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Earnings and Cash Flow Analysis

Chapter 7
Earnings and Cash Flow Analysis
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Fundamentals of Investments
Cash Flow is a Companys Lifeblood.
Earnings and Cash Flow Analysis
Sources of Financial Information
Sources of Financial Information
Financial Statements
Financial Statements
Work the Web
The Balance Sheet
The Balance Sheet
The Balance Sheet
The Income Statement
The Income Statement
The Cash Flow Statement
The Cash Flow Statement
Performance Ratios and Price Ratios
Performance Ratios and Price Ratios
Performance Ratios and Price Ratios
Work the Web
Financial Statement Forecasting
The Pro Forma Income Statement
The Pro Forma Cash Flow Statement
The Pro Forma Balance Sheet
Projected Profitability and Price Ratios
Projected Profitability and Price Ratios
Work the Web
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Adolph Coors Company Case Study
Chapter Review
Chapter Review

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Chapter 7

Chapter Organization
7.1
7.2

7.3

7.4
7.5

Sources of Financial Information


Financial Statements
A. The Balance Sheet
B. The Income Statement
C. The Cash Flow Statement
D. Performance Ratios and Price Ratios
Financial Statement Forecasting
A. The Pro Forma Income Statement
B. The Pro Forma Cash Flow Statement
C. The Pro Forma Balance Sheet
D. Projected Profitability and Price Ratios
Adolph Coors Company Case Study
Summary and Conclusions

Selected Web Sites

http://www.nyse.com
http://www.sec.gov
http://www.thestreet.com
http://www.uoutperform.com
http://www.investorsuniverse.com

Annotated Chapter Outline


7.1

Sources of Financial Information


Edgar: Electronic archive of company filings with the SEC.
10K: Annual company report filed with the SEC.
10Q: Quarterly updates of 10K reports filed with the SEC.

Reliable financial information is a prerequisite to doing good financial analysis.


There are many sources of financial information, including annual reports, The
Wall Street Journal, and SEC information, which includes the Edgar archives.
Edgar includes company 10Ks and 10Qs, as well as other financial data. The
internet also provides a wealth of financial information. The Selected Web Sites,
above, provide a good starting point for finding financial information on the web.

Earnings and Cash Flow Analysis

7.2

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Financial Statements
Balance sheet: Accounting statement that provides a snapshot view of a
company's assets and liabilities on a particular date.
Income statement: Summary statement of a firm's revenues and
expenses over a specific accounting period, usually a quarter or a year.
Cash flow statement: Analysis of a firm's sources and uses of cash over
the accounting period, summarizing operating, investing, and financing
cash flows.

The firm's balance sheet, income statement, and cash flow statement provide
essential, interrelated information necessary for performing a financial analysis.
Remind students that reading and interpreting these financial statements isn't just
"accounting work," it's a requirement of any good financial analyst.
A.

The Balance Sheet


Asset: Anything a company owns that has value.
Liability: A firm's financial obligation.
Equity: An ownership interest in the company.

The Borg balance sheet has four major asset categories: current assets, fixed
assets, investments, and other assets. It has three major liability categories:
current liabilities, long-term liabilities, and other liabilities. Stockholder equity is
the difference between total assets and total liabilities, and includes paid-in
capital and retained earnings. The fundamental accounting identity is:
Assets = Liabilities + Equity
This implies that the left side of the balance sheet always equals the right side.
Financial analysts also find it useful to condense a balance sheet down to its
principle categories.
B.

The Income Statement


Income: The difference between a company's revenues and expenses,
used to either pay dividends to stockholders, or kept as retained earnings
within the company to finance future growth.

The income statement reports revenue and expenses for a corporation over a
one-year (or quarter) period. Subtracting cost of goods sold and operating
expenses from net sales yields operating income. Subtracting investment

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income, interest expense, and income taxes yields net income, which is also
referred to as "the bottom line." Net income is apportioned to dividends and
retained earnings, in fact:
Net income = Dividends + Retained earnings
C.

The Cash Flow Statement


Cash flow: Income realized in cash form.
Noncash items: Income and expense items not realized in cash form.
Operating cash flow: Cash generated by a firm's normal business
operations.
Investment cash flow: Cash flow resulting from purchases and sales of
fixed assets and investments.
Financing cash flow: Cash flow originating from the issuance or
repurchase of securities and the payment of dividends.

The cash flow statement reports the sources and uses of a firm's cash over a
specified accounting period. The statement begins with net income, and adjusts it
for noncash charges to obtain the operating cash flow. The next two categories
of the statement include investment cash flow and financing cash flow. After
adjusting for these items, the result is the firm's net cash flow during the
accounting period.
D.

Performance Ratios and Price Ratios


Return on assets (ROA): Net income stated as a percentage of total
assets.
Return on equity (ROE): Net income stated as a percentage of
stockholder equity.

The firm's profitability ratios are calculated as follows:


Gross Margin = Gross profit / Sales
Operating Margin = Operating income / Sales
ROA = Net income / Total assets
ROE = Net income / Owners equity
The firm's per-share values are calculated as follows:
Book Value Per Share (BVPS) = Total equity / # shares outstanding
Earnings Per Share (EPS) = Net income / # shares outstanding
Cash Flow Per Share (CFPS) = Operating cash flow / # shares outstanding

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Notice that the cash flow used above refers to operating cash flow, not the cash
flow from the cash flow statement.
The firm's market value ratios are calculated as follows:
Price / Book (or Market / Book) = Stock price / BVPS
Price / Earnings (P/E) = Stock price / EPS
Price / Cash flow (P/CF) = Stock price / CFPS
7.3

Financial Statement Forecasting


Pro forma financial statements: Statements prepared using certain
assumptions about income, cash flow, and other items. Pro forma literally
means according to prescribed form.

To analyze the impact of possible changes, investments, or changes in sales for


the firm, it is necessary to construct pro forma financial statements for the firm
under various scenarios. This allows the analyst to investigate and analyze the
impact of these actions.
A.

The Pro Forma Income Statement

The pro forma income statement begins with a projection of sales, usually for
more than one scenario. The analyst then works down the income statement,
explaining assumptions that were made in footnotes.
B.

The Pro Forma Cash Flow Statement

The pro forma cash flow statement is prepared using the data from the pro forma
income statement. The resulting net cash flow is applied to adjust the cash
account on the pro forma balance sheet.
C.

The Pro Forma Balance Sheet

The pro forma balance sheet is created by starting with the prior year's balance
sheet, and then making adjustments that are consistent with the pro forma
income statement and cash flow statement.
D.

Projected Profitability and Price Ratios

Using the pro forma statements, the analyst now calculates the relevant ratios to
determine the impact of the projected changes. Using these ratios, the analyst
can compute projected stock prices as described in the last chapter. Three
estimates of the stock price can be obtained from:

BVPS x P/B
EPS x P/E

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CFPS x P/CF

These numbers may vary greatly. It will then be the analyst's job to determine
which stock prices are the most accurate, and the least sensitive to variance in
the estimates of the inputs.
7.4

Adolph Coors Company Case Study

In this section, the authors provide a complete analysis using the Adolph Coors
Company.
Lecture Tip: To reinforce the information in this chapter, it is helpful to introduce
a project or case that relates to this chapter's material. If grading is not a
consideration, the project could be done individually, with each student selecting
a different firm. To minimize grading, this project could be completed using
teams, with each team doing a different company, or even assigning all teams
the same firm. The advantage of all teams (or students) analyzing the same firm
is that all the computations can be completed beforehand by the instructor, which
is very helpful in answering student questions and checking the results.
One way of formatting this project is to require the students to select a firm and
gather the following material for the firm: annual report, 10K, Standard & Poor's
report, Dunn & Bradstreet report, and ValueLine report. Note that this material
can also be used for projects that relate to other chapters in the text. Using a
spreadsheet, the students will prepare an income statement, balance sheet, cash
flow statement, and ratio analysis for the firm. The instructor will then give
instructions for a change within the firm to allow a pro forma analysis. This could
be as easy as a change in sales of plus or minus ten percent. The students will
use this information to prepare complete pro formas for the firm, calculate ratios,
and then estimate projected stock prices for one-year hence. Since writing is very
important, the students should also prepare a report that includes the following:
describe what they did, provide a complete analysis of the firm, and make
recommendations for the future. Of course, a one-page Executive Summary
would be very beneficial.
7.5

Summary and Conclusions