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Chapter 3: Interpreting Financial Statements

Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc.

ObjectiveContrast Economic and

Accounting Models<=>

Value of Accounting Information

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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

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Chapter 3 ContentsChapter 3 Contents

• 3.1 Functions of Financial 3.1 Functions of Financial StatementsStatements

• 3.2 International 3.2 International Differences in AccountingDifferences in Accounting

• 3.3 Market values v. Book 3.3 Market values v. Book ValuesValues

• 3.4 Accounting v. Economic 3.4 Accounting v. Economic Measures of IncomeMeasures of Income

• 3.5 Return on Shareholders 3.5 Return on Shareholders v. Return on Equityv. Return on Equity

• 3.6 Analysis Using Financial 3.6 Analysis Using Financial RatiosRatios

• 3.7 The Financial Planning 3.7 The Financial Planning ProcessProcess

• 3.8 Constructing a Financial 3.8 Constructing a Financial Planning ModelPlanning Model

• 3.9 Growth & the Need for 3.9 Growth & the Need for External FinancingExternal Financing

• 3.10 Working Capital Mgnt.3.10 Working Capital Mgnt.

• 3.11 Liquidity & Cash Mgnt.3.11 Liquidity & Cash Mgnt.

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3.1 Functions of Financial Statements• 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

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3.2 Review of Financial Statements

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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

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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

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GPC Balance Sheet at Dec 31, 2xx1

2xx0 2xx1 ChangeAssetsCash & mkt'ble secs 100.0 120.0 20.0 Receivables 50.0 60.0 10.0 Inventories 150.0 180.0 30.0 *Current assets 300.0 360.0 60.0

Pp&e 400.0 490.0 90.0 Acc depreciation (100.0) (130.0) (30.0) *Net pp&e 300.0 360.0 60.0

**Total Assets 600.0 720.0 120.0

Liabilities & EquityAccounts payable 60.0 72.0 12.0 Short-term debt 90.0 184.6 94.6 *Current liabilities 150.0 256.6 106.6

Long-term debt 150.0 150.0 - **Total liabilities 300.0 406.6 106.6

Paid-in capital 200.0 200.0 - Retained earnings 100.0 113.4 13.4 *Shareholders equ 300.0 313.4 13.4

Liab + Shareholder 600.0 720.0 120.0

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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

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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

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GPC Income Statement for Year Ending 2xx1

Sales revenues 200.0 Cost of goods sold (110.0) *Gross margin 90.0

Gen sell, & admin exp (30.0) *Operating income 60.0

Interest expense (21.0) *Taxable income 39.0

Income tax (15.6) *Net income 23.4

Allocation to divs (10.0) *Chg retained earn 13.4

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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

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GPC Cash Flow Statement, forthe Year ending Dec 31, 2xx0

Net income 23.4 + Depreciation 30.0 - Increase in acc rec (10.0) - Increase in invent (30.0) + Increase in acc rec 12.0 *Total cash from operations 25.4

- Invest in new ppe (90.0) *Cash flow invest' activities (90.0)

-Div paid (10.0) + Inc short-term debt 94.6 *Cash flow from financing 84.6

**Chng cash & mkt securities 20.0

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GPC Balance Sheet at Dec 31, 2xx1

2xx0 2xx1 ChangeAssetsCash & mkt'ble secs 100.0 120.0 20.0 Receivables 50.0 60.0 10.0 Inventories 150.0 180.0 30.0 *Current assets 300.0 360.0 60.0

Pp&e 400.0 490.0 90.0 Acc depreciation (100.0) (130.0) (30.0) *Net pp&e 300.0 360.0 60.0

**Total Assets 600.0 720.0 120.0

Liabilities & EquityAccounts payable 60.0 72.0 12.0 Short-term debt 90.0 184.6 94.6 *Current liabilities 150.0 256.6 106.6

Long-term debt 150.0 150.0 - **Total liabilities 300.0 406.6 106.6

Paid-in capital 200.0 200.0 - Retained earnings 100.0 113.4 13.4 *Shareholders equ 300.0 313.4 13.4

Liab + Shareholder 600.0 720.0 120.0

GPC Income Statement for Year Ending 2xx1

Sales revenues 200.0 Cost of goods sold (110.0) *Gross margin 90.0

Gen sell, & admin exp (30.0) *Operating income 60.0

Interest expense (21.0) *Taxable income 39.0

Income tax (15.6) *Net income 23.4

Allocation to divs (10.0) *Chg retained earn 13.4

GPC Cash Flow Statement, forthe Year ending Dec 31, 2xx0

Net income 23.4 + Depreciation 30.0 - Increase in acc rec (10.0) - Increase in invent (30.0) + Increase in acc pay 12.0 *Total cash from operations 25.4

- Invest in new ppe (90.0) *Cash flow invest' activities (90.0)

-Div paid (10.0) + Inc short-term debt 94.6 *Cash flow from financing 84.6

**Chng cash & mkt securities 20.0

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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

4.1200$

8.2$

Re

MillionMillion

StartPricecomeEconomicIn

StartPricendsCashDivideStartPriceEndPrice

turn

• This is the Total Shareholder Return

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Returns to Shareholders v. Return on Equity (Continued)• Traditionally, corporate performance has

been measured by Return on Equity, ROE

%8.7300$

4.23$

Million

Million

rsEquityShareHolde

NetIncome

rsEquityShareHolde

IncomeAccountingROE

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Profitability

%6.72/4.313300

4.23

sEquityr'StockHolde

NetIncome (RoE)Equity on Return

%1.92/720600

60

alAssetsAverageTot

EBIT (RoA) Assetson Return

%30200

60Sales

EBIT (RoS) Saleson Return

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Asset Turnover

Times 3.02/720600

200

Assets Total Average

Sales Turnover Asset

Times 7.02/180150

110

Inventory Average

Sold Goods ofCost Turnover Inventory

Times 6.32/6050

200

sReceivable Average

Sales Turnover sReceivable

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Financial Leverage

Times 9.221

60

ExpenseInterest

EBIT Earnt Interest Times

%57720

6.406Assets Total

Debt Total Debt

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Liquidity

Times 7.06.256

180sLiabilitieCurrent

sReceivableCash Earnt Interest Times

Times 4.16.256

360sLiabilitieCurrent

AssetsCurrent Current

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Market Value

6.04.313

20.187

Shareper ValueBook

Shareper Price Book Market to

0.84.23

2.187

Shareper Earnings

SharePer Price Earnings toPrice

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Ratio Comparisons• Establish Your Perspective

• 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

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Relationships Amongst Ratios• It is sometimes valuable to decompose

ratios into sums, differences, products and quotients of other ratios. Many such schemes start with:

TurnoverAsset * saleson Return

*

Assets

Sales

Sales

EBIT

Assets

EBITRoA

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IllustrationIllustration

• (Table 3.7 & 3.8 of textbook)(Table 3.7 & 3.8 of textbook)– Consider two firms that are identical Consider two firms that are identical

except that Nodebt is financed using except that Nodebt is financed using $1,000,000 of equity and Halfdebt is $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and financed using $500,000 of equity and $500,000 of debt$500,000 of debt

– further assume that the EBIT of both further assume that the EBIT of both firms is $120,000 and tax is 40%firms is $120,000 and tax is 40%

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Case: Borrow at 10%Case: Borrow at 10%

Nodebt HalfdebtEBIT 120,000 120,000Interest 0 50,000Taxable Income 120,000 70,000Tax 48,000 28,000Net Income 72,000 42,000Equity 1,000,000 500,000ROE 7.20% 8.40%

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Case: Borrow at 15%Case: Borrow at 15%

Nodebt HalfdebtEBIT 120,000 120,000Interest 0 75,000Taxable Income 120,000 45,000Tax 48,000 18,000Net Income 72,000 27,000Equity 1,000,000 500,000ROE 7.20% 5.40%

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

Economic ROA ROE ROEConditions Nodebt Halfdebt Bad Year 1% 0.6% -4.8% Normal Year 12% 7.2% 8.4% Good Year 30% 18.0% 30.0%

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Year's Sales)

Year xxx0 xxx1 xxx2 xxx3 xxx1 xxx2 xxx3

Income StatementSales 200 240 288 100.0% 100.0% 100.0%Cost of goods sold 110 132 158 55.0% 55.0% 55.0%Gross margin 90 108 130 45.0% 45.0% 45.0%Selling, general & admin. expenses 30 36 43 15.0% 15.0% 15.0%EBIT 60 72 86 30.0% 30.0% 30.0%Interest expences 30 45 64 15.0% 18.8% 22.2%Taxes 12 11 9 6.0% 4.5% 3.1%Net income 18 16 13 9.0% 6.7% 4.7%Dividends 5 5 4 2.7% 2.0% 1.4%Change in shareholder's equity 13 11 9 6.3% 4.7% 3.3%

Balance SheetAssets: Cash & equivalents 10 12 14 17 6.0% 6.0% 6.0% Receivables 40 48 58 69 24.0% 24.0% 24.0% Inventories 50 60 72 86 30.0% 30.0% 30.0% Property, Plant & equipment 500 600 720 864 300.0% 300.0% 300.0% Total Assets 600 720 864 1037 360.0% 360.0% 360.0%Liabilities: Payables 30 36 43 52 18.0% 18.0% 18.0% Short-term debt 120 221 347 502 110.7% 144.6% 174.2% Long-term debt 150 150 150 150 75.0% 62.5% 52.1% Total Liabilities 300 407 540 704 203.7% 225.1% 244.3%Shareholder's equity 300 313 324 333 156.3% 134.9% 115.7%

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(Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3

Income StatementSales 200 240 288Cost of goods sold 110 132 158Gross margin 90 108 130Selling, general & admin. expenses 30 36 43EBIT 60 72 86Interest expences 30 45 64Taxes 12 11 9Net income 18 16 13Dividends 5 5 4Change in shareholder's equity 13 11 9

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Balance SheetAssets: Cash & equivalents 10 12 14 17 Receivables 40 48 58 69 Inventories 50 60 72 86 Property, Plant & equipment 500 600 720 864 Total Assets 600 720 864 1037Liabilities: Payables 30 36 43 52 Short-term debt 120 221 347 502 Long-term debt 150 150 150 150 Total Liabilities 300 407 540 704Shareholder's equity 300 313 324 333

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(Percent of Year's Sales)Year xxx1 xxx2 xxx3

Income StatementSales 100.0% 100.0% 100.0%Cost of goods sold 55.0% 55.0% 55.0%Gross margin 45.0% 45.0% 45.0%Selling, general & admin. expenses15.0% 15.0% 15.0%EBIT 30.0% 30.0% 30.0%Interest expences 15.0% 18.8% 22.2%Taxes 6.0% 4.5% 3.1%Net income 9.0% 6.7% 4.7%Dividends 2.7% 2.0% 1.4%Change in shareholder's equity6.3% 4.7% 3.3%

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Balance SheetAssets: Cash & equivalents 6.0% 6.0% 6.0% Receivables 24.0% 24.0% 24.0% Inventories 30.0% 30.0% 30.0% Property, Plant & equipment 300.0% 300.0% 300.0% Total Assets 360.0% 360.0% 360.0%Liabilities: Payables 18.0% 18.0% 18.0% Short-term debt 110.7% 144.6% 174.2% Long-term debt 75.0% 62.5% 52.1% Total Liabilities 203.7% 225.1% 244.3%Shareholder's equity 156.3% 134.9% 115.7%

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Year's Sales)

Year xxx0 xxx1 xxx2 xxx3 xxx1 xxx2 xxx3 F(sales)? xxx4

Income StatementSales 200 240 288 100.0% 100.0% 100.0% N/A 346Cost of goods sold 110 132 158 55.0% 55.0% 55.0% Yes 190Gross margin 90 108 130 45.0% 45.0% 45.0% N/A(Yes) 156Selling, general & admin. expenses 30 36 43 15.0% 15.0% 15.0% Yes 52EBIT 60 72 86 30.0% 30.0% 30.0% N/A 104Interest expences 30 45 64 15.0% 18.8% 22.2% No 87Taxes 12 11 9 6.0% 4.5% 3.1% N/A 7Net income 18 16 13 9.0% 6.7% 4.7% N/A 10Dividends 5 5 4 2.7% 2.0% 1.4% N/A 3Change in shareholder's equity 13 11 9 6.3% 4.7% 3.3% 7

Balance SheetAssets: Cash & equivalents 10 12 14 17 6.0% 6.0% 6.0% Yes 21 Receivables 40 48 58 69 24.0% 24.0% 24.0% Yes 83 Inventories 50 60 72 86 30.0% 30.0% 30.0% Yes 104 Property, Plant & equipment 500 600 720 864 300.0% 300.0% 300.0% Yes 1037 Total Assets 600 720 864 1037 360.0% 360.0% 360.0% N/A(Yes) 1244Liabilities: Payables 30 36 43 52 18.0% 18.0% 18.0% Yes 62 Short-term debt 120 221 347 502 110.7% 144.6% 174.2% No Long-term debt 150 150 150 150 75.0% 62.5% 52.1% No Total Liabilities 300 407 540 704 203.7% 225.1% 244.3% N/A 904Shareholder's equity 300 313 324 333 156.3% 134.9% 115.7% N/A 340

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million)

Year xxx0 xxx1 xxx2 xxx3 xxx4

Income StatementSales 200 240 288 346Cost of goods sold 110 132 158 190Gross margin 90 108 130 156Selling, general & admin. expenses 30 36 43 52EBIT 60 72 86 104Interest expences 30 45 64 87Taxes 12 11 9 7Net income 18 16 13 10Dividends 5 5 4 3Change in shareholder's equity 13 11 9 7

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million)

Year xxx0 xxx1 xxx2 xxx3 xxx4

Balance SheetAssets: Cash & equivalents 10 12 14 17 21 Receivables 40 48 58 69 83 Inventories 50 60 72 86 104 Property, Plant & equipment 500 600 720 864 1037 Total Assets 600 720 864 1037 1244Liabilities: Payables 30 36 43 52 62 Short-term debt 120 221 347 502 692 Long-term debt 150 150 150 150 150 Total Liabilities 300 407 540 704 904Shareholder's equity 300 313 324 333 340

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External Funds NeededExternal Funds Needed

%58.31

)30.01(*)40.01(*40.8684.5180.1036

)30.01(*)40.01(*)26.8740.86(300

)1)(1(][][

)1)(1)((

Million 0956.190$

)30.01(*)40.01(*)26.872.1*40.86((2.0*)84.5180.1036(

)1)(1)(((])[][(0

10

0

01

dtEBITSLSA

dtIntEBITEFAgrowth

dtIntS

SEBIT

S

SSSLSAEFN

37

External Funds Needed for Growth

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

$500

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Growth Rate

Ext

ern

al F

un

ds

Nee

ded

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Observation:Observation:

– Sometimes the new assets required to Sometimes the new assets required to generate income are not a high as in generate income are not a high as in this example, and the company may this example, and the company may able to support a level of growth with able to support a level of growth with no external funding (-0.00038 in our no external funding (-0.00038 in our case)case)

)1)(1(][][

)1)(1)((EF No dtEBITSLSA

dtIntEBITgrowth