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PART II. The Analysis of Financial Statements. Knowing the Business The Products The Knowledge Base The Competition The Regulatory constraints Strategy. 1. Analyzing Information In Financial Statements Outside of Financial Statements. 2. 3. 4. Chapter 11. Chapter 10. Chapter 12.

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The Analysis of Financial Statements

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The analysis of financial statements

PART II

The Analysis of Financial Statements


The analysis of financial statements1

  • Knowing the Business

  • The Products

  • The Knowledge Base

  • The Competition

  • The Regulatory constraints

  • Strategy

1

  • Analyzing Information

  • In Financial Statements

  • Outside of Financial Statements

2

3

4

Chapter 11

Chapter 10

Chapter 12

Chapter 8

Chapter 7

Chapter 9

Analyzing the balance sheet and income statement to reveal profitability

How the statement of shareholders’ equity is analyzed

How business activities are represented in financial statements

  • Forecasting Payoffs

  • Specifying Payoffs

  • Forecasting Payoffs

Convert Forecasts to a Valuation

Analyzing the cash flow statement to identify cash generation

Analyzing profitability to discover what drives it

Analyzing residual earnings growth to discover what drives it

Trading on the Valuation

Outside Investor:

Compare Value with Price toBUY, SELL or HOLD

Inside Investor:

Compare Value with Cost toACCEPT or REJECT Strategy

5

The Analysis of Financial Statements


Chapter 7

Chapter 7

Business Activities and

Financial Statements


Business activities and financial statements

Business Activities and Financial Statements

Link to Previous Chapters

Chapter 1 introduced the

firm’s operating, investing and

financing activities. Chapter

2 introduced the financial

statements. Chapters 5 and 6

outlined

valuation models that

anchor on those financial

statements.

This Chapter

How are

What

How are

How are the

This chapter shows how the

operating and

measures

operating and

cash flows of a

three business activities are

financing

capture the

financing assets

business

depicted in the financial

income

operating and

and liabilities

identified in

statements. It also shows how

identified in the

financing

identified in the

the cash flow

income

profitability ?

balance sheet?

statement ?

the statements are redesigned

statement?

to highlight these activities and

to prepare the statements for

applying the valuation models

in Chapter 5 and 6.

Link to Next Three Chapters

Chapters 8, 9 and 10

reformulate statements

according to the design

developed in this chapter.

Link to Web Page

Build your own analysis

spreadsheet using BYOAP


What you will learn in this chapter

What you will learn in this chapter

  • How businesses are organized to generate value for shareholders

  • The difference between operating and financing aspects of a business

  • How business activities are reported in financial statements

  • How financial statements are organized to highlight operating and financing activities

  • How business activities articulate and how financial statements articulate

  • The four cash flows of a business and how they relate to each other

  • Why free cash flow does not affect value added

  • A set of accounting relations that summarize how business activities drive financial statements


Cash flows between the firm and claimants in the capital market

Cash Flows Between the Firm and Claimants in the Capital Market

Cash received from debtholders and shareholders is (temporarily) invested in

financial assets. Cash payments to debtholders and shareholders are made

by liquidating financial assets (that is, selling debt). Net financing assets are debt

purchased from issuers, net of debt issued to debtholders. Net financing assets

can be negative (that is, debt sold to debtholders is greater than debt purchased).

Key: F = net cash flow to debtholders and issuers

d = net cash flow to shareholders

NFA = net financial assets = financial assets – financial liabilities


Business activities all cash flows

Business Activities: All Cash Flows

Cash generated from operations is invested in net financial assets (that is, it is used

to buy financial assets or to reduce financial liabilities). Cash investment in

operations is made by reducing net financial assets (that is, by liquidating financial

assets or issuing financial obligations). Cash from operations and cash investment

may be negative (such that, for example, cash can be generated by liquidating an

operating asset and investing the proceeds in a financial asset).

Key:F = net cash flow to debtholders and issuers

d = net cash flow to shareholders

C = cash flow from operations

I = cash investment

NFA = net financial assets

NOA = net operating assets = operating assets – operating liabilities


The analysis of financial statements

The Cash Conservation Equation

A fundamental accounting identity:

C = Net cash from operations

I = Net cash outflow for investing

C - I = Free cash flow

d = Net dividends (common dividends + share repurchases,less share issues)

F = Net cash outflow to debtholders and debt issuers

= Net principal payments for borrowing + net interest payments

The treasurer’s rule:

If : lend or buy down own debt

If : borrow or reduce lending


Applying the treasurer s rule microsoft

Applying the Treasurer’s Rule: Microsoft

In millions

2nd Quarter, 2004 2nd Quarter, 2005

Cash flow from operations$4,236$3,377

Cash investment in operations 172 177

Free cash flow 4,064 3,200

Cash interest received (after tax) 338 242

Cash available for shareholders 4,402 3,442

Net dividend:

Cash dividend $1,729 $33,498

Share repurchases 730 969

Share issues (189) 2,270(795) 33,672

Purchase (sale) of financial assets$2,132 $(30,230)


Applying the treasurer s rule general electric

Applying the Treasurer’s Rule: General Electric

In millions

2002

Cash flow from operations$34,848

Cash investment in operations 61,227

Free cash flow (26,379)

Interest paid (after tax) 6,082

Cash available to shareholders (32,461)

Net dividend:

Cash dividend $7,157

Share repurchases 985 8,142

Net issue of debt$40,603

As the treasurer had $57.8 billion of debt to repay, he issued

$97.9billion of new debt, for a net debt issue of $40.1 billion.


The analysis of financial statements

Reformulated Statement of Cash Flows


Reformulated cash flow statements microsoft

Reformulated Cash Flow Statements: Microsoft

In millions

1Q, 2004 1Q, 2005

Cash flow from operations (C) $4,236 $3,377

Cash investment (I) (172) (177)

Free cash flow (C – I) 4,064 3,200

Equity financing flows (d):

Dividends and share repurchases $2,459 $34,467

Share issues (189) 2,270 (795) 33,672

Debt financing flows (F):

Net purchase of financial assets 2,132(30,230)

Interest on financial assets (after tax) (338) (242)

Net issue of debt - -

Interest paid on debt (after tax) _____ _____

Total financing flows (d + F) $4,064 $3,200

C – I = d + F


Reformulated cash flow statement general electric

Reformulated Cash Flow Statement: General Electric

In millions

2002

Cash flow from operations (C) $34,848

Cash investment (I) (61,227)

Free cash flow (C – I) (26,379)

Equity financing flows (d):

Dividends and share repurchases $8,142

Share issues - 8,142

Debt financing flows (F):

Net purchase of financial assets -

Interest on financial assets (after tax) -

Net issue of debt (40,603)

Interest paid on debt (after tax) 6,082

Total financing flows (d + F) $(26,379)


Reformulated balance sheet

Reformulated Balance Sheet


Balance sheet restated

Balance Sheet Restated


Reformulated balance sheet nike inc

Reformulated Balance Sheet: Nike Inc.

(in millions of dollars)

2004 2003 2004 2003

Operating assets (OA) 6,728 6,241 Financial obligations (FO) 879 883

Operating liabilities (OL) 2,1771,911 Financial assets (FA) (1,168) (581)

Net financial obligations (NFO)(289) 302

Common equity (CSE) 4,8404,028

Net operating assets 4,5514,330 Total NFO + CSE 4,551 4,330

Balance sheet relations:

NOA = OA – OL = 6,728 – 2,177 = 4,551

NFO = FO – FA = 879 – 1,168 = (289) (a net financial asset position)

CSE = NOA – NFO = 4,551 + 289 = 4,840


Business activities all the stocks flows

Business Activities:All the Stocks & Flows

Net operating assets are employed in operations to generate operating

revenue (by selling goods and services to customers) and incur

operating expenses (by buying inputs from suppliers). ∆ indicates changes.

Key: F = net cash flow to debtholders and issuers

d = net cash flow to shareholders

C = cash flow from operations

I = cash investment

NFA = net financial assets

NOA = net operating assets

OR = operating revenue

OE = operating expense

OI = operating income

NFI = net financial income


Reformulated income statement

Reformulated Income Statement

  • The difference between operating revenue and operating expense is called operating income:

    Net financial expense can be negative (net financial income)


Reformulated income statement nike inc

Reformulated Income Statement: Nike Inc.

In millions

2004

Operating income (OI) 1,035

Net financial expense (NFE) 16

Comprehensive income (CI)1,019


Business activities and the financial statements

Business Activities and the Financial Statements

This figure shows how reformulated income statements, balance sheets,

and the cash flow statements report the operating and financing activities

of a business, and how the stocks and flows are uncovered

in the financial statements. Operating income increases net operating

assets and net financial expense increases net financial obligations. Free

cash flow is a “dividend” from the operating activities to the financial

activities: free cash flow reduces net operating assets and also reduces net

financial obligations. Net dividends to shareholders are paid out of net

financial obligations.


Stocks flows operating and financing activities

Stocks & Flows:Operating and Financing Activities

  • The change in NFO is given by

  • The change in NOA is given by

  • Operating income in the income statement flows to net operating assets in the balance sheet.

  • Free cash flow reduces NOA and reduces NFO (increases NFA).

    If the firm has net financial assets rather than NFO,

    NFAt = NFAt-1 + (Ct – It) + NFIt – dt


The reformulated statements nike inc 2004

The Reformulated Statements: Nike Inc., 2004

Reformulated Balance Sheets

2004 2003 2004 2003

Operating assets (OA) 6,728 6,241 Financial obligations (FO) 879 883

Operating liabilities (OL) 2,1771,911 Financial assets (FA) (1,168) (581)

Net financial obligations (NFO)(289) 302

Common equity (CSE) 4,8404,028

Net operating assets 4,5514,330 Total NFO + CSE 4,5514,330

Reformulated Income Statement, 2004

Operating income (OI) 1,035

Net financial expense (NFE) 16

Comprehensive income (CI) 1,019

Reformulated Cash Flow Statement, 2004

Free cash flow814

Equity financing flows:

Net dividend to shareholders (d)207

Debt Financing flows:

Net cash to debtholders/issuers (F)607

814


Accounting relations nike inc 2004

Accounting Relations: Nike Inc., 2004

Balance sheet relations:

NOA = OA – OL = 6,728 – 2,177 = 4,551

NFO = FO – FA = 879 – 1,168 = (289) (a net financial asset position)

CSE = NOA – NFO = 4,551 + 289 = 4,840

Income statement relations:

CI = OI – NFE = 1,035 – 16 = 1,019

Articulating relationsbetween statements:

The stocks and flows equation for equity:

CSE2004 = CSE2003 + CI2004 – d2004 = 4,028 +1,019 – 207 = 4,840

The free cash flow generation and disposition equations:

C – I = OI – ΔNOA = 1,035 – 221 = 814

C – I = NFE – ΔNFO + d = 16 – (-591) + 207 = 814

The stocks and flows equation for operating activities:

NOA2004 = NOA2003 + OI2004 – (C – I)2004 = 4,330 + 1,035 - 814 = 4,551

The stocks and flows equation for financing activities:

NFO2004 = NFO2003 + NFE2004 – (C – I)2004 + d2004 = 302 + 16 - 814 + 207 = -289


Tying it together what generates value

Tying it Together:What Generates Value?

  • From the balance sheet equation

    Given the way that NOA and NFO are calculated,

    which is the stocks and flows equation.

  • For this to be true, however, accounting must be Clean Surplus.

  • Free cash flow drops out in this calculation: Free cash flow (C - I) does not add value to shareholders. Free cash flow is a dividend from the operating activities to the financing activities

  • What generates value is the profit from operating and financing activities.


Stocks flows ratios business profitability

Stocks & Flows Ratios:Business Profitability

  • Separating operating and financing activities in the income statement identifies profit flows

  • Comparison of these flows with their balance sheet base yields the corresponding rates of return:

    Return on Net Operating Assets

    Return on Net Financial Assets

    If there are NFO rather than NFA, net borrowing cost is given by

  • Forecasting ROCE involves both the forecast of RNOA and RNFA (or NBC)


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