2 Working With Financial Statements - Introduction Chapter 2 - looked at the basic financial statement components; the balance sheet and income statement and the concept of cash flowCash Flow -cash flow identity - cash flow from assets = to cash flow paid to the suppliers of capital to the firm - creditors and shareholdershow to calculate cash flow from assetsoperating cash flownet capital spendingchanges in net working capitalChapter 3 - expands on the use of financial statements from a corporate finance perspective
3 Financial Statements and the role of Corporate Finance capital budgeting - where and how much should we investlong term financing - capital structureshort term financing - working capital managementrisk management - derivative securities and hedgingA good working knowledge of financial statements is important as F/S are the primary means of communicating financial information both internally and externally.many different ways of using F/S - or componentsmany different usersThe connection between accounting information contained in financial statements and shareholder value is tenuous
4 Financial Statements and Shareholder Value share price as established by the marketdividends paid from internally generated cash flowRelationship or ‘line of sight’ between business decision and the creation of shareholder value is usually not that clearanalysis ->understanding of financial statements is a starting point - understand the impact of business/financial decisions in terms of the balance sheet, income and cash flowthe next step in establishing the connection between the business decision and the creation of shareholder value is complex and not well understood
5 Financial Statements and Cash Flow Financial statements present cash flow with a focus on the sources and uses of cash (vs. the cash flow identity)Statement of Changes in Financial Position - sources and uses of cash
6 T3.2 Hermetic, Inc. Balance Sheet Balance Sheet as of December 31($ in thousands)AssetsCurrent AssetsCash $ $ 50Accounts receivableInventoryTotal $ $ 745Fixed assetsNet plant and equipmentTotal assets $1610 $1845
8 T3.3 Hermetic, Inc., Income Statement ($ in thousands)Net sales $710.00Cost of goods soldDepreciation 30.00Earnings before interest and taxes $200.00Interest 20.00Taxable incomeTaxes 53.45Net income $126.55Dividends $Addition to retained earnings
9 T3.4 Statement of Cash Flows Operating activities+ Net income+ Depreciation+ Any decrease in current assets (except cash)+ Increase in accounts payable– Any increase in current assets (except cash)– Decrease in accounts payableInvestment activities+ Ending fixed assets– Beginning fixed assets
10 T3.4 Statement of Cash Flows (concluded) Financing activities– Decrease in notes payable+ Increase in notes payable– Decrease in long-term debt+ Increase in long-term debt+ Increase in common stock– Dividends paid
11 T3.5 Hermetic, Inc. Statement of Cash Flows Operating activities+ Net income + $+ Depreciation+ Increase in payables– Increase in receivables –– Increase in inventory –$Investment activities+ Ending fixed assets +$1,100.00– Beginning fixed assets –+ Depreciation($ )
12 T3.5 Hermetic, Inc. Statement of Cash Flows (concluded) Financing activities+ Increase in notes payable + $ 65.00+ Increase in long-term debt– Dividends –$ 58.45Putting it all together, the net addition to cash for the period is:$91.55 – = $5.00
13 Standardized Financial Statements A standardized financial statement presenting all items in percentage terms.Balance sheets are shown as a % of assetsIncome statements are shown as a % of salesAn attempt to make comparisons of companies, who may be vastly different in terms of size, more effective.There are two general approaches to standardized financial statements:common sizecommon base year
14 Financial Statement Analysis Common - Size Statementsa standardized financial statement expressing all items in percentage termsthe balance sheet as a % of assets andthe income statement as a % of salesCommon-Base Year Financial Statement - Trend AnalysisA standardized financial statement presenting all items relative to a certain base year amountuseful in trend analysislends itself to plotting the trends graphically.
17 T3.6 Hermetic, Inc., Common-Size Balance Sheet More on Standardized StatementsSuppose we ask: “What happened to Hermetic’s net plant and equipment (NP&E) over the period?”1. Based on the 1999 and 2000 B/S, NP&E rose from $985 to $1100, so NP&E rose by $115 (a use of cash).2. If we standardized the 2000 numbers by dividing each by the number, we get a common base year statement. In this case, $1100/$985 = 1.117, so NP&E rose by 11.7% over this period.
18 T3.6 Hermetic, Inc., Common-Size Balance Sheet (concluded) More on Standardized Statements3. Did the firm’s NP&E go up or down? Obviously, it went up, but so did total assets. In fact, looking at the standardized statements, NP&E went from 61.2% of total assets to 59.6% of total assets.4. If we standardized the 2000 common size numbers by dividing each by the 1999 common size number, we get a combined common size, common base year statement. In this case, 59.6%/ 61.2% = 97.4%, so NP&E fell by 2.6% as a percentage of assets.(. *.) In absolute terms, NP&E is up by $115, or 11.7%, but relative to total assets, NP&E fell by 2.6%.
19 T3.7 Hermetic, Inc. Common-Size Income Statement Net sales %Cost of goods sold 67.6Depreciation 4.2Earnings before interest and taxes 28.2Interest 2.8Taxable income 25.4Taxes 7.5Net income %Dividends %Addition to retained earnings %
20 Wide range of users of financial ratios: Ratio Analysisrelationships determined from a firm’s financial information and used for comparison purposesSimilar to Common Size and Base Year Financial Statements, the use of financial ratios is an attempt to make comparisons of different sized companies more effective.We eliminate the size problem in ratios by focusing only on percentages, or multiples or time periodsWide range of users of financial ratios:Investment:financial analysts with major brokerage firmspension fund managers & money management firmsBond Rating FirmsLendersTable 3.8 in the text is a good summaryRatio Analysis
21 T3.8 Things to Consider When Using Financial Ratios What aspect of the firm or its operations are we attempting to analyze?Firm performance can be measured along “dimensions”-liquidity, capital structure, performanceWhat goes into a particular ratio?Historical cost? Market values?What is the unit of measurement?Dollars? Days? Turns?What would a desirable ratio value be? What is the benchmark? Is there an industry standard?Time-series analysis? Peer Group Analysis
22 T3.9 Categories of Financial Ratios Short-Term Solvency, or LiquidityAbility to pay bills in the short-runLong-Term Solvency, or Financial LeverageAbility to meet long-term obligationsAsset Management, or TurnoverIntensity and efficiency of asset useProfitabilityThe ability to control expensesMarket Valuefocusing on share market price
23 T3.10 Common Financial Ratios (Table 3.8) I. Short-Term Solvency, or Liquidity, RatiosCurrent assetsCurrent ratio =Current liabilitiesQuick ratio = (Current assets - inventory) / Current liabilitiesCash ratio = Cash / Current liabilitiesInterval measure =Average daily operating costs
24 T3.10 Common Financial Ratios (Table 3.8) (continued) II. Long-Term Solvency, or Financial Leverage RatiosTotal assets - Total equityTotal debt ratio =Total assetsDebt/equity ratio = Total debt/Total equityEquity multiplier = Total assets/Total equityLong-term debtLong-term debt ratio =Long-term debt + Total equityEBITTimes interest earned ratio =InterestEBIT + depreciationCash coverage ratio =
25 T3.10 Common Financial Ratios (Table 3.8) (continued) III. Asset Utilization, or Turnover, RatiosCost of goods soldInventory turnover =Inventory365 daysDays’ sales in inventory =Inventory turnoverSalesReceivables turnover =Accounts receivableDays’ sales in receivables =Receivables turnoverNWC turnover =NWCFixed asset turnover =Net fixed assetsTotal asset turnover =Total assets
26 T3.10 Common Financial Ratios (Table 3.8) (continued) IV. Profitability RatiosNet incomeProfit margin =SalesReturn on assets (ROA) =Total assetsReturn on equity (ROE) =Total equityOperating Margin Op. Income o
27 T3.10 Common Financial Ratios (Table 3.8) (concluded) V. Market Value RatiosPrice per sharePrice-earnings ratio =Earnings per shareMarket value per shareMarket-to-book ratio =Book value per shareDividend yield Dividend per share/current market price
28 Financial Ratios - Oil & Gas Industry There exists a unique set of ratios which are utilized in the oil & gas industry and with some variation in other resource based industries e.g.Reserve Life Indexlooks at how long the current reserve base will support a given level of productioncalculated as - year end proven producing reserves/year end productionOperating Costs per BOE - annual operating costs divided by yearly production on a BOE basisGeneral and Administrative Costs per BOEFinding and Onstream Cost per BOEimportant efficiency ratio measuring costs to add new reserves over a specified period of timeFinancial Ratios - Oil & Gas Industry
29 Financial Ratios - Oil & Gas Price to cash flow multipleshare price / cash from operations per shareas opposed to the traditional P/E ratioemphasizes cash flow instead of earnings
30 T The Du Pont Identity1. Return on equity (ROE) can be decomposed as follows:ROE = Net income/Total equity = Net income/Total equity Total assets/Total assets = Net income/Total assets Total assets/Total equity = _____________ Equity multiplier2. Return on assets (ROA) can be decomposed as follows:ROA = Net income/Total assets Sales/Sales = Net income/Sales Sales/Total assets = ______________ _______________
31 T The Du Pont Identity1. Return on equity (ROE) can be decomposed as follows:ROE = Net income/Total equity = Net income/Total equity Total assets/Total assets = Net income/Total assets Total assets/Total equity = ROA Equity multiplier2. Return on assets (ROA) can be decomposed as follows:ROA = Net income/Total assets Sales/Sales = Net income/Sales Sales/Total assets = Profit margin Total asset turnover
32 T The Du Pont Identity3. Putting it all together gives the Du Pont identity:ROE = ROA Equity multiplier = Profit margin Total asset turnover Equity multiplier4. Profitability (or the lack thereof!) thus has three parts:Operating efficiencyAsset use efficiencyFinancial leverage
34 T3.12 Using Financial Statement Information Why evaluate Financial Statements?Internal UsesAllocate capital by divisionMeasure and reward performanceCorporate/ Financial PlanningExternal UsesExtend trade credit to customersInvestor Community Ratio AnalysisBanks requiring loan covenantsCompetitor AnalysisValuing a target in an acquisitionBenchmarksYear on yearPeer group
35 T3.12 Using Financial Statement Information Problems with Financial Statement AnalysisThe need for theorywhat is the connection between financial statements and a firm’s true value and the associated risk ?Which ratios matter most?What is the “right” value for the ratioThe difficulty in establishing appropriate benchmarksConglomerates or diversified firmsNot identified in a single industry or sectorHard to find comparablesGlobal reachComparability of financial statements between countries with differences in accounting regulations
36 Quick QuizWhat is the Statement of Cash Flows and how do you determine sources and uses of cash?How do you standardize balance sheets and income statements and why is standardization useful?What are the major categories of ratios and how do you compute specific ratios within each category?What are some of the problems associated with financial statement analysis?
37 You should be able to: Summary Identify sources and uses of cash Understand the Statement of Cash FlowsUnderstand how to make standardized financial statements and why they are usefulCalculate and evaluate common ratiosUnderstand the Du Pont identityDescribe how to establish benchmarks for comparison purposes and understand some key problems that can arise