1. FINANCE AND ACCOUNTING NON-FINANCIAL PROFESSIONALS
FOR
NON-FINANCIAL PROFESSIONALS
TRAINING COURSE
Business Research and Service Institute
Pennsylvania, USA
brasi.org

2. AGENDA
1. Introduction to Business and Finance
2. Analyzing Information in Financial Statements
3. Time Value of Money
4. Capital and Returns
5. Valuations and Terminology

3. AGENDA
1. Introduction to Business and Finance
2. Analyzing Information in Financial Statements
3. Time Value of Money
4. Capital and Returns
5. Valuations and Terminology

4. Session 2 Analyzing Information in Financial Statements
CISCOM
Session 2
Analyzing Information in Financial Statements
Business Research and Service Institute

5. Understanding Financial Statements and Cash Flows
RECAP
Understanding Financial
Statements and Cash Flows

6. Compute a company’s profits as reflected by its income statement.
Statement Outcome
Determine a firm’s financial position at a point in time based on its balance sheet.
Measure a company’s cash flows.
Describe the limitations of financial statements.
Calculate a firm’s free cash flows and financing cash flows. 5

7. THE INCOME STATEMENT

8. Sales – Expenses = Profits
The Income Statement
It is also known as Profit/Loss Statement
It measures the results of firm’s operation over a specific period.
The bottom line of the income statement shows the firm’s profit or loss for a period.
Sales – Expenses = Profits 7

9. Income Statement Terms
Revenue (Sales)
Money derived from selling the company’s product or service
Cost of Goods Sold (COGS)
The cost of producing or acquiring the goods or services to be sold
Operating Expenses
Expenses related to marketing and distributing the product or service, general administrative expenses and depreciation expense
Financing Costs
The interest paid to creditors
Tax Expenses
Amount of taxes owed, based upon taxable income 8

10. Figure A 9

11. Figure A (cont.) 10

12. Common-Sized Income Statement
Common-sized income statement restates the income statement items as a percentage of sales.
Common-sized income statement makes it easier to compare trends over time and across firms in the industry.
See Table 1

13. Table 1

14. Profit-to-Sales Analysis from Common-Sized Income Statement
See Table 1
Gross profit margin (or percentage of sales going towards gross profit) is 34.3%
Operating profit margin (or percentage of sales going towards operating profit) is 8.5%
Net profit margin (or percentage of sales going towards net profit) is 4.9%

15. THE BALANCE SHEET

16. The Balance Sheet
The balance sheet provides a snapshot of a firm’s financial position at a particular date.
It includes three main items: assets, liabilities, and owner-supplied capital (shareholders’ equity).
Assets (A) are resources owned by the firm.
Liabilities (L) and owner’s equity (E) indicate how those resources are financed:
A = L + E
The transactions in balance sheet are recorded at cost price, so the book value of a firm may be very different from its current market value. 15

17. Figure B

18. Balance Sheet Terms: Assets
Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include:
Cash
Accounts Receivable (payments due from customers who buy on credit)
Inventory (raw materials, work in process, and finished goods held for eventual sale)
Other assets (ex.: Prepaid expenses are items paid for in advance) 17

19. Balance Sheet Terms: Assets
Long-Term Assets: Fixed Assets and Other Assets
Fixed Assets
Include assets that will be used for more than one year. Fixed assets typically include:
Machinery and equipment, Buildings, Land
Other Assets
Assets that are neither current assets nor fixed assets. They may include long-term investments and intangible assets such as patents, copyrights, and goodwill. 18

20. Balance Sheet Terms: Liabilities
Debt (Liabilities)
Money that has been borrowed from a creditor and must be repaid at some predetermined date.
Debt could be current (must be repaid within twelve months) or long-term (repayment time exceeds one year). 19

21. Balance Sheet Terms: Liabilities
Short-Term Debt (Current Liabilities)
Accounts payable (Credit extended by suppliers to a firm when it purchases inventories)
Accrued expenses (Short-term liabilities incurred in the firm’s operations but not yet paid for)
Short-term notes (Borrowings from a bank or lending institution due and payable within 12 months)
Long-Term Debt
Borrowings from banks and other sources for more than one year 20

22. Balance Sheet Terms: Equity
Equity: Shareholder’s investment in the firm in the form of preferred stock and common stock. Preferred stockholders enjoy preference with regard to payment of dividend and seniority at settlement of bankruptcy claims.
Treasury Stock: Stock that have been repurchased by the company.
Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years. Note that retained earnings are not equal to hard cash! 21

23. Balance Sheet: A = L + E ASSETS (A) Total Assets LIABILITIES (L)
Current Assets
Fixed Assets
Total Assets
LIABILITIES (L)
Current Liabilities
Long-Term Liabilities
Total Liabilities
OWNER’S EQUITY (E)
Preferred Stock
Common Stock
Retained Earnings
Total Owner’s Equity
Total Liabilities + Equity 22

24. Table 2

25. Table 2
Total assets decreased by $752 million due to reduction in current assets and in net fixed assets.
Total debt and equity decreased by $752 million due to paying of $263 owed on accounts payable, repurchasing stock of $2.608 billion, receipt of $335 million from issue of new stock, and increase in retained earnings of $1.769 billion.

26. Table 2

27. Table 2 (columns 4 & 5) Common-sized balance sheet reveals:
Inventories account for 25% of total assets and most of current assets
The total assets consist of about one-third current assets and two-third fixed assets
Approximately 50% of the company’s assets are financed by debt and 50% by equity

28. Debt Ratio
Debt ratio is the percentage of assets that are financed by debt.
Debt ratio is an indication of “financial risk.” Generally, the higher the ratio, the more risky the firm is, as firms have to pay interest on debt regardless of the earnings or cash flow situation.

29. Net Working Capital Net Working Capital
= Current assets – current liabilities
The larger the net working capital, the better the firm’s ability to repay its debt.
Net working capital can be positive or zero or negative. It is generally positive.
An increase in net working capital may not always be good news. For example, if the level of inventory goes up, current assets will increase and thus net working capital will also increase. However, increasing inventory level may well be a sign of inability to sell. 28

30. MEASURING CASH FLOWS

31. Measuring Cash Flows
Profits in the financial statements are calculated on “accrual basis” rather than “cash basis” (see next slide for accrual basis accounting).
Thus, profits are not equal to cash.

32. Accrual Basis Accounting
Accrual basis is the principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid.
Thus, sales revenue recorded in the income statement includes both cash and credit sales. Similarly, inventory purchases may not be entirely paid for in cash as suppliers may extend credit for some of the purchases.
Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense.

33. Sources and Uses of Cash
Sources of Cash
Uses of Cash
Decrease in an Asset
Example: Selling inventories or collecting receivables provides cash
Increase in Liability or Equity
Example: Borrowing funds or selling stocks provides cash
Increase in an Asset
Example: Investing in fixed assets or buying more inventories uses cash
Decrease in Liability or Equity
Example: Paying off a loan or buying back stock uses cash

34. How to Measure a Firm’s Cash Flows

35. Three Sources of Cash Flows
Cash flows from Operations (ex. Sales revenue, labor expenses)
Cash flows from Investments (ex. Purchase of new equipment)
Cash flows from Financing (ex. Borrowing funds, payment of dividends)

36. Three Sources of Cash Flows (cont.)
If we know the cash flows from operations, investments, and financing, we can understand the firm’s cash flow position better, that is, how cash was generated and how it was used.

37. Income Statement Conversion: From Accrual to Cash Basis
Cash Flow from Operations: Five Steps
Add back depreciation.
Subtract (add) any increase (decrease) in accounts receivable.
Subtract (add) any increase (decrease) in inventory.
Subtract (add) any increase (decrease) in other current assets.
Add (subtract) any increase (decrease) in accounts payable and other accrued expenses.

38. Figure D

39. Home Depot (cash flow from operations)

40. Cash Flow from Investing in Long-Term Assets
Long-term assets include fixed assets and other long-term assets. A firm may be engaged in acquisition and sale of such assets leading to cash flows.
Home Depot’s spent $1.126 billion on fixed assets (as observed by the change in gross fixed assets) and $159 million on other assets.

41. Cash Flows from Financing the Business
Cash Inflows
Cash Outflows
Borrowings (as reflected by increase in short-term and long-term debt)
Owner(s) invest in business (as reflected by an increase in stockholders’ equity)
Repayment of debt (as shown by decrease in short-term and/or long-term debt)
Payment of dividend
Repurchase of stock

42. Financing the Business Illustrated: Home Depot

43. Table 3

44. Tips for Statement of Cash Flows
Consider one section at a time.
You need only 2 items from the income statement: net income and depreciation expense.
Consider change for all items in the balance sheet, except: ignore accumulated depreciation and net fixed assets; ignore change in retained earnings.

45. GAAP AND IFRS

46. GAAP and IFRS
U.S. follows GAAP (Generally Accepted Accounting Principles) – a set of standards, conventions and rules established by FASB.
Most other countries follow IFRS (International Financial Reporting Standards) – a set of broad and general principles established by IASB.
IFRS is simpler and allows more room for discretion.

47. INCOME TAXES AND FINANCE

48. Income Taxes and Finance
Computing Taxable Income for Corporation
Gross Income
Dollar sales from a product or service less cost of production or acquisition
Taxable Income
Gross income less tax deductible expenses, plus interest income received and dividend income received
Tax Deductible Expenses: Include operating expenses (marketing, depreciation, administrative expenses) and interest expense. Dividends paid are not deductible. 47

49. Computing Taxable Income Table 448

50. Table 5 49

51. ACCOUNTING MALPRACTICE AND LIMITATIONS OF FINANCIAL STATEMENTS

52. Accounting Malpractice and Limitations of Financial Statements
Since accounting rules give managers discretionary powers, it is possible that two firms with similar financial performance may report different results.
There have been several cases of accounting malpractice where rules have been broken!

53. Key Terms Accounts payable Accounts receivable
Accrual basis accounting
Accounting book value
Accrued expenses
Accumulated depreciation
Additional paid-in-capital
Balance sheet
Capital gains
Cash
Cash basis accounting
Common size financial statements
Common stock
Common stock holders
Cost of goods sold
Current assets
Current debt
Debt
Debt ratio
Depreciation expense
Dividends per share
Earnings before taxes
Earnings per share
Equity
Fixed costs
Fixed assets
GAAP
Gross fixed assets

54. Key Terms (cont.) Gross profit Gross profit margin IFRS
Income statement
Inventories
Liquidity
Long-term debt
Marginal tax rate
Mortgage
Net fixed assets
Net income
Net profit margin
Net working capital
Operating expenses
Operating income
Paid-in capital
Par value
Preferred stockholders
Profit margins
Retained earnings
Short-term notes (debt)
Statement of cash flows
Taxable income
Variable costs

55. Figure C

56. Table 6

57. Evaluating a Firm’s Financial Performance

58. Learning Outcome Statements
purpose and importance of financial analysis.
Calculate and use a comprehensive set of measurements to evaluate a company’s performance.
Describe the limitations of financial ratio analysis. 57

59. The Purpose of Financial Analysis

60. The Purpose of Financial Analysis
A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g., a given ratio of A:B = 30:10 means A is 3 times B.
A ratio by itself may have no meaning. Hence, a given ratio is compared to:
ratios from previous years
ratios of other firms and/or leaders in the same industry 59

61. Uses of Financial Ratios: Within the Firm
Identify deficiencies in a firm’s performance and take corrective action.
Evaluate employee performance and determine incentive compensation.
Compare the financial performance of different divisions within the firm. 60

62. Uses of Financial Ratios: Within the Firm
Prepare, at both firm and division levels, financial projections.
Understand the financial performance of the firm’s competitors.
Evaluate the financial condition of a major supplier. 61

63. Uses of Financial Ratios: Outside the Firm
Financial ratios are used by:
Lenders in deciding whether or not to lend to a company.
Credit-rating agencies in determining a firm’s credit worthiness.
Investors (shareholders and bondholders) in deciding whether or not to invest in a company.
Major suppliers in deciding to whether or not to extend credit to a company and/or in designing the specific credit terms. 62

64. Measuring Key Financial Relationships

65. Question 1 How Liquid Is the Firm? Can It Pay Its Bills?
A liquid asset is one that can be converted quickly and routinely into cash at the current market price.
Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with which non-cash assets can be converted to cash to meet the financial obligations. 64

66. How Liquid Is the Firm? Liquidity is measured by two approaches:
Comparing the firm’s current assets and current liabilities
Examining the firm’s ability to convert accounts receivables and inventory into cash on a timely basis

67. Measuring Liquidity: Perspective 1
Compare a firm’s current assets with current liabilities using:
1. Current Ratio
2. Acid Test or Quick Ratio 66

68. Table 1

69. Table 2

70. Current Ratio
Current ratio compares a firm’s current assets to its current liabilities.
Equation: 69

71. Current Ratio
Current ratio compares a firm’s current assets to its current liabilities.
Equation:
Home Depot = $13,479M ÷ $10,122M = 1.33
Home Depot has $1.33 in current assets for every $1 in current liabilities. Home Depot’s liquidity is marginally lower than that of Lowe’s, which has a current ratio of 1.40. 70

72. Acid Test or Quick Ratio
Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the year with the liabilities that should be paid within the year.
Equation: 71

73. Acid Test or Quick Ratio
Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the year with the liabilities that should be paid within the year.
Equation:
Home Depot = ($545M + $1,085M) ÷ ( $10,122M) = 0.16
Home Depot has 16 cents in quick assets for every $1 in current debt. Home Depot is more liquid than Lowe’s, which has 12 cents for every $1 in current debt. 72

74. Measuring Liquidity: Perspective 2
Measures a firm’s ability to convert accounts receivable and inventory into cash:
3. Average Collection Period
4. Inventory Turnover 73

75. Days in Receivables (Average Collection Period)
How long does it take to collect the firm’s receivables?
Equation: . 74

76. Days in Receivables (Average Collection Period)
How long does it take to collect the firm’s receivables?
Equation:
Home Depot = ($1,085M) ÷ ($20,399M/365) = days
Home Depot (at days) is slower than Lowe’s (at 16 days) in collecting accounts receivable. 75

77. Days in Inventory How long is the inventory held before being sold?
Equation: 76

78. Days in Inventory How long is the inventory held before being sold?
Equation:
Home Depot = ($10,625M) ÷ ($44,693 ÷ 365)= 86.77days
Home Depot carries inventory for a shorter time than Lowe’s (95.80 days). 77

79. Home Depot vs. Lowe’s: Question #1 Summary
Ratio
Home Depot
Lowe’s
Current Ratio
1.33
1.40
Quick Ratio
0.16
0.12
Avg. Collection Period
19.41 days
16 days
Days in inventory
86.77 days
95.80 days 78

80. Question 2: Are the Firm’s Managers using the Company’s Assets Wisely?
This question focuses on the profitability of the assets in which the firm has invested. We consider the following ratios to answer the question:
5. Operating Return on Assets
6. Operating Profit Margin
7. Total Asset Turnover
8. Fixed Assets Turnover 79

81. Operating Return on Assets (ORA)
ORA indicates the level of operating profits relative to the firm’s total assets.
Equation: 80

82. Operating Return on Assets (ORA)
ORA indicates the level of operating profits relative to the firm’s total assets.
Equation:
Home Depot = $5,803 ÷ $40,125M = or 14.5%
Thus managers are generating 14.5 cents of operating profit for every $1 of assets (Lowe’s=10.6%) 81

83. Disaggregation of Operating Return on Assets

84. Managing Operations: Operating Profit Margin (OPM)
OPM examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit.
Equation: 83

85. Managing Operations: Operating Profit Margin (OPM)
OPM examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit.
Equation:
Home Depot = $5,803 ÷ $67,997M = or 8.5%
Home Depot managers are better than Lowe’s in managing the cost of goods sold and operating expenses, as the Operating Profit Margin for Lowe’s is only 7.3%. 84

86. Managing Assets: Total Asset Turnover
This ratio measures how efficiently a firm is using its assets in generating sales.
Equation: 85

87. Managing Assets: Total Asset Turnover
This ratio measures how efficiently a firm is using its assets in generating sales.
Equation:
Home Depot = $67,997 ÷ $40,125M = 1.69X
Home Depot is generating $1.69 in sales for every $1 invested in assets, which is higher than Lowe’s (1.45X). 86

88. Managing Assets: Fixed Asset Turnover
Examines efficiency in generating sales from investment in “fixed assets”
Equation: 87

89. Managing Assets: Fixed Asset Turnover
Examines efficiency in generating sales from investment in “fixed assets”
Equation:
Home Depot = $67,997M ÷ $25,060M = 2.71X
Home Depot generates $2.71 in sales for every $1 invested in fixed assets, which is much higher than Lowe’s (2.21X) 88

90. Figure 3

91. Home Depot vs. Lowe’s: Question #2 Summary
Ratio
Home Depot
Lowe’s
Operating Return on Assets
14.5%
10.6%
Operating Profit Margin
8.5%
7.3%
Total Asset Turnover
1.69X
1.45X
Fixed Asset Turnover
2.71X
2.21X 90

92. Question 3: How Is the Firm Financing Its Assets?
Here we examine the question: Does the firm finance its assets by debt or equity or both? We use the following two ratios to answer the question:
9. Debt Ratio
10. Times Interest Earned 91

93. Debt Ratio
This ratio indicates the percentage of the firm’s assets that are financed by debt (implying that the balance is financed by equity).
Equation: 92

94. Debt Ratio
This ratio indicates the percentage of the firm’s assets that are financed by debt (implying that the balance is financed by equity).
Equation:
Home Depot = $21,236M ÷ $40,125M = 0.53 or 53%
Home Depot finances 53% of it’s assets by debt and 47% by equity. This ratio is higher than Lowe’s debt ratio of 46%. 93

95. Times Interest Earned
This ratio indicates the amount of operating income available to service interest payments.
Equation: Times Interest Earned = Operating Profits ÷ Interest Expense 94

96. Times Interest Earned
This ratio indicates the amount of operating income available to service interest payments.
Equation: Times Interest Earned = Operating Profits ÷ Interest Expense
Home Depot = $5,803M ÷ $530M = 10.9X
Home Depot’s operating income is nearly 11 times the annual interest expense and higher than Lowe’s (9X) due to its relatively higher operating profits. 95

97. Times Interest Earned Note:
Interest is not paid with income but with cash.
Oftentimes, firms are required to repay part of the principal annually.
Thus, times interest earned is only a crude measure of the firm’s capacity to service its debt.

98. Home Depot vs. Lowe’s: Question #3 Summary
Ratio
Home Depot
Lowe’s
Debt Ratio
53%
46%
Times Interest Earned
10.9X
9.0X 97

99. Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by the Company’s Shareholders?
This is analyzed by computing the firm’s accounting return on common stockholder’s investment or return on equity (ROE).
Equation: 98

100. Note common equity includes both common stock and retained earnings.
Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by the Company’s Shareholders?
This is analyzed by computing the firm’s accounting return on common stockholder’s investment or return on equity (ROE).
Equation:
Note common equity includes both common stock and retained earnings. 99

101. ROE Home Depot = $3,338M ÷ $18,889M = 0.177 or 17.7%
Owners of Home Depot are receiving a higher return (17.7%) compared to Lowe’s (11.1%).
One of the reasons for higher ROE is the higher return on assets generated by Home Depot.
Also, Home Depot uses more debt. Higher debt translates to higher ROE under favorable business conditions.

102. Figure 4

103. Question #4 Summary: Home Depot vs. Lowe’s
Ratio
Home Depot
Lowe’s
Return on Equity
17.7%
11.1%
102

104. Question 5: Are the Firm’s Managers Creating Shareholder Value?
We can use two approaches to answer this question:
Market value ratios (P/E)
Economic Value Added (EVA)
These ratios indicate what investors think of management’s past performance and future prospects.
103

105. Price/Earnings Ratio
Measures how much investors are willing to pay for $1 of reported earnings.
Equation:
104

106. Price/Earnings Ratio
Measures how much investors are willing to pay for $1 of reported earnings.
Equation:
Home Depot = $36.77 ÷ $2.06 = 17.85X
Investors are willing pay more for Home Depot for every dollar of earnings per share compared to Lowe’s ($17.85 for Home Depot versus $16.90 for Lowe’s).
105

107. Price/Book Ratio Equation:
Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet.
Equation:
106

108. Price/Book Ratio Equation:
Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet.
Equation:
Home Depot = $36.77 ÷ $11.64 = 3.16X
A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid. The ratio is significantly higher than Lowe’s ratio of 1.95X suggesting that Home Depot is perceived as having better growth prospects relative to its risk.
107

109. Economic Value Added (EVA)
Shareholder value is created if the firm earns a return on capital that is greater than the investors’ required rate of return.
EVA attempts to measure a firm’s economic profit, rather than accounting profit. EVA recognizes the cost of equity in addition to the cost of debt (interest expense)
108

110. EVA for Home Depot Operating Return on assets = 14.5%
Total assets = $ billion
Assume cost of capital = 10%
EVA = (14.5% – 10%)* $40.125b = $1.806b

111. Question #5 Summary: Home Depot vs. Lowe’s
Ratio
Home Depot
Lowe’s
Price/Earnings
17.85X
16.90X
Price/Book Ratio
3.16X
1.95X
110

112. The limitations of financial ratio analysis

113. The Limitations of Financial Ratio Analysis
It is sometimes difficult to identify industry categories or comparable peers.
The published peer group or industry averages are only approximations.
Industry averages may not provide a desirable target ratio.
Accounting practices differ widely among firms.
A high or low ratio does not automatically lead to a specific conclusion.
Seasons may bias the numbers in the financial statements.
112

114. Key Terms Accounts receivable turnover ratio Acid-test (quick) ratio
Asset efficiency
Current ratio
Days in inventory
Days in receivables (average collection period)
Debt ratio
Economic value added
Financial ratios
Fixed asset turnover
Inventory turnover
Liquidity
Operating profit margin
Operating return on assets (OROA)
Price/book ratio
Price/earnings ratio
Return on equity
Times interest earned
Total asset turnover

115. Figure 2

116. Table 3

117. Table 3 (cont.)