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

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

• 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

 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

• - 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

 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)

• 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.

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
• 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.

 ROE = Net IncomeSales X Sales Assets X Assets Equity ROE = Profitability X Turnover X Multiplier ROE = OperatingEfficiency X AssetEfficiency X FinancialLeverage (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

• 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:

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