DUKE UNIVERSITY, FUQUA SCHOOL OF BUSINESS ACCOUNTG 512F: FUNDAMENTALS OF FINANCIAL ANALYSIS. Note on Financial Statements and Financial Ratios

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1 DUKE UNIVERSITY, FUQUA SCHOOL OF BUSINESS ACCOUNTG 512F: FUNDAMENTALS OF FINANCIAL ANALYSIS Note on Financial Statements and Financial Ratios I. Review of Financial Statements The Balance Sheet Financial reporting is based on the following accounting equation, which summarizes the balance sheet: Assets = Liabilities + Shareholders equity Productive Creditor Owner claims capacity claims (contributed capital plus undistributed earnings) Note: Shareholders equity is also sometimes called book value [of equity] or owners equity. The Balance Sheet is an arithmetic equality. In accounting, it is always true that the assets are equal to the sum of the liabilities and shareholders equity. Assets are future economic benefits that the firm controls because of past events or transactions. Examples include: cash, accounts receivable (these are amounts owed to the firm by its customers), inventories, land, investments in other firms, factories. Liabilities are obligations to sacrifice resources. For the most part, accounting liabilities are also legal obligations. Examples include: accounts payable (amounts owed by the firm to its suppliers), bank loans payable (amounts owed to banks). Shareholders equity is the residual, defined as Assets - Liabilities. Shareholders equity includes capital contributed by owners (common stock) plus the entire cumulative earnings of the firm that has not been distributed as dividends. Note that in consolidated firms (i.e., firms where there is a subsidiary controlled by the firm, but with less than 100% ownership), there is also non-controlling interest. 1 Non-controlling interest is the accounting value of the non-controlled portion of the subsidiary. The Balance Sheet lists specific items of Assets, Liabilities and Owners Equity. There are totals (sums of the values listed for the various items) displayed as well. 1 Non-controlling interest is the accounting value of the non-controlled portion of the subsidiary. Up until 2009 this used to be called Minority Interest (see the note on Common and Non-Common Equity for more details on noncontrolling interest). Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 1

2 The Income Statement Income, net income, earnings, profit (often used interchangeably). Negative income = loss or net loss Revenues Expenses + Gains Losses Asset inflows from Expired costs Other asset Other expired selling goods and associated with inflows costs services revenues Income not declared as dividends increases retained earnings this concept links the income statement (statement of operations) to the balance sheet Negative net income decreases retained earnings (or increase accumulated deficit). It occurs when expenses and losses exceed revenues and gains. Income can be calculated using two consecutive balance sheets and knowledge of dividends declared via the clean surplus relation: Beginning balance in retained earnings + income (or minus the loss) dividends = Ending balance in retained earnings. (Capital contributions are treated as negative dividends.) It means that all changes in book values flow through net income. Violations of clean surplus are called dirty surplus items. The clean surplus relation links the balance sheet and the income statement. The Statement of Cash Flows Shows the sources (inflows) and uses (outflows) of cash during a fiscal period. Arithmetically, the difference of inflows and outflows must equal the change in cash balances between two successive balance sheets. Cash inflows and outflows are shown in three categories: cash flows from operations, cash flows from investing and cash flows from financing. Focuses on cash inflows and outflows only. Any transactions that do not involve cash are not included (e.g., acquiring land, property, plant or equipment by assumption of a liability). Such transactions (if material) must be separately disclosed. The Statement of Owners Equity Shows the breakdown of items affecting the stockholders equity accounts during the period. This statement is often used to show comprehensive income (Statement of Financial Accounting Standards No. 130). Comprehensive income reflects all changes in owners equity in a period, except those resulting from owners (primarily stock issuances) and distributions to owners (primarily dividends and stock repurchases). The intent of the requirement that firms report comprehensive income is to include gains and losses that are not reflected in the income statement (and therefore, not included in net income), but which are reflected in the change of shareholders equity. The most common adjustments to owners equity are: Foreign currency translation gains (losses) Excess of additional pension liability over unrecognized prior service cost ( minimum pension liability adjustment) Unrealized holding gains (losses) for available-for-sale securities Deferred or unearned compensation related to employee stock option plans Guarantees of employee stock option debt Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 2

3 These adjustments are also referred to as dirty surplus items because they violate the clean surplus relation. Financial statement data for Hart Company follow, for the years : Hart Company Balance Sheets Assets Cash $100 $76 $40 $170 Accounts receivable Inventories Total current assets ,760 Gross property, plant & equipment 2,400 3,720 4,860 5,630 Accumulated depreciation (400) (520) (660) (840) Total assets $2,500 $3,936 $5,160 $6,550 Liabilities and shareholders' equity Accounts payable $250 $300 $350 $500 Short term borrowings Salaries payable Total current liabilities Bonds payable ,000 1,500 Common stock, par value $1 1,000 1,500 1,600 1,600 Additional paid in capital 200 1,000 1,200 1,200 Retained earnings ,350 Total liabilities & shareholders' equity $2,500 $3,936 $5,160 $6,550 Hart Company Income Statements $2,760 $3,100 $4,750 Cost of goods sold (1,573) (1,798) (2,803) Selling, general and administrative (510) (590) (750) Depreciation expense (120) (140) (180) Operating income ,018 Interest expense (500) (100) (160) Pretax income Income tax expense (17) (142) (257) Net income $40 $330 $600 Dividends $4 $6 $10 Important relations: Assets = Liabilities + Owners' Equity. This relation links the two sides of the balance sheet. For example, in 1991, total assets of $2,500 equal total liabilities ($900 = $400 + $500) plus shareholders equity ($1,600 = $1,000 + $200 + $400). Book value at time t = Book value at time t-1 + Net income in year t Net dividends in year t. See the Statement of Owners Equity. Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 3

4 Hart Company Statements of Cash Flows Cash flows from operations Net income $40 $ Depreciation expense (Increase) decrease in accounts receivable (100) (100) (300) (Increase) decrease in inventories (160) (160) (370) Increase (decrease) in accounts payable Increase (decrease) in salaries payable Cash flows from operations (20) Cash flows from investments Additions to PP&E (1,320) (1,140) (770) Cash flows from investing (1,320) (1,140) (770) Cash flows from financing Increase (decrease) in short term borrowings Issuance (payments) of bonds payable Issuance of common stock 1, Dividends paid (4) (6) (10) Cash flows from financing 1, Net increase (decrease) in cash (24) (36) 130 Beginning cash balance Ending cash balance Important relation: Net change in cash (per the ending balances in two consecutive balance sheets) = Cash flow from operations + Cash flow from investing + Cash flow from financing (all reported in the Statement of Cash Flows). This relation links the Balance Sheet with the Statement of Cash Flows. For example, in 1992, the change in cash per the balance sheet was -$24. Cash flow from operations in 1992 was -$20, cash flow from investment in 1992 was -$1,320 and cash flow from financing was $1,316; the aggregate of the three cash flows is $-24 (the change in the cash balances between 1991 and 1992). Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 4

5 Hart Company Statements of Owners Equity Common stock Additional Retained Accumulated other Total owners' Shares Amount paid in capital earnings comprehensive income equity Balance at Dec. 31, ,000 $1,000 $200 $400 $1,600 Net income $40 Foreign currency translation $0 Minimum pension liability $0 Unrealized holding gains $0 Comprehensive income $40 $0 $40 Cash dividends ($4) ($4) Repurchase common stock Issued common stock 500 $500 $800 $1,300 Balance at Dec. 31, 1992 $2,936 Net income $330 Foreign currency translation $0 Minimum pension liability $0 Unrealized holding gains $0 Comprehensive income $330 $0 $330 Cash dividends ($6) ($6) Repurchase common stock Issued common stock 100 $100 $200 $300 Balance at Dec. 31, 1993 $3,560 Net income $600 Foreign currency translation $0 Minimum pension liability $0 Unrealized holding gains $0 Comprehensive income $600 $0 $600 Cash dividends ($10) ($10) Repurchase common stock Issued common stock Balance at Dec. 31, 1994 $4,150 Important relation: Book value at time t = Book value at time t-1 + Net income in year t Net dividends in year t, where net dividends includes cash dividends, share repurchases and share issuances. There are no dirty surplus items for Hart Company. Hence the clean surplus relation should hold. For example, the book value of equity in 1992 ($2,936) equals book value of equity in 1991 ($1,600) plus net income in 1992 ($40) less net dividends paid in 1992 (-$1,296 = $4 - $500 (additional c/s) - $800 (additional paid in capital)). Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 5

6 II. Financial Ratios Important: Definitions of financial ratios are not set in stone (e.g., they are not governed by accounting standards). Different textbooks and manuals can and do define them differently. Below are common definitions. 1. Activity (short term; long term) Short term activity ratios Accounts receivable turnover revenue Average A/R Days A/R outstanding 365 A/R turnover Inventory turnover Cost of goods sold Average inventories Days inventory outstanding 365 Inventory turnover Accounts payable turnover Purchases 2 Average A/P Days payable outstanding 365 A/P turnover Long term activity ratios Total asset turnover (TAT) Fixed asset turnover Average total assets Average fixed assets 2. Liquidity Liquidity analysis Current ratio (working capital ratio) Quick ratio (acid test ratio) Times interest earned (interest coverage ratio) Current assets Current liabilities Cash + Marketable securities + A/R Current liabilities EBIT Interest expense 2 Firms are not required to separately disclose how much they purchased during the year. We can arrive at an approximate value for this number by solving the following equation for Purchases: Inventory t-1 + Purchases t = Inventory t + Cost of Goods Sold t, where t subscripts the ending value of the account for the current period. Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 6

7 Times interest earned (cash) Fixed charge coverage ratio Cash from operations + interest expense + taxes Interest expense Cash flow from operations + fixed charges + taxes Fixed charges 3. Solvency Solvency risk Financial leverage Debt to capital Debt to equity Long-term debt to equity Total assets Shareholders' Equity Total debt Debt + Shareholders' equity Total debt Shareholders' equity Long-term debt Shareholders' equity 4. Profitability Profitability Operations Profit margin %, Net profit margin Cost of goods sold percentage SG&A percentage Gross profit margin Operating leverage 3 Net income Cost of goods sold SG&A expenses CGS Total fixed costs 3 Note: some texts define operating leverage as total variable costs / sales. Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 7

8 Profitability Return on capital Return on assets (ROA), unadjusted Return on assets (ROA), adjusted for financing Return on invested capital (ROIC) Return on equity (ROE) Net income Average total assets 4 Net income + After-tax interest expense Average total assets NOPAT Average Invested Capital Net income Average common equity 5. Market ratios Market ratios Dividend payout Dividend yield Price-earnings ratio Market-to-book ratio Cash dividends paid on common equity Net income Cash dividends per share of common equity Price per share Price per share Net income per share Market value of equity Book value of equity 4 By average, we mean the average of last period s ending balance and this period s ending balance. Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 8

9 A. DuPont analysis (aka profitability decomposition); unadjusted for financing ROA = Net income x Average Assets = Profit margin % x Total Asset Turnover (TAT) ROE = Net income x x Assets Average Assets Average common equity = Profit margin % x Total asset turnover x Financial leverage B. DuPont Analysis (using adjusted for financing numbers) ROA = Net income + aftertax interest expense x Average Assets = Operating Profit margin % x Total Asset Turnover (TAT) ROE = Net profit x Pretax profit x EBIT x x Assets Pretax profit EBIT Assets Equity = Tax burden x Interest burden x ROS x TAT x Financial leverage Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 9

10 III. Terminology Term Notation Calculation Earnings before interest and taxes EBIT minus CGS minus SG&A minus (also called Operating Income) Depreciation/amortization Net income + Interest expense + Income taxes Earnings before interest, taxes, EBITDA EBIT + Depreciation/Amortization Expense Depreciation/amortization Net operating profits less adjusted taxes NOPAT EBIT less taxes on EBIT (EBIAT) Economic value added (aka Economic EVA NOPAT less capital charge Profit) 5 Capital charge = weighted average cost of capital times total invested capital Invested Capital IC Current assets + Net fixed assets Non-interest bearing debt = Interest bearing debt + Common shareholders equity (+ preferred shares + non-controlling interest, where applicable) Free cash flows to the unlevered firm FCFU Free cash flows ignoring effects of financing Free cash flows to common equity FCFCE Free cash flows considering the effects of financing Interest tax shield ITS Income taxes saved on the tax deductibility (in the US) of interest expenses 5 Stern Stewart holds the trademark on EVA. Stern Stewart also advocates a large number of adjustments to the accounting numbers to get to the true EVA. People tend to use the term EVA, however, for the concept with or without adjustments. Economic profit is McKinsey s version of the same economic concept. Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 10

11 IV. Comparing Financial Statements and Ratios Across and Within Firms Common-size financial statements express the components of the financial statements in terms of a common variable for each statement. For the balance sheet, it is common to use total assets as the scale variable, while for the income statement, total sales revenue is typically used. The sizing is done each year, using the value of the scale variable that year. By expressing each component of the balance sheet and the income statement as a percentage (of assets or revenues, respectively), one can compare firms of varying sizes. The common-size financial statements for Hart Company look as follows: Assets Cash % % % % Accounts receivable % % % % Inventories % % % % Total current assets % % % 1, % Gross property, plant & equipment 2, % 3, % 4, % 5, % Accumulated depreciation (400) % (520) % (660) % (840) % Total assets 2, % 3, % 5, % 6, % Liabilities and shareholders' equity Accounts payable % % % % Short term borrowings % % % % Salaries payable % % % % Total current liabilities % % % % Bonds payable % % 1, % 1, % Common stock at par 1, % 1, % 1, % 1, % Additional paid in capital % 1, % 1, % 1, % Retained earnings % % % 1, % Total liabilities & shareholders' equity 2, % 3, % 5, % 6, % , % 3, % 4, % Cost of goods sold (1,573) % (1,798) % (2,803) % Selling, general and administrative (510) % (590) % (750) % Depreciation expense (120) -4.35% (140) -4.52% (180) -3.79% Operating income % % 1, % Interest expense (500) % (100) -3.23% (160) -3.37% Pretax income % % % Income tax expense (17) -0.62% (142) -4.57% (257) -5.42% Net income % % % Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 11

12 Trend analysis expresses the change in the value of a period t+1 financial statement component measured relative to its value in period t as a percentage of its period t value. Negative values indicate declines in the item being measured (favorable if the variable is a liability/expense account, bad if it is asset/revenue account). Whereas common-size financial statements permit cross-sectional (i.e., across firm) comparisons controlling for variation in firm size, trend analysis permits within-firm comparisons over time. Trend analysis obviously controls for firm-specific features by using the same firm each year as its control in the next year. Whereas the point of common-size financial statement is to assess how a firm is performing relative to its peers, the point of trend analysis is to assess how the firm is doing relative to its past. A trend analysis for Hart Company would show the following: Assets Cash % % % Accounts receivable % % % Inventories % % % Total current assets % % 1, % Gross property, plant & equipment 2,400 3, % 4, % 5, % Accumulated depreciation (400) (520) 30.00% (660) 26.92% (840) 27.27% Total assets 2,500 3, % 5, % 6, % Liabilities and shareholders' equity Accounts payable % % % Short term borrowings % % % Salaries payable % % % Total current liabilities % % % Bonds payable % 1, % 1, % Common stock at par 1,000 1, % 1, % 1, % Additional paid in capital 200 1, % 1, % 1, % Retained earnings % % 1, % Total liabilities & shareholders' equity 2,500 3, % 5, % 6, % ,760 3, % 4, % Cost of goods sold (1,573) (1,798) 14.29% (2,803) 55.87% Selling, general and administrative (510) (590) 15.69% (750) 27.12% Depreciation expense (120) (140) 16.67% (180) 28.57% Operating income % 1, % Interest expense (500) (100) % (160) 60.00% Pretax income % % Income tax expense (17) (142) % (257) 81.67% Net income % % Copyright. Frank Ecker, Jennifer Francis, and Per Olsson. 12