LECTURE 2

FINANCIAL STATEMENTS, TAXES

CASH FLOW, AND FINANCIAL RATIOS

Ross, S. A., Westerfield, R. W. & Jordan B.D. (2013): Ch 2, 3

1
 Key Concepts and Skills

 Know the difference between book value

and market value

 Know the difference between accounting

income and cash flow

 Know the difference between average and

marginal tax rates

 Know how to determine a firm’s cash flow

from its financial statements

2
 Key Concepts and Skills
 Understand sources and uses of cash and the
Statement of Cash Flows
 Know how to standardize financial statements for
comparison purposes
 Know how to compute and interpret important
financial ratios
 Be able to compute and interpret the DuPont
Identity
 Understand the problems and pitfalls in financial
statement analysis

3
 Chapter Outline
 The Balance Sheet
 The Income Statement
 Taxes
 Cash Flow
 Cash Flow and Financial Statements: A Closer Look
 Standardized Financial Statements
 Ratio Analysis
 The Du Pont Identity
 Using Financial Statement Information

4
 Balance Sheet

 The balance sheet is a snapshot of the

firm’s assets and liabilities at a given point
in time

 Assets are listed in order of decreasing

liquidity
 Ease of conversion to cash
 Without significant loss of value

 Balance Sheet Identity

 Assets = Liabilities + Stockholders’ Equity

5
The Balance Sheet
Figure 2.1
 Net Working Capital
and Liquidity

 Net Working Capital

 = Current Assets – Current Liabilities
 Positive when the cash that will be received over the next 12 months
exceeds the cash that will be paid out
 Usually positive in a healthy firm

 Liquidity
 Ability to convert to cash quickly without
a significant loss in value
 Liquid firms are less likely to experience financial distress
 But liquid assets typically earn a lower return
 Trade-off to find balance between liquid and illiquid assets

7
U.S. Corporation Balance Sheet Table 2.1

8
 Market Value vs. Book Value
 The balance sheet provides the book value of the
assets, liabilities, and equity.

 Market value is the price at which the assets,

liabilities, or equity can actually be bought or sold.

 Market value and book value are often very

different. Why?

 Which is more important to the decision-making

process?

9
 Example 2.2
Klingon Corporation
 Income Statement

 The income statement is more like a video of

the firm’s operations for a specified period of
time.

 You generally report revenues first and then

deduct any expenses for the period

 Matching principle – GAAP says to show

revenue when it accrues and match the
expenses required to generate the revenue

11
U.S. Corporation Income Statement – Table 2.2

12
 Taxes

 The one thing we can rely on with taxes is

that they are always changing

 Marginal vs. average tax rates

 Marginal tax rate – the percentage
paid on the next dollar earned
 Average tax rate – the tax bill / taxable income
 Average tax rates vary widely across different
companies and industries

 Other taxes

13
 Example: Marginal vs. Average Rates

 Suppose your firm earns $4 million in

taxable income.
 What is the firm’s tax liability?
 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?

14
 The Concept of Cash Flow
 Cash flow is one of the most important
pieces of information that a financial
manager can derive from financial
statements
 The statement of cash flows does not
provide us with the same information
that we are looking at here
 We will look at how cash is generated from
utilizing assets and how it is paid to those
that finance the purchase of the assets

15
 Cash Flow From Assets

 Cash Flow From Assets (CFFA) = Cash Flow to

Creditors + Cash Flow
to Stockholders

 Cash Flow From Assets = Operating Cash Flow

– Net Capital Spending
– Changes in NWC

16
 Example: U.S. Corporation – Part I

 OCF (I/S) = EBIT + depreciation –

taxes = $547

 NCS (B/S and I/S) = ending net fixed assets

– beginning net fixed assets + depreciation
= $130

 Changes in NWC (B/S) = ending

NWC – beginning NWC = $330

 CFFA = 547 – 130 – 330 = $87

17
Example: U.S. Corporation – Part II
 CF to Creditors (B/S and I/S) = interest
paid – net new borrowing = $24

 CF to Stockholders (B/S and I/S) =

dividends paid – net new equity raised =
$63

 CFFA = 24 + 63 = $87

18
Cash Flow Summary - Table 2.6

19
 Example: Balance Sheet and Income
Statement Info

 Current Accounts
 2015: CA = 3625; CL = 1787
 2014: CA = 3596; CL = 2140

 Fixed Assets and Depreciation

 2015: NFA = 2194; 2014: NFA = 2261
 Depreciation Expense = 500

 Long-term Debt and Equity

 2015: LTD = 538; Common stock & APIC = 462
 2014: LTD = 581; Common stock & APIC = 372

 Income Statement
 EBIT = 1014; Taxes = 368
 Interest Expense = 93; Dividends = 285

20
 Example: Cash Flows

 OCF = 1,014 + 500 – 368 = 1,146

 NCS = 2,194 – 2,261 + 500 = 433
 Changes in NWC =
(3,625 – 1,787) – (3,596 – 2,140) = 382
 CFFA = 1,146 – 433 – 382 = 331

 CF to Creditors = 93 – (538 – 581) = 136

 CF to Stockholders = 285 – (462 – 372) = 195
 CFFA = 136 + 195 = 331
 The CF identity holds.

21
 Quick Quiz

 What is the difference between book value and

market value? Which should we use for decision-
making purposes?

 What is the difference between accounting income

and cash flow? Which do we need to use when
making decisions?

 What is the difference between average and

marginal tax rates? Which should we use when
making financial decisions?

 How do we determine a firm’s cash flows? What

are the equations, and where do we find the
information?

22
 Ethics Issues

 Why is manipulation of financial statements

not only unethical and illegal, but also bad
for stockholders?

23
 Comprehensive Problem
 Current Accounts
 2015: CA = 4,400; CL = 1,500
 2014: CA = 3,500; CL = 1,200
 Fixed Assets and Depreciation
 2015: NFA = 3,400; 2014: NFA = 3,100
 Depreciation Expense = 400
 Long-term Debt and Equity (R.E. not given)
 2015: LTD = 4,000; Common stock & APIC = 400
 2014: LTD = 3,950; Common stock & APIC = 400
 Income Statement
 EBIT = 2,000; Taxes = 300
 Interest Expense = 350; Dividends = 500
 Compute the CFFA

24
 Sample Balance Sheet
2015 2014 2015 2014
Cash 696 58 A/P 307 303

A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775
Total CA 2,256 1,675 LT Debt 843 1,091

Net FA 3,138 3,358 C/S 2,556 2,167

Total 5,394 5,033 Total Liab. 5,394 5,033

Assets & Equity

Numbers in millions of dollars

 Sample Income Statement

Revenues 5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income 689
EPS 3.61
Dividends per share 1.08

Numbers in millions of dollars, except EPS & DPS

 Sources and Uses of Cash

 Sources
 Cash inflow – occurs when we “sell” something
 Decrease in asset account (Sample B/S)
 Accounts receivable, inventory, and net fixed assets
 Increase in liability or equity account
 Accounts payable, other current liabilities, and
common stock

 Uses
 Cash outflow – occurs when we “buy” something
 Increase in asset account
 Cash and other current assets
 Decrease in liability or equity account
 Notes payable and long-term debt

27
 Statement of Cash Flows

 Statement that summarizes the sources and

uses of cash

 Changes divided into three major categories

 Operating Activity – includes net income and
changes in most current accounts
 Investment Activity – includes changes in fixed
assets
 Financing Activity – includes changes in notes
payable, long-term debt, and equity accounts,
as well as dividends

28
 Sample Statement of Cash Flows
Cash, beginning of year 58 Financing Activity

Operating Activity Decrease in Notes Payable -93

Net Income 689 Decrease in LT Debt -248

Plus: Depreciation 116 Decrease in C/S (minus RE) -94

Decrease in A/R 36 Dividends Paid -206

Decrease in Inventory 60 Net Cash from Financing -641
Increase in A/P 4
Increase in Other CL 309 Net Increase in Cash 638
Less: Increase in other CA -39
Net Cash from Operations 1,175 Cash End of Year 696

Investment Activity
Sale of Fixed Assets 104
Net Cash from Investments 104

Numbers in millions of dollars

29
 Standardized Financial Statements

 Common-Size Balance Sheets

 Compute all accounts as a percent of total assets

 Common-Size Income Statements

 Compute all line items as a percent of sales

 Standardized statements make it easier to compare

financial information, particularly as the company
grows

 They are also useful for comparing companies of

different sizes, particularly within the same industry

30
 Ratio Analysis

 Ratios allow for better comparison

through time or between companies

 As we look at each ratio, ask yourself

what the ratio is trying to measure and why that
information is important

 Ratios are used both internally and externally

31
 Categories of
Financial Ratios
 Short-term solvency or liquidity ratios

 Long-term solvency or financial leverage ratios

 Asset management or turnover ratios

 Profitability ratios

 Market value ratios

32
 Computing Liquidity Ratios
 Current Ratio = CA / CL
 2,256 / 1,995 = 1.13 times
B/S
 Quick Ratio = (CA – Inventory) / CL I/S
 (2,256 – 301) / 1,995 = .98 times
 Cash Ratio = Cash / CL
 696 / 1,995 = .35 times
 NWC to Total Assets = NWC / TA
 (2,256 – 1,995) / 5,394 = .05
 Interval Measure = CA / average daily operating costs
 2,256 / ((2,006 + 1,740)/365) = 219.8 days

33
 Computing Long-term Solvency Ratios

 Total Debt Ratio = (TA – TE) / TA

 (5,394 – 2,556) / 5,394 = 52.61%
B/S
 Debt/Equity = TD / TE I/S
 (5,394 – 2,556) / 2,556 = 1.11 times

 Equity Multiplier = TA / TE = 1 + D/E

 1 + 1.11 = 2.11

 Long-term debt ratio = LTD / (LTD + TE)

 843 / (843 + 2,556) = 24.80%

34
 Computing Coverage Ratios

 Times Interest Earned = EBIT / Interest

 1,138 / 7 = 162.57 times B/S
I/S

 Cash Coverage = (EBIT + Depreciation) / Interest

 (1,138 + 116) / 7 = 179.14 times

35
 Computing Inventory Ratios

 Inventory Turnover = Cost of Goods Sold / Inventory

 2,006 / 301 = 6.66 times

 Days’ Sales in Inventory = 365 / Inventory Turnover

 365 / 6.66 = 55 days
B/S
I/S

36 3-36
 Computing
Receivables Ratios

 Receivables Turnover = Sales / Accounts Receivable

B/S
 5,000 / 956 = 5.23 times I/S

 Days’ Sales in Receivables = 365 / Receivables Turnover

 365 / 5.23 = 70 days

37 3-37
 Computing Total
Asset Turnover
 Total Asset Turnover = Sales / Total Assets
 5,000 / 5,394 = .93 B/S

 It is not unusual for TAT < 1, especially if a firmI/Shas a

large amount of fixed assets

 NWC Turnover = Sales / NWC

 5,000 / (2,256 – 1,995) = 19.16 times

 Fixed Asset Turnover = Sales / NFA

 5,000 / 3,138 = 1.59 times

38
 Computing Profitability Measures

B/S
 Profit Margin = Net Income / Sales I/S
 689 / 5,000 = 13.78%

 Return on Assets (ROA) = Net Income / Total Assets

 689 / 5,394 = 12.77%

 Return on Equity (ROE) = Net Income / Total Equity

 689 / 2,556 = 26.96%

39
 Computing Market Value Measures - I

 Market Price = $87.65 per share

 Shares outstanding = 190.9 million
 PE Ratio = Price per share / Earnings per
share
 87.65 / 3.61 = 24.28 times

 Market-to-book ratio = Market value per

share / Book value
per share
 87.65 / (2,556 / 190.9) = 6.55 times

40
 Computing Market Value Measures - II

 Enterprise value = market value of stock

+ book value of liabilities
– cash
 16,732 + 2,838 – 696 = $18,874

 EBITDA ratio = Enterprise value / EBITDA

 18,874 / 1,138 = 16.6 times

41
 Deriving the DuPont Identity
 ROE = NI / TE

 Multiply by 1 (TA/TA) and then rearrange

 ROE = (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA * EM

 Multiply by 1 (Sales/Sales) again

and then rearrange
 ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
 ROE = PM * TAT * EM

42
 Using the DuPont Identity

 ROE = PM * TAT * EM
 Profit margin is a measure of the
firm’s operating efficiency – how well
it controls costs

 Total asset turnover is a measure of

the firm’s asset use efficiency – how well does it manage
its assets

 Equity multiplier is a measure of

the firm’s financial leverage

43
Expanded DuPont Analysis –
DuPont Data

44
Extended DuPont Chart

45
 Why Evaluate Financial Statements?

 Internal uses
 Performance evaluation – compensation
and comparison between divisions
 Planning for the future – guide in
estimating future cash flows

 External uses
 Creditors
 Suppliers
 Customers
 Stockholders

46
 Benchmarking

 Ratios are not very helpful by themselves; they

need to be compared to something

 Time-Trend Analysis
 Used to see how the firm’s performance
is changing through time
 Internal and external uses

 Peer Group Analysis

 Compare to similar companies
or within industries
 SIC and NAICS codes

47
 Potential Problems

 There is no underlying theory, so there is no way to

know which ratios are most relevant
 Benchmarking is difficult for diversified firms
 Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations
 Varying accounting procedures, i.e. FIFO vs. LIFO
 Different fiscal years
 Extraordinary events

48
 Work the Web Example

 The Internet makes ratio analysis much easier

than it has been in the past

 Click on the web surfer to go to www.reuters.com

 Click on Markets, then Stocks, then choose a company
and enter its ticker symbol
 Click on Financials to see what information is available

49
 Quick Quiz

 What is the Statement of Cash Flows and how

do you determine sources and uses of cash?

 How do you standardize balance sheets and income

statements and why is standardization useful?

 What are the major categories of ratios and how do

you compute specific ratios within each category?

 What are some of the problems associated

with financial statement analysis?

50 3-50
 Comprehensive Problem

 XYZ Corporation has the following financial information

for the previous year:

 Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M,

LTD = $3M

 Compute the ROE using the DuPont Analysis.

51