Financial Statement Analysis for Modeling

Integrated Financial Management

1

Oct 24, 2008

Financial Statement Analysis Contents

• •

Overview and objective of financial statement analysis Review and Re-formatting Statements for Financial Model  Income Statement – EBITDA and NOPLAT  Cash Flow Statement - Free Cash Flow and Equity Cash Flow

Financial ratio analysis  Management Performance  Valuation  Credit Analysis  Financial Model Drivers

Reference  Financial Ratio Calculations  Discussion of Economic Profit

Integrated Financial Management

2

Oct 24, 2008

Financial Statement Analysis - Introduction

• Corporate models involve making a projection of the financial statements of a company or a segment of a company. • You should be comfortable in reading various different financial statements to be effective at financial modeling and financial analysis. • Financial statement analysis is also important in:  Assessing management performance of a company and whether projections of improvement or sustainability are reasonable.  Assessing the value of a company from historic performance.  Assessing the reasonableness of financial projections provided by a company or the validity of earnings projections  Assessing whether the financial structure of a company is of investment grade quality

Integrated Financial Management

3

Oct 24, 2008

Objectives of Financial Statement Analysis • Financial Statement Analysis is Like Detective Work – How can we use information in financial statements to make assessments of various issue:  How can we quickly review the income statement. balance sheet and cash flow statement to determine how the stock market value of a company compares to inherent value.how can financial statement analysis be used in making projections.  How can we look the financial statements and assess risks associated with a company and whether the company has sufficient cash flow to pay off debt.  Finance and valuation are about projecting the future -.  The problem in any financial analysis and valuation is that measuring risk is very difficult Integrated Financial Management 4 Oct 24. 2008 .

financial performance is measured and value is assessed with various financial ratios.  Assess the potential for growth in economic profit – ROIC less WACC  Value the equity of the company relative to the stock price  Review the credit quality of the firm with financial ratios Integrated Financial Management 5 Oct 24. Some of the uses of financial ratios in assessing corporate models include:  Relate financial ratios to economic drivers in making financial forecasts  Use financial ratios to determine whether management is generating economic profit – compute ROIC and growth to examine sustainability.Financial Statement Analysis and Financial Projections • In corporate models.  Evaluate the sustainability of economic profit over the long-term in financial models – attempt to gather 10 years of data to find trends. 2008 .

must account for minority interest in financing of total EBITA  Deferred Debit Amortization • A key principle is that the financial data and the financial ratios are consistent and logical – work through simple examples Integrated Financial Management 6 Oct 24. 2008 . then mush add non-consolidated subsidiary companies  Exploration Expenses taken out of EBITDA  Make consistent between companies with different accounting policies  Goodwill (ROIC without goodwill)  Minority Interest (Include or exclude income and balance)  Total in EBITDA. Examples  Other Income in or out of EBITDA  If not in EBITDA.Double Counting and Judgments in Financial Ratio Analysis • • In analyzing financial statements judgments must be made in computing key data such as EBITDA and in developing financial ratios.

Income Statement Integrated Financial Management 7 Oct 24. 2008 .

but it does not include foreign exchange gains or losses. EBT and Net Income and explain what is happening to the company EBITDA includes operating earnings and other income. extraordinary income or interest income. EBIT.  EBITDA is a rough proxy for free cash flow  EBITDA is not generally shown on Income Statement  Potential Adjustments for items such as exploration expense  Compare EBIT to Net Assets and Net Capital • • • Ratio of EBITDA to Revenues should be shown for historic and projected periods EBITDA is related to un-levered cash flow while Net Income and EPS are after leverage NOPLAT is computed by EBIT less adjusted taxes.Income Statement • • Review trends in EBITDA. minority interest. 2008 . Integrated Financial Management 8 Oct 24. where taxes are computed through adjusting income taxes.

and can be a good reference for comparison of debt and value. and it ignores unique attributes of industries. but it has weaknesses:  EBIT is more important than DA  In credit analysis. does not consider required re-investment. says nothing about the quality of earnings. Integrated Financial Management 9 Oct 24. 2008 . EBITDA works better for low rated credits than high rated credits.Problems with EBITDA • EBITDA is useful in its simplicity. (Moody’s)  EBITDA is a better measure for companies with long-lived assets  EBITDA can be manipulated through accounting policies (operating expenses versus capital expenditures)  EBITDA ignores changes in working capital.

Must be consistent One school of thought (McKinsey) is that they should be valued separately since they will have different cost of capital etc. There is a debate about how to handle other income from non-consolidated subsidiary companies. • • • • • • • • NOPLAT = EBIT x (1-tax rate) NOPLAT = Net Income + Interest Expense x (1-tax) Integrated Financial Management 10 Oct 24.Simplified Income Statement • • Sales = + = = = = COGS Gross Margin SG&A Other Expenses Other Income EBITDA Depreciation and Amortization EBIT Interest Expense (income) EBT Income Taxes Minority Interest Net Income In this case. do not include in EBITDA and remove the asset balance from the invested capital. 2008 .

Analysis of Income Statement – Computation of EBITDA. Minority Interest. Preferred Dividends. Exploration Expense Integrated Financial Management 11 Oct 24. 2008 .

2008 .Income Statement Analysis • Example of Adjustments to EBITDA  Exploration Expenses (EBITDAX)  Rental and Lease Payments (EBITDR) • EBITDA Computation  Top Down – move other income  Bottom-up (Indirect) • EBITDA Notes  Interest Income out of EBITDA  Interest Expense not in EBITDA  Understand Non-cash Expenses  Deferred Mining Costs  Equity Income  Minority Interest Integrated Financial Management 12 Oct 24.

employees are compensated and the cash should be accounted for  Second. 2008 . • Think of options as giving stock to employees  If the treatment has changed over the years and it is a significant expense. free cash flow and valuation.  One can argue that this is two things  First. make adjustments to current or prior statements for consistency. The value of existing shareholders is diluted.  Think of options as giving free shares to employees. invested capital is increased and the new equity should be refelected Integrated Financial Management 13 Oct 24.Employee Stock Options • One can debate the treatment of employee stock options for EBITDA.

Cash Flow Statement Integrated Financial Management 14 Oct 24. 2008 .

Cash Flow Statement • Cash Flow has fundamental separation between  Operations  Capital expenditures (to maintain and grow operations) and  Financing • Operating Cash Flow  Add back items from the income statement that do not use cash (depreciation. 2008 . dry hole costs etc) • • Analyze how much cash flow the company generated and how it raised funds or disposed funds Use Cash Flow statement as a basis to compute free cash flow although cash flow not presented on the statement Integrated Financial Management 15 Oct 24.

Cash Flow Statement • • • • • • • • • • • • • • • • • • A. & Equipment 4) Inter-Corporate Investment C. Financing Cash Flows 1) “Cash Flow from Financing” 2) Dividend Payments 3) Proceeds from Equity or Debt Issuance 4) Equity Repurchased 5) Debt Principal Payments Integrated Financial Management 16 Oct 24. 2008 . Operating Cash Flows 1) “Cash Flow from Operations” 2) Cash Collections 3) Cash Outflows 4) Interest & Dividends Received 5) Interest Paid 6) Taxes B. Plant. Investing Cash Flows 1) “Cash Flow from Investments” 2) Cap Ex (Purchases) 3) Sale of Property.

2008 .Cash Flow Statement Example Integrated Financial Management 17 Oct 24.

The free cash flow must account for capital expenditures. repayments of debt. operating cash flow is net income plus depreciation. For example.The Notion of Free Cash Flow • In practice the term cash flow has many uses. this cash flow is not available for distribution to equity holders and debt holders. • Free cash flow consists of  Cash flow to equity holders  Cash flow to debt holders Integrated Financial Management 18 Oct 24. deferred items and other factors. • Free cash flow is the cash flow that is available to investors – FREE of obligations such as capital expenditures and taxes -. 2008 .to both debt and equity investors – after re-investing in plant. • Accountants define cash flow from operations as net income plus depreciation and other non-cash items less changes in working capital. and financing and paying taxes. However.

2008 .Importance of Free Cash Flow • Alternative Definitions. • Free Cash Flow in Valuation  PV of Free Cash Flow Defines Enterprise Value  The Relevant Discount Rate Is The Unlevered Discount Rate or the Weighted Average Cost of Capital  IRR on Free Cash Flow is the Project IRR  Free Cash Flow in Economic Value  FCF – Carrying Charge = Economic Profit Integrated Financial Management 19 Oct 24. but one correct concept  Free Cash Flow Is Also Known As Unleveraged Cash Flow  Unleveraged Cash Flow Is Not Distorted By The Capital Structure  Free Cash Flow should not change when the capital structure changes  Free Cash Flow should be the same as equity cash flow if no debt is outstanding and not cash balances are built up.

2008 .Fundamental Distinction in Financial Analysis – Free Cash Flow and Equity Cash Flow • Free Cash flow that is independent from financing  Valuation  Performance in managing assets  Claims on free cash flow  Cash flow to pay debt obligations  Comparisons unbiased by capital structure policy • Equity cash flow  Valuation of equity securities  Performance for shareholders Integrated Financial Management 20 Oct 24.

2008 .Cash Flow Statement in Financial Model • Analysis in Cash Flow Statements  Compute Cash Flow before Financing  Operating Cash Flow minus Capital Expenditures  Use Cash Flow Before Financing in Deriving Free Cash Flow  Equity Cash Flow  Dividends less Cash Investments  Cash Flow Before Financing less Maturities plus New Debt Issues  Last Line on Cash Flow Statement Includes  Change in Cash Balance  Change in Short-term Debt or Overdrafts  Beginning Balance + Change = Ending Cash  Beginning Balance of STD + Change = Ending Short-term Debt Integrated Financial Management 21 Oct 24.

the formula is:  EBITDA  Less: Taxes on EBIT  Less: Working Capital Investment  Less: Capital Expenditures • From Net Income  Net Income  Add: Net of Tax Interest  Add Depreciation. From the cash flow statement. Deferred Taxes and Other Non-Cash Changes  Less: Changes in Working Capital  Less: Capital Expenditures Some argue that free cash flow should not include non-operating items. the formula is:  Cash Before Financing  Plus: Interest Expense  Less: Tax Shield on Interest • From the income statement.Free Cash Flow Formulas • • Free cash flow can be computed from the income statement or from the cash flow statement. 2008 . Here the non-consolidated companies are treated in a similar manner as liquid investments Integrated Financial Management 22 Oct 24.

Free Cash Flow from NOPLAT • • Free cash flow can be computed using the notion of net operating profit less adjusted tax as follows (assuming no extraordinary income) Step 1: Compute NOPLAT  Net Income  Plus Net Interest after Tax  Plus Deferred tax  Equals NOPLAT • Step 2: Compute Free Cash Flow  NOPLAT  Plus: Depreciation  Less: Change in Working Capital  Less: Capital Expenditures  Equals Free Cash Flow Integrated Financial Management 23 Oct 24. 2008 .

2008 .Free Cash Flow Example Integrated Financial Management 24 Oct 24.

Balance Sheet Integrated Financial Management 25 Oct 24. 2008 .

Integrated Financial Management 26 Oct 24.  Deferred taxes depend on the way deferred taxes are modelled for cash flow purposes. 2008 .Balance Sheet Issues • Treat surplus cash as negative debt and debt as negative cash  Rule of thumb – cash is 2% of revenues  Example – when developing a basic cash flow model.  Unfunded pension expenses should be treated like debt – they involve a fixed obligation and they can be replaced with debt when they are funded. do not put deferred taxes as a component of equity. group the cash and the debt as one account and then separate this account on the balance sheet. If you model future changes in deferred taxes and take account of these in projections.

Plant Balances and Retirements • You can account for capital expenditures by subtracting accounts from the balance sheet.  The retirements are then use along with plant balance changes to derive the capital expenditures Integrated Financial Management 27 Oct 24. 2008 .  Be careful with retirements  Retirements reduce both the plant balance and the accumulated depreciation  Accumulated depreciation difference can be compared to the current depreciation expense and the difference is retirement.

depreciation rates. return on invested capital • Use to establish the historical analysis and where money was earned and where it is spent • Important as an audit tool in financial modeling • Total Assets = Total Liabilities + Total Equity Integrated Financial Management 28 Oct 24. return on average equity.Balance Sheet • Maintains value of assets – from original cost rather than market value and may be conservative • Used for base for many financial ratios – debt to capital. 2008 .

a number of adjustments should be made from actual balance sheets:  Surplus cash must be separated from other current assets  Short-term debt should be separated from other current liabilities  Current Portion of Long-term Debt should be classified as long-term debt for reconciliation  Common equity can be aggregated Integrated Financial Management 29 Oct 24. 2008 .Balance Sheet Adjustment • In modeling the balance sheet.

2008 .Balance Sheet Issues • Selected Balance Sheet Issues for Financial Analysis  Definition of Capital  Minority Interests  Short-term Debt  Preferred Stock  All Common Equity  Components of Equity Capital  Definition of Book Value per Share  Deferred Debits and Credits Integrated Financial Management 30 Oct 24.

Long Term Liabilities 1) Long-Term Debt 2) Capital Leases 3) Pension Liabilities 4) Others (Deferred Tax Liability. etc) Integrated Financial Management 31 Oct 24.Balance Sheet • • Total Assets” breaks into: A. Stock 1) Preferred 2) Common 3) Treasury • • • • • B. Fixed Assets 1) Net Property Plant and Equipment 2) Goodwill (Type 1) 3) Other • • • • “Total Liabilities” breaks into: A. Other (Translation Gains/Losses. etc) “Total Equity” breaks into: A. Current Liabilities 1) Accounts Payable 2) Current Portion of Long-Term Debt 3) Current Capital Lease Obligation B. Retained Earnings C. Current Assets 1) Cash & Cash Equivalents 2) Marketable Securities 3) Accounts Receivable 4) Inventories B. 2008 .

2008 .Balance Sheet Example Integrated Financial Management 32 Oct 24.

2008 .Balance Sheet Issues in Modeling • Compute Debt Balance from Separate Debt Balance • Understand Deferred Debits and Deferred Credits (for example deferred compensation or long-term pre-paid expenses) • Equity Balance from Retained Earnings Statement can be Incorporated in Statement • Incorporation of Asset write-ups or write-downs Integrated Financial Management 33 Oct 24.

Financial Ratio Analysis Integrated Financial Management 34 Oct 24. 2008 .

2008 .Contents • Introduction • Management Performance Ratios • Valuation Ratios • Credit Analysis Ratios Integrated Financial Management 35 Oct 24.

Tension between Equity Analysis and Asset Analysis • • • • • • • Free Cash Flow Project IRR ROIC (ROCE) WACC Enterprise Value EV/EBITDA Market to Replacement Cost • • • • • • • Equity Cash Flow Equity IRR ROE Cost of Equity Market Cap P/E Market to Book Value = Σ Value of Business Units = Debt + Equity Value In ratio analysis. 2008 . cash = negative debt Integrated Financial Management 36 Oct 24.

Financial Ratio Analysis • Purpose :  Evaluate relation between two or more economically important items (one is the starting point for further analysis) Cautions:  Accounting analysis is important (deferred taxes etc.) • Interpretation is key  What does the P/E mean  Is an interest coverage of 3.5 good  Why is the ROIC low  Should we use MB. 2008 . PE or EV/EBITDA • • Document financial ratios (numerator and denominator) with footnotes and comments Show components of numerator and denominator in rows above the ratio calculation Integrated Financial Management 37 Oct 24.

2008 . pre-tax or after-tax return on assets. other income and other investments in return on invested capital) • There is Not Necessarily One Single Correct Formula  For example. understand why the formula is developed (e.g.  Keep the numerator consistent with the denominator • Financial Ratios should be evaluated in the context of benchmarks  Credit ratios and bond rating standards  Returns and cost of capital  Operating ratios and history Integrated Financial Management 38 Oct 24.General Discussion of Financial Ratios • Financial Ratios Often Compares Income Statement or Cash Flow with Balance Sheet  In developing ratios.

Interest coverage and current ratio) • Model Evaluation  Ratios used to evaluate the assumptions and mechanics of financial forecasts Integrated Financial Management 39 Oct 24.g. 2008 . P/E) • Credit Analysis  Ratios that gauge the credit quality and liquidity of the company (e.g. ROIC) • Valuation  Ratios that are used to give an indication of the value of the company (e.g.Classes of Financial Ratios • Management Performance  Ratios that measure the historic economic performance of management and evaluate whether the economic performance can be maintained (e.

2008 .Ratios that Measure Management Performance Integrated Financial Management 40 Oct 24.

2008 .Class 1: Financial Indicators of Management Performance • Evaluate Whether Management is Doing a Good Job with Investor Funds (Not if the company is appropriately valued)  Return on Invested Capital  Return on Assets  Return on Equity  Market/Book Ratio  Market Value/Replacement Cost • Key Issue  Evaluate relative to risk  ROE versus Cost of Equity  ROIC versus WACC Integrated Financial Management 41 Oct 24.

is that reasonable. In reviewing the return on invested capital. you are gauging the strategy of the company in terms of whether economic profit is being realized. Integrated Financial Management 42 Oct 24. if the financial forecast has a very high ROE. you must assess whether economic profit implicit in the assumptions can in fact be realized. you are gauging the ability of a firm to realize economic profit. • When you interpret financial statistics.Basic Economic Principles. • When you assess assumptions in a financial forecast. when you compare the equity IRR with the equity cost of capital. 2008 . For example. does this demonstrate that the company has the potential to earn economic profit. ROIC and Financial Analysis • When you measure value. For example.

Return on Invested Capital Analysis • ROIC is not distorted by the leverage of the company • ROIC can be used to gauge economic profit and whether the company should grow operations • ROIC can be used to assess the reasonableness of projections  For example. if ROIC is very high and the company is in a competitive business with few barriers to entry. the forecast is probably not realistic. 2008 . • ROIC can be computed on a division basis EBIT and allocation of capital to divisions from net assets to gauge the profit of parts of the company • ROIC comes from sustainable competitive advantage and high market share Integrated Financial Management 43 Oct 24.

Formula for Return on Invested Capital • The return in invested capital formula can be for a division or an entire corporation. It is after tax and after depreciation. Formula:  ROIC = EBITAT/Invested Capital  Where:  EBITAT: Earnings before Interest Taxes and Goodwill Amortization less taxes on EBITAT  Taxes on EBITAT: Cash Income Taxes Less Tax on Interest Expense and Interest Income and Tax on Non-operating Income  Invested Capital less cash balance • • Adjustments  Other Assets  Cash Balances  Goodwill  Other Integrated Financial Management 44 Oct 24. Goodwill and goodwill amortization should be excluded. Cash balances should be excluded from the denominator and interest income from the numerator. 2008 .

EBIT Margin = EBIT/Sales  ROCE vs ROIC  ROCE is generally computed in an indirect way by starting with net income.Issues in Management Performance Evaluation • Basic Formula: ROIC versus WACC  How to compute ROIC  NOPLAT/Average Invested Capital  May or may not include goodwill – If goodwill is not included. 2008 . and adding net of tax interest and adding minorities Integrated Financial Management 45 Oct 24. compute NOPLAT without subtracting goodwill write-off and subtract net goodwill from invested capital  Reduce the invested capital by surplus cash balances  Some don’t include other income – then the invested capital should be reduced by other investments  Can compute with ratios  EBIT Margin x (1-t) * Asset Turn  Asset Turn = Sales/Assets.

Exxon Mobil Return on Average Capital Employed • Return on average capital employed (ROCE) is a performance measure ratio. which tend to be more cash flow based. 2008 . From the perspective of the business segments. These segment earnings include ExxonMobil’s share of segment earnings of equity companies. and exclude the cost of financing. ROCE is annual business segment earnings divided by average business segment capital employed (average of beginning and end-of-year amounts). Additional measures. both to evaluate management’s performance and to demonstrate to shareholders that capital has been used wisely over the long term. • • Integrated Financial Management 46 Oct 24. divided by total corporate average capital employed. The corporation has consistently applied its ROCE definition for many years and views it as the best measure of historical capital productivity in our capital intensive longterm industry. are used for future investment decisions. consistent with our capital employed definition. The corporation’s total ROCE is net income excluding the after-tax cost of financing.

Exxon Mobil Return on Capital Employed – Where are they making expenditures Integrated Financial Management 47 Oct 24. 2008 .

00) 54.00 (69.00 $ 19.00) $ 36.976.00 (1.00) (172.Exxon Mobil Return on Capital Return on average capital employed Net income Financing costs -after tax Third-party debt ExxonMobil share of equity companies All other financing costs – net -1 Total financing costs Earnings excluding financing costs 2005 -millions of dollars $ 36. Integrated Financial Management 48 Oct 24.339.00 31.373.00 20.00 (137.90 (1) “All other financing costs – net” in 2003 includes interest income (after tax) associated with the settlement of a U.510.775. tax dispute.00 (268.130.00 Average capital employed Return on average capital employed – corporate total $ 116.00) $ 25.00 2003 $ 21.30 $ 107. 2008 .00 1.534.330.00) 1.00) (185.00 23.570.80 $ 95.00) (295.00 2004 $ 25.S.00) (440.961.598.00) (144.

Illustration of Invested Capital Computation Integrated Financial Management 49 Oct 24. 2008 .

2008 .ROE and ROIC – Note how to compute growth rates from ROE and Retention Integrated Financial Management 50 Oct 24.

Morgan reviewed and analyzed the return on capital employed ("ROCE") of both Exxon and Mobil since 1993.P.P. 2008 .P. Integrated Financial Management 51 Oct 24. An example of use of this ratio is in the Exxon Mobile Merger: J. the combined entity's capital productivity would eventually be higher than the pro forma capital productivity of Exxon and Mobil.Example of Return on Capital Employed (Return on Invested Capital) in Financial Analysis •The argument has been made that the best measure to evaluate management performance that is not distorted by leverage (as in the case of ROE) or has the problems of ROA is the return on invested capital. Morgan observed that Exxon's ROCE has consistently been 2-3% above that of Mobil. Morgan's analysis indicated that if Mobil were to be merged with Exxon. J. Morgan indicated that it would be reasonable to assume that the benefits of this capital productivity increase would occur within three years of the closing of the merger. J. J.P.

Relationship Between Various Ratios and DuPont Analysis Profitability Asset Utilization Working Capital/ Sales Plus: Long-term capital/ Sales Equals:Capital employed/ Sales 1 divided by Capital Employed/ Sales Equals: Asset Turnover (Sales/ Capital Employed) Gross Margin = Gross profit/ Sales Less: Operating costs/ Sales Equals EBIT Margin (EBIT/ Sales) Multiplied by ROCE(EBIT/ Capital Employed ) Multiplied by (1 minus Tax Rate) ROCE(EBIT after Tax/ Capital Employed ) Integrated Financial Management 52 Oct 24. 2008 .

2008 . EBITDA Margin.Drivers of Value and Free Cash Flow from Financial Ratios • Revenues  Growth in Revenues • EBITDA Margin  Multiplied by • Revenues = EBITDA • Less: Depreciation Rate  Multiplied by • Fixed Assets = EBIT • Fixed Assets = Sales x Sales/Assets (Turnover) • Ratios Needed: Growth in Revenues. Depreciation Rate and Asset Turnover Integrated Financial Management 53 Oct 24.

2008 .Example of Using Ratios to Compute Free Cash Flow Integrated Financial Management 54 Oct 24.

Valuation Ratios include:  Universal Financial Ratios  Price to Earnings Ratio  Enterprise Value/EBITDA  PEG (P/E to Earnings Growth) Ratio  Market to Book Ratio  Industry Specific Financial Ratios  Value/Reserve  Value/Customer  Value/Plane Seat Integrated Financial Management 55 Oct 24. 2008 . Analysts should understand the drivers of different ratios.Class 2: Financial Indicators of Market Value • Financial Ratios can be used to analyze whether the valuation of a company is appropriate.

EBITDA. Book Value/Share or growth in EPS • The ratios can be used as benchmarks in valuing non-traded companies by using industry average valuation ratios. • Example to value non-traded company:  Value of company = EPS of Company x Industry Average P/E Ratio • Valuation ratios will be further discussed in the portion of the course where corporate models are used to value companies.Valuation Ratios and Benchmarks • Valuation ratios measure the stock market value of a company relative to some accounting measure such as EPS. Integrated Financial Management 56 Oct 24. 2008 .

P/E Ratio • The P/E Ratio is the most prominent valuation ratio. It is affected by estimated earnings growth. the ability of a company to earn economic profits and the growth in profitable operations. 2008 . Formula:  Share Price/Earnings per Share • Issues  Trailing Twelve Months and Forward Twelve Months – Generally use forward EPS  Formula: (1-g/r)/(k-g) • Problems  Affected by earnings adjustments  Causes too much focus on EPS  Distortions created by financing • Integrated Financial Management 57 Oct 24.

Illustration of EV Ratios and Computation of Market Value of Balance Sheet Components

Integrated Financial Management

58

Oct 24, 2008

Investment Banker Analysis of Comparable Multiples

Integrated Financial Management

59

Oct 24, 2008

Investment Banker Analysis of Multiples

Integrated Financial Management

60

Oct 24, 2008

Use of PE in Valuation • The long-run P/E ratio is often used in valuation. This process involves:  Project EPS  Compute Stable EPS  Compute P/E Ratio using formula  P/E = (1-g/r)/(k-g)  g – growth in EPS or Net Income  r – rate of return earned on equity  k – cost of equity capital  Related Formula for terminal value with NOPLAT (EBITAT)  (1-g/ROIC)/(WACC – g)  The formula demonstrates where value really comes from Integrated Financial Management 61 Oct 24. 2008 .

2008 .Liquidity and Solvency Credit worthiness: Ability to honor credit obligations (downside risk) Liquidity Ability to meet short-term obligations Focus: • Current Financial conditions • Current cash flows • Liquidity of assets Solvency Ability to meet long-term obligations Focus: • Long-term financial conditions • Long-term cash flows • Extended profitability Integrated Financial Management 62 Oct 24.

2008 .  Solvency  Debt Payback Ratios  Funds from Operations to Total Debt  Debt to EBITDA  Leverage Ratios  Debt to Capital (Include Short-term Debt)  Market Debt to Market Capital  Payment Ratios  Interest Coverage  Debt Service Coverage [Cash Flow/(Interest + Principal)]  Capital Investment Coverage  Operating Cash Flow/Capital Expenditures Integrated Financial Management 63 Oct 24. These ratios should be compared to benchmarks.Solvency Ratios • Ratios are the center of traditional credit analysis that assesses whether a company can re-pay loans.

covenants. triggers)  Off Balance Sheet Obligations (Guarantees. contingent liabilities)  Alternative Sources of Liquidity (Asset sales.Liquidity • Current Ratio  Current Assets to Current Liabilities  Current Assets less Inventory to Current Liabilities • Model Working Capital  Current Assets less Cash and Temporary Securities minus Current liabilities less Short-term Debt • Liquidity Assessment  Debt Profile (Maturities)  Bank Lines (Availability. support. 2008 . maturity. amount. capital spending flexibility) Integrated Financial Management 64 Oct 24. take-or-pay contracts. dividend flexibility.

Financial Ratios in Credit Analysis • Analyze financial ratios after determining the riskiness of a company. • Four ways to assess ratios:  Absolute Levels  Trends in historic ratios  Forecast ratios  Comparison with industry peers Integrated Financial Management 65 Oct 24. only certain key ratios need to be analyzed to complete an effective assessment. 2008 . • There are hundreds of ratios that could be analyzed.

 Used to determine the probability of default  A coverage ratio of 1 indicates that income just covers interest  Can be calculated either before.or after-tax  Consistency is important • Analysts also consider the stability and trend of earnings Integrated Financial Management 66 Oct 24. 2008 .Interest and Debt Service Coverage Ratios • Measure how many times the company’s earned income covers interest charges. etc.

2008 .S&P Benchmarks Integrated Financial Management 67 Oct 24.

S&P Benchmark for Manufacturing and Service Companies – Funds from Operations/Total Debt • The benchmark ratios differ according to the risk profile of a company as illustrated on the chart below. Company Business Risk Profile Well Above Average Above Average Average Below Average Well Below Average AAA 30% 20% AA A BBB 60% 50% 40% 35% 25% BB 70% 60% 55% 45% 35% 40% 50% 25% 40% 15% 30% 25% Integrated Financial Management 68 Oct 24. 2008 .

S&P Benchmarks Integrated Financial Management 69 Oct 24. 2008 .

2008 .S&P Utility Benchmarks Integrated Financial Management 70 Oct 24.

S&P Benchmarks Integrated Financial Management 71 Oct 24. 2008 .

S&P Ratio Definitions Integrated Financial Management 72 Oct 24. 2008 .

Objective of Analysis is Bankruptcy Probability • • Credit agencies use the ratios that differ by industry in establishing rating criteria Criteria can often be determined by industry Integrated Financial Management 73 Oct 24. 2008 .

2008 .Bond Ratings and Yield Spread Integrated Financial Management 74 Oct 24.

Don’t Put Miscellaneous Un-Explained Factors • Test Integrated Financial Management 75 Oct 24. 2008 .

Class 4: Model Assessment • Various ratios that some use to assess management performance are most appropriate for testing the validity of a model. Examples of these ratios include:  EBITDA/Revenue  Working Capital – Activity Ratios  Inventory Turnover  AR/Revenues. 2008 .  AP/Expenses  Income Tax Payable/Income Taxes  Depreciation Rate – Depreciation Expense/Gross PP&L  Depreciation Expense to Cap Exp  Average Interest Rate – Interest Expense/Average Debt  Capital Expenditure/Capacity Integrated Financial Management 76 Oct 24.

Other Ratios in Financial Modeling
• Other ratios should be computed in financial models to test the validity of assumptions and the structure of the model. For these ratios, the historic levels can be used to make forecasts of relevant assumptions. Examples include average interest rate, depreciation rate, working capital ratios, dividend payout ratio, EBITDA/Sales

Integrated Financial Management

77

Oct 24, 2008

Financial Ratio Assignment - Work with the PE Ratio

Integrated Financial Management

78

Oct 24, 2008

PE Ratio Exercise
• Find the file named P/E Ratio exercise • Complete the cork screw for determining the equity balance

Integrated Financial Management

79

Oct 24, 2008

Steps in the PE Ratio Exercise – Open the File Integrated Financial Management 80 Oct 24. 2008 .

false switches to establish the holding period and the terminal period • Do not use if statement • Rather.  = year <= final_year for the holding period  = year = final_year for the terminal period • When you multiply variables by the true or false.Step 1: Enter Switch Variables for the Holding Period • Use true. 2008 . the then the numbers are zero or one Integrated Financial Management 81 Oct 24.

2008 .Step 2: Compute the Equity Balance. Net Income and Dividends with a Cork Screw • Start with the beginning equity balance  Income = ROE x Beginning balance  Dividends = Income x Payout Ratio  Ending Balance = Beginning Balance + Income – Dividends • In subsequent periods  Beginning balance = Prior Period Ending Balance Integrated Financial Management 82 Oct 24.

2008 .Step 3: Compute Cash Flow in Holding Period and in Terminal Period • In the holding period  Cash flow = dividends • In the terminal period  Cash flow = dividends + Multiple x earnings per share  Where  Multiple = P/E Ratio from formula (1-g/r)/(k-g) • Use switch to make sure cash flow is not counted after the holding period  Cash Flow = dividends x switch Integrated Financial Management 83 Oct 24.

2008 .Step 4: Compute the Value of Cash Flow • Assume the discount rate is the hurdle rate • Each year the discount factor is  1/(1+r)^year • The value of cash flow is:  Discount factor x cash flow Integrated Financial Management 84 Oct 24.

Step 5: Compute the P/E Ratio • Compute the total value of the share  Value = ∑ cash flow x discount factor • Fill in Components  P/E = Value/First Year Earnings Integrated Financial Management 85 Oct 24. 2008 .

Experiment with P/E Ratio Using Microsoft Data • Assume  ROE = 17%  Cost of Equity = 17%  Payout Ratio = 50%  What is the P/E  Why • Assume  ROE = 17%  Cost of Equity = 12%  Payout Ratio = 100%  What is the P/E  Why Integrated Financial Management 86 Oct 24. 2008 .

Experiment with P/E Ratio • Assume  ROE = 17%  Cost of Equity = 12%  Dividend Payout = 50%  What is the P/E  Why Integrated Financial Management 87 Oct 24. 2008 .

Reference: Financial Ratio Formulas to Assess Management Performance Integrated Financial Management 88 Oct 24. 2008 .

a much less humble and far more challenging activity that links risk taking with direct payoffs. The other was forecasting. As the growth of trade transformed the principles of gambling into the creation of wealth. the inevitable result was capitalism. But capitalism could not have flourished without two new activities … The first was bookkeeping. 2008 . The primary subject in financial statement analysis is how can we read financial statements and evaluate the return of a company relative to the risk of a company. “The Remarkable Story of Risk” Integrated Financial Management 89 Oct 24.Introduction: Two Components of Trade The heart of any financial analysis is measurement of value through assessing risk and return. a humble activity but one that encouraged the dissemination of the new techniques of numbering and counting. the epitome of risktaking.

2008 . Integrated Financial Management 90 Oct 24.  You are assigned to perform a valuation of a company. You must determine the amount of debt and equity that can be used in the transaction.  You are structuring an M&A transaction. How would you determine whether the projections are reasonable by comparing the projections to history.Case Study of Financial Statement Analysis • Examples of Financial Statement Review  You receive financial projections as part of an offering memorandum or as part of a financing proposal. You must assess whether the earnings guidance from investment analysts are reasonable.

Profitability Analysis • • • • • • • • ROE = Net Income/ Avg. Total Debt + Avg. 2008 . Total Equity) Market Value per Share/Book Value per Share Market Value of Assets/Replacement Cost of Assets Gross Profit Margin = Gross Profit/ Sales Operating Margin = EBITDA/Sales Profit Margin = Net Income/ Sales Integrated Financial Management 91 Oct 24. Common Equity ROA = EBIT/ Total Assets ROIC = EBIT x (1-t)/ (Avg.

Return on Equity •Defines how much income management has made from the equity investment made by investors – the return is net income and the investment is the equity. •Formula: Net Income/(Beginning + Ending Equity)/2 Net Income after Preferred Dividends/(Average Common Equity) •The problem with ROE it that it mixes operating performance with financial structure. •Return on equity should be related to the risk associated with earnings -. making it difficult to understand the underlying performance.volatile earnings should imply a higher average return on equity •High or low return on equity in models High returns – check your assumptions Low returns – problems with management performance Integrated Financial Management 92 Oct 24. 2008 .

The ratio is generally pre-tax and total assets can distort the ratio.Return on Assets • Return in assets measures the amounts of income produced relative to investment in assets.  Financing by current liabilities not considered (for example ROA is the same for businesses that have different funding from suppliers) Integrated Financial Management 93 Oct 24. deferred taxes. deferred credits). • Formula: • EBIT/Average Total Assets • Problems:  Difference between capital and asset balance means that investment not measured (examples. 2008 .  Pre-tax means that taxes not considered even though taxes are real.

2008 . Cash balances should be excluded from the denominator and interest income from the numerator. •Formula: ROIC = EBITAT/Invested Capital Where:  EBITAT: Earnings before Interest Taxes and Goodwill Amortization less taxes on EBITAT  Taxes on EBITAT: Cash Income Taxes Less Tax on Interest Expense and Interest Income and Tax on Non-operating Income  Invested Capital less cash balance •Adjustments Other Assets Cash Balances Goodwill Other Integrated Financial Management 94 Oct 24.Formula for Return on Invested Capital •The return in invested capital formula can be for a division or an entire corporation. Goodwill and goodwill amortization should be excluded. It is after tax and after depreciation.

If a division or company. Alternative measures can be used to measure economic profit: Economic Profit Formula:  Economic profit = Invested Capital x (ROIC .WACC x Invested Capital • Integrated Financial Management 95 Oct 24.ROIC and Economic Profit • ROIC is the foundation for analyzing performance in EVA. 2008 .WACC)  Economic profit = EBITAT . then it should be earning economic profit.Capital Charge  Economic profit = EBITAT .

•Formula: Market Price/Book Value per Share •Problems: Investment does not inflate Incorporates benefits or costs of equity value from changes in the liability structure of the company.Market to Book Value •Management performance can be evaluated by measuring what equity investors think about the value of the company. 2008 . Today’s market value compared to the amount invested by shareholders (directly or indirectly through not retaining earnings) is measured by the market to book ratio. if it is 2. Integrated Financial Management 96 Oct 24. management has doubled value relative to the amount invested. •The ratio is related to ROE because if the ROE is greater than the cost of capital. If the ratio is 1.0. The ratio measures how much value management has created relative to the amount initially invested. management has not created value. the market value should be above the book value.0.

Example of Market to Book Ratio Integrated Financial Management 97 Oct 24. 2008 .

The more the value is above replacement cost.Market Value to Replacement Cost (Tobin’s Q) •Theoretical problems with the market to book ratio are addressed with a ratio known as Tobin’s Q. If replacement cost is lower than market value. the better job management is doing in managing assets: •Formula Tobin’s Q = Enterprise Value/Replacement Cost Where  Enterprise Value = Market Value of Equity plus market value of Debt •Problems How to measure replacement cost Adjusting replacement cost for asset age Integrated Financial Management 98 Oct 24. then shareholders are better off by liquidating the company and selling assets in the market. 2008 . This ratio compares market value to replacement cost rather than book value.

2008 .Reference: Formulas for Valuation Ratios Integrated Financial Management 99 Oct 24.

Enterprise Value. enterprise value is the present value of free cash flow plus the present value of residual. Equity Value and Equity Value per Share • • Before discussing valuation ratios it is helpful to define market capitalization and enterprise value. 2008 . Formulas:  Market Capitalization = Share Price x Number of Outstanding Shares (fully diluted)  Enterprise value = Market Capitalization plus Market Value of Debt • • In theory. In practice. Integrated Financial Management 100 Oct 24. the value of debt can often be estimated by the book value as long as the average interest rate is similar to the market yields on the company debt.

2008 . the ability of a company to earn economic profits and the growth in profitable operations. Formula:  Share Price/Earnings per Share • • Issues  Trailing Twelve Months and Forward Twelve Months  Formula: (1-r/g)/(k-g) • Problems  Affected by earnings adjustments  Causes too much focus on EPS  Distortions created by financing Integrated Financial Management 101 Oct 24.P/E Ratio • The P/E Ratio is the most prominent valuation ratio. It is affected by estimated earnings growth.

so market value is compared to cash flow: • Formula:  EV/EBITDA = Enterprise Value/EBITDA  Where  Enterprise Value = Book value of debt plus market value of equity Integrated Financial Management 102 Oct 24. accounting adjustments and can more effective comparisons across companies can be made. pre depreciation operating income is a proxy for cash flow.Enterprise Value/EBITDA • Some of the problems with the P/E ratio are rectified by the ratio of EV/EBITDA. 2008 . This ratio is not affected by leverage.Pre-tax. EBITDA .

Price to Cash Flow • To correct the P/E ratio for accounting adjustments that are non-cash such as depreciation and goodwill amortization. 2008 . This is similar to the P/E ratio except the denominator is cash flow rather than earnings. a ratio known as Price to cash flow is computed. • Cash Flow measure is very simple and not generally the free cash flow • Cash Flow is generally the net income plus depreciation Integrated Financial Management 103 Oct 24.

its price should be higher. 2008 .Price to Earnings Growth (PEG) • Due to the importance of earnings growth in the P/E ratio. Formula:  PEG = PE Ratio/Consensus Earnings Growth • Integrated Financial Management 104 Oct 24. this ratio attempts to measure the relative value of a company after accounting for earnings growth. the valuation of two companies can be compared even if they have different earnings growth. If a company has higher earnings growth. Therefore.

2008 .Internal Rate of Return • • • • • • Application to project finance rather than investment analysis Equity IRR analogous to the ROE Project IRR analogous to the ROIC Free cash flow used for project IRR Equity cash flow used for equity IRR Return on Equity Cash Flow in Gaza Strip Project Integrated Financial Management 105 Oct 24.

2008 .Reference: Financial Ratio Formulas for Credit Analysis Integrated Financial Management 106 Oct 24.

Days in Stock = 365/ Inventory TO Receivables Turnover = Sales/ Avg. Receivables Avg. 2008 . Working Cap Total Asset Turnover = Sales/ Average Total Assets •Liquidity Analysis Operating Cycle = Avg. Days Receivables Out Cash Cycle will be less.Ratio Analysis •Activity Analysis Inventory Turnover = COGS/Avg. Days in Stock + Avg. Days Receivables Out = 365/ Receivables Working Capital Turnover = Sales/ Avg. depending on use of credit Current Ratio = CA/CL Quick Ratio = (CA .Inventories)/ CL CFO Ratio = CFO/ CL •Solvency Analysis Debt-to-Cap = Total Debt/Total Capital Debt to Equity = Total Debt/ Total Equity (market values are preferable in this ratio) Times Interest Earned = EBIT/ Interest Expense Fixed Charge Coverage = EBIT (and before other fixed expenses)/Fixed Charges Cap Ex Ratio = CFO/ Cap Ex Integrated Financial Management 107 Oct 24. Inventory Avg.

Liquidity ratios measure the ability of a company to meet short-term obligations while interest coverage. (Note that credit ratios are not considered adequate for many assessments. • Credit ratios have been formalized into regression analysis by relating the defaults on companies to various financial ratios. 2008 .) Integrated Financial Management 108 Oct 24. but they are a starting point.Credit Analysis Ratios • A traditional use of financial ratios has been to assess the value of debt and the chance of default. debt service and capitalization ratios measure the ability to meet long-term obligations.

2008 .Classes of Credit Ratios • Interest Coverage    • EBIT/Interest Debt Service Coverage Ratio After tax coverage Debt to Capital     Total debt to capital Debt to equity Long term versus short term Market value versus book value • • Debt to Cash Flow Liquidity   Current Ratio Quick Ratio Integrated Financial Management 109 Oct 24.

EBIT/Interest is used more than the debt service coverage in corporate modeling because of the lumpiness in cash flow that occurs from bullet maturities: • Formula:  EBIT/Interest = EBIT/(Long + Short term Interest)  DSCR = (Operating Cash + Interest)/(Interest + Maturities) Integrated Financial Management 110 Oct 24.Interest and Debt Service Coverage • The interest coverage and debt service ratios measure the amount of buffer or comfort above interest expense and/or debt service that cash flow provides before obligations cannot be met from current operations. 2008 .

the capitalized value of contracts has been included. 2008 .Debt to Capital Ratio • The debt to capital ratio measures from a book perspective. The ratio has not been a very good predictor of bankruptcy. In some cases. • Formula:  Debt to Capital = (Long-term debt + Short-term debt)/(Long and Short term debt + Equity) Integrated Financial Management 111 Oct 24. It should include long and short term debt as well as capitalized lease payments. the amount of debt that is financing assets.

• Formula:  Debt/Cash Flow = (Long and Short term debt)/EBITDA • Note that EBITDA is an approximation of cash flow and it does not include capital expenditures. 2008 . Integrated Financial Management 112 Oct 24.Debt to Cash Flow • This ratio compares the cash flow with the amount of debt. The less cash flow relative to debt. the ratio can be considered the number of years of cash flow it takes to pay-off all of the debt. Inquisitively. the worse the credit and the higher the probability of default.

The quick ratio excludes inventories because they are not liquid. Liquidity ratios are relevant for suppliers and contractors.0 suggests that more is coming due then is on hand to pay the liabilities.Liquidity Ratios •Liquidity ratios measure the ability of a company to meet obligations that are coming due in the short-term. 2008 . •Formulas: •Current Ratio Current Assets/Current Liabilities •Quick Ratio Current Assets – Inventory/Current Liabilities (Cash + Marketable Securities + A/R)/Current Liabilities Integrated Financial Management 113 Oct 24. A ratio below 1.

2008 .Activity Ratios • Inventory turnover  CGS/Average Inventory  Days Inventory in Stock = 365/Inventory Turnover  Receivables Turnover = Sales/AR  Days Receivables Outstanding = 365/Receivables Turnover Integrated Financial Management 114 Oct 24.

2008 .Depreciation Rate • • In simple models. Depreciation Rate  Formula:  Depreciation Rate = Depreciation Expense/Gross Plant  Depreciation Expense divided by average gross plant balance  One divided by depreciation rate gives you the average life of plant • Accumulated Depreciation/Plant Balance  Indication of average age of the plant  Higher depreciation is older average age of the plant Integrated Financial Management 115 Oct 24. forecasts of depreciation expense can be made by applying the depreciation rate to gross plant property and equipment.

2008 .Financial Ratio Formulas for Model Assessment Integrated Financial Management 116 Oct 24.

EBITDA Margin • As explained above. the EBITDA margin can be a good ratio to determine if assumptions are reasonable:  Relationship between revenues and operating expenses  Compare forecast to history and evaluate why changes are occurring Integrated Financial Management 117 Oct 24. 2008 .

Average Interest Rate • The average interest rate is the interest expense divided by the average debt balance.  Average interest rate is the interest expense divided by the average debt balance  The average interest rate can be compared to prevailing interest rates Integrated Financial Management 118 Oct 24. 2008 . This can be used to assess whether the project interest rate is reasonable – particularly for long-term debt.

Capital Intensity • • Capital intensity is often discussed in finance. The capital intensity does not affect value or credit. Formula:  Capital Intensity = Capitalization/Revenues • Driven by  Life of Asset  Capital Cost Relative to Operating Cost  Required Return on Assets Integrated Financial Management 119 Oct 24. 2008 . but it is helpful in background on the business.

Financial Ratio Output in Corporate Models • • • Use financial ratios to test the validity of models (can the industry really sustain high profits) Use financial ratios to develop valuation from earnings multiples (P/E and EBIDA/Enterprise Value) Use financial ratios in residual value calculations Integrated Financial Management 120 Oct 24. 2008 .

2008 .Examples of Financial Ratio Analysis in Corporate Model Integrated Financial Management 121 Oct 24.

Examples of Financial Ratio Analysis in Corporate Model Integrated Financial Management 122 Oct 24. 2008 .

Financial Ratios and Ability to Earn Economic Profit

Integrated Financial Management

123

Oct 24, 2008

The Economics of Value Creation and Strategic Planning
In this section we review how value is created by business activity including how valuation relates to economic profit. The section covers the basic economic drivers of value in different circumstances and the actual value creation activities of various firms.

1. Microeconomics and the creation of value 2. Models of strategic choice and value 3. Assumption of efficient financial markets 4. Value Drivers, strategy and financial management

Integrated Financial Management

124

Oct 24, 2008

Why Does Economic Profit Depend on Barriers to Entry

Recall your basic economics course:  Economic profit is the net revenues earned by a company less all costs including opportunity cost (opportunity cost includes the risk adjusted cost of capital).  If companies are earning economic profit, more firms will enter the industry. If companies are not making economic profit, firms will exit the industry. Therefore, to sustain economic profit (a sustainable competitive advantage), firms must be able to keep up barriers to entry.

Integrated Financial Management

125

Oct 24, 2008

” economic profit can exist •If direct cost for a company is less than the direct cost for other firms in the industry because of efficient operations. economic profit can exist Integrated Financial Management 126 Oct 24. it may be possible to extend market power in one business to another business and realize economic profit •If a firm in a commodity industry makes investments when the commodity prices are high and “hits the cycle. economic profit can exist •If prices can be bundled for products.This Graph Implies that Value is Created as Follows: •Economic Profit = Price x Quantity less Direct Costs less Opportunity Cost •If price is above long-run marginal cost because of barriers to entry. 2008 .

the business models were easy to copy and economic profit was very hard to realize.Examples of Economic Profit that Could not be Sustained • Internet Companies  The internet bubble occurred because companies had “business models” that suggested high growth. In the industry. there had to be barriers to entry. But in order to really make profit. Integrated Financial Management 127 Oct 24. 2008 . • Enron  Enron’s business plan was to make money from being a player in commodity markets where there is a zero sum game. It is difficult to realize long term significant economic profit by making trades where there is an equal number of winners and losers.

the merger could not add value and it turned out to be a disaster. The investments caused prices to decline and only early entrants made money. Integrated Financial Management 128 Oct 24.Examples of Economic Profit that Could not be Sustained • Investments in Electricity Generation  After price spikes in electricity. 2008 . Without cost savings or revenue enhancements. • AT&T and NCR  The merger between AT&T and NCR did not contemplate achieving cost savings from the merger. many firms such as Calpine and Natural Gas companies made significant investments in electricity generation.

Integrated Financial Management 129 Oct 24. 2008 .Examples of Sustainable Economic Profit from Product Differentiation and Barriers to Entry • Microsoft  It can be argued that Microsoft makes its money not from extremely creative and innovative products. • General Electric  General electric operates in highly technical areas where it is difficult to enter the market. maintaining a turbine or requiring a jet engine. other firms cannot simply enter the market. If you are building a turbine. but from the ability to keep away competitors through standardization of platforms that are required with the internet.

higher prices and lower load factors. 2008 .Example of Economic Profit from an Efficient Cost Structure • Southwest Airlines versus United Airlines  Southwest Airlines has the same type of planes. low prices and high load factors. United Airlines has union problems. has extremely short layovers. • Freeport McMoran  Freeport developed a copper mine in a remote part of Indonesia where the ore grade was high and the copper could be mined from the surface. Integrated Financial Management 130 Oct 24. motivates its employees.

the types of business activities that lead to barriers can be complex: In classic economic theory. a highly skilled work force in financial services and software. However. excess capacity can exist in the capital intensive businesses and size alone has not turned out to be an effective barrier. capital intensive industries such as steel firms and automobile firms were thought to have market power from barriers to entry. 2008 . More interesting barriers to entry are from a strong name – in the advertising and financial services business. Integrated Financial Management 131 Oct 24. standardization of computer platforms and even barrier to entry from high stock prices.Barriers to Entry In thinking about barriers to entry.

Financial Statements and Reflection of Business Activities Investing Current: q q q q Planning Operating Sales q Cost of Goods Sold q Selling Expense q Administrative Expense q Interest Expense q Income Tax Expense q q q q q Financing Current: Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings Cash Accounts Receivable Inventories Marketable Securities Land. 2008 Assets Balance Sheet Cash Flow Statement of Cash Flows Integrated Financial Management . Buildings. & Equipment Patents Investments Noncurrent: q Noncurrent: q q q q q Net Income Income statement Liabilities & Equity Balance Sheet Statement of Shareholders’ Equity 132 Oct 24.

and extent of any trends to evaluate whether the trends will continue • Types of trend analysis:  Year-to-year Change Analysis  (Ln(revenue(t)/revenue(t-1))  (revenue(t)/revenue(t-1)-1)  Index-Number Trend Analysis  Prior x (1+growth) Integrated Financial Management 133 Oct 24.Traditional Financial Ratio Analysis – Comparative Trend Analysis • Purpose of trend analysis:  Evaluation of consecutive financial statements • Output of trend analysis:  Determine the direction. 2008 . speed.

Accounting Analysis in Financial Statements Process to evaluate and adjust financial statements to better reflect economic reality Comparability problems — across firms and across time Manager estimation error Distortion problems Earnings management Distortion of business Accounting Risk Integrated Financial Management 134 Oct 24. 2008 .

2008 .Ratio Analysis • • • • • • Analysis Issues Absolute Levels Trends Industry Benchmarks Industry Specific Ratios\ Common size analysis  Income statement and balance sheet for companies in an industry  Express income statement items as percent of revenues  Express balance sheet items as percent of total assets Integrated Financial Management 135 Oct 24.

2008 .Example of P/E and PEG Integrated Financial Management 136 Oct 24.