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Financial Statement Analysis EBinder

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0% found this document useful (0 votes)
5 views74 pages

Financial Statement Analysis EBinder

Uploaded by

Charles
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Statement

Analysis
Accounting Fundamentals

UNLOCKING CAREER POTENTIAL

Introduction
Uses of accounting information
Examples

• Profitability analysis
• Cash flow analysis
• Forecasting
• Corporate valuation
• Credit analysis
• Deal structuring (M&A, LBO, divestitures)
• Company profiles

Financial analysis

• Investors / analysts look from the outside in


• Analysis often based on simplifications or estimates
• Analyze the past in order to:
– Understand the business
– Form a view of the future
• Dissect the accounts to see:
– What made an account go up or down?
– What were the flows into and out of an account?
– What drives the level of the account?

4
Company accounts

• Company accounts are the raw material of financial analysis


• US
– 10K full year
– 10Q quarterly
• Non-US
– Annual report full year
– Interims every 6 months

Annual report
Key contents

MD&A

Income Balance Cash flow


statement sheet statement

Notes to the
financial statements

6
The financial statements

Financial statements

Balance sheet – Assets, liabilities and equity


– A snapshot at the period end

– Income, expenses and profit


Income statement
– For the entire period

– Cash inflows and outflows


Cash flow statement – For the entire period

8
Financial statements: The balance sheet

Liabilities

Assets Must equal

Equity

Assets = Liabilities + Equity

Balance sheet assets


An example
Current assets:
Cash and cash equivalents $ 346,529
Short-term investments —
Accounts receivable—trade, net 599,073
Inventories 750,970
Deferred income taxes —
Prepaid expenses and other 152,026
Total current assets 1,848,598
Property, plant and equipment, net 2,240,460
Goodwill 684,252
Other intangibles 379,305
Other assets 155,306
Deferred income tax 36,390
Total assets $ 5,344,371

10
Balance sheet liabilities
An example
Current liabilities

Accounts payable $ 474,266

Accrued liabilities 856,967

Accrued income taxes 23,243

Short-term debt 363,513

Current portion of long-term debt 499,923

Total current liabilities 2,217,912

Long-term debt 1,557,091

Other long-term liabilities 468,718

Deferred income taxes 53,188

Total liabilities 4,296,909

11

Balance sheet shareholders’ equity


An example
Stockholders’ equity
Preferred stock —
Common stock 299,281
Class B common stock 60,620
Additional paid-in capital 783,877
Retained earnings 5,897,603
Treasury—common stock shares, at cost (5,672,359)
Accumulated other comprehensive loss (371,025)
Stockholders’ equity 997,997
Non-controlling interests in subsidiaries 49,465
Total stockholders’ equity 1,047,462

12
Transaction examples
Balance sheet

Purchasing equipment (for cash) Borrowing

Cash Cash Liabilities

Equipment

Assets = Liabilities + Equity Assets = Liabilities + Equity

13

Income statement
An example
Net sales $ 7,386,626
Costs and expenses:
Cost of sales 4,003,951
Selling, marketing and administrative 1,969,308
Goodwill and other intangible asset impairment changes 280,802
Business realignment charges 94,806
Total costs and expenses 6,348,867
Operating profit 1,037,759
Interest expense, net 105,773
Other (income) expense, net 30,139
Income before incomes taxes 901,847
Provision for income taxes 388,896
Net income $ 512,951

14
Transaction examples
Balance Sheet and Income Statement

Revenue (received in cash) Expense (not paid yet)

Cash Equity Equity

Liabilities

Assets = Liabilities + Equity Assets = Liabilities + Equity

15

Cash flow statement


An example
Operating Activities
Net income $
512,951
Adjustments to reconcile net earnings to net cash provided by operating activities
Depreciation and amortization 244,928
Stock-based compensation expense 51,533
Excess tax benefits from stock-based compensation (24,839)
Deferred income taxes (38,537)
Non-cash business realignment and impairment charges 283,469
Contributions to pension and other benefit plans (53,273)
Loss on early extinguishment of debt 28,326
Write-down of equity investments 39,489
Changes in assets and liabilities, net of effects from business acquisitions and divestitures:
Accounts receivable—trade, net (24,440)
Inventories 52,049
Accounts payable and accrued liabilities (1,017)
Other assets and liabilities 143,817
Net cash provided by operating activities 1,214,456

16
Cash flow statement
An example
Investing Activities
Capital expenditure (329,707)
Capitalized software additions (27,103)
Proceeds from sales of property, plant and equipment 1,205
Proceeds from sale of business 32,408
Equity investments in tax credit qualifying partnerships (30,720)
Business acquisitions, net of cash and cash equivalents acquired (218,654)
Sale (purchase) of short-term investments 95,316
Net cash used in investing activities (477,255)
Financing Activities
Net increase in short-term debt 10,720
Long-term borrowings 599,031
Repayment of long-term debt (355,446)
Cash dividends paid (476,132)
Exercise of stock options 72,719
Excess tax benefits from stock-based compensation 24,839
Payment of contingent consideration (10,000)
Purchase of non-controlling interest (38,270)
Repurchase of common stock (582,623)
Net cash used in financing activities (755,162)
Effect of exchange rate changes on cash and cash equivalents (10,364)
(Decrease) increase in cash and cash equivalents (28,325)

17

Cash flow and balance sheet integration

• Cash from the balance sheet:


Assets
Current assets:
Cash and cash equivalents $ $
346,529 374,854

• Cash in the cash flow statement:


(Decrease) increase in cash and cash equivalents (28,325)
Cash and cash equivalents, beginning of period 374.854
Cash and cash equivalents, end of period $
346,529

18
Financial statements
Key links

Cash flow
statement
Cash Liabilities

Assets Equity

Retained Income statement


earnings

19

Debits and credits

Liabilities
Assets & Equity
+ Dr - Cr - Dr + Cr

Each transaction has both a debit and a credit

20
The Income Statement

UNLOCKING CAREER POTENTIAL

Overview

• Revenue
• Costs
• Profit margins
• Tax expense
• Net income
• EPS

2
The income statement

Revenue x
Making / buying your product Cost of goods sold (COGS) (x)
Gross profit x
Supporting the business Sales, general and admin. (SG&A) (x)
Operating profit x
Financing the business Interest / finance cost (x)
Profit before taxes x
Paying the government Tax cost (x)
Profit after tax / Net income x

Revenue
Revenue recognition

• Revenue from customers (sales)


• Recognized when goods delivered or services performed
• Issues:
– Deferred revenue
– Long term contracts
– Premature revenue recognition
• Gross vs net revenue
– Sales tax
– Discounts, rebates, returns, etc.
• Revenue recognition is important because revenue determines profit

Revenue vs. cash flow

At what point do customers pay?

Airline Supermarket Manufacturer

Cash pre-sale Cash at sale Cash post-sale

6
Key revenue links

Income statement Balance sheet and cash


flow statement

Cash

Sales Accounts receivable

Deferred revenue

Expenses
The income statement
Expenses

Sales x
Making / buying your product Cost of goods sold (COGS) (x)
Gross profit x
Supporting the business Sales, general and admin. (SG&A) (x)
Operating profit x
Financing the business Interest / finance cost (x)
Profit before taxes x
Paying the government Tax cost (x)
Profit after tax / net income x

Cost of good sold

• Cost of goods sold (COGS or COS)


• Costs of purchase / manufacturing
• Examples:
– Raw materials
– Depreciation of factory buildings and equipment
– Factory labor
– Factory maintenance costs
– Factory utilities and other direct costs

10
COGS example

• In the first year of operation, Co. A spent $100 on 10 units of production and sold 8 units at
$12 each.
• What is the Cost of Goods Sold (COGS) for the year?
Co A. Inventory and COGS calculations
Starting inventory (0 units) 0
Production Costs
- Materials 50
- Labor 40
- Other production overheads (incl. 10
depreciation) 100
Total Production Costs (10 units @ $10)
Cost of Goods Sold (8 units @ $10) 80
Ending inventory (2 units @ $10) 20

11

Selling, general and administrative (SG&A)

Non-production business costs


– Sales and marketing
– Support services (HR, IT, Finance, etc.)
– Head office costs (including management compensation, depreciation of non-production
related fittings and equipment, etc.)

12
SG&A example

At the start of the year, Co. A buys an accounting software package, which is
expected to last for 3 years, for $12 cash.
Co. A SG&A illustration
Acquired software (start of year) 0
Cash payment for accounting software 12
SG&A income statement expenses for the year 4
Acquired software (end of year) 8

13

Profit margins
Profit measurements

Revenue x

Cost of goods sold (COGS) (x)

Gross profit x

Sales, general and admin. (SG&A) (x)

Operating profit x

Interest / finance cost (x)

Profit before taxes x

Tax cost (x)

Profit after tax / Net income x

15

Profit margins: gross profit and EBIT

Income Statement
Gross Margin
Sales 100 60/100=60%
COGS 40
Gross Profit 60
SG&A 15
Operating Profit (EBIT) 45
EBIT Margin
Net interest expense 5 45/100=45%
Profit before tax 40
Tax 10
Net Income 30

16
Profit margins: EBITDA

EBITDA = EBIT + D&A expense


– D&A: Depreciation & Amortization
– D&A expense can be found in the Cash flow statement
– EBITDA reverses D&A out of the EBIT

Income Statement Assuming that:


Sales 100 - COGS includes depreciation of 8
COGS 40 - SG&A includes amortization of 2
Gross Profit 60
SG&A 15
EBITDA Margin
Operating Profit (EBIT) 45 55/100=55%
EBITDA (45+8+2) 55

17

Profit margins: PBT and PAT

Income Statement
Sales 100
COGS 40
Gross Profit 60
SG&A 15 PBT Margin
40/100=40%
Operating Profit (EBIT) 45
Net interest expense 5
Profit before tax 40
Net Margin
Tax 10 30/100=30%
Net Income 30

18
Profit margins
Summary

Profit margin Comments


Gross margin • Focuses on production efficiency and pricing power
EBIT margin • Reflects all operating costs
• Not influenced by capital structure
EBITDA margin • A modified EBIT metric
• Ignores D&A expenses
Profit before tax margin • Reflects both operating and financial earnings
• Ignores taxes
Net margin • Reflects all income and expenses

19

Normalized profits

• ‘One off’ income or expenses are usually removed from profit calculations to
facilitate comparisons and forecasting
• Non-recurring items are not expected to occur in the future
• They must be examined case-by-case
• Examples:
– Asset Impairments
– Business restructuring costs
– Large gains and losses on the sale of businesses or assets
– Large litigation costs

20
Normalized EBIT and EBITDA

Remove the impact of non-recurring income and expenses from


reported EBIT and EBITDA
Income Statement Reported Adjustment Normalized
Sales 1000 1000
COGS excl. Depreciation (550) (550)
Depreciation (50) (50)
SG&A (100) (100)
Restructuring expenses (100) 100 0
EBIT 200 300
EBITDA 250 350

Illustration assumes no Amortization expense

21

Tax expense
Tax expense

• P&L reports the tax expense related to the reported profits before tax
• Tax expense ≠ Tax paid (in cash) during the period
• Effective tax rate (ETR) = Tax expense / Profit before tax
– Average tax rate on the reported profit
– Based on accounting data
• Marginal tax rate (MTR) = Tax applicable to the additional unit of profit
– MTR measurement is based on assumptions
– Typically: statutory tax rate on corporate income in the relevant jurisdiction(s)

23

Effective Tax Rate (ETR)

Income Statement
Sales 100
COGS 40
Gross Profit 60
SG&A 15
Operating Profit (EBIT) 45
Net interest expense 5 ETR
10/40=25%
Profit before tax 40
Tax 10
Net Income 30

24
Using the ETR and MTR
Examples

• ETR used for:


– Forecasting total tax expense in financial models
– Taxing the EBIT in DCF models
• MTR used for:
– Normalizing the net income
– Calculating the cost of debt post-tax

25

Net income and EPS


Net income and the investment cycle

Assets

Reinvestment

Returns
Shareholders

Net
Income

27

Normalized net income

Remove the post-tax impact of non-recurring items from reported


Net Income
Income Statement Reported Adjustment Normalized
Sales 1000 1000
COGS and SG&A (700) (700)
Restructuring expenses (100) 100 0
EBIT 200 300
Net interest expense (60) (60)
Profit before tax 140 240
Tax (30) (21) [= 21% x 100] (51)
Net income 110 189

28
Earnings Per Share (EPS)

• Basic EPS = Net income / Basic Weighted Average number of Shares


Outstanding (WASO)
– Basic WASO uses actual share count
• Diluted EPS = Net income / Diluted WASO
– Diluted WASO includes the potential impact of dilutive contracts
• e.g. Options issued by the firm, convertible debt, etc.
– Diluted EPS is always lower than basic EPS

29

Equity metrics

• Return on equity = Net income / Book value of equity


• Payout ratio = Dividends / Net income
• Dividend yield = Dividend per share / Share price
• Earnings yield = Diluted EPS / Share price
• P/E ratio = Share price / Diluted EPS

30
Working Capital

UNLOCKING CAREER POTENTIAL

Overview

• Current assets
• Current liabilities
• Working capital
• Analyzing working capital

2
Current assets

Current assets

Assets expected to be used or sold within 1 year


Current assets Year 1 Year 2
Cash and cash equivalents 278,843 253,666
Short-term investments 635 1,100
Accounts receivable 469,221 463,231
Finished goods 280,712 241,897
Raw materials 339,370 351,088
Total inventories 620,082 592,985
Prepayments 180,997 170,245
Total current assets 1,549,778 1,481,227

4
Current assets: examples
From the notes of company accounts
• Cash and cash equivalents
– The Company considers all highly liquid investments with the original maturity of three
months or less to be cash equivalents.
• Accounts receivable
– In the normal course of business, the Company extends credit to customers that satisfy
pre-defined credit criteria.
– Accounts receivable are net of allowances and anticipated discounts.
• Inventories
– Inventories consist of materials, labor and overhead associated with the production
process.
– Inventories are valued at cost on a last-in, first-out (LIFO) basis for U.S. associated
companies and at the lower of cost (principally first-in, first-out basis) or market for non-
U.S. associated companies.

Inventory
Valuation

Mix Maintenance
Depreciation
Sand / water
Limestone

Factory labor
Utilities

Inventory

Cost of goods
Deliveries
sold when
delivered

6
Inventory
Income statement and balance sheet

Inventories
purchased

Inventories sold Inventories unsold

Inventory
COGS
asset

Inventory
Change during the period

• Beginning amount No. units x Unit cost of production

• Additions Purchases and manufacturing costs

• Subtractions When sold → become COGS (on P&L)

• Ending amount No. units x Unit cost of production


→ reported on balance sheet

8
Inventory valuation methods

• FIFO First-in first-out

• LIFO Last-in first-out


(not allowed by IFRS but common in the USA)

• Weighted average cost

Inventory valuation
Example

• No opening inventory
• Purchased 700 units for $6 each and later purchased 600 units for $8 each
• Sells 1,000 units at a price of $10 each
Inventory and Profit calculations LIFO FIFO
Opening inventory 0 0
Add: Purchases (700 @ 6 + 600 @ 8) 9,000 9,000
Less: Cost of goods sold (COGS) 7,200 6,600
(600 @ 8 + 400 @ 6) (700 @ 6 + 300 @ 8)
= Closing inventory 1,800 2,400
(300 @ 6) (300 @ 8)

Gross Profit 2,800 3,400


(10,000 – 7,200) (10,000 – 6,600)

10
Current liabilities

Current liabilities

Obligations which are payable within 1 year


Current liabilities Year 1 Year 2
Short-term debt 65,000
-
Accounts payable 371,349 327,671
Accrued expenses 500,552 413,942
Dividends payable 79,965 71,106
Income and other taxes payable 149,254 149,410
Total current liabilities 1,101,120 1,027,129

12
Examples of key types of current liabilities

• Short-term debt
– Interest-bearing debt due within one year and / or current portion of long-term debt
• Accounts payable
– Amounts owed to suppliers
• Accrued expenses
– Operating costs incurred during the year but not yet paid
• Dividends payable
– Dividends declared but not yet paid to shareholders
• Taxes payable

13

Working capital – Definition


and calculations
The accountant’s balance sheet

Current
Current
liabilities
assets

Non current
= liabilities
Non current
assets
Equity

15

Working capital

Current
Current
liabilities
assets

Non current
= liabilities
Non current
assets
Equity

WC is used in credit analysis


16
The analyst’s version of the balance sheet

Financial Current
assets operating
liabilities
Current
operating Non current
assets operating
= liabilities

Non current Debt


operating
assets
Equity
17

Operating working capital

Financial Current
assets operating
liabilities
Current
operating Non current
assets operating
liabilities
=
Non current Debt
operating
assets
Equity
18
Operating working capital
Example

Current assets Year 1 Current liabilities Year 1


Cash and cash equivalents 278,843 Short-term debt
Short-term investments 635 -

Accounts receivable 469,221 Accounts payable 371,349


Accrued expenses 500,552
Finished goods 280,712
Dividends payable 79,965
Raw materials 339,370
Income and other taxes payable 149,254
Total inventories 620,082
Total current liabilities 1,101,120
Prepayments 180,997
Total current assets 1,549,778

19

Operating working capital


Example (1 of 4)

Determine the balances in the following accounts on Day 1

Buy a widget on day 1 of the week for 10.0 in cash.


The widget will be sold for 20 on day 7 in cash.

Inventory

Cash Accounts receivable OWC

Accounts payable

20
Operating working capital
Example (2 of 4)

Determine the balances in the following accounts on Day 1

Buy a widget on day 1 of the week for 10.0 on credit payable in 30


days. The widget will be sold for 20 on day 7 in cash.

Inventory

Cash Accounts receivable OWC

Accounts payable

21

Operating working capital


Example (3 of 4)

Determine the balances in the following accounts on Day 7

Buy a widget on day 1 of the week for 10.0 on credit payable in 30


days. The widget is sold for 20 on day 7 in cash.

Inventory

Cash Accounts receivable OWC

Accounts payable

22
Operating working capital
Example (4 of 4)

Determine the balances in the following accounts on Day 7


Buy a widget on day 1 of the week for 10.0 on credit payable in 30
days. The widget is sold for 20 on day 7 on credit, payable in 60
days.

Inventory

Cash Accounts receivable OWC

Accounts payable

23

Should OWC be positive or negative?

Positive OWC requires funding


Financial assets
Debt
Operating
Working
Capital

Equity
Non current
assets

Resources Funding

24
Should OWC be positive or negative?

Negative OWC provides funding


Operating
Financial assets Working
Capital

Debt
Non current
assets
Equity

Resources Funding

25

Understanding OWC and its link with cash flow


Examples 1 and 2
• Example 1
Year 1 Year 2
OWC 200 250
Impact on cash flow? - (50)
– Negative cash flow impact of 50 during year 2 because increasing OWC requires more
funding
• Example 2
Year 1 Year 2
OWC 550 535
Impact on cash flow? - 15

– Positive cash flow impact of 15 because decreasing OWC releases cash

26
Understanding OWC and its link with cash flow
Examples 3 and 4

• Example 3
Year 1 Year 2
OWC (720) (680)
Impact on cash flow? - ?

• Example 4
Year 1 Year 2
OWC (440) (540)
Impact on cash flow? - ?

27

Operating working capital


Summary

• Driven by operating activities only


• Helps assess effectiveness of management
• Gives you insights into the operating dynamics of a business
• OWC calculation is often simplified by taking only 3 items:
= Inventories + Receivables - Accounts payable

28
Analyzing working capital –
Ratios

Understanding the cash cycle

Receive cash
from customers

0 21 30
days

Acquire Deliver 41
raw product 11 days funding
materials required
Pay
suppliers

30
The cash cycle for a home improvements retailer

Receivable days = 6.7


Payable days = 17.8
Inventory days = 66.7
OWC = $26.0m
Receive cash
from customers
0 17.8
66.7

Acquire Pay 73.4


raw suppliers Deliver
materials product

55.6 days funding required

31

The cash cycle for an IT supplier

Receivable days = 36.0


Payable days = 52.0
Inventory days = 6.5
OWC = $(537.0m)
Receive cash
from customers
0 6.5
52.0

Acquire Deliver 42.5


raw product Pay
materials suppliers

9.5 days free funding provided!

32
Estimating OWC days
Analyzing OWC components

Ending receivables
Receivable days = x 365
Sales

Ending payables
Payable days = x 365
Cost of goods sold

Ending inventories
Inventory days = x 365
Cost of goods sold

These ratios can also be calculated using averages (rather than ending balances)

33

Solutions to exercises
Operating working capital
Example (1 of 4)

Determine the balances in the following accounts on Day 1

Buy a widget on day 1 of the week for 10.0 in cash.


The widget will be sold for 20 on day 7 in cash.

Inventory + 10

Cash - 10 Accounts receivable OWC + 10

Accounts payable

OWC is 10 positive, cash impact is negative

35

Operating working capital


Example (2 of 4)

Determine the balances in the following accounts on Day 1

Buy a widget on day 1 of the week for 10.0 on credit payable in 30 days. The
widget will be sold for 20 on day 7 in cash.

Inventory + 10

Cash 0 Accounts receivable OWC 0

Accounts payable + 10

OWC is 0, there is no impact on cash because the


inventory of 10 has been funded for free by the suppliers

36
Operating working capital
Example (3 of 4)

Determine the balances in the following accounts on Day 7

Buy a widget on day 1 of the week for 10.0 on credit payable in 30 days. The
widget is sold for 20 on day 7 in cash.

Inventory + 10 – 10 = 0

Cash + 20 Accounts receivable OWC - 10

Accounts payable + 10

OWC is 10 negative, 10 of free financing has been


provided by suppliers. 20 of cash has been received from
customers

37

Operating working capital


Example (4 of 4)

Determine the balances in the following accounts on Day 7

Buy a widget on day 1 of the week for 10.0 on credit payable in 30 days. The
widget is sold for 20 on day 7 on credit, payable in 60 days.

Inventory + 10 – 10 = 0

Cash 0 Accounts receivable + 20 OWC + 10

Accounts payable + 10

OWC is 10 positive, 20 has been invested giving credit


to customers, but 10 has been provided, for free by
suppliers

38
Understanding OWC and its link with cash flow
Examples 3 and 4
• Example 3
Year 1 Year 2
OWC (720) (680)
Impact on cash flow? - (40)
– Negative cash flow impact of 40 during year 2 because increasing OWC requires more
funding
• Example 4
Year 1 Year 2
OWC (440) (540)
Impact on cash flow? - 100
– Positive cash flow impact of 100 during year 2 because decreasing OWC releases cash

39
Non-current Assets

Non-current assets
What are they?

• Long-term assets: intended to be held for more than one year


• ‘Strategic’ assets
• Key categories:
– Property, Plant & Equipment (PP&E)
– Intangible assets
– Financial assets
– Other (tax, pensions etc)

2
Non-current assets
Presentation example

Non current assets Year 1 Year 2


Land 81,231 78,625
Buildings and building equipment 734,623 717,374
Machinery and equipment 2,055,063 1,886,018
Total property, plant and equipment, at cost 2,870,917 2,682,017
Less accumulated depreciation 1,310,853 1,259,502
Net property, plant and equipment 1,560,064 1,422,516
Deferred charges and other assets 214,457 194,382
Goodwill 1,422,957 1,147,603
Other intangible assets 484,256 415,870
Total non current assets 3,681,734 3,180,371

Accounting for non current


assets – Depreciation &
Amortization
Depreciation & amortization

• A process that spreads the cost of an asset over its useful life
• Applied to PP&E (depreciation) and to intangibles (amortization)

Depreciable
Original cost “How many years value
of asset are we going to use
this asset for?”
Salvage
value

Depreciation & amortization

• The process results in a series of expenses over a number of years


• D&A are non-cash expenses

Year 1

Year 2
Depreciable “The asset will last
me five years” Year 3
value
Year 4

Year 5

6
Depreciation & amortization

Expense
Accelerated
(higher in the earlier years)

Straight-line (constant)
40

20

Time

Accounting for PP&E and intangibles

• Expensed over their life: depreciation & amortization


• Exceptions:
– Assets with indefinite useful life
– Goodwill
• Any assets not subject to D&A must be tested for impairment annually
• Impairment: a permanent reduction in the value of the asset

8
Goodwill

• Asset which is created only when a business acquisition is made


– = Purchase price - Fair value of the net assets acquired
• Example:
– Price paid in the business acquisition = 100
– Fair value of the net assets acquired = 75
– Goodwill = 25
• Goodwill recognises the payment made for assets that cannot be separately
recognised on the acquirer’s balance sheet

NCA Analysis – BASE and


Ratios
PP&E
BASE analysis

Beginning amount

Additions Purchase of PP&E (capital expenditure)

Subtractions Depreciation

Ending amount

11

Intangible assets
BASE analysis

Beginning amount

Additions Purchase of intangible assets

Subtractions Amortization

Ending amount

12
Ratio analysis

Capex How capex intensive is the business?


Sales

‘PP&E turnover’
Sales
What is the relationship between the
Net PP&E investment (PP&E) and the sales?

Capex
Is PP&E growing?
Depreciation

13
Debt and Equity

UNLOCKING CAREER POTENTIAL

Long term funding


Introduction

Equity Debt

• Provided by • Provided by investors


shareholders (lenders)
• Permanent capital • Borrower must repay it
• Voting rights: • Examples: bonds and
influence / control loans
• Higher risk • Lower risk

2
Equity Financing

Equity

Provide funds

Shareholders Corporation
2
(May) receive
dividends
1) Equity investments do not have a maturity
2) Dividends are discretionary payments

4
Common stock

• Shares have a ‘par’ or ‘nominal’ value


– Reported in the ‘common stock’ (aka ‘share capital’) account on balance sheet
• Issue price is always higher than par
• Difference between issue price and par is reported in ‘additional paid in
capital’ (APIC) (aka ‘share premium’)
Example
Co. A issues 100 new shares at a price of 5 each
Par value per share = 1
Increase in Common Stock account 100
= 1 x 100
Increase in APIC account 400
= (5 – 1) x 100
Increase in total equity 500
5

Number of Shares

The number of shares a company is


Authorized allowed to issue

Issued Total number of existing shares

Own shares repurchased and held by


Repurchased the company (‘treasury stock’)

Outstanding = Issued - Repurchased

6
Retained earnings
BASE analysis

Beginning amount

Additions Net income

Subtractions Dividends

Ending amount

Equity
Balance sheet presentation
Par value of all shares
Common stock
issued

Excess over par


APIC
on all shares issued

Cash cost of all shares


Treasury stock
repurchased

Retained Cumulative net income less


earnings dividends distributed

8
Preferred stock

• Preference shares
• Only some companies have them
• Ranks above common stock on liquidation
• Debt-like characteristics:
– No voting rights (usually)
– No maturity (usually)
– Regular dividend payments (like interest)

Preferred stock ≠ Common stock

Debt Financing
Financial debt

Lend funds
1

Lenders 2
Pay interest Borrower

3
Repay funds

11

Debt
Key terms

Amount How much is borrowed?

Maturities When is the amount repaid?


How is it calculated? How often is it
Interest paid?
Is it repaid before or after other
Seniority financing instruments?

Covenants Rules that the borrower must follow

Other E.g. collateral, events of default etc

12
Debt instruments
Examples

Short-term debt Long-term debt


(maturities < 1 year) (maturities > 1 year)

• Bank overdrafts • Corporate bonds / notes


• Revolving facilities • Bank loans
• Notes payable
• Commercial paper
• Current portion of long-term debt

13

Debt metrics

• Net debt = Total debt – Liquid financial assets


– Liquid financial assets: Cash, cash equivalents, securities
• Debt / Equity
– Financial leverage
• Debt / EBITDA
– Ability to repay debt
• EBITDA / Interest Expense
– Ability to pay interest

14
Leverage illustration
House purchase

Debt Debt
Initial $2m $2m
house House
value value
$3m Equity increases Equity
$1m to increases
$4m to
(33%) $2m
(100%)

15

Return measures
Return on capital

• Measures the return on the amount of financing invested in the company


• A ‘rate’ of return
• Definition of ‘capital’ and definition of ‘return’ must be consistent with each
other How much did the investment
generate during the period?

Return
Return on
capital =
Capital
How much capital was
invested?

17

Return on equity (ROE)

Measures the return on the shareholders’ investment

Net income
Return on
equity =
Shareholders’ equity

18
ROE decomposition (DuPont analysis)

ROE can be decomposed into factors

Net income Sales Assets


ROE = x x
Sales Assets Equity

Net income Asset turnover Equity multiplier


margin Investment Leverage
Profitability efficiency

19

Return on invested capital (ROIC)

• This version of return looks at the total amount of capital provided by


investors (shareholders and debtholders)
• Aka ‘return on capital employed’ (ROCE)
• Usually calculated unlevered (before interest) Before or after tax

Return on Operating profit


invested =
capital Debt and equity
Invested capital

20
ROIC Decomposition

ROIC can be decomposed into factors

Operating profit Sales


ROIC = x
Sales Invested capital

Operating profit Net operating assets


margin turnover
Profitability Efficiency

21
Cash Flow Statement

UNLOCKING CAREER POTENTIAL

Key cash flow rules


Assets and cash flow

1. Assets increase Cash falls


– For example:
• If PP&E increases, this is normally due to capital expenditure
• Capital expenditure usually requires cash payments

2. Assets fall Cash increases


– For example:
• If receivables fall, this is normally because a customer has paid
• A customer payment is an inflow of cash

Liabilities & Equity and cash flow

3. L&E increase Cash increases


– For example:
• If debt increases, this is normally due to new debt being raised
• Raising debt provides cash

4. L&E fall Cash falls


– For example:
• If payables fall, this is normally because a supplier has been paid
• Paying a supplier causes an outflow of cash

4
Rules of cash flow
Summary

• Assets have an inverse relationship with cash flow


– They are uses of funds
• Liabilities and equity have a direct relationship with cash flow
– They are sources of funds

Applying the cash flow rules


Understanding the cash flow statement

The cash flow statement is a mathematical reconciliation of two consecutive


balance sheets

Year 1 Year 2 Change


Cash 50 55 5
Inventories 30 20
Net PP&E 40 45
Debt 60 50
Retained earnings 60 70

What has caused cash to increase by 5?

Understanding the cash flow statement (cont.)

The cash flow statement is a mathematical reconciliation of two consecutive


balance sheets

Year 1 Year 2 Change in cash


Cash 50 55
Inventories 30 20 10
Net PP&E 40 45 (5)
Debt 60 50 (10)
Retained earnings 60 70 10
Matches the change
in cash between
Net cash flow 5 Year 1 and Year 2

8
Cash flow categories

Three cash flow categories

Operating (CFO) Investing (CFI) Financing (CFF)


Key components: Key components: Key components:

• Payments from • Purchase and • Equity issuance


customers (sales) sale of long-term • Dividends
• Payments to suppliers assets
and employees • Share buy-back
• PP&E • Debt issuance
• Interest
• Intangibles • Debt repayment
• Tax
• Financial assets

10
Categorising cash flows

Change
Year 1 Year 2 Category
in cash
Cash 50 55
Inventories 30 20 10 Operating
Net PP&E 40 45 (5) Operating & Investing
Debt 60 50 (10) Financing
Retained earnings 60 70 10 Operating & Financing

Some cash flows must be split into components


(using BASE analysis)

11

Splitting the movement of PP&E


PP&E BASE

Beginning balance 40

Additions Capex ?? 8 CFI

CF
Subtractions Depreciation (3) O

Ending balance 45

12
Splitting the movement of retained earnings
Retained earnings BASE

Beginning balance 60

CF
Additions Net income 12 O

Subtractions Dividend ?? (2) CFF

Ending balance 70

13

Cash flow categories


Year 2
Net Income 12
Depreciation 3
Change in inventories 10
Cash flow from operations 25

Capital expenditure (8)


Cash flow from investing (8)

Change in debt (10)


Dividends paid (2)
Cash flow from financing (12)
Net cash flow 5
14
Completing the cash flow
statement

Cash reconciliation

The net cash flow shown in the cash flow statement must be reconciled with the
cash shown on balance sheet

Beginning cash 50 from balance sheet


Net cash flow for this period 5 from cash flow statement
Ending cash 55

Must match the cash shown


on balance sheet

16
The complete cash flow statement
Year 2
Net Income 12
Depreciation 3
Change in inventories 10
Cash flow from operations 25
Capital expenditure (8)
Cash flow from investing (8)
Change in debt (10)
Dividends paid (2)
Cash flow from financing (12)
Net cash flow 5

Beginning cash balance 50


Net cash flow 5
Ending cash balance 55

17

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