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Corporate Finance Interpreting Financial Statements

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Corporate Finance Interpreting Financial Statements Dr. Markus R. Neuhaus Dr. Marc Schmidli, CFA Winter Term 2009 * Markus Neuhaus I Corporate Finance I neuhauma_at_ethz.ch – PowerPoint PPT presentation

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Title: Corporate Finance Interpreting Financial Statements


1
Corporate FinanceInterpreting Financial
Statements
  • Dr. Markus R. Neuhaus
  • Dr. Marc Schmidli, CFA

2
Corporate Finance Course overview
  • 18.09. Fundamentals (4 hours) M. Neuhaus
    M.Schmidli
  • 25.09 Investment Management M. Neuhaus P.
    Schwendener
  • 02.10. Business Valuation (4 hours) M. Neuhaus
    M. Bucher
  • 09.10. No Lecture No Lecture
  • 16.10. Value Management M. Neuhaus, R. Schmid
    F. Monti
  • 23.10. No Lecture No Lecture
  • 30.10. No Lecture No Lecture
  • 06.11. No lecture No Lecture
  • 13.11. Mergers Acquisitions III (4 hours) M.
    Neuhaus D. Villiger
  • 20.11 Tax and Corporate Finance (4 hours) Markus
    Neuhaus
  • 27.11. Legal Aspects R.
    Watter
  • 04.12. Financial Reporting M. Neuhaus M. Jeger
  • 11.12. Turnaround Management M. Neuhaus
    Markus Koch
  • 18.12.

M. Neuhaus
Summary, repetition
3
Markus R. Neuhaus PricewaterhouseCoopers AG,
Zürich PWC Phone 41 58 792 4000 Email markus.ne
uhaus_at_ch.pwc.com
  • Grade CEO
  • Qualification Doctor of Law (University of
    Zurich), Certified Tax Expert
  • Career Development Joined PwC in 1985 and became
    Partner in 1992.
  • Subject-related Exp. Corporate Tax
  • Mergers Acquisitions
  • Lecturing SFIT Corporate Finance, University of
    St. Gallen Tax Law
  • Multiple speeches on leadership, business,
    governance, commercial and tax law
  • Published Literature Author of commentary on the
    Swiss accounting rules Publisher of book on
    transfer pricing Author of multiple articles
    on tax and commercial law, MA, IPO, etc.
  • Other professional roles Member of the board of
    économiesuisse, member of the board and
    chairman of the tax chapter of the Swiss
    Institute of Certified Accountants and Tax
    Consultants

Winter Term 2009
3
Markus Neuhaus I Corporate Finance I
neuhauma_at_ethz.ch
4
Marc Schmidli PricewaterhouseCoopers AG, Zürich
PWC Phone 41 58 792 15 64 Email marc.schmidli_at_c
h.pwc.com
  • Grade Director
  • Qualification Dr oec. HSG., CFA charterholder
  • Career Development Corporate Finance
    PricewaterhouseCoopers since July 2000
  • Lecturing Euroforum Valuation in MA
    situations
  • Guest speaker at ZfU Seminars, Uni Zurich,
    ETH, etc.
  • Published Literature Finanzielle Qualität in der
    schweizerischen Elektrizitätswirtschaft
  • Various articles in Treuhänder, HZ, etc.

5
Contents
  • Learning targets
  • Pre-course reading
  • Lecture Interpreting Financial Statements
  • Pre-course reading case studies / questions
  • Solutions to case studies

6
Learning targets
  • Framework for financial statement analysis
  • Understanding the need for financial statement
    analysis
  • Understanding the financial reporting system
  • Refreshing principal elements of financial
    statements (Balance sheet, income and cash flow
    statements)
  • Analysis of financial statements
  • Understand the purpose and use of ratio analysis
  • Being able to apply the various ratio analyses
  • Being able to evaluate corporate performance by
    the integrated analysis of ratios

7
Contents
  • Learning targets
  • Pre-course reading
  • Lecture Interpreting Financial Statements
  • Pre-course reading case studies / questions
  • Solutions to case studies

8
Pre-course reading
  • Books
  • Mandatory reading
  • Brigham, Houston (2009) Chapter 4 (pp. 84-109)
  • White, Sondhi, Fried (2003) Chapter 3 (pp.
    74-99)
  • Optional reading
  • Brigham, Houston (2009) Chapter 3 (pp. 53-75)
  • Slides
  • Slides 1 to 11 mandatory reading
  • Other Slides optional reading, will be dealt
    within the lecture

9
Contents
  • Learning targets
  • Pre-course reading
  • Lecture Interpreting Financial Statements
  • Pre-course reading case studies / questions
  • Solutions to case studies

10
Agenda I
  • 1. Introduction
  • Financial analysis
  • Classes of users
  • Need for financial statement analysis
  • 2. Ratio analysis
  • Significance of ratio analysis
  • Sources
  • Financial reporting systems and standards
  • Important groups of ratio analysis

11
Agenda II
  • 3. Case study
  • Beans Incorporation vs. Garlic Incorporation
  • 4. QA and discussion

12
Agenda Introduction
  • Financial analysis
  • Classes of users
  • Need for financial statement analysis

13
Financial analysis
  • Evaluation of a firms performance and
    development mainly by
  • identifying the key drivers of a firms
    performance and financial position
  • calculating and interpreting important ratios of
    the firm
  • Balanced Scorecard (soft hard)
  • A well rounded financial analysis takes into
    account not only the financials alone but also
    surrounding factors which can have significant
    influence on the firms development. Financial
    management does not operate in a vacuum.

Source White, Sondhi, Fried (2003), 2ff.
14
Classes of users
  • Internal users (such as managers or board
    members)
  • External users of financial information encompass
    a wide range of interests but can be classified
    into three general groups
  • Credit and equity investors
  • Government, regulatory bodies, tax authorities
  • General public and special interest groups, labor
    unions and consumer groups

Source White, Sondhi, Fried (2003), 4.
15
Need for financial statement analysis
  • Internal
  • financial statements provide the company with
    information on its performance and development
    over time and are a crucial basis for most
    financial decisions (i.e. investment, financing)
  • Costs
  • Efficiency
  • Profitability
  • Investments
  • Financing (needs)
  • External
  • financial statements facilitate the interaction
    between the company and its business environment
    by providing third parties with essential
    information on the companys development
  • Creditors
  • Investors
  • Shareholders
  • Government

Financial analysis has great significance and
impact on a companys development as it
influences expectations on the capital markets
16
Agenda Ratio analysis
  • Significance of ratio analysis
  • Sources
  • Financial reporting systems and standards
  • Important groups of ratio analysis

17
Ratio analysis
  • Financial statements help predict the future
    development of a company
  • Firm A has total debt of 200m whereas firm B
    has total debt of 2mm. Which firm is stronger,
    more liquid? Or which firm is more likely to
    generate higher cash flows?
  • ? Figures standing alone, such as total debt,
    are not really helpful
  • ? By putting debt into perspective with other
    appropriate figures, we are able to
    predict which firm is more likely to succeed
  • ? such comparisons are ratio analysis

The debt burden can be evaluated (a) by
comparing each firms debt with its assets and
(b) by comparing the interest the company has to
pay with the income it has available
Source Brigham, Houston (2009), 103.
18
help predict the future development of a company
Significance of ratio analysis
  • As a companys value is determined by its ability
    to generate cash today and in the future, ratio
    analysis has great importance
  • Share price development
  • Credit rating
  • However, there is no generally used list of
    ratios that could be applied to any company
  • Groups of ratios1)
  • Liquidity ratios
  • Asset management ratios
  • Debt or financing ratios
  • Profitability ratios
  • Market value ratios

1) Details later see page 25ff.
19
Principal elements of financial statements as
primary source for financial analysis
  • Balance sheet
  • Income statement
  • Statement of cash flows
  • Statement of stockholders equity
  • Further sources Broker/analyst reports,
    Bloomberg, Reuters, Factset etc.

Collectively, these interrelated financial
statements provide relevant and timely
information about the past and are essential for
making crucial business decisions about
investment or financing activities today and in
the future. Financial statements are a key
component to build trust in the financial
community.
Source White, Sondhi, Fried (2003), 5.
20
Financial reporting systems and standards
  • Reporting systems and standards compel the
    company to meet a great number of requirements in
    order to ensure that the financial statements
    are, above all, transparent and comparable
  • The two most commonly used standards are
  • IFRS (International Financial Reporting
    Standards)
  • US GAAP (United States Generally Accepted
    Accounting Principles)
  • Differences are found mainly in the
    classification of certain events (e.g. whether an
    interest payment is reported under operating
    costs or financing costs etc.). Both aim to
    provide a true and fair viewof the companys
    performance.
  • In addition, there are local GAAPs (Generally
    Accepted Accounting Principles). In Switzerland
    we have rules in the Code of Obligation which
    permit hidden reserves and the FER
    (Fachempfehlung für Rechnungslegung) which is a
    light form of IFRS.

Source White, Sondhi, Fried (2003), 5ff.
21
Balance sheet
  • Snapshot of the companys assets and liabilities
    at a certain reporting date
  • Assets Liabilities Equity

Source Brigham, Houston (2009), 58.
22
Income statement
  • Reports on the performance of a firm, the results
    of its operating activities
  • Matching principle revenues and related costs
    must be accounted for during the same period of
    time. This requires the recognition of expenses
    incurred to generate revenues in the same period
    as the related revenues (revenue recognition,
    accrual method).

Source Brigham, Houston (2009), 61.
23
Statement of cash flow
  • The cash flow statement represents the cash
    generated by a company during the given
    accounting period
  • Separated into three categories (I) operating
    activities, (II) investing activities, (III)
    financing activities
  • The investment section illustrates how cash was
    spent whereas section III, financing shows how
    those investments were financed
  • In the long run, cash flows from operating
    activities should considerably increase
    investments should be equal to depreciation (plus
    a bit more to support stable growth)
  • ? In this example, the company has an operating
    problem as the cash flow from operating
    activities is negative
  • CAPEX capital expenditures

Source Brigham, Houston (2009), 63.
24
Statement of retained earnings
  • Changes in retained earnings occur because
    stockholders allow the management to retain and
    invest funds that otherwise would be paid out as
    dividend
  • Thus, the retained earnings position is not cash
    and is not available for spending

Source Brigham, Houston (2009), 66.
25
Important groups of financial ratios
  • Liquidity ratios
  • Is the company able to pay its debts as they
    become due this year?
  • Asset management ratios
  • Does the amount of assets seem to be reasonable
    in relation to current and projected sales? And
    how efficiently does the company use its assets?
  • Debt or financing ratios
  • To what extent is the company using financial
    leverage? Risk from capital structure?
  • Profitability ratios
  • How profitable is the company? How much output
    does the company generate in relation to a
    certain input?
  • Market value ratios
  • How do the earnings and results appear in
    relation to the stock price?

Source Brigham, Houston (2009), 84ff.
26
Liquidity ratios
  • If a company is getting into financial
    difficulties, it will pay its bills more slowly,
    borrowing money from banks and from suppliers.
    This leads to increased current liabilities which
    causes the current ratio to decrease. If current
    liabilities grow faster than current assets, this
    is a an indication of financial difficulties.
  • Inventories are a firms least liquid current
    asset and therefore most likely to suffer losses
    if they have to be sold in liquidation. A company
    should be able to pay current liabilities with
    current assets less inventories.

Source Brigham, Houston (2009), 87f.
27
Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Liquidity ratios
  • If a company is getting into financial
    difficulties, it will pay its bills more slowly,
    borrowing money from banks and from suppliers.
    This leads to increased current liabilities which
    causes the current ratio to decrease. If current
    liabilities grow faster than current assets, this
    is a an indication of financial difficulties.
  • Inventories are a firms least liquid current
    asset and therefore most likely to suffer losses
    if they have to be sold in liquidation. A company
    should be able to pay current liabilities with
    current assets less inventories.

Source Brigham, Houston (2009), 87f.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Asset management ratios
  • Inventory turnover indicates whether a company
    (compared with peer companies) holds too much
    inventory, which is very unproductive and
    represents an investment with a low return
  • DSO shows the average collection period or how
    long customers usually take to pay their bills.
    The higher the DSO, the more money is lost,
    because the company has to finance the gap with
    expensive loans etc.
  • The fixed assets turnover ratio indicates how
    effectively the company is using its fixed assets
    compared with peer companies.

Source Brigham, Houston (2009), 88ff.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Asset management ratios
  • Inventory turnover indicates whether a company
    (compared with peer companies) holds too much
    inventory, which is very unproductive and
    represents an investment with a low return
  • DSO shows the average collection period or how
    long customers usually take to pay their bills.
    The higher the DSO, the more money is lost,
    because the company has to finance the gap with
    expensive loans etc.
  • The fixed assets turnover ratio indicates how
    effectively the company is using its fixed assets
    compared with peer companies.

Source Brigham, Houston (2009), 88ff.
33
Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Asset management ratios
  • Inventory turnover indicates whether a company
    (compared with peer companies) holds too much
    inventory, which is very unproductive and
    represents an investment with a low return
  • DSO shows the average collection period or how
    long customers usually take to pay their bills.
    The higher the DSO, the more money is lost,
    because the company has to finance the gap with
    expensive loans etc.
  • The fixed assets turnover ratio indicates how
    effectively the company is using its fixed assets
    compared with peer companies.

Source Brigham, Houston (2009), 88ff.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Debt or financing ratios
  • Creditors prefer a low debt to equity ratio
    whereas stockholders may want more leverage as it
    can magnify expected earnings (? pecking order
    theory). The optimal ratio between debt and
    assets is highly dependent on the firms business
    and industry.
  • The TIE ratio measures the extent to which
    operating costs can decline before the firm is
    unable to meet its interest costs. Not being able
    to pay interest costs will bring legal troubles
    and can result in bankruptcy.

Source Brigham, Houston (2009), 91ff.
37
Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Debt or financing ratios
  • Creditors prefer a low debt to equity ratio
    whereas stockholders may want more leverage as it
    can magnify expected earnings (? pecking order
    theory). The optimal ratio between debt and
    assets is highly dependent on the firms business
    and industry.
  • The TIE ratio measures the extent to which
    operating costs can decline before the firm is
    unable to meet its interest costs. Not being able
    to pay interest costs will bring legal troubles
    and can result in bankruptcy.

Source Brigham, Houston (2009), 91ff.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Profitability ratios
  • The profit margin on sales shows the profit per
    unit of sales
  • This ratio shows the raw earning power of the
    firms assets excluding potential influence from
    interest payments or leverage effects.
  • Stockholders want to earn a return on their money
    invested. This ratio indicates the profitability
    of a stockholders invested money from an
    accounting perspective

Source Brigham, Houston (2009), 95ff.
41
Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Profitability ratios
  • The profit margin on sales shows the profit per
    unit of sales
  • This ratio shows the raw earning power of the
    firms assets excluding potential influence from
    interest payments or leverage effects.
  • Stockholders want to earn a return on their money
    invested. This ratio indicates the profitability
    of a stockholders invested money from an
    accounting perspective

Source Brigham, Houston (2009), 95ff.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
Winter Term 2009
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Profitability ratios
  • The profit margin on sales shows the profit per
    unit of sales
  • This ratio shows the raw earning power of the
    firms assets excluding potential influence from
    interest payments or leverage effects.
  • Stockholders want to earn a return on their money
    invested. This ratio indicates the profitability
    of a stockholders invested money from an
    accounting perspective

Source Brigham, Houston (2009), 95ff.
Winter Term 2009
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
Winter Term 2009
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Market value ratios
Numbers of shares 50m Share price 23
  • This ratio shows how much an investor is willing
    to pay per unit of reported earnings. Thus, the
    P/E ratio indicates, by comparison with its
    peers, whether a company is regarded as being
    risky or expected to have poor growth.

Cash flow net income DA
  • Depending on the industry, a firms stock price
    is tied more closely to cash flow than net
    income.
  • Remember Net income DA cash flow
  • The market to book ratio typically exceeds 1.0 as
    the balance sheet does not reflect inflation or
    goodwill. In addition, this ratio provides an
    indication whether a company is able to earn high
    returns.

Source Brigham, Houston (2009), 98ff.
47
Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
Winter Term 2009
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Market value ratios
Numbers of shares 50m Share price 23
  • This ratio shows how much an investor is willing
    to pay per unit of reported earnings. Thus, the
    P/E ratio indicates, by comparison with its
    peers, whether a company is regarded as being
    risky or expected to have poor growth.

Cash flow net income DA
  • Depending on the industry, a firms stock price
    is tied more closely to cash flow than net
    income.
  • Remember Net income DA cash flow
  • The market to book ratio typically exceeds 1.0 as
    the balance sheet does not reflect inflation or
    goodwill. In addition, this ratio provides an
    indication whether a company is able to earn high
    returns.

Source Brigham, Houston (2009), 98ff.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Market value ratios
Numbers of shares 50m Share price 23
  • This ratio shows how much an investor is willing
    to pay per unit of reported earnings. Thus, the
    P/E ratio indicates, by comparison with its
    peers, whether a company is regarded as being
    risky or expected to have poor growth.

Cash flow net income DA
  • Depending on the industry, a firms stock price
    is tied more closely to cash flow than net
    income.
  • Remember Net income DA cash flow
  • The market to book ratio typically exceeds 1.0 as
    the balance sheet does not reflect inflation or
    goodwill. In addition, this ratio provides an
    indication whether a company is able to earn high
    returns.

Source Brigham, Houston (2009), 98ff.
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Balance sheet and income statement
Source Brigham, Houston (2009), 61.
Source Brigham, Houston (2009), 58.
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Agenda Case study
  • Beans Incorporation vs. Garlic Incorporation

53
Case study Interpretation of financial
statements
  • Your client tells you he is interested in
    investing in a company from the food industry as
    he sees great growth potential in this industry
  • He has already selected two potential targets and
    now wants your professional advice on which
    company is more likely to report good results in
    the future
  • Please try to give your client your opinion based
    on what you have learned in this course
  • Read the financial statements and calculate the
    ratios based on 2008 figures
  • Compare these ratios with those of the other
    company and with those of the industry average

54
Case study Beans Incorporation I
Beans Inc.
55
Case study Beans Incorporation II
Beans Inc.
  • By analyzing its financial statements, what are
    the strengths and weaknesses of this company?
  • Where do you see risks or opportunities?

56
Case study Garlic Incorporation I
Garlic Inc.
57
Case study Garlic Incorporation II
Garlic Inc.
  • By analyzing its financial statements, what are
    the strengths and weaknesses of this company?
  • Where do you see risks or opportunities?

58
Case study Solution guideline
  • Liquidity ratios
  • Asset management ratios
  • Debt ratios
  • Profitability ratios
  • Market value ratios
  • Try to assess whether the given company shows a
    healthy relation between profitability, liquidity
    and risk
  • If a company shows high exposure to risky
    investments, one expects the profitability to be
    accordingly
  • Try to come to a conclusion on which company is
    more likely to pursue an expansive strategy and
    strengthen its position within the market
  • In terms of ability to generate cash flows,
    capital structure and working capital management

59
Case study Solution guideline II
  • Try to compare the companies with each other and
    put the results into perspective using the
    industry average values on the right
  • Industry average figures can be seen as a guide
  • Why is the company less profitable than average
    peer companies?
  • Why does one company have such a high P/E
    multiple and what does that mean for the
    operating business?
  • ? Financial statements can never fully answer
    such questions. However, they can raise the right
    questions

Source Brigham, Houston (2009), 103.
60
Contents
  • Learning targets
  • Pre-course reading
  • Lecture Interpreting Financial Statements
  • Pre-course reading case studies / questions
  • Solutions to case studies

61
Solutions to Case Study
  • Will be distributed after lecture

Winter Term 2009
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