1. The Analysis of Financial Statements
PART II
The Analysis of Financial Statements

2. The Analysis of Financial Statements1
Knowing the Business
The Products
The Knowledge Base
The Competition
The Regulatory constraints
Strategy 2
Analyzing Information
In Financial Statements
Outside of Financial Statements 3
Forecasting Payoffs
Specifying Payoffs 4
Convert Forecasts to a Valuation 5
Trading on the Valuation
Outside Investor:
Compare Value with Price to BUY, SELL or HOLD
Inside Investor:
Compare Value with Cost to ACCEPT or REJECT Strategy
Chapter 7
How business activities are represented in financial statements
Chapter 8
How the statement of shareholders’ equity is analyzed
Chapter 9
Analyzing the balance sheet and income statement to reveal profitability
Chapter 10
Analyzing the cash flow statement to identify cash generation
Chapter 11
Analyzing profitability to discover what drives it
Chapter 12
Analyzing residual earnings growth to discover what drives it

3. Business Activities and
Chapter 7
Business Activities and
Financial Statements

4. Business Activities and Financial Statements
Link to Previous Chapters
Chapter 1 introduced the
firm’s operating, investing and
financing activities. Chapter
2 introduced the financial
statements. Chapters 5 and 6
outlined
valuation models that
anchor on those financial
statements.
This Chapter
This chapter shows how the
How are the
How are
How are
What
cash flows of a
operating and
operating and
measures
three business activities are
business
financing assets
financing
capture the
depicted in the financial
identified in
and liabilities
income
operating and
statements. It also shows how
the cash flow
identified in the
identified in the
financing
the statements are redesigned
statement ?
balance sheet?
income
profitability ?
to highlight these activities and
statement?
to prepare the statements for
applying the valuation models
in Chapter 5 and 6.
Link to Next Three Chapters
Chapters 8, 9 and 10
reformulate statements
according to the design
developed in this chapter.
Link to Web Page
Build your own analysis
spreadsheet using BYOAP

5. What you will learn in this chapter
How businesses are organized to generate value for shareholders
The difference between operating and financing aspects of a business
How business activities are reported in financial statements
How financial statements are organized to highlight operating and financing activities
How business activities articulate and how financial statements articulate
The four cash flows of a business and how they relate to each other
Why free cash flow does not affect value added
A set of accounting relations that summarize how business activities drive financial statements

6. Cash Flows Between the Firm and Claimants in the Capital Market
Cash received from debtholders and shareholders is (temporarily) invested in
financial assets. Cash payments to debtholders and shareholders are made
by liquidating financial assets (that is, selling debt). Net financing assets are debt
purchased from issuers, net of debt issued to debtholders. Net financing assets
can be negative (that is, debt sold to debtholders is greater than debt purchased).
Key: F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
NFA = net financial assets = financial assets – financial liabilities

7. Business Activities: All Cash Flows
Cash generated from operations is invested in net financial assets (that is, it is used
to buy financial assets or to reduce financial liabilities). Cash investment in
operations is made by reducing net financial assets (that is, by liquidating financial
assets or issuing financial obligations). Cash from operations and cash investment
may be negative (such that, for example, cash can be generated by liquidating an
operating asset and investing the proceeds in a financial asset).
Key: F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
C = cash flow from operations
I = cash investment
NFA = net financial assets
NOA = net operating assets = operating assets – operating liabilities

8. The Cash Conservation Equation
A fundamental accounting identity:
C = Net cash from operations
I = Net cash outflow for investing
C - I = Free cash flow
d = Net dividends (common dividends + share repurchases, less share issues)
F = Net cash outflow to debtholders and debt issuers
= Net principal payments for borrowing + net interest payments
The treasurer’s rule:
If : lend or buy down own debt
If : borrow or reduce lending

9. Applying the Treasurer’s Rule: Microsoft
In millions
2nd Quarter, nd Quarter, 2005
Cash flow from operations $4, $3,377
Cash investment in operations
Free cash flow , ,200
Cash interest received (after tax)
Cash available for shareholders , ,442
Net dividend:
Cash dividend $1, $33,498
Share repurchases
Share issues (189) 2, (795) ,672
Purchase (sale) of financial assets $2, $(30,230)

10. Applying the Treasurer’s Rule: General Electric
In millions
2002
Cash flow from operations $34,848
Cash investment in operations ,227
Free cash flow (26,379)
Interest paid (after tax) ,082
Cash available to shareholders (32,461)
Net dividend:
Cash dividend $7,157
Share repurchases ,142
Net issue of debt $40,603
As the treasurer had $57.8 billion of debt to repay, he issued
$97.9billion of new debt, for a net debt issue of $40.1 billion.

11. Reformulated Statement of Cash Flows

12. Reformulated Cash Flow Statements: Microsoft
In millions
1Q, Q, 2005
Cash flow from operations (C) $4, $3,377
Cash investment (I) (172) (177)
Free cash flow (C – I) , ,200
Equity financing flows (d):
Dividends and share repurchases $2, $34,467
Share issues (189) 2, (795) 33,672
Debt financing flows (F):
Net purchase of financial assets , (30,230)
Interest on financial assets (after tax) (338) (242)
Net issue of debt
Interest paid on debt (after tax) _____ _____
Total financing flows (d + F) $4, $3,200
C – I = d + F

13. Reformulated Cash Flow Statement: General Electric
In millions
2002
Cash flow from operations (C) $34,848
Cash investment (I) (61,227)
Free cash flow (C – I) (26,379)
Equity financing flows (d):
Dividends and share repurchases $8,142
Share issues ,142
Debt financing flows (F):
Net purchase of financial assets
Interest on financial assets (after tax)
Net issue of debt (40,603)
Interest paid on debt (after tax) ,082
Total financing flows (d + F) $(26,379)

14. Reformulated Balance Sheet

15. Balance Sheet Restated

16. Reformulated Balance Sheet: Nike Inc.
(in millions of dollars)
Operating assets (OA) , , Financial obligations (FO)
Operating liabilities (OL) 2, , Financial assets (FA) (1,168) (581)
Net financial obligations (NFO) (289)
Common equity (CSE) , ,028
Net operating assets , , Total NFO + CSE , ,330
Balance sheet relations:
NOA = OA – OL = 6,728 – 2,177 = 4,551
NFO = FO – FA = 879 – 1, = (289) (a net financial asset position)
CSE = NOA – NFO = 4, = 4,840

17. Business Activities: All the Stocks & Flows
Net operating assets are employed in operations to generate operating
revenue (by selling goods and services to customers) and incur
operating expenses (by buying inputs from suppliers). ∆ indicates changes.
Key: F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
C = cash flow from operations
I = cash investment
NFA = net financial assets
NOA = net operating assets
OR = operating revenue
OE = operating expense
OI = operating income
NFI = net financial income

18. Reformulated Income Statement
The difference between operating revenue and operating expense is called operating income:
Net financial expense can be negative (net financial income)

19. Reformulated Income Statement: Nike Inc.
In millions
2004
Operating income (OI) ,035
Net financial expense (NFE)
Comprehensive income (CI) ,019

20. Business Activities and the Financial Statements
This figure shows how reformulated income statements, balance sheets,
and the cash flow statements report the operating and financing activities
of a business, and how the stocks and flows are uncovered
in the financial statements. Operating income increases net operating
assets and net financial expense increases net financial obligations. Free
cash flow is a “dividend” from the operating activities to the financial
activities: free cash flow reduces net operating assets and also reduces net
financial obligations. Net dividends to shareholders are paid out of net
financial obligations.

21. Stocks & Flows: Operating and Financing Activities
The change in NFO is given by
The change in NOA is given by
Operating income in the income statement flows to net operating assets in the balance sheet.
Free cash flow reduces NOA and reduces NFO (increases NFA).
If the firm has net financial assets rather than NFO,
NFAt = NFAt-1 + (Ct – It) + NFIt – dt

22. The Reformulated Statements: Nike Inc., 2004
Reformulated Balance Sheets
Operating assets (OA) , , Financial obligations (FO)
Operating liabilities (OL) 2, , Financial assets (FA) (1,168) (581)
Net financial obligations (NFO) (289)
Common equity (CSE) , ,028
Net operating assets , , Total NFO + CSE , ,330
Reformulated Income Statement, 2004
Operating income (OI) ,035
Net financial expense (NFE)
Comprehensive income (CI) ,019
Reformulated Cash Flow Statement, 2004
Free cash flow
Equity financing flows:
Net dividend to shareholders (d)
Debt Financing flows:
Net cash to debtholders/issuers (F)
814

23. Accounting Relations: Nike Inc., 2004
Balance sheet relations:
NOA = OA – OL = 6,728 – 2,177 = 4,551
NFO = FO – FA = 879 – 1, = (289) (a net financial asset position)
CSE = NOA – NFO = 4, = 4,840
Income statement relations:
CI = OI – NFE = 1,035 – 16 = 1,019
Articulating relations between statements:
The stocks and flows equation for equity:
CSE2004 = CSE CI2004 – d2004 = 4,028 +1,019 – 207 = 4,840
The free cash flow generation and disposition equations:
C – I = OI – ΔNOA = 1,035 – = 814
C – I = NFE – ΔNFO + d = 16 – (-591) = 814
The stocks and flows equation for operating activities:
NOA2004 = NOA OI2004 – (C – I)2004 = 4, , = 4,551
The stocks and flows equation for financing activities:
NFO2004 = NFO NFE2004 – (C – I) d2004 = = -289

24. Tying it Together: What Generates Value?
From the balance sheet equation
Given the way that NOA and NFO are calculated,
which is the stocks and flows equation.
For this to be true, however, accounting must be Clean Surplus.
Free cash flow drops out in this calculation: Free cash flow (C - I) does not add value to shareholders. Free cash flow is a dividend from the operating activities to the financing activities
What generates value is the profit from operating and financing activities.

25. Stocks & Flows Ratios: Business Profitability
Separating operating and financing activities in the income statement identifies profit flows
Comparison of these flows with their balance sheet base yields the corresponding rates of return:
Return on Net Operating Assets
Return on Net Financial Assets
If there are NFO rather than NFA, net borrowing cost is given by
Forecasting ROCE involves both the forecast of RNOA and RNFA (or NBC)