Ch 3- Financial Statements, Cash Flow, Taxes

Question 1

at the most fundamental level what are the two things that firms do

Answer 1

generate cash
spend cash

Question 2

What are the two ways firms use cash

Answer 2

Buying assets
Making payments

Question 3

If there is an increase in an asset account

Answer 3

firm used cash

Question 4

If there is a decrease in an asset account

Answer 4

asset was sold, cash was earned

Question 5

How to analyze a balance sheet in terms of cash flows

Answer 5

-look and analyze how that impacts cash

Question 6

-If A/R increased? how this impact cash
-If Inventory increase?
-If Fixed Asset increase?
-If A/P increase?
-If Long term debt increase?
-If Common share/stock increase?

Answer 6

Cash decreased
Cash Decreased
DECREASE
increase
increase
increase

Question 7

INCREASE IN ASSET or DECREASE IN LIABILITY/EQUITY is a use of cash (-)

Answer 7

DECREASE IN ASSET or INCREASE IN LIABILITY/EQUITY is a source of cash (+)

Question 8

How to check if our cash flow is correct

Answer 8

see if the final number we get is the same as the cash listed insofp

Question 9

Where does interest go in the socf

Answer 9

operating activities

Question 10

Common base year statement

Answer 10

Comparing financial statements to a given base year

Question 11

Comon size statemetns

Answer 11

Presenting everything as a percentage of something else

% of total assets

Question 12

What is Ratio Analysis

Answer 12

using ratios to break down financial statmeetns

Question 13

5 types of ratios

Answer 13

short term solvency/liquidity
long term solvency/leverage
asset managmeent/tunover
profitability
market value

Question 14

Short term solvency ratios

Answer 14

how liquid are funds? Can we pay bills?

current ratio ($ or times)
quick ratio (Acid test) (current assets-inventory/current liability)
cash ratio (cash+cash eq/current liability)
nwc to ta (net working capital/ta)

Question 15

turnover

Answer 15

inv turnover
days sales in inv
recievables turnover
days sales in recievables
nwc turnover
fixed asset turnover
ta turnover

Question 16

financial leverage ratios / long term solvency

Answer 16

-total debt ratio
-debt-equity
-equity multiplier (total assets/total equity, also it is 1+ debt equity ratio)

long term debt ratio
times interest earned
cash coverage ratio

Question 17

Profitability

Answer 17

profit margin
return on assets (roa)
return on equity (roe)

Question 18

market value ratios

Answer 18

price earning ratio (p/e)
PEG ratio
market to book ratio
EV/EBITDA

Question 19

Asset Management, or turnover, measures

Answer 19

how efficiently are you using ur asset

-Inventory Turnvoer & Days Sales in Inventory
-Recievables turnover and days sales in recievables
-NWC turnover
-Fixed asset turnover
-total asset turnover

Question 20

Profitability measuers

Answer 20

-profit margin
-roa
-roe

Question 21

DuPont Identity

Answer 21

ROE= net income/total eq

-> MULTIPLY IT BY ASSETS/ASSETS

the new ratio is:
ROE= NI/Assets x Assets/Total Eq

or

ROE= ROA x Equity multiplier

OR
ROE= ROA x (1+ Debt-Equity Ratio)

if you mulitply it by sales/sales

you get

ROE= profit margin x total asset turnover x equity multiplier [DUPONT IDENTITY]

Question 22

What does the DuPont identity tell us

Answer 22

ROE is affected by
1. operating efficiency (Cuz profit margin)
2. asset use efficieny (ttoal asset turnover)
3. financial leverage (cuz equity multiplier)

WHEN ANY OF THESE INCREASE, RETURN ON EQUITY WILL ALSO ICNREASE

Question 23

Considering the DuPont identity, it appears that the ROE could be leveraged up by increasing the amount of
debt in the firm. It turns out that this happens only when the firm’s ROA exceeds the interest rate on the debt.

Answer 23

Considering the DuPont identity, it appears that the ROE could be leveraged up by increasing the amount of
debt in the firm. It turns out that this happens only when the firm’s ROA exceeds the interest rate on the debt.

Question 24

IF roe improves what could be the cause?

Answer 24

increase in profit margin, total asset turnover, or equtiy mulitplier

Question 25

TIME-TREND ANALYSIS

Answer 25

One standard we could use is history. In our Prufrock example, we looked at two years of data. More
generally, suppose we find that the current ratio for a particular firm is 2.4 based on the most recent
financial statement information. Looking back over the last ten years, we might find that this ratio has
declined fairly steadily.
Based on this, we might wonder if the liquidity position of the firm has deteriorated. It could be, of course,
that the firm has made changes to use its current assets more efficiently, that the nature of the firm’s business
has changed, or that business practices have changed. If we investigate, these are all possible explanations.
This is an example of what we mean by management by exception—a deteriorating time trend may not be
bad, but it does merit investigation

Question 26

PEER GROUP ANALYSIS

Answer 26

The second means of establishing a benchmark is to identify firms that are similar in the sense that they
compete in the same markets, have similar assets, and operate in similar ways. In other words, we need to
identify a peer group. This approach is often used together with time-trend analysis and the two approaches
are complementary.
In our analysis of Prufrock, we used an industry average without worrying about where it came from. In
practice, matters are not so simple because no two companies are identical. Ultimately, the choice of which
companies to use as a basis for comparison involves judgment on the part of the analyst. One common way
of identifying peers is based on the North American Industry Classification System (NAICS) codes.
These are five-digit codes established by the statistical agencies of Canada, Mexico, and the United States
for statistical reporting purposes. Firms with the same NAICS code are frequently assumed to be similar.
Various other benchmarks are available. You can turn to Statistics Canada publications and websites that
include typical statements of financial position, statements of comprehensive income, and selected ratios for
firms in about 180 industries. Other sources of benchmarks for Canadian companies include financial
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databases available from The Financial Post Datagroup and Dun & Bradstreet Canada. Several financial
institutions gather their own financial ratio databases by compiling information on their loan customers. In
this way, they seek to obtain more up-to-date information than is available from services like Statistics
Canada and Dun & Bradstreet.
Obtaining current information is not the only challenge facing the financial analyst. Most large Canadian
corporations do business in several industries so the analyst must often compare the company against
several industry averages. Keep in mind that the industry average is not necessarily where firms would like to
be. For example, agricultural analysts might know that farmers are suffering with painfully low average
profitability coupled with excessive debt. Despite these shortcomings, the industry average is a useful
benchmark for the management by exception approach we advocate for ratio analysis.

Question 27

Problems with Financial Statement Analysis

Answer 27

As we discuss in other chapters, there are many cases where financial theory and economic logic provide
guidance to making judgments about value and risk. Very little such help exists with financial statements.
This is why we can’t say which ratios matter the most and what a high or low value might be.
One particularly severe problem is that many firms are conglomerates, owning more or less unrelated lines
of business. The consolidated financial statements for firms such as BCE Inc. don’t really fit any neat
industry category. More generally, the kind of peer group analysis we have been describing works best when
the firms are strictly in the same line of business, the industry is competitive, and there is only one way of
operating.
Another problem that is becoming increasingly common is having major competitors and natural peer
group members in an industry scattered around the globe. As we discussed in Chapter 2, the trend
toward adopting IFRS improves comparability across many countries but the U.S. remains on GAAP. This
complicates interpretation of financial statements for companies with operations in both the U.S. and
Canada as well as internationally.
Even companies that are clearly in the same line of business may not be comparable. For example, electric
utilities engaged primarily in power generation are all classified in the same group. This group is often
thought to be relatively homogeneous. However, utilities generally operate as regulated monopolies, so
they don’t compete with each other. Many have shareholders, and many are organized as cooperatives with
no shareholders. There are several different ways of generating power, ranging from hydroelectric to
nuclear, so their operating activities can differ quite a bit. Finally, profitability is strongly affected by
regulatory environment, so utilities in different locations can be very similar but show very different profits.
Several other general problems frequently crop up. First, different firms use different accounting procedures
for inventory, for example. This makes it difficult to compare statements. Second, different firms end their
fiscal years at different times. For firms in seasonal businesses (such as a retailer with a large Christmas
season), this can lead to difficulties in comparing statements of financial position because of fluctuations in
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accounts during the year. Finally, for any particular firm, unusual or transient events, such as a onetime
profit from an asset sale, may affect financial performance. In comparing firms, such events can give
misleading signals.