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  • 1. Introduction to Financial Analysis for Corporations by George W. Blazenko and Kirk Vandezande All Rights Reserved © 1998 Chapter 2 Using Financial Statements in Financial Analysis “Things must be made as simple as possible, but not simpler.” — A. Einstein 2–1
  • 2. Contents of Chapter 2: Using Financial Statements in Financial Analysis 2–2
  • 3. Contents of Chapter 2: Using Financial Statements in Financial Analysis..................................2 (2.1) 4 (2.2) 6 A SPREADSHEET TEMPLATE FOR FINANCIAL RATIOS 7 (2.3) 8 GROSS OPERATING PROFIT 10 NET OPERATING MARGIN (EBITDA MARGIN) 10 DEPRECIATION 11 NET INCOME 12 GAINS AND LOSSES 12 PROVISION FOR INCOME TAX AND DEFERRED TAX (FUTURE INCOME TAX LIABILITY) 13 (2.4) 17 ASSETS 17 (2.5) 21 THE FINANCIAL DEFINITION OF INVESTED CAPITAL 21 THE OPERATING DEFINITION OF INVESTED CAPITAL 22 INVESTED CAPITAL RATIOS 24 EBITDA MARGIN AND INVESTED-CAPITAL TURNOVER 28 (2.6) 30 THE RATE OF RETURN ON EQUITY 30 (2.7) 32 (2.8) 33 TURNOVER RATIOS 33 THE CASH CONVERSION CYCLE 35 (2.9) 35 THE OPERATIONAL DEFINITION OF FREE CASH FLOW 37 THE FINANCIAL DEFINITION OF FREE CASH FLOW 38 AFTER–TAX NET DISTRIBUTIONS TO DEBT–HOLDERS 39 NET DISTRIBUTIONS TO SHAREHOLDERS 40 NET DISTRIBUTIONS TO FINANCIAL ASSET–HOLDERS 40 2–3
  • 4. (2.1) Financial accounting is the process of producing and disseminating information about the economic activities of a firm. Accountants prepare annual and quarterly reports, and more specifically, financial statements, to transmit this information to interested readers. Many different groups of decision-makers require information from financial statements. These groups include shareholders, creditors, employees, suppliers, government, and social interest groups. Financial statements are general summaries of economic activity because user groups have diverse interests. Perhaps because of this diversity of needs, accountants take pains to ensure the accuracy of the information presented in financial statements but they provide no guidance on their use. One goal of this book, therefore, is to explain how investors can use financial statement information to analyze business investments. For at least two reasons, communication is weaker between professional accountants and the users of financial statements than between other professionals and the users of their services. First, accounting principles and the pronouncements of regulatory agencies tightly constrain the content and format of statements issued for corporations and especially for publicly traded firms. Therefore, accountants have only limited room to respond to vary their treatment of the facts. Second, not only do users of financial statements have little opportunity to make direct requests of accountants for individual treatment, but also the users of financial statements must share one official set of statements, in spite of diverse interests. Since the relationship is weak between users of financial statement and producers of financial statement, a second goal of this book is to provide a framework for those who will prepare financial statement to assess the informational requirements of investors. In this chapter, we integrate ratio calculations into a discussion of financial statements. This integration highlights the use of financial statements in financial analysis. The perspective developed in this chapter has its origins in the financial industry. We emphasize the perspective of financial analysts, who use financial ratios to make investment decisions, rather than the perspective of accounting and 2–4
  • 5. corporate finance texts, which is more abstract. An excellent treatment of financial ratios is found in the text read by candidates for The Canadian Securities Course.1 Financial ratios measure business performance, efficiency, and risk. If used carefully, ratios can be valuable as a tool to assess the financial health of a firm. For most ratios, however, it is difficult to determine whether the value of a ratio for a firm is good or bad, high or low. The reason for this uncertainty is that economic theory is not yet sufficiently strong to offer analytic benchmarks. Until we have a more complete theoretic picture, we must resort to using relative rather than absolute comparisons. We use ratios in two general ways, by looking at trends in data over time, and by comparing firm-specific data to industry benchmarks. In trend analysis, we look for improvement or deterioration in ratios relative to prior values of the same ratio. In an industry comparison, we see how a firm has performed relative to its industry. Each of these methods of comparison can reveal important firm characteristics. Benchmarking is an especially valuable use of ratios. Suppose for example, that we forecast operating results predicted for a new business venture. If our forecast financial statements produce financial ratios that are far from the industry average or far from the firm’s historic experience, then we have grounds to reconsider the assumptions of the planning exercise. In this way, ratio analysis imposes discipline on the assumptions we use in financial planning. We use ratio analysis again when we discuss financial planning and capital budgeting in later chapters of this book. 1 Any individual who sells financial securities in Canada must pass the Canadian Securities Course. It is excellent preparation for anyone who pursues a career in finance. For further information, follow this hyperlink 2–5
  • 6. (2.2) Financial managers should be familiar with a number of limitations to the use of financial ratios. First, there is no objective standard for most ratios. What constitutes a high or a low value for a ratio is often a question for business judgment rather than economic theory. Second, differences between firms' accounting methods limit the comparability of many ratios. Therefore, where there is a choice as to measure, seek to use ratios that are unaffected by arbitrary choices of accounting treatment. Third, some ratios that share the same name are calculated in different ways. Different accounts can be included or excluded; and broader or narrower interpretations might be employed for different classes of financial assets. Because theory in this area is not yet strong enough to tell us exactly what or how to measure, then naturally, different analysts employ different measures, and in different ways. The set of ratios described in this chapter, which is essentially the same as the ratios in The Canadian Securities Course text, is well suited to financial analysis. There are also limitations particular to industry comparisons of financial ratios. First, many firms operate in more than one industry. Ratios that you calculate for such a firm are a weighted average of the ratios associated with its different industry operations. Unless you decompose financial data for such a firm by industry, an overall comparison to one industry is not likely to be meaningful. Second, an industry average might not be an appropriate objective for your firm. If a whole industry is inefficient, it makes little sense to applaud a move towards the industry average. On the other hand, a firm that is better than the industry in any one dimension is not necessarily in peak financial health. Third, industry averages conceal significant variation, which typically exists for any ratio across firms in the industry. One interpretation of this variation is that, even for firms in the same industry, there is not necessarily a “best” value for a particular ratio. There may, in fact, be different paths to robust financial condition. 2–6
  • 7. Lastly, industry comparison is a narrow perspective on corporate benchmarking. Remember that the objective of a firm is to maximize shareholder wealth. While you, as an employee of your firm, may be particularly interested in how the firm performs relative to your competitors, shareholders have a broader perspective. Shareholders are restricted neither to investing in any one firm, nor to investing in any one industry. Each firm must compete globally for the financial resources of dispassionate investors who choose to invest wherever they like, in many different firms and in many different industries. If an industry performs poorly relative to other industries, each firm in the industry suffers the financial consequences just as surely as if a firm performs poorly relative to industry competitors. If your objective is to maximize shareholder wealth, then you must maintain a broader perspective on performance than the perspective allowed by a simple industry comparison of ratios. A financial analyst certainly must know the limitations of financial ratios. Nonetheless, don’t make the mistake of dismissing ratios simply because they are prepared by accountants or because they are often used mechanically and thoughtlessly by untrained individuals. There is a wealth of information in financial statements, but to put this information to effective work we must understand how they are produced, and to keep this information in perspective, we need the conceptual framework of investment analysts. A Spreadsheet Template for Financial Ratios All the ratios discussed in this chapter are calculated for an actual firm, Anchor Lamina, in the worksheet embedded below. Anchor Lamina, with plants in Ontario, Michigan, and Germany, specializes in custom tooling for the automotive industry. Ratios More than a textbook illustration of ratio analysis, the Anchor Lamina workbook serves also as a template for ratio analysis of other firms. The required inputs are the income statement and the 2–7
  • 8. balance sheet. The spreadsheet then automatically calculates each of the performance measures we develop in this chapter. The following section begins our discussion of financial ratios and financial analysis by describing the two principal financial statements: the income statement and the balance sheet. The discussion is illustrated with selections from an annual report of Chirco Kraft Company, Limited. Chirco Kraft is one of North America's largest independent manufacturers of printed circuits and micro-electronic products used in computers, telecommunications and other electronic systems. (2.3) Within the confines of generally accepted accounting principles and other accounting conventions, the income statement measures the increment to shareholders' wealth over a specific period of time – generally a quarter or a year. The shareholder orientation of this statement makes it of central importance to existing and potential shareholders. Income statements appear in a variety of forms but all satisfy the fundamental relationship: Net Income = Revenues — Expenses. Revenue is a measure of the benefit of sales events in a period: price times the number of units sold summed over the different products and services sold by the firm. Exhibit 2-1 presents the 1988 income statement for Chirco Kraft, where we see that Sales for 1988 were $91,374,000. 2–8
  • 9. CHIRCO KRAFT Co. Statement of Income for the year ended December 31, 1988 (in thousands) Sales $ 91,374 Less: Cost of Sales 69,036 Gross Profit $ 22,338 Selling, General and Administrative Expenses 8,479 Other Expenses – Earnings before interest, tax, depreciation, and $ 13,859 amortization (EBITDA) Depreciation 6,376 Earnings before Interest and Tax (EBIT) $ 7,483 Less: Interest Expense 782 Less: Provision for Income Taxes Current Taxes 1,873 Deferred Taxes 539 Net Income $ 4,289 Exhibit 2–1: Sample Income Statement A common decomposition of financial statement expenses is Costs of Sales (also referred to as costs of goods sold), Selling, General and Administrative Expenses, Depreciation, and Interest. Costs of Sales measures expenses associated with production: materials and supplies, direct labor costs, freight-in, heat, light, power, insurance and safety, maintenance and repairs, salaries, and warehouse costs. Selling, General and Administrative Expenses include all commercial expenses of operation not directly related to production but incurred in the course of business activity: sales commissions, advertising expense, marketing expense, freight-out, pension, retirement, profit sharing, provision for bonus and stock options, and other employee benefits. Occasionally, depreciation is included in general and administrative expenses. 2–9
  • 10. Gross Operating Profit Sales less Costs of Sales equals Gross Income or Gross Profit From Operations. Gross profit is a measure of the profitability of a firm's production. The term “operations” is typically used in connection with a firm's fundamental business activity (before distributions are made to suppliers of capital – like dividends and interest). This separation of operations from financing activity is of critical importance if one is to disentangle shareholders' benefits from a firm's business activity and shareholders' benefits from financing activities. Because gross profit is measured in dollars, inter-firm comparison of gross profit is meaningless until we consider the size of each firm. Financial analysts facilitate inter-firm comparison by calculating gross profit margin: gross profit divided by sales. Because gross profit margin is a percentage, it is comparable across firms. However, because financial accountants have discretion in the classification of expenses as “cost of goods sold” or “general and administrative,” the comparability of this ratio across firms is limited. For Chirco Kraft, gross profit is $22,338,0000 and gross profit margin is 24.45%. Net Operating Margin (EBITDA Margin) Gross profit less selling, general, and administrative expenses (before depreciation and amortization) equals earnings before interest, tax, depreciation and amortization which is often abbreviated as EBITDA2. EBITDA measures profitability of a firm's operations, net of both production and commercial expenses. Financial analysts calculate net operating margin (which is also referred to as the EBITDA margin) as EBITDA divided by sales. EBITDA EBITDA Margin = Sales In 1988, Chirco Kraft’s EBITDA margin was $13,859/$91,374 = 15.2% 2 EBITDA is also typically calculated before the line items “other income” and “extraordinary income” (or loss). Each of these amounts is either non-recurring or outside the firm’s normal business practice. Therefore, EBITDA as described in the text above is sometimes referred to as “EBITDA from core operations.” For simplicity, unless otherwise stated in this electronic book, when we use the term EBITDA we really mean EBITDA from core operations. 2 – 10
  • 11. The EBITDA margin is designed for comparability across firms because taxes, interest expense, depreciation and amortization are excluded. These four income statement line items are influenced by the idiosyncratic characteristics of individual firms. For example, tax expense varies with firm size, and with the existence of prior year losses that offset current-year taxable income. Interest expense depends on the amount of debt used by a firm, which is more or less discretionary. Accountants choose depreciation schedules and this choice need not be the same even for firms in the same industry. For these reasons, any financial ratio that depends on tax expense, depreciation, or interest has limited comparability across firms. The EBITDA margin is a measure of operating efficiency. It measures the fraction of $1 of sales, which goes to the “bottom” line after production and commercial expenses. In later chapters, we will see that the EBITDA margin is also a measure of “operating risk.” In the appendix to this chapter, the EBITDA margin is sorted and presented for 302 different industry averages. The median value for the EBITDA margin for firms in the North American economy is approximately 10.5%. This value is useful for benchmarking North American firms with respect to operating efficiency and operating risk. Depreciation Economic depreciation is the change (generally a reduction) in the fair market value of an asset during an accounting period arising from deterioration in its earnings ability. Because the value of an asset depends upon the cash flow that it produces, economic depreciation reflects the reduction in future cash flows expected to be generated by the asset. An obvious factor in economic depreciation is asset usage. Assets used more intensely deteriorate more quickly, and therefore, economic depreciation should depend on the level of use. Nonetheless, the objectivity principle of financial accounting requires that financial statements be prepared from readily verifiable data. Therefore, accountants estimate economic depreciation according to predefined schedules that are invariant to asset use. For example, the most commonly used depreciation schedule is straight-line depreciation. Yearly depreciation equals the cost of the asset, less estimated salvage value, divided by estimated years of useful life. 2 – 11
  • 12. Shareholders bear the burden of economic asset depreciation and net income recognizes economic depreciation, but only with a crude approximation. This approximation is the “depreciation” line item that is seen on the income statement as an expense. Note well, however, that the deduction for depreciation is non-cash expense. Firms do not actual pay, in the sense of a cash outflow, for depreciation. They do, however, benefit from the tax deduction for depreciation that is allowed by the government for the purpose of income taxation. Net Income Net operating profit less interest, taxes, depreciation and amortization equals net income (often referred to as earnings). Net income divided by sales is net profit margin. Within the confines of generally accepted accounting principles (GAAP), net profit margin is the increase in shareholders' wealth for every dollar increase in sales, or equivalently, the net benefit of sales activity to shareholders. For this reason, net profit margin is also referred to as return on sales. Interest is subtracted in the calculation of net profit margin, and therefore, this interpretation is conditional on the current financial structure of the firm (i.e., the firm's use of debt financing). Net profit margin is a commonly calculated financial ratio but because it incorporates interest, taxes, depreciation and amortization, its usefulness for inter-firm comparison is limited. For inter-firm comparison, the EBITDA margin is a more reliable measure of operating efficiency. Gains and Losses Dispositions of assets (or an entire business venture) lead accountants to recognize associated capital gains or capital losses as a line item on the income statement. Capital gains or losses may have accrued over a significant period of time but they are recognized for accounting purposes only when an identifiable economic transaction occurs. Capital gains and losses are treated in a similar way for income tax purposes. 2 – 12
  • 13. Provision for Income Tax and Deferred Tax (Future Income Tax Liability) Income tax reported on the income statement does not represent the amount that a firm will pay to the government. This fact leads to a common labeling of this financial statement line item as provision for income taxes rather than income tax. Taxes actually paid equal taxable income multiplied by a corporate tax rate. The Income Tax Act mandates the procedure for calculating taxable income. Generally, taxable income is calculated as revenues minus allowable expense deductions. The Income Tax Act allows the accounting definition of revenues for income tax purposes. Most accounting expenses are also allowable deductions but a major exception is depreciation. Accounting depreciation is not an allowable deduction in calculating taxable income. Instead, the income tax act prescribes a specific system of depreciation rules for income tax purposes – the capital cost allowance. For tax purposes, similar assets are pooled and treated as one asset. The annual capital cost allowance for each depreciable asset pool equals the book value of the pool (its undepreciated capital cost) multiplied by a statutory depreciation rate. These rates, and detailed instructions for their application, may be found in the Income Tax Act or in references like those cited at the end of the chapter. Immediately after the purchase of an asset, capital cost allowance – depreciation for tax purposes – tends to exceed accounting depreciation. If one interprets accounting depreciation as an attempt by financial accountants to estimate economic depreciation, then the excess of capital cost allowance above financial statement depreciation is a tax incentive (a government subsidy) for firms that purchase depreciable assets. The financial statement line item provision for income tax calculates tax on a what-if basis: the taxes that would be paid if the government dictated financial statement depreciation and not capital cost allowance in calculating taxable income. When the capital cost allowance is greater than financial statement depreciation, then the provision for income taxes is greater than the actual income taxes paid. The difference between the provision for income taxes and actual taxes is called deferred taxes or future income tax liability. The difference between capital cost 2 – 13
  • 14. allowance and accounting depreciation is the primary reason for the existence of deferred tax in financial statements. Actual income taxes are often called current taxes. The provision for income tax equals current taxes plus deferred taxes. Current taxes and deferred taxes are the cash and non-cash components, respectively, of the provision for income tax. The following equation describes the relationship between these tax calculations: provision for income tax = current tax +deferred tax. (accounting) (actual $ amt) (subsidy) More formally, let t = corporate tax rate EBITDA = earnings before interest, tax, depreciation and amortization i = interest ∆ = economic and financial statement depreciation CCA = capital cost allowance Then t × (EBITDA – i – ∆ ) = t × (EBITDA – i – CCA) + (t) × (CCA – ∆ ) (provision for income tax) = (current tax) + (deferred tax) To illustrate these calculations, consider Chirco Kraft as an example. A tax-related footnote in the Chirco Kraft annual report reveals that the corporate tax rate is 36 percent (i.e., t = 0.36). From exhibit 2-1, we also see that EBITDA = 13,859 i = 782 ∆ = 6,376 The provision for income tax is 36 percent of operating income adjusted for interest and accounting depreciation. Provision for income tax = (0.36) × ($13,859 – $782 – $6,376) = $2,412 Current tax = $1,873 Deferred Tax = $539 2 – 14
  • 15. If the government allowed only the accounting estimate of economic depreciation, $6,376,000, as a tax deduction for depreciation, taxes payable would equal the provision for income tax, $2,412,000. Because CCA exceeds accounting depreciation, actual taxes paid (i.e., current taxes) are less, only $1,873,000. The difference between these two amounts is deferred tax, $539,000. CCA is calculated and reported only on a firm’s income tax return. Because this information is private, it is not generally available to external financial analysts. However, under the assumption that the difference between financial statement depreciation and CCA is the only reason for deferred tax, reported amounts for current and deferred tax can be used to calculate the implied capital cost allowance which was used: Current taxes = $1,873 = (0.36) × ($13,859 – $782 – CCA) ⇒ CCA = $7,874 or else like this, deferred taxes = $539 = (0.36) × (CCA – $6,376) ⇒ CCA = $7,874 Notice that implied capital cost allowance is greater than financial statement depreciation: $7,874,000 > $6,376,000. This difference reflects the tax incentive for purchase of depreciable assets. The amount by which Chirco Kraft is able to reduce its tax bill because of the excess of capital cost allowance above economic depreciation is deferred tax. In this example, deferred tax equals $539,000 [that is 0.36 × ($7,874,000 - $6,376,000)], the value of the government subsidy. Deferred tax is part of provision for income tax, and provision for income tax is an expense subtracted from net income (before tax and extraordinary items) in calculating net income. The interpretation of deferred tax as a tax subsidy seems incompatible with provision for income taxes as an expense. A better interpretation is that deferred tax is subtracted in calculating net income in order to decompose the change in shareholders' wealth over an accounting reporting period into a part which arises from business activity – net income – and part which arises from the depreciation tax subsidy – deferred tax. The sum of net income and deferred tax is an estimate of the increase in shareholders' wealth over a year. For Chirco Kraft in 1988, this total increase is $4,289,000 + $539,000 = $4,828,000: the first amount arises from business activity, 2 – 15
  • 16. the second is a tax subsidy. Notice that it is important to correctly interpret net income and deferred tax because deferred tax can be a large fraction of wealth increase. We have interpreted deferred tax as a subsidy given by the government to firms to encourage the purchase of depreciable assets. Because subsidies accrue to the residual claimants in the firm (shareholders), deferred tax can be interpreted as “equity” on the balance sheet. Also, because deferred tax is not associated with any other identifiable financial asset (recall the definition of a financial asset from Chapter One), it must be associated with the residual financial asset – common equity. Some accountants argue that deferred taxes eventually reverse, that the firm “owes” tax authorities, and hence it is a liability. Note, however, that when the mismatch between the provision for taxes and current taxes is reversed, the difference flows to retained- earnings. This flow arises because, other things equal, net income is higher after the reversal than before and deferred income tax on the balance sheet falls. This reversion into retained- earnings highlights the fact that deferred tax is typically best treated as equity for the purpose of financial analysis. Financial analysts sometimes interpret deferred tax as an “interest free loan” from the government. There is a sense in which deferred tax can be interpreted as a “liability.” Deferred tax approximates “recapture of depreciation3” which would be paid by the firm to the government if the firm were to cease operations and sell their depreciable assets at the accounting book value. Under this interpretation, deferred tax is a contingent liability. Not only is this an “interest free loan” from the government but payment is at an indeterminate time in the future. Recapture of depreciation is paid only under very special tax circumstances associated with the liquidation of depreciable assets. Thus, the interpretation of deferred tax as equity makes the most sense for a firm that is unlikely to face forced liquidation of all depreciable assets. The interpretation of deferred tax as an approximation of recapture of depreciation is investigated in some detail in a problem at the end of this chapter. 3 See the chapter on taxes for a discussion of depreciation recapture. The word “recapture” implies that the firm has taken “too much” depreciation for tax purposes, and therefore, the government “wants it back.” 2 – 16
  • 17. (2.4) The purpose of the accounting balance sheet is to summarize resources of the firm available for conducting business operations (assets) and claims against these assets (liabilities and shareholders equity). The accounting balance sheet describes transaction amounts rather than values. On the other hand, it is the purpose of financial analysis to estimate investment values. Fiscal year-end balance sheets for 1987 and 1988 for Chirco Kraft are illustrated in exhibit 2-2. Assets Assets are commonly categorized as current assets and non-current assets. Current assets are those assets which are expected to be transformed (in the normal course of business activity) into cash in the relatively near term (i.e., within a fiscal year). The most commonly described current assets on the balance sheet are Cash and Marketable Securities, Accounts Receivable, and Inventories. Marketable securities are financial assets of other corporations or governments held as short-term investments. Because marketable securities are extremely liquid, they are considered cash equivalents. Accounts receivable are amounts due from customers less an estimate of amounts unlikely to be paid (doubtful accounts). Inventories include both finished product inventories and and raw materials inventories. Inventory is recorded at cost of purchase or production. Chirco Kraft Co. Comparative Balance Sheets for fiscal years 1987 and 1988 (in thousands) 1987 1988 Assets Current Assets Short-term investments $1,779 $2,318 Account receivable 14,096 12,152 Income taxes – 1,318 Inventories 12,561 12,552 Prepaid expenses 133 536 Total Current Assets 28,569 28,876 2 – 17
  • 18. Fixed Assets 43,313 44,065 Total Assets $71,882 $72,941 Exhibit 2–2: Sample Balance Sheet When finished goods are sold, the periodic cost of goods sold is incremented and inventory on the balance sheet is decremented (recall the accounting matching principle). The balance sheet figure for inventories depends upon whether inventory is decremented by the cost of units first placed in inventory (first in first out inventory accounting – FIFO) or by the cost of units last placed in inventory (last in first out inventory – LIFO). During inflationary periods, inventory value is greater, cost of goods is lesser, and net income is greater with FIFO inventory accounting (because units first in inventory are likely to be less costly) than with LIFO accounting. Thus, if FIFO is used for tax purposes, taxable income and taxes payable are higher than if LIFO is used. Non-current assets are held by corporations to support production and commercial operations over a relatively longer horizon than a fiscal year. The most common category of non-current Chirco Kraft Co. Comparative Balance Sheets for fiscal years 1987 and 1988 (in thousands) 1987 1988 Liabilities Current Liabilities Bank indebtedness $1,104 $3,014 Accounts-payable and accrued liabilities 11,204 9,522 Income taxes 775 – Current portion of long-term debt 1,722 1,519 Total Current Liabilities $14,805 $14,055 Long-term debt 3,553 10,190 Deferred income taxes 7,617 8,156 Total Liabilities $25,975 $32,401 2 – 18
  • 19. Shareholders' Equity Share capital 17,100 17,100 Retained earnings 28,807 23,440 Total Equity 45,907 40,540 Total Liabilities and Owners’ Equity $71,882 $72,941 Exhibit 2–2 (continued): Sample Balance Sheet assets described on an accounting balance sheet is Property, Plant and Equipment (often labeled fixed assets). These fixed assets are recorded at original cost less accumulated depreciation. The financial side of the balance sheet – liabilities and shareholders' equity – describes cumulative (over time) sources of funds used to finance the firm’s assets. Liabilities are commonly segregated into current liabilities and non-current, or long-term, liabilities. Current liabilities are expected to be paid within a fiscal year. Current liabilities are commonly composed of short-term debt, accounts payable, income taxes payable, salaries and wages payable, and the current portion of long-term debt. Short-term debt is formal borrowing by the firm from either commercial banks or by selling short-term debt securities. The market in which short-term debt securities trade is called the money market. The term money is used because securities that trade in this market have many characteristics of money. In particular, such debt instruments mature in less than one year and carry minimal risk of default. Short-term borrowing of Chirco Kraft is from a commercial bank and therefore their financial statement line item is labeled bank indebtedness. Accounts payable are amounts owing suppliers. Wages and salaries payable are amounts owing employees. Chirco Kraft refers to these amounts as accrued liabilities and includes them with accounts payable. The current portion of long-term debt is the amount of principal on long-term debt that the firm expects to repay over the course of the upcoming fiscal year. The increment to Chirco Kraft’s retained earnings between 1988 and 1987 is $23,440 – $28,807 = ($5,367). Net income was $4,289. The difference between these two numbers implies that Chirco Kraft paid dividends (no new issues of shares or share repurchases during 1988) in the amount of $5,367 + $4,289 = $9,656. Alternatively, we can obtain this value in the following way: absent any distributions to shareholders, retained earnings in 1988 should be $28,807 + $4,289 = $33,096 (i.e., 2 – 19
  • 20. beginning balance plus net income). Because retained earnings in 1988 is only $23,440, dividends must equal the difference: $33,096 – $23,440 = $9,656. 2 – 20
  • 21. (2.5) The Financial Definition of Invested Capital The total of all funds that have been invested by financial asset-holders in a firm is referred to as “invested capital.” The term “invested” is used because these funds are associated with identifiable financial assets sold by the firm. Invested capital is a measure of expenditure by financial asset-holders rather than a measure of the current value of these financial assets. All accounts on the financial side of the balance sheet that are associated with financial asset investing are included in the calculation of invested capital. Invested capital is a commonly used measure in the investment industry because it provides a good organizing framework for Chirco Kraft Co. Invested Capital as of December 31,1987 (thousands) Bank Indebtedness $1,104 + Short-term Debt – + Dividends Payable – + Current Portion of long-term Debt 1,722 + Long-term Debt 3,553 + Deferred Taxes 7,617 + Preferred Shares – + Share Capital 17,100 + Retained Earnings 28,807 + Other Financial Assets – = Invested Capital $59,903 Exhibit 2–3: Sample Calculation of Invested Capital analysis. It helps to separate the two sides of the “coin” which is the corporation, the operating side and the financial side. A defining feature of the components of invested capital is that their composition is, more or less, at the discretion of the firm. For example, in place of raising more 2 – 21
  • 22. equity, firms may choose more long-term debt, or firms may choose to roll over short-term debt continually, or firms may use preferred shares, et cetera. Within the general framework of the financial definition of invested capital, there are a number of ways to calculate invested capital. In particular, various accounts can be included or excluded. One definition in common use is applied in Exhibit 2-3 to year-end 1987 results for Chirco Kraft (see also Chapter 6 of the Canadian Securities Course). At the end of 1987, financial asset-holders had invested a sum total of approximately $59.9 million into the financial assets of Chirco Kraft. The Operating Definition of Invested Capital If invested capital measures the amount that financial asset-holders have invested in the financial assets of a firm, then the other side of the coin (the corporation) must measure the amount which the firm has invested into business activity on behalf of all financial asset-holders. This is the operating definition of invested capital. Firms make two general types of business investments. First, firms invest in what might be termed their “trading” function. Firms make trades associated with the two components of the income statement, revenues and expenses. Sales represent trades that firms make with their customers. Expenses represent trades that the firm makes with their suppliers, employees, landlords, and the government. Firms must make an investment into short-term assets in order to support this trading function. For example, accounts receivable are held to support credit sales. Inventories are held to ensure that sales can take place when requested by customers. Some of these short-term investments can be financed with deferred payments associated with trades that the firm makes with product and service suppliers. These deferred payments are measured on the accounting balance sheet as, for example, “accounts payable,” “wages payable,” and “income taxes payable.” Income taxes payable can be thought of as a deferred payment for the infrastructure services provided by the government. The net amount which firms must hold to support the trading function associated with their operations is referred to as “trade capital.” 2 – 22
  • 23. Trade capital equals current assets minus current liabilities on the balance sheet but excluding from current liabilities those accounts that are purely financial in nature. The excluded accounts are related to financial asset investing and are not operational in nature (that is, they are more or less not directly related to operations). Accounts that reasonably can be excluded are dividends payable, short-term debt, and the current portion of long-term debt. Trade capital is similar to net working capital. Net working capital is defined as current assets less current liabilities. The difference between trade capital and net working capital is that trade capital excludes any current liability accounts that are purely financial in nature. The second investment that firms make into business activity is net fixed assets. This investment is required to support the long-term production and commercial activities of the firm. Net fixed assets equals the cost basis of fixed assets, net of accumulated depreciation. The sum of trade capital, net fixed assets and other assets (as appropriate) equals invested capital. The amount financial asset-holders have invested in the firm is equal to the amount the firm has invested into its business activity. In exhibit 2-4 below, the accounting balance sheet is rearranged into a balance sheet referred to as an invested capital balance sheet. The right-hand side shows the investments made by financial asset-holders. The left hand-side shows the investments made by the firm into business operations. In exhibit 2-4, trade capital is calculated as total current assets less accounts payable, and less accrued liabilities. Long-term debt is the sum of the current portion of long-term debt and long- term debt. Equity is the sum of share capital, retained earnings, and deferred taxes. Because deferred taxes represent corporate profitability that has not been allowed (by financial accountants) to flow through to retained earnings, it is interpreted as “equity” for the purpose of financial analysis. 2 – 23
  • 24. Chirco Kraft Co. Invested Capital Balance Sheets for fiscal years 1987 and 1988 (in thousands) 1987 1988 1987 1988 Trade Capital $16,590 $19,354 Bank Debt $1,104 $3,014 Net Fixed Assets $43,313 $44,065 Long-Term Debt 5,275 11,709 Equity 53,524 48,696 Invested Capital $59,903 $63,419 Invested Capital $59,903 $63,419 Exhibit 2–4: Sample Invested Capital Balance Sheet Invested Capital Ratios A number of interesting ratios can be calculated using invested-capital and its component parts. First, the debt-to-invested capital ratio is: Debt (short - term debt + long - term debt + other liabilities) Debt-to-Invested Capital = Invested Capital For Chirco Kraft at the end of 1987 the debt to invested-capital ratio is (1,104 + 5,275)/59,903 = 10.65%. This ratio indicates that 10.65% of the investment made by the firm into business activity was financed by debtholders. The industry averages reported in the appendix of this chapter indicate that a typical value for debt to invested capital is in the range of 40 to 50%. Debt-to-invested capital is a measure of the debt use of a firm. There are two reasons why an analyst might be interested in a firm’s debt use. First, debt imposes additional risk on shareholders beyond the risk associated with a firm’s operations. Second, because interest is tax-deductible, debt reduces a firm’s taxes payable. 2 – 24
  • 25. A second invested capital ratio is trade capital to invested capital. This ratio measures the fraction of the firm’s investment in business activity that is short-term and held to support the trading function of the firm. Other things equal (in particular, the level of a firm’s sales), firms would prefer to reduce their investment in trade capital. If a firm can maintain sales but decrease trade capital, the rate of return that the firm earns for all financial asset-holders, the rate of return on invested capital, is increased. The trade-off between lesser trade capital and reduced sales is referred to as a firm’s trade capital (or working capital) problem. Trade Capital Trade Capital-to-Invested Capital = Invested Capital For Chirco Kraft at the end of 1987 the trade-capital-to-invested capital ratio is $16,590/59,903 = 27.7% Trade-capital-to-invested capital is reported for industry averages in the appendix to this chapter. Notice that the range of industry averages is from approximately zero to over 80%. This wide range indicates that for many firms, trade capital is an important component of investment in business activity. Recognition of this fact is important for focusing the financial planning and analysis efforts of these firms. When planning for expansion of business activity, all firms, and these firms in particular, should recognize incremental trade capital investment that is invariably required. A third invested-capital ratio is the rate of return on invested capital. The rate of return on invested capital is the rate of return that the firm earns for all financial asset-holders on the funds they originally invested. Because invested capital measures the expenditure by a firm on business activity, the rate of return on invested capital measures the return the firm earns on this investment. The rate of return on invested capital is not a rate of return on market value but a rate of return on funds expended. The comparison of rates of return on funds expended to rates of return on market values is an important corporate performance benchmark that is developed in this electronic book. 2 – 25
  • 26. The rate of return on invested capital is EBITDA divided by invested capital at the beginning of the period (b.o.p.). Any financial return calculation uses funds invested at the beginning of the investment period relative to benefits received over the course of the period. The rate of return to invested capital is abbreviated as ROIC. EBITDA ROIC = Rate of Return on Invested Capital = Invested Capital (b.o.p.) The ROIC for Chirco Kraft in 1988 was $13,859/59,903 = 23.1%. The representation of the benefits of a firm’s operating activity as a fraction of invested capital is generally very insightful because we all have some understanding of what constitutes a high or a low return in financial markets. The task of performance evaluation is one of determining appropriate performance measures and benchmarks. There are a number of variants and more comprehensive measures for the rate of return on invested capital. The rate of return on invested capital after depreciation is calculated as earnings before interest and tax (EBIT) divided by invested capital at the beginning of the period (b.o.p.). EBIT ROIC after depreciation = Invested Capital (b.o.p.) It should be recognized that although depreciation is a non-cash charge, if one takes a prospective orientation, ROIC after depreciation can be interpreted as a prediction of the rate of return that can be earned on invested capital in the future after replacement of deteriorated assets. The ROIC after depreciation for Chirco Kraft in 1988 was $7,483/$59,903 = 12.5%. The rate of return on invested capital after depreciation and after tax is calculated as EBIT times one minus the corporate tax rate divided by invested capital at the beginning of the period. The rate of return on invested capital after depreciation and after tax recognizes not only future 2 – 26
  • 27. replacement of deteriorated assets but also taxes payable as a result of operating activities and deductibility of depreciation charges for tax purposes4. EBIT × (1 - tax rate) ROIC after tax and after depreciation = Invested Capital (b.o.p.) The ROIC after depreciation and after tax for Chirco Kraft in 1988 was 8.0%, calculated as $7,483 × (1– 0.36) ÷ $59,903. A fourth invested-capital ratio is invested capital turnover. Invested capital turnover is a measure of the ability of a business to generate sales. Other things equal, firms that can increase sales without an increase in invested capital are more efficient. Because this notion is most appropriate for investment in business activity before incremental investment in the current period, this ratio is best calculated using invested capital (b.o.p.). Invested-capital turnover5 is calculated as sales for the period divided by invested capital (b.o.p.). Sales Invested Capital Turnover = Invested Capital (b.o.p.) The 1988 invested capital turnover ratio for Chirco Kraft was $91,374/$59,903 = 1.52. Invested capital turnover is an inverse measure of “capital intensity.” Firms that require greater investments into business activity to generate a dollar of sales are said to be capital intense. Firms that require large investment in fixed assets, which often have payoffs over many years (for example, utilities), have low invested-capital turnover. While firms have some influence over their invested-capital turnovers (for example, revenues depend upon product pricing), the example of utilities highlights the fact that invested capital turnover is, in large part, based on the technology of the industry in which a firm operates. For firms in North America, the median 4 The distinction between financial statement depreciation and CCA is not made in this return measure. 5 Rather than invested capital turnover, accountants tend to use asset-turnover, which is yearly sales divided by the book-value of all of a firm’s assets. 2 – 27
  • 28. invested-capital turnover ratio is approximately 1.5 (see the industry average ratios in the appendix). Using the definitions of EBITDA margin and invested capital turnover, you can illustrate that the rate of return on invested capital before depreciation and before tax is equal to the product of the EBITDA margin and invested capital turnover. ROIC can be calculated as EBITDA Margin × Invested Capital Turnover EBITDA Sales ROIC = × Sales Invested Capital (b.o.p.) EBITDA ROIC = Invested Capital (b.o.p.) For Chirco Kraft, if we multiply the 1988 EBITDA margin by the invested capital turnover (0.152 × 1.52), we get 23.1%, which is the same as our calculation above. EBITDA Margin and Invested-Capital Turnover EBITDA margin and invested capital turnover are related in one way because their product (EBITDA margin × invested capital turnover) gives us ROIC before depreciation and before tax. EBITDA margin and invested capital turnover are related to each other in another way, too. As is evident from the industry averages in the appendix, industries with low invested capital turnover tend to have high EBITDA margins. The reason for this relationship is a combination of the returns required by financial-asset investors and competition faced by firms in their product markets. These relationships highlight the inextricable co-dependant relationship between the operations of firms and financial markets. No firm can ignore this relationship. Why does there exist an inverse relationship between invested capital turnover and EBITDA margin? Here is a thought experiment meant to give you the intuition. 2 – 28
  • 29. Assume that financial markets expect the same ROIC from all firms. Call this the benchmark ROIC. A firm that earns precisely the benchmark ROIC has just enough cash flow to pay every investor’s opportunity cost of capital. Any firm that earns a return above the benchmark ROIC accumulates more wealth than is needed to cover its investors’ opportunity cost. The fortunate investors own the extra wealth, so the market prices of their financial assets (i.e., the tradable values of common shares, bonds, preferred shares, etc.) increase. If such exceptional performance persists, these firms can easily attract additional funds for investment in their business. On the other hand, a firm that earns less than the benchmark ROIC cannot pay investors as much as they can earn elsewhere. If such performance persists, investors will not invest in the securities of lagging firms. Without capital, under-performing firms will be forced to liquidate. To take the argument one step further, consider the effect of competition in product markets. If firms in a particular industry earn a ROIC in excess of the benchmark, not only is this particular firm likely to expand its operations, but also competitors are likely to enter the industry and the product market the firm in question. Thus, a firm’s operations depend (at least in part) upon whether firms have ROIC’s which exceed or fall short of the benchmark ROIC. Entry by competitors tends to undermine increases in product price and ease shortages in products. On the other hand, if an industry cannot earn its benchmark ROIC, firms shut down, industry supply shrinks and product prices rise. These observations imply that, at least over the long-term, ROIC’s of firms (even across industries) will tend toward the financial market benchmark. We mentioned above that invested capital turnover is in large part determined by the industry in which a firm operates. For example, firms in the utility industry tend to be capital intense and have low invested capital turnovers. If ROIC for every firm tends to the industry ROIC benchmark, but some firms in an utility industry have relatively low invested capital turnover, then (other things equal) they are likely to have relatively great EBITDA margins. The reason for this negative association between invested capital turnover and EBITDA margin is the influence of financial markets on product pricing (given the level of competition in the industry). 2 – 29
  • 30. Consider the electrical utiliy industry. For utilities to get earn an adequate rate of return for their suppliers of capital, they must offset a relatively low invested capital turnover with a relatively large EBITDA margin. This EBITDA margin is not reduced (at least significantly) by product price-competition because of barriers to entry in the industry associated with low invested capital turnover (i.e., high required fixed asset investment). In addition, if competitors were to enter the product market, product prices would fall, and ROIC would drop below the industry ROIC benchmark. Then the industry is unattractive for additional investment. Firms consolidate or leave the industry until product prices tend to increase. EBITDA returns to its original level and equilibrium is achieved once more between the product market and the financial market. (2.6) In the invested capital balance sheet shown in Exhibit 2–4, book equity was calculated as the sum of share capital, retained earnings and deferred tax. The traditional decomposition of equity on the accounting balance sheet into share capital and retained earnings (and any other additional accounts) might be useful to ensure full employment of accountants, but it is of little use to financial analysts. The sum of these amounts is a measure of the amount which shareholders have invested in the firm, either directly through the purchase of common shares or indirectly through retained earnings. It is not terribly useful to know the source of the funds invested by shareholders. The Rate of Return on Equity If the primary objective of a firm is the maximization of shareholders’ wealth, then an important measure of corporate performance is the rate of return that the firm earns on funds originally invested by shareholders. The rate of return on equity is calculated as net income over the period in question divided by “book equity” at the beginning of the period. The rate of return on equity is abbreviated as ROE. 2 – 30
  • 31. Net Income available to common + Deferred Tax ROE = Rate of Return on Equity = Book Equity (b.o.p.) Deferred tax appears in the numerator of ROE because deferred tax is truly an addition to common equity6. ROE for Chirco Kraft in 1988 was ($4,289+539) ÷ $53,524 = 9.0%. ROE can also be calculated using the following relationship: (ROIC after tax and after depreciation) × (Invested Capital) equals (After-tax interest) – Deferred Taxes + ROE × Book Equity In the case of Chirco Kraft in 1988, substituting from above yields this equation: 0.08 × $59,903 = $782 × (1– 0.36) – $539 + ROE × $53,524 Solving this equation for ROE shows that ROE = 9.0%, which is the value we calculated above. A third way to calculate ROE is by multiplying three ratios: net profit margin, invested capital turnover, and invested-capital to equity. ROE = Net Profit Margin × Invested Capital Turnover × Invested Capital to Equity Net Income + Deferred Tax Sales IC (b.o.p.) Net Income + Deferred Tax = × × = Sales IC (b.o.p.) Equity (b.o.p.) Equity (b.o.p.) For Chirco Kraft in 1987, their invested capital to equity ratio was $59,903 ÷ $53,524 = 1.12. For 1988, Chirco Kraft’s net profit margin was ($4,289 + $539) ÷ $91,374 = 5.284%, and their invested-capital turnover was 1.52. ROE can, therefore, be calculated as ROE = 0.05284 × 1.52 × 1.12 = 9% 6 Instead of the above, for simplicity, analysts often-times calculate ROE as net income divided by book equity, where book equity is possibly at the end of the period. 2 – 31
  • 32. (2.7) The liquidity of any investment is a measure of the likelihood that it can be sold (i.e., liquidated) without loss of value. Long-term assets are often difficult to liquidate. Thus, in the hypothetical case of forced liquidation of a firm’s operating investment, it is of interest to know whether a firm could pay all its current liabilities from only its current assets. Presuming no loss of value in this liquidation (in other words, presuming that current assets can be liquidated dollar for dollar as they are represented on the accounting balance sheet), the ability of a firm to meet its current liabilities is measured by the current ratio. The current ratio is calculated as current assets divided by current liabilities. Current Assets Current Ratio = . Current Liabilities Using the numbers from the 1988 balance sheet for Chirco Kraft, its current ratio is $28,876 ÷ $14,055 = 2.05. Is a declining current ratio good news or bad news for a firm? The answer to this question is that it depends upon the firm’s circumstances. The current ratio should not be used independently of other information and other analysis of a firm’s financial health. A declining current ratio that is associated with sales growth might be interpreted to mean which a firm is making more efficient use of its trade capital. On the other hand, a declining current ratio that is accompanied by a sales decline might be an indication that the firm is having financial difficulties. In the hypothetical exercise of liquidating a firm’s current assets and paying off current liabilities, it is often recognized that there is more potential for a loss in value when inventories are liquidated than when other current assets are liquidated. The quick ratio, which is a more exacting measure of liquidity than the Current Ratio, is current assets less inventory divided by current liabilities. Current Assets - Inventory Quick Ratio = Current Liabilities 2 – 32
  • 33. Using the numbers from the 1988 Chirco Kraft balance sheet, we find that its current ratio is ($28,876 – $12,552) ÷ $14,505 = 1.125. (2.8) For many firms, an important component of their investment into business activity is in the form of trade capital. Recall that if firms can reduce trade capital without reducing sales, the rate of return on invested capital increases to the benefit of all financial asset-holders in the firm, including shareholders. It is important, therefore, to assess the efficiency of a firm’s trade capital utilization. Turnover Ratios Three turnover ratios are used to measure the number of times (on average) that the major current asset accounts of a firm are “zeroed” (or liquidated) during a year, accounts receivable turnover, inventory turnover, and accounts payable turnover. To calculate each turnover ratio, we divide an income statement line item by the current account balance that it “generates.” Account receivable turnover is calculated as Sales divided by Accounts Receivable. Sales Accounts Receivable Turnover = Accounts Receivable From the 1988 financial statements for Chirco Kraft, accounts receivable turnover is $91,374 ÷ $12,152 = 7.52. This number means that Chirco Kraft collected its average accounts receivable balance 7.52 times during the year. In other words, the accounts receivable balance was liquidated 7.52 times during the year. The number of days it takes to collect a dollar of accounts receivable is referred to as the accounts receivable collection period. The accounts receivable collection period is calculated as the number of days during the year divided by accounts-receivable turnover. 2 – 33
  • 34. 365 Accounts-Receivable Collection Period = Accounts Receivable Turnover For Chirco Kraft in 1988, accounts-receivable collection period is 365 ÷ 7.52 = 48.54 days. Inventory turnover is calculated as cost of goods sold divided by inventory. Cost of Goods Sold Inventory Turnover = Inventory Using the numbers from the 1988 financial statements for Chirco Kraft, inventory turnover is $69,036 ÷ $12,552 = 5.5. This number means that Chirco Kraft sold or used its average inventory balance 5.5 times during the year. The number of days it takes to sell or use inventory is referred to as the inventory conversion period. The inventory conversion period is calculated as the number of days during the year divided by inventory turnover. 365 Inventory Conversion Period = Inventory Turnover For Chirco Kraft in 1988, the inventory conversion period is 365 ÷ 5.5 = 66.36 days. Accounts payable turnover is calculated as Cost of Goods Sold divided by Accounts Payable. Cost of Goods Sold Accounts Payable Turnover = Accounts Payable Using the numbers from the 1988 financial statements for Chirco Kraft, accounts payable turnover is $69,036 ÷ $9,522 = 7.25. This number means that Chirco Kraft pays its average accounts balance 7.25 times per year. The number of days it takes to make payments is referred to as the accounts payable deferral period. The accounts payable deferral period is calculated as the number of days during the year divided by accounts payable turnover. 2 – 34
  • 35. 365 Accounts Payable Deferral Period = Accounts Payable Turnover For Chirco Kraft in 1988, accounts payable deferral is 365 ÷ 7.25 = 50.34 days. The Cash Conversion Cycle The cash conversion cycle is a summary measure of a firm’s trade capital utilization. It measures the length of time (in days) a dollar is “outside” the firm as it circulates through the firm’s fundamental trade capital accounts: inventory, accounts receivable, and accounts payable. All else equal, firms would like to minimize the cash conversion cycle. The cash conversion cycle is calculated as the inventory conversion period plus the accounts receivable collection period less the accounts payable deferral period. Cash Conversion Cycle equals Inventory Conversion Period Plus Accounts Receivable Collection Period Less Accounts Payable Deferral Period The cash conversion cycle for Chirco Kraft is 48.54 + 66.36 –50.34 = 64.56 days. There is no absolute standard for the cash conversion cycle, and therefore, firms use trend analysis and industry comparisons to determine whether cash conversion is improving or deteriorating. Soenen (1993) reports the cash conversion cycle for a number of different industries. (2.9) Cash flow is the lifeblood of any firm. Firms with abundant cash flow thrive and grow; firms strangled by insufficient cash flow wither and die. Even short periods of inadequate cash flow have traumatic effects on firms and their employees. It is critically important, therefore, that you be able to trace and evaluate the flow of cash through your firm. Cash flow is investigated in this subsection using the concept of free cash flow. Free cash flow (FCF) plays a very 2 – 35
  • 36. important role in financial analysis. In later chapters of this book, predicted future free cash flow is the foundation of corporate valuation, the method we use for setting the value of a firm’s assets in place. Likewise, predicted incremental free cash flow from a new business venture is central to the evaluation of prospective real asset investments. Because of these important uses of free cash flow, it is essential to develop this concept early in our discussion. Let us begin with a casual and intuitive description of free cash flow. Free cash flow is the net amount of cash that flows into a firm as the result of operations. Inflows arise from this past investments in business activity. In the current period, the firm bears the “fruit” of past investment. In addition, the firm might make additional investments into business activity. These investments are composed of increments to trade capital and capital expenditure. Capital expenditure is the dollar investment into plant, property, and equipment. The difference between these two cash flows (the first is typically an inflow and the second is typically an outflow) is free cash flow. The adjective “free” refers to the fact that this net cash flow is available (i.e., free) to be distributed in one way or the other to financial asset holders. This relationship between cash flow arising from operations and distributions to financial asset holders implies that there is both a financial and an operational definition for free cash flow. This “sources and uses of funds” relation indicates that the net amount received from a firm’s operating activities is distributed to suppliers of capital: debt-holders and shareholders (plus any other financial asset-holders). The conceptual definition of free cash flow is all the cash from a firm’s operating activities that can be distributed back to financial asset-holders without affecting the current growth of a firm. However, the firm need not necessarily make this distribution. The firm might distribute these free cash flows to financial asset-holders, or use them for new business opportunities, or use them to pay down existing debt, all without reducing the value of existing assets. Calculations that apply this conceptual definition of free cash flow are developed in the following sub- section7. 7 The methods of calculating free cash flow that we develop do suffer from some conceptual difficulties. More comprehensive methods for calculating free cash flow are given in Hackel and Livnat (1992). 2 – 36
  • 37. The Operational Definition of Free Cash Flow Free cash flow can be calculated as funds from operations less incremental investment: Free Cash Flow = Funds from operations - Incremental Investment. Funds from operations (FFO) are the benefit of past investments in business activity. There are a number of ways to calculate funds from operations. First, Funds from operations = [EBITDA – CCA] × (1 – tax rate) + CCA CCA is added in this calculation because it is a non-cash charge. In the case of Chirco Kraft in 1988, we determined that CCA was $7,874. Funds from operations is, therefore, [13,859 - 7,874]*(1-0.36) + $7,874 = $11,704. This amount is available for reinvestment into business activity or for payment to financial asset holders. A second way to calculate FFO is Funds from operations = EBITDA – Current Tax – Interest Tax Shield The interest tax shield is the amount by which the corporation’s taxes are reduced because of the payment of interest. It is calculated as the corporate tax rate times the interest payment. The interest tax shield is subtracted in this definition of FFO because this tax benefit arises from the financing activities of a firm and not from its operations. The interest tax shield for Chirco Kraft in 1988 was (0.36) × 782 = $281.5. Using this definition for Chirco Kraft in 1988, FFO is, therefore, $13,859 – $1,873 – $281.5 = $11,704.5. Third, FFO can also be calculated as net income plus the sum of all non-cash charges plus distributions made to suppliers of invested capital, which have been subtracted in the calculation of net income. Funds from operations also equals Net Income + Depreciation + Deferred Tax + After-Tax Interest By the third definition, funds from operations for Chirco Kraft in 1988 can be calculated as $4,289 + $6,376 + $539 + (1 – 0.36) × $782 = $11,704.5. 2 – 37
  • 38. The final component of FCF is the incremental investment in business activity made by the firm for the period in question. First, the incremental investment in trade capital for 1988 can be found by subtracting trade capital at the end of 1987 from trade capital at the end of 1988 (e.g., trade capital in 1988 minus trade capital in 1987). Incremental investment in trade capital is, therefore, $19,354 – $16,590 = $2,764. Second, capital expenditure can be found by subtracting beginning of period net fixed assets from end-of-period net fixed assets and adding depreciation. For Chirco Kraft in 1988, net capital expenditure was $44,065 – $43,313 + $6,376 = $7,128. Lastly, incremental investment in business activity for the period is the sum of capital expenditure and incremental investment in trade capital. The incremental investment in business activity in 1988 for Chirco Kraft was $7,128 + $2,764 = $9,892. Free cash flow is equal to funds from operations less incremental investment in business activity. For Chirco Kraft in 1988, free cash flow is $11,704.5 - $9,892 = $1,812.5. This amount is available for distribution to financial asset-holders of the firm. Free cash flow can also be calculated as Free Cash Flow = Cash flow from operations - Capital Expenditure Cash flow from operations is equal to FFO less the change in trade capital for the period, and therefore, this calculation for free cash flow is equivalent to that developed above. In the case of Chirco Kraft in 1988, CFO = $11,704.5 - $2,764 = $8,940. Therefore, from the above equation, FCF = $8,940 – 7,128 = $1,812.5. The Financial Definition of Free Cash Flow There is also a financial definition of FCF. This definition measures the sum of all net amounts flowing from the firm to financial asset-holders: 2 – 38
  • 39. Free Cash Flow = After Corporate Tax Net Distributions to Debt-holders plus Net Distributions to Shareholders plus Net Distributions to Other Financial Asset-Holders. Each of these distributions represents the flow of cash from the firm to financial asset holders. “Other” financial assets holders in the above representation of free cash flow include, for example, leaseholders, warrants, managerial stock options, and convertible bonds. After–Tax Net Distributions to Debt–Holders Net distributions to debtholders equals after-tax interest plus principal repayments less the sale of new debt over the period in question. After-corporate-tax interest rather than interest itself is used in this calculation for two reasons. First, interest is tax deductible for the firm, and therefore, the actual cost to the firm of making a dollar of interest payment is lesser by the rate of taxation (presuming the firm is in a tax-paying position). Second, in financial analysis, it is conceptually important to separate the operating activities of a firm from its financing activities. Because the benefit of interest deductibility to a firm arises from a financial activity (i.e., borrowing), this benefit (from the firm’s perspective) should be attributed to this financing activity in the free cash flow calculation. In other words, from the firm’s perspective, the “cost” of making interest payments to debtholders is less because of this benefit. Net new borrowing, which is the difference between the sale of new debt and principal repayments can be found by taking the difference between end-of-period and beginning-of- period debt (both short-term and long-term) on the invested capital balance sheet. For Chirco Kraft in 1988, the net increment to debt was (3,014+11,709) – (1,104+5,275) = 8,344. The fact that this number is positive indicates that Chirco Kraft has done some borrowing over the course of the year. If you take after tax interest of (1– 0.36) × $782 in 1988 less new borrowing of $8,344, we find that net distributions to debtholders is $500.5 × $8,344 = ($7,843.5). The fact that this number is negative indicates there has been a net cash inflow from debtholders. 2 – 39
  • 40. Net Distributions to Shareholders Net distributions to shareholders equal the sum of dividends plus any share repurchases less new issues of shares. For Chirco Kraft, the increment to retained earnings between 1988 and 1987 is $23,440 – $28,807 = ($5,367). Net income was $4,289. The discrepancy between these two numbers indicates that Chirco Kraft paid dividends in the amount of $5,367 + $4,289 = $9,656. Alternatively, we can obtain this value in the following way: absent any distributions to shareholders, retained earnings in 1988 should be $28,807 + $4,289 = $33,096 (i.e., beginning balance plus net income). Because retained earnings in 1988 is only $23,440, dividends must equal the difference: $33,096 – $23,440 = $9,656. Net Distributions to Financial Asset–Holders Chirco Kraft has only debt and equity in its financial structure, and therefore, net distributions to financial asset-holders equals the sum of net distributions to debtholders and net distributions to shareholders. For Chirco Kraft in 1988 this sum is ($7,843.5) + $9,656 = $1,812.5. This is free cash flow calculated using the financial definition. In finding free cash flow with the financial definition, we have uncovered the fact that Chirco Kraft has financed a large dividend with additional borrowing. (2.10) Financial accounting is the process of producing and disseminating information about the economic activities of a firm. Annual and quarterly reports, and more specifically financial statements, transmit this information to interested individuals and groups. Users of financial statement information include shareholders, creditors, employees, suppliers, government, and social interest groups. Financial statements are general-purpose summaries of economic activity because user groups have diverse interests. A goal of this electronic book is, therefore, to describe how investors can use financial statement information to analyze a firm as a potential investment. 2 – 40
  • 41. Financial accountants – the producers of financial statements – differ from other professional groups because they rarely if ever meet directly with users of their services. Not only must financial accountants interpret needs of users, but they must also jointly satisfy user groups whose informational requirements differ. Since the relationship between financial statement users and producers is weak, this electronic book is intended not only for users but also for producers of financial statements as a framework with which to assess the informational requirements of investors. An important aspect of this electronic book is a framework for interpreting and reorienting financial statement information for investment analysis. This chapter begins the development of this framework by describing the two principal financial statements: the income statement and the balance sheet. These statements are illustrated by using the annual report of Chirco Kraft Company Limited as an example. Chirco Kraft is one of North America's largest independent manufacturers of sophisticated printed circuits and micro- electronic products for telecommunications, computers and other electronic systems. In this chapter, we integrate ratio calculations with a discussion of the use of financial statements. This integration is intended to illustrate the use, rather than preparation, of financial statements. The perspective adopted in this chapter has its origins in the financial industry. Because financial analysts use financial ratios to make investment decisions, their perspective is generally more insightful than the perspective of those who prepare financial statements. Unfortunately, the rather mechanical treatment of financial ratios found in most accounting textbooks is copied and presented verbatim in most corporate finance textbooks. Alternatively, a good introduction to the application of financial statements in the financial industry can be found in the textbook used for The Canadian Securities Course. This course is required of any individual who sells financial securities in Canada. 2 – 41
  • 42. (2.11) 1. Financial Statements and Free Cash Flow. Based on the following information for ABC Ltd., prepare an income statement for 1999 and balance sheets for 1998 and 1999. Assume a flat 40% tax rate throughout. Next, for 1999, calculate Funds From Operations, Change in Invested Capital, and Free Cash Flow. Find net distributions to debtholders and net distributions to shareholders. Verify that free cash flow is equal to the sum of net after corporate tax distributions to debtholders and net distributions to shareholders. There is no deferred tax in this problem, so you can reasonably assume that financial statement depreciation and capital cost allowance are equal. Selected Information for ABC, Ltd (All figures in thousands) 1998 1999 Sales $3,790 $3,990 Production Costs 2,043 2,137 Depreciation 975 1,018 Interest 225 267 Dividends 200 205 Current Assets 2,140 2,346 Net Fixed Assets 6,770 7,087 Accounts Payable 994 1,126 Long-term Debt 2,869 2,956 Solution 2. Invested Capital, ROIC, Trade-Capital, Free Cash Flow. ABC Co. Ltd. has the following year-end accounting balance sheet. Current Assets $500,000 Accounts Payable $200,000 Net Fixed Assets $1,500,000 Short-Term Debt 400,000 Equity 1,400,000 Equity on the balance sheet represents the sum of all the accounting “equity” accounts. Expected sales for the upcoming year are $4,500,000. Costs of goods sold are 65% of sales and other operating expenses are $850,000. The interest rate on ABC’s short-term debt is 10% per annum. ABC’s tax-rate is 23%. ABC expects to maintain the level of its short-term debt into the indefinite future. 2 – 42
  • 43. a) Calculate ABC’s invested capital turnover, EBITDA margin, and rate of return on invested capital (before tax, no depreciation in this problem). b) ABC anticipates no capital expenditure in the upcoming year. ABC expects to pay dividends equal to net income. Find free cash flow, net after corporate tax distributions to debtholders and net distributions to shareholders. Does ABC have a free cash flow surplus or deficit? If ABC has a free cash flow deficit, how is it financed? If ABC has a free cash flow surplus, how is it distributed? c) ABC intends to expand its operations. Sales are expected to increase by $1,000,000 per annum. In addition, “other” operating expenses will increase by $200,000 per annum. Costs of goods sold, as a fraction of sales is not expected to change. This expansion requires a one-time incremental investment of $400,000 in trade capital and a capital expenditure in the amount of $300,000. ABC intends to finance these expenditures with long-term debt. Does ABC’s before tax rate of return on invested capital (for the entire firm) increase or decrease as the result of the expansion? d) What is the after tax IRR on the business expansion? Solution 3. Rate of Return on Assets and Rate of Return on Invested Capital. Compare and contrast the rate of return on “invested capital” and the rate of return on “assets” as measures of corporate performance for evaluating the financial health of a firm. Solution 4. The EBITDA Margin. The range for EBITDA margin for industries in the North American economy is from approximately zero to about 60%. What characteristics of industries lead to high or low EBITDA margin? Explain and discuss. Solution 5. The Difference between the Rate of Return on Assets and ROIC. The rate of return on assets is a commonly used ratio that is calculated as net income divided by the accounting definition of assets. The purpose of this question is to illustrate that the rate of return on invested capital is a better measure of the rate of return on investment in 2 – 43
  • 44. business activity. In this question, invested capital and “assets” are the same. Ignore depreciation in this problem. You have the following information for ABC Co. Ltd. Earnings before interest and tax $100 Interest Expense 5 Earnings before tax 95 Tax at (30%) 28.5 Earnings after tax 66.5 Assets = Invested Capital = $500, Equity = $450 a) Calculate ABC’s ROE, ROA, and ROIC times one minus the tax-rate. b) Suppose that ABC recapitalizes by selling $200 million in debt at 10% per annum. ABC uses the proceeds of this financial-asset sale to repurchase $200 million of its common shares. Presume that this recapitalization has no effect on ABC’s operating performance (in other words, ROIC is not expected to change after the recapitalization). Calculate ABC’s ROE, ROA, and ROIC times one minus the tax rate. Explain why ROA is an inadequate measure of the rate of return to investment in business activity. c) Give two reasons for the increase in ROE after the recapitalization. Discuss some of the advantages and disadvantages of debt use by firms. 6. The EBITDA Margin. Explain the significance of EBITDA margin in financial analysis. 7. Free cash flow and net distributions to financial asset-holders. ABC is a non-growing firm: it retains no earnings and pays all residual cash flows after interest and tax to shareholders as dividends. ABC is financed with common shares and short-term debt. ABC’s trade capital equals inventory plus accounts receivable less accounts payable. Ignore depreciation and CCA in this problem. ABC sells widgets. Projected sales are 1,000,000 units per annum into the future. Product price is $2.80 per unit. Costs of goods sold equal 60% of Sales. General and administrative expenses are $100,000 per annum. ABC’s accounts receivable turnover is 6.5. Inventory turnover is 5.5. Accounts payable turnover is 4.0. 2 – 44
  • 45. ABC’s past expenditure into capital assets is $2,225,000. ABC has financed its operations (in part) with $1,000,000 in short-term debt that pays interest at a rate of 12% per annum (paid annually). ABC’s only other financial asset is common equity. ABC anticipates to make no additional expenditures in the foreseeable future on capital assets. ABC pays annual dividends equal to Net Income, and therefore, ABC is a non-growing firm. The corporate tax rate is 35%. There are 1,000,000 shares of ABC stock, which trade on the Newton stock exchange. a) Find the rate of return on equity for ABC. b) Decompose ABC’s rate of return on equity into the product of net profit margin, asset- turnover, and the asset to equity ratio. In these calculations, use invested-capital as your definition of assets. c) ABC is contemplating a change in its product pricing policy, which may require changes in its trade-capital investment. If ABC reduces its product price to $2.70 per unit it anticipates an increase in per unit sales to 1,200,000 units per annum. As the result of increase in per annum dollar sales, what will be the new level of trade capital for ABC? Accounts receivable turnover, inventory turnover, and accounts payable turnover are not expected to change. The remaining parts of this problem relate to the policy change described in (c). d) ABC repurchases no shares over the year. In addition, they sell no new shares. ABC will use short-term debt for any required financing (at the end of the year). How much will ABC need to borrow at the end of the year? e) Find Funds from operations for ABC. Find incremental investment in business activity. Find Free Cash Flow. f) Find Net Distributions to Shareholders. Find Net Distributions to Debtholders. 8. Rate of Return on Equity. Consider the following invested capital balance sheet for ABC Company for year-end 1994. Trade Capital 3,200,000 s.t. debt 1,900,000 Deferred Tax 100,000 Common Equity 500,000 Net Fixed Assets 800,000 Retained 1,500,000 Earnings ABC has a contribution margin per dollar sales of 20%. (Contribution margin is defined as unit product/service price minus unit variable cost dividend by unit price). Fixed costs per annum (before depreciation) are $200,000. Dollar sales for the upcoming year are expected 2 – 45
  • 46. to be $3,000,000. The interest rate on short-term debt is 10% per annum. ABC expects no incremental investment into business activity for the year. ABC’s tax-rate is 35%. Depreciation on ABC’s fixed assets is 11% per annum. Capital cost allowances are 15% per annum on the undepreciated capital cost (UCC) of ABC’s depreciable assets. The UCC balance for ABC is the same as net fixed assets on the invested capital balance sheet. a) Find expected net income for the upcoming year. b) Find after-tax expected funds from operations. c) Use the above financial information on ABC Company as a guide to your answer to the final part of this question. As a financial analyst, which calculation do you believe to be the best indicator of the rate of return which a firm earns for its shareholders on funds they originally invested (i.e., on amounts expended by shareholders rather than market- values), (A), (B), or (C): net income (A) common equity (b.o. p. ) + retained earnings (b.o. p. ) net income + deferred tax for the year (B) common equity (b.o. p. ) + retained earnings (b.o. p. ) + deferred tax (b.o. p. ) net income (C) common equity (b.o. p. ) + retained earnings (b.o. p. ) + deferred tax (b.o. p. ) Explain. d) Using your answer to (c) above, calculate the rate of return on equity. Solution 9. The Current Ratio. A firm has current assets of $500,000. What is the change in the current ratio (now equal to 2.0) if the following actions are taken independently? In other words, you should have five separate responses for the five parts of this problem below. Other than the common information given on current assets and the current ratio, information from no one part of the question should be used in any other part. a) pays $77,500 of accounts payable with cash. b) collects $43,000 in accounts receivable. c) purchases merchandise worth $51,300 on account. d) Sells production machinery for $90,000. e) Sells merchandise on account that cost $53,500. Gross profit margin is 33%. 2 – 46
  • 47. 10. Financial Analysis. There are three principal questions a financial analyst or investor must investigate for any investment. Identify these questions. Suppose you are a financial analyst who is charged with evaluating the performance of a corporation over the recent past. Discuss the measures and ratios that you might calculate to answer or investigate these questions for the firm under consideration. 11. Ratio Analysis in EXCEL. Below is an embedded “workbook” composed of three worksheets. The first worksheet is an income statement and the second is a balance sheet. In the third worksheet, calculate the indicated financial ratios for each of the years 1990-1993. In every cell of this solution template, you should replace the “X” cell identifier with a spreadsheet formula that uses inputs from the first two worksheets to calculate the indicated ratio. The tax rate for the firm in this problem is 36%. A suggested solution is contained in the second embedded workbook entitled “Solution”. Solution 12. Calculate Free Cash Flow. The following information is available on the financial accounts of ABC Corporation. 1999 Sales 1,600 Cost of Goods Sold 800 General and Administrative Expenses 250 Interest 50 Depreciation 40 tax at 40% 184 1998 1999 2 – 47
  • 48. Accounts Receivable 150 ? Inventory 200 ? Net Fixed Assets ? ? Short Term Debt 500 ? Accounts Payable 100 ? Equity ? ? NOTE: “Equity” represents the sum of all of the accounting equity accounts. The following additional financial information is available for ABC. The rate of return on invested capital (b.o.p.) after tax and after depreciation for 1999 is 15.3%. This return is calculated as EBITDA less depreciation times one minus the tax rate divided by beginning of period invested capital. Dividends for 1999 are $85. ABC paid off its short-term debt in 1999 and sold additional common shares. In 1999, inventory turnover was 4.0, the accounts payable deferral period was 40 days, and the cash conversion cycle was 60 days. The component ratios of the cash conversion cycle are calculated using 365 days in a year. In addition, these ratios use only the 1999 financial statements (i.e., not beginning of period balance sheet amounts). Capital expenditure in 1999 was $135. Required : Based on the information at hand, find free cash flow using both the operational and the financial definitions for 1999. Solution 13. Calculate Free Cash Flow. The following information is available on the financial accounts of ABC Corporation. 1999 Sales ? Cost of Goods Sold ? General and Administrative Expenses 250 Interest 50 Depreciation 40 tax at 40% 274 1998 1999 Accounts Receivable 150 200 Inventory ? ? Net Fixed Assets ? 3056 Short Term Debt 500 ? Accounts Payable ? 100 Equity ? ? 2 – 48
  • 49. NOTE: “Equity” represents the sum of all of the accounting equity accounts. The following additional financial information is available for ABC. The rate of return on invested capital (b.o.p.) after tax and after depreciation for 1999 is 15.0%. This return is calculated as EBITDA less depreciation times one minus the tax rate divided by beginning of period invested capital. Dividends for 1999 are $95. ABC incremented the level of its short-term debt by $300 in 1999. ABC repurchased $200 of its outstanding shares in 1999. Incremental investment in trade capital in 1999 was $145. In 1999, inventory turnover was 4.0, the accounts receivable collection period was 40 days. The accounts receivable collection period is calculated using 365 days in a year. In addition, inventory turnover and the accounts receivable collection period use only the 1999 financial statements (i.e., not beginning of period balance sheet amounts). Required: Based on the information at hand, find free cash flow using both the operational and the financial definitions for 1999. Solution 14. Deferred Income Taxes and Recapture of Depreciation. ABC has a tax year-end that is the same as its fiscal year end. Today, ABC (at the beginning of its fiscal year) is beginning its operations (i.e., a startup company). ABC will make an investment of $350,000 into trade capital and $1,500,000 into depreciable assets. ABC plans to use 5% as a declining balance depreciation charge for financial statement purposes. The CCA rate for ABC’s depreciable assets is 10% per annum. ABC is financed entirely with equity. ABC is a “non-growing” firm. They plan no additional investments into either trade capital or depreciable assets. However, trade capital is “rolled over” year after year; trade capital is neither liquidated nor incremented. Sales are predicted to be $1,000,000 per annum. ABC’s contribution margin is 20%. Fixed costs per annum are $50,000. These costs are deductible for income tax purposes. ABC makes an annual dividend payment, at the end of their fiscal year, equal to the sum of net income plus deferred income tax (DIT) from the income statement. Ignore the ½ year rule for CCA calculations in this question. Use a spreadsheet to solve this problem. a) What are ABC’s net income, income statement DIT, and dividends in exactly 10 years? b) What is deferred tax on the balance sheet for ABC in exactly 10 years? c) Accounting “equity” is the sum of retained earnings plus share capital. What is ABC’s accounting book equity in exactly 10 years? d) Demonstrate, for (say) a 10-year period, that the sum of balance sheet DIT and book equity remains the same. 2 – 49
  • 50. e) Suppose ABC liquidates their business activity in exactly 10 years. They liquidate trade capital “dollar for dollar” without depreciation (i.e., for $350,000). They sell depreciable assets for the accounting book value (after depreciation). Calculate the tax bill associated with “recapture of depreciation” which is owed to the government (i.e., the tax rate times the sale price of the asset less the UCC for the asset class). Verify that deferred tax on the balance sheet is equal to recapture of depreciation. (see chapter 5 of this electronic book for a discussion of “recapture of depreciation.”). f) In what year does deferred tax reverse itself and become negative? 15. Free Cash Flow and the Invested Capital Balance Sheet. The following information is available on the financial accounts of ABC Corporation. 1996 Sales 2,000 Cost of Goods Sold 1,400 General and Administrative Expenses 200 Interest 60 depreciation (which equals CCA) 35 corporate tax rate ? 1995 1996 Accounts Receivable 268 ? Inventory 100 ? Net Fixed Assets 3000 Short Term Debt 600 ? Accounts Payable 200 ? Equity ? 2,517 NOTE: “Equity” represents the sum of all of the accounting equity accounts. The following additional financial information is available for ABC. ABC has a trade capital to sales ratio of 10% (i.e., trade capital for the end of the fiscal year divided by sales for that same year). ABC has financed its operations with short-term debt and with common equity. Dividends for 1996 are $95. ABC borrowed additional short-term debt in 1996. They also repurchased $200 of shares in 1996. Free cash flow in 1996 was $25. Required: Based on the information at hand, and the definition(s) of free cash flow, determine the invested capital balance sheet for ABC for both 1995 and 1996. For each year find trade capital, net fixed assets, short-term debt and “equity.” What was ABC’s corporate tax rate in 1996? What was ABC’s expenditure for plant property and equipment for 1996 (i.e., capital expenditure)? Find free cash flow for 1996 using the operating definition. 2 – 50
  • 51. Solution 16. Optimal Trade Capital. Comment on the following assertion. “If a firm can reduce its trade capital usage, then it should definitely do so.” Solution 17. Cash Flow. ABC has a contribution margin of 20% and fixed costs of $450,000 per annum. Their corporate tax rate is 40%. For financial statement purposes, ABC takes depreciation charges on its net fixed assets at the rate of 5% per annum on the declining balance. Capital cost allowance is the same as financial statement depreciation. As of December 31, 1996, ABC has financed its investment in business activity with short-term debt and with common equity. ABC has a trade capital to sales ratio of 12%. This ratio is calculated as trade capital at the end of the year divided by yearly sales for the associated year (for example trade capital at December 31, 1996 divided by yearly sales ended December 31, 1996). This ratio is not expected to change in the foreseeable future. ABC has net fixed assets of $250,000 at December 31, 1996. ABC is doing some short term financial planning. They predict sales, for the year ending December 31, 1997, of $3,000,000. Their invested capital turnover based on this prediction and December 31, 1996 invested capital is 3.0 (i.e., predicted 1997 sales divided by year-end 1996 invested capital is 3.0). If ABC requires any financing to accommodate their 1997 sales, they plan to increment (or decrement) their short term borrowing. If ABC borrows, or repays existing short-term debt, they plan to do so at the end of 1997. The interest rate on short-term debt is 10% per annum. ABC’s predicted 1997 net income is $42,000. ABC expects to pay no dividends to their shareholders in 1997. ABC expects no capital expenditures or asset sales in 1997. ABC expects no share repurchases or new share issues in 1997. a) (10 marks) Use 1997 predicted net income to help you determine short-term debt at December 31, 1996. What is invested capital at December 31, 1996? Calculate ABC’s predicted 1997 rate return on equity (using beginning of period equity). b) (10 marks) Does it appear that ABC will need incremental short-term borrowing (at the end of 1997) or can they pay down some of their short-term debt? What is the most likely reason for the change in ABC’s debt use? c) (10 marks) For 1997, calculate ABC’s free cash flow using both the operating and the financial definitions. 2 – 51
  • 52. d) (10 marks) Without doing any numerical calculations, do you believe that ABC’s operating leverage has increased or decreased between 1996 and 1997? Explain. Solution 18. Free Cash Flow and the Rate of Return on Invested Capital. The following information is available on the financial accounts of ABC Corporation. 1997 Sales ? Cost of Goods Sold ? General and Administrative Expenses ? Interest 35 Depreciation (which equals CCA) 100 Corporate tax (at 40%) ? Net Income ? 1996 1997 Accounts Receivable 250 275 Inventory 150 175 Net Fixed Assets ? ? Short Term Debt ? 400 Accounts Payable 200 225 Equity ? ? NOTE: “Equity” represents the sum of all of the accounting equity accounts. The following additional financial information is available for ABC: For both 1996 and 1997, ABC had a trade capital to invested capital ratio of 25% (trade capital at the end of the year divided by invested capital at the end of the year). ABC has financed its operations with short-term debt and with common equity. ABC undertakes borrowing or repayment of debt at the end of the year. Therefore, ABC’s interest charge on its income statement is equal to outstanding short-term debt at the beginning of 1997 (end of 1996) times the interest rate on this debt which is 7% per annum. Dividends for 1997 are $95. ABC issued shares for $200 in 1997. Required: Based on the information at hand, and the definition(s) of free cash flow developed in class, find free cash flow for 1997 using both the operating and the financial definitions. Find ABC’s 1997 rate of return on invested capital, after tax and after depreciation, using beginning of period invested capital. Solution 2 – 52
  • 53. 19. Free Cash Flow and the Rate of Return Equity. The following information is available on the financial accounts of ABC Corporation. 1998 depreciation $30 interest 10 1997 1998 Trade Capital 150 ? Short-term Debt ? 250 Net Fixed Assets 300 ? Equity 350 ? NOTES: “Equity” represents the sum of all of the accounting equity accounts (e.g., share- capital plus retained earnings). You can presume that depreciation for tax and for financial statement purposes is the same, and therefore, there is no deferred income tax in this problem (i.e., capital cost allowance is the same as financial statement depreciation). Any incremental short-term borrowing undertaken by ABC during 1998 was at the end of the year. Therefore, ABC’s interest expense for 1998 is the interest rate on short-term debt times short-term debt at the beginning of 1998 (end of 1997). Alternatively, if instead, ABC paid down any short-term debt during 1998, this was also done at the end of 1998. ABC has financed its business activity with short-term debt and with common equity. In 1998, ABC’s rate of return on equity (ROE) was 20%. ROE is calculated with equity at the end of 1998. ABC paid dividends of $26 during 1998. ABC had no share issues or share repurchases during 1998. Also in 1998, ABC’s EBITDA margin was 25%. Their trade capital to sales ratio was 30%, both trade capital and sales are measured at the end of 1998. ABC’s tax rate is 40%. Required: Using both the operating and the financial definitions, find ABC’s free cash flow for 1998. Solution 20. Ratios. Discuss briefly how each of the following five ratios is calculated and what each is intended to measure: (a) EBITDA margin, 2 – 53
  • 54. (b) debt to assets, (c) times interest earned, (d) quick ratio (acid test ratio), (e) asset turnover. Solution 21. Incremental Rate of Return on Invested Capital. Generally, ABC Company Ltd. has been a non-growing firm. Per annum sales have been $8,000,000. However, as the result of a favourable international trade agreement between Canada and the United States, in the upcoming year, sales are expected to increase to $10,000,000 per annum and remain at this higher level indefinitely into the future. ABC has a trade capital to sales ratio of 20% and an invested-capital turnover ratio of 1.25. Trade capital to sales is calculated as trade capital at the beginning of the year divided by sales for the upcoming year. Invested-capital turnover is calculated as sales for the upcoming year divided by invested-capital at the beginning of the year. ABC’s depreciation is 5% of net fixed assets at the beginning of any year. Subsequent to the change in sales, these ratios and rates are expected to remain unchanged. Capital cost allowance (CCA) is equal to financial statement depreciation. ABC makes maintenance capital expenditures at year-end equal to financial statement depreciation. Maintenance capital expenditures “maintain” the quality of ABC’s assets and prevent revenue deterioration. Generally, other than in the upcoming year, ABC makes no capital expenditures for the purpose of growth. However, at the beginning of the upcoming year, to accommodate the increased level of permanent sales, incremental trade capital assets and additional depreciable assets will be needed. In addition, as the result of the increase in depreciable assets, per annum year-end maintenance capital expenditures will also increase. Thereafter, because ABC will be once more a non-growing firm (that is, trade capital will not increase and capital expenditure for the purpose of growth will again be zero). ABC’s contribution margin per dollar sales is 25%. The tax-rate is 40%. Find the rate of return on ABC’s incremental investment into business activity after tax and after depreciation (equivalently, after tax and after additional maintenance capital expenditures) arising from the greater expected level of dollar sales. Solution 2 – 54
  • 55. 22. Free Cash Flow, Invested Capital, Financial Statements The following information is available on the financial accounts of ABC Corporation. 1999 EBITDA ? depreciation ? interest ? 1998 1999 Trade Capital ? 200 Short-term Debt ? ? Net Fixed Assets ? ? Equity ? 520 Invested Capital 500 850 NOTES: “Equity” represents the sum of all of the accounting equity accounts (e.g., share- capital plus retained earnings). You can presume that depreciation for tax and for financial statement purposes is the same, and therefore, there is no deferred income tax in this problem (i.e., capital cost allowance is the same as financial statement depreciation). ABC’s net incremental borrowing for 1999 was $120. Because this borrowing was at the end of 1999, ABC’s interest expense for 1999 is the interest rate on short-term debt times short-term debt at the beginning of 1999 (end of 1998). The interest rate on ABC’s short- term debt is 10% per annum. ABC made net capital expenditures of $365 at the end of 1999. Because these capital expenditures were at the end of 1999, ABC’s depreciation expense for 1999 (also CCA) is a rate for depreciation times net fixed assets at the beginning of 1999 (end of 1998) prior to the capital expenditure. The depreciation rate is 5% per annum. ABC paid dividends to shareholders of $50 during 1999. ABC’s tax rate is 40%. ABC had a free cash flow deficit of $100 for 1999. Required: Find ABC’s rate of return on invested capital for 1999, before tax and before depreciation, using beginning of period invested capital. Was ABC a net seller of common shares or a net repurchaser of its common shares in 1999? Solution (2.12) 2 – 55
  • 56. 1. The Canadian Securities Course. Toronto: The Canadian Securities Institute, 1995. 2. Robert C. Higgins. Analysis for Financial Management, fifth ed. Chicago: Irwin, 1998. 3. Erich A. Helfert. Techniques of Financial Analysis, eighth ed. Chicago: Irwin, 1994. 4. Diana R. Harrington and Brent D. Wilson. Financial Analysis, third ed. Chicago: Irwin, 1989. 5. Kenneth Hackel and Joshua Livant Cash Flow and Security Analysis, Chicago, Business- One Irwin, 1992. 6. Soenen, L.A, “Cash Conversion Cycle and Corporate Profitability,” Journal of Cash Management (July/August, 1993), 53-57. 7. G.I. White, A.C. Sondhi, D. Fried. The Analysis and Use of Financial Statements. New York: John Wiley & Sons, 1994. 2 – 56
  • 57. (2.13) (Within Embedded Icon Below) In this appendix a number of industry-average financial ratios are reported. The data are from the COMPUSTAT database, which is maintained and distributed by Standard and Poors Corporation. The COMPUSTAT database is a commonly used source of firm-specific financial data for both practicing financial analysts and academics. Firms included in the database are selected by Standard and Poors based on investor interest. All firms trade on the NYSE, the ASE, or the OTC stock exchanges in the United States. Some Canadian firms that have their shares “interlisted” on one of these exchanges are also included. The data is from (by and large) quarterly financial statements of firms. The time interval of the data is from (approximately) the beginning of 1989 to the end of 1999. Each industry average is based on the ratios of at least five firms. DEFINITIONS SIC is the standard industry code classification of industries. In the low thousands, firms are from the extractive industries where little processing is required. The middle thousands are processing and manufacturing firms. The higher thousands are retail and service companies. INVESTED CAPITAL is debt included in current liabilities plus the book-value of common equity plus the book-value of preferred equity plus short-term debt plus long-term debt plus other liabilities plus deferred tax. EBITDA MARGIN is average earnings before interest, tax, depreciation, and amortization divided by average sales. CONTRIBUTION MARGIN is a statistical estimate of a firm’s contribution-margin per dollar sales which is defined as (revenues - variable costs)/revenues. Contribution-margin tends to be greater than EBITDA-margin because contribution-margin is “before” fixed expenses while EBITDA-margin is “after” fixed expenses. However, in the following tables, there are some industries for which contribution-margin is lesser than EBITDA margin. This discrepancy arises because contribution-margin is an estimate and is therefore subject to estimation variation. In fact, all ratios should be interpreted as estimates of actual firm characteristics. For those who are statistically inclined, contribution-margin is estimated as the slope coefficient in the simple linear regression of annual EBITDA against annual sales. INVESTED-CAPITAL TURNOVER is average of quarterly sales times 4.0 divided by the average of invested capital. The multiplication by 4 is required to transform quarterly sales to a yearly equivalent. DEBT TO INVESTED-CAPITAL is the average of short-term debt plus long-term debt plus “other liabilities” divided by the average of invested capital. TRADE-CAPITAL TO INVESTED-CAPITAL is the average of trade capital divided by the average of invested capital. Trade-capital is current assets less current liabilities (excluding 2 – 57
  • 58. short-term debt, the current portion of long-term debt, and dividends payable from current liabilities). TRADE-CAPITAL TO SALES is the average of trade capital divided by the average of annualized sales. Trade-capital is current assets less current liabilities (excluding short-term debt, the current portion of long-term debt, and dividends payable from current liabilities). REVENUE BASED RISK is the fraction of EBITDA variability that is explained by sales. This measure is between 0 and 1. A high value indicates that relatively more EBITDA variability arises from sales. Firms which have high revenue based risk tend to be “marketing” types of firms. On the other hand, a value of revenue-based-risk close to zero indicates that relatively more of EBITDA variability arises from cost factors (for example, unpredictable changes in fixed or variable costs). Firms that are more production oriented and have less established technologies tend to have lesser values for revenue based risk. For those who are statistically inclined, “revenue based risk” is the coefficient of determination (i.e., R2) in the simple linear regression of annual EBITDA against annual sales. Industry Ratios 2 – 58