Financial Statements in Financial Analysis Chapter 2

Limitations of Financial Statements Limitations of Financial Statements for Financial Analysis: Historical Accounting policy GAAP: Inputs comparability Constrains financial measurement Theory of business is not sufficiently strong to give us absolute standard Most ratios we benchmark with relative comparisons: Industry average comparison Trend analysis

Limitations of Financial Statements The exception is finance and returns . We always benchmark returns with a financial market opportunity cost (an absolute standard) Ratios can be calculated in different ways by different financial analysts. Financial statements and financial ratios are at best ½ of a complete analysis

Ratios: EBITDA margin (Net operating margin) Measure of operating profitability per $1 of Sales. Benchmark ≈ 12.5%

Invested Capital Investment Expenditure for an entire business: Invested Capital (IC) Definitions of Invested Capital: The financial definition of IC: IC is the total amount invested (expended)by financial asset holders of a firm into the financial assets of a firm

Invested Capital The financial definition Bank Indebtedness + other S.T. Debt + Dividends Payable + Current Portion of L.T. Debt + L.T. Debt + Deferred Tax + Preferred Shares + Shared Capital + Retained Earnings + Other = Invested Capital

Invested Capital The operating definition of IC: IC is the total amount invested (expended) by the firm into the business activity for the benefit of all the financial asset holders. This investment can be decomposed into two parts: Trade Capital Fixed Assets

Invested Capital Trade Capital is the net investment required to support the trading function of the firm (broadly defined) Current Assets (CA) held to support Sales less CL held to support input purchase function (Account Payable, Accrued Liability, Taxes Payable, Wages Payable). Net Working Capital (NWC), but exclude from CL those accounts which are purely financial in nature (S.T.Debt, Current portion of the L.T.Debt, Dividends Payable)

Invested Capital Balance Sheet Fixed Assets (plant, property and equipment) to support the longer term production and commercial activities of the firm (plus other assets as appropriate) Invested Capital Balance Sheet Operational side: Financial side: Trade Capital “Debt” Net Fixed Assets “Equity” Invested Capital Invested Capital

Invested Capital Ratios Trade Capital to Invested Capital Trade Capital to Sales

Invested Capital Ratios Invested Capital turnover Debt to Invested Capital

Return Ratios ROIC (after depreciation and after tax) The Rate of Return on Equity (ROE)

The Relationship between ROIC and ROE rD – interest rate on debt t – corporate tax rate

Free Cash Flow Free Cash Flow (FCF) is the net flow of cash from business investment available and paid out to financial asset holders. Operating Definition – the after tax “benefits” of prior business investment less incremental business investment. After tax “benefits” of business investment is Funds From Operation (FFO)

Funds From Operation Two basic calculations for FFO: Top-down FFO = (EBITDA – CCA)(1 – t) + CCA Bottom-up FFO = NI + Depreciation + Deferred Tax + + Other Non-cash charges + After Tax Interest

Free Cash Flow FCF = FFO – Incremental Investments ΔTC Capital Expenditure Other business investments FCF = FFO – ΔTC – CAPX - Other

Free Cash Flow What kind of companies have FCF positive ? Old, mature (not new venture) Profitable Not growth oriented What kind of companies have FCF negative? New ventures Growth oriented Less profitable

Free Cash Flow Financial Definition of FCF - sum of all payments out to financial asset holders. FCF = After Tax Net Distribution to Debt-holders + + Net Distribution to Shareholders + + Net Distribution to Other Financial Asset-Holders To Debt-holders: Interest*(1-t) + Principal Repayment - New Borrowing To Shareholders: Dividends + Share Repurchase - New Issue of Shares

Credit Measures Ability to repay debt Inverse measure of Credit Risk Times Interest Earned (Coverage Ratio) Fixed Payments Coverage Ratio

Measures of Liquidity Liquidity – ability to transform an asset into cash without loss of value Current Ratio Quick Ratio

Efficiency of Trade Capital Utilization Account Receivable Turnover Account Receivable Collection Period

Efficiency of Trade Capital Utilization Inventory Turnover Inventory Conversion Period

Efficiency of Trade Capital Utilization Accounts Payable Turnover Accounts Payable Deferral Period

The Cash Conversion Cycle The Cash Conversion Cycle is the average amount of time that a dollar is “outside” the firm as it circulates through the fundamental working capital accounts of a firm. Cash Conversion Cycle = Inventory Conversion Period + Account Receivable Collection Period - Accounts Payable Deferral Period