ENGINEERING FINANCE
CSE 8363 / EF 720-N
Summer 2001
(Lectures # 2 & 3)
Analysis of Financial Statements
Annual report and its purpose
Financial Statements vs Report Cards
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Balance Sheet
Income Statements
Statement of retained earnings
Accounting income vs. cash flow
Statement of cash flows
Cash and other assets
Liabilities and stockholders’ equity
Preferred and common stocks
Retained earnings
Inventory accounting
Depreciation method
Operating Assets = Cash, A/Rs, Inventories and fixed assets required to operate the business
Non-operating Assets = Marketable securities, Inv. in subsidiaries, land for future use etc.
Working capital
Operating working capital = Current assets used in operations
Net Op. working capital = Op. Working capital – A/P – Accruals
Net Operating profit after taxes (NOPAT) = EBIT * (1 – Tax rate)
Free Cash Flow = The cash that is actually available for distribution to investors. It is defined as
after-tax operating profit minus the amount of investment in working capital and fixed assets
necessary to sustain the business.
Market Value Added (MVA) = Market value of equity – Equity capital supplied by shareholders
Economic Value Added (EVA) = Net operating profit after taxes (NOPAT) – After tax dollar
cost of capital used to support operations
1
Federal Income Tax System
Individual vs. Corporate Income Taxes
Progressive tax rate system
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Taxable income
Marginal tax rate
Average tax rate
Taxes on dividend and interest income
Interest on most munis is not subjected to federal income taxes
70% of dividend received by one corporation from another corporation is excluded from taxable
income.
Capital Gains vs. Ordinary Income
Corporate Loss Carry-Back and Carry-Forward
Improper Accumulation to Avoid Payment of Dividends
Taxation of S Corporations
Depreciation
FINANCIAL RATIOS
Liquidity Ratios:
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Current Ratio
Quick or Acid Test, Ratio
Current ratio = Current assets/ Current liabilities
Quick ratio = (current assets – Inventories) / Current liabilities
Asset Management Ratios:
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Inventory Turnover
Days Sales Outstanding (DSO)
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
Debt Management Ratios
2
Effect of Financial Leverage on Stockholder’s return
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Debt Ratio
Times Interest Earned
Fixed Charge Coverage
Profitability Ratios
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Profit margin on Sales
Basic Earning Power (BEP)
Return on Total Assets
Return on Common Equity
Market Value Ratios:
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Price/Earning Ratio
Market/Book Ratio
Trend Analysis
Du Pont Chart and Equation:
ROA= Net Income/Total Assets
=(Net Inc./ Sales) * (Sales/ Total Assets)
= Profit margin * Asset T. O.
Equity multiplier = Total assets/ Comm. equity
ROE= Profit Margin * Assets T. O. *Equity multiplyer
Benchmarking
Uses and Limitations of Ratio Analysis
Different divisions in different industries
Best to focus on best in class
Effect of inflation on balance sheet
Seasonal factors
Window Dressing
Different accounting practices
Generalization difficult
Looking beyond the numbers
Dependence on one key customer
Dependence on one key product
3
Single supplier
Overseas business
Competition
Future prospects
Legal and regulatory environment
4