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Financial Statements

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Page 1: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Financial Statements

Page 2: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

The Big Three Accounting Statements1. The Balance Sheet

2. The Income Statement

3. The Statement of Cash Flows

2

Page 3: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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1) The Balance Sheet

A snapshot of the firm Assets ≡ Liabilities +

Stockholder’s Equity Left Hand Side must

balance with the Right Hand Side

Current Assets

Fixed Assets

Tangible Intangible

LHS

Shareholder Equity

Current Liabilities

Long-Term Debt

RHS

Page 4: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Balance Sheet Analysis When analyzing a balance sheet, the Finance

Manager should be aware of three concerns:1. Liquidity

2. Debt versus Equity

3. Value versus Cost

Page 5: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Liquidity Refers to the ease & quickness that an assets can be

converted to cash without a significant loss in value Generally the more liquid the asset the lower the rate of

return The more liquid a firm’s assets, the less likely the

firm is to experience problems meeting short-term cash obligations (Ex. payroll) A profitable but illiquid firm will experience financial

distress Current assets are more liquid than fixed assets

Page 6: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Debt versus Equity Debt → Liability

Promise to payout cash, an IOU Equity is the residual

Assets – Liabilities ≡ Equity Debt represents a senior claim on firm assets

If the firm goes bankrupt debt holders get paid before equity holders

Page 7: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Value versus Cost Cost: What did we pay for it

Accountants are historiansGAAP requires assets be recorded at cost

Book value

Market value: What would it cost TODAY Cost and Market Value are two completely

different conceptsWhat did we pay for it, versus what can we sell it for

Page 8: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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2) The Income Statement

Income ≡ Revenue – Expenses Measure how the company has performed over

some period of time Generally comprised of four parts:

1. Operating

2. Non-Operating

3. Taxes

4. Bottom Line

Page 9: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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U.S.C.C. Income Statement

Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income

$2,262 1,655

327 90

$190 29

$219 49

$170 84

$86

Page 10: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Income Statement Analysis There are several things to keep in mind

when analyzing an income statement:1. INCOME IS NOT CASH

2. Matching Principal

3. Non-Cash Items

Page 11: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Matching GAAP requires that revenues be recorded

along with the expenses incurred to produce them

Thus, income may be reported even though no cash has changed hands

Page 12: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Non-Cash Items The income statement will also record

expenses, where no money is exchanged Depreciation is the simplest example

No firm ever writes a check for “depreciation.”

Page 13: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Taxes “In this world nothing is certain but death and

taxes.” Ben Franklin

Taxes represent a major cost to the firm Taxes are subject to political, not economic forces

Therefore taxes do not need to make economic sense Companies are subject to two different tax rates

Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income

Page 14: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Marginal versus Average Rates Suppose your firm earns $4 million in taxable

income. What is the firm’s tax liability?

.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,356,100

Rate from table 2.3 What is the average tax rate?

What is the marginal tax rate?

If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

Page 15: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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3) The Statement of Cash Flows

The three components are:Cash flow from operating activitiesCash flow from investing activitiesCash flow from financing activities

Attempts to change Net Income to a Cash number

Page 16: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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U.S.C.C. Cash Flow from Operations

Start with net income, and then add back non-cash expenses , and changes in accounts

OperationsNet IncomeDepreciationDeferred TaxesChanges in Assets and Liabilities

Accounts ReceivableInventoriesAccounts PayableAccrued ExpensesNotes PayableOther

Total Cash Flow from Operations

$869013

-24111618-3

$199

-8

Page 17: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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U.S.C.C. Cash Flow from Investing

Cash flows from the acquisition sales of fixed assets (i.e., net capital expenditures).

The cash from sales of our fixed assets minus the cost of fixed assets we bought

Acquisition of fixed assetsSales of fixed assets

Total Cash Flow from Investing Activities

-$19825

-$173

Page 18: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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U.S.C.C. Cash Flow from Financing

Cash flows to and from equity and debt investors in the firm

Retirement of debt (includes notes)Proceeds from long-term debt salesDividendsRepurchase of stockProceeds from new stock issue

Total Cash Flow from Financing

-$73 86

-43

43

$7

-6

Page 19: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Finance and the Accounting Finance is concerned with:

Market Values and Cash Flows Accounting:

Care about historical costsAccounting numbers (NOT CASH)

But Accounting is often called the language of finance

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Page 20: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Quick Quiz

1. What is the difference between book value and market value? Which should we use for decision making purposes?

2. What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

3. What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

4. How do we determine a firm’s cash flows? What are the equations, and where do we find the information?

Page 21: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Financial Statements Analysis and Long-Term PlanningChapter 3

Page 22: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Financial Statement Analysis

Attempts to compare different companies and/or to track how a company is developing

Relies of their financial statements Generally follows 1 of 2 methods

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Page 23: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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1) Common-Size Statements

Report everything as a percent the top numberTotal assets for the Balance Sheet Sales for the Income Statement

Page 24: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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2) Ratio Analysis Ratio of one financial number to another Ask yourself:

How is the ratio computed?What is the ratio trying to measure and why?What does the value indicate?How can we improve the company’s ratio?

Page 25: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Categories of Financial Ratios

Short-term solvency (liquidity ratios) Long-term solvency (financial leverage ratios) Asset management (turnover ratios) Profitability ratios Market value ratios

Page 26: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Liquidity Ratios How easily can the firm meet its short term obligations

Why is this important?

Current Ratio = CA / CL 708 / 540 = 1.31 times

Quick Ratio (Acid Test) =(CA – Inventory) / CL (708 - 422) / 540 = 0.53 times

Cash Ratio = Cash / CL 98 / 540 = 0.18 times

Page 27: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Leverage Ratios How easily can the firm meet its long term obligations

Why is this important?

Total Debt Ratio = (TA – TE) / TA (3588 - 2591) / 3588 = 28%

Debt/Equity = TD / TE (3588 – 2591) / 2591 = 38.5%

Equity Multiplier = TA / TE = 1 + D/E 1 + .385 = 1.385

Page 28: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Coverage Ratios How easily can the firm payoff its debt holders

Why is this important?

Times Interest Earned = EBIT / Interest691 / 141 = 4.9 times

Cash Coverage= (EBIT + Depreciation)/Interest(691 + 276) / 141 = 6.9 times

Page 29: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Inventory Ratios How efficiently is the firm managing inventory

Why is this important?

Inventory Turnover = Cost of Goods Sold / Inventory1344 / 422 = 3.2 times

Days’ Sales in Inventory = 365 / Inventory Turnover365 / 3.2 = 114 days

Page 30: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Receivables Ratios How quickly does the firm get paid

Why is this important?

Receivables Turnover = Sales / Accounts Receivable2311 / 188 = 12.3 times

Days’ Sales in Receivables = 365 / Receivables Turnover365 / 12.3 = 30 days

Page 31: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Total Asset Turnover How efficient is the firm turning assets into sales

Why is this important?

Total Asset Turnover = Sales / Total Assets2311 / 3588 = 0.64 times

It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets. Why?

Page 32: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Profitability Measures

How efficient is the firm’s operationsWhy is this important?

Profit Margin = Net Income / Sales 363 / 2311 = 15.7%

Return on Assets (ROA) = Net Income / Total Assets 363 / 3588 = 10.1%

Return on Equity (ROE) = Net Income / Total Equity 363 / 2591 = 14.0%

Page 33: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Breaking Down ROE

If we break down ROE we can see how firms generate returns for investors

ROE = NI / TE →PM * TAT * EM Aside: Algebra

ROE = NI / TE ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM

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Page 34: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Where are returns generated

ROE = PM * TAT * EMProfit margin: How well does the firm controls costsTotal asset turnover: How well does the firm

manages its assetsEquity multiplier: How levered is the firm

The better the managers handle these aspects of the firm the greater the return generated

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Page 35: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Market Value Measures How do people feel about the firm

Why is this important?

PE Ratio = Price per share / Earnings per share88 / 11 = 8 times

Market-to-book ratio = market value per share / book value per share88 / (2591 / 33) = 1.12 times

Page 36: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

Using Financial Statement Analysis

Ratios by themselves are not very usefulIs a profitability ratio of 9% good?

Time-Trend AnalysisCompare this years ratios to prior ratios

Peer Group AnalysisCompare your ratios to other firms in the industry

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Page 37: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Issues with Financial Statement Analysis

There is no definitive way to run the analysis It’s hard to find the right benchmarking

Especially for diversified firms Firms use different accounting procedures, and

year ends Extraordinary, or one-time, events

Page 38: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Long-Term Financial Planning These are the big decisions, planning where the

company is goingCapital budgeting: Does Nike start a magazine?Capital structure: Do we issue stock or bonds?

Generally these decisions are based on pro forma financial statementFinancial statements based on what we think will happen

in the future

Page 39: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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External Financing and Growth At low levels of growth a company can use the cash it

generates to meet its investment requirements At higher levels of growth the company’s cash on hand

will not be enough to finance all the investments the company wants, it now has to go to the capital market Sell Stock or Bonds External financing helps a firm grow faster than relying on

internal funds alone

Page 40: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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The Internal Growth Rate This is how fast the company can grow using

only the money it makes

IGR = (ROA * b )/ (1 – ROA * b) b is the plowback ratio Measure how much of net income is reinvested in

the firm b = Addition to Retained Earnings / Net Income

Page 41: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Calculating the Internal Growth Rate

Using the information from the Hoffman Co. ROA = 66 / 500 = 0.132 b = 44/ 66 = .66700

Internal Growth Rate (ROA * b )/ (1 – ROA * b) (0.132 * 0.667) / (1 – 0.132 * 0.667 )= 0.0965 Hoffman Co. can grow at 9.65% using only internal funds

Page 42: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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The Sustainable Growth Rate This is how fast the firm can grow using

internal funds and external funds, but leaving the D/E ratio the sameWill this be higher or lower than the IGR?

SGR = (ROE * b )/ (1 – ROE * b)

Page 43: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Calculating the Sustainable Growth Rate

Using the Hoffman Co.ROE = 66 / 250 = 0.264b = 0.667

Sustainable Growth Rate(ROE * b )/ (1 – ROE * b)(0.264 * 0.667) / (1 – 0.264 * 0.667 )= 0.214Hoffman Co. can grow at 21.4% without changing

its capital structure

Page 44: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Long-term Planning Caveats

Our financial planning models cannot tell us what is the best policy to follow

Our models are simplifications of the real world, and as such can miss important aspects of a situation

However, firms need to have a long-term plan

Page 45: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Quick Quiz1. How do you standardize balance sheets and

income statements?2. Why is standardization useful?3. What are the major categories of financial ratios?4. How do you compute the ratios within each

category?5. What are some of the problems associated with

financial statement analysis?

Page 46: Financial Statements. The Big Three Accounting Statements 1. The Balance Sheet 2. The Income Statement 3. The Statement of Cash Flows 2

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Quick Quiz

6. What is the purpose of long-range planning?7. What are the major decision areas involved in

developing a plan?8. What is the percentage of sales approach?9. What is the internal growth rate?10. What is the sustainable growth rate?11. What are the major determinants of growth?