“Why does free cash flow have such an important effect on a firm’s value?”

| August 30, 2015

“Why does free cash flow have such an important effect on a firm’s value?”

Discussion 1

Why does free cash flow have such an important effect on a firm’s value?

Free cash flow is the amount of cash that can be withdrawn without harming the firm’s ability to operate and to produce future cash flows.  It is an indication of the liquidity of a company.  This number is more importanta than total earnings because indicates the amount of cash that can be distributed to investors or invested in capital projects.  This number is used by both security analysts and managers.  Security analysts use it to evaluate the value of a company’s stock.  Mangers use it to determine the value of proposed capital budgeting projects and potential mergers.  A negative cash flow may not necessarily be bad if it is the result of an investment that will eventually be profitable.  But, ideally cash flow will never be negative.


a. For this firm, I think the ratios most useful would be the current ratio because it shows the firms liquidity. They should also know the debt to capital and days sales outstanding.
Current Ratio: 303/85 = 3.6x
Debt to Capital: (29+50)/(79+351) = 20.1%
DSO: 66/(795/365) = 30 days

b. profit margin x total assets turnover x equity multiplier
(27/795) x (795/450) x (450/315)
3.4% x 1.8% x 1.4% = 8.6%
Compared to the industry average, the profit margin of the company is not in jeopardy. However, the total assets turnover is lower than where it would hope to be.

c. Considering all of the ratios calculated, the income statement seems to be accountable for the low profits. because inventory turnover and DSO are not in line with the industry average. Those ratios are due to the inventories and accounts receivable. The balance sheet is in line with the expected industry averge when considering the current assets and liabilities. However, the total assets, common equity and invested capital show a low return.

d. The firms return on total assets is 6%, where it should be at 9%. As well as the return on common equity. The industry’s average ROE is 12.86%, but the company’s is 8.6%

e. If the firm suddenly grew in sales. I believe the ratios would still be valid for this particular statement, however the new sales would be an improvement.

C) Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?
– The income statement is represented by Profit Margin which looks good compared to the industry. However, other measures where balance sheet items are included such as assets turnover ratio and return on equity, the ratios are far worse than the industry average, which means that the balance sheet accounts are responsible for the low performance of the firm.
D) Which specific accounts seem to be most out of line relative to other firms in the industry?
-Total asset turnover seemed to be the most out of place at 1.77 compared to 3.0 of the industry.
E) If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis? How might you correct for such potential problems?
– If the sales grow rapidly without increasing the total assets, then the total assets turnover ratio will improve dramatically. As a result the ROE will also improve. However, such problems like liquidity, increase in accounts receivable, may hinder the growth and increase the risk of things like bad debts.

Juyeon Kim

Problem 4-24

Industry Average Ratios                            a.
Current ratio        3x    Tixed assets turnover        6x        Asset management                        2015    2105
Debt-to-capital ratio        20%    Total assets turnover        3x        Inventory turnover= Sales/Inventories                     4.076923077    4.08    10
Times interest earned        7x    Profit margin        3%
EBITDA coverage        9x    Return on total assets        9%        Fixed asset turnover = Sales/Net fixed assets                    5.408163265    5.41    6
Inventory turnover        10x    Return on common equity        12.86%
Days sales outstanding        24 days    Return on invested capital        11.50%        Total assets turnover = Sales/ Total assets                    1.766666667    1.77    3

Balance Sheet as of December 31, 2015 (Millions of Dollars)
Cash and equivalents        78    Accounts payable        45
Accounts receivable        66    Other current liabilities        11        Profitability
Investories        195    Notes payable        29        Profit margin= Net income / Sales                    0.033962264    3.40%    3%
Total current assets        303    Total current liabilities        85
Long-term debt        50
Total liabilities        135        Return on total assets= Net income/ Total assets                    0.06    6%    9%
Gross fixed assets        225    common stock        114
Less depreciation        78    Retained earnings        201        Return on common equity = Net income / Common equity                    0.085714286    8.57%    12.86%
Net fixed assets        147    Total stockholders’ equity        315
Total assets        450    Total liabilities and equity        450
Income Statement for Year Ended December 31, 2015 (Millions of Dollars)                            Equity multiplier= Total assets/ Common equity                    1.428571429
Net sales                795.0
Cost of goods sold                660.0            DuPont Equation: ROE= Profit margin * Total Asset Turnover * Equity Multiplier                            0.085714286
Gross profit                135.0            Therefore,     8.57%
Selling expenses                73.5            Industry Average: ROE =         0.128571429
EBITDA                61.5            Therefore,    12.86%
Depreciation expenses                12.0
Earnings before interest and taxes (EBIT)                49.5            The firm’s profit margin 3.40 is bettern than the industry 3. However, by comparing firm’s return on equity ratio, the firm is lower than industry. Return on equity (ROE) indicates a company’s profitability by showing how much profit a company can produce with the money that shareholders invested. The firm’s ROE is worse than the industry.
Interest expense                4.5
Earnings before taxes (EBT)                45.0
Taxes (40%)                18.0
Net income                27.0

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