FINANCE 7311 Review & Financial Statement Analysis Dr. Ashvin VibhakarFall 2000

Outline Review of Basic Finance The Corporation The Accounting Model Cash Flows Financial Statement Analysis

Review of Basic Finance Efficient Markets Rates of Return Time Value of Money Bond Valuation Stock Valuation

EFFICIENT MARKETS Markets are in equilibrium Expected Returns = Required returns Expectations are rational Information is reflected in price – Information – Reflected in Price No Arbitrage

EFFICIENT MARKETS  Why do we care whether or not markets are efficient?  Prices direct economic activity  Rates of return (cost of capital)  Valuation (market multiples)

RATES OF RETURN REQUIRED RETURN – required by investor – depends on RISK EXPECTED RETURN – given current price & expected future CF’s REALIZED RETURN – actual return

RISK Represents the CHANCE that ACTUAL returns turn out to be much different than EXPECTED Statistically: Variance Standard Deviation

TIME VALUE OF MONEY SINGLE CASH FLOWS V n = V o x (1 + R) n FV = PV x (1 + R) n PV = FV x (1 + R) -n MULTIPLE CASH FLOWS PERPETUITY PV = CF / R

TIME VALUE OF $, cont. ANNUITY PV = CF X [1/ R (1 - 1/(1 + R) n ] Calculator: PV - present value FV - future value CF - periodic payment amount R - discount rate N - number of CF’s or periods Ordinary - end of period Due - beginning of period

BOND VALUATION CF = coupon rate x par ÷ 2 (semi-ann.) N = number of semi-annual periods FV = par amount of bond R = investor’s required rate of return PV = price of bond Solving for R ===> Yield to Maturity

STOCK VALUATION Present value of future dividends Assumption about Time Path More Generally, CF 1) No Growth --> Perpetuity V t = CF t+1 /R 2) Constant Growth --> Gordon Model V t = CF t+1 / (R - g)

THE CORPORATION REAL ASSETS ----> CASH FLOWS CLAIMANTS ----> - EMPLOYEES/CREDITORS - BONDHOLDERS - STOCKHOLDERS MANAGEMENT TEAM

A Picture of the Corporation Real Assets & Financial Assets ASSETS Bondholders Shareholders 3rd Parties Govt; other CF’s Business Risk Financial Risk Investment Financing

MANAGEMENT OBJECTIVE: ALLOCATE COPORATE RESOURCES IN A WAY WHICH: - Maximizes the value of the firm - Maximizes current share price AGENCY PROBLEM - Management makes decisions which are inconsistent with the above

MANAGEMENT DECISIONS INVESTMENT DECISION --> What should be in the circle 1) Short-term assets --> Working capital - inventory policy - A/R and A/P policy - nature and amount of S-T financing 2) L-T Assets --> Capital Budgeting - Which assets add most VALUE to the firm?

Mgmt Decisions, cont. FINANCING DECISION - How Should Assets Be Financed? - What is the Proper Mix of Debt and Equity? How much debt should a company have? - Risk - Taxes - Costs of financial distress - Over / Under Investment Problem

BUSINESS RISK Assets are the SOURCE of BUSINESS RISK DEMAND & SUPPLY VARIABILITY COMPETITION (ease of entry) TECHNOLOGY REGULATION MGMT DEPTH & BREADTH OPERATING LEVERAGE

THE ACCOUNTING MODEL CONFORMS TO PICTURE: NWCDEBT L-T ASSETSEQUITY LHS = CIRCLE RHS = RECTANGLES

Debt Interest Bearing - ‘Permanent’ Capital Reclassify S-T portion of notes payable Lines of Credit Include as part of NWC

ACCOUNTING PRINCIPLES COST PRINCIPLE: ONLY TRANSACTIONS RECORDED COST ≠ MARKET IN GENERAL MATCHING PRINCIPLE PERFORMANCE MEASUREMENT ACCRUAL V. CASH BASIS ACCTG.

FINANCIAL STATEMENTS BALANCE SHEET - Assets & Liab. as of a point in time INCOME STATEMENT - Period of time - Include effect of accruals - Not the same as Cash Flow. Why?

BALANCE SHEET ASSETS -> something owned - Listed in order of liquidity - NWC & Long-term Liability -> something owed - listed in order of Claim Priority Retained Earnings -> owned - owed - Cum. Earnings not paid as dividends

INCOME STATEMENT GENERAL FORMAT SALES - COS GROSS PROFIT - OPERATING EXPENSES EBIT (OPERATING PROFIT) – EARNINGS W/O REGARD TO DEBT & TAX SITUATION

Income Statement, cont. EBIT - INTEREST EBT (TAXABLE INCOME) - Taxes NET INCOME NET INCOME ≠ CASH FLOW  WHY?

Cash Flow v. Net Income Non-Cash Expenses 3 Depreciation 3 Amortization 3 Write-offs Accruals 3 Timing Differences

CASH FLOW ASSETS = DEBT + EQUITY CF FROM ASSETS = CF’S TO D + E USES: - CF’S CONSISTENT W/ PICTURE - SOURCES / USES OF CASH - VALUATION (PROJECTED CF’S)

CF’S FROM ASSETS Operating Cash Flow EBIT + DEPRECIATION (NON-CASH ITEMS) - TAXES - ∆NWC - CAPITAL SPENDING

CF’S TO B/H & S/H CF’S TO B/H: INTEREST – NET CHANGE IN DEBT CF’S TO S/H: DIVIDENDS - NET CHANGE IN COMMON STOCK

Taxes and Cash Flow Historical - Analyzing company’s CF Use Tax number from Income Stmt Projections - Free Cash Flow for valuation purposes Use Tax Rate x EBIT

RATIO ANALYSIS FINANCIAL COMPARISON TOOL RAW FINANCIAL STATEMENTS - SIZE DIFFERENCES - DOLLAR AMOUNTS SAY LITTLE KEY: COMPARABILITY DEFINITIONS DIFFER

BENCHMARKS Historical Ratios of Company - Trend Analysis - Assumes: Continuation of past Other Companies / Industry - RMA, S&P, Hoover - Industry Publications Projections (Forecasts)

COMMON SIZE F/S BALANCE SHEET EXPRESS EACH ITEM AS % OF ASSETS INCOME STATEMENT EXPRESS EACH ITEM AS % OF SALES COMMON BASE EXPRESS EACH ITEM AS % OF BASE YEAR (GROWTH RATE)

RATIO GROUPS LIQUIDITY ACTIVITY LEVERAGE PROFITABILITY MARKET

LIQUIDITY Ability to meet current Obligations Of Interest to Short-term Creditors l CURRENT RATIO l QUICK RATIO

ACTIVITY RATIOS Measures Effective Asset Use Of Interest to management & investors ASSET TURNOVER INVENTORY TURNOVER DAYS SALES IN INVENTORY DAYS SALES OUTSTANDING

LEVERAGE RATIOS USE OF DEBT FINANCING Ability to meet debt payments Important to long-term creditors DEBT RATIO TIMES INTEREST EARNED DAYS PAYABLE O/S

PROFITABILITY RATIOS COMBINED USE OF DEBT & ASSETS IMPORTANT TO MGMT & INVESTORS PROFIT MARGIN GROSS MARGIN OPERATING MARGIN RETURN ON ASSETS (ROA) RETURN ON EQUITY (ROE)

DUPONT & ROIC DUPONT DECOMPOSITION OF ROE Profitability X Asset Turnover X Leverage ROIC EBIT X (1 - T) / (EQUITY + DEBT) NOT AFFECTED BY LEVERAGE COMPARE WITH WACC

MARKET RATIOS P/E RATIO What investors are willing to pay for a $ of earnings (Current / Forecast) What creates a high P/E? MARKET/BOOK Usually much different than 1. EX: S&P 500 CURRENTLY = 6.4 WHY?

LIMITATIONS NO THEORY TO DEFINE ‘GOOD’ #’S HISTORICAL; NOT ECONOMIC MOST AS OF SINGLE POINT IN TIME – SEASONAL OPERATIONS – ONE-TIME EFFECTS DESIGNED FOR MANUFACTURERS

ECONOMIC V. ACCTG. EARNINGS UNREALIZED GAINS & LOSSES COST OF EQUITY ‘HIGH’ CORPORATE PROFITS EVA - attempts to account for cost of equity