FIN 4461 Final Exam Study Guide
Statement of Cash Flows Questions 1. Where to find cash dividends and cash paid for share repurchases 2. Be able to identify significant differences between NI and NCOA to explain why they may differ significantly in a given year. 3. Be able to determine if a company is investing in securities (cash outflow in the investing section) or selling and/or allowing securities to mature (cash inflow in the investing section). 4. In the financing section, be able to identify if a company is borrowing and thus increasing its debt (inflow) and/or repaying debt (cash outflow). 5. In the financing section, be able to identify if a company is paying dividends, and/or repurchasing stock
1. Paying of cash dividends and share repurchases (repurchase of common stock) is located in the Financing Activities 2. Non-cash items like depreciation and amortization can misrepresent a company's actual financial position. NCOA turns accrual cash expenses and adds them into income, also include changes to assets. The net income is the bottom line and what matters especially if it's a net loss, even if NCOA is positive. 3. Negatives in the investing sections are cash outflow for purchasing investments and long-term assets while cash inflows are for selling of long-term assets or maturity of investments. 4. Negatives in the financing activities refer to either paying cash outflows for dividends, repurchases, long-term liabilities while positives refer to issuances of equity such as common stock, taking on more debt like note payables or long-term borrowings. 5. Both paying cash dividends and repurchasing stock are negative cash outflows in the financing activities.
Credit Sales versus Cash Sales
¤ A difficulty in computing receivables' liquidity is the problem of credit sales versus cash sales • Net sales include both credit and cash sales ¤ Credit sales should only be used when determining the receivables' liquidity • Including cash sales will cause the receivables' liquidity to be overstated ¤ Internal Analyst determines the credit sales figure and eliminates the issue of credit sales versus cash sales ¤ External Analysts must not mislead the liquidity figures. • Usually not an issue since firms usually either sell only on cash terms or credits terms (manufacturers). • When there is a firm that has both credit and cash sales (retail department stores), though receivables' liquidity is overstated, it can be still used to make comparisons.
Accounts Receivable Turnover Times & Accounts Receivable Turnover in Days
¤ A/R Turnover Times = Sales & Service Revenue/AR Balance • Financing Revenue is usually not included • Higher values mean that AR is collected and is favorable ¤ Accounts Receivable Turnover in Days = 365/AR Turnover Times • Reflect the firm's credit and collection policies • Indicates how many days it takes to collect AR • Low Values is favorable due to AR Turnover Times being high and means that AR is quickly collected • High values are usually unfavorable unless the firm is conservative on collecting its AR
Times Interest Earned Ratio
¤ Also called Interest Coverage Ratio, indicates a company's ability to earn/cover its periodic interest payments or in other words, the firm's long-term debt-paying ability from its income statement view. ¤ High values are favorable indicating that the firm is in good record paying off their debts. ¤ Low values are unfavorable indicating that the firm isn't paying off their debt in an adequate rate, leaving a bad record. ¤ Use net interest expense if interest expense is not shown. ¤ Discounted Operations and Extraordinary items are excluded from calculating Times Interest Earned
Dividend payout ratio
¤ Alternative way to calculate • Dividend Payout Ratio = Total common dividends/Net Income ¤ Measures the portion of current earnings per common share being paid out in dividends ¤ A stable dividend policy is developed by consideration of recurring earnings ¤ Lower payout typically found in growth firms ¤ Higher payout typically found in firms that are not growing.
Investment Ratios: How do we appear to our shareholders?
¤ Compares the market value per share to other per share amounts and indicates the level of dividend payment. • Primarily concerned with returns to shareholders 1. Earnings per Share (EPS) 2. Price/Earnings (P/E) Ratio 3. Dividend payout Ratio 4. Dividend Yield 5. Book Value per Share
Direct Method Statement of Cash Flows
¤ Converts the income statement from an accrual basis to a cash basis • Encouraged by SFAS No. 95 ¤ Supplemental information required • Reconciliation of net income to cash provided by operations ¤ Operating section describes income statement accounts in terms of receipts or payments ¤ Cash receipts • From customers • From other operating sources ¤ Cash payments • For merchandise • To employees • For other operating expenses ¤ Operating Activities Format (Straight Forward): • Add in receipts from customers or for operating positive cash sources • Subtract for payments for utilities, suppliers, employees, and other operating expenses ¤ Investing and FInancing follows the same pattern as operating for being straight forward. • Add in cash inflows and subtract cash outflows
Debt to Equity Ratio
¤ Debt to Equity Ratio = Total liabilities/Total Equity • Low values are favorable because it means that the firm is in a better position to pay its debts. ¤ The Debt to Equity Ratio indicates the firm's long-term debt-paying ability just like the Debt Ratio. • The Debt to Equity Ratio helps to determine how well creditors are protected in case of insolvency. ¤ Debt to Equity and Debt Ratio has the same objectives, therefore they are alternatives to each other. ¤ Both the Debt to Equity Ratio and Debt Ratio share the same issues as the Debt Ratio regarding the classifications of liabilities.
Current Ratio
¤ Determines the short-term debt-paying ability ¤ Focus is on the relationship between current assets and current liabilities • Inter-firm comparison is possible and meaningful ¤ Minimum current ratio is 2.00 in most cases • Lower than that amount of current ratio indicates lower liquidity • Industry averages provide contextual benchmarks whether the current ratio is good for certain firms ¤ Considerations involves: • Quality of inventory and receivables • Inventory cost flow assumptions
Efficiency Ratios: Are we using the firm's resources efficiently?
¤ Efficiency ratios measure the efficiency of managing the assets, resources of the firm, cash, accounts receivable, inventory, and PP&E. ¤ Used by the company's management for variety of purposes: • To determine the frequency of restocking inventory • Improving operation processes and collection policies for receivables ¤ Efficiency ratios includes: 1. Asset Turnover 2. Accounts Receivable Turnover Times 3. Accounts Receivable Turnover in Days 4. Inventory Turnover 5. Inventory Turnover in Days
Equity Multiplier
¤ Equity Multiplier = Total Assets/Total Equity ¤ Like the debt ratio, the equity multiplier measures the amount of financial leverage ¤ A low equity multiplier means that the company is less reliant on debt. This is favorable. ¤ A high equity multiplier indicates that a company is using a high amount of debt to finance assets. This is unfavorable.
Free Cash Flow (FCF)
¤ FCF = Net Cash from Operating Activities (NCOA) - Capital Expenditures (PP&E purchases) ¤ Free Cash Flow reflects the amount of cash available for business activities after allowances for investing and financing activity requirements to maintain productive capacity at current levels. ¤ Adequate free cash flow allows for growth and financial flexibility.
Statement of Cash Flows: Financing Activities
¤ Financing Activities include cash transactions that primarily affect external borrowings, long-term liability, and stockholders' equity accounts ¤ Both Cash inflows or outflows are considered good, it just depends on the situation and point of view. • A firm is attractive or doing well to receive cash inflows from outside sources. • On the other hand, cash outflows mean that the firm is able to pay off debts which is also good. ¤ Cash inflows from • Sale of common or preferred stock • Proceeds from borrowing or issuance of bonds, mortgages, notes, and other short and long-term borrowings ¤ Cash outflows for • Payment of dividends • Reacquisition of capital stock (treasury stock repurchases) • Payment of principal amounts on loans or other borrowings
Gross Profit Margin (GP%)
¤ Gross profit margin = Gross profit/Net Sales Revenue • Sales Revenue - COGS = Gross Profit (or gross margin) • High Gross Profit Margin means that the firm is making more profit rather than paying off their expenses, this is favorable • Low Gross Profit Margin means that the firm is paying more for expenses rather than making a profit. ¤ Gross Profit Margin Analysis: • Managers budget gross profit levels into their predictions of profitability • Used in cost control • Estimate inventory levels for interim financial statements and insured losses in merchandising industries • Used by the auditor and Internal Revenue Service to judge the accuracy of accounting systems
Working Capital
¤ Indicates short-run solvency of a business ¤ Subject to understatement if certain assets are understated (i.e., LIFO inventory) ¤ Longitudinal comparison appropriate • Current working capital should be compared to past working capital numbers to determine if current numbers are reasonable ¤ Inter-firm comparison is of no value because of their size differences • Larger firms has more Working Capital compared to smaller firms
Debt Ratio
¤ Indicates the firm's long-term debt-paying ability. • Firms with stable earnings can handle more debt than industries that have cyclical earnings. • Safer to use short-debt and long-term debt in the numerator as it is implicity stated to be debt. ¤ The debt ratio indicates the percentage of assets financed by creditors, and it helps to determine how well creditors are protected in case of insolvency. • Low values are favorable because it means that firm has less debt to assets due to paying off its debt. ¤ Compatibility issues: • Debt ratio comparing firms within the same industry or competitors can be misleading due to firms having substantially hidden assets or liabilities. • Firms can have differences in whether or not to include short-term liabilities in total liabilities since the debt ratio measures the ability of the firm to pay its long-term debt and typically short-term liabilities are paid with the current assets. • GAAP has certain items included in liabilities knowing that there is a future payment for those items while some items do not. Includes Reserves, Deferred Taxes, Noncontrolling interests, and redeemable preferred stock.
Dividend Yield
¤ Indicates the relationship between the dividends per common share and the market price per common share • Dividends per share is found at the bottom of the income statement or in the Statement of SE. ¤ The yield depends on a firm's dividend policy and market price. ¤ Low Dividend Yield satisfies many investors if the company has a record of above-average return on common equity. • Firms that want to do reinvestment of profits usually have a low dividend yield. ¤ Investors that want current income prefer a high dividend yield.
Indirect Method Statement of Cash Flows
¤ Indirect method or reconciliation method or backdoor method • Adjusts net income for items that affected net income but did not affect cash such as depreciation expense & for changes in the Current Asset and Current Liability account • Supplemental information required like cash paid for income taxes and for interest ¤ Operating Activities (Items in the Income Statements except for COGS & Current Assets & Liabilities) • Starts with Net income • Add items not affecting operating activities like depreciation expense • Add decreases in Current Assets & losses • Subtract increases in Current Assets & gains • Add increases in expenses & current liabilities • Subtract decreases in expenses & current liabilities ¤ Treat Investing and Financing Activities the same as the Direct Method, only Operating is different.
Inventories
¤ Inventories are held for sale in the ordinary course of business and are used in the production of goods ¤ Trading concern of inventories appears when there is a single (merchandise) inventory account • Easy to determine ¤ Manufacturing concern of inventories are hard to determine and appears in 3 distinct inventory accounts 1. Raw materials inventory 2, Work-in-process inventory 3. Finished goods inventory ¤ Perpetual System • A continuous record of physical quantities is maintained • Inventory and cost of goods sold are updated as sales and purchases take place • Records are verified through physical inventory ¤ Periodic System • Periodic physical counts to determine the quantity • Attach costs to ending inventory based on selected cost flow assumption(s)
Inventory Turnover Times
¤ Inventory Turnover Times = COGS/Inventory Balance or Cost of Sales/Inventory Balance ¤ Inventory Turnover Times indicates the liquidity of inventory • Higher values is favorable since it means inventory balance is low indicating that the firm is selling. • Lower values are the opposite and are unfavorable ¤ Comparison Issues • Use caution when comparing a mix of natural and calendar year companies • Cost flow assumption issues such as LIFO yields lower inventory value and higher inventory turnover • Inter-industry comparisons may not be reasonable ¤ Inventory Turnover in Days = 365/Inventory Turnover Times • Lower values means that the firm requires low amount of days to sell inventory. This is favorable • High values means it takes longer days to sale and its unfavorable.
Statement of Cash Flows: Investing Activities
¤ Investing Activities involves the lending and collecting money, acquiring and selling of investments and other long-term assets • Long-Term Liabilities are not investing activities ¤ Negative Cash Flows or Cash Outflows from Investing Activities are often seen as good, it implies that the firm is getting larger and is expanding. ¤ Cash inflows from • Receipts from loans collected • Sales of debt or equity securities of other corporations • Sale of property, plant, and equipment ¤ Cash outflows for • Loans to other entities • Investment in debt or equity securities of other entities • Purchase of property, plant, and equipment
Liquidity Ratios: Are we meeting our current obligations?
¤ Measure a firm's ability to meet cash needs as they arise, within the next 12 months. ¤ Important Items/Topics Regarding Liquidity: • Receivables • Cash versus Credit Sales • Inventories ¤ Liquidity Ratios 1. Account Receivable Turnover Times 2. Account Receivable Turnover in days 3. Inventory turnover times 4. Inventory turnover in days 5. Working Capital 6. Current Ratio 7. Quick Ratio
Profitability Ratios: Are we generating enough returns on revenues and investments?
¤ Measure the ability to generate profits • Essentially the overall performance of a firm ¤ High Values are desired on these ratios as the company wants to do well and investors want them to well to get a return on their investments. 1. Return on Sales (ROS) or Net Profit Margin 2. Return on Assets (ROA) 3. Return on Equity (ROE) 4. DuPont Analysis of ROE 5. Gross Profit Margin (GPM) 6. Earnings per Share (EPS) 7. Quality of Income (QOI)
Return on Assets (ROA)
¤ Measures how productively a company uses its assets to generate profits. ¤ A high ROA depends on managing asset investments to produce the greatest amount of revenues and controlling expenses to keep net income high. • A high percentage means that the firm managed its asset usage well and is making a profit. ¤ ROA is the most comprehensive measure of profitability since it takes into account both the profitability of each dollar of revenue (ROS) and sales volume (Asset Turnover) • It is the best overall measure of profitability that excludes the source of financing.
Solvency Ratios: Are we handling debt appropriately
¤ Measures the ability of the company to survive over a long period of time. 1. Debt Ratio 2. Debt to Equity Ratio 3. Times Interest Earned Ratio 4. Free Cash Flow
Quick Ratio
¤ Measures the immediate liquidity of the firm ¤ Relates the most liquid assets to current liabilities • Excludes inventory and any items below it in the balance sheet current assets section. • A more conservative computation excludes other current assets that do not represent current cash flow ¤ Minimum acid-test ratio is 1.00 in most cases • Industry averages provide contextual benchmarks for certain firms • Consideration involves the quality of receivables ¤ Numerator is either Current assets - inventory or quick assets • Quick assets include cash & equivalents, ST investments, & Receivables.
Price to Earnings (P/E) Ratio
¤ Measures the relationship between the market price of a share of common stock and that stock's current earnings per share • Use of diluted earnings per share gives a more conservative P/E ratio since diluted EPS < basic EPS ¤ Investors use the P/E ratio to measure how "expensive" a company's stock is compared to EPS. • It does not explain why a stock is expensive or cheap ¤ Investors also view P/E ratio as a gauge of the future earnings power of a firm • P/E ratio of the firm is compared against its competitors, Industry average, and exchange averages ¤ High-growth-potential firms have higher P/E ratios • P/E ratio is a function of the market ¤ A high P/E ratio is a value over 25 indicates investors view as a "growth" stock or a stock that is overvalued • A low P/E ratio is under 20 indicates that could be undervalued or could be "junk;" not viewed as a growth stock • Average P/E ranges from about 20-25
Return on Sales (ROS) or Net Profit Margin
¤ Net Profit margin or ROS = Net income/Total Revenue • High Value for Net Profit margin means that the firm is keeping more of their revenue as profit. • Low Value means the firm is paying more expenses from its operating revenue rather than making a profit. ¤ Reflects NI dollar amount generated by each dollar of sales • For example, if net profit margin = 5%, then the firm generated $5 of NI for each $100 of revenue. ¤ Net Profit margin is based only on data from the income statement • Does not include revenue growth from a prior year. ¤ Focus is on controlling expenses to maximize profit. ¤ Net profit margin can increase from a previous year yet NI may have declined • Firm's expenses as a percentage of revenue declined but the firm generated less revenue in the current year. • Likewise, the net profit margin may have increased, yet total income declined due to less revenue
Operating Income Margin
¤ Operating Income Margin = Operating Income/Total Revenue • A high percentage is favorable indicating that the firm is keeping majority of their revenues • A low percentage is the opposite and this is unfavorable . ¤ Includes only operating income in the numerator (excludes non-operating items) ¤ Also include any other operating revenue in the denominator such as service or financing revenue if included in the operating section of the income statement.
Statement of Cash Flows: Operating Activities
¤ Operating activities include cash transactions that primarily affect current assets and current liabilities • Include the cash effects of events that enter into the determination of net income, the income statement ¤ The primary source of cash for an established company with a strong cash position should be operating activities. • Cash inflows are very important for the longevity of a firm as cash from operating activities is the only renewable source of cash. ¤ Cash inflows from • Sale of goods or services • Cash from interest income and dividends ¤ Cash outflows for payments • For acquisitions of inventory • To employees • For taxes • For interest expenses • For other expenses
Quality of Income Ratio
¤ Quality of Income = Net cash flow from operating activities (NCOA)/Net income • A good value for this ratio is for it to be over 1 • NCOA is usually more variable than Net Income
Return on Equity (ROE)
¤ ROE = Net income/Total Equity • An extremely high ROE percentage is favorable if net income is extremely large compared to equity because a company's performance is so strong. • However, an extremely high ROE is often due to a small equity account compared to net income, which indicates risk. Closer inspection of the financial statements is needed. ¤ ROE measures profitability relative to the amount of equity invested and retained in a firm. • ROE also measures how effectively stockholders' equity is used to produce income. • Measures the return to common and preferred stockholders ¤ If a firm has no liabilities, then ROA = ROE • The higher a firm's total liabilities (so lower its equity), the higher its ROE.
Receivables
¤ Receivables are claims to future cash inflows • Consist of Accounts and Notes receivables ¤ Trade receivables arise from sales to customers and are typically collected within 30 days ¤ Installment receivables • May be carried as a current asset, yet collection may be significantly longer than trade receivables thus it is usually considered to be of lower quality. ¤ Valuation problems • The entity incurs costs for the use of the funds until receivables are collected • Collection might not be made ¤ Valuation of receivables • Waiting period is ignored • Assume stipulated rate of interest is fair • Notes that are noninterest-bearing, or carry an unreasonable rate, or are for an amount different from the value of transaction are recorded at present value ¤ Causes of impairment that hampers valuation of receivables are: • Uncollectibility • Discounts allowed • Allowances given • Sales returns
Sales to Fixed Assets
¤ Sales to Fixed Assets = Total Revenue/Net PP&E ¤ Measures the ability to make productive use of property, plant, and equipment by generating sales dollars • High percentage means good productivity (favorable) and usage of PP&E while a low percentage is inadequate percentage and usage of PP&E (unfavorable). • Helpful when comparing companies when one has more intangible assets. • Exclude construction in progress from net fixed assets • Possible distortions are when there are old fixed assets or a labor-intensive industry
Earnings Per Share (EPS)
¤ The amount of income earned on a share of common stock during an accounting period • Required disclosure for corporate income statements • Pertains only to common stock • Per share amounts for discontinued operations and extraordinary items must be presented in the income statement and the notes to the financial statements ¤ Earnings per share for recurring items are significant for the primary analysis ¤ Retroactive recognition must be given to events such as stock dividend and stock split ¤ Diluted EPS is calculated the same as basic EPS plus the dilutive effect of potentially dilutive securities in the denominator. Basic EPS > Diluted EPS • Potentially dilutive securities: Convertible securities, options, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per common share are potential dilutive securities
Total Asset Turnover
¤ Total Asset Turnover = Total Revenue/Total Assets • A high percentage value means that the firm is generating a lot of operating revenue with its assets. ¤ Measures the ability of the firm to generate sales & service revenue using its assets • A measure of efficiency. • Show as a number, not as a percentage. ¤ Can be potentially distorted by including non-productive assets such as Investments & Construction in Progress
Book Value per Share
¤ Total stockholders' equity/Number of common shares outstanding at year-end ¤ Preferred equity should be measured at liquidation value if available & is excluded from total equity ¤ Book Value per Share whether good or bad is determined when it is compared to the Market value • Book value reflects past unrecovered asset costs • Market value reflects the potential of the firm ¤ Investors is interested in the market value than the book value • If the Market value is less than the book value then the firm is lacking potential. Unfavorable. • If the Market value is more than the book value then the firm has the potential to be worth more than the book numbers.
