operating profit margin, and net profit margin. Source: 2

3 Cash flow statement 5 Developed from Balance Sheet and Income Statement data The purpose of the cash flow statement is to show where an entities cash is being generated (cash inflows), and where its cash is being spent (cash outflows), over a specific period of time (usually quarterly and annually). It is important for analyzing the liquidity and long term solvency of a company. The cash flow statement uses cash basis accounting instead of accrual basis accounting which is used for the balance sheet and income statement by most companies. This is important because a company may accrue accounting revenues but may not actually receive the cash. This could produce profits and taxes payable but not provide the resources to stay solvent. Cash flow from Cash Operating activities: Cash in and out from the day-to day business operations Investing activities: Outflow of cash for long term assets (land, buildings, etc.) and inflows from sale of assets, business, securities, etc. Finance activities: cash outflow to investors and inflow from sales of bonds, issuing stocks, etc. Cash and Cash equivalents Cash Treasury bills maturing within 90 days or less Investment funds Foreign currency on hand Checking account `Free savings account Operating Activities Cash flows related to selling goods and services `Cash effects of transaction associated with the determination of income Examples Cash received from sales Cash payments to suppliers or employees Cash payments for taxes and other expenses Investing Activities Acquiring / disposing of securities Acquiring / disposing of non-current assets Lending money / collecting on loans Example Cash payments to acquire property, plant and equipment 6 3

etc. Cash repayment of loans Cash payments to shareholders as dividends 7 https://www.slideshare.

4 Financing Activities Borrowing from creditors / repaying the principal Obtaining resources from owners Providing owners with a return on their investment Examples Cash received from issuing shares, bonds, etc. Cash repayment of loans Cash payments to shareholders as dividends

7 Trend Analysis 13 Horizontal Vertical Ratio Analysis Analysis Analysis vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp Horizontal Analysis Balance Sheet 14 vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp 7

8 Horizontal Analysis - Balance Sheet 15 $12,000 $23,500 = $(11,500) vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp Horizontal Analysis - Balance Sheet 16 CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80, ,000 Prepaid expenses 3,000 1,200 Total current assets 155, ,700 ($11,500 $23,500) 100% = 48.9% Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160, ,000 Total assets $ 315,000 $ 289,700 vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp 8

9 Horizontal Analysis - Balance Sheet 17 CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and 1998 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ $ Increase (Decrease) Amount % ,000 $ 60,000 80,000 3, ,000 23,500 $ (11,500) 40,000 20, ,000 (20,000) 1,200 1, ,700 (9,700) 40, , , ,000 $ 40,000 85, , ,700 $ 35,000 35,000 25,300 (48.9) 50.0 (20.0) (5.9) vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp Horizontal Analysis Income Statement 18 There were increases in both cost of goods CLOVER CORPORATION sold (14.3%) and operating expenses (2.1%). Compa ra tive Income Sta te me nts These increased costs more than offset the For the Ye a rs Ende d De ce mbe r 31, 1999 a nd 1998 increase in sales, yielding an overall Incre a se (De cre a se ) decrease in net income Amount % Ne t sa le s $ 520,000 $ 480,000 $ Cost of goods sold 360, ,000 Gross ma rgin 160, ,000 Ope ra ting e x pe nse s 128,600 Sales increased by 8.3%126,000 while net Ne t ope ra ting income 31,400 39,000 Inte re st e x pe nse income decreased 6,400 by 21.9%. 7,000 Ne t income be fore ta x e s 25,000 32,000 Le ss income ta x e s (30%) 7,500 9,600 Ne t income $ 17,500 $ 22,400 $ 40,000 45,000 (5,000) 2,600 (7,600) (600) (7,000) (2,100) (4,900) (3.0) 2.1 (19.5) (8.6) (21.9) (21.9) (21.9) vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp 9

10 Vertical Analysis Balance Sheet 19 Sa m ple Com pa ny Ba la nce Shee t (Asse ts) At De cem be r 31, 1999 a nd 1998 % of Total Assets Ca sh $ 82,000 $ 30,000 17% 8% Accts. Rec. 120, ,000 25% 26% Inve ntory 87,000 82,000 18% 21% $82,000 $483,000 = 17% rounded La nd 101,000 90,000 21% 23% 110,000 $387,000 =100,000 8% rounded Equipm e$30,000 nt 23% 26% Accum. De pr. (17,000) (15,000) -4% -4% Tota l $ 483,000 $ 387, % 100% vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp Vertical Analysis Balance Sheet 20 Sample Company Balance Sheet (Liabilities & Stockholders' Equity) At December 31, 1999 and 1998 % of Total Assets Acts. Payable $ 76,000 $ 60,000 16% 16% Wages Payable 33,000 17,000 7% 4% Notes Payable 50,000 50,000 10% 13% $76,000 $483,000 = 16% rounded Common Stock 170, ,000 35% 41% Retained Earnings 154, ,000 32% 26% Total $ 483,000 $ 387, % 100% vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp 10

11 21 Questions so far? Next, financial ratios Financial Ratios 22 Financial ratios allow internal and external users to analyze the financial health of a company Financial ratios allow the analysis of (a) the health of an individual company, (b) the health of an individual company over time, (c) the health of companies in combination, and/or (d) the health of companies in comparison 11

12 Types of Financial Ratios Liquidity Operating/Efficiency/Activity Financial Leverage/Debt Profitability/Performance Valuation: ratios based on share price (e.g. price/earnings, price/sales, etc.), will not be discussed in this class (1) Liquidity 24 What is liquidity? Liquidity describes the degree to which an asset can be quickly bought or sold in the market without affecting the asset's price. Liquidity ratio: shows a firm s ability to cover its current and short-term financial liabilities with its current assets; the higher the liquidity, the more liquid the company is These are of particular interest to those extending short-term credit to the company Uses financial numbers from the Balance Sheet 12

13 Liquidity Ratios 25 Current ratio = Current Assets / Current Liabilities A current ratio of 2 is generally acceptable; it's a comfortable financial position for most Short-term creditors may prefer a high current ratio to reduce their risk whereas shareholders may prefer a low current ratio, which indicate the company s assets are working to grow the business Quick ratio = (Current Assets Inventory) / Current Liabilities Current assets include cash, accounts receivable, and notes receivable; these assets include current assets minus inventory. The quick ratio is helpful because not all assets liquidate quickly or have easily identifiable liquidation values. Also referred to as the acid test

2017 2016 27 2017 Current Ratio = Total Assets / Total Liabilities = 14365.60 / 8915.50 = 1.61 2016 Current Ratio = Total Assets / Total Liabilities = 14312.50 / 8428.50 = 1.69 Liquidity/Acid Test Exercise 28 Form a group of 2 3 students.

14 Current Ratio = Total Assets / Total Liabilities = / = Current Ratio = Total Assets / Total Liabilities = / = 1.69 Liquidity/Acid Test Exercise 28 Form a group of 2 3 students. Visit the course website, select Readings. Choose a pair of related companies. Open both companies financial statements and select Annual Data. Compare data for the most recent period or date. Assume you re an investor interested in purchasing stock. Calculate the Quick Ratio for both companies *Quick ratio = (Total Assets Total Inventory) / Total Liabilities* Based only on this information, which company would you be more likely to invest in? Why? 14

15 (2) Operating/Efficiency Ratios Measures the efficiency of a company's use of its assets and liabilities in generating sales revenue to the company (the higher the ratio, the more efficient). Asset turnover ratios consider how efficiently a company uses its assets Total Assets Turnover = Annual Sales / Total Assets 29 Measures a company's ability to generate sales from its assets Inventory Turnover = Cost of Goods Sold / Average Inventory Measures the number of times inventory is sold or used in a time period (e.g. a year) In Google Finance, Cost of Goods Sold (COGS) = Cost of Revenue Average Inventory = (2017 Inventory Inventory) / 2 Use both the Income Statement (COGS) and Balance Sheet (Inventory) Operating Ratio Exercise 30 Form a group of 2 3 students. Visit the course website, select Readings. Choose a pair of related companies. Open both companies financial statements and select Annual Data. Compare data for the most recent period or date. Calculate the Inventory Turnover for both companies *Inventory Turnover = Cost of Goods Sold / Average Inventory* Which company has a higher inventory turnover? Why do you think this is? 15

16 (3) Financial Leverage/Debt Ratios 31 Measures the ability of a company to meet its long-term debt obligations, such as long term loans, pension liabilities, lease payments, interest payments on debt, etc. Debt ratios compare the overall debt of a company to its assets or equity; Debt Ratio = Total Debt / Total Assets A high ratio implies that assets are being financed primarily with debt, rather than equity, and is considered to be a risky approach to financing Debt-to-Equity = Total Liabilities / Shareholders' Equity Measures a company s debt relative to the total value of its stock, often used to gauge the extent to which a company is taking on debt as a means of leveraging (i.e. attempting to increase its value by using borrowed money to fund various projects) A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt (aggressive leveraging practices are often associated with high levels of risk) Financial Leverage Exercise 32 Form a group of 2 3 students. Visit the course website, select Readings. Choose a pair of related companies. Open both companies financial statements and select Annual Data. Compare data for the most recent period or date. Assume you re an investor interested in purchasing stock. Calculate the Debt Ratio for both companies *Debt Ratio = Total Debt / Total Assets* Based only on this information, which company would you be more likely to invest in? Why? 16

17 (4) Profitability/Performance Ratios 33 Measures a company s overall efficiency and performance More specifically, profitability ratios measure a company s ability to generate earnings compared to the company s expenses over a specific period of time. Profit Margin (Return on Sales) = Net Income / Net Sales Measures the percentage of profit from operations after deducting operating expenses, interest expense, taxes, and preferred stock dividends from revenues (common stock dividends are the only major debit item left out of the equation) Return on Equity = Net Income / Owner s Equity Measures the profitability of a company in relation to the book value of shareholder equity (i.e. how well a company uses investments to generate earnings growth Owner s/stockholder s Equity = Common Stock + Retained Earnings Profitability Exercise 34 Form a group of 2 3 students. Visit the course website, select Readings. Choose a pair of related companies. Open both companies financial statements and select Annual Data. Compare data for the most recent period or date. Assume you re an investor interested in purchasing stock. Calculate the Profit Margin for both companies *Profit Margin = Net Income / Net Sales* Which company has a greater profit margin? Why do you think this is the case for the most recent year? 17

18 Problems with Financial Ratios 35 Lack of comparability different companies may use different accounting policies, which will impact their financial ratios. For example, a company using a last-in-first-out valuation will be considerably different from a company using a first-in-first-out. The ratios won t be comparable because the valuations aren t comparable. Ratios are based on book value ratios are often based on historical numbers, which can be misleading. Assets are a good example they maybe worth more or less, thus influencing liquidity ratios. Lack of understanding causation ratios tell us what happened, but not why it happened. Often, the why is more important than the what. Lack of management measurements although ratios are based on indicators of how well a company is doing, one of the key determinents of a successful company is the quality of management. The quality of management is not well captured by financial ratios. Important Resources 36 Business Backer: provides a helpful infographic explaining the financial statements we ve discussed in class BDC s Financial Ratio Tools: includes many of the ratios discussed in class BDC s Business Plan Template: a very helpful tool to use when putting your business plan together; includes templates for the financial statements we ve discussed in class 18

Dragon s Den Report Requirements A Balance Sheet An Income Statement A Cash Flow Statement Vertical / horizontal analysis At least one liquidity ratio At least one operating ratio At least one

19 Dragon s Den Report Requirements A Balance Sheet An Income Statement A Cash Flow Statement Vertical / horizontal analysis At least one liquidity ratio At least one operating ratio At least one leverage ratio At least one profitability ratio 37 WOOD 465 *We highly encourage you to review your financial statements and analyses with us prior to submitting your final report* 38 Questions? 19

Gateway NACM Credit Conference Presented by: Curtis Litchfield, CCE September 19, 2018

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