1' Financial Statements

1
1. Financial Statements

• Evaluating financial health of a company
• Computing cash flows (basis for evaluating
  projects)

2. The Discounted Cash Flow method for valuing
bonds, stocks and projects
2
The Balance Sheet

• Assets Liabilities Shareholders Equity
• Tabulates a companys assets and liabilities at a
  specific point in time (snapshot of the firm)
  info on the value of the assets and the capital
  structure
• Sorting of
• Assets by liquidity, i.e. how fast they can be
  converted into cash
• Liabilities by maturity, i.e. when they must be
  paid

Net working capital
3
(No Transcript)
4
Income statement

• Revenue Expenses Income
• Records transactions over a specific time period
  (1 year)
• Prepared in accordance with the matching
  principle
• revenues must be matched with expenses.
• revenues and costs are recognized when goods are
  sold or services are provided (cash inflows or
  outflows does not necessarily occur at the same
  time)

5
U.S. COMPOSITE CORPORATION
Income Statement
20X2
(in millions)
Total operating revenues
2,262
the firms revenues and expenses from principal
operations
Cost of goods sold
- 1,655
Selling, general, and administrative expenses
- 327
Depreciation
- 90
Operating income
190
Other income
29
Other income and all financing costs, such as
interest expense
Earnings before interest and taxes
219
Interest expense
- 49
Pretax income
170
the amount of taxes levied on income.
Taxes
- 84
Current 71
Deferred 13
Net income
86
Retained earnings
43
Dividends
43
6
From earnings to cash flows

• In corporate finance our primary interest is cash
  flows, i.e. real money that go to investors
  (debtholders and equityholders) at all points in
  time crucial for valuing projects and the firm
  as a whole
• CF (firm) CF (debt) CF (equity)
• Problems with Income Statement
• Recognizing revenues and costs does not mean that
  actual cash inflows and outflows have occurred
• Contains non-cash items (depreciation, deferred
  taxes)
• Does not take into account capital expenditures
  and changes in NWC

7
So, how to determine cash flows?

• Start from Operating Cash Flow
• OCF EBIT Taxes Depreciation
• Determine how much is used for capital spending
  and changes in NWC (see balance sheet)
• CF from assets OCF Capex ?NWC
• Capex Change in Fixed Assets Depreciation
• NWC Current Assets Current Liabilities
• Determine what each category of investors get out
  of CF(A) CF(A) CF(B)CF(S)

8
Financial Cash Flow of the U.S.C.C.
20X2
(in millions)
Operating Cash Flow EBIT 219 Depreciation
90 Current Taxes (71) OCF 238
Cash Flow of the Firm
Operating cash flow
238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
9
Financial Cash Flow of the U.S.C.C.
20X2
(in millions)
Cash Flow of the Firm
Operating cash flow
238
Capital Spending Purchase of fixed assets
198 Sales of fixed assets (25) Capital
Spending 173 ( ? total fixed assets
depreciation)
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
10
Financial Cash Flow of the U.S.C.C.
20X2
(in millions)
Cash Flow of the Firm
Operating cash flow
238
(Earnings before interest and taxes
Changes in NWC NWC grew from 275 million in 20X2
from 252 million in 20X1. This increase of 23
million is the addition to NWC.
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
11
Financial Cash Flow of the U.S.C.C.
20X2
(in millions)
Cash Flow of the Firm
Operating cash flow
238
(Earnings before interest and taxes
Cash Flow to Creditors Interest 49 Retirement
of debt 73 Debt service 122 Proceeds from
new debt sales (86) Total 36
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
12
Financial Cash Flow of the U.S.C.C.
20X2
(in millions)
Cash Flow of the Firm
Operating cash flow
238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Cash Flow to Stockholders Dividends
43 Repurchase of stock
6 Cash to Stockholders 49 Proceeds from new
stock issue (43) Total
6
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
13
Financial Cash Flow of the U.S.C.C.
20X2
(in millions)
The cash from received from the firms assets
must equal the cash flows to the firms creditors
and stockholders
Cash Flow of the Firm
Operating cash flow
238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
14
Financial Ratio Analysis

• Aggregates info from financial statements by
  forming indicators of the firms financial
  condition (ratios)
• Trend Analysis
• Cross-Sectional Analysis

15
Types of ratios

• Liquidity (short-term solvency) ratios
• Activity ratios
• Leverage ratios
• Profitability ratios
• Market value ratios

16
Liquidity ratios

• Measuring short-term liquidity
• Current Ratio Current Assets / Current
  Liabilities
• Too low CR may be a sign of financial trouble
• Too high CR may mean poor operating practices
• Quick Ratio
• (Current Assets Inventories) / Current
  Liabilities

17
Activity ratios

• How well the company uses its productive
  resources
• Total Asset Turnover Sales / Average Total
  Assets
• Effectiveness in using the total assets
• Accounts Receivable Turnover Sales / Average
  Accounts Receivable
• Average Collection Period 365 / Accounts
  Receivable Turnover
• Too long ACP may mean lenient credit policy,
  failure to collect on time, bad quality of
  receivables
• Inventory Turnover Cost of Goods Sold /
  Average Inventory
• Days in Inventory 365 / Inventory Turnover
• Too many days is a bad thing if products become
  obsolete

18
Financial leverage ratios

• Measures of risk, likelihood of default
• Debt Ratio Total Debt / Total Assets
• Debt-to-Equity Ratio Total Debt / Total Equity
• Interest Coverage EBIT / Interest
• Meeting interest payments out of EBIT (can be
  modified to be based on cash flows instead of
  earnings Cash Flow Coverage)

19
Debt Ratio Debt-Equity RatioSpectrum
Manufacturing

• 
  1999 1998 1997
• Total Liabilities 8,456
  7,609 3,695
• Total Assets 13,396
  12,117 7,794
• Stockholders Equity 4,940
  4,508 4,099
• Debt Ratio 0.63
  0.63 0.47
• Debt-Equity Ratio
  1.71 1.69 0.90
• Industry Average (Debt
  Ratio) 0.55
• Industry Average (Debt-Equity
  Ratio) 1.22
• Creditors are exposed to more risk than the
  industry average
• The risk is growing over time, impairing the
  firms ability to borrow

20
Times Interest EarnedSpectrum Manufacturing

• 
  1999 1998 1997
• Net Operating Income (EBIT) 1,265
  1,775 1,915
• Interest Expense 389
  363 142
• Interest Coverage
  3.3X 4.9X 13.5X
• 
  Industry Average 5.4X
• Although the ratio is going down, its still OK
  to provide security to creditors

21
Profitability ratios

• Help evaluate managerial performance
• Gross Profit Margin EBIT / Sales
• Net Profit Margin Net Income / Sales
• Profit margins measure the ability to control
  expenses in relation to sales
• Gross Return on Assets (ROA) EBIT / Total
  Assets
• Net Return on Assets (ROA) Net Income / Total
  Assets
• Measure profitability of the overall firm
• Return on Equity (ROE) Net Income / Equity
• Measures profitability from the perspective of
  the equity investor
• Payout Ratio Cash Dividends / Net Income

22
The DuPont Analysis

• Gives an understanding of what is causing changes
  in ROE and through which variables it can be
  improved
• E.g., if it is hard to change Net Profit Margin,
  a firm can play with Total Asset Turnover and
  Equity Multiplier. But should be careful with EM
  since it increases risk

23
Du Pont AnalysisSpectrum Manufacturing

• 1997-1999
• Year Net Profit x Total Asset x
  Equity ROE ()
• Margin () Turnover Multiplier
• 1997 4.3
  2.8 1.9
  22.9
• 1998 3.0
  2.3 2.7
  18.6
• 1999 2.6
  1.6 2.7
  11.2
• The firm is following a dangerous path
  increasing leverage does not help revert the
  trend of decreasing ROE, while at the same time
  raises financial risk.

24
Market Value Ratios

• Measures of the firms prospects
• Price-to-Earnings Share Price / EPS
• EPS Net Income / of shares
• Dividend Yield DPS / Share Price
• Market-to-Book Ratio Market Equity Value /
  Book Equity Value
• Book Share Price Equity / of shares
• Tobins Q Market Value of Debt Equity /
  Replacement Value of Assets

25
Basics of valuation

• Value Sum of discounted cash flows
• Future cash flows have lower value. Discount rate
  R
• time value of money
• Present value of a single cash flow at T
• PV0 CFT/(1R)T
• Perpetuity Ct C, tgt0
• PV0 C/R
• Growing perpetuity (with const rate g) Ct
  (1g)t-1C
• PV0 C/(R - g)
• Annuity Ct C, t 1,,T
• PV0 (C/R) 1 1/(1R)T
• Growing annuity (with const rate g)
• PV0 (C/(R-g)) 1 (1g)T/(1R)T

26
Pricing bonds, stocks and projects

• Bond with coupon C and face value F (at T)
• P0 (C/R) 1 1/(1R)T FT/(1R)T
• Stocks with dividends growing with const rate g
• PV0 Div1/(R-g)
• Project NPV St CFt/(1R)t (where CF can be
  outflows too)
• Two big issues
• How to compute cash flows?
• What is the proper discount rate?