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CHAPTER 17Projecting Cash Flow and EarningsFinancial Statements and Ratio Analysis, Chapter 7, Third Edition

Chapter Sections:Sources of Financial InformationFinancial StatementsFinancial Statement ForecastingStarbucks Company Case Study (Adolph Coors, Chapter 7, Third Edition)

Chapter 17 of the fourth edition and Chapter 7 of the third edition deal mainly with financial statements and ratio analysis. It is

important enough to warrant our attention. We will look at all the ratios but only compute a few. We will skip the forecasting.

CHAPTER 7, THIRD EDITION

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Financial Statements Balance Sheet

A financial summary of a firm’s assets, liabilities, and shareholders’ equity at a given point in time

Income Statement A financial summary of the operating results of firm

covering a specified period of time, usually 3 months (quarterly results) and 1 year (annually results)

Cash Flow Statement A financial summary of a firm’s cash flow and

other events that caused changes in the company’s cash position (again, quarterly & annually)

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Balance Sheet Assets

Anything a company owns that has value Liabilities

A firm’s financial obligations Equity

An ownership interest in the company

Assets = Liabilities + Equity Assets – Liabilities = Equity

Current versus Long-term

(continued)Financial Statements

Balance Sheet Example

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Income Statement Income

The difference between a company’s revenues and expenses, used to pay dividends to stockholders or kept as retained earnings within the company to finance future growth

Net Income = Revenue – Expenses But some income and expenses are not always

received or paid in cash That’s why there is the Cash Flow Statement…

(continued)Financial Statements

Income Statement Example

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Cash Flow Statement a.k.a. Statement of Cash Flows Cash Flow – Income realized in cash form Non-cash Item – Income and expense items not

realized in cash form Operating Cash Flow – Cash generated by a firm’s

normal business operations Investment Cash Flow – Cash flow resulting from

purchases and sales of fixed assets and investments Financing Cash Flow – Cash flow originating from the

issuance or repurchase of securities and payment of dividends

(continued)Financial Statements

Cash Flow Statement Example

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Sources of Financial Statements SEC EDGAR

Annual Report – 10K Quarterly Update – 10Q Regulation FD (Fair Disclosure)

Requires companies to make public disclosures of material information fairly An “Earnings Call” is scheduled for a set date & time

Countless Other Sources

I have heard many investors opine that nowadays there is simply too much information.

“Wisdom Sold Separately.” – Nick Murray

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Financial Ratios Financial Ratios

The relation between two financial quantities expressed as the quotient of one divided by the other

Ratio Analysis The study of the relationships between financial

statement accounts

Recall that there is no one ratio that can accurately sum up the overall general state of a company. Each ratio must be considered in the context of all the

information gathered. Plus you must consider any ratio in the context of the industry the company exists within. (We will see an example soon.)

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Financial Ratios – Common Stock Common Stock Ratios – a.k.a. Market Ratios

Financial ratios that convert key information about a firm to a per-share basis

Price/Earnings Ratio – P/E Price/Earnings to Growth Ratio – PEG Dividends per Share Dividend Yield Dividend Payout Ratio Book Value per Share Price-to-Book-Value, Price-to-Cash Flow, Price-to-

SalesThese ratios use data from the Balance Sheet or the Income Statement or both.

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Financial Ratios – Common Stock Price / Earnings Ratio – a.k.a. P/E

Market Price divided by Earnings per Share

Market Price of Common StockPrice / Earnings Ratio = –––––––––––––––––––––––––––––

Earnings per Share

REVIEW: The most popular stock market statistic. Historically, P/E ratios were in the 5 to 12 range for mature companies and 14 to 20 range for

growing companies. Greater than 20 was unusual. Today, it is commonplace.

The P/E ratio also tells you how long it will take in years (assuming no changes in earnings) for the company to earn back its price. A P/E of 3 will

take three years; a P/E of 20 will take twenty years.

(continued)

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P/E Ratios and Specific Industries

Exxon – 10.36 Google – 20.47

J.P. Morgan – 8.72

Chevron – 8.16CononoPhillips – 8.52BP – 5.90

Yahoo – 18.12Sohu – 12.46Baidu – 44.64

Biogen Idec – 23.10Life Technologies – 21.47Illumina – 82.90

Citigroup – 8.91Wells Fargo – 11.00US Bank – 11.91

General Mills – 16.20 Bristol Myers – 15.12Hormel – 17.15Kellogg’s – 15.65Kraft – 19.05

Pfizer – 16.65 Merck – 18.87Eli Lilly – 10.05

As of 27 February 2012

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Amgen – 16.69

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P/E Ratios and Specific Industries

“Take a nice little company that has been making shoelaces for 40 years and sells at a respectable six times earning ratio. Change the name from Shoelaces, Inc. to

Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word

“furth-burners” which no one understands. A word that no one understands entitles you to double your entire score. Therefore, we have six times earnings for the shoelace

business and 15 earnings for electronics and silicon, or a total of 21 times earnings. Multiply this by two for furth-burners and we now have a score of 42 times earnings for

the new company” – Jack Dreyfus, Founder, Dreyfus FundsA Random Walk Down Wall Street

Today, replace furth-burners with nanotechnology and replace electronics and silicon with social networking and China.

(continued)

How can we account for the wide P/E disparity between different industries and different companies within industries? Again, it is the expectation of future earnings and

dividend growth by investors

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Financial Ratios – Common Stock Price/Earnings to Growth Ratio – a.k.a. PEG

Compares the P/E ratio to the rate of growth

Stock’s P/E RatioPEG Ratio = ––––––––––––––––––––––––––––––––––––

3- or 5-Year Growth Rate in Earnings

A PEG Ratio of 1.0 means that P/E Ratio matches its growth rate. Historically, a PEG Ratio of 1.0 was desirable since it meant that the P/E Ratio equaled the growth rate. Anything above 1.0 was considered high.

Now, greater than 1.0 is common.

(continued)

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Financial Ratios – Common Stock Dividends per Share

Measure of how much dividends each share of stock will receive

Dividends Annual Dividends Paid to Stockholders per = ––––––––––––––––––––––––––––––––––––––– Share Number of Shares Outstanding

REVIEW: As we discussed, dividends became taboo during the 1990’s. Since the 2000-2002 bear market, investors have changed their minds about

dividends. Dividends can be discussed in polite company again!

(continued)

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Financial Ratios – Common Stock Dividend Yield

Measure of how much dividends are as a percentage of the stock price

Dividend Dividends per Share = –––––––––––––––––––––––––––– Yield Market Price per Share

REVIEW: This important statistic allows an investor to compare a company to other forms of investments that pay income (such as savings accounts or bonds).

Traditionally, 4% to 6% was considered good. Currently, the S&P 500 is yielding just over 2% (while 10-year Treasury bonds are yielding less than 2%

and savings accounts are yielding far less than 1%.) Some stocks are paying much more while many growth stocks are paying no dividends.

(continued)

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Financial Ratios – Common Stock Dividend Payout Ratio

Measures of how much of a company earnings are being paid out to shareholders in the form of dividends

Dividends per SharePayout Ratio = ––––––––––––––––––––––

Earnings per Share

REVIEW: More mature companies often pay out almost all their earnings in the form of dividends. Growing companies retain their earnings (called

Retained Earnings) to support the growth of the company.

(continued)

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Financial Ratios – Common Stock Book Value per Share

Measure of the net worth of a company on a per share basis

Book Value Common Stockholders’ Equity per = –––––––––––––––––––––––––––––––– Share Number of Shares Outstanding

REVIEW: Book Value per Share tells an investor how much assets are behind each share of stock. In other words, if all the assets of the company were liquidated, how much would each shareholder receive? It is common for the actual market price of a share to be above the book value per share since the company is worth more intact than if it were dissolved. Today, it

is common for the market price to be far above the book value.

(continued)

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Financial Ratios – Common Stock Price-to-Book-Value per Share

Ratio of the market price to the book value per share

Price-to- Market Price per ShareBook-Value = –––––––––––––––––––––––– per Share Book Value per Share

REVIEW: Given that the Book Value per Share is often less than the market price, the Price-to-Book-Value Per Share tells an investor how far above

the book value the market value is. If the Price-to-Book-Value per Share = 1.0, they are the same. Today, Price-to-Book-Value per Shares of 3 to 4

are not uncommon and some are much higher.

(continued)

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Financial Ratios – Common StockPrice-to-Cash Flow Ratio

Current price divided by current cash flow per shareCash flow often differs from earnings per share

For several reasons, but the most common reason is…Depreciation is not an actual cash expenditure

But there are many reasons cash flow & earnings differ“Good quality” versus “poor quality” earnings

REVIEW: During the Internet mania, many companies were reporting record earnings. At the same time, their cash flow was negative. How could that

be?

Current PricePrice-Cash Flow Ratio = ––––––––––––––––––––––––––––

Cash Flow per Share

(continued)

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Financial Ratios – Common Stock Price-to-Sales Ratio

Current price divided by annual sales per share Historically, a higher Price-to-Sales Ratio

suggested a higher sales growth And a lower Price-to-Sales Ratio suggested a lower

sales growth

REVIEW: During the Internet mania, many analysts used Price-to-Sales instead of Price-to-Earnings since most all of the new companies never

generated any earnings!

Current PricePrice-to-Sales Ratio = –––––––––––––––––––––––––––––

Annual Sales per Share

(continued)

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Financial Ratios – Profitability Profitability Ratios

Financial ratios that measure a firm’s returns by relating profits to sales, assets, or equity

Net Profit Margin – a.k.a. After-Tax Profit Margin Gross Margin Operating Margin Return on Assets Return on Equity – a.k.a. Return on Investment

Profitability Ratios allow one to measure the ability of a firm to earn an adequate return on sales, total assets and invested capital.

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Financial Ratios – Profitability Net Profit Margin – a.k.a. After-Tax Profit

Margin The rate of profit being earned from earnings after

expenses and taxes

Net IncomeNet Profit Margin = ––––––––––––––––––

Total Revenue

The higher, the better. It varies greatly from industry to industry.

(continued)

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Financial Ratios – Profitability Gross Margin

The rate of profit being earned from gross profit

Gross ProfitGross Margin = –––––––––––––––––––––

Total Revenue

Again, the higher, the better. And again, it varies greatly from industry to industry.

(continued)

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Financial Ratios – Profitability Operating Margin

The rate of profit being earned from net income adjusting for non-cash items

Operating IncomeOperating Margin = –––––––––––––––––––––––

Total Revenue

Yep, you guessed it. The higher, the better. And it varies greatly from industry to industry. So when we are looking at a specific company, we

always need to look at its competitors within the industry. When we find a company that is atypical of its competitors in an industry, it is a signal that

we have more investigative work to do.

(continued)

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Financial Ratios – Profitability Return on Assets (ROA)

Measures how profitable a company is relative to its total assets

Net IncomeReturn on Assets = ––––––––––––––––––––––

Total Assets

Return on Assets looks at the amount of resources a company needs to support operations. It reveals how effective the company is in generating

profits from the assets it has available. The higher, the better. Very popular ratio.

(continued)

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Financial Ratios – Profitability Return on Equity (ROE) – a.k.a. Return on Investment

Measure of the overall profitability of a company in relation to the shareholders’ equity

Net IncomeReturn on Equity = ––––––––––––––––––––––––––––

Total Stockholders’ Equity

Because Return on Equity uses Stockholders’ Equity instead of Total Assets for the denominator, Return on Equity is sensitive to the amount of debt a company is carrying. Specifically, if a company carries a great amount of debt, ROE will be much larger than ROA. “You are using other people’s

money to make your money.” Some investors think this is good; others are worried about the possible negative consequences of too much debt.

(continued)

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Financial Ratios – Liquidity Liquidity Ratios

Financial ratios concerned with a firm’s ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due

Current Ratio Ratio of current assets to current liabilities

Net Working Capital Current assets – current liabilities

Acid Test Ratio – a.k.a. Quick Ratio These ratios use data from the Balance Sheet

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Financial Ratios – Liquidity Current Ratio

One of the more popular financial measures

Current AssetsCurrent Ratio = –––––––––––––––––––

Current Liabilities

The Current Ratio is a good indicator of how stable a company is. Anything over 1.0 is normally considered acceptable. If your current

assets equal or exceed your current liabilities, you should be able to satisfy your short-term obligations without any problems. Obviously, the greater

the number is, the better.

(continued)

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Financial Ratios – Liquidity Net Working Capital

Absolute dollar measure of liquidity

Net Working Capital = Current Assets – Current Liabilities

Net Working Capital is the Current Ratio in dollar terms. If the Current Ratio is greater than 1.0, then Net Working Capital will be positive. If the Current Ratio is less than 1.0, then Net Working Capital will be negative.

The higher the Net Working Capital, the better. (This statistic is less popular than the Current Ratio. It really is not a ratio but is often

discussed when discussing the Current Ratio and other liquidity ratios.)

(continued)

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Financial Ratios – Liquidity Acid Test Ratio – a.k.a. Quick Ratio

A more stringent version of the Current Ratio

Acid Cash + Accts recv + Short-term investments + Other current assets Test = ––––––––––––––––––––––––––––––––––––––––––Ratio Current Liabilities

Unlike the Current Ratio, the Acid Test Ratio excludes inventory. This ratio measures the ability of the company to meet its short-term obligations

even if its current inventory becomes obsolete or undesirable and hence, difficult or impossible to be turned into cash. Anything greater than 1.0 is

considered adequate.

(continued)

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Financial Ratios – Activity Activity Ratios

Financial ratios that are used to measure how well a firm is managing its assets

Accounts Receivable Turnover Inventory Turnover Total Asset Turnover These ratios use data from the Balance Sheet and

the Income Statement

Activity ratios measure a firm’s ability to convert different accounts within their balance sheets into cash or sales. Companies will try to turn their

production into cash or sales as fast as possible because this will generally lead to higher revenues.

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Financial Ratios – Activity Accounts Receivable Turnover

Measure of how accounts receivable are managed

Total RevenueAccounts Receivable Turnover = –––––––––––––––––––––

Accounts Receivable

The higher the number, the better. It indicates the return a company is getting from its investment in accounts receivable. By maintaining accounts receivable, firms are indirectly extending interest free loans to their clients. A high ratio implies that the company operates either on a cash basis, or its

extension of credit and collection of accounts receivable is efficient. A low ratio implies that the company should re-assess its credit policies in order to

ensure the timely collection of imparted credit not earning interest for the firm. (Or that may just be how that industry operates. Example: Defense.)

(continued)

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Financial Ratios – Activity Inventory Turnover

Measure of how inventory is managed

Total RevenueInventory Turnover = ––––––––––––––––––

Inventory

The higher the number, the less time an item spends in inventory and the better the return the company is able to earn from funds tied up in

inventory. As with all ratios, this ratio must be compared against industry averages. A low turnover implies poor sales and, therefore, excess

inventory. A high ratio implies either strong sales or ineffective inventory buying / maintenance. High inventory levels are unhealthy because they

represent an investment with a rate of return of zero. It also opens the company up to trouble in the case of falling prices or obsolete products.

(continued)

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Financial Ratios – Activity Total Asset Turnover

Measure of how total assets are managed

Total RevenueTotal Asset Turnover = ––––––––––––––––––––

Total Assets

The Total Asset Turnover Ratio measures the firm’s efficiency at using assets to support sales and revenue, the higher the number the better.

Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover.

(continued)

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Financial Ratios – Leverage Leverage Ratios

Financial ratios that are used to measure the amount of debt being used to support operations and the ability of the firm to service its debt

Debt-Equity Ratio – a.k.a. Debt-to-Equity Ratio Times Interest Earned Total Debt to Total Assets These ratios use data from the Balance Sheet or

the Income Statement

Debt is often referred to as leverage. The idea is that you are using other people’s money to make money. You are using the borrowed money as a

“lever” to increase your earnings. When one firm buys another firm using borrowed money, it is often referred to as a “leveraged buyout.”

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Financial Ratios – Leverage Debt-Equity Ratio

A measure of a company's financial leverage calculated by dividing long-term debt by shareholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets

Long-term DebtDebt-Equity Ratio = –––––––––––––––––––––––––––

Total Stockholder’s Equity

A higher Debt-Equity Ratio generally means that a company has been aggressive in financing its growth with debt. This can result in lower

earnings as a result of the additional interest expense. Sometimes investors only use interest bearing long-term debt instead of total liabilities. The

lower, the better.

(continued)

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Financial Ratios – Leverage Times Interest Earned (TIE)

Measures the ability of a company to meet its fixed interest payments

Times Earnings before Interest & Taxes Interest = ––––––––––––––––––––––––––––––––– Earned Interest Expense

Times Interest Earned is used to determine how frequently interest payments are earned by the company during a year. The higher, the better.

Normally, 3 or 4 is considered adequate.

(continued)

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Financial Ratios – Leverage Total Debt to Total Assets

Measure of how much of the company’s total assets have been financed by debt

Total LiabilitiesTotal Debts to Total Assets = –––––––––––––––––––

Total Assets

Total Debt to Total Assets includes both short-term and long-term debt and assets. If it varies substantially from the Debt-Equity Ratio, the company

may be relying heavily on short-term debt. A heavy reliance on short-term debt can denote more risk.

(continued)

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CHAPTER 17 – REVIEW

Financial Statements and Ratio Analysis

Chapter Sections:Sources of Financial InformationFinancial StatementsFinancial Statement ForecastingAdolph Coors Company Case Study

Next week: Chapter 7, Stock Price Behavior and Market Efficiency