LECTURE 2

EBF 1023 Basic Finance

Analysis of Financial Statements
A managers primary goal is to maximize the value
of the firms stock (shareholders wealth).
Value of the firm= firms future cash flow

How an investor estimate future cash flow?
How a manager decide which actions will most likely
increase the cash flow?

The answer lie in the study of financial statement that
publicly traded firms must provide to investors
- institutional investor-bank, insurance companies, pension funds..
- individuals investor- you & me!!



Analysis of Financial Statements

Understanding
Financial Statements,
Taxes, and Cash
Flows
(Chapter 2 )

Evaluating a Firms
Financial
Performance
(Chapter 3)


Financial Statements, Cash
Flow, and Taxes
Key Financial Statements
Balance sheet
Income statements
Statement of retained earnings
Statement of cash flows
Accounting income vs. cash flow
taxes
The Annual Report
Balance sheet
provides a snapshot of a firms financial position at one point in
time.

Income statement
summarizes a firms revenues and expenses over a given period
of time.

Statement of retained earnings
shows how much of the firms earnings were retained, rather than
paid out as dividends.

Statement of cash flows
reports the impact of a firms activities on cash flows over a given
period of time.
SALES
- EXPENSES
= PROFIT
Income Statement
SALES
- EXPENSES
= PROFIT
Income Statement
Revenue
Income Statement
SALES
- EXPENSES
= PROFIT
Cost of Goods Sold




Income Statement
SALES
- EXPENSES
= PROFIT
Cost of Goods Sold
Operating Expenses



Income Statement
SALES
- EXPENSES
= PROFIT
Cost of Goods Sold
Operating Expenses
(marketing, administrative)


Income Statement
SALES
- EXPENSES
= PROFIT
Cost of Goods Sold
Operating Expenses
(marketing, administrative)
Financing Costs

Income Statement
SALES
- EXPENSES
= PROFIT
Cost of Goods Sold
Operating Expenses
(marketing, administrative)
Financing Costs
Taxes
SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS (NI)
Income Statement
SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)

- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
Income Statement
SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)

- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
Income Statement
Balance Sheet
Total Assets =
Outstanding
Debt
+
Shareholders
Equity
Liabilities
Balance Sheet
Assets
Liabilities (Debt) & Equity
Balance Sheet
Assets
Liabilities (Debt) & Equity
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses
Fixed Assets
Machinery & Equipment
Buildings and Land
Other Assets
Investments & patents
Current Liabilities
Accounts Payable
Accrued Expenses
Short-term notes
Long-Term Liabilities
Long-term notes
Mortgages
Equity
Preferred Stock
Common Stock (Par value)
Paid in Capital
Retained Earnings
A Typical Balance Sheet


Total Assets
I
Current Assets
*Cash & Equivalents
*Account Receivable
*Inventory
I
Long-Term (Fixed) Assets
*Net plant and Equipment
*Other Long-Term Assets


Total Liabilities &
Equity
I
Current Liabilities
*Accrued wages & taxes
*Account payable
*Notes payable
I
Long-Term Debt
I
Stockholders Equity
*Common stock
*Retained Earning
Net Working Capital= Current Assets Current Liabilities
=
Assets
Current Assets:
assets that are relatively liquid, and are
expected to be converted to cash within
a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
Assets
Fixed Assets:
Machinery and equipment, buildings,
and land.
Assets
Other Assets:
any asset that is not a current asset
or fixed asset.
Intangible assets, such as patents
and copyrights.
Financing
Debt
Financing
Equity
Financing
Financing
Debt Capital:
financing provided by a creditor.

Short-term debt:
borrowed money that must be repaid
within the next 12 months.
Accounts payable, other payables
such as interest or taxes payable,
accrued expenses, short-term notes.

Long-term debt:
loans from banks or other sources
that lend money for longer than 12
months.
Financing
Equity Capital:
shareholders investment in the
firm.
Preferred Stockholders:
receive fixed dividends, and have
higher priority than common
stockholders in event of
liquidation of the firm.
Common Stockholders:
residual owners of a business.
They receive whatever is left after
creditors and preferred
stockholders are paid.
Free Cash Flows
Free cash flow:
Cash flow that is free and available to be
distributed to the firms investors (both
debt and equity investors).
Free Cash Flows
Cash Flows from
Assets
=
Cash Flows from
Financing
Cash flows generated
through the firms assets =
Cash flows paid to - or
received from - the firms
investors (creditors &
stockholders)
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Operating income
+ depreciation
- cash tax payments
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
[Change in current
assets]
-
[change in non-interest
bearing current liabilities]
Calculating Free Cash Flows:
An Asset Perspective
After-tax cash flow
from operations
less
investment in net
operating
working capital
less
investments in fixed
and other assets
Change in gross
fixed assets, and
any other assets
that are on the
balance sheet.
Calculating Free Cash Flows:
A Financing Perspective
Interest payments to creditors
- change in debt principal
- dividends paid to stockholders
- change in stock

= Financing Free Cash Flows
Tax Example:
Space Cow Computer has sales of $32 million, cost
of goods sold at 60% of sales, cash operating
expenses of $2.4 million, and $1.4 million in
depreciation expense.
The firm has $12 million in 9.5% bonds
outstanding. The firm will pay $500,000 in
dividends to its common stock holders.

If the Tax rate is 34% Calculate the firms tax
liability.
Sales $32,000,000
Cost of Goods Sold (19,200,000)
Operating Expenses (2,400,000)
Depreciation Expense (1,400,000)
EBIT or NOI 9,000,000
Interest Expense (1,140,000)
Taxable Income 7,860,000
Total Tax payment
$7,860,000 x .34 = $2,672,400

Evaluating a Firms
Financial Performance

Financial Ratio Analysis
Are our decisions maximizing
shareholder wealth?
We will want to answer questions
about the firms

i) Liquidity
ii) Efficient use of Assets
iii) Leverage (financing)
iv) Profitability

Financial Ratios
Tools that help us
determine the financial
health of a company.
We can compare a
companys financial ratios
with its ratios in previous
years (trend analysis).
We can compare a
companys financial ratios
with those of its industry.
Example:
CyberDragon
Corporation
CyberDragons
Balance Sheet ($000)
Assets: Liabilities & Equity:
Cash $2,540 Accounts payable 9,721
Marketable securities 1,800 Notes payable 8,500
Accounts receivable 18,320 Accrued taxes payable 3,200
Inventories 27,530 Other current liabilities 4,102
Total current assets 50,190 Total current liabilities 25,523
Plant and equipment 43,100 Long-term debt (bonds) 22,000
less accum deprec. 11,400 Total liabilities 47,523
Net plant & equip. 31,700 Common stock ($10 par) 13,000
Total assets 81,890 Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890
Sales (all credit) $112,760
Cost of Goods Sold (85,300)
Gross Profit 27,460
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Earnings before interest and taxes (EBIT) 11,520
Interest charges:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest charges (3,160)
Earnings before taxes (EBT) 8,360
Taxes (assume 40%) (3,344)
Net Income 5,016
CyberDragons Income Statement
CyberDragon
Other Information

Dividends paid on common stock $2,800
Earnings retained in the firm 2,216
Shares outstanding (000) 1,300
Market price per share 20
Book value per share 26.44
Earnings per share 3.86
Dividends per share 2.15
Financial Ratios



Liquidity
Efficient use of Assets
Profitability
Leverage (financing)
Why are ratios useful?
Standardize numbers-
facilitate comparisons.

highlight weaknesses
& strengths.

Ratio comparisons should be made
through time and with competitors
Trend analysis
Peer (or Industry) analysis
1. Liquidity Ratios
Do we have enough liquid
assets to meet approaching
obligations?
Liquidity
Acid Test /
Quick ratio
current ratio
Average Collection Period
What is CyberDragons


Current Ratio?
What is CyberDragons Current
Ratio?
current assets
current liabilities
What is CyberDragons Current
Ratio?
If the average current ratio
for the industry is 2.4, is this
good or not?
50,190
25,523
= 1.97
below the industry average.
Liquidity position is weak.
What is the firms

Acid Test Ratio?
What is the firms Acid Test Ratio?
current assets - inventories
current liabilities
What is the firms Acid Test Ratio?
Suppose the industry average is 0.92.
What does this tell us?
50,190 - 27,530
25,523
= 0.89
What is the firms

Average Collection Period?
What is the firms Average
Collection Period?
accounts receivable
daily credit sales
What is the firms Average
Collection Period?
If the industry average is 47 days,
what does this tell us?
18,320
112,760/365
= 59.3 days
2. Operating Efficiency Ratios
Measure how efficiently the
firms assets generate
operating profits.
Operating Efficiency Ratios
Operating Income
Return on Investment (OIROI)
Total Assets
turnover ratios
Accounts
Receivable Turnover
Operating
Profit Margin
Inventory
Turnover
What is the firms

Operating Income Return on
Investment (OIROI)?
What is the firms Operating
Income Return on Investment
(OIROI)?
operating income
total assets
Assuming Industry OIROI is 15%.
Slightly below the industry average
The OIROI reflects product pricing and the
firms ability to keep costs down.
What is the firms Operating
Income Return on Investment
(OIROI)?
11,520
81,890
= 14.07%
What is their

Operating Profit Margin?
What is their Operating Profit
Margin?
operating income
sales
What is their Operating Profit
Margin?
If the industry average is 12%. What can
you conclude?
11,520
112,760
= 10.22%
What is their

Total Asset Turnover?
What is their Total Asset
Turnover?
sales
total assets
What is their Total Asset
Turnover?
The industry average is 1.82 times.
The firm needs to figure out how to
squeeze more sales dollars out of its
assets.
112,760
81,890
= 1.38 times
What is the firms

Accounts Receivable Turnover?
What is the firms Accounts
Receivable Turnover?
credit sales
accounts receivable
What is the firms Accounts
Receivable Turnover?
CyberDragon turns their A/R over
6.16 times per year. The industry
average is 8.2 times. Is this efficient?
112,760
18,320
= 6.16 times
What is the firms

Inventory Turnover?
What is the firms Inventory
Turnover?
cost of goods sold
inventory
What is the firms Inventory
Turnover?
CyberDragon turns their inventory
over 3.1 times per year. The industry
average is 3.9 times. Is this efficient?
85,300
27,530
= 3.10 times
Low inventory turnover:
The firm may have too much inventory,
which is expensive because:
Inventory takes up costly warehouse space.
Some items may become spoiled or obsolete.
What is the firms

Fixed Asset Turnover?
What is the firms Fixed Asset
Turnover?
sales
fixed assets
What is the firms Fixed Asset
Turnover?
If the industry average is 4.6 times,
what does this tell us about
CyberDragon?
112,760
31,700
= 3.56 times
3. Leverage Ratios / Debt
Mgmt (financing decisions)
Measure the impact of using debt
capital to finance assets.
Firms use debt to lever (increase)
returns on common equity.
Leverage Ratios / Debt Mgmt
Debt
Ratio
Times-Interest-
Earned (TIE) ratio
How does Leverage work?
Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year total $15,000.


ROE =

(ignore taxes for this example)
How does Leverage work?
Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year total $15,000.


ROE = = 15%


15,000
100,000
How does Leverage work?
Suppose the same $100,000 firm is
financed with half equity, and half 8%
debt (bonds). Earnings are still
$15,000.

ROE =
How does Leverage work?
Suppose the same $100,000 firm is
financed with half equity, and half 8%
debt (bonds). Earnings are still
$15,000.

ROE = =
15,000 - 4,000
50,000
How does Leverage work?
Suppose the same $100,000 firm is
financed with half equity, and half 8%
debt (bonds). Earnings are still
$15,000.

ROE = = 22%
15,000 - 4,000
50,000
What is CyberDragons

Debt Ratio?
What is CyberDragons Debt
Ratio?
total debt
total assets
What is CyberDragons Debt
Ratio?
47,523
81,890
= 58%
If the industry average is 47%, what
does this tell us?

Can leverage make the firm more profitable?
Can leverage make the firm riskier?
What is the firms

Times Interest Earned Ratio?
What is the firms Times
Interest Earned Ratio?
operating income
interest expense
What is the firms Times
Interest Earned Ratio?
The industry average is 6.7 times. This
is further evidence that the firm uses
more debt financing than average.
11,520
3,160
= 3.65 times
4. Return on Equity/
Profitability
How well are the firms managers
maximizing shareholder
wealth?
What is CyberDragons

Return on Equity (ROE)?
What is CyberDragons
Return on Equity (ROE)?
net income
common equity
What is CyberDragons
Return on Equity (ROE)?
5,016
34,367
= 14.6%
The industry average is 17.54%.
Is this what we would expect,
given the firms leverage?
Conclusion:
Even though CyberDragon
has higher leverage than the
industry average, they are
much less efficient, and
therefore, less profitable.
The DuPont Model
Brings together:

Profitability
Efficiency
Leverage
ROE = x / (1- )

Net Profit Total Asset Debt
Margin Turnover Ratio
The DuPont Model
ROE = x / (1- )

= x /(1- )

= x / (1 - )

= 14.6%
Net Profit Total Asset Debt
Margin Turnover Ratio



Net Income Sales Total Debt
Sales Total Assets Total Assets



5,016 112,760 47,523
112,760 81,890 81,890


The DuPont Model
The DuPont Model
ROE = x / (1- )

Net Profit Total Asset Debt
Margin Turnover Ratio
net income
common equity
Special gift for guys!!
End of Lecture 2



Thank you
for your attention!!