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5   a framework for reformulating financial statements
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  • 1. Lecture 5 Ch. 7 and 8 from PenmanFor a brief review of the principals ofpresentation of Financial Statements see:http://www.docstoc.com/docs/15908274/IFRS-Presentation-of-Financial-Statements
  • 2. Analysis of financial statementLearning objectives:• Relationship between capital market and the firm.• The difference between operating and financing aspects.• Interrelationship between the three financial statements: income statement, statement of financial position (B/S) & Cash flow statement.• Why reformulation of the statements is necessary? 7-2
  • 3. The Firm, Its Claimants & the Capital Market The firm The capital market Net cashflow to debtholders (F) C Interest payment Debtholders Cash from debt Dividend payment I Shareholdersti v t c a g n t ar ep O ti v t c a g n c na n F Cash from share issues i ti v t c a g n t s ev n I iNOA NFA Net cashflow to s/holders (d) i i i i Operating activities Financing activities i i 7-3
  • 4. Flows of cash between the firm and the providers of capital The firm Capital markets•Cash received fromdebtholders and shareholders is ue bt rs iss de lde(temporarily) invested in F or thofinancial assets. eb rs Net Financial Assets (NFA) D•Cash payments to debtholdersand shareholders are made by rs deliquidating financial assets ol eh d ar Sh•Net financial assets are debtpurchased from issuers, net ofdebt issued to debtholders. Financing Activities•Net financial assets can benegative, i.e. Net financial F=net cash flow to debtholders and issuersobligation, when debt issued to d=net cash flow to shareholdersdebtholders is greater than debt NFA=net financial assets= financial assets –purchased. financial liabilities 7-4
  • 5. Business Activities: All Cash Flows The firm Capital markets• Cash investment in ue bt rs i ss de ldeoperations is made by o r tho C F Net Operating Assets (NOA) Net Financial Assets (NFA)reducing net financial rs eb Dassets (i.e. by liquidatingfinancial assets or issuing rs definancial obligations). ol eh d ar I Sh• Cash generated fromoperations is invested in Operating Financingnet financial assets (i.e. it Activities Activitiesis used to buy financialassets or to reduce F= net cash flow to debtholders and issuersfinancial liabilities). d= net cash flow to shareholders C= cash flow from operations• Cash from operations I= cash investmentand cash investment may NFA= net financial assetsbe negative NOA= net operating assets = operating assets – operating liabilities 7-5
  • 6. The Cash Conservation EquationA fundamental accounting identity: C −I ≡d +FC = Net cash from operationsI = Net cash outflow for investingC-I = Free cash flowd = Net dividends (common dividends + share repurchases – share issues)F = Net cash outflow to debtholders and debt issuers = Net borrowing principal payments + net interest paidi = Net interest cash outflow The treasurer’s rule: If C− I−i> d => lend the cash or repay own debt If C− I −i< d => issue debt or reduce lending 7-6
  • 7. Applying the Treasurer’s Rule: Microsoft 2nd Quarter, 2004 2nd Quarter, 2005 In millions In millionsCash flow from operations $4,236 $3,377Cash investment in operations 172 177Free cash flow 4,064 3,200Cash interest received (after tax) 338 242Cash available for shareholders 4,402 3,442Net dividend: Cash dividend $1,729 $33,498 Share repurchases 730 969 Share issues (189) 2,270 (795) 33,672Purchase of financial assets, $2,132 $(30,230)or redemption of own bonds/debt(sale of financial assets,or issue debt/bonds) 7-7
  • 8. Reformulated Statement of Cash Flows to match the cash conservation equationCash flows from operations CCash investment (I)Free cash flow C-IEquity financing flows: Dividends and share repurchases XX Share issues (XX) dDebt financing flows: Net purchases of financial assets XX Interest on financial assets (XX) F Net issue of debt (XX) Interest on debt XXTotal financing flows: d+F 7-8
  • 9. Reformulated Cash Flow Statements: Microsoft 2Q, 2004 2Q, 2005Cash flow from operations (C) $4,236 $3,377Cash investment (I) (172) (177)Free cash flow (C – I) 4,064 3,200Equity financing flows (d):Dividends and share repurchases $2,459 $34,467Share issues (189) 2,270 (795) 33,672Debt financing flows (F):Net purchase of financial assets 2,132 (30,230)Interest on financial assets (after tax) (338) (242) 7-9
  • 10. The Reformulated Balance Sheet• Published balance sheets list items classified into current & long-termcategories – useful for credit analysis•Reformulation of BS into operating and financial assets(liabilities)makes it useful for equity investorsAssetsOperating assets OAFinancial assets FATotal Assets OA + FALiabilities and EquityOperating liabilities OLFinancial obligations FOCommon stockholders’ equity CSETotal Liab. & Equity OL + FO + CSE 7-10
  • 11. The Reformulated Balance SheetOperating AssetsOperating assets OAOperating liabilities (OL)Net operating assets NOAFinancial Obligations & Owners’ EquityFinancial liabilities FOFinancial assets (FA)Net financial obligations NFOCommon equity CSETotal NFO & Equity NFO + CSE ⇒NOA – NFO = CSE note that CSE is simply the book value of equity (i.e., BV) 7-11
  • 12. Reformulated Income StatementThe difference between operating revenue and operating expense is called operating income: OI = OR – OEIncome Statement Operating revenue OR Operating expense (OE)Operating income * OI Financial expense (FE) Financial revenue FINet financial (expense) income* (NFE) or NFIEarnings Earn* OI and NFI should be after tax 7-12
  • 13. Stocks & flows in business activities Product and input markets The firm Capital marketsNet operating assets ue bt rs iss de lde sare employed in er or tho OR C F m Net Operating Assets (NOA) Net Financial Assets (NFA) eb to rsoperations to us D Cgenerate operatingrevenue (by selling rs degoods and services to rs ol lie eh pp OE d arcustomers) and incur I Sh Suoperating expenses(by buying inputs OR- OE=OI OI - ∆ NOA=C-Ifrom suppliers). C-I - ∆ NFA+NFI=d Operating and investment Financing Activities Activities F=net cash flow to debtholders and issuers NOA=net operating assets d=net cash flow to shareholders OR=operating revenue C=cash flow from operations OE=operating expense I=cash investment OI=operating income NFA=net financial assets NFI=net financial income 7-13
  • 14. Creation and disposition of FCFThe source of FCFFCF is created from cash income (OI) generated by operations after reinvesting part of it in net operating assets (ΔNOA): C – I = OI – ΔNOAThe utilisation (disposition) of FCFUtilisation of FCF depends on whether the firm is a net lender (i.e. has NFA) or a net borrower (i.e. has NFO), and whether it is a net payer of interest (NFE) or a net receiver of interest (NFI).E.g.: If the firm is a net lender and net receiver of interest, the FCF along with NFI is used to invest in NFA and pay net dividends: C – I + NFI = ΔNFA + d  C – I = ΔNFA – NFI + dE.g.: If the firm is a net debtor and net payer of interest, the free cash flow is be used to reduce NFO, pay NFE net dividends: C – I = NFE – ΔNFO + d
  • 15. The drivers of DividendsRe-arranging the above equations for a ‘net lender’ firm gives: d = (C – I) + NFI – ΔNFAi.e. Net dividends are paid out of FCF and interest earned on fin. assets, and by selling fin. assetsSimilarly, re-arranging the equation for a ‘net debtor’ firm gives: d = (C – I) – NFE + ΔNFOi.e. Dividends are paid out of FCF after servicing interest and by increasing borrowing = > dividends might be a poor indicator of value generation
  • 16. Articulation of Reformulated Financial Statements Income Statement NIt = OIt -NFEt Balance Sheet Net operating assets Net financial obligationsNOAt = NOA t -1 + OIt - (Ct-It) NFOt = NFOt-1 + NFEt – (Ct-It) + dt Common stockholders equity CSEt = CSEt-1 + OIt – NFEt - dt Cashflow Statement FCF or Ct-It = dt + Ft
  • 17. Value generation & business profitability• Separating operating and financing activities in the income statement identifies profit flows• Comparison of these flows with their balance sheet base yields the corresponding rates of return: Return on Net Operating Assets RNOA t = OI t [ ( NOA 1 + NOA t −1 ) ] 2 t Return on Net Financial Assets RNFA t = NFI t [ ( NFA 1 2 + NFA t −1 ) ] t If there are NFO rather than NFA, net borrowing cost is given by NBC t = NFE t [ ( NFO 1 2 t + NFO t −1 ) ]• Value is generated by operating activities => analysts should focus on RNOA 7-17
  • 18. Analysis of the statement of shareholder equity• Provides summary of all transactions that affect shareholder equity• Provides reconciliation of beginning and ending owners’ equity• Because earnings reported in the income statement is not comprehensive, analysis of shareholder equity is necessary.=> Should be in the focus of the equity analysts
  • 19. A typical statement of shareholders’ Equity:Opening book value of equity (ordinary and preferred)+ Net share transactions with common stockholders + Capital contributions (paid in capital from share issues) - Share repurchases (into treasury stock or against paid-in capital)+ Net share transactions with preferred shareholders + Capital contributions (share issues) - Share redemptions+ Change in retained earnings + Net income - Common dividends - Preferred dividends - Some share repurchases+ Accumulated other comprehensive income+ Earnings restatements due to change in accounting+ Increase in equity from issuing stock optionsClosing book value of equity (ordinary and preferred) 8-19
  • 20. The Governing Accounting RelationBook value, end of period = Book value, beginning of period + Comprehensive income - Net payout to shareholdersInvestors are interested in book value for ordinary (common) shareholders.⇒ Need to reformulate the equity statement to exclude items that are not part of ordinary shareholders’ equity, and include items that are part of ordinary shareholders’ equity. 8-20
  • 21. Reformulated Statement of Stockholders’ EquityOpening book value if common equity (CSEt-1) + Net transactions with common shareholders + Capital contributions (share issues) - Share repurchases - Common dividends + Comprehensive income to common shareholders + Net income + Other comprehensive income - Preferred dividendsClosing book value of common equity (CSEt)Note that preferred equity is taken out of the common shareholders equitystatement. Preferred equity should be treated as a liability. 8-21
  • 22. Benefits of reformulation• Gives a clear picture of the growth in common equity over time• Distinguishes clearly between sources growth: – From new investment or disinvestment by the owners – Additions to equity from running the business (income)• distinguishes the creation of value from its distribution
  • 23. Reformulation: The Steps1. Restate beginning and ending balances for items incorrectly included in or excluded from common equity – Preferred stock – Minority interest reported within equity + Dividends payable to common shareholders (if excluded initially) – Equity from stock-based compensation2. Calculate net transactions with shareholders Cash dividends + share repurchases – share issues (Cash dividends = Dividends declared – change in dividends payable)3. Calculate comprehensive income = Net income + “Other comprehensive income” – Earnings from accounting changes – Preferred dividends – Hidden dirty-surplus losses 8-23
  • 24. Nike Equity Statement for 2008 8-24
  • 25. Note: Footnotes to the 10-K indicate Nike had $112.9 million in dividends payable at the end of 2008 and $92.9 million at the end of 2007.
  • 26. Nike: The Reformulated StatementBalances: 2008 2007Reported $7,825.3 7,025.4Dividends payable 113.0 92.9Stock-based compensation (141.0)Restated balance $7,797.3 $7,118.3 8-26
  • 27. Useful ratios for analysing the statement of shareholders’ equityPayout and Retention Ratios Dividends Dividend Payout = Comprehensive Income Dividends + Stock Repurchases Total Payout Ratio= Comprehensive Income Dividends Dividends-to-Book Value= Book Value of CSE +Dividends +Stock Repurchases Dividends+StockRepurchses Total Payout-to-Book Value= Book Value of CSE + Dividends + StockRepurchases Comprehensive Income - Dividends Retention Ratio= =1- Dividend Payout Ratio Comprehensive Income 8-27
  • 28. Ratio Analysis (continued)Shareholder Profitability Ratio Growth Ratios Transactions with shareholders Net Investment Rate= Beginning Book Value of CSE Change in CSE Comprehensive Income+Net Transactions with ShareholdersGrowth Rate of CSE= = Beginning CSE Beginning CSE 8-28
  • 29. Hidden Dirty Surplus• Shareholders lose when shares are issued at less than the market price (e.g. exercise of options)• This loss, however, is not recorded as expense.• What is the nature of this loss? If options are part of a compensation package, this loss is an employee compensation expense. If from a conversion of a bond, preferred stock or warrants, the loss is a financing expense.• What is the amount of the loss? Market price - exercise price. 8-29