Corporate Finance 1-1 Week 3 Financial Statement Analysis II 1-1
Asset Efficiency or Turnover Measures 1-2 A first broad measure of efficiency is asset turnover: Sales Asset Turnover = Total Assets Fixed Asset Turnover: since total assets includes assets like cash that are not directly involved in generating sales, Global s manager might also look at Global s fixed asset turnover: Sales Fixed Asset Turnover = Fixed Assets 1-2
Asset Efficiency or Turnover Measures 1-3 How efficiently we turn our inventory into sales Sales Inventory Turnover = Inventory Receivables Turnover The firm s accounts receivable in terms of the number of days worth of sales that it represents: Accounts Receivable Days = Accounts Receivable Average Daily Sales 1-3
Leverage Ratios 1-4 Times Interest Earned (TIE): a measure of long-term solvency Cash Coverage Ratio : Use interest bearing debt (notes payable, LT debt) 1-4
DuPont Identity 1-5 This expression says that ROE can be thought of as net income per dollar of sales (profit margin) times the amount of sales per dollar of equity ROE = Net Income Sales Net Income Sales = Total Equity Sales Sales Total Equity 1-5
DuPont Analysis 1-6 This final expression says that ROE is equal to net income per dollar of sales (profit margin) times sales per dollar of assets (asset turnover) times assets per dollar of equity (a measure of leverage called the equity multiplier). ROE = Net Income Sales Total Assets Net Income Sales Total Assets = Sales Total Equity Total Assets Sales Total Assets Total Equity 1-6
Example 1-7 Problem: The following table contains information about Wal-Mart (WMT) and Nordstrom (JWN). Compute their respective ROEs and then determine how much Wal-Mart would need to increase its profit margin in order to match Nordstrom s ROE. Profit Margin Asset Turnover Equity Multiplier Wal-Mart 3.6% 2.4 2.6 Nordstrom 7.7% 1.7 2.4 1-7
Example (continued) 1-8 Solution: Plan: The table contains all the relevant information to use the DuPont Identity to compute the ROE. We can compute the ROE of each company by multiplying together its profit margin, asset turnover, and equity multiplier. In order to determine how much Wal-Mart would need to increase its margin to match Nordstrom s ROE, we can set Wal-Mart s ROE equal to Nordstrom s, keep its turnover and equity multiplier fixed, and solve for the profit margin. 1-8
Example (continued) 1-9 Execute: Using the DuPont Identity, we have: ROE WMT = 3.6% x 2.4 x 2.6 = 22.5% ROE JWN = 7.7% x 1.7 x 2.4 = 31.4% Now, using Nordstrom s ROE, but Wal-Mart s asset turnover and equity multiplier, we can solve for the margin that Wal-Mart needs to achieve Nordstrom s ROE: 31.4% = Margin x 2.4 x 2.6 Margin = 31.4% / 6.24 = 5.0% 1-9
Example (continued) 1-10 Evaluate: Wal-Mart would have to increase its profit margin from 3.6% to 5% in order to match Nordstrom s ROE. It would be able to achieve Nordstrom s ROE even with a lower margin than Nordstrom (5.0% vs. 7.7%) because of its higher turnover and slightly higher leverage. 1-10
Valuation Ratio 1-11 Analysts and investors use a number of ratios to gauge the market value of the firm. The most important is the firm s price-earnings ratio (P/E): The P/E ratio is a simple measure that is used to assess whether a stock is over- or under-valued based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders. P / E Ratio Market Capitalization = = Net Income Share Price Earnings per Share 1-11
Example 1-12 Problem: Consider the following data from 2006 for Wal-Mart Stores and Target Corporation ($ billions): Wal-Mart Stores (WMT) Target Corporation (TGT) Sales 345 60 Operating Income 19 5 Net Income 11 3 Market Capitalization 190 49 Cash 7 1 Debt 36 10 Compare Wal-Mart and Target s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales. 1-12
Summary: Income Statement Ratios 1-16 1-16
Summary: Income Statement Ratios 1-17 1-17
The Statement of Cash Flows 1-18 The firm s statement of cash flows utilizes the information from the income statement and balance sheet to determine how much cash the firm has generated, and how that cash has been allocated, during a set period. Cash is important because it is needed to pay bills and maintain operations and is the source of any return of investment for investors. 1-18
The Statement of Cash Flows 1-19 The statement of cash flows is divided into three sections which roughly correspond to the three major jobs of the financial manager: Operating activities Investment activities Financing activities 1-19
The Statement of Cash Flows 1-20 An official accounting statement called the statement of cash flows helps to explain the change in accounting cash and equivalents. In finance, the value of the firm is its ability to generate financial cash flow. Operating cash flow(ocf) is the cash flow generated by business activities, including sales of good and services. It reflects tax payments, but not financing, capital spending, or changes in net working capital OCF vs. accounting statement of OCF 1-20
U.S.C.C. Financial Cash Flow 1-21 Cash Flow of the Firm Operating cash flow $238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending -173 (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital -23 Total $42 Cash Flow of Investors in the Firm Debt $36 (Interest plus retirement of debt minus long-term debt financing) Equity 6 (Dividends plus repurchase of equity minus new equity financing) Total $42 Operating Cash Flow: EBIT $219 Depreciation $90 Current Taxes -$71 OCF $238 1-21
U.S.C.C. Income Statement 1-22 The operations section of the income statement reports the firm s revenues and expenses from principal operations. Total operating revenues $2,262 Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Addition to retained earnings $43 Dividends: $43 1-22
U.S.C.C. Cash Flow from Operations 1-23 To calculate cash flow from operations, start with net income, add back non-cash items like depreciation and adjust for changes in current assets and liabilities (other than cash). Operations Net Income Depreciation Deferred Taxes Changes in Assets and Liabilities Accounts Receivable Inventories Accounts Payable Accrued Expenses Other Total Cash Flow from Operations $86 90 13-24 11 16 18-8 $202 1-23
Global Corporation s Statement of Cash Flows for 2007 and 2006 1-24 1-24
The Statement of Cash Flows 1-25 Operating Activity Use the following guidelines to adjust for changes in working capital: Accounts receivable: when a sale is recorded as part of net income, but the cash has not yet been received from the customer, we must adjust the cash flows by deducting the increases in accounts receivable. This increase represents additional lending by the firm to its customers and it reduces the cash available to the firm. 1-25
The Statement of Cash Flows 1-26 Operating Activity (cont d) Accounts payable: similarly, we add increases in accounts payable. Accounts payable represents borrowing by the firm from its suppliers. This borrowing increases the cash available to the firm. 2-26 1-26
The Statement of Cash Flows 1-27 Operating Activity (cont d) Inventory: finally, we deduct increases to inventory. Increases to inventory are not recorded as an expense and do not contribute to net income (the cost of the goods are only included in net income when the goods are actually sold) However, the cost of increasing inventory is a cash expense for the firm and must be deducted. 1-27
The Statement of Cash Flows 1-28 Investment Activity Subtract the actual capital expenditure that the firm made. Similarly, also deduct other assets purchased or investments made by the firm, such as acquisitions. 1-28
The Statement of Cash Flows 1-29 Financing Activity The last section of the statement of cash flows shows the cash flows from financing activities Dividends paid and the difference between a firm s net income and the amount it spends on dividends, which is referred to as the firm s retained earnings for that year. 1-29
Payout Ratio and Retained Earnings 1-30 Retained Earnings: Retained Earnings = Net Income Dividends Payout Ratio: Dividends Payout Ratio = Net Income 1-30
Other Financial Statement Information 1-31 Other pieces of information contained in the financial statements: Management Discussion and Analysis Statement of Stockholders Equity Notes to the Financial Statements 1-31
Financial Reporting in Practice 1-32 The Sarbanes-Oxley Act In 2002, Congress passed the Sarbanes-Oxley Act (SOX). While SOX contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders SOX attempted to achieve this goal in three ways: Overhauling incentives and independence in the auditing process Stiffening penalties for providing false information Forcing companies to validate their internal financial control processes. 1-32