Chapter 3: Interpreting Financial Statements
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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
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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