Transcript FINANCE 7311 - University of Arkansas at Little Rock

FINANCE 7311
Review & Financial
Statement Analysis
Dr. Ashvin Vibhakar
Fall 2000
Outline
 Review
of Basic Finance
 The Corporation
 The Accounting Model
 Cash Flows
 Financial Statement Analysis
Review of Basic Finance
Efficient
Markets
Rates of Return
Time Value of Money
Bond Valuation
Stock Valuation
EFFICIENT MARKETS

Markets are in equilibrium
 Expected Returns = Required returns
 Expectations are rational
 Information is reflected in price
– Information
– Reflected in Price

No Arbitrage
EFFICIENT MARKETS
Why do we care whether or not markets
are efficient?
 Prices
direct economic activity
 Rates of return (cost of capital)
 Valuation (market multiples)
RATES OF RETURN

REQUIRED RETURN
– required by investor
– depends on RISK

EXPECTED RETURN
– given current price & expected future CF’s

REALIZED RETURN
– actual return
RISK

Represents the CHANCE that ACTUAL
returns turn out to be much different
than EXPECTED

Statistically:
Variance
Standard Deviation
TIME VALUE OF MONEY

SINGLE CASH FLOWS
Vn = Vo x (1 + R)n
FV = PV x (1 + R)n
PV = FV x (1 + R)-n

MULTIPLE CASH FLOWS
PERPETUITY

PV = CF / R

TIME VALUE OF $, cont.
ANNUITY
PV = CF X [1/ R (1 - 1/(1 + R)n ]
Calculator:
PV - present value
FV - future value
CF - periodic payment amount
R - discount rate
N - number of CF’s or periods
Ordinary - end of period
Due - beginning of period
BOND VALUATION
CF = coupon rate x par ÷ 2 (semi-ann.)
N = number of semi-annual periods
FV = par amount of bond
R = investor’s required rate of return
PV = price of bond
Solving for R ===> Yield to Maturity
STOCK VALUATION

Present value of future dividends
 Assumption about Time Path
 More Generally, CF
1) No Growth --> Perpetuity
Vt = CFt+1/R
2) Constant Growth --> Gordon Model
Vt = CFt+1 / (R - g)
THE CORPORATION

REAL ASSETS ----> CASH FLOWS

CLAIMANTS ---->
- EMPLOYEES/CREDITORS
- BONDHOLDERS
- STOCKHOLDERS

MANAGEMENT TEAM
A Picture of the Corporation
Real Assets & Financial Assets
Financing
Investment
CF’s
ASSETS
Bondholders
Shareholders
Business Risk
Financial Risk
3rd Parties
Govt; other
MANAGEMENT

OBJECTIVE: ALLOCATE COPORATE
RESOURCES IN A WAY WHICH:
- Maximizes the value of the firm
- Maximizes current share price

AGENCY PROBLEM
- Management makes decisions which are
inconsistent with the above
MANAGEMENT DECISIONS

INVESTMENT DECISION --> What
should be in the circle
1) Short-term assets --> Working capital
-
inventory policy
A/R and A/P policy
nature and amount of S-T financing
2) L-T Assets --> Capital Budgeting
-
Which assets add most VALUE to the firm?
Mgmt Decisions, cont.

FINANCING DECISION
-
How Should Assets Be Financed?
What is the Proper Mix of Debt and Equity?

How much debt should a company have?
-
Risk
Taxes
Costs of financial distress
Over / Under Investment Problem
-
BUSINESS RISK
Assets are the SOURCE of BUSINESS
RISK

DEMAND & SUPPLY VARIABILITY
 COMPETITION (ease of entry)
 TECHNOLOGY
 REGULATION
 MGMT DEPTH & BREADTH
 OPERATING LEVERAGE
THE ACCOUNTING MODEL

CONFORMS TO PICTURE:
NWC
L-T ASSETS

LHS = CIRCLE

RHS = RECTANGLES
DEBT
EQUITY
Debt

Interest Bearing - ‘Permanent’ Capital
Reclassify S-T portion of notes payable

Lines of Credit
Include as part of NWC
ACCOUNTING PRINCIPLES

COST PRINCIPLE:



ONLY TRANSACTIONS RECORDED
COST ≠ MARKET IN GENERAL
MATCHING PRINCIPLE


PERFORMANCE MEASUREMENT
ACCRUAL V. CASH BASIS ACCTG.
FINANCIAL STATEMENTS

BALANCE SHEET
- Assets & Liab. as of a point in time

INCOME STATEMENT
- Period of time
- Include effect of accruals
- Not the same as Cash Flow. Why?
BALANCE SHEET

ASSETS -> something owned
- Listed in order of liquidity
- NWC & Long-term

Liability -> something owed
- listed in order of Claim Priority

Retained Earnings -> owned - owed
- Cum. Earnings not paid as dividends
INCOME STATEMENT
GENERAL FORMAT





SALES
- COS
GROSS PROFIT
- OPERATING EXPENSES
EBIT (OPERATING PROFIT)
– EARNINGS W/O REGARD TO DEBT & TAX SITUATION
Income Statement, cont.

EBIT
 - INTEREST
 EBT (TAXABLE INCOME)
 - Taxes
 NET INCOME
NET INCOME ≠ CASH FLOW
 WHY?

Cash Flow v. Net Income

Non-Cash Expenses
 Depreciation
 Amortization
 Write-offs

Accruals
 Timing Differences
CASH FLOW

ASSETS = DEBT + EQUITY

CF FROM ASSETS = CF’S TO D + E

USES:
- CF’S CONSISTENT W/ PICTURE
- SOURCES / USES OF CASH
- VALUATION (PROJECTED CF’S)
CF’S FROM ASSETS

Operating Cash Flow
EBIT
+ DEPRECIATION (NON-CASH ITEMS)
- TAXES
- ∆NWC
 - CAPITAL SPENDING

CF’S TO B/H & S/H

CF’S TO B/H:
INTEREST
– NET CHANGE IN DEBT

CF’S TO S/H:
DIVIDENDS
- NET CHANGE IN COMMON STOCK
Taxes and Cash Flow
Historical - Analyzing company’s CF
Use Tax number from Income Stmt
Projections - Free Cash Flow for
valuation purposes
Use Tax Rate x EBIT
RATIO ANALYSIS

FINANCIAL COMPARISON TOOL
 RAW FINANCIAL STATEMENTS
- SIZE DIFFERENCES
- DOLLAR AMOUNTS SAY LITTLE

KEY: COMPARABILITY
 DEFINITIONS DIFFER
BENCHMARKS

Historical Ratios of Company
- Trend Analysis
- Assumes: Continuation of past

Other Companies / Industry
- RMA, S&P, Hoover
- Industry Publications

Projections (Forecasts)
COMMON SIZE F/S

BALANCE SHEET
EXPRESS EACH ITEM AS % OF ASSETS

INCOME STATEMENT
EXPRESS EACH ITEM AS % OF SALES

COMMON BASE
EXPRESS EACH ITEM AS % OF BASE YEAR
(GROWTH RATE)
RATIO GROUPS

LIQUIDITY
 ACTIVITY
 LEVERAGE
 PROFITABILITY
 MARKET
LIQUIDITY
Ability to meet current Obligations
Of Interest to Short-term Creditors

CURRENT RATIO
 QUICK RATIO
ACTIVITY RATIOS
Measures Effective Asset Use
Of Interest to management & investors

ASSET TURNOVER
 INVENTORY TURNOVER
 DAYS SALES IN INVENTORY
 DAYS SALES OUTSTANDING
LEVERAGE RATIOS
USE OF DEBT FINANCING
Ability to meet debt payments
Important to long-term creditors

DEBT RATIO
 TIMES INTEREST EARNED
 DAYS PAYABLE O/S
PROFITABILITY RATIOS
COMBINED USE OF DEBT & ASSETS
IMPORTANT TO MGMT & INVESTORS

PROFIT MARGIN
 GROSS MARGIN
 OPERATING MARGIN
 RETURN ON ASSETS (ROA)
 RETURN ON EQUITY (ROE)
DUPONT & ROIC

DUPONT DECOMPOSITION OF ROE
Profitability X Asset Turnover X Leverage

ROIC
EBIT X (1 - T) / (EQUITY + DEBT)


NOT AFFECTED BY LEVERAGE
COMPARE WITH WACC
MARKET RATIOS

P/E RATIO
What investors are willing to pay for a $ of
earnings (Current / Forecast)
What creates a high P/E?

MARKET/BOOK
Usually much different than 1.
EX: S&P 500 CURRENTLY = 6.4 WHY?
LIMITATIONS
NO THEORY TO DEFINE ‘GOOD’
 #’S HISTORICAL; NOT ECONOMIC
 MOST AS OF SINGLE POINT IN TIME

– SEASONAL OPERATIONS
– ONE-TIME EFFECTS

DESIGNED FOR MANUFACTURERS
ECONOMIC V. ACCTG.
EARNINGS

UNREALIZED GAINS & LOSSES
 COST OF EQUITY
‘HIGH’ CORPORATE PROFITS
EVA - attempts to account for cost of equity