financial statements. the big three accounting statements 1. the balance sheet 2. the income...
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Financial Statements
The Big Three Accounting Statements1. The Balance Sheet
2. The Income Statement
3. The Statement of Cash Flows
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1) The Balance Sheet
A snapshot of the firm Assets ≡ Liabilities +
Stockholder’s Equity Left Hand Side must
balance with the Right Hand Side
Current Assets
Fixed Assets
Tangible Intangible
LHS
Shareholder Equity
Current Liabilities
Long-Term Debt
RHS
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Balance Sheet Analysis When analyzing a balance sheet, the Finance
Manager should be aware of three concerns:1. Liquidity
2. Debt versus Equity
3. Value versus Cost
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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
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Debt versus Equity Debt → Liability
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
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Value versus Cost Cost: What did we pay for it
Accountants are historiansGAAP requires assets be recorded at cost
Book value
Market value: What would it cost TODAY Cost and Market Value are two completely
different conceptsWhat did we pay for it, versus what can we sell it for
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2) The Income Statement
Income ≡ Revenue – Expenses Measure how the company has performed over
some period of time Generally comprised of four parts:
1. Operating
2. Non-Operating
3. Taxes
4. Bottom Line
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U.S.C.C. Income Statement
Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income
$2,262 1,655
327 90
$190 29
$219 49
$170 84
$86
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Income Statement Analysis There are several things to keep in mind
when analyzing an income statement:1. INCOME IS NOT CASH
2. Matching Principal
3. Non-Cash Items
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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
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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.”
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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
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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?
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3) The Statement of Cash Flows
The three components are:Cash flow from operating activitiesCash flow from investing activitiesCash flow from financing activities
Attempts to change Net Income to a Cash number
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U.S.C.C. Cash Flow from Operations
Start with net income, and then add back non-cash expenses , and changes in accounts
OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities
Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther
Total Cash Flow from Operations
$869013
-24111618-3
$199
-8
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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 assetsSales of fixed assets
Total Cash Flow from Investing Activities
-$19825
-$173
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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 salesDividendsRepurchase of stockProceeds from new stock issue
Total Cash Flow from Financing
-$73 86
-43
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$7
-6
Finance and the Accounting Finance is concerned with:
Market Values and Cash Flows Accounting:
Care about historical costsAccounting numbers (NOT CASH)
But Accounting is often called the language of finance
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Quick Quiz
1. What is the difference between book value and market value? Which should we use for decision making purposes?
2. What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
3. What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
4. How do we determine a firm’s cash flows? What are the equations, and where do we find the information?
Financial Statements Analysis and Long-Term PlanningChapter 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
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1) Common-Size Statements
Report everything as a percent the top numberTotal assets for the Balance Sheet Sales for the Income Statement
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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?
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Categories of Financial Ratios
Short-term solvency (liquidity ratios) Long-term solvency (financial leverage ratios) Asset management (turnover ratios) Profitability ratios Market value ratios
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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 (708 - 422) / 540 = 0.53 times
Cash Ratio = Cash / CL 98 / 540 = 0.18 times
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Leverage Ratios How easily can the firm meet its long term obligations
Why is this important?
Total Debt Ratio = (TA – TE) / TA (3588 - 2591) / 3588 = 28%
Debt/Equity = TD / TE (3588 – 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E 1 + .385 = 1.385
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Coverage Ratios How easily can the firm payoff its debt holders
Why is this important?
Times Interest Earned = EBIT / Interest691 / 141 = 4.9 times
Cash Coverage= (EBIT + Depreciation)/Interest(691 + 276) / 141 = 6.9 times
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Inventory Ratios How efficiently is the firm managing inventory
Why is this important?
Inventory Turnover = Cost of Goods Sold / Inventory1344 / 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory Turnover365 / 3.2 = 114 days
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Receivables Ratios How quickly does the firm get paid
Why is this important?
Receivables Turnover = Sales / Accounts Receivable2311 / 188 = 12.3 times
Days’ Sales in Receivables = 365 / Receivables Turnover365 / 12.3 = 30 days
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Total Asset Turnover How efficient is the firm turning assets into sales
Why is this important?
Total Asset Turnover = Sales / Total Assets2311 / 3588 = 0.64 times
It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets. Why?
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Profitability Measures
How efficient is the firm’s operationsWhy 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%
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
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Where are returns generated
ROE = PM * TAT * EMProfit margin: How well does the firm controls costsTotal asset turnover: How well does the firm
manages its assetsEquity multiplier: How levered is the firm
The better the managers handle these aspects of the firm the greater the return generated
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Market Value Measures How do people feel about the firm
Why is this important?
PE Ratio = Price per share / Earnings per share88 / 11 = 8 times
Market-to-book ratio = market value per share / book value per share88 / (2591 / 33) = 1.12 times
Using Financial Statement Analysis
Ratios by themselves are not very usefulIs a profitability ratio of 9% good?
Time-Trend AnalysisCompare this years ratios to prior ratios
Peer Group AnalysisCompare your ratios to other firms in the industry
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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
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Long-Term Financial Planning These are the big decisions, planning where the
company is goingCapital budgeting: Does Nike start a magazine?Capital structure: Do we issue stock or bonds?
Generally these decisions are based on pro forma financial statementFinancial statements based on what we think will happen
in the future
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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
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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
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Calculating the Internal Growth Rate
Using the information from the Hoffman Co. ROA = 66 / 500 = 0.132 b = 44/ 66 = .66700
Internal Growth Rate (ROA * 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
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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 sameWill this be higher or lower than the IGR?
SGR = (ROE * b )/ (1 – ROE * b)
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Calculating the Sustainable Growth Rate
Using the Hoffman Co.ROE = 66 / 250 = 0.264b = 0.667
Sustainable Growth Rate(ROE * b )/ (1 – ROE * b)(0.264 * 0.667) / (1 – 0.264 * 0.667 )= 0.214Hoffman Co. can grow at 21.4% without changing
its capital structure
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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
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Quick Quiz1. How do you standardize balance sheets and
income statements?2. Why is standardization useful?3. What are the major categories of financial ratios?4. How do you compute the ratios within each
category?5. What are some of the problems associated with
financial statement analysis?
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Quick Quiz
6. What is the purpose of long-range planning?7. What are the major decision areas involved in
developing a plan?8. What is the percentage of sales approach?9. What is the internal growth rate?10. What is the sustainable growth rate?11. What are the major determinants of growth?