1. Chapter 3: Interpreting Financial Statements
Objective
Contrast Economic and
Accounting Models
<=>
Value of Accounting
Information
Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc.

2. Financial Statements Review
Financial Statements Provide:
current and historical information to owners and creditors
a convenient way for owners and creditors to set performance targets
a convenient standard template for financial planning

3. Chapter 3 Contents 3.1 Functions of Financial Statements
3.2 International Differences in Accounting
3.3 Market values v. Book Values
3.4 Accounting v. Economic Measures of Income
3.5 Return on Shareholders v. Return on Equity
3.6 Analysis Using Financial Ratios
3.7 The Financial Planning Process
3.8 Constructing a Financial Planning Model
3.9 Growth & the Need for External Financing
3.10 Working Capital Mgnt.
3.11 Liquidity & Cash Mgnt.

4. 3.1 Functions of Financial Statements
Provide information to the owners & creditors of a firm about the current status and past performance
Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm
Provide a convenient templates for financial planning

5. 3.2 Review of Financial Statements

6. The Balance Sheet
Summarizes a firms assets, liabilities, and owner’s equity at a moment in time
Amounts measured at historical values and historical exchange rates
Prepared according to GAAP, Generally Accepted Accounting Principles
GAAP modified occasionally by the Financial Accounting Standards Board
Exchange-listed companies must comply with Securities and Exchange Commission (SEC) rules

7. The Balance Sheet Major Divisions: Assets
Current assets (less than a year)
Long-term assets (longer than a year
Depreciation
Liabilities and Stockholder’s Equity
Liabilities
Current Liabilities
Long-term debt
Equity

9. The Income Statement
Summarizes the profitability of a company during a time period
Major Divisions:
Revenue & cost of goods sold
Gross margin
General administrative and selling expenses (GS&A)
Operating income
Debt service
Taxable income
Corporate Taxes
Net income

10. The Income Statement Important Reminders:
Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity
Accounts show historical values, not market values.
The shareholder’s equity may be much higher or lower than the market value of the firm.
The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet

12. The Cash-Flow Statement
Show the cash that flowed into and from a firm in during a time period
Focuses attention on a firm’s cash situation
A firm may be profitable and short of cash
Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods
The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes

15. 3.4 Returns to Shareholders v. Return on Equity
Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income
This is the Total Shareholder Return

16. Returns to Shareholders v. Return on Equity (Continued)
Traditionally, corporate performance has been measured by Return on Equity, ROE

17. Profitability

18. Asset Turnover

19. Financial Leverage

20. Liquidity

21. Market Value

22. Ratio Comparisons Establish Your Perspective Benchmarks Sources
Shareholder
employee, Management, or Union
Creditor
Predator, Customer, Supplier, Competitor, Trade Association
Benchmarks
Other companies ratios
The firm’s historical ratios
Data extracted from financial markets
Sources
Dun & Bradstreet, Robert Morris, Commerce Department's Quarterly Financial Report, Trade Associations

23. Relationships Amongst Ratios
It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with:

24. Illustration (Table 3.7 & 3.8 of textbook)
Consider two firms that are identical except that Nodebt is financed using $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and $500,000 of debt
further assume that the EBIT of both firms is $120,000 and tax is 40%

25. Case: Borrow at 10%

26. Case: Borrow at 15%

27. Case: Borrow at 10%: Effect of Business Cycle on ROE

36. External Funds Needed

38. Observation:
Sometimes the new assets required to generate income are not a high as in this example, and the company may able to support a level of growth with no external funding ( in our case)