Princeple corporate Finance Accounting semester 5 college

1. Lecture 3
Financial Analysis
Principles of Corporate Finance
Dr. Abdullah Hamoud
Main source: Ross, Westerfield and Jordan (2010). Fundamentals of Corporate Finance, 9th ed. McGraw-Hill

2. Financial Statements
The four required financial statements are:
▪ The balance sheet,
▪ The income statement,
▪ The shareholders` statement
▪ The statement of cash flows

3. The Balance Sheet
▪ The balance sheet is a snapshot of the firm.
▪ It is a convenient means of organizing and
summarizing what a firm owns (its assets),
what a firm owes (its liabilities), and the
difference between the two (the firm’s equity)
at a given point in time.
▪ Thus, the balance sheet shows the current
financial position.

4. The Balance Sheet
▪ The balance sheet is potentially useful to
many different parties:
o A supplier might look at the size of accounts
payable to see how promptly the firm pays its bills.
o A potential creditor would examine the liquidity and
degree of financial leverage.
o Managers within the firm can track things like the
amount of cash and the amount of inventory the
firm keeps on hand.

5. How the balance sheet is constructed?

6. The Balance Sheet Equation
Assets Liabilities
Stockholder's
Equity
= +

7. The Balance Sheet

8. The Balance Sheet
Current Assets
• Cash and other marketable securities, which are short-
term, low-risk investments that can be easily sold and
converted to cash within a year
• Accounts receivable, which are amounts owed to the
firm by customers who have purchased goods or
services on credit;
• Inventories, which are composed of raw materials as
well as work-in-progress and finished goods;
• Other current assets, which is a catch-all category that
includes items such as prepaid expenses.

9. The Balance Sheet
Fixed Assets
• Assets like real estate or machinery that
produce tangible benefits for more than one
year: property, plant and equipment
• Reduced by the value recorded for this
equipment through a yearly deduction called
depreciation
• Intangible assets: goodwill, patent, trademark

10. The Balance Sheet
Current Liabilities
• Accounts payable, the amounts owed to
suppliers for products or services purchased on
credit.
• Notes payable, loans that must be repaid within
a year.
• Accrual items, Accrued expenses

11. The Balance Sheet
Long-term Liabilities
• Deferred taxes
• Long-term debt
Stockholders’ Equity
• Preferred stock
• Common stock
• Capital surplus
• Accumulated retained earrings

12. Balance Sheet Analysis
There are three things to keep in mind when
analyzing a balance sheet :
1.Accounting liquidity
2.Debt versus equity
3.Market value versus book value (value versus
cost)

13. Balance Sheet Analysis
Liquidity
Refers to the ease and quickness with which
assets can be converted to cash—without a
significant loss in value.
▪ Current assets are relatively liquid and include cash
and assets we expect to convert to cash over the
next 12 months.
▪ Fixed assets are, for the most part, relatively illiquid.

14. Balance Sheet Analysis
Liquidity
▪ The more liquid a firm’s assets, the less likely the
firm is to experience problems meeting short term
obligations.
▪ Liquid assets are generally less profitable to hold.
For example, cash holdings are the most liquid of all
investments, but they sometimes earn no return at
all—they just sit there.

15. Balance Sheet Analysis
Debt versus equity
▪ To the extent that a firm borrows money, it usually
gives first claim to the firm’s cash flow to creditors.
▪ Equity holders are entitled to only the residual value,
the portion left after creditors are paid.
▪ The value of this residual portion is the shareholders’
equity in the firm, which is just the value of the firm’s
assets less the value of the firm’s liabilities:
Shareholders’ equity = Assets + Liabilities

16. Balance Sheet Analysis
Debt versus equity
▪ The use of debt in a firm’s capital structure is called
financial leverage.
▪ The more debt a firm has (as a percentage of assets),
the greater is its degree of financial leverage.
▪ Financial leverage increases the potential reward to
shareholders, but it also increases the potential for
financial distress and business failure.

17. Balance Sheet Analysis
Market value versus book value
▪ The values shown on the balance sheet for the
firm’s assets are book values and generally
are not what the assets are actually worth.
▪ Audited financial statements generally show
assets at historical cost.
▪ Assets are “carried on the books” at what the
firm paid for them, no matter how long ago
they were purchased or how much they are
worth today.
▪

18. Balance Sheet Analysis
Market value versus book value
In this example, shareholders’ equity is actually worth almost twice as much
as what is shown on the books. The distinction between book and market
values is important precisely because book values can be so different from
true economic value.

19. The Income Statement
The income statement measures performance
over some period of time, usually a quarter or a
year.
The income statement equation is:
Revenues Expenses Income
- =

20. The Income Statement
If we think of the balance sheet as a snapshot,
then we can think of the income statement as a
video recording covering the period between
before and after pictures.

21. The Income Statement

22. The Income Statement
Calculating Earnings and Dividends per Share

23. Income Statement Analysis
There are three things to keep in mind when
analyzing an income statement:
1.Generally Accepted Accounting Principles
(GAAP)
2. Noncash Items
3. Time and Costs

24. Income Statement Analysis
GAAP
• The matching principal of GAAP dictates that
revenues be matched with expenses.
• Thus, income is reported when it is earned,
even though no cash flow may have occurred.

25. Income Statement Analysis
Noncash Items
• Depreciation is the most apparent. No firm
ever writes a check for “depreciation.”
• when we purchase a machine, the cash flow
occurs immediately, but we recognize the
expense of the machine over time as it is used
in the production process (i.e., depreciation).
• Another noncash item is deferred taxes, which
does not represent a cash flow.
• Thus, net income is not cash.

26. Income Statement Analysis
Time and Costs
• In the short run, certain equipment, resources,
and commitments of the firm are fixed, but the
firm can vary such inputs as labor and raw
materials.
• In the long run, all inputs of production (and
hence costs) are variable.

27. Income Statement Analysis
Time and Costs
• Financial accountants do not distinguish
between variable costs and fixed costs.
Instead, accounting costs usually fit into a
classification that distinguishes product costs
from period costs.
• Product costs: raw materials, direct labor, and
manufacturing overhead •
• Period costs: selling, general and
administrative expenses.

28. Sources and Uses of Cash
▪ Activities that bring in cash are called sources
of cash.
▪ Activities that involve spending cash
are called uses (or applications) of cash.
▪ We need to trace the changes in the firm’s
balance sheet to see how the firm obtained
and spent its cash during some period.

29. Sources and Uses of Cash- Example

30. ▪ We see that inventory rose by $29. This is a net use
because Prufrock effectively paid out $29 to increase
inventories.
▪ Accounts payable rose by $32. This is a source of cash
because Prufrock effectively has borrowed an additional
$32 payable by the end of the year.
▪ Notes payable, on the other hand, went down by $35, so
Prufrock effectively paid off $35 worth of short-term debt—a
use of cash.
Sources and Uses of Cash- Example

31. ▪ The net addition to cash is just the difference between
sources and uses, and our $14 result here agrees with the
$14 change shown on the balance sheet.
Sources and Uses of Cash- Example
▪ Based on this, we can summarize the sources and uses of
cash from the balance sheet as follows:

32. Financial Ratios
▪ To avoid the problems involved in comparing
companies of different sizes financial ratios
are calculated and compared.
▪ Financial ratios are traditionally grouped into
the following categories:
1. Short-term solvency (liquidity) ratios.
2. Long-term solvency (financial leverage) ratios.
3. Asset management (turnover) ratios.
4. Profitability ratios.
5. Market value ratios.

33. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ Short-term solvency ratios are intended to
provide information about a firm’s liquidity, and
these ratios are sometimes called liquidity
measures.
▪ The primary concern is the firm’s ability to pay
its bills over the short run without undue
stress. Consequently, these ratios focus on
current assets and current liabilities.

34. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ The current ratio is a measure of short-term
liquidity.
▪ The unit of measurement is either dollars or times.
▪ It is computed as follows:
1-1 Current Ratio

35. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ This ratio is the same as the current ratio, just
inventory is excluded.
▪ It is computed as follows:
1-2 Quick (Acid-Test) Ratio

36. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ This ratio consider cash only.
▪ It is computed as follows:
1-3 Cash Ratio

37. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ The difference between current assets and
current liabilities is the firm’s net working
capital, the capital available in the short term
to run the business.
▪ It is computed as follows:
Net Working Capital ≡ Current Assets – Current
Liabilities
1-4 Net working capital

38. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ The difference between current assets and
current liabilities is the firm’s net working
capital, the capital available in the short term
to run the business.
▪ It is computed as follows:
Net Working Capital =
Current Assets – Current Liabilities
1-4 Net working capital

39. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ Positive when the cash that will be received
over the next 12 months exceeds the cash that
will be paid out.
▪ Usually positive in a healthy firm
1-4 Net working capital

40. Financial Ratios
1- Short-term solvency (liquidity) ratios.
▪ It is computed as follows:
1-5 Net working capital to total assets