1. FINANCIAL ANALYSIS Principles of Corporate Finance Tenth Edition Understanding Financial Statement Financial Statement Analysis Slides by Matthew Will McGraw-Hill/Irwin

2. Dr Noryati Ahmad Understanding Financial Statements: Income statement Balance sheet Statement of Retained Earnings Statement of Cash Flows Understanding Financial Statements: Income statement Balance sheet Statement of Retained Earnings Statement of Cash Flows

3. Dr Noryati Ahmad Why this topic matters to you? Management – Need to understand who are interested in the stockholders’ report and why. – How the financial statements will be analyzed by those both inside and outside the firm? Marketing – Understand the effects of your decisions on the financial statements, particularly the income statement and the statement of cash flows – How analysis of ratios, especially those involving sales figures will affect the firm’s decisions about levels of inventory, credit policies and pricing decisions.

4. Dr Noryati Ahmad Why this topic matters to you? Operations – How costs of operations are reflected in the firm’s financial statements – How analysis of ratios, especially those of assets, cost of goods sold or inventory could affect requests for new equipment or facilities Information systems – What data should be included in the firm’s financial statements to design systems that will supply such data to those preparing the financial statements and to those who use the data for ratio calculations

5. Dr Noryati Ahmad 1. The Income Statement 2.The Balance Sheet 3.Statement of Retained Earnings 4.Statement of Cash Flows The Four Key Financial Statements:

6. Dr Noryati Ahmad The Four Key Financial Statements: Income statement – summarizes a firm’s revenues and expenses over a given period of time.

7. Lowe’s Companies

8. Dr Noryati Ahmad SALES - EXPENSES = PROFIT Income Statement

9. Dr Noryati Ahmad SALES - EXPENSES = PROFIT Income Statement Revenue

10. Dr Noryati Ahmad Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold

11. Dr Noryati Ahmad Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses

12. Dr Noryati Ahmad Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative)

13. Dr Noryati Ahmad Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative) Financing Costs

14. Dr Noryati Ahmad Income Statement SALES - EXPENSES = PROFIT Cost of Goods Sold Operating Expenses (marketing, administrative) Financing Costs Taxes

15. Dr Noryati Ahmad SALES - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS Income Statement

16. Dr Noryati Ahmad SALES - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS Income Statement

17. Dr Noryati Ahmad SALES - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS Income Statement

18. Dr Noryati Ahmad The Four Key Financial Statements: Balance sheet – provides a snapshot of a firm’s financial position at one point in time.

19. Dr Noryati Ahmad The Balance Sheet summarizes firm’s financial position at a given point in time. assets - what firm owns, liabilities - what firm has borrowed, equity represents owners’ investment. ASSETS LIABS & OE Short-lived assets Current assets Long-lived real assets Fixed assets Non-physical assets like patents & trademarks Intangible assets LIABS & OE Short-term liabilities Current liabilities Debt obligations Debt Equity investment Equity

20. Lowe’s Companies

22. Other Data (end of 2008) Net working capital = current assets - current liabilities = 9,251 – 8,022 = $1,229 million Total revenues - costs - depreciation = EBIT 48,230 – 42,887 – 1,539 = $3,804 million 1,470 million shares outstanding Stock price =$18.19 per share

23. Dr Noryati Ahmad Balance Sheet Total Assets = Outstanding Debt + Shareholders’ Equity

24. Dr Noryati Ahmad Balance Sheet

25. Dr Noryati Ahmad Balance Sheet Assets

26. Dr Noryati Ahmad Balance Sheet Assets Liabilities (Debt) & Equity

27. Dr Noryati Ahmad Balance Sheet Assets Liabilities (Debt) & Equity Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Buildings and Land Other Assets Investments & patents Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term notes Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

28. Dr Noryati Ahmad Assets Current Assets:

29. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.

30. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. – Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

31. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. – Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets:

32. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. – Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land.

33. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. – Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets:

34. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. – Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets: any asset that is not a current asset or fixed asset.

35. Dr Noryati Ahmad Assets Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year. – Cash, marketable securities, accounts receivable, inventories, prepaid expenses. Fixed Assets: machinery and equipment, buildings, and land. Other Assets: any asset that is not a current asset or fixed asset. – Intangible assets, such as patents and copyrights.

36. Dr Noryati Ahmad Financing Debt Capital:

37. Dr Noryati Ahmad Financing Debt Capital: financing provided by a creditor.

38. Dr Noryati Ahmad Financing Debt Capital: financing provided by a creditor. Short-term debt:

39. Dr Noryati Ahmad Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months.

40. Dr Noryati Ahmad Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. – Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

41. Dr Noryati Ahmad Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. – Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. Long-term debt:

42. Dr Noryati Ahmad Financing Debt Capital: financing provided by a creditor. Short-term debt: borrowed money that must be repaid within the next 12 months. – Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes. Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

43. Dr Noryati Ahmad Financing Equity Capital:

44. Dr Noryati Ahmad Financing Equity Capital: shareholders’ investment in the firm.

45. Dr Noryati Ahmad Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders:

46. Dr Noryati Ahmad Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.

47. Dr Noryati Ahmad Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders:

48. Dr Noryati Ahmad Financing Equity Capital: shareholders’ investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm. Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

49. Dr Noryati Ahmad The Balance Sheet – Malaysian Style FIXED ASSETS (RM’000) Properties250,000 Land130,000 Subsidiary companies170,000550,000 Current Assets60,000 Current liabilities32,000 Net current assets28,000 Goodwill50,000 TOTAL NET ASSETS628,000 FINANCED BY: Share capital125,000 Share premium65,000 Reserves78,000 Total Shareholders Funds268,000 Debenture220,000 Mortgage bonds140,000 Total long-term liabilities360,000 TOTAL FINANCING628,000

50. Dr Noryati Ahmad Other data No. of shares EPS DPS Stock price Lease pmts 2002 100,000 -$1.602 $0.11 $2.25 $40,000 2001 100,000 $0.88 $0.22 $8.50 $40,000

51. Dr Noryati Ahmad The Four Key Financial Statements: Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends.

52. Dr Noryati Ahmad Statement of Retained Earnings (20X2) Balance of retained earnings, 31/12/20X1 Add: Net income, 20X2 Less: Dividends paid Balance of retained earnings, 31/12/20X2 $203,768 (160,176) (11,000) $32,592

53. Dr Noryati Ahmad The Four Key Financial Statements: Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

54. Dr Noryati Ahmad Cash flow Statement Shows how funds are generated and used during a certain period. Provides answers to questions such as: - Why was money borrowed during the period? - Why did firm issue additional shares? - What was done to firm's net profits? - How did firm retire long-term debt? - How did firm finance additional plants & equipments? not only provides insight into company’s investment, financing & operating activities and also ties together the income statement and previous and current balance sheets.

55. Dr Noryati Ahmad Concepts Behind the Statement of Cash Flows

56. Dr Noryati Ahmad Statement of Cash Flows (20X2) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops. (160,176) 116,960 378,560 353,600 (280,960) (572,160) (164,176)

57. Dr Noryati Ahmad Statement of Cash Flows (20X2) L-T INVESTING ACTIVITIES Investment in fixed assets FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing NET CHANGE IN CASH Plus: Cash at beginning of year Cash at end of year (711,950) 436,808 400,000 (11,000) 825,808 (50,318) 57,600 7,282

58. Dr Noryati Ahmad Financial Statements CASH FLOW STATEMENT Cash flows from Operations Net cash flows from operations after taxes and interest expenses Cash Flows from Investing Includes acquisition of real assets (capital expenditures) and disposal and purchase of financial assets. Cash flows from Financing Net cash flow from the issue and repurchase of equity, from the issue & repayment of debt and after dividend payments = Net Change in Cash Balance

59. Dr Noryati Ahmad ASSETS20X220X1Direction of Change SourcesUses Cash and cash equivalents178175+3 Account receivables678740-62 Inventories,1,3291,235+94 Prepaid Expenses2117+4 Accumulated tax prepayments3529+6 Current Assets2,2412,196 Fixed assets at costs1,5961,538 Less: Accumulated Depreciation(857)(791) Net Fixed Assets739747-8 Investment, Long Term65-+ Other Assets, Long Term205 Total Assets3,2503,148

60. Dr Noryati Ahmad LIABILITIES AND SHAREHOLDERS EQUITY 20X220X1Direction of Change SourcesUses Bank Loans and notes payable448356+92 Accounts Payable148136+12 Accrued Taxes36127-91 Other Accrued Liabilities191164+27 Current Liabilities823783 Long Term Debt631627+4 Shareholders’ Equity Common stock, RM1 par value 421 Additional paid-in capital361 Retained earning1,014956+58 Total shareholders’ equity1,7961,738 Total liabilities and shareholders’ equity 3,2503,148

61. Dr Noryati Ahmad SOURCES OF FUNDSUSES OF FUNDS Any decrease in assets (-) E.g. selling some fixed assets and reducing inventories are also sources of funds Any increase in assets (+) E.g. buying additional fixed assets and building up inventories are uses of funds Any increase in claims (liability/shareholders’ equity) (+) E.g. bank loan is a source of funds Any decrease in claims (liability/shareholders. Equity) (-) E.g. Settling company’s loan is a use of fund

62. Dr Noryati Ahmad Question???? Is an increase in cash a source or a use of fund?

63. Dr Noryati Ahmad Answer It is an asset, therefore an increase in an asset is said to be a use of fund. The real source might have been increased borrowing that could have gone to increase inventory but instead went to increase the cash account

64. Dr Noryati Ahmad Total operating CF + Total Investment CF + Total Financing CF Net change in Cash & MS* *Note: Net increase (decrease) in cash + marketable securities should be equal to difference between cash & MS on the balance sheet at the beginning and end of year.

65. Dr Noryati Ahmad Interpretation of Cash Flow Statement: CF related to: CF Pattern OperationsInvestmentsFinancing 1+-+ 2++- 3+-- 4-++ Explanations: 1 – using CF from operations & new financing for investment 2 – CF from operations and sale of assets used to reduce debt 3 – CF from operations used to expand business and repay creditors 4 – inadequate CF from operations, covered by selling assets and borrowing more or issuing more equity.

66. Dr Noryati Ahmad Free Cash Flows Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors).

67. Dr Noryati Ahmad Free Cash Flows Cash Flows from Assets = Cash Flows from Financing Cash flows generated through the firm’s assets = Cash flows paid to - or received from - the firm’s investors (creditors & stockholders)

68. Dr Noryati Ahmad Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets

69. Dr Noryati Ahmad Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Operating income + depreciation - cash tax payments

70. Dr Noryati Ahmad Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets [Change in current assets] - [change in non-interest bearing current liabilities]

71. Dr Noryati Ahmad Calculating Free Cash Flows: An Asset Perspective After-tax cash flow from operations less investment in net operating working capital less investments in fixed and other assets Change in gross fixed assets, and any other assets that are on the balance sheet.

72. Dr Noryati Ahmad EXERCISES

73. Interpretation of Financial Ratios

74. Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. It is of interest to shareholders, creditors, and the firm’s own management.

75. Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis – Used to evaluate a firm’s performance over time Cross-sectional analysis – Used to compare different firms at the same point in time

76. Using Financial Ratios: Types of Ratio Comparisons (cont.) Cross-sectional analysis – Industry comparative analysis One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance – Benchmarking A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate

77. Using Financial Ratios: Types of Ratio Comparisons (cont.) Combined Analysis – Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

78. Using Financial Ratios: Types of Ratio Comparisons (cont.) TABLE 1

79. Using Financial Ratios: Types of Ratio Comparisons (cont.) Figure 1

80. Common Size Balance Sheet For S&P Composite Index Firms during 2008

81. Common Size Income Statement For S&P Composite Index Firms during 2008

82. Financial Ratios 2008 Ratios for S&P 500 firms

83. Comparing Performance Lowe’sHome Depot Performance Measures Market value added ($ millions) 8,68417,856 Market to book ratio 1.52 EVA ($ millions) 7851,882 Return on capital (ROC) 119.3 Return on equity (ROE) 13.613.1 Return on assets (ROA) 7.76.1

84. Comparing Performance Lowe’sHome Depot Efficiency Measures Asset turnover 1.561.61 Inventory turnover 4.174.03 Days in inventory 87.690.5 Receivables turnover * 195.356.5 Average collection period (days) * 1.96.5 Profit margin 4.63.2 Operating profit margin 5.24.1

85. Comparing Performance

86. GROUPS OF FINANCIAL RATIOS Liquidity ratios  Measure ability to meet short-term obligations on time Efficiency ratios  Measure ability to convert various accounts into sales or cash Leverage ratios  Measure amount of other people’s money being used to generate profits Profitability ratios  Measure ability of the company to generate profits with respect to sales, assets, or owners’ funds Market ratios  Measure how well investors in the marketplace feel the firm is doing in terms of risk and return

87. LIQUIDITY RATIOS

88. Liquidity Ratios How solvent is the firm? Can it meet payments of short-term obligations? Show a firm’s ability to meet current liabilities with its most liquid assets

89. Liquidity Ratios

90. EFFICIENCY RATIOS

91. Measuring Efficiency OR For Lowe’s How fast are assets being converted into sales? Shows relative efficiency with which a firm utilizes its total assets to generate sales

92. Measuring Efficiency OR

93. Merging with suppliers or customers generally increases the profit margin, but this increase is offset by a reduction in asset turnover. The DuPont System

94. LEVERAGE RATIOS

95. Measuring Leverage

96. Degree of indebtedness? Ability to service interest? indicates relationship between funds provided by long-term creditors versus those provided by owners

97. Measuring Leverage leverage ratio asset turnover Operating profit margin debt burden

98. PROFITABILITY RATIOS

99. Measuring Profitability Net profit margin=Net profits Sales * profits after deducting all costs, expenses, interest and taxes measures management’s effectiveness in generating profits with available assets How much return with respect to sales? Assets? Investments?

100. Measuring Profitability Lowe’s Profitability Measurements

101. MARKET VALUE RATIOS

102. P/E Ratio=Market price of shares EPS Amount investors are willing to pay for every dollar of company’s earnings Used to assess investors’ confidence in a company Can be used as basis for share valuation

103. Lowe’s Companies Measuring Performance: Market-to-Book Ratio Ratio of market value of equity to book value of equity. Gives value investors willing to pay for every share of common stock. Enable comparison made with other firms.

104. Lowe’s Companies Market Capitalization – Total market value of equity, equal to share price times number of shares outstanding. Market Capitalization = $18.19 × 1,470 = $26,739 mil Market Value Added – Market capitalization minus book value of equity. MVA = $26,739 - $18,055 = $8,684 million

105. Market Values Stock market measures of company performance, 2008 (dollar values in millions). Companies are ranked by market value added.

106. Measuring Performance Economic Value Added (EVA) – Net income minus a charge for the cost of capital employed. Also called residual income. Residual Income – Net Dollar return after deducting the cost of capital or

107. Measuring Performance Economic Value Added (EVA) of Lowe’s

108. Measuring Performance

109. DuPont System of Analysis The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below

110. The DuPont System asset turnover Operating profit margin

111. The DuPont System A breakdown of ROE and ROA into component ratios

112. DuPont System of Analysis (cont.)

113. Modified DuPont Formula The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

114. ROE = 6.1% X 2.06 = 12.6% Modified DuPont Formula (cont.) Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return. Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields:

115. Exercises