lecture 2: financial statements c. l. mattoli 1 (c) red hill capital corp., delaware, usa

Lecture 2: Financial Statements

C. L. Mattoli

1(C) Red Hill Capital Corp.,

Delaware, USA

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 period’s balance sheet flows into the next.


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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.


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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)


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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: owner’s 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

Current AssetsCashA/RInventory

Current LiabilitiesAccrued ExpensesA/PSR Debt

Long term assetsTang. fixed assetsIntangibles

Non-current liabilities, including Long term debt

Equity

Net WC = CA - CL

E = A - L


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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.


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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.


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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 company’s debts, what would be leftover would belong to the owners.


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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 company’s financial health.


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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 company’s viability.

If NWC is negative, it would appear that the firm will not be able to make it through the year.


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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.


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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 firm’s 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 week’s 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.


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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.


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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.


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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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26

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 (10%x$10 million). ……..

(C) Red Hill Capital Corp., Delaware, USA

27

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 (5%x$90 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.

(C) Red Hill Capital Corp., Delaware, USA

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.


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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 owner’s 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 owner’s 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

Text example 2.2: Battler Company

Balance Sheets

Book Value versus Market Value

Book Market Book Market

Assets 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

We show a sample comparison of book (accounting) value and market (economic) values in the example, below.


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The Income Statement (IS)


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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


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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).


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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.


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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.


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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.


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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.


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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.


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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.


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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 (SG&A), again, including some fixed and variable costs.


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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


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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.


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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.


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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.


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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.


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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


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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.


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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.


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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.


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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%


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What really is cash flow?


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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.


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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.


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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.


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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.


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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.


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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 – ΔNWC, where the symbol, Δ (called “delta”) is a common symbol for change.


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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.


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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.


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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 CFTC&O, which just says that sources of funds is equal to uses of the funds.

We show some slides from the book, below.


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Table 2.5 from text book: CF identity


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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

CFTC&O= 24 + 63 = $87 = CFFA


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Working with Financial Statements in Finance


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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.


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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.


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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.


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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.


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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.


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Common-size example

In the next several slides we show example B/S and I/S from the book’s 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.


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Sample Balance Sheet example from authors

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

Numbers in thousands


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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


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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%


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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%


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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 shareholder’s 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).


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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.


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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.


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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.


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Ratio classification We will cover ratios that can be put into the

following general classifications:

1. Growth rates

2. Rates of return

3. Profitability ratios

4. Efficiency ratios - Turnovers

5. ST solvency - liquidity ratios

6. LT solvency

7. Market value ratios


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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 = [(II1+I1) – II1]/II1 =rate of return.


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Liquidity ratios (ST Solvency) Being in business is an every day thing. If

you don’t 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.


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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%.


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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 what’s 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.


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Current ratio

We usually like to see a ratio of at least one because that also means that NWC is positive (CA > 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.


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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 > 1, it will get bigger; if it started off< 1, it will get even smaller.


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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.


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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.


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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.


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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.


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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.


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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 EBIT+D, EBDIT.

Thus, a better comparison can be had in Cash Coverage Ratio = EBDIT/I.


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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 firm’s 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


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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 firm’s 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.


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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.


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LT Solvency ratios. We can also find a relationship between

these two: EM = A/E = [E+L]/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.


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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 company’s PP&E.


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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.


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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


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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, PE’s 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.


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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.


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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.


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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, don’t 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.


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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] x[rev/A] x[A/E] = PM TAT EM, which is known as the DuPont Identity.


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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.


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Textbook Table 3.5


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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.


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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.


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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 L+E side of the BS: more debt, RE or new E.


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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 L+E 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%.


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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.


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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%.


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Sustainable Growth It is the maximum growth theoretical growth

rate that can be achieved for the firm’s 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.


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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).


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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.


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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.


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Using Information from Financial Statements


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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.


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Uses of Financial Statements

External uses would be by creditors, including suppliers, and a firm might look at a supplier’s 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).


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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.


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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.


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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 & Poor’s (S&P) 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.


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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.


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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.


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Helpful Hint

(C) Red Hill Capital Corp., Delaware, USA 137

Tutorial Problems

In chapter two of the text (page 43), attempt

● critical thinking questions 2.1–2.5 ● problems 5–14, 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.


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Exam caliber question A company pays a fully-franked dividend of

$700.

1. What $ tax credit will the shareholder get?

2. How much will she claim as dividend income on her taxes?

3. How much money will she have to pay out of her own pocket if her marginal tax rate is 40%?

(C) Red Hill Capital Corp., Delaware, USA 139

END


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lecture 2: financial statements c. l. mattoli 1 (c) red hill capital corp., delaware, usa

Documents

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