FIN 468 Intermediate Corporate Finance Topic 2 Financial Statements Larry Schrenk Instructor 1 of 22 Topics The Statements Ratio Analysis and Types of Ratios DuPont Equation Forecasting Pro Forma Statements 2 of 22 The Statements 3 of 22 Stock versus Flow 1 Income Statement Flow 2 Balance Sheet 3 Statement of Cash Flows Flow Stock 4 of 22 Balance Sheet Organization Assets LHS Firm Value Organized by Receivable Liquidity Allocation of Firm s Investable Funds Assets Portfolio Liabilities RHS Claims on Firm Value Organized by Payable Liquidity Allocation of Return and Risk to Investors Claims Portfolio Income Statement Organization Sales Earnings Variable Costs Gross Costs From Unit Production Fixed Costs EBIT From Total Production Interest EBT After Financing Included Taxes Net Income After Taxes Included Dividends Additions to Retained EarningsRetained by the Firm Ratio Analysis and Types of Ratios 7 of 22 Principles 1 2 3 4 5 6 7 Consider the Perspective Toolbox Approach Check Annualization Beware of Anomalies Ratios as Red Flags Use Customized Ratios No Official Rules Classification 1 2 3 4 5 Short Term Solvency Liquidity Long Term Solvency Leverage Efficiency Profitability Market Value Use Comparisons Time Trend Analysis Firm s Performance over Time Peer Group Analysis Similar Companies or Industry Analysis Short Term Solvency Form Purpose Measure of Short Term C ash Inflow Measure of Short Term C ash Outflow Short Term Liquidity Can the Firm Meet Current Obligations Examples Cash Ratio Current Ratio Quick Ratio Long Term Solvency Degree of Leverage Analysis Form Purpose Measure of Debt Measure Asset Base Long Term Liquidity Can the Firm Remain Solvent Examples Total Debt Ratio Debt Equity Ratio Long Term Solvency Coverage Analysis Form Measure of Short Term C ash Inflow Interest Payment Purpose Firm Service its Long Term Obligations Is Bankruptcy a Concern Examples Times Interest Earned TIE Cash Coverage Efficiency Analysis Sales or other Benchmark Balance Sheet Asset Form Purpose How Efficiently does the Firm Use the Value Invested in each Asset Balance Sheet Assets as Portfolio Liquidity Return Trade Of Examples Turnover Analysis Profitability Analysis Form Purpose Earnings C ash Flow Asset Benchmark Is the Firm Generating Reasonable Earnings Relative to Total Assets or Equity NOTE Accounting Measures Examples Return on Assets ROA Return on Equity ROE Market Value Analysis No Common Form or Purpose Use of Market Data Examples PE Ratio Market to Book Ratio Some Cautions No Underlying Theory Diversified Firms Globalization Varying Accounting Procedures Diferent Fiscal Years DuPont Equation 18 of 22 DuPont Equations Analysis Decomposition Analysis Not Calculation The DuPont Equation Net Income ROE Total Equity Net Income Sales Total Assets Sales Total Assets Total Equity Profit Total Assets Equity Margin Turnover Multiplier Profitability Effeciency Leverage Extending the DuPont Equation Forecasting Pro Forma Statements 22 of 22 Percent of Sales Approach Some items vary directly at least approximately with sales Driver Percent of Sales Approach Some items may not vary with sales Items whose value cannot be easily changed Items whose value is determined by other variables and Items under the policy control of the firm Financing policy long term debt and equity Payout policy dividends Income Statement Costs may vary directly with sales Why Depreciation and interest expense may not vary directly with sales Why Dividends generally do not vary directly with sales Why Balance Sheet Assets Generally current assets vary directly with sales Why Generally long term assets do not vary directly with sales Why Balance Sheet Liabilities Many current liabilities vary directly with sales Why But notes payable do not vary with sales Why Long term debt does not vary with sales Why Balance Sheet Equity How does retained earnings change Changes on equity and all the various sub groups do not vary with sales Why External Financing Needed EFN After applying the percentage of sales method the balance sheet will most likely not balance External Financing Funds Needed EFN diference between forecasted increase in assets and the forecasted increase in liabilities and equity External Financing Needed EFN EFN is the new capital that must be raised This is often called the plug EFN can be negative Financing policy determines the type of instruments to be used i e whether new funds are raised through debt equity or some combination of the two Pro Forma Example Exogenous Parameters Annual Sales Increase 10 Firm Policies Payout ratio 75 Financing EFN will be raised through equity Pro Forma Example Color Codes Red Numbers are those which change with sales e g accounts receivable Blue numbers are those that do not change with sales e g fixed assets Purple numbers are those whose value is determined by firm policies e g dividends Black numbers are values which are entirely a function of other variables e g retained earnings Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 COGS 1 644 Depreciation 276 EBIT 391 Interest Paid 141 EBT Taxes Net Income Dividends 250 85 165 121 Addition to Ret Earn 44 Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 COGS 1 644 Depreciation 276 EBIT 391 Interest Paid 141 EBT Taxes Net Income Dividends Changes with Sales No Change 250 85 Pre Determined 165 121 Addition to Ret Earn 44 Follows Policy Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 2 542 COGS 1 644 Depreciation 276 EBIT 391 Interest Paid 141 EBT Taxes Net Income Dividends 250 85 165 121 Addition to Ret Earn 44 Increases by 10 Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 2 542 COGS 1 644 1 808 Depreciation 276 EBIT 391 Interest Paid 141 EBT Taxes Net Income Dividends 250 85 165 121 Addition to Ret Earn 44 Increases with Sales Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 2 542 COGS 1 644 1 808 Depreciation 276 EBIT 391 Interest Paid 141 EBT Taxes Net Income Dividends 276 250 85 165 121 Addition to Ret Earn 44 No Change No Capital Invest Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 2 542 COGS 1 644 1 808 Depreciation 276 276 EBIT 391 458 Interest Paid 141 141 EBT Taxes Net Income Dividends 250 85 165 121 Addition to Ret Earn 44 No Change Debt Not Changed Pro Forma Income Statement Income Statement 2006 pro forma Sales 2 311 2 542 COGS 1 644 1 808 Depreciation 276 276 EBIT 391 458