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FIN 468: Intermediate Corporate Finance

FIN 468: Intermediate Corporate Finance. Topic 2–Financial Statements Larry Schrenk, Instructor. Topics. The Statements Ratio Analysis and Types of Ratios DuPont Equation Forecasting Pro Forma Statements. The Statements. Stock versus Flow. Income Statement Flow

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FIN 468: Intermediate Corporate Finance

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  1. FIN 468: Intermediate Corporate Finance Topic 2–Financial Statements Larry Schrenk, Instructor

  2. Topics • The Statements • Ratio Analysis and Types of Ratios • DuPont Equation • Forecasting Pro Forma Statements

  3. The Statements

  4. Stock versus Flow • Income Statement Flow • Balance Sheet Stock • Statement of Cash Flows Flow

  5. Balance Sheet Organization Liabilities (RHS) • Claims on Firm Value • Organized by ‘Payable’ Liquidity • Allocation of Return and Risk to Investors • Claims Portfolio Assets (LHS) • Firm Value • Organized by ‘Receivable’ Liquidity • Allocation of Firm’s Investable Funds • Assets Portfolio

  6. Income Statement Organization Earnings…▪ From Unit Production From Total Production After Financing Included After Taxes Included Retained by the Firm ▪ Sales – Variable Costs Gross Costs – Fixed Costs EBIT – Interest EBT – Taxes Net Income – Dividends Additions to Retained Earnings

  7. Ratio Analysis and Types of Ratios

  8. Principles • Consider the Perspective • Toolbox Approach • Check Annualization • Beware of Anomalies • Ratios as Red Flags • Use Customized Ratios • No Official Rules

  9. Classification • Short-Term Solvency (Liquidity) • Long-Term Solvency (Leverage) • Efficiency • Profitability • Market Value

  10. Use • Comparisons • Time-Trend Analysis • Firm’s Performance over Time • Peer Group Analysis • Similar Companies or Industry Analysis

  11. Short-Term Solvency • Form • Purpose • Short-Term Liquidity • Can the Firm Meet Current Obligations? • Examples • Cash Ratio, Current Ratio, Quick Ratio

  12. Long-Term Solvency: Degree of Leverage Analysis • Form • Purpose • Long-Term Liquidity • Can the Firm Remain Solvent? • Examples • Total Debt Ratio, Debt/Equity Ratio

  13. Long-Term Solvency: Coverage Analysis • Form • Purpose • Firm Service its Long-Term Obligations? • Is Bankruptcy a Concern? • Examples • Times Interest Earned (TIE), Cash Coverage

  14. Efficiency: Analysis • Form • Purpose • How Efficiently does the Firm Use the Value Invested in each Asset? • Balance Sheet Assets as Portfolio • Liquidity-Return Trade-Off • Examples • Turnover Analysis

  15. Profitability: Analysis • Form • Purpose • Is the Firm Generating Reasonable Earnings Relative to Total Assets or Equity • NOTE: Accounting Measures • Examples • Return on Assets (ROA), Return on Equity (ROE)

  16. Market Value: Analysis • No Common Form or Purpose • Use of Market Data • Examples • PE Ratio, Market-to-Book Ratio

  17. Some Cautions • No Underlying Theory • Diversified Firms • Globalization • Varying Accounting Procedures • Different Fiscal Years

  18. DuPont Equation

  19. DuPont Equations: Analysis • Decomposition • Analysis, Not Calculation

  20. The DuPont Equation

  21. Extending the DuPont Equation

  22. Forecasting Pro Forma Statements

  23. Percent of Sales Approach • Some items vary directly (at least approximately) with sales. • ‘Driver’

  24. Percent of Sales Approach • Some items may not vary with sales • Items whose value cannot be easily changed • Items whose value is determined by other variables, and • Items under the policy control of the firm: • Financing policy: long-term debt and equity • Payout policy: dividends

  25. Income Statement • Costs may vary directly with sales. Why? • Depreciation and interest expense may not vary directly with sales. Why? • Dividends generally do not vary directly with sales. Why?

  26. Balance Sheet–Assets • Generally current assets vary directly with sales. Why? • Generally long-term assets do not vary directly with sales. Why?

  27. Balance Sheet–Liabilities • Many current liabilities vary directly with sales. Why? • But notes payable do not vary with sales. Why? • Long term debt does not vary with sales. Why?

  28. Balance Sheet–Equity • How does retained earnings change? • Changes on equity (and all the various sub-groups)do not vary with sales. Why?

  29. External Financing Needed (EFN) • After applying the percentage of sales method, the balance sheet will most likely not balance. • External Financing/Funds Needed (EFN) • difference between • forecasted increase in assets and • the forecasted increase in liabilities and equity.

  30. External Financing Needed (EFN) • EFN is the new capital that must be raised. • This is often called the ‘plug’ • EFN can be negative. • Financing policy determines the type of instruments to be used, i.e., whether new funds are raised through debt, equity or some combination of the two.

  31. Pro Forma Example • Exogenous Parameters • Annual Sales Increase: 10% • Firm Policies: • Payout ratio: 75% • Financing: EFN will be raised through equity.

  32. Pro Forma Example • Color Codes • Red Numbers are those which change with sales, e.g., accounts receivable. • Blue numbers are those that do not change with sales, e.g., fixed assets. • Purple numbers are those whose value is determined by firm policies, e.g., dividends. • Black numbers are values which are entirely a function of other variables, e.g. retained earnings.

  33. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 COGS $1,644 Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

  34. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 COGS $1,644 Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44 Changes with Sales No Change Pre-Determined Follows Policy

  35. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 Increases by 10% COGS $1,644 Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

  36. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Increases with Sales Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

  37. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276$276No Change: No Capital Invest. EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

  38. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276$276 EBIT $391 $458 Interest Paid $141$141 No Change (Debt Not Changed) EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

  39. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276$276 EBIT $391 $458 Interest Paid $141$141 EBT $250 $317 Taxes $85$108 Tax Rate is 34% Net Income $165 Dividends $121 Addition to Ret. Earn. $44

  40. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276$276 EBIT $391 $458 Interest Paid $141$141 EBT $250 $317 Taxes $85$108 Net Income $165 $209 Dividends $121 $157 Dividends are 75% of Net Income Addition to Ret. Earn. $44

  41. Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276$276 EBIT $391 $458 Interest Paid $141$141 EBT $250 $317 Taxes $85$108 Net Income $165 $209 Dividends $121 $157 Addition to Ret. Earn. $44 $52 Add to Retained Earning

  42. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 Accounts Receivable $688 Inventory $922 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588

  43. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 Inventory $922 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increases with Sales

  44. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increases with Sales

  45. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922$1,014 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increases with Sales

  46. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922$1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Fixed Assets)

  47. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922$1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600$600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Fixed Assets)

  48. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922$1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600$600 Total Fixed Asst $1,680$1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 New Total Assets

  49. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922$1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600$600 Total Fixed Asst $1,680$1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increase with Sales

  50. Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922$1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600$600 Total Fixed Asst $1,680$1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196$196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Financing Policy)

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