Financial Statements

Spring 2023
Lecture 2

Prof. Chiyoung Cheong

Financial Statements and Cash Flow
(Chapter 2)

Our emphasis is on determining a firm’s cash flow from its

financial statements (not on preparing financial statements)
Keep in mind: Cash flow is a company’s lifeblood .

Other objectives:
Know the difference between book value and market value
Know the difference between accounting income and cash flow

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Financial Statements
• There are four main financial reports:
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Owners’ Equity (Ignored by us)

We use information in these statements to estimate

Operating and Free Cash Flows

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 Difference between
Accounting and finance perspectives
• Accounting is transactions based, not cash flow based.

• Very simple example: You invest $1,000 today in some safe investment. You know for sure that
you will receive $3,000 in one year.
Accounting Perspective: You have earned $2,000 today. You are earning nothing next year.
Accounting entry: +$2,000 today.
Finance Perspective: You are losing $1,000 today. You are gaining $3,000 tomorrow.
Finance entry: –$1,000 today
+$3,000 next year. (Note: future payments will be reduced for possible
non-payment risk, time value of money, etc.)
U.S. Corporation Income Statement
 Income Statement
• The income statement measures performance
over a specified period of time (period,
quarter, year).
• Report revenues first and then deduct any
expenses for the period
• End result = Net Income = “Bottom Line”
• Dividends paid to shareholders
• Addition to retained earnings
• Income Statement Equation:
• Net Income = Revenue - Expenses
Balance Sheet

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The Balance Sheet
• A snapshot of the firm’s assets and liabilities
at a given point in time (“as of …”)
• Assets
− Left-hand side (or upper portion)
− In order of decreasing liquidity
• Liabilities and Owners’ Equity
• Right-hand side (or lower portion)
• In ascending order of when due to be paid
• Balance Sheet Identity
▪ Assets = Liabilities + Stockholders’ Equity
The Balance Sheet
Figure 2.1
Total Value of Assets Total Value of Liabilities
and Shareholders' Equity

Net
Working Current Liabilities
Current Assets Capital

Long Term Debt

Fixed Assets

1. Tangible
2. Intangible Shareholder Equity
The Balance Sheet
• Net working capital
• Current Assets minus Current Liabilities
• Usually positive for a healthy firm
• Liquidity
− Speed and ease of conversion to cash without
significant loss of value
− Valuable in avoiding financial distress
• Debt versus Equity
− Shareholders’ equity = Assets - Liabilities
The Concept of Cash Flow
• Cash flow = one of the most important
pieces of information that can be derived from
financial statements
• The accounting Statement of Cash Flows does
not provide the same information that we are
interested in here
• Our focus: how cash is generated from
utilizing assets and how it is paid to those
who finance the asset purchase.
Cash Flow From Assets
• Cash Flow From Assets (CFFA)
= Operating Cash Flow (OCF)
– Net Capital Spending (NCS)
– Changes in NWC (ΔNWC)

• Cash Flow From Assets (CFFA)

= Cash Flow to Creditors (CF/CR)
+ Cash Flow to Stockholders (CF/SH)
 Example: U.S. Corporation
Balance Sheet U.S. Corporation
Assets Liabiities & Owners' Equity
2009 2010 2009 2010 Income Statement
Current Assets Current Liabilities Net sales $1,509
Cash $104 $160 Accounts Payable $232 $266
Accounts Receivable 455 688 Notes Payable 196 123
Cost of goods sold 750
Inventory 553 555 Total $428 $389 Depreciation 65
Total $1,112 $1,403
Earnings before interest and taxes $694
Fixed Assets
Net Fixed assets $1,644 $1,709 Long-term debt $408 $454 Interest Paid 70
Owners' equity Taxable income $624
Common stock and
paid-in surplus 600 640
Taxes 212
Retained earnings 1,320 1,629 Net Income $412
Total $1,920 $2,269
Dividends $103
Total Liabilties &
Total assets $2,756 $3,112 Owners Equity $2,756 $3,112 Addition to retained earnings $309

• CFFA = OCF – NCS - ΔNWC

OCF = EBIT + depreciation – taxes

NCS = ending net FA– beginning net FA + depreciation

ΔNWC = ending NWC – beginning NWC

CFFA = = $87
 Example: U.S. Corporation
U.S. Corporation
Balance Sheet U.S. Corporation
Assets Liabiities & Owners' Equity Income Statement
2009 2010 2009 2010 Net sales $1,509
Current Assets Current Liabilities Cost of goods sold 750
Cash $104 $160 Accounts Payable $232 $266
Depreciation 65
Accounts Receivable 455 688 Notes Payable 196 123
Inventory 553 555 Total $428 $389 Earnings before interest and taxes $694
Total $1,112 $1,403 Interest Paid 70
Fixed Assets Taxable income $624
Net Fixed assets $1,644 $1,709 Long-term debt $408 $454 Taxes 212
Owners' equity
Net Income $412
Common stock and
paid-in surplus 600 640
Dividends $103
Retained earnings 1,320 1,629 Addition to retained earnings $309
Total $1,920 $2,269
Total Liabilties & Owners
Total assets $2,756 $3,112 Equity $2,756 $3,112

• CFFA = CF/CR + CF/SH

CF/CR = interest paid – net new borrowing
=
CF/SH = dividends paid – net new equity
=
CFFA = = $87
Accounting numbers are not cash flows
We’ll use cash flows instead of earnings or net
income
• To go from accounting earnings (EBIT) to cash flows,
we must:
– Add back non-cash expenses, such as
depreciation and amortization,
– Deduct net investment in long-term assets (aka
capital expenditures)
– Deduct net investment in working capital
(inventory, accounts receivable and payable)
Accounting treatment of capital
expenditures and depreciation
• Investment in long-term assets (capital expenditures) are not treated as
accounting expenses. But they do cause immediate cash outflows:
therefore, we deduct capital expenditures
• Accounting assumes capital expenditures) are incurred gradually across
years of use (depreciation), not when they are actually made!
• Since depreciation is not an actual cash expense, it does not reduce the
cash flows.
• However, depreciation reduces taxable income and taxes. Therefore we
add depreciation back.
Investment in Working capital
• Accounting records operating revenues and operating
expenses when these are incurred.
• Accountants record a sale when it's done, not when it is
paid for! The difference goes to accounts receivable.
• Accountants record an operating expenditure when it is
incurred, not when it is paid for! The difference goes to
accounts payable.
• The differences between when operating revenues and
operating expenses are incurred and when they are actually
paid for are captured by the change in working capital.
• Change in Working Capital =change in current assets –
change in current liabilities
• increase in working capital reduces cash flows in that
year
• decrease in working capital increases cash flows in that
year
Calculating Cash Flow From Assets
(Free Cash Flows)
Sales /Revenues
– Cash Operating Expenses (COSG and SSG&A)
EBITDA or Operating Income
– non-cash expenses (e.g., depreciation)
EBIT or Net Operating Income
– Income Taxes
Net Operating Profits after Taxes (NOPAT or NOI×(1-tax rate))
+ Depreciation
Operating Cash Flows
– Change in non-cash working capital
– Capital expenditures
– Change in other assets net
Cash Flow From Assets
Financial Statement Analysis
• When valuing a company, you must
understand how it operates and its financial
characteristics.
• Assists in determining strengths and weaknesses.
• Useful when making projections.
• Financial statement analysis (I)
• Ratio analysis (including Du Pont Identity)

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Ratio analysis
• We do not blindly assume that ratios will stay constant
• Instead, we compare them to some benchmark:
• How a firm’s ratios have changed over time?
• (Time-series analysis)

• How they compare with those of other firms in the industry?

• (Cross-sectional analysis)
• Understand how ratios would look in future. Account for:
• Changes in product mix
• Product life cycle effects
• Competitive scenario, etc.

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Time-series Comparison

• Comparing with earlier periods

• Consider the impact of changes in economic,
industry, and firm-specific conditions.
• Some precautions
• Has the firm made a change to its product mix
(ex. Merger)
• Has the firm changed its accounting methods?
• Adjustment for industry conditions (is a 10%
increase in profitability good if the industry
experienced a 15% increase)

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 Time-series Comparison

• Product life cycle: Products move through 4 life cycles:

introduction, growth, maturity, and decline.
• Introduction & growth: Product development and
promotion
• High R&D expenses, high advertising and promotion
spending, large capital investments
• Maturity: Competition increases and cost reductions
occur
• Decline: Sales decline and profit opportunities
diminish

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Cross-section Comparison
• Comparing to other firms, the impact of
firm-specific conditions is much clearer.

• Difficulties in comparison
• Need to find firms with similar products, size,
age.
• May have different accounting methods?

• Published Industry Ratios (Books)

• Robert Morris Associates – Annual Statement
Studies
• Dun and Bradstreet – Industry Norms & Ratios
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Ratio Analysis
• Ratio analysis is a tool – Like with all tools you must
• Understand its possible uses
• Know its limitations.

• Thus, you should keep a few questions in the back of your mind.
• What does this ratio tell us and why? (intended use)
• What does a high ratio mean?
• What does a low ratio mean?

• How may the ratio be misleading? (limitations)

• Different accounting information
• Based on historical information
• There are far too many ratios

• Understand time trends and cross-sectional trends in ratios

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Facts about Ratio Analysis
• Ratios provide relative measure to interpret financial
statements
• Eliminate problems associated with comparing firms with different
sizes
• There are MANY important financial ratios
• The most important ratios may vary by industry
• We will cover commonly used ratios, however, the list is not
exhaustive
• Four main categories of ratios that we are interested
in:
• Liquidity ratios: firm’s ability to pay bills in the short-term
• Leverage ratios: long-term solvency of the firm
• Asset usage or Efficiency ratios: how efficiently assets
are being used to generate sales
• Profitability ratios: how efficient the firm is in generating
profits from its assets

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Category I: Liquidity Ratios
• What do they measure?
• Firm’s short-term solvency: how well can the
firm pay its bills without undue stress
• A high current ratio or quick ratio indicates that
firm is “liquid”
• but too high a ratio might mean that the firm is
inefficient (i.e., cash is lying around unnecessarily)

• Some important issues to consider:

• How liquid are inventory and receivables?
• Does the firm have easy access to borrowing?
• Because then it can afford to maintain a low current
ratio

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Liquidity Ratios

Current ratio = Current Assets

Current Liabilitie s
CA - inventory
Quick ratio =
CL
Cash ratio = Cash
CL

Interval measure = CA
Avg. daily operating costs

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Category II: Leverage Ratios
• What do they measure?
• Firm’s long-term solvency
• Two categories:
• Leverage ratios measure amount of debt on firm’s
balance sheet
• If these ratios are “too high”, it might indicate possibility of
financial distress/ bankruptcy
• If ratios are “too low”, it could indicate the firm is not
utilizing all the benefits of debt
• Coverage ratios measure firm’s ability to service
interest payments
• High coverage ratios: firm can generate enough earnings
(cash) to make interest payments

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Leverage Ratios

Total Debt
• Debt Equity Ratio =
Equity
Total Debt
• Total Debt Ratio =
Total Assets
Long Term Debt
• LT Debt Ratio =
Long Term Debt+Equity
Total Assets
• Equity Multiplier =
Equity
EBIT+Depreciation/Amortization
• Cash Coverage =
Interest Payment

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Category III: Efficiency Ratios

• What do they measure?

• how efficiently the firm use its assets to generate sales

• Investigates both fixed and current assets

• Turnover ratios: How much sales are you generating
using an underlying asset?
• Numerator is generally sales (or COGS)
• Denominator is always an asset

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Asset usage (Efficiency) Ratios
COGS
• Inventory Turnover =
Inventory
365
• Days’ Sales in Inventory=
Inventory Turnover
Sales
• Receivables Turnover =
Receivables
365
• Days’ Sales in Receivables=
Receivables Turnover
Sales
• NWC Turnover =
NWC
Sales
• Fixed Assets Turnover=
Net Fixed Assets
Sales
• Asset Turnover =
Total Assets

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Interpretation Behind Turnover Ratios

• Example
Suppose Sales=$1,500 and Receivables=$250
• Receivables turnover =
• Days sales in receivables =
• i.e., the firm takes days on average to collect
its bills from customers

• Similar intuition behind Days sales in

payables, and Days sales in inventory

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Category IV: Profitability Ratios

Net Income
• Net Profit Margin (NPM) =
Sales

Net Income
• Return on Assets (ROA) =
Total Assets

Net Income
• Return on Equity (ROE) =
Equity

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Profitability Ratios
• These ratios are the bottom line and show how well
the firm is able to control expenses and generate
revenue.

• They reflect the impact of all other categories of

ratios

• Relationship between profitability ratios and other

ratios? (Du Pont identity)

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Du Pont Identity
• ROA and ROE can be decomposed as follows:

ROA = Net income

Totalassets
= Net income  Sales
Sales Totalassets
= Net Profit Margin  Asset turnover

ROE = Net income

Equity
Net income
=  Totalassets
Totalassets Equity
= ROA  " Equity multiplier" Du-Pont Identity

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Interpreting Du Pont Identity
ROE
= ROA × Equity Multiplier
= Profit Margin × Total Asset Turnover × Equity Multiplier

• ROE is determined by:

• Operating efficiency (“NPM”)
• Note: This is “operating” only by accounting standards,
and not by the finance interpretation!
• Asset use efficiency (“asset turnover”)
• Financial leverage ( “equity multiplier”)

• Notice that:
• Equity multiplier = 1 + debt-equity ratio

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Interpreting Du Pont Identity
• Du Pont Identity can help in understanding:
• Trends in ROE across time, i.e., how ROE will change over a
product’s life cycle
• Why ROEs differ across firms/ industries
• Whether a firm’s ROE is sustainable or not

• Note: The 3 components in the ROE decomposition

are not independent
• If you increase financial leverage, that will have an impact
on other components as well
• It would be wrong to conclude that a firm can keep
increasing its ROE by increasing its financial leverage

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ROA Decomposition by Industry

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Growth Rate and Payout Policy
• Out of their net income, firms can either pay dividends
or reinvest
• Amount reinvested shows up in retained earnings

• High growth firms typically have low payout ratios (i.e.,

high reinvestment ratios)
• Payout ratio, b = Dividends/ Net income
• Reinvestment ratio = 1 – payout ratio = 1 - b
• Low payout allows these firms to reinvest in new projects
• How do firms finance growth?
• What is a reasonable growth rate we can assume?
• Two feasible growth rates

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Theory: Feasible Growth Rates
• Sustainable growth: Maximum growth feasible with
out external equity financing and a constant debt to
equity ratio

ROE  (1 − b )
g=
1 − ROE  (1 − b )

• Internal growth: Maximum growth feasible with no

external financing

ROA  (1 − b )
g=
1 − ROA  (1 − b )
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Key Points
• A firm’s performance can be analyzed along
4 dimensions:
• S-T solvency or liquidity: Ability to pay bills in
the short run.
• L-T solvency or leverage: Ability to meet long
term obligations.
• Asset management or turnover: Intensity and
efficiency of asset use.
• Profitability: Ability to control expenses.
• DuPont Identity: Figure out where profits
come from

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