FINANCE 7311FINANCE 7311

Review & Financial

Statement Analysis

Dr. Ashvin Vibhakar Fall 2000

OutlineOutlineReview of Basic FinanceThe CorporationThe Accounting ModelCash FlowsFinancial Statement Analysis

Review of Basic FinanceReview of Basic Finance

Efficient MarketsRates of ReturnTime Value of MoneyBond ValuationStock Valuation

EFFICIENT MARKETSEFFICIENT MARKETSMarkets are in equilibriumExpected Returns = Required returnsExpectations are rationalInformation is reflected in price

– Information– Reflected in Price

No Arbitrage

EFFICIENT MARKETSEFFICIENT MARKETS Why do we care whether or not markets

are efficient?

Prices direct economic activity Rates of return (cost of capital) Valuation (market multiples)

RATES OF RETURNRATES OF RETURNREQUIRED RETURN

– required by investor– depends on RISK

EXPECTED RETURN– given current price & expected future CF’s

REALIZED RETURN– actual return

RISKRISKRepresents the CHANCE that ACTUAL

returns turn out to be much different than EXPECTED

Statistically: Variance Standard Deviation

TIME VALUE OF MONEYTIME VALUE OF MONEYSINGLE CASH FLOWS

Vn = Vo x (1 + R)n

FV = PV x (1 + R)n

PV = FV x (1 + R)-n

MULTIPLE CASH FLOWS PERPETUITY

PV = CF / R

TIME VALUE OF $, cont.TIME VALUE OF $, cont.ANNUITY

PV = CF X [1/ R (1 - 1/(1 + R)n ] Calculator:

PV - present value FV - future value CF - periodic payment amount R - discount rate N - number of CF’s or periods

Ordinary - end of period Due - beginning of period

BOND VALUATIONBOND VALUATION CF = coupon rate x par ÷ 2 (semi-ann.) N = number of semi-annual periods FV = par amount of bond R = investor’s required rate of return PV = price of bond

Solving for R ===> Yield to Maturity

STOCK VALUATIONSTOCK VALUATIONPresent value of future dividendsAssumption about Time PathMore Generally, CF 1) No Growth --> Perpetuity

Vt = CFt+1/R

2) Constant Growth --> Gordon Model Vt = CFt+1 / (R - g)

THE CORPORATIONTHE CORPORATIONREAL ASSETS ----> CASH FLOWS

CLAIMANTS ----> - EMPLOYEES/CREDITORS- BONDHOLDERS- STOCKHOLDERS

MANAGEMENT TEAM

A Picture of the CorporationA Picture of the Corporation Real Assets & Financial Assets

ASSETS

Bondholders

Shareholders

3rd PartiesGovt; other

CF’s

Business RiskFinancial Risk

Investment Financing

MANAGEMENTMANAGEMENTOBJECTIVE: ALLOCATE COPORATE

RESOURCES IN A WAY WHICH:- Maximizes the value of the firm- Maximizes current share price

AGENCY PROBLEM- Management makes decisions which are

inconsistent with the above

MANAGEMENT DECISIONSMANAGEMENT DECISIONSINVESTMENT DECISION --> What

should be in the circle 1) Short-term assets --> Working capital

- inventory policy- A/R and A/P policy- nature and amount of S-T financing

2) L-T Assets --> Capital Budgeting- Which assets add most VALUE to the firm?

Mgmt Decisions, cont.Mgmt Decisions, cont.FINANCING DECISION- How Should Assets Be Financed?- What is the Proper Mix of Debt and Equity?

How much debt should a company have?- Risk- Taxes- Costs of financial distress- Over / Under Investment Problem

BUSINESS RISKBUSINESS RISK Assets are the SOURCE of BUSINESS

RISK DEMAND & SUPPLY VARIABILITY COMPETITION (ease of entry) TECHNOLOGY REGULATION MGMT DEPTH & BREADTH OPERATING LEVERAGE

THE ACCOUNTING MODELTHE ACCOUNTING MODELCONFORMS TO PICTURE:

NWC DEBT L-T ASSETS EQUITY

LHS = CIRCLE

RHS = RECTANGLES

DebtDebt

Interest Bearing - ‘Permanent’ Capital

Reclassify S-T portion of notes payable

Lines of Credit

Include as part of NWC

ACCOUNTING PRINCIPLESACCOUNTING PRINCIPLESCOST PRINCIPLE:

ONLY TRANSACTIONS RECORDED COST ≠ MARKET IN GENERAL

MATCHING PRINCIPLE PERFORMANCE MEASUREMENT ACCRUAL V. CASH BASIS ACCTG.

FINANCIAL STATEMENTSFINANCIAL STATEMENTSBALANCE SHEET

- Assets & Liab. as of a point in time

INCOME STATEMENT- Period of time- Include effect of accruals- Not the same as Cash Flow. Why?

BALANCE SHEETBALANCE SHEETASSETS -> something owned

- Listed in order of liquidity- NWC & Long-term

Liability -> something owed- listed in order of Claim Priority

Retained Earnings -> owned - owed- Cum. Earnings not paid as dividends

INCOME STATEMENTINCOME STATEMENT GENERAL FORMAT SALES - COS GROSS PROFIT - OPERATING EXPENSES EBIT (OPERATING PROFIT)

– EARNINGS W/O REGARD TO DEBT & TAX SITUATION

Income Statement, cont.Income Statement, cont. EBIT - INTEREST EBT (TAXABLE INCOME) - Taxes NET INCOME

NET INCOME ≠ CASH FLOW WHY?

Cash Flow v. Net IncomeCash Flow v. Net Income

Non-Cash ExpensesDepreciationAmortizationWrite-offs

AccrualsTiming Differences

CASH FLOWCASH FLOWASSETS = DEBT + EQUITY

CF FROM ASSETS = CF’S TO D + E

USES:- CF’S CONSISTENT W/ PICTURE- SOURCES / USES OF CASH- VALUATION (PROJECTED CF’S)

CF’S FROM ASSETSCF’S FROM ASSETSOperating Cash Flow EBIT + DEPRECIATION (NON-CASH ITEMS) - TAXES

- ∆NWC- CAPITAL SPENDING

CF’S TO B/H & S/HCF’S TO B/H & S/HCF’S TO B/H:

INTEREST – NET CHANGE IN DEBT

CF’S TO S/H: DIVIDENDS - NET CHANGE IN COMMON STOCK

Taxes and Cash FlowTaxes and Cash Flow

Historical - Analyzing company’s CF Use Tax number from Income Stmt

Projections - Free Cash Flow for valuation purposes

Use Tax Rate x EBIT

RATIO ANALYSISRATIO ANALYSISFINANCIAL COMPARISON TOOLRAW FINANCIAL STATEMENTS

- SIZE DIFFERENCES- DOLLAR AMOUNTS SAY LITTLE

KEY: COMPARABILITYDEFINITIONS DIFFER

BENCHMARKSBENCHMARKSHistorical Ratios of Company

- Trend Analysis- Assumes: Continuation of past

Other Companies / Industry- RMA, S&P, Hoover- Industry Publications

Projections (Forecasts)

COMMON SIZE F/SCOMMON SIZE F/SBALANCE SHEET

EXPRESS EACH ITEM AS % OF ASSETS

INCOME STATEMENT EXPRESS EACH ITEM AS % OF SALES

COMMON BASE EXPRESS EACH ITEM AS % OF BASE YEAR

(GROWTH RATE)

RATIO GROUPSRATIO GROUPSLIQUIDITYACTIVITYLEVERAGEPROFITABILITYMARKET

LIQUIDITYLIQUIDITY Ability to meet current Obligations Of Interest to Short-term Creditors

CURRENT RATIO QUICK RATIO

ACTIVITY RATIOSACTIVITY RATIOS Measures Effective Asset Use Of Interest to management & investors

ASSET TURNOVERINVENTORY TURNOVERDAYS SALES IN INVENTORYDAYS SALES OUTSTANDING

LEVERAGE RATIOSLEVERAGE RATIOS USE OF DEBT FINANCING

Ability to meet debt payments Important to long-term creditors

DEBT RATIOTIMES INTEREST EARNEDDAYS PAYABLE O/S

PROFITABILITY RATIOSPROFITABILITY RATIOS COMBINED USE OF DEBT & ASSETS IMPORTANT TO MGMT & INVESTORS

PROFIT MARGINGROSS MARGINOPERATING MARGINRETURN ON ASSETS (ROA)RETURN ON EQUITY (ROE)

DUPONT & ROICDUPONT & ROICDUPONT DECOMPOSITION OF ROE

Profitability X Asset Turnover X Leverage

ROIC EBIT X (1 - T) / (EQUITY + DEBT)

NOT AFFECTED BY LEVERAGE COMPARE WITH WACC

MARKET RATIOSMARKET RATIOSP/E RATIO

What investors are willing to pay for a $ of earnings (Current / Forecast)

What creates a high P/E?

MARKET/BOOK Usually much different than 1. EX: S&P 500 CURRENTLY = 6.4 WHY?

LIMITATIONSLIMITATIONSNO THEORY TO DEFINE ‘GOOD’ #’S HISTORICAL; NOT ECONOMICMOST AS OF SINGLE POINT IN TIME

– SEASONAL OPERATIONS– ONE-TIME EFFECTS

DESIGNED FOR MANUFACTURERS

ECONOMIC V. ACCTG. ECONOMIC V. ACCTG. EARNINGSEARNINGS

UNREALIZED GAINS & LOSSESCOST OF EQUITY

‘HIGH’ CORPORATE PROFITS

EVA - attempts to account for cost of equity