DEFINITIONS

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DEFINITIONS

  1. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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

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