Financial Management PDF - WGU

Financial Management AUTHORS James C. Brau, Ph.D., CFA, CFP® Brigham Young University Andrew L. Holmes, Ph.D., CFA Brigham Young University Benjamin M. Blau, Ph.D Utah State University About the Authors 0.1About the Authors James C. Brau This video can be viewed online. James C. Brau Dr. Jim Brau, a...

Financial Management AUTHORS James C. Brau, Ph.D., CFA, CFP® Brigham Young University Andrew L. Holmes, Ph.D., CFA Brigham Young University Benjamin M. Blau, Ph.D Utah State University About the Authors 0.1About the Authors James C. Brau This video can be viewed online. James C. Brau Dr. Jim Brau, a Professor of Finance, is the editor of the Journal of Entrepreneurial Finance at the Marriott School of Management. He received his undergraduate training at the United States Military Academy at West Point and served three years as an Airborne Ranger infantry officer in the United States Army and another five years in the Army National Guard and Army Reserves. While in the reserves, Jim earned his Ph.D. from Florida State University in business administration and finance. Jim joined the Marriott School faculty in April 1999 and was honorably discharged as an Army Captain in June 1999. In 2004, Jim earned the Charted Financial Analyst designation. In 2011, he became the Finance Department Associate Chair. Among his awards are West Point Distinguished Cadet (top 5% of Senior class in academics, physical fitness, and leadership), West Point dean's list all eight semesters, FSU Phi Kappa Phi Outstanding Graduate Scholar Award (Valedictorian), three FSU teaching awards (one college level and two university level), four BYU teaching awards (three department level and one college level), two BYU research awards (one department level and one college level), three best-paper awards, and the BYU University Young Scholar Award (universitywide). Andrew L. Holmes This video can be viewed online. Andrew L. Holmes Dr. Andrew Holmes is a Professor of Finance at Brigham Young University. Raised by entrepreneurial parents, he brings an innovative spirit to all his endeavors. During his appointment as Associate Department Chair, Dr. Holmes championed the process to create an independent finance major and developed the curriculum. Currently serving as Chair of the finance department at BYU, he is most concerned with the acquisition and optimization of department resources to ensure achievement of departmental goals in teaching and research. Dr. Holmes has garnered a number of teaching awards during his time as a professor, including the Teaching Excellence Award at the Marriott School of Management and the Citizenship award for the BYU Department of Finance. Benjamin M. Blau This video can be viewed online. Benjamin M. Blau Dr. Benjamin Blau graduated with honors and received a Ph.D. in Finance from the University of Mississippi in June 2008 after receiving both his Bachelors Degree (Finance, 2002) and Masters Degree (Economics, 2005) at Utah State University. Ben is passionate about both teaching and research. Before joining the faculty at USU, he taught at the Marriott School at Brigham Young University and was recognized for “Outstanding Undergraduate Teaching” in 2009. In 2012, he was recognized as the Huntsman School Teacher of the Year in the Huntsman School of Business at Utah State University. Ben’s research interests revolve around the efficiency of financial markets, the effects of regulation, and the flow of information into asset prices. He has published approximately 25 articles in top financial economics journals such as the Journal of Banking and Finance, Financial Management, the Journal of Corporate Finance, the Journal of Risk and Insurance, and the Journal of Empirical Finance. Topic 1: Overview of Finance 1.1What Is Finance? This video can be viewed online. LEARNING OBJECTIVES 1 2 3 Explain how the basic types of financial instruments (financial securities) are traded. Explain how the global financial system and the global economy relate to business entities and a country’s economy. Explain how a financial manager’s decision framework is affected by the global environment and its risk. A commonly used definition of economics is the study of management or the allocation of scarce resources. Like most business disciplines, finance is a subfield within economics. Here, finance is the study of management or the allocation of capital. Capital is broadly defined, but for a working definition, we will assume that capital is a financial asset or the value of an asset. Examples of capital might range from cash to machinery or equipment used by a business. As a student, your main learning objective throughout this course will be to understand the costs and the benefits associated with investing in capital. For the most part, our discussion will be focused on a firm's investment in new capital. For example, a firm might want to invest in new machinery to improve the efficiency of production. Another firm might be looking to invest in labor— perhaps a larger sales force—in order to increase firm revenue. While our focus will be from the firm's perspective, perhaps this course will be most applicable to those who are looking to invest their own resources into stocks, bonds, or other financial instruments. Before we get started, let's discuss three important areas in finance: 1. Corporate Finance: The first area is corporate finance, which focuses on financial decision making by a firm's management. 2. Investments: The second area is investments. This area is devoted to understanding the various types of financial instruments—such as stocks, bonds, etc.—and how to value these instruments. 3. Banking or Financial Institution: The third area is banking. Almost everyone taking this course will have already visited a bank and will understand that banks make money by paying depositors a smaller interest rate than the interest rate they charge to borrowers. Hopefully, we will understand that the management or allocation of capital is important in each of these three areas. In this course, we will explore financial markets and discuss the differences between bonds and stocks. We will learn methods to value stocks and bonds. From the corporation's perspective, we will understand the tradeoff between using debt (bonds) or equity (stocks) to finance some investment. We will also learn about capital budgeting, which is the planning of a firm's long-term investments. Finally, we will conclude by introducing methods that will allow us to determine the value of an entire firm. Are you ready? Healthcare Management Viewpoint This video can be viewed online. This assessment can be taken online. 1.2Financial Securities In the previous section, we mentioned the terms "stocks" and "bonds." In this section, we will provide an overview of not only stocks and bonds, but also of other financial instruments like treasury securities. In fact, let's begin by discussing each of these financial securities. 1. Treasury Securities : Treasury securities are generally bonds that are issued by the U.S. government. The U.S. government is constantly investing in various projects that range from national defense to freeway improvements. When tax revenues fall short of covering these and other governmental costs, the U.S. Treasury will issue bonds. These bonds are effectively loans provided by the public to the government and will vary in length. Some of these bonds are as short as 60-day loans, while other bonds are loans that are paid over a 30-year period. 2. Corporate Bonds : Just as the U.S. government might need to borrow money to cover costs or investments in new projects, firms also borrow from the public. Consider Google, the Internet giant, worth more than $300 billion as of 2013. Google might be looking to invest another $50 billion in low-orbiting satellites; however, because of its size, the company cannot walk into a local bank hoping for a $50-billion loan. Instead, Google will likely issue bonds with a face value of $1,000 that make one or two annual coupon payments a year and might be paid back over a 20-year period. If Google were to go bankrupt, then as part of the bankruptcy, those who hold Google’s bonds will have access to the company’s assets when they are liquidated. 3. Stocks : Most finance students have heard of the many legends of those that have made or lost billions of dollars by investing in stocks. Before we can have that discussion, we need to become familiar with what a stock is. A stock is a share of ownership in a company. If Google did not want to borrow money from bondholders to finance the $50-billion loworbiting satellite project, Google could sell shares of ownership in the company. Investors might be willing to buy shares of ownership in Google because they believe that this satellite project will be extremely profitable. Google will use the proceeds from the sale of these shares to fund the project. If Google were to fail, shareholders claim rank below those of bondholders when claiming the assets of the firm. This assessment can be taken online. 1.3Primary Financial Markets Along with an understanding of the various types of securities, it might be important to know some details about how firms issue these securities. In this section, we will discuss primary financial markets, that is, the markets in which these securities are first issued. Like other types of markets where buyers and sellers meet, primary financial markets are where the issuers (the firms) and the buyers (the investors) will engage in an exchange. We will begin by discussing the issuance of bonds, and we will then discuss the issuance of stocks. To understand how the primary market works, we need to understand what a syndicate is. A syndicate is a group that is temporarily formed to handle a bond or stock issue. Syndicates are generally made up of large investment banks or other types of institutional investors. These large investment banks that make up a syndicate might also be the underwriters of the security issue. An underwriter has the responsibility of determining the value of the security and then, in some cases, the underwriter will purchase all of the securities from the issuer and then sell them to other investors. In general, a firm issuing a bond can place the bonds with a syndicate in two ways. The first way is through a competitive sale. Those wishing to underwrite the bond issue will submit bids (on the bond's prices and interest rate) to the issuing firm. The firm will then select the underwriter that offered the highest price and lowest interest rate. The underwriter will then sell the bonds to various investors at (hopefully) a slightly higher price than that at which the bonds were purchased. The second way is through a negotiated sale. Like the competitive sale, a negotiated sale is the process of underwriters submitting proposals including bids. However, this latter type of sale involves a more thorough interview process with the underwriters. Further, the issuing firm will carefully select the management team that will place these bonds. The primary market for stock issuance works in a similar way to the bond primary market. However, some terminology is different. A firm that is going public (or selling shares of ownership for the first time) is going to perform an initial public offering (IPO). These IPOs are sometimes called new equity offerings. However, much of the underwriting occurs in a similar manner, which we have discussed above. This assessment can be taken online. 1.4Secondary Financial Markets For those eager students that want to learn about the stock market, this section is for you. In the previous section, we discussed primary financial markets, or the markets where securities are issued for the first time. Secondary financial markets are where securities are traded after the initial offering. Said differently, the secondary market for stocks is commonly referred to as the stock market. Markets are where assets are priced. For those who have taken any economics courses, you will remember that prices of any good or asset are determined by supply (the sellers) and demand (the buyers). The secondary market, particularly for stocks, is a fascinating market to watch prices change and move as supply and demand changes in response to new information. There are two types of secondary markets that we will discuss. The first type is an auction market. Those who have been to any type of auction before would have seen that an auctioneer will take bids from the public and sell to the highest bidder. Similarly, an auction financial market has a physical location and prices are determined by the highest price an investor is willing to pay. The New York Stock Exchange (NYSE), the world's largest secondary financial market, is an example of an auction market. 1 The second type of secondary markets is a dealer market. Unlike an auction market, a dealer market does not require a physical location. Instead, in a dealer market, securities are bought and sold through a network of dealers that trade for themselves. For example, a dealer might hold inventory in a particular stock and be willing to sell to those that demand the stock and buy from those that will supply the stock. NASDAQ, which is the second largest secondary market in the world, is an example of a dealer market.2 Most stocks that are listed on NASDAQ have multiple dealers for each stock. The idea behind having multiple dealers providing liquidity to investors is that the dealers must compete with one another, thus lowering the cost of transacting. This assessment can be taken online. 1.5The Role of Financial Markets Financial markets, while fairly sophisticated in the way they operate, play an important role in society. From the firm's perspective, these markets have reduced the cost of borrowing from the public or selling ownership to the public. Think of pharmaceutical companies that are in need of financing to produce the latest drug that can treat cancer. Without a market that allows buyers and sellers to exchange, it would become extremely costly for companies to increase their production. Financial markets reduce the cost to companies for obtaining financing by providing liquidity to those that wish to trade securities. In the previous section, we have discussed two large secondary financial markets: the NYSE and NASDAQ. The NYSE has a single individual with the title of specialist, who provides liquidity. That is, the specialist is hired by the NYSE to provide a "fair and orderly" market, meaning the specialist is to hold an inventory of a particular stock and must be willing to buy from those that wish to sell and sell to those that wish to buy. Because the specialist faces risk in holding an inventory of a stock that is fluctuating in price, the specialist will charge a slightly higher ask (or offer) price to those that want to buy and will be willing to pay a slightly lower bid price to those that want to sell. For example, the price of some stock is approximately $100 per share. Suppose an investor submits an order to buy the stock. The specialist might only be willing to sell for $100.03. A few minutes later, an order is submitted by another investor to sell the stock to the specialist. However, the specialist might only be willing to buy from the seller for $99.97. The difference between the bid price and the ask price is called the bid-ask spread. In this example, the bid-ask spread is $0.06. This is the compensation to the specialist for the risk that he or she bears for his or her willingness to provide liquidity. A similar process is followed for NASDAQ stocks with the exception that there are multiple dealers providing liquidity. This assessment can be taken online. 1.6Trading in Financial Markets While nearly all the trades on the NYSE used to execute through a specialist, the emergence of electronic trading has reduced the specialist's role. Today, so many orders are submitted by so many different investors that some orders will execute electronically. Figure 1-1, for example, shows the average daily volume (number of shares traded) on the NYSE from 1960 to 2005. In 1960, the average daily trade volume on the NYSE was 3 million shares. By 2005, the volume had increased to nearly 1.8 billion shares. This increase in volume suggests that more and more trades occur each year and that financial markets are becoming increasingly liquid. There are several different types of orders used by investors, but we will focus on the two most common types: market orders and limit orders. Market orders are time sensitive while limit orders are price sensitive. Recall our example in the previous section about a $100 stock. If an investor submitted a market order to buy the $100 stock, the execution price would be at the current ask price which, in our example, was $100.03. However, the investor could instead submit a limit order to buy at a price of $100.00. In this case, the order would not execute until the specialist was willing to lower the ask price to $100.00 or a different investor submitted a limit sell order with a price of $100.00. If the latter were to occur, the limit sell order at $100 and the limit buy order at $100 would cross and execute without the specialist quoting different ask or bid prices. Much of the trading that occurs on the NYSE (and many other markets) is accomplished because limit buy orders and limit sell orders cross and execute. As we discussed in the previous section, financial markets reduce the cost for companies to obtain financing through either issuing bonds or stocks. This happens primarily because financial markets provide much-needed liquidity. In the last several years, providing liquidity has become the full-time job of several high-frequency traders. These high-frequency traders, which are mostly computers acting according to complex trading algorithms, will submit thousands of limit orders in a minute or two—both on the buy and the sell side. Their objective is to pick up a $0.01 or $0.02 bid-ask spread millions of times in a day. Figure 1-1: NYSE Average Daily Trade Volume This assessment can be taken online. 1.7Efficiency in Market Prices Nobel Laureate Economist Milton Friedman was interested in the subtlety of prices in an economy. We might see a gallon of milk on sale and priced at $3 and might suddenly become motivated to buy it. Friedman discussed the three roles of prices. First, prices convey information to consumers. Perhaps the newly priced milk is of lower quality or the grocer has excess inventory. Either way, we can infer something informative about the change in prices. Second, prices affect incentives. For instance, a sophisticated consumer might not be in the market for a brand new car at its current price. However, the dealership could incentivize the consumer by dramatically lowering the price. Third, prices affect the distribution of income. Nearly all students would agree that the price of garbage collection is lower than the price of health care. Thus, it should come as no surprise that the providers of health care (doctors) earn higher wages than providers of garbage collection. Likewise, prices in financial markets also convey information, affect incentives for investors, and similarly affect the distribution of income for both the investor and the firm that has issued the security. In this section, we are most concerned with the first role of prices in financial markets. When we discuss whether market prices are efficient, we are interested in determining whether prices fully reflect all of the available information about a particular security. Markets that are efficient will have prices that fully reflect the available information about a specific security. Markets that are inefficient will have securities that are mispriced, or the security prices will not reflect all available information. Take, for example, a company that has recently announced unexpectedly strong earnings. Upon the announcement, an efficient market will bid up the stock price of the company to fully reflect the strong earnings. Another example might be a company that has recently been named as a defendant in a class-action lawsuit. Upon the announcement of this class-action lawsuit, if stock prices take months to reflect this information, this might be evidence of market inefficiency. The purpose of discussing the price response to new information is based on the idea that as firms make sound, profitable decisions, their stock price (in an efficient market) should increase in relation to the firm's profitability. In the next section, we will discuss this in more detail. This assessment can be taken online. 1.8Calculating Security Returns With an understanding of efficient markets, next, we will discuss how to measure whether prices change in response to information, by learning how to calculate security returns. In a general sense, there are two types of returns: dollar returns and percentage returns. Dollar returns are calculated by taking the difference between the price of the security during the previous time period and the price of the security at the current time period, plus any additional cash flow that came from the security. For instance, bonds pay a coupon (or interest) payment once or twice a year while stocks will sometimes pay a dividend. Mathematically, dollar returns are calculated in the following way. Dollar Returns = P t − P t − 1 + C F t In this equation, P t is the sold price, P t-1 is the bought price, and CF t is the cash flow (coupons for bonds; dividends for stocks). Percentage returns are calculated by simply dividing the dollar returns by the price of the security at time t-1, or the previous time period. Percentage Returns = ( P t − P t − 1 P t − 1 + C F t P t − 1 ) × 100 Recall that in the last section, we used two examples to help in our understanding of market efficiency. The first example was a firm announcing unexpectedly high quarterly earnings. Figure 1-2 shows the percentage returns, as calculated above, for a large sample of stocks that announce quarterly earnings. We divide the sample into four groups based on the size of the unexpected earnings. As seen in the figure, firms with the highest unexpected earnings had substantially large positive percentage returns on the announcement day and on the day after the announcement day. Similarly, firms with the lowest unexpected earnings had large negative percentage returns on the announcement day and on the day after. Figure 1-2: Percentage Returns Around Unexpected Earnings In our second example, we discussed the possibility that some firm would be named as a defendant in a class-action lawsuit. Using all of the U.S. stocks that fit into this sample, Figure 1-3 shows percentage returns surrounding the lawsuit filing date. As seen in the figure, percentage returns become negative during the four days prior to the filing and remain negative until two days after the filing. These results seem to indicate that the market knew about the information in the lawsuit filing before the lawsuit was even filed. In either case, Figure 1-2 and Figure 1-3 seem to suggest that markets incorporate new information into stock prices. Figure 1-3: Returns Around Class-Action Law Suit Filings This assessment can be taken online. 1.9The Goal of the Firm Here, we will discuss the main objective or goal of most companies. In the past few sections, we have covered topics related to how stock prices are determined by supply and demand in financial markets and how new information can affect the demand for stocks and subsequently change stock prices. It is easy to think of cases about how management decision-making will lead to new information. Think about cases when a firm releases a new product or announces the acquisition of another competing company. These decisions will undoubtedly affect the stock price of the firm. The goal of the firm is, therefore, to maximize shareholder value. This is usually accomplished by profitable decision-making by management, investing capital into projects that will increase the firm's stock price, and avoiding those investments that cost more money than they bring in. Maximizing shareholder value might mean different things to different companies depending on the type of company. A privately held company—or a company with shares that are not available to the public—may define value differently compared to a publicly held company (or a company with shares that are available to the public). Take, for instance, a private company that is made up of a few owners from a particular family. Privately held family businesses likely place more value on keeping the business in the family, and make decisions with that in mind. For publicly traded companies, the most reasonable and reliable signal of whether management is indeed maximizing shareholder value is by looking at the firm's share price. In cases where management does not use the company's resources in a way that maximizes shareholder value, the price of the company's stock will decrease in an efficient market. In the next section, we will discuss a few issues with the goal of companies being to maximize profit or maximize shareholder value. This assessment can be taken online. 1.10Issues Relating to the Maximization of Shareholder Value The first issue relating to the maximization of shareholder value is agency costs. Agency costs are defined as costs that are incurred when management does not act in the best interests of shareholders. Most shareholders (or owners) have delegated the responsibility of running the day-to-day operations of the firm to management. What happens when management has incentives different from those of the shareholder? For example, a particular manager might really want to remodel his office on the company's dime. Does remodeling an office maximize shareholders' value? More commonly, management might wish to invest capital in particular projects that may not maximize shareholders' value. A company's marketing team may come up with an advertising campaign that might improve sales and might even be considered profitable. However, what if capital can be better spent on acquiring new machinery to improve efficiency and, consequently, the bottom line? Agency costs are real costs and the way that most firms mitigate some of these costs is by aligning managers' interests with shareholders' interests. Most commonly, management might be compensated with shares of ownership in the company. The second issue regarding profit maximization is the potential effect of focusing solely on profits. Is it good for society to have corporations motivated primarily by profit? There are cases when the pursuit of profit has led to unethical behavior by some. For example, in 2001, the Texas-based energy company Enron misreported the financial statements of the company, misled investors, and eventually filed for bankruptcy. Some estimate that more than $10 billion of shareholder value was destroyed because of the scandal. While Enron is an important test case for the unethical maximization of profits, greed and unethical behavior are not always synonymous and should be looked at separately. Think of the benefits that come to society from profitable corporations. Profitable businesses are efficiently providing goods or services that are demanded by the marketplace. Further, profitable businesses are employing other workers and are providing their employees the means to consume goods and services from other businesses in the economy. The employees' consumption improves the profitability of other businesses, which leads to the hiring of more employees and so on. The benefits that arise from this economy occur because corporations are attempting to maximize profit. Footnotes This assessment can be taken online. 1.11Topic 1 Review Select the correct answer This assessment can be taken online. Topic 2: Financial Statements Part 1—The Income Statement and Balance Sheet 2.1The Income Statement and Balance Sheet Introduction This video can be viewed online. LEARNING OBJECTIVES 1 2 3 4 Describe the scope and structure of the major financial statements. Describe the primary differences between accounting income and income for tax purposes. Explain the structure of financial statements and how they are related to one another. Illustrate where information from company accounts is entered onto financial statements. Jimmy Aweshock, a recent college graduate, is a new equity analyst with High Return, LLC (HR). HR is a private equity fund emphasizing growth equity (i.e., growth equity investors provide funding to firms with proven products to support the growth/expansion to profitability). Jimmy’s first task is to evaluate ElectroCar. As part of the training program, HR assigns Jimmy a senior mentor. To help him get started, the mentor provides Jimmy with income statements and balance sheets for the last two years as well as a list of questions. Table 2-1 ElectroCar Income Statement Income Statement - ElectroCar (in $1000s) 20X2 20X1 Revenue $413,256 $204,242 - Cost of Goods 383,189 142,647 Gross Profit 30,067 61,595 - Selling, Gen, and Admin 150,372 104,102 - Research & Development 273,978 208,981 - Other Expenses 1,540 2,391 EBIT (395,823) (253,879) - Interest Expense 254 EBT (396,077) (253,922) - Tax Expense 136 Net Income (396,213) (254,411) 43 489 Table 2-2 ElectroCar Balance Sheet Balance Sheet - ElectroCar (in $1000s) 20X2 20X1 Current Assets: Cash $220,984 $278,742 Receivables 26,842 9,539 Inventory 268,504 50,082 Other CA 8,438 9,414 524,768 347,777 Total Current Assets Property, Plant & Equip. 562,300 310,171 Other Non-Current Assets 27,122 30,439 Total Assets $1,114,190 $713,448 Current Liabilities: Accounts Payable $343,180 $88,250 Current Maturities 55,206 8,983 Other Curr. Liab. 140,722 94,106 Total Current Liabilities 539,108 191,339 Long-Term Debt 411,460 271,165 Other Long Term Liabilities 38,922 26,899 Total Liabilities 989,490 489,403 Common Equity 1,190,306 893,437 Retained Earnings (1,065,606) (669,392) Total Equity $124,700 Total Liab and Equity $1,114,190 $713,448 $224,045 Questions to Consider 1. Where in the product lifecycle is ElectroCar? What evidence is there on the financial statements? 2. Identify two examples of accruals in ElectroCar’s financial statements. 3. On the income statement, ElectroCar reports $413,256,000 in revenue. Did ElectroCar collect $413,256,000 in cash from their customers? 4. What does the large increase in accounts payable say about ElectroCar’s cash position? 5. Did ElectroCar increase its long-term debt? If so, by how much? 6. How much did ElectroCar pay in dividends during 20x2? 2.2The Basics If you ask someone on the street to explain financial statements, they will likely give you a blank stare. This is understandable since the truth is financial statements are the result of a complex process and are very difficult to interpret. In this topic area, we examine two of the three basic financial statements: the balance sheet and income statement. In the next topic area, we review the statement of cash flows (SCF). Each of these statements has a particular role in describing the economic character of a firm: 1. The income statement shows the results of operations over time. Think of the income statement as a video camera tracking performance for a period. 2. The balance sheet offers a "snapshot" of the firm's assets and financing at a particular point in time. It can be viewed as a still shot of what the firm has at one particular moment. 3. The SCF tracks all cash in and out of the firm. You might be asking, "Why is a finance course starting with a long discussion on accounting?" The answer is that while finance is the purer faith, the accountants control the data! If you want to analyze a company, you must first understand its current financial position and operations. In other words, if you want to understand a company, you must understand its financial statements. 1 Finance vs. Accounting Accounting is backward-looking and risk free. Finance is forward-looking and involves massive uncertainty. There's an important caveat here. Specifically, understanding what has happened in the past is not enough. Accounting, and the set of financial statements produced by accountants, is risk-free and backward-looking. In contrast, finance is forward-looking and loaded with uncertainty. While financial statements represent an important source of data for financial analysis, they by no means constitute the complete set. Analyzing the past is merely a springboard to understanding the future. As you read this topic, please remember our goal is not to turn you into an accountant. If you want to be an accountant, this course will not help. There is a big difference between a financial statement preparer (i.e., an accountant) and a financial statement user (i.e., a financial analyst). The goal of this topic is to start you down the path to being a successful financial statement user. 2.3What is 'Accrual Accounting' and Why Do We Use It Anyway? To understand financial statements, we need to have a good understanding of two related concepts: accrual accounting and the matching principle. In the simplest terms, accrual accounting allows managers to decide what is "recognized" on the financial statements (note: while not exactly the same in the accounting world, we use the terms accrual accounting and GAAP accounting interchangeably; GAAP stands for Generally Accepted Accounting Principles). Consider a firm that makes chairs. In 20x1, they spend $75,000 to produce 1,000 chairs but sell zero chairs. In 20x2, they produce zero chairs but sell the 1,000 chairs produced in 20x1 for $100 each. What would the financial statements look like for this firm in each of the two periods? With cash accounting, the firm would simply report the cash in and out. In 20x1, the cash-based reporter would show $0 of revenue and $75,000 of expense. In contrast, during 20x2, the cashbased reporter will recognize a revenue of $100,000 from the sale of the 1,000 chairs but shows $0 expenses. Figure 2-3 shows a simplified income statement for the cash reporter. The cash-based reporter shows a big negative net income in 20x1 and a big positive net income in 20x2. The firm's operations entailed producing 1,000 chairs for $75,000 and selling them for $100,000 leading to an operating profit of $25,000. However, because the operations are arbitrarily split across reporting periods, cash accounting leads to wild gyrations in reported operating performance between periods and a poor understanding of the firm. Table 2-3 Simplified Income Statement for Cash Reporter 20X1 20X2 Revenue $0 $100,000 - Cost -75,000 0 Net Income -$75,000 $100,000 Accrual Accounting vs. Cash Accounting Cash accounting: cash in = revenue; cash out = expense Accrual accounting: Revenues are recognized when the earnings process is complete; expenses are "matched" to recognized revenues With accrual accounting, the firm decides what revenues torecognize. In general terms, revenues are to be recognized when the earnings process is complete and receipt of payment is likely. But, when is the process complete? When an order is taken? When product is delivered? When payment is received? When the customer is satisfied? As you can see, management has considerable discretion over reported revenue. Moreover, the accrual system also employs the matching principle. The matching principle requires that revenue recognized must be matched with the expenses incurred to generate the revenue. So, while both accrual and cash systems report $0 in revenue during 20x1, an accrual firm matches $0 revenues with $0 expenses. No revenues, no expenses! Likewise, the revenue from the two systems will be the same in 20x2. However, the accrual system "matches" the $100,000 in revenue with the $75,000 in expenses incurred to generate the revenue. See Table 2-4. Table 2-4 Simplified Income Statement for Accrual Reporter 20X1 20X2 Revenue $0 $100,000 - Cost 0 75,000 Net Income $0 $25,000 Hopefully, the value of the accrual system is obvious. By showing a very large net loss followed by a very large net income, the cash system does little to enhance our understanding of the firm. By reporting a $0 net income the first year with a modest net income the second year, the accrual system provides a much more accurate portrayal of the firm's operations. As you deepen your knowledge of accrual accounting you will likely incur some heartburn. However, try to view accrual accounting as your friend. Or, at least remember that it is NOT necessarily your enemy! This assessment can be taken online. 2.4The Income Statement—The Basic Layout There is a very old joke that asks, "How can you tell when a politician is lying?" The answer, of course, is that his lips are moving. A close correlate applies to income statements. How can you tell when an income statement is misleading? When there are numbers on the page! While this may be something of an exaggeration, a naïve review of an income statement will almost always lead to erroneous conclusions. Do not confuse the economic concept of cash flow with the accounting concept of net income. Cash flow is a fact, while net income is only an opinion. In some cases, to really understand what is reported in the financial statements, an analyst may have to slog through 200 pages of footnotes. The outward simplicity of the reported financial statements masks a truly complex process. There are fictions in all basic financial statements. However, most analysts regard the income statement as the hardest to interpret. So, when thinking about net income, remember the following: Cash-based income. While not a formal metric, cash income is based on cash in and cash out of the firm. Many small-business people think of net cash from operations as "profit." Intuitively, cash-based income is similar to what we call Cash Flow from Operations (i.e., CFO) in the next topic area. Income for tax purposes. Not surprisingly, the government has its own system for calculating income. While not as simple or intuitive as cash-based income, income for tax purposes is more straightforward than accounting income. This is the income used to determine the amount of tax a firm must pay. Income for tax purposes generally involves fewer managerial choices than accounting income. Accounting income. Accounting income is reported on the firm's income statement as net income. Calculation of net income requires managers to make many choices. When constructing the income statement, essentially every line item involves significant discretion about what is reported. Hence, the interpretation of net income requires a solid understanding of the accrual accounting process (remember: we are using the terms accrual accounting and GAAP accounting interchangeably). What do you mean by "income"? Cash-based income--an informal metric based on cash in and out of the firm Income for tax purposes--based on the government's definition of income, this is the amount of income the government will tax Accounting income--the income calculated using accrual accounting (aka, GAAP). Accounting income is the best metric for understanding the operations of the firm. Unfortunately, it is also the most complicated. The basic income statement equation is Revenue – expenses = net income. Table 2-5 gives an illustration of a simple income statement in good order. In the hands of a naïve reader, the income statement appears straightforward. Unfortunately, the use of accrual accounting means that every line item on the income statement requires management to make judgments about what is reported. In the best case, this means that we must know what principles management is using as they compile the income statement. In the worst case, management uses their discretion to "manage" the reported results. As a financial statement user, you must also be a skeptic. Table 2-5 Simple Income Statement Income Statement Revenues - Cost of Goods Sold Gross Profit - Operating Expenses (including wage and rent expense, non-direct labor, office and clerical expense, depreciation expense, etc.) Earnings Before Interest & Taxes (EBIT) - Interest Expense Earnings Before Taxes - Tax Expense = Net Income The basics of the income statement are deceptively simple. Start with revenue, deduct categorized expenses, and arrive at net income. As we show in the next section, it is a rare company for which a simplistic stroll through the income statement leads to an accurate understanding of the firm's operations. After all, there is a reason why the reported statements need dozens or hundreds of pages of footnotes! This assessment can be taken online. 2.5The Income Statement—A Closer Look Let's walk through the major line items on the income statement to get a feel for potential hazards (see Figure 2-5 in the previous section): Revenue: Consider a company that signs a contract one month, ships the product the next, and receives payment two months later. When should revenue be recognized? Accrual accounting requires revenue be recognized when "earned"—but when did that happen? Management's discretion over revenue recognition is significant. Revenue and cash collected can be very different. Cost of Goods Sold (COGS): COGS represents the direct costs (direct materials and direct labor) associated with production and suffers from the same recognition predicament as revenue. Think back to our discussion of the matching principle: regardless of when a company incurs cost, it is reported only when the associated revenue is recognized. Neither revenue nor COGS represents actual cash. Gross Profit: Subtracting COGS from revenue gives us the company's gross profit. Operating Expenses: Operating expenses include costs incurred through the company's operations that are not directly associated with production. For example, this includes office expense, administrative expense, depreciation expense, and research and development (R&D) expense. The complexities are many. For example, the purchase of copy paper will eventually be recorded as an operating expense. But when? When the purchase is made or when the supplies are used? EBIT: Subtracting operating expenses from gross profit yields EBIT (aka operating profit). Interest Expense: While the details are beyond the scope of our discussion, there are times when a company pays interest that does not get reported on the income statement and there are other times when a company does not pay interest and reports it anyway! Tax Expense: Isn't tax expense the amount the firm paid in taxes? Unfortunately, no. Firms keep two sets of books. One set is for the IRS and the other is for everybody else. Tax expense as reported on the income statement may have little resemblance to taxes actually paid. Net Income: Subtracting both interest and taxes from EBIT leaves us with net income. However, every line item involved in calculating net income is subject to accounting assumptions, timing differences, subjectivity, and even purposeful deceit. Revenue is not how much cash we collected; COGS and operating expenses are not how much cash we paid; interest expense is not interest paid; and tax expense is not tax paid. No wonder great care is required when interpreting net income! Remember, net income is an opinion. This assessment can be taken online. 2.6The Balance Sheet—The Basic Layout As noted in the introduction, the balance sheet is a snapshot of what the firm owns (i.e., assets) and how it finances those assets. The basic equation that governs the balance sheet is Asset = Liabilities + Owner's Equity Commonly, we solve for Equity (Equity = Assets - Liabilities). Either way it is expressed, this equation is a basic economic truth. All assets have to be financed either with other people's money (think: borrowing or liabilities) or your own money (think: equity). Table 2-6 shows the basic form of the balance sheet. Table 2-6 Standard Form of a Balance Sheet Balance Sheet Assets Liabilities & Owners' Equity (asset side) (financing side) Current Assets Current Liabilities Cash Accounts Payable Marketable Securities Accruals Accounts Receivable Notes Payable Inventory = Total Current Liabilities = Total Current Assets Long-Term Liabilities Fixed Assets = Total Long-Term Liabilities Gross Fixed Assets Less: Accumulated Depreciation = Net Fixed Assets Equity Common Stock Additional Paid-In Capital = Total Assets Retained Earnings = Total Equity = Total Liabilities and Equity Total assets (A) always equal total liabilities (L) plus owner's equity (OE). All assets must be financed! Therefore, assets and financing must balance. To understand the balance sheet, you must understand the historical cost principle. There is a tug-of-war on the balance sheet between fair value and historical cost reporting. Most analysts are interested in fair, or market, value. Unfortunately, most of the line items on the balance sheet are stated at historical cost. The historical cost principle means that when an asset is purchased (or a liability incurred) it is recorded at cost. That is okay…when we buy something, we usually pay market value. But what happens as time passes? Suppose a firm purchased a parcel of raw land in downtown San Francisco in 1972 for $1 million. On the 1972 balance sheet, the land would be recorded at $1 million. No problem. But what if the firm is still holding the land today? Since land is reported at historical cost, the balance sheet value today will still be $1 million. It does not take much knowledge of California real estate to know that land worth $1 million in 1972 is probably worth many times that today. The accrual accounting system makes no adjustment for changes in the market value of assets reported at historical cost. Unfortunately, the problem does not stop there. Remember, A = L + OE. Since the balance sheet must "balance," any misstatement of value on the asset side must have an equal and offsetting misstatement on the financing side. Hence, if our land's value is misstated on the asset side, there must be something wrong on the financing side as well. As financial statement users, we may want to "recast" the financial statements to reflect economic reality. But, financial statement preparers using GAAP/accrual accounting will simply report the historical cost (less accumulated depreciation, if any). Having struggled through the complexity of the income statement, you may have initially felt more optimistic about understanding a balance sheet. As our land value story illustrates, the accounting system introduces many complexities into the balance sheet as well. As with the income statement, interpreting the balance sheet will require great care. This assessment can be taken online. 2.7The Balance Sheet—Asset Side Let's stroll through the major line items on the asset side of the balance sheet (see Figure 2-6 in the previous section): Current Assets – At the top of the asset side of the balance sheet, we see the current assets. Current assets are cash or assets that will be converted into cash within the next year. They are listed in order of liquidity. Common current assets include the following: Cash: You know what cash is... Marketable Securities: Marketable securities are generally short-term, high-quality securities such as US Treasury Bills and certificates of deposit (CDs). Accounts Receivable (AR): The balance in AR represents cash not yet collected from customers on goods previously sold. When there are questionable accounts (i.e., customers who may not pay us), management should take action to reduce the AR balance. To the extent that management does not recognize potentially bad debt, the listed AR balance is deceiving. Inventories are usually the least liquid current asset. They include any raw material, work-in-progress, and finished goods. Inventories are subject to a number of potential risks, such as salability, spoilage, and shrinkage. From an accounting standpoint, the reported value of inventory on a company's balance sheet can be significantly impacted by management discretion. Depreciation Expense vs. Accumulated Depreciation Equipment lasting more than one year is "depreciated" through time. If an asset costs $100 and will last 5 years, a firm can choose to claim $20 in depreciation expense each year on the income statement. The total of all depreciation claimed against the firm's fixed assets is known as accumulated depreciation on the balance sheet. Fixed Assets: Fixed assets provide benefit to the firm for more than one year and are usually recorded on the balance sheet at historical cost. On simplified balance sheets, this is frequently reported as PP&E (property, plant, & equipment). Gross PP&E: This is the original cost of all non-current assets held for use by the firm. However, fixed assets get used up. Hence, Gross PP&E is offset by Accumulated Depreciation. Depreciation expense is an income statement item whereby the firm claims the expense of using up fixed assets (more on this later). Accumulated depreciation is the total of all depreciation claimed against Gross PP&E. Net PP&E:Book value is defined as original purchase price (historical cost) minus accumulated depreciation. It can be calculated for the firm's entire capital stock, in which case, we take Gross PP&E minus accumulated depreciation to get Net PP&E. Book value can also be calculated for an individual asset. Unfortunately, the accounting rules for calculating depreciation rarely mirror economic depreciation so book value can be very different from the fair value of the asset. Understanding the performance and prospects of a firm requires a good understanding of fixed assets. This assessment can be taken online. 2.8The Balance Sheet—Financing Side Let's take a closer look at the line items on the financing side (see Figure 2-6): Current Liabilities: Current liabilities are obligations that require cash in the next year and are usually listed in order of maturity (shortest first). At a minimum, the current liability section includes accounts payable, accrued items, and notes payable: Accounts Payable (AP): AP is money owed to suppliers as a result of purchases made on credit. Think of AP as the opposite of AR. When the firm buys materials on credit a payable is created; conversely, when it sells goods on credit a receivable is created. Notes Payable (NP): Unlike AP, NP involves an explicit interestbearing arrangement with the lender. Accruals: Accruals represent expenses incurred but not yet paid (note: while not discussed here, there are also accrued assets). For example, a company may not pay wages until April 10th for an employee's labor in March. On a March 31st balance sheet, the wages owed employees for March will be recognized as an accrued item called accrued wages. Long-Term Liabilities: Long-term liabilities include debt obligations with maturity longer than one year. The valuation of long-term debt obligations is complex. For now, simply recognize that the value of long-term debt as stated on the balance sheet can be significantly different from market value. Equity: Since Asset = Liabilities + Equity, misstatements found in the assets and/or liabilities sections must be offset somewhere; "somewhere" is frequently in the equity section. Because of this effect, the book value of equity usually bears little resemblance to the market value of the company's equity. Typical equity accounts include common stock (CS), additional paid-in capital (APIC), and retained earnings (RE): CS and APIC: For archaic reasons, proceeds from issuing equity (stock) are split between CS and APIC. Adding CS and APIC yields the value of all the common stock issued by the firm. RE: RE represents the cumulative total of earnings not paid out as dividends to stockholders over the entire history of the entity. RE are the earnings of the company that have been plowed back (or retained) to finance the firm's asset base. As such, RE is not cash on the books and cannot be used to pay bills or invest in assets because these funds have already been plowed back into the firm. In the real world, balance sheets may be a tad easier to navigate than income statements. But, there are still significant pitfalls for analysts to decipher on the balance sheet. This assessment can be taken online. 2.9Linking the Income Statement and Balance Sheet The reported financial statements for a period are highly integrated. For our purposes, it is particularly important to understand the primary linkage between the income statement and the balance sheet. In particular, there is a very simple and important relationship between net income, dividends, and RE. Remember, there are only two things a company can do with net income: 1) pay it out as dividends to shareholders, or 2) retain it within the firm. Those are the only options for net income – pay it out or plow it back. Algebraically, we could express this as follows: Net Income = Dividends + Change in RE This relationship will show up several times in later topics as a tool for linking financial statements. It is also useful for RE forecasting, which describes the change in the RE account from year to year. Recognizing that RE changes by the amount of current earnings NOT paid as dividends, we get this year's RE equals the sum of last year's RE balance plus the change in RE from the current year, or New RE = Old RE + Change in RE Solving this equation for the change in RE and substituting into the net income equation yields: New RE = Old RE + Net Income - Dividends This last relationship is worth remembering—you see it quite frequently in financial analysis. In fact, there are several times this identity will be valuable even in an introductory course such as this one! This assessment can be taken online. 2.10Topic 2 Review Select the correct answer This assessment can be taken online. Topic 3: Financial Statements Part 2—The Statement of Cash Flows 3.1The Statement of Cash Flows Introduction This video can be viewed online. LEARNING OBJECTIVES 1 2 3 4 5 Explain the relationship of environmental factors to the recording and classification of cash flows for decision making. Differentiate between net income and cash flow, including understanding the components of the cash flow statement. Calculate cash flows from operations, investments, and financing given appropriate data. Explain how changes in line items on the finance statements affect the calculation of cash flow from operations. Calculate free cash flow and cash flow from operations based on sources of financial information. The Logan Enterprises Case Jim Bland is an equity analyst with Partners Analytics. Mr. Bland’s job is to assess the sustainability of firms in which the company is considering investing. As part of this analysis, he carefully considers the sources of cash in and out of the firm. Currently, Mr. Bland is evaluating Logan Enterprises. Logan’s balance sheet for 20x1 and 20x2 is presented below. Additionally, from the annual report, Mr. Bland obtains the following information: The firm had no asset disposals in 20x2 The firm reported a net income of $150 Table 3-1 Logan Enterprises Balance Sheet 20x1 20x2 Assets Cash $500 $700 Marketable Securities 100 100 Accounts Receivable 900 1,100 Inventories 1,700 2,000 Total Current Assets 3,200 3,900 Gross Fixed Assets 3,300 3,500 Accumulated Depreciation 2,400 2,500 Net Fixed Assets 900 1,000 Total Assets $4,100 $4,900 Liabilities and Equity Accounts Payable $300 $500 Notes Payable 400 300 Accruals 100 100 Total Current Liabilities 800 900 Long-Term Debt 900 1,500 Total Liabilities 1,700 2,400 Common Stock (Par Value and Paid in Capital) 2,000 2,000 Retained Earnings 400 500 Total Stockholders' Equity 2,400 2,500 Total Liabilities and Equity $4,100 $4,900 Questions to Consider 1. How does CFO differ from net income? 2. What is Logan’s CFO? 3. What is Logan’s CFI? 4. What is Logan’s CFF? 5. What does examining the SCF tell us about Logan? 3.2The Statement of Cash Flows (SCF)—Overview and "The Myth" The SCF is the third of the three basic financial statements. It is also the most honest. After all, it is cash flow, not net income, that reveals the true health of a company. The SCF explains cash in and cash out of the company for a given year. All cash flows are divided into three groups: cash flows from operations (CFO), cash flows from investing (CFI), and cash flows from financing (CFF). The sum of all of these cash flows is equal to the company's change in cash (i.e., ending cash − beginning cash). For example, if a company's balance sheet for the current year shows a cash balance that is $16,000 higher than the previous year, the sum of CFO plus CFI plus CFF will equal $16,000. The line items on the cash flow statement serve to show why and where the increase occurred and what type of activity (i.e., operating, investing, or financing) caused it. The three subdivisions of the SCF—operations, investing, and financing—refer to the three types of decisions made by managers: 1. Operational decisions for a company include what to produce, how to produce it, whom to sell it to, whom to use for suppliers, etc. CFO measures the net cash impact of operating decisions. 2. Investing activities involve decisions concerning the purchase and sale of long-term assets, such as conveyor belts or the construction of new production facilities. CFI measures the net cash impact of investing decisions. 3. Financing decisions deal with the issuance of debt and equity, the repayment of debts or repurchase stock, and the payment of dividends. CFF measures the net cash impact of financing decisions. The standard form for the statement of cash flows is presented in Table 3-2, which lists operating, investing, and financing cash flows (in that order), followed by the net change in cash. There is a myth about the SCF of which you should be aware. Specifically, many people mistakenly believe " cash flow can't be misstated." Like most good myths, there is an element of truth. Specifically, GROSS cash flow is hard to misstate (not impossible, but hard). However, this is NOT true of CFO, CFI, or CFF individually. While it is difficult to misstate gross cash flow (i.e., the sum of CFO, CFI, and CFF), there are many ways to shift cash flows between categories. We will discuss a few of these as we progress through the statement. Remember the categorization of cash flow is flexible and is impacted by the firm's operating environment. In particular, the firm's operating environment can impact the categorization in several ways: Core activities - the firm's core activities will impact the way cash flows are categorized. For instance, two firms can purchase similar lathes and categorize the cash outflow differently. For a machine shop, the lathe is likely a long-term asset and the cash flow will be part of CFI. For an equipment dealer, the lathe is likely inventory and will be included in CFO. Cash flow management - some managers will "manage" (i.e., increase or decrease) reporting of cash flows. For instance, a manager whose bonus is impacted by CFO may be tempted to recategorize some items to make CFO appear larger. While most of the techniques to recategorize cash flows are beyond the scope of this course, it is relatively easy to do for a year or two without violating the rules of GAAP accounting. Market pressure - even if a manager's personal income is not impacted, there are other pressures to manipulate cash flow categorization in the market place. For instance, a firm that is in the process of raising capital does NOT want to show a decrease in CFO. Hence, managers may be willing to use their discretion over accounting choices to increase the reported level of CFO. As with the income statement and balance sheet, the moral here is to be careful when interpreting the SCF. While gross cash flows are difficult to alter, it is relatively easy to increase one category by decreasing another. Table 3-2 Standard Form for the Statement of Cash Flows Statement of Cash Flows (dated for period ended) Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash + Beginning Cash = End Cash This assessment can be taken online. 3.3CFO vs. Net Income CFO includes all cash flows related to producing and selling the firm's product, such as cash coming in from customers, cash flowing out for raw materials and operating expenses, and cash flowing out for taxes. While this may appear to be the same way net income is calculated, don't be fooled. Net income is an accounting concept—it is not CFO. There are many reasons why net income will differ from CFO. Consider the following: 1. As discussed in our review of the income statement, revenue (used to calculate net income) is not the same as cash collected from sales because of changes in accounts receivable (AR). If AR increases during the year, then the firm has recognized sales associated with the increased AR as revenue but has not yet collected the cash. Thus, to understand the cash collected from customers, we need to subtract the increase in AR from cash collected. The opposite is true of a decrease in AR. Remember, revenue does not equal cash collected! 2. Suppose a firm shows a gain or loss from the sale of property, plant, and equipment (PP&E) during the year because old equipment was sold for more than book value (Note: Gain on Sale = Sale Price − Book Value). The gain or loss is included in net income. However, a gain or loss on the sale of PP&E is not attributable to CFO. Cash from the sale of equipment is associated with the firm's investing activities and is part of CFI. Hence, the gain on the sale of PP&E is included in net income but is not part of CFO. 3. Depreciation expense is a significant source of difference between net income and CFO. Depreciation expense is included in the calculation of net income but it does not represent an outflow of cash. It is a non-cash expense created for tax purposes. No cash changes hands as a result of a firm claiming depreciation expense on the income statement. To adjust net income to reflect actual cash flow from operations, we must add depreciation expense back to net income. While net income is a useful concept, it does not represent cash. Further, CFO is more important to the financial analyst than net income in many situations. Logan Enterprises Case Question How exactly does CFO differ from Net Income? Use the information in the case to explain the answer. This assessment can be taken online. 3.4Calculating CFO—A Simplified Approach How do we calculate CFO? The most commonly used method by financial analysts is called the indirect method. The indirect method is a "bottom-up" approach where we start with net income and adjust for differences between net income and CFO. If there were no non-cash expenses and no changes in any operating balance sheet accounts, net income would equal CFO. However, as discussed above, this is rarely the case. Figure 3-1 shows a simplified methodology for calculating CFO. The simplification, employed throughout this text, is that we assume there are no asset disposals (i.e., the firm does not sell any PP&E). This means that we don't have to worry about adjusting for a gain or loss on the sale of equipment. Gains and losses are important; but we will leave those details for your accounting class! As Figure 3-1 shows, the first part of the CFO calculation is very straightforward: add non-cash expenses such as depreciation expense to net income. Why? Recall that depreciation expense is a non-cash item created for tax purposes. More complex financial statements may include other non-cash expenses such as amortization or depletion allowance. If depreciation expense is not explicitly stated on the income statement, we can infer it as the change in accumulated depreciation on the balance sheet (our simplifying assumption of no asset disposals makes this possible). The bracketed part of the CFO calculation in Figure 3-1 refers to changes in operating accounts. Recall our discussion in the last section about how an increase in AR means that the firm didn't collect as much cash as is recognized in revenue? The same logic applies to all operating accounts. Generally, current assets other than cash are operating asset accounts and current liabilities other than notes payable are operating liability accounts. To calculate CFO, we need to adjust net income for changes in the operating asset and liability accounts. As we look at each of these accounts, we have to note whether the change from last year to this year indicates an inflow or outflow of cash and adjust net income accordingly. We discuss this process in the next section. Figure 3-1: Calculating CFO This assessment can be taken online. 3.5CFO—Impounding Changes in Balance Sheet Operating Accounts As we noted at the end of the last section, the calculation of CFO starts with net income and adds non-cash expenses such as depreciation. However, we also have to adjust for changes in operating asset and liability accounts. Calculating CFO Remember This Increased assets = outflow of cash Increases in an operating asset account imply an outflow of cash. For assets to increase, cash must have been used to acquire the asset. Imagine that you increase your personal assets by purchasing a car. You buy a car by paying cash to the seller. It's the same for all asset accounts: an increase in an asset account indicates that cash has left the firm (note: if you get a loan to buy the car, the liability will be part of CFF!). The opposite is also true. A decrease in an asset account indicates an inflow of cash. Liabilities work in an opposite manner. Increases in liability accounts signal an inflow of cash; decreases signify an outflow of cash. For example, if accounts payable increases from last year, we owe more money to our suppliers. If we owe more money to our suppliers, we paid out less cash than what is implied by net income. If we paid out less cash, then cash has gone up. In contrast, a decrease in accounts payable must indicate that we paid cash to our suppliers. Think of your personal credit card bill: payables (i.e., your credit card balance) go down when we pay them, and paying them requires an outflow of cash. Consider This Why don't we consider changes in cash to CFO? We do not need to make an adjustment for change in the cash account. Why? Because the change in cash is the end result of the entire SCF! The sum of CFO, CFI, and CFF is the change in cash. To summarize, the CFO implications of changes in: Operating asset accounts (e.g., AR and inventory) are Increases = an outflow of cash Decreases = an inflow of cash Operating liability accounts (e.g., accounts payable and accrued wages) are Increases = an inflow of cash Decreases = an outflow of cash Remember This Increases in liabilities = increased cash One warning with current liabilities: notes payable is frequently included in the current liabilities section of the balance sheet but for the purposes of the SCF is considered a financing account (i.e., part of CFF). This is true of all formal borrowing arrangements, such as long-term debt. When calculating CFO, be sure to not adjust net income for changes in notes payable. Totaling all of these operating account adjustments and adding the result to the depreciation-adjusted net income yields the CFO. As we discuss below, CFO can be an important measure of firm health. Logan Enterprises Case Question What is Logan Enterprise’s CFO? Use all of the information in the case to calculate the answer/solution. This assessment can be taken online. 3.6Cash Flow from Investing (CFI) CFI involves any cash in or out of the company due to investment in or disposal of fixed assets. As noted previously, we are simplifying our discussion by assuming the firm doesn't sell any fixed assets. For a large company today, calculating CFI can be complex; however, for our purposes, we will assume all investing activity is fully reflected in the PP&E account. This simplifies our calculation to a straightforward evaluation of changes in PP&E. CFI calculated as Change in Gross PP&E - or Change in Net PP&E + Depreciation Recall that PP&E can be stated as either gross (i.e., before we deduct accumulated depreciation) or net (i.e., after we deduct accumulated depreciation). An increase in gross PP&E from one year to the next represents a use of cash (we had to use cash to purchase more fixed assets). For example, if gross PP&E increases by $1 million during the year, then the company acquired $1 million of new PP&E. Given our usual assumption of no assets disposals along with data on beginning and ending gross PP&E, the calculation of CFI is simple: CFI = Gross PP&E end - Gross PP&E begin. Many balance sheets only report net PP&E (recall: Net PP&E = Gross PP&E Accumulated Depreciation; accumulated depreciation is the total of all depreciation claimed against the firm's assets). In this case, CFI can be calculated as: CFI = Change in Net PPE + depreciation expense. To illustrate, assume a firm has depreciation expense for 20x2 of $250 and reports net PP&E as 20X2 20X1 Net PP&E $1,300 $1,100 All else equal, the purchase of new equipment will increase the reported value of PP&E while depreciation expense decreases reported value. In our example, if the firm didn't purchase any new equipment during 20x2, the reported value of Net PP&E for 20x2 would be $850 (i.e., beginning net PP&E of $1,100 minus the depreciation expense for the period of $250). Since ending PP&E for 20x2 is $1,300, the firm purchased enough new equipment to offset the impact of the depreciation expense and increase net PP&E to $1,300. Hence, the firm's investment expenditure must have been $1,300 − $850 = $450 = CFI for 20x2. More simply: C F I = Change in Net PP&E + Depreciation Expense = ( $ 1 , 300 − $ 1 , 100 ) + $ 250 = $ 200 + $ 250 = $ 450 Note that the $450 is an increase in assets and as such represents an OUTFLOW of cash. If we assume that accumulated depreciation at the end of 20x1 was $500, we can work backwards to see the relationship between the two ways of calculating CFI. That is, the change in Gross PP&E and the Change in Net PP&E plus depreciation expense both equal $450 as shown in the following table: FYI Net PP&E = Gross PP&E – Accumulated Depreciation; so, $1,100 = Gross PP&E - $500 Gross PP&E = $1,600 20X2 Gross PP&E 20X1 $2,050 $1,600 Less: Accumulated Depreciation $750 Net PP&E $500 $1,300 $1,100 Logan Enterprises Case Question What is Logan Enterprise’s CFI? Use all of the information in the case to calculate the answer/solution. This assessment can be taken online. 3.7Cash Flow from Financing (CFF) The third of our three cash flow categories is CFF. CFF is the net cash impact from financing and includes cash flows resulting from increased borrowing, debt repayment, stock issuance, stock repurchase, or dividend payment. We can calculate CFF by comparing the appropriate balance sheet accounts from one year to the next. An increase in a financing account (e.g., debt, including notes payable, and equity) signals a cash inflow. A decrease in a financing account indicates a cash outflow associated with repaying lenders or repurchasing stock. Consider This What happens to Net Income? There are only two possibilities: 1) pay dividends to equity holders or 2) increase retained earnings! Dividends paid to the firm's owners/equity holders during the year are also a cash outflow attributable to CFF. However, dividends are not explicitly listed on the balance sheet or the income statement. How do we know if a company has paid dividends? Recall that there are only two things we can do with net income: 1) we can pay it out as dividends or 2) we can retain it within the company. Therefore, we can calculate dividends by comparing the change in the retained earnings (RE) account to net income. If our new RE balance is lower than the sum of our old RE balance plus net income, we know that we must have paid part of our net income as dividends. How much was paid in dividends? We can use our RE relationship discussed above to calculate dividends paid: Dividends = ( Old RE + Net Income ) − New RE Note that this is the same relationship we learned in the equation at the end of the section on income statements! To illustrate, consider a firm that reports the following data: Net Income = $1,000 Beginning RE = $12,200 Ending RE = $13,000 How much did the firm pay in dividends? Using our formula, we get Dividends = ( $ 12 , 200 + $ 1 , 000 ) − $ 13 , 000 = $ 200 So, of the $1,000 in net income, the firm paid dividends of $200 and retained $800. However, thinking about it may be easier than memorizing a formula: RE increased by $800, so of the $1000 in net income, $800 was retained, meaning that the other $200 must have been paid out as dividends! Remember: there are only two things you can do with net income! The $200 paid as dividends represents a cash outflow. As a result, CFF for the year will be $200 lower. Logan Enterprises Case Question What is Logan Enterprise’s CFF? Use all of the information in the case to calculate the answer/solution. This assessment can be taken online. 3.8Visualizing Interaction Between the SCF and the Balance Sheet The SCF is a useful tool for any financial analyst. While there are many issues beyond the scope of this discussion, the SCF allows us to unwind many of the accrual accounting assumptions/fictions on the income statement and balance sheet and get a better look at what really matters: cash! To get cash impacts requires extensive use of changes in balance sheet accounts. However, for the budding financial analyst, a frequent source of consternation is deciding which balance sheet line items are associated with each cash flow category. Consider the balance sheet accounts in Figure 3-2. Figure 3-2: T-Account Balance Sheet Recall that the calculation of CFO is C F O = Net Income + depreciation expense ± changes in operating assets (Note: add decreases and subtract increases) ± changes in operating liability accounts (Note: add increases and subtract decreases) However, which line items are "operating asset" and "operating liability" accounts? Viewing the balance sheet in T-account form, the operating asset and operating liability accounts are at the top on both the asset and financing sides. The circled area in Figure 3-3 shows the operating accounts. There are important exceptions. As discussed earlier, changes in the cash account are not included in CFO. Similarly, there are current liability accounts, such as notes payable, that are financing accounts and therefore must be included in CFF. However, generally, when calculating CFO, you will look for changes in accounts at the top of both sides of the balance sheet. Figure 3-3: The Operating Accounts What about CFI? Recall that CFI focuses on cash from acquisition and disposal of fixed assets. These accounts are found at the bottom of the asset side of the balance sheet. If you are keeping track, you will notice that CFO and CFI consume the top of both sides and the bottom of the asset side of the balance sheet. The only area of the balance sheet remaining is the bottom of the financing side and the only cash flow category left is CFF. Luckily, the two are a match! That is, the cash impacts of financing decisions are linked to the bottom of the financing side of the balance sheet. Figure 3-4 shows our simple balance sheet with a color coding to link the balance sheet and the SCF. It may seem a trifle simplistic, but given the complexity of trying to understand the economic character of a firm through the meat-grinder of accrual accounting, a simple approach is frequently the best. Figure 3-4: Operating, Investing, and Financing Accounts This assessment can be taken online. 3.9What Can We Learn from the SCF? Okay, so we now know something about the basics of the SCF. While there are a few things more fun than studying the SCF, did we go through all of that for the pure joy of it? (Author's note: please recognize the sarcasm in the last sentence.) In fact, we can learn a lot about a firm from the SCF. Consider two firms, A and B, that both increased cash by $15 million in the last year. Table 3-3 present the firms' SCF. Table 3-3 Comparison of Firm A and Firm B CFO $122 CFO -$22 CFI -$41 CFI -$21 CFF -$66 CFF $58 Change in Cash $15 Change in Cash $15 + Beginning Cash $22 + Beginning Cash $22 Ending Cash Ending Cash $37 SCF for Firm A SCF for Firm B ($ in millions) ($ in millions) $37 Notice that both firms have exactly the same starting cash balance and the same change in cash for the year. However, that is where the similarity ends: The most striking difference is in CFO. Firm A's operations provided $122 million in cash while Firm B's operations consumed $22 million. Incurring negative CFO for a year or two doesn't mean that the firm is dying. However, a firm cannot sustain negative CFO in the long run. If a firm is burning cash in its operations, the cash has to come from somewhere. Any way you look at it, negative CFO is not sustainable: Fund with cash balances? Eventually, the cash is used up. Fund by selling assets? Eventually, all the assets are sold. Fund by borrowing? Eventually, the bankers start laughing at you. Fund by selling equity? Eventually, the equity markets ignore you. The firms also have significant differences in CFI. CFI represents investment. Why is Firm B not investing as much as Firm A? A likely reason is that they are constrained because of the cash outflow associated with operations. Differences in CFF are very significant. Firm A has cash outflow from financing of $66 million. This can occur because the firm paid dividends to equity holders, repurchased equity, or paid off creditors. Conversely, Firm B brought $58 million in cash into the firm from financing. Without looking at the balance sheet, we cannot be sure about the source of this cash. However, a good bet is that the firm is borrowing money today to fund losses on their operations. It is also important to recognize what we cannot learn from the SCF. If we ask which firm is performing better, the available data certainly points to Firm A. However, we don't know if this represents good performance even for Firm A. It might be that other management teams in the same industry are generating even more cash and creating more value for investors. To make a general assessment of performance, we will have to take a much closer look at what other management teams are achieving. We leave that story for the next topic area. Logan Enterprises Case Question What does examining the SCF tell us about Logan? Use the information in the case to calculate the answer. This assessment can be taken online. 3.10CFO vs. Free Cash Flow (FCF) Suppose you own 100% of a firm that generates CFO of $1 million in 20x2. Can you personally take $1 million as your compensation? Can you take the CFO every year? The answer is "no." CFO cannot be distributed to the owners of a firm because CFO does not allow for required reinvestment. Equipment and buildings wear out over time and must be replaced. If we disgorged all CFO from the firm, there is no cash with which to reinvest, and eventually, there would be no firm left to generate CFO! That's where FCF becomes important. FCF is distributable cash! That is, FCF represents the cash that can be distributed after funding required reinvestment in PP&E as well as increased working capital. FCF comes in two flavors: FCF to the firm (FCFF) and to equity (FCFE). FCFF is the cash distributable to all the providers of capital (i.e., to both debt and equity holders) and is most commonly used in financial analysis. FCFE is the cash distributable to the equity holders after satisfying all obligations to debt holders. Dividends are the cash actually distributed to stockholders; FCFE is cash that is distributable to stockholders after funding required reinvestment. The base equation for measuring FCFF is as follows: F C F F = E B I T ( 1 − tax rate ) + Depreciation − C A P E X − Increases in NWC Where Tax rate = percent of earnings a firm pays in tax Depreciation = Depreciation expense EBIT = Earnings before interest and taxes CAPEX = Capital expenditure on PP&E; frequently measured as CFI NWC = Net working capital (current assets − current liabilities) changes Note: the first two element, EBIT (1-tax rate), is referred to as Net Operating Profit After Taxes (NOPAT) FCFF is a measure of cash flows before either creditors or owners are compensated. Thus, we use EBIT instead of net income. We add back depreciation because it is a non-cash expense. We subtract CAPEX and increases in NWC because these represent required reinvestment to keep the firm operating. Likewise, the calculation of FCFE is F C F E = N I + Depreciation − C A P E X − Increases in NWC + Increases in Debt where Increases in debt = new borrowings minus any repayment of old debt FCFE measures the cash distributable to equity holders after all obligations (including interest and principle to debt holders) and required reinvestment are satisfied. As we will see later in this course, FCF is one of the most important concepts in finance. Logan Enterprises Case Question Professor Holmes wraps up/finalizes the Logan Enterprises case by relating it to the statement of cash flows. This assessment can be taken online. 3.11Topic 3 Review Select the correct answer This assessment can be taken online. Topic 4: Ratio Analysis 4.1Ratio Analysis Introduction This video can be viewed online. LEARNING OBJECTIVES 1 2 3 4 Explain the issues that arise when using accounting information for financial analysis. Calculate the key ratios related to leverage, efficiency, productivity, and liquidity. Explain how returns are bottom-line measures to assess a company’s performance and can be used to compare trends among similar companies. Describe when financial statement entries must follow given guidelines and when judgment can be used. Maynard Goldstein, CFA, is a senior analyst with a large mutual fund. As part of the portfolio management team, Mr. Goldstein has been asked to perform a headto-head analysis of Barrett Industries and Scott Corp. Both Barrett and Scott compete in the automation hardware market. Unfortunately for both firms, the overall market has been shrinking for the last several years. Hence, both firms have experienced modest declines in revenue. From the firm’s database, Mr. Goldstein obtains a battery of standard ratios for both firms for the past five years. Table 4-1 Ratios for Barrett Industries Barrett Industries 20x1 20x2 20x3 20x4 20x5 Current ratio 3.09 2.79 2.51 2.19 1.99 Acid-test ratio 1.67 1.75 1.65 1.36 1.32 Average collection period 53.16 62.00 56.29 58.63 52.48 Accounts receivable turnover 6.87 5.89 6.48 6.23 6.95 Inventory turnover 3.28 3.87 4.00 3.73 4.21 Operating income return on investment 0.22 0.15 0.16 0.08 0.09 Gross profit margin 0.40 0.39 0.38 0.38 0.40 Operating profit margin 0.10 0.08 0.08 0.04 0.05 Total asset turnover 2.10 1.95 2.07 1.85 1.85 Fixed asset turnover 18.13 18.81 23.21 18.64 16.29 Debt ratio Times interest earned Return on equity Table 4-2 Ratios for Scott Corporation Scott Corp. 0.43 0.79 0.71 0.69 0.66 14.00 6.31 4.31 2.30 2.78 0.18 0.27 0.04 0.02 0.36 20x1 20x2 20x3 20x4 20x5 Current ratio 1.85 1.86 2.05 2.07 2.26 Acid-test ratio 1.28 1.22 1.33 1.25 1.43 Average collection period 80.75 75.92 69.69 63.96 64.71 Accounts receivable turnover 4.52 4.81 5.24 5.71 5.64 Inventory turnover 4.45 4.11 5.24 5.71 5.64 Operating income return on investment 0.21 0.24 0.25 0.16 0.16 Gross profit margin 0.41 0.41 0.42 0.38 0.40 Operating profit margin 0.14 0.14 0.15 0.09 0.10 Total asset turnover 1.51 1.64 1.71 1.77 1.67 Fixed asset turnover 8.58 10.06 9.96 8.28 6.93 Debt ratio 0.37 0.38 0.40 0.36 Times interest earned Return on equity 0.41 27.54 23.45 24.73 12.60 16.41 0.20 0.23 0.25 0.12 0.14 Questions to Consider 1. What does examination of the ratios tell us about each firm's liquidity? 2. What does examination of the ratios tell us about each firm's efficiency? 3. What does examination of the ratios tell us about each firm's financing? 4. What does examination of the ratios tell us about each firm's profitability? 5. What are the major differences between the two firms? 4.2Why Ratios? Suppose you want to understand the economic character of Twitter and decide to use Facebook as a comparison standard. Does it make sense to compare revenue, profits, or assets? A head-to-head comparison of most financial variables is meaningless because of the different size of the firms. However, if you divide the revenue of each firm by assets, you produce the asset turnover ratio (more later). The Asset Turnover measures the dollars of revenue generated for each dollar of assets yielding a much more insightful comparison between the two firms than revenues alone. By scaling key variables (i.e., revenues) by economically relevant attributes (i.e., assets), we unleash a powerful tool for understanding a firm. Ratio analysis is such a popular tool for three reasons: 1. Standardization: Knowing that one company has $1 million in outstanding debt while another has $100,000 tells us nothing about the relative debt load of the firms. However, once we standardize each firm's debt by an economically meaningful variable such as assets to discover that one firm has 90% of assets financed with debt and the other only 20%, we gain much greater insight into the relative debt load of the firms. 2. Flexibility: Ratio analysis is not governed by a set of rules such as Generally Accepted Accounting Principles (GAAP). Rather, the process of calculating and evaluating ratios is economic analysis governed only by the prowess of the analyst. Which ratios are relevant? How many years of data should be used? What about the impact of accounting differences? Ratio analysis is a Darwinian process where the best analysts achieve the greatest benefit. 3. Focus: Ratios allow us to quickly discover areas in need of investigation. One common misconception is that ratios tell you what is happening in a company. This is not the case. Ratios don't answer questions about the company; ratios tell you what questions to ask. A ratio that changes through time or deviates from industry norms is essentially a red flag saying, "FOCUS HERE." The fact that the ratio is changing does not tell us much, but the reason behind the change could make a huge difference in our analysis and subsequent actions. Numerous "standard" ratios are commonly used in practice. However, in ratio analysis there is no GAAP Police! If the small subset of ratios we discuss doesn't suit your needs, make up your own! However, to get a feel for the process, let us divide the most common ratios into four categories: 1) liquidity, 2) asset use efficiency, 3) financing, and 4) profitability. This assessment can be taken online. 4.3Liquidity Ratios Liquidity ratios speak to a firm's ability to meet short-term obligations. While everybody is concerned about liquidity, short-term creditors such as banks and suppliers are particularly interested. Let's have a look at the most common liquidity ratios: Current Ratio = Current Assets / Current Liabilities: Current liabilities are obligations that will require cash within the next year. Current assets are items that will generate cash within the next year. The current ratio is a direct comparison between these variables. Higher current ratios are usually interpreted to mean a better likelihood that the firm will be able to meet its short-term obligations. Quick Ratio = (Current Assets - Inventory) / Current Liabilities: Notice that the only difference between the quick ratio and the current ratio is the quick ratio omits inventory from the numerator. Why? Of the major items found in the current asset section of the balance sheet, inventory is by far the least liquid. Hence, the quick ratio employs a more stringent test of what is considered a liquid asset. A company with a high quick ratio is usually viewed as having greater ability to meet short-term obligations. Ratios You Need to Know: Liquidity Current ratio = current assets / current liabilities Quick ratio = (current assets - inventory) / current liabilities AR turnover = credit sales / AR Average collection period = 365 / AR turnover Inventory turnover = COGS / inventory Days on hand = 365 / inventory turnover Accounts Receivable (AR) Turnover= Credit Sales / AR: AR turnover describes the number of times a firm's AR account "turns over" in a year. An AR turnover ratio of 12 means the company collects its entire AR 12 times per year, or about once per month. Average Collection Period (ACP) = 365 / AR Turnover: The ACP simply converts the AR turnover into a day count measure. AR turnover of 6 indicates that receivables are turned 6 times per year or about every 60 days. Correspondingly, the ACP = 365/6 = 60 days (approximately). Thus, on average, the firm collects cash 60 days after a sale. AR turnover and ACP provide the same information. Inventory Turnover = COGS / Inventory: Just as AR turnover is the number of times the company turns its receivables each year, inventory turnover is the number of times the firm turns (or sells) its inventory annually. Days on Hand (DOH) = 365 / Inventory Turnover: DOH simply converts the inventory turnover into a day count metric. If inventory turnover is 2, the firm has about 180 days (365 / 2) of inventory on hand. Important Point: you cannot gauge liquidity by any one ratio. You must take an integrated view of all the ratios! Barrett Industries Case Questions What does examination of the ratios tell us about each firms’ liquidity? Use the data in the case to find the answer. This assessment can be taken online. 4.4Efficiency Ratios Efficiency ratios measure how effectively a company/management team uses assets to generate sales or profits. The most commonly used efficiency ratios are: Total Asset Turnover (TAT) = Sales / Total Assets: Literally, this ratio measures how many dollars in sales the firm generates per dollar of assets. A TAT of three indicates that for every $1 of assets, the firm is generating $3 in sales. All else equal, more efficient asset-utilizers generate more sales per dollar of assets—they have high total asset turnover ratios. But remember, "all else" is almost never equal! Ratios You Need to Know: Efficiency Total Asset turnover = sales / total assets Fixed Asset turnover = sales / fixed assets OIROI = operating income / total assets Fixed Asset Turnover (FAT) = Sales/Fixed Assets:FAT calculates sales generated per dollar of fixed assets. Fixed assets include all non-current assets, or total assets minus current assets. To some extent, current assets volume is a reflection of management's risk preferences. Managers with low risk tolerance will maintain higher current asset levels. In contrast, a company's fixed asset holdings are largely determined by the industry in which it operates. Hence, FAT removes the management-influenced current assets from the denominator and compares sales solely to the long-term assets used to produce the company's product. Operating Income Return on Investment (OIROI) = EBIT / Total Assets: OIROI describes the relationship between operating profit (aka EBIT) and the company's asset base. OIROI tells us how much pre-tax, pre- financing profit the company generates per dollar of assets. When we calculate the return on a portfolio, we measure the increase or "profit" generated during a period as a percentage of the assets invested. Conceptually, OIROI does the same thing for a firm. If we generate $100 in operating profit on an asset investment of $1,000, we have earned a 10% return. Like all ratios, accounting choices can significantly impact efficiency ratios. Consider two firms that are economically identical. However, when it comes to compiling financial statements, one of the firms calculates depreciation assuming a 50-year useful life and the other assumes a 10-year useful life. What does this mean for our ratio analysis? The firm with the long useful life assumption will have a smaller depreciation expense and, therefore, report larger assets. Since sales are unaffected, the firm with long life/small depreciation/high assets will appear to have lower asset turnover. Don't be fooled! The firms are identical; the reported difference is due solely to accounting choices. Our job as business analysts is to make sure we don't falsely attribute economic meaning to non-economic factors. When Is Good Really Bad? When analyzing ratios, don't be too quick to conclude that "higher (or lower) is better." Consider the TAT for two firms: Firm A = 1.2 and Firm B = 2.2. Is Firm B a more efficient firm? As with all ratios, there is a good reason and a bad reason to have a high TAT: Good: Financing assets is costly. So, all else equal, squeezing more sales/profits out of each dollar in assets is good. Bad: What if all else isn't equal? It might be the case that Firm B has failed to reinvest in new technology/automation. While the rest of the industry utilizes robots to make high-quality products with low operating expense, Firm B may be using unionized labor toiling with sticks and rocks. Clearly, this is not a competitive advantage! Barrett Industries Case Questions What does examination of the ratios tell us about each firms’ efficiency? Use the data in the case to find the answer. This assessment can be taken online. 4.5Financing Ratios Firms can have dramatically different strategies when it comes to financing assets. Financing, or solvency, ratios are intended to highlight the differences. Recall the balance sheet equation: Assets = liabilities + owners' equity. The equation is both simple and profound. All assets MUST be financed. Financing ratios describe in what proportions the firm uses equity and/or debt to finance assets. Debt Ratio = Total Liabilities / Total Assets: The debt ratio measures the proportion of the firm's assets financed with debt. For example, a debt ratio of.4 literally means that for every dollar of assets held by the firm, 40 cents is financed with debt. Of course, because there are only two types of financing, one minus the debt ratio would then show the proportion financed with equity. Hence, a firm that finances each dollar of assets with 40 cents of debt must finance the other 60 cents with equity. Ratios You Need to Know: Financing Debt ratio = total liabilities/total assets Interest-bearing debt to total capital (IBDTC) = interest-bearing debt/total capital Times interest earned (TIE) = EBIT / Interest expense Financial leverage ratio (FLR) = total assets/equity Interest-Bearing Debt to Total Capital (IBDTC) = Interest-Bearing Debt / (Interest-Bearing Debt + Owners' Equity):IBDTC is a more precise measure of a firm's financial structure. Interest-bearing debt carries explicit interest costs. In a simple case, interest-bearing debt can be calculated as total liabilities minus accounts payable and accruals. Since accounts payable and accruals do not have explicit interest costs, omitting them from the calculation allows us to focus more directly on management's formal financing decisions. The Times Interest Earned Ratio (TIE) = EBIT / Interest Expense: Literally, this ratio tells us how many times a company covers (or can pay) interest expense given operating profit. For instance, if a company has an operating profit of $1,000 and an annual interest expense of $100, the TIE of 10 means the firm can pay interest expense 10 times over out of operating profits. An alternative interpretation is that the firm's operating profit can fall by 90% before the firm must take more drastic measures to pay interest. There are many expenses on the income statement. Why do we care so much about a company's interest expense? Unlike most other expenses, a firm that misses an interest payment will have to explain the reasons for the missed payment to a bankruptcy judge. Financial Leverage Ratio (FLR) = Total Assets / Equity: The FLR is similar to the debt ratio. In a very simplistic firm, 40% debt implies the other 60% must be financed with equity. Thus, 60% equity financing (or equity/assets) implies an FLR of 1.67 (assets/equity). The impact of the financing choice on both profitability and risk cannot be overstated. Barrett Industries Case Questions What does examination of the ratios tell us about each firm's financing? Use the data in the case to find the answer. This assessment can be taken online. 4.6Profitability Ratios Profitability ratios can be divided into two categories—those based on sales and those based on investment (i.e., assets or equity). For managers and shareholders, profitability ratios are of paramount importance. Return on Assets (ROA) = Net Income / Total Assets: The intuition behind the ROA calculation is straightforward: bottom-line earnings as a percent of all the capital invested. ROA is more or less comparable across industries and thus is a good profitability ratio to use when benchmarking a firm against a multi-industry group. Think of ROA as net earnings as a percent of all assets entrusted to management. Ratios You Need to Know: Profitability Investment Based: ROA = NI / assets ROE = NI / equity Sales Based: Gross margin = (sales - COGS) / sales Operating margin = EBIT / sales Net margin = NI / sales Return on Equity (ROE) = Net Income / Owners' Equity:ROE speaks to the very heart of the free enterprise system by answering the question: " As an owner of this business, how much did I earn as a percentage of each dollar invested?" Given the question answered, there is little surprise that ROE is one of the most important metrics by which managers are evaluated. Notice the similarity between ROA and ROE. The numerators are the same and the denominators are related by the balance sheet equation. The difference in ROA and ROE speaks to the effectiveness of the firm's financing policy. A firm that is effectively using debt will have an ROE that exceeds ROA. Managers that consistently deliver high ROE will find many lucrative opportunities in the business world. Gross Margin = Gross Profit / Sales: Gross margin measures the percent of revenue remaining after the cost of the goods sold. High gross margins are usually associated with an efficient production process. Operating Margin = EBIT / Sales:Operating margin is the percent of sales remaining after covering the cost of the goods sold AND operating expenses. Since operating margin is pre-interest, we frequently use it to compare firms with different capital structures (i.e., different amounts of debt). Net Margin = Net Income / Sales:Net margin measures the percent of revenue that drops to the bottom line. That is, a 5% net margin indicates that for every dollar of revenue, 5 cents remains for the equity holders after all other costs are covered. For the margin ratios, notice all three have sales in the denominator. Moreover, the numerators are the three primary profitability sub-totals from the income statement: gross profit, EBIT, and net income. Hence, the progression from gross to operating to net margin corresponds to the flow of the income statement. Hence, the margin measures are usually analyzed as a set. At the Margin… The difference in the margin ratios is frequently telling. Consider Alpha Incorporated's margins relative to the industry average: Alpha Industry Average Gross Margin 54% 60% Operating Margin 22% 28% Net Margin 12% 6% Alpha has a lower operating margin than the industry. Does this indicate an operating expense control problem? Probably not. Alpha's operating (and net) margin is 6% below industry average. However, the percent of sales consum