Chapter 3: Interpreting Financial Statements Objective Contrast Economic and Accounting Models Value of Accounting Information Copyright © Prentice Hall Inc 2000 Author: Nick Bagley, bdellaSoft, Inc Financial Statements Review – Financial Statements Provide: • current and historical information to owners and creditors • a convenient way for owners and creditors to set performance targets • a convenient standard template for financial planning Chapter Contents • 3.1 Functions of Financial Statements • 3.6 Analysis Using Financial Ratios • 3.2 International Differences in Accounting • 3.7 The Financial Planning Process • 3.3 Market values v Book Values • 3.8 Constructing a Financial Planning Model • 3.4 Accounting v Economic Measures of Income • 3.5 Return on Shareholders v Return on Equity • 3.9 Growth & the Need for External Financing • 3.10 Working Capital Mgnt • 3.11 Liquidity & Cash Mgnt 3.1 Functions of Financial Statements • Financial Statements: – Provide information to the owners & creditors of a firm about the current status and past performance – Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm – Provide a convenient templates for financial planning 3.2 Review of Financial Statements The Balance Sheet • Summarizes a firms assets, liabilities, and owner’s equity at a moment in time • Amounts measured at historical values and historical exchange rates • Prepared according to GAAP, Generally Accepted Accounting Principles – GAAP modified occasionally by the Financial Accounting Standards Board • Exchange-listed companies must comply with Securities and Exchange Commission (SEC) rules The Balance Sheet • Major Divisions: – Assets • Current assets (less than a year) • Long-term assets (longer than a year – Depreciation – Liabilities and Stockholder’s Equity • Liabilities – Current Liabilities – Long-term debt • Equity GPC Balance Sheet at Dec 31, 2xx1 2xx0 Assets Cash & mkt'ble secs Receivables Inventories *Current assets 2xx1 Change 100.0 50.0 150.0 300.0 120.0 60.0 180.0 360.0 20.0 10.0 30.0 60.0 400.0 (100.0) 300.0 490.0 (130.0) 360.0 90.0 (30.0) 60.0 **Total Assets 600.0 720.0 120.0 Liabilities & Equity Accounts payable Short-term debt *Current liabilities 60.0 90.0 150.0 72.0 184.6 256.6 12.0 94.6 106.6 Long-term debt **Total liabilities 150.0 300.0 150.0 406.6 106.6 Paid-in capital Retained earnings *Shareholders equ 200.0 100.0 300.0 200.0 113.4 313.4 13.4 13.4 Liab + Shareholder 600.0 720.0 120.0 Pp&e Acc depreciation *Net pp&e The Income Statement • Summarizes the profitability of a company during a time period • Major Divisions: – Revenue & cost of goods sold » Gross margin – General administrative and selling expenses (GS&A) » Operating income – Debt service » Taxable income – Corporate Taxes » Net income The Income Statement • Important Reminders: – Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity – Accounts show historical values, not market values • The shareholder’s equity may be much higher or lower than the market value of the firm – The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet 10 Illustration • (Table 3.7 & 3.8 of textbook) – Consider two firms that are identical except that Nodebt is financed using $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and $500,000 of debt – further assume that the EBIT of both firms is $120,000 and tax is 40% 24 Case: Borrow at 10% EBIT Interest Taxable Income Tax Net Income Equity ROE Nodebt Halfdebt 120,000 120,000 50,000 120,000 70,000 48,000 28,000 72,000 42,000 1,000,000 500,000 7.20% 8.40% 25 Case: Borrow at 15% EBIT Interest Taxable Income Tax Net Income Equity ROE Nodebt Halfdebt 120,000 120,000 75,000 120,000 45,000 48,000 18,000 72,000 27,000 1,000,000 500,000 7.20% 5.40% 26 Case: Borrow at 10%: Effect of Business Cycle on ROE Economic Conditions Bad Year Normal Year Good Year ROA ROE ROE Nodebt Halfdebt 1% 0.6% -4.8% 12% 7.2% 8.4% 30% 18.0% 30.0% 27 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 (Percent of Year's Sales) xxx1 xxx2 xxx3 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin expenses EBIT Interest expences Taxes Net income Dividends Change in shareholder's equity 200 110 90 30 60 30 12 18 13 240 132 108 36 72 45 11 16 11 288 158 130 43 86 64 13 100.0% 100.0% 100.0% 55.0% 55.0% 55.0% 45.0% 45.0% 45.0% 15.0% 15.0% 15.0% 30.0% 30.0% 30.0% 15.0% 18.8% 22.2% 6.0% 4.5% 3.1% 9.0% 6.7% 4.7% 2.7% 2.0% 1.4% 6.3% 4.7% 3.3% 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 6.0% 6.0% 6.0% 24.0% 24.0% 24.0% 30.0% 30.0% 30.0% 300.0% 300.0% 300.0% 360.0% 360.0% 360.0% 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 18.0% 18.0% 18.0% 110.7% 144.6% 174.2% 75.0% 62.5% 52.1% 203.7% 225.1% 244.3% 156.3% 134.9% 115.7% Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 28 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin expenses EBIT Interest expences Taxes Net income Dividends Change in shareholder's equity 200 110 90 30 60 30 12 18 13 29 240 132 108 36 72 45 11 16 11 288 158 130 43 86 64 13 Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 30 (Percent of Year's Sales) Year xxx1 xxx2 xxx3 Income Statement Sales 100.0% 100.0% 100.0% Cost of goods sold 55.0% 55.0% 55.0% Gross margin 45.0% 45.0% 45.0% Selling, general & admin expenses 15.0% 15.0% 15.0% EBIT 30.0% 30.0% 30.0% Interest expences 15.0% 18.8% 22.2% Taxes 6.0% 4.5% 3.1% Net income 9.0% 6.7% 4.7% Dividends 2.7% 2.0% 1.4% Change in shareholder's equity 6.3% 4.7% 3.3% 31 Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 6.0% 6.0% 6.0% 24.0% 24.0% 24.0% 30.0% 30.0% 30.0% 300.0% 300.0% 300.0% 360.0% 360.0% 360.0% 18.0% 18.0% 18.0% 110.7% 144.6% 174.2% 75.0% 62.5% 52.1% 203.7% 225.1% 244.3% 156.3% 134.9% 115.7% 32 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 (Percent of Year's Sales) xxx1 xxx2 xxx3 F(sales)? xxx4 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin expenses EBIT Interest expences Taxes Net income Dividends Change in shareholder's equity 200 110 90 30 60 30 12 18 13 240 132 108 36 72 45 11 16 11 288 158 130 43 86 64 13 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 100.0% 100.0% 100.0% N/A 55.0% 55.0% 55.0% Yes 45.0% 45.0% 45.0% N/A(Yes) 15.0% 15.0% 15.0% Yes 30.0% 30.0% 30.0% N/A 15.0% 18.8% 22.2% No 6.0% 4.5% 3.1% N/A 9.0% 6.7% 4.7% N/A 2.7% 2.0% 1.4% N/A 6.3% 4.7% 3.3% 346 190 156 52 104 87 10 Yes Yes Yes Yes N/A(Yes) 21 83 104 1037 1244 Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 6.0% 6.0% 6.0% 24.0% 24.0% 24.0% 30.0% 30.0% 30.0% 300.0% 300.0% 300.0% 360.0% 360.0% 360.0% 18.0% 18.0% 18.0% Yes 110.7% 144.6% 174.2% No 75.0% 62.5% 52.1% No 203.7% 225.1% 244.3% N/A 156.3% 134.9% 115.7% N/A 33 62 904 340 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 xxx4 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin expenses EBIT Interest expences Taxes Net income Dividends Change in shareholder's equity 200 110 90 30 60 30 12 18 13 34 240 132 108 36 72 45 11 16 11 288 158 130 43 86 64 13 346 190 156 52 104 87 10 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 xxx4 Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 21 83 104 1037 1244 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 62 692 150 904 340 35 External Funds Needed EFN = ( A[ S ] − L[ S ]) S1 − S S − (( EBIT0 − Int )(1 − t )(1 − d ) S0 S0 = (1036.80 − 51.84) * 0.2 − ((86.40 *1.2 − 87.26) * (1 − 0.40) * (1 − 0.30) = $190.0956 Million EFA + ( EBIT − Int )(1 − t )(1 − d ) growth = A[ S ] − L[ S ] − EBIT (1 − t )(1 − d ) 300 + (86.40 − 87.26) * (1 − 0.40) * (1 − 0.30) = 1036.80 − 51.84 − 86.40 * (1 − 0.40) * (1 − 0.30) = 31.58% 36 External Funds Needed for Growth $500 External Funds Needed $450 $400 $350 $300 $250 $200 $150 $100 $50 $0 0% 5% 10% 15% 20% 25% 30% Growth Rate 37 35% 40% 45% 50% Observation: – Sometimes the new assets required to generate income are not a high as in this example, and the company may able to support a level of growth with no external funding (-0.00038 in our case) growthNo EF ( EBIT − Int )(1 − t )(1 − d ) = A[ S ] − L[ S ] − EBIT (1 − t )(1 − d ) 38 [...]... 10 3 7 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 xxx4 Balance Sheet Assets: Cash & equivalents Receivables Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 21 83 104 1037 1244 30 120 150 300... RoA = = * Assets Sales Assets = Return on sales * Asset Turnover 23 Illustration • (Table 3.7 & 3.8 of textbook) – Consider two firms that are identical except that Nodebt is financed using $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and $500,000 of debt – further assume that the EBIT of both firms is $120,000 and tax is 40% 24 Case: Borrow at 10% EBIT Interest Taxable Income... 1.4% 6.3% 4.7% 3.3% 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 6.0% 6.0% 6.0% 24.0% 24.0% 24.0% 30.0% 30.0% 30.0% 300.0% 300.0% 300.0% 360.0% 360.0% 360.0% 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 18.0% 18.0% 18.0% 110.7% 144.6% 174.2% 75.0% 62.5% 52.1% 203. 7% 225.1% 244.3% 156.3% 134.9% 115.7% Balance Sheet Assets: Cash & equivalents Receivables... Shareholder's equity 6.0% 6.0% 6.0% 24.0% 24.0% 24.0% 30.0% 30.0% 30.0% 300.0% 300.0% 300.0% 360.0% 360.0% 360.0% 18.0% 18.0% 18.0% 110.7% 144.6% 174.2% 75.0% 62.5% 52.1% 203. 7% 225.1% 244.3% 156.3% 134.9% 115.7% 32 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 (Percent of Year's Sales) xxx1 xxx2 xxx3 F(sales)? xxx4 Income Statement Sales Cost of goods sold... 720 864 17 69 86 864 1037 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 100.0% 100.0% 100.0% N/A 55.0% 55.0% 55.0% Yes 45.0% 45.0% 45.0% N/A(Yes) 15.0% 15.0% 15.0% Yes 30.0% 30.0% 30.0% N/A 15.0% 18.8% 22.2% No 6.0% 4.5% 3.1% N/A 9.0% 6.7% 4.7% N/A 2.7% 2.0% 1.4% N/A 6.3% 4.7% 3.3% 346 190 156 52 104 87 7 10 3 7 Yes Yes Yes Yes N/A(Yes) 21 83 104 1037 1244 Balance Sheet... equity 6.0% 6.0% 6.0% 24.0% 24.0% 24.0% 30.0% 30.0% 30.0% 300.0% 300.0% 300.0% 360.0% 360.0% 360.0% 18.0% 18.0% 18.0% Yes 110.7% 144.6% 174.2% No 75.0% 62.5% 52.1% No 203. 7% 225.1% 244.3% N/A 156.3% 134.9% 115.7% N/A 33 62 904 340 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 xxx4 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin expenses... Equity • Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income ( EndPrice − StartPrice ) + CashDividends Re turn = StartPrice EconomicIncome $ − 2.8Million = = = −1.4 StartPrice $200Million • This is the Total Shareholder Return 15 Returns to Shareholders v Return on Equity (Continued) • Traditionally, corporate performance has been measured... Needed EFN = ( A[ S ] − L[ S ]) S1 − S 0 S − (( EBIT0 1 − Int )(1 − t )(1 − d ) S0 S0 = ( 1036 .80 − 51.84) * 0.2 − ((86.40 *1.2 − 87.26) * (1 − 0.40) * (1 − 0.30) = $190.0956 Million EFA + ( EBIT − Int )(1 − t )(1 − d ) growth = A[ S ] − L[ S ] − EBIT (1 − t )(1 − d ) 300 + (86.40 − 87.26) * (1 − 0.40) * (1 − 0.30) = 1036 .80 − 51.84 − 86.40 * (1 − 0.40) * (1 − 0.30) = 31.58% 36 ... Inventories Property, Plant & equipment Total Assets Liabilities: Payables Short-term debt Long-term debt Total Liabilities Shareholder's equity 10 40 50 500 600 12 48 60 600 720 14 58 72 720 864 17 69 86 864 1037 30 120 150 300 300 36 221 150 407 313 43 347 150 540 324 52 502 150 704 333 30 (Percent of Year's Sales) Year xxx1 xxx2 xxx3 Income Statement Sales 100.0% 100.0% 100.0% Cost of goods sold 55.0% 55.0%... 5.40% 26 Case: Borrow at 10%: Effect of Business Cycle on ROE Economic Conditions Bad Year Normal Year Good Year ROA ROE ROE Nodebt Halfdebt 1% 0.6% -4.8% 12% 7.2% 8.4% 30% 18.0% 30.0% 27 GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3 (Percent of Year's Sales) xxx1 xxx2 xxx3 Income Statement Sales Cost of goods sold Gross margin Selling, general & admin expenses