Chapter 3 Flashcards
Sources and uses of cash
• Sources
– Cash inflow – occurs when we “sell” something
– Decrease in asset account
– Increase in liability or equity account
• Uses
– Cash outflow – occurs when we “buy” something
– Increase in asset account
– Decrease in liability or equity account
Relationship between assets and cash and liabilities and cash
Assets+ Cash -
Assets - cash +
Liabilities + Cash+
Liabilities - cash -
Statement of cash flows
• Statement that summarizes the sources and uses of cash
• Changes divided into three major categories
– Operating Activity – includes net income and changes in most current accounts
– Investment Activity – includes changes in fixed assets
– Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends
Standardized financial statements
- Difficult to compare financial statements of two companies because of differences in size.
- To start making comparisons, we try to standardize the statements. Standardized statements make it easier to compare financial information, particularly as the company grows. They are also useful for comparing companies of different sizes, particularly within the same industry
Standarized financial statements - common size statements of financial position & common size statements of comprehensive income
Common-Size Statements of Financial Position
– Compute all accounts as a percent of total assets
Balance sheet
Common-Size Statements of Comprehensive Income – Compute all line items as a percent of sales
Income statement
Ratio Analysis
• Another way of avoiding the problem of comparing companies of different sizes is to calculate and compare financial ratios.
• 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
Typical information sources of ration analysis and who is interested in this information.
• Typical Information Sources: Income Statement & Balance Sheet
• Who is interested in financial ratios?
Creditors: (a) Getting interest paid; (b) getting principal repaid
Shareholders: (a) Ultimately, value of the shares;(b) profitability and indebtedness as far as their effects on value
Managers: (a) Ultimately, what value shareholders place on their performance; (b) profitability, liquidity and indebtedness;
(c) compensation
Categories of financial ratios
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability and market ratios
Short term, solvency or liquidity measures
- Short-term solvency ratios provide information about a firm’s liquidity.
- Can the firm’s pay its bills over the short-run without undue stress?
Short term, solvency or liquidity measures - calculations
- current ration = CA/CL
Benchmark between 1.5-3 times - quick ratio = (CA - inventory)/ CL
Benchmark: one to one ratio is acceptable - cash ratio = cash/ CL
Benchmark: a cash ration >1 is generally favoured
Long term solvency measures
- Address the firm’s long-run ability to meet its obligations or, more generally, its financial leverage.
- These are sometimes called financial leverage ratios or just leverage ratios.
Profitability and asset management or turnover measures
• Profitability ratios measure how efficiently the firm uses its assets and how efficiently the firm manages its operations. The focus in this group is on the bottom line, net income.
• Asset management/turnover: the measures are sometimes called asset utilization ratios / measures of turnover
– Whatdotheymeasure?
– Whyaretheyimportant?
Looks at how efficiently a firm uses its assets to generate sales
Deriving the Du point
➢Du Pont Identity - Popular expression breaking ROE into three parts:
Profit margin: is a measure of the firm’s operating efficiency - how well does it control costs
Total asset turnover: is a measure of the firms asset use efficiency - how well does it manage its assets
Financial leverage: Equity multiplayer
➢ Using the Du Pont Identity: The DuPont method is useful in helping us determine where our profitability is coming from, as well as identifying weaknesses.
Using financial statement information
• 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
Benchmarking
Ratios are not very helpful by themselves; they need to be compared to something
• Time-Trend Analysis
– Used to see how the firm’s performance is changing
through time
– Internal and external uses
• Peer Group Analysis
– Compare to similar companies or within industries
Potential problems
• There is no underlying theory, so there is no way to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes comparison
more difficult because of differences in accounting regulations
• Varying accounting procedures, i.e. FIFO vs. LIFO
• Different fiscal years
• Extraordinary events: Unusual events such as one-time profit from an asset sale, may affect financial performance.
Potential problems
• There is no underlying theory, so there is no way to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes comparison
more difficult because of differences in accounting regulations
• Varying accounting procedures, i.e. FIFO vs. LIFO
• Different fiscal years
• Extraordinary events: Unusual events such as one-time profit from an asset sale, may affect financial performance.
