Introduction and Financial Analysis

Outline

I. Review of basic finance efficient markets rates of return time value of money bond valuation stock valuation

II. The corporation & corporate finance

• 'picture' of corporation
• three major decisions
• business risk
  

III. The accounting model

• relation to picture
• fund. Principles
• balance sheet
• income stmt
• cash flow analysis
  

IV. Financial statement analysis

• ratios: defined
• sample apparel company
  

I. Review of Intro. Finance

Course theme: Value

- cash flow

- return

Topics:

Efficient markets

Rates of return

Time value of money

- PV & FV

- perpetuity

- annuity

Bond valuation

Stock valuation

1. Efficient markets -

• markets are in equilibrium, or moving there
  
• expected returns = required returns
  
• expectations are rational
  
• information is reflected in current price
  
• arbitrage

- defined

- no arbitrage

2. Rates of return -

Rate of return is just the growth rate of money

=  Value /Beginning Value

R = (Vt+1 - Vt) / Vt

1 + R = Vt+1 / Vt

To compute: need an ending value (Vt+1) and a beginning value (Vt)

3 rates of return:

Required return - rate of return required by investor to purchase security. Depends on risk of security

Expected (ex-ante) return - rate of return investor expects, given current price and expected dividends & growth (stock) and expected interest and principal payments (bonds; YTM)

Realized (ex-post) return - rate of return actually achieved by investor, given the current price and actual dividends or interest received

Risk: the chance that ex-post returns turn out to be much different than expected returns

Statistically: Variance or Standard Deviation

3. Time value of money -

Single cash flows

Vn = V₀(1+R)ⁿ

FV = PV * (1+R)ⁿ

PV = FV * (1+R)^-n

Multiple cash flows

Perpetuity -

Infinite stream of consecutive, equal CF's

PV = CF/R

ex: no growth stock: P0 = D1/R

Annuity -

Finite stream of consecutive, equal CF's

PV = CF * [1/R(1 - 1/(1+R)ⁿ)]

Calculator:

PV, FV, CF, R, N

• Ordinary annuity - CF at end of period

• Annuity due - CF at beginning

4. Bond valuation -

• CF = coupon rate x par ÷ 2 (semi-annual)

• N = number of semi-annual payments

• FV = par amount (1,000)

• R = investor required rate of return (÷2)

• PV = price of bond

Can use other inputs to solve for R ==> Yield to Maturity


5. Stock valuation - present value of future dividends (CF's)

• No growth: perpetuity ==> P0 = D1/R

• Constant growth - dividend grows at constant rate g ==> P0 = D1 / (R - g)

II. The Corporation & Corporate Finance

1. Concept of corporation: (handout 1)

Real or physical assets ---==> cash flows.

Claimants to the cash flows ==>

• Employees/creditors

• Bondholders

• Stockholders

Management team

Management objective:

Allocate corporate resources in a way that maximizes the value of the firm.

A bundle of assets which generates CF's

• NWC
• Long-term assets

2. Three major finance decisions

1st two decisions: which assets should the firm invest in?

1. Long-term assets -

Capital budgeting decision - the process of analyzing, selecting and monitoring investment in long-term assets

Criteria: Which assets add the most value to the firm? NPV, IRR > cost of capital

2. Short-term assets -

Working capital management

• What is optimal level of inventory?
• What is optimal A/R policy?
• What is optimal level of cash?
• What is optimal A/P policy?
• Amount & nature of S-T financing

3. Financing decision - how should the assets be financed? What is proper mix of debt & equity?

How much debt should company have?

- financial leverage & risk

- advantages: interest deductible

- disadvantages: costs of financial distress

What are terms of debt?

- long-term or short-term?

- secured; unsecured; convertible

3. Business risk

• Assets are the source of business risk
• Demand & supply variability
• Competition - ease of entry
• Exposure to technology
• Regulation
• Management depth & breadth
• Degree of operating leverage
• Input/output price variability

III. The Accounting Model

1. Relation to picture:

• NWC Debt
• L-T assets Equity
  

Where:

• NWC = current assets - current liab.
• L-T assets --> fixed assets (PP&E)
• D & E --> right side of picture (capital)
  

2. Fundamental principles -

Cost principle - transactions are recorded at historical cost

• only transactions are recorded
• cost not equal to market in general (later)

Matching principle - costs should be matched with the corresponding revenues

• purpose: performance measurement
• accrual accounting v. Cash basis
  

Sample Apparel Co.

Financial Statements

3. Balance Sheet:

List of assets & liabilities, at point in time

Assets - something owned; resource

• - listed in order of liquidity
• - NWC & long-term

Liability - something owed

- listed in order of claim priority

Retained Earnings - what is owned minus what is owed

- earnings not paid out as dividends

- not cash

 

Different accounting methods

- Lifo v. Fifo (effect on F/S?)

- F/S v. Tax => deferred taxes

Fixed asset acquisition

- record asset at cost

- depreciate over time (charge to expense)

- economic depreciation _ accounting depreciation

4. Income statement

Sales

COS

Gross Profit

Expenses (adm., Selling, acct, other)

EBIT (Operating Earnings)

Interest

EBT

Taxes

Net Income

• numbers for a period of time
• numbers are accrual, not cash, basis
• net income _ cash flow because of depreciation, amortization & accruals

5. Computation of Cash Flows (stmt of cf)

• Defines CF's in way consistent w/ picture
• Information about sources/uses of CF's
• Valuation - with projected data

From accounting identity: A = D + E

===> CF's from Assets = CF's to B/H and S/H

example

Ratio analysis - a financial comparison tool

Financial statements can't be analyzed in a vacuum

- what can you say about Sample Apparel?

- dollar amounts say little

Benchmarks:

1. Historical ratios of company (trend analysis)

2. Other companies

3. Industry ratios (SIC codes)

• Robert Morris & Assoc. (RMA)
• Standard and Poors
• Industry Publications

4. Projections

Common size financial statments:

• Common Size Balance Sheet

express each item as % of total assets

• Common Size Income Statement

express each item as % of total sales

• Common base

express each item as % of base year

specific ratios - ratios designed to address specific areas or questions

Who uses ratios?

• S-T creditors
• L-T creditors
• Investors
• Managment (performance)
  

Note: Definitions differ, depending on the book or source. The key is comparability.

Five broad groups:

1. Liquidity

2. Activity (asset management)

3. Leverage

4. Profitability

5. Market

Liquidity

Indicate the ability of the company to meet its current obligations

Of interest to short-term creditors; banks

1. Current ratio ------> (current assets) / (current liabilities)

• ability of firm to meet current obligations with current assets
• what is a good current ratio?
  
  

2. Quick ratio -----> (cur. Assets - inv) / (current liabilities)

• ability to meet current obligations without having to liquidate inventory
• inventory considered least liquid

 

Activity ratios

• indicate how well company is employing its assets
• bad mgmt ==> execess financing
• bad debts
• obsolete inventory
• these ratios are of primary interest to analysts and management
  

1. Asset turnover --------> (sales) / (total assets)

• may use average of beginning and ending assets
• may use monthly average (seasonal co)
• indicates # of dollars of sales generated from a $ of assets; or conversely, the
• dollars of assets needed to generate a $ of sales
• depends on age & nature of business
• may not detect problems

2. Inventory turnover ---------> (cost of sales) / (inventory)

• may use average inventory instead
• indicates how often inventory 'sells out' per year
• clearly an important ratio for management
  
  

2a. Days sales in inventory ---------> (365) / (Inv. Turn)

avg # of days of sales being held in inventory; same info as inventory turn

3. Days sales outstanding --------> (Accts. Rec) / (sales/365)

• may use average receivables
• indicates avg. # of days of sales which are still uncollected
• indicates how long, on average it takes to collect a sale
• useful for pro-forma's
• clearly important to management
  
  

Leverage ratios

measure the use of debt financing

ability of firm to meet fixed debt pymts

important to long-term creditors

Financial leverage - the use of debt financing, which has the effect of magnifying (levering) possible outcomes.

contrast with operating leverage. Is debt financing good or bad?

1. Debt ratio ----------> (total debt) / (total assets)

• some definitions exclude current liab.
• some definitions use only long-term debt
• measures % of funds supplied by creditors
  

Also: Debt/Equity

Assets/Equity (equity multiplier)

These provide same information

2. Times interest earned --------> (EBIT) / (interest exp.)

measures ability of firm to meet interest payments

2a. Cash coverage ratio ---------> (EBIT + noncash exp) / (interest exp.)

• measures ability of firm to meet interest payments from a cash flow standpoint
• particularly important for highly leveraged companies

3. Days payable o/s ----------> (accounts payable) / (C.O.S./365)

• indicates how quickly company pays its bills
• indicates # days of purchases still unpaid
• analog to days sales o/s
  
  

Profitability ratios

They measure the combined effect of asset and debt management

Very important to both management & investment analysts

1. Profit margin ---------> (net income) / (sales)

• sometimes called 'net margin'
• indicates % of a sales $ which reaches the bottom line; profit per $ of sales
• like total asset turnover, it may not reveal underlying problems
  
  

2. Gross margin ---------> (gross profit) / (sales)

• indicates underlying profitability of production process
• what causes gross margins to change?
  

3. Operating margin ---------> (operating profit) / (sales)

• indicates profitability, allowing not only for production, but also mktg, acctg, & admin. costs
• profitability w/o regard to tax situation and leverage
• sometimes use assets -> earning power

4. Return on assets (ROA) ----------> (net income) / (total assets)

• indicates profitability of assets
• using EBIT, or EBIT after taxes probably makes more sense
• may use average or beginning assets
  

5. Return on Equity (ROE) ----------> (net income) / (equity)

• indicates what S/H earned on the book value of their investment
• may use average or beginning equity
• do not confuse w/ return on investment
  
  
  

Dupont Analysis

DuPont analysis is useful for determining the components of ROE. That is, what `drives' ROE.

(1) How many $sales can be squeezed out of every $ of assets

(2) How much of each $sales gets to net income

(3) How much has this been leveraged

• indicates source of return on equity
• useful in discussing relation between growth and financing needs; later
• some analysts will include a tax effect

ROIC - return on invested capital

= EBIT * (1 - t) / (Equity + Debt)

• not affected by leverage
• also called return on net assets
  

Market ratios

P/E ratio ----------> price per share / earnings per share

• indicates what investors are willing to pay per $ of current earnings
• some analysts use forecast earnings
• what creates high P/E ratios?

- price too high?

- earnings too low?

Market/book ---------> mkt value of equity / book value of equity

• indicates relation between book value of equity and market value of equity
• S&P 500: currently approx. 6.4 Why?
• assets not recorded

- brand name (Oreos, Mercedes, etc.)

- management talent

- customer base

- future growth

Liabilities not recorded:

- bad management

Economic v. Accounting earnings:

Accounting earnings do not measure:

• unrealized gains/losses (timing diff)
• cost of equity
  

==> apparently high income doesn't mean company is doing well

Limitations of ratio analysis

• no theory to say what a 'good' ratio is
• comparability is most important
• numbers are historical; not economic
• most are as of a point in time

- seasonal operations

- may want to use averages; depends on use

• inflation can distort ratios (appendix)
• most designed for manufacturing co's

- some not appropriate for services

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