1 Finance School of Management Chapter 3: Interpreting Financial Statements Objective Contrast Economic and Accounting Models Value of Accounting Information

2 Finance School of Management Chapter 3 Contents  Review of Financial Statements  Market Values v. Book Values  Accounting v. Economic Measures of Income  Return on Shareholders v. Return on Equity  Analysis Using Financial Ratios  The Relation Among Ratios  Limitations of Ratio Analysis  Purpose and Process of Financial Planning  Managing Working Capital

3 Finance School of Management Review of Financial Statements  Financial Statements –Provide information (clues) 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 on the managers of the firm. –Provide a convenient templates for financial planning.

4 Finance School of Management The Balance Sheet  Summarizing a firm’s assets (what it owns), liabilities (what it owes), and net worth (owners’ equity) at a moment in time. –Amounts measured at historical values (acquisition cost) and historical exchange rates. –Prepared according to GAAP (Generally Accepted Accounting Principles). –Exchange-listed companies must comply with SEC (Securities and Exchange Commission) rules.

5 Finance School of Management  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 Net Working Capital = Current Assets - Liabilities –Long-term debt Equity The Balance Sheet

6 Finance School of Management GPC Balance Sheet at Dec 31, 2xx1 2xx1 2xx Market Price Per Share

7 Finance School of Management The Income Statement  Summarizing the profitability of a company during a time period. –the difference of revenues and expenses –also to be called the statement of the earnings or the statement of profit and loss

8 Finance School of Management  Major Divisions –Revenue & cost of goods sold Gross margin –General selling and administrative expenses (GS&A) Operating income –Interest expense Taxable income –Corporate Taxes Net income The Income Statement

9 Finance School of Management GPC Income Statement for Year Ending 2xx1 Sales revenues200.0 Cost of goods sold(110.0) *Gross margin90.0 Gen sell, & admin exp(30.0) *Operating income60.0 Interest expense(21.0) *Taxable income39.0 Income tax(15.6) *Net income23.4 Allocation to divs(10.0) *Chg retained earn13.4

10 Finance School of Management  It is important to remember –Retained earnings are not added to the cash balance of the firm, but are added to shareholder’s equity. –Accounts show historical values, not market values. The Income Statement

11 Finance School of Management The Cash-Flow Statement  Shows the cash that flowed into and from a firm 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. Net income is based on accrual accounting methods, and affected by many judgments about issues such as how to value the inventory, depreciate the tangible assets, and amortize the intangible assets.

12 Finance School of Management GPC Cash Flow Statement, for the Year ending Dec 31, 2xx1 Net income Depreciation Increase in acc rec(10.0) - Increase in invent(30.0) + Increase in acc pay12.0 *Total cash from operations Invest in new ppe(90.0) *Cash flow invest' activities(90.0) -Div paid(10.0) + Inc short-term debt94.6 *Cash flow from financing84.6 **Chng cash & mkt securities20.0

13 Finance School of Management GPC Income Statement for Year Ending 2xx1 Sales revenues200.0 Cost of goods sold(110.0) *Gross margin90.0 Gen sell, & admin exp(30.0) *Operating income60.0 Interest expense(21.0) *Taxable income39.0 Income tax(15.6) *Net income23.4 Allocation to divs(10.0) *Chg retained earn13.4 GPC Cash Flow Statement, for the Year ending Dec 31, 2xx1 Net income Depreciation Increase in acc rec(10.0) - Increase in invent(30.0) + Increase in acc pay12.0 *Total cash from operations Invest in new ppe(90.0) *Cash flow invest' activities(90.0) -Div paid(10.0) + Inc short-term debt94.6 *Cash flow from financing84.6 **Chng cash & mkt securities20.0

14 Finance School of Management Notes on Financial Statements  More information relevant to understanding the true financial condition of the company in the notes to the financial statements. –An explanation of accounting methods used –Greater details regarding certain assets or liabilities –Information regarding the equity structure of the firm –Documentation of changes in operations –Off-balance-sheet items

15 Finance School of Management Market Values v. Book Values  Book value: the official accounting values of assets and shareholders’ equity  Two reasons why the market price of a company’s stock does not equal its book value –The book value does not include all of a firm’s assets and liabilities. –The assets and liabilities included on a firm’s official balance sheet are valued at original acquisition cost less depreciation, rather than at current market value.

16 Finance School of Management  The accounting balance sheet often omits some economically significant assets. –Intangible assets: a good reputation, a knowledge base –Goodwill: the difference between the acquisition price and the book value when a firm is acquired  The accounting balance sheet also omits some economically significant liabilities. –Contingent liabilities: costly lawsuits Market Values v. Book Values

17 Finance School of Management  IBM’s equipment for shell molding –Purchased for $3.9 million 3 years ago –The book value at $2.6 million after 3 years depreciation –The market value has fallen to $1.2 million because of technological change in the manufacture of computer shells.  Inventory of copper to be used in the manufacturing process of heating furnaces –You paid $29,000 at the beginning of the year. –The market value has risen to $60,000.  For decision-making purposes, the correct value to use is the market value, whenever available. –Marking to market Which is Relevant for Financial Decision-Making

18 Finance School of Management  Accounting measure of net income Revenue - Expenses - Taxes  Economic measure of net income Net cash flow to shareholders + Change in value of existing shareholders’ equity –The accounting net income of GPC Corp. in 20x1 was $23.4 million. –Net cash flow to GPC shareholders was $10 million, and the price of GPC stock fell from $200 to $ Thus, its economic income in 20x1 was $10 million - $12.8 million = -$2.8 million Accounting v. Economic Measures of Income

19 Finance School of Management Returns to Shareholders v. Return on Equity  Recall:  This is the total shareholder return.  4%.1 200$ 8.2$ Re      Million StartPrice comeEconomicIn StartPrice ndsCashDivideStartPriceEndPrice turn Capital gain or loss Interest payments

20 Finance School of Management  Traditionally, corporate performance has been measured by Return on Equity, ROE % $ 4.23$    Million EquityShareholders Net Income EquityShareholders IncomeAccounting ROE Returns to Shareholders v. Return on Equity

21 Finance School of Management Analysis Using Financial Ratios  Despite the differences between accounting and economic financial principle, a firm’s published statements can often offer some clues about its financial condition and provide insights into its past performance that may be relevant for the future.

22 Finance School of Management Profitability  %6.7 2/ sEquityr'StockHolde NetIncome (RoE)EquityonReturn      %1.9 2/ alAssetsAverageTot EBIT (RoA) AssetsonReturn     % Sales EBIT (RoS) SalesonReturn  

23 Finance School of Management Asset Turnover    Times 3.0 2/ Assets Total Average Sales TurnoverAsset Times 7.0 2/ Inventory Average Sold Goods ofCost TurnoverInventory Times 6.3 2/ sReceivable Average Sales Turnover sReceivable            

24 Finance School of Management Financial Leverage Times ExpenseInterest EBIT EarnedInterest Times % Assets Total Debt Total Debt    

25 Finance School of Management Liquidity Times sLiabilitieCurrent sReceivableCash testor acid Quick, Times sLiabilitieCurrent AssetsCurrent     

26 Finance School of Management Market Value

27 Finance School of Management Ratio Comparisons  Establish Your Perspective –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

28 Finance School of Management Relationships Amongst Ratios  It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with: TurnoverAsset * Sales onReturn *   Assets Sales EBIT Assets EBIT RoA

29 Finance School of Management Differences between ROS and ATO across Industries  A “low” ROS or ATO ratio need not be a sign of a trouble firm. Supermarket chain Public utility ROSATOROA= *

30 Finance School of Management The Effect of Financial Leverage  An increase in a firm’s financial leverage will increase its ROE if and only if its ROA exceeds the interest rate on the borrowed funds.  Increased financial leverage magnifies the variability that firms experience in their ROE over the business cycle and increases the likelihood of bankruptcy.  From the perspective of a creditor, an increase in a firm’s debt ratio is generally a negative sign. ROE ＝ (1 － Tax Rate) ×[ROA ＋ Debt/Equity×(ROA － Interest Rate)]

31 Finance School of Management  A firm’s profitability as reflected in its financial statements may sometimes seem awful but may just be inevitable result of a long-run strategy of restructuring or repositioning which will ultimately make the firm much more profitable.  It is difficult to define a set of comparable firms to serve as a benchmark for judging a company’s performance.  Financial statements reflect the conventions of the accounting profession, which may not reflect what is most relevant from a financial decision-maker’s perspective. Limitations of Ratio Analysis

32 Finance School of Management The Financial Planning Process  Financial Planning is a dynamic process following a cycle of –making plans, –implementing them, and –revising them in the light of actual results.  Strategic plans  Planning horizon

33 Finance School of Management Steps of Financial Planning Process  Forecasting the key external factors that determine the demand for the firm’s products and its production costs.  Forecasting the firm’s revenues, expenses, cash flows, and estimating the implied need for external financing.  Establishing performance targets.  Measuring actual performance, correcting actions and adjusting targets.  Distributing the rewards and starting again the planning cycle.

34 Finance School of Management An Illustration: GPC  Percent-of-sales method –making a forecast of sales for the next year. –assuming that most of the items on the income statement and balance sheet will remain the same ratio to sales as in the previous year. Additional Financing Needed ＝ Change in Assets – Increase in Retained Earnings – Increase in Payables

35 Finance School of Management GPC Financial Statements: 2xx1-2xx3

36 Finance School of Management GPC Common-Size Financial Statements: 2xx1-2xx3 2xx1 Cash & mkt'ble secs6.0 Receivables24.0 Inventories30.0 Pp&e300.0 Assets360.0% payables 18.0 Short-term debt110.7 Long-term debt75.0 liabilities203.7 Shareholders’ equ xx22xx3Balance Sheet Sales revenues Cost of goods sold Gross margin Gen sell, & admin exp EBIT Interest expense taxes Net income dividends Chg retained earn 100.0% (55.0) 45.0 (15.0) 30.0 (15.0) (6.0) 9.0 (2.7) 6.3 2xx1 2xx22xx % (55.0) 45.0 (15.0) 30.0 (18.8) (4.5) 6.7 (2.0) % (55.0) 45.0 (15.0) 30.0 (22.2) (3.1) 4.7 (1.4) % %

37 Finance School of Management GPC Forecast Financial Statements: 2xx1-2xx3 15% 8%

38 Finance School of Management Sustainable Growth Rate  Assumptions: –The firm will not issue any new equity shares, so that growth in equity capital occurs only through the retention of earnings. –The firm will not increase its ratio of debt to equity, so that external debt financing will grow at the same rate as equity grows through retained earnings. Sustainable Growth Rate = Earings Retention Rate × ROE  Implications: –The maximum sustainable growth rate is equal to the firm’s ROE. –If a firm tries to grow faster than this rate, it will have to issue new shares and/or increase its debt.

39 Finance School of Management An Illustration: Rapid Industries 2xx0 2xx1 Assets$2,000,000 Debt1,000,000 Equity1,000,000 2xx22xx3Balance Sheet Sales Net income Dividends Chg retained earn &1,000, ,000 80, ,000 2xx1 2xx22xx3 &1,120, ,000 89, ,400 &1,254, , , ,528 $2,240,000 1,120,000 $2,508,800 1,254,400 $2,809,856 1,404,928  Asset Turnover = 0.5 Times per Year  Debt/Equity Ratio = 1.0  Dividend Payout Ratio = 0.4  ROE = 20% per Year Sustainable Growth Rate = 0.6 × 20%=12%

40 Finance School of Management  In most cases cash must be paid out to cover expenses before any cash is collected from the sale of the firm’s products. –If a firm’s need for working capital is permanent rather than seasonal, it usually seeks long-term financing for it. –Seasonal financing needs are met through short-term financing arrangements.  The main principle of efficient working capital management –To minimize the amount of the firm’s investment in nonearning assets such as receivables and inventories. –To maximize the use of “free” credit such as prepayments by customers, accrued wages, and accounts payable. Working Capital Management

41 Finance School of Management The Cash Flow Cycle Time OrderedArrives Finished Goods Sold Cash Received Invoice ReceivedCash Paid Payables Period Inventory Period Receivables Period Raw Material Purchased Cash Cycle Time  A firm can reduce its need for working capital by: –reducing the amount of time that goods are held in inventory. –collecting accounts receivable more quickly. –paying its own bills more slowly.