LECTURE 2EBF 1023 Basic FinanceAnalysis of Financial Statements

A managers primary goal is to maximize the value of the firms stock (shareholders wealth).Value of the firm= firms future cash flow

How an investor estimate future cash flow?How a manager decide which actions will most likely increase the cash flow?The answer lie in the study of financial statement that publicly traded firms must provide to investors -institutional investor-bank, insurance companies, pension funds..-individuals investor- you & me!!

Analysis of Financial Statements

Understanding Financial Statements, Taxes, and Cash Flows (Chapter 2 ) Evaluating a Firms Financial Performance (Chapter 3)

Financial Statements, Cash Flow, and TaxesKey Financial Statements Balance sheet Income statements Statement of retained earnings Statement of cash flowsAccounting income vs. cash flowtaxes

The Annual ReportBalance sheet provides a snapshot of a firms financial position at one point in time.

Income statement summarizes a firms revenues and expenses over a given period of time.

Statement of retained earnings shows how much of the firms earnings were retained, rather than paid out as dividends.

Statement of cash flows reports the impact of a firms activities on cash flows over a given period of time.

Income Statement SALES - EXPENSES = PROFIT

Income Statement SALES - EXPENSES = PROFITRevenue

Income Statement SALES - EXPENSES = PROFITCost of Goods Sold

Income Statement SALES - EXPENSES = PROFITCost of Goods SoldOperating Expenses

Income Statement SALES - EXPENSES = PROFITCost of Goods SoldOperating Expenses (marketing, administrative)

Income Statement SALES - EXPENSES = PROFITCost of Goods SoldOperating Expenses (marketing, administrative)Financing Costs

Income Statement SALES - EXPENSES = PROFITCost of Goods SoldOperating Expenses (marketing, administrative)Financing CostsTaxes

Income Statement SALES- Cost of Goods Sold GROSS PROFIT- Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT)- Income Taxes EARNINGS AFTER TAXES (EAT)- Preferred Stock Dividends- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS (NI)

Income Statement SALES- Cost of Goods Sold GROSS PROFIT- Operating Expenses OPERATING INCOME (EBIT)

- Interest Expense EARNINGS BEFORE TAXES (EBT)- Income Taxes EARNINGS AFTER TAXES (EAT)- Preferred Stock Dividends- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Income Statement SALES- Cost of Goods Sold GROSS PROFIT- Operating Expenses OPERATING INCOME (EBIT)

- Interest Expense EARNINGS BEFORE TAXES (EBT)- Income Taxes EARNINGS AFTER TAXES (EAT)- Preferred Stock Dividends- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Balance Sheet Total Assets =OutstandingDebt+ShareholdersEquityLiabilities

Balance SheetAssetsLiabilities (Debt) & Equity

Balance Sheet Current Assets Cash Marketable Securities Accounts Receivable InventoriesPrepaid ExpensesFixed Assets Machinery & Equipment Buildings and LandOther AssetsInvestments & patentsAssetsLiabilities (Debt) & EquityCurrent Liabilities Accounts Payable Accrued Expenses Short-term notesLong-Term Liabilities Long-term notes MortgagesEquity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

A Typical Balance Sheet

Total AssetsICurrent Assets*Cash & Equivalents*Account Receivable *InventoryILong-Term (Fixed) Assets*Net plant and Equipment*Other Long-Term Assets

Total Liabilities & EquityICurrent Liabilities*Accrued wages & taxes*Account payable*Notes payableILong-Term DebtIStockholders Equity*Common stock*Retained EarningNet Working Capital= Current Assets Current Liabilities=

AssetsCurrent Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

AssetsFixed Assets: Machinery and equipment, buildings, and land.

AssetsOther Assets: any asset that is not a current asset or fixed asset.Intangible assets, such as patents and copyrights.

FinancingDebt FinancingEquity Financing

FinancingDebt Capital: financing provided by a creditor.

Short-term debt: borrowed money that must be repaid within the next 12 months. Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

FinancingEquity Capital: shareholders investment in the firm. Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.Common Stockholders:residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

Free Cash FlowsFree cash flow: Cash flow that is free and available to be distributed to the firms investors (both debt and equity investors).

Free Cash FlowsCash Flows from Assets=Cash Flows from FinancingCash flows generated through the firms assets=Cash flows paid to - or received from - the firms investors (creditors & stockholders)

Calculating Free Cash Flows:An Asset PerspectiveAfter-tax cash flow from operationslessinvestment in net operating working capitallessinvestments in fixed and other assets

Calculating Free Cash Flows:An Asset PerspectiveAfter-tax cash flow from operationslessinvestment in net operating working capitallessinvestments in fixed and other assets Operating income + depreciation - cash tax payments

Calculating Free Cash Flows:An Asset PerspectiveAfter-tax cash flow from operationslessinvestment in net operating working capitallessinvestments in fixed and other assets [Change in current assets]- [change in non-interest bearing current liabilities]

Calculating Free Cash Flows:An Asset PerspectiveAfter-tax cash flow from operationslessinvestment in net operating working capitallessinvestments in fixed and other assets Change in gross fixed assets, and any other assets that are on the balance sheet.

Calculating Free Cash Flows:A Financing PerspectiveInterest payments to creditors - change in debt principal - dividends paid to stockholders - change in stock

= Financing Free Cash Flows

Tax Example:

Space Cow Computer has sales of $32 million, cost of goods sold at 60% of sales, cash operating expenses of $2.4 million, and $1.4 million in depreciation expense. The firm has $12 million in 9.5% bonds outstanding. The firm will pay $500,000 in dividends to its common stock holders.

If the Tax rate is 34% Calculate the firms tax liability.

Sales $32,000,000Cost of Goods Sold (19,200,000)Operating Expenses (2,400,000)Depreciation Expense (1,400,000)EBIT or NOI 9,000,000Interest Expense (1,140,000)Taxable Income 7,860,000

Total Tax payment $7,860,000 x .34 = $2,672,400

Evaluating a Firms Financial Performance

Financial Ratio AnalysisAre our decisions maximizing shareholder wealth?

We will want to answer questions about the firms

i) Liquidityii) Efficient use of Assetsiii) Leverage (financing)iv) Profitability

Financial RatiosTools that help us determine the financial health of a company.We can compare a companys financial ratios with its ratios in previous years (trend analysis).We can compare a companys financial ratios with those of its industry.

Example:CyberDragon Corporation

CyberDragons Balance Sheet ($000) Assets:Liabilities & Equity: Cash$2,540Accounts payable 9,721 Marketable securities 1,800Notes payable 8,500 Accounts receivable18,320Accrued taxes payable 3,200 Inventories27,530Other current liabilities 4,102 Total current assets 50,190Total current liabilities 25,523 Plant and equipment43,100Long-term debt (bonds) 22,000 less accum deprec.11,400Total liabilities 47,523 Net plant & equip.31,700Common stock ($10 par) 13,000 Total assets 81,890Paid in capital 10,000Retained earnings 11,367Total stockholders' equity 34,367Total liabilities & equity 81,890

CyberDragons Income Statement Sales (all credit) $112,760 Cost of Goods Sold (85,300) Gross Profit 27,460 Operating Expenses: Selling (6,540) General & Administrative (9,400) Total Operating Expenses (15,940) Earnings before interest and taxes (EBIT) 11,520 Interest charges: Interest on bank notes: (850) Interest on bonds: (2,310) Total Interest charges (3,160) Earnings before taxes (EBT) 8,360 Taxes (assume 40%) (3,344) Net Income 5,016

CyberDragonOther Information Dividends paid on common stock$2,800 Earnings retained in the firm 2,216 Shares outstanding (000) 1,300 Market price per share 20 Book value per share 26.44 Earnings per share 3.86 Dividends per share 2.15

Financial Ratios

LiquidityEfficient use of AssetsProfitabilityLeverage (financing)

Why are ratios useful?Standardize numbers- facilitate comparisons.

highlight weaknesses & strengths.

Ratio comparisons should be made through time and with competitorsTrend analysisPeer (or Industry) analysis

1. Liquidity RatiosDo we have enough liquid assets to meet approaching obligations?

Liquidity Acid Test / Quick ratiocurrent ratioAverage Collection Period

What is CyberDragons

Current Ratio?

What is CyberDragons Current Ratio?current assetscurrent liabilities

What is CyberDragons Current Ratio?If the average current ratio for the industry is 2.4, is this good or not?below the industry average.Liquidity position is weak.

What is the firms

Acid Test Ratio?

What is the firms Acid Test Ratio?current assets - inventoriescurrent liabilities

What is the firms Acid Test Ratio?Suppose the industry average is 0.92.What does this tell us?

What is the firms

Average Collection Period?

What is the firms Average Collection Period?accounts receivabledaily credit sales

What is the firms Average Collection Period?If the industry average is 47 days, what does this tell us?

2. Operating Efficiency RatiosMeasure how efficiently the firms assets generate operating profits.

Operating Efficiency RatiosOperating Income Return on Investment (OIROI)Total Assets turnover ratiosAccounts Receivable TurnoverOperating Profit MarginInventory Turnover

What is the firms

Operating Income Return on Investment (OIROI)?

What is the firms Operating Income Return on Investment (OIROI)?operating incometotal assets

What is the firms Operating Income Return on Investment (OIROI)?Assuming Industry OIROI is 15%. Slightly below the industry average The OIROI reflects product pricing and the firms ability to keep costs down.

What is their

Operating Profit Margin?

What is their Operating Profit Margin?operating incomesales

What is their Operating Profit Margin?If the industry average is 12%. What can you conclude?

What is their

Total Asset Turnover?

What is their Total Asset Turnover?salestotal assets

What is their Total Asset Turnover?The industry average is 1.82 times. The firm needs to figure out how to squeeze more sales dollars out of its assets.

What is the firms

Accounts Receivable Turnover?

What is the firms Accounts Receivable Turnover?credit salesaccounts receivable

What is the firms Accounts Receivable Turnover?CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?

What is the firms

Inventory Turnover?

What is the firms Inventory Turnover?cost of goods soldinventory

What is the firms Inventory Turnover?CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient?

Low inventory turnover:The firm may have too much inventory, which is expensive because:Inventory takes up costly warehouse space.Some items may become spoiled or obsolete.

What is the firms

Fixed Asset Turnover?

What is the firms Fixed Asset Turnover?salesfixed assets

What is the firms Fixed Asset Turnover?If the industry average is 4.6 times, what does this tell us about CyberDragon?

3. Leverage Ratios / Debt Mgmt (financing decisions)Measure the impact of using debt capital to finance assets.Firms use debt to lever (increase) returns on common equity.

Leverage Ratios / Debt MgmtDebt RatioTimes-Interest-Earned (TIE) ratio

How does Leverage work?Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.

ROE =

(ignore taxes for this example)

How does Leverage work?Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.

ROE = = 15%

15,000100,000

How does Leverage work?Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.

ROE =

How does Leverage work?Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.

ROE ==15,000 - 4,00050,000

How does Leverage work?Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.

ROE == 22%15,000 - 4,00050,000

What is CyberDragons

Debt Ratio?

What is CyberDragons Debt Ratio?total debttotal assets

What is CyberDragons Debt Ratio?If the industry average is 47%, whatdoes this tell us?

Can leverage make the firm more profitable?Can leverage make the firm riskier?

What is the firms

Times Interest Earned Ratio?

What is the firms Times Interest Earned Ratio?operating incomeinterest expense

What is the firms Times Interest Earned Ratio?The industry average is 6.7 times. This is further evidence that the firm usesmore debt financing than average.

4. Return on Equity/ ProfitabilityHow well are the firms managers maximizing shareholder wealth?

What is CyberDragons

Return on Equity (ROE)?

What is CyberDragonsReturn on Equity (ROE)?net incomecommon equity

What is CyberDragonsReturn on Equity (ROE)?The industry average is 17.54%.Is this what we would expect, given the firms leverage?

Conclusion:Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.

The DuPont ModelBrings together:

ProfitabilityEfficiencyLeverage

The DuPont Model Net Profit Total Asset Debt Margin Turnover RatioROE = x / (1- )

The DuPont Model Net Profit Total Asset Debt Margin Turnover Ratio

Net Income Sales Total Debt Sales Total Assets Total Assets

5,016 112,760 47,523 112,760 81,890 81,890

ROE = x / (1- )

= x /(1- )

= x / (1 - ) = 14.6%

The DuPont Model Net Profit Total Asset Debt Margin Turnover RatioROE = x / (1- )

net incomecommon equity

Special gift for guys!!

End of Lecture 2

Thank you for your attention!!

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