Basics of Financial Analysis 83

charge coverage ratio can be expanded to accommodate the sinking funds

and preferred stock dividends as fixed charges.
Up to now, we considered earnings before interest and taxes as funds
available to meet fixed financial charges. EBIT includes noncash items such
as depreciation and amortization. If an investor is trying to compare funds
available to meet obligations, a better measure of available funds is cash
flow from operations, as reported in the statement of cash flows. A ratio
that considers cash flows from operations as funds available to cover inter-
est payments is referred to as the cash flow interest coverage ratio.
Cash flow interest coverage ratio
Cash flow from operations + Interest + Taxes
=
Interest
The amount of cash flow from operations that is in the statement of
cash flows is net of interest and taxes. So we have to add back interest and
taxes to cash flow from operations to arrive at the cash flow amount before
interest and taxes in order to determine the cash flow available to cover
interest payments.
For Fictitious for the current year,
$1,800,000+$400,000+$400,000
Cash flow interest coverage ratio =
$400, 000
$2, 600, 000
= = 6.5 times
$400, 000

This coverage ratio indicates that, in terms of cash flows, Fictitious has
6.5 times more cash than is needed to pay its interest. This is a better picture
of interest coverage than the five times reflected by EBIT. Why the differ-
ence? Because cash flow considers not just the accounting income, but non-
cash items as well. In the case of Fictitious, depreciation is a noncash charge
that reduced EBIT but not cash flow from operations—it is added back to
net income to arrive at cash flow from operations.

Recap: Financial Leverage Ratios Summarizing, the financial leverage ratios for
Fictitious Corporation for the current year are:
Debt-to-assets ratio = 45.45%
Debt-to-equity ratio = 83.33%
Interest coverage ratio = 5.00 times
Fixed charge coverage ratio = 2.14 times
Cash flow interest coverage ratio = 6.50 times
84 BACKGROUND

These ratios indicate that Fictitious uses its financial leverage as follows:

■ Assets are 45% financed with debt, measured using book values.
■ Long-term debt is approximately two-thirds of equity. When equity is
measured in market value terms, long-term debt is approximately one-
sixth of equity.

These ratios do not indicate:

■ What other fixed, legal commitments the firm has that are not included
on the balance sheet (for example, operating leases).
■ What the intentions of management are regarding taking on more debt
as the existing debt matures.

Common-Size Analysis
An investor can evaluate a company’s operating performance and financial
condition through ratios that relate various items of information contained
in the financial statements. Another way to analyze a firm is to look at its
financial data more comprehensively.
Common-size analysis is a method of analysis in which the components
of a financial statement are compared with each other. The first step in com-
mon-size analysis is to break down a financial statement—either the balance
sheet or the income statement—into its parts. The next step is to calculate
the proportion that each item represents relative to some benchmark. This
form of common-size analysis is sometimes referred to as vertical common-
size analysis. Another form of common-size analysis is horizontal common-
size analysis, which uses either an income statement or a balance sheet in
a fiscal year and compares accounts to the corresponding items in another
year. In common-size analysis of the balance sheet, the benchmark is total
assets. For the income statement, the benchmark is sales.
Let us see how it works by doing some common-size financial analysis
for the Fictitious Corporation. The company’s balance sheet is restated in
Table 3.4. This statement does not look precisely like the balance sheet we
have seen before. Nevertheless, the data are the same but reorganized. Each
item in the original balance sheet has been restated as a proportion of total
assets for the purpose of common size analysis. Hence, we refer to this as
the common-size balance sheet.
In this balance sheet, we see, for example, that in the current year cash is
3.6% of total assets, or $400,000/$11,000,000 = 0.036. The largest invest-
ment is in plant and equipment, which comprises 63.6% of total assets.
Basics of Financial Analysis 85

TABLE 3.4Fictitious Corporation Common-Size Balance Sheets for Years Ending

December 31
Current Year Prior Year
Assets
Cash 3.6% 2.0%
Marketable securities 1.8% 0.0%
Accounts receivable 5.5% 8.0%
Inventory 16.4% 10.0%
Current assets 27.3% 20.0%
Net plant and equipment 63.5% 70.0%
Intangible assets 9.2% 10.0%
Total assets 100.0% 100.0%
Liabilities and Shareholder Equity
Accounts payable 4.6% 4.0%
Other current liabilities 4.6% 1.0%
Long-term debt 36.4% 50.0%
Total liabilities 45.4% 56.0%
Shareholders’ equity 54.6% 44.0%
Total liabilities and shareholder equity 100.0% 100.0%

On the liabilities side, that current liabilities are a small portion (9.1%) of
liabilities and equity.
The common-size balance sheet indicates in very general terms how
Fictitious has raised capital and where this capital has been invested. As
with financial ratios, however, the picture is not complete until trends are
examined and compared with those of other firms in the same industry.
In the income statement, as with the balance sheet, the items may be
restated as a proportion of sales; this statement is referred to as the common-
size income statement. The common-size income statements for Fictitious
for the two years are shown in Table 3.5. For the current year, the major
costs are associated with goods sold (65%); lease expense, other expenses,
interest, taxes, and dividends make up smaller portions of sales. Looking at
gross profit, EBIT, and net income, these proportions are the profit margins
we calculated earlier. The common-size income statement provides informa-
tion on the profitability of different aspects of the firm’s business. Again, the
picture is not yet complete. For a more complete picture, the investor must
look at trends over time and make comparisons with other companies in the
same industry.
86 BACKGROUND

TABLE 3.5 Fictitious Corporation Common-Size Income Statement for Years

Ending December 31
Current Year Prior Year
Sales 100.0% 100.0%
Cost of goods sold 65.0% 66.7%
Gross profit 35.0% 33.3%
Lease and administrative expenses 15.0% 16.7%
Earnings before interest and taxes 20.0% 16.7%
Interest expense 4.0% 5.6%
Earnings before taxes 16.0% 16.7%
Taxes 4.0% 5.7%
Net income 12.0% 11.1%
Common dividends 6.0% 5.6%
Retained earnings 6.0% 5.5%

Using Financial Ratio Analysis

Financial analysis provides information concerning a firm’s operating per-
formance and financial condition. This information is useful for an inves-
tor in evaluating the performance of the company as a whole, as well as of
divisions, products, and subsidiaries. An investor must also be aware that
financial analysis is also used by investors and investors to gauge the finan-
cial performance of the company.
But financial ratio analysis cannot tell the whole story and must be
interpreted and used with care. Financial ratios are useful but, as noted
in the discussion of each ratio, there is information that the ratios do not
reveal. For example, in calculating inventory turnover we need to assume
that the inventory shown on the balance sheet is representative of inven-
tory throughout the year. Another example is in the calculation of accounts
receivable turnover. We assumed that all sales were on credit. If we are
on the outside looking in—that is, evaluating a firm based on its financial
statements only, such as the case of a financial investor or investor—and
therefore do not have data on credit sales, assumptions must be made that
may or may not be correct.
In addition, there are other areas of concern that an investor should be
aware of in using financial ratios:

■ Limitations in the accounting data used to construct the ratios.

Basics of Financial Analysis 87

■ Selection of an appropriate benchmark firm or firms for comparison

purposes.
■ Interpretation of the ratios.
■ Pitfalls in forecasting future operating performance and financial condi-
tion based on past trends.

CASH FLOW ANALYSIS

One of the key financial measures that an analyst should understand is the
company’s cash flow. This is because the cash flow aids the analyst in as-
sessing the ability of the company to satisfy its contractual obligations and
maintain current dividends and current capital expenditure policy without
relying on external financing. Moreover, an analyst must understand why
this measure is important for external parties, specifically stock analysts cov-
ering the company. The reason is that the basic valuation principle followed
by stock analysts is that the value of a company today is the present value of
its expected future cash flows. In this section, we discuss cash flow analysis.

Difficulties with Measuring Cash Flow

The primary difficulty with measuring a cash flow is that it is a flow: Cash
flows into the company (i.e., cash inflows) and cash flows out of the com-
pany (i.e., cash outflows). At any point in time, there is a stock of cash on
hand, but the stock of cash on hand varies among companies because of
the size of the company, the cash demands of the business, and a company’s
management of working capital. So what is cash flow? Is it the total amount
of cash flowing into the company during a period? Is it the total amount of
cash flowing out of the company during a period? Is it the net of the cash
inflows and outflows for a period? Well, there is no specific definition of
cash flow—and that’s probably why there is so much confusion regarding
the measurement of cash flow. Ideally, a measure of the company’s operating
performance that is comparable among companies is needed—something
other than net income.
A simple, yet crude method of calculating cash flow requires simply add-
ing noncash expenses (e.g., depreciation and amortization) to the reported
net income amount to arrive at cash flow. For example, the estimated cash
flow for Procter & Gamble (P&G) for 2002, is
Estimated cash flow = Net income + Depreciation and amortization
= $4,352 million + 1,693 million
= $6,045 million
88 BACKGROUND

This amount is not really a cash flow, but simply earnings before deprecia-
tion and amortization. Is this a cash flow that stock analysts should use in
valuing a company? Though not a cash flow, this estimated cash flow does
allow a quick comparison of income across firms that may use different
depreciation methods and depreciable lives. As an example of the use of this
estimate of cash flow, Guide to Using the Value Line Investment Survey,
published by Value Line, Inc., reports a cash flow per share amount, calcu-
lated as reported earnings plus depreciation, minus any preferred dividends,
stated per share of common stock (p. 19).
The problem with this measure is that it ignores the many other sources
and uses of cash during the period. Consider the sale of goods for credit.
This transaction generates sales for the period. Sales and the accompanying
cost of goods sold are reflected in the period’s net income and the estimated
cash flow amount. However, until the account receivable is collected, there
is no cash from this transaction. If collection does not occur until the next
period, there is a misalignment of the income and cash flow arising from this
transaction. Therefore, the simple estimated cash flow ignores some cash
flows that, for many companies, are significant.
Another estimate of cash flow that is simple to calculate is earnings
before interest, taxes, depreciation, and amortization (EBITDA). However,
this measure suffers from the same accrual-accounting bias as the previous
measure, which may result in the omission of significant cash flows. Addi-
tionally, EBITDA does not consider interest and taxes, which may also be
substantial cash outflows for some companies.1
These two rough estimates of cash flows are used in practice not only
for their simplicity, but because they experienced widespread use prior to the
disclosure of more detailed information in the statement of cash flows. Cur-
rently, the measures of cash flow are wide-ranging, including the simplistic
cash flow measures, measures developed from the statement of cash flows,
and measures that seek to capture the theoretical concept of free cash flow.

Cash Flows and the Statement of Cash Flows

Prior to the adoption of the statement of cash flows, the information regard-
ing cash flows was quite limited. The first statement that addressed the issue
of cash flows was the statement of financial position, which was required
starting in 1971 (APB Opinion No. 19, “Reporting Changes in Financial
Position”). This statement was quite limited, requiring an analysis of the
sources and uses of funds in a variety of formats. In its earlier years of adop-
tion, most companies provided this information using what is referred to as
the working capital concept—a presentation of working capital provided and
1
For a more detailed discussion of the EBITDA measure, see Eastman (1997).