17-1

Earnings and Cash Flow Analysis

• The goal of this segment is to show you the financial accounting concepts necessary to:

– Understand basic financial statements, and – Perform earnings and cash flow analysis using

basic financial statements.

• Keep in mind: Cash flow is a company’s lifeblood.

17-2

Overview

• Sources of Financial Information

• Financial Statements– The Balance Sheet– The Income Statement– The Cash Flow Statement– Performance Ratios and Price Ratios

17-3

Overview Part II

• Financial Statement Forecasting – The Percentage of Sales Approach– The Pro Forma Income Statement– The Partial Pro Forma Balance Sheet– External Financing Needed (EFN)– The Pro Forma Balance Sheet– Projected Profitability and Price Ratios

• Starbucks Corporation Case Study

17-4

Sources of Financial Information

• The Securities and Exchange Commission (SEC) requires companies to prepare and submit regular reports

– When received by the SEC, these reports are freely made available through Electronic Data Gathering and Retrieval (EDGAR) archives.

– 10K: Annual company report filed with the SEC.

– 10Q: Quarterly updates of 10K reports.

– Companies file many reports with the SEC.

• Internet– Web sites, like finance.yahoo.com, provide some financial information

17-5

Preferential Financial Information

• The SEC Regulation FD (Fair Disclosure) requires companies making a public disclosure of material nonpublic information to do so fairly without preferential recipients.

– Material nonpublic information is previously unknown information that could reasonably be expected to affect the price of a security.

– Most companies satisfy Regulation FD by distributing important announcements via an 8K report on Edgar.

17-6

Three Important Financial Statements

• The Balance Sheet:– Provides a snapshot view of a company’s assets and liabilities.– The Balance Sheet is as of a particular date.

• The Income Statement:– Provides a summary of a firm’s revenues and expenses.– The Income Statement is over a specific accounting period, usually a

quarter or a year.

• The Cash Flow Statement:– Is an analysis of the sources and uses of cash by the firm over an

accounting period.– Summarizes operating, investing, and financing cash flows.

17-7

The Balance Sheet

• Asset - Anything a company owns that has value.

• Liability - A firm’s financial obligation.

• Equity - An ownership interest in the company.

• The fundamental accounting identity:

Assets = Liabilities + Equity

17-8

Borg Corporation Balance Sheet

17-9

Borg Corporation, Condensed Balance Sheet

17-10

The Income Statement

• Income - The difference between a company’s revenues and expenses.

• Income is used to:– pay dividends to stockholders or,– kept as retained earnings to finance future growth.

Net income = Revenues – Expenses

= Dividends + Retained earnings

17-11

Borg Corporation, Income Statement

17-12

The Cash Flow Statement

• Net Income does not equal cash flow.– Net income contains non-cash items. – Non-cash items are income and expenses not realized in cash

form.– Depreciation can be a significant non-cash item.

• Cash flow represents all income realized in cash form.– Adjusting net income for non-cash items yields Operating Cash

Flow.– Investment Cash Flow includes any purchases or sales of fixed

assets and investments. – Financing Cash Flow includes funds raised by issuing

securities, or expended by repurchasing outstanding securities.

17-13

Borg Corporation,Condensed Cash Flow Statement

17-14

Performance, or Profitability, Ratios

• Four common performance ratios often reported in 10Ks and 10Qs to help investors interpret financial information are:

• Note that ROA and ROE are calculated using the current year-end values for total assets and stockholder equity.

• Although one could use prior-year values, it is more common to use current year-end values.

Equity rStockholde

Income Net (ROE)Equity on Return

Sales Net

Income Operating Margin Operating

AssetsTotal

Income Net (ROA) Assetson Return

Sales Net

Profit Gross Margin Gross

17-15

Example: Calculating Profitability Ratios

• Using the data provided by the Borg Company in the year 2536, we can calculate the profitability ratios:

9.00%$40,000

$3,600

Equity rStockholde

Income Net (ROE)Equity on Return

4.09%$88,000

$3,600

AssetsTotal

Income Net (ROA) Assetson Return

7.27%$110,000

$8,000

Sales Net

Income Operating Margin Operating

19.09%$110,000

$21,000

Sales Net

Profit Gross Margin Gross

17-16

Price Ratio Inputs

• Annual reports will often report per-share calculations of book value, earnings, and operating cash flow.– Per share calculations require the number of shares outstanding.– Cash flow per share uses operating cash flow!

gOutstandin Shares

Flow Cash Operating (CFPS) Share perFlow Cash

gOutstandin Shares

Income Net (EPS) Share per Earnings

gOutstandin Shares

Equity rStockholde (BVPS) Share per ValueBook

17-17

Example: Calculating Price Ratio Inputs

• For the Borg Company in the year 2536:

$3.302,000

$6,600

gOutstandin Shares

Flow Cash Operating (CFPS) Share perFlow Cash

$1.802,000

$3,600

gOutstandin Shares

Income Net (EPS) Share per Earings

$20.002,000

$40,000

gOutstandin Shares

Equity rStockholde (BVPS) Share per ValueBook

17-18

Price Ratios

• Using the inputs we just calculated, we can calculate three important Price Ratios:

CFPS

Price Stock (P/CF) RatioFlow Cash to Price

EPS

Price Stock (P/E) Ratio Earnings Price

BVPS

Price Stock (P/B) Ratio Book to Price

17-19

Example: Calculating Price Ratios

• For the Borg Company, these three ratios are:

12.12$3.30

$40

CFPS

Price Stock (P/CF) RatioFlow Cash to Price

22.22$1.80

$40

EPS

Price Stock (P/E) Ratio Earnings Price

2.00$20

$40

BVPS

Price Stock (P/B) Ratio Book to Price

17-20

Financial Statement Forecasting, I.

• You are an analyst employed by Vulcan Ventures, and you are assigned as an analyst for the Borg Corp.

– In December 2536, Borg announces the completed acquisition of some distribution outlets from Klingon Enterprises, LLC.

– The stated purpose of the acquisition is to increase sales.

– Borg also announces plans for a marketing campaign—goal: increase sales to $137,500.

• Your job is to examine the potential financial impact from these announcements on the Borg Corp.

• How do you proceed?

17-21

Financial Statement Forecasting, II.

• You decide to build pro forma financial statements using the percentage of sales approach.

• Under this approach:– Every accounting item increases at the same rate as sales.– This may be reasonable for some items and unreasonable for

others—as an analyst you must judge this “reasonableness.” • Reasonable: accounts receivable• Not Reasonable: long-term debt

Long-term debt levels are decided by management.

17-22

Building the Pro Forma Income Statement, I.

• A sales level of $137,500 for year 2537 represents a 25% increase over sales in the year 2536.

• Assumptions:– Ratio of total costs to net sales is about 94.55% in 2536. You assume

this ratio to be 94.55% in 2537 too.– Depreciation can be handled many ways. As a practical matter, you use

the percentage of sales approach.• Depreciation to sales in 2536 was $3,000 / $110,000.• For 2537, you estimate depreciation as:

($3,000 / $110,000) × $137,500 = $3,750.

17-23

Building the Pro Forma Income Statement, II.

• Assumptions, cont.

– Interest Expense: 4% interest on short-term debt, 8% interest on long-term debt, and 5% interest on debt issued to finance the new outlets.

– To maintain the ratio of total costs to net sales (94.55%), you use other operating expenses as the “plug” so you set it to $12,500.

– Tax rate of 40%.

– Dividends are a constant percentage of net income.

17-24

The Pro Forma Income Statement

17-25

Building the Pro Forma Balance Sheet

• You assume some balance sheet items vary with sales but others do not (“n/a” is next to the items that do not).

• Asset accounts that do:– Cash– Accounts receivable– Prepaid expenses– Materials and supplies– Inventory

• However, the only liability account that you assume does is accounts payable.

17-26

The Partial Pro Forma Balance Sheet, I.

17-27

The Partial Pro Forma Balance Sheet, II.

• Inspecting the partial pro forma balance sheet:– Assets are projected to increase by $22,000.– However, without additional financing (i.e., short-term or long-

term debt), liabilities and equity will increase by only $4,400.

• What do you do about this $17,600 difference (labeled external financing needed (EFN)?

• After all, the balance sheet must balance.

17-28

The Partial Pro Forma Balance Sheet, III.

• First, note that EFN points out a potentially serious problem for Borg: The company cannot increase sales to $137,500 unless it can raise $17,600 in additional financing.

• If Borg management does not want to take on more debt or raise more equity, then they cannot increase sales to $137,500.

• You assume that the ratio of current assets to current liabilities should remain constant.– This means that Borg should borrow $2,500 more short-term.– This leaves $15,100 to be financed via long-term debt.

These are the amounts shown at the bottom of Table 17.6

17-29

The Pro Forma Balance Sheet

17-30

Another Scenario to Consider

• Hidden assumption: You assumed that Borg was using its fixed assets at 100% of capacity (i.e., increasing sales increased fixed assets).

• But suppose there is some capacity slack.– Suppose you find out from Borg management that Borg is currently

running at 75% of capacity.– That is, current sales level is 75% of full capacity sales level.

$146,667 .75 / $110,000 capacity -Full

salescapacity -Full .75 $110,000 Sales Current

Therefore, sales could increase by about 1/3 before any new fixed assets are required.

17-31

The Resulting Pro Forma Balance Sheet

17-32

Notes on this New Pro Forma Balance Sheet

• A sales level of $137,500 increases assets (other than fixed assets) by $7,000.

• Accounts payable increase by $1,250.

• A sales level of $137,500 increases retained earnings by $3,150 (after dividends are paid).

• The difference between the increase in assets and the increases in liabilities and shareholder equity would be $2,600 (without additional financing).

• The balance sheet balances if Borg borrows $2,600 more in short-term debt.

17-33

Projected Profitability and Price Ratios,The Borg Corporation

Year2536

Year2537

Gross Margin 19.09% 25.00%

Operating Margin 7.27% 10.83%

Return on Assets (ROA) 4.09% 4.09% (I) 4.74% (II)

Return on Equity (ROE) 9.00% 10.43%

Book Value per share (BVPS) $20.00 $21.57

Earnings per share (EPS) $1.80 $2.25

Cash Flow per share (CFPS) $3.30 $4.25

(I) Borg running at full capacity; (II) Borg running at 75% capacity

17-34

Projected Stock Prices for Year 2537,The Borg Corporation

• Assume that the current stock price is $40.

• Which projected stock price is “right”?– Clearly depends on which price ratio financial markets will use to

price Borg shares.– Your job as an analyst will be to assess the situation and make an

investment recommendation (supported by facts, investigation, and analysis).

Year 2537Stock Price

P/B times BVPS 2.00 × $21.57 $43.14

P/E times EPS 22.22 × $2.25 $50.00

P/CF times P/CF 12.12 × $4.25 $51.51

17-35

Starbucks Corporation,Case Study

• The purpose of studying the Borg Corporation was to help you gain an understanding of basic financial statements, and how to make financial projections.

• To further illustrate these concepts, let’s perform an analysis using a real company—which provides a challenge!

• We will use the 2007 financial statements for Starbucks Corporation.– Suppose sales increases 24.3% or 16.9%?– The numbers that follow are in $thousands (except EPS).

17-36

Starbucks Corporation,2007 and 2006 Condensed Balance Sheet

17-37

Starbucks Corporation, 2007 and2006 Condensed Income Statements

17-38

Pro Forma Statements, Notes I.

• The pro forma income statements correspond to a 24.3% increase and a 16.9% increase in sales.

• We employ the percentage of sales approach.– Assume that gross margin, operating margin, and interest income are

the same percentage of sales for 2008 as they were in 2007– Assume the tax rate remains constant– Net effect: Profit margin remains constant at about 7.1%.– Assume no dividends are paid

• Assume Starbucks will not issue or repurchase shares– All net income will flow to retained earnings– Number of shares remains at 770.1 million

• These assumptions lead to EPS of $1.08 and $1.02, respectively.

17-39

Starbucks Corporation,2008 Pro Forma Income Statement

17-40

Starbucks Corporation,2008 Partial Pro Forma Balance Sheet

17-41

Starbucks Corporation,2008 Pro Forma Balance Sheet

17-42

Pro Forma Statements, Notes II.

• Using the high sales estimate, EFN is about $110 million.

• Using the low sales estimate, EFN is a negative $130 million.– Current assets grow about $490 million less than net income– Current liabilities increase by about $249 million– Quite the “cash cow”

• This is $130 million of “excess” cash. How will management decide to use it?– Buy other companies– Look for new ways to expand the company– Buy back shares– Declare a cash dividend

• Existing profit margin enjoyed by Starbucks is such that considerable growth can be financed out of sales.

17-43

Projected Profitability and Price Ratios,Starbucks Corporation

2007

2008(High Sales

Forecast)

2008(Low Sales

Forecast)

Gross Margin 57.5% 57.5% 57.5%

Operating Margin 10.1% 10.0% 10.0%

Return on Assets (ROA) 12.6% 12.6% 12.3%

Return on Equity (ROE) 29.4% 26.8% 25.6%

Earnings per share (EPS) $0.87 $1.08 $1.02

Book Value per share (BVPS) $2.97 $4.05 $3.99

Fiscal Year End Stock Price $26.20:

P/E Ratio: 30.11 P/E × EPS: $32.52 $30.71

P/B Ratio: 8.82 P/B × EPS: $35.72 $35.19

Analysts Estimates were $23-37 for Starbucks Shares for 2008