Other cash-flow measures

EBITDA = Earnings before interest, taxes, depreciation, and amortization

• However, EBITDA does not measure cash flow well if there are large changes in working
capital and suffers from the same manipulation potential as net income.
• For example, “channel stuffing” would increase earnings and EBITDA, but no cash is
collected (instead, accounts receivable increase).

Free Cash Flows (Operating cash flow minus CAPEX) Net cash flow from operating activities - Investment on PPE
• Companies often disclose free cash flow using their own custom definition
• There are several alternate definitions of operating cash flow.
• Cash flow from operations before interest expense
• EBIT × (1- tax rate) + Depreciation and non-cash expenses +/- ∆ working capital
• NOPAT +/- ∆ working capital
• NOPAT = Net operating profits after tax = EBITDA – Cash taxes on EBITDA
To calculate free cash flow, start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by
subtracting current liabilities from current assets. Then subtract capital expenditure (or spending on plants and equipment):
Net Income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
= Free Cash Flow
 Cash flows over a company’s life cycle

Positive
Financing
Cash Flow

0
Operating
Investing
Negative

Introductory
Introductor Growth Maturity Decline
Phase
5.21
 Framework for ratio analysis
Return on equity (ROE)
provides a very powerful
analysis framework

Today’s session Sessions 6 - 10

5.24
 Additional common profitability ratios
Profit margin = Net income / Sales
How much of each dollar in revenue earned by a company translates into profit. In other words,
after covering ALL expenses, how much profit remains (percentage wise)?

Gross profit margin = Gross profit / Sales = (Sales – COGS) / Sales

High ratio indicates some combination of higher product pricing and low product costs. This
ratio is heavily influenced by competitive advantage of the firm and varies significantly by
industry.

Operating profit margin = Operating profit / Sales

Measures the overall level of profitability of the company’s main operations. An operating margin
increasing faster than gross margin indicates the company is controlling operating costs (e.g.
SG&A).

Pretax profit margin = Earnings before tax / Sales

This ratio reflects the effect of leverage and non-operating income / expenses. Pretax margin
also includes items that are non-recurring in nature.
5.25
 Evaluating A/R
Ratios that we can use to evaluate the company’s accounts receivable include:

୅ୡୡ୭୳୬୲ୱ ୖୣୡୣ୧୴ୟୠ୪ୣǡ ୬ୣ୲

Common size A/R =
୘୭୲ୟ୪ ୟୱୱୣ୲ୱ
Measures the number
of times A/R is
ୗୟ୪ୣୱ collected per year
A/R turnover =
୅୴ୣ୰ୟ୥ୣ ୅ୡୡ୭୳୬୲ୱ ୖୣୡୣ୧୴ୟୠ୪ୣǡ ୬ୣ୲

Measures the number

ଷ଺ହ of days it takes to
Days Sales Outstanding (DSO) = collect A/R
୅ୡୡ୭୳୬୲ୱ ୖୣୡୣ୧୴ୟୠ୪ୣ ୲୳୰୬୭୴ୣ୰

5.28
 Evaluating inventory
Ratios that we can use to evaluate the company’s inventory

୍୬୴ୣ୬୲୭୰୷
Common size inventory =
୘୭୲ୟ୪ ୟୱୱୣ୲ୱ
Measures the number
of times inventory is
େ୓ୋୗ sold per year
Inventory turnover =
୅୴ୣ୰ୟ୥ୣ ୍୬୴ୣ୬୲୭୰୷

Measures the number

ଷ଺ହ of days it takes to sell
Days Inventory Outstanding (DIO) = inventory
୍୬୴ୣ୬୲୭୰୷ ୲୳୰୬୭୴ୣ୰

5.30
 Evaluating A/P
Ratios that we can use to evaluate the company’s accounts payable

୅ୡୡ୭୳୬୲ୱ ୔ୟ୷ୟୠ୪ୣ
Common size A/P =
୘୭୲ୟ୪ ୟୱୱୣ୲ୱ
Measures the
number of times A/P
େ୓ୋୗ is paid per year
A/P turnover =
୅୴ୣ୰ୟ୥ୣ ୅ୡୡ୭୳୬୲ୱ ୔ୟ୷ୟୠ୪ୣ

Measures the
ଷ଺ହ number of days it
Days Payables Outstanding (DPO) = takes to pay A/P
୅ୡୡ୭୳୬୲ୱ ୔ୟ୷ୟୠ୪ୣ ୲୳୰୬୭୴ୣ୰

5.32
 Cash conversion cycle
• Cash conversion cycle (CCC) = DIO + DSO – DPO
• All things equal, a lower CCC is preferable because it means the company is out
of pocket for operating cash flow, for a fewer number of days.
• To improve CCC: decrease DIO and DSO & increase DPO
• CCC can be positive or negative
• CCC varies widely by industry and firm size
ƒ Larger firms and those with significant power over suppliers and vendors can
stretch DPO
ƒ Cash-based operations such as retailers and restaurants have DSO = 0 which
decreases CCC
ƒ Service firms with no inventory have DIO = 0 which decreases CCC

5.36
 Evaluating PP&E
Ratios that we can use to evaluate the company’s PP&E
Measures the
୔୔Ƭ୉ revenue earned per
Common size PP&E = unit of investment
୘୭୲ୟ୪ ୟୱୱୣ୲ୱ

ୗୟ୪ୣୱ
PP&E turnover = Measures the number
୅୴ୣ୰ୟ୥ୣ ୔୔୉ǡ ୬ୣ୲
of years the PPE has
been in service
୅ୡୡ୳୫୳୪ୟ୲ୣୢ ୢୣ୮୰ୣୡ୧ୟ୲୧୭୬
Average age of PP&E assets =
ୈୣ୮୰ୣୡ୧ୟ୲୧୭୬ ୣ୶୮ୣ୬ୱୣ

Measures the
୔୔୉ǡ ୥୰୭ୱୱ average life of PPE
Average PP&E useful life =
ୈୣ୮୰ୣୡ୧ୟ୲୧୭୬ ୣ୶୮ୣ୬ୱୣ across all categories

5.40