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  1. 1. FINANCE 7311 Lecture 1 Review & Financial Statement Analysis
  2. 2. Course Objectives <ul><li>Accounting and Financial Analysis Tools </li></ul><ul><ul><li>Financial Statement Analysis </li></ul></ul><ul><ul><li>Projected Financial Statements and Cash Budgets </li></ul></ul><ul><li>The Financing Decision </li></ul><ul><ul><li>How Much Debt should a company have? </li></ul></ul><ul><ul><li>What is the cost of capital? How do we estimate it? </li></ul></ul><ul><ul><li>Other pros and cons of debt v. equity. What is an IPO? </li></ul></ul><ul><li>The Investment Decision </li></ul><ul><ul><li>How do we value a real investment proposal? </li></ul></ul><ul><ul><li>How do we value the firm? </li></ul></ul><ul><ul><li>Major corporate transactions </li></ul></ul><ul><li>What is Risk Management? </li></ul>
  3. 3. Outline – Lecture 1 <ul><li>Review of Basic Finance </li></ul><ul><li>The Corporation </li></ul><ul><li>The Accounting Model </li></ul><ul><li>Cash Flows </li></ul><ul><li>Financial Statement Analysis </li></ul><ul><li>Rapps Company </li></ul>
  4. 4. Review of Basic Finance <ul><li>Rates of Return </li></ul><ul><li>Efficient Markets </li></ul><ul><li>Time Value of Money </li></ul>
  5. 5. RATES OF RETURN <ul><li>REQUIRED RETURN </li></ul><ul><ul><li>required by investor </li></ul></ul><ul><ul><li>depends on RISK </li></ul></ul><ul><li>EXPECTED RETURN </li></ul><ul><ul><li>given current price & expected future CF’s </li></ul></ul><ul><li>REALIZED RETURN </li></ul><ul><ul><li>actual return </li></ul></ul>
  6. 6. RISK <ul><li>Represents the CHANCE that ACTUAL returns turn out to be much different than EXPECTED </li></ul><ul><li>Statistically: </li></ul><ul><ul><li>Variance </li></ul></ul><ul><ul><li>Standard Deviation </li></ul></ul>
  7. 7. EFFICIENT MARKETS <ul><li>Markets are in equilibrium </li></ul><ul><li>Expected Returns = Required returns </li></ul><ul><li>Expectations are rational </li></ul><ul><li>Information is reflected in price </li></ul><ul><ul><li>Information </li></ul></ul><ul><ul><li>Reflected in Price </li></ul></ul><ul><li>No Arbitrage </li></ul>
  8. 8. EFFICIENT MARKETS <ul><li>Why do we care whether or not markets are efficient? </li></ul><ul><li>Prices direct economic activity </li></ul><ul><li>Rates of return (cost of capital) </li></ul><ul><li>Valuation (market multiples) </li></ul>
  9. 9. TIME VALUE OF MONEY <ul><li>SINGLE CASH FLOWS </li></ul><ul><ul><li>V n = V o x (1 + R) n </li></ul></ul><ul><ul><li>FV = PV x (1 + R) n </li></ul></ul><ul><ul><li>PV = FV x (1 + R) -n </li></ul></ul><ul><li>MULTIPLE CASH FLOWS </li></ul><ul><ul><li>PERPETUITY </li></ul></ul><ul><ul><ul><li> PV = CF / R </li></ul></ul></ul>
  10. 10. TIME VALUE OF $, cont. <ul><li>ANNUITY </li></ul><ul><ul><li>PV = CF X [1/ R (1 - 1/(1 + R) n ] </li></ul></ul><ul><ul><li>Calculator: </li></ul></ul><ul><ul><ul><li>PV - present value </li></ul></ul></ul><ul><ul><ul><li>FV - future value </li></ul></ul></ul><ul><ul><ul><li>CF - periodic payment amount </li></ul></ul></ul><ul><ul><ul><li>R - discount rate </li></ul></ul></ul><ul><ul><ul><li>N - number of CF’s or periods </li></ul></ul></ul><ul><ul><li>Ordinary - end of period </li></ul></ul><ul><ul><li>Due - beginning of period </li></ul></ul>
  11. 11. THE CORPORATION <ul><li>REAL ASSETS ----> CASH FLOWS </li></ul><ul><li>CLAIMANTS ----> </li></ul><ul><ul><li>EMPLOYEES/CREDITORS </li></ul></ul><ul><ul><li>BONDHOLDERS </li></ul></ul><ul><ul><li>STOCKHOLDERS </li></ul></ul><ul><li>MANAGEMENT TEAM </li></ul>
  12. 12. A Picture of the Corporation <ul><li>Real Assets Financial Assets </li></ul>ASSETS Bondholders Shareholders 3rd Parties Govt; other FCF’s Business Risk Financial Risk Investment Financing Investors Financial Markets
  13. 13. MANAGEMENT <ul><li>OBJECTIVE : ALLOCATE COPORATE RESOURCES IN A WAY THAT: </li></ul><ul><ul><li>Maximizes the value of the firm </li></ul></ul><ul><ul><li>Maximizes current share price </li></ul></ul><ul><li>AGENCY PROBLEM </li></ul><ul><ul><li>Management makes decisions that are inconsistent with the above </li></ul></ul>
  14. 14. MANAGEMENT DECISIONS <ul><li>INVESTMENT DECISION --> What should be in the circle </li></ul><ul><li>1) Net short-term assets --> Net Working capital </li></ul><ul><ul><ul><li>inventory policy </li></ul></ul></ul><ul><ul><ul><li>A/R and A/P policy </li></ul></ul></ul><ul><ul><ul><li>nature and amount of S-T financing </li></ul></ul></ul><ul><li>2) L-T Assets --> Capital Budgeting </li></ul><ul><ul><ul><li>Which assets add most VALUE to the firm? </li></ul></ul></ul>
  15. 15. Mgmt Decisions, cont. <ul><li>FINANCING DECISION </li></ul><ul><li>How Should Assets Be Financed? </li></ul><ul><li>What is the Proper Mix of Debt and Equity? </li></ul><ul><li>How much debt should a company have? </li></ul><ul><li>Financial leverage & risk </li></ul><ul><li>Interest tax deductible </li></ul><ul><li>Costs of financial distress </li></ul>
  16. 16. Mgmt Decisions, cont. <ul><li>Related Concerns: </li></ul><ul><ul><li>Corporate Governance – Agency issues </li></ul></ul><ul><ul><li>Risk Management </li></ul></ul>
  17. 17. Value of Corporation <ul><li>Value of anything = PV of expected future cash flows </li></ul><ul><li>Corporation  use Free Cash Flows </li></ul><ul><li>EBIT </li></ul><ul><li>+ Depreciation </li></ul><ul><li>- Taxes </li></ul><ul><li>-  NWC </li></ul><ul><li>- Capital Spending </li></ul><ul><li> Free Cash Flows </li></ul>
  18. 18. Value of Corporation <ul><li>V = </li></ul><ul><li>Investment Decision  Max FCF </li></ul><ul><li>Financing Decision  Min WACC </li></ul><ul><li>Together: Maximize V </li></ul>
  19. 19. BUSINESS RISK <ul><li>Assets are the SOURCE of BUSINESS RISK </li></ul><ul><ul><li>DEMAND & SUPPLY VARIABILITY </li></ul></ul><ul><ul><li>COMPETITION (ease of entry) </li></ul></ul><ul><ul><li>TECHNOLOGY </li></ul></ul><ul><ul><li>REGULATION </li></ul></ul><ul><ul><li>MGMT DEPTH & BREADTH </li></ul></ul><ul><ul><li>OPERATING LEVERAGE </li></ul></ul><ul><ul><li>SKILLED PROFESSIONALS </li></ul></ul>
  20. 20. THE ACCOUNTING MODEL <ul><li>CONFORMS TO PICTURE: </li></ul><ul><ul><li>NWC DEBT </li></ul></ul><ul><ul><li>L-T ASSETS EQUITY </li></ul></ul><ul><li>LHS = CIRCLE </li></ul><ul><li>RHS = RECTANGLES </li></ul>
  21. 21. Debt <ul><li>Interest Bearing - ‘Permanent’ Capital </li></ul><ul><ul><li>Reclassify S-T portion of notes payable </li></ul></ul><ul><li>Lines of Credit </li></ul><ul><ul><li>Include as part of NWC </li></ul></ul>
  22. 22. ACCOUNTING PRINCIPLES <ul><li>COST PRINCIPLE: </li></ul><ul><ul><ul><li>ONLY TRANSACTIONS RECORDED </li></ul></ul></ul><ul><ul><ul><li>COST Not Equal to MARKET IN GENERAL </li></ul></ul></ul><ul><li>MATCHING PRINCIPLE </li></ul><ul><ul><ul><li>PERFORMANCE MEASUREMENT </li></ul></ul></ul><ul><ul><ul><li>ACCRUAL V. CASH BASIS ACCTG. </li></ul></ul></ul>
  23. 23. FINANCIAL STATEMENTS <ul><li>BALANCE SHEET </li></ul><ul><ul><li>Assets & Liabilities as of a point in time </li></ul></ul><ul><li>INCOME STATEMENT </li></ul><ul><ul><li>Period of time </li></ul></ul><ul><ul><li>Include effect of accruals </li></ul></ul><ul><ul><li>Not the same as Cash Flow. Why? </li></ul></ul>
  24. 24. BALANCE SHEET <ul><li>ASSETS -> something owned </li></ul><ul><ul><li>Listed in order of liquidity </li></ul></ul><ul><ul><li>NWC & Long-term </li></ul></ul><ul><li>Liability -> something owed </li></ul><ul><ul><li>listed in order of Claim Priority </li></ul></ul><ul><li>Retained Earnings -> owned - owed </li></ul><ul><ul><li>Cum. Earnings not paid as dividends </li></ul></ul>
  25. 25. INCOME STATEMENT <ul><li>GENERAL FORMAT </li></ul><ul><li>SALES </li></ul><ul><li>- COS </li></ul><ul><li>GROSS PROFIT </li></ul><ul><li>- OPERATING EXPENSES </li></ul><ul><li>EBIT (OPERATING PROFIT) </li></ul><ul><ul><li>EARNINGS W/O REGARD TO DEBT & TAX SITUATION </li></ul></ul>
  26. 26. Income Statement, cont. <ul><li>EBIT </li></ul><ul><li>- INTEREST </li></ul><ul><li>EBT (TAXABLE INCOME) </li></ul><ul><li>- Taxes </li></ul><ul><li>NET INCOME </li></ul><ul><li>NET INCOME  CASH FLOW </li></ul><ul><li>WHY? </li></ul>
  27. 27. Cash Flow v. Net Income <ul><li>Non-Cash Expenses </li></ul><ul><ul><li>Depreciation </li></ul></ul><ul><ul><li>Amortization </li></ul></ul><ul><ul><li>Write-offs </li></ul></ul><ul><li>Accruals </li></ul><ul><ul><li>Timing Differences </li></ul></ul>
  28. 28. A Note About Taxes <ul><li>For purposes of analyzing past cash flows: </li></ul><ul><ul><li>Taxes = tax amount from income statement </li></ul></ul><ul><li>For Valuation Purposes (projected CF’s) </li></ul><ul><ul><li>Taxes = EBIT x t </li></ul></ul><ul><ul><li>Where t = corporate tax rate </li></ul></ul>
  29. 29. RATIO ANALYSIS <ul><li>FINANCIAL COMPARISON TOOL </li></ul><ul><li>RAW FINANCIAL STATEMENTS </li></ul><ul><ul><li>SIZE DIFFERENCES </li></ul></ul><ul><ul><li>DOLLAR AMOUNTS SAY LITTLE </li></ul></ul><ul><li>KEY: COMPARABILITY </li></ul><ul><li>DEFINITIONS DIFFER </li></ul>
  30. 30. Ratios: Users & Measurement <ul><li>Users: </li></ul><ul><ul><li>Management (Investors) </li></ul></ul><ul><ul><li>Suppliers </li></ul></ul><ul><ul><li>Lenders (Bondholders) </li></ul></ul><ul><li>Units of Measure: </li></ul><ul><ul><li># Times (turnover) </li></ul></ul><ul><ul><li># Days </li></ul></ul><ul><ul><li>% </li></ul></ul>
  31. 31. BENCHMARKS <ul><li>Historical Ratios of Company </li></ul><ul><ul><li>Trend Analysis </li></ul></ul><ul><ul><li>Assumes: Continuation of past </li></ul></ul><ul><li>Other Companies / Industry </li></ul><ul><ul><li>RMA, S&P, Hoover, Yahoo </li></ul></ul><ul><ul><li>Industry Publications </li></ul></ul><ul><li>Projections (Forecasts) </li></ul>
  32. 32. COMMON SIZE F/S <ul><li>BALANCE SHEET </li></ul><ul><ul><li>EXPRESS EACH ITEM AS % OF ASSETS </li></ul></ul><ul><li>INCOME STATEMENT </li></ul><ul><ul><li>EXPRESS EACH ITEM AS % OF SALES </li></ul></ul><ul><li>COMMON BASE </li></ul><ul><ul><li>EXPRESS EACH ITEM AS % OF BASE YEAR (GROWTH RATE) </li></ul></ul>
  33. 33. RATIO GROUPS <ul><li>LIQUIDITY </li></ul><ul><li>ACTIVITY </li></ul><ul><li>LEVERAGE </li></ul><ul><li>PROFITABILITY </li></ul><ul><li>MARKET </li></ul>
  34. 34. LIQUIDITY <ul><li>Ability to meet current Obligations </li></ul><ul><li>Of Interest to Short-term Creditors </li></ul><ul><li>CURRENT RATIO </li></ul><ul><li>QUICK RATIO </li></ul>
  35. 35. ACTIVITY RATIOS <ul><li>Measures Effective Asset Use </li></ul><ul><li>Of Interest to management & investors </li></ul><ul><li>ASSET TURNOVER </li></ul><ul><li>INVENTORY TURNOVER </li></ul><ul><li>DAYS SALES IN INVENTORY </li></ul><ul><li>DAYS SALES OUTSTANDING </li></ul>
  36. 36. LEVERAGE RATIOS <ul><li>USE OF DEBT FINANCING </li></ul><ul><ul><li>Ability to meet debt payments </li></ul></ul><ul><ul><li>Important to long-term creditors </li></ul></ul><ul><li>DEBT RATIO </li></ul><ul><li>TIMES INTEREST EARNED </li></ul><ul><li>DAYS PAYABLE O/S </li></ul>
  37. 37. PROFITABILITY RATIOS <ul><ul><li>COMBINED USE OF DEBT & ASSETS </li></ul></ul><ul><ul><li>IMPORTANT TO MGMT & INVESTORS </li></ul></ul><ul><li>PROFIT MARGIN </li></ul><ul><li>GROSS MARGIN </li></ul><ul><li>OPERATING MARGIN </li></ul><ul><li>RETURN ON ASSETS (ROA) </li></ul><ul><li>RETURN ON EQUITY (ROE) </li></ul>
  38. 38. DUPONT & ROIC <ul><li>DUPONT DECOMPOSITION OF ROE </li></ul><ul><ul><li>Profitability X Asset Turnover X Leverage </li></ul></ul><ul><li>ROIC (Return on Invested Capital) </li></ul><ul><ul><li>EBIT X (1 - T) / (EQUITY + DEBT) </li></ul></ul><ul><ul><ul><li>NOT AFFECTED BY LEVERAGE </li></ul></ul></ul><ul><ul><ul><li>COMPARE WITH WACC </li></ul></ul></ul>
  39. 39. MARKET RATIOS <ul><li>P/E RATIO </li></ul><ul><ul><li>What investors are willing to pay for a $ of earnings (Current / Forecast) </li></ul></ul><ul><ul><li>What creates a high P/E? </li></ul></ul><ul><li>MARKET/BOOK </li></ul><ul><ul><li>Usually much different than 1. </li></ul></ul><ul><ul><li>EX: S&P 500 CURRENTLY = 3.5 WHY? </li></ul></ul>
  40. 40. LIMITATIONS <ul><li>NO THEORY TO DEFINE ‘GOOD’ </li></ul><ul><li>#’S HISTORICAL; NOT ECONOMIC </li></ul><ul><li>MOST AS OF SINGLE POINT IN TIME </li></ul><ul><ul><li>SEASONAL OPERATIONS </li></ul></ul><ul><ul><li>ONE-TIME EFFECTS </li></ul></ul><ul><li>DESIGNED FOR MANUFACTURERS </li></ul>
  41. 41. ECONOMIC V. ACCTG. EARNINGS <ul><li>UNREALIZED GAINS & LOSSES </li></ul><ul><li>COST OF EQUITY </li></ul><ul><li>‘ HIGH’ CORPORATE PROFITS </li></ul><ul><li>EVA - attempts to account for cost of equity </li></ul>