2 Financial Statements Articulation

Financial Statement Analysis and
Valuation
Dr. Martin Staehle

Institut fr Unternehmensrechnung und Controlling (IUC)
Universitt Bern
Course Overview
Section 1: Valuation and Financial Analysis

Section 2: Financial Statements: Articulation
Section 3: Financial Statements: Reformulation
Section 4: Standard Valuation Models
Section 5: Residual Earnings Valuation
Section 6: Abnormal Earnings Growth Valuation
Section 7: Ratios and Multiple Analysis
Section 8: The Analysis of Leverage
Section 9: The Analysis of Growth
Section 10: The Analysis of Accounting
Source: All slides in this presentation build on Penman, Stephen (2010): Financial Statement Analysis and Security Valuation, 4th Ed.
page 2
Introduction
What will you learn in Section 2?
The articulation of financial statements:

Learn how the components of financial statements relate to each
other
Learn about motives and the role of accrual accounting as
compared to cash flow information
Learn how to shift the perspective to the operating business of the
firm
page 3
2 Financial Statements: Articulation
Introduction: Relating financial statements to the business
For fundamental analysis and valuation we need to understand the

business of the firm
One does not buy a stock, one buys a business
Financial statements provide the information we are interested in
Financial reports are the lens on the business
page 4
Learning objective: How do the components of financial statements fit together?
Beginning stocks Flows Ending stocks
Beginning Balance Sheet Ending Balance Sheet
Cash (Net change in cash) Cash
+ Other Assets + Other Assets

Statement of Shareholders Equity
Total Assets Total Assets
Net Investment by owners
- Liabilities - Liabilities
Net income and other earnings
= Owners equity = Net change in owners equity = Owners equity
Income Statement
Revenues
- Expenses
= Net income
page 5
Balance sheet: The STOCK component
The balance sheet equation: Assets minus liabilities equal equity
Asset. An asset is a resource controlled by the entity as a

result of past events and from which future economic benefits
are expected to flow to the entity. [F 4.4(a)]
Liability. A liability is a present obligation of the entity arising
from past events, the settlement of which is expected to result
in an outflow from the entity of resources embodying economic
benefits. [F 4.4(b)]
Asset/Liability-principle
End-of period focus: Assets minus liabilities measure equity,
the residual economic benefit in accounting terms
Fair Value-measurement: Mark-to-market measurement if
possible
page 6
Income statement: The FLOW component
Income statement equation: Revenue minus costs equals income

Economic benefits of the period (update equity)
Comprehensive Income (CI): Net Income plus Other
Comprehensive Income (OCI, see also section 3)
Income. Income is increases in economic benefits during the

accounting period in the form of inflows or enhancements of assets
or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants. [F 4.25(a)]
Matching principle:
Focus on changes: Match costs with revenue for each accounting
period to measure income, the change in economic benefits
Historic cost accounting
page 7
Equity statement: Equity is the residual claim of shareholders
Change in claims of shareholders in each period form

Comprehensive income1 (revenues and costs from market
transactions and (re-) valuation of assets and liabilities) and
Transactions with owners, i.e. net dividends: Payments to
shareholders (dividends, share repurchases) less amounts
received from shareholder (share issues)
Equity. Equity is the residual interest in the assets of the entity after
deducting all its liabilities. [F 4.4(c)]
Residual principle:
Accounting residual vs. value: Measurement of accounting equity
follows from the measurement of assets
1 Not including dirty surplus items in reformulated comprehensive income (see section 3) page 8
Cash Flow statement: The other FLOW component
Cash flows from operating, financing and investment activities

The potential to generate cash determines success or failure
The cash flow statement depicts sources and uses of cash:
No measurement, rather a listing
Cash flows are inflows and outflows of cash and cash equivalents.
.. subject to an insignificant risk of changes in value. [IAS 7]
Balance of:
Source of funds: Free cash flow from operations
Use of funds: Cash to debt and equity
page 9
Cash Flow statement: Why not just cash-accounting?
Focus on value generation and value consumption: Cash flows

may not relate to the business and value generation of the firm
Financing and investment: Capital contributions / dividends
are transactions with shareholders. Investment intends to
create future value
Timing: The time of receiving cash is often not the time where
value is generated
Fundamental intention of double entry book-keeping: Using

accruals to associate generation and consumption of value
Measurement and timing of value generation
page 10
Accounting accruals: Measurement under double-entry book

keeping
Periodization of cash flows and timing of value recognition

Non-cash related economic benefits (e.g. customer
receivables, revaluations of assets and liabilities)
Cash related changes without economic benefits (e.g.
investment, transactions with shareholders)
Issues with accruals: Informative value, relevance and reliability

(see section 10 on conservatism)
page 11
How do the components of financial statements fit together?

Beginning stocks Flows Ending stocks
Beginning Balance Sheet Ending Balance Sheet
Cash (Net change in cash) Cash
+ Other Assets + Other Assets

Statement of Shareholders Equity
Total Assets Total Assets
Net Investment by owners
- Liabilities - Liabilities
Net income and other earnings
= Owners equity = Net change in owners equity = Owners equity
Income Statement
Revenues
- Expenses
= Net income
page 12
Learning objective: Accounting relations of operating and financing

activities operations investments and financing
Cus- OR C F Debt
tomers holders
Net
Net
oper-
financial
ating
assets
assets
(NFA)
(NOA)
Suppli- OE I d Share-
ers holder
The creation The distribution

of value of value
F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
C = cash flow from operations
I = cash investment
OR = operating revenue page 13
OE = operating expense
Financing activities: Sources
Transactions with shareholders (d) F Debt

Net dividend to shareholders: holders
Dividends and share repurchases Net
less contributions of shareholders financial
assets
(NFA)
d
Transactions with debtholders (F) Share-
holder
Net debt financing flow: Interest and
principle repayments less cash
received from debtholders
page 14
Financing activities: Net financial assets

(NFA) / Net financial obligations (NFO)
NFA = FA FO (FA > FO); F Debt

holders
Net
NFO = FO FA (FO > FA) financial
assets
(NFA)
Net financial assets: The firm has excess d Share-
cash / debt instruments as assets on the holder
balance sheet
Net financial obligations: The firm is a net

issuer of debt (as liabilities on balance
sheet)
page 15
Financing activities: Net financial expense

(NFE) / Net financial interest (NFI)
F
NFE = Financial expense (FE) Financial Debt
holders
income (FI); FE > FI, usually if FO > FA Net
financial
assets
NFI = FI FE; FI > FE, usually if FA > FO (NFA)
d Share-
holder
Flows from transactions in financial
markets (e.g. interest earnings): Usually
no source of value generation
page 16
Financing activities: Changes in Net financial

assets (NFA) / Net financial obligations (NFO)
+ NFA = + increase lending or reduce F Debt

borrowing + NFI d holders
Net
financial
assets
+ NFO = + increase borrowing or reduce (NFA)
lending + NFE - d d Share-
holder
Cash flows with debtholders and

shareholders determine NFA / NFO
page 17
Operating activities: Net operating assets
NOA = OA - OL OR
Cus-
tomers
Operating assets and liabilities: Assets and Net
oper-
liabilities used in the business of producing ating
and selling goods and services to assets
(NOA)
customers OE
Suppli-
ers
Net operating liabilities higher than

operating assets? Unusual and the firm
needs NFA for equity to be positive
page 18
Operating activities: Operating income
OI = Operating revenue (OR) Operating Cus-

OR
tomers
expense (OE)
Net
oper-
ating
Flows from transactions in product or assets
(NOA)
service markets (e.g. machines): Source OE
Suppli-
of value generation ers
Measurement of value generation by

accruals
Measurement of OI usually after tax
page 19
Operating activities: Free cash flow from

operations
C-I C
Operating cash flow (C): Net cash flow from Net

Net
operations, i.e. revenues less (cash) costs oper-
financial
for wages etc. ating
assets
assets
(NFA)
(NOA)
Investment cash flow (I): Cash investment in I
operations
Making use of NOA should create cash (C)

that can be invested in NFA (reduce NFO)
unless investment is high (I)
page 20
Operating activities: Free cash

flow sources
Cus-
OR C
CI = OI - NOA tomers
Net
Net
oper-
financial
ating
Free cash flow derive from assets
assets
(NFA)
(NOA)
operations or from liquidating OE I
Suppli-
operating assets ers
page 21
Operating activities: Net operating

asset sources
Cus-
OR C
tomers
NOAt = NOAt-1 + OI - (CI)
Net
Net
oper-
financial
ating
NOA increase by operating assets
assets
(NFA)
(NOA)
income NOA decrease by the flow OE I
Suppli-
to NFA (Free cash flows) ers
Accruals affect NOA via OI
page 22
Operating activities: The role of accruals
OI - NOA = CI
OI C NOA I
Income w/o cash flow: Accounting valuations of assets and

liabilities different to cash flows (no cash investment). Revenue
and expenses w/o cash flows (e.g. receivables)
No income w cash flow: Accruals that off-set cash flows, e.g.
investment that is recognised (later depreciation is a negative
accrual)
page 23
Operating and financing activities:

Cash Conservation Property
C F Debt
C-I = d + F holders
Net
Net
oper-
financial
What is generated will be paid to ating
assets
assets
capital providers (NOA)
(NFA)
I d Share-
holder
page 24

Free cash flow use
C F
C-I = NFA NFI + d, Debt
holders
or: C-I = NFE NFO + d Net
Net
oper-
financial
ating
assets
assets
(NFA)
Free cash flow use: Investment (NOA)
I d Share-
in financial assets or distribution holder
page 25
Financing activities: Free cash flow use
The treasurers rule:

If C I i d : lend or buy down own debt
If C I i d : borrow or reduce lending
Where: i is net interest outflow (net interest paid minus net

interest earned after tax, payments in NFE net of tax)
From C-I = d + F, it is obvious that investments in financial assets

/ liabilities are necessary to equilibrate cash flows
page 26

Net financial assets
C F
NFAt = NFAt-1 + (CI) + NFI d, Debt
holders
Net
Net
oper-
financial
NFOt = NFOt-1 - (CI) + NFE + d ating
assets
assets
(NFA)
(NOA)
I d Share-
NFA increases by the flow from holder
NOA (subject to NFI) and
decreases by the flow to owners
page 27
Financing activities: Getting back to dividends
The dividend drivers equation: F Debt

d C - I NFI - NFA if FA > FO holders
d C - I - NFE NFO if FO> FA Net

financial
assets
(NFA)
d Share-
holder
page 28
How do flows map with financing and operating activities?
Cus- OR C F Debt
tomers holders
Net
Net
oper-
financial
ating
assets
assets
(NFA)
(NOA)
ers holder F = net cash flow to
debtholders and issuers
d = net cash flow to
shareholders
OR OE = OI C = cash flow from
OI NOA = C - I operations
I = cash investment
C I = NFA - NFI + d OR = operating revenue
OE = operating expense
OI = operating income
Operating Activities NFI = net financial income
Financing Activities
page 29
How do stocks map with financing and operating activities?
Cus- OR C F Debt
tomers holders
Net
Net
oper-
financial
ating
assets
assets
(NFA)
(NOA)
ers holder
CSE = Common Shareholder
Equity
NOA = Net Operating Assets
CSE = NOA + NFA NFA = Net Financial Assets
CSE = NOAt-1 + OI - (C-I) + NFAt-1 + (C-I) + NFI - d C-I = Free Cash Flow from
operations
CSE = CSEt-1 + CI - d d = Net dividends
CI = Comprehensive Income
OI = operating income
NFI = net financial income
Operating Activities
Financing Activities
page 30
Exercises: Penman, Financial Analysis
Chapter 2 Exercises:
Exercise E2.3., p. 61
Exercise E2.7., p.62
Chapter 7 Exercises:
page 31

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Financial Statement Analysis and

Dr. Martin Staehle

Section 1: Valuation and Financial Analysis

What will you learn in Section 2?

The articulation of financial statements:

Introduction: Relating financial statements to the business

For fundamental analysis and valuation we need to understand the

One does not buy a stock, one buys a business

Financial statements provide the information we are interested in

Financial reports are the lens on the business

Learning objective: How do the components of financial statements fit together?

Beginning stocks Flows Ending stocks

Beginning Balance Sheet Ending Balance Sheet

Cash (Net change in cash) Cash

+ Other Assets + Other Assets

Balance sheet: The STOCK component

The balance sheet equation: Assets minus liabilities equal equity

Asset. An asset is a resource controlled by the entity as a

Income statement equation: Revenue minus costs equals income

Income. Income is increases in economic benefits during the

Equity statement: Equity is the residual claim of shareholders

Change in claims of shareholders in each period form

Cash Flow statement: The other FLOW component

Cash flows from operating, financing and investment activities

Cash Flow statement: Why not just cash-accounting?

Focus on value generation and value consumption: Cash flows

Fundamental intention of double entry book-keeping: Using

Accounting accruals: Measurement under double-entry book

Periodization of cash flows and timing of value recognition

Issues with accruals: Informative value, relevance and reliability

How do the components of financial statements fit together?

Beginning Balance Sheet Ending Balance Sheet

Cash (Net change in cash) Cash

+ Other Assets + Other Assets

Learning objective: Accounting relations of operating and financing

The creation The distribution

Financing activities: Sources

Transactions with shareholders (d) F Debt

Financing activities: Net financial assets

NFA = FA FO (FA > FO); F Debt

Net financial obligations: The firm is a net

Financing activities: Net financial expense

Financing activities: Changes in Net financial

+ NFA = + increase lending or reduce F Debt

Cash flows with debtholders and

Net operating liabilities higher than

Operating activities: Operating income

OI = Operating revenue (OR) Operating Cus-

Measurement of value generation by

Measurement of OI usually after tax

Operating activities: Free cash flow from

Operating cash flow (C): Net cash flow from Net

Making use of NOA should create cash (C)

Operating activities: Free cash

Operating activities: Net operating

Accruals affect NOA via OI

Operating activities: The role of accruals

Income w/o cash flow: Accounting valuations of assets and

Operating and financing activities:

Operating and financing activities:

Financing activities: Free cash flow use

The treasurers rule:

Where: i is net interest outflow (net interest paid minus net