FINANCE 7311

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FINANCE 7311

• Review Financial
• Statement Analysis

Dr. Ashvin Vibhakar Fall 2000
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Outline

• Review of Basic Finance
• The Corporation
• The Accounting Model
• Cash Flows
• Financial Statement Analysis

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Review of Basic Finance

• Efficient Markets
• Rates of Return
• Time Value of Money
• Bond Valuation
• Stock Valuation

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EFFICIENT MARKETS

• Markets are in equilibrium
• Expected Returns Required returns
• Expectations are rational
• Information is reflected in price
• Information
• Reflected in Price
• No Arbitrage

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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)

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RATES OF RETURN

• REQUIRED RETURN
• required by investor
• depends on RISK
• EXPECTED RETURN
• given current price expected future CFs
• REALIZED RETURN
• actual return

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RISK

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

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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

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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 CFs or periods
• Ordinary - end of period
• Due - beginning of period

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BOND VALUATION

• CF coupon rate x par 2 (semi-ann.)
• N number of semi-annual periods
• FV par amount of bond
• R investors required rate of return
• PV price of bond
• Solving for R gt Yield to Maturity

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STOCK VALUATION

• Present value of future dividends
• Assumption about Time Path
• More Generally, CF
• 1) No Growth --gt Perpetuity
• Vt CFt1/R
• 2) Constant Growth --gt Gordon Model
• Vt CFt1 / (R - g)

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THE CORPORATION

• REAL ASSETS ----gt CASH FLOWS
• CLAIMANTS ----gt
• EMPLOYEES/CREDITORS
• BONDHOLDERS
• STOCKHOLDERS
• MANAGEMENT TEAM

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A Picture of the Corporation

• Real Assets Financial Assets

Financing
Investment
Bondholders
CFs
ASSETS
Shareholders
Business Risk
Financial Risk
3rd Parties Govt other
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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

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MANAGEMENT DECISIONS

• INVESTMENT DECISION --gt What should be in the
  circle
• 1) Short-term assets --gt Working capital
• inventory policy
• A/R and A/P policy
• nature and amount of S-T financing
• 2) L-T Assets --gt Capital Budgeting
• Which assets add most VALUE to the firm?

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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

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BUSINESS RISK

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

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THE ACCOUNTING MODEL

• CONFORMS TO PICTURE
• NWC DEBT
• L-T ASSETS EQUITY
• LHS CIRCLE
• RHS RECTANGLES

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Debt

• Interest Bearing - Permanent Capital
• Reclassify S-T portion of notes payable
• Lines of Credit
• Include as part of NWC

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ACCOUNTING PRINCIPLES

• COST PRINCIPLE
• ONLY TRANSACTIONS RECORDED
• COST ? MARKET IN GENERAL
• MATCHING PRINCIPLE
• PERFORMANCE MEASUREMENT
• ACCRUAL V. CASH BASIS ACCTG.

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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?

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BALANCE SHEET

• ASSETS -gt something owned
• Listed in order of liquidity
• NWC Long-term
• Liability -gt something owed
• listed in order of Claim Priority
• Retained Earnings -gt owned - owed
• Cum. Earnings not paid as dividends

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INCOME STATEMENT

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

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Income Statement, cont.

• EBIT
• - INTEREST
• EBT (TAXABLE INCOME)
• - Taxes
• NET INCOME
• NET INCOME ? CASH FLOW
• WHY?

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Cash Flow v. Net Income

• Non-Cash Expenses
• Depreciation
• Amortization
• Write-offs
• Accruals
• Timing Differences

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CASH FLOW

• ASSETS DEBT EQUITY
• CF FROM ASSETS CFS TO D E
• USES
• CFS CONSISTENT W/ PICTURE
• SOURCES / USES OF CASH
• VALUATION (PROJECTED CFS)

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CFS FROM ASSETS

• Operating Cash Flow
• EBIT
• DEPRECIATION (NON-CASH ITEMS)
• - TAXES
• - ?NWC
• - CAPITAL SPENDING

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CFS TO B/H S/H

• CFS TO B/H
• INTEREST
• NET CHANGE IN DEBT
• CFS TO S/H
• DIVIDENDS
• - NET CHANGE IN COMMON STOCK

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Taxes and Cash Flow

• Historical - Analyzing companys CF
• Use Tax number from Income Stmt
• Projections - Free Cash Flow for valuation
  purposes
• Use Tax Rate x EBIT

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RATIO ANALYSIS

• FINANCIAL COMPARISON TOOL
• RAW FINANCIAL STATEMENTS
• SIZE DIFFERENCES
• DOLLAR AMOUNTS SAY LITTLE
• KEY COMPARABILITY
• DEFINITIONS DIFFER

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BENCHMARKS

• Historical Ratios of Company
• Trend Analysis
• Assumes Continuation of past
• Other Companies / Industry
• RMA, SP, Hoover
• Industry Publications
• Projections (Forecasts)

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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)

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RATIO GROUPS

• LIQUIDITY
• ACTIVITY
• LEVERAGE
• PROFITABILITY
• MARKET

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LIQUIDITY

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

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ACTIVITY RATIOS

• Measures Effective Asset Use
• Of Interest to management investors
• ASSET TURNOVER
• INVENTORY TURNOVER
• DAYS SALES IN INVENTORY
• DAYS SALES OUTSTANDING

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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

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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)

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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

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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 SP 500 CURRENTLY 6.4 WHY?

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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

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ECONOMIC V. ACCTG. EARNINGS

• UNREALIZED GAINS LOSSES
• COST OF EQUITY
• HIGH CORPORATE PROFITS
• EVA - attempts to account for cost of equity