cf ii interpreting_fs_2009_pre_lecture

Winter Term 2009 1Markus Neuhaus I Corporate Finance I [email protected]

Corporate FinanceInterpreting Financial StatementsDr. Markus R. NeuhausDr. Marc Schmidli, CFA

Corporate Finance: Course overview

18.09. Fundamentals (4 hours) M. Neuhaus & M.Schmidli

25.09 Investment Management M. Neuhaus & P. Schwendener

02.10. Business Valuation (4 hours) M. Neuhaus & M. Bucher

09.10. No Lecture No Lecture

16.10. Value Management M. Neuhaus, R. Schmid & F. Monti



06.11. No lecture No Lecture

13.11. Mergers & Acquisitions I&II (4 hours) M. Neuhaus & D. Villiger

20.11 Tax and Corporate Finance (4 hours) Markus Neuhaus

27.11. Legal Aspects R. Watter

04.12. Financial Reporting M. Neuhaus & M. Jeger

11.12. Turnaround Management M. Neuhaus & Markus Koch

18.12. Summary, repetition M. Neuhaus


• Grade CEO• Qualification Doctor of Law (University of Zurich), Certified Tax Expert• Career Development Joined PwC in 1985 and became Partner in 1992. • Subject-related Exp. Corporate Tax

Mergers + Acquisitions• Lecturing SFIT: Corporate Finance, University of St. Gallen: Tax Law

Multiple speeches on leadership, business, governance, commercial and tax law

• Published Literature Author of commentary on the Swiss accounting rulesPublisher of book on transfer pricingAuthor of multiple articles on tax and commercial law, M+A,

IPO, etc.• Other professional roles: Member of the board of économiesuisse, member of the board

and chairman of the tax chapter of the Swiss Institute of Certified Accountants and Tax Consultants

Markus R. NeuhausPricewaterhouseCoopers AG, Zürich

Phone: +41 58 792 4000Email: [email protected]


Marc SchmidliPricewaterhouseCoopers AG, Zürich

Phone: +41 58 792 15 64Email: [email protected]

• Grade Director• Qualification Dr oec. HSG., CFA charterholder• Career Development Corporate Finance PricewaterhouseCoopers since July

2000• Lecturing Euroforum – Valuation in M&A situations

Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc.

• Published LiteratureFinanzielle Qualität in der schweizerischen Elektrizitätswirtschaft

Various articles in „Treuhänder“, HZ, etc.


Contents

Learning targets Pre-course reading Lecture „Interpreting Financial Statements“ Pre-course reading case studies / questions Solutions to case studies


Learning targets

Framework for financial statement analysis

Understanding the need for financial statement analysis

Understanding the financial reporting system

Refreshing principal elements of financial statements (Balance sheet, income and cash flow statements)

Analysis of financial statements

Understand the purpose and use of ratio analysis

Being able to apply the various ratio analyses

Being able to evaluate corporate performance by the integrated analysis of ratios


Contents



Pre-course reading

Books Mandatory reading:

Brigham, Houston (2009): Chapter 4 (pp. 84-109) White, Sondhi, Fried (2003): Chapter 3 (pp. 74-99)

Optional reading: Brigham, Houston (2009): Chapter 3 (pp. 53-75)

Slides Slides 1 to 11 – mandatory reading Other Slides – optional reading, will be dealt within the lecture


Contents



Agenda I

1. Introduction

Financial analysis

Classes of users

Need for financial statement analysis

2. Ratio analysis

Significance of ratio analysis

Sources

Financial reporting systems and standards

Important groups of ratio analysis


Agenda II

3. Case study

Beans Incorporation vs. Garlic Incorporation

4. Q&A and discussion


Agenda: Introduction

Financial analysis

Classes of users



Evaluation of a firm‘s performance and development mainly by

identifying the key drivers of a firm‘s performance and financial position

calculating and interpreting important ratios of the firm

Balanced Scorecard (soft – hard)

A well rounded financial analysis takes into account not only the financials alone but also surrounding factors which can have significant influence on the firm’s development. Financial management does not operate in a vacuum.

Financial analysis

Source: White, Sondhi, Fried (2003), 2ff.

Environment

Financial Statements

Business

Macroeconomic situation, industry, market

Balance sheet, income statement, cash flow, stockholders’ equity, budget

Management, products, margins, technology, knowledge base, competition

Financial Analysis


Internal users (such as managers or board members)

External users of financial information encompass a wide range of interests but can be classified into three general groups:

Credit and equity investors

Government, regulatory bodies, tax authorities

General public and special interest groups, labor unions and consumer groups

Classes of users

Source: White, Sondhi, Fried (2003), 4.



Internal:financial statements provide the company with information on its performance and development over time and are a crucial basis for most financial decisions (i.e. investment, financing)

Costs

Efficiency

Profitability

Investments

Financing (needs)

External:financial statements facilitate the interaction between the company and its business environment by providing third parties with essential information on the company’s development

Creditors

Investors

Shareholders

Government

Financial analysis has great significance and impact on a company‘s development as it influences

expectations on the capital markets


Agenda: Ratio analysis


Sources


Important groups of ratio analysis


Ratio analysis

Financial statements help predict the future development of a company

Firm A has total debt of $ 200m whereas firm B has total debt of $ 2mm. Which firm is stronger, more liquid? Or which firm is more likely to generate higher cash flows?

Figures standing alone, such as total debt, are not really helpful

By putting debt into perspective with other appropriate figures, we are able to predict which firm is more likely to succeed

such comparisons are ratio analysis

The debt burden can be evaluated (a) by comparing each firm‘s debt with its assets and (b) by comparing the

interest the company has to pay with the income it has available

Source: Brigham, Houston (2009), 103.



As a company’s value is determined by its ability to generate cash today and in the future, ratio analysis has great importance

Share price development

Credit rating

However, there is no generally used list of ratios that could be applied to any company

Groups of ratios1): Liquidity ratios Asset management ratios Debt or financing ratios Profitability ratios Market value ratios

„help predict the future

development of a company”

1) Details later: see page 25ff.


Principal elements of financial statements as primary source for financial analysis

Balance sheet Income statement Statement of cash flows Statement of stockholders‘ equity

Further sources: Broker/analyst reports, Bloomberg, Reuters, Factset etc.

Collectively, these interrelated financial statements provide relevant and timely information about the past and are essential for making crucial business decisions about investment or financing activities today and in the future. Financial statements are a key component to build trust in the financial community.Source: White, Sondhi, Fried (2003), 5.



Reporting systems and standards compel the company to meet a great number of requirements in order to ensure that the financial statements are, above all, transparent and comparable

The two most commonly used standards are:

IFRS (International Financial Reporting Standards)

US GAAP (United States Generally Accepted Accounting Principles)

Differences are found mainly in the classification of certain events (e.g. whether an interest payment is reported under operating costs or financing costs etc.). Both aim to provide a “true and fair view”of the company’s performance.

In addition, there are local GAAPs (Generally Accepted Accounting Principles). In Switzerland we have rules in the Code of Obligation which permit hidden reserves and the FER (Fachempfehlung für Rechnungslegung) which is a light form of IFRS.

Source: White, Sondhi, Fried (2003), 5ff.


Balance sheet

Snapshot of the company‘s assets and liabilities at a certain reporting date

Assets = Liabilities + Equity

Balance Sheet

(chf m) 2008 2007

AssetsCash and cash equivalents 10 80 Accounts receivable 375 315 Inventories 615 415 Current assets 1'000 810

Net plant and equipment 1'000 870 Non-current assets 1'000 870

Total assets 2'000 1'680

Liabilities and EquityAccounts payable 60 30 Notes payable 110 60 Accruals 140 130 Total current liabilities 310 220

Long-term bonds 750 580 Total debt 1'060 800

Common stock (50'000'000 shares) 130 130 Retained earnings 810 750 Total equity 940 880

Total liabilities and equity 2'000 1'680



Income statement

Reports on the performance of a firm, the results of its operating activities Matching principle = revenues and related costs must be accounted for during the same

period of time. This requires the recognition of expenses incurred to generate revenues in the same period as the related revenues (revenue recognition, accrual method).


Income Statement

(chf in millions) 2008 2007

Net Sales 3'000.0 2'850.0 Operating Costs (2'616.2) (2'497.0)

EBITDA 383.8 353.0 Amortization - - Depreciation (100.0) (90.0)

EBIT 283.8 263.0 Interest (88.0) (60.0) Taxes (78.3) (81.2)

Net Income 117.5 121.8

Common dividends 57.5 53.0 Addition to retained earnings 60.0 68.8


Statement of cash flow

The cash flow statement represents the cash generated by a company during the given accounting period

Separated into three categories: (I) operating activities, (II) investing activities, (III) financing activities

The investment section illustrates how cash was spent whereas section III, financing shows how those investments were financed

In the long run, cash flows from operating activities should considerably increase; investments should be equal to depreciation (plus a bit more to support stable growth)

In this example, the company has an operating problem as the cash flow from operating activities is negative

CAPEX = capital expenditures


Statement of Cash Flow

(chf in millions) 2008

Operating activitiesNet Income 117.5

AdditionsDepreciation and Amortization 100.0 Increase in accounts payable 30.0 Increase in accruals 10.0

SubstractionsIncrease in accounts receivable (60.0) Increase in inventories (200.0)

Net cash provided by operating activities (2.5)

Long-term investing activitiesCash used to acquire fixed assets (CAPEX) (230.0)

Financing activitiesIncrease in notes payable 50.0 Increase in bonds 170.0 payments of dividens (57.5)

Net cash provided by financing activities 162.5

Net decrease in cash and equivalents (70.0)

Cash and equivalents at beginning of the year 80.0 Cash and equivalents at end of the year 10.0


Statement of retained earnings

Changes in retained earnings occur because stockholders allow the management to retain and invest funds that otherwise would be paid out as dividend

Thus, the retained earnings position is not cash and is not available for spending


Statement of retained earnings

(chf in millions) 2008

Balance of retained earnings as of 2007 750.0 Add: Net income 2008 117.5 Less: Dividend to common stockholders (57.5)

Balance of retained earnings as of 2008 810.0


Important groups of financial ratios

Liquidity ratiosIs the company able to pay its debts as they become due this year?

Asset management ratios

Does the amount of assets seem to be reasonable in relation to current and projected sales? And how efficiently does the company use its assets?”

Debt or financing ratios

To what extent is the company using financial leverage? Risk from capital structure?

Profitability ratios

How profitable is the company? How much output does the company generate in relation to a certain input?

Market value ratios

How do the earnings and results appear in relation to the stock price?

Source: Brigham, Houston (2009), 84ff.


Liquidity ratios

3.2x 310

1000

sliabilitie Current

assets Current ratio Current

1.2x 310

615-1000

sliabilitie Current

sinventorie - assets Current ratio Quick

Inventories are a firm’s least liquid current asset and therefore most likely to suffer losses if they have to be sold in liquidation. A company should be able to pay current liabilities with current assets less inventories.

If a company is getting into financial difficulties, it will pay its bills more slowly, borrowing money from banks and from suppliers. This leads to increased current liabilities which causes the current ratio to decrease. If current liabilities grow faster than current assets, this is a an indication of financial difficulties.

Source: Brigham, Houston (2009), 87f.


Balance sheet and income statement

Balance Sheet

(chf m) 2008 2007









Income Statement









Liquidity ratios

3.2x 310

1000

sliabilitie Current

assets Current ratio Current

1.2x 310

615-1000

sliabilitie Current

sinventorie - assets Current ratio Quick

Inventories are a firm’s least liquid current asset and therefore most likely to suffer losses if they have to be sold in liquidation. A company should be able to pay current liabilities with current assets less inventories.

If a company is getting into financial difficulties, it will pay its bills more slowly, borrowing money from banks and from suppliers. This leads to increased current liabilities which causes the current ratio to decrease. If current liabilities grow faster than current assets, this is a an indication of financial difficulties.

Source: Brigham, Houston (2009), 87f.