Lecture 2: Financial Statements

1
Lecture 2 Financial Statements

• C. L. Mattoli

2
Intro

• To begin financial analysis, we need financial
  information.
• One of the most common forms of financial
  information is the financial statements of
  companies or other businesses.
• The three important financial statements are
  income statement, balance sheet and cash flow
  statements, which show how one periods balance
  sheet flows into the next.

3
Intro

• Remember, again, that finance is not accounting,
  so we will need to use financial information in
  the proper manner.
• Moreover, as we study how to properly use
  financial data, it will help you to understand
  accounting even better.
• It will also help you to understand the
  limitations of accounting and how it differs from
  finance.

4
Intro

• In particular, you should understand the
  difference between income and cash flow and
  accounting value versus market value
• To those ends, we will discuss financial
  statements. Then, we will pick them apart to see
  what we can use for financial analysis. And
  finally, we will look at financial analytical
  systems.

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The Balance Sheet (BS)
6
Balance sheet

• The first statement that you can prepare for a
  business, is the balance sheet or statement of
  financial position.
• The balance sheet (BS) gives a picture of what
  the company owns (assets) and owes (liabilities).
• The difference between them owners equity
  (equity) at a given point of time.
• Assets, left-hand side liabilities and equity
  are on the right. In an abstract equation we can
  write A L E.
• It is published quarterly in accounting, it is
  kept current on a day-to-day basis.

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Abstract Basic Balance Sheet
Net WC CA - CL
Current Assets Cash A/R Inventory
Current Liabilities Accrued Expenses A/P SR Debt
Non-current liabilities, including Long term debt
Long term assets Tang. fixed assets Intangibles
Equity
E A - L
8
Assets

• First break assets down into current assets and
  fixed assets.
• Current assets have a life of less than a year.
• Examples are cash (and equivalents), inventory,
  and A/R (accounts receivable money owed from
  customers for credit sales).
• Fixed assets two sub-types tangible (physically
  real), like machinery or a building, and
  intangible, like patents or trademarks.

9
Liabilities

• Liabilities current liabilities and long-term
  (LT) liabilities.
• Current liabilities (CL) come due for payment
  within a year.
• Include short-term (ST) loans, current portion of
  LT debt due for repayment, A/P (accounts payable
  to, e.g., suppliers), accrued expenses.
• LT liabilities are LT debts, such as LT bank
  loans and bond and debenture securities.

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Equity

• Other portion of the right-hand side of the
  balance sheet is shareholders or owners
  equity.
• Equity is the difference between assets and
  liabilities.
• Usually, breakdown of equity into initial equity
  that was contributed to start the firm and
  retained earnings (RE), which represents the
  profits that the firm has made and reinvested in
  the business.

11
Equity

• Accounting value of the firm may or may not have
  anything to do with actual value.
• If you sold all of the assets (at their value on
  the balance sheet) and you used that money to
  liquidate all of the companys debts, what would
  be leftover would belong to the owners.

12
Working Capital (WC)

• Some further definitions for the balance sheet
  have to do with ST items.
• Both CA and CL are part of working capital (WC).
• We also define net WC as CA CL.
• We use Net WC as a first measure of the companys
  financial health.

13
Working Capital (WC)

• Since CL must be paid within a year, and CA are
  expected to be liquidated within a year, a
  positive NWC is a preliminary indication of the
  companys viability.
• If NWC is negative, it would appear that the firm
  will not be able to make it through the year.

14
Liquidity

• We used the term liquidate, in the last few
  slides.
• The word, liquid, means something, like water or
  milk, which are called liquids.
• In finance, the term liquidity refers to how fast
  and how easily an asset can be converted to cash.
• When we say easy that means, basically, without
  loss of value in the sale.

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Liquidity

• Anything can be sold at a reduced price, but when
  we say that an asset is liquid, then, we mean
  that it can be sold quickly without a big loss in
  value.
• Things, like securities, saving accounts, and
  precious metals, like gold and silver, are fairly
  liquid assets.
• Things, like real estate or a large piece of used
  specialty equipment are probably not very liquid.

16
The importance of liquidity

• One of the things that we will study is WC
  management, so you might guess that liquidity is
  important.
• The greater the liquidity of the company, the
  more likely that it will be able to pay off its
  debts and take on new assets.
• The importance of liquidity is even recognized in
  the actual set-up of the balance sheet.
• The balance sheet is constructed, on both sides,
  in decreasing order of liquidity.

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The importance of liquidity

• Thus the most liquid assets and liabilities are
  at the top, then, the next most liquid, etc.
• Beyond the simple fact that we want to be able to
  meet our short term debts and have short term
  assets to do our business, well, there is another
  reason that we have to manage WC profit.
• Short-term assets tend to earn low or no return,
  like cash.
• Short-term liabilities can be costly, like an
  emergency loan to meet current shortfalls in
  revenue.

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Table 2.1 OZ Company Balance Sheet

• Below, we show an excerpt from the text book,
  showing a basic balance sheet.
• Notice that items appear on the BS in decreasing
  order of liquidity, down the sheet.

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Debt compared to Equity

• Since debt and equity (common plus preferred)
  make up the firms capital, it is worth looking
  at them, both, in greater detail.
• Under most, if not all, laws around the world,
  creditors stand at the front of the line, in
  liquidation of the firm. As we mentioned, in
  last weeks lecture, debt is senior to equity
  with finer gradations for debt and equity.
• By liquidation, we mean any type of winding up of
  the business, including forced liquidation
  (bankruptcy) or voluntary.

20
Debt compared to Equity

• Logically, from a legal perspective, if you
  borrow money from someone, you should be legally
  liable for the repayment.
• So, debt should be repaid, in any event, before
  the owner of the business can walk away with his
  leftovers equity.
• Also, the debt holders are, somehow, taking less
  of the risk in the business than the equity
  holder owners, which is as it should be.

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Debt compared to Equity

• That has one advantage, debt holders will demand
  less of a profit on their money than those who
  put money into the firm as owners.
• However, there is also a downside to debt
  payments on debt, including interest, the charge
  for borrowing, and eventual payment of the
  principal (the amount borrowed, in the first
  place), must be made in the ordinary course of
  business.

22
Debt compared to Equity

• Affect on profit, since interest is an ongoing
  expense against income, but, debtors can sue, in
  court, if the debtor is in default of his
  contractual payments.
• The amount of payment that the plaintiff sues for
  is what will be awarded by the court.
• However, consider that there could be a domino
  effect from a default and a lawsuit, which might
  force the company into involuntary liquidation.

23
Debt compared to Equity

• The equity entitles the owners to what is left
  after selling all assets and liquidating
  liabilities.
• Equity holders are also entitled to all of the
  net cash flows that are leftover, each period,
  after everyone else is paid.
• Out of that excess CF, the firm might make cash
  payments to equity holders, called dividend
  payments. The rest of the money will be
  reinvested in the firm as the RE portion of
  equity, and the firm will grow in accounting
  value.

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Financial Leverage

• The use of debt in the capital mix is referred to
  as financial leverage.
• We speak of financial leverage because the use of
  debt can, therefore, magnify gains and losses.
• As we shall learn later in this module, finance
  likes to look at things in terms of ratios of one
  financial number to another.

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Financial Leverage

• One of the fundamental ratios in finance is
  called a rate of return.
• If I say I earned 1,000 on an investment, your
  first questions should be how much did you
  invest to get that income?
• The rate of return on in vestment (ROI) is the
  ratio of income from investment to initial
  investment Inc/II.

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Leverage

• Why do we call it leverage? Because there is a
  magnification effect, like when we use a lever to
  lift something
• For example, assume that you have 10 million
  (your equity), and that you can make a 10 return
  on money. With only your money, you would make
  1 million (10x10 million). ..

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Leverage

• Next, assume that you borrow 90 million (debt)
  for 5 interest. Then, you make 10 million (10
  x 100 million), pay 4.5 million for the debt
  (5x90 million), so net income is 5.5 million
  (10-4.5 million).
• Our return on equity is quite enhanced, levered.
  It is, now, 5.5 million/10 million 55
  instead of the un-levered 10 return.

28
Market value vs. book (acctg) value

• The true value of something is what you could
  sell it for (in, e.g., a market) market value.
• The numbers shown in a BS are the book values of
  the firms assets and liabilities.
• Under Australian Accounting Standards (AAS),
  assets are usually carried on the books at
  historical cost, no matter when the asset was
  acquired and what it is actually worth.

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Market value vs. book (acctg) value

• For CA, the book value should be close to market
  value.
• Oh the other hand, a piece of old machinery that
  has been depreciated over the years will probably
  have a book value different from the actual value
  in the market for old machinery.
• However, assets that are expected to appreciate
  in value, like real estate, must be periodically
  revalued.

30
Market value vs. book (acctg) value

• Any adjustments to value are recorded in an Asset
  Revaluation Reserve Account (ARRA), on the books,
  and that ARRA is another sub-part of the owners
  equity account (E).
• Investors and managers are interested in knowing
  market values, not book.
• First of all, as we discussed, book value may not
  be representative of market value.

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Market value vs. book (acctg) value

• In addition, many of true assets are not even
  listed on the BS. These are things, like brand
  name, management/employee skill, and reputation.
• Some people have said that the value of the
  names, Microsoft, Coca Cola and IBM, alone, are
  worth 50 billion.
• Moreover, since owners equity is a residual, A
  L, its book value will differ from market.
• In finance, when we speak of value, we are
  usually referring to market value (economic).

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Example 2.2 Market vs. Book
We show a sample comparison of book (accounting)
value and market (economic) values in the
example, below.
Text example 2.2 Battler Company Text example 2.2 Battler Company Text example 2.2 Battler Company Text example 2.2 Battler Company Text example 2.2 Battler Company Text example 2.2 Battler Company
Balance Sheets Balance Sheets Balance Sheets Balance Sheets Balance Sheets Balance Sheets
Book Value versus Market Value Book Value versus Market Value Book Value versus Market Value Book Value versus Market Value Book Value versus Market Value Book Value versus Market Value
Book Market Book Market
Assets Assets Assets Liabilities and Shareholders Equity Liabilities and Shareholders Equity Liabilities and Shareholders Equity
NWC 400 600 LTD 500 500
NFA 700 1,000 SE 600 1,100
1,100 1,600 1,100 1,600
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The Income Statement (IS)
34
The income statement

• The income statement reveals financial
  performance over some extended period of time,
  usually, a quarter, half, or whole year.
• In a simple abstract equation Income Revenue
  Expense (Inc Rev Exp).
• We show a basic income statement in the next
  slide.

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Textbook Table 2.2
36
Income Statement

• The first items on an income statement are
  revenues.
• The next item is expenses against income.
• Then, we include financing charges, like interest
  expense.
• From that, we get taxable income (pre-tax income,
  PTI).
• Then, calculate taxes, subtract them out to get
  net income (after-tax income, ATI).

37
Income Statement

• Companies usually also report earnings per share
  (EPS), which is ATI/number of shares.
• Out of income, some cash dividends might be paid
  out to shareholders (owners), and the rest of it
  goes to retained earnings (RE).
• In looking at the IS, we must be aware of AAS,
  cash versus non-cash items (like depreciation),
  time and cost.

38
AAS and the IS

• According to AAS, revenue is recorded when it
  accrues (revenue recognition principle) when the
  earnings process is virtually completed and the
  value of the transaction is known.
• In practice, that means at the time of sale,
  which may not be the same as when payment is
  made.
• Expenses are based on a matching principle costs
  associated with the sale are subtracted on the
  IS.
• As a result, the income statement will not
  necessarily represent the actual cash flows that
  have occurred during the period.

39
Non-cash Items

• A major reason that accounting income differs
  from actual cash flows is that accounting income
  statements include non-cash items.
• Depreciation is one of the most common non-cash
  charges.
• You buy equipment for 1 million that will be
  used for 10 years of production, instead of
  deducting all of it now, accounting will
  depreciate the cost over 10 years.

40
Non-cash Items

• Thus, each year, 1 million/10 years 100,000
  depreciation (called straight-line depreciation
  because it is the same each year), will be
  expensed against revenues.
• The depreciation charge is not an actual cash
  flow. After all, you spent the money for the
  machinery (actual cash outflow) when you bought
  it.

41
Non-cash Items

• Depreciation arises in accounting, again, based
  on a matching principle of allocating costs to
  revenues, matching costs with benefits.
• As we shall discover in future modules, the
  financial managers is critically interested in
  the actual timing of cash flows (time value), in
  order to come up with proper values of things.

42
Time Costs

• We have been dividing up things into LT and ST.
  The difference between the two, in economics, is
  that in the LT all business costs are variable
  costs.
• In the short run, some costs, like interest
  payments and office rent, are fixed, while
  others, like production costs, are variable.
• In finance, it is sometimes important to be able
  to break out fixed and variable costs for
  analysis.

43
Time Costs

• A problem is that accounting tends to group costs
  as product costs and period costs.
• Product costs will be things associated with
  production, like materials, labor, and
  manufacturing overhead some, fixed some
  variable.
• Period costs will include things, like selling,
  general, and administrative (SGA), again,
  including some fixed and variable costs.

44
Earnings management?

• Because of the leeway in accounting rules,
  companies have choices about how to account for
  expenses and revenues.
• Given that, they can actually manipulate the
  numbers that lead to net income on their income
  statements.
• Such discretion allows companies to engage in
  earnings management.
• Sometimes, the notes to financial statement are
  helpful to understand all of the numbers on a
  more objective level.

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Taxation
46
Intro

• Taxes will be an important aspect of earnings for
  both individuals and corporations.
• First of all, you only get to keep income after
  taxes.
• Tax rates, around the world, can range from 10
  or less to more than 50, so they can be a large
  slice of the pie.
• We look at taxes in Australia for corporations
  and people.

47
Corporate Taxes

• The current corporate tax rate, in Australia, is
  a flat-rate of 30 on all income.
• In a flat-rate tax, there is only one tax rate, a
  percentage of income that is owed as taxes.
• Thus, if income before tax is 1 million, then,
  taxes are 30 x 1 million 300,000, and net
  income AT 700,000 1 million - 300,000 1
  million x (1 tax rate) 1 million x 70
  700,000.

48
Personal Tax rates

• The personal taxation system, in Australia is
  called a graduated, or progressive, tax system.
• In a graduated tax system, different tax rates,
  marginal tax rates, are applied to different
  portions of income.
• For the first 6,000, the marginal tax rate is
  0.
• If you earn between 6,000 and 25,000, you will
  owe 0 on the first 6,000 and 15 on the income
  above 6,000.
• For example, if your earnings were 25,000, then,
  your tax would be 0 x 6,000 15 x 19,000
  2,850.

49
Personal Tax rates

• Your marginal tax rate on your next dollar of
  income would be 30 of the extra income.
• We can also talk of your average tax rate, which
  is just equal to your total taxes paid as a
  percentage of pre-tax income.
• Thus, in the present case, your average tax rate
  would be 2,850/25,000 11.4, which is below
  your marginal rates.
• In the next slide we show current marginal rates
  for individuals, in Australia.

50
Marginal tax rates
Taxable income Marginal tax rate
0 6 000 nil
6 001 25,000 15
25,001 75,000 30
75,001 150,000 40
over 150,000 45
51
Taxation of partnerships

• Partnership income is figured out before taxes.
• Then, partners are given income statements for
  their portion of the total PT income.
• Each partner reports his partnership income as
  part of his total income, and does his own taxes.
• If the partner is an individual, he adds it to
  his other income and does individual taxes.
• If a partner is a corporation, its income from
  the partnership becomes part of its total
  corporate income for tax purposes.

52
Dividend taxation in Australia

• In the so-called classical taxation system,
  corporate profits are taxed some of the ATI is
  paid out to shareholders, who are taxed again on
  their dividend income.
• Thus, in a classical system, corporate profits
  are double taxed.
• In the imputation system, the company tells the
  shareholder how much tax it paid on the income
  that made the dividend.
• The shareholder, then, adds that tax imputation
  franking credit to his cash dividend income.

53
Dividend taxation in Australia

• Next he calculates his annual taxes on an amount
  equal to the dividend tax credit.
• Finally, he subtracts out the tax credit for what
  the company has already paid, and he finds how
  much tax he owes or is owed to him from the
  government.
• In this way, the shareholder is effectively
  paying his tax rate on the pre-tax corporate
  income that made the dividend.

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Dividend taxation in Australia

• There is no double taxation.
• For example, if dividend income was 700, then,
  the company had 1,000 700/( 1 30) as
  pretax income and paid taxes of 300 30 x
  1,000.
• The shareholder gets the 700 cash dividend plus
  a tax credit of 300, and uses it as described
  above.
• In the next slide, we show an example from the
  textbook.

55
Effect of a 700 dividend fully franked at 30
tax rate
Percent 150/700 -21.4 0/700 0 100/700 14.3 150/700 21.4
56
What really is cash flow?
57
The flow of cash

• What we care about, in finance, is the actual
  cash that flows into and out of a business and
  when.
• The accounting statement of cash flows of a
  company is helpful, but it is not the exact
  information that we need, in finance.
• Since the BS is broken up into liabilities and
  equity equals assets, cash flows will go from
  assets to pay creditors and owners.
• CF from assets CF to creditors CF to owners.

58
CF from Assets

• CF from assets has 3 parts operating income,
  capital spending, and change in net WC.
• Operating CF is what results from the day-to-day
  operation of the business.
• It is equal to earnings before interest and taxes
  (EBIT), and, therefore, does not include the
  costs of financing the business, since they are
  not operating costs.
• Thus it includes revenues less expenses, except
  for depreciation, which is not a CF, and
  interest, which is a CF for financing, not
  operation.

59
CF from Assets

• Taxes are not included because we want to see CF
  from the operation of assets.
• Also, in the normal operation of a business,
  their will be capital expenditures (capital
  spending). So, some of the cash flow will need to
  be reinvested in the firm.
• The other thing that happens in the business is a
  change in WC. Inventories might be built up or
  depleted. More credit might be got from or paid
  off to suppliers. This is a natural
  investment/divestment in the course of business.
• Accounting and accountants often define operating
  CF different from finance.

60
CF from Assets

• The next thing we consider is how much of the CF
  coming from the assets will be reinvested in
  assets.
• Part of our money will be put into capital
  spending (CS) for fixed assets. We might also
  sell some fixed assets. The difference, spending
  sales of assets net CS.
• Note that it can be a negative number.

61
CF from assets

• The final part of reinvestment is investment in
  ST assets, CA.
• Investment in CA may also lead to changes in CL,
  for example, if we buy inventory on credit (A/P)
  from our supplier.
• Thus, we focus on changes in NWC.
• As an example of a bad reason that inventories
  increase, consider that the firm produced more
  than it sold.

62
CF from assets

• We have to consider the investment in inventory
  that resulted. It will be there to sell in the
  next period and reduce our need for future
  production.
• The complete equation is, then, CF from A Op CF
  NCS ?NWC, where the symbol, ? (called
  delta) is a common symbol for change.

63
CF from assets

• Another name for CF from A is free CF because it
  is the CF that is free, after spending for new
  assets and WC, to be used to pay creditors and
  owners.
• The term free CF is used by different people to
  mean slightly different things, but the general
  idea of free CF is to denote what we are calling
  CF from A, here.

64
CF to creditors and owners.

• We define CF to creditors or debt-holders as
  interest paid on debt less net change in
  borrowings I (new debt debt paid off) I
  ND ODP.
• CF to owners equals cash dividends paid less net
  equity raised (to account for also buying in some
  outstanding shares).
• To find new equity raised, we look at the paid-in
  capital sub-account of owners equity.

65
The CF identity

• We have just constructed a changes in financial
  position or a cash flow statement, although not
  the one from accounting.
• CF statements take you from one balance sheet to
  the next, and we have, basically, done that.
• The final CF equation equates CFFA to CFTCO,
  which just says that sources of funds is equal to
  uses of the funds.
• We show some slides from the book, below.

66
Table 2.5 from text book CF identity
67
Text Example OZ Company

• OCF (IS) EBIT depreciation taxes 547
• NCS (BS and IS) ending net fixed assets
  beginning net fixed assets depreciation 130
• Changes in NWC (B/S) ending NWC beginning NWC
  1014 - 684 330
• CFFA 547 130 330 87
• CF to Creditors (B/S and I/S) interest paid
  net new borrowing 70 - 45 24
• CF to Stockholders (B/S and I/S) dividends paid
  net new equity raised 103 - 40 63
• CFTCO 24 63 87 CFFA

68
Working with Financial Statements in Finance
69
Prologue

• The reason that it is necessary to have a good
  working knowledge of financial statements, what
  they mean, what they contain, and what they lack,
  is that they are the main means of reporting
  financial information, both within a firm and to
  the outside.
• In finance, we are concerned with value, but even
  mangers of a firm probably do not have the market
  values for all assets and liabilities in the firm.

70
Prologue

• As a result, many times the only thing that we
  will have are the reported figures from financial
  statements, especially, if we are on the outside
  of the firm.
• Thus, our job of determining if something can
  create economic value becomes even more
  difficult, given those limitations.
• Moreover, as we shall learn in future modules,
  the past and present are not as important as the
  future for valuing things, and we will only ever
  be able to project the future.

71
Standardized Financial Statements

• Although finance does have some formulas for
  direct evaluation of things, like stocks, bonds,
  projects, and whole businesses, one of the themes
  that we shall see throughout finance is
  comparative analysis.
• In that regard, for example, we can make an
  approximate equation for the price of a stock,
  but the price-to-earnings ratio (P/E) method of
  stock analysis, comparing the P/E of one stock to
  others, is the one that most securities analysts
  rely on.

72
Standardized Financial Statements

• In fundamental stock analysis, analysts analyze
  the financial statements of companies and make
  comparisons based on that sort of analysis.
• To do so, we, again, have to consider a question
  that we raised earlier. Ratios are a better
  means of comparing things between companies
  because the sizes of the two companies might be
  drastically different. Just because one company
  has 1 billion in revenue and another has only
  10 million does not mean that the first one is
  better.

73
Standardized Financial Statements

• Even comparing financials for a company in
  different periods of time can be ineffective, if
  the size of the company has changed,
  significantly, over the intervening period
  between the two periods.
• A beginning means of comparison we create
  so-called common-size statements by converting
  all of the numbers to percentage instead of
  dollars.

74
Common-size example

• In the next several slides we show example B/S
  and I/S from the books slides.
• Then, in the two slides after those, we convert
  those ordinary statements into common-sized
  statements.
• There are additional examples in the book that
  are used for the same purposes, in the book, that
  we will use ours for, in the lecture notes.

75
Sample Balance Sheet example from authors
Numbers in thousands
Cash 6,489 A/P 340,220
A/R 1,052,606 N/P 86,631
Inventory 295,255 Other CL 1,098,602
Other CA 199,375 Total CL 1,525,453
Total CA 1,553,725 LT Debt 871,851
Net FA 2,535,072 C/S 1,691,493
Total Assets 4,088,797 Total Liab. Equity 4,088,797
76
Sample Income Statement from authors
Revenues 3,991,997
Cost of Goods Sold 1,738,125
Expenses 1,205,530
Depreciation 308,355
EBIT 739,987
Interest Expense 42,013
Taxable Income 697,974
Taxes 272,210
Net Income 425,764
EPS 2.17
Dividends per share 0.86
of shares 196,205
77
Sample Balance Sheet example from authors
Cash 0.2 A/P 8.3
A/R 25.7 N/P 2.1
Inventory 7.2 Other CL 26.9
Other CA 4.9 Total CL 37.3
Total CA 38.0 LT Debt 21.3
Net FA 62.0 C/S 41.4
Total Assets 100.0 Total Liab. Equity 100.0
78
Sample Income Statement from authors
Revenues 100.0
Cost of Goods Sold (COGS) 43.5
Expenses 30.2
Depreciation 7.7
EBIT 18.5
Interest Expense 1.1
Taxable Income 17.5
Taxes 6.8
Net Income 10.7
EPS 10.7
Dividends per share (DPS) 4.2
79
A few notes about the examples

• Note that for the balance sheet, percentages are
  of total assets (liabilities equity), which is
  at the bottom of the balance sheet.
• On the income statement, we take a percentage of
  the top line, revenues.
• From the sheets, we see, for example, that
  shareholders equity was 41.4 of total assets.
  We can also see that equity is about 2/3 of total
  long term capital (LT debt equity).

80
A few notes about the examples

• Inventory was 7.2 of total assets, while A/P was
  8.3.
• On the income statement, we see that COGS was
  44.1 of total revenues, while interest expense
  was only 1.1, and net income AT, was 10.7 of
  revenue, which means also that about 90 of
  revenues went to pay expenses.
• These common-size financial statements are a
  beginning step in allowing us to more usefully
  compare one company to another.

81
Ratio Analysis fundamental analysis

• In module one, we first mentioned the usefulness
  of ratios, when we looked at income on
  investment, in a ratio with initial investment,
  and called it a rate return on investment.
• The percentages, in common-size balance sheets
  are simple ratios item/total assets or
  item/revenues.
• We understand that ratios are best for examining
  financial statements.

82
Ratio Analysis fundamental analysis

• We know that sometimes the only source of
  financial information is what is in those
  statements.
• So, we might as well make the best use of ratios
  with financial statement data. We try to think
  of all types of ratios of one item on a financial
  statement with another financial statement item.
  That is called ratio analysis.

83
Ratio classification

• We will cover ratios that can be put into the
  following general classifications
• Growth rates
• Rates of return
• Profitability ratios
• Efficiency ratios - Turnovers
• ST solvency - liquidity ratios
• LT solvency
• Market value ratios

84
Growth rates rates of return

• We gave a definition in Mod 1 of rate of return
  on investment as the percentage of initial
  investment represented by income, or Income from
  investment/initial investment (take 100 time
  that actual number to get ).
• A growth rate is the percentage difference
  between the value of something at one time and
  another, or Growth rate (V2 V1)/V1.
• Thus, we see that rate of return can be thought
  of as growth rate of investment (II2 II1)/II1
  (II1I1) II1/II1 rate of return.

85
Liquidity ratios (ST Solvency)

• Being in business is an every day thing. If you
  dont have enough money to pay the bills, today,
  you might be out of business, tomorrow.
• It takes liquidity to be able to meet bills when
  due, since future bills are going into current
  liabilities, and there is no guarantee of future
  sales. There are also CA.
• Thus, liquidity ratios will use items from CA and
  CL.

86
Current ratio

• The first liquidity ratio, the current ratio, is
  the least strict liquidity measure.
• It is given as Current ratio CA/CL with the
  idea that, if necessary, under perfect
  conditions, how well could current assets be used
  to liquidate current liabilities.
• Using information from our simple example
  financial statements, we get Current ratio
  CA/CL 1,553,725/1,525,453 1.02 102.

87
Current ratio

• So, current assets could more than cover CL.
• The current ratio is usually stated as 1.02X or
  as 1.02 of coverage, instead of .
• A high current ratio might be reassuring
  concerning liquidity according to the CA the firm
  has, now, to pay whats on the books, CL, that
  has to be paid over the ST.
• It might also point to inefficient use of ST
  assets, as they generally earn a low return.

88
Current ratio

• We usually like to see a ratio of at least one
  because that also means that NWC is positive (CA
  gt CL), which is usual for a financially healthy
  firm.
• Transactions outside the WC portion of the
  balance sheet can also affect the CR. For
  example, if the company raises LT funding, the
  proceeds will increase cash, which will increase
  the CR.

89
Current ratio

• In the end, there is always more to it than that.
  We have to also look at the industry and the
  company, itself.
• For example, a company with a large revolving
  credit line might not need a high CR.
• If the company uses cash to pay of some CL. Then,
  its ratio will move away from 1 if it started
  off gt 1, it will get bigger if it started offlt
  1, it will get even smaller.

90
Current ratio

• If a firm buys inventory, nothing happens to the
  CR because it is just a cash flow within CA.
• If the firm makes sales out of inventory, the CR
  should rise since inventory is usually carried at
  cost, and the sale will be above cost, so the
  cash received will be larger than the inventory
  in this cash flow within CA.

91
Quick Ratio (Acid Test)

• Since inventory is usually the least liquid of
  CA, the next ratio leaves out inventory and
  defines Quick ratio CA Inventory/CL.
• For our example, Quick ratio CA
  Inventory/CL 1,553,725 295,255/1,525,453
  0.852 x.
• Notice that, while using cash to buy inventory
  did not affect the CR, it will affect the Quick
  Ratio.

92
Quick Ratio (Acid Test)

• The final ST liquidity measure that we shall look
  at it the Cash Ratio Cash/CL. It puts the ST
  liquidity situation in the harshest light. Cash
  ratio 6,489/1,525,453 0.004 x. Cash would
  cover only 0.4 of CL.
• Only a very short-term creditor might be
  concerned about the quick ratio.

93
LT Solvency ratios.

• Since debt (leverage) is what really needs to be
  paid off, LT solvency measures will try to
  quantify how well a company should be able to
  meet its LT debt obligations.
• Since we want to know how well a firm will be
  able to pay off its debt, the first type of
  ratio, coverage ratios, looks at how much
  interest payments represent of the profits that
  can be used to pay them.

94
LT Solvency ratios.

• Times interest Earned (TIE) (AKA Interest
  Coverage Ratio) means how many times could we
  cover our interest payments by using profits
  before interest and taxes, EBIT, so TIE
  EBIT/Interest.
• Note this measure is really talking about
  interest payments on both LT ST debt. Usually,
  financial statements do not break out interest on
  ST and LT debt, separately.

95
LT Solvency ratios.

• Actually, the cash flow available to make
  interest payments (I) is larger than just EBIT
  because EBIT is after depreciation (D), and
  depreciation is a non-cash charge. In modern
  financial parlance, we call EBITD, EBDIT.
• Thus, a better comparison can be had in Cash
  Coverage Ratio EBDIT/I.

96
LT Solvency ratios.

• An additional step that might be taken to measure
  the firms ability to pay fixed financing costs
  would be to add payments on financial leases,
  both to EBDIT and to I, and calculate the next
  level coverage ratio.
• A final step to look more deeply into the firms
  liability would be to do a fixed charge ratio to
  see how well earning can cover all of the fixed
  charges of the business.
• We show the first two ratios for example
  financials TIE 739,987 / 42,013 17.6 x Cash
  Coverage 739,987 308,355/ 42,013 24.95x

97
LT Solvency ratios.

• Another common tool is financial leverage ratios,
  which allow us too look at how much LT debt is a
  factor in the firms financing.
• The Total Debt Ratio includes all debt of all
  maturities to all creditors, which is, basically,
  all liabilities, or TDR A E/A.
• It shows what percentage of assets are
  counterbalanced by liabilities.

98
LT Solvency ratios.

• For our example company, we have TDR (TA
  TE)/TA (4,088,797 1,691,493) / 4,088,797
  58.63.
• Another way to look at things is with the Equity
  Multiplier, EM A/E.
• It tells us how many times we have been able to
  magnify our equity investment to acquire assets.
• For the example, we get EM A/E
  4,088,797/1,691,493 2.42 x.

99
LT Solvency ratios.

• We can also find a relationship between these
  two EM A/E EL/E 1 D-E.
• Then, we also define the debt-to-equity ratio as
  TD/E.
• Again, we have a relationship TD/E TD/A/E/A
  TDR/1/EM TDR x EM.
• So, if you know 2, you can get the 3rd.
• For the example, D/E (4,088,797 1,691,493) /
  1,691,493 1.417 x.

100
Asset management Turnover Ratios

• Another important question is how efficiently the
  company makes use of its assets to generate
  sales.
• Total Asset Turnover TAT Revenues/Assets. It
  show how many dollars of revenues can be
  generated per dollar of assets.
• The interpretation of the number requires further
  investigation into the companys PPE.

101
Asset management Turnover Ratios

• While a naïve conclusion would be that the
  higher, the better because that would seem to
  indicate that more sales are generated per dollar
  of asset, old equipment, on the books, would also
  make it higher, whereas new equipment would make
  it smaller.
• Old equipment would make the asset number
  smaller, while new equipment would make it
  larger, and it appears on the bottom of TAT.

102
Asset management Turnover Ratios

• The inverse of TAT (1/TAT) is called the capital
  intensity ratio (CIR). This ratio shows the
  dollar investment in assets that is needed to
  generate 1 in sales.
• For our example, TAT 3,991,997/4,088,797 0.98x

103
Asset management Turnover Ratios

• Other turnover ratios are more specific. For
  example, Inventory turnover is defined as
  COGS/Inventory. Instead of sales, it uses cost
  since inventories are usually carried at cost.
• Thus, inventory turnover shows how many times
  inventory are sold during the year.
• For our example, IT 1,738,125 / 295,255 5.89
  x. So inventory is turned over about 6 time/year.

104
Asset management Turnover Ratios

• We can get a more understandable number by taking
  the days in a year and dividing that be IT.
• Days of sales in inventory 365/IT. So, for our
  example DSI 365/5.89 62 days.
• DSI tells us how long items are held in
  inventory, on average, before being sold out,
  i.e., how quickly inventory can be sold.
• Sometimes people also look at inventory/sales
  ratios.

105
Asset management Turnover Ratios

• The other important aspect of sales that we
  should study is on the A/R side. If we sell on
  credit we have A/R, and it is useful to look at
  Receivables Turnover ART Revenues/A/R.
• It tells us how many times per year A/R are
  collected and the money is redeployed for new
  credit sales.

106
Asset management Turnover Ratios

• Then, we also find Days of sales in receivables
  365/ART Average collection period.
• For our example, ART 3,991,997/1,052,606 3.79
  and ACP 365/3.79 96 days.
• These types of figures should also be looked at
  by the company when it is analyzing its credit
  policies.
• A/P Turnover is similarly defined as COGS/AP. We
  can them compare all of the numbers for days to
  sell, days to collect, and days to pay of
  suppliers, to further get an idea of efficiency.

107
Profitability Measures

• Ratio analysis is quite naturally suited for
  examining profitability.
• The profit margin tells us what percentage of
  each dollar of revenues goes to the bottom line
  profits. Profit Margin PM Net
  Income/Revenues.
• We cannot analyze this number out of context.
  For example, food supermarket chains usually
  operate at around 1 margin, while other
  industries might be much higher.

108
Profitability Measures

• For the example, PM 425,764/3,991,997 10.67,
  which we could have read directly from a
  common-size income statement .
• Next, we look at two measures of return, by
  combining income statement and balance sheet
  numbers.
• The most common returns that are calculated from
  accounting data are return on total assets, ROA
  net income/Assets I/A, and return on book
  equity, ROE I/E.

109
Profitability Measures

• While these numbers are informative, we must
  remember that they are based on accounting data,
  so they will not be comparable to the other types
  of returns that we will be concentrating on, in
  finance, like returns on actual investments or
  interest rates on debt.
• Often, to make the distinction between these and
  other returns, they are usually specifically
  called return on book assets and book equity (or
  net worth).
• For the example, ROA 425,764/4,088,797
  10.41 ROE 425,764/1,691,493 25.17.
• ROE is higher than ROA because of leverage.

110
Mixed Market/Accounting ratios

• We have been looking at ratios of accounting
  numbers, but in the end, we are really interested
  in market values.
• Thus, the final step in our discussion of ratios
  relates accounting numbers to market numbers.
• To begin, we define earnings per share, EPS Net
  income available for common shareholders/ shares
  outstanding.
• We say net income available to common
  shareholders because, sometimes, there is also
  another component of capital, preferred
  (preference) stock shares.

111
Mixed Market/Accounting ratios

• Preferred stock is ahead of common stock in
  seniority, it pays a fixed annual dividend, but
  it has less rights, otherwise, than those of the
  common shareholder, and it is a smaller component
  of equity, too.
• Therefore, if there are preferred shares
  outstanding, dividends must be paid on those
  shares before we get to the income that is left
  over for the common shareholders.
• We say of shares outstanding because the
  company might have shares in reserve issued but
  not outstanding.

112
Mixed Market/Accounting ratios

• For our example EPS 425,764/96205 2.17.
• Using EPS, we define our first hybrid,
  market/accounting ratio, the price-earnings
  ratio, PE price per share of stock/EPS.
• Notice, the inverse of PE is EPS/Price, which is
  in the form of a rate of return. It represents
  the one-year return on investment in a share.
• In reality, PEs that are very low are usually
  associated with shares of companies whose EPS is
  expected to grow rapidly, although that might not
  happen, in fact.

113
Mixed Market/Accounting ratios

• The use of PE methods in real securities analysis
  is a primary means of valuation because it is a
  comparative method
• As we shall see later, it is difficult to value
  stock using the standard methods of value that we
  will learn about in future modules.
• The problem is that there is a lot of emotion and
  other psychological factors that determine stock
  market prices.

114
Mixed Market/Accounting ratios

• By using PE analysis, we can at least compare the
  PE of our stock with those of other stocks in the
  same industry and in the market.
• Analysts usually calculate PE based on future
  EPS, rather than present.
• PE is also a statistic that is shown for a stock
  in the financial newspaper, but care must be
  taken to look at which EPS is used, i.e., past or
  future projected EPS.

115
Mixed Market/Accounting ratios

• The next mixed measure compares market value to
  book value, Market-to-book market
  value/share/book value/share total market
  capitalization/book equity.
• Since accounting values, in general, dont have
  anything to do with market values, Mkt-to-bk is
  usually greater than 1.
• The counterexample is purely financial
  businesses, which usually do have most of their
  accounting numbers as marked-to-market, and
  Mkt-to-bk can actually be slightly less than 1
  for those kinds of companies.

116
The DuPont system of ratios

• We have already seen some relationships among
  ratios. The DuPont system organizes and relates
  financial ratios in a meaningful way that shows
  the interplay among them.
• We begin with ROE. We make an expansion ROE
  Net inc/E Inc/A/A/E ROA x equity
  multiplier ROA x 1 D/E ratio.
• We can further expand this ratio as ROE net
  inc/rev xrev/A xA/E PM ?TAT ? EM, which is
  known as the DuPont Identity.

117
The DuPont system of ratios

• The DuPont identity shows us that ROE is
  determined by the interplay of profit margin,
  asset turnover, and leverage.
• It also shows us where the problem lies, margins,
  efficiency or capitalization, if there is a
  problem with ROE.
• There is a detailed layout of the DuPont system
  in figure 3.1, page 64 of the textbook. We show
  table 3.5 from the book that lists all of the
  ratios, in the next slide.

118
Textbook Table 3.5
119
Growth

• Corporations may pay some of their net income to
  shareholders, in the form of cash dividends (D).
  
• What it does not pay out in cash to shareholders
  is ploughed back into the firm for investment in
  the firm, as retained earnings (RE).
• Thus, we define two ratios to describe this
  division of earnings, the dividend payout ratio
  DPR dividends/earnings D/E
  dividends/share/EPS DPS/EPS and the earnings
  retention ratio ERR earnings
  retained/earnings 1 DPR, and is also known as
  the ploughback ratio.

120
Growth

• For our example, DPR 0.86/2.17 39.63 and ERR
  100 - 39.63 60.37.
• The importance of the ERR is that, if a firm is
  to grow larger, it must continue to invest in its
  business to get larger. The 2 ways that it can
  do that are either to plough back money into the
  firm, and grow internally, or to return to the
  capital markets to raise more funds, externally.
• Just as the two ratios are related, the decision
  to pay dividends has an interplay with the
  reinvestment decision. Which is part of the
  financing policy decisions of the firm.

121
Growth

• Many people focus on growth in sales as a proxy
  for growth in the business, but to grow sales, we
  must grow assets.
• Recalling, for example, TAT, if the TAT is
  constant, and sales increase, that means total
  assets will have to increase. The increase in
  assets must be financed by an increase on the LE
  side of the BS more debt, RE or new E.

122
Internal Growth

• To begin, we consider the amount of growth that a
  firm could sustain, if it relied only on RE.
  Then, the internal growth rate IGR ROA ?
  ERR/1 ROA ? ERR ER/A/(A ER)/A
  ER/A ER.
• The last part of the equation shows its
  definition as internal growth rate, as the LE
  side of the BS increases by ER, and Assets
  increase to what they are now, A from A ER.
• For our example, we have IGR (0.1041)(0.6037)/1
  (0.1041)(0.6037) 6.71.

123
Internal Growth

• If a company relies only on internal funds for
  growth, its debt as a percentage of capital will
  fall, over time, whether or not the company
  actually reduces the value of debt on the books
  because equity increases.
• Often, firms have a target capital structure that
  they try to.
• Thus, we can also consider how fast the firm can
  grow, if it wants to maintain its total debt
  ratio and only use internal funds to grow equity.

124
Sustainable Growth

• In this case, the firm will plough back funds
  from earnings and borrow more debt in such a way
  as to keep its debt ratio fixed.
• Then, we define the sustainable growth rate SGR
  ROE ? ERR/1 ROE ? ERR ER/E/(E ER)/E
  ER/E ER.
• For our example, SGR (0.2517)(0.6037)/1
  (0.2517)(0.6037) 17.92.

125
Sustainable Growth

• It is the maximum growth theoretical growth rate
  that can be achieved for the firms assets, in
  that, if equity grows at that rate from only
  internal funding, then, the rest of right hand
  side has to also grow at that rate, in order to
  maintain a fixed debt-equity ratio.
• That also means that the firm will have to
  increase its borrowings to grow.
• That is the reason that SGR is higher than IGR.

126
Determinants of Growth

• The DuPont identity shows us that growth in
  equity is the product of PM, TAT, and EM.
• Since the SGR equation contains only two factors,
  ROE and ERR, we can look at how changes in all
  four of the factors in the breakdown of SGR will
  affect it.
• First, if the PM increase, that will result in an
  increase in ER, which will increase ROE and SRG
  (operating efficiency).
• If asset turnover is increased, that will also
  lead to an increase in SGR (asset usage
  efficiency).

127
Determinants of Growth

• If the debt equity ratio is increased, that
  should also lead to an increase in SGR (financial
  policy).
• The final component is ERR (dividend policy). If
  the firm reduces its DPR, it will have more
  internally generated funds to grow, and SGR will
  increase.

128
Determinants of Growth

• This analysis shows how the firms four major
  concerns interact to affect its ability to grow.
• Then, if we go back to the question of growth in
  sales, we see that, if we want sales to grow
  faster than SGR, then, either one or more of
  those four factors must increase and or new
  equity must be raised externally.

129
Using Information from Financial Statements
130
Uses of Financial Statements

• We use financial statements for analysis because
  they are the only source of data, in many cases.
• Surely, market data would be more appropriate for
  analysis, and, if we can get it, we should use
  it.
• For internal purposes, firms will analyze this
  data partly as an anchor for making projections
  into the future.
• Another common internal use is for performance
  evaluation of managers.

131
Uses of Financial Statements

• External uses would be by creditors, including
  suppliers, and a firm might look at a suppliers
  financials before making a decision to engage
  their services. Indeed, credit-rating agencies
  will use the information to as a basis for credit
  ratings.
• Large customers will also evaluate financial
  statements with an aim of deterring if the firm
  can meet their needs over future time.
• Firms can also look at their completion's
  financials in developing their own future
  strategy.
• Financial statements will also be analyzed by
  those seeking targets in the market for corporate
  control (takeovers).

132
Benchmarks for analysis

• We have built up our financial ratio analysis as
  a comparative framework, so how can we compare?
• The first way is time-trend analysis. We compare
  the ratios of a specific firm to those ratios
  over the past to see how they are changing.
• That could turn up bad trends that may signal
  real future trouble. Then, we can look more
  deeply into the reasons for the trend to
  determine if it really does signal trouble.

133
Benchmarks for analysis

• The other basis for comparison is peer group
  comparisons. We try to identify firms in the
  same business or industry as the firm that we are
  analyzing.
• Although that seems like a good idea, in theory,
  in practice it may be difficult to find exact
  peers. Consider, for example, a conglomerate
  that has diverse businesses, like making popcorn
  and computers.

134
Benchmarks for analysis

• One means of trying to get there is through the
  use of the Global Industry Classification
  Standard codes (GISC), developed jointly by
  Standard Poors (SP) and Morgan Stanley
  Capital International (MSCI) in 1999.
• These codes give a breakdown, on an international
  scale, into 10 sectors, 24 industry groups, 64
  industries, and 139 sub-industries, with 2 to 8
  digit codes.

135
Problems with Fin Stmt Analysis

• We have said, from the start, that analysis using
  financial statement data is not what we would
  want in a perfect world.
• We use the method because comparative methods
  work well, in many cases, in finance. Ratios are
  a good method for comparison, but we need to
  compare ratios, in order to make them more
  useful.
• Even for companies in the same industry and
  country, accounting allows leeway in accounting
  for many things, including revenues, expenses,
  and inventories.

136
Problems with Fin Stmt Analysis

• Another real problem is that accounting standards
  are different in different countries.
• A final problem has to do with looking more
  deeply into the financials. For example, a
  one-time profit from one event or another can
  skew the ratios in a particular year.
• One source for trying to iron out some of those
  problems is to look at the notes to the financial
  statement, which will give us more detailed
  information about some of these things.

137
Helpful Hint
138
Tutorial Problems

• In chapter two of the text (page 43), attempt
• ? critical thinking questions 2.12.5
• ? problems 514, and web questions 2.1 2.2.
• In chapter three of the text (page 78), attempt
• ? critical thinking questions 3.1, 3.4 3.5
• ? problems 1 to 6, 11, 12, 15, 16, 20, 21, 34, 36
  37.

139
Exam caliber question

• A company pays a fully-franked dividend of 700.
• What tax credit will the shareholder get?
• How much will she claim as dividend income on her
  taxes?
• How much money will she have to pay out of her
  own pocket if her marginal tax rate is 40?

140
END