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Financial Statement Analysis and Security Valuation Stephen H. Penman

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

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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  1. Financial Statement Analysisand Security ValuationStephen 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

  2. Part II The Analysis of Financial Statements

  3. Layout of Part II Part II Page 208 Chapter 8 The Statement of Stockholders’ Equity Operating assets/liabilities Financing assets/liabilities Chapter 9 The Balance Sheet and Income Statement Operating income/expense Financing income/expense Chapter 12 The Analysis of Growth and Sustainable Earnings Chapter 10 The Statement of Cash Flows Chapter 7 The business activities - Financing - Investing - Operating and the financial statements Chapter 11 The Analysis of Profitability

  4. Business Activities and Financial Statements Chapter 7

  5. 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

  6. Business Activities:All the Stocks & Flows Product and Input Markets Customers Suppliers Capital Markets The Firm • Ch.1 - Firm has 3 activities • Financing • Operating • Investing • Ch. 2 - Financial Statements record • Stocks • Flows Debt Holders or Issuers Share Holders

  7. Cash Flows Between the Firm and Claimants in the Capital Market Chapter 7 Page 212 Figure 7.1 F d Capital Markets The Firm Debt Holders or Issuers Net Financial Assets (NFA) Share Holders Financing Activities • F is net cash flow to debt holders (or issuers) • d is net dividend to shareholders

  8. Business Activities:ALL THE CASH FLOWS Chapter 7 Page 214 Figure 7.2 C I (NFO) Capital Markets The Firm • C is net cash (flow) from operations F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) d Share Holders Operating Activities Financing Activities • I is net cash invested in operating assets • C-I is “free cash flow” • If NFA are negative, they are Net Financial Obligations (NFO)

  9. The Cash Conservation Equation Chapter 7 Pages 213-215 A fundamental accounting identity: • 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

  10. 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) For financial obligations (FO) (it is interest paid) For given interest payments and net dividends, cash flow from operations (C) reduces borrowing and cash investment (I) increases it

  11. Reformulated Statementof Cash Flows Chapter 7 Page 215 Cash flows from operations C Cash investment in operations (I) Free cash flow from operations C - I Equity financing flows: Dividends and share repurchases XX Share issues (XX) d Debt financing flows: Net purchase of financial assets XX Interest on financial assets (XX) Net issue of debt (XX) Interest on debt XX F Total financing flows d + F

  12. Business Activities:ALL THE CASH FLOWS Chapter 7 Page 214 Figure 7.2 C I (NFO) Capital Markets The Firm • C is net cash (flow) from operations F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) d Share Holders Operating Activities Financing Activities • I is net cash invested in operating assets • C-I is “free cash flow” • If NFA are negative, they are Net Financial Obligations (NFO)

  13. Balance Sheet Chapter 7 Page 216 Assets Operating assets OA Financial assets FA Total Assets OA + FA Equities Operating liabilities OL Financial obligations FO Common stockholders’ equity CSE Total Equities OL + FO + CSE

  14. Balance Sheet Reformulated Chapter 7 Page 216 Operating Assets Operating assets OA Operating liabilities (OL) Net operating assets NOA Financial Obligations & Owners’ Equity Financial liabilities FO Financial assets (FA) Net financial obligations NFO Common equity CSE Total NFO & Equity NFO + CSE NOA = OA - OL NFA = FA - FO CSE = NOA + NFA (Usually NFA is negative: NFO) CSE = NOA - NFO

  15. Business Activities:All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Product and Input Markets Capital Markets The Firm OR Customers F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) C I OE Suppliers d Share Holders OI - DNOA = C - I C - I = D NFA - NFI + d Operating Activities Financing Activities • OR is operating revenue • OE is operating expense • NFI is net financial income OR - OE = OI • D indicates change • NFA can be negative (NFO)

  16. Business Activities:All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Product and Input Markets Capital Markets The Firm OR Customers F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) C I OE Suppliers d Share Holders OI - DNOA = C - I C - I -D NFA + NFI = d Operating Activities Financing Activities • OR is operating revenue • OE is operating expense • NFI is net financial income OR - OE = OI • D indicates change • NFA can be negative (NFO)

  17. Business Activities:All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Product and Input Markets Capital Markets The Firm OR Customers F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Obligat’ns (NFO) C I OE Suppliers d Share Holders OI - DNOA = C - I C - I +D NFO - NFE = d Operating Activities Financing Activities • OR is operating revenue • OE is operating expense • NFE is net financial expense OR - OE = OI • D indicates change • NFA can be negative (NFO)

  18. Income Statement Chapter 7 Page 217 The difference between operating revenue and operating expense is called operating income: OI = OR - OE Net financing expense can be negative (net financial income) Income Statement Operating income Operating revenue OR Operating expense (OE) OI Net financing expense Interest expense XX Interest revenue (XX) (NFE) Comprehensive income Earnings

  19. Business Activities and theFinancial Statements Chapter 7 Summary INCOME STATEMENT earnt = OIt - NFEt BALANCE SHEET Net Operating Assets NetFinancial 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

  20. Stocks & Flows:Operating Activities Chapter 7 Pages 220-221 • The change in NFO is given by • The change in NOA is given by • 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

  21. Tying it Together:What Generates Value? Chapter 7 Page 222 • From the balance sheet equation • By the way NOA and NFO are calculated, 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.

  22. 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

  23. 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

  24. 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 Return on Net Financial Assets If there are NFO rather than NFA, net borrowing cost Forecasting ROCE (at the heart of the valuation model) involves both the forecast of RNOA and RNFA (or NBC)

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