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7
Earnings and Cash Flow Analysis
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Earnings and Cash Flow Analysis
• Our goal in this chapter is to show you the financial
accounting concepts necessary to:
– Understand basic financial statements, and
– Perform earnings and cash flow analysis using basic financial
statements.
• Keep in mind: Cash flow is a company’s lifeblood.
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Sources of Financial Information, I.
• An excellent primary source: annual reports
– Look for the shamrock (♣) in The Wall Street Journal
• Found in the Journal on the daily stock price report page
• The shamrock indicates that the company will send an annual
report to you, if you request it through the Journal.
• Internet
– The New York Stock Exchange website provides a directory of
websites for companies listed on the NYSE
– http://finance.yahoo.com provides some basic financial
information if you enter the stock symbol
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Sources of Financial Information, II.
• The Securities and Exchange Commission (SEC)
requires companies to prepare and submit regular
reports
– When received by the SEC, these reports are freely made
available through Electronic Data gathering and Retrieval
(EDGAR) archives
– 10K: Annual company report filed with the SEC
– 10Q: Quarterly updates of 10K reports
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Sources of Financial Information, III.
• Also, the SEC Regulation FD (Fair Disclosure) requires
companies making a public disclosure of material
nonpublic information to do so fairly without
preferential recipients.
– Material nonpublic information is important, previously
unknown information that could significantly impact share
prices
– Most companies satisfy Regulation FD by distributing important
announcements via e-mail alerts to those who register for the
service at the company’s website (look in the investor relations
section).
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Three Important Financial Statements
• The Balance Sheet:
– Provides a snapshot view of a company’s assets and liabilities
– The Balance Sheet is as of a particular date.
• The Income Statement:
– Provides a summary of a firm’s revenues and expenses
– The Income Statement is over a specific accounting period,
usually a quarter or a year.
• The Cash Flow Statement:
– Is an analysis of the sources and uses of cash by the firm over
an accounting period
– Summarizes operating, investing, and financing cash flows
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The Balance Sheet
• Asset - Anything a company owns that has value.
• Liability - A firm’s financial obligation.
• Equity - An ownership interest in the
company.
• The fundamental accounting identity:
Assets = Liabilities + Equity
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Borg Corporation Balance Sheet
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Borg Corporation,
Condensed Balance Sheet
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The Income Statement
• Income - The difference between a company’s
revenues and expenses, used to pay dividends to
stockholders or kept as retained earnings within the
company to finance future growth.
Net income
= Revenues – Expenses
= Dividends + Retained earnings
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Borg Corporation,
Condensed Income Statement
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The Cash Flow Statement
• Net Income does not equal cash flow.
– Net income contains non-cash items.
– Non-cash items are income and expenses not realized in cash
form.
– Depreciation can be a significant non-cash item.
• Cash flow represents all income realized in cash form.
– Adjusting net income for non-cash items yields Operating
Cash Flow.
– Investment Cash Flow includes any purchases or sales of
fixed assets and investments.
– Financing Cash Flow includes funds raised by issuing
securities, or expended by repurchasing outstanding securities.
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Borg Corporation,
Condensed Cash Flow Statement
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Performance, or Profitability, Ratios
•
Four common performance ratios often reported in 10Ks and 10Qs to
help investors interpret financial information are:
Gross Margin 
Gross Profit
Net Sales
Operating Margin 
•
•
Operating Income
Net Sales
Return on Assets (ROA) 
Net Income
Total Assets
Return on Equity (ROE) 
Net Income
Stockholde r Equity
Note that ROA and ROE are calculated using the current year-end
values for total assets and stockholder equity.
Although one could use prior-year values, it is more common to use
current year-end values.
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Example: Calculating Profitability Ratios
• Using the data provided by the Borg Company in the
year 2536, we can calculate the profitability ratios:
Gross Margin 
Gross Profit $20.000

 22.22%
Net Sales
$90,000
Operating Margin 
Operating Income
$7,000

 7.78%
Net Sales
$90,000
Return on Assets (ROA) 
Net Income
$3,644

 3.64%
Total Assets $100,000
Return on Equity (ROE) 
Net Income
$3,644

 7.29%
Stockholde r Equity $50,000
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Price Ratio Inputs
• Annual reports will often report per-share calculations of book
value, earning, and operating cash flow.
– Per share calculations require the number of shares outstanding.
– Cash flow per share uses operating cash flow!
Book Value per Share (BVPS) 
Earnings per Share (EPS) 
Stockholder Equity
Shares Outstandin g
Net Income
Shares Outstandin g
Cash Flow per Share (CFPS) 
Operating Cash Flow
Shares Outstandin g
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Example: Calculating Price Ratio Inputs
• For the Borg Company in the year 2536:
Book Value per Share (BVPS) 
Earings per Share (EPS) 
Stockholde r Equity $50,000

 $25
Shares Outstandin g
2,000
Net Income
$3,644

 $1.82
Shares Outstandin g 2,000
Cash Flow per Share (CFPS) 
Operating Cash Flow $6,644

 $3.32
Shares Outstandin g
2,000
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Price Ratios
• Using the inputs we just calculated, we can calculate three
important Price Ratios:
Price to Book Ratio (P/B) 
Stock Price
BVPS
Price Earnings Ratio (P/E) 
Stock Price
EPS
Price to Cash Flow Ratio (P/CF) 
Stock Price
CFPS
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Example: Calculating Price Ratios
• For the Borg Company, these three ratios round to:
Price to Book Ratio (P/B) 
Stock Price $40

 1.6
BVPS
$25
Price Earnings Ratio (P/E) 
Stock Price
$40

 22
EPS
$1.82
Price to Cash Flow Ratio (P/CF) 
Stock Price
$40

 12
CFPS
$3.32
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Financial Statement Forecasting, I.
• Suppose you are an analyst employed by Vulcan
Ventures, and you are an analyst for the Borg Corp.
– One day, Borg announces the completed acquisition of a 50%
interest in Ferengi Traders.
• Half the acquired shares do not carry voting rights.
• Therefore, on the balance sheet, the acquisition is treated as an
investment.
• The stated purpose of the acquisition is to expand sales outlets.
• Also, Borg announces an expanded marketing campaign.
– You must examine the potential financial impact on the Borg
Corp. How do you proceed?
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Financial Statement Forecasting, II.
• You must get detailed information about this acquisition.
• You must make assumptions about future income, cash
flow, and other items.
– You might have an optimistic scenario
– You might have a pessimistic scenario, or both.
• Then, using your assumptions and scenarios, you build
pro forma financial statements.
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The Pro Forma Income Statement
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The Pro Forma Cash Flow Statement
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The Pro Forma Balance Sheet
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Projected Profitability and Price Ratios,
The Borg Corporation
Original
Gross Margin
Optimistic
Pessimistic
22.22%
25.00%
20.00%
Operating Margin
7.78%
10.83%
3.00%
Return on Assets (ROA)
3.64%
7.70%
0.77%
Return on Equity (ROE)
7.29%
14.43%
1.54%
Book Value per share (BVPS)
$25.00
$28.63
$24.88
Earnings per share (EPS)
$1.82
$4.13
$0.38
Cash Flow per share (CFPS)
$3.32
$3.98
$0.48
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Projected Stock Prices,
The Borg Corporation
• Current Stock Price: $40.
Optimistic
Pessimistic
BVPS times P/B
$45.81
$39.81
EPS times P/E
$90.86
$8.36
CFPS times P/CF
$47.76
$5.76
• Which projected stock price is “right”?
– Clearly depends on which sales scenario is realized.
– Clearly depends on which price ratio financial markets will use
to price Borg shares.
– Your job as an analyst will be to assess the situation and
make an investment recommendation (supported by facts,
investigation, and analysis).
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Adolph Coors Company,
Case Study
• The purpose of studying the Borg Corporation was to
help you gain an understanding of basic financial
statements, and how to make financial projections.
• To further illustrate these concepts, let’s perform an
analysis using a real company—which provides a
challenge!
• We will use the 2002 financial statements for Adolph
Coors Company.
– Suppose sales increase 10% or decrease 10%?
– The numbers that follow are in $thousands (except EPS).
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Adolph Coors,
2002 Condensed Balance Sheet
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Adolph Coors,
2002 Condensed Income Statement
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Adolph Coors,
2002 Cash Flow Statement
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Pro Forma Statements, Notes I.
• The pro forma income statements correspond to a 10
percent increase and a 10 percent decrease in sales
and cost of good sold.
• This causes gross margin to increase or decrease by
10 percent, too.
• For convenience, italics indicate when actual 2002
values are used.
• Because operating expenses are assumed to be
constant at 2002 levels, operating income varies a lot.
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Pro Forma Statements, Notes II.
• Tax rates are assumed the same as in 2002 (helps us
calculate net income).
• Dividends remain at 2002 levels (helps us calculate
retained earnings).
• Retained earnings on the balance sheet are adjusted
by retained earnings from the income statement.
• Cash on the balance sheet must be adjusted to reflect
the net cash increase from the cash flow statement.
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Pro Forma Statements, Notes III.
• Because retained earnings and the net cash increase
are not equal, the balance sheet will not balance!
• But, all items making up the difference appear on the
cash flow statement.
– Must adjust plant, property, and equipment and goodwill to
reflect changes in depreciation and amortization.
– Must adjust operating assets and current liabilities, too.
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Adolph Coors,
2003 Pro Forma Income Statement
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Adolph Coors,
2003 Pro Forma Cash Flow Statements
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Adolph Coors,
2003 Pro Forma Balance Sheet
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Projected Profitability and Price Ratios,
Adolph Coors Company
Original
+10 Percent
-10 Percent
36.06%
36.06%
36.06%
Operating Margin
7.90%
10.46%
4.77%
Return on Assets (ROA)
3.76%
4.81%
1.53%
Return on Equity (ROE)
16.46%
20.62%
7.38%
$27.15
$33.17
$28.43
Earnings per share (EPS)
$4.47
$6.84
$2.10
Cash Flow per share (CFPS)
$7.15
$11.39
$6.65
Gross Margin
Book Value per share (BVPS)
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Projected Stock Prices,
Adolph Coors Company
• 2002 Year-end Stock Price: $61.25.
+10 Percent
-10 percent
BVPS times P/B
$74.83
$64.13
EPS times P/E
$93.74
$28.74
CFPS times P/CF
$97.58
$56.94
• As with the Borg Corporation, these projected stock
prices reflect widely varying degrees of sensitivity to the
sales scenarios.
– EPS and CFPS are especially sensitive to the sales scenario.
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Useful Internet Sites
• www.nyse.com (The website of the New York Stock
Exchange provides a directory of websites for
companies whose stocks are listed at the NYSE.)
• www.sec.gov (reference for electronic data archives,
EDGAR)
• www.street.com (see research/tools for earnings
estimates)
• www.uoutperform.com (reference for a summary for
valuing stocks)
• www.investorsuniverse.org (see the education center)
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Chapter Review, I.
• Sources of Financial Information
• Financial Statements
–
–
–
–
The Balance Sheet
The Income Statement
The Cash Flow Statement
Performance Ratios and Price Ratios
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Chapter Review, II.
• Financial Statement Forecasting
–
–
–
–
The Pro Forma Income Statement
The Pro Forma Cash Flow Statement
The Pro Forma Balance Sheet
Projected Profitability and Price Ratios
• Adolph Coors Company Case Study
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