Financial Statements and Ratios Text: Chapter 2

How do you describe a firm’s financial situations ?

Financial Statements Balance sheet Income statement Statement of cash flow

What assets do you own?

Asset = Liability + Shareholders’ Equity The Balance Sheet An accountant’s snapshot of the firm’s ACCOUNTING value as of a particular date. Concept of Stock, rather than Flow The Balance Sheet Identity is: Asset = Liability + Shareholders’ Equity

The Balance Sheet of the NCKU Corp. (in $ millions) 20X2 and 20X1 Balance Sheet NCKU COMPOSITE CORPORATION Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

Items of Current Assets Cash easy and exact measurement could change in short time. Marketable securities Receivables pay attention to increase of AR Inventory Change of inventory policy (LIFO vs.. FIFO)

Items of Fixed Assets Property, Plant and Equipment Other assets depreciation policy Other assets Intangible assets Patent, copyright, Trademark, Goodwill Recorded at costs R&D is an expense How to estimate Patents, human capital in labor, management skills, growth opportunity and goodwill?

Balance Sheet Analysis When analyzing a balance sheet, the financial manager should be aware of three concerns: Accounting liquidity Debt versus equity Value versus cost

Accounting Liquidity Refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid. The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets.

Debt versus Equity Generally, when a firm borrows it gives the bondholders first claim on the firm’s cash flow. Thus shareholder’s equity is the residual difference between assets and liabilities.

Value versus Cost Under GAAP audited financial statements of firms in the NCKU carry assets at cost. Market value is a completely different concept.

The Income Statement The income statement measures operating performance over a specific period of time.

NCKU COMPOSITE CORPORATION NCKU Income Statement NCKU COMPOSITE CORPORATION Income Statement 20X2 (in $ millions) The operations section of the income statement reports the firm’s revenues and expenses from principal operations Total operating revenues $2,262 Cost of goods sold - 1,655 Selling, general, and administrative expenses - 327 Depreciation - 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense - 49 Pretax income $170 Taxes - 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43

NCKU COMPOSITE CORPORATION NCKU Income Statement NCKU COMPOSITE CORPORATION Income Statement 20X2 (in $ millions) The non-operating section of the income statement includes all financing costs, such as interest expense. Total operating revenues $2,262 Cost of goods sold - 1,655 Selling, general, and administrative expenses - 327 Depreciation - 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense - 49 Pretax income $170 Taxes - 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43

NCKU COMPOSITE CORPORATION NCKU Income Statement NCKU COMPOSITE CORPORATION Income Statement 20X2 (in $ millions) Total operating revenues $2,262 Cost of goods sold - 1,655 Selling, general, and administrative expenses - 327 Depreciation - 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Usually a separate section reports as a separate item the amount of taxes levied on income. Interest expense - 49 Pretax income $170 Taxes - 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43

NCKU COMPOSITE CORPORATION NCKU Income Statement NCKU COMPOSITE CORPORATION Income Statement 20x2 (in $ millions) Total operating revenues $2,262 Cost of goods sold - 1,655 Selling, general, and administrative expenses - 327 Depreciation - 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense - 49 Net income is the “bottom line”. Pretax income $170 Taxes - 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43

Deferred Tax Results from difference in accounting and taxable income Accounting purpose is usually to match revenue and costs to present firm performance Tax purpose may be to reducing current tax payable to government.

Example Accounting Purpose Y1 50000 30000 20000 5000 Tax Purpose Y1 45000 5000 1250 3750 Y2 30000 20000 5000 0 Y3 15000 35000 8750 -3750 Accounting Income Before Depreciation and Tax Income tax expense (25%) Straight Line Depreciation Accounting Income before Tax Taxable Income Income Tax payable Increase in Deferred Tax Tax Depreciation

Income Statement Analysis None Cash Items Depreciation is the most apparent. No firm ever writes a check for “depreciation”.

Statement of Cash Flow Cash flow comes in from three channels: Operating activities Non-cash flow items from income statement Changes in operation-related items Investment activities Balance sheet Financing activities Right-hand side of balance sheet

Cash Flow from Operating Activities

NCKU Cash Flow from Operations Net Income Depreciation Deferred Taxes $86 90 13

To Estimate Operating Cash Flow NCKU COMPOSITE CORPORATION Income Statement 20X2 (in $ millions) Collect all revenues? Total operating revenues $2,262 Cost of goods sold - 1,655 Related with  inventory Selling, general, and administrative expenses - 327 Depreciation - 90 Operating income $190 Related with AP Other income 29 Earnings before interest and taxes $219 Interest expense - 49 Pretax income $170 Taxes - 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43

An example Sales: $2262 Minus AR $269 this year? Plus AR $280 last year $2262 - $269 + $280 = $2262 - ($269 - $280) = $2273 > $2262 Changes in AR  in assets: inflow, so………. in assets : outflow

Cash Inflow vs. Outflow Increase in asset Increase in liability Increase in inventory Increase in AR

Estimate Operating Cash Flow (DIY) (in $ millions) 20X2 and 20X1 Balance Sheet NCKU COMPOSITE CORPORATION Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

NCKU Cash Flow from Operations To calculate cash flow from operations, start with net income, add back non-cash items like depreciation and adjust for changes in current assets and liabilities (other than cash). Operations Net Income Depreciation Deferred Taxes Changes in Assets and Liabilities Accounts Receivable Inventories Accounts Payable Accrued Expenses Other Total Cash Flow from Operations $86 90 13 -24 11 16 18 $202 -8

Cash Flow from Investment Activities What are they?

The Balance Sheet of the NCKU Corp. (in $ millions) 20X2 and 20X1 Balance Sheet NCKU COMPOSITE CORPORATION Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Net = 149 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Net = 24 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

NCKU Flow from Investing Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures). Acquisition of fixed assets Sales of fixed assets Total Cash Flow from Investing Activities -$198 25 -$173

Cash Flow from Financing Activities What are they?

The Balance Sheet of the NCKU Corp. (in $ millions) 20X2 and 20X1 Balance Sheet NCKU COMPOSITE CORPORATION Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

NCKU Cash Flow from Financing Net = 13 Cash flows to and from creditors and owners include changes in equity and debt. Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total Cash Flow from Financing -$73 86 -43 43 $4 -6 Change in notes payable -3

The Balance Sheet of the NCKU Corp. (in $ millions) 20X2 and 20X1 Balance Sheet NCKU COMPOSITE CORPORATION Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Net = 43 Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

NCKU Cash Flow from Financing Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total Cash Flow from Financing -$73 86 -43 43 $4 -6 Change in notes payable -3

NCKU Statement of Cash Flows Operations Net Income Depreciation Deferred Taxes Changes in Assets and Liabilities Accounts Receivable Inventories Accounts Payable Accrued Expenses Other Total Cash Flow from Operations $86 90 13 -24 11 16 18 $202 -8 Acquisition of fixed assets Sales of fixed assets Total Cash Flow from Investing Activities -$198 25 -$173 Investing Activities Financing Activities Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total Cash Flow from Financing -$73 86 -43 43 $4 -6 Change in Cash (on the balance sheet) $33

Current Assets – Current Liability Net Working Capital Net Working Capital = Current Assets – Current Liability NWC is usually growing with the sales.

The Balance Sheet of the NCKU (in $ millions) 20X2 and 20X1 Balance Sheet NCKU COMPOSITE CORPORATION $252m = $707- $455 Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 $275m = $761m- $486m Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Here we see NWC grow to $275 million in 20X2 from $252 million in 20X1. Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: $23 million Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 par value) 55 32 Capital surplus 347 327 This increase of $23 million is an investment of the firm. Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

Financial Ratios

Leverage Ratios Problem with high leverage? The effect of high leverage 3

Leverage Ratios total liabilities Total debt ratio = total assets Times interest earned = EBIT interest payments Cash cover age ratio = EBIT + depreciation interest payments 4

Liquidity Ratios 6

Some points To have better-looking current ratio Shift short-term debt to long-term debt Importance of maturity match between financing and investment

Efficiency Ratios # of days for the goods to be produced and sold How Quickly customers pay their bills 8

Profitability Ratios 9

Profitability Improvement? Earnings Management Early reorganization of sales Cuts in R&D spending Assets sales Increase in other incomes Changes in accounting policies

Other Profitd-related Ratios 10

Market Value Ratios Multiples 11

The DuPont System A breakdown of ROE and ROA into component ratios: 13

The DuPont System 14

The DuPont System Asset turnover Net profit margin 15

The DuPont System 16

The DuPont System leverage ratio asset turnover profit margin debt burden 17

Problems of Ratios Accounting value is not market value Account receivable may never get into your pocket The choice of accounting method Diversification reduces the clarity of financial statements How to choose appropriate benchmark? Window Dressing

Lessons from Using FS Analysis FSs are generally not exact estimation of inventory, bad debts and others There is a wide managerial latitude in accounting policy Accounting looks backward FSs are just a snapshot in time, providing little most recent information Ratios help, but not always trust-worthy

Lessons from Using FS Analysis You should keep in mind: Measures of profitability do not take risk or timing of cash flows into account. Financial ratios are linked to one another.

Conclusions Financial analysis is like a lamp shining on a dim landscape, it neither shines very far into the future, nor completely illuminating current conditions