FINS3625 Applied Corporate Finance

Semester 1, 2015

Week 2

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Chapter 2 Introduction to Financial Statement Analysis

2.1 Firms Disclosure of Financial Information

2.2 The Balance Sheet

2.3 The Income Statement

2.4 The Statement of Cash Flows

2.5 Other Financial Statement Information

2.6 Financial Statement Analysis

2.7 Financial Reporting in Practice

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2.1 Financial Statement

Financial Statement Financial statements are accounting reports that a firm issues

periodically to describe its past performance.

Investors, financial analysts, managers and other interested parties rely on financial statements to obtain reliable information about a corporation.

Preparation of Financial Statements Generally Accepted Accounting Principles (GAAP).

International Financial Reporting Standards (IFRS).

Makes it easier to compare financial results of different firms.

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2.1 Financial Statement

Types of Financial Statements Balance sheet

Income statement

Statement of cash flows

Statement of changes in shareholders (or stockholders) equity

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2.2 Balance Sheet

A snapshot in time of the firms financial position

The Balance Sheet Equation: Assets = Liabilities + Shareholders Equity

Assets What the company owns

Liabilities What the company owes

Shareholders Equity The difference between the value of the firms assets and liabilities

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2.2 Balance Sheet

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2.2 Assets

Current Assets: cash or asset expected to be turned into cash within one year Cash

Accounts receivable

Inventories

etc

Long-Term (or Non- Current) Assets: assets that produce benefits for more than one year Property, plant, & equipment

Depreciation

Goodwill Amortization

etc

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2.2 Liabilities

Current Liabilities: due to be paid within one year Accounts payable

Short-term debt payable

Wages payable

etc

Long-Term Liabilities: liabilities that extend beyond one year Long-term debt

Capital leases

etc

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2.2 Liabilities

The difference between current assets and current liabilities is the firms net working capital, the capital available in the short term to run the business.

Net Working Capital = Current Assets Current Liabilities

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2.2 Shareholders Equity

The difference between the firms assets and liabilities is the shareholders equity, also called the book value of equity. Based on historical costs rather than true value.

Fails to capture some valuable assets such as reputation.

Not necessarily an accurate assessment of the true value of the firms equity.

Market value of equity (market capitalization) Market Price per Share x Number of Shares Outstanding.

Depends on what investors expect those assets to produce in the future.

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2.6 Balance Sheet Analysis

Market-to-Book Ratio

Value shares: low M/B ratio; Growth shares: high M/B ratio

Debt-Equity Ratio

Measures the extent to which the firm relies on debt as a source of financing, or leverage.

Enterprise Value

Assesses the value of the underlying business assets.

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Market Value of EquityMarket-to-Book Ratio

Book Value of Equity

Total DebtDebt-Equity Ratio

Total Equity

Enterprise Value Market Value of Equity Debt Cash

2.6 Balance Sheet Analysis

Example: In January 2009, Rylan Corporation had a market capitalization of 110 million, a market-to-book ratio of 2.2, a book debt to equity ratio of 1.4, and cash of $6.3 million. What was Rylans enterprise value? Book value of equity = $110m / 2.2 = $50m

Total debt = $50m 1.4 = $70m

Enterprise value = $110m + $70m - $6.3m = $173.7m

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2.3 Income Statement

Total Sales Cost of Sales = Gross Profit

Gross Profit Operating Expenses = Operating Income

Operating Income Other Income/Expenses = Earnings Before Interest and Taxes (EBIT)

EBIT Interest Income/Expenses Taxes = Net Income

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2.3 Income Statement

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2.6 Income Statement Analysis

Profitability Ratios

Gross Margin

Reflects firms ability to sell a product for more than the cost of producing it.

Net Profit Margin

Shows the fraction of each dollar in revenues that is available to equity holders after the firm pays its expenses plus interest and taxes.

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Sales

ProfitGrossMarginGross

Net IncomeNet Profit Margin

Total Sales

2.6 Income Statement Analysis

EBITDA

Earnings Before Interests, Taxes, Deprecation and Amortization Depreciation and amortization are not actual cash expenses.

EBITDA reflects the cash a firm has earned from its operations.

Investment Returns

Return on Equity (ROE)

Return on Assets (ROA)

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Net IncomeReturn on Equity

Book Value of Equity

AssetsTotal

IncomeNetAssetsonReturn

2.6 The DuPont Identity

First term measures firms overall profitability.

Second term measures firms efficiency in utilizing its assets to generate sales.

Third term is another measure of leverage. A higher Equity multiplier implies a greater reliance on debt financing.

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EquityofValueBook

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNetROE

Net Profit Margin Asset Turnover Equity Multiplier

Return On Assets

2.6 Valuation Ratios

PriceEarnings Ratio (P/E)

A very commonly used measure.

Meaningless when the firm has negative earnings.

Solution: look at enterprise value relative to sales.

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Market Capitalization Share PriceP / E Ratio

Net Income Earnings per Share

2.4 The Statement of Cash Flows

Net income typically does not equal the amount of cash the firm has earned because of: Non-Cash Expenses (e.g. Depreciation and Amortization)

Uses of cash not on the Income Statement (e.g. Investment in Property, Plant, and Equipment)

Three sections of cash flow statements: Operating activities

Investment activities

Financing activities

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2.4 Three sections in cash flow statement

Operating Activities

Adjust net income by all non-cash items related to operating activities and changes in net working capital Add depreciation and amortization

Deduct accounts receivable

Deduct inventories

Add accounts payable

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2.4 Three sections in cash flow statement

Investment Activities

Shows the cash required for investment activities Capital Expenditures (i.e. purchases of new property, plant, and

equipment) do not appear immediately as expenses on the income statement => deduct

Similarly, sales of properties etc are not recognized as income => add

Financing Activities

Shows the cash flows from financing activities Examples of cash outflows: dividend payments, share repurchases

Examples of cash inflows: increase in borrowing

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2.4 Three sections in cash flow statement

Example:

Solution: Depreciation affects cash flow via 2 channels: net income & operating

activities cash flow.

Pre-tax income falls by 1m tax expense falls by 0.26m net income falls by 0.74m.

Operating activities cash flow rises by 1m.

Therefore, the net impact is 1m - 0.74m = 0.26m

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2.7 Financial Reporting in Practice

Enron Considered as one of the most successful companies in America.

Executives manipulated financial statements to mislead investors.

Example: recording money borrowed as income while hiding the future obligations to pay it back.

WorldCom Another record-breaking scandal.

Fraud: reclassify operating expenses as long-term capital expenditures.

Sarbanes-Oxley Act (SOX)

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Chapter 19 Valuation and Financial Modeling

19.1 Valuation Using Comparables

19.2 The Business Plan

19.3 Building the Financial Model

19.4 Estimating the Cost of Capital

19.5 Valuing the Investment

19.6 Sensitivity Analysis

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19.1.1 Valuation Using Comparables

A useful approach to obtain a rough idea of the value of the firm.

The trick is to find a comparable firm that: (1) has a fair and observable price; and

(2) is similar to the firm of interest as possible.

Consider Ideko Corporation, a privately held firm. Assume that we are interested in knowing whether $150 million is a reasonable price for this firm.

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19.1.1 Valuation Using Comparables

Based on the proposed price of $150 million, further assume that we have obtained the following ratios:

Problem of using comparables: unreliable for a precise estimation

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Comparable firms

19.2 & 19.3 Building the Financial Model

Computation 1:

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19.2 & 19.3 Building the Financial Model

Computation 2:

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19.2 & 19.3 Building the Financial Model

Computation 3:

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Our ultimate mission

19.2 & 19.3 Building the Financial Model

Useful information:

1. Sales = Market Size x Market Share x Average Sales Price

2. Raw Materials = Market Size x Market Share x Raw Materials per Unit

3. Direct Labor = Market Size x Market Share x Direct Labor Cost per Unit

4. S&M = Sales x (S&M % of Sales)

5. Admin = Sales x (Admin % of Sales)

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19.2 & 19.3 Building the Financial Model

Computation 1:

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19.2 & 19.3 Building the Financial Model

Computation 2

:

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19.2 & 19.3 Building the Financial Model

Computation 3:

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19.5 Valuing the Investment

The Multiples Approach to Continuation Value

Practitioners generally estimate a firms continuation value (also called the terminal value) at the end of the forecast horizon using a valuation multiple The EBITDA multiple is the multiple most often used in practice.

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Continuation Enterprise Value at Forecast Horizon

EBITDA at Horizon EBITDA Multiple at Horizon

19.5 Valuing the Investment

Based on the information we have so far:

A few notes: EV/Sales = 292,052 / 158,626 = 1.8

P/E (levered) = 172,052 / 10,545 = 16.3

P/E (unlevered) = 292,052 / 15,849 = 18.4

The estimation seems reasonable, or arguably conservative.

One issue: future multiples of the firm are being compared with current multiples of its competitors.

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Homework

Chapter 2: 8, 25

Chapter 19: 1, 5, 9

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