Chapter 2 ACN reesi 3 4.4 Prerer DEMaARzO Introduction to Financial Statement Analysis CORPORATE FINANCEChapter Outline 2.1 Firms’ Disclosure of Financial Information 2.2 The Balance Sheet 2.3 Balance Sheet Analysis 2.4 The Income Statement 2.5 Income Statement Analysis 2.6 The Statement of Cash Flows 2.7 Other Financial Statement Information 2.8 Financial Reporting in Practice Copyright © 2011 Pearson Prentice Hal. I righis reserved.Learning Objectives 1. List the four major financial statements required by the SEC for publicly traded firms, define each of the four statements, and explain why each of these financial statements is valuable. 2. Discuss the difference between book value of stockholders’ equity and market value of stockholders’ equity; explain why the two numbers are almost never the same. 3. Compute the following measures, and describe their usefulness in assessing firm performance: the debt-equity ratio, the enterprise value, earnings per share, operating margin, net profit margin, accounts receivable days, accounts payable days, inventory days, interest coverage ratio, return on equity, return on assets, price- earnings ratio, and market-to-book ratio. 4. Discuss the uses of the DuPont identity in disaggregating ROE, and assess the impact of increases and decreases in the components of the identity on ROE. 2-3 Copyright © 2011 Pearson Prentice Hal. lights reserved.Learning Objectives * Describe the importance of ensuring that valuation ratios are consistent with one another in terms of the inclusion of debt in the numerator and the denominator. + Distinguish between cash flow, as reported on the statement of cash flows, and accrual-based income, as reported on the income statement; discuss the importance of cash flows to investors, relative to accrual-based income. + Explain what is included in the management discussion and analysis section of the financial statements that cannot be found elsewhere in the financial statements. + Explain the importance of the notes to the financial statements. + List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud. Copyright ©2011 Pearson Prentice Hal, Al ights reserved 2-42.1 Disclosure of Financial Information e Financial Statements — Firm-issued accounting reports with past performance information — Filed with the SEC * 10Q ~- Quarterly © 10K - Annual —- Must also send an annual report with financial statements to shareholders Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-52.1 Disclosure of Financial Information (cont'd) e Preparation of Financial Statements -— Generally Accepted Accounting Principles (GAAP) — Auditor ¢ Neutral third party that checks a firm’s financial statements Copyright ©2011 Pearson Prentice Hal, Al ights reserved 2-62.1 Disclosure of Financial Information (cont'd) ¢ Types of Financial Statements — Balance Sheet — Income Statement - Statement of Cash Flows - Statement of Stockholders’ Equity Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-72.2 Balance Sheet e A snapshot in time of the firm’s financial position ¢ The Balance Sheet Identity: Assets = Liabilities + Stockholders' Equity 2-82.2 Balance Sheet (cont'd) e Assets —- What the company owns ¢ Liabilities - What the company owes e Stockholder’s Equity - The difference between the value of the firm’s assets and liabilities Copyright © 2011 Pearson Prentice Hal. lights reserved.2.2 Balance Sheet (cont'd) e Assets — Current Assets: Cash or expected to be turned into cash in the next year * Cash ¢ Marketable Securities « Accounts Receivable « Inventories * Other Current Assets - Example: Pre-paid expenses Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-102.2 Balance Sheet (cont'd) e Assets — Long-Term Assets « Net Property, Plant, & Equipment - Book Value = Acquisition cost - Depreciation (and Accumulated Depreciation) ¢ Goodwill and intangible assets - Amortization * Other Long-Term Assets - Example: Investments in Long-term Securities Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-11Table 2.1 Global Conglomerate Corporation Balance Sheet for 2009 and 2008 GLOBAL CONGLOMERATE CORPORATION Consolidated Balance Sheet Year Encied December 31 (in $ millions) Assets Current Assets Cash Accounts receivable Inventories Other current assets Total current assets Long-Term Assets Land Buildings Equipment Less accumulated depreciation Net property, plant, and equipment Goodwill and intangible assets Other long-term assets Total long-terr Total Assets, Copyright © 2011 Pearson Prentice Hal. lights reserved. 2009 22 165 153 20 570 22.2 36.5 397 (18.7) 797 20.0 1207 1777 2008 195 13.2 143 10 48.0 20.7 30.5 332 (975) 66.9 200 148.9 2-122.2 Balance Sheet (cont'd) e Liabilities — Current Liabilities: Due to be paid within the next year * Accounts Payable « Short-Term Debt/Notes Payable ¢ Current Maturities of Long-Term Debt © Other Current Liabilities - Taxes Payable - Wages Payable Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-132.2 Balance Sheet (cont'd) e Net Working Capital — Current Assets — Current Liabilities Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-142.2 Balance Sheet (cont'd) ¢ Liabilities — Long-Term Liabilities « Long-Term Debt * Capital Leases « Deferred Taxes Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-15Table 2.1 (cont'd) Global Conglomerate Corporation Balance Sheet for 2009 and 2008 GLOBAL CONGLOMERATE CORPORATION Consolidated Balance Sheot Year Ended December 31 (in $ millions) and Stockholders’ Equity 20092008 Accounts payable 292 245 Notes payable/short-term debt 35 © 32 Current maturities of long-torm debt 133° 12.8 Other current liabilities 20 40 Total current liabilities 430 44.0 Long-Term Liabilities Long-term debt 999 763 Capital lease obligations = = Total debt 999 763 Deferred taxes 76 74 Other long-term liabilities = = Total long-term liabilities 1075 837 Total Liabilities 1555 127.7 Stockholders’ Equity 222 212 Total Liabilities and Stockholders’ Equity Wi7 1489 2-16 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.2 Balance Sheet (cont'd) e Equity — Book Value of Equity * Book Value of Assets - Book Value of Liabilities - Could possibly be negative - Market Value of Equity (Market Capitalization) e¢ Market Price per Share x Number of Shares Outstanding - Cannot be negative Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-17Textbook Example 2.1 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? How does the market capitalization compate to Global’s book value of equity? Copyright © 2011 Pearson Prentice Hal. I righis reserved.Textbook Example 2.1 (cont'd) Solution Global’s market capitalization is (3.6 million shares) x ($14/share) = $50.4 million. This market capitalization is significantly higher than Global's book value of equity of $22.2 million, Thus, investors are willing to pay 50.4/22.2 = 2.27 times the amount Global's shares are “worth” according to their book value. Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-19Alternative Example 2.1 e Problem — Rylan Enterprises has 5 million shares outstanding. - The market price per share is $22. - The firm’s book value of equity is $50 million. - What is Rylan’s market capitalization? — How does the market capitalization compare to Rylan’s book value of equity? Copyright © 2011 Pearson Prentice Hall. lights reserved. 2-20Alternative Example 2.1 ¢ Solution — Rylan’s market capitalization is $110 million e 5 million shares x $22 share = $110 million. « The market capitalization is significantly higher than Rylan’s book value of equity of $50 million. Copyright © 2011 Pearson Prentice Hall. lights reserved. 2-212.3 Balance Sheet Analysis - Liquidation Value * Value of the firm if all assets were sold and liabilities paid - Market-to-Book Ratio Market Value of Equity Book Value of Equity Market-to-Book Ratio = * Value Stocks - Low M/B ratios * Growth stocks - High M/B ratios Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-222.3 Balance Sheet Analysis (cont'd) ¢ Debt-Equity Ratio -— Measures a firm's leverage Debt-Equity Ratio = Hotel: Debt Total Equity - Using Book Value versus Market Value e Enterprise Value Enterprise Value = Market Value of Equity + Debt — Cash 2-23 Copyright © 2011 Pearson Prentice Hal. lights reserved.Textbook Example 2.2 Problem In January 2009, H. J. Heinz Co, (HINZ) had a share price of $36.95, 314.44 million shares outstanding, a market-to-book ratio of 7.99, a book debt-equity ratio of 3.70, and cash of $0.93 billion. What was Heinz’s market capitalization? What was its enterprise value? Copyright © 2011 Pearson Prentice Hal. I righis reserved.Textbook Example 2.2 (cont'd) Solution Heinz had a market capitalization of $36.95 x 314.44 million shares = $11.62 billion. We divide the market value of equity by Heinz’s market-to-book ratio to calculate Heinz’s book value of equity as 11.62/7.99 = $1.45 billion. Given a book debt-equity ratio of 3.70, Heinz had total debt of 3.70 1.45 = $5.37 billion. Thus, Heinz’s enterprise value was 11.62 + 5.37 — 0.93 = $16.06 billion. Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-25Alternative Example 2.2 e Problem - In January 2009, Rylan Corporation (from Alternative Example 2.1) had a market capitalization of 110 million, a market-to-book ratio of 2.2, a book debt to equity ratio of 1.4, and cash of $6.3 million. What was Rylan’s enterprise value? Copyright © 2011 Pearson Prentice Hall. lights reserved. 2-26Alternative Example 2.2 ¢ Solution - As stated in Alternative Example 2.1, Rylan’s book value of equity was $50 million. Given a book debt-equity ratio of 1.4, Rylan had total debt of 1.4 X 50 = 70 million. Thus, Rylan’s enterprise value was 110+70 - 6.3 = $173.7 million. 2-27 Copyright © 2011 Pearson Prentice Hall. lights reserved.2.3 Balance Sheet Analysis (cont'd) e Other Balance Sheet Information — Current Ratio ¢ Current Assets / Current Liabilities — Quick Ratio « (Current Assets - Inventories) / Current Liabilities Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-282.4 Income Statement e Total Sales/Revenues — minus ¢ Cost of Sales - equals © Gross Profit 2-29 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.4 Income Statement (cont'd) © Gross Profit — minus ¢ Operating Expenses ¢ Selling, General, and Administrative Expenses «R&D * Depreciation & Amortization —- equals ¢ Operating Income 2-30 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.4 Income Statement (cont'd) ¢ Operating Income — plus/minus e Other Income/Other Expenses - equals e Earnings Before Interest and Taxes (EBIT) 2-31 Copyright © 2011 Pe.2.4 Income Statement (cont'd) Earnings Before Interest and Taxes (EBIT) — plus/minus Interest Income/Interest Expense - equals Pre-Tax Income 2-322.4 Income Statement (cont'd) e Pre-Tax Income — minus e Taxes - equals « Net Income 2-33 Copyright © 2011 Pearson Prentice Hal. lights reserved.Table 2.2 Global Conglomerate Corporation Income Statement Sheet for 2009 and 2008 GLOBAL CONGLOMERATE CORPORATION Income Statement Year Ended December 31 (in $ millions) 2009 2008 Total sales 1867 176.1 Cost of sales (153.4) (147.3) Gross Profit 333 288 Selling, general, and administrative expenses (13.5) (13.0) Research and development (8.2) (7.6) Depreciation and amortization (1.2) ay Operating Income 10.4 7A Other income - - Eamings before interest and taxes (EBIT) 10.4 7A Interest income (expense) (7.7) (4.6) Pretax income 27 25 Taxes (0.7) (0.6) Net Income 2.0 19 Earnings per share: $0.556 $0.528 Diluted earnings per share: $0.526 '$0.500 Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-342.4 Income Statement (cont'd) e Earnings per Share EPS = Net Income _ $2.0 million = $0.556 per share Shares Outstanding 3.6 million shares Stock Options Convertible Bonds Dilution - Diluted EPS 2-35 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.5 Income Statement Analysis - Profitability Ratios ¢ Gross Margin GrossMargin = S08sProfit Sales * Operating Margin Operating Income Operating Margin = Sales ¢ Net Profit Margin Net Profit Margin = Net Income Total Sales Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-362.5 Income Statement Analysis (cont'd) e Working Capital Days — Accounts Receivable Days Accounts Receivable Accounts Receivable Days = ——————_—__—_ Average Daily Sales e EBITDA — Reflects the cash a firm has earned from its operations 2-37 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.5 Income Statement Analysis (cont'd) e Leverage Ratios/Interest Coverage Ratios — EBIT / Interest Expense - Operating Income / Interest Expense — EBITDA / Interest Expense 2-38 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.5 Income Statement Analysis (cont'd) e Investment Returns - ROA Net Income Return on Assets = ————_ Total Assets - ROE Net Income Return on Equity = ——~" SCOr’e _ Book Value of Equity 2-39 Copyright © 2011 Pearson Prentice Hal. lights reserved.2.5 Income Statement Analysis (cont'd) e The DuPont Identity Net Income Sales Total Assets ROE = bx bs - Sales Total Assets Book Valueof Equity J { ' TY i Net Profit Margin Asset Turnover Equity Multiplier U J Y Return On Assets. 2-40 Copyright © 2011 Pearson Prentice Hal. lights reserved.Textbook Example 2.3 Problem For the year ended November 2008, Wal-Mart Stores had sales of $403.9 billion, net income of $13.7 billion, assets of $167.8 billion, and a book value of equity of $65.5 billion, For the same period, Target (TGT) had sales of $65.3 billion, net income of $2.6 billion, total assets of $47.0 billion, and a book value of equity of $13.6 billion. Compare these firms’ profitability, asset turnover, equity multipliers, and recurn on equity during this period. If Target had been able to match Wal-Mart's asset turnover in 2008, what would its ROE have been? Copyright © 2011 Pearson Prentice Hal. I righis reserved.Textbook Example 2.3 (cont’d) Solution Wal-Mart’s net profit margin was 13.7/403.9 = 3.39%, which was below Target's net profic margin of 2.6/65.3 = 3.98%. On the other hand, Wal-Mart used its assets more efficiently, with an asset turnover of 403.9/167.8 = 2.41, compared to only 65.3/47.0 = 1.39 for Target. Finally, Target had greater leverage (in terms of book value), with an equity multiplier of 47.0/13.6 = 3.46, relative to Wal-Mart's equity multiplier of 167.8/65.5 = 2.56. Next, let’s compute the ROE of each firm directly, and using the DuPont Identity: Wal-Mart ROE = aoe 20.91% = 3.39% x 2.41%2.56 Target ROE= 19.1% = 3.98% x 1.39 x 3.46 13.6 Note that duc to its lower asset turnover, Target had a lower ROE than Wal-Mart despite its higher net profit margin and leverage. If Target had been able to match Wal-Mart’ asser turnover, its ROE would have been 3.98% x 2.41 x 3.46 = 33.2%. Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-422.5 Income Statement Analysis (cont'd) - Valuation Ratios « P/E Ratio Market Capitalization Share Price P/E Ratio = — _ Net Income Earnings per Share * Enterprise Value to Operating Income Market valueof Equity + Debt — Cash Enterprise Value to EBIT = EBIT « Enterprise Value to Sales Market valueof Equity + Debt — Cash Enterprise Value toSales = Sales Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-43Textbook Example 2.4 Problem Consider the following data for the year ended November 2008 for Wal-Mart Stores and Target Corporation ($ billions): Wal-Mart Stores (WMT) Target Corporation (TGT) Sales 403.9 65.3 Operating Income 23.3 5.1 Net Income 137 26 Market Capitalization 218.9 26.3 Cash 59 0.9 Debt 474 20.3 Compare Wal-Mart and Target's operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales. Copyright © 2011 Pearson Prentice Hal. I righis reserved.Textbook Example 2.4 (cont'd) Solution ‘Wal-Mart had an operating margin of 23.3/403.9 = 5.8%, a net profit margin of 13.7/403.9 = 3.4%, and a P/E ratio of 218.9/13.7 = 16.0. Its enterprise value was 218.9 + 47.1 — 5.9 = $260.1 billion, which has a ratio of 260.1/23. 1.2 to operating income and 260.1/403.9 = 0.64 to sales, Target had an operating margin of 5.1/65.3 = 7.8%, a net profit margin of 2.6/65.3 = 3.98%, and a P/E ratio of 26.3/2.6 = 10.1. Its enterprise value was 26.3 + 20.3 — 0.9 = $45.7 billion, which has a ratio of 45,7/5.1 .0 to operating income and 45.7/65.3 = 0.70 to sales. Note that despite their large difference in size, Target and Wal-Mart's enterprise value to oper- ating income and enterprise value to sales ratios were rather similar. Their P/E multiples differed, however, due to the differences in the firms’ leverage. Copyright © 2011 Pearson Prentice Hal. lights reserved. 2-45