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

III. The accounting model

IV. Financial statement analysis

 

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 -

- 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



4. Bond valuation -


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


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




II. The Corporation & Corporate Finance

1. Concept of corporation: (handout 1)

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

Claimants to the cash flows ==>

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

 

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

 

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

 

III. The Accounting Model

 

1. Relation to picture:

Where:

2. Fundamental principles -

Cost principle - transactions are recorded at historical cost

Matching principle - costs should be matched with the corresponding revenues

Sample Apparel Co.

Financial Statements

     
INCOME STATEMENT
  1997 1996
Sales

308,277,570

298,158,005

Cost of Sales

264,816,700

254,851,955

Gross Profit

43,460,870

43,306,050

Operating Expenses

35,534,200

36,767,825

Operating Earnings

7,926,670

6,538,224

Interest expense

1,626,438

1,812,813

Other (income) expense

(334,375)

(536,300)

Earnings before taxes

6,634,608

5,261,712

Taxes

2,521,151

1,999,451

Net Income

4,113,457

3,262,261

Depreciation Expense

2,128,350

 
     
BALANCE SHEET
  1997 1996
Cash & marketable securities 6,871,800 6,943,800
Accounts receivable 34,265,375 30,530,351
Inventory 53,734,000 51,585,313
Total current assets 94,871,175 89,059,464
Property, plant & equipment 26,335,900 23,443,600
Less: accumulated depreciation (15,539,500) (13,411,150)
Net property, plant & equipment 10,796,400 10,032,450
Other assets 637,250 548,200
Total assets 106,304,825 99,640,114
     
Accounts payable 28,827,025 21,535,881
Other payables 384,000 293,405
Total current liabilities 29,2110,25 21,829,286
Long-term debt 12,707,888 10,664,840
Shareholders' equity:    
Common stock 1,875,000 1,875,000
Retained earnings 62,510,913 58,397,456
Total equity 64,510,913 60,272,456
Total liabilities & equity 106,304,825 99,640,114
     

3. Balance Sheet:

List of assets & liabilities, at point in time

Assets - something owned; resource

 

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


5. Computation of Cash Flows (stmt of cf)

From accounting identity: A = D + E

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

 

example

Cash Flows from Assets:    
Operating CF's:    
EBIT (7,926,670+334,375) 8,261,045
+ depreciation   2,128,350
- taxes   (2,521,151)
Operating CF's   7,868,244
- NWC   (3,887,294)
- Capital Spending (2,892,300+89,050) (2,981,350)
CF's from Assets:   999,600
     
CF's to B/H:    
Interest   1,626,438
net  in debt   (626,838)
    999,600
CF's to S/H:    
Dividends   0
net  in C/S   0
Total CF's to B/H & S/H:  

999,600


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)

4. Projections

Common size financial statments:

express each item as % of total assets

express each item as % of total sales

express each item as % of base year

specific ratios - ratios designed to address specific areas or questions

Who uses ratios?

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)

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

 

Activity ratios

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

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

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)

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)

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.)

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

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)

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

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

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

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

Dupont Analysis

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

 

           
ROE = Net Income

Sales

X

Sales

Assets

X

Assets

Equity

ROE = Profitability X Turnover X Multiplier
           
ROE = Operating

Efficiency

X Asset

Efficiency

X Financial

Leverage

  (2)   (1)   (3)

 

(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

 

ROIC - return on invested capital

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

Market ratios

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

- price too high?

- earnings too low?

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

- 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:

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

Limitations of ratio analysis

- seasonal operations

- may want to use averages; depends on use

- some not appropriate for services


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