Transcript Financial Statement Analysis and Security Valuation

Financial Statement Analysis
and Security Valuation
Stephen H. Penman
Prepared by
Peter D. Easton and Gregory A. Sommers
Fisher College of Business
The Ohio State University
With contributions by
Stephen H. Penman – Columbia University
Luis Palencia – University of Navarra, IESE Business School
McGraw-Hill/Irwin
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Part II
The Analysis of
Financial Statements
McGraw-Hill/Irwin
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Part II
Page 208
Chapter 7
Layout of
Part II
The business activities
- Financing
- Investing
- Operating
and the financial statements
Chapter 8
The Statement of
Stockholders’ Equity
Chapter 11
Operating assets/liabilities
Financing assets/liabilities
Chapter 9
Operating income/expense
The Balance Sheet
and Income Statement
Financing income/expense
Chapter 10
The Analysis of
Profitability
Chapter 12
The Analysis of
Growth and
Sustainable Earnings
The Statement of
Cash Flows
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Business Activities and
Financial Statements
Chapter 7
McGraw-Hill/Irwin
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What You Will Learn in This Chapter
Chapter 7
Page 211
• How businesses are organized to generate value for shareholders
• The difference between operating and financing aspects of a business
• How business activities are reported in financial statements
• How financial statements are organized to highlight value added
• How business activities articulate and how financial statements
articulate
• The four cash flows of a business and how they relate to each other
• Why free cash flow does not affect value added
• How accrual accounting captures value added
• A set of accounting relations that summarize how business activities
drive financial statements
• A template for how we will reformulate and articulate
the financial statements
McGraw-Hill/Irwin
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Business Activities:
All the Stocks & Flows
Product and
Input Markets
The Firm
Capital
Markets
Customers
Debt Holders
or Issuers
Suppliers
Share
Holders
• Ch.1 - Firm has 3 activities
– Financing
– Operating
– Investing
• Ch. 2 - Financial Statements record
– Stocks
– Flows
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Cash Flows Between the Firm and
Claimants in the Capital Market
Chapter 7
Page 212
Figure 7.1
Capital
Markets
The Firm
F
Net
Financial
Assets
d
(NFA)
Debt Holders
or Issuers
Share
Holders
Financing Activities
• F is net cash flow to debt holders (or issuers)
• d is net dividend to shareholders
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Chapter 7
Page 214
Figure 7.2
Business Activities:
ALL THE CASH FLOWS
Capital
Markets
The Firm
Net
Operating
Assets
C
I
(NOA)
Operating Activities
Net
Financial
Assets
(NFO)
(NFA)
Debt Holders
or Issuers
d
Share
Holders
Financing Activities
•
I is net cash invested in operating assets
•
C is net cash (flow) from operations
•
C-I is “free cash flow”
•
If NFA are negative, they are Net Financial Obligations (NFO)
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F
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The Cash Conservation Equation
A fundamental accounting identity:
CI d F
Chapter 7
Pages 213-215
CCE
•
•
•
•
C = Net cash from operations
I = Net cash outflow for investing (purchases, divestments)
C - I = Free cash flow
d = Net dividends to shareholders (including common dividends, stock
issues...)
• F = Net cash outflow for debt financing (principal + interest)
The treasurer’s rule:
– If C - I - i > d : lend or buy down own debt
– If C - I - i < d : borrow or reduce lending
i is net interest paid
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Financial Activities:
Stocks & Flows
The cash flows flow into/out of the financial assets: their change must
be explained by the four flows components of the equation.
For Financial Assets (FA)
FA t  FA t 1  C t  I t   i t  d t
For financial obligations (FO)
FO t  FO t 1  C t  I t   i t  d t
(it is interest paid)
For given interest payments and net dividends, cash flow from
operations (C) reduces borrowing and cash investment (I) increases it
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Reformulated Statement
of Cash Flows
Chapter 7
Page 215
Cash flows from operations
Cash investment in operations
Free cash flow from operations
Equity financing flows:
Dividends and share repurchases
Share issues
C
(I)
C-I
XX
(XX)
d
Debt financing flows:
Net purchase of financial assets
Interest on financial assets
Net issue of debt
Interest on debt
XX
(XX)
(XX)
XX
F
Total financing flows
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d+F
7-11
Chapter 7
Page 214
Figure 7.2
Business Activities:
ALL THE CASH FLOWS
Capital
Markets
The Firm
Net
Operating
Assets
C
I
(NOA)
Operating Activities
Net
Financial
Assets
(NFO)
(NFA)
Debt Holders
or Issuers
d
Share
Holders
Financing Activities
•
I is net cash invested in operating assets
•
C is net cash (flow) from operations
•
C-I is “free cash flow”
•
If NFA are negative, they are Net Financial Obligations (NFO)
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F
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Chapter 7
Page 216
Balance Sheet
Assets
Operating assets
Financial assets
Total Assets
OA
FA
OA + FA
Equities
Operating liabilities
Financial obligations
Common stockholders’ equity
Total Equities
OL
FO
CSE
OL + FO + CSE
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Chapter 7
Page 216
Balance Sheet Reformulated
Operating Assets
Operating assets
Operating liabilities
Net operating assets
OA
(OL)
NOA
Financial Obligations & Owners’ Equity
Financial liabilities
Financial assets
Net financial obligations
Common equity
Total NFO & Equity
NOA
NFA
CSE
CSE
FO
(FA)
NFO
CSE
NFO + CSE
= OA - OL
= FA - FO
= NOA + NFA (Usually NFA is negative: NFO)
= NOA - NFO
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Chapter 7
Page 218
Figure 7.3
Business Activities:
All the Stocks & Flows
Product and
Input Markets
Customers
Suppliers
Capital
Markets
The Firm
OR
OE
Net
Operating
Assets
(NOA)
OR - OE = OI
OI - DNOA =
Operating Activities
• OR is operating revenue
• OE is operating expense
• NFI is net financial income
McGraw-Hill/Irwin
C
I
Net
Financial
Assets
(NFA)
C-I
C - I = D NFA - NFI
+
F
Debt Holders
or Issuers
d
Share
Holders
d
Financing Activities
• D indicates change
• NFA can be negative (NFO)
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Chapter 7
Page 218
Figure 7.3
Business Activities:
All the Stocks & Flows
Product and
Input Markets
Customers
Suppliers
Capital
Markets
The Firm
OR
OE
Net
Operating
Assets
(NOA)
OR - OE = OI
OI - DNOA =
Operating Activities
• OR is operating revenue
• OE is operating expense
• NFI is net financial income
McGraw-Hill/Irwin
C
I
Net
Financial
Assets
(NFA)
C-I
C - I - D NFA + NFI
=
F
Debt Holders
or Issuers
d
Share
Holders
d
Financing Activities
• D indicates change
• NFA can be negative (NFO)
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Chapter 7
Page 218
Figure 7.3
Business Activities:
All the Stocks & Flows
Product and
Input Markets
Customers
Suppliers
Capital
Markets
The Firm
OR
OE
Net
Operating
Assets
(NOA)
OR - OE = OI
OI - DNOA =
C
I
Net
Financial
Obligat’ns
(NFO)
C-I
C - I + D NFO - NFE
=
F
Debt Holders
or Issuers
d
Share
Holders
d
Operating Activities
Financing Activities
• OR is operating revenue
• OE is operating expense
• NFE is net financial expense
• D indicates change
• NFA can be negative (NFO)
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Chapter 7
Page 217
Income Statement
The difference between operating revenue and operating
expense is called operating income:
OI = OR - OE
Income Statement
Operating income
Operating revenue
Operating expense
Net financing expense
Interest expense
Interest revenue
Comprehensive income
OR
(OE)
XX
(XX)
OI
(NFE)
Earnings
Net financing expense can be negative (net financial income)
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Business Activities and the
Financial Statements
Chapter 7
Summary
INCOME
STATEMENT
earnt = OIt - NFEt
BALANCE
SHEET
Net Operating Assets
Net Financial Obligations
NOAt = NOAt-1 + OIt - (Ct - It)
NFOt = NFOt-1 - (Ct - It) + NFEt + dt
CSEt = CSEt-1 + OIt - NFEt - dt
CASH FLOW
STATEMENT
Ct - It = dt + Ft
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Stocks & Flows:
Operating Activities
Chapter 7
Pages 220-221
• The change in NFO is given by
NFO t  NFO t 1  C t  I t   NFE t  d t
• The change in NOA is given by
NOA t  NOA t 1  OI t  C t  I t 
• Operating income in the income statement flows to net operating assets
in the balance sheet.
• Free cash flow reduces NOA and reduces NFO (increases NFA). Free
cash flow can be seen as a dividend paid from operating to financial
activities
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Tying it Together:
What Generates Value?
Chapter 7
Page 222
• From the balance sheet equation
CSE t NOAt NFOt
• By the way NOA and NFO are calculated,
CSEt  NOAt 1  OI t  Ct  I t   NFOt-1  Ct  I t   NFEt  d t
 NOAt 1  NFOt-1  OI t  NFEt  d t
 CSEt 1  earnt  d t
which is the stocks and flows equation.
• For this to be true, however, accounting must be
Clean Surplus.
• Free cash flow drops out in the previous equation:
Free cash flow (C - I) does not add value to shareholders.
• What generates value is the profit from operating and
financing activities.
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Value Added and Accrual Accounting
Chapter 7
Page 223
OI and NFE are accounting measures and so are determined
by accounting principles
NI = (C - I) + i + I + new accruals
OI = (C - I) + I + new operating accruals
= C + new operating accruals
NFE = i + new financing accruals
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Accruals and the Balance Sheet
Chapter 7
Page 223
NOAt = NOAt-1 + It + new operating accrualst
NFOt = NFOt-1 - (Ct - It) + it + new financial accrualst + dt
and
CSEt = CSEt-1 + DNOAt - DNFOt
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Stocks & Flows Ratios:
Business Profitability
Chapter 7
Page 224
Separating operating and financing activities in the Income Statement
identifies profit flows
Comparison of these flows with their asset base yields the corresponding
rates of return:
Return on Net Operating Assets
 NOA
RNOA t  OI t
1
2
t
 NOA t 1 
t
 NFA t 1 
Return on Net Financial Assets
RNFA t  NFI t
 NFA
1
2
If there are NFO rather than NFA, net borrowing cost
NBC t  NFE t
 NFO
1
2
t
 NFOt 1 
Forecasting ROCE (at the heart of the valuation model) involves both the
forecast of RNOA and RNFA (or NBC)
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