Chapter 3 Interpreting Financial Statements Objective 1 Copyright

Chapter 3 Contents • 3. 1 Functions of Financial Statements • 3. 6 Analysis Using Financial Ratios • 3. 2 International Differences in Accounting • 3. 7 The Financial Planning Process • 3. 3 Market values v. Book Values • 3. 8 Constructing a Financial Planning Model • 3. 4 Accounting v. Economic Measures of Income • 3. 9 Growth & the Need for External Financing • 3. 5 Return on Shareholders v. Return on Equity • 3. 10 Working Capital Mgmt. • 3. 11 Liquidity & Cash Mgmt. 2

Financial Statements Review – Financial Statements Provide: • current and historical information to owners and creditors • a convenient way for owners and creditors to set performance targets • convenient standard templates for financial planning 3

3. 1 Functions of Financial Statements • Financial Statements: – Provide information to the owners & creditors of a firm about the current status and past performance – Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm – Provide a convenient templates for financial planning 4

3. 2 Review of Financial Statements – Balance Sheets – Income Statements – Cash-Flow Statements 5

The Balance Sheet • Summarizes a firms assets, liabilities, and owner’s equity at a moment in time • Amounts measured at historical values and historical exchange rates • Prepared according to GAAP, Generally Accepted Accounting Principles – GAAP modified occasionally by the Financial Accounting Standards Board • Exchange-listed companies must comply with Securities and Exchange Commission (SEC) rules 6

The Balance Sheet • Major Divisions: – Assets • Current assets (less than a year) • Long-term assets (longer than a year – Depreciation – Liabilities and Stockholder’s Equity • Liabilities – Current Liabilities – Long-term debt • Equity 7

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The Income Statement • Summarizes the profitability of a company during a time period • Major Divisions: – Revenue & cost of goods sold » Gross margin – General administrative and selling expenses (GS&A) » Operating income – Debt service » Taxable income – Corporate Taxes » Net income 9

The Income Statement • Important Reminders: – Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity – Accounts show historical values, not market values • The shareholder’s equity may be much higher or lower than the market value of the firm – The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet 10

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The Cash-Flow Statement • Show the cash that flowed into and from a firm in during a time period – Focuses attention on a firm’s cash situation • A firm may be profitable and short of cash – Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods • The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes 12

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Notes to Financial Statements • Explains accounting methods used • Details of assets and liabilities • Details of equity structure • Documents changes in operation • Documents off-balance-sheet items 15

Reviewing Published Accounts • Usual order • Correct order – feel quality of the paper, review pictures – produce estimates – read Chair’s report – review accounts – compare your numbers & report’s – read notes – read Chair’s report – produce estimates – check pictures, etc. – read notes 16

Reasons for this Ordering – Form your own unbiased expectations independently of the latest financial report – Notes to accounts give the numbers more precise meaning – Compare your numbers and the firm’s to tell you where to focus when reading the chair’s report. Look for omissions and conflicts – Compare the PR-Department’s public image with your (now) informed investor’s view 17

3. 3 Market v. Book Values • Not all assets and liabilities are included, and others are understate and/or overstated – Intangible assets such as patents may have some value included, but brand loyalty, technological knowhow, or a highly trained loyal workforce will not be valued. Goodwill may be included, but soon loses its connection to market value because of accounting depreciation and market fluctuations – Some contingent liabilities such as law-suits are not routinely disclosed, or only disclosed in the notes – Accountants are beginning to mark-to-market the assets of pension funds 18

3. 4 Accounting v. Economic Measures of Income • Economist’s Measure of Net Income – Net cash flow to shareholders plus change in market value of existing shareholders equity • Accountant's Measure of Net Income Revenue Less Expenses Less Taxes – The above two measures would be equal if accountants marked all relevant assets and liabilities to market (they don’t!) 19

Accounting v. Economic Measures of Income: Example • GPC’s accounting net income was plus $23, 400, 000 in 2001 • Assume the total market value of the stock fell from $200, 000 to $187, 000 from year 2 xx 0 to 2 xx 1. We saw earlier that the cash dividend to shareholders was $10, 000. The economic income in year 2 xx 1 was minus $2, 800, 000 • The Accounting and Economic measures of Income may differ substantially 20

3. 5 Returns to Shareholders v. Return on Equity • Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income • This is the Total Shareholder Return 21

Returns to Shareholders v. Return on Equity (Continued) • Traditionally, corporate performance has been measured by Return on Equity, ROE 22

Returns to Shareholders v. Return on Equity (Conclusion) • Thus, we see that there is no correspondence between a firm's ROE in any year & the total rate of return earned by shareholders on their investment in the company’s stock 23

3. 6 Analysis using Financial Ratios • Despite the differences in accounting and financial principles, the published accounts of a firm yield clues about its financial condition • Five aspects of a firms performance: • Profitability • Asset turnover • Financial leverage • Liquidity • Market value 24

Profitability 25

Asset Turnover 26

Financial Leverage 27

Liquidity 28

Market Value 29

Ratio Comparisons • Establish Your Perspective • Shareholder • Employee, Management, or Union • Creditor • Predator, Customer, Supplier, Competitor, Trade Association • Benchmarks • Other companies ratios • The firm’s historical ratios • Data extracted from financial markets • Sources • Dun & Bradstreet, Robert Morris, Commerce Department's Quarterly Financial Report, Trade Associations 30

Relationships Amongst Ratios • It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with: 31

Ratio Analysis Limitations • Ratio analysis indicates where you might profitably focus your attention, but it can also mislead you – Look for collaborating evidence for the hypotheses you form from the ratios • Sound long-term goals of a firm may cause ratios to look awful. Management-by-ratios may not be in the firms long-term interest • Companies in the same industry may have very different distribution channels, and accounting methods, leading to markedly different ratios that are none-the-less appropriate to each company 32

Comment: • Always keep in mind that financial statements are prepared according to accounting standards and traditions, and that they do not fully satisfy the needs of a financial analysts • They do yield useful information if used with care and understanding 33

Effect of Financial Leverage • Financial leverage simply means the use of borrowed money – Shareholders of a firm use financial leverage to boost their ROE • This increases the sensitivity of ROE to fluctuations in the firm’s underlying profitability as measured by its ROA 34

Illustration • (Table 3. 7 & 3. 8 of textbook) – Consider two firms that are identical except that Nodebt is financed using $1, 000 of equity and Halfdebt is financed using $500, 000 of equity and $500, 000 of debt – further assume that the EBIT of both firms is $120, 000 and tax is 40% 35

Case: Borrow at 10% 36

Case: Borrow at 15% 37

Case: Borrow at 10%: Effect of Business Cycle on ROE 38

Conclusion: • From the perspective of – Creditors: increasing debt is unambiguously harmful, and bond rating agencies will downgrade the firm’s securities – Shareholders: may benefit, depending on the sign of (ROA-interest rate) and ROA 39

3. 7 The Financial Planning Process • “I don’t give a strawberry what happens. I want you all to stonewall it. Let them plead the Fifth Amendment, cover-up or anything else, if it’ll save it, save the plan. ” – Richard Milhous Nixon on Planning (22 March, 1973) (Bowdlerized to avoid offending accounting students) 40

Introduction to Planning • This section navigates us through the financial planning process, using the historical financial statements for a manufacturing firm as our embarkation point • Later, we discuss short-term planning and the management of working capital 41

The Financial Planning Process – Financial planning is a dynamic process that follows a cycle of making plans, implementing them, and revising them in the light of actual results 42

The Financial Planning Process – Starting point is the strategic plan • Strategy guides the financial planning process by establishing overall business development guidelines and growth targets • Which businesses does the firm want to – enter – expand – contract – exit • and how quickly? 43

The Financial Planning Process – Length of the planning horizon • The longer the financial plan, the less detailed it should be (in general) • The revision of a financial plan is generally a function of the length of the planning horizon – Short-term plans are revised frequently, long-term plans are revised much less frequently 44

The Financial Planning Process – The financial planning horizon may be broken down into several steps: • Management forecasts the key external factors, including level of economic activity, inflation, interest rates, and the competition’s output and prices • Based on above, they next forecast revenues, expenses, cash flows, and implied need for external financing 45

The Financial Planning Process • Specific performance targets are generated for the divisions, functions and key individuals of the firm • Periodic measurements of performance are made, and compared to the plan in order to correct either the plan or performance • Periodically, key personnel are counseled, rewarded or punished, and a new iteration is instigated 46

The Financial Planning Process: Notes – Some variables must be forecast well in advance because exploitation requires a long lead-time, others may be reacted to immediately – Some variables are highly volatile, and can’t be forecast effectively, so the best we can do is to plan for the unknown (contingency planning) 47

The Financial Planning Process: Notes – Planning horizons must be appropriate – For a magazine stand, a two year planning horizon may be far too long – A pharmaceutical business (with long newplant construction lead-times, and long drug development/testing/approval procedures) needs a planning horizon that may be as long a ten years 48

The Financial Planning Process: Notes – A plan should always lead to decisions that justify the cost of its preparation • Proper planning is, in essence, part of the process of decision making. Any part of a plan that does not lead to a decision is probably a waste of managerial resources 49

The Financial Planning Process: – A plan should make reasonable tradeoffs between flexibility and the cost of flexibility • Recall that in capital budgeting, options were sometimes very valuable 50

3. 8 Constructing a Financial Planning Model • The next slide shows the history of GPC 51

• GPC Financial Statements, Years xxx 1 - xxx 3 • (Nearest $ Million) • Year • xxx 0 • xxx 1 • xxx 2 • xxx 3 • (Percent of Year's Sales) • xxx 1 • xxx 2 • xxx 3 • Income Statement • Sales • Cost of goods sold • Gross margin • Selling, general & admin. expenses • EBIT • Interest expenses • Taxes • Net income • Dividends • Change in shareholder's equity • 200 • 110 • 90 • 30 • 60 • 30 • 12 • 18 • 5 • 13 • 240 • 132 • 108 • 36 • 72 • 45 • 11 • 16 • 5 • 11 • 288 • 158 • 130 • 43 • 86 • 64 • 9 • 13 • 4 • 9 • 100. 0% • 55. 0% • 45. 0% • 15. 0% • 30. 0% • 15. 0% • 18. 8% • 22. 2% • 6. 0% • 4. 5% • 3. 1% • 9. 0% • 6. 7% • 4. 7% • 2. 0% • 1. 4% • 6. 3% • 4. 7% • 3. 3% • 10 • 40 • 500 • 600 • 12 • 48 • 600 • 720 • 14 • 17 • 58 • 69 • 72 • 86 • 720 • 864 • 1037 • 6. 0% • 24. 0% • 300. 0% • 360. 0% • 30 • 120 • 150 • 300 • 36 • 221 • 150 • 407 • 313 • 43 • 347 • 150 • 540 • 324 • 18. 0% • 110. 7% • 144. 6% • 174. 2% • 75. 0% • 62. 5% • 52. 1% • 203. 7% • 225. 1% • 244. 3% • 156. 3% • 134. 9% • 115. 7% • Balance Sheet • Assets: • Cash & equivalents • Receivables • Inventories • Property, Plant & equipment • Total Assets • Liabilities: • Payables • Short-term debt • Long-term debt • Total Liabilities • Shareholder's equity 52 • 52 • 502 • 150 • 704 • 333

• (Nearest $ Million) • Year • xxx 0 • xxx 1 • xxx 2 • xxx 3 • Income Statement • Sales • Cost of goods sold • Gross margin • Selling, general & admin. expenses • EBIT • Interest expenses • Taxes • Net income • Dividends • Change in shareholder's equity • 200 • 110 • 90 • 30 • 60 • 30 • 12 • 18 • 5 • 13 53 • 240 • 132 • 108 • 36 • 72 • 45 • 11 • 16 • 5 • 11 • 288 • 158 • 130 • 43 • 86 • 64 • 9 • 13 • 4 • 9

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• (Percent of Year's Sales) • Year • xxx 1 • xxx 2 • xxx 3 • Income Statement Sales Cost of goods sold Gross margin Selling, general & admin exp. EBIT Interest expenses Taxes Net income Dividends Change in equity • 100. 0% • 55. 0% • 45. 0% • 15. 0% • 30. 0% • 15. 0% • 18. 8% • 22. 2% • 6. 0% • 4. 5% • 3. 1% • 9. 0% • 6. 7% • 4. 7% • 2. 0% • 1. 4% • 6. 3% • 4. 7% • 3. 3% 55

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Constructing a Financial Planning Model • Percent-of-sales method – First examine which items in the income statement have maintained a fixed ratio to sales • This enables us to decide which items should be forecast on projected sales, and which need to be forecast on another basis 57

Constructing a Financial Planning Model • Percent-of-sales method – The second step is to forecast sales • This is a major exercise, but we will assume that sales will continue to grow at 20% next year (as it has in the past) 58

Constructing a Financial Planning Model • Percent-of-sales method – The third step is to forecast those items that have been assumed to vary with sales 59

Constructing a Financial Planning Model • Percent-of-sales method – The fourth and final step is to forecast the missing items that have not been assumed to vary with sales – We need some assumptions: 60

Constructing a Financial Planning Model • Assumptions: – Interest rate on long-term debt is 8%, and on short-term debt is 15% – To avoid complexity, we assume that interest is computed on the yearend long- and shortterm balances (we can re-address this later) – interest = 0. 08*501. 72 + 0. 15*150 = 87. 26 61

Constructing a Financial Planning Model – The income statement may now be constructed given the dividend pay-out ratio and tax rate (30% and 40%) – The change in equity is added to the equity for year xxx 3, to give the new balance for year xxx 4 – “Total assets” is available, so the “Total liabilities” may now be computed 62

GPC Financial Statements, Years xxx 1 - xxx 3 Year xxx 0 (Nearest $ Million) xxx 1 xxx 2 xxx 3 (Percent of Year's Sales) xxx 1 xxx 2 xxx 3 F(sales)? xxx 4 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin. expenses EBIT Interest expenses Taxes Net income Dividends Change in shareholder's equity 200 110 90 30 60 30 12 18 5 13 240 132 108 36 72 45 11 16 5 11 288 158 130 43 86 64 9 13 4 9 100. 0% N/A 55. 0% Yes 45. 0% N/A(Yes) 15. 0% Yes 30. 0% N/A 15. 0% 18. 8% 22. 2% No 6. 0% 4. 5% 3. 1% N/A 9. 0% 6. 7% 4. 7% N/A 2. 7% 2. 0% 1. 4% N/A 6. 3% 4. 7% 3. 3% 346 190 156 52 104 87 7 10 3 7 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 6. 0% Yes 24. 0% Yes 300. 0% Yes 360. 0% N/A(Yes) 21 83 104 1037 1244 30 120 150 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 18. 0% Yes 110. 7% 144. 6% 174. 2% No 75. 0% 62. 5% 52. 1% No 203. 7% 225. 1% 244. 3% N/A 156. 3% • 134. 9% • 115. 7% • N/A 63 62 904 • 340

Example Completed – We complete the balance sheet by recognizing that there are only two accounts that need to be estimated, Short-term debt, and Long-term debt – The sum is then 904 (Liabilities) - 62 (Payables) = $842 Million – Assume no change in long-term debt – Short-term debt =$842 - 150 = $692 million 64

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3. 9 Growth & Need for External Finance • In order to grow by 20%, the firm will need an additional 692 - 502 = $190 million in external funding (all short-term funding in the example) • It is sometimes useful to be able to compute the external funds needed directly: 67

Growth & Need for External Finance • Let – S 1 be the sales in next year – S 0 be the sales this year – A[S] be the assets that vary with sales – L[S] be the liabilities that vary with sales – d be the dividend pay-out ratio – t be the tax rate 68

External Funds Needed 69

Some Questions: – Here the same logic was used to derive an equation rather than a set of accounts – The equations answer the questions: • What external funds are required to support a sales growth rate, g, of 20%? • If I have external funds available equal to $30 million, what level of sales growth does this support? 70

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Observation: – Sometimes the new assets required to generate income are not as high as in this example, and the company may be able to support a level of growth with no external funding (-0. 00038 in our case) 72

Sustainable Rate of Growth • As a practical matter, a firm that does not issue new equity will have its debt constrained by the debt ratio • Sustainable Rate of Growth = (1 -d)*ROE 73

3. 10 Working Capital Management • Many businesses that fail do so because of poor management of working capital, not poor profitability • Working capital Current assets - current liabilities 74

Efficient Management of Working Capital Principle: – Minimize the investment in non-earning assets such as • receivables • inventories – Maximizing the use of free credit such as • prepayments by customers • accrued wages • accounts payable 75

Cash Cycle Time • Cash Cycle Time = Inventory period + receivable period - payables period 76

3. 11 Liquidity and Cash Budgeting – A firm may be profitable, and have a sizable net worth, but if it is illiquid it will be damaged by forced assets sales and by laying-off trained workers – Banks are much more receptive to funding a planned cash shortfall than funding a shortfall that should have been forecast – Construct a Cash Budget 77