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DEFINITIONS

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  • 1. Introduction to Corporate Financial Analysis Introduction to Corporate Financial Analysis by George W. Blazenko All Rights Reserved © 2008 Chapter 2 Financial Statements in Financial Analysis “There's no business like show business, but there are several businesses like accounting.” – David Letterman “The average parent may, for example, plant an artist or fertilize a ballet dancer and end up with a certified public accountant.” – Ellen Goodman (b. 1941), U.S. journalist. “Goodman’s Victory Garden,” Close to Home, Simon & Schuster (1979). 41
  • 2. Financial Statements in Financial Analysis Chapter Two Contents (2.1) 44 (2.2) 46 2.2.1 47 (2.3) 48 2.3.1 50 2.3.2 50 2.3.3 51 2.3.4 52 2.3.5 53 (2.4) 53 2.4.1 54 (2.5) 56 2.5.1 56 2.5.2 57 2.5.3 59 2.5.4 63 (2.6) 65 2.6.1 65 (2.7) 67 (2.8) 68 2.8.1 68 2.8.2 70 (2.9) 71 2.9.1 72 2.9.2 74 2.9.3 75 2.9.4 75 (2.10) 77 (2.11) 79 42
  • 3. Introduction to Corporate Financial Analysis (2.12) (Within Embedded Icon Below)...........................................................................80 DEFINITIONS 80 (2.13) 82 EBITDA 92 EBITDA 93 EBITDA 94 EBITDA 95 EBITDA 95 EBITDA 96 EBITDA 97 EBITDA 98 EBITDA 98 (2.11) 103 OPERATING DEFINITION of FCF..............................................................................112 FINANCIAL DEFINITION OF FCF.............................................................................112 (2.15) 119 43
  • 4. Financial Statements in Financial Analysis (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 decision-makers groups 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, accountants take pains to ensure accuracy of the information presented in financial statements but they provide no guidance on their use. One goal of this book is to explain how investors 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. 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 set of statements, in spite of diverse interests. Since the relation 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 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 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. 44
  • 5. Introduction to Corporate Financial Analysis 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 for most ratios. Until we have a more complete theoretic picture, we must resort to using relative rather than absolute comparisons. Relative comparisons include trend analysis and industry average comparisons of ratios. In trend analysis a financial analyst determines whether a ratio is improving or deteriorating, not whether it is good or bad. In an industry average comparison, an analyst determines whether a ratio is better or worse than the industry, not whether it is good or bad. There is one exception to the general rule that the theory of business is not sufficiently strong to give us absolute benchmarks. The exception is the theory of finance. In finance we can benchmark returns against financial market determined opportunity cost returns. How to calculate those financial market opportunity costs is a major objective of this text-book and all of financial study. Any return, like, for example, the rate of return on invested capital (ROIC) or the rate of return on equity (ROE), that we calculate in this chapter can be benchmarked against financial market opportunity costs. We reserve that benchmarking for later in this textbook after we have learnt more about financial markets and how these markets determine opportunity cost rates of return. It makes little sense to benchmark a firm’s ROIC or ROE against industry averages or past values of these return ratios. These are relative benchmarks when a much better absolute benchmark is available. The financial opportunities available to shareholders and other financial asset-holders are much broader than the particular firm under investigation or even its industry. Investors can invest in the financial assets of any public company around the world. To recognize this broad perspective for opportunity costs of investors we must benchmark returns against financial market returns of about the same risk. 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 45
  • 6. Financial Statements in Financial Analysis ratio analysis again when we discuss financial planning and capital budgeting in later chapters of this book. (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. 46
  • 7. Introduction to Corporate Financial Analysis 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. 2.2.1 All the ratios discussed in this chapter are calculated for Tim Horton’s in the worksheet embedded below. Tim Horton's Ratios 47
  • 8. Financial Statements in Financial Analysis More than a textbook illustration of ratio analysis, the Tim Horton’s 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 data for Tim Horton’s have been retrieved from a database call COMPUSTAT which is a product of Standard and Poor’s Corporation. This database provides mostly financial statement information on over 10,000 publicly traded North American firms. The graphical user interface for the database is called Research Insight. Research Insight has many predefined reports. Two of these reports are an income statement and a balance sheet for a company over the last five fiscal years. We use these two reports to calculate ratios for Tim Horton’ in the above EXCEL spreadsheet. In producing these two reports, Research Insight adjusts the financial statements of companies to standardize accounting conventions. This standardization enhances ratio comparability across companies. Research Insight also uses a common set of line items for both the income statement and the balance sheet for all companies, which also enhances ratio comparability across companies. 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. We illustrate the discussion with the financial statements of Tim Horton’s. (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. 48
  • 9. Introduction to Corporate Financial Analysis 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 2007 income statement for Tim Horton’s where we see that Sales for 2007 are $1,895.9 million. 31-Dec-07 31-Dec-06 31-Dec-05 31-Dec-04 Sales 1895.9 1424.3 1271.5 1112.1 Cost of Goods Sold 1099.2 968.3 855.0 744.3 selling and administrative 251.7 94.1 93.5 71.3 Operating Income Before Depreciation 544.9 361.9 322.9 296.6 Depreciation & Amortization 83.6 62.4 61.8 57.3 Operating Profit 461.3 299.5 261.2 239.2 Interest 16.7 25.9 15.9 13.6 Non-Operating Income/Expense -38.5 39.3 30.7 28.4 Special Items 2.3 -3.3 -39.6 0.0 Pretax Income 408.4 309.6 236.4 254.1 Total Income Taxes 138.9 86.8 72.4 83.7 Minority Interest 0.0 0.0 0.0 0.0 Income Before Extraordinary Items 269.6 222.8 163.9 170.4 Preferred Share Dividends 0.0 0.0 0.0 0.0 Available For Common 269.6 222.8 163.9 170.4 Savings Common Stock Equivalents 0 0 Adjusted Available for Common 269.6 222.8 163.9 170.4 Extraordinary Items 0.0 0.0 0.0 0.0 Discontinued Operations 0.0 0.0 0.0 0.0 Net Income 269.6 222.8 163.9 170.4 Earnings per share 1.17 1.02 1.07 DATA SECTION: Dividends Per Share 0 0.00 0.00 0.00 dividends to common 0.28 0.14 0.0 0.0 dividends to preferred 0 0.0 0.0 0.0 outstanding shares 188.5 191.1 160 160 effective tax rate 0.340 0.280 0.306 0.329 Exhibit 2–1: Tim Horton’s Income Statement 49
  • 10. Financial Statements in Financial Analysis 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. 2.3.1 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 Tim Horton’s, 2007 gross profit is $1,895.9-$1,099.2 = $796.7 and gross profit margin is 42.0%. 2.3.2 Gross profit less selling, general, and administrative expenses (before depreciation and amortization) equals earnings before interest, tax, depreciation and amortization which is often 50
  • 11. Introduction to Corporate Financial Analysis 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 2007, Tim Horton’s EBITDA margin was $544.9/$1,895.9 = 28.7% 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. 2.3.3 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 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. 51
  • 12. Financial Statements in Financial Analysis 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. 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. 2.3.4 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. 52
  • 13. Introduction to Corporate Financial Analysis 2.3.5 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. (2.4) 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. Exhibit 2-2 illustrates fiscal year-end balance sheets for 2004 to 2007 for Tim Horton’s. 53
  • 14. Financial Statements in Financial Analysis 31-Dec-07 Dec. 31, 2006 Dec. 31, 2005 Dec. 31 2004 Current Assets Cash & Equivalents 195.4 151.1 159.7 107.4 Net Receivables 115.7 107.0 83.4 262.1 Inventories 60.3 35.4 25.7 26.0 Prepaid expenses 0.0 0.0 0.0 0.0 Other Current Assets 20.3 38.6 26.4 23.6 391.6 332.0 295.2 419.2 Long Term Assets Gross Plant Property & Equipment 1364.7 1,222.2 1,010.0 Accumulated Depreciation 365.3 311.4 254.1 Net Plant Property & Equipment 1203.3 999.4 910.8 755.9 Investments at Equity 137.2 119.9 121.2 121.7 Other Investments 17.4 14.2 12.9 116.3 Intangibles 3.1 3.2 3.6 30.2 Deferred Charges 0.0 0.0 0.0 0.0 Other Assets 9.8 28.9 26.3 16.7 1,762.5 1,497.6 1,370.0 1,459.9 Current Liabilities Long Term Debt Due in One Year 6.1 4.7 968.9 158.3 Notes Payable 0.0 0.0 0.0 0.0 Accounts payable 133.4 99.2 94.4 78.7 Taxes Payable 34.5 23.3 54.0 60.0 Accrued Expenses 113.8 39.4 66.0 49.6 Other Current Liabilities 39.5 69.6 34.7 18.2 327.3 236.2 1,218.1 364.8 Liabilities Long-term Debt 384.6 337.9 75.5 205.1 Deferred Taxes -18.4 15.3 13.0 19.4 Investment Tax Credit 0.0 0.0 0.0 0.0 Minority Interest 0.0 0.0 0.0 0.0 Other Liabilities 66.9 34.2 29.7 21.6 433.1 387.4 118.1 246.1 Preferred Stock Preferred Stock - Redeemable 0.0 0.0 0.0 0.0 Preferred Stock - Non-Redeemable 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Equity Common Stock 0.2 0.2 0.2 0.2 Capital Surplus 778.1 787.9 64.9 194.0 Retained Earnings 459.0 149.5 -31.3 654.8 Less Treasury Stock 235.2 63.6 0 0 1,002.1 874.0 33.8 849.0 Total Liabilities & Equity 1,762.5 1,497.6 1,370.0 1,459.9 Exhibit 2–2: Tim Horton’s Balance Sheet 2.4.1 Assets are commonly categorized as current assets and non-current assets. Current assets are 54
  • 15. Introduction to Corporate Financial Analysis 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. 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). 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 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 that trades short-term debt securities is called the money market. The term money is used because securities that trade in this market have many characteristics of 55
  • 16. Financial Statements in Financial Analysis money. In particular, such debt instruments mature in less than one year and carry minimal risk of default. Accounts payable are amounts owing suppliers. Wages and salaries payable are amounts owing employees. These amounts are contained within the line item Accrued Expenses. The current portion of long-term debt or equivalently Long Term Debt Due in One Year is the amount of principal on long-term debt that the firm expects to repay over the course of the upcoming fiscal year. Tim Horton’s primary sources of long term financing are long term debt and common equity. At the end of 2007 Tim Horton’s long term debt was $384.6. Since long term debt due in one year is the amount of principal on long term debt scheduled to be repaid over the course of the upcoming year, long term debt on the balance sheet is the amount of principal on long term debt scheduled to be repaid after one year from today. Tim Horton’s has four common equity accounts. Common stock is the original investment by the founders of Tim Horton’s (0.2 for 2007). Capital Surplus is the amount from the sale of new shares to new common shareholders (778.1 for 2007). Retained earnings is the accumulation of net income over the years less cash dividends (459 for 2007). Finally, Treasury Stock is the cost of repurchasing shares from former shareholders (235.2 in 2007). (2.5) 2.5.1 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 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 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 56
  • 17. Introduction to Corporate Financial Analysis is, more or less, at the discretion of the firm. For example, in place of raising more 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. Exhibit 2-3 gives one definition of Invested Capital in common use by investors (see the Canadian Securities course) applied to Tim Horton’s for 2007. Financial Definition of Invested Capital Bank Indebtedness 0 Other Short Term Debt 0 L.T. Debt(with Curr. Port.) and L.T. Liabilities 457.6 Deferred Taxes -18.4 Preferred Shares 0 Common Stock and Share Capital 780.1 Retained Earnings less Treasury Stock 223.8 Other Financial Assets 0 1,441.3 Exhibit 2-3: 2007 Tim Horton’s Invested Capital 2.5.2 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 business investments for 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 57
  • 18. Financial Statements in Financial Analysis 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.” 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 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 the business investments of the firm. 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 business investments made by the firm. Exhibit 2-4 calculates trade capital as total current assets less accounts payable, less accrued expenses, less taxes payable and less other current liabilities. Long-term debt is the sum of the 58
  • 19. Introduction to Corporate Financial Analysis current portion of long-term debt, long-term debt, and other long term liabilities. Equity is Common Stock plus Capital Surplus plus Retained Earnings plus Deferred Tax less Treasury Stock. We 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), we interpreted Deferred Tax as “equity” for the purpose of financial analysis. 31-Dec-07 31-Dec-06 31-Dec-05 31-Dec-04 Operational Definition of Invested Capital Trade Capital 70.5 100.6 46 212.7 Net Plant, Property, and Equipment+other assets 1,370.80 1,165.50 1,074.80 1,040.70 Invested Capital 1,441.30 1,266.10 1,120.80 1,253.40 Financial Definition of Invested Capital short-term debt 0 0 0 0 long-term debt (including current portion) 457.6 376.8 1,074.00 385 Preferred Shares 0 0 0 0 Equity plus deferred tax +distributions payable 983.7 889.4 46.8 868.4 Invested Capital 1,441.30 1,266.10 1,120.80 1,253.40 Exhibit 2–4: Invested Capital Balance Sheet 2.5.3 We can calculate a number of interesting ratios with 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 Tim Horton’s at the end of 12007 the debt to invested-capital ratio is 457.6/1,441.3 = 31.75%. This ratio indicates that 31.75% of Tim Horton’s business investment is financed with debt. 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%. A comparison of Tim Horton’s with 59
  • 20. Financial Statements in Financial Analysis this benchmark means that Tim Horton’s uses less debt than does a typical business. Debt-to- invested capital is a measure of corporate debt use. There are two reasons why an analyst might be interested in debt use. First, debt imposes additional risk on shareholders beyond the risk associated with business operations. Second, because interest is tax-deductible, debt reduces a firm’s taxes payable. A second invested capital ratio is trade capital to invested capital. This ratio measures the fraction of the firm’s business investment 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 trade capital investment. If a firm can maintain sales but decrease trade capital, the rate of return on invested capital, the rate of return that the firm earns for all financial asset-holders increases. 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 Tim Horton’s at the end of 2007, the trade-capital-to-invested capital ratio is $70.5/1,441.3 = 4.89%. The appendix to this chapter reports trade-capital-to-invested capital for industry averages. 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 business investment. 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 on a firm’s business investment for financial asset-holders. Because invested capital measures business expenditure, 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 60
  • 21. Introduction to Corporate Financial Analysis rates of return on funds expended to rates of return on market values is an important corporate performance benchmark that is developed in this book. The rate of return on invested capital (before tax and before depreciation) 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. We abbreviate the rate of return to invested capital as ROIC. EBITDA ROIC = Rate of Return on Invested Capital = Invested Capital (b.o.p.) The ROIC for Tim Horton’s in 2007 is $544.9/1,266.1 = 43.0%. 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 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 replacement of deteriorated assets but also taxes payable as a result of operating activities and deductibility of depreciation charges for tax purposes3. EBIT × (1 - tax rate) ROIC after tax and after depreciation = Invested Capital (b.o.p.) The ROIC after depreciation and after tax for Tim Horton’s for 2007 is 24.0%, calculated as (544.9-83.6)×(1– 0.34) ÷ $1,266.1. 3 The distinction between financial statement depreciation and CCA is not made in this return measure. 61
  • 22. Financial Statements in Financial Analysis Because ROIC is a return, it should be benchmarked against an absolute standard, an opportunity cost from financial markets, rather than a relative benchmark like an industry average or a trend analysis. Our investigation of financial markets as we proceed through this textbook will allow us to calculate these financial market opportunity costs to use as a ROIC benchmark. A fourth invested-capital ratio is invested capital turnover. Invested capital turnover is a measure of the ability of a business to generate sales from business investment. Other things equal, firms that can increase sales without an increase in invested capital are more efficient. Below we calculate invested-capital turnover4 as sales for the period divided by invested capital (b.o.p.), Sales Invested Capital Turnover = Invested Capital (b.o.p.) The 2007 invested capital turnover ratio for Tim Horton’s is $1,895.9/1,266.1=1.5. Invested capital turnover is an inverse measure of “capital intensity.” Firms that require great business investments to generate a dollar of sales are said to be capital intense. Firms that require large fixed asset investment, 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 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 the product of the EBITDA margin and invested capital turnover. ROIC = EBITDA Margin × Invested Capital Turnover 4 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. 62
  • 23. Introduction to Corporate Financial Analysis EBITDA Sales ROIC = × Sales Invested Capital (b.o.p.) EBITDA ROIC = Invested Capital (b.o.p.) For Tim Horton’s, if we multiply the 2007 EBITDA margin by the invested capital turnover (0.287×1.5), we get 43.0%, which is the same as our calculation above. 2.5.4 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. 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 63
  • 24. Financial Statements in Financial Analysis 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). 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 64
  • 25. Introduction to Corporate Financial Analysis 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 is the sum of Common Stock, Capital Surplus, Retained Earnings and Deferred Tax less Treasury Stock. Book Equity measures shareholder investment in the firm, either directly through the purchase of common shares or indirectly through retained earnings and deferred tax. Generally, it is not useful for financial analysis to recognize the decomposition of these amounts into their component parts. 2.6.1 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. We abbreviate the rate of return on equity as ROE. Net Income available to common ROE = Rate of Return on Equity = Book Equity (b.o.p.) ROE for Tim Horton’s in 2007 is $269.6/$889.4 = 30.3%. A second 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 Sales IC (b.o.p.) Net Income = × × = Sales IC (b.o.p.) Equity (b.o.p.) Equity (b.o.p.) 65
  • 26. Financial Statements in Financial Analysis For Tim Horton’s in 2006, their invested capital to equity ratio is $1,266.1 ÷ $889.4 = 1.42. For 2007, Tim Horton’s net profit margin was $269.6/1,895.9 = 14.2%, and their invested-capital turnover was 1.5. ROE can, therefore, be calculated as ROE = 0.142 × 1.5 × 1.42 = 30.3% Because ROE is a return, it should be benchmarked against an absolute standard, an opportunity cost from financial markets, rather than a relative benchmark like an industry average or a trend analysis. Our investigation of financial markets as we proceed through this textbook will allow us to calculate these financial market opportunity costs to use as an ROE benchmark. Notice that Tim Horton’s 2007 ROE exceeds their 2007 ROIC (after tax and after depreciation), 30.3%>24%. As we will see in chapter 3, ROE does not always exceed ROIC. Here, however, for Tim Horton’s in 2007, there are two reasons that ROE exceeds ROIC. The first reason is the benefit of financial leverage. Financial leverage is a two edged sword, sometimes it works out, sometimes it does not. The fact that ROE>ROIC for Tim Horton’s in 2007 indicates that financial leverage benefits shareholders in this year. Tim Horton’s borrows at low rates and makes business investments at greater rates (before tax), to the benefit of shareholders. In addition, shareholders are the primary beneficiaries of tax deductibility of interest, which increases ROE above ROIC. ROE and ROIC (after tax and after depreciation) tend to move in tandem with one another for firms. That is, if ROIC is great, then ROE tends to be great as well. We give the formal relation between ROE and ROIC in the following equation, Debt BVE ROIC = (1 − t )* rD * + ROE * IC IC where t is the corporate tax rate, rD is the interest rate that a firm pays on its debt, Debt is debt outstanding on the invested capital balance sheet, BVE is the book value of equity on the invested capital balance sheet, and IC is invested capital. 66
  • 27. Introduction to Corporate Financial Analysis Debt BVE Note that in the special case ROIC = ROE , because = 1− , ROIC = ROE = (1 − t ) * rD IC IC . This is a special type of financial break-even for shareholders. If a firm makes business investments at the same rate that it borrows, then both ROIC and ROE equal the after tax return on debt. Amazing! If a firm makes business investments at a rate (before tax) greater than it borrows, then ROE exceeds ROIC. We have calculated all of the terms in the above equation for Tim Horton’s in 2007 with the exception of rD, the interest rate that Tim Horton’s pays on its debt. We could calculate this amount, or reconcile it with other calculations from Tim Horton’s financial statements. However, these calculations require that we adjust ROIC for other income that appears on its income statement, which is more analysis than we are prepared to do at the moment. (2.7) Liquidity of any investment is a measure of the likelihood that it can be sold (i.e., liquidated) without value loss. 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 value loss 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 2007 balance sheet of Tim Horton’s, its current ratio is $391.6/$327.3 = 1.2. This number says that in a hypothetical liquidation of Tim Horton’s current assets they could cover their current liabilities 1.2 times over. 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 67
  • 28. Financial Statements in Financial Analysis current ratio that is associated with profit 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 profit 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, financial analysts often recognize that there is more potential for value loss 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 Using the numbers from the 2007 Tim Horton’s balance sheet, we find that its current ratio is ($391.6-60.3) ÷ $327.3 = 0.95. This number says that, ignoring inventories, in a hypothetical liquidation of current assets, Tim Horton’s could not cover all of its current liabilities. (2.8) For many firms, an important component of their business investment is 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. 2.8.1 Financial analysts use three turnover ratios 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 Sales divided by Accounts Receivable. 68
  • 29. Introduction to Corporate Financial Analysis Sales Accounts Receivable Turnover = Accounts Receivable From the 2007 financial statements for Tim Horton’s, accounts receivable turnover is $1,895.9/115,7 = 16.4. This number means that Tim Horton’s collects their receivables 16.4 times per year. Because Tim Horton’s is in the food service industry, and most of their sales are for cash, receivables are not generated from customers, but instead from franchise fees. The number of days it takes to collect a dollar of receivables is the accounts receivable collection period. The accounts receivable collection period is the number of days during the year divided by the receivable turnover. 365 Accounts-Receivable Collection Period = Accounts Receivable Turnover For Tim Horton’s in 2007, the receivable collection period is 365 ÷ 16.4 = 22.3 days. Because receivable terms are often due in 20 days in business, we can use the collection period to benchmark how well a firm is doing with collections. Inventory turnover is cost of goods sold divided by inventory. Cost of Goods Sold Inventory Turnover = Inventory Using the numbers from the 2007 Tim Horton’s financial statements, inventory turnover is $1,099.2/$60.3 = 18.2. This number means that Tim Horton’s sold or used its inventory balance 18.2 times during the year. The number of days it takes to sell or use inventory is the inventory conversion period, which is the number of days during the year divided by inventory turnover. 365 Inventory Conversion Period = Inventory Turnover For Tim Horton’s in 2007, the inventory conversion period is 365 ÷ 18.2 = 20.0 days. Since Tim Horton’s inventory is primarily supplies for food service, it is not surprising that this conversion period is short. 69
  • 30. Financial Statements in Financial Analysis Accounts payable turnover is Cost of Goods Sold divided by Accounts Payable. Cost of Goods Sold Accounts Payable Turnover = Accounts Payable Using Tim Horton’s 2007 financial statements, accounts payable turnover is $1,099.2 ÷ $133.4 = 8.2. This number means that Tim Horton’s pays its average accounts balance 8.2 times per year. The number of days it takes to make payments is 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. 365 Accounts Payable Deferral Period = Accounts Payable Turnover For Tim Horton’s in 2007, accounts payable deferral is 365 ÷ 8.2 = 44.3 days. Notice that Tim Horton’s delays payments to suppliers longer than it takes them to collect their receivables. 2.8.2 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 Tim Horton’s is 22.3 + 20.0 – 44.3= -2 days. There is no absolute standard for the cash conversion cycle, and therefore, firms use trend analysis and industry 70
  • 31. Introduction to Corporate Financial Analysis comparisons to determine whether cash conversion is improving or deteriorating. Soenen (1993) reports the cash conversion cycle for a number of different industries. It is unusual, however, for a firm to have a negative cash conversion cycle. Similarly, it is possible, but not likely, for a firm to have negative trade capital. These firms often have considerable market power over many small suppliers that they can force to finance their current assets. Since most firms do not have this type of market power, negative cash conversion cycles and negative trade capital are not common. (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 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 business investments that we analyze in chapter 9. Because of these important uses of free cash flow, it is essential to develop this concept early in our study of corporate financial analysis. 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 past investments in business activity. In the current period, the firm bears the “fruit” of past investment. In addition, the firm might make additional business investments. These investments are composed of trade capital increments and capital expenditure. Capital expenditure is the dollar investment into plant, property, and equipment (that is, depreciable assets). 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 71
  • 32. Financial Statements in Financial Analysis financial asset holders implies that there is both a financial and an operating definition of 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 definition of free cash flow (FCF) are developed in the following sub-section5. 2.9.1 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. The above calculation for FFO is called the top down calculation because it begins near the top of a typical income statement. An external financial analyst, one that does not work for the firm under study, does not likely know a firm’s CCA. CCA is a line item on a firm’s income tax return. But a corporate income tax return is private information and not generally publicly accessible. Second, 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. 5 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). 72
  • 33. Introduction to Corporate Financial Analysis Funds from operations also equals Net Income + Depreciation + Deferred Tax + other non-cash charges +After-Tax Interest All of the above terms in the FFO calculation are income statement line items. Deferred tax, for example, is income statement deferred tax (if available) and not balance sheet deferred tax. For Tim Horton’s income statement deferred tax is not reported and there appear to be no non-cash charges other than depreciation. Funds from operations for Tim Horton’s in 2007 is $269.6 + $83.6 + (1 – 0.34) × $16.7 = $364.2. Because the above FFO calculation begins with Net Income, it is called “bottom up.” The final component of FCF is incremental business investment made by the firm for the period in question. There are at least two parts to this final component. First, incremental trade capital investment for Tim Horton’s for 2007 is trade capital at the end of 2007 less trade capital at the end of 2006 (the change in trade capital). Incremental trade capital investment is, $70.5-100.6 = -30.1 (see exhibit 2.4 for the numbers). Because firms make trade capital investments to support their trading function – primarily sales, trade capital typically increases when a firm’s sales increase and vice versa. However, things don’t always turn out as we expect in financial analysis and for Tim Horton’s in 2007, trade capital fell even though their 2007 sales increased above their 2006 sales (see exhibit 2.1). Second, capital expenditure is the change in net fixed assets and other assets over the period plus depreciation. For Tim Horton’s in 2007, net capital expenditure is $1,370.80 – $1,165.5 + $83.6 = $288.9 (see exhibit 2-4 for the NFA plus other assets numbers and exhibit 2-1 for 2007 depreciation). Incremental business investment for the period is the sum of capital expenditure and incremental investment in trade capital. The incremental business investment in 2007 for Tim Horton’s is $288.9-$30.1=$258.8. 73
  • 34. Financial Statements in Financial Analysis Free cash flow is equal to funds from operations less incremental business investment. For Tim Horton’s in 2007, free cash flow is $364.2-$258.8 = $105.4. This amount is available for distribution to financial asset-holders of the firm. Because this amount is positive, Tim Horton’s has a Free Cash Flow surplus. Firms that have negative Free Cash Flow have a Free Cash Flow deficit. Zero is, therefore, a natural benchmark for FCF. In order to survive in the long term firm eventually have to have FCF surpluses. However, FCF deficits in the near term are not necessarily bad. A FCF deficit indicates that a firm is investing more in new business investments than it can “finance” from its own operations. Therefore, it must sell new financial assets to investors to makeup this deficit. As long as these investments are productive – that is, they are positive NPV and create financial asset-holder wealth, they should be made by the firm. As financial analysts, we expect that eventually when anticipated FFO benefits of these new investments begin to accrue and incremental investment slows down, the firm’s FCF will turn positive. 2.9.2 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. If FCF is negative then the net flow is from financial asset-holders to the firm. 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, preferred shareholders, leaseholders, warrants, managerial stock options, and convertible bonds. 74
  • 35. Introduction to Corporate Financial Analysis 2.9.3 Net distributions to debtholders is 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 Tim Horton’s in 2007, the net increment to debt was $457.6-$376.8 = $80.8 (see exhibit 2-4 for the numbers). The fact that this number is positive indicates that Tim Horton’s has done some borrowing over the course of the year. If you take after tax interest of (1– 0.34) × $16.7 (see exhibit 2-1 for the numbers) in 2007 less new borrowing of $80.8, we find that net distributions to debtholders is -$69.8. The fact that this number is negative indicates there has been a net cash inflow from debtholders to Tim Horton’s. 2.9.4 Net distributions to shareholders equal the sum of dividends plus any share repurchases less new issues of shares. The information section at the bottom of the income statement in exhibit 3-1 tells us that Tim Horton’s paid dividends of 0.28 million to their shareholders in 2007. In addition, Tim Horton’s might have either sold new shares to shareholder or repurchased shares from their existing shareholders. To find out whether Tim Horton’s did either of these two things, consider the following for book equity in exhibit 2-4. Recall that book equity is the sum of share capital and retained earnings. BVE stands for BOOK Value of Equity, 75
  • 36. Financial Statements in Financial Analysis BVEEND=BVEBEG + NI – DIV + NEW ISSUE - REPURCHASE OF SHARES NI stands for Net Income and DIV stands for Dividends. For Tim Horton’s in 2007 (see exhibits 2-4 and 2-1 for the numbers), BVE2007 = 983.7 = 889.4 + 269.6 – 0.28 + NEW ISSUE - REPURCHASE OF SHARES Rearrange to find, NEW ISSUE - REPURCHASE OF SHARES = -175.0 Because this number is negative, in 2007, Tim Horton’s had a net share repurchase in the amount of $175 million. A share repurchase puts cash in the hand of a financial asset-holder (former shareholders), and therefore, this amount has a positive sign in the financial definition of FCF. The financial definition of FCF applied to Tim Horton’s for 2007 is After Tax Interest 11 Debt Repayment -80.8 Dividends 0.3 Share Repurchase 175 Free Cash Flow 105.5 Other than some rounding that we have done, FCF in the financial definition in the above table equals FCF in the operating calculation as it should The financial definition of FCF tells us how a firm has distributed a FCF surplus to its financial asset holders or how it has financed a FCF deficit from its financial asset holders. In 2007, Tim Horton’s did some incremental borrowing and distributed their FCF surplus to common shareholder through a share repurchase. 76
  • 37. Introduction to Corporate Financial Analysis (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. 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. We illustrate these statements using Tim Horton’s as an example. Tim Horton’s is in the food service industry and is possibly the largest maker of donuts in the world. 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 77
  • 38. Financial Statements in Financial Analysis 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. 78
  • 39. Introduction to Corporate Financial Analysis (2.11) 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. 79
  • 40. Financial Statements in Financial Analysis (2.12) (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 80
  • 41. Introduction to Corporate Financial Analysis 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 81
  • 42. Financial Statements in Financial Analysis (2.13) 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. 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. 82
  • 43. Introduction to Corporate Financial Analysis 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 business investment. 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 business investment. c) Give two reasons for the increase in ROE after the recapitalization. Discuss some of the advantages and disadvantages of debt use by firms. 83
  • 44. Financial Statements in Financial Analysis Solution 6. The EBITDA Margin. Explain the significance of EBITDA margin in financial analysis. Solution 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. 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 business investment. Find Free Cash Flow. f) Find Net Distributions to Shareholders. Find Net Distributions to Debtholders. Solution 8. Rate of Return on Equity. Consider the following invested capital balance sheet for ABC Company for year-end 1994. 84
  • 45. Introduction to Corporate Financial Analysis 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 to be $3,000,000. The interest rate on short-term debt is 10% per annum. ABC expects no incremental business investment 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. 85
  • 46. Financial Statements in Financial Analysis e) Sells merchandise on account that cost $53,500. Gross profit margin is 33%. Solution 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. Solution 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”. Template 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 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 86
  • 47. Introduction to Corporate Financial Analysis 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 ? ? 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 87
  • 48. Financial Statements in Financial Analysis 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. 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? Solution 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 ? 88
  • 49. Introduction to Corporate Financial Analysis 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. 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 business investment 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). 89
  • 50. Financial Statements in Financial Analysis 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. 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 90
  • 51. Introduction to Corporate Financial Analysis 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, (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 91
  • 52. Financial Statements in Financial Analysis 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 business investment after tax and after depreciation (equivalently, after tax and after additional maintenance capital expenditures) arising from the greater expected level of dollar sales. Solution 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 92
  • 53. Introduction to Corporate Financial Analysis 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 23. The Relation Between ROIC and ROE Today, ABC has invested capital of $4,000,000. Trade capital and net fixed assets are 34% and 66% of invested capital respectively. Invested capital has been financed with short-term debt and with common equity. The interest rate on short-term debt is 10% per annum. ABC’s tax rate is 40%. Depreciation is 5% of beginning-of-period net fixed assets. No capital expenditures are required for the upcoming year. Based on predicted sales in the upcoming year, ABC’s EBITDA is $1,000,000. Other things equal, ABC’s rate of return on equity (using beginning of period equity) at predicted sales for the upcoming year, is equal to their predicted rate of return on invested capital after tax and after depreciation (using beginning of period invested capital) plus 10%. That is at predicted sales, ROE=ROIC+0.10. Required: What is ABC’s beginning of period (i.e., today) debt to equity ratio? Solution 24. The Relation Between ROIC and ROE The following information is available on the financial accounts of ABC Corporation. 2007 EBITDA ? Depreciation ? Interest ? 2007 Trade Capital 200 Short-term Debt ? Net Fixed Assets 800 Equity ? Invested Capital 1,000 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 neither borrowed incrementally nor repaid short-term debt during 2007, and therefore, its interest expense for 2007 is the opening balance for 2007 (same as the closing balance) times the interest rate on its short-term debt, which is 6.25% per annum. ABC’s tax rate is 40%. 93
  • 54. Financial Statements in Financial Analysis ABC’s rate of return on invested capital for 2007, after tax and after depreciation, using end of period invested capital is 27%. ABC’s ROE for 2007 using end of period book equity is 42.5%. Required: Find ABC’s debt to equity ratio for 2007. Solution 25. ROA and ROE. ABC has return on equity (ROE) of 24 percent and a return on assets (ROA) of 16%. Required: Find ABC’s debt to equity ratio. Solution 26. Relation Between ROIC and ROE The following information is available on the financial accounts of ABC Corporation. 2007 EBITDA ? Depreciation ? Interest ? 2007 Trade Capital ? Short-term Debt 400 Net Fixed Assets 800 Equity ? Invested Capital ? 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). The interest rate on ABC’s short-term debt is 8% per annum. ABC’s tax rate is 40%. ABC’s rate of return on equity (ROE) for 2007 using end of period book equity is 16.8%. Their rate of return on invested capital for 2007, after tax and after depreciation, using end of period invested capital, is 12%. Required: Find ABC’s 2007 year-end invested capital. Solution 27. ROA, ROE, and Net Profit Margin ABC company limited has a 4 percent net profit margin, a return on equity (ROE) of 32 percent, a return on assets (ROA) of 16 percent. Required: 94
  • 55. Introduction to Corporate Financial Analysis (a) Find ABC’s asset turnover ratio. (b) Find ABC’s debt to equity ratio. Suggested Solution 28. ROIC and ROE The following information is available on the financial accounts of ABC Corporation. 2008 EBITDA 400 Depreciation 25 Interest ? 2008 Trade Capital ? Short-term Debt ? Net Fixed Assets ? Equity 600 Invested Capital ? 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 neither borrowed incrementally nor repaid short-term debt during 2008, and therefore, its interest expense for 2008 is the opening balance for 2008 (same as the closing balance) times the interest rate on its short-term debt, which is 8% per annum. ABC’s tax rate is 40%. ABC’s rate of return on invested capital for 2008, after tax and after depreciation, using end of period invested capital equals its 2008 ROE using end of period equity. Required: Find ABC’s 2008 interest expense (in dollars). Suggested Solution 29. ROIC Versus ROE The following information is available on the financial accounts of ABC Corporation. 2008 EBITDA 600 Depreciation 40 Interest 2008 Trade Capital ? Short-term Debt ? Net Fixed Assets ? Equity ? Invested Capital ? 95
  • 56. Financial Statements in Financial Analysis 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). The interest rate on ABC’s short-term debt is 9% per annum. ABC paid down no debt during 2008, and therefore, their opening debt balance for 2008 equals their closing 2008 debt balance. ABC’s tax rate is 40%. ABC’s rate of return on equity (ROE) for 2008 using end of period book equity is 20%. Their year-end 2008 debt to invested capital ratio is 25%. Required: Find ABC’s 2008 Invested Capital. Suggested Solution 30. ROIC Comment on the following assertion. “A primary determinant of a firm’s rate of return on invested capital (after tax and after depreciation) is corporate debt use.” Use no numerical examples in your response. A complete response is required for full marks. Suggested Solution 31. ROIC Versus ROE The following information is available on the financial accounts of ABC Corporation. 2008 EBITDA 700 Depreciation 520 Interest 100 2008 Trade Capital ? Short-term Debt ? Net Fixed Assets ? Equity ? Invested Capital ? NOTES: “Equity” is 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 paid down no debt during 2008, and therefore, their opening debt balance for 2008 equals their closing 2008 debt balance. ABC’s tax rate is 40%. ABC’s 2008 rate of return on equity (with 2008 year-end book equity) equals their 2008 rate of return on invested capital (after tax, after depreciation, with 2008 year-end invested capital). Required: Find ABC’s year-end 2008 equity to invested capital ratio (2008 year-end equity divided by 2008 year-end invested capital). 96
  • 57. Introduction to Corporate Financial Analysis Suggested Solution 32. ROIC Versus ROE The following information is available on the financial accounts of ABC Corporation. 2008 EBITDA ? Depreciation 400 Interest ? 2008 Trade Capital ? Short-term Debt 900 Net Fixed Assets ? Equity ? Invested Capital ? NOTES: “Equity” is 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 neither borrowed incrementally nor repaid short-term debt during 2008, and therefore, its interest expense for 2008 is the opening balance for 2008 (same as the closing balance) times the interest rate on its short-term debt, which is 10% per annum. ABC’s tax rate is 40%. ABC’s rate of return on invested capital for 2008, after tax and after depreciation, using end of period invested capital is 20%. ABC’s 2008 ROE using end of period equity is 26%. Required: (a) Find ABC’s 2008 year-end Invested Capital. (b) Find ABC’s 2008 EBITDA. Suggested Solution 33. ROIC Versus ROE Comment on the following assertion. “When a firm does well on its business investments, that is, EBITDA is high, the rate of return on invested capital (ROIC) is correspondingly high and exceeds the rate of return on equity (ROE). On the other hand, when a firm does poorly on its business investments, ROIC is low and is below ROE.” State whether or not you agree with the assertion and then explain why. Use no numerical examples in your response. A complete response is required for full marks. Suggested Solution 34. Free Cash Flow The following information is available on the financial accounts of ABC Corporation. 97
  • 58. Financial Statements in Financial Analysis 1999 EBITDA ? depreciation 20 interest 25 1998 1999 Trade Capital ? ? Short-term Debt ? 300 Net Fixed Assets ? ? Equity 520 ? Invested Capital ? 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 did some incremental borrowing during 1999. 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 (e.g. net of disposals) of $165 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 surplus of $100 for 1999. Required: Find ABC’s rate of return on invested capital for 1999, after tax and after depreciation, using beginning of period invested capital. Was ABC a net purchaser or seller of its own common shares in 1999? What was is the amount of shares sold or repurchased? Solution 35. Free Cash Flow The following information is available on the financial accounts of ABC Corporation. 1999 EBITDA ? depreciation ? interest 25 1998 1999 Trade Capital 180 200 Short-term Debt ? ? Net Fixed Assets ? ? Equity ? 520 Invested Capital 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). 98
  • 59. Introduction to Corporate Financial Analysis ABC’s did some incremental borrowing during 1999. 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 8% per annum. ABC made net capital expenditures (e.g. net of disposals) 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, after tax and after depreciation, using beginning of period invested capital. Was ABC a net seller of its common shares or a net purchaser of its common shares in 1999? What is the dollar amount of shares sold or repurchased? Solution 36. Free Cash Flow The following information is available on the financial accounts of ABC Corporation. 2003 EBITDA 450 Depreciation ? Interest ? 2002 2003 Trade Capital 550 ? Short-Term Debt ? ? Net Fixed Assets ? 745 Equity 800 Invested Capital ? ? NOTES: "Equity" represents the sum of all of the accounting equity accounts (that is, 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 or future income tax liability in this problem (i.e., capital cost allowance is the same as financial statement depreciation). ABC repaid $200 of their short-term debt at year-end 2003. Therefore, ABC's 2003 interest expense is the interest rate on short-term debt times short-term debt at the beginning of 2003 (year-end 2002). The interest rate on ABC's short-term debt is 8% per annum. ABC made capital expenditures of $365 at year-end 2003. Because these capital expenditures were at year- end, ABC’s 2003 depreciation expense (also CCA) is a rate for depreciation times Net Fixed Assets at the beginning of 2003 (year-end 2002). The depreciation rate is 5% per annum. ABC paid dividends to shareholders of $X during 2003. ABC's tax rate is 40%. Also, during 2003, ABC sold new shares to new shareholders in the amount of $125 (no shares were repurchased). ABC’s 2003 free cash flow was $253. Required: How much did ABC pay in dividends (in total rather than per share) to shareholders 99
  • 60. Financial Statements in Financial Analysis during 2003? Solution 37. Free Cash Flow The following information is available on the financial accounts of ABC Corporation. 2003 EBITDA 450 Depreciation ? Interest ? 2002 2003 Trade Capital ? ? Short-Term Debt ? ? Net Fixed Assets 300 630 Equity 517 700 Invested Capital ? NOTES: "Equity" represents the sum of all of the accounting equity accounts (that is, 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 or future income tax liability in this problem (i.e., capital cost allowance is the same as financial statement depreciation). ABC's 2003 interest expense is the interest rate on short-term debt times short-term debt at the beginning of 2003 (year-end 2002). The interest rate on ABC's short-term debt is 8% per annum. ABC made capital expenditures of $365 at year-end 2003. Because these capital expenditures were at year-end, ABC’s 2003 depreciation expense (also CCA) is a rate for depreciation times Net Fixed Assets at the beginning of 2003 (year-end 2002). ABC paid dividends to shareholders of $50 during 2003. ABC's tax rate is 40%. Also, during 2003, ABC sold new shares to new shareholders in the amount of $100 (no shares were repurchased). ABC’s 2003 free cash flow was $253. Required: Determine the amount of ABC’s short-term debt repayment or the increment to short-term debt borrowing at year-end 2003. Solution 38. Free Cash Flow The following information is available on the financial accounts of ABC Corporation. 2008 EBITDA ? Depreciation ? Interest 35 2007 2008 Trade Capital 650 ? Short-Term Debt ? ? Net Fixed Assets ? 860 Equity 900 100
  • 61. Introduction to Corporate Financial Analysis Invested Capital ? ? NOTES: "Equity" represents the sum of all of the accounting equity accounts (that is, 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 or future income tax liability in this problem (i.e., capital cost allowance is the same as financial statement depreciation). ABC repaid $200 of their short-term debt at year-end 2008. The interest rate on ABC’s debt is 10% per annum. ABC made capital expenditures of $385 at year-end 2008. Because these capital expenditures were at year-end, ABC’s 2008 depreciation expense (also CCA) is a rate for depreciation times Net Fixed Assets at the beginning of 2008 (year-end 2007). The depreciation rate is 5% per annum. ABC paid dividends to shareholders of $X during 2008. ABC's tax rate is 40%. Also, during 2008, ABC sold new shares to new shareholders in the amount of $125 (no shares were repurchased). ABC’s 2008 free cash flow was $353. Required: (a) Determine ABC’s 2008 dividend payment, $X. (b) Determine ABC’s 2008 rate of return on invested capital, after tax and after depreciation, using beginning of period invested capital. Solution 39. Free Cash Flow The following information is available on the financial accounts of ABC Corporation. 2008 EBITDA ? Depreciation ? Interest ? 2007 2008 Trade Capital 845 Short-Term Debt 540 480 Net Fixed Assets 640 ? Equity ? ? Invested Capital ? ? NOTES: "Equity" represents the sum of all of the accounting equity accounts (that is, 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 or future income tax liability in this problem (i.e., capital cost allowance is the same as financial statement depreciation). ABC repaid some of their short-term debt at year-end 2008. The interest rate on ABC’s debt is 10% per annum. ABC made capital expenditures of $105 at year-end 2008. Because these capital expenditures were at year-end, ABC’s 2008 depreciation expense (also CCA) is a rate for depreciation times Net Fixed Assets at the beginning of 2008 (year-end 2007). The depreciation rate is 5% per annum. ABC paid dividends to shareholders of $55 during 2008 (in total rather than per share). ABC's tax rate is 40%. ABC’s 2008 free cash flow was $283. Required: Determine ABC’s 2008 rate of return on invested capital after tax and after depreciation using beginning of period invested capital. 101
  • 62. Financial Statements in Financial Analysis Solution 102
  • 63. Introduction to Corporate Financial Analysis (2.11) 1. Financial Statements and Free Cash Flow. ABC, Ltd Income Statement for fiscal year 2010 (All figures in thousands) NOTES Sales $3,990.000 Given Production Costs 2,137.000 Given Depreciation 1,018.000 Given EBIT $835.000 Interest 267.000 Given Taxable Income $568.000 Taxes (at 40%) 227.200 Net Income $340.800 Dividends $205.000 Given Added to Retained Earnings 135.800 ABC, Ltd Comparative Statement of Financial Position for fiscal years 1998 and 1999 (All figures in thousands) 1998 1999 NOTES Current Assets 2,140 2,346 Net Fixed Assets 6,770 7,087 Total Assets $8,910 $9,433 Current Liabilities 994 1,126 Long-term Debt 2,869 2,956 Equity 5,047 5,351 Equity is the Plug Figure $8,910 $9,433 a) FUNDS FROM OPERATIONS FFO = Net Income + Depreciation + after-tax Interest = $340.800 + $1,018 + (1–.40) × $267 = $1,519.000 FFO may also be calculated as FFO = EBITDA – Current Tax – Interest Tax Shield = $(835 + 1,018) – $227 – 0.40 × $267 = $1,519.000 b) INVESTMENTS MADE BY THE FIRM Increment to Trade Capital Trade capital in 1999 = $2,346 – $1,126 = $1,220 Trade capital in 1998 = $2,140 – $994 = 1,146 Incremental trade capital $ 74 Net Capital Expenditures Net Fixed Assets in 1999 $7,087 103
  • 64. Financial Statements in Financial Analysis Less: Net Fixed Assets in 1998 (6,770) Add: Depreciation Expense in 1999 1,018 Incremental capital asset investment $ 1,335 Incremental Investment in Business Activity Incremental Investment in Trade Capital $ 74 Net Capital Expenditures 1,335 $ 1,409 c) FREE CASH FLOW (Operating Definition) FCF = FFO – Incremental Investment Into Business Activity = $1,519 – $1,409 = $110.000 d) AFTER CORPORATE TAX DISTRIBUTIONS TO SUPPLIERS OF CAPITAL Cash Paid to Debtholders, after corporate taxes = After-tax Interest – Net Increase in Long-term Debt = (1– 0.40) × $267 – $(2,956 – 2,869) = $73.200 Net Payments to Shareholders = Dividends – Net contribution of Equity Capital = Net Income – (Ending Equity – Starting Equity) = $340.800 – $(5,351 – 5,047) = $36.800 e) CHECK: Total distributions to investors equals Free Cash Flow: Cash Paid to Debtholders $ 73.200 Net Payments to Shareholders 36.800 After Corporate Tax Distributions = FCF $ 110.000 2. Invested Capital, ROIC, Trade-Capital, Free Cash Flow. a) Invested Capital Turnover = SALES ÷ IC = 4,500,000 ÷ 1,800,000 = 2.5. = $340.800 – $(5,351 – 5,047) = $36.800 EBITDA = 0.35 × 4,500,000 – 850,000 = 725,000. EBITDA margin = 725,000 ÷ 4,500,000 = 16.1%. ROIC (before tax) = 725,000 ÷ 1,800,000 = 40.28% b) In this problem, there is no indication of capital expenditure, or incremental investment in business activity. Therefore, FCF = FFO. There is also no indication of CCA, therefore, FFO equals EBITDA multiplied by one minus the corporate tax rate. Free cash flow = (1−0.23) × 725,000 = $558,250. Net after corporate tax payments to debtholders after corporate tax interest = (1−0.23) × $40,000 = $30,800. Net payments to Shareholders = dividends = net income = (1−0.23) × (725,000-40,000) = 527,450. Notice that the sum of net after corporate tax payments to debtholders plus net payments to shareholders is equal to free cash flow: = 558,250. c) In this new environment, Invested Capital = $(1,800,000 + 400,000 + 300,000) = 2,500,000. EBITDA = 0.35 × $5,500,000 – $1,050,000 = $875,000 ROIC before tax = $875,000 ÷ $2,500,000 = 35% The expansion decreases ROIC. However, you should note that simply because ROIC falls, the firm should not necessarily abandon plans for the expansion. The expansion 104
  • 65. Introduction to Corporate Financial Analysis might nonetheless be a positive NPV investment that should be undertaken. We discuss real asset valuation and more about corporate investment decisions in later chapters of the electronic book. d) The after-tax per annum benefit is (1−0.23)(0.35 × 1,000,000 – 200,000) = $115,500. The incremental investment into business activity is, therefore, 115,500 ÷ 700,000 = 16.5% per annum. 3. Rate of Return on Assets and Rate of Return on Invested Capital. ROA is an inadequate measure of return to investment in business activity because it confuses financial activity with operating activity. As a firm uses more debt in its financial structure, ROA decreases because the interest charge increases. However, the firm is no more or less efficient in its operations after the recapitalization, but yet, ROA decreases. Corporate financial structures are more or less at the discretion of the firm, and therefore, it is hard to compare ROA across firms. Two firms might be equally efficient with respect to operations but the one with the greater debt will have the lesser ROA. Also, it is difficult to use ROA in a trend analysis because the debt use of a particular firm might increase or decrease over time, and therefore, changes in ROA are not necessarily the result of operating efficiencies. 4. The EBITDA Margin. Invested capital turnover is determined in large part 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 turnover. If ROIC across utility firms tends to some appropriate financial market benchmark (by competition) but firms have relatively low invested capital turnover, then (other things equal) they are likely to have relatively great EBITDA margins. It is fairly easy to show that ROIC (before tax) can be calculated as EBITDA margin times invested capital turnover. Capital intense industries (high invested capital turnover) must tend to have higher EBITDA margins in order to generate an adequate rate of return on their investment. 5. The Difference between the Rate of Return on Assets and ROIC. a) ROE = 66.5/450 = 14.78%, ROA = 66.5/500 = 13.33%, ROIC = 70/500 = 14%. b) ROE = (100 – 25) × (1–0.30) ÷ 250 = 21% ROA = 75 × (1–0.30) ÷ 500 = 10.5% ROIC = 100 × (1–0.30) ÷ 500 = 14% Note that ROIC does not change after the recapitalization. ROA is an inadequate measure of return to investment in business activity because it confuses financial activity with operating activity. The firm is no more or less efficient in its operations after the recapitalization, yet ROA increases. c) ROE increases due to: i) financial leverage. Shareholders benefit from financial leverage because ROIC > debt rate. The firm can borrow at 10% and invest at 20%. ii) interest tax shields. Interest is tax deductible, and therefore, with increased debt use, the firm’s tax bill is reduced. 6. EBITDA Margin. 105
  • 66. Financial Statements in Financial Analysis 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 EBITDA. 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. The EBITDA margin is designed for comparability across firms because tax, interest, depreciation, and amortization are excluded. These income-statement line items are influenced by the idiosyncratic characteristics of individual firms. For example, taxes paid can vary by firm size or by whether or not the firm has prior year losses, which can be used to offset current-year taxable income. Interest depends on the debt use of 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 uses tax, depreciation, or interest has limited comparability across firms. EBITDA margin is a normalized measure of operating efficiency. It measure the dollar amount going to the “bottom line” from operations per one dollar of sales. Not only is the EBITDA margin a measure of operating efficiency, but also, in Chapter 3 of this book, we demonstrate that EBITDA margin is an inverse measure of operating risk. Other things equal, shareholders bear greater risk with less efficient firms. 7. Free cash flow and net distributions to financial asset-holders. a)Find ROE when you sell 1,000,000 units at $2.80 per unit. ROE = Net Income ÷ Book Equity = $585,000 ÷ $1,541,223.77 = 37.9568 % Net Income = (1– 0.35)×(2,800,000×(1–0.60) – 100,000 – 0.12×1,000,000) = $585,000 Total Assets = A/R + Inv + Net Fixed Assets = $ (2800,000 ÷ 6.5 + 1,680,000 ÷ 5.5 + 2,225,000) = $ (430,769.23 + 305,454.54 + 2,225,000) = $2,961,223.77 Equity = Total Assets – A/P – Debt = $ (2,961,223.77 – (1,680,000 ÷ 4.0) – 1,000,000) = $ 1,541,223.77 Trade Cap = $ (430,769.23 + 305,454.54 – 420,000) = $ 316,223.77 b)DuPont Decomposition of ROE using Invested Capital in place of Assets: ROE = (Net Inc ÷ Sales) × (Sales ÷ InvCap) × (InvCap ÷ Equity) 585,000 2,800 ,000 2,541,223.77 = × × = 0.208928 × 1.1018 × 1.6488 = 37.9568 % 2 ,800,000 2 ,541,223.77 1,541,223.77 c)Change pricing policy. Sell 1,200,000 units at $2.70 per unit. Find trade capital. Projected Sales = $2.70/unit × 1,200,000 units = $3,240,000 CoGS = (1– 0.40) × $3, 240,000 = $1,944,000 A/R = $3,2400,000 ÷ 6.5 = $498,461.54 Inventory = $1,944,000 ÷ 5.5 = $353,454.54 A/P = $1,944,000 ÷ 4.0 = $486,000 Trade Capital = $ (498,461.54 + 353,454.54 – 486,000) = $ 365,916.08 Net Income = (1– 0.35)×(3,240,000×(1–0.60) – 100,000 – 0.12×1,000,000) = $699,400 d)Additional funds needed. Find New Borrowing: FCF = FFO – Increase in Trade Cap – Increase in PPE = Net Distribution to Debt + Net Distribution to Equity (assumed at year end) = (After-tax Interest – New Borrowing) + Net Income New Borrowing = After-tax Interest + Net Income – FCF = After-tax Interest + Net Income – FFO + Increase in Trade Cap + Incr PPE 106
  • 67. Introduction to Corporate Financial Analysis = Increase in Trade Cap = $ (365,916.08 – 316,223.77) = $ 49,692.31 e)Find FFO, Incremental Investment in Business, and Free Cash Flow FFO = Net Income + After-tax Interest = $699,400 + (1– 0.35)($120,000) = $777,400 Inv in Business = Increase in Trade Cap = $ 49,692.31 FCF = FFO – Increase in Trade Cap = $ (777,400 – 49,692.31) = $727,707.69 f)Find Net Distributions to Investors Distr’s to Debt = After-tax Interest – Increase in Debt = (1– 0.35)($120,000) – $ 49,692.31 = $ 28,307.69 Distr to Equity = Dividends – New Contrib. from Shareholders = Net Income = $699,400 FCF (Fin Defn) = Distr’s to Debt + Distr to Equity = $ (28,307.69 + 699,400) = $ 727,707.69 8. Rate of Return on Equity. a) net income = (0.2*(3,000,000)-200,000-88,000-0.1*1,900,000)*0.65 = $79,300 b) FFO = (EBITDA-CCA)*(1-taxrate)+CCA = 0.65*(0.2*3,000,000-200,000-0.15*800,000)+0.15*800,000 = $302,000. c) If deferred tax is interpreted as a tax subsidy, and subject to the constraints of GAAP, net income plus deferred tax (from the income statement) is the best measure of the increase in shareholders' wealth for a year. Also deferred tax plus share capital plus retained earnings is the best measure of the funds originally invested by shareholders in a firm, and therefore, the calculation labeled (B) is the best measure of ROE. d) deferred tax for the year is 0.35*(0.15*800,000-0.11*800,000) = $11,200. ROE = (79,300+11,200)/(100,000+500,000+1,500,000) = 4.31%. 9. The Current Ratio. Current assets are 500,000 and current liabilities are 250,000. a) Current ratio is $422,500 ÷ $172,500. b) Current assets remain $500,000, and therefore, current ratio is unchanged. c) Current ratio is $551,300 ÷ $301,300. d) Current ratio is $590,000 ÷ $250,000. e) Because the gross margin is 67%, COG = $35,845. Inventory falls by this much but A/R increases by $53,500. Therefore, current ratio is $517,655 ÷ $250,000. 10. Financial Analysis. A financial analyst must consider three principal questions for any investment. These questions depend upon whether the investment was made in the past (retrospective investigation) or whether the investment is under current consideration (a prospective investigation). These question are summarized in the following exhibit: Exhibit 1-1 Fundamental Questions of Financial Analysis Retrospective Analysis Prospective Analysis (1) What was the expenditure? (1) What is the required expenditure? (2) What is realized rate of return? (2) What is the expected rate of return? (3) What is the risk of the (3) What is the risk of the investment? investment? For a firm as a whole (rather than its financial assets), a number of ratios and measures can be used to help answer the above 3 questions. First, invested capital measures the amount 107
  • 68. Financial Statements in Financial Analysis invested by a firm into business activity (assets which can still earn a rate of return). Invested capital, therefore, attempts to answer the expenditure question. Second, the rate of return on invested capital measures the return that the firm earns on behalf of all financial asset-holders. Lastly, a number of ratios and measures were developed in this chapter to measure various aspects of risk. Financial risk can be measure by some type of debt to asset or debt to equity ratio. Times interest earned measures the ability of the firm to make interest payments. Liquidity ratios like the current ratio measure the ability of the firm to make payments that are required in the relatively near term. In chapter 3 of this EBOOK, addition measures of corporate risk are developed. 11. Ratio Analysis in EXCEL. Follow these links for the spreadsheet template and the spreadsheet answer. Template Solution 12.Calculate Free Cash Flow Given the information shown in the question, calculate Free Cash Flow from both the operating definitions and the financing definition, and then confirm that they are equal. a) ROIC = (EBITDA – Depr)×(1– 0.40) ÷ InvCap (b.o.p.) = 0.153 EBITDA = $ (1,600 – 800 – 250) = $550 Invested Capital (b.o.p.) = $ 510 (0.60) ÷ 0.153 = $ 2,000 b) Funds from operations (FFO) = Net Income + Non-Cash Expenses + after-tax Interest FFO = $ (1,600 – 800 – 250 – 50 – 40) × (1– 0.40) + 40 + 50 × (1– 0.40) = $ 346 c) Use Turnover Ratios to extract ending Balance Sheet information: Inventory = CoGS ÷ Inv T/O = $ 800 ÷ 4.0 = $ 200 A/P = CoGS/365 × A/P Def Per = $ 800 × (40/365) = $ 87.671 A/R Coll = Cash Conv – Inv Conv + A/P Def = 60 – 365 ÷ 4 + 40 = 8.75 days A/R = (Sales/365) × 8.75 = $1,600 ÷ (365/8.75) = 38.356 End Trade Capital = $ (38.356 + 200 – 87.671) = $150.685 d) Beginning Net Fixed Assets = Invested Cap (b.o.p.) – Trade Capital (b.o.p.) = $2,000 – $ (150 + 200 – 100) = $ (2,000 – 250) = $1,750 e) By the Balance Sheet Equation, b.o.p. Assets = $2,100 and b.o.p. Equity is $1,500 f) Calculate ending Invested Capital. Net Fixed Assets = Net Fixed Assets (b.o.p.) + Acquis – Depr = $1,750 +$135 – $40 = $ 1,845 Ending Inv Cap = Ending Net Fixed Assets + End Trade Cap = $1,845 + $150.685 = $ 1,995.685 g) All debt financing is repaid in the year. Then Ending Equity = Inv Cap = $ 1,995.685 Ending Assets = Equity + A/P = $ 1,995.685 + $ 87.671 = $2,083.356 h) Calculate contributed Equity Capital Ending Equity = Bgn Equity + NetInc – Divs + ContrCap ContrCap = Ending Equity – Bgn Equity – NetInc + Divs $ (1,995.685 – 1,500 – 276 + 85) = 304.685 i) FREE CASH FLOW, Operating Definition FFO = Net Income + Non-Cash Expenses + after-tax Interest 108
  • 69. Introduction to Corporate Financial Analysis = $ (276 + 40 + 50 × (1 – 0.40)) = $ 346 FCF = FFO – Incremental Investment in Assets = $ 346 – $135 – $ (150.685 – 250) = $ 310.315 j) FREE CASH FLOW, Financing Definition Net CF to Debt = After-tax Interest – Increase in Debt = $ (50 × (1 – 0.40) + 500) = $ 530 Net CF to Equity = Div’s – Incremental Equity Capital Contributed = $ (85 – 304.685) = $ – 219.685 k) CHECK FIGURE. FCF = Net CF to Debt + Net CF to Equity $ 310.315 = $ 530 – 219.685 13.Calculate Free Cash Flow. We are asked to find Free Cash Flow from partially completed financial statements. This answer assumes that the accounting period starts in the year 1998 and ends in the year 2010 (even if your version of the electronic book says differently). You must complete the financial statements to solve the problem, so you might as well begin with them. From the information given, you can make the following deductions: a) Note that the turnover ratios use the ending balance sheet entries. Then Sales = 365 × A/R ÷ (A/R Coll Period) = 365 × 200/ 40 = 1,825 b) Tax Liability = 274 and the tax rate is 40%. Then Taxable Income = 274 ÷ 0.40 = 685 c) Work backwards through the Income Statement to find Cost of Goods Sold: 685 = 1825-CoGS – 250 – 50 – 40 6 CoGS = 800 d) With CoGS, you may use Inventory turnover to solve for ending Inventory: Ending Inventory = CoGS ÷ (Inv T/o) = 800 ÷ 4 = 200 e) Next, solve for ending Trade Capital and beginning Trade Capital. TC1995 = (200 + 200 – 100) = 300. Therefore, TC1994 = (300 – 145) = 155 f) Solve for Invested Capital and beginning Net Fixed Assets. This is the trickiest part of the problem. Given ROIC = 15%, IC1994 = (1825 – 800 – 250 – 40)×(1–0.40) ÷ 0.15 = 2940. Next, IC1994 = 2940 = TC1994 + NFA1994 NFA1994 = (2940 – 155) = 2785 Now we may calculate Free Cash Flow by the operating definition. First finish the income statement to show that Net Income = 411. Calculate Funds from operations: Operational Definition of Free Cash Flow FFO = Net Income + Depr + after-tax Int Exp = (411 + 40 + (1–0.40) × 50) = 481 FTC = 145 (given) Net Capital Expenditure = NFA1995 – NFA1994 + Depr = (3056 – 2785 + 40) = 311 Free Cash Flow = (481 – 145 – 311) = 25 Financial Definition of Free Cash Flow Net Cash Flow to Shareholders = Dividends + Share Repurchases = (95 + 200) = 295 Net Cash Flow to Debt = After-tax interest + Repayment of Debt = 50 × (1–0.40) – 300 = – 270 Free Cash Flow = 295 – 270 = 25 14. Deferred Income Taxes and Recapture of Depreciation. Follow this link to the spreadsheet answer: 109
  • 70. Financial Statements in Financial Analysis Solution 15.Free Cash Flow and the Invested Capital Balance Sheet. EBITDA = $(2,000 – 1,400 – 200) = $400. EBT = $(400 – 60 – 35) = $305 Invested Capital 1995 1996 1995 1996 Trade Capital 168 200 s.t. Debt 600 918 NFA 3,000 3,235 Equity 2,568 2,517 IC 3,168 3,435 IC 3,168 3,435 Note that $2,517 = $2,568 + NI – $95 – $200. So NI = $244. Also, NI = (1-t) × EBT, so $244 = (1–t) × $305, and therefore, (1–t) = 0.80 and t = 0.20. Now FCF =$25 = (1–0.20) × $60 + $95 + $200 – X, where X is the incremental borrowing in 1996. You find that X = $318. As of 1996, Short-term Debt as of 1996 equals $(600 + 318) = $918. Capital expenditure is $(3,235 – 3,000 + 35) = $270. Incremental investment in trade capital is $(200 – 168) = $32. FFO is $(400 – 35) × (1– 0.20) + $35 = $327. By the operating definition of FCF, FCF = $(327– 270– 32) = $25. 16.Optimal Trade Capital. Trade capital measures the firm’s investment in business activity that is short-term and held to support its trading function. 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 which the firm earns for all its financial asset-holders, the rate of return on invested capital, is increased. However, a firm cannot unduly reduce trade capital. If it does so, sales are jeopardized. For example, if a firm does not offer credit (in order to reduce trade capital), customers might alternatively purchase from competitors. The trade-off between lesser trade capital and reduced sales is referred to as a firm’s trade capital (or working capital) problem. 17.Cash Flow. Invested Capital Balance Sheet 1996 1997 1996 1997 Trade Capital 750,000 S-t debt 675,000 Plug=230,500 NFA 250,000 237,500 “Equity” 325,000 367,000 IC 1,000,000 597,500 IC 1,000,000 597,500 Proforma Income Statement, 1997 Sales 3,000,000 VC 2,400,000 FC 450,000 EBITDA 150,000 Deprec 12,500 Interest 0.1*(OB1996) Tax ? 110
  • 71. Introduction to Corporate Financial Analysis Net Income 42,000 $42,000 = (1–0.40) × [150,000-12,500 – 0.10 × (OB1996)], so OB1996 = $675,000. a) ROE = $42,000 ÷ $325,000 = 12.92%. b) ABC can pay down debt by $675,000 – $230,500 = $444,500. The most likely reason for reduced debt is lesser sales in 1997. One can infer this decrease from lesser trade capital. When trade capital is liquidated, the proceeds are often used to pay down debt. c) FCF - the operating definition. FFO= $42,000 + $12,500 + (1– 0.40) × $67,500 = $95,000; Capital Exp. = 0, Change in Trade Cap = – $390,000, so FCF = $ (95,000 + 390,000) = $485,000. FCF - the financial definition. Dividends =0, after tax interest = 0.6*67,500=40,500, repayment of debt = 444,500, so FCF = 0+40,500+444,500 = 485,000. d) It appears that sales have decreased for ABC between 1995 and 1996. If this decrease has arisen from lesser sales volume, then operating leverage has increased. Recall that unit sales is one of the determinants of operating leverage. 18. Free Cash Flow and the Rate of Return on Invested Capital. From the statement of the problem, from the definition of trade capital, and from the fact that the tradecapital to invested capital ratio is 25% for both 1996 and 1997, you can find the invested capital balance sheet for 1996 and 1997. 1996 1997 1996 1997 Trade Capital 200 225 s.t.debt 500 400 NFA 600 675 Equity 300 500 800 900 800 900 Equity in 1997 = 500 = 300 + NI1997 – 95 + 200 (Dividends are $95, the share issue in 1997 is $200). Solving this equation, you find that net income for 1997 (NI1997) equals $95. Operating Definition of FCF: Using one of the definitions of FFO, FFO = $(95 + 100 + (1–0.40) × 35) = $216 The change in trade capital is 25. Capital expenditure is 675-600+100 = 175. Therefore, FCF for 1997 is 216-25-175=16. Financial Definition of FCF After corp. tax interest is (1–0.40) × $35 = $21 Repayment of debt is $100, Dividends are $95, Share issue is $200. The sum of the first three numbers less the last is FCF. FCF = $16. Net Income is 95. Therefore, EBT = $95 ÷ (1– 0.40) = $158.33 EBITDA= $(158.33 + 35 + 100) = $293.33 ROICBOP = (1–0.40) × $(293.33 – 100) ÷ $800 = 14.5% 19. Free Cash Flow and the Rate of Return on Equity. From the statement of the problem: 111
  • 72. Financial Statements in Financial Analysis 1997 1998 1997 1998 Trade Capital 150 ? s.t. debt 100 250 NFA 300 ? Equity 350 ? Invested Capital 450 ? Invested Capital 450 ? Also, ROE = NI/Equity1998 = 0.2, So, Equity1998 = 5NI, substitute for equity in the first relation: 5NI = 350 + NI –26, Solving, you find that NI = 81, and Equity1998 = 405. IC1998 = 250 + 405 = 655. EBT = NI/0.6 = 81/0.6 = 135. EBITDA = 135+30+10 = 175. Sales = 175/0.25 = 700, TC1998 = 0.3*700 = 210. NFA1998 = 655-210 = 445. OPERATING DEFINITION of FCF FFO = 81+30+0.6*10 = 117 ∆TC = 210-150 = 60 cap. exp. = 445 – 300 + 30 = 175, so, FCF = 117 – 60 –175 = -118 FINANCIAL DEFINITION OF FCF after tax interest = 0.6*10 = 6 dividends = 26 repayment of debt = 100-250 = -150. FCF = 6+26-150 = -118 20.Ratios. (a) The EBITDA margin is a calculated as EBITDA (earnings before interest, tax, depreciation, and amortization) divided by revenue. The EBITDA margin is both a measure of operating efficiency and an inverse measure of operating risk (see chapter 3 of this electronic book for the operating discussion of risk). As a measure of operating efficiency, the EBITDA margin measures the operating increment to EBITDA (after fixed operating costs) from an extra dollar of revenue. (b) The debt to asset ratio is calculated as the book value of debt divided by the book value of assets. Several different definitions of both “debt” and “assets” are possible but the basic calculation is the same. The debt to asset ratio is a measure of financial leverage, that is, the debt use of a firm. Other things equal, the greater is the debt to asset ratio, the greater is the financial risk imposed on shareholders by corporate use of debt. The effect of this greater debt use is, typically, greater variability of rates of return on equity for shareholders, and, also, greater average rate of return on equity. (c) Times interest earned (TIE) is calculated as earnings before interest and tax (EBIT) divided by interest. TIE measures the ability of a firm to cover its interest payments with earnings. The greater is TIE, the better is the credit worthiness of the firm. (d) The quick ratio is calculated as current assets less inventory divided by current liabilities. The quick ratio is a measure of liquidity. Liquidity measures how quickly an asset can be converted into cash (through sale typically) without undue loss of value. Inventory is subtracted from current assets in the quick ratio in recognition of the fact that, oftentimes, the inventory cannot be liquidated without undue loss of value. 112
  • 73. Introduction to Corporate Financial Analysis (e) Asset turnover is calculated as revenues divided by the book value of assets. Asset turnover measures sales that are generated per one dollar invested into assets. That is, asset turnover is a measure of the efficiency of asset use. Other things equal, shareholders are better off with a greater asset turnover because there is a lesser need in the firm for either debt or equity financing in the firm. In this instance, for example, a firm with a greater asset turnover could pay greater dividends to its shareholders. 21.Incremental Rate of Return on Invested Capital IC = TC+NFA = 1,600,000+4,800,000 = 6,400,000. Depreciation = maintenance capital expenditure = 0.05*4,800,000 = 240,000. In the new environment, IC = 2,000,000 + 6,000,000 = 8,000,000. Depreciation = 0.05*6,000,000 = 300,000. Therefore, ∆IC = 8,000,000-6,400,000 = 1,600,000 and ∆depreciation = 300,000-240,000 = 60,000. Because the change in sales is 2,000,000, the incremental rate of return is: 0.6*(0.25*2,000,000-60,000)/1,600,000 = 16.5%. Notice that the contribution to EBITDA is taxable and the increment to CCA is tax deductible. 22.Free Cash Flow, Invested Capital, Financial Statements TC1999 = 850-650 = 200 NFA1999 = NFA1998*0.95+365-650. Therefore, NFA1998=300. deprec1999=0.5*300=15. Therefore, TC1998=500-300 = 200. s.t.debt1998 = 330-120 = 210. Equity1998=500-210 = 290. Invested Capital 1998 1999 1998 1999 Trade Capital 200 200 s.t.debt 210 330 NFA 300 650 equity 290 520 Invested Capital 500 850 Invested Capital 500 850 FCF=-100=FFO-∆TC-cap.exp.=FFO-0-365. Therefore, FFO=265. FFO=265=0.6*(EBITDA-15)+15. Therefore, EBITDA=431.67. Therefore, ROIC before tax, before deprec and b.o.p. = 431.67/500 = 86.33%. NI=0.6*(431.67-15-21)=237.4. Equity1999=520=290+237.4-50-share repurchase. Therefore, share repurchase = -42.6. 23.The Relation Between ROIC and ROE TC=1,360,000. NFA=2,640,000. D+E=4,000,000. deprec=0.05*2,640,000=132,000. ROIC=0.6*(1,000,000-132,000)/4,000,000=0.1302. Therefore, ROE=0.2302. ROE=0.6*(1,000,000-132,000-0.1*D)/(4,000,000-d)=0.2302. Solving, D=2,350,176, so E=1,649,823, so D/E=1.4245. 24.The Relation Between ROIC and ROE Recall: 113
  • 74. Financial Statements in Financial Analysis D BVE ROIC = (1 − t )* i * + ROE * , IC IC where i is the interest rate on debt. Then, D  D  .27 = 0.6*0.0625* + 0.425* 1 −  1000  1000  Solve to find, D = 400, which means that BE = 600, and D/BE=400/600 = 0.6666. 25. ROA and ROE. Recall: NI NI S BVA ROE = BVE = S BVA BVE , (the Dupont formula) and, NI NI S ROA = BVA = S BVA 0.24=0.16*(BVA/BE), so, 1.5=BVA/BVE BVA=D+BVE 1.5*BVE=D+BVE So, 0.5*BVE=D, Therefore, D/BVE=0.5. 26.Relation Between ROIC and ROE This question is based on the relation between ROIC and ROE, D BVE ROIC = (1 − t )* i * + ROE * , IC IC where i is the interest rate on debt. Then, 400  400  .12 = 0.6*0.08* + 0.168*  1 −  IC  IC  Solve to find, IC = $1,000 27. ROA, ROE, and Net Profit Margin Recall: NI NI S BVA ROE = = , (the Dupont formula) BVE S BVA BVE and, NI NI S ROA = = BVA S BVA a). 0.16=0.04*(S/BVA), so S/BVA=4. b). 0.32=0.16*BVA/BVE, so, BVA/BVE=2 BVA=D+BVE 2*BVE=D+BVE So, BVE=D, Therefore, D/BVE=1. 114
  • 75. Introduction to Corporate Financial Analysis 28.ROIC and ROE Recall, DEBT BVE ROIC = (1 − t )* r * + ROE * IC IC where, ROIC is the rate of return on invested capital after depreciation and after tax, ROE is the rate of return on equity, “r” is the interest rate on debt, DEBT is the book value of debt, BVE is the book value of equity. Also recall that if ROIC=ROE, then ROIC=(1-t)*r, so, ROIC=0.6*0.08=0.048, 0.6*(400 − 25) = 0.048 , IC So, IC=4,687.5, Therefore, DEBT=4,687.6-600=4,087.5. Finally, interest expense = 0.08*4,087.5 = $237 29.ROIC Versus ROE Recall, DEBT BVE ROIC = (1 − t )* r * + ROE * IC IC where, ROIC is the rate of return on invested capital after depreciation and after tax, ROE is the rate of return on equity, “r” is the interest rate on debt, DEBT is the book value of debt, BVE is the book value of equity. ROIC=0.6*0.09*0.25+0.2*0.75=0.1635, 0.6*(600 − 40) = 0.1635 , IC So, IC=$2,055.0 30.ROIC The rate of return on invested capital, after depreciation and after tax (ROIC), is a measure of operating return. It measures the return that a firm earns for financial assets holders when it invests into business activity. It is an operating return for all financial asset-holders rather than for any particular class of financial asset-holder – like shareholders. We can calculate ROIC as one minus the corporate tax rate times the difference between EBITDA depreciation divided by invested capital. The primary determinants of ROIC are profitability, measured by EBITDA, and depreciation. ROIC does not depend upon financial structure. ROIC can be high or low regardless of whether financial structure is modest or great. In particular, because ROIC depends upon EBITDA and EBITDA is before interest, which reflects financial structure, ROIC does not depend upon corporate debt use. Any influence that financial structure has on ROIC is at best secondary. 115
  • 76. Financial Statements in Financial Analysis 31.ROIC Versus ROE Because ROIC=ROE,  700 − 520   700 − 520 − 100  0.6*   = 0.6*    IC08   BVE08  BVE08 Debt08 Solve to find, =0.44444, and therefore, =1-0.4444444 = 0.5555555. IC08 IC08 32.ROIC Versus ROE Recall, DEBT BVE ROIC = (1 − t )* r * + ROE * IC IC where, ROIC is the rate of return on invested capital after depreciation and after tax, ROE is the rate of return on equity, “r” is the interest rate on debt, DEBT is the book value of debt, BVE is the book value of equity. debt BVE ROIC= 0.2 = 0.6*0.1* + 0.26* , or, IC IC debt  debt  debt 0.2 = 0.6*0.1* + 0.26*  1 −  , solve to find, = 0.3 IC  IC  IC Since, debt=900, IC=3000. EBITDA − 400 0.2 = 0.6* 3000 Solve, to find, EBITDA=$1,400. 33.ROIC Versus ROE The statement is incorrect. The rate of return on invested capital, after depreciation and after tax (ROIC), is a measure of operating return. It measures the return that a firm earns for financial assets holders when it invests into business activity. It is an operating return for all financial asset-holders rather than for any particular class of financial asset-holder – like shareholders. We can calculate ROIC as one minus the corporate tax rate times the difference between EBITDA depreciation divided by invested capital. The primary determinants of ROIC are profitability, measured by EBITDA, and depreciation. ROIC does not depend upon financial structure. ROIC can be high or low regardless of whether financial structure is modest or great. In particular, because ROIC depends upon EBITDA and EBITDA is before interest, which reflects financial structure, ROIC does not depend upon corporate debt use. Rate of return on equity (ROE) is net income divided by book equity. When the firm does well with its business investments, that is, ROIC exceeds the after tax rate of return paid on debt, then ROE exceeds ROIC and vice versa. So, when a firm’s ROIC is high, ROE is higher. When ROIC is low, then ROE is lower. The highs for ROE are higher than for ROIC. The lows for ROE are lower than for ROIC. 116
  • 77. Introduction to Corporate Financial Analysis 34.Free Cash Flow NFA1998 = 20/0.05 = 400, therefore, NFA1999 = 400+165-20 = 545 StDebt1998 = 25/0.10 = 250, therefore, borrowing = 300-250=50. Design the Invested Capital balance sheet and fill in the blanks: Invested Capital 1998 1999 1998 1999 TC 370 305 S.T.Debt 250 300 NFA 400 545 “Equity” 520 550 IC 770 850 IC 770 850 Because TC1998=370 and TC1999=305, ∆TC=305-370=-65. One can use either the operating or financial definitions of FCF to solve the remainder of the problem: In the operating definition of FCF: 100=FF0-(-65)-165, so, FFO=200. Now, FFO=(1-0.4)*(EBITDA-20)+20, so EBITDA1999=320. Alternatively, using the financial definition of FCF: 100=0.6*25-50+50+repurchase of shares. So, repurchase of shares = 85. Since, EQ1999=EQ1998+NI-dividends-share repurchase, 550=520+NI-50-85, so NI=165. Thus, 165=0.6*(EBITDA-20-25), so EBITDA=320. Therefore, the ROIC is 0.6*(320-20)/770=23.37%. ABC repurchased shares in the amount of $85. 35. Free Cash Flow StDebt1998 = 25/0.08 = 312.5. Deprec1999=0.05*670=33.5. Therefore, NFA1999=670+365-33.5=1001.5. Design the Invested Capital balance sheet and fill in the blanks: Invested Capital 1998 1999 1998 1999 TC 180 200 S.T.Debt 312.5 681.5 NFA 670 1001.5 “Equity” 537.5 520 IC 850 1201.5 IC 850 1201.5 Because TC1998=180 and TC1999=200, ∆TC=200-180=20. Using the operating definition of FCF: -100=FF0-20-365, so, FFO=285. Now, FFO=285=(1-0.4)*(EBITDA-33.5)+33.5, so EBITDA1999=452.66. Therefore, the required ROIC is 0.6*(452.66-33.5)/850=29.59%. NI=0.6*(EBITDA-25-33.5)=236.5 Since, EQ1999=EQ1998+NI-dividends-share repurchase, 520=537.5+236.5-50-repurchase. So, repurchase of shares = $204. ABC repurchased shares in the amount of $204. 36.Free Cash Flow Suggested Solution: 2002 2003 2002 2003 TC 550 210 S.T. Debt 355 155 NFA 400 745 “Equity” 595 800 117
  • 78. Financial Statements in Financial Analysis IC 950 955 950 955 745=NFA02+365-0.05*NFA02, so, NFA02=400, and DEPREC03=0.05*400=20 FFO=(0.6*(450-20)+20=278 CAPX=365 FCF=278-ΔTC-365, so ΔTC=-340, So, TC03=550-340=210. So IC03=745+210=955. STDebt03=955-800=155. Repayment of debt in 03 was $200, so, STDebt02=155+200=355. EQ02=950-355=595. Interest03=0.08*355=28.4 NI03=(450-20-28.4)*0.06=240.96 EQ03=800=595+240.96-X+125, so, X=160.96 37. Free Cash Flow Suggested Solution: 2002 2003 2002 2003 TC 2,633.67 2,299.67 S.T. Debt 2,416.67 2,229.67 NFA 300 630 “Equity” 517 700 IC 2,933.67 2929.67 2,933.67 2929.67 630=300+365-deprec, so, deprec=35. 517=700+NI03-50+100, So, NI03=133, EB=133/0.6=221.67. 221.67=450-35-I So, I=199.33. Therefore, STDebt02=199.33/0.8=2,416.67. IC02=517+2416.67=2,933.67. TC02=2,933.67-300=2,633.67 253=(450-35)*0.6+35-ΔTC-365, so ΔTC=-334. TC03=2,633.67-334=2,299.67 So IC03=2,299.67+630=2,929.67 STDebt03=2,929.67-700=2,229.67 Repayment of debt in 03 = 2,416.67-2,229.67=187 38. Free Cash Flow (a) 353=0.6*35+200+X-125, X=257 38. Debt07=35/0.1=350 Debt08=350-200=150 IC08=900+150=1050 TC08=1050-860=190 860=NFA07+385-0.05*NFA07, so, NFA07=500, deprec=0.05*500=25 IC07=500+650=1150 EQ07=1150-350=800 900=800+NI08-257+125, so, NI08=232, 232=0.6*(EBITDA-25-35), so, EBITDA=466.67, ROIC=0.6*(466.67-25)/1150=22% 118
  • 79. Introduction to Corporate Financial Analysis 39. Free Cash Flow (a) NFA07=35/0.07=700 (b) CAPX=ΔNFA+deprec=845-700+35=180 (c) IC07=640+700=1340 Debt07=1340-800=540 Interest=540*0.1=54 Debt08=540-200=340 IC08=340+920=1260 TC08=1260-845=415 ΔTC=415-640=-225 FCF=283=FFO+225-180, so, FFO=238 FFO=0.6*(EBITDA-35)+35, so, EBITDA=373.33 NI08=0.6*(373.33-35-54)=170.6 EQ08=920=800+170.6-55+NewIssue, so, NewIssue=4.4 ROIC=0.6*(373.33-35)/1340=15.15% (2.15) accounts payable........................................55 Economic depreciation...............................51 Accounts payable.......................................56 financial analysis........................................48 accounts payable deferral period...............70 financial definition of FCF........................74 accounts payable turnover..........................68 financial ratios............................................48 Accounts Receivable..................................55 free cash flow.............................................71 accounts receivable collection period........69 Funds from operations...............................72 accounts receivable turnover......................68 General and Administrative Expenses.......50 assets..........................................................53 generally accepted accounting principles. 48, balance sheet..............................................53 52 business investments..................................57 Gross Profit................................................50 capital expenditure...............................71, 73 gross profit margin.....................................50 capital intensity..........................................62 income statement........................................48 Capital Surplus...........................................56 income taxes payable.................................55 cash conversion cycle.................................70 Incremental business investment...............73 Common stock...........................................56 incremental trade capital investment.........73 COMPUSTAT...........................................48 industry averages........................................47 costs of goods sold.....................................50 Inventories..................................................55 current assets........................................54, 58 inventory conversion period......................69 current liabilities........................................58 inventory turnover......................................68 Current liabilities.......................................55 invested capital........................56, 57, 58, 72 current portion of long-term debt..............55 invested capital balance sheet....................58 current ratio................................................67 invested capital turnover............................62 debt to invested capital...............................59 Liquidity.....................................................67 Debt-to-Invested Capital............................59 Long Term Debt Due in One Year............56 Deferred Tax..............................................65 maximization of shareholders’ wealth.......65 depreciation................................................52 maximize shareholder wealth....................47 dividends....................................................75 net fixed assets...........................................58 earnings......................................................52 Net fixed assets..........................................58 EBITDA.....................................................51 net income..................................................52 EBITDA margin..................................51, 62 net profit margin........................................52 119
  • 80. Financial Statements in Financial Analysis net working capital.....................................58 Retained earnings.......................................56 non-current assets.......................................54 share repurchase.........................................75 operating definition of invested capital.....57 shareholders' wealth...................................52 opportunity cost returns.............................45 short-term debt...........................................55 Property, Plant and Equipment..................55 Standard and Poor’s Corporation...............48 quick ratio..................................................68 the rate of return on invested capital..........45 rate of return on equity........................45, 65 trade capital....................................58, 60, 71 rate of return on invested capital.........60, 61 Trade capital...............................................58 Research Insight.........................................48 Treasury Stock...........................................56 120

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