Working with Financial Statements

• A firm’s financial statements contain a wealth of important information which can

inform the astute analyst regarding its overall health, how well operational or
strategic adjustments are impacting returns, and provides an opportunity to
benchmark performance to other similar entities.
• Although the IFRS standard provides for 5 separate statements, here we are focused on the two
we rely upon the most: the income statement and balance sheet.
• All accounting standards attempt to capture much of the same information so learning how ideas
are represented, rather than memorizing definitions, is what leads to mastery in this area.

• To reinforce the basics and prepare you to estimate the financial implications of decisions
for firms facing complex situations, we will review some of analytical tools which can be
derived from them, and consider how to construct forecast financial statements in a way that
helps us approximate the firm’s funding needs (or capacity to pay out to investors).
A Very Basic Business

• Imagine a lemonade stand selling 20 glasses of juice for $0.25 each

• Direct juice costs are $0.10 a glass and there is “overhead” of $1.00 for their signage. It pays
no wages to the owner, just profit (also no taxes).

• Profit for a period is calculated by subtracting total costs from total revenues.
• For the day, profit is: [(20 x $0.25) – (20 x $0.10) - $1.00 = $2.00]
• Alternately: [20 x ($0.25 - $0.10) - $1.00 = $2.00]

• What happens if relevant inflows or outflows occur outside the period?

• In terms of daily profits, if signage was created the day before sales are made, the enterprise
will appear to lose money on day 1 but make money on day 2.
• Putting those two days together however shows the firm as profitable.
The Matching Principle

• To get around this timing issue (which complicates management), accountants

developed a practice which matches revenues to their relevant costs.
• If a sale is booked in some period its costs are “matched” to it, even if they were incurred
before the sale and after the actual cash was received.

• This allows us to consider what the incremental flows (profits) would be if all the
transactions had happened at the same time.
• In this way, we can analyze the profitability of an activity cycle rather than an arbitrary period

• This means that the profits for a given period may not actually line up with cash
flowing into or out of the business.
• While accounting profits are a useful consideration in planning, they fail to capture some
potentially important information, like timing. (more on this later)
Financial Statements: Income Statement
Income Statement for ABC Corp.
for the year ended Dec 31, 2023
• The I/S reports revenue earned over
some period, as well as the expenses Revenues $ 6,700,000
incurred to earn that income. Cost of Goods Sold $ 4,020,000
Gross Profit $ 2,680,000
• Cost are organized from the most to Selling and Administrative expenses $ 1,500,000
Earnings before Interest and Taxes (EBIT) $ 1,180,000
least attributable. Interest Expense $ 450,000
• The “margin” earned after various kinds Earnings before tax (EBT) $ 730,000
of costs are removed can be informative Income Taxes (32%) $ 233,600
for benchmarking
Net Income $ 496,400
• Gross margin is the % flow through
after “direct costs” Dividends $ 100,000
• EBIT margin after operational costs Retained Earnings $ 396,400
• Profit margin after all costs (NI/Rev)
Balancing Assets and Financing

• Its one thing to know that a firm or project is profitable but an important
consideration is the amount of money tied up to make those profits.
• What assets are needed to support the enterprise and how were they financed?
• Assets can be financed with the firm’s money (equity) or another’s (debt)

• A balance sheet shows both of these things:

• One side lists assets, the other lists liabilities and owners equity.
• Top to bottom items are listed from most liquid, to least liquid

• Unlike an income statement (which covers a period of time), a balance sheet is a

financial ‘snapshot’ at one point in time which may or may not be representative of
average (or current) conditions.
Financial Statements: Balance Sheet

• Just like operational leverage, financial leverage increases the range of outcomes
for equity investors. Debt amplifies the return on equity (ROE), for good or bad.
Balance Sheet for DEF Corp
as at Dec 31, 2023

ASSETS FINANCING (Liabs & SH’s Equity)

Cash 5 Accrued wages and taxes 5
Marketable Securities 10 Accounts payable 5
Accounts Receivable 10 Long-term debt 20
Inventory 25 Paid-in capital 40
Net Fixed Assets 100 Retained earnings 80
TOTAL 150 150
Analysing Financials

• Now that you know how they are built, let’s talk about what they can tell us
• Historical analysis: benchmarking levels and stability
• Analysing forecasts: sources of cash flow variation

• What metrics should we care about?

• Prices: P/E, P/BV, EV/S, EV/EBITDA, EV/CFFA
• Returns and leverage: ROA, ROE, D/E
• Liquidity: current and quick ratios, TIE, cash coverage
• Working Capital Analysis: cash conversion cycle

• On their own, most ratios won’t “tell you” anything - you need to benchmark and
then try to understand what motivates changes or differences.
Benchmarking to Comparable Firms

• Select 6-10 comparable firms to calculate a composite based on the types of assets
they use to generate the key metric.
• Seek out comparable firms first by industry, then geography, then size. The objective is to select
firms expected to use similar assets and thus face similar business risk (K eU).

• When comparing to an industry group, recall that industries can have skewed prices
during bubbles or crashes (all tech stocks had high prices in 1999)
• Be mindful of accounting differences when benchmarking to a specific competitor or across
borders (revenue recognition, inventory valuation, pension and benefit liabilities)
• Benchmarking against industry groups removes a lot of “unique” firm risks.

• Be careful about being too specific as it can lead to a small sample which can be
dominated by outliers or common problems.
• Pre-2008 crisis GM, Ford & Chrysler all benchmarked their results to one another…
Benchmarking with Accounting Ratios

• Over the past 5-10 years, a company will have displayed a range of values
according to different price ratios, as will its family of comparable firms.

• Comparing the current value of a firm to its own history informs us about the
relative valuation of the business

• Comparing to an industry mean or median provides us with relative measures of

effectiveness and risk.
• They lead us to identify “cheapest of a group” but that isn’t necessarily “cheap” on
an absolute or historical basis.
• A company trading at a P/E of 40 that has been at 50 for the last 2 years while its
industry averages 60, is NOT undervalued
Prices and Enterprise Values

• Price ratios generally use “per share” metrics but whole-company measures
provide the same values (X/50) / (Y/50) = (X/Y).
• Price/Earnings: Earnings can be re-stated and are subject to accrual manipulation.
Affected by the Rf rate.
• Price/Book Value: A good metric for industrial firms with machines and inventory but a
poor metric for services, tech, or firms with intangible assets.

• Ratios based on stock prices are affected by differences in capital structure more
than those based on enterprise value so EV ratios are favoured by some analysts.
• Enterprise Value/Sales: Good for industry comparison.
• Enterprise Value/EBITDA: Like P/E but less affected by leverage.
• Enterprise Value/CFFA: (cash flow from assets, aka free cash flow). Focuses on cash
rather than earnings.
Returns and Leverage

• Combining data from the I/S and B/S, we can calculate the rates of return:
• On assets (ROA = net income / assets), and on equity (ROE = net income / shareholder’s equity).

• By expanding the ROE formula, we can see how astute managers can increase the returns
earned by shareholders:
• ROE = net income / equity
• ROE = (net income / sales) * (sales / assets) * (assets / equity) = [ROA * (assets / equity)]
• ROE = (profit margin) * (asset turnover) * (equity multiplier)
• Asset turnover measures how effectively assets are used to generate sales.

• A common measure of a firm’s financial leverage is its debt/equity ratio (D/E).

• This is different from the “equity multiplier” in the Dupont equation above, but related.
• A = D + E; therefore A/E = (D+E)/E = D/E + 1
• There are no hard rules for what constitutes too much leverage but it IS important to remember that a
leveraged investment that goes bad can lead to bankruptcy.
Liquidity

• Current and Quick ratios: Prudence suggests these be higher than their industry
averages but very high numbers may indicate an excess amount of idle cash.
• The quick ratio drops inventory from the current ratio. Best used when inventories can’t be
sold off for full price in a hurry.
• A current ratio of 1 or more is held to indicate safety (liquidity) but firms with superior working
capital management will have lower ratios relative to those carrying excess inventories.

• Times-Interest-Earned: (EBIT/I). High values indicate safety but also a lost

opportunity to capture tax shields.

• Cash coverage: [(EBIT+Depr)/I]. Firms with high depreciation expenses will

show poorly on TIE but have good cash coverage. Safety thresholds vary by
industry but cash coverage benchmarks are higher than TIE ones.
Working Capital

• Although there are several working capital ratios, the most powerful is a
composite diagnostic however, the Cash Conversion Cycle.
• It estimates the average time between when a firm pays its bills and when it gets paid.
• The shorter it is (negative even!), the faster a firm turns over its working capital and the more
rapidly it can grow without recourse to outside funding.

Cash Conversion Cycle = avg. age of Inv. + avg. age of A/R – avg. age of A/P

• Be careful and don’t blindly optimize around this number!

• Minimizing working capital investments can be counter-productive where A/R and
inventory policies are part of a firm’s strategy but having a faster CCC is usually a good
indicator of efficiency.
Forecasting Financials

• Our second block today considers how to estimate what financial statements might
look like going forward based on assumptions about revenue growth, cost structure,
financing needs, etc
• This is an important aspect of financial management as it allows us to project what our financing
needs or what excess flows might be available to investors
• They also enable us to forecast financial ratios, approximate the impact of shifts in strategy or
operations, and make estimates of the economic value of the firm.

• These forecasts are only as good as their inputs and it is important to recognize the
limits of our ability to predict future tax rates, expenses, sales growth, and other
important inputs. Garbage in, garbage out.
Forecasting Income Statements

• The first step requires a sales forecast up until the horizon.

• This can come from industry estimates of market size and firm estimates of market share.
• Be careful when relying on managerial estimates that may be more aspirational than realistic

• Variable costs (direct materials and labour) per unit may change as the firm grows
but mature firms tend to have stable gross margins (costs grow as a % to sales).
• You may wish to average this over a few recent years if the most recent is not representative.

• Fixed costs depend on the need for overhead and usually looks like a staircase.
• If there is slack capacity in the system a firm may increase sales without adding fixed assets.
• A best practice in long-term forecasting is to average capex over the asset life cycle but is not
be appropriate for start-ups which are building their asset base.
Pro-Forma Income Statement

Year 1 Year 2 Year 3

(40% of sales)
(assumed not to change)
(gross profit less fixed costs)

(of EBT = EBIT less interest)

Improving the I/S Forecast

• The proceeding example was very simplified in that we assumed sales could
increase without an increase in overhead (or debt, same interest expense).
• While that may be possible in some cases, the expansion of sales often requires an expansion
in fixed assets which necessitates capex but also increases depreciation expenses.
• We consider this in the next example.

• Depreciation expenses in Canada are dealt with through the Capital Cost
Allowance (CCA) system which allows firms to write of a % of the remaining
value of assets. Its complicated (call accounting for details).
• Conversely, “straight line” depreciation, which writes of a % of price annually, may be used
internally but it does not reflect the actual cash flows resulting from taxation (CCA rules).
Forecasting the Balance Sheet

• Depending on the nature of the output, projects (or firms) which expand over time
need to maintain sufficient assets to sustain additional sales.
• As a result, a rapid expansion of sales can sometimes lead to a firm’s need for new assets
outstripping its available cash resources.
• This may involve the purchase of long-lived assets (plant, property, equipment) from time to
time but rising sales tends to require the expansion of “current” assets (cash, inventory,
receivables, etc) on a more granular scale.

• The technique shown here constructs the balance sheet in three steps:
1. A basic % of sales forecast (will not balance)
2. Tweaking the assumptions of the model (will not balance)
3. Meeting needs or disbursing funds via policy variables (balances)
The Balance Sheet (baseline)

Spontaneous
If sales rise, assets The historical balance sheet. liabilities also
used to produce likely to grow
sales must grow. as a % of sales

Cash 5 Accruals 5
Securities 10 Payables 5
Receivables 10 Short-term debt 20 Policy
Inventory 25
Current assets 50 Long-term debt 40 variables
Net fixed assets 100 Common equity 80 requiring
decision.
Total assets 150 Total Liabilities 150
Forecasting a Balance Sheet (first pass)

• Start by setting assets and non-financial liabilities as a % of sales and extrapolate

• THIS WILL NOT BALANCE but shows the required funds necessary for it to do so.
Second-Pass Balance Sheet – External Funds Required

• Our first improvement is to account for the increase in equity from retained
earnings (the portion of net income not paid as dividends).

• Another is to recognize that cash and securities balances do not have to rise as a
fraction of sales (marketable securities can be sold off too).
• Marketable securities are where “excess” cash is usually parked as they earn some return while
the purchasing power of cash degrades with inflation.
• Similarly, accruals and pre-paid expenses usually vary throughout the year but should not
necessarily rise as a % of sales.
• I kept cash and accruals flat and liquidated marketable securities in year 1.

• Once again, the forecast will NOT balance as is and instead it shows what is need
for balance (in this case, more external funds).
Pro Forma Balance Sheet (second pass)

• Assuming cash remains %

Year 1 Year 2 Year 3

constant, we liquidate Sales 120 100.0% 132 145 160

marketable securities and we Cash 5 4.2% 5.00 5.00 5.00

include retained earnings from Securities 10 8.3% 0.00 0.00 0.00
Receivables 10 8.3% 11.00 12.08 13.33
each year, the forecast Inventory 25 20.8% 27.50 30.21 33.33
required funds changes Net fixed assets 100 83.3% 110.00 121.00 133.10
Total assets 150 125.0% 153.50 168.29 184.77
dramatically.
Accruals 5 4.2% 5.00 5.00 5.00
Payables 5 4.2% 5.50 6.04 6.67
• The firm is still projected to Short-term debt 20 16.7% 20.00 20.00 20.00
need external funds but not Long-term debt
Equity
40
80
33.3%
66.7%
40.00
85.50
40.00
93.50
40.00
104.50
until year 2 and the estimated Total liabilities and equity 150 125.0% 156.00 164.54 176.17
amount is substantially External Funds Required -2.50 3.75 8.60

reduced.
Final Pass Balance Sheet

• Based on our forecast of external funds required, the next step is to consider where
that money will come from (or where it will go).
• We can either reduce assets or increase funding (or grow slower?)
• If external funds required is negative, it implies you have extra resources available which you
can use to increase assets, or return funding to source (dividends or debt repayment).

• In practice, positive external funds required is usually met by increasing debt and
negative funds required means a build up of cash.
• A savvy manager will seek to raise funds from the lowest cost source while deploying excess
funds to debt repayment, stock repurchases, or increased dividends (if it looks sustainable).
• Increasing the use of debt will affect the interest expense of future years.
 Cash Flow Statement for XYZ Corp
for the year ended Dec 31, 2023

Linked Statements Cash flow from Operations

Net Income 4500
Depreciation (+) 175
increase in A/R (-) -750
increase in prepaids (-) -42
• A good way to ensure your model works is to increase in Inv (-) -600
construct a cash flow statement. increase in accruals (+)
increase in A/P (+)
25
1200
• Its not required (CFSs can be built from I/S and B/S TOTAL 4508
data) but can sometimes be helpful.
Cash flow from Financing
increase in short-term debt (+) 100
increase in long-term debt (+) -300
• All three statements should flow into each repurchase of shares (-) -200
sale of new shares (+) 0
other if properly prepared. dividends paid (-) -500
• Net income (I/S) feeds into the operating cash TOTAL -900
(CFS) Cash flow from Investing
• Changes in asset and liability accounts (B/S) feed new capital expenditures (-) -2200
into cash flows (CFS) proceeds from sale of LT assets (+) 85
TOTAL -2115
• The net change in cash (CFS) should be the
difference between cash at the time the B/S is TOTAL CHANGE IN CASH 1493
prepared (t=1) and the last time it was (t=0) so as to
reconcile it with reality.