Becomes a check on the reported net earnings figure

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becomes a check on the reported net earnings figure, but is not a substitute for net earnings. Companies with high net income but low CFO may be using income recognition techniques that are suspect. The ability of a firm to generate cash from operations on a consistent basis is one indication of the financial health of the firm. For most firms, CFO is the “life blood” of the firm. Analysts search for trends in CFO to indicate future cash conditions and the potential for cash flow problems. Cash flow from investing activities (CFI) is an indication of how the firm is investing its excess cash. The analyst must consider the ability of the firm to continue to grow and to expand activities, and CFI is a good indication of the attitude of management in this area. Analysis of this component of total cash flow indicates the type of capital expenditures being made by management to either expand or maintain productive activities. CFI is also an indicator of the firm’s financial flexibility and its ability to generate sufficient cash to respond to unanticipated needs and opportunities. A decreasing CFI may be a sign of a slowdown in the firm’s growth. Cash flow from financing activities (CFF) indicates the feasibility of financing, the sources of financing, and the types of sources management supports. Continued debt financing may signal a future cash flow problem. The dependency of a firm on external sources of financing (either borrowing or equity financing) may present problems in the future, such as debt servicing and maintaining dividend policy. Analysts also use CFF as an indication of the quality of earnings. It offers insights into the financial habits of management and potential future policies. 8. a. CF from operating activities = $260 – $85 – $12 – $35 = $128 b. CF from investing activities = –$8 + $30 – $40 = –$18 c. CF from financing activities = –$32 – $37 = –$69 19-3
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9. a. QuickBrush has had higher sales and earnings growth (per share) than SmileWhite. Margins are also higher. But this does not mean that QuickBrush is necessarily a better investment. SmileWhite has a higher ROE, which has been stable, while QuickBrush’s ROE has been declining. We can see the source of the difference in ROE using DuPont analysis: Component Definition QuickBrush SmileWhite Tax burden (1 – t) Net profits/pretax profits 67.4% 66.0% Interest burden Pretax profits/EBIT 1.000 0.955 Profit margin EBIT/Sales 8.5% 6.5% Asset turnover Sales/Assets 1.42 3.55 Leverage Assets/Equity 1.47 1.48 ROE Net profits/Equity 12.0% 21.4% While tax burden, interest burden, and leverage are similar, profit margin and asset turnover differ. Although SmileWhite has a lower profit margin, it has a far higher asset turnover. Sustainable growth = ROE × plowback ratio ROE Plowback ratio Sustainable growth rate Ludlow’s estimate of growth rate QuickBrush 12.0% 1.00 12.0% 30% SmileWhite 21.4% 0.34 7.3% 10% Ludlow has overestimated the sustainable growth rate for both companies. QuickBrush has little ability to increase its sustainable growth – plowback
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becomes a check on the reported net earnings figure but is...

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