RATIO ANALYSIS AND CASH FLOW CONSTRUCTION

INTRODUCTION

The purpose of this presentation is to discuss some of the essential

concepts of financial statement and cash flow analysis. As a first step,
financial ratios will be examined. Financial ratios are a significant tool to
analyze and compare the relationship between different pieces of financial
information and understand the operations of the firm. Following this
discussion, we will examine the construction of cash flow statements and
consider how changes in various accounts impact the cash flow balance.
Accordingly, the presentation will be divided into two parts: a review of
ratio analysis and the construction and analysis of cash flow statements.

RATIO OVERVIEW

Different individuals have varied uses of financial ratios.

Additionally, financial research firms often do not compute ratios in exactly
the same way, which can add to a user's confusion. Generally, ratios are
grouped into four categories and examined in terms of

a) the ratio's trend, and

b) its value relative to some norm such as an industry average.

Analysts and users most commonly group ratios into four categories:

1) Operating or profit margin ratios,

2) Liquidity ratios,
3) Managerial or turnover ratios, and
4) Leverage and coverage ratios.

An outline of some of the more common ratios which fall into each
category is presented on the following two pages. A profitability analysis

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 category is also provided at the end of this outline so that we can better
understand how profitability, turnover and leverage interact to determine a
firm's return on equity. For each of these ratios, several questions may
come to mind. Specifically,

1) How is each computed?

2) What is it intended to measure and of what interest is it?
3) What might a high or low value be telling us?
4) How might ratios be misleading and what relationship might a
particular change in a ratio have to the cash balance?

The discussion following the ratio list attempts to address some of

these questions and then analyze the behavior of certain ratios.

COMMON FINANCIAL RATIO TABLE

Operating or Profit Margins

Gross Profit Margin (%) = {(Net Revenue - Cost of Goods Sold) / Net Revenue} * 100

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Operating Profit Margin (%) = {(Gross Prof Mar. - Operating Exp.) / Net Revenue} * 100
-- (where operating expenses includes depreciation, office and sales salaries, office overhead,
utilities, etc.)
Net Profit Margin (%)= {Net Income After Tax (ie, NIAT) / Net Revenue} * 100

Liquidity

Current Ratio = Current Assets / Current Liabilities

Quick (or Acid Test) Ratio = (Current Assets - Inventory) / Current Liabilities

Managerial or Turnover

Asset Turnover = Net Revenue / Total Assets

Net Working Capital Turnover = Net Revenue / (Current Assets - Current Liabilities)

Receivables Turnover = Net Revenue / Net Trade Receivables

Inventory Turnover (Retailing) = Net Revenue / Inventory OR
Inventory Turnover (Manufact) = Cost of Sales / Inventory
Payables Turnover = Cost of Sales / Trade Payables

Length of time an item is in an account = 365 / Turnover

(Example: 365 / Inventory Turnover is the amount of time between the purchase of raw
materials and sale of finished goods.)

Operating Cycle = Days Inventory + Days Receivables

Cash Cycle = Days Inventory + Days Receivables - Days Accounts Payables

Leverage Ratios

Leverage = Interest Bearing Debt (ie, IBD) / Net Worth (ie, NW)
Debt to Assets = IBD / Total Assets
Average Cost of Debt = Interest Expense (ie, IntExp) / IBD

Profitability Analysis

Return on Investment (ROI) = EBIT / (IBD + NW)

Net Profit Margin = NIAT / Net Revenue

Return on Assets (ROA) = (NIAT / Net Rev) *(Net Rev / Total Assets)
= NIAT / Total Assets
Return on Equity (ROE) = (NIAT / Net Rev) * (Net Rev / Total Assets) * (Total Assets / NW)

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 = NIAT / NW
= [ROI + (IBD / NW * (ROI - IntExp / IBD)] * (1 - tax rate)

Coverages (From FAMAS Cash Flow Spreadsheet Analysis)

Fixed Charge Coverage

(Unallocated Cash Flow = EBITDA - Cash Taxes - Dividends - Unfinanced Capex

where Unfinanced Capex (ie, UnCap) = Gross Cap. Expenditures - New L.T. Debt;
where L.T. Debt = Additional Term Debt or Capitalized Leases.)

(EBITDA - Cash Taxes - Div - UnCap) / (Mandatory Debt Retirement + IntExp)

where Mandatory Debt Retirement (ie, MDR) is the current maturities of long-
term debt)
(EBITDA - Cash Taxes - Div - Capex) / (MDR + IntExp)
.
Cash Flow Leverage:
IBD / (EBITDA - Taxes - Div - Non Financed CAPEX - IntExp)

Cash Flow Coverages

Interest Coverage Ratios

EBITDA / IntExp
EBITDA / (MDR + IntExp)
(EBITDA - UnCap) / IntExp
(EBITDA - UnCap) / (MDR + IntExp)

Operating or Profit Margins

This set of ratios is intended to measure how efficiently a firm uses

its assets and manages its operations. The profit margins measure, in an
accounting sense, how much income is generated from a dollar of the firm's
total revenue. All other things being equal, a high profit margin is
preferred to a low profit margin.
[It should be noted that the lowering of a firm's sales price per unit will
normally increase unit volume (resulting in a higher asset turnover) but
profit margins will decrease. Total profit may go up or down depending

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upon how profit margins and asset turnover interacts. This profitability
analysis is demonstrated in the final category of the ratio listings..
NOTE: The fact that profit margins are smaller isn't necessarily bad.]

Liquidity

The current ratio is a rough indication of a firm's ability to service its

current liabilities or obligations. Both the numerator and the denominator
reflect accounts that will either be converted to (assets) or require payment
(liabilities) from cash within the next year. Since inventory is the least
liquid of the current asset account items and also the item which is the least
reliable as measured by market value (since quality or potential for
obsolescence is not reflected in book value), a "quicker" measure of a firm's
ability to meet its current debt obligations would eliminate inventory from
current assets. The quick ratio indicates the relative amounts of cash, cash
equivalents and receivables the firm's books indicate can meet its current
obligations.

Managerial or Turnover

Asset managerial or turnover ratios are sometimes referred to as

asset utilization ratios. In general, these ratios are designed to measure how
efficiently a firm uses a particular asset category relative to revenue
generated or another income statement-related account. As an example,
asset or net working capital turnover measures how efficiently these two
items are utilized in generating revenue. A higher turnover suggests greater
efficiency in utilizing assets.

If a firm's liquidity ratios are not in line with industry standards or a

desired trend, it may be beneficial to examine the inventory, receivable or
payable turnover ratios to determine if they are efficiently utilized. As an
example, the firm may have a low current ratio due to low levels of
accounts receivables. This would also be indicated by a high receivables
turnover rate which, all other things equal, would be desirable. However, if
the quicker collections and more aggressive cash flow were coming at the
expense of higher potential sales (due to restrictive credit availability to its
customers), this may pose some concern to management.

If we divide the days in the year by a particular turnover rate, the

result tells us the average number of days that a particular item will be in
that account.

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 Thus, 365 / inventory turnover reveals the number of days from the
time of the purchase of raw materials to their sale as finished goods;
365/ receivables turnover reveals the number of days from the time
of the sale of the finished goods on credit to the collection of the accounts
receivable for that given sale, and lastly,
365 / accounts payable reveals the number of days from the time we
purchase our inventory on credit to the day we must pay cash for the
accounts payable.

From a cash flow standpoint, a high inventory and receivables

turnover would be desirable since it indicates a quicker production and
collection process for the firm. However, a low payables turnover would
be more desirable since it indicates a firm is able to delay payment for a
longer period of time, assuming the firm does not violate its credit
agreements with its suppliers.

Operating and Cash Cycle

The concepts in the preceding discussion can also be used to show the
number of days that cash is required to support the sale of a good.
Briefly, consider a company embarking on a sales expansion.
a) its cost of goods sold for the year is estimated to be $3,650,000,
- daily costs would average $10,000 per day,
b) the firm expects the production cycle to be
1) 40 days between receipt of inventory and sale of goods, and
2) 30 days between sale and collection of the receivables,
c) the firm's operating cycle of 70 days would require a $700,000 cash
source to support the sales growth.
Questions:

1. If payment of the initial costs, such as the payment of inventory

purchases, could be delayed for 15 days, what is the cash cycle?

Answer: the cash cycle would be 55 days (40 + 30 - 15) and result in a
$550,000 initial cash source requirement.

2. Assume the gross profit margin [( Rev. - CofGS)/Rev] = 20%.

Net Revenue would then equal $4,562,500 [(Rev - $3,650,000)/Rev = .2)],
a 25% markup on cost.

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What is the receivables turnover?

Answer: Rev/ Rec = ($4,562,500 / $375,000)

= (365 * 10,000 * 1.25 ) / (30 * 10,000 * 1.25)
= 12.1667

Note: If the accounts receivable turnover increased, both the cash and
operating cycle would be reduced, which in turn would reduce the cash or
funds needs for the sales expansion. Receivables turnover is not affected
by the profit margin (1.25 is in both the numerator and the denominator)
nor by a sales increase. It would only be affected by a decrease in the level
of days sales outstanding (30).

Interaction of Turnover and Profitability

The profit margin does not effect turnover, collections do. However,
turnover will interact with the profit margin to impact the various profit
measurements. This interaction is demonstrated with the following
example..

A company currently has:

Sales: $100,000
Cost of Goods Sold: Variable at 60% of Sales
Depreciation Expense: Fixed at $10,000
Administrative Expense: Fixed at $ 5,000
Average Collection Time: 30 days from date of sale

The company is considering a change in its collection policy to stimulate

sales growth. It estimates that if it would increase its allowable payment
period for its receivables to 50 days, its sales would increase by 5 percent
per year.
(Note: Currently, 30 days or 1/12 of annual sales are uncollected in the
accounts receivable balance. This represents $8,333 uncollected on the
balance sheet.

The income statement impact is:

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 Before Change After Change
Sales $100,000 $105,000
-Cost of Goods Sold - 60,000 - 63,000
Gross Profit $ 40,000 $ 42,000
-Depreciation - 10,000 - 10,000
-Admin. Expense - 5,000 - 5,000
Operating Profit $ 25,000 $ 27,000

Questions:

1. What happens to the gross and operating profit margin after the change?
Before Change After Change
Gross Profit Margin $40,/$100, = 40% ____/____ = 40%
Operating Profit Margin $25,/$100, = 25% ____/____ = 27%

What situation in the cost structure caused the gross profit margin to remain
constant while the operating profit margin improved?

2. How does this change affect average receivables and receivables

turnover?
Before change After Change
Aver. Receivables $100,000*(30/365) ________*(_____/_____)
= $8,219 = $14,383
Receivables Turn. $100,000/$8,219 ________/________
= 12.167 times = 7.3 times

3. Has cash flow increased (assume no taxes)?

What is the additional net income?

Is more or less cash collected from the sales change?

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4. If funds can be obtained at 10%, what is the effect on net income after
tax?
Change in net income - Financing of additional assets = ?

__________ - ____________ = $1,383.60.

Leverage and Coverage Ratios

Leverage ratios are often viewed as a firm's long-term ability to meet

its obligations. Briefly, leverage ratios reflect the relationship of a firm's
fixed financial obligations to debt or assets. Since a portion of the debt on
the balance sheet may be trade credit, the focus of many of the ratios is on
the interest bearing portion of total debt.

There are various coverage ratios that provide insight into a firm's
ability to service its financial obligations. The main difference in these
ratios is the particular cash flow measurement and its coverage of a
particular obligation.

Numerous coverage ratios from the FAMAS cash flow spread sheet
analysis are presented in the coverage categories presented in the coverage
categories of the Common Financial Ratio Table. In general, the coverage
ratios show the relationship of various earnings components (ie, EBITDA -
additional cash deductions from income and/or unfinanced capital
expenditures) as a percentage of financing demands for the period (ie,
Interest Expense and/or current maturities of debt obligations).

Profitability Analysis

Return on equity (ROE) is, in an accounting sense, a measure of the

firm's profitability as a percent of the owner's investment or equity in the
firm. Profitability analysis reveals that the ROE is affected by the net profit
margin, the asset turnover and financial leverage. Often, attempts to
stimulate sales (higher asset turnover) are generated by some sales
incentive such as a lower unit selling price (lower profit margin). The
impact of this interaction is picked up in the profitability analysis presented
in the table. Weakness or strength in either profit margins or turnover will
have a negative or positive effect on ROE and this result will be magnified
by the degree of leverage the firm selects. This decomposition is a
convenient way of approaching financial statement analysis. If ROE is
unsatisfactory, this decomposition can aid one in beginning to look for the

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problem areas. The mechanics of the ROE analysis will be provided in the
following brief example.

ROE Analysis Example

A company has the following financial data:

Sales $10,000 Assets $5,000

- Cost of Sales - 5,000
- Selling, Admin - 4,000 IBD (@ 10%) $3,000
& Depr. Exp _______ NW $2,000
Other Oper Inc. $ 1,000
+ Other Inc. 0
EBIT $ 1,000
- Int Exp 300
EBT $ 700
- Tax (30%) 210
NIAT $ 490

Questions:

1) Determine the ROE components through the following two methods?

ROE = NIAT / NW = NIAT/Rev * Rev/Assets * Assets/NW

= ____/____ = _____ / _____ * _____ / _____ * _____ / _____

= .245 = .049 * 2 * 2.5

ROE = [ ROI + IBD / NW * ( ROI - IntExp / IBD)] * (1-t)

= [_____/_____ + _____ / _____ * (____ / ____ - _____ / _____)] * ____

=[ .20 + 1.5 * ( .20 - .10 )] * .70

= NIAT / NW = .245

2) How is each method interpreted?

RATIO ANALYSIS AND BANKRUPTCY PREDICTION

Although an individual ratio may indicate a particular strength or

weakness in a company, no individual ratio can adequately evaluate the

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overall strength or weakness in a company. Developed by Edward I.
Altman in 1968, the Altman Z-Score has become one of the most accepted
and tested predictors of bankruptcy potential for a firm. Although it was
originally developed from a sample of manufacturing firms, it is also
applied to nonmanufacturing firms. Essentially, it considers strength or
weakness in five key ratios as an indication of a firm's bankruptcy
potential. The five ratios are:

X1 = (Current Assets - Current Liabilities) / Total Assets;

X2 = Retained Earnings / Total Assets;
X3 = (EBT + Interest) / Total Assets;
X4 = Equity Market Value / Total Liability;
X5 = Net Sales / Total Assets.

If a company's equity is not publicly traded, a firm's book value of

equity may be substituted for equity market value in variable X4.
However, with this substitution in variable X4, the Altman Z-Score has
proven to be a less reliable predictor of bankruptcy.
Altman identified these variables and combined them to provide an
indication of the firm's bankruptcy potential. The Z-Score is calculated as:

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

Z-Scores above 3 are generally considered safe in terms of

bankruptcy while scores below 1.8 are considered to have a high
probability of potential bankruptcy. Scores between 1.8 and 3 are
considered to fall in the grey area which should cause both management
and potential lenders to be highly concerned and take corrective actions.
One might consider use of the Altman Z-Score in determining the credit
worthiness of the firm.

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