Lecture 2. Financial Statements, Cash Flows, and Taxes and Analysis of Financial Statements (Ch 2, Ch3)

Transcription

1 Lecture 2. Financial Statements, Cash Flows, and Taxes and Analysis of Financial Statements (Ch 2, Ch3)

2 Basic concepts of Financial Statements (FSs) Why the company needs to construct FSs? To provide information about financial situation of the company to shareholders, creditors, employees, and other principals, also to external analysts. Cash flow vs. Balance A cash flow (CF) is a transfer of wealth per unit of time. A balance is the accumulation of wealth at a point in time. Like a snapshot at a single point in time. Realized CF vs. Accrued CF A realized cash flow is a transfer of wealth accompanied by a flow of funds. An accrued cash flow is a transfer of wealth per unit of time that is not accompanied by a flow of funds. FSs include both realized and accrued CF. Accrual accounting basis : economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received).

3 The Annual FSs Balance sheet provides a snapshot of a firm s financial positi on at one point in time. Income statement summarizes a firm s revenues and expense s over a given period of time. Statement of stockholders equity shows how much of the fir m s earnings were retained, rather than paid out as dividends. Statement of cash flows reports the impact of a firm s activiti es on cash flows over a given period of time.

4 Balance Sheet (B/S) B/S summarizes the many different types of wealth that the company owns (assets, uses of funds) and owes (liabilities: sources of funds). The total amounts of assets and liabilities/stockholders equity must be identical. Total Assets = Total Liabilities + Stockholders Equity

5 Balance Sheet

6 Income Statement (IS)

7 Statement of Stockholders Equity It shows how much of the firm s earnings were retained, rather than paid out as dividends.

8 Statement of Cash Flows

9 Free Cash Flow Free cash flow = operating cash flow capital expenditures +Increase in net working capital * Net working capital : change in current assets change in short-term liabilities a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes. Ex) one way to estimate the value of firms is V = t=1 (1 + discount rate) t Free cash flow t

10 IFRS (International Financial Reporting Standards) A set of international accounting standards stating how particular types of transactions and other events should be reported in financial statements. IFRS are issued by the International Accounting Standards Board (IASB). As of August 2008, more than 113 countries around the world, including all of Europe, currently require or permit IFRS reporting and 85 require IFRS reporting for all domestic, listed companies. It requires, Statement of Financial Position Statement of Comprehensive Income separate statements comprising an Income Statement and separately a Statement of Comprehensive Income Statement of Changes in Equity (SOCE) Cash Flow Statement or Statement of Cash Flows Notes, including a summary of the significant accounting policies

11 Analysis of Financial Statements (Ch 3) How to analyze the financial statements? Use Ratio Analysis Five major categories for ratio analysis. Liquidity ratio Can the firm be able to pay off its debts as they come due? If not, the firm has the liquidity problem. Activity Ratio Is the firm using its assets efficiently? Debt (Leverage) ratio : How does the firm finance and whether the firm can pay off its long term debt. Profitability ratio : How profitably the firm is operating by using its equity or assets. Market value ratio : What investors think about the firm and its future project.

12 Liquidity It asks whether the firm is able to pay off its debts as they come due. If not, the firm has the liquidity problem.

13 Asset management Ratio It asks whether the firm is using its assets efficiently. i.e. how much sales does a unit of assets can create? Inventory turnover= Sales/Inventories Total Asset turnover= Sales/Total assets Which firm has higher turnover ratio? (create greater sales using a unit of assets). Whole sale firm vs Jewelry shop Firms with lower margin have higher turnover ratio.

14 Debt management (Leverage) Ratio It asks how the firm financed and whether the firm can pay off its long term debt. Debt ratio= Total debt/total assets Equity ratio = Total equity/total assets = 1- debt ratio Is the higher debt ratio always bad? Not necessarily, discuss this later.

15 Profitability Ratio How profitably the firm is operating by using its equity or assets. Net Profit Margin = Net Income/Total Sales ROA= Net income/total assets ROE= Net income/total common equity ROE is the most important to shareholders.

16 ROE and ROA ROE and shareholder wealth are correlated, (it is the most important to sha reholders) But problems can arise when ROE is the sole measure of performance. ROE does not consider risk (biggest problem). ROE focuses only on return and a better measure would consider risk and return. ROE does not consider the amount of debts (i.e. consider only equity). It can not precisely show the ability of managers to create earning s using total assets. Therefore, ROE might encourage managers to make investment d ecisions that do not benefit shareholders. (ex, Decrease equity, the n ROE automatically gets higher, even if net income does not cha nge).

17 Market value Ratio What investors think about the firm and its future project. Two types of firm value : Market value of firms = Number of shares * current share price Book value of firms = total equity in the balance sheet. M/B= Market price/book value per share M/B: How much investors are willing to pay for $1 of book value equity. Most widely used. P/E= Price/Earnings per share P/E: How much investors are willing to pay for $1 of earnings. Good measure to company showing the market price to the ability to produce earnings But has some problems. Estimated time can be different.

18 The DuPont System (Analysis of ROE) Dupont decompose the ROE, focusing on profit margin, asset turnover, and (the inverse of) equity ratio (equity multiplier). ROE Profit margin Total assets turnover Equity multiplier ROE (NI/Sales) (Sales/TA) (TA/Equity)

19 Practice : DuPont System The Company s financial statements for year 2525 show Balance Sheet, 12/31/2525 Income, 1/1 12/31/2525 This Company is in an industry where the average net profit margin is 7.39%, the debt-toasset ratio (= Debt /Total assets) is 38.0%, and return on equity is 37.34%. For the company relative to the industry, select the one statement most consistent with the DuPont analysis. a. the company s asset turnover indicates sales are unusually small relative to its assets b. the company s asset turnover indicates sales are unusually large relative to its assets c. the company s equity multiplier indicates the firm has an unusually large debt burden d. the company s profit margin indicates its revenues are unusually small relative to its costs e. the company s equity multiplier indicates the firm has an unusually small debt burden

20 Potential Problems and Limitations of Financ ial Ratio Analysis Different operating and accounting practices can distort comparisons. Ex) net income is affected by the method of depreciation, which results in the change of ROE. Window dressing techniques can make statements and ratios look better. Sometimes it is hard to tell if a ratio represents good or bad. Ex) High current ratio may represent higher liquidity, but the firm is conservative. High PE ratio may represent high growth potentials, but the firm would be overvalued. Seasonal factors can distort ratios. Ex) The ratios of ice-cream firms would be very weak during the winter.

21 Some Exercises Dongguk Corp. s net income is $2 million this year. It has 500,000 shares of common stock and the price per share is currently $40. The company expects an increase in their net income to $3.25 million next year. If the number of shares also increases to 650,000 shares next year and if the price/earnings ratio (PER) stays the same as this year, what will be its stock price next year? Dongguk univ. has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The university s goal is to increase the ROE to 10%. The university thinks that they need to increase debt ratio (that is to borrow more money and reduce equity) to increase the ROE. At which debt ratio (=debts/total assets) will ROE be 10%? (p89, 3-20) Pearl Oriental needs $1 million of assets to get started, and it expects to have a basic earning power ration of 20%. Pearl will own no securities, so all of its income will be operating income. If it so chooses, Pearl can finance up to 50% of its assets with debt, which will have an 8% interest rate. Assuming a 40% tax rate on all taxable income, what is the difference between Pearl s expected ROE if it finances with 50% debt versus its expected ROE if it finances entirely with common stock? Also, try 3-6, 3-7 (pp 86.) 3-2 ~ 3-6, 3-10, 3-14, 3-15, 3-20 (pp 87)