MBA 643 Managerial Finance Lecture 3: Financial Statements, Taxes, and Ratios

Spring 2006 Jim Hsieh

Why Do We Care About This Topic?

Financial managers need to know how much cash flow is generated by assets and need accurate forecasts of other accounting figures (e.g., sales) to make accurate investment and financing decisions Investment bankers and deal makers need to know how much to bid for a company in a takeover Investors and creditors need to know how much earnings or cash is generated from assets and from operations to determine the financial solvency of a company

Factors that Affect Stock Price

The general concept of valuation
Value of asset (price) = the discounted value of all relevant future cash flows

P=tCFt(1+r)-t
Projected cash flows to stockholders Timing of the cash flow stream Risk of the cash flows
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Three Major Financial Statements (1). The Balance Sheet

Definition: A balance sheet shows the resources of a firm (assets) and the claims on those resources (liabilities and shareholders equity) at a particular point in time. It measures a firms financial position. Book Value versus Market Value of the Firm
Current Assets
Cash & Marketable Securities Receivables Inventories

Liabilities
Payables Accruals ST and LT debt

Fixed Assets
Tangible Intangible 4

Shareholders Equity

Three Major Financial Statements (2). The Income Statement

Definition: An income statement shows the revenues, expenses, and net income of a firm over a period of time. It measures a firms operating performance. Example 1: Procter & Gamble (for fiscal year ended June 30, 2002)
Revenues Less: COGS Less: Administrative & other expenses EBITDA Less: Depreciation & Amortization EBIT (Operating Income) Less: Interest expense Less (Add): Other non-operating expense (income) EBT (Taxable Income) Less: Income Taxes Net Income $40,238 20,989 10,878 $8,371 1,693 $6,678 603 (308) $6,383 2,031 $4,352

Three Major Financial Statements (2). The Income Statement

NOPAT (Net Operating Profit After Tax): The profit the firm would have had if it had no debt and no nonoperating income/expenses. NOPAT = EBIT*(1-Tax rate) Example 2: How much is P&Gs NOPAT in 2002?
Tax rate = 2,031/6,383 = 0.3182 NOPAT = 6,678*(1-0.3182) = 4,553

Three Major Financial Statements (3). The Statement of Cash Flows

Definition: A statement of cash flows shows a firms net cash flow (receipts minus payments) from three of the principal business activities (operating, investing, and financing) over a period of time.

Change in cash flows = cash inflows cash outflows

Free Cash Flows (FCF)

Definition: Free cash flow is the cash available for distribution to all investors (bondholders and stockholders) after the firm has made all of the investments. Formulae to calculate FCF:
FCF = NOPAT Net Investment (Change) in Operating Capital Net Investment in Operating Capital = Operating capital in this year operating capital in the previous year Operating Capital = Working capital + Net fixed assets = (Current Assets Current Liabilities) + NFA = [(Cash + Marketable securities + Accounts receivable + Inventories) (Accounts payable + Accruals)] + NFA
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Free Cash Flows (contd)

Example 3: What is P&Gs FCF in 2002? Step 1: Calculate operating capital in 2002 and 2001. OC2002 = (12,166-12,704) + 13,349 = 12,811 OC2001 = (10,889-9,846)+13,095 = 14,138 Step 2: Calculate net investment in operating capital. NIOC2002 = 12,811 14,138 = -1,327 Step 3: Calculate FCF. FCF2002 = NOPAT NIOC = 4,553 (-1,327) = 5,880
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How to Use Financial Ratios?

Choose the right benchmarks
Time trend comparison Peer group comparison

Understand the limitations of financial ratios

Different firms use different accounting procedures
Window dressing issues

Seasonal and non-current items/events may distort financial performance No underlying theory helps us to establish benchmarks It is difficult to evaluate conglomerates from the consolidated financial statements GAAP is not applicable to all international companies
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Five Major Groups of Financial Ratios

(1). Short-term Liquidity (Solvency) Measures Current ratio = Current assets/Current liabilities Quick (or Acid-test) ratio = (Current assets-Inventory)/Current liabilities

For P&G: Current ratio = 12,166/12,704 = 0.96 (Industry avg.=1.06) Quick ratio = 0.69 (0.57)

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Five Major Groups of Financial Ratios

(2). Long-term Liquidity Measures Total debt ratio = (Total assets-Total equity)/Total assets Debt-equity ratio = Total debt/Total equity Long-term debt ratio = (LT debt)/(LT debt+Total equity) Times interest earned ratio = EBIT/Interest Cash coverage ratio = (EBIT+Depreciation)/Interest Total debt ratio = 27,070/40,776 = 0.66 Debt-equity ratio = 1.98 (2.04) LT debt ratio = 0.45 Time interest earned ratio = 11.08 Cash coverage ratio = 13.88

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Five Major Groups of Financial Ratios

(3). Asset Management (Turnover) Measures Inventory turnover ratio = Sales/Inventories Days sales outstanding = Receivables/(Avg sales per day) = Receivables/(Annual sales/360)
Average collection period

Fixed assets turnover ratio = Sales/Net fixed assets Total assets turnover ratio = Sales/Total assets Inventory turnover ratio = 40,238/3,456 = 11.64 (5.32) Days sales outstanding = 3,090/(40,238/360) = 27.65 (10.48) Fixed assets turnover ratio = 3.01 Total assets turnover ratio = 0.99 (1.27)
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Five Major Groups of Financial Ratios

(4). Profitability Measures

Profit margin = Net income/Sales Return on assets = Net income/Total assets Return on equity = Net income/total equity Profit margin = 4,352/40,238 = 0.11 (0.10) Return on assets = 0.11 (0.11) Return on equity = 0.32 (0.34)

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Five Major Groups of Financial Ratios

(5). Market Value Measures
EPS = Net income/Total shares outstanding PE ratio = Price per share/Earnings per share Market-to-book ratio = Price per share/Book value per share Price-to-cash flow ratio = Price per share/Cash flow per share = Price per share/[(Net income + Depreciation & Amortization)/Total shares outstanding] EPS = 4,352/1,300.8 = 3.35 PE ratio = 90.03/3.346 = 26.91 (28.93) Market-to-book ratio = 90.03/(13,706/1,300.8) = 8.55 (9.36) Price-to-cash flow ratio = 90.03/[(4,352+1,693)/1,300.8] = 19.37 (22.22)

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Put Some Ratios Together -- The Du Pont System

ROE = Net income/Total equity = (Net income/Total assets)*(Total assets/Total equity) = ROA*Equity multiplier = (Net income/Sales)*(Sales/Total assets)*(Total assets/Total equity) =(Profit margin)*(Total assets turnover)*(Equity multiplier) ROE = 0.32 = (0.108)*(0.987)*(2.975)

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Market Value Added (MVA)

Definition: MVA is the market value of equity beyond the book value of equity. It measures the effects of managerial actions since the very inception of the firm. MVA = Market value of equity Book value of equity Example 4: What is P&Gs MVA in 2002? P&Gs stock price was $90.03 on July 1st, 2002.

MVA = MV(E)-BV(E) = $90.03*1,300.8 13,706 = 103,405

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Economic Value Added (EVA)

Definition: EVA is the value added to shareholders by management, recognizing the implicit cost of capital of funds used by the firm. It measures the effects of managerial actions during a given year. EVA = NOPAT (Operating capital)*(%Cost of capital) Example 5: What is P&Gs EVA in 2002? P&Gs cost of capital was 10% in 2002. EVA = 4,553 12,811*0.1 = 3,271.9
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Taxes
Two different types of tax rate:
Marginal tax rate versus Average tax rate

Taxes have a major impact on financial decisions

Taxes and cash flows can be changed by the use of debt

Example 6: If you were both debt and equity holders, which firm would generate more cash flows for you? (Assume NI=CF)
Firm A Firm B

EBIT 100 Interest 40 Pretax income 60 Tax (35%) 21 NI 39 Net cash flow 79

100 0 100 35 65 65
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