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Applied Corporate Finance

Semester 1, 2015

Week 2

Chapter 2 Introduction to Financial

Statement Analysis
2.1 Firms Disclosure of Financial Information

2.2 The Balance Sheet

2.3 The Income Statement
2.4 The Statement of Cash Flows
2.5 Other Financial Statement Information
2.6 Financial Statement Analysis

2.7 Financial Reporting in Practice

2.1 Financial Statement

Financial Statement
Financial statements are accounting reports that a firm issues
periodically to describe its past performance.
Investors, financial analysts, managers and other interested parties
rely on financial statements to obtain reliable information about a

Preparation of Financial Statements

Generally Accepted Accounting Principles (GAAP).
International Financial Reporting Standards (IFRS).
Makes it easier to compare financial results of different firms.

2.1 Financial Statement

Types of Financial Statements

Balance sheet
Income statement
Statement of cash flows
Statement of changes in shareholders (or stockholders) equity

2.2 Balance Sheet

A snapshot in time of the firms financial position

The Balance Sheet Equation:

Assets = Liabilities + Shareholders Equity

What the company owns

What the company owes

Shareholders Equity
The difference between the value of the firms assets and liabilities

2.2 Balance Sheet

2.2 Assets
Current Assets: cash or asset expected to be turned
into cash within one year

Accounts receivable

Long-Term (or Non- Current) Assets: assets that

produce benefits for more than one year
Property, plant, & equipment



2.2 Liabilities
Current Liabilities: due to be paid within one year

Accounts payable
Short-term debt payable
Wages payable

Long-Term Liabilities: liabilities that extend beyond

one year
Long-term debt
Capital leases

2.2 Liabilities
The difference between current assets and current
liabilities is the firms net working capital, the capital
available in the short term to run the business.
Net Working Capital = Current Assets Current

2.2 Shareholders Equity

The difference between the firms assets and
liabilities is the shareholders equity, also called the
book value of equity.
Based on historical costs rather than true value.
Fails to capture some valuable assets such as reputation.
Not necessarily an accurate assessment of the true value of the firms

Market value of equity (market capitalization)

Market Price per Share x Number of Shares Outstanding.
Depends on what investors expect those assets to produce in the


2.6 Balance Sheet Analysis

Market-to-Book Ratio

Market Value of Equity

Market-to-Book Ratio
Book Value of Equity
Value shares: low M/B ratio; Growth shares: high M/B ratio

Debt-Equity Ratio

Debt-Equity Ratio

Total Debt
Total Equity

Measures the extent to which the firm relies on debt as a source of

financing, or leverage.

Enterprise Value
Enterprise Value Market Value of Equity Debt Cash
Assesses the value of the underlying business assets.

2.6 Balance Sheet Analysis

Example: In January 2009, Rylan Corporation had a
market capitalization of 110 million, a market-tobook ratio of 2.2, a book debt to equity ratio of 1.4,
and cash of $6.3 million. What was Rylans enterprise
Book value of equity = $110m / 2.2 = $50m
Total debt = $50m 1.4 = $70m
Enterprise value = $110m + $70m - $6.3m = $173.7m


2.3 Income Statement

Total Sales Cost of Sales = Gross Profit
Gross Profit Operating Expenses = Operating Income
Operating Income Other Income/Expenses =
Earnings Before Interest and Taxes (EBIT)
EBIT Interest Income/Expenses Taxes = Net Income


2.3 Income Statement


2.6 Income Statement Analysis

Profitability Ratios
Gross Margin
Gross Margin

Gross Profit

Reflects firms ability to sell a product for more than the cost of
producing it.

Net Profit Margin

Net Profit Margin

Net Income
Total Sales

Shows the fraction of each dollar in revenues that is available to equity

holders after the firm pays its expenses plus interest and taxes.


2.6 Income Statement Analysis

Earnings Before Interests, Taxes, Deprecation and
Depreciation and amortization are not actual cash expenses.
EBITDA reflects the cash a firm has earned from its operations.

Investment Returns
Return on Equity (ROE)
Return on Equity

Net Income
Book Value of Equity

Return on Assets (ROA)

Return on Assets Net Income

Total Assets

2.6 The DuPont Identity

Total Assets
Net Income


Total Assets Book Value of Equity

Net Profit Margin

Asset Turnover

Equity Multiplier

Return On Assets

First term measures firms overall profitability.

Second term measures firms efficiency in utilizing its
assets to generate sales.
Third term is another measure of leverage.
A higher Equity multiplier implies a greater reliance on debt financing.


2.6 Valuation Ratios

PriceEarnings Ratio (P/E)

P / E Ratio

Market Capitalization
Share Price

Net Income
Earnings per Share

A very commonly used measure.

Meaningless when the firm has negative earnings.
Solution: look at enterprise value relative to sales.


2.4 The Statement of Cash Flows

Net income typically does not equal the amount of
cash the firm has earned because of:
Non-Cash Expenses (e.g. Depreciation and Amortization)
Uses of cash not on the Income Statement (e.g. Investment in
Property, Plant, and Equipment)

Three sections of cash flow statements:

Operating activities
Investment activities
Financing activities


2.4 Three sections in cash flow statement

Operating Activities
Adjust net income by all non-cash items related to
operating activities and changes in net working capital

Add depreciation and amortization

Deduct accounts receivable
Deduct inventories
Add accounts payable


2.4 Three sections in cash flow statement

Investment Activities
Shows the cash required for investment activities
Capital Expenditures (i.e. purchases of new property, plant, and
equipment) do not appear immediately as expenses on the income
statement => deduct
Similarly, sales of properties etc are not recognized as income => add

Financing Activities
Shows the cash flows from financing activities
Examples of cash outflows: dividend payments, share repurchases
Examples of cash inflows: increase in borrowing


2.4 Three sections in cash flow statement


Depreciation affects cash flow via 2 channels: net income & operating
activities cash flow.
Pre-tax income falls by 1m tax expense falls by 0.26m net
income falls by 0.74m.
Operating activities cash flow rises by 1m.
Therefore, the net impact is 1m - 0.74m = 0.26m

2.7 Financial Reporting in Practice

Considered as one of the most successful companies in America.
Executives manipulated financial statements to mislead investors.
Example: recording money borrowed as income while hiding the future
obligations to pay it back.

Another record-breaking scandal.
Fraud: reclassify operating expenses as long-term capital expenditures.

Sarbanes-Oxley Act (SOX)


Chapter 19 Valuation and Financial

19.1 Valuation Using Comparables

19.2 The Business Plan

19.3 Building the Financial Model
19.4 Estimating the Cost of Capital
19.5 Valuing the Investment
19.6 Sensitivity Analysis


19.1.1 Valuation Using Comparables

A useful approach to obtain a rough idea of the value
of the firm.
The trick is to find a comparable firm that:
(1) has a fair and observable price; and
(2) is similar to the firm of interest as possible.

Consider Ideko Corporation, a privately held firm.

Assume that we are interested in knowing whether
$150 million is a reasonable price for this firm.


19.1.1 Valuation Using Comparables

Based on the proposed price of $150 million, further
assume that we have obtained the following ratios:
Comparable firms

Problem of using comparables: unreliable for a

precise estimation

19.2 & 19.3 Building the Financial Model

Computation 1:


19.2 & 19.3 Building the Financial Model

Computation 2:


19.2 & 19.3 Building the Financial Model

Computation 3:

Our ultimate mission


19.2 & 19.3 Building the Financial Model

Useful information:
1. Sales = Market Size x Market Share x Average Sales
2. Raw Materials = Market Size x Market Share x Raw
Materials per Unit
3. Direct Labor = Market Size x Market Share x Direct
Labor Cost per Unit
4. S&M = Sales x (S&M % of Sales)
5. Admin = Sales x (Admin % of Sales)


19.2 & 19.3 Building the Financial Model

Computation 1:


19.2 & 19.3 Building the Financial Model

Computation 2


19.2 & 19.3 Building the Financial Model

Computation 3:


19.5 Valuing the Investment

The Multiples Approach to Continuation Value
Practitioners generally estimate a firms continuation
value (also called the terminal value) at the end of
the forecast horizon using a valuation multiple
The EBITDA multiple is the multiple most often used in practice.
Continuation Enterprise Value at Forecast Horizon
EBITDA at Horizon EBITDA Multiple at Horizon


19.5 Valuing the Investment

Based on the information we have so far:

A few notes:

EV/Sales = 292,052 / 158,626 = 1.8

P/E (levered) = 172,052 / 10,545 = 16.3
P/E (unlevered) = 292,052 / 15,849 = 18.4
The estimation seems reasonable, or arguably conservative.

One issue: future multiples of the firm are being

compared with current multiples of its competitors.

Chapter 2: 8, 25
Chapter 19: 1, 5, 9