1. Financial Statements

2. The Big Three Accounting Statements
The Balance Sheet
The Income Statement
The Statement of Cash Flows

3. 1) The Balance Sheet A snapshot of the firm
Current Assets
Fixed Assets
Tangible Intangible
LHS
Shareholder Equity
Current Liabilities
Long-Term Debt
RHS
A snapshot of the firm
Assets ≡ Liabilities + Stockholder’s Equity
Left Hand Side must balance with the Right Hand Side

4. Balance Sheet Analysis
When analyzing a balance sheet, the Finance Manager should be aware of three concerns:
Liquidity
Debt versus Equity
Value versus Cost

5. Liquidity
Refers to the ease & quickness that an assets can be converted to cash without a significant loss in value
Generally the more liquid the asset the lower the rate of return
The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term cash obligations (Ex. payroll)
A profitable but illiquid firm will experience financial distress
Current assets are more liquid than fixed assets

6. Debt versus Equity Debt → Liability Equity is the residual
Promise to payout cash, an IOU
Equity is the residual
Assets – Liabilities ≡ Equity
Debt represents a senior claim on firm assets
If the firm goes bankrupt debt holders get paid before equity holders

7. Value versus Cost Cost: What did we pay for it
Accountants are historians
GAAP requires assets be recorded at cost
Book value
Market value: What would it cost TODAY
Cost and Market Value are two completely different concepts
What did we pay for it, versus what can we sell it for

8. 2) The Income Statement Income ≡ Revenue – Expenses
Measure how the company has performed over some period of time
Generally comprised of four parts:
Operating
Non-Operating
Taxes
Bottom Line

9. U.S.C.C. Income Statement Total operating revenues $2,262
Cost of goods sold
1,655
Selling, general, and administrative expenses
327
Depreciation 90
Operating income
$190
Other income 29
Earnings before interest and taxes
$219
Interest expense 49
Pretax income
$170
Taxes 84
Current: $71
Deferred: $13
Net income
$86

10. Income Statement Analysis
There are several things to keep in mind when analyzing an income statement:
INCOME IS NOT CASH
Matching Principal
Non-Cash Items

11. Matching
GAAP requires that revenues be recorded along with the expenses incurred to produce them
Thus, income may be reported even though no cash has changed hands

12. Non-Cash Items
The income statement will also record expenses, where no money is exchanged
Depreciation is the simplest example
No firm ever writes a check for “depreciation.”

13. Taxes
“In this world nothing is certain but death and taxes.” Ben Franklin
Taxes represent a major cost to the firm
Taxes are subject to political, not economic forces
Therefore taxes do not need to make economic sense
Companies are subject to two different tax rates
Marginal – the percentage paid on the next dollar earned
Average – the tax bill / taxable income

14. Marginal versus Average Rates
Suppose your firm earns $4 million in taxable income.
What is the firm’s tax liability?
.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,356,100
Rate from table 2.3
What is the average tax rate?
What is the marginal tax rate?
If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

15. 3) The Statement of Cash Flows
The three components are:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Attempts to change Net Income to a Cash number

16. U.S.C.C. Cash Flow from Operations
Start with net income, and then add back non-cash expenses , and changes in accounts
Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations
$86 90 13
-24 11 16 18 -3
$199 -8

17. U.S.C.C. Cash Flow from Investing
Cash flows from the acquisition sales of fixed assets (i.e., net capital expenditures).
The cash from sales of our fixed assets minus the cost of fixed assets we bought
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
-$198 25
-$173

18. U.S.C.C. Cash Flow from Financing
Cash flows to and from equity and debt investors in the firm
Retirement of debt (includes notes)
Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing
-$73 86
-43 43 $7 -6

19. Finance and the Accounting
Finance is concerned with:
Market Values and Cash Flows
Accounting:
Care about historical costs
Accounting numbers (NOT CASH)
But Accounting is often called the language of finance

20. Quick Quiz
What is the difference between book value and market value? Which should we use for decision making purposes?
What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
How do we determine a firm’s cash flows? What are the equations, and where do we find the information?

21. Financial Statements Analysis and Long-Term Planning
Chapter 3

22. Financial Statement Analysis
Attempts to compare different companies and/or to track how a company is developing
Relies of their financial statements
Generally follows 1 of 2 methods

23. 1) Common-Size Statements
Report everything as a percent the top number
Total assets for the Balance Sheet
Sales for the Income Statement

24. 2) Ratio Analysis Ratio of one financial number to another
Ask yourself:
How is the ratio computed?
What is the ratio trying to measure and why?
What does the value indicate?
How can we improve the company’s ratio?

25. Categories of Financial Ratios
Short-term solvency (liquidity ratios)
Long-term solvency (financial leverage ratios)
Asset management (turnover ratios)
Profitability ratios
Market value ratios

26. Liquidity Ratios
How easily can the firm meet its short term obligations
Why is this important?
Current Ratio = CA / CL
708 / 540 = 1.31 times
Quick Ratio (Acid Test) =(CA – Inventory) / CL
( ) / 540 = 0.53 times
Cash Ratio = Cash / CL
98 / 540 = 0.18 times

27. Leverage Ratios How easily can the firm meet its long term obligations
Why is this important?
Total Debt Ratio = (TA – TE) / TA
( ) / 3588 = 28%
Debt/Equity = TD / TE
(3588 – 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E
= 1.385

28. Coverage Ratios How easily can the firm payoff its debt holders
Why is this important?
Times Interest Earned = EBIT / Interest
691 / 141 = 4.9 times
Cash Coverage= (EBIT + Depreciation)/Interest
( ) / 141 = 6.9 times

29. Inventory Ratios How efficiently is the firm managing inventory
Why is this important?
Inventory Turnover = Cost of Goods Sold / Inventory
1344 / 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 3.2 = 114 days

30. Receivables Ratios How quickly does the firm get paid
Why is this important?
Receivables Turnover = Sales / Accounts Receivable
2311 / 188 = 12.3 times
Days’ Sales in Receivables = 365 / Receivables Turnover
365 / 12.3 = 30 days

31. Total Asset Turnover
How efficient is the firm turning assets into sales
Why is this important?
Total Asset Turnover = Sales / Total Assets
2311 / 3588 = 0.64 times
It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets. Why?

32. Profitability Measures
How efficient is the firm’s operations
Why is this important?
Profit Margin = Net Income / Sales
363 / 2311 = 15.7%
Return on Assets (ROA) = Net Income / Total Assets
363 / 3588 = 10.1%
Return on Equity (ROE) = Net Income / Total Equity
363 / 2591 = 14.0%

33. Breaking Down ROE
If we break down ROE we can see how firms generate returns for investors
ROE = NI / TE →PM * TAT * EM
Aside: Algebra
ROE = NI / TE
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM

34. Where are returns generated
ROE = PM * TAT * EM
Profit margin: How well does the firm controls costs
Total asset turnover: How well does the firm manages its assets
Equity multiplier: How levered is the firm
The better the managers handle these aspects of the firm the greater the return generated

35. Market Value Measures How do people feel about the firm
Why is this important?
PE Ratio = Price per share / Earnings per share
88 / 11 = 8 times
Market-to-book ratio = market value per share / book value per share
88 / (2591 / 33) = 1.12 times

36. Using Financial Statement Analysis
Ratios by themselves are not very useful
Is a profitability ratio of 9% good?
Time-Trend Analysis
Compare this years ratios to prior ratios
Peer Group Analysis
Compare your ratios to other firms in the industry

37. Issues with Financial Statement Analysis
There is no definitive way to run the analysis
It’s hard to find the right benchmarking
Especially for diversified firms
Firms use different accounting procedures, and year ends
Extraordinary, or one-time, events

38. Long-Term Financial Planning
These are the big decisions, planning where the company is going
Capital budgeting: Does Nike start a magazine?
Capital structure: Do we issue stock or bonds?
Generally these decisions are based on pro forma financial statement
Financial statements based on what we think will happen in the future

39. External Financing and Growth
At low levels of growth a company can use the cash it generates to meet its investment requirements
At higher levels of growth the company’s cash on hand will not be enough to finance all the investments the company wants, it now has to go to the capital market
Sell Stock or Bonds
External financing helps a firm grow faster than relying on internal funds alone

40. The Internal Growth Rate
This is how fast the company can grow using only the money it makes
IGR = (ROA * b )/ (1 – ROA * b)
b is the plowback ratio
Measure how much of net income is reinvested in the firm
b = Addition to Retained Earnings / Net Income

41. Calculating the Internal Growth Rate
Using the information from the Hoffman Co.
ROA = 66 / 500 = 0.132
b = 44/ 66 =
Internal Growth Rate
(ROA * b )/ (1 – ROA * b)
(0.132 * 0.667) / (1 – * )=
Hoffman Co. can grow at 9.65% using only internal funds

42. The Sustainable Growth Rate
This is how fast the firm can grow using internal funds and external funds, but leaving the D/E ratio the same
Will this be higher or lower than the IGR?
SGR = (ROE * b )/ (1 – ROE * b)

43. Calculating the Sustainable Growth Rate
Using the Hoffman Co.
ROE = 66 / 250 = 0.264
b = 0.667
Sustainable Growth Rate
(ROE * b )/ (1 – ROE * b)
(0.264 * 0.667) / (1 – * )= 0.214
Hoffman Co. can grow at 21.4% without changing its capital structure

44. Long-term Planning Caveats
Our financial planning models cannot tell us what is the best policy to follow
Our models are simplifications of the real world, and as such can miss important aspects of a situation
However, firms need to have a long-term plan

45. Quick Quiz
How do you standardize balance sheets and income statements?
Why is standardization useful?
What are the major categories of financial ratios?
How do you compute the ratios within each category?
What are some of the problems associated with financial statement analysis?

46. Quick Quiz What is the purpose of long-range planning?
What are the major decision areas involved in developing a plan?
What is the percentage of sales approach?
What is the internal growth rate?
What is the sustainable growth rate?
What are the major determinants of growth?