1. Financial Statements in Financial Analysis
Chapter 2

2. Limitations of Financial Statements
Limitations of Financial Statements for Financial Analysis:
Historical
Accounting policy GAAP:
Inputs comparability
Constrains financial measurement
Theory of business is not sufficiently strong to give us absolute standard
Most ratios we benchmark with relative comparisons:
Industry average comparison
Trend analysis

3. Limitations of Financial Statements
The exception is finance and returns .
We always benchmark returns with a financial market opportunity cost (an absolute standard)
Ratios can be calculated in different ways by different financial analysts.
Financial statements and financial ratios are at best ½ of a complete analysis

4. Ratios: EBITDA margin (Net operating margin)
Measure of operating profitability per $1 of Sales.
Benchmark ≈ 12.5%

5. Invested Capital Investment Expenditure for an entire business:
Invested Capital (IC)
Definitions of Invested Capital:
The financial definition of IC:
IC is the total amount invested (expended)by financial asset holders of a firm into the financial assets of a firm

6. Invested Capital The financial definition
Bank Indebtedness + other S.T. Debt + Dividends Payable + Current Portion of L.T. Debt + L.T. Debt + Deferred Tax + Preferred Shares + Shared Capital + Retained Earnings + Other = Invested Capital

7. Invested Capital The operating definition of IC:
IC is the total amount invested (expended) by the firm into the business activity for the benefit of all the financial asset holders.
This investment can be decomposed into two parts:
Trade Capital
Fixed Assets

8. Invested Capital
Trade Capital is the net investment required to support the trading function of the firm (broadly defined)
Current Assets (CA) held to support Sales less CL held to support input purchase function (Account Payable, Accrued Liability, Taxes Payable, Wages Payable).
Net Working Capital (NWC), but exclude from CL those accounts which are purely financial in nature (S.T.Debt, Current portion of the L.T.Debt, Dividends Payable)

9. Invested Capital Balance Sheet
Fixed Assets (plant, property and equipment) to support the longer term production and commercial activities of the firm (plus other assets as appropriate)
Invested Capital Balance Sheet
Operational side: Financial side:
Trade Capital “Debt”
Net Fixed Assets “Equity”
Invested Capital Invested Capital

10. Invested Capital Ratios
Trade Capital to Invested Capital
Trade Capital to Sales

11. Invested Capital Ratios
Invested Capital turnover
Debt to Invested Capital

12. Return Ratios ROIC (after depreciation and after tax)
The Rate of Return on Equity (ROE)

13. The Relationship between ROIC and ROE
rD – interest rate on debt t – corporate tax rate

14. Free Cash Flow
Free Cash Flow (FCF) is the net flow of cash from business investment available and paid out to financial asset holders. Operating Definition – the after tax “benefits” of prior business investment less incremental business investment. After tax “benefits” of business investment is Funds From Operation (FFO)

15. Funds From Operation Two basic calculations for FFO: Top-down
FFO = (EBITDA – CCA)(1 – t) + CCA
Bottom-up
FFO = NI + Depreciation + Deferred Tax +
+ Other Non-cash charges + After Tax Interest

16. Free Cash Flow FCF = FFO – Incremental Investments
ΔTC
Capital Expenditure
Other business investments
FCF = FFO – ΔTC – CAPX - Other

17. Free Cash Flow What kind of companies have FCF positive ?
Old, mature (not new venture)
Profitable
Not growth oriented
What kind of companies have FCF negative?
New ventures
Growth oriented
Less profitable

18. Free Cash Flow
Financial Definition of FCF - sum of all payments out to financial asset holders.
FCF = After Tax Net Distribution to Debt-holders +
+ Net Distribution to Shareholders +
+ Net Distribution to Other Financial Asset-Holders
To Debt-holders: Interest*(1-t)
+ Principal Repayment
- New Borrowing
To Shareholders: Dividends
+ Share Repurchase
- New Issue of Shares

19. Credit Measures Ability to repay debt Inverse measure of Credit Risk
Times Interest Earned (Coverage Ratio)
Fixed Payments Coverage Ratio

20. Measures of Liquidity
Liquidity – ability to transform an asset into cash without loss of value
Current Ratio
Quick Ratio

21. Efficiency of Trade Capital Utilization
Account Receivable Turnover
Account Receivable Collection Period

22. Efficiency of Trade Capital Utilization
Inventory Turnover
Inventory Conversion Period

23. Efficiency of Trade Capital Utilization
Accounts Payable Turnover
Accounts Payable Deferral Period

24. The Cash Conversion Cycle
The Cash Conversion Cycle is the average amount of time that a dollar is “outside” the firm as it circulates through the fundamental working capital accounts of a firm. Cash Conversion Cycle = Inventory Conversion Period + Account Receivable Collection Period - Accounts Payable Deferral Period