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Understanding Financial Statements
Topic 02
GSB711 – Managerial Finance
Readings:
Chapter: Accounting and Finance (Pages 5...
Topics Covered…
The Balance Sheet
The Income Statement
The Statement of Cash Flows
Accounting Practice & Malpractice
T...
Topics Covered
Measuring Leverage
Measuring Liquidity
Calculating Sustainable Growth
Interpreting Financial Ratios
The Rol...
The Balance Sheet
Definition
   Financial statement  that show the value of the firm’s assets and liabilities at a particu...
Balance Sheet
PepsiCo Balance Sheet (December 31, 2006) $Millions
Telstra’s Balance Sheet
Telstra’s Balance Sheet
Telstra’s Balance Sheet
The Balance Sheet
Current Liabilities
	Payables
	Short-term Debt
+
Long-term Liabilities
+
Shareholders’ Equity
Current As...
The Balance Sheet
Common-Size Balance Sheet
All items in the balance sheet are expressed as a percentage of total assets.
Common Size Balance Sheet
Market Value vs. Book Value
Book Values are determined by GAAP
Market Values are determined by current values
Generally Ac...
Market Value vs. Book Value
Example
According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, asset...
Market Value vs. Book Value
Market Value Balance Sheet
Assets = $11.5 bil			Debt = $4 bil
					Equity = $7.5 bil
Example (...
Definition
   Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from ...
The Income Statement
Earnings Before Income & Taxes (EBIT)
EBIT = Total Revenues - costs 	– deprecation
		= 	35,753 	–...
Pepsico Income Statement (year end 2006)
Net Sales				          35,753
COGS					          15,762
Selling, G&A expenses...
Differences
“Profits” subtract depreciation (a non-cash expense)
“Profits” ignore cash expenditures on new capital (the ex...
The Statement of Cash Flows
Definition
   Financial statement that shows the firm’s cash receipts and cash payments over a...
Pepsico Statement of Cash Flows (excerpt - year end 2006)
Net Income					5,642
Non-cash expenses
	Depreciation				1,406
	O...
Telstra’s Income Statement
Telstra’s Income Statement
Cash Flows
Free Cash Flow (FCF)
Cash available for distribution to investors after firm pays for new investments or additi...
Telstra’s Cash Flow Statement
Telstra’s Cash Flow Statement
Telstra’s Cash Flow Statement
Taxes
The one thing we can rely on with taxes is that they are always changing
Marginal vs. average tax rates
Marginal – t...
Value and Value Added
Market Capitalization
Total market value of equity, equal to share price times number of shares outs...
Value and Value Added
PepsiCo Balance Sheet (December 31, 2006) $Millions
Pepsico Income Statement (year end 2006)
Net Sales				          35,753
COGS					          15,762
Selling, G&A expenses...
Value and Value Added
Market-to-Book Ratio
Ratio of market value of equity to book value of equity.
Value and Value Added
Stock market measures of company performance, 2006. Companies are ranked by market value added. (dol...
Measuring Profitability
Economic Value Added (EVA)
Net income minus a charge for the cost of capital employed. Also called...
Measuring Profitability
Economic Value Added (EVA) of PepsiCo
Measuring Profitability
Accounting measures of company performance, 2006. Companies are ranked by return on equity.
Measuring Profitability
Return on Equity (ROE)
Net income as a percentage of shareholders’ equity	
Return on Capital (ROC)...
Measuring Profitability
PepsiCo Profitability Measurements
Measuring Efficiency
OR
For PepsiCo
OR
Measuring Efficiency
The DuPont System
A breakdown of ROE and ROA into component ratios
The DuPont System
asset
turnover
Operating profit
margin
Measuring Leverage
Measuring Leverage
Measuring Leverage
leverage
ratio
asset
turnover
Operating
 profit
margin
debt
burden
Measuring Liquidity
Liquidity Ratios
Percent of Sales Approach
Some items vary directly with sales, while others do not
Income Statement
Costs may vary directl...
Growth and External Financing
At low growth levels, internal financing (retained earnings) may exceed the required investm...
The Internal Growth Rate
The internal growth rate tells us how much the firm can grow assets using retained earnings as th...
Sustainable Growth
Determinants of Growth
Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage...
Interpreting Financial Ratios
PepsiCo Ratios
Interpreting Financial Ratios
PepsiCo Ratios (continued)
Interpreting Financial Ratios
Selected 2006 financial ratios for industry groups in Standard & Poor’s Composite Index
Why Evaluate Financial Statements?
Internal uses
Performance evaluation – compensation and comparison between divisions
Pl...
Benchmarking
Ratios are not very helpful by themselves; they need to be compared to something
Time-Trend Analysis
Used to ...
Potential Problems
There is no underlying theory, so there is no way to know which ratios are most relevant
Benchmarking i...
Important Questions
It is important to remember that we are working with accounting numbers and ask ourselves some importa...
Summary
Financial statements
Book value vs market value
Cashflow statement
Standardized financial statements
Financial Rat...
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GSB711-Lecture-Note-02-Understanding-Financial-Statements

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This is the second presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at understanding financial statements, with breakdowns of example statements.

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GSB711-Lecture-Note-02-Understanding-Financial-Statements

  1. 1. Understanding Financial Statements Topic 02 GSB711 – Managerial Finance Readings: Chapter: Accounting and Finance (Pages 52 - 75) Questions: 1, 3, 8, 9 and Problems: 11, 13, 15 and 20. Chapter: Measuring Corporate Performance (Pages 76 – 107) Questions: 1, 3, 4, 6, 7 and Problems: 11, 17, 22 and 26
  2. 2. Topics Covered… The Balance Sheet The Income Statement The Statement of Cash Flows Accounting Practice & Malpractice Taxes Value and Value Added Measuring Profitability Measuring Efficiency Analyzing the Return on Assets: The Du Pont System
  3. 3. Topics Covered Measuring Leverage Measuring Liquidity Calculating Sustainable Growth Interpreting Financial Ratios The Role of Financial Ratios–and a Final Note on Transparency
  4. 4. The Balance Sheet Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in time (from an accounting perspective).
  5. 5. Balance Sheet PepsiCo Balance Sheet (December 31, 2006) $Millions
  6. 6. Telstra’s Balance Sheet
  7. 7. Telstra’s Balance Sheet
  8. 8. Telstra’s Balance Sheet
  9. 9. The Balance Sheet Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets = The Main Balance Sheet Items
  10. 10. The Balance Sheet Common-Size Balance Sheet All items in the balance sheet are expressed as a percentage of total assets.
  11. 11. Common Size Balance Sheet
  12. 12. Market Value vs. Book Value Book Values are determined by GAAP Market Values are determined by current values Generally Accepted Accounting Principles (GAAP) Procedures for preparing financial statements. Equity and Asset “Market Values” are usually higher than their “Book Values”
  13. 13. Market Value vs. Book Value Example According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion. Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.
  14. 14. Market Value vs. Book Value Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil Example (continued) Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil
  15. 15. Definition Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting perspective). The Income Statement
  16. 16. The Income Statement Earnings Before Income & Taxes (EBIT) EBIT = Total Revenues - costs – deprecation = 35,753 – 27,292 – 1,406 = $ 7,055 million
  17. 17. Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS 15,762 Selling, G&A expenses 11,530 Depreciation expense 1,406 EBIT 7,055 Net interest expense 66 Taxable Income 6,989 Income Taxes 1,347 Net Income 5,642 The Income Statement
  18. 18. Differences “Profits” subtract depreciation (a non-cash expense) “Profits” ignore cash expenditures on new capital (the expense is capitalized) “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur “Profits” do not consider changes in working capital Profits vs. Cash Flows
  19. 19. The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time.
  20. 20. Pepsico Statement of Cash Flows (excerpt - year end 2006) Net Income 5,642 Non-cash expenses Depreciation 1,406 Other 0 Changes in working capital A/R=(464) A/P=(86) Inv=(233) other=1,956 CL=155 1,328 Cash Flow from operations 8,376 Cash Flow from investments (933) Cash provided by financing (7,508) Net Change in Cash Position (65) The Statement of Cash Flows
  21. 21. Telstra’s Income Statement
  22. 22. Telstra’s Income Statement
  23. 23. Cash Flows Free Cash Flow (FCF) Cash available for distribution to investors after firm pays for new investments or additions to working capital FCF = EBIT - taxes + depreciation - change in net working capital - capital expenditures
  24. 24. Telstra’s Cash Flow Statement
  25. 25. Telstra’s Cash Flow Statement
  26. 26. Telstra’s Cash Flow Statement
  27. 27. Taxes The one thing we can rely on with taxes is that they are always changing Marginal vs. average tax rates Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income Tax Imputation Franked Dividends Other taxes
  28. 28. Value and Value Added Market Capitalization Total market value of equity, equal to share price times number of shares outstanding. Market Value Added Market capitalization minus book value of equity.
  29. 29. Value and Value Added PepsiCo Balance Sheet (December 31, 2006) $Millions
  30. 30. Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS 15,762 Selling, G&A expenses 11,530 Depreciation expense 1,406 EBIT 7,055 Net interest expense 66 Taxable Income 6,989 Income Taxes 1,347 Net Income 5,642 Value and Value Added
  31. 31. Value and Value Added Market-to-Book Ratio Ratio of market value of equity to book value of equity.
  32. 32. Value and Value Added Stock market measures of company performance, 2006. Companies are ranked by market value added. (dollar values in millions)
  33. 33. Measuring Profitability Economic Value Added (EVA) Net income minus a charge for the cost of capital employed. Also called residual income. Residual Income Net Dollar return after deducting the cost of capital
  34. 34. Measuring Profitability Economic Value Added (EVA) of PepsiCo
  35. 35. Measuring Profitability Accounting measures of company performance, 2006. Companies are ranked by return on equity.
  36. 36. Measuring Profitability Return on Equity (ROE) Net income as a percentage of shareholders’ equity Return on Capital (ROC) Net income plus Interest as a percentage of long-term capital. Return on Assets (ROA) Net income plus interest as a percentage of total assets
  37. 37. Measuring Profitability PepsiCo Profitability Measurements
  38. 38. Measuring Efficiency OR For PepsiCo OR
  39. 39. Measuring Efficiency
  40. 40. The DuPont System A breakdown of ROE and ROA into component ratios
  41. 41. The DuPont System asset turnover Operating profit margin
  42. 42. Measuring Leverage
  43. 43. Measuring Leverage
  44. 44. Measuring Leverage leverage ratio asset turnover Operating profit margin debt burden
  45. 45. Measuring Liquidity
  46. 46. Liquidity Ratios
  47. 47. Percent of Sales Approach Some items vary directly with sales, while others do not Income Statement Costs may vary directly with sales - if this is the case, then the profit margin is constant Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings Balance Sheet Initially assume all assets, including fixed, vary directly with sales Accounts payable will also normally vary directly with sales Notes payable, long-term debt and equity generally do not because they depend on management decisions about capital structure The change in the retained earnings portion of equity will come from the dividend decision
  48. 48. Growth and External Financing At low growth levels, internal financing (retained earnings) may exceed the required investment in assets As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money Examining the relationship between growth and external financing required is a useful tool in long-range planning
  49. 49. The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. Using the information from Tasha’s Toy Emporium ROA = 1200 / 9500 = .1263 B = .5
  50. 50. Sustainable Growth
  51. 51. Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm
  52. 52. Interpreting Financial Ratios PepsiCo Ratios
  53. 53. Interpreting Financial Ratios PepsiCo Ratios (continued)
  54. 54. Interpreting Financial Ratios Selected 2006 financial ratios for industry groups in Standard & Poor’s Composite Index
  55. 55. Why Evaluate Financial Statements? Internal uses Performance evaluation – compensation and comparison between divisions Planning for the future – guide in estimating future cash flows External uses Creditors Suppliers Customers Stockholders
  56. 56. Benchmarking Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firm’s performance is changing through time Internal and external uses Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes
  57. 57. Potential Problems There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years Extraordinary events
  58. 58. Important Questions It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process How does our plan affect the timing and risk of our cash flows? Does the plan point out inconsistencies in our goals? If we follow this plan, will we maximize owners’ wealth?
  59. 59. Summary Financial statements Book value vs market value Cashflow statement Standardized financial statements Financial Ratios Financial Planning Internal growth rate Sustainable growth rate Evaluating financial statements

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