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    • 1. Chapter 3: Interpreting Financial Statements Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley Objective Contrast Economic and Accounting Models <=> Value of Accounting Information
    • 2. Chapter 3 Contents
      • 3.1 Functions of Financial Statements
      • 3.2 Review of Financial Statements
      • 3.3 Market values v. Book Values
      • 3.4 Accounting v. Economic Measures of Income
      • 3.5 Return on Shareholders v. Return on Equity
      • 3.6 Analysis Using Financial Ratios
      • 3.7 The Financial Planning Process
      • 3.8 Constructing a Financial Planning Model
      • 3.9 Growth & the Need for External Financing
      • 3.10 Working Capital Mgmt.
      • 3.11 Liquidity & Cash Mgmt.
    • 3. 3.1 Functions of Financial Statements
      • Financial Statements:
        • Provide information to the owners & creditors of a firm about the current status and past performance
        • Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm
        • Provide a convenient templates for financial planning
    • 4. The Balance Sheet
      • Summarizes a firms assets, liabilities, and owner’s equity at a moment in time
      • Amounts measured at historical values and historical exchange rates
      • Prepared according to GAAP, G enerally A ccepted A ccounting P rinciples
        • GAAP modified occasionally by the Financial Accounting Standards Board
      • Exchange-listed companies must comply with S ecurities and E xchange C ommission (SEC) rules
    • 5. The Balance Sheet
      • Major Divisions:
        • Assets
          • Current assets (less than a year)
          • Long-term assets (longer than a year
            • Depreciation
        • Liabilities and Stockholder’s Equity
          • Liabilities
            • Current Liabilities
            • Long-term debt
          • Equity
    • 6.  
    • 7. The Income Statement
      • Summarizes the profitability of a company during a time period
      • Major Divisions:
        • Revenue & cost of goods sold
              • Gross margin
        • General administrative and selling expenses (GS&A)
              • Operating income
        • Debt service
              • Taxable income
        • Corporate Taxes
              • Net income
    • 8. The Income Statement
      • Important Reminders:
        • Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity
        • Accounts show historical values, not market values
          • The shareholder’s equity may be much higher or lower than the market value of the firm
            • The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet
    • 9.  
    • 10. The Cash-Flow Statement
      • Show the cash that flowed into and from a firm in during a time period
        • Focuses attention on a firm’s cash situation
          • A firm may be profitable and short of cash
        • Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods
          • The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes
    • 11.  
    • 12.  
    • 13. 3.3 Market v. Book Values
      • Not all assets and liabilities are included, and others are understate and/or overstated
        • Intangible assets such as patents may have some value included, but brand loyalty, technological know-how, or a highly trained loyal workforce will not be valued. Goodwill may be included, but soon loses its connection to market value because of accounting depreciation and market fluctuations
        • Some contingent liabilities such as law-suits are not routinely disclosed, or only disclosed in the notes
        • Accountants are beginning to mark-to-market the assets of pension funds
    • 14. Accounting v. Economic Measures of Income: Example
      • GPC’s accounting net income was plus $23,400,000 in 2001
      • Assume the total market value of the stock fell from $200,000,000 to $187,200,000 from year 2xx0 to 2xx1. We saw earlier that the cash dividend to shareholders was $10,000,000. The economic income in year 2xx1 was minus $2,800,000
      • The Accounting and Economic measures of Income may differ substantially
    • 15. 3.5 Returns to Shareholders v. Return on Equity
      • Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income
      • This is the Total Shareholder Return
    • 16. Returns to Shareholders v. Return on Equity (Continued)
      • Traditionally, corporate performance has been measured by Return on Equity, ROE
    • 17. Returns to Shareholders v. Return on Equity (Conclusion)
      • Thus, we see that there is no correspondence between a firm's ROE in any year & the total rate of return earned by shareholders on their investment in the company’s stock
    • 18. 3.6 Analysis using Financial Ratios
      • Despite the differences in accounting and financial principles, the published accounts of a firm yield clues about its financial condition
      • Five aspects of a firms performance:
          • Profitability
          • Asset turnover
          • Financial leverage
          • Liquidity
          • Market value
    • 19. Profitability
    • 20. Asset Turnover
    • 21. Liquidity
    • 22. Financial Leverage Financial Leverage
    • 23. Market Value
    • 24. Ratio Comparisons
      • Establish Your Perspective
          • Shareholder
          • Employee, Management, or Union
          • Creditor
          • Predator, Customer, Supplier, Competitor, Trade Association
      • Benchmarks
          • Other companies ratios
          • The firm’s historical ratios
          • Data extracted from financial markets
      • Sources
          • Dun & Bradstreet, Robert Morris, Commerce Department's Quarterly Financial Report, Trade Associations
    • 25. Relationships Amongst Ratios
      • It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with:
    • 26. Ratio Analysis Limitations
      • Ratio analysis indicates where you might profitably focus your attention, but it can also mislead you
        • Look for collaborating evidence for the hypotheses you form from the ratios
      • Sound long-term goals of a firm may cause ratios to look awful. Management-by-ratios may not be in the firms long-term interest
      • Companies in the same industry may have very different distribution channels, and accounting methods, leading to markedly different ratios that are none-the-less appropriate to each company
    • 27. Comment:
      • Always keep in mind that financial statements are prepared according to accounting standards and traditions , and that they do not fully satisfy the needs of a financial analysts
      • They do yield useful information if used with care and understanding
    • 28. Effect of Financial Leverage
      • Financial leverage simply means the use of borrowed money
        • Shareholders of a firm use financial leverage to boost their ROE
          • This increases the sensitivity of ROE to fluctuations in the firm’s underlying profitability as measured by its ROA
    • 29. Illustration
      • (Table 3.7 & 3.8 of textbook)
        • Consider two firms that are identical except that Nodebt is financed using $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and $500,000 of debt
        • further assume that the EBIT of both firms is $120,000 and tax is 40%
    • 30. Case: Borrow at 10%
    • 31. Case: Borrow at 10%: Effect of Business Cycle on ROE
    • 32. Conclusion:
      • From the perspective of
        • Creditors: increasing debt is unambiguously harmful, and bond rating agencies will downgrade the firm’s securities
        • Shareholders: may benefit, depending on the sign of (ROA-interest rate) and ROA
    • 33. 3.7 Financial Planning Process
      • This section navigates us through the financial planning process, using the historical financial statements for a manufacturing firm as our embarkation point
      • Later, we discuss short-term planning and the management of working capital
    • 34. The Financial Planning Process
        • Financial planning is a dynamic process that follows a cycle of making plans, implementing them, and revising them in the light of actual results
    • 35. The Financial Planning Process
        • Starting point is the strategic plan
          • Strategy guides the financial planning process by establishing overall business development guidelines and growth targets
          • Which businesses does the firm want to
            • enter
            • expand
            • contract
            • exit
          • and how quickly?
    • 36. The Financial Planning Process
        • Length of the planning horizon
          • The longer the financial plan, the less detailed it should be (in general)
          • The revision of a financial plan is generally a function of the length of the planning horizon
            • Short-term plans are revised frequently, long-term plans are revised much less frequently
    • 37. The Financial Planning Process
        • The financial planning horizon may be broken down into several steps:
          • Management forecasts the key external factors, including level of economic activity, inflation, interest rates, and the competition’s output and prices
          • Based on above, they next forecast revenues, expenses, cash flows, and implied need for external financing
    • 38. The Financial Planning Process
          • Specific performance targets are generated for the divisions, functions and key individuals of the firm
          • Periodic measurements of performance are made, and compared to the plan in order to correct either the plan or performance
          • Periodically, key personnel are counseled, rewarded or punished, and a new iteration is instigated
    • 39. The Financial Planning Process: Notes
        • Some variables must be forecast well in advance because exploitation requires a long lead-time, others may be reacted to immediately
        • Some variables are highly volatile, and can’t be forecast effectively, so the best we can do is to plan for the unknown (contingency planning)
    • 40. The Financial Planning Process: Notes
        • Planning horizons must be appropriate
        • For a magazine stand, a two year planning horizon may be far too long
        • A pharmaceutical business (with long new-plant construction lead-times, and long drug development/testing/approval procedures) needs a planning horizon that may be as long a ten years
    • 41. The Financial Planning Process: Notes
        • A plan should always lead to decisions that justify the cost of its preparation
          • Proper planning is, in essence, part of the process of decision making. Any part of a plan that does not lead to a decision is probably a waste of managerial resources
    • 42. 3.8 Constructing a Financial Planning Model
      • The next slide shows the history of GPC
    • 43.
      • GPC Financial Statements, Years xxx1 - xxx3
      • (Nearest $ Million)
      • (Percent of Year's Sales)
      • Year
      • xxx0
      • xxx1
      • xxx2
      • xxx3
      • xxx1
      • xxx2
      • xxx3
      • Income Statement
      • Sales
      • 200
      • 240
      • 288
      • 100.0%
      • 100.0%
      • 100.0%
      • Cost of goods sold
      • 110
      • 132
      • 158
      • 55.0%
      • 55.0%
      • 55.0%
      • Gross margin
      • 90
      • 108
      • 130
      • 45.0%
      • 45.0%
      • 45.0%
      • Selling, general & admin. expenses
      • 30
      • 36
      • 43
      • 15.0%
      • 15.0%
      • 15.0%
      • EBIT
      • 60
      • 72
      • 86
      • 30.0%
      • 30.0%
      • 30.0%
      • Interest expenses
      • 30
      • 45
      • 64
      • 15.0%
      • 18.8%
      • 22.2%
      • Taxes
      • 12
      • 11
      • 9
      • 6.0%
      • 4.5%
      • 3.1%
      • Net income
      • 18
      • 16
      • 13
      • 9.0%
      • 6.7%
      • 4.7%
      • Dividends
      • 5
      • 5
      • 4
      • 2.7%
      • 2.0%
      • 1.4%
      • Change in shareholder's equity
      • 13
      • 11
      • 9
      • 6.3%
      • 4.7%
      • 3.3%
      • Balance Sheet
      • Assets:
      • Cash & equivalents
      • 10
      • 12
      • 14
      • 17
      • 6.0%
      • 6.0%
      • 6.0%
      • Receivables
      • 40
      • 48
      • 58
      • 69
      • 24.0%
      • 24.0%
      • 24.0%
      • Inventories
      • 50
      • 60
      • 72
      • 86
      • 30.0%
      • 30.0%
      • 30.0%
      • Property, Plant & equipment
      • 500
      • 600
      • 720
      • 864
      • 300.0%
      • 300.0%
      • 300.0%
      • Total Assets
      • 600
      • 720
      • 864
      • 1037
      • 360.0%
      • 360.0%
      • 360.0%
      • Liabilities:
      • Payables
      • 30
      • 36
      • 43
      • 52
      • 18.0%
      • 18.0%
      • 18.0%
      • Short-term debt
      • 120
      • 221
      • 347
      • 502
      • 110.7%
      • 144.6%
      • 174.2%
      • Long-term debt
      • 150
      • 150
      • 150
      • 150
      • 75.0%
      • 62.5%
      • 52.1%
      • Total Liabilities
      • 300
      • 407
      • 540
      • 704
      • 203.7%
      • 225.1%
      • 244.3%
      • Shareholder's equity
      • 300
      • 313
      • 324
      • 333
      • 156.3%
      • 134.9%
      • 115.7%
    • 44.
      • (Nearest $ Million)
      • Year
      • xxx0
      • xxx1
      • xxx2
      • xxx3
      • Income Statement
      • Sales
      • 200
      • 240
      • 288
      • Cost of goods sold
      • 110
      • 132
      • 158
      • Gross margin
      • 90
      • 108
      • 130
      • Selling, general & admin. expenses
      • 30
      • 36
      • 43
      • EBIT
      • 60
      • 72
      • 86
      • Interest expenses
      • 30
      • 45
      • 64
      • Taxes
      • 12
      • 11
      • 9
      • Net income
      • 18
      • 16
      • 13
      • Dividends
      • 5
      • 5
      • 4
      • Change in shareholder's equity
      • 13
      • 11
      • 9
    • 45.  
    • 46.
      • (Percent of Year's Sales)
      • Year
      • xxx1
      • xxx2
      • xxx3
      • Income Statement
      Sales
      • 100.0%
      • 100.0%
      • 100.0%
      Cost of goods sold
      • 55.0%
      • 55.0%
      • 55.0%
      Gross margin
      • 45.0%
      • 45.0%
      • 45.0%
      Selling, general & admin exp.
      • 15.0%
      • 15.0%
      • 15.0%
      EBIT
      • 30.0%
      • 30.0%
      • 30.0%
      Interest expenses
      • 15.0%
      • 18.8%
      • 22.2%
      Taxes
      • 6.0%
      • 4.5%
      • 3.1%
      Net income
      • 9.0%
      • 6.7%
      • 4.7%
      Dividends
      • 2.7%
      • 2.0%
      • 1.4%
      Change in equity
      • 6.3%
      • 4.7%
      • 3.3%
    • 47.  
    • 48. Constructing a Financial Planning Model
      • Percent-of-sales method
        • First examine which items in the income statement have maintained a fixed ratio to sales
          • This enables us to decide which items should be forecast on projected sales, and which need to be forecast on another basis
    • 49. Constructing a Financial Planning Model
      • Percent-of-sales method
        • The second step is to forecast sales
          • This is a major exercise, but we will assume that sales will continue to grow at 20% next year (as it has in the past)
    • 50. Constructing a Financial Planning Model
      • Percent-of-sales method
        • The third step is to forecast those items that have been assumed to vary with sales
    • 51. Constructing a Financial Planning Model
      • Percent-of-sales method
        • The fourth and final step is to forecast the missing items that have not been assumed to vary with sales
        • We need some assumptions:
    • 52. Constructing a Financial Planning Model
      • Assumptions:
        • Interest rate on long-term debt is 8%, and on short-term debt is 15%
        • To avoid complexity, we assume that interest is computed on the yearend long- and short-term balances (we can re-address this later)
        • interest = 0.08*501.72 + 0.15*150 = 87.26
    • 53. Constructing a Financial Planning Model
        • The income statement may now be constructed given the dividend pay-out ratio and tax rate (30% and 40%)
        • The change in equity is added to the equity for year xxx3, to give the new balance for year xxx4
        • “Total assets” is available, so the “Total liabilities” may now be computed
    • 54.
      • 134.9%
      • 115.7%
      • N/A
      • 340
      GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Year's Sales) Year xxx0 xxx1 xxx2 xxx3 xxx1 xxx2 xxx3 F(sales)? xxx4 Income Statement Sales 200 240 288 100.0% 100.0% 100.0% N/A 346 Cost of goods sold 110 132 158 55.0% 55.0% 55.0% Yes 190 Gross margin 90 108 130 45.0% 45.0% 45.0% N/A(Yes) 156 Selling, general & admin. expenses 30 36 43 15.0% 15.0% 15.0% Yes 52 EBIT 60 72 86 30.0% 30.0% 30.0% N/A 104 Interest expenses 30 45 64 15.0% 18.8% 22.2% No 87 Taxes 12 11 9 6.0% 4.5% 3.1% N/A 7 Net income 18 16 13 9.0% 6.7% 4.7% N/A 10 Dividends 5 5 4 2.7% 2.0% 1.4% N/A 3 Change in shareholder's equity 13 11 9 6.3% 4.7% 3.3% 7 Balance Sheet Assets: Cash & equivalents 10 12 14 17 6.0% 6.0% 6.0% Yes 21 Receivables 40 48 58 69 24.0% 24.0% 24.0% Yes 83 Inventories 50 60 72 86 30.0% 30.0% 30.0% Yes 104 Property, Plant & equipment 500 600 720 864 300.0% 300.0% 300.0% Yes 1037 Total Assets 600 720 864 1037 360.0% 360.0% 360.0% N/A(Yes) 1244 Liabilities: Payables 30 36 43 52 18.0% 18.0% 18.0% Yes 62 Short-term debt 120 221 347 502 110.7% 144.6% 174.2% No Long-term debt 150 150 150 150 75.0% 62.5% 52.1% No Total Liabilities 300 407 540 704 203.7% 225.1% 244.3% N/A 904 Shareholder's equity 300 313 324 333 156.3%
    • 55. Example Completed
        • We complete the balance sheet by recognizing that there are only two accounts that need to be estimated, Short-term debt, and Long-term debt
        • The sum is then 904 (Liabilities) - 62 (Payables) = $842 Million
        • Assume no change in long-term debt
        • Short-term debt =$842 - 150 = $692 million
    • 56.  
    • 57.  
    • 58. 3.9 Growth & Need for External Finance
      • In order to grow by 20%, the firm will need an additional 692 - 502 = $190 million in external funding (all short-term funding in the example)
    • 59. Some Questions:
          • What external funds are required to support a sales growth rate, g, of 30%?
          • If I have external funds available equal to $30 million, what level of sales growth does this support?
    • 60.  
    • 61. 3.10 Working Capital Management
      • Many businesses that fail do so because of poor management of working capital, not poor profitability
      • Working capital
        • Current assets - current liabilities
    • 62. Efficient Management of Working Capital Principle:
        • Minimize the investment in non-earning assets such as
          • receivables
          • inventories
        • Maximizing the use of free credit such as
          • prepayments by customers
          • accrued wages
          • accounts payable
    • 63. Cash Cycle Time
      • Cash Cycle Time = Inventory period + receivable period - payables period
    • 64. 3.11 Liquidity and Cash Budgeting
        • A firm may be profitable, and have a sizable net worth, but if it is illiquid it will be damaged by forced assets sales and by laying-off trained workers
        • Banks are much more receptive to funding a planned cash shortfall than funding a shortfall that should have been forecast
        • Construct a Cash Budget