AFP Financial Planning & Analysis Learning System Session 2, Sunday, April 2nd (1:30-5:00)

AFP Financial Planning & Analysis Learning System Session 2, Sunday, April 2nd (1:30-5:00)

Chapters Covered Financial Accounting and Reporting: Part I, Domain B Chapter 7 Ratio Analysis: Part I, Domain B Chapter 8 Financial Statement Projections: Part II, Domain B Chapter 10 2

Key Accounting Concepts Elements Assets Liabilities Equity Revenues Expenses Accounts refer to the records within each element I recommend spending some time with Exhibit I.B.7-1 on page IB-50 Accrual accounting versus cash accounting Matching principle 3

Accounting Standards Global Accounting Standards International Financial Reporting Standards (IFRS) as pronounced by the International Accounting Standards Board (IASB) U.S. Accounting Standards Generally Accepted Accounting Principles (GAAP) as pronounced by the Financial Accounting Standards Board (FASB) IFRS is focused more on principles, while GAAP is more rules based 4

The Income Statement 5

The Income Statement 6

The Income Statement Revenue Cost of Goods Sold = Gross Profit Amounts earned from the sale of products or services to customers. The expense associated with providing the goods or services whose sale is recognized as revenue. Measures the profitability of the end product considering only the direct costs associated with creating the product. 7

The Income Statement Includes: Payroll costs Marketing and advertising Promotion costs R&D Some taxes Office expenses and supplies Shipping and distribution expenses Gross Profit SG&A Expenses= EBITDA Rent, utilities, maintenance and insurance All costs (other than interest and income taxes) not directly connected to producing the goods or services the organization sells. 8

The Income Statement Cost - Residual Value = Period Depreciation Useful Life Examples: Buildings Machinery Vehicles Furniture Technology items EBITDA Depreciation and Amortization = EBIT Assets that provide value over more than the operating cycle. Considered capital expenses. 9

Depreciation Expense Examples A machine has a depreciable basis of $1,000,000 and a useful life of 4 years. At the end of 4 years, it is expected that the machine will be sold for $100,000. It is also expected that the machine will produce 200,000 units of output per year over the 4 year period. S-L Dep Exp = ($1,000,000-$100,000)/4 = $225,000 DDB Dep Exp Year 1 = ($1,000,000)*(2/4) = $500,000 DDB Dep Exp Year 2 = ($1,000,000-$500,000)*(2/4) = $250,000 Units of Production Dep Exp Year 1 = [($1,000,000-$100,000)/800,000]*[200,000]= $225,000 It s purely a coincidence that S-L and Units of Production are equivalent 10

The Income Statement EBIT Interest Expense = Net Income Before Taxes The interest an organization pays to bondholders, banks and private lenders, including revolving bank debt (plus interest on capital leases). This is a subtotal line. It is used to calculate the effective tax rate for the initial estimation of the provision for income taxes. 11

The Income Statement ETR = Income Tax Income Before Tax Income Before Taxes Income Tax Expense + or Extraordinary Items = Net Income Events or transactions that are both highly abnormal for the particular operations, type of business, industry or geographic region and infrequent; they are not expected to occur often, given the particular environment. The Bottom Line 12

More on the Income Statement Exam prep note: Be able to work through a simplified I/S from the top-down. However, watch out for the question s desired earnings or profitability measure. That is, the question may provide enough info to solve for net income, but the question may just ask for EBIT 13

Forecasting with Common-Sized Income Statements With the information provided by the common-sized income statement, we can make forecasts for subsequent years Suppose that Revenues are expected to grow by 15% in 2014. What would be the effect on CGS and the Gross Profit Margin (in 2014)? 14

The Income Statement 15

Forecasting with Common-Sized Income Statements 1. Expected Revenue Growth is 15% Projected Revenues in 2014 = $56,206*1.15= $64,636.90 2. Project CGS in 2014 using the Common-Sized Income Statement CGS 2014 = $64,636.90*0.64 = $41,367.62 3. Projected GPM 2014 = $23,252.789$3:,52;.2< =35.999% $23,252.78 There are many other applications that can work similarly. Be prepared for them. 16

Earnings Per Share (EPS) A widely used measure of profitability and must be reported on the income statement if the company is publicly traded. Basic EPS = Net Income - Preferred Dividends Weighted Average Outstanding Shares 17

Basics of the Balance Sheet Snapshot Most are classified The Swiss Army Knife of Financial Identities: Assets = Liabilities + Equity It can be used to think through many qualitative questions 18

The Balance Sheet 19

The Balance Sheet Assets Liabilities Shareholders Equity 20

The Balance Sheet - Assets 21

The Balance Sheet - Liabilities 22

The Difference between Debt and Liabilities Liabilities are amounts owed, regardless of form Liabilities Debt refers only to obligations that require interest payments Debts are a subset of liabilities Debt Accounts Payable 23

Liabilities Current Liabilities Accounts payable (A/P) Deferred revenue Accrued liabilities Income taxes payable Short-term debt Current maturities of long-term debt Noncurrent Liabilities Long-term debt Deferred income taxes Other noncurrent liabilities (pension obligations, health care, long-term compensation, other operating and administrative activities) 24

Shareholders Equity 25

The Statement of Cash Flows Income Income Where from? statement (bottom line) statement Change in ( ) balance sheet Change in ( ) balance sheet Change in ( ) balance sheet Supporting statements To From prior period income statement current period income statement 26

Sources and Uses of Funds Source of funds: 1. Decrease in an asset 2. Increase in a liability Use of funds: 1. Increase in an asset 2. Decrease in a liability 27

The Statement of Cash Flows Indirect method Direct method; provides more information 28

More on Statement of Cash Flows Know: The effects of changes in assets and liabilities How to calculate CF from Operations How to calculate the change in cash and equivalents if given CF from Operations, CF from Investments, and CF from Financing The linkages between the income statement and balance sheet; IB-107 through 110 29

Uses of Financial Ratios Trend Analysis Time-series Comparison Across Firms Cross-sectional 30

Types of Ratios Type of Ratio Liquidity (Working Capital) Leverage Activity (Efficiency) Profitability Market Value What Is Measured An organization s ability to pay off its short-term debt obligations while still funding ongoing operations The types of force multipliers (i.e., financial and operational) an organization uses to increase its value and the extent to which it relies on them How efficiently an organization is able to turn its assets into sales or cash An organization s ability to generate earnings as compared to its expenses and other costs over a specified timeperiod. How an organization is valued by investors 31

Liquidity Ratios: Current Ratio Current assets may include: Cash Marketable securities Accounts receivable Inventories Current Ratio = Current liabilities may include: Current Assets Current Liabilities Accounts payable Short-term notes payable Currently-maturing long-term debt Accrued taxes and other expenses 32

Liquidity Ratios Quick Ratio Cash Ratio Cash + Cash Equivalents + Short Term Investments + Accounts Receivable Current Liabilities OR Cash + Cash Equivalents + Marketable Securities Current Liabilities Current Assets Inventories Other Current Assets Current Liabilities 33

More on Liquidity Ratios Note the relationship between the Current Ratio and the Quick Ratio CR >= QR When interpreting expected changes in liquidity ratios, the beginning value of the ratio is important to note, due to the nature of certain financial transactions. What is the impact on the Quick Ratio if an A/P is paid off with Cash from the B/S? 34

An Example Suppose that your firm pays off an accounts payable with $20,000 in cash. Prior to the transaction the current ratio equals 1.20. What effect will this transaction have the current ratio? 35

Financial & Operational Leverage Financial leverage. This is the extent to which an organization uses debt rather than equity to finance its assets, or how much debt the company has in relation to its assets and/or to its shareholders equity. 36

Leverage Ratios Debt to Total Assets Ratio Long-term Debt to Equity Ratio Total Debt Total Assets Long-Term Debt Shareholder s Equity 37

Leverage Ratios: Debt to Equity Total Debt Shareholders Equity OR Total Debt Total Assets Total Liabilities 38

Leverage Ratios Degree of Operating Leverage Ratio % Change in EBIT % Change in Sales Degree of Financial Leverage Ratio % Change in EPS % Change in EBIT OR % Change in Net Income % Change in EBIT 39

Leverage Ratios: Degree of Total Leverage 40

Leverage Ratios: Coverage Ratios Interest Coverage = EBIT Interest Expense Cash Coverage = EBIT + Depreciation Interest Expense 41

Activity Ratios Average Accounts Receivable Turnover Net Credit Sales Average Accounts Receivable Days Sales Outstanding (Average Accounts Receivable Days) Average Accounts Receivable Net Credit Sales x Number of Days in the Period 42

Activity Ratios Average Inventory Turnover COGS Average Inventory Days Inventory Outstanding (Inventory Days) Average Inventory COGS* x Number of Days in the Period 43

Activity Ratios Average A/P Turnover Total Supplier Purchases Average Accounts Payable OR COGS Average Accounts Payable OR Period Purchases Accounts Payable @ Ending Balance Days Payable Outstanding (Accounts Payable Days) Average Accounts Payable COGS* x Number of Days in the Period * or Cost of Sales 44

Forecasting with Turnover Measures Suppose that revenues are expected to grow to $64,636.90 2014. What would be the A/R impact? From ShopNow s 2013 Income Statement and Balance Sheet: Avg AR Turnover = `2,<82 (`,8b5c2,8b<)/< = 10.07 45

Forecasting with Turnover Measures Holding the A/R T/O measure constant, a forecasted revenue level of $64,636.90 in 2014 implies a 2014 average A/R level of: $6,418.76 10.07 = 23,252.78 g 46

Activity Ratios Cash Conversion Cycle DIO + DSO - DPO Where: DIO = Days Inventory Outstanding DSO = Days Sales Outstanding DPO = Days Payables Outstanding 47

More on the CCC DIO = (Inv /(CGS/365) DSO = (AR/(Revenues/365)) DPO = (AP/(CGS/365)) 48

Activity Ratios Average Asset Turnover Average Fixed Asset Turnover Revenue Average Total Assets Revenue Average Fixed Assets OR Revenue Average Net PP&E 49

Activity Ratios Average Working Capital Turnover Revenue Average Current Assets Average Current Liabilities 50

Profitability Measures: The Margins Gross Margin = mnonpqnr 9stuv mnonpqn EBITDA Margin = { }~ mnonpqn EBIT Margin = { }~ mnonpqn Profit Margin = } mnonpqn 51

Profitability Ratios ROA ROE Net Income Average Total Assets Net Income Average Shareholders Equity 52

DuPont Analysis GOAL Operating Efficiency Asset Efficiency Financial Leverage METRIC Profit Margin Average Total Assets Turnover Average Equity Multiplier EQUATION Net Income Revenue Revenue Average Total Assets Average Total Assets Average Equity 53

DuPont Example 1 If the profit margin is 0.157, total asset turnover is 0.64, and the Equity multiplier is 1.39, then ROE is? 54

DuPont Example 2 Firm Z has a 7% profit margin, an ROE of 17%, and total asset turnover of 1.71. What is the Equity Multiplier? 55

DuPont Example 3 Firm W has sales of $9,980, total assets of $3,140, and a debt-to-equity ratio of 0.25. If the return on equity is 16%, what is NI? 56

Earnings per Share (EPS); warning see pg ib-164 Basic EPS = Net Income Preferred Dividends Weighted Average Outstanding Shares Diluted EPS = (Net Income Preferred Dividends) + (Conv. Preferred Dividends + After-Tax Interest) Weighted Average Outstanding Shares + Diluted Shares 57

Economic Profit W eighed A C verage ost of EVA = NOPAT (Average Capital Employed x WACC) C apital 58

EVA Example A firm has an operating profit of $80,000. The firm s tax rate is 30% and the weighted average cost of capital is 9.0%. The company s capital structure consists of $250,000 in debt and $300,000 of equity. What is the firm s EVA? 59