1
Finance School of Management
Chapter 3,Interpreting
Financial Statements
Objective
Contrast Economic and
Accounting Models
Value of Accounting
Information
2
Finance School of Management
Chapter 3 Contents
? Review of Financial
Statements
? Market Values v,Book
Values
? Accounting v,Economic
Measures of Income
? Return on Shareholders v,
Return on Equity
? Analysis Using Financial
Ratios
? The Relation Among
Ratios
? Limitations of Ratio
Analysis
? Purpose and Process of
Financial Planning
? Managing Working
Capital
3
Finance School of Management
Review of Financial Statements
? Financial Statements
– Provide information (clues) to the owners &
creditors of a firm about the current status and past
performance,
– Provide a convenient way for owners & creditors to
set performance targets & to impose restrictions on
the managers of the firm,
– Provide a convenient templates for financial
planning,
4
Finance School of Management
The Balance Sheet
? Summarizing a firm’s assets (what it owns),
liabilities (what it owes),and net worth (owners’
equity) at a moment in time,
– Amounts measured at historical values (acquisition
cost) and historical exchange rates,
– Prepared according to GAAP (Generally Accepted
Accounting Principles),
– Exchange-listed companies must comply with SEC
(Securities and Exchange Commission) rules,
5
Finance School of Management
? Major Divisions
– Assets
? Current assets (less than a year)
? Long-term assets (longer than a year)
– Depreciation
– Liabilities and Stockholder’s Equity
? Liabilities
– Current Liabilities
Net Working Capital = Current Assets - Liabilities
– Long-term debt
? Equity
The Balance Sheet
6
Finance School of Management GPC Balance Sheet at Dec 31,2xx1
2xx1 2xx0
200.0 187.2
Market Price
Per Share
2xx0 Change
Assets
Cash & mkt'ble secs 100.0 120.0 20.0
Receivables 50.0 60.0 10.0
Inventories 150.0 180.0 30.0
*Current assets 300.0 360.0 60.0
Pp&e 400.0 490.0 90.0
Acc depreciation (100.0) (130.0) (30.0)
*Net pp&e 300.0 360.0 60.0
**Total Assets 600.0 720.0 120.0
Liabilities & Equity
Accounts payable 60.0 72.0 12.0
Short-term debt 90.0 184.6 94.6
*Current liabilities 150.0 256.6 106.6
Long-term debt 150.0 150.0 -
**Total liabilities 300.0 406.6 106.6
Paid-in capital 200.0 200.0 -
Retained earnings 100.0 113.4 13.4
*Shareholders equ 300.0 313.4 13.4
Liab + Shareholder 600.0 720.0 120.0
2xx1
7
Finance School of Management
The Income Statement
? Summarizing the profitability of a company
during a time period,
– the difference of revenues and expenses
– also to be called the statement of the earnings or
the statement of profit and loss
8
Finance School of Management
? Major Divisions
– Revenue & cost of goods sold
? Gross margin
– General selling and administrative expenses
(GS&A)
? Operating income
– Interest expense
? Taxable income
– Corporate Taxes
? Net income
The Income Statement
9
Finance School of Management
GPC Income Statement for Year Ending 2xx1
Sales revenues 200.0
Cost of goods sold (110.0)
*Gross margin 90.0
Gen sell,& admin exp (30.0)
*Operating income 60.0
Interest expense (21.0)
*Taxable income 39.0
Income tax (15.6)
*Net income 23.4
Allocation to divs (10.0)
*Chg retained earn 13.4
10
Finance School of Management
?It is important to remember
– Retained earnings are not added to the cash
balance of the firm,but are added to
shareholder’s equity,
– Accounts show historical values,not market
values,
The Income Statement
11
Finance School of Management
The Cash-Flow Statement
? Shows the cash that flowed into and from a firm
during a time period,
– Focuses attention on a firm’s cash situation,
? A firm may be profitable and short of cash,
– Unlike the balance sheet and income statement,cash
flow statements are independent of accounting
methods,
? Net income is based on accrual accounting methods,
and affected by many judgments about issues such as
how to value the inventory,depreciate the tangible
assets,and amortize the intangible assets,
12
Finance School of Management
GPC Cash Flow Statement,for
the Year ending Dec 31,2xx1
Net income 23.4
+ Depreciation 30.0
- Increase in acc rec (10.0)
- Increase in invent (30.0)
+ Increase in acc pay 12.0
*Total cash from operations 25.4
- Invest in new ppe (90.0)
*Cash flow invest' activities (90.0)
-Div paid (10.0)
+ Inc short-term debt 94.6
*Cash flow from financing 84.6
**Chng cash & mkt securities 20.0
13
Finance School of Management
G P C B a l a n c e S h e e t a t D e c 3 1,2 x x 1
2xx0 2xx1 C h a n g e
A s s e t s
C a s h & m k t ' b l e s e c s 1 0 0, 0 1 2 0, 0 2 0, 0
R e c e i v a b l e s 5 0, 0 6 0, 0 1 0, 0
I n v e n t o r i e s 1 5 0, 0 1 8 0, 0 3 0, 0
* C u r r e n t a s s e t s 3 0 0, 0 3 6 0, 0 6 0, 0
P p & e 4 0 0, 0 4 9 0, 0 9 0, 0
A c c d e p r e c i a t i o n ( 1 0 0, 0 ) ( 1 3 0, 0 ) ( 3 0, 0 )
* N e t p p & e 3 0 0, 0 3 6 0, 0 6 0, 0
* * T o t a l A s s e t s 6 0 0, 0 7 2 0, 0 1 2 0, 0
L i a b i l i t i e s & E q u i t y
A c c o u n t s p a y a b l e 6 0, 0 7 2, 0 1 2, 0
S h o r t - t e r m d e b t 9 0, 0 1 8 4, 6 9 4, 6
* C u r r e n t l i a b i l i t i e s 1 5 0, 0 2 5 6, 6 1 0 6, 6
L o n g - t e r m d e b t 1 5 0, 0 1 5 0, 0 -
* * T o t a l l i a b i l i t i e s 3 0 0, 0 4 0 6, 6 1 0 6, 6
P a i d - i n c a p i t a l 2 0 0, 0 2 0 0, 0 -
R e t a i n e d e a r n i n g s 1 0 0, 0 1 1 3, 4 1 3, 4
* S h a r e h o l d e r s e q u 3 0 0, 0 3 1 3, 4 1 3, 4
L i a b + S h a r e h o l d e r 6 0 0, 0 7 2 0, 0 1 2 0, 0
GPC Income Statement
for Year Ending 2xx1
Sales revenues 200.0
Cost of goods sold (110.0)
*Gross margin 90.0
Gen sell,& admin exp (30.0)
*Operating income 60.0
Interest expense (21.0)
*Taxable income 39.0
Income tax (15.6)
*Net income 23.4
Allocation to divs (10.0)
*Chg retained earn 13.4
GPC Cash Flow Statement,for
the Year ending Dec 31,2xx1
Net income 23.4
+ Depreciation 30.0
- Increase in acc rec (10.0)
- Increase in invent (30.0)
+ Increase in acc pay 12.0
*Total cash from operations 25.4
- Invest in new ppe (90.0)
*Cash flow invest' activities (90.0)
-Div paid (10.0)
+ Inc short-term debt 94.6
*Cash flow from financing 84.6
**Chng cash & mkt securities 20.0
14
Finance School of Management
Notes on Financial Statements
?More information relevant to understanding the
true financial condition of the company in the
notes to the financial statements,
–An explanation of accounting methods used
–Greater details regarding certain assets or liabilities
–Information regarding the equity structure of the
firm
–Documentation of changes in operations
–Off-balance-sheet items
15
Finance School of Management
Market Values v,Book Values
?Book value,the official accounting values of assets
and shareholders’ equity
?Two reasons why the market price of a company’s
stock does not equal its book value
–The book value does not include all of a firm’s assets
and liabilities,
–The assets and liabilities included on a firm’s official
balance sheet are valued at original acquisition cost
less depreciation,rather than at current market value,
16
Finance School of Management
? The accounting balance sheet often omits some
economically significant assets,
– Intangible assets,a good reputation,a knowledge base
– Goodwill,the difference between the acquisition price
and the book value when a firm is acquired
? The accounting balance sheet also omits some
economically significant liabilities,
– Contingent liabilities,costly lawsuits
Market Values v,Book Values
17
Finance School of Management
? IBM’s equipment for shell molding
– Purchased for $3.9 million 3 years ago
– The book value at $2.6 million after 3 years depreciation
– The market value has fallen to $1.2 million because of technological
change in the manufacture of computer shells,
? Inventory of copper to be used in the manufacturing
process of heating furnaces
– You paid $29,000 at the beginning of the year,
– The market value has risen to $60,000,
? For decision-making purposes,the correct value to use is
the market value,whenever available,
– Marking to market
Which is Relevant for Financial Decision-Making
18
Finance School of Management
? Accounting measure of net income
Revenue - Expenses - Taxes
? Economic measure of net income
Net cash flow to shareholders + Change in value of existing
shareholders’ equity
– The accounting net income of GPC Corp,in 20x1 was $23.4
million,
– Net cash flow to GPC shareholders was $10 million,and the price
of GPC stock fell from $200 to $187.2,Thus,its economic income
in 20x1 was
$10 million - $12.8 million = -$2.8 million
Accounting v,Economic Measures of Income
19
Finance School of Management
Returns to Shareholders v,Return on Equity
?Recall,
? This is the total shareholder return,
( )
4%, 1 200 $ 8, 2 $
Re
- = - = =
+ - =
Million
Million
StartPrice
come EconomicIn
StartPrice
nds CashDivide StartPrice EndPrice turn
Capital
gain or
loss
Interest
payments
20
Finance School of Management
? Traditionally,corporate performance has been
measured by Return on Equity,ROE
% 8, 7 300 $ 4, 23 $ = =
=
=
Million
Million
Equity Shareholders
Net Income
Equity Shareholders
Income Accounting ROE
Returns to Shareholders v,Return on Equity
21
Finance School of Management
Analysis Using Financial Ratios
? Despite the differences between accounting and
economic financial principle,a firm’s published
statements can often offer some clues about its
financial condition and provide insights into its
past performance that may be relevant for the
future,
22
Finance School of Management
Profitability
( ) % 6, 7 2 / 4, 313 300
4, 23
sEquity r' StockHolde
NetIncome (RoE)Equity on Return
= + =
=
( ) % 1, 9 2 / 720 600
60
alAssets AverageTot
EBIT (RoA) Assetson Return
= + =
=
% 30 200 60
Sales
EBIT (RoS) Saleson Return
= =
=
23
Finance School of Management
Asset Turnover
( )
( )
( ) Times 3,0 2 / 720 600
200
Assets Total Average
Sales Turnover Asset
Times 7,0 2 / 180 150 110
Inventory Average
Sold Goods ofCost Turnover Inventory
Times 6,3 2 / 60 50 200
s Receivable Average
Sales Turnover sReceivable
= + =
=
= + =
=
= + =
=
24
Finance School of Management
Financial Leverage
Times 9,2 21 60
Expense Interest
EBIT Earned Interest Times
% 57 720 6, 406
Assets Total
Debt Total Debt
= =
=
= =
=
25
Finance School of Management
Liquidity
Times 7,0 6, 256 180
s Liabilitie Current
s Receivable Cash test or acid Quick,
Times 4,1 6, 256 360
s Liabilitie Current
Assets Current Current
= =
+ =
= =
=
26
Finance School of Management
Market Value
6.0
4.313
20.187
S h a r ep er V a l u eB o o k
S h a r ep er P r i c e
B o o k M a r k et t o
0.8
4.23
2.187
S h a r ep er Ea r n i n g s
S h a r eP er P r i c e
Ea r n i n g s toP r i c e
==
=
==
=
27
Finance School of Management
Ratio Comparisons
? Establish Your Perspective
– Shareholder
– Employee,Management,or Union
– Creditor
– Predator,Customer,Supplier,Competitor,Trade
Association
? Benchmarks
– Other companies’ ratios
– The firm’s historical ratios
– Data extracted from financial markets
28
Finance School of Management
Relationships Amongst Ratios
? It is sometimes valuable to decompose ratios into
sums,differences,products and quotients of
other ratios,Many such schemes start with,
Turnover Asset *Sales on Return
*
=
= = Assets Sales Sales EBIT Assets EBIT RoA
29
Finance School of Management
Differences between ROS and ATO
across Industries
? A,low” ROS or ATO ratio need not be a sign of a
trouble firm,
Supermarket chain
Public
utility
0.0
2 0.2
0
5.0
0.5
0.1
0 0.1
0
ROS ATO ROA = *
30
Finance School of Management
The Effect of Financial Leverage
? An increase in a firm’s financial leverage will increase
its ROE if and only if its ROA exceeds the interest rate on
the borrowed funds,
? Increased financial leverage magnifies the variability that
firms experience in their ROE over the business cycle
and increases the likelihood of bankruptcy,
? From the perspective of a creditor,an increase in a firm’s
debt ratio is generally a negative sign,
ROE＝ (1－ Tax Rate) × [ROA＋ Debt/Equity× (ROA－ Interest Rate)]
31
Finance School of Management
? A firm’s profitability as reflected in its financial
statements may sometimes seem awful but may just be
inevitable result of a long-run strategy of restructuring
or repositioning which will ultimately make the firm
much more profitable,
? It is difficult to define a set of comparable firms to serve
as a benchmark for judging a company’s performance,
? Financial statements reflect the conventions of the
accounting profession,which may not reflect what is
most relevant from a financial decision-maker’s
perspective,
Limitations of Ratio Analysis
32
Finance School of Management
The Financial Planning Process
? Financial Planning is a dynamic process following
a cycle of
– making plans,
– implementing them,and
– revising them in the light of actual results,
? Strategic plans
? Planning horizon
33
Finance School of Management
Steps of Financial Planning Process
? Forecasting the key external factors that determine the
demand for the firm’s products and its production costs,
? Forecasting the firm’s revenues,expenses,cash flows,
and estimating the implied need for external financing,
? Establishing performance targets,
? Measuring actual performance,correcting actions and
adjusting targets,
? Distributing the rewards and starting again the planning
cycle,
34
Finance School of Management
An Illustration,GPC
? Percent-of-sales method
– making a forecast of sales for the next year,
– assuming that most of the items on the income statement
and balance sheet will remain the same ratio to sales as
in the previous year,
Additional Financing Needed
＝ Change in Assets – Increase in Retained Earnings – Increase in Payables
35
Finance School of Management
GPC Financial Statements,2xx1-2xx3
2xx0 2xx1
Cash & mkt'ble secs 10.00 12.00
Receivables 40.00 48.00
Inventories 50.00 60.00
Pp&e 500.00 600.00
Assets 600.00 720.00
payables 30.00 36.00
Short-term debt 120.00 221.40
Long-term debt 150.00 150.00
liabilities 300.00 407.40
Shareholders’ equ 300.00 312.60
14.40
57.60
72.00
720.00
864.00
43.20
346.95
150.00
540.15
323.85
2xx2
17.28
69.12
86.40
864.00
1,036.80
51.84
501.72
150.00
703.56
333.24
2xx3 Balance Sheet
Sales revenues
Cost of goods sold
Gross margin
Gen sell,& admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
200.00
(110.00)
90.00
(30.00)
60.00
(30.00)
(12.00)
18.00
(5.40)
12.60
240.00
(132.00)
108.00
(36.00)
72.00
(45.21)
(10.72)
16.07
(4.82)
11.25
288.00
(158.40)
129.60
(43.20)
86.40
(64.04)
(8.94)
13.41
(4.02)
9.39
2xx1 2xx2 2xx3
36
Finance School of Management
GPC Common-Size Financial Statements,2xx1-2xx3
2xx1
Cash & mkt'ble secs 6.0
Receivables 24.0
Inventories 30.0
Pp&e 300.0
Assets 360.0%
payables 18.0
Short-term debt 110.7
Long-term debt 75.0
liabilities 203.7
Shareholders’ equ 156.3
2xx2 2xx3 Balance Sheet
Sales revenues
Cost of goods sold
Gross margin
Gen sell,& admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
100.0%
(55.0)
45.0
(15.0)
30.0
(15.0)
(6.0)
9.0
(2.7)
6.3
2xx1 2xx2 2xx3
100.0%
(55.0)
45.0
(15.0)
30.0
(18.8)
(4.5)
6.7
(2.0)
4.7
100.0%
(55.0)
45.0
(15.0)
30.0
(22.2)
(3.1)
4.7
(1.4)
3.3
6.0
24.0
30.0
300.0
360.0%
18.0
144.6
62.5
225.1
134.9
6.0
24.0
30.0
300.0
360.0%
18.0
174.2
52.1
244.3
115.7
37
Finance School of Management
GPC Forecast Financial Statements,2xx1-2xx3
2xx0 2xx1
Cash & mkt'ble secs 10.00 12.00
Receivables 40.00 48.00
Inventories 50.00 60.00
Pp&e 500.00 600.00
Assets 600.00 720.00
payables 30.00 36.00
Short-term debt 120.00 221.40
Long-term debt 150.00 150.00
liabilities 300.00 407.40
Shareholders’ equ 300.00 312.60
14.40
57.60
72.00
720.00
864.00
43.20
346.95
150.00
540.15
323.85
2xx2
17.28
69.12
86.40
864.00
1,036.80
51.84
501.72
150.00
703.56
333.24
2xx3 Balance Sheet
Sales revenues
Cost of goods sold
Gross margin
Gen sell,& admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
200.00
(110.00)
90.00
(30.00)
60.00
(30.00)
(12.00)
18.00
(5.40)
12.60
240.00
(132.00)
108.00
(36.00)
72.00
(45.21)
(10.72)
16.07
(4.82)
11.25
288.00
(158.40)
129.60
(43.20)
86.40
(64.04)
(8.94)
13.41
(4.02)
9.39
2xx1 2xx2 2xx3
20.74
82.94
103.68
1,036.80
1,244.16
62.21
691.81
150.00
904.02
340.14
2xx3
345.60
(190.08)
155.52
(51.84)
103.68
(87.26)
(6.57)
9.85
(2.96)
6.90
2xx4e
38
Finance School of Management
Sustainable Growth Rate
? Assumptions,
– The firm will not issue any new equity shares,so that growth in
equity capital occurs only through the retention of earnings,
– The firm will not increase its ratio of debt to equity,so that
external debt financing will grow at the same rate as equity grows
through retained earnings,
Sustainable Growth Rate = Earings Retention Rate × ROE
? Implications,
– The maximum sustainable growth rate is equal to the firm’s ROE,
– If a firm tries to grow faster than this rate,it will have to issue new
shares and/or increase its debt,
39
Finance School of Management
An Illustration,Rapid Industries
2xx0 2xx1
Assets $2,000,000
Debt 1,000,000
Equity 1,000,000
2xx2 2xx3 Balance Sheet
Sales
Net income
Dividends
Chg retained earn
&1,000,000
200,000
80,000
120,000
2xx1 2xx2 2xx3
&1,120,000
224,000
89,600
134,400
&1,254,400
250,880
100,352
150,528
$2,240,000
1,120,000
1,120,000
$2,508,800
1,254,400
1,254,400
$2,809,856
1,404,928
1,404,928
? Asset Turnover = 0.5 Times per Year
? Debt/Equity Ratio = 1.0
? Dividend Payout Ratio = 0.4
? ROE = 20% per Year
40
Finance School of Management
? In most cases cash must be paid out to cover expenses before
any cash is collected from the sale of the firm’s products,
– If a firm’s need for working capital is permanent rather than seasonal,
it usually seeks long-term financing for it,
– Seasonal financing needs are met through short-term financing
arrangements,
? The main principle of efficient working capital management
– To minimize the amount of the firm’s investment in nonearning assets
such as receivables and inventories,
– To maximize the use of,free” credit such as prepayments by
customers,accrued wages,and accounts payable,
Working Capital Management
41
Finance School of Management
The Cash Flow Cycle
Time
Ordered Arrives Finished Goods Sold Cash Received
Invoice Received Cash Paid
Payables Period
Inventory Period Receivables Period
Raw
Material
Purchased
Cash Cycle Time
? A firm can reduce its need for working capital by,
– reducing the amount of time that goods are held in inventory,
– collecting accounts receivable more quickly,
– paying its own bills more slowly,
Finance School of Management
Chapter 3,Interpreting
Financial Statements
Objective
Contrast Economic and
Accounting Models
Value of Accounting
Information
2
Finance School of Management
Chapter 3 Contents
? Review of Financial
Statements
? Market Values v,Book
Values
? Accounting v,Economic
Measures of Income
? Return on Shareholders v,
Return on Equity
? Analysis Using Financial
Ratios
? The Relation Among
Ratios
? Limitations of Ratio
Analysis
? Purpose and Process of
Financial Planning
? Managing Working
Capital
3
Finance School of Management
Review of Financial Statements
? Financial Statements
– Provide information (clues) to the owners &
creditors of a firm about the current status and past
performance,
– Provide a convenient way for owners & creditors to
set performance targets & to impose restrictions on
the managers of the firm,
– Provide a convenient templates for financial
planning,
4
Finance School of Management
The Balance Sheet
? Summarizing a firm’s assets (what it owns),
liabilities (what it owes),and net worth (owners’
equity) at a moment in time,
– Amounts measured at historical values (acquisition
cost) and historical exchange rates,
– Prepared according to GAAP (Generally Accepted
Accounting Principles),
– Exchange-listed companies must comply with SEC
(Securities and Exchange Commission) rules,
5
Finance School of Management
? Major Divisions
– Assets
? Current assets (less than a year)
? Long-term assets (longer than a year)
– Depreciation
– Liabilities and Stockholder’s Equity
? Liabilities
– Current Liabilities
Net Working Capital = Current Assets - Liabilities
– Long-term debt
? Equity
The Balance Sheet
6
Finance School of Management GPC Balance Sheet at Dec 31,2xx1
2xx1 2xx0
200.0 187.2
Market Price
Per Share
2xx0 Change
Assets
Cash & mkt'ble secs 100.0 120.0 20.0
Receivables 50.0 60.0 10.0
Inventories 150.0 180.0 30.0
*Current assets 300.0 360.0 60.0
Pp&e 400.0 490.0 90.0
Acc depreciation (100.0) (130.0) (30.0)
*Net pp&e 300.0 360.0 60.0
**Total Assets 600.0 720.0 120.0
Liabilities & Equity
Accounts payable 60.0 72.0 12.0
Short-term debt 90.0 184.6 94.6
*Current liabilities 150.0 256.6 106.6
Long-term debt 150.0 150.0 -
**Total liabilities 300.0 406.6 106.6
Paid-in capital 200.0 200.0 -
Retained earnings 100.0 113.4 13.4
*Shareholders equ 300.0 313.4 13.4
Liab + Shareholder 600.0 720.0 120.0
2xx1
7
Finance School of Management
The Income Statement
? Summarizing the profitability of a company
during a time period,
– the difference of revenues and expenses
– also to be called the statement of the earnings or
the statement of profit and loss
8
Finance School of Management
? Major Divisions
– Revenue & cost of goods sold
? Gross margin
– General selling and administrative expenses
(GS&A)
? Operating income
– Interest expense
? Taxable income
– Corporate Taxes
? Net income
The Income Statement
9
Finance School of Management
GPC Income Statement for Year Ending 2xx1
Sales revenues 200.0
Cost of goods sold (110.0)
*Gross margin 90.0
Gen sell,& admin exp (30.0)
*Operating income 60.0
Interest expense (21.0)
*Taxable income 39.0
Income tax (15.6)
*Net income 23.4
Allocation to divs (10.0)
*Chg retained earn 13.4
10
Finance School of Management
?It is important to remember
– Retained earnings are not added to the cash
balance of the firm,but are added to
shareholder’s equity,
– Accounts show historical values,not market
values,
The Income Statement
11
Finance School of Management
The Cash-Flow Statement
? Shows the cash that flowed into and from a firm
during a time period,
– Focuses attention on a firm’s cash situation,
? A firm may be profitable and short of cash,
– Unlike the balance sheet and income statement,cash
flow statements are independent of accounting
methods,
? Net income is based on accrual accounting methods,
and affected by many judgments about issues such as
how to value the inventory,depreciate the tangible
assets,and amortize the intangible assets,
12
Finance School of Management
GPC Cash Flow Statement,for
the Year ending Dec 31,2xx1
Net income 23.4
+ Depreciation 30.0
- Increase in acc rec (10.0)
- Increase in invent (30.0)
+ Increase in acc pay 12.0
*Total cash from operations 25.4
- Invest in new ppe (90.0)
*Cash flow invest' activities (90.0)
-Div paid (10.0)
+ Inc short-term debt 94.6
*Cash flow from financing 84.6
**Chng cash & mkt securities 20.0
13
Finance School of Management
G P C B a l a n c e S h e e t a t D e c 3 1,2 x x 1
2xx0 2xx1 C h a n g e
A s s e t s
C a s h & m k t ' b l e s e c s 1 0 0, 0 1 2 0, 0 2 0, 0
R e c e i v a b l e s 5 0, 0 6 0, 0 1 0, 0
I n v e n t o r i e s 1 5 0, 0 1 8 0, 0 3 0, 0
* C u r r e n t a s s e t s 3 0 0, 0 3 6 0, 0 6 0, 0
P p & e 4 0 0, 0 4 9 0, 0 9 0, 0
A c c d e p r e c i a t i o n ( 1 0 0, 0 ) ( 1 3 0, 0 ) ( 3 0, 0 )
* N e t p p & e 3 0 0, 0 3 6 0, 0 6 0, 0
* * T o t a l A s s e t s 6 0 0, 0 7 2 0, 0 1 2 0, 0
L i a b i l i t i e s & E q u i t y
A c c o u n t s p a y a b l e 6 0, 0 7 2, 0 1 2, 0
S h o r t - t e r m d e b t 9 0, 0 1 8 4, 6 9 4, 6
* C u r r e n t l i a b i l i t i e s 1 5 0, 0 2 5 6, 6 1 0 6, 6
L o n g - t e r m d e b t 1 5 0, 0 1 5 0, 0 -
* * T o t a l l i a b i l i t i e s 3 0 0, 0 4 0 6, 6 1 0 6, 6
P a i d - i n c a p i t a l 2 0 0, 0 2 0 0, 0 -
R e t a i n e d e a r n i n g s 1 0 0, 0 1 1 3, 4 1 3, 4
* S h a r e h o l d e r s e q u 3 0 0, 0 3 1 3, 4 1 3, 4
L i a b + S h a r e h o l d e r 6 0 0, 0 7 2 0, 0 1 2 0, 0
GPC Income Statement
for Year Ending 2xx1
Sales revenues 200.0
Cost of goods sold (110.0)
*Gross margin 90.0
Gen sell,& admin exp (30.0)
*Operating income 60.0
Interest expense (21.0)
*Taxable income 39.0
Income tax (15.6)
*Net income 23.4
Allocation to divs (10.0)
*Chg retained earn 13.4
GPC Cash Flow Statement,for
the Year ending Dec 31,2xx1
Net income 23.4
+ Depreciation 30.0
- Increase in acc rec (10.0)
- Increase in invent (30.0)
+ Increase in acc pay 12.0
*Total cash from operations 25.4
- Invest in new ppe (90.0)
*Cash flow invest' activities (90.0)
-Div paid (10.0)
+ Inc short-term debt 94.6
*Cash flow from financing 84.6
**Chng cash & mkt securities 20.0
14
Finance School of Management
Notes on Financial Statements
?More information relevant to understanding the
true financial condition of the company in the
notes to the financial statements,
–An explanation of accounting methods used
–Greater details regarding certain assets or liabilities
–Information regarding the equity structure of the
firm
–Documentation of changes in operations
–Off-balance-sheet items
15
Finance School of Management
Market Values v,Book Values
?Book value,the official accounting values of assets
and shareholders’ equity
?Two reasons why the market price of a company’s
stock does not equal its book value
–The book value does not include all of a firm’s assets
and liabilities,
–The assets and liabilities included on a firm’s official
balance sheet are valued at original acquisition cost
less depreciation,rather than at current market value,
16
Finance School of Management
? The accounting balance sheet often omits some
economically significant assets,
– Intangible assets,a good reputation,a knowledge base
– Goodwill,the difference between the acquisition price
and the book value when a firm is acquired
? The accounting balance sheet also omits some
economically significant liabilities,
– Contingent liabilities,costly lawsuits
Market Values v,Book Values
17
Finance School of Management
? IBM’s equipment for shell molding
– Purchased for $3.9 million 3 years ago
– The book value at $2.6 million after 3 years depreciation
– The market value has fallen to $1.2 million because of technological
change in the manufacture of computer shells,
? Inventory of copper to be used in the manufacturing
process of heating furnaces
– You paid $29,000 at the beginning of the year,
– The market value has risen to $60,000,
? For decision-making purposes,the correct value to use is
the market value,whenever available,
– Marking to market
Which is Relevant for Financial Decision-Making
18
Finance School of Management
? Accounting measure of net income
Revenue - Expenses - Taxes
? Economic measure of net income
Net cash flow to shareholders + Change in value of existing
shareholders’ equity
– The accounting net income of GPC Corp,in 20x1 was $23.4
million,
– Net cash flow to GPC shareholders was $10 million,and the price
of GPC stock fell from $200 to $187.2,Thus,its economic income
in 20x1 was
$10 million - $12.8 million = -$2.8 million
Accounting v,Economic Measures of Income
19
Finance School of Management
Returns to Shareholders v,Return on Equity
?Recall,
? This is the total shareholder return,
( )
4%, 1 200 $ 8, 2 $
Re
- = - = =
+ - =
Million
Million
StartPrice
come EconomicIn
StartPrice
nds CashDivide StartPrice EndPrice turn
Capital
gain or
loss
Interest
payments
20
Finance School of Management
? Traditionally,corporate performance has been
measured by Return on Equity,ROE
% 8, 7 300 $ 4, 23 $ = =
=
=
Million
Million
Equity Shareholders
Net Income
Equity Shareholders
Income Accounting ROE
Returns to Shareholders v,Return on Equity
21
Finance School of Management
Analysis Using Financial Ratios
? Despite the differences between accounting and
economic financial principle,a firm’s published
statements can often offer some clues about its
financial condition and provide insights into its
past performance that may be relevant for the
future,
22
Finance School of Management
Profitability
( ) % 6, 7 2 / 4, 313 300
4, 23
sEquity r' StockHolde
NetIncome (RoE)Equity on Return
= + =
=
( ) % 1, 9 2 / 720 600
60
alAssets AverageTot
EBIT (RoA) Assetson Return
= + =
=
% 30 200 60
Sales
EBIT (RoS) Saleson Return
= =
=
23
Finance School of Management
Asset Turnover
( )
( )
( ) Times 3,0 2 / 720 600
200
Assets Total Average
Sales Turnover Asset
Times 7,0 2 / 180 150 110
Inventory Average
Sold Goods ofCost Turnover Inventory
Times 6,3 2 / 60 50 200
s Receivable Average
Sales Turnover sReceivable
= + =
=
= + =
=
= + =
=
24
Finance School of Management
Financial Leverage
Times 9,2 21 60
Expense Interest
EBIT Earned Interest Times
% 57 720 6, 406
Assets Total
Debt Total Debt
= =
=
= =
=
25
Finance School of Management
Liquidity
Times 7,0 6, 256 180
s Liabilitie Current
s Receivable Cash test or acid Quick,
Times 4,1 6, 256 360
s Liabilitie Current
Assets Current Current
= =
+ =
= =
=
26
Finance School of Management
Market Value
6.0
4.313
20.187
S h a r ep er V a l u eB o o k
S h a r ep er P r i c e
B o o k M a r k et t o
0.8
4.23
2.187
S h a r ep er Ea r n i n g s
S h a r eP er P r i c e
Ea r n i n g s toP r i c e
==
=
==
=
27
Finance School of Management
Ratio Comparisons
? Establish Your Perspective
– Shareholder
– Employee,Management,or Union
– Creditor
– Predator,Customer,Supplier,Competitor,Trade
Association
? Benchmarks
– Other companies’ ratios
– The firm’s historical ratios
– Data extracted from financial markets
28
Finance School of Management
Relationships Amongst Ratios
? It is sometimes valuable to decompose ratios into
sums,differences,products and quotients of
other ratios,Many such schemes start with,
Turnover Asset *Sales on Return
*
=
= = Assets Sales Sales EBIT Assets EBIT RoA
29
Finance School of Management
Differences between ROS and ATO
across Industries
? A,low” ROS or ATO ratio need not be a sign of a
trouble firm,
Supermarket chain
Public
utility
0.0
2 0.2
0
5.0
0.5
0.1
0 0.1
0
ROS ATO ROA = *
30
Finance School of Management
The Effect of Financial Leverage
? An increase in a firm’s financial leverage will increase
its ROE if and only if its ROA exceeds the interest rate on
the borrowed funds,
? Increased financial leverage magnifies the variability that
firms experience in their ROE over the business cycle
and increases the likelihood of bankruptcy,
? From the perspective of a creditor,an increase in a firm’s
debt ratio is generally a negative sign,
ROE＝ (1－ Tax Rate) × [ROA＋ Debt/Equity× (ROA－ Interest Rate)]
31
Finance School of Management
? A firm’s profitability as reflected in its financial
statements may sometimes seem awful but may just be
inevitable result of a long-run strategy of restructuring
or repositioning which will ultimately make the firm
much more profitable,
? It is difficult to define a set of comparable firms to serve
as a benchmark for judging a company’s performance,
? Financial statements reflect the conventions of the
accounting profession,which may not reflect what is
most relevant from a financial decision-maker’s
perspective,
Limitations of Ratio Analysis
32
Finance School of Management
The Financial Planning Process
? Financial Planning is a dynamic process following
a cycle of
– making plans,
– implementing them,and
– revising them in the light of actual results,
? Strategic plans
? Planning horizon
33
Finance School of Management
Steps of Financial Planning Process
? Forecasting the key external factors that determine the
demand for the firm’s products and its production costs,
? Forecasting the firm’s revenues,expenses,cash flows,
and estimating the implied need for external financing,
? Establishing performance targets,
? Measuring actual performance,correcting actions and
adjusting targets,
? Distributing the rewards and starting again the planning
cycle,
34
Finance School of Management
An Illustration,GPC
? Percent-of-sales method
– making a forecast of sales for the next year,
– assuming that most of the items on the income statement
and balance sheet will remain the same ratio to sales as
in the previous year,
Additional Financing Needed
＝ Change in Assets – Increase in Retained Earnings – Increase in Payables
35
Finance School of Management
GPC Financial Statements,2xx1-2xx3
2xx0 2xx1
Cash & mkt'ble secs 10.00 12.00
Receivables 40.00 48.00
Inventories 50.00 60.00
Pp&e 500.00 600.00
Assets 600.00 720.00
payables 30.00 36.00
Short-term debt 120.00 221.40
Long-term debt 150.00 150.00
liabilities 300.00 407.40
Shareholders’ equ 300.00 312.60
14.40
57.60
72.00
720.00
864.00
43.20
346.95
150.00
540.15
323.85
2xx2
17.28
69.12
86.40
864.00
1,036.80
51.84
501.72
150.00
703.56
333.24
2xx3 Balance Sheet
Sales revenues
Cost of goods sold
Gross margin
Gen sell,& admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
200.00
(110.00)
90.00
(30.00)
60.00
(30.00)
(12.00)
18.00
(5.40)
12.60
240.00
(132.00)
108.00
(36.00)
72.00
(45.21)
(10.72)
16.07
(4.82)
11.25
288.00
(158.40)
129.60
(43.20)
86.40
(64.04)
(8.94)
13.41
(4.02)
9.39
2xx1 2xx2 2xx3
36
Finance School of Management
GPC Common-Size Financial Statements,2xx1-2xx3
2xx1
Cash & mkt'ble secs 6.0
Receivables 24.0
Inventories 30.0
Pp&e 300.0
Assets 360.0%
payables 18.0
Short-term debt 110.7
Long-term debt 75.0
liabilities 203.7
Shareholders’ equ 156.3
2xx2 2xx3 Balance Sheet
Sales revenues
Cost of goods sold
Gross margin
Gen sell,& admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
100.0%
(55.0)
45.0
(15.0)
30.0
(15.0)
(6.0)
9.0
(2.7)
6.3
2xx1 2xx2 2xx3
100.0%
(55.0)
45.0
(15.0)
30.0
(18.8)
(4.5)
6.7
(2.0)
4.7
100.0%
(55.0)
45.0
(15.0)
30.0
(22.2)
(3.1)
4.7
(1.4)
3.3
6.0
24.0
30.0
300.0
360.0%
18.0
144.6
62.5
225.1
134.9
6.0
24.0
30.0
300.0
360.0%
18.0
174.2
52.1
244.3
115.7
37
Finance School of Management
GPC Forecast Financial Statements,2xx1-2xx3
2xx0 2xx1
Cash & mkt'ble secs 10.00 12.00
Receivables 40.00 48.00
Inventories 50.00 60.00
Pp&e 500.00 600.00
Assets 600.00 720.00
payables 30.00 36.00
Short-term debt 120.00 221.40
Long-term debt 150.00 150.00
liabilities 300.00 407.40
Shareholders’ equ 300.00 312.60
14.40
57.60
72.00
720.00
864.00
43.20
346.95
150.00
540.15
323.85
2xx2
17.28
69.12
86.40
864.00
1,036.80
51.84
501.72
150.00
703.56
333.24
2xx3 Balance Sheet
Sales revenues
Cost of goods sold
Gross margin
Gen sell,& admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
200.00
(110.00)
90.00
(30.00)
60.00
(30.00)
(12.00)
18.00
(5.40)
12.60
240.00
(132.00)
108.00
(36.00)
72.00
(45.21)
(10.72)
16.07
(4.82)
11.25
288.00
(158.40)
129.60
(43.20)
86.40
(64.04)
(8.94)
13.41
(4.02)
9.39
2xx1 2xx2 2xx3
20.74
82.94
103.68
1,036.80
1,244.16
62.21
691.81
150.00
904.02
340.14
2xx3
345.60
(190.08)
155.52
(51.84)
103.68
(87.26)
(6.57)
9.85
(2.96)
6.90
2xx4e
38
Finance School of Management
Sustainable Growth Rate
? Assumptions,
– The firm will not issue any new equity shares,so that growth in
equity capital occurs only through the retention of earnings,
– The firm will not increase its ratio of debt to equity,so that
external debt financing will grow at the same rate as equity grows
through retained earnings,
Sustainable Growth Rate = Earings Retention Rate × ROE
? Implications,
– The maximum sustainable growth rate is equal to the firm’s ROE,
– If a firm tries to grow faster than this rate,it will have to issue new
shares and/or increase its debt,
39
Finance School of Management
An Illustration,Rapid Industries
2xx0 2xx1
Assets $2,000,000
Debt 1,000,000
Equity 1,000,000
2xx2 2xx3 Balance Sheet
Sales
Net income
Dividends
Chg retained earn
&1,000,000
200,000
80,000
120,000
2xx1 2xx2 2xx3
&1,120,000
224,000
89,600
134,400
&1,254,400
250,880
100,352
150,528
$2,240,000
1,120,000
1,120,000
$2,508,800
1,254,400
1,254,400
$2,809,856
1,404,928
1,404,928
? Asset Turnover = 0.5 Times per Year
? Debt/Equity Ratio = 1.0
? Dividend Payout Ratio = 0.4
? ROE = 20% per Year
40
Finance School of Management
? In most cases cash must be paid out to cover expenses before
any cash is collected from the sale of the firm’s products,
– If a firm’s need for working capital is permanent rather than seasonal,
it usually seeks long-term financing for it,
– Seasonal financing needs are met through short-term financing
arrangements,
? The main principle of efficient working capital management
– To minimize the amount of the firm’s investment in nonearning assets
such as receivables and inventories,
– To maximize the use of,free” credit such as prepayments by
customers,accrued wages,and accounts payable,
Working Capital Management
41
Finance School of Management
The Cash Flow Cycle
Time
Ordered Arrives Finished Goods Sold Cash Received
Invoice Received Cash Paid
Payables Period
Inventory Period Receivables Period
Raw
Material
Purchased
Cash Cycle Time
? A firm can reduce its need for working capital by,
– reducing the amount of time that goods are held in inventory,
– collecting accounts receivable more quickly,
– paying its own bills more slowly,
