The balance sheet equation: Assets = Liabilities + Shareholders’ Equity.

Depreciation is not an actual cash expense.

Book value(or carrying amount) of an asset is equal to its acquisition cost less accumulated
depreciation.

intangible assets: brand names and trademarks, patents, customer relationships and
employees.

Goodwill: When a firm acquires another company, the difference between the price paid for
the company and the book value assigned to its intangible assets is recorded separately as
Goodwill.

Amortization (or impairment charge): If the firm assesses that the value of these intangible
assets declined over time, it will reduce the amount listed on the balance sheet by an
amortization (or impairment charge) that captures the change in value of the acquired
assets. Like depreciation, amortization is not an actual cash outflow.

Net working capital: The difference between current assets and current liabilities, the
capital available in the short term to run the business (=current assets – current liabilities).

book value of equity: The difference between the firm’s assets and liabilities is the
shareholders’ equity. Many of the assets listed on the balance sheet are valued based on
their historical cost rather than their true value today. The true value today of an asset may
be very different from its book value. Also many of the firm’s valuable assets are not
captured on the balance sheet.

The total market value of a firm’s equity equals the market price per share x the number of
shares, referred to as the company’s market capitalization. It depends on what investors
expect those assets to produce in the future.

Market Capitalization = #shares * price per share

Market Value Added (MVA) = Market Value of Equity – Book Value of Equity

Cf. Growth Option = MV – Assets-in-place – Value Stocks vs. Growth Stocks

Balance Sheet Analysis

The book value of a firm’s equity is not a good estimate of the liquidation value of the firm
(sell assets – pay off debts = liquidation value). We could better use the market value
(market capitalization) to determine it.

Market-to-book ratio (also called the price-to-book or P/B ratio), which is the ratio of a
firm’s market capitalization to the book value of shareholders’ equity.
Market-to-Book Ratio = Market value of equity / Book value of equity
This ratio is one way a company’s share price provides feedback to its managers on the
market’s assessment of their decisions. Analysts often classify firms with low market-to-
book ratios as value stocks, and those with high market-to-book ratios as growth stocks.

Low High
Market-to-Book Value stocks Growth stocks
Book-to-market Growth stocks Value stocks

Debt-Equity Ratio = Total debt / total equity

We can calculate this ratio using either book or market values for equity and debt. Market
debt-equity ratio has important conseqences for the risk and return of its shares.(h12)

Enterprise value = Market value of equity(=market capitalization) + debt - cash

The enterprise value can be interpreted as the cost to take over the business.

Current ratio = current assets / current liabilities

Quick ratio = (Current assets – inventory) / current liabilities

Creditors often compare a firm’s current assets and current liabilities to assess whether the
firm has sufficient working capital to meet its short-term needs. This can be done with the
current or quick ratio. A higher current or quick ratio implies less risk of the firm
experiencing a cash shortfall in the near future.
The Income Statement

Depreciation and amortization, expenses on the income statement, are not actual cash
expenses but they represent an estimate of the costs that arise from wear and tear to
obsolescence of the firm’s assets.

EPS = Earnings per share = Net Income / Shares outstanding

If the stock options are “exercised” the company issues new shares and the number of
shares outstanding will grow. The number of shares may also grow if the firm issues
convertible bonds, a form of debt that can be converted to shares. Because there will be
more shares in total to divide into the same earnings, this growth in the number of shares is
referred to as dilution. Firms disclose the potential for dilution by reporting diluted EPS,
which represents earnings per share for the company calculated as though share options
had been exercised or convertible debt had been converted.

Gross margin = Gross Profit / Sales

A firm’s gross margin reflects its ability to sell a product for more than the cost of producing
it.
Operating margin = Operating profit / sales
EBIT margin = EBIT / Sales.
Net profit margin = Net income / total sales
The net profit margin shows the fraction of each dollar in sales that is available to equity
holders after the firm pays its expenses plus interest and taxes.

Working capital ratios: shows us how efficiently the firm is managing its net working capital:
-Accounts receivable days = accounts receivable / average DAILY sales(=sales/365)
This ratio shows how many days it takes to collect payment from customers.
-Accounts payable days = accounts payable / average DAILY purchases

-Inventory days = inventory / average DAILY Cost of Goods Sold

Analysts and financial managers often evaluate the firm’s return on investment by
comparing its income to its investment using ratios such as the firm’s return on equity.
Return on Equity (ROE) = Net income / Book value of equity
A high ROE may indicate the firm is able to find investment opportunities that are very
profitable. Another common measure is return on assets (ROA), which is:

Return on Assets = Net income / total assets

The DuPont Identity= (Net Income/Sales) x (Sales/Total Assets) x (Total Assets/ Total Equity)

=ROE = Net profit margin x Asset Turnover x Equity Multiplier

= Return on Assets x Equity Multiplier

Equity multiplier = indicates the value of assets held per euro or dollar of shareholders
equity. The equity multiplier will be greater the firm’s reliance on debt financing.
Analysts and investors use a number of ratios to gauge the market value of the firm. The
most common is the firm’s price-earnings ratio (P/E)

P/E ratio = Market Capitalization/ Net income = Share price / Earnings per share
= P x N / Net income = P / EPS

The P/E ratio is a simple measure that is used to assess whether a share is over- or under-
valued based on the idea that the value of a share should be proportional to the level of
earnings it can generate for its shareholders. It tend to be higher for industries with higher
expected growth rates. The P/E ratio is not meaningful when the firm’s earnings are
negative. In this case, it is common to look at the firm’s enterprise value relative to sales.

Retained Earnings = Net income – Dividends

The statement of cash flows

There are two reasons that net income does not correspond to cash earned. First, there
are non-cash entries on the income statement, such as depreciation and amortization.
Second, certain uses of cash, such as the purchase of a building or expenditures on
inventory, are not reported on the income statement.

The statement of cash flows is divided into three sections: operating activities, investment
activities and financing activities. The first section, operating activity, starts with net income
from the income statement. It then adjusts this number by adding back all non-cash entries
related to the firm’s operating activities. The next section, investment activity, lists the cash
used for investment. The third section, financing activity, shows the flow of cash between
the firm and its investors.

Operating activity
1. Depreciation is not an actual cash outflow. Thus, we add it back to the net income when
determining the amount of cash the firm has generated.
2. Next, we adjust for changes to net working capital (=current assets – current liabilities)
that arises from changes to accounts receivable, accounts payable or inventory. Deduct
increases in NWC.
1. Accounts receivable: asset -> deduct
2. Accounts Payable: liability -> add
3. Inventory: asset -> deduct

Investment activity
Purchases of new property, plant and equipment are referred to as capital expenditures.
They do not appear immediately as expenses on the income statement. We subtract the
actual capital expenditure that the firm made.

Financing activity
Dividends paid to shareholders are a cash outflow. Also listed under financing activity is any
cash the company received from the sale of its own shares, or cash spent buying
(repurchasing) its own shares. The last items to include in this section result from changes to
short-term and long-term borrowing.

When evaluating a project, the project is assumed to be financed by 100% equity.

- For unlevered firms: Tax = Ebit * tax rate
where EBIT = Rev – Cost – Depreciation
then,
Unlevered net incomes (or net profit, after – tax profit)
= EBIT – Tax
= EBIT * (1-t)
= (Rev – Cost – Depre) * (1-t)
= Rev – Cost – Depre - Tax

Depreciation (Depre) is a non-cash expense and thus, should be adjusted in FCF calculation.
Capital expenditures (CapEx) are actual cash outflows when an asset is purchased and thus,
should be included in FCF calculation.

Most project will require an investment in net working capital (NWC).

- For example, trade credit is the difference between receivables and payables.
NWC = Current Assets - Current Liabilities
= Cash + Inventory + Receivables – Payables

FCF = Cash available for distribution to investors, both equity holders and debt holders, after
firm pays for new investments or additions to working capital
FCF = Unlevered net income + Depre – CapEx - NWC∆

Recall,
Unlevered net incomes = EBIT * (1-t) = (Rev – Cost – Depre) * (1-t)

Measuring Profitability

 When accountants draw up income statement, they start with revenues and then
deduct operating and other costs to compute accounting profits.

 However, a business that breaks even in terms of accounting profits sometimes

makes a loss; it is failing to cover the (opportunity) cost of capital.

 Hence, to see whether the firm has truly created value, we need to measure
whether it has earned a profit after deducting all costs, including the cost of its
capital.

Economic Value Added (EVA)

 For 100% equity firm, Net income – (cost of equity * equity)

 EVA is a better measure of a company’s performance than is accounting income.
Accounting income is calculated after deducting all costs except the cost of capital. By
contrast, EVA recognizes that companies need to cover their opportunity costs before
they add value.
Economic Profit
The term EVA was coined by the consulting firm, Stern Stewart & Co.

Other consulting firms have their own versions of residual income. For example, McKinsey &
Co. uses economic profit (EP).
- EP = Residual income
= (ROI – cost of capital) * capital invested

Measuring Profitability
• Return on Equity (ROE):
net income
ROE =
equity
• Return on Assets (ROA)
net income +interst (1−tax)
ROA =
aseets
• Retuen on (long-term) Capital (ROC):
net income +interest ( 1−tax )
ROC =
¿ debt +equity
• The profit margin measures the proportion of sales that finds its way into profit
gross profit
Gross profit margin =
sales
net income +interest (1−tax)
Operating profit margin =
sales
net income
Net profit margin =
sales

Measuring Efficiency
The DuPont System
A company’s success depends not only on the efficiency with which it uses its asset to
generate sales (“asset turnover”) but also on how profitable those sales are
(“operating profit margin”).

Measuring
Liquidity

Sustainable Growth
Taxes

 Taxes have a major impact on financial decisions

 Marginal Tax Rate is the tax that the individual pays on each extra dollar of income.

 Average Tax Rate (=Effective Tax Rate) is the total tax bill divided by taxable income.

After-tax interest rate

• Taxes reduce the amount of interest an inve stor can keep, and we refer to this reduced
amount as the after-tax interest rate.

• If t=tax rate,
R – (r x t) = r(1-t)