gsb711-lecture-note-02-understanding-financial-statements
DESCRIPTION
This is the second presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at understanding financial statements, with breakdowns of example statements.TRANSCRIPT
Understanding Financial Statements
Topic 02GSB711 – Managerial Finance
Readings:Chapter: Accounting and Finance (Pages 52 - 75)
Questions: 1, 3, 8, 9 and Problems: 11, 13, 15 and 20. Chapter: Measuring Corporate Performance (Pages 76 – 107)
Questions: 1, 3, 4, 6, 7 and Problems: 11, 17, 22 and 26
GSB711 Managerial Finance – Topic 02 Page No. 2
Topics Covered…
• The Balance Sheet• The Income Statement• The Statement of Cash Flows• Accounting Practice & Malpractice• Taxes• Value and Value Added• Measuring Profitability• Measuring Efficiency• Analyzing the Return on Assets: The Du Pont
System
GSB711 Managerial Finance – Topic 02 Page No. 3
Topics Covered
• Measuring Leverage• Measuring Liquidity• Calculating Sustainable Growth• Interpreting Financial Ratios• The Role of Financial Ratios–and a Final Note on
Transparency
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The Balance Sheet
Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in
time (from an accounting perspective).
Balance SheetPepsiCo Balance Sheet (December 31, 2006) $Millions
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Telstra’s Balance Sheet
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Telstra’s Balance Sheet
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Telstra’s Balance Sheet
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The Balance SheetThe Main Balance Sheet Items
Current AssetsCash & SecuritiesReceivablesInventories
+
Fixed AssetsTangible AssetsIntangible Assets Current Liabilities
PayablesShort-term Debt
+
Long-term Liabilities
+
Shareholders’ Equity=
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The Balance Sheet
• Common-Size Balance Sheet– All items in the balance sheet are expressed as a
percentage of total assets.
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Common Size Balance Sheet
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Market Value vs. Book Value
Book Values are determined by GAAPMarket Values are determined by current values
• Generally Accepted Accounting Principles (GAAP)– Procedures for preparing financial statements.
Equity and Asset “Market Values” are usually higher than their “Book Values”
GSB711 Managerial Finance – Topic 02 Page No. 13
Market Value vs. Book Value
ExampleAccording to GAAP, your firm has equity
worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.
Q: What is the market value of your assets?A: Since (Assets=Liabilities + Equity),
your assets must have a market value of $11.5 billion.
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Market Value vs. Book Value
Example (continued)
Book Value Balance SheetAssets = $10 bil Debt = $4 bil
Equity = $6 bil
Market Value Balance SheetAssets = $11.5 bil Debt = $4 bil
Equity = $7.5 bil
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The Income Statement
Definition Financial statement that shows the
revenues, expenses, and net income of a firm over a period of
time (from an accounting perspective).
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The Income Statement
Earnings Before Income & Taxes (EBIT)
EBIT = Total Revenues - costs – deprecation= 35,753 – 27,292 – 1,406= $ 7,055 million
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The Income Statement
Pepsico Income Statement (year end 2006)Net Sales 35,753COGS 15,762Selling, G&A expenses 11,530Depreciation expense 1,406EBIT 7,055Net interest expense 66Taxable Income 6,989Income Taxes 1,347Net Income 5,642
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Profits vs. Cash Flows
Differences• “Profits” subtract depreciation (a non-cash
expense)• “Profits” ignore cash expenditures on new
capital (the expense is capitalized)• “Profits” record income and expenses at the
time of sales, not when the cash exchanges actually occur
• “Profits” do not consider changes in working capital
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The Statement of Cash Flows
Definition Financial statement that shows the firm’s cash
receipts and cash payments over a period of time.
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The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year end 2006)
Net Income 5,642Non-cash expenses
Depreciation 1,406Other 0
Changes in working capital A/R=(464) A/P=(86) Inv=(233) other=1,956 CL=155 1,328
Cash Flow from operations 8,376Cash Flow from investments (933)Cash provided by financing (7,508)Net Change in Cash Position (65)
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Telstra’s Income Statement
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Telstra’s Income Statement
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Cash Flows
• Free Cash Flow (FCF)– Cash available for distribution to investors after firm
pays for new investments or additions to working capital
FCF = EBIT - taxes + depreciation- change in net working capital- capital expenditures
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Telstra’s Cash Flow Statement
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Telstra’s Cash Flow Statement
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Telstra’s Cash Flow Statement
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Taxes
• The one thing we can rely on with taxes is that they are always changing
• Marginal vs. average tax rates– Marginal – the percentage paid on the next dollar earned– Average – the tax bill / taxable income– Tax Imputation
• Franked Dividends
• Other taxes
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Value and Value Added
• Market Capitalization– Total market value of equity, equal to share price times
number of shares outstanding.
• Market Value Added– Market capitalization minus book value of equity.
share)per (priceshares) (# tion CapitalizaMarket
ValueBook Equity -tion CapitalizaMarket MVA
GSB711 Managerial Finance – Topic 02 Page No. 29
Value and Value AddedPepsiCo Balance Sheet (December 31, 2006) $Millions
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Value and Value Added
Pepsico Income Statement (year end 2006)
Net Sales 35,753COGS 15,762Selling, G&A expenses 11,530Depreciation expense 1,406EBIT 7,055Net interest expense 66Taxable Income 6,989Income Taxes 1,347Net Income 5,642
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Value and Value Added
• Market-to-Book Ratio– Ratio of market value of equity to book value of equity.
76
36815$
457102$
equity of book value
equity of uemarket valratiobook -to-Market
.
,
,
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Value and Value Added
• Stock market measures of company performance, 2006. Companies are ranked by market value added. (dollar values in millions)
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Measuring Profitability
• Economic Value Added (EVA)– Net income minus a charge for the cost of capital
employed. Also called residual income.• Residual Income
– Net Dollar return after deducting the cost of capital
Equity Equity ofCost - IncomeNet
Income Residual
EVA
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Measuring Profitability
• Economic Value Added (EVA) of PepsiCo
Equity Equity ofCost - IncomeNet
Income Residual
EVA
million $4,527
14,251.095 - 5,642
Income Residual
EVA
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Measuring Profitability
• Accounting measures of company performance, 2006. Companies are ranked by return on equity.
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Measuring Profitability
• Return on Equity (ROE)– Net income as a percentage of shareholders’ equity
• Return on Capital (ROC)– Net income plus Interest as a percentage of long-term
capital.• Return on Assets (ROA)
– Net income plus interest as a percentage of total assets
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Measuring Profitability
396.14,251
5,642
equity
incomenet =equityon Return
185.31,727
2395,642=
assets total
Interest IncomeNet =assetson Return
355.564,16
2395,642
equity debt termLong
Interest IncomeNet =capitalon Return
PepsiCo Profitability Measurements
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Measuring Efficiencyyear ofstart at assets total
Sales=ratioover Asset turn
assets totalAverage
Sales=ratioover Asset turn
OR
13.131,727
35,753
year ofstart at assets total
Sales=ratioover Asset turn
16.12/)930,29(31,727
35,753
assets totalAverage
Sales=ratioover Asset turn
OR
For PepsiCo
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Measuring Efficiency
sold/365 goods ofcost
year ofstart at inventory =Inventoryin Days Average
year ofstart at inventory
sold goods ofcost =ratioturnover Inventory
salesdaily average
year ofstart at sreceivable=period collection Average
year ofstart at sreceivable
sales=Turnover sReceivable
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The DuPont System
• A breakdown of ROE and ROA into component ratios
sales
Interest IncomeNet =MarginProfit Operating
sales
IncomeNet =MarginProfit
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The DuPont System
sales
interestIncomeNet x
assets
sales=ROA
assetturnover
Operating profitmargin
assets
interest IncomeNet =ROA
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Measuring Leverage
equity+debt termlong
debt termlong=ratiodebt termLong
equity
debt termlong=ratioequity Debt
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Measuring Leverage
Total debt ratio =total liabilities
total assets
Times interest earned =EBIT
interest payments
Cash coverage ratio =EBIT + depreciation
interest payments
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Measuring Leverage
interestIncomeNet
IncomeNet x
sales
interestIncomeNet x
assets
salesx
equity
assets=ROE
leverage
ratio
assetturnover
Operating profit
margin
debtburden
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Measuring Liquidity
Net working capital
to total assets ratio=
Net working capital
Total assets
Current ratio =current assets
current liabilities
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Liquidity Ratios
Cash ratio =cash + marketable securities
current liabilities
Quick ratio =cash + marketable securities + receivables
current liabilities
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Percent of Sales Approach• Some items vary directly with sales, while others do not• Income Statement
– Costs may vary directly with sales - if this is the case, then the profit margin is constant
– Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant
– Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings
• Balance Sheet– Initially assume all assets, including fixed, vary directly with
sales– Accounts payable will also normally vary directly with sales– Notes payable, long-term debt and equity generally do not
because they depend on management decisions about capital structure
– The change in the retained earnings portion of equity will come from the dividend decision
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Growth and External Financing
• At low growth levels, internal financing (retained earnings) may exceed the required investment in assets
• As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money
• Examining the relationship between growth and external financing required is a useful tool in long-range planning
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The Internal Growth Rate
• The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.
• Using the information from Tasha’s Toy Emporium– ROA = 1200 / 9500 = .1263– B = .5
%74.6
0674.5.1263.1
5.1263.bROA - 1
bROA RateGrowth Internal
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Sustainable Growth
Plowback ratio =earnings - dividends
earnings
= 1 - payout ratio
Payout ratio =dividends
earnings
Growth in equity from plowback =earnings - dividends
earnings
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Determinants of Growth
• Profit margin – operating efficiency• Total asset turnover – asset use efficiency• Financial leverage – choice of optimal debt ratio• Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
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Interpreting Financial Ratios
• PepsiCo Ratios
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Interpreting Financial Ratios
• PepsiCo Ratios (continued)
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Interpreting Financial Ratios
• Selected 2006 financial ratios for industry groups in Standard & Poor’s Composite Index
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Why Evaluate Financial Statements?
• Internal uses– Performance evaluation – compensation and comparison
between divisions– Planning for the future – guide in estimating future cash
flows• External uses
– Creditors– Suppliers– Customers– Stockholders
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Benchmarking
• Ratios are not very helpful by themselves; they need to be compared to something
• Time-Trend Analysis– Used to see how the firm’s performance is changing
through time– Internal and external uses
• Peer Group Analysis– Compare to similar companies or within industries– SIC and NAICS codes
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Potential Problems
• There is no underlying theory, so there is no way to know which ratios are most relevant
• Benchmarking is difficult for diversified firms• Globalization and international competition
makes comparison more difficult because of differences in accounting regulations
• Varying accounting procedures, i.e. FIFO vs. LIFO• Different fiscal years• Extraordinary events
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Important Questions
• It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process– How does our plan affect the timing and risk of our cash
flows?– Does the plan point out inconsistencies in our goals?– If we follow this plan, will we maximize owners’ wealth?
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Summary• Financial statements• Book value vs market value• Cashflow statement• Standardized financial statements• Financial Ratios• Financial Planning• Internal growth rate• Sustainable growth rate• Evaluating financial statements