GSB711-Lecture-Note-02-Understanding-Financial-Statements

Understanding Financial Statements

Topic 02GSB711 – Managerial Finance

Readings:Chapter: Accounting and Finance (Pages 52 - 75)

Questions: 1, 3, 8, 9 and Problems: 11, 13, 15 and 20. Chapter: Measuring Corporate Performance (Pages 76 – 107)

Questions: 1, 3, 4, 6, 7 and Problems: 11, 17, 22 and 26

GSB711 Managerial Finance – Topic 02 Page No. 2

Topics Covered…

• The Balance Sheet• The Income Statement• The Statement of Cash Flows• Accounting Practice & Malpractice• Taxes• Value and Value Added• Measuring Profitability• Measuring Efficiency• Analyzing the Return on Assets: The Du Pont

System


Topics Covered

• Measuring Leverage• Measuring Liquidity• Calculating Sustainable Growth• Interpreting Financial Ratios• The Role of Financial Ratios–and a Final Note on

Transparency


The Balance Sheet

Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in

time (from an accounting perspective).

Balance SheetPepsiCo Balance Sheet (December 31, 2006) $Millions


Telstra’s Balance Sheet


The Balance SheetThe Main Balance Sheet Items

Current AssetsCash & SecuritiesReceivablesInventories

+

Fixed AssetsTangible AssetsIntangible Assets Current Liabilities

PayablesShort-term Debt

+

Long-term Liabilities

+

Shareholders’ Equity=


The Balance Sheet

• Common-Size Balance Sheet– All items in the balance sheet are expressed as a

percentage of total assets.


Common Size Balance Sheet


Market Value vs. Book Value

Book Values are determined by GAAPMarket Values are determined by current values

• Generally Accepted Accounting Principles (GAAP)– Procedures for preparing financial statements.

Equity and Asset “Market Values” are usually higher than their “Book Values”



ExampleAccording to GAAP, your firm has equity

worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.

Q: What is the market value of your assets?A: Since (Assets=Liabilities + Equity),

your assets must have a market value of $11.5 billion.



Example (continued)

Book Value Balance SheetAssets = $10 bil Debt = $4 bil

Equity = $6 bil

Market Value Balance SheetAssets = $11.5 bil Debt = $4 bil

Equity = $7.5 bil


The Income Statement

Definition Financial statement that shows the

revenues, expenses, and net income of a firm over a period of

time (from an accounting perspective).



Earnings Before Income & Taxes (EBIT)

EBIT = Total Revenues - costs – deprecation= 35,753 – 27,292 – 1,406= $ 7,055 million



Pepsico Income Statement (year end 2006)Net Sales 35,753COGS 15,762Selling, G&A expenses 11,530Depreciation expense 1,406EBIT 7,055Net interest expense 66Taxable Income 6,989Income Taxes 1,347Net Income 5,642


Profits vs. Cash Flows

Differences• “Profits” subtract depreciation (a non-cash

expense)• “Profits” ignore cash expenditures on new

capital (the expense is capitalized)• “Profits” record income and expenses at the

time of sales, not when the cash exchanges actually occur

• “Profits” do not consider changes in working capital


The Statement of Cash Flows

Definition Financial statement that shows the firm’s cash

receipts and cash payments over a period of time.


The Statement of Cash Flows

Pepsico Statement of Cash Flows (excerpt - year end 2006)

Net Income 5,642Non-cash expenses

Depreciation 1,406Other 0

Changes in working capital A/R=(464) A/P=(86) Inv=(233) other=1,956 CL=155 1,328

Cash Flow from operations 8,376Cash Flow from investments (933)Cash provided by financing (7,508)Net Change in Cash Position (65)


Telstra’s Income Statement


Cash Flows

• Free Cash Flow (FCF)– Cash available for distribution to investors after firm

pays for new investments or additions to working capital

FCF = EBIT - taxes + depreciation- change in net working capital- capital expenditures


Telstra’s Cash Flow Statement


Taxes

• The one thing we can rely on with taxes is that they are always changing

• Marginal vs. average tax rates– Marginal – the percentage paid on the next dollar earned– Average – the tax bill / taxable income– Tax Imputation

• Franked Dividends

• Other taxes


Value and Value Added

• Market Capitalization– Total market value of equity, equal to share price times

number of shares outstanding.

• Market Value Added– Market capitalization minus book value of equity.

share)per (priceshares) (# tion CapitalizaMarket

ValueBook Equity -tion CapitalizaMarket MVA


Value and Value AddedPepsiCo Balance Sheet (December 31, 2006) $Millions



Pepsico Income Statement (year end 2006)

Net Sales 35,753COGS 15,762Selling, G&A expenses 11,530Depreciation expense 1,406EBIT 7,055Net interest expense 66Taxable Income 6,989Income Taxes 1,347Net Income 5,642



• Market-to-Book Ratio– Ratio of market value of equity to book value of equity.

76

36815$

457102$

equity of book value

equity of uemarket valratiobook -to-Market

.

,

,



• Stock market measures of company performance, 2006. Companies are ranked by market value added. (dollar values in millions)


Measuring Profitability

• Economic Value Added (EVA)– Net income minus a charge for the cost of capital

employed. Also called residual income.• Residual Income

– Net Dollar return after deducting the cost of capital

Equity Equity ofCost - IncomeNet

Income Residual

EVA



• Economic Value Added (EVA) of PepsiCo

Equity Equity ofCost - IncomeNet

Income Residual

EVA

million $4,527

14,251.095 - 5,642

Income Residual

EVA



• Accounting measures of company performance, 2006. Companies are ranked by return on equity.



• Return on Equity (ROE)– Net income as a percentage of shareholders’ equity

• Return on Capital (ROC)– Net income plus Interest as a percentage of long-term

capital.• Return on Assets (ROA)

– Net income plus interest as a percentage of total assets



396.14,251

5,642

equity

incomenet =equityon Return

185.31,727

2395,642=

assets total

Interest IncomeNet =assetson Return

355.564,16

2395,642

equity debt termLong

Interest IncomeNet =capitalon Return

PepsiCo Profitability Measurements


Measuring Efficiencyyear ofstart at assets total

Sales=ratioover Asset turn

assets totalAverage


OR

13.131,727

35,753

year ofstart at assets total


16.12/)930,29(31,727

35,753

assets totalAverage


OR

For PepsiCo


Measuring Efficiency

sold/365 goods ofcost

year ofstart at inventory =Inventoryin Days Average

year ofstart at inventory

sold goods ofcost =ratioturnover Inventory

salesdaily average

year ofstart at sreceivable=period collection Average

year ofstart at sreceivable

sales=Turnover sReceivable


The DuPont System

• A breakdown of ROE and ROA into component ratios

sales

Interest IncomeNet =MarginProfit Operating

sales

IncomeNet =MarginProfit


The DuPont System

sales

interestIncomeNet x

assets

sales=ROA

assetturnover

Operating profitmargin

assets

interest IncomeNet =ROA


Measuring Leverage

equity+debt termlong

debt termlong=ratiodebt termLong

equity

debt termlong=ratioequity Debt


Measuring Leverage

Total debt ratio =total liabilities

total assets

Times interest earned =EBIT

interest payments

Cash coverage ratio =EBIT + depreciation

interest payments


Measuring Leverage

interestIncomeNet

IncomeNet x

sales

interestIncomeNet x

assets

salesx

equity

assets=ROE

leverage

ratio

assetturnover

Operating profit

margin

debtburden


Measuring Liquidity

Net working capital

to total assets ratio=

Net working capital

Total assets

Current ratio =current assets

current liabilities


Liquidity Ratios

Cash ratio =cash + marketable securities

current liabilities

Quick ratio =cash + marketable securities + receivables

current liabilities


Percent of Sales Approach• Some items vary directly with sales, while others do not• Income Statement

– Costs may vary directly with sales - if this is the case, then the profit margin is constant

– Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant

– Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings

• Balance Sheet– Initially assume all assets, including fixed, vary directly with

sales– Accounts payable will also normally vary directly with sales– Notes payable, long-term debt and equity generally do not

because they depend on management decisions about capital structure

– The change in the retained earnings portion of equity will come from the dividend decision


Growth and External Financing

• At low growth levels, internal financing (retained earnings) may exceed the required investment in assets

• As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money

• Examining the relationship between growth and external financing required is a useful tool in long-range planning


The Internal Growth Rate

• The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

• Using the information from Tasha’s Toy Emporium– ROA = 1200 / 9500 = .1263– B = .5

%74.6

0674.5.1263.1

5.1263.bROA - 1

bROA RateGrowth Internal


Sustainable Growth

Plowback ratio =earnings - dividends

earnings

= 1 - payout ratio

Payout ratio =dividends

earnings

Growth in equity from plowback =earnings - dividends

earnings


Determinants of Growth

• Profit margin – operating efficiency• Total asset turnover – asset use efficiency• Financial leverage – choice of optimal debt ratio• Dividend policy – choice of how much to pay to

shareholders versus reinvesting in the firm


Interpreting Financial Ratios

• PepsiCo Ratios



• PepsiCo Ratios (continued)



• Selected 2006 financial ratios for industry groups in Standard & Poor’s Composite Index


Why Evaluate Financial Statements?

• Internal uses– Performance evaluation – compensation and comparison

between divisions– Planning for the future – guide in estimating future cash

flows• External uses

– Creditors– Suppliers– Customers– Stockholders


Benchmarking

• Ratios are not very helpful by themselves; they need to be compared to something

• Time-Trend Analysis– Used to see how the firm’s performance is changing

through time– Internal and external uses

• Peer Group Analysis– Compare to similar companies or within industries– SIC and NAICS codes

http://www.naics.com/


Potential Problems

• There is no underlying theory, so there is no way to know which ratios are most relevant

• Benchmarking is difficult for diversified firms• Globalization and international competition

makes comparison more difficult because of differences in accounting regulations

• Varying accounting procedures, i.e. FIFO vs. LIFO• Different fiscal years• Extraordinary events


Important Questions

• It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process– How does our plan affect the timing and risk of our cash

flows?– Does the plan point out inconsistencies in our goals?– If we follow this plan, will we maximize owners’ wealth?


Summary• Financial statements• Book value vs market value• Cashflow statement• Standardized financial statements• Financial Ratios• Financial Planning• Internal growth rate• Sustainable growth rate• Evaluating financial statements

GSB711-Lecture-Note-02-Understanding-Financial-Statements

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