Fundamentals of Corporate FinanceFourth EditionRobert

Fundamentals of Corporate
Finance
Fourth Edition
Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W.
Bates, Ph.D.;
Stuart Gillan, Ph.D.
Chapter 4
Analyzing Financial Statements
Chapter 4: Analyzing Financial
Statements
2Copyright ©2018 John Wiley & Sons, Inc.
Learning Objectives
1. Explain the three perspectives from which financial
statements can be
viewed
2. Describe common-size financial statements, explain why they
are used, and
be able to prepare and use them to analyze the historical
performance of a
firm

3. Discuss how financial ratios facilitate financial analysis and
be able to
compute and use them to analyze a firm’s performance
4. Describe the DuPont system of analysis and be able to use it
to evaluate a
firm’s performance and identify corrective actions that may be
necessary
5. Explain what benchmarks are, describe how they are
prepared, and discuss
why they are important in financial statement analysis
6. Identify the major limitations in using financial statement
analysis
Perspectives on Financial Statement Analysis
• Stockholders focus on net cash flows, risk, rate of
return, and the market value of the firm’s stock
• Managers focus on rate of return, efficient use of
assets, controlling costs, increasing net cash flows,
increasing the market value of the firm’s stock, and job
security
• Creditors focus on the predictability of revenues and
expenses, the ability to meet short-term obligations,
the ability to make loan payments as schedule, and
avoidance of changes in risk

Guidelines for Financial Statement Analysis
• Understand which perspective: stockholder, manager,
or creditor
• Use audited financial statements
• Use 3 to 5 years of statements to enable trend analysis
• Benchmark to competitors of similar size with similar
products and services
Common-Size Financial Statements
• Common-size financial statements show the dollar
amount of each item as a percentage of a reference
value
o Common-size balance sheet may use total assets as the
reference value; each item is expressed as a percentage of
total assets
o Common-size income statement may use net sales as the
reference value; each item is expressed as a percentage of net
sales

Common-Size Balance Sheet
• The Common-Size Balance Sheet standardizes the
amount in a balance sheet account by converting the
dollar value of each item to its percentage of total
assets
o Dollar values on a regular balance sheet provide information
on the number of dollars associated with a balance sheet
account
o Percentage values on a common-size balance sheet provide
information on the relative size or importance of the dollars
associated with a balance sheet account
Common-Size Income Statement
• The most useful way to prepare a common size income
statement is to express each account as a percentage of
net sales
• Each expense is interpreted as the cost incurred to
generate $1 in sales

Financial Ratios and Firm Performance
• Financial ratios establish a common reference point
across firms, even though the numerical value of the
reference point will differ from firm-to-firm
o Ratios make it easier to compare the performance of large
firms to that of small firms
o Ratios make it easier to compare the current and historical
performance of a single firm as the firm changes over time
(trend analysis)
Categories of Common Financial Ratios
• Liquidity ratios
• Efficiency ratios
• Leverage ratios
• Profitability ratios
• Market Value ratios

Short-Term Liquidity Ratios
• Liquidity ratios indicate a firm’s ability to pay short-term
obligations with short-term assets without endangering the firm.
In general, higher ratios are a favorable indicator
Equation 4.1
�� =
��
��
Equation 4.2
�� =
�� − ��
��
Efficiency Ratios (1 of 2)
• Efficiency ratios indicate a firm’s ability to use assets to
produce sales. These are also called turnover ratios. In
general, higher numbers are a favorable indicator. For
Days Sales in Inventory, however, a lower number is

favorable.
Equation 4.3
�� =
��
��
Equation 4.4
�� =
365 ��
��
Efficiency Ratios (2 of 2)
Equation 4.5
�� =
��
��
Equation 4.6
�� =
365 ��
��

Asset Turnover Ratios
Equation 4.7
�� =
��
��
Equation 4.8
�� =
��
��
Leverage Ratios
• Leverage ratios indicate whether a firm is using the
appropriate
amount of debt financing. In general, higher ratios indicate
greater potential return and greater bankrup tcy risk.
Equation 4.9
�� =
��
��

Equation 4.10
�� =
��
��
Equation 4.11
�� =
��
��
Coverage Ratios
• For the following ratios, a higher number generally
indicates less bankruptcy risk and (possibly) lower
potential return
Equation 4.12
�� =
��
��
Equation 4.13
��ℎ �� =
��
��

Profitability Ratios (1 of 2)
• Profitability ratios indicate whether a firm is generating
adequate profit from its assets. In general, higher
ratios indicate better performance.
Equation 4.14
�� =
�� − ��
��
Equation 4.15
�� =
��
��
Profitability Ratios (2 of 2)
Equation 4.16
�� =
��
��

Equation 4.17
�� = �� =
��
��
Equation 4.18
�� =
��
��
Equation 4.19
�� = �� =
��
��
Market Value Indicators
• Market value ratios indicate how the market is valuing
the firm’s equity. Higher ratios indicate greater
shareholder wealth.
Equation 4.20
�� ℎ �� =
��
�ℎ ��

Equation 4.21
�� =
�� ℎ ��
�� ℎ ��
Equation 4.22
�� =
�� ℎ ��
�� ℎ ��
The DuPont System
• Diagnostic tool for evaluating a firm’s financial health
• Uses related ratios that link the balance sheet and
income statement
• Based on two equations that connect a firm’s ROA and
ROE
• Used by management and shareholders to understand
factors that drive ROE
ROA and ROE Equations

Equation 4.23
�� = �� × ��
��
Equation 4.24
�� = �� × ��
The DuPont Equation
Equation 4.25
�� = �� × ��
�� × ��
Equation 4.26
�� =
��
��
×
��
��
×

��
��
Equations 4.25 and 4.26 show that ROE is driven by
profitability,
operating efficiency, and amount of leverage (debt)
Selecting a Benchmark
• A ratio or ratio analysis is relevant only when compared
to an appropriate benchmark
o Trend Analysis – comparison to the firm’s historical
performance
o Industry Analysis – comparison to the aggregate of firms in
the same industry
• Standard Industrial Classification (SIC) System
• North American Industry Classification System (NAICS)
o Peer Group Analysis – comparison to a select group of firms
in
the same industry

Limitations of Financial Statement Analysis
• Weaknesses of financial statement analysis
o Not an exact science
o Relies on accounting data and historical costs
o Few guidelines or principles for determining whether a ratio
is
“high” or “low,” or is a reason for confidence or for concern
Copyright
Copyright © 2018 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work
beyond that permitted in
Section 117 of the 1976 United States Act without the express
written permission of the

copyright owner is unlawful. Request for further information
should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up
copies for his/her own use only and not for distribution or
resale. The Publisher assumes
no responsibility for errors, omissions, or damages, caused by
the use of these programs
or from the use of the information contained herein.
Fundamentals of Corporate
Finance
Fourth Edition
Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W.
Bates, Ph.D.;
Stuart Gillan, Ph.D.
Chapter 1
The Financial Manager and the Firm
Chapter 1: The Financial Manager and
the Firm

Learning Objectives
1. Identify the key financial decisions facing the financial
manager
of any business
2. Identify common forms of business organization in the
United
States and their respective strengths and weaknesses
3. Describe the typical organization of the financial function in
a
large corporation
4. Explain why maximizing the value of the firm’s stock is the
appropriate goal for management
5. Discuss how agency conflicts affect the goal of maximizing
stockholder value
6. Explain why ethics is an appropriate topic in the study of
corporate finance
The Role of the Financial Manager (1 of 2)
• Maximize Shareholder Wealth

o Maximizing the price of a firm’s stock will maximize the
value
of a firm and the wealth of its shareholders/owners
• Stakeholders
o Managers, employees, suppliers, creditors, and the
government
The Role of the Financial Manager (2 of 2)
• It’s All About Cash Flows
o Positive residual cash flow may be paid to firm owners as
dividends or invested in the firm
o The larger the positive residual cash flow, the greater the
value of a firm
o Negative residual cash flow, over the long run, leads to
bankruptcy or closing a business
The Role of the Financial Manager

• Three Fundamental Decisions in Financial Management
o Capital Budgeting: identify which long-term assets to acquire
to maximize
net benefits for the firm
o Financing: determine how to pay for short-term and long-term
assets by
finding the best combination of short-term debt, long-term debt,
and
equity
o Working Capital: decide how to manage short-term resources
and
obligations by adjusting current assets and current liabilities to
promote
growth in cash flow
• Poor decisions about capital budgeting, financing, or working
capital may lead to bankruptcy or business failure
Forms of Business Organization
• Sole proprietorships
• Partnerships
• Corporations

Sole Proprietorship
• Owned by a single person who is financially responsible for
the
actions and obligations of the business
• Advantages
o Easiest to create and control
o Easiest to dissolve
o Right to all profits
• Disadvantages
o Owner’s personal assets at risk due to unlimited liability for
firm
obligations
o Equity only from owner or business profit
o Business income taxes as personal income
o Difficult to transfer ownership
Partnership

• A business owned by more than one person; one or more of
them is financially responsible for the actions and obligations
of
the business
• Advantages
o Limited protection of owner’s personal assets
o Owner’s limited liability for firm obligations
o More sources of equity
o More sources of expertise
• Disadvantages
o Shared control
o Shared profit harder to dissolve
Corporation
• A business owned by more than one person; none of them are
financially
responsible for the actions and obligations of the business. The
corporation is
responsible for its obligations and actions.
• Advantages

o Protects personal assets
o No shareholder liability for business
o Easiest to change ownership
o Greatest access to sources of funds
• Disadvantages
o Most difficult and expensive to establish
o Dilutes individual control over the firm
o Overall higher taxes on income for shareholders
Hybrid Forms of Business Organization
• Limited Liability Partnerships (LLPs)
• Limited Liability Companies (LLCs)
• Both combine limited liability with tax advantages of a
partnership

Managing the Financial Function
• Organizational Structure
o Chief Financial Officer (CFO), responsible for the quality of
the financial
reports received by the Chief Executive Officer (CEO)
o Positions Reporting to the CFO
• Treasurer
• Risk Manager
• Controller
• Internal Auditor
o External Auditor
o Audit Committee
o Compliance and Ethics Director
The Goal of the Firm
• Why not maximize market share?

o Giving away goods or services for free will maximize a firm’s
market share
for a while, but the firm will not be able to pay its bills and stay
in business
• Why not maximize profits?
o Accounting profit differs from economic profit
o Profit earned may not equal cash received
• Maximize the value of the firm’s stock
o Future cash flows are considered
o The timing of future cash flows is considered
o The risks associated with having to wait to for cash flows are
considered
• Management decisions affect cash flows and therefore stock
prices
Agency Relationship
• An agency relationship is created when the owner (a
principal) of a business hires an employee (an agent)

• The owner surrenders some control over the enterprise
and its resources to the employee
• Separating ownership from control creates the
potential for agency conflicts
Agency Conflicts
• An agency relationship exists between stockholders
(principals)
and the firm’s hired management (agents)
• Ownership and Control
o In large corporations, shared ownership among many
shareholders may
result in relatively little control over management
o Shareholders own the corporation, but managers control the
firm’s assets
and may use them for their own benefit
Agency Costs
• Agency Costs are costs that arise from incurring and
preventing
conflicts of interest between a firm’s owners and its managers

• These costs may reduce positive residual cash flow, stock
price,
and shareholder wealth
• Agency costs can be reduced by
o Increased oversight
o Aligning incentives
• Giving agents the right incentives to reduce agency costs
o Managers tend to focus on wealth maximization when their
compensation
depends on stock price
Aligning the Interests of Managers and
Stockholders
• Board of Directors has oversight over the CEO and
major capital decisions
• Managerial labor market provides incentives to run the
company well
• Internal competition among managers
• Large stockholders also monitor managerial decisions
• Corporate raiders search for takeover targets

• Legal and regulatory constraints limit managerial
behavior
Sarbanes-Oxley and Regulatory Reform
(1 of 2)
• Better corporate governance reduces agency costs by
requiring
o More effective monitoring of managers’ activities
o Programs that promote appropriate behavior by managers
o Penalties for executives who do not fulfill their fiduciary
responsibilities
Sarbanes-Oxley and Regulatory Reform
(2 of 2)
• The new regulations require all public corporations to
implement the following strategies:
o Ensure greater board independence
o Establish internal accounting controls
o Establish compliance programs

o Establish an ethics program
o Expand the audit committee’s oversight powers
The Importance of Ethics in Business
• What are Ethics?
o Ethics are society’s standards for judging whether an action is
right or wrong
o Business Ethics are society’s standards for acceptable
behavior applied to business and financial markets
Ethics in Corporate Finance (1 of 2)
• Examples of Ethical Conflict in Business
o Agency Cost
• Employee’s unacceptable use of employer’s computer
• Conflict of Interest

o Mortgage contract which a home-buyer is unlikely to fulfill
but earns a mortgage broker more money–
• Information Asymmetry
o Seller knows about prior damage to the vehicle but the
potential buyer does not
Ethics in Corporate Finance (2 of 2)
• Business Behavior
o Regulation and market forces are not enough to maintain
integrity in the
marketplace
o Business norms must be based on ethical beliefs, customs, and
practices
• Ethical Behavior
o It is sometimes difficult to judge whether behavior is ethical
or not
• Was the manager too careful?
• Did the manager take too much risk?
• Consequences of Unethical Behavior
o Inefficiency in the economy and costs to society
o High legal and social costs

o Problems such as the recent financial crisis in the U.S.
Copyright
Copyright © 2018 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work
beyond that permitted in
Section 117 of the 1976 United States Act without the express
written permission of the
copyright owner is unlawful. Request for further information
should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up
copies for his/her own use only and not for distribution or
resale. The Publisher assumes
no responsibility for errors, omissions, or damages, caused by
the use of these programs
or from the use of the information contained herein.

Fundamentals of Corporate FinanceFourth EditionRobert

Fundamentals of Corporate FinanceFourth EditionRobert

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