Professor John Zietlow MBA 621

1. Chapter 2 Financial Statements And Cash Flow Analysis Professor John ZietlowMBA 621 Spring 2006

2. Chapter 2 Overview • 2.1 Financial Statements • Balance Sheet • Income Statement • Statement of Retained Earnings • Statement of Cash Flows • Notes to Financial Statements • 2.2 Cash Flow Analysis • The Firm’s Cash Flows • Depreciation and Cash Flows • Sources and Uses of Cash • Developing and Interpreting the Statement of Cash Flows • 2.3 Analyzing Performance Using Ratio Analysis • Liquidity Ratios • Activity Ratios • Debt Ratios • Profitability Ratios • Market Ratios

3. Four Key Financial Statements Are Required By U.S. Securities & Exchange Commission 1. Income Statement • Details Firm’s Revenues, Expenses & Profits During Period • By Definition: Profit (Income) = Revenues - Expenses 2. Balance Sheet • Details Firms Assets, Liabilities & Capital At Period’s End • By Definition: Assets = Liabilities + Stockholders’ Equity • Assets Listed In Decreasing Order of Liquidity; Cash First 3. Statement Of Retained Earnings • Reconciles Net Income, Cash Dividends & Change In Retained Earnings Between Beginning & End Of Period 4. The Statement Of Cash Flows • Summarizes Firm’s Sources & Uses Of Cash and How Cash Position Changes Over A Period

4. The Uses (And Misuses) Of Financial Statements • All Public Companies Must Provide These Statements • Must Be Filed With SEC, Given To Shareholders • Must Be Prepared & Audited According To GAAP • U.S. Accounting Standards More “Rigorous” Than Most • Enron Collapse Has Thrown U.S. Accounting Into Crisis • Accrual Accounting: When Revenue & Expenses Realized? • Realized When Sale Is Made; Not When Payment Received • In U.S., Must Prepare Quarterly & Annual Statements • Other Countries Only Require Semi-Annual Or Annual Filings • Statements Are The Principal Tools Used To Evaluate Firm • Used By Management, S/Hs, Creditors, Security Analysts • Typically Use “Ratio Analysis” To Evaluate Firm’s Condition • Are Imperfect Measures Of Firm’s Condition Or Prospects • Though Essential, Statements Must Be Interpreted Cautiously

5. Global Petroleum Company Balance Sheet Assets ($ Millions)December 31

6. Global Petroleum Company Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

7. Global Petroleum Company Income Statement ($ Millions)December 31

8. Global Petroleum Comp Income Statement Dividends & Earnings Per Share ($Mn)12/31 1 Based on 178,719,400 and 185,433,100 shares outstanding as of December 31, 2003 and 2002, respectively.

9. Global Petroleum Co Statement Of Retained Earnings ($ Mn), Year Ending Dec 31, 2003

10. Cash FlowsThe firm’s cash flows (1) Operating flows (2) Investment flows Labor Accrued Wages Payment of accruals Purchase Fixed Assets Payment of CreditPurchases Sale Raw Materials AccountsPayable Depreciation Business Interests Work inProcess OverheadExpenses Purchase CashandMarketabaleSecurities FinishedGoods Sale Operating (incl.Depreciation) andInterest Expense (3) Financing flows Borrowing Debt (Short Termand Long Term) Payment Repayment Taxes Refund Sales Cash Sales Sale of Stock Equity Repurchase of Stock AccountsReceivables Payment of Cash Dividends Collection of Credit Sales Pattern of Cash Flows Through a Firm

11. Sources Decreases in any asset Increase in any liability Net profits after taxes Depreciation and other non-cash charges Sale of stock Uses Increase in any asset Decrease in any liability Net loss Dividends paid Repurchase or retirement of stock Sources and Uses of Corporate Cash Flow

12. Global Petroleum Co Statement Of Cash Flows ($ Millions), Year Ending Dec 31, 2003

13. Global Petroleum Comp Statement Of Cash Flows ($Mn), Year Ending Dec 31, 2003

14. Five Basic Types Of Financial Ratios Used To Analyze A Firm • Liquidity Ratios measure a firm’s ability to satisfy its short-term obligations as they come due.Greater liquidity preferred. • Activity ratios measure the speed with which various accounts are converted into sales or cash. Higher activity preferred. • Debt Ratios indicate the amount of borrowed money being used by the firm. Lower debt ratio implies greater safety. • Profitability Ratios measure the returns of the firm to its sales, assets, or equity. Higher profitability (almost) always preferred. • Market ratios relate the firm’s market value as measured by its current share price to certain accounting values. Higher valuation ratios preferred.

15. Exxon Mobil Company Balance Sheet Assets ($ Millions)December 31

16. Exxon Mobil Company Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

17. Liquidity Ratios For Exxon Mobil Corporation The current ratio measures the firm’s ability to meet its short-term obligations. Should be greater than 1.00. The quick ratio (also known as acid-test ratio) subtracts inventory from current ratio. Theory: quick ratio measures current assets that can be turned into cash quickly. Inventory difficult to liquidate fast.

18. Dell Computer Corporation Balance Sheet Assets ($ Millions)February 1

19. Dell Computer Corporation Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 02/01

20. Dell Computer Corporation Income Statement ($ Millions)February 1

21. Activity Ratios For Dell Computer Corporation Inventory turnover measures how many times each year the firm “turns over” (sells) its inventory. Use cost of goods sold (“cost of revenue”) rather than sales in the numerator of this ratio. Fixed asset turnover measures the efficiency with which the firm uses its fixed assets to generate sales. This ratio varies greatly by industry; Ratio will be low for capital-intensive firms (steelworks), high for labor- intensive companies (grocery stores).

22. Activity Ratios For Dell Computer Corporation (Continued) Average collection period is used to evaluate credit and collection policies. Computed by dividing accounts receivable by average daily sales, which must itself be computed by dividing annual sales by 365. Average collection period is often called days’ sales outstanding (DSO). This directly measures how much the firm has invested in A/R.

23. Activity Ratios For Dell Computer Corporation (Continued) Total asset turnover measures the efficiency with which the firm uses all its assets to generate sales. This ratio also varies greatly by industry.

24. The Uses Of Debt Ratios • Financial leverage : the use of fixed-cost financing by firms to magnify returns to shareholders • Also magnifies financial risk (risk of failure & default) • There are two general types of debt measures: • measures of the degree of indebtedness and • measures of the ability to service debts. • The degree of indebtedness measures debt relative to other balance sheet amounts. • A popular measure is the debt ratio. • The ability to service debts measures a firm’s ability to make contractual payments required over the life of a debt. • The firm’s ability to pay certain fixed charges is measured by using coverage ratios. • Higher coverage ratios are preferred, but not too high. • Almost all debt ratios show strong industry patterns

25. Lowe’s Companies, Inc.Balance Sheet Assets ($ Millions)December 31

26. Lowe’s Companies, Inc.Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

27. Lowe’s Companies, Inc.Income Statement ($ Millions)December 31

28. Debt Ratios For Lowe’s Companies, Inc. The debt ratio measures the proportion of the firm’s total assets financed by creditors. This is the broadest measure of indebtedness; includes loans plus accounts payable, taxes payable and other accrued liabilities. An alternative measure of indebtedness, the debt-equity ratio, focuses only on long-term debt and equity. Thus often called a capitalization ratio.

29. Debt Ratios For Lowe’s Companies, Inc.(Continued) The times interest earned ratio measures the firm’s ability to make contractual interest payments. The higher the ratio, the more easily the firm can make its interest payments. Does not measure ability to cover principal repayments.

30. Using Profitability Ratios • Profitability Ratios allow analysts to evaluate the firm’s earnings with respect to sales, assets, or equity. • Important indicator of current status, profitability ratios also watched for signs of future problems • A common-size income statement expresses revenues & expenses as a percentage of sales. • Especially useful in comparing performance across years • Three frequently cited ratios of profitability are: • The gross profit margin • The operating profit margin, and • The net profit margin

31. Wal-Mart Stores, Inc.Balance Sheet Assets ($ Millions)December 31

32. Wal-Mart Stores, Inc.Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

33. Wal-Mart Stores, Inc.Income Statement ($ Millions)December 31

34. Profitability Ratios for Wal-Mart Stores, Inc. The gross profit margin measures the percentage of each sales dollar remaining after the firm pays the direct costs of the goods produced (gross profit = sales – cost of goods sold). The operating profit margin measures profitability as EBIT divided by sales. EBIT measures profits remaining after all costs deducted from sales except interest and taxes.

35. Profitability Ratios For Wal-Mart Stores, Inc.(Continued) The net profit margin measures the percentage of each sales dollar remaining after all costs are deducted. Highly variable across industries. Earnings per share measures net profit earned by the firm per share of common stock outstanding.

36. Profitability Ratios For Wal-Mart Stores, Inc.(Cont) The return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with its available assets. The return on equity (ROE) measures the return earned on the owners’ investment in the firm. This is the closest thing to a single “universal” ratio as a measure of performance.

37. Using Financial Ratios For Cross-Sectional and Trend Analysis • Cross-sectional analysis: comparing different firms’ financial ratios at the same point in time. • Usually compared to firm(s) in same industry • Sources of comparison data include D& B Industry Norms & Key Business Ratios, RMA Studies • In benchmarking, a firm compares its ratio values to those of competitors that it wishes to emulate • Trend analysis is applied when a financial analyst evaluates performance over time. • Developing trends can be seen using multiyear comparison • The DuPont system used as a search technique to find the key areas responsible for the firm’s financial condition.

38. The DuPont System of Analysis • The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. • Developed by DuPont in late-1950s; still widely used • The system merges the income statement and balance sheet into two summary measures of profitability: • return on assets (ROA) and • return on equity (ROE). • The DuPont system first brings together a firm’s net profit margin with its total asset turnover. • Profit margin measures the firm’s profitability on sales • Turnover indicates how efficiently the firm has used its assets to generate sales. ROA = Net Profit Margin x Total Asset Turnover

39. Using The DuPont System of Analysis Substituting the net profit margin and total asset turnover formulas into the DuPont equation and simplifying results in the formula given earlier: If the 2001 values of the net profit margin and total asset turnover for Wal-Mart, are substituted into the DuPont formula, the result is: ROA = 3.06% x 2.608= 7.99%

40. Using The DuPont System of Analysis (Continued) The second step in the DuPont system uses the modified DuPont formula. This formula relates the firm’s return on assets (ROA) to the return on equity (ROE). ROE is calculated by multiplying the return on assets (ROA) by the financial leverage multiplier, the ratio of total assets to stockholders’ equity: The advantage of the DuPont system is that it allows the firm to break its ROE into a profit-on-sales component (net profit margin), an efficiency-of- asset-use component (total asset turnover), and a use-of-leverage component (financial leverage multiplier).

41. PepsiCo, Inc.Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/29

42. PepsiCo Inc.Income Statement ($ Millions)December 31

43. Market Ratios For PepsiCo The price/earnings (P/E) ratio measures the amount investors are willing to pay for each dollar of the firm’s earnings. Varies widely by industry. The market-to-book (M/B) ratio assesses how investors view the firm’s past and expected future performance. It relates the market value of the firm’s shares to their book (accounting) value. To calculate the M/B ratio for PepsiCo, first need to find bookvalue per share.

44. Caveats On The Use Of Ratio Analysis • No single ratio can provide sufficient information to judge the overall performance of the firm • Only ROE remotely useful for comparing all firms • The financial statements being compared should be dated at the same point in time during the year • Seasonality can be very important for certain firms • Use audited financial statements whenever possible • Financial data must be developed consistently • Use of differing accounting treatments—especially relative to inventory and depreciation—can distort ratio results • Consider the effects of inflation in C-S or T-S comparisons. • International comparisons should be viewed with suspicion • Especially true comparing across systems (US vs German)

45. Demonstrating Translation Exposure • Translation exposure is a purely accounting concept • It measures the potential change in a consolidated financial statement from a change in exchange rates • Key measure is the difference between exposed assets and exposed liabilities • Exp assets: those whose $ value will change if ER changes • Exp liabilities: those whose $ value will change if ER changes • $ values of non-exposed assets do not change if ER changes • Assume a US Firm has a UK subsidiary and that ER initially $2.00/£, but then changes to $1.50/£ (pound depreciates) • Under Current Rate method, all assets and liab translated at new (current) ER of $1.50/£ • Equity accounts translated at old ER of $2.00/£

46. Translation Gains & Losses For US Firm With UK Subsidiary After £ Depreciation

47. Accounting For Translation Gains And Losses • In our example, US parent company suffered $5,000,000 translation loss • $ value of assets declined by $7.5 mm ($30 mm - $22.5 mm) • $ value of liab declined by only $2.5 mn ($30 mm-$27.5 mm) • $ value of equity accounts remain unchanged; translated at historical ER • Translation loss accounted for in a “Cumulative Translation Adjustment” equity account • Debit (loss) balance increased by translation losses, reduced by translation gains • Not actually realized (run through income statement) unless subsidiary sold or closed down.