SESSION OBJECTIVES At the end of this session participants should be able to:  Understand the FIO model  Understand the process of value creation  Identify the drivers of value  Identify links between financial statements

The Process of Value Creation Creating economic value for the owners Selecting and sourcing prudent funding options Selecting and making sound resource commitments Operating resources in a competitive, cost-effective manner

The three basic decisions made by management Operating Decisions Financing Decisions Investment Decisions The Three Basic Business Decisions

INCOME STATEMENT ANALYSIS

THE INCOME STATEMENT IT IS OF PRIME IMPORTANCE TO CEO IT IS A PERIOD STATEMENT IT IS BASED ON THE ‘MATCHING’ PRINCIPLE STATEMENT OF VALUE CREATION REVENUE - EXPENSES = INCOME

INCOME STATEMENT CLASSIFICATIONS SALES PRICE X VOLUME REVENUE EXPENSES PRODUCT VS. DIRECT VS. PERIOD COST INDIRECT COST INCOME DIVIDENDS + RETAINED EARNINGS - = VARIABLE VS FIXED COST

INCOME STATEMENT ITEMS REVENUE Price X Volume - COST OF GOODS SOLD Product Cost Direct Expense Fixed and Variable Expense - SELLING,GENERAL, AND ADMINISTRATIVE Period Cost, Indirect Expense, Fixed and Variable Cost - INTEREST Financing Cost - TAXES = NET INCOME

COMMON SIZED ANALYSIS COMMON SIZE ANALYSIS CONVERTS EACH ITEM ON THE INCOME STATEMENT INTO A PERCENTAGE IN ORDER FOR ANALYSIS TO BE PERFORMED ON A COMMON BASIS. EACH ITEM IS EXPRESSED AS A PER CENT OF REVENUES. PERCENT OF TOTAL APPLES AND APPLES IDENTIFY TRENDS

COMMON SIZED ANALYSIS THE INCOME STATEMENT FACSIMILIE CO. For the Period Ending 12/31/XX REVENUES $ % - COST OF GOODS SOLD = GROSS MARGIN S.G.& A = OPERATING INCOME INTEREST EXPENSE = NET INCOME BEFORE TAX TAXES ON INCOME = NET INCOME 594 8

PERCENT ANALYSIS ALLOWS ONE TO TRACK CHANGES IN FINANCIAL STATEMENTS FROM ONE REPORTING PERIOD TO THE NEXT CALCULATE THE CHANGE IN AN ITEM, THEN, DIVIDE THAT BY PREVIOUS YEARS TOTAL EXAMPLE: PERCENT CHANGE = (THIS YEAR - LAST YEAR) DIVIDED BY LAST YEAR PERCENT CHANGE FOR COST OF GOODS: ( ) / 4849 = 16.0%

INCOME STATEMENT RATIOS RETURN ON SALES Net Income / Total Sales GROSS MARGIN Gross Margin / Total Sales S. G. & A. RATIO S.G.&A. Expenses / Total Sales INTEREST COVERAGE Operating Income / Interest Expense OPERATING MARGIN Operating Income / Sales NET MARGIN Net Income / Sales

INCOME STATEMENT- LINKS TO BALANCE SHEET BALANCE SHEET INCOME STATEMENT ACCOUNTS RECEIVABLE REVENUES INVENTORY - COST OF GOODS - OTHER EXPENSES RETAINED EARNINGS =NET INCOME

LIMITATIONS OF INCOME STATEMENT EXPENSES ARE NOT DETAILED DEPRECIATION AND COST OF GOODS ARE UNDERSTATED IN INFLATIONARY PERIODS CAPITALIZATION VS. EXPENSING IGNORES THE COST OF EQUITY FINANCING

SUMMARY INCOME STATEMENT PROVIDES INFORMATION  REVENUES  EXPENSES  NET INCOME YOU HAVE LEARNED HOW TO CALCULATE AND ANALYZE THE INCOME STATEMENT USING:  COMMON SIZE ANALYSIS  PERCENT CHANGE ANALYSIS ANALYSIS DOES NOT SHOW UNDERLYING CAUSES

BALANCE SHEET ANALYSIS

THE BALANCE SHEET IT IS A SNAP SHOT SHOWING WHAT THE COMPANY OWNS AND OWES AT A POINT IN TIME HOW MUCH DID WE INVEST? HOW IS THE INVESTMENT FINANCED? WHAT ASSETS DO WE OWN?  TANGIBLE/ INTANGIBLE  SHORT TERM/ LONG TERM ASSETS = LIABILITIES + OWNERS’ EQUITY IT IS OF PRIME IMPORTANCE TO CFO

THE BALANCE SHEET CURRENT ASSETS FIXED ASSETS CASH A/R INVEN- TORY OTHER NET P.&E. OTHER CURRENT LIABILITIES LONG TERM LIABILITIES OWNER’S EQUITY = ACCTS. PAYABLE WAGES PAYABLE ACCRUALS LONG TERM DEBT RETAINED EARNINGS

INVESTMENT IN FIXED ASSETS  DEPRECIATION EXPENSE  ACCUMULATED DEPRECIATION  DEPRECIATION METHODS F STRAIGHT LINE F ACCELERATED  BOOK VALUE  ECONOMIC VALUE

INVESTMENT IN WORKING CAPITAL WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES MEASURES THE NET INVESTMENT IN OPERATING CASH CYCLE WORKING CAPITAL NECESSARY TO:  PRODUCE PRODUCT  MAINTAIN DAY-TO-DAY OPERATIONS  MAKE SALES

CAPITAL DEBT + OWNER’S EQUITY = INVESTED CAPITAL ANY INVESTMENT EARNING RETURNS IS CAPITAL  DEBT: INTEREST  EQUITY: DIVIDENDS & STOCK PRICE BALANCE SHOWS HOW ASSETS WERE FINANCED LEVERAGE: PROPORTION OF CAPITAL FROM DEBT

INVESTMENT CAPITAL FROM INVESTMENT SHORT TERM LOANS WORKING CAPITAL LONG TERM DEBT = + OWNER’S EQUITY FIXED ASSETS THE RETURN TO THE PROVIDERS OF CAPITAL COMES FROM THE EARNINGS FROM INVESTMENTS

THE BALANCE SHEET AND MANAGEMENT ACTION WORKING CAPITAL LONG TERM LIABILITIES CREDIT POLICY DEBT POLICIES PRODUCTION SCHEDULES PENSIONS PAYMENT POLICY TAX DEFERMENT FIXED ASSETS OWNER’S EQUITY EQUIPMENT PURCHASES STOCK ISSUANCE ACQUISITIONS REPURCHASE LONG TERM INVESTMENTS DIVIDEND POLICY

BALANCE SHEET RATIOS QUICK RATIO DEBT AS A PERCENT OF CAPITALIZATION DEBT TO EQUITY FINANCIAL LEVERAGE DAY’S SALES O/S INVENTORY TURNOVER Current Assets - Inventories Current Liabilities Total Debt Debt + Equity Total Debt Equity Assets Equity Accounts Receivable Average Daily Credit Sales Cost of Goods Sold Average Inventory

BALANCE SHEET- LINKS TO THE INCOME STATEMENT BALANCE SHEET INCOME STATEMENT ACCOUNTS RECEIVABLE REVENUES INVENTORY - COST GOODS - OTHER EXPENSES RETAINED EARNINGS = NET INCOME

LIMITATIONS OF THE BALANCE SHEET HISTORICAL COST RESULTS IN UNDERVALUED ASSETS SUCH AS REAL ESTATE SOME LIABILITIES NOT RECORDED (OFF BALANCE SHEET FINANCING) INTANGIBLE ASSETS MIS-PRICED BALANCE SHEET LOOKS BACKWARD

SUMMARY BALANCE SHEET PROVIDES KEY INFORMATION SIZE OF ACCOUNT BALANCES NEW INVESTMENTS FINANCING OF NEW INVESTMENTS FINANCIAL TOOLS AVAILABLE TO ANALYZE BALANCE SHEET PERCENT CHANGE COMMON SIZE RATIO ANALYSIS

CASH FLOW STATEMENT

WHY EXAMINE CASH FLOW? A COMPANY IS A COLLECTION OF PROJECTS EACH GENERATING CASH. CASH FLOW STATEMENTS TOTAL THE SOURCES AND USES OF CASH FOR ALL PROJECTS. CASH FLOW STATEMENT ANALYSIS ALLOWS US TO DETERMINE: NEED FOR EXTERNAL FUNDING ABILITY TO PAY CASH RETURN TO INVESTORS RELATIONSHIP BETWEEN INVESTMENT AND GENERATION OF CASH IT IS OF PRIME IMPORTANCE TO COO

THE CASH FLOW CYCLE FOUR STAGES FINANCING INVESTING OPERATING RETURNING Financing Investing Operating Returning

THE CASH CYCLE- FINANCING (OWNER’S ) (LENDERS) CASH EQUITY LIABILITIES

THE CASH CYCLE- INVESTING CASH FIXED ASSETS LABOR, MATERIALS, OVERHEAD,ETC. INVENTORY

THE CASH CYCLE- OPERATING INVENTORY SALE REVENUE I.O.U. ACCOUNTS RECEIVABLE CASH SG&A

THE CASH CYCLE- RETURNING OWNERS LENDERS EQUITYLIABILITIES CASH TAXES

THE CASH CYCLE ACCOUNTS RECEIVABLE CASH TAXES FIXED ASSETS LAB, MTLS, ETC SG&A INVENTORY REVENUE EQUITY LIABILITIES

THE CASH FLOW STATEMENT RECONCILES THE BEGINNING AND ENDING CASH BALANCES CATEGORIZES CASH FLOW BY ACTIVITY OPERATING INVESTING FINANCING CASH FLOWS FROM OPERATIONS CASH FLOWS FROM INVESTING + CASH FLOWS FROM FINANCING + NET CHANGE IN CASH =