Interpreting & Forecasting Financial Statements, Taxes and Cash Flow

1. Chapter Three Interpreting & Forecasting Financial Statements, Taxes and Cash Flow

2. Chapter Outline • Judging the performance of a company? • Financial Statements • The Balance Sheet (Balansräkning ) • The Income Statement (Resultaträkning) • Cash Flow • Ratio Analysis • Financial Planning to Avoid Bankruptcy • Financial Leverage • Financial Planning • Sustainable Growth rate

3. I- Balance Sheet • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of liquidity • Liquidity • Ability to convert to cash quickly without a significant loss in value • Liquid firms are less likely to experience financial distress • But, liquid assets earn a lower return • Too much and too little liquidity undesirable.

4. The Balance Sheet - Figure 2.1 Kortfristiga Skulder Omsättningstillgångar

5. Net Working Capital and Liquidity • Net Working Capital • Current Assets – Current Liabilities • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out • Usually positive in a healthy firm • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity

6. Example 1:US Corporation Balance Sheet –Table1

7. Market Vs. Book Value • The balance sheet provides the book value of the assets, liabilities and equity. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • Market value and book value are often very different. • Which is more important to the decision-making process?

8. Example 2. Klingon Corporation

9. II- Income Statement • The income statement is more like a video of the firm’s operations for a specified period of time. • You generally report revenues first and then deduct any expenses for the period • Matching principle – GAAP to show revenue when it accurse and match the expenses required to generate the revenue

10. US Corporation Income Statement – Table 2 (EBIT)

11. Taxes • Marginal vs. average tax rates • Marginal–the percentage paid on the next dollar earned • Average – the tax bill / taxable income • Suppose your firm earns $4 million in taxable income. • What is the firm’s tax liability? • What is the average tax rate? • What is the marginal tax rate? • Tax liability Tax Bill : Tableau • .15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + • .39(335,000–100,000) + .34(4,000,000–335,000)= $1,356,100 • Average rate: 1,356,100 / 4,000,000 = .339025 (33.9%) • Marginal rate: comes from the table (34%)

12. III-The Concept of Cash Flow • Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements • Cash Flow From Assets (CFFA) • Two ways to calculate it: • See Next Page for Details

13. Cash Flow Summary Table 3 Long

14. Example: US Corporation • Operating Cash flow (OCF):= EBIT+ depreciation–taxes • = 694 +65- 212 = $547 • Net Capital Spending (NCS): • = ending net fixed assets – beginning net fixed assets + depreciation = 1709 – 1644 + 65 = $130 • Changes in NWC = ending NWC – beginning NWC = (1403-389) - (1112-428) = $330 • CFFA = 547 – 130 – 330 = $87 or • CF to Creditors = interest paid – net new long borrowing • = 70 - 46 = $24 • CF to Stockholders = dividends paid – net new equity raised • = 103 - 40 = $ 63 • CFFA = 24 + 63 = $87

15. Example 3 : Balance Sheet and IncomeStatement Information • Current Accounts • 1998: Current Assets (CA) = 4500; Current Liability(CL)=4300 • 1999: CA = 2000; CL = 1700 • Fixed Assets and Depreciation • 1998: Net Fixed Assets (NFA) = 3000; 1999: NFA = 4000 • Depreciation expense = 300 • LT Liabilities and Equity • 1998: Long Term Debt (LTD) = 2200; Common Equity = 500; Retained Earning (RE)= 500 • 1999: LTD = 2800; Common Equity = 750; RE = 750 • Income Statement Information (1999) • EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250

16. Example 3: Cash Flows • OCF = EBIT + depreciation – taxes • = 2700 + 300 – 1000 = 2000 • NCS = ending net fixed assets – beginning net fixed assets + depreciation = 4000 – 3000 + 300 = 1300 • Changes in NWC = ending NWC – beginning NWC • = (2000 – 1700) – (4500 – 4300) = 100 • CFFA = 2000 – 1300 – 100 = 600 or • CF to Creditors = interest paid – net new long borrowing • = 200 – (2800 – 2200) = - 400 • CF to Stockholders = dividends paid – net new equity raised • = 1250 – (750 – 500) = 1000 • CFFA = -400 + 1000 = 600.

17. Sources and Uses of Cash Flows: Example 4 • Fundamentally 2 activities: • SOURCE (S): sales of: prod., real assets, bonds or stocks. • (-) Assets or (+) (liabilities or equity) are source. Inflow. • Uses (U): ( purchases of materials, L , buying real assets, pay debt, repurchasing of stocks or pay dividends). •  (+)Assets or (-) (liabilities or equity) are uses. Outflow

18. Example 4: Calculating Cash Flows

19. IV- Ratio Analysis • Ratios allow for better comparison through time or between companies • What the ratio is trying to measure • Why is that information important • Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios

20. Example 5: Sample Balance Sheet Numbers in thousands

21. Example 5: Sample Income Statement,2000 Numbers in thousands, except EPS & DPS

22. Computing Ratios for 2000 • 1- Computing Liquidity Ratios(Short-term-Solvency) • Current Ratio = CA / CL • 1,801,690 / 1,780,785 = 1.01 times • Quick Ratio = (CA – Inventory) / CL • (1,801,690 – 388,947) / 1,780,785 = .835 times • 2- Computing Long-term Solvency Ratios • Total Debt Ratio = (TA – TE) / TA • (4,931,444 – 1,761,044) / 4,931,444 = .6429 times or 64.29% • The firm has 64% in debt (and 36 equity) for ever $1 assets • Debt/Equity = TD / TE • (4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times • or : .6429/.3571= 1.8 • Equity Multiplier = TA / TE = 4,931,444/ 1,761,044=2.8 • Or (TE + TD)/TE = 1 + D/E = 1 + 0,64289/0.3571 = 2.8

23. Computing Ratios • 3- Computing Total Asset Turnover (Asset Management) • Total Asset Turnover = Sales / Total Assets • 4,335,491 / 4,931,444 = .88 times • Measure of asset use efficiency • 4- Computing Profitability Measures • Profit Margin = Net Income / Sales • 471,916 / 4,335,491 = .1088 times or 10.88% • Return on Assets (ROA) = Net Income / Total Assets • 471,916 / 4,931,444 = . 0957 times or 9.57% • Return on Equity (ROE) = Net Income / Total Equity • 471,916 / 1,761,044 = .2680 times or 26.8%

24. Computing Ratios • 5- Computing Market Value Measures • Assume Market Price = $60.98 per share • Shares outstanding = 205,838,910 • EPS: Earnings/# shares outstanding • 471,916/205,838=2,29 • PE Ratio = Price per share / Earnings per share • 60.98 / 2.29 = 26.6 times • Book Value per Share = TE/# of shares • (1,761,044,000 / 205,838,910) = 8,55 • Market-to-book ratio = market value per share / book value per share • 60.98 / (1,761,044,000 / 205,838,910) = 7.1 times

25. Deriving the DuPont Identity • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TE) (TA / TA) assets/assets • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange • ROE = (NI / TA) (TA / TE) (Sales / Sales) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM • Using the Du Pont Identity • ROE = PM * TAT * EM • ROE = 0.1088 (0.88) (2.8) = 26.8% • Profit margin is a measure of the firm’s operating efficiency – how well does it control costs • Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets • Equity multiplier is a measure of the firm’s financial leverage

26. Why Evaluate Financial Statements? • Internal uses • Performance evaluation • Planning for the future • External uses • Creditors - Suppliers - Customers- Stockholders • Benchmarking • Time-Trend Analysis • Peer Group Analysis • Potential Problems: • There is no underlying theory, • Varying accounting procedures -Different fiscal years- Extraordinary events

27. V- The Effect of Financial Leverage • Debt is a negative sign→↑risk • But, deduction (avdrag +). • ↑Leverage →↑ROE if and onlyif (ROA > i). Originally AU BL • Assets 1000 000 1000 000 • Equity 1000 000 500 000 • Debt 000 500 000 • EBIT 120 000 120 000 • ROA 12% 12% • Case (1): if i=10% • EBIT 120 000 120 000 • Interest exp. 0 50 000 • Taxable income 120 000 70 000(40%) • Taxes (40%) 48 000 28 000 • NI 72 000 42 000 • Eq. 1000 000 500 000 • ROE( NI//Eq) 7.2% 8.4% • ROA 12% 12%

28. VI-Long Term Financial Planning and Growth • Elements of Financial Planning • Investment in new assets • Degree of financial leverage • Cash paid to shareholders • Liquidity requirement • Financial Planning Process • Planning Horizon – • Aggregation - • Assumptions and Scenarios • Make realistic assumptions about important variables • Determine at least a worst case, normal case and best case scenario • The importance of Financial Planning: • Avoiding surprises (Grow broke?)

29. Financial Planning Model Ingredients • Sales Forecast • Pro Forma Statements • Asset Requirements • Financial Requirements • Plug Variable • Economic Assumptions

30. Constant growth planning Model : every item increase as sales Example

31. Example: Pro Forma Income Statement • Initial Assumptions • Sales will grow by 15% • All items are tied directly to sales

32. Example: Pro Forma Balance Sheet • Case I • Dividends are the plug • Each item ↑by 15% • Dividends = 460– 90= 370 • Case II • Debt is the plug and no dividends are paid • The entire NI is retained earning • Equity = 600+460 = 1060 • Debt= 1150-1060= 90

33. Exempel 2 You expect your sales, costs and assets to grow by 10% next year. You will not pay any dividends. Construct pro forma statement, Income Statement Current Projected Sales $800 $880 Costs $700$770 Taxable income $100 $110 Taxes (34%) $ 34$ 37 Net income $ 66 $ 73 Balance Sheet Current Projected Current Projected Assets $400 $440 Debt $150 $117 Equity $250$323 Total $400 $440 Total $400 $440

34. Continue Example 2 Step 1 Step 2 Step 3 Step 4

35. Plowback and Dividend Payout Ratios • Your company has net income of $1,600 for the year. You paid out $400 in dividends to your stockholders. • What is the dividend payout ratio? What is the plowback ratio? What is the dollar increase in retained earnings?

36. Sustainable Growth Rate in Sales - No new stocks issue and No increase in the D/E ratio • Sustainable growth rate in Sales • g = ROE x (1-Dividend payout ratio) • Example : A company has the following in 2006 • Asset turnover (Sales/Assets) ) = 0.5 times per year • D/E = 1 - Dividends payout ratio = 0.4 • ROE = 20% a year - Sales = $1 million. • The company must have the following in 2006: • Assets were = $2m • Debt = $1m and shareholder equity =1m • Net Income = equity (1m) x ROE (20%)= $200 000 . • Dividends = 200 000(0.4) = $80 000 • Retained earning = $120 000 • Sustainable growth in 2007 • g = ROE (1-dividend payout ratio) = .20 (0.6)= 12% • Increase in sales: (1000 000 x 1.12)= 1 120 000 • Increase in assets: 2000 000 x 1.12 = 2 240 000