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									Introduction to Financial
   Statement Analysis

       P.V. Viswanath
       Functions of Financial Statements

 They provide information to the owners and
  creditors of the firm about the company’s current
  status and past financial performance
 Financial statements provide a convenient way for
  owners and creditors to set performance targets and
  to impose restrictions on the managers of the firm.
 Financial statements provide convenient templates
  for financial planning.

                      P.V. Viswanath                2
                The 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, i.e. ease
 of conversion to cash without significant loss
 of value
Liabilities are listed in order of time to

                     P.V. Viswanath               3

 Assets are divided into current assets and long-term
  assets. Current assets are:
      Cash and marketable securities
      Accounts receivable
      Inventories
      Other current assets, such as prepaid expenses
 Long-term assets include net property, plant and
  equipment (net PP&E).
      This consists of the original cost of PP&E reduced each
       year by an amount called depreciation that is intended to
       account for wear-and-tear and obsolescence.
                           P.V. Viswanath                          4

 When a firm acquires another firm, it will acquire a set of
  assets that must be listed on its balance sheet. Often it will
  pay more for these assets than their book value on the
  acquired firm’s balance sheet.
 The difference is listed as goodwill.
 Trade-marks, patents and other such assets, along with
  goodwill are called intangible assets.
 If their value decreases over time, they will be reduced by an
  amortization charge.
 Amortization, like depreciation is not a cash expense.

                          P.V. Viswanath                       5

 Liabilities are divided into current and long-term liabilities.
 Liabilities that will be satisfied in one year are known as
  current, and include:
      Accounts payable,
      Notes payable, short-term debt and all repayments of debt that will
       occur within the year.
      Items such as salary or taxes that are owed but have not yet been
 The difference between current assets and current liabilities
  is known as (net) working capital.

                               P.V. Viswanath                                6
                      Long-term liabilities

 Long-term debt is any loan or debt obligation with a maturity of more
  than one year.
 Capital leases are long-term lease contracts that obligate the firm to
  make regular payments in exchange for the use of an asset.
 Deferred taxes are taxes that are owed but not yet paid. Firms keep two
  sets of books – one for financial reporting and one for tax purposes.
  Deferred tax liabilities arise when the firm’s financial income exceeds its
  income for tax purposes. If a firm depreciates assets faster for tax
  purposes than for reporting purposes, its tax paid will be less than tax
  due according to reported income. Hence it will look as if the firm has
  not paid taxes that it owes.
 Over time, the discrepancy will disappear and the tax due will be “paid.”
  Hence deferred tax is recorded as a liability.

                               P.V. Viswanath                               7
                  Stockholder’s Equity

 The sum of current liabilities and long-term liabilities is total
  liabilities. The difference between the firm’s asset and its
  liabilities is Stockholders’ Equity or the book value of
 This number often does not provide us with an accurate
  assessment of the firm’s equity because book values are
  based on historical quantities and not on market values.
 The market price of a share times shares outstanding is
  called market capitalization; this reflects what investors
  expect the firms assets to produce in the future that can be
  distributed to shareholders.

                           P.V. Viswanath                         8
           Market Value vs. Book Value

According to Generally Accepted Accounting Principles
   (GAAP), your firm has equity worth $6 billion, debt worth
   $4 billion, assets worth $10 billion. The market values your
   firm’s 100 million shares at $75 per share and the debt at $4
Q: What is the market value of your assets?
A: Since (Assets=Liabilities + Equity), your assets must have a
   market value of $11.5 billion.

In this example, the market value of debt is the same as the
   book value of debt, but this need not always be true.
                          P.V. Viswanath                       9
           Market Value vs. Book Value
            Book Value Balance Sheet
Assets = $10 bil            Debt = $4 bil
                            Equity = $6 bil

           Market Value Balance Sheet
Assets = $11.5 bil          Debt = $4 bil
                            Equity = $7.5 bil

                      P.V. Viswanath            10
                The Balance Sheet Identity

Current Assets                              Current Liabilities
       Cash & Securities
                                                   Short-term Debt
            +               =               Long-term Liabilities
Fixed Assets
       Tangible Assets                                 +
       Intangible Assets
                                            Shareholders’ Equity
                           P.V. Viswanath                            11
               Pepsico Inc. Balance Sheet (in mil. $)

Assets                          28-Dec-02     29-Dec-01 Liabilities                                    28-Dec-02     29-Dec-01
Current Assets Cash And                                    Current Liabilities                               6,052         4,998
               Cash Term
               Short                 1,638            683                    Accounts Payable                5,490         3,484
               Net                     207            966            Short/Current Long Term Debt              562           354
               Receivables           2,531          2,1 42                   Other Current Liabilities           -           ,1
                                                                                                                            1 60
               Inventory             1,342            ,31
                                                    1 0 Total Current Liabilities                          6,052         4,998
         Other Current Assets          695            752 Long Term Debt                                     2,187         2,651
Total Current Assets                6,413         5,853 Other long-term liabilities                          5,937         5,398
Long Term Investments                 2,611         2,871 Total Liabilities                                14,176        13,021
Property Plant and Equipment         7,390         6,876 Common Stock & Other Paid-up Capital                   30            43
Goodwill                             3,631         3,374 Retained Earnings                                   9,268         8,605
Intangible Assets                    1,588          1,467 Total Stockholders' Equity                       9,298         8,674
Other Assets                          1,841         1,254
Total Assets                       23,474        21,695 Tot Liabs & Shareholders' Equity                  23,474        21,695

                                                    P.V. Viswanath                                                         12
              Income Statement

The income statement is like a video of the
 firm’s operations for a specified period of
You report revenues first and then deduct any
 expenses for the period.
Matching principle – GAAP requires the
 income statement to show revenue when it
 accrues and match the expenses required to
 generate the revenue.

                   P.V. Viswanath            13
                          Earnings Calculations

 Gross Profit
        The difference between sales revenues and the costs incurred to make and sell the
 Operating Expenses
    Expenses in the ordinary course of running the business, but not directly related to
         producing the goods; includes administrative expenses, marketing expenses, R&D
 Earnings before Interest and Taxes (EBIT)
        Includes other sources of income or expenses that arise from activities that are not the
         central part of the business, e.g. investment income.
 Pretax Income and Net Income (NI)
        From EBIT, we deduct interest paid and corporate taxes to determine Net Income.
        EPS = NI/Shares Outstanding

                                        P.V. Viswanath                                         14
        Income Statement
       Pepsico Inc. (in mil. $)

               As of year ending     Dec 02    Dec 01
Revenue                               25,112    26,935
Cost of Goods Sold                    10,523     9,837
Gross Profit                          14,589    17,098
SG&A Expense                           8,523    11,608
Depreciation & Amortization            1,112     1,082
Operating Income                       4,954     4,408
Nonoperating Income                      316       227
EBIT                                    5046      4248
Interest                                 178       219
Income Before Taxes                    4,868     4,029
Income Taxes                           1,555     1,367

                    P.V. Viswanath                       15
        Accounting vs Economic Measures of
 The return to a stockholder of investing in a stock is simply
  the rate of return on his investment:
      Ending Price of Share - Beginning Price  Cash Dividend
                      Beginning Price of Share
 Accountants often measure corporate performance using the
  return on equity (ROE):
                            Net Income
               ROE 
                       Shareholde rs' Equity
 A big difference between the two is that the ROE does not
  incorporate the impact on the share price of future expected
  superior (or inferior) returns
                          P.V. Viswanath                      16
                   Ratio Analysis

 Ratios also allow for better comparison through
  time or between companies
 As we look at each ratio, ask yourself what the ratio
  is trying to measure and why is that information
 Ratios are used both internally and externally

                      P.V. Viswanath                 17
             Categories of Financial Ratios

 Liquidity ratios
      Short-term solvency or how easily the firm can lay its hands on cash.
 Financial leverage ratios
      Show long-term solvency; how heavily the firm is in debt.
 Efficiency or turnover ratios
      Indicate how productively the firm is using its assets
 Profitability ratios
      Used to measure the firm’s return on its investments
 Market value ratios

                               P.V. Viswanath                             18
         Computing Profitability Measures

 Profit Margin = Net Income / Sales
      3313/ 25112 = 0.1319 times or 13.19%
 Operating Profit Margin = (Operating Income) / Sales
      (4954) / 25112 = 0.1973 times or 19.73%
 Return on Assets (ROA) = (Net Income) / Av TA
      (3313) / [(23474+21695)/2] = 0.1467 times or 14.67%
 Return on Equity (ROE) = Net Income / Average Equity
      3313 / [(9298+8674)/2] = 0.3687 times or 36.87%

                             P.V. Viswanath                  19
       Computing Leverage Ratios for 2002
 Total Debt Ratio = (Total Debt) / TA
      Total debt, here, is usually interpreted to mean all debt-like
       obligations, which is effectively total liabilities
      (14176) / 23,474 = .6039 times or 60.39%
      The firm finances almost 60% of their assets with debt.
 Debt/Equity = Tot Debt / Tot Eq
      14,176 / 9,298 = 1.5246 times
 These numbers can also be computed for long-term debt (i.e.
  long-term liabilities):
 Long Term Debt Ratio = LT Debt/ Total Assets = (2,187 +
  5,937)/ 23,474 = 0.3461
 Long Term Debt/Equity = (2,187 + 5,937)/9,298 = 0.87375

                                P.V. Viswanath                          20
             Computing Coverage Ratios

 Determinants of the riskiness of a firm’s debt

 Times Interest Earned = EBIT / Interest
      (4868 + 178) / 178 = 28.35 times
 Cash Flow Coverage = (EBIT + Depreciation) /
      (4868 + 178 + 1112) / 178 = 34.60 times

                          P.V. Viswanath           21
            Computing Liquidity Ratios

 Current Ratio = CA / CL
     6413 /6052 = 1.06 times
 Quick Ratio = (CA – Inventory) / CL
     (6413 – 1342) / 6052 = 0.838 times
 Cash Ratio = Cash / CL
     1,638 / 6,052 = .276 times
 Net Working Capital to TA Ratio = NWC/TA
     (6413-6052)/ 23474 = 0.154

                          P.V. Viswanath     22
             Computing Inventory Ratios

 Inventory Turnover = Cost of Goods Sold /
  Average Inventory
      10523 / [(1342+1310)/2] = 7.94 times
 Days’ Sales in Inventory = 365 / Inventory
  Turnover = Av Inv/(COGS/365)
    365 / 7.94 = 45.99 days
 When you have ratios with Income Statement numbers in
  the numerator and Balance Sheet numbers in the
  denominator, use average of year beginning and year end

                          P.V. Viswanath                    23
          Computing Receivables Ratios

 Receivables Turnover = Sales / Av Accounts
     25112 / [(2531+2142)/2] = 10.75 times
 Average Collection Period = Days’ Sales in
  Receivables = 365 / Receivables Turnover = Av
  Receiv/ (Av Sales)
     365 / 10.75 = 33.96 days

                         P.V. Viswanath           24
         Computing Total Asset Turnover

 Total Asset Turnover = Sales / Av Total Assets
      25112 / [(23474+21695)/2] = 1.11 times
 Measure of asset use efficiency
 Not unusual for TAT < 1, especially if a firm has a
  large amount of fixed assets.
 What is a reasonable value for TAT will depend on
  the industry in question

                          P.V. Viswanath            25
         Computing Market Value Measures

 Market Price (end of 2002) = $42.22 per share
 Shares outstanding = 1753 million
 P/E Ratio = Price per share / Earnings per share
       42.22 / 1.89 = 22.34 times
 Market-to-book ratio = mkt value per share / book value per share
       42.22 / (9298 / 1753) = 7.96 times
 Enterprise Value
       The value of the underlying business assets – computed as Mkt Value of
        Equity + Debt – Cash = 42.22(1,753) + 14,176 - 1,638 = 86,549.66m.
       This can be interpreted as the cost to take over the entire business.

                                     P.V. Viswanath                              26
            Payout and Retention Ratios

 Dividend payout ratio = Cash dividends / Net
      Cash dividend equals common dividend + preferred divs
      1041 / 3313 = .3142 or 31.42%
 Plowback ratio = Retention ratio = 1 – payout ratio
      1 – 0.3142 = 0.6858 = 68.58%

                         P.V. Viswanath                    27

 Ratios are not very helpful by themselves; they need
  to be compared to something
 Time-Trend Analysis
     Used to see how the firm’s performance is changing
      through time
     Internal and external uses
 Peer Group Analysis
     Compare to similar companies or within industries
     SIC and NAICS codes

                          P.V. Viswanath                   28
          Standardized Financial Statements

 Common-Size Balance Sheets
      Compute all accounts as a percent of total assets
 Common-Size Income Statements
      Compute all line items as a percent of sales
 Standardized statements make it easier to compare financial
  information, particularly as the company grows
 They are also useful for comparing companies of different
  sizes, particularly within the same industry

                               P.V. Viswanath                   29
                Statement of Cashflows

 A firm’s cashflows can be quite different from its
  net income. For example:
      The income statement does not recognize capital
       expenditures as expenses in the year that the capital
       goods are paid for. Those expenses are spread over time
       as a deduction for depreciation.
      The income statement recognizes revenues and expenses
       when sales are made, even though the money may not
       have been collected (revenues) or paid out (expenses).

                          P.V. Viswanath                     30
            The Statement of Cashflows

 The statement of cashflows shows the firm’s cash
  inflows and outflows from
      Operations
      Investments and
      Financing
 The form of this statement is determined by
  accounting standards.

                         P.V. Viswanath              31
                Statement of Cash Flows:
                   Operating Activities
 Operating activities are earnings-related
  activities. Generally these relate to Income Statement
  activities, and items included in working
  capital. Included are:
      Sales and expenses necessary to obtain sales
      Related operating activities, such as extending credit to
      investing in inventories
      obtaining credit from suppliers
      payment of taxes
      insurance payments
      Other activities that don't easily fit into the other two
       categories, such as settlements in lawsuits.

                             P.V. Viswanath                        32
          Statement of Cash Flows:
      Investing and Financing Activities
 Investing activities relate to the acquisition
  and disposal of noncash assets: assets which
  are expected to generate income for the
  company over a period of time. These include
  lending funds and collecting on these loans.
 Financing activities relate to the contribution,
  withdrawing and servicing of funds to support
  business activities.

                     P.V. Viswanath              33
        Pepsico Inc. (in mil. $)
    Statement of Cash Flows 2002
N e t Inc o m e                                                           3 ,3 13
O pe ra t ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
Depreciatio n                                                                ,1 2
A djustments To Net Inco me                                                  -390
Changes In A cco unts Receivables                                            -260
Changes In Liabilities                                                       704
Changes In Invento ries                                                       -53
Changes In Other Operating A ctivities                                        201
T o t a l C a s h F lo w F ro m O pe ra t ing A c t iv it ie s            4 ,6 2 7
Inv e s t ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
Capital Expenditures                                                        -1,437
Investments                                                                  757
Other Cashflo ws fro m Investing A ctivities                                  153
T o t a l C a s h F lo ws F ro m Inv e s t ing A c t iv it ie s            -527
F ina nc ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
Dividends P aid                                                           -1,041
Sale P urchase o f Sto ck                                                  -1,734
Net B o rro wings                                                            -404
T o t a l C a s h F lo ws F ro m F ina nc ing A c t iv it ie s           - 3 ,17 9
Effect Of Exchange Rate Changes                                                34
C ha nge In C a s h a nd C a s h E quiv a le nt s                         $ 955

                                      P.V. Viswanath                                 34
              Notes to Financial Statements

 The Notes to the Financial Statements are
  frequently very useful in assessing the financial
  health of the firm. They often contain:
      An explanation of accounting methods used
          Straight-line versus accelerated depreciation
          LIFO vs FIFO
          Restatement of results from prior years using the new standards
      Greater details regarding certain assets and liabilities
          Conditions and expiration dates of long- and short-term debt,
           leases, etc.

                               P.V. Viswanath                                35
           Notes to Financial Statements

   Information regarding the equity structure of the firm
       Conditions attached to the ownership of shares; these can be
        particularly useful to assess the firm’s vulnerability to takeovers.
   Documentation of changes in operations
       Acquisitions and Divestitures and their impact
   Off-balance sheet items
       Forward contracts, swaps, options and other derivative contracts,
        which do not appear in the balance sheet, but which can affect a
        firm greatly. A lot of Enron’s problems had to do with such off-
        balance sheet items.

                              P.V. Viswanath                               36
               Determinants of Growth

   Profit margin – operating efficiency
   Total asset turnover – asset use efficiency
   Financial leverage – choice of optimal debt ratio
   Dividend policy – choice of how much to pay to
    shareholders versus reinvesting in the firm

                        P.V. Viswanath                  37
                      The Du Pont Identity

 ROA = NI/ TA
      ROA = (NI/ Sales)*(Sales / TA)
      ROA = (Net Profit Margin)*(Asset Turnover)
 ROE = NI / TE
      ROE = (NI/Sales)*(Sales/TA)*(TA/TE)
          = Net Profit Margin*Asset Turnover*Equity Multiplier
 Net Profit margin is a measure of the firm’s operating efficiency
  – how well it controls costs
 Total asset turnover is a measure of the firm’s asset use
  efficiency – how well it manages its assets
 Equity multiplier is a measure of the firm’s financial leverage

                               P.V. Viswanath                     38
  Determinants of Earnings Growth Rate

 Earnings in any period depends on the investment base, as well as
  the rate of return that the firm earns on that investment base:
 Et+1 = (TEt)ROE
      = (TEt-1 + DTEt)(ROE), where DTEt is the increment in total
  equity in period t over and above that in period t-1.
       = (TEt-1)ROE + (DTEt)(ROE)
       = Et + (DTEt)(ROE);
 Hence Et+1 - Et = (DTEt)(ROE)
 Dividing both sides by Et , we get gt = (DTEt/Et)(ROE)
 We have assumed that ROE does not change, i.e. that the debt-
  equity ratio will be kept constant, as we can see from the DuPont
 Hence for this formula to be exactly correct, debt must be increased
  and equity decreased in such a way as to keep the debt ratio
  constant, assuming that the assets side of the business maintains a
  constant profitability. This is the assumption.
                              P.V. Viswanath                         39
                          Sustainable Growth
 The sustainable growth rate tells us how fast the firm can grow, without
  increasing financial leverage and without any additional outside equity.
 We have already seen that gt = (DTEt/Et)(ROE)
 If only internal funds are used, then DTEt is simply retained earnings.
 Hence, sustainable growth rate (of earnings) = retention ratio x ROE
       0.6858 x 0.3687 = 0.2528 or 25.28%
       If the firm can continue to earn 36.87% on its equity and can plow back 68.58%
        of earnings into operations, its earnings and equity should both grow at 25.28%
 As discussed above, ROE is assumed to be constant, i.e. that the debt-equity
  ratio will be kept constant.
 However, if the firm will not have access to new debt financing, the
  business can only grow at a lower rate, which is called the internal growth

                                    P.V. Viswanath                                 40
                        Internal Growth Rate

The rate at which the business as a whole, i.e. the total assets of the firm can
grow without additional external financing is called the internal growth rate.
                    Internal          retained earnings
                    growth rate          total assets
                        retained earnings net income     equity
                                        x           x
                           net income       equity     total assets
              Internal         Sustainable
                                    x
              growth rate Growth Rate total assets
   0.2169 x (9298+8674) /(23474+21695) = 0.2528 x 0.3979 = 0.1006 or
   This differs from the sustainable growth rate in that there is no presumption
    that additional debt can be obtained.
   However, as we have seen, without keeping financial leverage constant, it’s
    unreasonable to assume that ROE will remain constant. Hence this final
    decomposition is a little suspect.
                                      P.V. Viswanath                            41

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