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Chapter 3: Interpreting Financial Statements


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Chapter 3: Interpreting Financial Statements

  1. 1. Chapter 3: Interpreting Financial Statements Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc. Objective Contrast Economic and Accounting Models <=> Value of Accounting Information
  2. 2. Financial Statements Review <ul><ul><li>Financial Statements Provide: </li></ul></ul><ul><ul><ul><li>current and historical information to owners and creditors </li></ul></ul></ul><ul><ul><ul><li>a convenient way for owners and creditors to set performance targets </li></ul></ul></ul><ul><ul><ul><li>a convenient standard template for financial planning </li></ul></ul></ul>
  3. 3. Chapter 3 Contents <ul><li>3.1 Functions of Financial Statements </li></ul><ul><li>3.2 International Differences in Accounting </li></ul><ul><li>3.3 Market values v. Book Values </li></ul><ul><li>3.4 Accounting v. Economic Measures of Income </li></ul><ul><li>3.5 Return on Shareholders v. Return on Equity </li></ul><ul><li>3.6 Analysis Using Financial Ratios </li></ul><ul><li>3.7 The Financial Planning Process </li></ul><ul><li>3.8 Constructing a Financial Planning Model </li></ul><ul><li>3.9 Growth & the Need for External Financing </li></ul><ul><li>3.10 Working Capital Mgnt. </li></ul><ul><li>3.11 Liquidity & Cash Mgnt. </li></ul>
  4. 4. 3.1 Functions of Financial Statements <ul><li>Financial Statements: </li></ul><ul><ul><li>Provide information to the owners & creditors of a firm about the current status and past performance </li></ul></ul><ul><ul><li>Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm </li></ul></ul><ul><ul><li>Provide a convenient templates for financial planning </li></ul></ul>
  5. 5. 3.2 Review of Financial Statements
  6. 6. The Balance Sheet <ul><li>Summarizes a firms assets, liabilities, and owner’s equity at a moment in time </li></ul><ul><li>Amounts measured at historical values and historical exchange rates </li></ul><ul><li>Prepared according to GAAP, G enerally A ccepted A ccounting P rinciples </li></ul><ul><ul><li>GAAP modified occasionally by the Financial Accounting Standards Board </li></ul></ul><ul><li>Exchange-listed companies must comply with S ecurities and E xchange C ommission (SEC) rules </li></ul>
  7. 7. The Balance Sheet <ul><li>Major Divisions: </li></ul><ul><ul><li>Assets </li></ul></ul><ul><ul><ul><li>Current assets (less than a year) </li></ul></ul></ul><ul><ul><ul><li>Long-term assets (longer than a year </li></ul></ul></ul><ul><ul><ul><ul><li>Depreciation </li></ul></ul></ul></ul><ul><ul><li>Liabilities and Stockholder’s Equity </li></ul></ul><ul><ul><ul><li>Liabilities </li></ul></ul></ul><ul><ul><ul><ul><li>Current Liabilities </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Long-term debt </li></ul></ul></ul></ul><ul><ul><ul><li>Equity </li></ul></ul></ul>
  8. 9. The Income Statement <ul><li>Summarizes the profitability of a company during a time period </li></ul><ul><li>Major Divisions: </li></ul><ul><ul><li>Revenue & cost of goods sold </li></ul></ul><ul><ul><ul><ul><ul><li>Gross margin </li></ul></ul></ul></ul></ul><ul><ul><li>General administrative and selling expenses (GS&A) </li></ul></ul><ul><ul><ul><ul><ul><li>Operating income </li></ul></ul></ul></ul></ul><ul><ul><li>Debt service </li></ul></ul><ul><ul><ul><ul><ul><li>Taxable income </li></ul></ul></ul></ul></ul><ul><ul><li>Corporate Taxes </li></ul></ul><ul><ul><ul><ul><ul><li>Net income </li></ul></ul></ul></ul></ul>
  9. 10. The Income Statement <ul><li>Important Reminders: </li></ul><ul><ul><li>Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity </li></ul></ul><ul><ul><li>Accounts show historical values, not market values. </li></ul></ul><ul><ul><ul><li>The shareholder’s equity may be much higher or lower than the market value of the firm. </li></ul></ul></ul><ul><ul><ul><ul><li>The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet </li></ul></ul></ul></ul>
  10. 12. The Cash-Flow Statement <ul><li>Show the cash that flowed into and from a firm in during a time period </li></ul><ul><ul><li>Focuses attention on a firm’s cash situation </li></ul></ul><ul><ul><ul><li>A firm may be profitable and short of cash </li></ul></ul></ul><ul><ul><li>Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods </li></ul></ul><ul><ul><ul><li>The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes </li></ul></ul></ul>
  11. 15. 3.4 Returns to Shareholders v. Return on Equity <ul><li>Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income </li></ul><ul><li>This is the Total Shareholder Return </li></ul>
  12. 16. Returns to Shareholders v. Return on Equity (Continued) <ul><li>Traditionally, corporate performance has been measured by Return on Equity, ROE </li></ul>
  13. 17. Profitability
  14. 18. Asset Turnover
  15. 19. Financial Leverage
  16. 20. Liquidity
  17. 21. Market Value
  18. 22. Ratio Comparisons <ul><li>Establish Your Perspective </li></ul><ul><ul><ul><li>Shareholder </li></ul></ul></ul><ul><ul><ul><li>employee, Management, or Union </li></ul></ul></ul><ul><ul><ul><li>Creditor </li></ul></ul></ul><ul><ul><ul><li>Predator, Customer, Supplier, Competitor, Trade Association </li></ul></ul></ul><ul><li>Benchmarks </li></ul><ul><ul><ul><li>Other companies ratios </li></ul></ul></ul><ul><ul><ul><li>The firm’s historical ratios </li></ul></ul></ul><ul><ul><ul><li>Data extracted from financial markets </li></ul></ul></ul><ul><li>Sources </li></ul><ul><ul><ul><li>Dun & Bradstreet, Robert Morris, Commerce Department's Quarterly Financial Report, Trade Associations </li></ul></ul></ul>
  19. 23. Relationships Amongst Ratios <ul><li>It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with: </li></ul>
  20. 24. Illustration <ul><li>(Table 3.7 & 3.8 of textbook) </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>further assume that the EBIT of both firms is $120,000 and tax is 40% </li></ul></ul>
  21. 25. Case: Borrow at 10%
  22. 26. Case: Borrow at 15%
  23. 27. Case: Borrow at 10%: Effect of Business Cycle on ROE
  24. 36. External Funds Needed
  25. 38. Observation: <ul><ul><li>Sometimes the new assets required to generate income are not a high as in this example, and the company may able to support a level of growth with no external funding (-0.00038 in our case) </li></ul></ul>