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FINANCE 7311

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

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FINANCE 7311

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  1. FINANCE 7311 Review & Financial Statement Analysis Dr. Ashvin Vibhakar Fall 2000

  2. Outline Review of Basic Finance The Corporation The Accounting Model Cash Flows Financial Statement Analysis

  3. Review of Basic Finance • Efficient Markets • Rates of Return • Time Value of Money • Bond Valuation • Stock Valuation

  4. EFFICIENT MARKETS • Markets are in equilibrium • Expected Returns = Required returns • Expectations are rational • Information is reflected in price • Information • Reflected in Price • No Arbitrage

  5. 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)

  6. RATES OF RETURN • REQUIRED RETURN • required by investor • depends on RISK • EXPECTED RETURN • given current price & expected future CF’s • REALIZED RETURN • actual return

  7. RISK • Represents the CHANCE that ACTUAL returns turn out to be much different than EXPECTED • Statistically: • Variance • Standard Deviation

  8. 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

  9. 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

  10. 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

  11. 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)

  12. THE CORPORATION • REAL ASSETS ----> CASH FLOWS • CLAIMANTS ----> • EMPLOYEES/CREDITORS • BONDHOLDERS • STOCKHOLDERS • MANAGEMENT TEAM

  13. A Picture of the Corporation • Real Assets & Financial Assets Financing Investment Bondholders CF’s ASSETS Shareholders Business Risk Financial Risk 3rd Parties Govt; other

  14. 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

  15. 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?

  16. 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

  17. BUSINESS RISK • Assets are the SOURCE of BUSINESS RISK • DEMAND & SUPPLY VARIABILITY • COMPETITION (ease of entry) • TECHNOLOGY • REGULATION • MGMT DEPTH & BREADTH • OPERATING LEVERAGE

  18. THE ACCOUNTING MODEL • CONFORMS TO PICTURE: • NWC DEBT • L-T ASSETS EQUITY • LHS = CIRCLE • RHS = RECTANGLES

  19. Debt • Interest Bearing - ‘Permanent’ Capital • Reclassify S-T portion of notes payable • Lines of Credit • Include as part of NWC

  20. ACCOUNTING PRINCIPLES • COST PRINCIPLE: • ONLY TRANSACTIONS RECORDED • COST ≠ MARKET IN GENERAL • MATCHING PRINCIPLE • PERFORMANCE MEASUREMENT • ACCRUAL V. CASH BASIS ACCTG.

  21. 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?

  22. 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

  23. INCOME STATEMENT • GENERAL FORMAT • SALES • - COS • GROSS PROFIT • - OPERATING EXPENSES • EBIT (OPERATING PROFIT) • EARNINGS W/O REGARD TO DEBT & TAX SITUATION

  24. Income Statement, cont. • EBIT • - INTEREST • EBT (TAXABLE INCOME) • - Taxes • NET INCOME • NET INCOME ≠ CASH FLOW • WHY?

  25. Cash Flow v. Net Income Non-Cash Expenses Depreciation Amortization Write-offs Accruals Timing Differences

  26. 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)

  27. CF’S FROM ASSETS • Operating Cash Flow • EBIT • + DEPRECIATION (NON-CASH ITEMS) • - TAXES • - ∆NWC • - CAPITAL SPENDING

  28. 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

  29. 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

  30. RATIO ANALYSIS • FINANCIAL COMPARISON TOOL • RAW FINANCIAL STATEMENTS • SIZE DIFFERENCES • DOLLAR AMOUNTS SAY LITTLE • KEY: COMPARABILITY • DEFINITIONS DIFFER

  31. BENCHMARKS • Historical Ratios of Company • Trend Analysis • Assumes: Continuation of past • Other Companies / Industry • RMA, S&P, Hoover • Industry Publications • Projections (Forecasts)

  32. 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)

  33. RATIO GROUPS • LIQUIDITY • ACTIVITY • LEVERAGE • PROFITABILITY • MARKET

  34. LIQUIDITY • Ability to meet current Obligations • Of Interest to Short-term Creditors • CURRENT RATIO • QUICK RATIO

  35. ACTIVITY RATIOS • Measures Effective Asset Use • Of Interest to management & investors • ASSET TURNOVER • INVENTORY TURNOVER • DAYS SALES IN INVENTORY • DAYS SALES OUTSTANDING

  36. 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

  37. 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)

  38. 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

  39. 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?

  40. 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

  41. ECONOMIC V. ACCTG. EARNINGS • UNREALIZED GAINS & LOSSES • COST OF EQUITY • ‘HIGH’ CORPORATE PROFITS • EVA - attempts to account for cost of equity

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