2024 Introduction to Corporate Finance Lecture 2 PDF

BUST08030 Introduction to Corporate Finance Lecture 2 Corporate Published Information Dr Zhehao Jia University of Edinburgh Business School Roadmap  The importance of corporate information  3 statements Income statement Balance sheet Cash flo...

BUST08030 Introduction to Corporate Finance Lecture 2 Corporate Published Information Dr Zhehao Jia University of Edinburgh Business School Roadmap  The importance of corporate information  3 statements Income statement Balance sheet Cash flow statement 2024 BUST08030 ICF 2  The importance of corporate information 2024 BUST08030 ICF 3 Recall last lecture  Information asymmetry is everywhere Management & Shareholders Company (Borrowers) & Creditors …  E.g. Signalling theory (You getting accepted and graduating from the UofE. Top managers voluntary reduce salary. Company going IPO. Company voluntary information disclosure.) 2024 BUST08030 ICF 4 The role of financial reporting Mitigating the information asymmetry is essential for the market to function well. “Huge upside potential with very minimum risk…” The compulsory disclosure of financial statement is crucial in this process. A major source of information on performance. Contains large amounts of verbal and numerical information. When firms try to “dodge” the responsibility, the market will punish: Consequences of inadequate financial reporting The financial reporting  A UK limited company is required to publish three financial statements per year.  A US public company needs to submit a pack of 10-K and 10-Q filing to SEC.  Analysts will eagerly study all of this information for any clues about the company’s future performance. Financial analyst report EXAMPLE 2024 BUST08030 ICF 7 Financial analyst report EXAMPLE 2024 BUST08030 ICF 8 Financial statements and accounting principles  These are accounting rules and standards that companies need to adhere to when they prepare financial statements and reports.  Globally, most firms now prepare their accounts in accordance with International Financial Reporting Standards (IFRS), as laid out by the International Accounting Standards Board (IASB).  GAAP, also referred to as US GAAP, is an acronym for Generally Accepted Accounting Principles. This set of guidelines is set by the Financial Accounting Standards Board (FASB) and adhered to by most US companies. 2024 BUST08030 ICF 9 The financial reporting Figure. Length of 10-Ks and changes to 10-Ks over time. Cohen et al. (2020) 2024 BUST08030 ICF 10 Example: Apple SEC Edgar: https://www.sec.gov/edgar/search/ 2024 BUST08030 ICF 11 Example: Apple  What are these reports?  10-K is an annual report  10-Q is a quarterly report  8-K is a report of unscheduled material events or corporate changes  List of other report types here. 2024 BUST08030 ICF 12  The three statements 2024 BUST08030 ICF 13 Financial Statements and Supplementary Data  Income statement  Profit & loss statement; consolidated statements of operations  Reports a company’s income, taxes, expenses, and profits  Balance sheet  Reports a company’s assets, liabilities, and equity (Assets = Equity + Liabilities or Assets = Equity + Debt). This idea will come up again when we discuss “capital structure”.  Cash flow statement  Reports a company’s cash flow activities i.e. operating, investing, and financing.  How items in the income statement and changes in the balance sheet affects the firm’s cash and cash equivalents.  Statement of equity  Reports the change in equity of the company e.g. shares issued/redeemed, dividends paid, how profit/loss from operation affects the firm’s value of equity. 2024 BUST08030 ICF 14 A Note on “The Notes to the Accounts”  Accounts help us navigate through the complexity of a corporation according to specific rules.  We need to be able to compare, understand, gather, extract information, hence standardised accounting rules make a lot of sense.  However, businesses are complex. Judgment calls are made and explanations needed, that’s where the notes to the financial accounts come into play.  Any serious finance-related job means that we learn to love accounts (and the notes).  Example from Marks & Spencer Group PLC Accounts: 6 pages Notes to the Accounts: 62 pages Total page count Annual Report: 216 pages 2024 BUST08030 ICF 15 What about non-financial measure? M&S Annual Report 2024 BUST08030 ICF 16  The three statements Income statement 2024 BUST08030 ICF 17 Income Statement  Revenue generally refers to amounts charged (and expected to be received) for the delivery of goods or services in the ordinary activities of a business.  Expenses reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business.  At the bottom of the income statement, companies report net income (companies may use other terms such as “net earnings” or “profit or loss”).  There is flexibility in how companies may present the income statement, the analyst should always verify the order of years, how expenses are grouped and reported, and how to treat items presented as negatives.  𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 + 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 − 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 + − 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔(𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙) 2024 BUST08030 ICF 18 Important Income Statement figures  Gross Profit (Gross Margin) Revenue less cost of sales  Operating Profit (Operating Income) Deducting operating expenses such as selling, general, administrative (SG&A), and research and development expenses from gross profit. Operating profit reflects a company’s profits on its usual business activities before deducting taxes, and for non-financial companies, before deducting interest expense. Operating profit is sometimes referred to as EBIT (earnings before interest and taxes).  NOPAT: Net Operating Profit After Tax Makes comparing companies easier by removing the impact of their capital structure  EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortisation Most important measure for analysts (removes accounting differences when comparing across nations) 2024 BUST08030 ICF 19 Income Statement Ratios  One aspect of financial performance is profitability  Net profit margin Net profit margin measures the amount of income that a company was able to generate for each pound of revenue. A higher level of net profit margin indicates higher profitability and is thus more desirable. 𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅  Gross profit margin The gross profit margin measures the amount of gross profit that a company generated for each pound of revenue. A higher level of gross profit margin indicates higher profitability and thus is generally more desirable. 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅  Earnings per share (EPS) EPS is an input into ratios such as the price/earnings ratio, especially important for equity investor. Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. 𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 −𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝑬𝑬𝑬𝑬𝑬𝑬 = 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 2024 BUST08030 ICF 20  The three statements Balance sheet 2024 BUST08030 ICF 21 Balance Sheet  This financial statement basically lays out what a company owns and owes at a particular point in time Left side of the balance shows all assets the firm owns and uses to generate revenues. Right side represents the liabilities of the firm – money that the firm has borrowed from both creditors and shareholders Total assets = Total liabilities + Total shareholders’ equity 2024 BUST08030 ICF 22 Balance Sheet WHERE IS THE MONEY WHERE DOES THE MONEY INVESTED? COME FROM?  Discloses what an entity owns, what it owes, and what the owners’ claims are at a specific point in time. ASSETS EQUITY AND LIABILITY  Helps assess a company’s ability to pay for its near- term operating needs, meet future debt obligations, NON-CURRENT ASSETS EQUITY and make distributions to owners. Shareholder equity Machinery Patents  Assets (tangible and intangible) What the company owns. LONG-TERM LIABILITIES Resources controlled by the company as a result of past events and from Loans which future economic benefits are expected to flow to the entity. Bonds  Liabilities What the company owes. CURRENT ASSETS Inventory SHORT-TERM LIABILITIES Obligations of a company arising from past events, the settlement of which is Overdraft expected to result in an outflow of economic benefits from the entity. Cash Debt (