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Corporate Finance

Week 3
Financial Statement
Analysis

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Topics Covered
Firms’ Disclosure of Financial Information
The Balance Sheet & its Analysis
The Income Statement & its Analysis
The Statement of Cash Flows
Other Financial Statement Information
Financial Reporting in Practice

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Firms’ Disclosure of Financial Information
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Financial statements: accounting reports

that a firm issues periodically to describe (
)
Who needs financial statements?
– Investors, financial analysts, managers, and
other interested parties such as creditors
Why?
– rely on financial statements to obtain (
) about a corporation.
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Firms’ Disclosure of Financial Information 1- 4

Financial Statements
The four required financial statements are
– The balance sheet,
– The income statement,
– The statement of cash flows,
– and the statement of stockholders’ equity

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The Balance Sheet

The current financial position (assets, liabilities,
and stockholders’ equity) of the firm at a (
)
The balance sheet identity is:
Assets ≡ ( )+( )
Stockholders’ equity is the ( ) value of
the firm’s equity
– It differs from the ( ) value of the firm’s
equity, its ( )
Three concerns: liquidity, debt vs. equity and
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value vs. cost
Global Conglomerate Corporation 1- 6

Balance Sheet for 2014 and 2015

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Global Conglomerate Corporation 1- 7

Balance Sheet for 2014 and 2015

The assets are listed in

order by ( )
it would normally take a firm
with ongoing operations to
convert them into cash
Clearly, cash is much more
liquid than property, plant,
and equipment.

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The Balance Sheet

Current Assets
– Cash and other marketable securities, which are
( ), ( ) investments that can be
easily sold and converted to cash (e.g. 1-yr
government bonds)
– Accounts receivable, which are amounts ( )
to the firm by customers who have purchased
goods or services on credit;
– Inventories, which are composed of ( )
as well as ( ) and finished goods;
– Other current assets, which is a catch-all
category that includes items such as prepaid
expenses 3- 8
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The Balance Sheet

Long-Term Assets
– Assets like real estate or machinery that
produce tangible benefits for ( )
– Depreciation: ( ) the value recorded for
this equipment each year by deducting (
)
– according to a depreciation schedule that
depends on an asset’s life span
– Other long-term assets can include such items
as property not used in business operations

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The Balance Sheet

Current Liabilities
– Accounts payable, the amounts ( )
for products or services purchased with credit
– Notes payable, loans that must be (
). ( ) of long-term debt
that will occur within the next year would also be
listed here as current maturities of long-term debt
– Accrual items, such as salary or taxes that are
owed but have not yet been paid, and deferred or
unearned revenue

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Net Working Capital

The firm’s net working capital: the capital
available in the short term to run the
business:

Net Working Capital = Current Assets –

Current Liabilities

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The Balance Sheet

Long-Term Liabilities: liabilities that extend
beyond one year
– Long-term debt: any loan or debt obligation
with a maturity of more than ( )
• When a firm needs to raise funds to purchase an asset or make
an investment, it may borrow those funds through a long-term
loan
– Capital leases: long-term lease contracts that
obligate the firm to make regular lease
payments in exchange for use of an asset
– Deferred taxes: owed but have not yet been
paid
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The Balance Sheet

Total liabilities = current liabilities + long-
term liabilities

Stockholders’ Equity
– Book value of equity: the net worth of the firm
from an accounting perspective
– Market capitalization: the total market value
of a firm’s equity  ( ) per share
×( ) outstanding

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Exercise I
Problem:
If Global has 3.6 million shares outstanding,
and these shares are trading for a price of
$14 per share, what is Global’s market
capitalization in 2015? How does the
market capitalization compare to Global’s
book value of equity?

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M/B Ratio
M/B ratio (or P/B ratio): ratio of a firm’s
market capitalization to the book value of
stockholders’ equity:
Market Value of Equity
Market-to-Book Ratio 
Book Value of Equity
– Value stocks vs. growth stocks

Market value of the firm’s equity vs.

Enterprise value
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Market-to-Book Ratios in 2006

* Market to Book Ratio for Alphabet (Google, P/B ratio) as of Sept. 1, 2020 =
5.36 vs. That for Tesla as of Aug. 31, 2020 = 38.46. 3- 19
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Enterprise Value
Enterprise value : value of business itself
– MV of outstanding shares of stock plus MV of
outstanding interest bearing debt less cash on hand
– Cost to ( ) the business
– Enterprise Value = Market Value of Equity
+ Debt – Cash
EV Multiples:

– a proxy for how ( ) would take for an

acquisition to earn enough to pay off its costs
– to estimate the value of a firm’s ( ) business
rather than just focusing on the value of its equity 3- 20
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DE Ratio
The debt-equity ratio is a common ratio
used to assess a firm’s ( )
Total Debt
Debt-Equity Ratio 
Total Equity
Two useful variations: DE ratio, Equity
multiplier

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Total Debt Ratio

Total Debt Ratio (D/V) : considers all
debts of all maturities to all creditors
(leverage ratio)

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Current Ratio & Quick Ratio

The ratio of current assets to current
liabilities:
Current Assets
Current Ratio =
Current Liabilities
The ratio of current assets other than
( ) to current liabilities:
Current Assets - Inventory
Quick Ratio =
Current Liabilities
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Summary: Balance Sheet Ratios

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The Income Statement

The income statement lists the firm’s
revenues and expenses over a period of time.
– The last line of the income statement shows the
firm’s net income (or earnings),
– measuring its ( ) during the period.
– sometimes called a profit and loss, or “P&L,”
statement
Income = Revenue - Expenses

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Earnings Per Share

Net income reported on a ( ) basis

Net Income $2.0 million

EPS    $0.556 per share
Shares Outstanding 3.6 million shares

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Income Statement Analysis

The income statement provides very useful
information
– regarding the profitability of a firm’s business
– and how it relates to the value of the firm’s
shares.
We now discuss several ratios that are often
used to evaluate a firm’s performance and
value.

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Income Statement Analysis

Profitability Measures
– Gross Margin vs. Operating Margin vs. Net
Profit Margin
– Investment Returns
– EBITDA Margin
Asset Efficiency or Turnover Measures
Leverage Ratios
The DuPont Identity
Valuation Ratios
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Income
Total Revenue
Gross Income CGS
Operating Income
Selling, general,
Net Income & administrative
expenses
Taxes Depreciation
Non-
operating
expenses

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 Income (cont’d)
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Operating income vs. EBIT vs. EBITDA

– OI & EBIT: Similar, but strictly speaking
different
– EBIT(income from operations): after adjusting
for other sources of income or expenses
– = NI+I+T ≈ [ ]+I+T=
≈ OI
– EBITDA=EBIT+D(&Amortization)

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 Income (cont’d)
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Operating income vs. EBIT vs. EBITDA

– EBITDA=EBIT+D(&Amortization) : D is a
non-cash expense, but depreciating assets will be
ultimately replaced  a better measure of
( ), ( )
– EBIT & EBITDA : used to analyze and compare
profitability between companies and industries
because it abstracts from differences in earnings
from a firm’s ( ) and ( )

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Profitability Measures
The operating margin reveals how much a
company earns ( ) from
each dollar of ( ):
Operating Income
Operating Margin 
Total Sales

The net profit margin shows the fraction of

each dollar in revenues that is available to
( ) after the firm pays interest
and taxes: Net Income
Net Profit Margin 
Total Sales
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Profitability Measures
 Investment Returns:
– Evaluating the firm’s return on investment by
comparing its income to its investment

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Profitability Measures
 EBITDA Margin:
– EBITDA margin looks more directly at
( ) than does net income
– and does not include the effect of capital structure
or taxes.

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Asset Efficiency or Turnover Measures

A first broad measure of efficiency is asset
turnover:
Sales
Asset Turnover =
Total Assets

Fixed Asset Turnover: since total assets

includes assets like cash that are (
), managers might also
look at the fixed asset turnover:
Sales
Fixed Asset Turnover =
Fixed Assets
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Asset Efficiency or Turnover Measures

How efficiently we turn our inventory into
sales Sales
Inventory Turnover =
Inventory
Receivables Turnover

 The firm’s accounts receivable in terms of the

number of days’ worth of sales that it represents:
Accounts Receivable
Accounts Receivable Days 
Average Daily Sales 3- 36
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Leverage Ratios
Times Interest Earned (TIE): a measure of
long-term solvency, or interest coverage ratio

Cash Coverage Ratio :

Use interest bearing debt (notes payable, LT

debt)

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Exercise II
Problem
– Assess Rylan’s ability to meet its interest obligations
by calculating interest coverage ratios using both
EBIT and EBITDA. Income Statement
2012 2011
Revenues $500,000,000 $450,000,000
Less: Cost of Goods Sold $225,000,000 $200,000,000
Gross Profit $275,000,000 $250,000,000
Less: Operating Expenses $150,000,000 $140,000,000
EBITDA $125,000,000 $110,000,000
Less: Depreciation $25,000,000 $22,500,000
EBIT $100,000,000 $87,500,000
Less: Interest Expense $10,000,000 $9,000,000
EBT $90,000,000 $78,500,000
Less: Taxes (40%) $36,000,000 $31,400,000
Net Income $54,000,000 $47,100,000 3- 38
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DuPont Identity
ROE : net income per dollar of sales (profit
margin) times the amount of sales per dollar
of equity

 Net Income  Sales   Net Income  Sales 

ROE =      
 Total Equity  Sales   Sales  Total Equity 

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DuPont Analysis
ROE is equal to net income per dollar of sales
( ) times sales per dollar of assets
( ) times assets per dollar of
equity (the measure of leverage called the
).

 Net Income  Sales  Total Assets   Net Income  Sales  Total Assets 
ROE =        
 Sales  Total Equity  Total Assets   Sales  Total Assets  Total Equity 

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Exercise III

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Valuation Ratio
 The most important is the firm’s price-earnings
ratio (P/E):
 The P/E ratio is a simple measure that is used to
assess whether a stock is over- or under-valued
based on the idea that the value of a stock should
be proportional to ( ) it can
generate for its shareholders.

Market Capitalization Share Price

P / E Ratio  
Net Income Earnings per Share

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Exercise IV

Problem:

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Summary: Income Statement Ratios

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The Statement of Cash Flows

The firm’s statement of cash flows utilizes
the information from the income statement
and balance sheet
– to determine how much cash the firm has
generated, and how that cash has been allocated,
during a set period.
Cash is important because it is needed to
pay bills and maintain operations and is the
source of any return of investment for
investors.

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The Statement of Cash Flows

The statement of cash flows is divided into
three sections which roughly correspond to
the three major jobs of the financial
manager:
– Operating activities
– Investment activities
– Financing activities

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The Statement of Cash Flows

An official accounting statement called the
statement of cash flows helps to explain the
( ) in accounting cash and
equivalents.
In finance, the value of the firm is its ability
to generate financial cash flow.
– 𝐶𝐹 𝐴 ≡ 𝐶𝐹 𝐵 + 𝐶𝐹(𝑆)
– OCF vs. accounting statement of OCF

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The Statement of Cash Flows

In finance, the value of the firm is its ability
to generate ( ) (cont.).
– Operating cash flow(OCF) is the cash flow generated by
business activities, including sales of good and services.
– It reflects ( ), but not financing,
capital spending, or changes in net working
capital
– OCF = EBIT(=NI+I+T) + D –T, accounting CF
from operations = NI + D + (D.T + ∆ in assets)
– The difference b/w the CF of the firm and the
statement of CF is ( ) if other items are negligible!
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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm Operating Cash Flow:

Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes) EBIT $219
Capital spending -173
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital -23 Current Taxes -$71
Total $42
Cash Flow of Investors in the Firm OCF $238
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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U.S.C.C. Income Statement

Total operating revenues $2,262

The operations Cost of goods sold 1,655
section of the Selling, general, and administrative expenses 327
Depreciation 90
income
Operating income $190
statement Other income 29
reports the firm’s Earnings before interest and taxes $219
Interest expense 49
revenues and Pretax income $170
expenses from Taxes 84
principal Current: $71
Deferred: $13
operations. Net income $86
Addition to retained earnings $43
Dividends: $43
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U.S.C.C. Cash Flow from Operations

To calculate cash Operations

flow from Net Income $86
operations, start Depreciation 90
Deferred Taxes 13
with net income, Changes in Assets and Liabilities
add back non-cash Accounts Receivable -24
items like Inventories 11
Accounts Payable 16
depreciation and Accrued Expenses 18
adjust for changes Other -8
in current assets Total Cash Flow from Operations $202
and liabilities (other
than cash).

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Global Corporation’s Statement of 1- 60

Cash Flows for 2007 and 2006

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The Statement of Cash Flows

Operating Activity
 Use the following guidelines to adjust for changes
in working capital:
– Accounts receivable: adjust the cash flows by
deducting the increases in accounts receivable
– Accounts payable: add increases in accounts
payable

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The Statement of Cash Flows

Operating Activity (cont’d)
– Inventory: finally, deduct increases to
inventory.
– Increases to inventory are not recorded as an
expense and do not contribute to net income
– However, the cost of increasing inventory is a
cash expense for the firm and must be deducted.

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The Statement of Cash Flows

Investment Activity
– Subtract the actual capital expenditure that the
firm made.
– Similarly, also deduct other assets purchased or
investments made by the firm, such as
acquisitions.

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The Statement of Cash Flows

Financing Activity
– Dividends paid and the difference between a
firm’s net income and the amount it spends on
dividends:

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Payout Ratio and Retained Earnings

Retained Earnings:

Retained Earnings = Net Income–Dividends

Payout Ratio:
Dividends
Payout Ratio =
Net Income

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Other Financial Statement Information

Other pieces of information contained in the

financial statements:
– Management Discussion and Analysis
– Statement of Stockholders’ Equity
– Notes to the Financial Statements

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Financial Reporting in Practice

The Sarbanes-Oxley Act (SOX)
– In 2002, Congress passed the SOX, while SOX
contains many provisions,
– the overall intent of the legislation was to improve the
accuracy of information given to both boards and to
shareholders
 SOX attempted to achieve this goal in three ways:
– Overhauling incentives and independence in the
auditing process
– Stiffening penalties for providing false information
– Forcing companies to validate their internal financial
control processes.
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