Keyconceptsfrom

FINANCIALSTATEMENTS
 Objectives
Goal:Quickoverviewoffinancialstatementconceptsthatare
mostimportantforcorporatefinance
Importantfor:
Capitalbudgeting:
e.g.,projectingcashflows
Beginswithfinancialstatementdata
Requiresgoodknowledgeofworkingcapital,depreciation,taxes
Valuationandcapitalstructure:
e.g.,whatkeyratiosreallycapture
Markettobook,ROA,ROE,leverage
Whatdothesemean?

Enterprisevalue
NetDebt
Debt/Capital
Price/Earnings
Interestcoverage
BALANCESHEETS
(ACCOUNTINGVS.FINANCE)
 BalanceSheet
ListsfirmsAssets&Liabilities
A snapshotofthefirms(book)financialpositionatagivenpoint
intime
BalanceSheetIdentity:
Assets=Liabilities(+StockholdersEquity;weshouldreallythinkofequityasjustone
typeofliability)
 Threewaysofthinkingaboutabalancesheet
1. Accounting
BookAssets=BookLiabilities
2. Financing(bookvalues)
(Net)OperatingAssets=(Net)BookCapital
Wecangettothisbyrearranging(1)
3. Financing(marketvalues)
EnterpriseValue=MarketValueofCapital
Herewellneedmarketvalues
Needtomovebeyondjustaccountingnumbers
 Example:BalanceSheet(GlobalCorp.)

Assets Liabilities
CurrentAssets Currentliabilities
Cash 23.2 AccountsPayable 29.2
Accounts receivable 18.5 Notespayable/shorttermdebt 5.5
Inventories 15.3 TotalCurrentLiabilities 34.7
TotalCurrentAssets 57.0 LongTermLiabilities
LongTerm Assets Longterm debt 113.2
Property,plantandequipment 113.1 StockholdersEquity
TotalLongterm Assets 113.1 Commonstockandpaidin surplus 8.0
Retainedearnings 14.2
TotalStockholdersequity 22.2
TotalAssets 170.1 TotalLiabilities(andstockholdersequity) 170.1
 CurrentAssets
Assetsconvertibletocashorotherbenefitsinlessthanoneyear
Cashandothermarketablesecurities
Cash,treasurybillsandbonds,stocksandbondsofotherfirms,etc
Usuallyeasytosellandconverttocash
Accountsreceivable
amountsowedtothefirmbyitscustomers
Inventories
rawmaterials,workinprogress,finishedgoods
Othercurrentassets
includesitemssuchasprepaidexpenses
 LongTermAssets
Assetsthatproducebenefitsformorethanoneyear
E.g.,buildings,machinery,officeequipment,etc
Mostoftheseassetsvalueisreducedyearlythrough
depreciation
Depreciationscheduleisdeterminedbyaccountingrules,and
notdirectlyrelatedtoactualdecreasesineconomicvalue
 LiabilitiesandStockholdersequity
CurrentLiabilities
Shorttermdebtorportionoflongtermdebttobepaidwithinayear
Accountspayable
Amountfirmowestosuppliers
Accrualitems
E.g.,wagesortaxesthatareowedbuthavenotyetbeenpaid; deferredor
unearnedrevenue(firmhasreceivedpaymentbutnotyetdeliveredproduct)
LongTermLiabilities
Longtermdebt(maturinginmorethanayear)
Stockholdersequity
Alsocalledbookvalueofequity
 Letsrearrangethebalancesheet!
Moveliabilitiesthatisresultofoperatingbusiness(i.e.,notfinancing)totheleft
Thisexampleissupersimple:Onlyaccountspayableshouldbemoved
Normally,alsoaccruedexpenses,otherliabilities,incometaxespayable,etc
Movecash(andanyothernonoperatingassets)toright
SubtractcashfromdebttogetNetdebt
Technicallyonlyexcesscash,butwhatisexcess?
Operating Accounts FinancialAccounts
NetWorking Capital Net Debt
Accounts receivable 18.5 Notespayable/shorttermdebt 5.5
Inventories 15.3 Longterm debt 113.2
AccountsPayable 29.2 Cash 23.2
TotalNetWorkingCapital 4.6 TotalNetDebt 95.5
NetFixedAssets StockholdersEquity
Property,plantandequipment 113.1 Stockholdersequity 22.2
NetOperatingAssets 117.7 Net BookCapital 117.7
BookValuesvs.CurrentCost/LiquidationValues
Thecurrentpriceofanassetisoftendifferentfrombookvalue!
1. Bookvalue
Valueasrecordedinbalancesheet
Bookassetvalue=Cost Cumulativedepreciation(canbeverydifferentfrom
currentprice)
E.g,consideranofficebuildinginNewYorkthatwaspurchased40yearsago
2. Liquidationvalue
Whatwecouldbuy/selltheassetsfor
Ifbookvaluesareveryclosetotheliquidationvalueofmostassets,thenbook
valueofequitymightbeusedtoestimatetheliquidationvalueofthefirm:
whatwouldequityholdershaveleftifwesoldeverythingandpaidoffalldebts?
 Example
Assets Liabilities
CurrentAssets Currentliabilities
Cash 23.2 AccountsPayable 29.2
Accounts receivable 18.5 Notespayable/shorttermdebt 5.5
Inventories 15.3 TotalCurrentLiabilities 34.7
Totalcurrent 57.0 LongTermLiabilities
LongTerm Assets Longterm debt 113.2
Forwhatitemson
Property,plantandequipment 113.1 StockholdersEquity
balancesheetarebook
TotalLongterm Assets 113.1 Commonstockandpaidin surplus 8.0
valuesoftencloseto
Retainedearnings 14.2
themarketvalue?
TotalStockholdersequity 22.2
TotalAssets 170.1 TotalLiabilities(andstockholders 170.1
equity)
 Marketvalueofthefirm
Enterprisevalue(EV)isthemarketvalue oftheunderlyingbusiness
operations:
Enterprisevalue=Marketcapitalization+Debt Excesscash

Valueofallfinancialclaimsonthefirm
Marketcapitalizationisthemarketvalueofequity:
Pricepershare*Numberofshares
Shouldweusebookormarketvaluesofdebt?
Forcash,thebookmarketisthesameasmarketvalue!(unlesssomething
funnyisgoingon,whereadollarisntactuallyworthadollar)
 Example:Marketcapitalization
GlobalCorp.has3.6millionsharesoutstanding,andthesesharestradeat
$10pershare
WhatisGlobals marketcapitalization?
HowdoesGlobals marketcapcomparetoitsbookvalueofequity?
Solution:
Globals marketcapitalizationis:(3.6millionshares) ($10/share)=$36
million
Recall:Globals bookvalueofequitywas$22.2million(seebalancesheet)
Whatcoulddriveanydifferencebetweenthesevalues?
 Example:Enterprisevalue
Globals marketcapis$36million
Fromthebalancesheeet,weseethefirmhas$5.5millioninshortterm
debt,$113.2millioninlongtermdebt,and$23.2millionincash.
WhatisGlobals enterprisevalue?
Solution
Globals enterprisevalueis:$36+$5.5+$113.2 $23.2=$131.5million
Whatstheeconomicmeaningofthisnumber?
Itsthemarketsexpectationofthepresentvalueofallfuturecashflows
thataregoingtogotothefirmsfinancialclaimants(e.g,ownersofthe
firmsdebtandequity)!
Letstransformthebalancesheetintomarketvalues
Marketvalueofthebusinessoperationsisnottiedtobookvalueofoperatingassets
Howmuchthebusinessisworthdependsonhowmuchfreecashflow(FCF)the
businessisexpectedtogenerateandwithwhatrisk Weusuallyapproximate
marketvalueofdebt
withbookvalueofdebt

Assets Liabilities
Net Debt(MarketValue)
EnterpriseValue =PV(FreeCashFlow)
Notespayable/shorttermdebt 5.5
Longterm debt 113.2
Cash 23.2
NetDebt 95.5
MarketValueofEquity
MarketCapitalization 36
Enterprise Value 131.5 (Net) MarketValueofthefirm 131.5

Weknowthesenumbershavetobethesame!
 Wecanrearrangethisidentityaswewish

Cash Cash Market

Debt EVDebt cap.
Cash Debt
EV
EV
Market
cap. Market
cap.

EV=NetDebt+Marketcap EV+Cash=Debt+Marketcap, EV Debt+Cash=Marketcap,

i.e.,EV+Cash=Financial i.e.,EV NetDebt=Marketcap
claimsonthefirm (weregoingtousethisalot!)
 Example
ImaginearestaurantbusinessinSanFrancisco
Itsonlyassetisabuildingtherestaurantpurchasedfor$100,000in
the1970swhentherestaurantwasfounded
Nowvalueonthebuildinghassincebeendepreciatedto$40,000
Therestaurantcouldsellthebuildingnowfor$3million
Therestaurantproduces$1millioninannualprofits(freecash
flows),andtherestauranthasnodebtorcash
Whataresomedifferentassetvalueswecanthinkabouthere?
INCOMESTATEMENT
 TheIncomeStatement
Listsfirmsrevenuesandexpensesoveraperiodoftime
Example:GlobalCorp.sIncomeStatement

Thetoplineshowsnet
sales(orrevenues)

The bottomlineshowsnet
income(orearnings)
 Earningspershare(EPS)
EPSisnetincomeonapersharebasis:
GlobalCorp.hasanetincomeof$2.0million,and3.6millionshares
(thenumberofsharesarenotlistedintheincomestatement,soneedtofindthoseelsewhere)
$ .
Then,EPS= $0.556
# .
FullydilutedEPSincreasesnumberofsharesby:
Stockoptionsheldbyemployees
Sharesthatcanbeconvertedfromanyconvertiblebonds
SupposeGlobalemployees havebeengiven0.2million
options,whatisGlobals fullydilutedEPS?
 EBITDA
EBITDA:Earningsbeforeinterest,taxes,depreciation,andamortization
Roughmeasureofhowmuchcashflowfirmearnedfromitsbusinessandisleft
topay:
Equityholders(E),Debtholders(I),government(T),andtopayfornewinvestments
D&Aarenotcashflows,butinvestmentsareinthelongruntheycanceleachotherout!

WhatistheEBITDAfor
GlobalCorpin2010?
THESTATEMENTOFCASHFLOWS
 StatementofCashFlows
Thestatementofcashflowsusesinformationfromboththeincomestatement
andbalancesheettodetermine:
1. howmuchcashthefirmhasgenerated duringtheyear
2. howthatcashhasbeenallocated
Threesections(oftencalledactivities):
1. Operatingactivities
2. Investmentactivities
3. Financingactivities
Thefinallinecalculatesthesumacrossallthreeactivities
=Theoverallchangeinthefirmscashbalanceoverthetimeperiod
Sanitycheck:thisfinallineshouldcorrespondwiththechangeincashonthe
balancesheetbetweenthisyearandlastyear
Example:Global
Corp.sStatement
ofCashFlows

(note:itsveryimportantto
understandthesign ofthe
cashfloweffectsof
receivables,payables,
inventory,etc)
 OperatingActivities
Depreciation:
Addbackdepreciationtonetincome,sinceitisnotacashoutflow(buthasbeendeductedas
anexpenseontheincomestatement)
Accountsreceivable (AR):
Asalehasbeenrecordedaspartofrevenueswhichflowsdowntonetincome,butthe
customerhasnotpaidyet,soweadjustbysubtracting anyincreasesinaccountsreceivable
i.e., anincreaseinARmeansthefirmislendingmoremoneytocustomers(soithaslesscash)
Accountspayable(AP):
Conversely,weadd anyincreasesinaccountspayable
APrepresentsborrowingbythefirmfromitssuppliersbypayingthemslowlymore
borrowingmeansmorecashonhandrightnow
Inventory:
Wesubtract increasesininventory
Increasestoinventoryarenotrecordedasanexpenseforcalculatingnetincome;but,thefirm
hasstillpaid forthisinventorywhichmeansacashoutflowforthefirm
 InvestmentandFinancingActivities
InvestmentActivitiesshowscashflowsfrom:
Capitalpurchasedandsold(e.g.,machinery,plant,land...)
Investmentsecuritiespurchasedandsold(e.g.,treasurybonds,or
othersecuritiesexceptthefirmsown equityanddebt)
FinancingActivitiesshowscashflowsfrom:
Dividendspaid
Cashreceivedfromsaleofstockorcashspentrepurchasingshares
Changesindebt
Issuingdebtimpliespositivecashflow,repaymentnegative
 DepreciationandTaxes
Depreciationisnotacashflow!
But,depreciationaffectscashflowsindirectly,because
depreciationaffectspretaxearnings,whichaffectstaxes,
whichisacashflow!
Inotherwords:
Depreciation Pretaxearnings Taxes Cashflows
 Example:Depreciationandtaxes
SupposeGlobalCorp.hasanadditional$1millionindepreciation,andGlobals taxrateis26%
WhatwouldbetheimpactonGlobals netincome?
HowwoulditimpactGlobals cashflow?
Solution
Operatingincome,EBIT,andpretaxincomewouldallfallby$1million(EBITDAisunchanged)
ThiswouldreduceGlobals taxbillby26% $1million=$0.26million
SoNetIncomewouldfallby1 0.26=$0.74million
Onthecashflowstatement,weaddbackthedepreciationof$1millionasitisnotacashoutflow
Socashfromoperatingactivitieswouldriseby0.74+1=$0.26million;noeffectontheother
cashflowstatementactivities
Globals cashbalancewouldincreaseby$0.26million;thisisequaltotheamountoftaxsavings!
Takeaway:Depreciationreducesafirmstaxes,andthereforeincreasesthefirmscashflow(badfor
reportedearnings,butthisisactuallygoodforinvestors!)
COMMONLYUSEDRATIOS
 MarkettoBookRatio
Market capitalization
Market to Book
Book value of equity
AlsocalledPricetoBook(whenonapersharebasis)
Oftenusedtoclassifyfirmsinto:
Value(lowM/B)
Growth(highM/B)
ExamplesofMarkettoBookRatios
 P/ERatio

Oneofthemostwidelyusedratiostocomparefirm
valuations
AhigherP/Eratiousuallyimplies:
Themarketexpectsnetincometogrowfaster,and/or
Theearningsarelessrisky(lowersystematicrisk)
 SalesProfitabilityRatios
Grossmargin howmuchacompanyearnsfromeachdollarofsalesafterpaying
forthedirectcostofthesoldgoods:
Gross profit
Gross margin
Sales
Operatingmargin howmuchacompanyearnsbeforeinterestandtaxesfrom
eachdollarofsales(includesoverheadsuchasSG&A,R&D,depreciationincosts):
Operating income
Operating margin
Sales
Netprofitmargin howmuchthatisavailabletoequityholdersafterthefirm
alsopaysinterestandtaxes(fromeachdollarofsales):
Net income
Net profit margin
Sales
 ROEandROA
ReturnonEquity
Net income
ROE
Book value of equity
Comparingfirmsincometoitsbookequityvalue
However,bookequityisoftennotverymeaningful,inwhichcasethisratioisntmeaningfuleither
BothNetincomeandBookequityaresensitivetoleveragechoiceswhichmeansitissenselesstocompare
thisratioacrossfirmswithdifferentleverage
ReturnonAssets
Net income Interest expense
ROA
Total assets
Comparingfirmsincome(flowingtobothequity anddebtholders)toitsbookassets
Bookassetsmayalsonotbeverymeaningful,especiallyforfirmswithlotsofcumulateddepreciationand
forfirmswithintangibleassets
Note:ROAissometimesdefinedasNetIncome/Assets;thisispoorpracticeandmakesthenumbereven
lessmeaningful!Why?
 Leverageratios
D Totaldebt
=
E Totalequity
D Totaldebt
=
E+D Totalequity+Totaldebt
(D/(E+D)issometimescalleddebttocapital)
WeoftenuseNetDebt(DC)insteadofD,butthiscandependonsituation
Bookleverage
Usingbookvaluesforequityanddebt
Marketleverage
Marketvalueforequity
Usually,bookvaluefordebt,eventhoughmarketvalueofdebtcouldtechnicallybebetter
 InterestCoverageRatio
Ameasureofincome
Interestcoverage=
Interestpayments
Captureshoweasilyafirmisabletocoveritsinterest
payments
Whichincomemeasureisbestinnumerator?
Dependsslightlyonthesituation,buteitheroperatingincome,
EBIT,orEBITDA
DonotuseNetIncomeinthisratio!Why?
 WorkingCapital/Liquidity
NWC net working capital Current assets Current liabilities

Current assets
Current ratio
Current liabilities

Current assets inventory

Quick ratio
Current liabilities

Thesemeasurewhetherfirmhas(shortterm)assetsavailabletomeet
billsthatarecomingdue
 Workingcapitalturnover
Measurestheefficiencyofhowmuchworkingcapitalthe
businessrequires
Thelessworkingcapital,thebetter!
360

360

360

 Example:Ratios&EnterpriseValue
PeabodyProductshas:
sharepriceof$46.15with316.2millionsharesoutstanding,
amarkettobookratioof7.99,
abookdebttobookequityratioof2.64,
cashof$560million
WhatisPeabodysmarketcapitalization?
Whatis Peabodysenterprisevalue?
Solution
Peabodyhasmarketcapitalizationof:$46.15 316.2millionshares=$14.59billion
Tofindtheenterprisevalue,weneedtosolveforthe(book)valueofdebt:
Markettobook=7.99=$14.59billion/bookequity,thenbookequity=$14.59
billion/7.99=$1.83billion
BookdebttoBookequity=2.64,sothebookvalueofPeabodysdebtis$1.83
billion 2.64=$4.83billion
Thus,Peabodysenterprisevalueis(EnterpriseValue=MarketValueofEquity+Debt
Cash)=14.59+4.83 0.56=$18.86billion.
WHERETOFINDFINANCIAL
STATEMENTS?
 Sourcesoffinancialstatementdata
Commercialdatabases
E.g.,CapitalIQ,Bloomberg
TheseareavailableintheMarketInformationLab
Benefits:Dataisstandardized;Canquicklybecollectedandcomparedacrossmanyfirmsand
years
Downsides:Canbeexpensive;Standardizationmayleadtoimportantdetailsthatunderliethe
numbersbeingomitted
SecuritiesandExchangeCommission(SEC)website
http://www.sec.gov/edgar.shtml
CompaniesthatpubliclysellsecuritiesarerequiredtofilefinancialstatementswiththeSEC
Benefits:Free;Includesalotmoredetailedinformation(includingmanagementsdiscussion,
footnotes,etc)
Downsides:Canonlyanalyzeonefinancialstatementatatime
(Thisisusuallythesourceofthedatathatisusedinthecommercialdatabases)
EDGAREXAMPLE