WK - 2 - Understanding Financial Statements PDF

Basic Financial Statements
The balance sheet, which summarises what a firm owns

and owes at a point in time.
The income statement, which reports on how much a
firm earned in the period of analysis.
The statement of cash flows, which reports on cash

inflows and outflows to the firm during the period of
analysis.
Understanding Financial Statements 1
The Balance Sheet

The balance sheet provides a snapshot of the firms
financial position at a moment in time.
Net working capital

+FA= LTD + SH Equity
Fixed A= Net asset : asset - total accu

depreciation
The Balance Sheet

The balance sheet identity
Assets = Liabilities + Stockholders equity
The left-hand (LHS) side: the firms assets
LHS details the uses of the firms funds.

Often listed in order by the length of time it normally would take
a firm with ongoing operations to convert them into cash.
The right-hand (RHS) side: the firms total liabilities and
shareholder equity
RHS details the sources of the firms funds.
Often listing short-term liabilities first, then long-term liabilities
and owners wealth
The Balance Sheet

Global Corporation
2011 and 2012 Balance Sheet ($millions)
Assets
2011
2012
Liabilities and Equity
Current assets: Highly liquid asset ( treasury bill) Current liabilities:

Cash and equivalents
$104
$160
Accounts payable
Accounts receivable
455
688
Notes payable
Inventory
553
555
Accrued expenses
Total current assets
$1,112
$1,403
Total current liabilities
Fixed assets:
Property, plant and equip.
$1,233
Intangible assets and others
411
Total fixed assets
$1,644
Long-term debt
$1,280
429
$1,709
Liquidity VS Profitability?
Trade off
Total assets
$2,756
$3,112
Owners equity
Common stock and
paid-in surplus
Retained earnings
Total equity
Total liabilities and equity
2011
2012
$232
157
39
$428
$266
98
25
$389
$408
$454
600
640
1,320
1,629
$1,920 $2,269
$2,756 $3,112
Shareholders equity: retained or payout? Issue common

stock ?
Common stock +Paid in surplus= $60
Nominal value+ extra = full number
The Balance Sheet

Liquidity versus profitability
Assets listed in order of decreasing liquidity
An asset has a high degree of liquidity if it can be easily converted into cash
without significant loss of value.
Liquid firms are less likely to experience financial distress
Liquid assets, however, earn a lower return
Net working capital (NWC)

NWC = Current Assets Current Liabilities
NWC is positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out.
NWC is usually positive in a healthy firm.
The Balance Sheet

Debt and equity
Debt: when a firm borrows, it gives the bondholders first claim on
the firms cash flow.
Financial risk : total cash flow used to pay creditor increases and left
less to shareholders
The use of debt in a firmsRe

capital
structure
is called financial leverage;
increased
as D increases
the more debt a firm has, the higher the degree of financial leverage.
Interest-bearing debt
Pay creditor ------ preferred SH ---- ordinary SH( residual claim)
Equity: shareholders equity is the capital from the owners, which
gives the owners residual claim on the firms cash flows

How does a firms equity change?
Preferred stock: presenting capital from issuing preferred stock,
which is a hybrid security, sharing some characteristics with equity

and some with debt. Ignore cozy many companies do not hv preferred share
or they can be converted to OS
The Balance Sheet

Book value vs. market value
Book value: under generally accepted accounting principles
(GAAP), audited financial statements of firms carry assets at cost.

So the accounting numbers are based on costs (though they are
consider human capital
often referred to as book value). -I.e.didn't
Change of management won't change BV of Asset
-backward looking
Market value: market value is realizable, which is the price at which
buyers and sellers trade the assets.

Market value is the price at which the assets, liabilities, or equity
Forward looking
can actually be bought or sold.
- record everything
Market value and book value are often very different. Why?
Which one is more important to the decision-making process?

We use market value for Equity
MV>BV mostly
The Balance Sheet

MV for listed companies ONLY
MARKET IS efficient : MV is appreciate of companies FV
If not : cannot rely on MV
Example: value of equity (31 Dec 2007)

Company
Aetna Inc.
Amazon.com Inc.
Coca-Cola Co
Delta Airlines Inc
Duke Energy
Ford Motor Co.
Google, Inc.
Harley-Davidson Inc.
Hewlett-Packard Co.
IBM
Intel Corp.
Kraft Foods
Scotts Miracle-Gro Co.
Washington Mutual Inc.
($millions)
Book value
Market value
10,038
28,651
1,197
38,538
21,744
142,256
10,113
4,351
21,199
25,455
5,628
14,853
22,690
216,376
2,375
11,140
38,526
133,320
28,470
149,744
42,762
155,108
27,295
50,047
479
2,732
25,584
11,828
Market value
to book value
2.9
32.2
6.5
0.4
1.2
2.6
9.5
4.7
3.5
5.3
3.6
1.8
5.7
0.5
The Balance Sheet

Example: The Cooney Corporation has fixed assets with a book value of
$700 and an appraised market value of about $1,000. Net working capital is
$400 on the books, but approximately $600 would be realized if all the
current accounts were liquidated. Cooney has $500 in long-term debt, both
book value and market value. What is the book value of the equity? What is
the market value?
Liabilities & shareholders equity
Assets
Net working capital

Net fixed assets
Book
Market
$400
$600
Long-term debt
700
1,000
Shareholders equity
$1,100
$1,600
Book
Market
$500
$500
600
1,100
$1,100
$1,600
NWC+NCA= NCL+ Equity

No matter use what value, LHS=RHS
The Income Statement

The income statement is more like a video of the firms
operations, for a specified period of time. It shows the revenues,
expenses, and net income of a firm over the period of time.
Accrual principle of accounting

We report revenues first, and then deduct any expenses for the
period. The amount of taxes levied on income is then separately

reported.
The generally accepted accounting principles (GAAP) says to
show revenue when it accrues and match the expenses required

to generate the revenue.

Global Corporation
2012 Income Statement ($million)
Net sales (Revenues)
Cost of goods sold (COGS)
Depreciation
Earnings before interest and taxes (EBIT)
Interest paid
Taxable income (EBT)
Taxes (at 30%)
Net income (NI)
Dividends
Addition to retained earnings
$1,509
750
65
$ 694
70
$ 624
187
$ 437
$109
328
Operating CF
different from
Financing CF
Mature companies : pay regular divi


Income vs. cash flow
The matching principal of GAAP dictates that revenues be
matched with expenses: Income is reported when it is earned,

no matter whether cash flow has occurred.
Because there are non-cash items that are expenses against
revenues, but that do not affect cash flows, net income is a mix
of cash and non-cash items.
Non-cash items such as:
Depreciation: presents a typical non-cash item: no firm ever writes a
check for depreciation.
Deferred taxes: which do not involve current-year cash flows.
FCF=[ R-C]* (1-tax rate)+ t*Dep-change in NWC-cap Exp

Depreciation
Depreciation is the allocation of the acquisition cost of fixed
assets to the periods that benefit from the use of the assets,
which depends on three elements:
Useful life of assets (number of years)
Salvage value (after use of assets)
Depreciation method
Depreciation methods
Depending on the use, or class of an asset
Different countries have different rules
Straight-line depreciation method (e.g. real property):
Depreciation per year = (Initial cost salvage value) /No of years

Taxes
Taxes are critical to much of finance theory and have a major
impact on the firms financial decisions.

Every dollar paid in tax enriches government instead of shareholders.
Progressive tax system: tax rate increases with income level.

Marginal tax rate: the percentage paid on the next dollar earned.
Average tax rate: the tax bill over taxable income.
The average tax rate reported for past years earnings can be
quite different from the expected tax rate for future earnings.
MTR: used for future CF
ATR: delayed tax
We use MTR in this course !!
The Statement of Cash Flow

The statement of cash flow reports a companys inflows
and outflows of cash. Not useful to determine financial CF or
FCF ?
This statement converts information from the firms income
statement and balance sheet into cash flows for the period.
The CF statement is divided into three parts that represent the
firms cash flows from each of the following, respectively:

Operating activities
Investing activities
Financing activities
It determines the change in cash (the first item in balance sheet).
Evaluating Financial Performance

Motivation
To evaluate management performance
To understand the levers of performance
Return on equity (ROE)

Net Income
Return on Equity =
Shareholders Equity
USE Beginning year of

E!
ROE measures earnings per dollar of invested equity capital (i.e.,
percentage return to owners on their investment).

ROE is by far the most popular financial performance measure
among investors and senior managers.


Decomposition of ROE
Net Income
Sales
Assets
ROE =
Sales
Assets
Shareholders Equity
= Profit Margin Asset Turnover Financial Leverage
It shows the three levers of ROE.
increases, leverage decreases.
It provides further information as why the firms ROE is high or

low, and in which direction (or which component) the ROE can
be further improved.

Profit margin
Profit margin measures the fraction of each dollar of sales
that trickles down through the income statement to profits.

Profit margin can differ greatly from firm to firm, depending
on the nature of products and the companys competitive

strategy.
Profit margin reflects
The firms pricing strategy

The managements ability to control operating costs

Asset turnover
Asset turnover is the sale generated per dollar of assets. It
measures asset intensity.

Asset turnover can differ greatly from firm to firm, depending on
the nature of products and the companys competitive strategy.

Asset turnover also depends on:
Managerial effort and creativity in controlling assets
Managements ability to control current assets

Financial Leverage
Financial leverage increases when the proportion of debt relative
to equity (i.e., debt ratio) used to finance the business increases.

Debt
Debt to Capital raio =
Debt + Equity
Debt
Debt to Equity ratio =
Equity
Debt: interest-bearing liabilities
Book value or market value (what is the market value?)
The firms financing policy determines its financial leverage.
Market value !
BV OF DEBT = MV of debt
MV of Equty = market cap of E = common stock SP* number of common stock
Not included preference share

ROE and the Three Levers (2007)
Return on
Equity (%)
Adobe System
15.5
Chevron
24.2
Florida Power and Light
11.4
Genentech
22.6
Low 11.7
JP Morgan Chase
Merck
18.0
Metflix
15.6
Morfolk Southern
15.1
Safeway
13.3
Scotts Miracle-GroHigh because high FL23.5
Profit
Asset
Financial
Margin X Turnover X Leverage
22.9
8.7
7.2
22.8
13.2
13.5
5.6
15.6
2.1
3.9
0.55
1.44
0.48
0.63
0.07
0.50
1.86
0.36
2.40
1.27
1.23
1.93
3.31
1.57
12.68
2.66
1.50
2.69
2.63
4.75
Red: important driver of Roe

ROE and Related Measures

Is ROE a reliable financial yardstick?
No. Dis :
1. Timing 2. Risk
Timing/valuation problems
It is based on the book value of shareholders equity

Just accounting performance measure not finance measure. Financial leverage, we use MV of E.
It is backward looking
Net income : last year. Not predictable for next year.
Focusing on a single year, it fails to capture the full impact of

multi-period decisions
Net income in one year not indicative of general year
The risk problem: it looks only at return while ignoring risk.

High business risk , high
risk!
ROE and Related Measures

The earnings yield
Net Income
Earnings Yield =
Market Value of Shareholders Equity
Earnings per Share
=
Price per Share
The price to earnings ratio

Price per Share
Price to Earnings ratio (P/E) =
Earnings per Share
Closely relate to ROE
Better than ROE for valuation purpose.
ROA and ROC

Return on assets (ROA)
After tax operating income.
EBIT (1 Tax Rate)

ROA =
Total Assets
ROA is a measure of the efficiency of the firms assets allocation
for the capital provided by owners and creditors.

Understand differences between ROE and ROA
Which measure is more indicative of shareholders interest, or a
ROE.
firms overall performance?
ROA
Which measure is more sensitive to the firms financing policy?

Net income VS ebit*( 1-t)
ROA:
ROE is more sensitive to financial leverage !
ROA and ROC

Return on capital invested (ROC)
EBIT (1 Tax Rate)
ROC =
Debt + Equity Cash
The denominator, which is referred to as invested capital,
measures the book value of operating assets (i.e., cash here

means excess cash, which is a non-operating asset)
Take out of this cash, company's business won't be affected.
Both ROA and ROC can be similarly decomposed into two
components: profit margin and asset/capital turnover.

As shown on next slide, profit margin and asset turnover tend to vary
inversely: adding value to a product (thus a higher profit margin)
requires lots of assets, leading to lower asset turns.
Trade off !
Increase profit margin gonna
sacrifice asset turnover.
ROA and ROC

ROA: be similar in competitive market and same industry.
Comparison between Coca-Cola vs. Pepsi

ROA
Profit Margin
Asset Turnover
Year
2000
C-C
10.45%
Pepsi
11.90%
C-C
10.60%
Pepsi
10.70%
C-C
0.98
Pepsi
1.11
2001
17.71%
12.25%
19.80%
9.90%
0.90
1.24
2002
12.45%
14.10%
15.60%
13.20%
0.80
1.07
2003
15.90%
14.08%
20.70%
13.20%
0.77
1.06
2004
15.47%
14.96%
22.10%
14.30%
0.70
1.05
2005
2006
16.56%
16.95%
12.80%
18.81%
21.10%
21.10%
12.50%
16.00%
0.79
0.80
1.03
1.17
Average
15.07%
14.13%
18.71%
12.83%
0.82
1.10
Similar ROA ,ROE
Significant different in:

Profit margin and asset turnover.
Interest Coverage Ratio

Definition
EBIT
Interest coverage ratio =
Interest expenses
This ratio measures a firms capacity to meet interest and
principal payments from predebt, pretax earnings.

It is considered as an indicator of a firms default risk.
Alternative versions of the coverage ratio can be obtained by
redefining the denominator or the numerator.

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Basic Financial Statements

The balance sheet, which summarises what a firm owns

The statement of cash flows, which reports on cash

Understanding Financial Statements 1

The Balance Sheet

Net working capital

Fixed A= Net asset : asset - total accu

The Balance Sheet

LHS details the uses of the firms funds.

The Balance Sheet

Liabilities and Equity

Current assets: Highly liquid asset ( treasury bill) Current liabilities:

Shareholders equity: retained or payout? Issue common

The Balance Sheet

Liquid firms are less likely to experience financial distress

Liquid assets, however, earn a lower return

Net working capital (NWC)

The Balance Sheet

the firms cash flow.

The use of debt in a firmsRe

Pay creditor ------ preferred SH ---- ordinary SH( residual claim)

Equity: shareholders equity is the capital from the owners, which

gives the owners residual claim on the firms cash flows

Preferred stock: presenting capital from issuing preferred stock,

which is a hybrid security, sharing some characteristics with equity

Understanding Financial Statements 6

The Balance Sheet

(GAAP), audited financial statements of firms carry assets at cost.

Market value: market value is realizable, which is the price at which

buyers and sellers trade the assets.

Which one is more important to the decision-making process?

The Balance Sheet

Example: value of equity (31 Dec 2007)

The Balance Sheet

Net working capital

NWC+NCA= NCL+ Equity

The Income Statement

Accrual principle of accounting

period. The amount of taxes levied on income is then separately

show revenue when it accrues and match the expenses required

Understanding Financial Statements 10

The Income Statement

Mature companies : pay regular divi

The Income Statement

matched with expenses: Income is reported when it is earned,

The Income Statement

The Income Statement

impact on the firms financial decisions.

Progressive tax system: tax rate increases with income level.

The Statement of Cash Flow

This statement converts information from the firms income

firms cash flows from each of the following, respectively:

Understanding Financial Statements 15

Evaluating Financial Performance

Return on equity (ROE)

USE Beginning year of

ROE measures earnings per dollar of invested equity capital (i.e.,

percentage return to owners on their investment).

among investors and senior managers.

Evaluating Financial Performance

It shows the three levers of ROE.

increases, leverage decreases.

It provides further information as why the firms ROE is high or