Financial Statements
The Big Three Accounting
Statements
1.
2.
3.
The Balance Sheet
The Income Statement
The Statement of Cash Flows
2
1) The Balance Sheet
LHS
 A snapshot of the firm
 Assets ≡ Liabilities +
Stockholder’s Equity
Current
Assets
 Left Hand Side must
balance with the Right
Hand Side
Fixed
Assets
Tangible
Intangible
RHS
Current
Liabilities
Long-Term
Debt
Shareholder
Equity
3
Balance Sheet Analysis

When analyzing a balance sheet, the Finance
Manager should be aware of three concerns:
1.
2.
3.
Liquidity
Debt versus Equity
Value versus Cost
4
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
5
Debt versus Equity

Debt → Liability
 Promise

Equity is the residual
 Assets

to payout cash, an IOU
– Liabilities ≡ Equity
Debt represents a senior claim on firm assets
 If
the firm goes bankrupt debt holders get paid
before equity holders
6
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
7
2) The Income Statement
Income ≡ Revenue – Expenses
 Measure how the company has performed over
some period of time
 Generally comprised of four parts:
Operating
2. Non-Operating
3. Taxes
4. Bottom Line
1.
8
U.S.C.C. Income Statement
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
$2,262
1,655
327
90
$190
29
$219
49
$170
84
$86
9
Income Statement Analysis

There are several things to keep in mind
when analyzing an income statement:
INCOME IS NOT CASH
2. Matching Principal
3. Non-Cash Items
1.
10
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
11
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.”
12
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
 Average – the tax bill / taxable income
dollar earned
13
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?
14
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
15
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
-8
$199
16
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
17
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
-6
43
$7
18
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
19
Quick Quiz
1.
2.
3.
4.
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?
20
Financial Statements
Analysis and LongTerm Planning
Chapter 3
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

22
1) Common-Size Statements
 Report
everything as a percent the top
number
 Total
assets for the Balance Sheet
 Sales for the Income Statement
23
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?
24
Categories of Financial Ratios
Short-term solvency (liquidity ratios)
 Long-term solvency (financial leverage ratios)
 Asset management (turnover ratios)
 Profitability ratios
 Market value ratios

25
Liquidity Ratios

How easily can the firm meet its short term obligations
 Why

Current Ratio = CA / CL
 708

/ 540 = 1.31 times
Quick Ratio (Acid Test) =(CA – Inventory) / CL
 (708

is this important?
- 422) / 540 = 0.53 times
Cash Ratio = Cash / CL
 98
/ 540 = 0.18 times
26
Leverage Ratios

How easily can the firm meet its long term obligations
 Why

is this important?
Total Debt Ratio = (TA – TE) / TA
 (3588

Debt/Equity = TD / TE
 (3588

- 2591) / 3588 = 28%
– 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E
1
+ .385 = 1.385
27
Coverage Ratios

How easily can the firm payoff its debt holders
 Why

Times Interest Earned = EBIT / Interest
 691

is this important?
/ 141 = 4.9 times
Cash Coverage= (EBIT + Depreciation)/Interest
 (691
+ 276) / 141 = 6.9 times
28
Inventory Ratios

How efficiently is the firm managing inventory
 Why

Inventory Turnover = Cost of Goods Sold /
Inventory
 1344

is this important?
/ 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory
Turnover
 365
/ 3.2 = 114 days
29
Receivables Ratios

How quickly does the firm get paid
 Why

Receivables Turnover = Sales / Accounts
Receivable
 2311

is this important?
/ 188 = 12.3 times
Days’ Sales in Receivables = 365 /
Receivables Turnover
 365
/ 12.3 = 30 days
30
Total Asset Turnover

How efficient is the firm turning assets into sales
 Why

Total Asset Turnover = Sales / Total Assets
 2311

is this important?
/ 3588 = 0.64 times
It is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets. Why?
31
Profitability Measures

How efficient is the firm’s operations
 Why

Profit Margin = Net Income / Sales
 363

/ 2311 = 15.7%
Return on Assets (ROA) = Net Income / Total Assets
 363

is this important?
/ 3588 = 10.1%
Return on Equity (ROE) = Net Income / Total Equity
 363
/ 2591 = 14.0%
32
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
33
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
34
Market Value Measures

How do people feel about the firm
 Why

PE Ratio = Price per share / Earnings per share
 88

is this important?
/ 11 = 8 times
Market-to-book ratio = market value per share /
book value per share
 88
/ (2591 / 33) = 1.12 times
35
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
36
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

37
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
38
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
39
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
40
Calculating the Internal Growth Rate

Using the information from the Hoffman Co.
 ROA
= 66 / 500 = 0.132
 b = 44/ 66 = .66700

Internal Growth Rate
* b )/ (1 – ROA * b)
 (0.132 * 0.667) / (1 – 0.132 * 0.667 )= 0.0965
 Hoffman Co. can grow at 9.65% using only internal funds
 (ROA
41
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)
42
Calculating the Sustainable Growth
Rate

Using the Hoffman Co.
ROE
= 66 / 250 = 0.264
b = 0.667

Sustainable Growth Rate
* b )/ (1 – ROE * b)
(0.264 * 0.667) / (1 – 0.264 * 0.667 )= 0.214
Hoffman Co. can grow at 21.4% without changing
its capital structure
(ROE
43
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

44
Quick Quiz
1.
2.
3.
4.
5.
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?
45
Quick Quiz
6.
7.
8.
9.
10.
11.
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?
46