ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
GLOSSARY
The Market: Dow
DJIA = Dow Jones Industrial Average: 30 companies, cross section of industry, blue chip companies,
most stable  most NYSE but Apple isn’t. Weighted average of the stock prices, not market equity
capitalization (doesn’t consider # of shares issued). Rarely changes but w the BKs and the tech
increases there have been some. Dow is owned by CME Gp (sold by News Corp), the Dow Jones
Board determines which companies are on the Dow.
Bull Market: rising
Bear market: falling
S&P: Standard and Poor’s 500
B/c 500 companies instead of 30, it is more diverse than the Dow. Chosen on basis of market size,
liquidity, and industry. Weights market equity cap, not stock price.
Market Equity Capitalization: stock price x number of shares outstanding
Aka shareholder value, or equity value
Value driver: thing essential to long-term success of the business
Can be as basic as a quality advantage like a unique set of operative skills
Can be a intangible as the tech expertise of an R&D team
Other examples: hard to emulate business model; band recognition
Stock option: right to buy shares tomorrow at today’s price
Investment base: how much a company has to work with to create profit (?)
Working capital: current assets – current liabilities (can company pay off current liabilities if all due now)
Retained earnings: part of net profit not paid in dividends?
Bottom line – dividends = retained earnings
b/c bottom line already has expenses and capitalized expenses removed?
Solvency: ability to pay debt obligations when due
Liquidity: ability to convert to cash
PROFITS
Top line = gross revenues = net sales (?)
Subtract COGS to get gross profits
Gross profits = Revenues – COGS (or cost of earning revenue)
Subtract SG&A, repairs, and depreciation to get EBIT
Operating profits/EBIT = gross profts – addl operating costs
Subtract interest paid and earned to get pretax profits
Pretax profits = EBIT – other interest and expenses
Subtract taxes to get bottom line
Bottom line / net profit / net earnings = pretax profits – taxes
Top line gross revenue – COGS – SG&A – interest + other income – taxes = bottom line net
profits
Subtract dividends to get retained earnings
If extraordinary expenses, then this bottom line is called net profit from continuing
operations
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
THEMES
 Shareholder Value
 Give adequate return on capital invested  investors can freely move their money so we want to give
adequate return on investment to keep money, hence concern w stock price even tho essentially
meaningless
 Maximizing SH value in the long run results in all short term issues being met (employee satisfaction,
customer loyalty, etc)
 Financial Goals
 (1) Maximize SH value on a long-term basis
 (2)Maximize performance/growth with least commitment of resources
 Don’t tie up cash in A/R or inventories
 You need to generate profits to have a sustainable cash flow
 You get cash flow from selling goods, obtaining credit, issuing stock, selling PPE, borrowing money.
Of those, only selling goods is has no limits.
 You need to have revenue growth to generate profits
 Revenue growth is top line, which feeds to profits, bottom line
 Cash flow is ultimate driver of business and stock performance
OUTLINE
 INTRODUCTION TO ACCOUNTING AND FINANCE
 Sources of Financial Capital
 Debt (debtholders)  e.g. banks, public bonds, other long term debt
 Financial claim is the amount borrowed (principal) plus rate of return (interest)
 Financial claim backed by assets
 Priority over SH in BK
 Equity (stockholders)
 Owners of the company, represented by stock and voting interest
 Common stock: no guaranteed financial return, no claim to distribution of profits
 How do SH get income?
 Dividends
 Stock price appreciation
 What is Shareholder Value (or equity value or equity market cap)?
 Equity market cap: price per share x outstanding shares
 Public v Private held companies
 Public:
 traded on stock exchanges
 Full disclosure of financial information require
 Private
 Stock is illiquid
 Limited disclosure of financial information required
 Discussion of stock exchanges  see glossary above
 Creating SH Value  (1) dividends and (2) stock price appreciation
 How generally?
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
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 Manage risk
 Build future profits
 Increase cash flows
(1) Setting business strategy w deliberate recognition of the goal of creating SH value
 Competitive advantages
 Products
 Markets
 Investing/divseting using sound financial discipline
 E.g.: Motorola split in two and divested and sold its cell phone to Google?
(2) Narrow gap btwn potential and actual value-creation performance
 How well it could be run v. how well it actually is run
 How?
 Sell underutilized assets
 Divest underperforming business units
 Why?
 Hostile takeovers
 Running out of cash
 E.g. Kodak on BK edge, selling patents
(3) Understand what drives the value (value drivers and core competencies)
 4 prongs
 Branding
 Customer loyalty
 Strategic relationships
 Market selection
(4) Tie management compensation to value or value measure
 How
 Stock options: better performing company increases future value of stock so you make more
profit when you exercise the option in the future
 Restricted stock: delayed compensation (think Sec 79  )
 Long term orientation: I think this just means train management to orient themselves to the
long term? Or pay them based on long term and not short term performance?
 E.g. complaint against Wall Street is that management was rewarded based on short term results
and not long term value creation
(5) Communication w investors and customer stakeholders
 Release comprehensive, accurate, and timely information
 SH disclosure rules now:
 But now with Fair Disclosure Act 2000 you have to release all info to everyone at once? Not
key investors before?
 Downside of FD Act?
 Netflix didn’t “test drive” their split and price increase, resulted in huge backlash?
(6) Understand your customer
 Prongs
 Customer satisfaction
 Customer retention
 Competitiveness metrics
 Market surveys and data analysis
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
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E.g. FB data collection is THE reason for their success (b/c FB is indirect profit generator its
customers are the advertisers)
 Conscious Capitalism  creating SH value
 Conscious capitalism means integrating all interests of all stakeholders?
 If successfully implemented, it will support long term SH value creation
 Long term interests of shareholders should not be in conflict with other stakeholders
 Why?  boycotts, lawsuits, bad press, gov’t regulation
 E.g.: McDonald’s annual SH report from CEO
 Praises the deep base of management talent, the “three legged stool” method of
operator/owners, supplies, and employees, yet the “customer is the boss”  aka you hit all of the
strategies and you create SH value
 Financial Goals
 Maximize SH value on a long-term basis  long term consideration of SH value will also result if
meeting other stakeholders’ concerns and interests (e.g. employees)  conscious capitalism
 “sub-goal”: maximize performance/growth with least commitment of resources  minimize debt
and equity, retain profits to grow
 The Business System
 Overview
 All decisions reflect a trade-off
 Limited resources
 Cost/benefit analysis
 Impact short term v long term
 Operations: “utilization of assets/resources”
 Price and volume and operating costs (fixed and variable)
 Goal: “supporting revenue growth while keeping control of operational costs”
 Use marketing to increase revenues in desirable markets
 E.g. Barnes & Noble’s Nook saved it while Borders folded
 Operationally efficient
 Investment: “attainment of assets/resources”
 Creates an investment base, and depreciate the investment base
 New investment adds to investment base
 Disinvestment removes from investment base
 Depreciation reduces investment base (but can help increase new investment?)
 Goals
 Minimize investment required by company
 Fixed assets and working capital are investments required by company? And accounts
receivable?
 Whereas investing in PP&E and inventory tends to use outside financing?
 Can be just as bad to invest too little as too much
 Financing: “funding of assets/resources”
 The flow?
 start with operating profit after taxes: this is paid into:
  dividends
  interest on debt
  retained earnings
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
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Retained earnings are part of funding potential (representing SH equity), and long term debt
is other part of funding potential
 Goals:
 minimize level of investment required from investors
 retain profits to grow business
 External financing
 Long term debt
 Selling shares
 Internal financing
 Operating profit after taxes (minus interest and dividends) = retained earnings
Class exercise – airline industry – see notes
Financial Statements overview
 Operations section: income statement shows revenues, costs, profits
 Investment section: reflected on the Balance Sheet, snapshot in time
 Financing section: balance sheet as well
Business Models and Strategies
 Three Requirements to a Business Model
 (1) Positive customer value proposition
 Meet existing need in unique way, at a good value
 Develop a product which creates a not-yet-realized need
 (2) Establishing positive cash flow potential
 Profit margins (price goods high)
 Resource velocity (sell a lot at a low price)
 (3) Competitive differentiation
 Use key resources (people, branding, proprietary tech)
 Process strengths (consistency, scalable nature of business model)
 Generic Business Models
 Business Model: the process by which a company generates revenues and profits by meeting a
specified customer need.
 Direct Model  revenue from consumers, sale of goods
 Indirect model  revenue from 3rd party (e.g. advertisers)
 Hybrid model  user fee and 3rd party fee
 Businesses have no duty to disclose model to consumer stakeholder
Accounting Overview: Principles and Guidelines
 Foundational Principles for Accounting
 Relevance
 Reliability
 Comparability
 Consistency
 See if I can get notes re: what this means...I think it means the figure reported has to mean
something, be reliable representation of what is means, be comparable to other stats from other
businesses, and be consistent?
 The SEC  legal authority over accounting rules and practices
 Gets authority from Congress
 Delegates its accounting rulemaking and oversight to the Financial Accounting Standards
Board (FASB)  FASB promulgates guidelines and SEC accepts
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
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SEC purpose is to enforce proper financial disclosure of pertinent information pertaining to
public companies
 Does NOT opine on or ensure reasonableness of investments offered to the public
 US Guidelines: Generally Accepted Accounting Principles (GAAP)
 FASB determines GAAP, legally non-binding but establishes standards of practice
 SOX (2002)
 Established oversight and punishment for the accountants
 Reestablished the integrity of the financial reporting system
 Not corporate governance for the Enron scandal, for Arthur Anderson who contributed
to Enron by illegal auditing
 But the Big Four are already stretched, unlikely another will fail and go to 3...
(i) e.g. Ernst & Young survived scandal b.c Lehman had already failed
 Auditor independence
 But are you really independent when a big client is paying you millions?
 Reinforces importance of internal controls
 But CEO/CFO sign off on the audits anyway?
 SOX does not apply to privately held companies
 Criticisms of SOX
 Increased transaction costs
 But full employment act for accountants 
 International Guidelines
 International accounting is becoming more standardized
 Used to be determined by regulatory bodies within each country!
 Globalization required standardization
 International Accounting Standards Board (IASB)
 Working to establish common standards called International Financial Reporting
Standards (IFRS) (like an international GAAP)
 Since 2005 all publically traded EU companies have adopted IFRS
 GAAP is more rules based, IFRS is more principle based, but GAAP moving towards IFRS
flexibility
 GAAP: look for loopholes
 IFRS: no way to enforce complaince
 Accounting Overview: General Rules
 (1): Carry at cost: Carrying values are recorded at cost (with exception for certain financial assets
and liabilities)
 Carrying value: what you show the asset to be worth
 Recorded at cost: what you paid for it
 (2): Adjustments to recorded values are made only if value declines
 Exception: marked to market for stocks in other companies held as assets
 (3): Accrual Method: revenues and costs are recognized when committed to, not when cash moves
hands
 (4): Costs are recorded in same period as associated revenues are recognized
 E.g. salaries are recorded in the period for the revenue made even if not paid to employees yet
 (5): Reserves/allowances required to reflect potential negative outcomes of known risks
 Conservationism prevails: show a reserve or a footnote
 Accounting Overview: Accounting v. Finance
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
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Accounting is backward looking  shows what happened
 Rigid guidelines
 Finance is forward looking  how do we make investments that will generate future cash flow?
 No guidelines, but standard methodologies
 Conservation of value: if it doesn’t change long-term cash flow it doesn’t add value
 Reviews industry / company trends
 Compares financial and stock market performance among industry players, to aid in investment
decision-making.
 Makes investments that are expected to create shareholder value.
 Use both accounting data and financial tools to make economically rational decisions
 FINANCIAL STATEMENTS
 Financial Statements Overview
 Where do we get them?
 Public Company: filed pursuant to the SEC: 10-K, 10-Q, 8-K, Annual Report
 Private Company: limited availability, usually only if audited
 What does it tell us?
 “cumulative effects of all management’s past decisions”
 Actual performance
 Solvency, profitability, cash generation
 Balance Sheet
 Own assets? Liabilities owed against those assets?
 Solvency
 Consolidated financial data
 snapshot in time, shows financial condition of company on a specific date
 Capitalized expenditures here (versus expensed outlays on the income statement)
 Key Categories
 Assets: properties used in business that are owned and have monetary value (tangible or
intangible)
 Liabilities: amounts owed to all creditors.
 Specific obligations representing claims against the business
 Repayment which has priority over owners
 Owner’s Equity / book value / stockholder’s equity / net worth
 Value accountants have placed on the company’s books
 Owners have residual claims on assets
 No obligation for company to repay
 Assets
 Assets listed in order of decreasing liquidity
 Current Assets: Cash or assets reasonably expected to be converted into cash within a year
 Fixed Assets: longer life assets used in the operation of the business, depreciated
 Other Assets: financial investments (stocks and bonds), minority interests in other companies
 Intangible Assets: no physical substance, basis of valuation is cost.
 Only included on balance sheet if significant
 “must be reasonable evidence of future benefits with certainty of duration”
 Goodwill: “excess of price paid in an arm’s length transaction over the fair market value of
the assets acquired”
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 Therefore (1) acquisition taken place and (2) they paid more than the written up market
value
 Prior to 2002 you amortized goodwill, now you don’t as long as it is not impaired
 Liabilities
 Current Liabilities: due within one year (e.g. notes payable, A/P, accrued liabilities, unearned
revenues, current portion of long term debt)
 Long term liabilities: debt obligations due after one year (e.g. bank debt, deferred taxes)
 Off balance sheet liabilities: operating leases, loan guarantees
 Listed in footnotes
 Represents financial risks not shown directly on balance sheet
 Working Capital
 Working Capital = Current Assets – Current Liabilities
 “Ability to pay off debts if all due now”
 Must mean current liabilities though...
 Theoretically: represents cheap credit. Assets not funded by liabilities.
 Include current cash? High working capital desired
 Exclude current cash? Low working capital desired
 Prof Brown dislikes incl cash b/c high cash on balance sheet is deceptive
 Owner’s Equity
 Paid in Capital: $ invested by SH  issuing more stock
 Retained Earnings: accumulation of earnings not paid in dividends
 Treasury stock: value of repurchased shares  reduces equity
 A growing SH equity shows solvency
 What is not on the balance sheet?
 Skilled workforce
 Strong brand names (unless in goodwill from acquisition)
 Isn’t a patent an intangible?
 Customer loyalty
 Certain other intangibles
 Market value of the stock
 Income Statement (aka consolidated statement of income)
 Addresses:
 Are company’s revenues growing?
 Is company able to control its expenses?
 Unlike balance sheet, it is for a period btwn two dates, not on one date
 Indicates if company is profitable
 Top line v. bottom line
 Bottom line growth = net profit = net earnings
 Top line growth = gross revenues = net sales (?)
 Incl A/R, so not just cash
 Every expenditure a company makes, first classify the cost
 Inventory?  balance sheet until sold, then moved to income statement
 R&D? Salaries?  expensed on income statement
 Operating expenses are on income statement, assets are capitalized on balance sheet until sold
or depreciated
 Types of Profits
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Total revenues / net sales / top line  reflecting dollar proceeds from sale of goods
Gross profits = revenues – COGS or cost of earning revenue
 Represents how much money is made after considering the cost of making the money
 Profits generally is a term recognizing costs subtracted from revenue, interchangeable with
earnings or income
 Operating profits/EBIT = gross profit – addl operating costs
 E.g. “selling general and administrative” (“SG&A”)
 General repairs/maintenance
 Depreciation
 Represents earning power of the company
 Pretax profits = operating profits – other expenses and income
 Subtracting expenses that are related to non-operating assets, adding income from interest
 Net profits = pretax profits - taxes
Earnings per share / net profit per share
 EPS = bottom line / avg # of shares outstanding for the year
 “what the company chooses to show to you”
 Get the # of shares from balance sheet, average the two yrs
 Best to just use the EPS reported by company though on income statement
What does bottom line represent?
 Amount of profit/loss generated for the owners
 Increase in owner’s equity on the balance sheet (after dividends paid)
What does bottom line not represent?
 Amnt of cash rec’d by owners
 Dividends not always paid, profit can be held as retained earnings
 Amnt of cash generated  it is profit generated, not cash
Extraordinary Expenses  non-recurring in nature
 the revenues and expenses are not consolidated above
 shown on income statement after bottom line
 Why? Eases investor analysis by segmenting out revenues and costs not recurring
 Related to disposition of business or product line, e.g., closing a factory, selling a location, closing
a division
 Makes bottom line called “net profits (or net income) from continuing operations”
Pro-forma earnings:
 Intended to portray ongoing earnings or core earnings
 Omits expenses not expected in the future
 NB: Not projected earnings
 Can ignore certain expenses if they release an earnings release telling public what they’re
ignoring, and also what the number would have been if they followed GAAP
 E.g. GAAP accounting is very conservative, didn’t allow 9/11 losses to be extraordinary, so
companies released GAAP and a pro-forma earnings statements
Depreciation and amortization
 Specific expenses on income statement (from gross profits to EBIT)
 Depreciation:
 Represents aging of physical property, a non-cash operating expense
 Tax deductible expense on income statement
 Reduces fixed assets on balance sheet (accumulated depreciation)
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 spreads the capital investment costs over the estimated useful life of the asset
 Land is not depreciable
 Residual value: scrap value
 Calculating depreciation
 Straight line: simplest and most widely used
 Annual depreciation charge = (cost – scrap value) / useful lifespan (in yrs)
 Amortization: for intangibles
 Goodwill is not amortized unless determined to be impaired
 Patents and copyrights are amortized on a regular schedule
 Asset v. Expense
 All expenditures show up as asset or expense
 When asset is sold it moves to income statement as COGS
 BUT b/c an asset that is not sold is never moved to income statement, you have an expenditure
never recorded  solution? CASH FLOW STATEMENT
 Capitalizing: expenditure recorded as asset on balance sheet
 Expensing: expenditure flows thru to income statement
 Cash Flow Statement
 Why do we need a cash flow statement?
 Accounting uses accrual method, so revenues are not equal to cash
 Expenses not represented on income statement, and income included on income statement
that is not cash
 E.g.: extension of credit, capitalized expenditures, inventory, depreciation
 Cash flow statement starts with net profit (bottom line) which has already accounted for all
inflows and outflows
 Answers key questions:
 What is the source of the company’s cash flow?
 How is company using its cash outside of normal operating expenses? (e.g. for dividends,
PPE?)
 Sources and Uses of Cash: Operating Activities
 Start with net profit (bottom line positive, it is a source of cash)
 Sources of Cash
 Add on depreciation, taxes, other non-cash expenses deducted on income statement
 Add on decreases in assets: subtract last yr and this yr inventory on balance sheet
 Add on increases in liabilities: A/P, current liabilities, salaries
 Uses of Cash
 ?? payments on interest?
 Sources and Uses of Cash: Investing Activities
 Purchases and sales of PPE, subsidiaries, and securities
 Sources and Uses of Cash: Financing Activities
 Sources
 Issuing stock
 Borrowing debt
 Uses
 Paying dividends
 Repurchase of stock
 Debt repayment
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 Borrowing more adds cash  does paying off interest reduce cash? Paying off principal?
 I think paying off principal reduces cash but paying interest is accounted for in the net
profit that we start with
 So what’s left from balance sheet not on cash flow?
 SH Equity
 SH Equity = Common stock + paid in capital
 Doesn’t this formula not incl retained earnings?
 Retained Earnings = net profit + dividends
 If your net profits exceed your retained earnings (bottom line of income statement exceeds
retained earnings on balance sheet) then cash flow should reflect dividends paid
 Reading the cash flow statement:
 If you add the $10,024 from operating activities, the $13,805 used by investing activities, and the
$2728 from financing activities, you get -1053. Used cash!
 If you check balance sheet, change in cash and marketable securities from 2009 to 2010 is $1053.
 You need to grow the business to get revenues to get net profits to get cash growth to then further
grow the business
 Impact of growth on cash flow
 Investment: PPE, acquisitions, inventory
 Operations: more salaries, more marketing, more distribution channels
 Financing: greater interest to be paid b/c borrowed more debt
 Eventually, cash flow from operations but be sufficient to justify increased investment
 Is the investment affordable?
 Check balance of cash and marketable securities
 Operating cash flow
 Ability to borrow debt or issue equity
 PERFORMANCE MEASURES
 Performance Measures Overview
 Making comparisons
 Absolutes ok, but not helpful really
 Stock prices cannot be compared
 Performance measurements the best method
 Measures of (1) performance, and (2) commitment of resources
 Performance
 Supporting revenue growth while keeping control of operational costs
 “maximize your profit margin”
 Minimize level of investment required
 Low working capital, low fixed capital, low investor capital (issuing equity dilutes SH value)
 Assessed from diff viewpoints: management (growth), lenders (solvency), owners
 Remember, mgmt takes risks, lenders risk adverse
 Performance Measures: Five Year Compound Growth Rate
 End = Start x (1 + rate) 5
 Excel: RATE(# of periods, payments (always 0), neg starting value, ending value)
 Remember, 5 periods, 6 data points
 Interpreting:
 Your CGR higher than industry’s? Gaining market share
 Straight line btwn start and end, so tells you nothing about volatility in the middle
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
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Concerned about volatility? Use an annual rate
Companies can skew by using longer periods or setting the period start and end to maximize
growth
 Cannot use for percentages, only for absolute #s!
 Same Store Sales Growth / Comparable Store Sales Growth): can limit a company’s GCR to just a
store or group of stores
 Compare with total sales growth to see impact of store openings
 Underlying health of the business is measured in same store sales growth
 Performance Measures: Profit Margins:
 What it can tell us
 GCR is top live growth, what about profit growth? Profit margin
 Looks at Income Statement, relationship of cost of making the good to money it brings in
 Identify where costs are getting out of hand, or trends are bad
 XXX Profit Margin = XXX Profit / Top Line Revenue
 Can use for any profit line (gross, EBIT, pretax, net)
 1 percentage point = 100 basis points  2% is in fact a big drop (REC data)
 What influences a profit margin?  everything above it
 Gross profit margin:
 (1) Top line revenue (Revenue component)
 Revenue = price x volume
(i) So if they are not pricing high enough, GPM erodes
 (2) Gross profit (COGS component)
 Cost of raw material increases, increasing COGS (and we didn’t pass along the price
increase)
 (3) Changing product mix (product mix component): selling more of one particular item
over another, even if the total sold is still the same, will shift GPM
 Operating Profit Margin (EBIT)
 Analyze a profit margin thru expense ratios
 Expense ratio = expense / net sales
 E.g., “SGA as a percentage of revenue decreased, almost completely offset the gross profit
margin erosion.”
 Also, 4% net profit margin is a “low margin business”
 Includes operating expenses like SG&A, R&D, and marketing
 Pretax profit margin
 Includes amount of financial leverage and interest expenses associated with it
 Net profit margin
 Includes tax burden
 Performance Measures: Recourse Management
 Minimize asset investment without sacrificing revenues
 Inventory Turnover: high
 I think this is revenue / inventory, so it’s high not b/c you’re selling a lot but because you have
little stuck on the books
 A/R Days Outstanding: low
 A/P Days Outstanding: high
 New working capital as a % of revenue: low
 Fixed asset turnover: high
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON

Revenue / PPE = Fixed asset turnover  so the less assets you have to hold for revenues the
better
 Performance Measures: Return Measures
 Useful for:
 Assesses both performance and asset utilization
 Most relevant to SH creation (esp ROE)
 ROA (Return on Assets):
 ROA = net profit / avg total assets
 Relates annual profits to total assets in the business needed to generate profit
 ROIC (return on invested capital)
 Relates profits (before financing costs / EBIT) to the total invested capital
 ROIC = EBIT [(1-tax rate)] / (interest bearing debt + equity)]
 Tax rate = income taxes paid / pretax income
 Invested capital is the average over the two balance sheet periods
 Long term debt + notes payable + current maturities = interest bearing debt
 In English, take your EBIT and tax affect it (so we take out taxes but not the interest) and then
divide by total capital
 I wonder if you can take net profit, add the interest paid and dividends paid back in (instead of tax
affected EBIT) and get the same thing?
 In example, a 400 basis point increase was a good trend
 ROE (return on equity)
 ROE = net profit / avg SH equity
 Most relevant to SH value creation
 ROE is a f(x) of (1) Profitability; (2) Asset utilization; (3) Financial leverage
 Relates net profits to book value of SH investment
 Profitability
 Increase profit margins to increase ROE (control costs, raise prices)
 Asset Utilization
 Minimize investment by turning inventory over and collecting on receivables
 Just-in-Time delivery, sell off unused fixed assets
 Financial Leverage
 The extent to which debt has been used in the capital structure
 Use debt  borrow and play with other people’s money, invest it at a higher rate of
return than you’re paying interest
 Increases risk of firm but also increases return to SH
 Increase proportion of fixed costs (interest and principal payments)
 Financial leverage = All interest bearing debt / total invested capital
 Idea is if your debt exceeds your equity, you’re playing with someone else’s money
 Total invested capital is interest bearing debt + SH equity
 Interest bearing debt = Long term debt + notes payable + current maturities
(i) So ROIC takes tax affected EBIT and divides by total invested capital, whereas
Financial Leverage interest bearing debt over total invested capital
(ii) So ROIC relates profits to investments needed, and Financial Leverage relates debt
investment as a percentage of total investment
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 But how does Financial Leverage affect ROE? B/C more financial leverage = more interest
payments = less net profit? Or more financial leverage = increased net profits from sales,
and the denom of SH equity remains same?
 Liquidity ratio = current assets / current liabilities
 can company repay its current obligations with current assets?
 We want this way above 1 (but too high indicates inefficient working capital)
 Include cash in current assets
 Interest Coverage
 Do your annual profits cover annual interest payments?
 Interest Coverage = EBIT / Interest Expense
 Doesn’t consider maturing debts and principal repayments
 Limitations of ROE
 Single period focus: net profits from one year
 Ignores the risk of financial leverage
 Doesn’t relate specifically to cash flow
 Doesn’t relate returns to market value of equity (just to book value)
 Performance Measures: Shareholder Value Measures
 TSR (Total Shareholder Return)
 Why? High ROE correlates with high SH value creation, but TSR is a direct measure of SH value
creation.
 It is in the 10K, but we can calculate it too
 TSR = [(ending stock price - beginning stock price) + dividends paid per share] / beginning stock
price
 Stock price appreciation + dividends paid, divided by the beginning stock price
 Paper return: it is not cash in SH pocket but SH value creation
 P/E Ratio (Price / Earnings ratio)
 Most common SH value measurement, lingo “trading at a multiple of...”
 P/E = stock price / EPS
 Because if I am willing to pay more for a stock than what the stock is earning, I am confident
it will grow in the future
 Limitations
 mature companies may have lower P/E b.c of concern about future growth
 companies nearing BK have high P/E b/c EPS is so low
 Dividend Payout / Dividend Yield
 Dividend payout = annual dividend per share / EPS
 Implications?  Higher dividend payout indicates less invested for growth
 Making dividends over what the company earns per share?
 Divided Yield = annual dividend per share / stock price per share
 Making dividends over the market value?
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 RISK ANALYSIS
 Financial Theory of Risk: variation = risk
 It’s not about avoiding risk, it’s about being compensated for taking on risk
 Higher the risk, higher the expected return
 Possible distribution of outcomes from a particular action
 Less possible outcomes, less risky
 Sharp bell curve = less risky b/c the spike is narrow?
 Types of Risk
 Unsystematic risk (specific risk)
 Those risks specific to a particular company or industry
 Can be mitigated by diversification of investments
 Systematic risk (market risk)
 Cannot be eliminated by diversification
 “investors must me appropriately compensated for investing in securities with greater
sensitivity to market risk”  meaning that b/c investors can diversity to cover for specific risk, but
the only way to cover for market risk is by increased compensation?
 Assessing Risk
 Factors affecting risk (“assessing risk”)
 Variation in cash flow
 Dependant on:
 Stage in life cycle  predictability of cash flow
(i) Start-ups have less predictable cash flow
 Industry
(i) Highly regulated industries low risk
(ii) Rapidly changing industries high risk
 Financial Leverage / company-specific factors
 Investors must be compensated
 Risk/return analysis is evident in all rational investment pricing
 Evaluating the Audit (“Auditing Risk Assessment”)
 Integrity of the data  factors influencing data integrity:
 Data integrity is key to investors’ ability to assess risk
 Complexity
 Business innovation
 Financial reporting can’t capture new / innovative business models
 Speaks to the tension btwn GAAP rules based and int’l theory-based
 Managerial Discretion
 Quality of earnings
(i) Discretion
1. Variation of reported results
2. Affects comparability btwn companies
3. Even w GAAP there is still a lot of room for management discretion
(ii) Fluid areas  areas to look for red flags and misinterpretation of earnings
1. Revenue recognition
a. Premature revenue recognition
i. Percent of completion  proportioning revenues out over the time of
the project (e.g. shipping industry)
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON

ii. Concerns raised if long term gov’t K, and gov’t is cutting funding
iii. Mis-estimation of the time the project will take
b. Gross v. Net
i. Notes indicate Groupon example, but that example was including both
the cut they got from merchant and total coupon revenue sales, not
removing amount that went back to merchant...
c. Uncollected Revenues (risk if you see a lot on the balance sheet)
i. E.g.: if the company’s revenues are growing, the dollar value for
doubtful accounts should be larger. Otherwise company isn’t planning
accordingly?
2. Expense recognition
a. Capitalizing what should be expensed
b. Valuation of COGS  red flag if the inventory accounting system changed
i. LIFO
ii. FIFO
iii. Rising cost environment / falling cost environment and the impact on
COGS
c. Depreciation
d. Asset write-down / impairments
e. Contingency reserves
 MD&A: Management Discussion and Analysis
(i) Must include a supplementary discussion w the 10K filing giving meaningful
narrative behind the financial numbers
(ii) Full transparency required
(iii) Avoid boilerplate
(iv) What’s the point of the MD&A?  but remember all of this comes from company
management
1. Potential effects of material changes on operational results
2. Known trends, uncertainties, and potential effects
3. Changes in accounting policies and assumptions
4. Gives investor sufficient information to determine whether past results are
indicative of future performance
(v) Is this a special section in 10K or a general term for the risks in front of and the FNs to
the financial statements?
How do you ensure data integrity?
 Internal controls  Proper ways to measure things
 Policy
 Tests / statistical sampling
 Disciplinary action
 External controls
 Auditor qualifications/certifications  assurance engagements
(i) Financial statements prepared in accordance with GAAP?
(ii) Financial statements “presents fairly” the company’s financial condition?
1. No legal definition of “presents fairly”
2. Requires “overall material accuracy and completeness”
3. Goes beyond mere accordance with GAAP
(iii) Company’s internal controls effective?
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
1. Do the auditors check the internal controls?
 No one is fudging the numbers
 Since Arthur Anderson, concerns about external auditor independence have surfaced
(i) But remember auditing does not prevent bad business decisions, just forces
disclosure
 Types of Audit Risk
 Inherent risk – assertion of an internal error without appropriate checks
 The general risk something is misstated on a statement, without considering internal controls,
due to error or fraud
 Control risk – likelihood we have error given the internal controls
 We don’t have the internal control to detect the error?
 Detection risk – likelihood risk would go undetected
 We have the appropriate control to detect the error, it just isn’t sensitive enough to detect it?
 Materiality
 If it affects less than 5% of net profits it is immaterial
 If it affects more than 10% is it material and we cannot live with the risk in the system
 Capital Structure Decision-Making
 How we make decisions
 Understand the corporate structure
 Then project cash flow needs
 Then choose how to finance: debt or equity
 Purpose of financing is to support corporate strategy
 Company Life Cycle
 Pre-revenue phase
 What is it?
 You want to create a business from your great idea
 Development a product or service
 Possible market testing
 Preliminary business model discussions
 Financing  “seed capital”
 Highly risky
 Personal assets, friends and family
 Start-up Phase
 What is it?
 Launching of products and services
 Focus is on gaining momentum, becoming self-sustaining
 How to finance
 Negative cash flow  equity financing
 No one will lend to you as a start-up, no assets to secure
 But little access to capital markets
 Answer: sympathetic or highly sophisticated investors
 Family and friends
 Angels
(i) More favorable terms
(ii) More focused on business success than high returns
 Venture capital
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON

(i) Provides professional managerial and technical expertise
(ii) Looking for high returns
(iii) Requires relinquishment of some control
(iv) May have restrictions and covenants
Rapid Growth Phase / Second Stage Financing
 What is it?
 Expanding market share / growing market
 Some companies grow too fast and are never profitable
 Nearing profitability
 High working capital and fixed asset needs require external financing
 How to finance
 Preferred stock
 Preference over the common stock held by the founders
 Rights given to investors  what rights would they want?
(i) Ownership anti-dilution  can participate in late rounds of equity release
(ii) Piggy back rights
(iii) Economic anti-dilution  purchase price adjustments if they have to sell for less in a
future round
(iv) First dividend payments? Was this my thought?
(v) No drag alongs? Was this my thought?
(vi) Voting rights? Was this my thought?
 Straight preferred: basically a debt instrument, you’re guaranteed a dividend and you
get a redemption value at the end
 Convertible preferred: converts to common stock later?
 Convertible Debt
 Assumption is that the company will perform well enough and then the debt is
converted to equity
 Benefits
(i) More protection for investor  hedge against risk of equity in a start-up
(ii) Less dilution of control for founders
 Risks
(i) Why accept debt returns with equity risk?
 Warrants attached (e.g. right to buy stock as a specified price / guaranteed a specific
percentage of ownership)
(i) E.g. your convertible debt is $1mil, your warrant coverage is 25%, so you convert
into 1.25mil of equity
 IPOs
 Marketability of their equity desired by early investors
 Restricted for management
(i) Does this mean SEC has rules on mgmt dumping their shares?
 Underwriting required
(i) Timing
(ii) Pricing
(iii) Distribution
 Capital Leases  avoid having to finance capital assets that you can lease
 Secured by assets
 Ownership retains at manufacturer
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 Option to buy at end of the lease period for nominal amount
 Maturation Phase
 What is it?
 Stagnant / declining growth in the market
 High cash generation
 Lower investment needs / lower need for external financing
 Can invest their own cash
 Can divest to generate cash
 Finance Activity
 Investing their own cash, divesting assets
 Dividend payments and stock repurchases
 Avoiding equity dilution
 Long term bonds / bank financing
 Short term access to credit for liquidity
 Lines of credit
 Commercial paper
 Declining Phase
 What is it?
 Actual decline in revenues
 Marginally profitable
 Liquidation of assets
 Generation of cash exceeds reinvestment needs
 Financing Activity – recapitalization
 Finance strategy becomes primary focus over business strategy
 “management LBO”  high levels of financial leverage to replace equity  high risk, high
return
 Financing Considerations
 Designing Financial Securities
 Not significantly constrained by law or regulation
 Must appeal to investors
 Must meet company needs
 1. Cost of Incremental Funds
 Credit worthiness
 Degree of financial leverage
 Source of financing: debt, preferred stock, common stock, hybrid securities
 Prevailing rates
 2. Risk Exposure
 Operating risk, financial risk
 Measured by variability of earnings
 Heightened by fixed financial charges
 Varies during company life cycle
 3. Flexibility
 Keeping future funding options open  equity now means debt can be used later
 Less vulnerable to timing issues later - ??
 4. Timing
 Impacted by changing conditions in the financial market
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 Affects cost spreads between different funding options
 5. Control
 Restrictive covenants in debt agreement
 Ownership dilution of equity
 6. Market Signaling
 Issuing equity may signal conservatism
 Issuance of debt may imply management is optimistic about future / ability to pay off the debt
 Financing Overview
 Debt Advantages
 Least costly to company due to tax deductibility of interest and preferred status
 “allows for maturity matching with assets” ??
 Doesn’t dilute SH
 Potential booting of ROE and EPS
 Debt Disadvantage
 Reduces future financing flexibility
 Exposes company to greater risk of cash flow variability
 Default risk and distress costs (?)
 Common Stock Advantages
 Least risky to company
 Flexibility for future financing
 Common Stock Disadvantages
 Highest cost to company
 Loss of control
 EPS dilution and ownership dilution
 Sustainable Growth
 Rapid growth: can send you into BK
 Slow growth: can send you into BK
 Sustainable growth: increases SH equity
 Actual growth > g*
 Profitability must increase
 Asset utilization must improve
 Dividend payout must decrease
 Financial leverage must increase
 New equity must be issued
 Actual growth < g*
 Increase dividend payout
 Retire debt
 Repurchase stock
 Time Value of Money
 Inflation
 Opportunity Costs
 Earnings potential from interest
 Risk
 Will debtor die?
 Formulas
 PV($1) in Y(n) = 1 x [1/(1 + k)n], where k = interest rate
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
 Interest rate = discount rate = required rate of return
 “present value requires discounting future cash flows”

“closer the stream of inflows is to today the more the stream is worth today”  time adjusted
analysis
 “the lower the perceived risk (e.g. the discount rate) the more it is worth today”  risk adjusted
analysis
 HYPO: bonds: as IR increases bond prices fall, as IR decrease bond prices rise
 Bond Pricing
 Example Yield Rates
 10 yr T bond  2.06%
 Dow Corp Bond  3.34%
 Commercial Paper
 HYBs (junk)  6.67%
 Dow stocks  11%
 S+P 500 stock  12.5%
 VC (?) 40-50% (venture capital?)
 Valuation Overview
 How do I determine which valuation standard to use (base value)?  value variations perfectly
legitimate
 Purpose of valuation
 Size/influence of block being valued
 Forced or voluntary transaction
 Relative marketability of block
 Going Concern Values  are we valuing this business as a going concern? Ability to continue with
business operations without foreseeable threat of liquidation; selling the business as a f(x) business.
 Control Value/Acquisition Value/”highest and best use value”/Full Enterprise Value
 What another entity will pay for the company
 Acquisition premium over marketable minority interest value (over “unaffected stock price”)
reflects buyers’ plans
 Synergies (savings from consolidated 2 companies, or enhanced revenues)
 anticipated expense savings
 benefits of heightened leverage
 Publically-traded company
 Tender offer price for 80% of total outstanding stock of public company
 The price needed to get BoD to approve
 Issues of fairness
(i) Why should buyer incur acquisition premium for what they’re bringing to the table?
(ii) Are they really paying fair price or just $1 more than other bidder?
 Privately-held company: value to majority owner
 Marketable Minority Interest Value: public “unaffected” trading price  really just market cap~
 aggregation of publically traded minority interests  market cap!
 minority discount from the control value
 Value associated with:
 100-shares traded as quoted
 Illiquid stock holding “put rights,” e.g. stock held in ESOPs
 Active company stock repurchase programs
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON






Non-Marketable Minority Interest Value
 Discount from public price to reflect lack of marketability (e.g. privately held stock)
 Liquidity is a valued attribute
 Hypothetical cost of doing an IPO
 Restrictive stock transactions
 Value associated with
 Restricted stock issued to mgmt
 Private company stock holding no marketability rights and no near-term plans to go
public
 Liquidation Value (aka book value is highest option)
 likely to result in lowest value to SH, based on value of underlying assets and liabilities
 assets become discounted, esp PP&E, so you’re probably way under book value
 goodwill valued at 0 (maybe some for patents though)
 liquidation value is only used as means of assessing value if it is ONLY OPTION
Establishing Values - Overview
 Fair Market Value orientation: the price paid by a willing buyer to a willing seller, neither under
compulsion to buy or sell, having complete information and appropriate time necessary to transact.
 How do we determine FMV?  Valuations as forward looking
 Reflects expectations for future earnings
 Applying some market multiple to current to near term projected earrings  e.g. P/E multiples
 Discounted projected future cash flows of company (DCF) to arrive as present value
 Why do we value companies?
 Acquisition  make a tender offer, or ripe for a takeover
 Non-marketable minority interest  determine sale of stock to employees of gifting to estate
P/E Valuation – for marketable minority interest valuation
 Remember, P/E is price per share divided by EPS  so we’re market oriented, not book oriented
 Look at P/E of competitors
 Profit margins compared with competitors
 Branding strength, market share
 Life cycle stage and revenue growth compared with competitors
 Financial leverage compared with competitors
 Higher risk b/c more leverage?
 Lower risk b/c making better use of leverage?
 ROE, ROIC
 “the higher the expected growth in earnings the higher the P/E to be applied”
 “the better the operating performance the higher the P/E to be applied”
 Market to book ratios
 Can compare ratio but not absolutes
 How much market value exceeds book value as a ratio
Change of Control Multiples – comparing acquisitions of companies in similar industries
 Price multiples based on EBITDA
Earnings v. Cash Flow
 Accounting earnings (e.g. P/E) are useful for valuation only. Earnings as a proxy for cash flow
projections (e.g. DCF).
DCF Valuation  used for minority or controlling interest value
 Projected cash flow  key elements of cash flow statement
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON





 projected net income + depreciation
 additions to WC
 capital expenditures
usually for a 5 yr period?
“estimate made of continuing value to reflect value beyond projected period?
How might projected cash flow differ for minority interest v. controlling interest?
 How they estimate expenses (?)
Cash flows discounted to present value reflect the investor’s required rate of return
 Captures both risk and return
Discount rate = cost of capital
 Money is not freely provided
 Returns required is a real cost to the company
 Dent: interest payments and any discount to the par value of the bond (bond yield)
 Equity: dividends and expected stock price appreciation
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ACCOUNTING & FINANCE – PROF. BROWN, SPRING 2012 – DANA PETERSON
NEWS DISCUSSED
 SOPA and PIPA  Hollywood response v. the internet’s response
 Kodak’s BK
 Selling off patents and suing to protect patents
 Cost cutting on exec benefits
 Something about printer company?
 Groupon
 Facebook v. Groupon, and the poor business model of Groupon
 Also Groupon discussed 2/20/2012?
 4/2/2012
 Groupon caught for false reporting
 Should Ernst & Young have caught it?
 “earnings before everything”
 Also people were returning Groupons rec’d as gifts
 Probably went IPO too early
 Apple
 stock shot up (1/30/2012)
 Something about releasing info about something in China?
 Google fell? Apple released stronger earnings than expected?
 Removed from S&P b/c too much weight (2/20/2012)
 Apple charges subsidy to Verizon to use iPhone, Verizon makes up that cost in the 2yr contract, but
won’t do it on intl markets? (2/27/2012)
 Buying back stock b/c Apple has too much cash and nothing to do with it (3/26)
 Something about Pinterest
 Facebook IPO
 Filed S-1 (2/6/2012)  first step in an IPO
 Risk factors listed in an S-1
 The news outlets picked up that tech growth is phone based and overseas, and FB has no
experience in mobile ads (FB is indirect income stream model)
 FB in the S-1 mentioned new strategies like having sponsored stories and adds on the news feeds
 Lasars? An investment finance firm folding
 P&G cutting non-manufacturing jobs
 Sears is selling off real estate
 $200mil in real estate being sold!
 Divesting the domestic Sears business
 SEC likely to follow intl accounting principles over GAAP rules
 Annie’s Mac doing IPO (3/26)
 Lots of new IPOs at the moment?
 Do we really have job growth?
 Bernanke says no, it’s artificial
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