This is the second presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at understanding financial statements, with breakdowns of example statements.

1. Understanding Financial Statements Topic 02 GSB711 – Managerial Finance Readings: Chapter: Accounting and Finance (Pages 52 - 75) Questions: 1, 3, 8, 9 and Problems: 11, 13, 15 and 20. Chapter: Measuring Corporate Performance (Pages 76 – 107) Questions: 1, 3, 4, 6, 7 and Problems: 11, 17, 22 and 26

2. Topics Covered… The Balance Sheet The Income Statement The Statement of Cash Flows Accounting Practice & Malpractice Taxes Value and Value Added Measuring Profitability Measuring Efficiency Analyzing the Return on Assets: The Du Pont System

3. Topics Covered Measuring Leverage Measuring Liquidity Calculating Sustainable Growth Interpreting Financial Ratios The Role of Financial Ratios–and a Final Note on Transparency

4. The Balance Sheet Definition Financial statement that show the value of the firm’s assets and liabilities at a particular point in time (from an accounting perspective).

5. Balance Sheet PepsiCo Balance Sheet (December 31, 2006) $Millions

6. Telstra’s Balance Sheet

7. Telstra’s Balance Sheet

8. Telstra’s Balance Sheet

9. The Balance Sheet Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets = The Main Balance Sheet Items

10. The Balance Sheet Common-Size Balance Sheet All items in the balance sheet are expressed as a percentage of total assets.

11. Common Size Balance Sheet

12. Market Value vs. Book Value Book Values are determined by GAAP Market Values are determined by current values Generally Accepted Accounting Principles (GAAP) Procedures for preparing financial statements. Equity and Asset “Market Values” are usually higher than their “Book Values”

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

14. Market Value vs. Book Value Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil Example (continued) Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil

15. Definition Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting perspective). The Income Statement

16. The Income Statement Earnings Before Income & Taxes (EBIT) EBIT = Total Revenues - costs – deprecation = 35,753 – 27,292 – 1,406 = $ 7,055 million

17. Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS 15,762 Selling, G&A expenses 11,530 Depreciation expense 1,406 EBIT 7,055 Net interest expense 66 Taxable Income 6,989 Income Taxes 1,347 Net Income 5,642 The Income Statement

18. Differences “Profits” subtract depreciation (a non-cash expense) “Profits” ignore cash expenditures on new capital (the expense is capitalized) “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur “Profits” do not consider changes in working capital Profits vs. Cash Flows

19. The Statement of Cash Flows Definition Financial statement that shows the firm’s cash receipts and cash payments over a period of time.

20. Pepsico Statement of Cash Flows (excerpt - year end 2006) Net Income 5,642 Non-cash expenses Depreciation 1,406 Other 0 Changes in working capital A/R=(464) A/P=(86) Inv=(233) other=1,956 CL=155 1,328 Cash Flow from operations 8,376 Cash Flow from investments (933) Cash provided by financing (7,508) Net Change in Cash Position (65) The Statement of Cash Flows

21. Telstra’s Income Statement

22. Telstra’s Income Statement

23. Cash Flows Free Cash Flow (FCF) Cash available for distribution to investors after firm pays for new investments or additions to working capital FCF = EBIT - taxes + depreciation - change in net working capital - capital expenditures

24. Telstra’s Cash Flow Statement

25. Telstra’s Cash Flow Statement

26. Telstra’s Cash Flow Statement

27. Taxes The one thing we can rely on with taxes is that they are always changing Marginal vs. average tax rates Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income Tax Imputation Franked Dividends Other taxes

28. Value and Value Added Market Capitalization Total market value of equity, equal to share price times number of shares outstanding. Market Value Added Market capitalization minus book value of equity.

29. Value and Value Added PepsiCo Balance Sheet (December 31, 2006) $Millions

30. Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS 15,762 Selling, G&A expenses 11,530 Depreciation expense 1,406 EBIT 7,055 Net interest expense 66 Taxable Income 6,989 Income Taxes 1,347 Net Income 5,642 Value and Value Added

31. Value and Value Added Market-to-Book Ratio Ratio of market value of equity to book value of equity.

32. Value and Value Added Stock market measures of company performance, 2006. Companies are ranked by market value added. (dollar values in millions)

33. Measuring Profitability Economic Value Added (EVA) Net income minus a charge for the cost of capital employed. Also called residual income. Residual Income Net Dollar return after deducting the cost of capital

34. Measuring Profitability Economic Value Added (EVA) of PepsiCo

35. Measuring Profitability Accounting measures of company performance, 2006. Companies are ranked by return on equity.

36. Measuring Profitability Return on Equity (ROE) Net income as a percentage of shareholders’ equity Return on Capital (ROC) Net income plus Interest as a percentage of long-term capital. Return on Assets (ROA) Net income plus interest as a percentage of total assets

37. Measuring Profitability PepsiCo Profitability Measurements

38. Measuring Efficiency OR For PepsiCo OR

39. Measuring Efficiency

40. The DuPont System A breakdown of ROE and ROA into component ratios

41. The DuPont System asset turnover Operating profit margin

42. Measuring Leverage

43. Measuring Leverage

44. Measuring Leverage leverage ratio asset turnover Operating profit margin debt burden

45. Measuring Liquidity

46. Liquidity Ratios

47. Percent of Sales Approach Some items vary directly with sales, while others do not Income Statement Costs may vary directly with sales - if this is the case, then the profit margin is constant Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings Balance Sheet Initially assume all assets, including fixed, vary directly with sales Accounts payable will also normally vary directly with sales Notes payable, long-term debt and equity generally do not because they depend on management decisions about capital structure The change in the retained earnings portion of equity will come from the dividend decision

48. Growth and External Financing At low growth levels, internal financing (retained earnings) may exceed the required investment in assets As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for money Examining the relationship between growth and external financing required is a useful tool in long-range planning

49. The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. Using the information from Tasha’s Toy Emporium ROA = 1200 / 9500 = .1263 B = .5

50. Sustainable Growth

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

52. Interpreting Financial Ratios PepsiCo Ratios

53. Interpreting Financial Ratios PepsiCo Ratios (continued)

54. Interpreting Financial Ratios Selected 2006 financial ratios for industry groups in Standard & Poor’s Composite Index

55. Why Evaluate Financial Statements? Internal uses Performance evaluation – compensation and comparison between divisions Planning for the future – guide in estimating future cash flows External uses Creditors Suppliers Customers Stockholders

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

57. Potential Problems There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years Extraordinary events

58. Important Questions It is important to remember that we are working with accounting numbers and ask ourselves some important questions as we go through the planning process How does our plan affect the timing and risk of our cash flows? Does the plan point out inconsistencies in our goals? If we follow this plan, will we maximize owners’ wealth?

59. Summary Financial statements Book value vs market value Cashflow statement Standardized financial statements Financial Ratios Financial Planning Internal growth rate Sustainable growth rate Evaluating financial statements