Chapter 3: Interpreting Financial Statements Objective Contrast Economic and Accounting Models <=> Value of Accounting Information Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc.

Financial Statements Review Financial Statements Provide: current and historical information to owners and creditors a convenient way for owners and creditors to set performance targets a convenient standard template for financial planning

Chapter 3 Contents 3.1 Functions of Financial Statements 3.2 International Differences in Accounting 3.3 Market values v. Book Values 3.4 Accounting v. Economic Measures of Income 3.5 Return on Shareholders v. Return on Equity 3.6 Analysis Using Financial Ratios 3.7 The Financial Planning Process 3.8 Constructing a Financial Planning Model 3.9 Growth & the Need for External Financing 3.10 Working Capital Mgnt. 3.11 Liquidity & Cash Mgnt.

3.1 Functions of Financial Statements Provide information to the owners & creditors of a firm about the current status and past performance Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm Provide a convenient templates for financial planning

3.2 Review of Financial Statements

The Balance Sheet Summarizes a firms assets, liabilities, and owner’s equity at a moment in time Amounts measured at historical values and historical exchange rates Prepared according to GAAP, Generally Accepted Accounting Principles GAAP modified occasionally by the Financial Accounting Standards Board Exchange-listed companies must comply with Securities and Exchange Commission (SEC) rules

The Balance Sheet Major Divisions: Assets Current assets (less than a year) Long-term assets (longer than a year Depreciation Liabilities and Stockholder’s Equity Liabilities Current Liabilities Long-term debt Equity

The Income Statement Summarizes the profitability of a company during a time period Major Divisions: Revenue & cost of goods sold Gross margin General administrative and selling expenses (GS&A) Operating income Debt service Taxable income Corporate Taxes Net income

The Income Statement Important Reminders: Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity Accounts show historical values, not market values. The shareholder’s equity may be much higher or lower than the market value of the firm. The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet

The Cash-Flow Statement Show the cash that flowed into and from a firm in during a time period Focuses attention on a firm’s cash situation A firm may be profitable and short of cash Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes

3.4 Returns to Shareholders v. Return on Equity Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income This is the Total Shareholder Return

Returns to Shareholders v. Return on Equity (Continued) Traditionally, corporate performance has been measured by Return on Equity, ROE

Profitability

Asset Turnover

Financial Leverage

Liquidity

Market Value

Ratio Comparisons Establish Your Perspective Benchmarks Sources Shareholder employee, Management, or Union Creditor Predator, Customer, Supplier, Competitor, Trade Association Benchmarks Other companies ratios The firm’s historical ratios Data extracted from financial markets Sources Dun & Bradstreet, Robert Morris, Commerce Department's Quarterly Financial Report, Trade Associations

Relationships Amongst Ratios It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with:

Illustration (Table 3.7 & 3.8 of textbook) Consider two firms that are identical except that Nodebt is financed using $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and $500,000 of debt further assume that the EBIT of both firms is $120,000 and tax is 40%

Case: Borrow at 10%

Case: Borrow at 15%

Case: Borrow at 10%: Effect of Business Cycle on ROE

External Funds Needed

Observation: Sometimes the new assets required to generate income are not a high as in this example, and the company may able to support a level of growth with no external funding (-0.00038 in our case)