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

MBA 643 Managerial Finance Lecture 3: Financial Statements, Taxes, and Ratios. Spring 2006 Jim Hsieh. Why Do We Care About This Topic?.

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

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  1. MBA 643Managerial FinanceLecture 3: Financial Statements, Taxes, and Ratios Spring 2006 Jim Hsieh

  2. 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

  3. 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

  4. 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 firm’s financial position. • Book Value versus Market Value of the Firm • Current Assets • Cash & Marketable Securities • Receivables • Inventories • Fixed Assets • Tangible • Intangible • Liabilities • Payables • Accruals • ST and LT debt Shareholders’ Equity

  5. 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 firm’s operating performance. • Example 1: Procter & Gamble (for fiscal year ended June 30, 2002)

  6. 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 non-operating income/expenses. • NOPAT = EBIT*(1-Tax rate) • Example 2: How much is P&G’s NOPAT in 2002? Tax rate = 2,031/6,383 = 0.3182 NOPAT = 6,678*(1-0.3182) = 4,553

  7. Three Major Financial Statements(3). The Statement of Cash Flows • Definition: A statement of cash flows shows a firm’s 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

  8. 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

  9. Free Cash Flows (cont’d) • Example 3: What is P&G’s 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

  10. 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

  11. 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)

  12. 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

  13. 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)

  14. 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)

  15. 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)

  16. Put Some Ratios Together-- The Du Pont System • ROE = Net income/Total equity = (Net income/Totalassets)*(Totalassets/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)  

  17. 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&G’s MVA in 2002? P&G’s stock price was $90.03 on July 1st, 2002. MVA = MV(E)-BV(E) = $90.03*1,300.8 – 13,706 = 103,405

  18. 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&G’s EVA in 2002? P&G’s cost of capital was 10% in 2002. EVA = 4,553 – 12,811*0.1 = 3,271.9

  19. 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 AFirm B EBIT 100 100 Interest 40 0 Pretax income 60 100 Tax (35%) 2135 NI 3965 Net cash flow 79 65

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