Financial Statements, Taxes and Cash Flow

1
Chapter
2
Intro to Financial Statements Analysis
2
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 firms cash flow from its
  financial statements

3
Key Concepts and Skills

• Know how to standardize financial statements for
  comparison purposes
• Know how to compute and interpret important
  financial ratios
• Know the determinants of a firms profitability
  and growth
• Understand the problems and pitfalls in financial
  statement analysis

4
Chapter Outline

• The Balance Sheet
• The Income Statement
• Taxes
• Cash Flow

5
Balance Sheet

• The balance sheet is a snapshot of the firms
  assets and liabilities at a given point in time
• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
• Assets Liabilities Stockholders Equity

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Balance Sheet

• Assets Liabilities Owners
  Equity

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Market 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?

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Income Statement
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Income Statement

• The income statement is more like a video of the
  firms operations for a specified period of time.
• You generally report revenues first and then
  deduct any expenses for the period
• Matching principle GAAP say to show revenue
  when it accrues and match the expenses required
  to generate the revenue

10
Ratio Analysis

• Ratios also 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 is that
  information important
• Ratios are used both internally and externally

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Standardized Financial Statements

• Common-Size Balance Sheet
• Compute all accts as of Tot. Assets
• Common-Size Income Statements
• Compute all accts as of Sales
• Standardized stmts make it easier to compare
  financial info, particularly as firm grows
• Also useful for comparing co.s of different
  sizes, particularly in same industry

12
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

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Sample Balance Sheet
Cash 6,489 A/P 340,220
A/R 1,052,606 N/P 86,631
Inventory 295,255 Other CL 1,098,602
Other CA 199,375 Total CL 1,525,453
Total CA 1,553,725 LT Debt 871,851
Net FA 2,535,072 C/E 1,691,493
Total Assets 4,088,797 Total Liab. Equity 4,088,797
Numbers in thousands
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Sample Income Statement
Revenues 3,991,997
Cost of Goods Sold 1,738,125
Gross Profit 2,253,872
Expenses 1,269,479
Depreciation 308,355
EBIT 739,987
Interest Expense 42,013
Taxable Income 697,974
Taxes 272,210
Net Income 425,764
Shs outstanding 205,838.594
EPS 2.17
Dividends per share 0.86
Numbers in thousands, except EPS DPS
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Computing Liquidity Ratios

• Current Ratio CA / CL
• 
  1.02 times
• Quick Ratio (CA Inventory) / CL
• 
  .825 times
• Cash Ratio Cash / CL
• 
  .004 times
• Net Working Capital CA-CL
• 
  

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Long-term Solvency Measures

• Total Debt Ratio (TA TE) / TA
• 
  .5863 times or 58.63
• The firm finances almost 59 of their assets with
  debt.
• Debt/Equity TD / TE
• 
  1.417 times
• Equity Multiplier TA / TE 1 D/E
• 
  2.417

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Computing Coverage Ratios

• Times Interest Earned EBIT / Interest
• 
  17.6 times
• Cash Coverage (EBIT Depreciation) / Interest
• 
  24.95 times

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ASSET MGMT RATIOSComputing Inventory Ratios

• Inventory Turnover Sales / Inventory
• 
  13.52 times
  
• Days Sales in Inventory 365 / Inventory
  Turnover
• 
  27 days

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Computing Receivables Ratios

• Receivables Turnover Sales / Accounts
  Receivable
• 
  3.79 times
• Days Sales in Receivables 365 / Receivables
  Turnover
• 
  96 days

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Computing Total Asset Turnover

• Total Asset Turnover Sales / Total Assets
• 
  .98 times
• Measure of asset use efficiency
• Not unusual for TAT lt 1, especially if a firm has
  a large amount of fixed assets

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Computing Profitability Measures

• Profit Margin Net Income / Sales
• 
  .1067 times or 10.67
• Return on Assets (ROA) Net Income / Total
  Assets
• 
  .1041 times or 10.41
• Return on Equity (ROE) Net Income / Total
  Equity
• 
  .2517 times or 25.17

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Computing Market Value Measures

• Market Price 61.625 per share
• Shares outstanding 205,838,594
• PE Ratio Price per share / Earnings per share
• 
  28.4 times
• Market-to-book ratio market value per share /
  book value per share
• 
  7.5 times

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Market Value Measures

• Value Stocks Firms w/ low Mrkt to Book ratios
• Growth Stocks Firms w/ high Mrkt to Book ratios
• Market Capitalization Mrkt Value of Common
  Equity
• Enterprise Value MV equity MV debt Cash
  mrktbl securities. Measures value of firms
  underlying business

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Using the Du Pont Identity

• ROE PM TAT EM
• Profit margin is a measure of the firms
  operating efficiency how well does it control
  costs
• Total asset turnover is a measure of the firms
  asset use efficiency how well does it manage
  its assets
• Equity multiplier is a measure of the firms
  financial leverage

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Payout and Retention Ratios

• Dividend payout ratio Cash dividends / Net
  income
• 
  .3963 or 39.63
• Retention ratio Additions to retained earnings
  / Net income 1 payout ratio
• 
  .6037 60.37
• Or
  .6037 60.37

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The Internal Growth Rate

• The internal growth rate tells us how much the
  firm can grow assets using retained earnings as
  the only source of financing.

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The Sustainable Growth Rate

• The sustainable growth rate tells us how much the
  firm can grow by using internally generated funds
  and issuing debt to maintain a constant debt
  ratio.

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Determinants of Growth

• Profit margin operating efficiency
• Total asset turnover asset use efficiency
• Financial leverage choice of optimal debt ratio
• Dividend policy choice of how much to pay to
  shareholders versus reinvesting in the firm

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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

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Benchmarking

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

31
Quick Quiz

• 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 the major determinants of a firms
  growth potential?
• What are some of the problems associated with
  financial statement analysis?

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Taxes

• The one thing we can rely on with taxes is that
  they are always changing
• Marginal vs. average tax rates
• Marginal the percentage paid on the next dollar
  earned
• Average the tax bill / taxable income
• Other taxes

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Example Marginal Vs. Average Rates

• Suppose your firm earns 4 million in taxable
  income.
• What is the firms tax liability?
• What is the average tax rate?
• What is the marginal tax rate?
• If you are considering a project that will
  increase the firms taxable income by 1 million,
  what tax rate should you use in your analysis?

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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

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Cash Flow Problem 2-19

• Belyk Paving has sales of 2,000,000. COGS, SGA,
  and depreciation expenses were 1,200,000,
  300,000, 400,000 respectively. It also had
  interest expense of 150,000, a 35 tax rate.
  Ignore any tax loss carry back or forward
  provisions,
• What is the Net Income?
• What is the Operating Cash Flow?

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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 firms cash flows? What
  are the equations and where do we find the
  information?