Flashcards in Financial statements Deck (17)
What data is used for the financial statements?
Value of a firm
Balance sheet analysis
Assets (-> sorted by liquidity)
Claims: Liabilities (→ sorted by term structure), equity (sorted by legal obligation)
Income statement analysis: EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortization
→ To calculate EBITDA add back depreciation*/amortization** to EBIT
→ As depreciation / amortization is NOT paid in cash, EBITDA is a better measure of financial strength than is net income
* Costs of tangible assets that wear out in the production process
** Costs of intangible assets that wear out in the production process
Income statement analysis: COGS
Cost of goods sold (COGS) includes labor, raw materials, and other expenses directly related to the production or purchase of the items or services sold in that period. COGS includes depreciation!
Income statement analysis: Net income available to common shareholders:
Net income available to common shareholders equals revenues less expenses, taxes, and preferred dividends (but before paying common dividends)
→ Also referred to as net income, accounting profit, profit, or earnings
→ A firm may use its net income to pay dividends, to increase inventories, to finance accounts receivable, to invest in fixed assets, to reduce debt, or to buy back common stock, keep it as cash in the bank.
Statement of stockholder's equity
- Changes in stockholders’ equity during the accounting period
- The position “retained earnings” does not represent assets but is instead a claim against assets.
- Retained earnings allow reinvestment ($170 million) instead of distributing the money as dividends, and management spent this money on new assets.
- Even if a company reports record earnings and shows an increase in its retained earnings account, it still may be short of cash.
Statement of Cash flow
→ Cash fluctuations throughout a year due to the firm's usage of net income
→ Company’s activities effecting the cash position, thus generating or using cash:
(3) and financing activities
= Summary of the resulting cash balance
→ Noncash adjustments: depreciation, amortization, deferred taxes, noncash reporting
→ Working capital adjustments:
(1) Increases in noncash current assets decrease cash
(2) Increases in current liabilities increase cash
Analysis of MicroDriveInc.
- Firm covered large cash outlays by borrowing heavily and by liquidating short-term investments!
- How is it possible that neither balance sheet nor income statement equitiy statement did show the problem at this extent?
- Profits as reported on the income statement can be “doctored” by tactics: → depreciating assets too slowly,
→ not recognizing bad debts promptly
(1) By far more difficult to simultaneously doctor profits & working capital accounts
(2) Acknowledge positive net income can be reported on the day bancruptcy is declared!!!!
- Thus, look first at the trend in net cash flow provided by operating activities! Net cash flow from operations almost always begins to deteriorate much earlier!
Net Cash Flow
Net cash flow = net income available for distribution to common shareholders (May also be interpreted as the profit a company would have if it did not have to replace fixed assets as they wear out)
→ Depreciation and amortization usually are the largest noncash items, and in many cases the other noncash items roughly net out to zero.
→ It is similar to the net cash flow from operating activities shown on the statement of cash flows, except that the net cash flow from operating activities also includes the impact of working capital.
→ Net income, net cash flow, and net cash flow from operating activities each provide insight into a company’s financial health
→ But better measurement is: free operating cash flow (FCF)
Free cash flow
→ The intrinsic value of a company’s operations is determined by the stream of cash flows that the operations will generate now and in the future.
→ The value of operations depends on all the future expected free cash flows
→ FCF is ...
(1) defined as after-tax operating profit minus the amount of new
investment in working capital and fixed assets necessary to sustain the business.
(2) the amount of cash that is available for distribution to all investors, including shareholders and debtholders.
(3) after the company has made all investments necessary to sustain ongoing operations
Free Cash Flow Calculation
Step 1: Nopat
Step 2: Net operating working capital
Step 3: Total net operating capital
Step 4: Net investment in operating capital
Step 5: Free Cash Flow
Usage of Free Cash Flow
1. Pay interest to debtholders, keeping in mind that the net cost to the company is the after-tax interest expense.
2. Repay debtholders (e.g. partial pay off of the debt)
3. Pay dividends to shareholders.
4. Repurchase stock from shareholders vs. net issuance
5. Buy short-term investments or other nonoperating assets
The fundamental value of a company to its investors depends on the present value of its expected future FCFs, discounted at the company’s weighted average cost of capital (WACC). WACC reflects individual & market risk!
Performance evaluation - Return on Invested Capital
→ to determine whether or not growth is actually adding value to the firm → how much NOPAT is generated by each unit of operating capital
Performance Evaluation - Market Value Added (MVA)
→ the primary goal of management should be to maximize the firm’s intrinsic stock price.
→ Market Value Added (MVA) and Economic Value Added (EVA) do attempt to compare intrinsic measures with market measures
Market Value Added (MVA) = measure of shareholder wealth
→ is the difference between the market value of the firm’s stock and the cumulative
amount of equity capital that was supplied by shareholders.
Performance Evaluation - Economic Value Added
→ MVA measures the effects of managerial actions since the inception of a company
→ Economic Value Added (EVA) focuses on managerial effectiveness in a given year.
→ EVA = the residual income that remains after the cost of all capital, including equity capital, has been deducted (because shareholders give up the opportunity to invest and earn returns elsewhere when they provide capital to the firm = opportunity cost)
→ EVA reflects „true“ profit, whereas accounting profit does not impose a charge for equity capital