Relationship between matching and revenue recognition Incur cost  in current  period for the purpose of  generating revenu...
Financial accounting of a firm: Assets - Liabilities = book value of firm (stockholders’ equity) Revenues -  expenses = ne...
Revealing the environmental aspects of financial information <ul><li>Environmental Assets (?): </li></ul><ul><li>Preventio...
Using Financial Statements to predict future earnings and cash flows Book value <ul><li>Adjustments for: </li></ul><ul><li...
Analyzing financial accounting numbers <ul><li>Assessing the business environment </li></ul><ul><li>- Company’s strategy, ...
Financial Statement Analysis <ul><li>Comparisons across time </li></ul><ul><li>- GAAP requires disclosure of account numbe...
Comparisons within the Financial Statements Common-size Financial Statement On the  Income Statement , express all items a...
Comparisons within the Financial Statements Common-size Financial Statement 100 $  628 100 $  1,218 Total 66 415 54 663 St...
Comparisons within the Financial Statements <ul><li>Financial Ratios </li></ul><ul><li>Profitability ratios </li></ul><ul>...
Financial Ratio Analysis <ul><li>Profitability Ratios </li></ul><ul><li>Return on Equity (ROE) </li></ul><ul><li>Net incom...
Financial Ratio Analysis <ul><li>Leverage Ratios </li></ul><ul><li>Common Equity Leverage </li></ul><ul><li>Net income / {...
Financial Ratio Analysis <ul><li>Solvency Ratios </li></ul><ul><li>Current Ratio </li></ul><ul><li>Current Liabilities / C...
Financial Ratio Analysis <ul><li>Asset Turnover Ratios </li></ul><ul><li>Receivables Turnover </li></ul><ul><li>Net Credit...
Financial Ratio Analysis <ul><li>Other Ratios </li></ul><ul><li>Earnings per Share </li></ul><ul><li>Net Income / Average ...
Some Ratios for Well-Known Companies 0.62 1.48 (0.01) 0.05 2.13 0.90 1.73 Price/Earnings ratio 1.61 4.56 (2.20) 1.03 0.66 ...
DuPont Model x = x PROFIT MARGIN Net Income + Interest Sales ASSET TURNOVER Sales Avg. Assets LONG-TERM DEBT ASSETS Cost o...
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Financial Management – Winter 2005 – 1 February to 3 March

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Financial Management – Winter 2005 – 1 February to 3 March

  1. 1. Relationship between matching and revenue recognition Incur cost in current period for the purpose of generating revenue Decide in what period the revenue is to be generated Expense cost on income statement Capitalize cost on balance sheet Income Statement Future Period Income Statement Current Period Expense Expense Net Income Net Income Principles of Revenue recognition Revenue Revenue 1. 2. 3a. 3b.
  2. 2. Financial accounting of a firm: Assets - Liabilities = book value of firm (stockholders’ equity) Revenues - expenses = net income Revealing the environmental aspects of financial information Position of a firm Performance of a firm <ul><li>Environmental activities of a firm: </li></ul><ul><li>Prevention: Eliminate sources of environmental impact </li></ul><ul><li>Assessment: Measure & monitor potential sources of environmental impact </li></ul><ul><li>Control: Manage environmental impact to avoid environmental damage </li></ul><ul><li>Failure: Remediate environmental damage </li></ul>
  3. 3. Revealing the environmental aspects of financial information <ul><li>Environmental Assets (?): </li></ul><ul><li>Prevention </li></ul><ul><li>Assessment </li></ul><ul><li>Control </li></ul><ul><li>Failure </li></ul><ul><li>Environmental Liabilities: </li></ul><ul><li>Prevention (?) </li></ul><ul><li>Assessment (?) </li></ul><ul><li>Control (?) </li></ul><ul><li>Failure </li></ul><ul><li>Environmental Revenues (?): </li></ul><ul><li>Prevention </li></ul><ul><li>Assessment </li></ul><ul><li>Control </li></ul><ul><li>Failure </li></ul><ul><li>Environmental Expenses: </li></ul><ul><li>Prevention </li></ul><ul><li>Assessment </li></ul><ul><li>Control </li></ul><ul><li>Failure </li></ul><ul><li>Example for environmental revenues – Electric Utilities: </li></ul><ul><li>Revenues from selling electricity from renewable resources </li></ul><ul><li>Revenues from selling electricity from non-renewable resources </li></ul>
  4. 4. Using Financial Statements to predict future earnings and cash flows Book value <ul><li>Adjustments for: </li></ul><ul><li>Business environment </li></ul><ul><li>Unrecorded events </li></ul><ul><li>Management bias </li></ul>True value <ul><li>Business environment </li></ul><ul><li>- What is the prognosis for the overall economy? </li></ul><ul><li>- What is the prognosis for the company’s industry? </li></ul><ul><li>- What is the company’s overall strategy? </li></ul><ul><li>- Does the company compete through product innovation or cost reduction? </li></ul><ul><li>Unrecorded events </li></ul><ul><li>- Human resources are not included in the balance sheet </li></ul><ul><li>- Most of the assets are carried at historical cost </li></ul><ul><li>- Statements ignore the effect of inflation (stable dollar assumption) </li></ul><ul><li>Management bias </li></ul><ul><li>- Statements are used by investors and creditors to assess and influence a firm </li></ul><ul><li>- Often, management salaries are directly tied to the financial performance and position of the firm </li></ul>
  5. 5. Analyzing financial accounting numbers <ul><li>Assessing the business environment </li></ul><ul><li>- Company’s strategy, type of industry, relationship to overall economy </li></ul><ul><li>- Competitors, barriers to entry </li></ul><ul><li>- Supply chain structure, bargaining power, relationship to suppliers and customers </li></ul><ul><li>Reading and studying the financial statements and footnotes </li></ul><ul><li>- The Audit Report </li></ul><ul><li>- Identify key items on Financial Statements </li></ul><ul><li>- Significant transactions (earnings persistence) </li></ul><ul><li>- The Footnotes </li></ul><ul><li>Assessing earnings quality (Quality of FS information) </li></ul><ul><li>- Overstating operating performance </li></ul><ul><li>- Taking a Bath </li></ul><ul><li>- Creating Hidden Reserves </li></ul><ul><li>- Off-Balance-Sheet Financing </li></ul><ul><li>Analyzing the Financial Statements </li></ul><ul><li>- Comparisons across time </li></ul><ul><li>- Comparisons with the industry </li></ul><ul><li>- Comparisons within the Financial Statements </li></ul><ul><li>Predicting future earnings and/or cash flows </li></ul><ul><li>- After completion of the first four steps, analysts usually prepare predictions </li></ul>
  6. 6. Financial Statement Analysis <ul><li>Comparisons across time </li></ul><ul><li>- GAAP requires disclosure of account numbers for current and preceding years (Balance sheet 2 years, all others 3 years) </li></ul><ul><li>- Often even longer time-series are published by the companies </li></ul><ul><li>- Historic trends as indicator of future trends </li></ul><ul><li>Comparisons within the industry </li></ul><ul><li>- Compare accounting numbers to those of similar companies (e.g. in same industry) </li></ul><ul><li>- Industry surveys report information concerning industry averages </li></ul><ul><li>- Different industries typically have different ‘normal’ accounting numbers (e.g. retailers have high inventory, pharmaceutical firms have large R&D costs) </li></ul><ul><li>Comparisons within the Financial Statements </li></ul><ul><li>- Common-size Financial Statements Facilitates identification of changes in the structure of financial flows and stocks </li></ul><ul><li>- Financial Ratios </li></ul><ul><li>Many ratios possible, no fixed rules </li></ul><ul><li>Typically, averages are used for stock numbers, i.e. balance sheet accounts </li></ul>Financial accounting numbers are only meaningful when compared to other relevant numbers (Is a reported income of $1 billion large or small?).
  7. 7. Comparisons within the Financial Statements Common-size Financial Statement On the Income Statement , express all items as percentages of net sales. On the Balance Sheet , express all items as percentages of total assets.
  8. 8. Comparisons within the Financial Statements Common-size Financial Statement 100 $ 628 100 $ 1,218 Total 66 415 54 663 Stockholders’ equity 13 81 26 318 Long-term liabilities 21 $ 132 20 $ 237 Current liabilities 100 $ 628 100 $ 1,218 Total 32 202 43 526 Long-term assets 68 $ 426 57 $ 692 Current assets Balance Sheet 5 $ 66 5 $ 88 Net income 21 (275) 20 (345) Expenses & charges 74 (947) 75 (1,284) Cost of sales 100 $ 1,288 100 $ 1,717 Net sales Income Statement % 1999 % 2000
  9. 9. Comparisons within the Financial Statements <ul><li>Financial Ratios </li></ul><ul><li>Profitability ratios </li></ul><ul><li>These ratios relate financial returns to stockholders (net income) and creditors (interest payments) to a variety of account numbers. </li></ul><ul><li>Leverage ratios </li></ul><ul><li>Leverage refers to using borrowed funds to generate returns for stockholders. E.g. borrowing at 8% and creating returns of 12% is using leverage effectively. Leverage creates additional returns, but also commits the firm to future cash obligations. </li></ul><ul><li>Solvency ratios </li></ul><ul><li>Solvency ratios measure a firms ability to meet its debt payments as the come due. </li></ul><ul><li>Asset turnover ratios </li></ul><ul><li>These ratios measure the speed with which assets move through operations, i.e. the number of times that assets are acquired, used and replaced. </li></ul><ul><li>Other ratios There are numerous other performance measures like earnings per share. </li></ul>
  10. 10. Financial Ratio Analysis <ul><li>Profitability Ratios </li></ul><ul><li>Return on Equity (ROE) </li></ul><ul><li>Net income / Average Stockholders’ Equity </li></ul><ul><li>Return on Assets (ROA) </li></ul><ul><li>{Net Income + [Interest Expense · (1-Tax Rate)]} / Average Total Assets </li></ul><ul><li>Return on Sales (Profit Margin) </li></ul><ul><li>{Net Income + [Interest Expense·(1-Tax Rate)]} / Net Sales </li></ul>
  11. 11. Financial Ratio Analysis <ul><li>Leverage Ratios </li></ul><ul><li>Common Equity Leverage </li></ul><ul><li>Net income / {Net Income + [Interest Expense·(1-Tax Rate)]} </li></ul><ul><li>Capital Structure Leverage </li></ul><ul><li>Average Total Assets / Average Stockholders’ Equity </li></ul><ul><li>Debt / Equity Ratio </li></ul><ul><li>Average Total Liabilities / Average Stockholders’ Equity </li></ul><ul><li>Long-Term Debt Ratio </li></ul><ul><li>Long-term Liabilities / Total Assets </li></ul>
  12. 12. Financial Ratio Analysis <ul><li>Solvency Ratios </li></ul><ul><li>Current Ratio </li></ul><ul><li>Current Liabilities / Current Assets </li></ul><ul><li>Quick Ratio </li></ul><ul><li>(Cash + Marketable Securities + Net Accounts Reveivable) / Current Liabilities </li></ul><ul><li>Interest Coverage </li></ul><ul><li>(Net Income + Tax Expense + Interest Expense) / Interest Expense </li></ul><ul><li>Accounts Payable Turnover </li></ul><ul><li>Cost of Goods Sold / Average Accounts Payable </li></ul>
  13. 13. Financial Ratio Analysis <ul><li>Asset Turnover Ratios </li></ul><ul><li>Receivables Turnover </li></ul><ul><li>Net Credit Sales / Average Accounts Receivable </li></ul><ul><li>Inventory Turnover </li></ul><ul><li>Cost of Goods Sold / Average Inventory </li></ul><ul><li>Fixed Assets Turnover </li></ul><ul><li>Sales / Average Fixed Assets </li></ul><ul><li>Total Asset Turnover </li></ul><ul><li>Sales / Average Total Assets </li></ul>
  14. 14. Financial Ratio Analysis <ul><li>Other Ratios </li></ul><ul><li>Earnings per Share </li></ul><ul><li>Net Income / Average Number of Common Shares Outstanding </li></ul><ul><li>Price / Earnings (P/E) Ratio </li></ul><ul><li>Market Price per Share / Earnings per Share </li></ul><ul><li>Dividend Yield Ratio </li></ul><ul><li>Dividends per Share / Market Price per Share </li></ul><ul><li>Stock Price Return </li></ul><ul><li>{Market Price (1) – Market Price (0) + Dividends} / Market Price (0) </li></ul>
  15. 15. Some Ratios for Well-Known Companies 0.62 1.48 (0.01) 0.05 2.13 0.90 1.73 Price/Earnings ratio 1.61 4.56 (2.20) 1.03 0.66 1.42 1.57 Earnings per share 0.54 0.06 1.05 2.52 2.75 0.66 1.21 Asset Turnover N/A N/A 10.79 5.53 60.38 N/A 5.52 Inventory Turnover 6.40 0.10 N/A 72.79 10.75 10.66 8.34 Receivables Turnover 5.05 1.64 (7.51) 136.86 N/A N/A 9.13 Interest Coverage 0.49 0.24 1.37 1.75 1.48 2.32 1.04 Current Ratio 2.19 13.83 7.70 1.45 2.41 1.32 3.85 Capital Structure Leverage 0.77 0.39 1.13 0.99 1.00 1.00 0.89 Common Equity Leverage 0.07 0.54 (0.39) 0.06 0.07 0.39 0.12 Profit Margin 0.04 0.03 (0.41) 0.15 0.20 0.26 0.14 Return on Assets 0.07 0.17 (3.56) 0.22 0.49 0.34 0.48 Return on Equity AT&T Bank of America Amazon Home Depot Dell Microsoft Colgate Palmolive
  16. 16. DuPont Model x = x PROFIT MARGIN Net Income + Interest Sales ASSET TURNOVER Sales Avg. Assets LONG-TERM DEBT ASSETS Cost of Goods sold / Sales Selling & Admin. Exp. / Sales Interest Exp. / Sales Taxes / Sales Other Expenses / Sales OPERATING PERFORMANCE INVESTING PERFORMANCE FINANCING PERFORMANCE x Receivables Turnover Sales / Avg. Accounts Receivable Inventory Turnover Cost of Goods Sold / Avg. Inventory Fixed Assets Turnover Sales / Avg. Fixed Assets Current Ratio Quick Ratio Interest Coverage Accounts Payable Turnover RETURN ON EQUITY Net Income Avg. Stock Equity RETURN ON ASSETS Net Income + Interest Avg. Assets COMMON EQUITY LEVERAGE Net Income Net Income + Interest CAPITAL STRUCTURE LEVERAGE Avg. Assets Avg. Stock Equity

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