Contents of Chapter 2: Using Financial Statements in Financial Analysis
Contents of Chapter 2: Using Financial Statements in Financial Analysis..................................2
A SPREADSHEET TEMPLATE FOR FINANCIAL RATIOS 7
GROSS OPERATING PROFIT 10
NET OPERATING MARGIN (EBITDA MARGIN) 10
NET INCOME 12
GAINS AND LOSSES 12
PROVISION FOR INCOME TAX AND DEFERRED TAX (FUTURE INCOME
TAX LIABILITY) 13
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
THE RATE OF RETURN ON EQUITY 30
TURNOVER RATIOS 33
THE CASH CONVERSION CYCLE 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
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
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
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
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
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.
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.
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
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
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.
CHIRCO KRAFT Co.
Statement of Income
for the year ended December 31, 1988
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
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.
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 Margin =
In 1988, Chirco Kraft’s EBITDA margin was $13,859/$91,374 = 15.2%
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
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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.
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.
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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 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.
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Provision for Income Tax and Deferred Tax (Future Income Tax
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
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allowance and accounting depreciation is the primary reason for the existence of deferred tax in
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
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
Provision for income tax = (0.36) × ($13,859 – $782 – $6,376) = $2,412
Current tax = $1,873
Deferred Tax = $539
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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
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,
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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 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
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.
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.”
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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 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
Chirco Kraft Co.
Comparative Balance Sheets
for fiscal years 1987 and 1988
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
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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
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
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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.,
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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.
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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.
as of December 31,1987
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
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
2 – 22
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
2 – 23
Chirco Kraft Co.
Invested Capital Balance Sheets
for fiscal years 1987 and 1988
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 =
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
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-to-Invested Capital =
For Chirco Kraft at the end of 1987 the trade-capital-to-invested capital ratio is $16,590/59,903
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
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
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.
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
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
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.).
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
The distinction between financial statement depreciation and CCA is not made in this return measure.
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
invested-capital turnover ratio is approximately 1.5 (see the industry average ratios in the
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
ROIC = ×
Sales Invested Capital (b.o.p.)
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
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 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
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
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
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
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
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
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)
(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%
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
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 Ratio = .
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
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 Assets - Inventory
Quick Ratio =
2 – 32
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.
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
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.
Accounts Receivable Turnover =
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
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 =
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.
Inventory Conversion Period =
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 =
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
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.
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
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-
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
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
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
Free Cash Flow =
After Corporate Tax Net Distributions to Debt-holders
Net Distributions to Shareholders
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
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
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
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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.
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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)
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
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 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
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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?
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.
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.
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
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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.
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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
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
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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):
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. )
(C) common equity (b.o. p. ) + retained earnings (b.o. p. ) + deferred tax (b.o. p. )
d) Using your answer to (c) above, calculate the rate of return on equity.
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%.
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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
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”.
12. Calculate Free Cash Flow.
The following information is available on the financial accounts of ABC Corporation.
Cost of Goods Sold 800
General and Administrative Expenses 250
tax at 40% 184
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