Corporate Finance

Lecture: Accounting Review

SHEN Tao （沈涛） Tsinghua University
Outline
1 Firms’ Disclosure of Financial Information
2 The Balance Sheet
3 The Income Statement
4 The Statement of Cash Flows
5 Other Financial Statement Information
6 Financial Statement Analysis
7 Financial Reporting in Practice
 Disclosure of Financial Information
 Financial statements are accounting reports that a firm issues
periodically to describe its past performance.
 Investors, financial analysts, managers, and other interested
parties such as creditors rely on financial statements to obtain
reliable information about a corporation.

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 Financial Statements

 The three main financial statements are

 The balance sheet,
 The income statement,
 The statement of cash flows
 In the United States, the Financial Accounting Standards
Board (FASB) establishes Generally Accepted Accounting
Principles (GAAP) to provide a common set of rules and a
standard format for public companies to use when they prepare their
reports.
 makes it easier to compare the financial results of different firms.
 Investors also need assurance for accuracy.
 Corporations are required to hire a neutral third party, known as
an auditor, to check the annual financial statements, to ensure
that the annual financial statements are reliable and prepared
according to GAAP.
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 The Balance Sheet

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Vodafone Group Plc Consolidated
Statements of Financial Position in £m
 The Balance Sheet

 The balance sheet shows the current financial position (assets,

liabilities, and stockholders’ equity) of the firm at a single
point in time.
 Assets list the firm’s cash, inventory, property, plant and
equipment, and any other investments the company has made.
 Liabilities show the firm’s obligations to its creditors.

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 The Balance Sheet
 Stockholders’ equity is the book value of the firm’s equity.
It is the difference between the firm’s assets and liabilities. It
differs from the market value of the firm’s equity, its market
capitalization, because of the way assets and liabilities are
recorded for accounting purposes.

Assets = Liabilities + Stockholders’ Equity

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 Assets: Current Assets
 Cash and other marketable securities, which are short-term, low-
risk investments that can be easily sold and converted to cash like
government debt that matures within a year.
 Accounts receivable, which are amounts owed to the firm by
customers who have purchased goods or services on credit;
 Inventories, which are composed of raw materials as well as work-in-
progress and finished goods;
 Other current assets, which is a catch-all category that includes
items such as prepaid expenses

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 Assets: Long-Term Assets

 Assets like real estate or machinery that produce tangible

benefits for more than one year.
 Reduce the value recorded for this equipment through a yearly
deduction called depreciation according to a depreciation
schedule that depends on an asset’s life span.
 Goodwill and intangible assets

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 Liabilities: Current Liabilities

 Accounts payable, the amounts owed to suppliers for products

or services purchased with credit.
 Notes payable, loans that must be repaid in the next year. Any
repayment of long-term debt that will occur within the next year
would also be listed here as current maturities of long-term debt
 Accrual items, such as salary or taxes that are owed but have not
yet been paid, and deferred or unearned revenue.

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 Net Working Capital
 The difference between current assets and current liabilities
is the firm’s net working capital, the capital available in
the short term to run the business.
 Firms with low (or negative) net working capital may face a
shortage of funds unless they generate sufficient cash from
their ongoing activities

Net Working Capital = Current Assets – Current Liabilities

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 Liabilities: Long-Term Liabilities
 When a firm needs to raise funds to purchase an asset or
make an investment, it may borrow those funds through a
long-term loan. That loan would appear on the balance sheet
as long-term debt, which is any loan or debt obligation
with a maturity of more than a year.
 Capital leases are long-term lease contracts that obligate
the firm to make regular lease payments in exchange for use
of an asset.
 Deferred taxes are taxes that are owed but have not yet
been paid.

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 Equity
 Book value of equity (or Stockholders’ Equity):
represents the net worth of the firm from an accounting
perspective
 Market capitalization: the total market value of a firm’s
equity.
Market Cap= Price × Number of Shares Outstanding
 Market value does not depend on the historical cost
 Depends on what investors expect those assets to produce in
the future.

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 Book Equity and Market Cap
 Book equity are valued on the historical cost, rather than the
true value today.
 Many of the firm’s valuable assets are not captured on the
balance sheet. (expertise, reputation, brand, etc)
 Book value of equity can be negative (liabilities exceed assets),
and that is not necessarily an indication of poor performance.

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 Balance Sheet Analysis
 Market-to-Book Ratio
Market Value of Equity
Market-to-Book Ratio 
Book Value of Equity
 It is a indicator of potential growth and of manager’s ability
to generate value from the firm’s assets above their historical
cost.
 Firms with low market-to-book ratios are called value firms.
 Firms with high market-to-book ratios are called growth
firms.

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 Balance Sheet Analysis

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 Balance Sheet Analysis
Leverage ratios
 Debt-Equity Ratio: a measure of leverage.

total debt
Book Debt - to - Equity Ratio =
book value of equity
total debt
M arket Debt - to - Equity Ratio =
market value of equity

 A firm’s market debt-equity ratio measures its financial

health, and it has important consequences for the risk and
return of its stock.

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 Balance Sheet Analysis
 The enterprise value of a firm assesses the value of the
underlying business assets, unencumbered by debt and
separate from any cash and marketable securities

Enterprise Value = Market Value of Equity +

Debt – Cash

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 Balance Sheet Analysis
 Example:
In October 2007, H.J. Heinz Co. (HNZ) had a share price of
$46.78, 319.1 million shares outstanding, a market-to-book
ratio of 8.00, a book debt-equity ratio of 2.62, and cash of
$576 million.
1. What was Heinz’s market capitalization?
2. What was its enterprise value?

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 Balance Sheet Analysis
Liquidity ratios
 Current Ratio

Current Assets
Current Ratio =
Current Liabilities
 Quick Ratio
Current Assets- Inventory
Quick Ratio 
Current Liabilitie s
 They measure liquidity of the business, a higher ratio implies less risk
of experiencing a cash shortfall in the near future.

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Book Value vs. Market Value
 Generally Accepted Accounting Principles (GAAP)
generally require that the balance sheet be presented in
largely historical cost terms.
 Finance is interested in the market value of the assets and
liabilities presented on the balance sheet.
 For some items the difference is negligible, yet for others
it can be significant.
 Book Value vs. Market Value
 Book value and market value can lead you to significantly
different conclusions

Book Value Balance Sheet Market Value Balance Sheet

Cash $10 AP $100 Cash $10 AP $98

AR $100 AR $98
Inventory $100 Debt $300 Inventory $90
Debt $290
Plant & Equip $490 Plant & Equip $640
Patents $100
Total Assets $600 Equity $200
MV Equity $550
Total Assets $938
 Income Statement
 The income statement lists the firm’s revenues and
expenses over a period of time. The last or “bottom” line of
the income statement shows the firm’s net income, which
is a measure of its profitability during the period. The
income statement is sometimes called a profit and loss, or
“P&L” statement and the net income is also referred to as
the firm’s earnings.

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 Income Statement

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 Income Statement
 Earnings Per Share: Net income reported on a per-share basis.

Net Income $2.0 million

EPS    $0.556 per share
Shares Outstanding 3.6 million shares

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Income Statement
 Earnings Per Share
 Fully diluted EPS increases number of shares by:
 Stock options issued to employees
 The right to buy a certain number of shares by a specific date at a specific price
 Shares issued due to conversion of convertible bonds
 Convertible bonds are corporate bonds with a provision that gives the
bondholder an option to convert each bond into a fixed number of shares of
common stock
 Income Statement Analysis

 Profitability Ratios

Gross Profit
Gross M argin 
Total Sales
Operating Income
Operating Margin 
Total Sales
Net Income
Net Profit Margin 
Total Sales

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 Income Statement Analysis
 Asset Efficiency

Sales
Asset Turnover 
Total Assets

Sales
Fixed Asset Turnover =
Fixed Assets

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 Income Statement Analysis
 Working Capital Ratios
 Accounts Receivable Days
Accounts Receivable
Accounts Receivable Days 
Average Daily Sales
Measures the firm’s accounts receivable in terms of the number
of days’ worth of sales.
 Accounts Payable Days
 Inventory Days

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 Income Statement Analysis
 Working Capital Ratios
 Inventory Turnover Ratio

Annual cost of Sale

Inventory Turnover 
Inventory
It measures how efficiently we turn our inventory into sale.
 accounts receivable turnover
 accounts payable turnover

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 Income Statement Analysis
 EBITDA: Earning Before Interest, Taxes, Depreciation and
Amortization.

EBITDA  EBIT  DA
Because depreciation and amortization are not cash expenses
for the firm, EBITDA measures cash earned from operations.

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 Income Statement Analysis
 Interest Coverage Ratio

Operating Income
Interest Coverage Ratio 
Interest Expense
Measures how easily the firm will be able to cover its interest
payment.

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 Income Statement Analysis
 Investment Returns

Net Income
Return on Equity 
Book Value of Equity
 Evaluating the firm’s return on investment by comparing its income to
shareholder’s investment

Net Income  Interest Expense

Return on Asset 
Total Asset
 Evaluating the firm’s return on investment by comparing its income to
its assets
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Income Statement Analysis
 Investment Returns
 Return on Invested Capital
 After-tax profit generated by the business, excluding interest, compared
to capital raised that has already been deployed
 Income Statement Analysis
 DuPont Identity

Net Income
Return on Equity 
Book Equity
 Net Income   Sale   Total Assets 
     
 Sale   Total Assets   Total Equity 
 Profit M argin  Asset Turnover  Equity M ultiplier
where equity multiplier is a measure of leverage.

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 Income Statement Analysis
Valuation ratio
 Market-to-book
 P/E Ratio: Price-Earning Ratio. It is a simple measure that is used
to assess whether a stock is over- or under-valued based on the
idea that the value of a stock should be proportional to the level of
earnings it can generate for its shareholders.
Market Capitalization Share Price
P / E Ratio  
Net Income Earnings per Share
 How to measure it?
 Total value and per-share based
 Risk and P/E? Growth and P/E

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Income Statement Analysis
 PEG Ratio
 P/E ratios can vary widely across industries and tend to be
higher for industries with higher growth rates
 One way to capture the idea that a higher P/E ratio can be
justified by higher expected earnings growth
 It is the ratio of the firm’s P/E to its expected earnings growth
rate
 The higher the PEG ratio, the higher the price relative to
growth, so some investors avoid companies with PEG ratios
over 1
Profits vs. Cash Flow
 GAAP requires that you “match” expenses with the corresponding
revenues.
 As a result accruals are recorded when activity is not matched
with the corresponding revenue or expense.
 Benefit - consistency and comparability of income statements
period to period.
 Weakness - Obscures the receipt and disbursement of cash.

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GAAP versus Cash Flow Time Line
Revenue recognized
and
matched expenses

Sale of goods
on credit

Time
Pay Payroll Pay Collect
for checks utilities accounts
raw goods issued receivable

Cash flow Cash flow Cash flow Cash flow

Out Out Out In

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 Profit vs. Cash Flow Example
 Imagine XYZ Corp. makes widgets at a cost of $100 in
year one.
 The widgets are sold on credit for $125 in year two.
 The receivable is paid in year three.
 How does the accounting profit by year differ from the
economic cash flow?

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Further comments
 Accounting
 Past activity at Historical Cost
 Focus on comparability period to period
 Revenue recognition drives Income Statement
 Finance
 Interested in Future Cash Flows
 Focus on Valuation
 Actual timing of Cash Flows drives NPV
 Finance practitioners must understand accounting methods
in order to interpret the impact accounting practices have on
the cash position and future cash flow.
Statement of Cash flows
 The firm’s statement of cash flows utilizes the information from the
income statement and balance sheet to determine how much cash the
firm has generated, and how that cash has been allocated, during a set
period.
 From the perspective of investor, it may be the most important
information of the three financial statements.
 Divided into three sections which roughly correspond to the three
major jobs of the financial manager:
 Operating activities
 Investment activities
 investing activities includes purchasing and selling long-term assets and marketable
securities, as well as making and collecting on loans.
 Financing activities
 issuing and buying back capital stock, as well as borrowing and repaying loans on a
short- or long-term basis (issuing bonds and notes). Dividends paid are also included
in this category
 Statement of Cash flows

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 Statement of Cash flows
 Operating Activity
 Accounts receivable: When a sale is recorded as part of net
income, but the cash has not yet been received from the
customer, we must adjust the cash flows by deducting the
increases in accounts receivable. This increase represents
additional lending by the firm to its customers and it reduces
the cash available to the firm.
 Accounts payable: Similarly, we add increases in accounts
payable. Accounts payable represents borrowing by the firm
from its suppliers. This borrowing increases the cash available to
the firm.

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 Statement of Cash flows
 Operating Activity (cont’d)
 Inventory: Finally, we deduct increases to inventory.
Increases to inventory are not recorded as an expense and do
not contribute to net income (the cost of the goods are only
included in net income when the goods are actually sold).
However, the cost of increasing inventory is a cash expense for
the firm and must be deducted.

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 Statement of Cash flows
 Investment Activity
 Subtract the actual capital expenditure that the firm made.
Similarly, also deduct other assets purchased or investments
made by the firm, such as acquisitions.
 Depreciation: not a cash expense in P&L; Investment: a cash
expense outside P&L
 Financing Activity
 The last section of the statement of cash flows shows the cash
flows from financing activities: cash flows between firm and its
investors.
 Interest expense?

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 Statement of Cash flows
 Retained Earning

Retained Earnings = Net Income–Dividends

Dividends
Payout Ratio =
Net Income

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Financial Reporting in Practice: Enron
 Enron was the most well known of the accounting scandals of
the early 2000s.
 Enron started as an operator of natural-gas pipelines but
evolved into a global trader dealing in a range of products
including gas, oil, electricity, and even broadband Internet
capacity.
 December 2001, Enron to file what was, at the time, the
largest bankruptcy filing in U.S. history. By the end of that
year, the market value of Enron’s shares had fallen by over
$60 billion.
Financial Reporting in Practice: Enron
 Enron executives had been manipulating Enron’s financial
statements to mislead investors and artificially inflate the
price of Enron’s stock and maintain its credit rating. In 2000,
for example, 96% of Enron’s reported earnings were the
result of accounting manipulation.
 sold assets at inflated prices to other firms, together with a
promise to buy back those assets at an even higher future price.
Thus, Enron was effectively borrowing money, receiving cash
today in exchange for a promise to pay more cash in the future.
 recorded the incoming cash as revenue and then hid the
promises to buy them back in a variety of ways.
Financial Reporting in Practice: Dynegy
 The round-trip trades essentially involved the sale of natural
resources to a counterparty, with the repurchase of the
resources from the same party at the same price.
 Dynegy treated the cash from the sale of the asset as an
operating cash flow, but classified the repurchase as an
investing cash outflow.
 The total cash flows of the contracts traded by Dynegy in
these round-trip trades totaled $300 million.
Financial Reporting in Practice:
WorldCom
 Enron’s record as the largest bankruptcy of all time lasted only
until July 21, 2002,when WorldCom, which at its peak had a
market capitalization of $120 billion, filed for bankruptcy.
 the fraud was to reclassify $3.85 billion in operating expenses as
long-term capital expenditures. The immediate impact of this
change was to boost WorldCom’s reported earnings: Operating
expenses are deducted from earnings immediately, whereas capital
expenditures are depreciated slowly over time.
 This manipulation would not boost WorldCom’s cash flows,
because long-term investments must be deducted on the cash flow
statement at the time they are made.
Financial Reporting in Practice:
Adelphia Communications
 the company classified this labor expense as a fixed asset.
While this practice is fairly common in the
telecommunications industry, Adelphia capitalized a higher
percentage of labor than is common.
 The effect of this classification was that the labor was treated
as an investment cash flow, which increased the operating
cash flow.
Accounting Fraud: summary
 Enron and Dynegy : boosts operating cash inflow by financing,
and hides the financing activity (repayment as new
investment, or hundreds SPEs)
 WorldCom and Adelphia Communications:
 Capitalize expense
 investment cash outflow boosts operating cash inflow
 Revenue is easy to manipulate, while cash flow is not (at least
the overall).
 Detect suspicious revenue
 Investors care about operating cash flows
Statement of Cash flows
 the statement of cash flow can be presented by means of two ways:
 The indirect method
 The direct method
 The indirect method is preferred: shows a reconciliation from
reported net income to cash provided by operations.
 Steps for calculating the cash flow from operations using the
indirect method:
 Start with net income.
 Add back non-cash expenses. (Such as depreciation and amortization)
 Adjust for gains and losses on sales on assets.
 Add back losses
 Subtract out gains
 Account for changes in all current assets and liabilities except notes
payable and dividends payable.
Statement of Cash flows: indirect
method
 In general, candidates should utilize the following rules
 Increase in assets = use of cash (-)
 Decrease in assets = source of cash (+)
 Increase in liability or capital = source of cash (+)
 Decrease in liability or capital = use of cash (-)
Statement of Cash flows: direct
method
 The Direct Method presents cash flows from activities through a
summary of cash outflows and inflows. However, this is not the
method preferred by most firms as it requires more information
to prepare.
 Cash Flow from Operations
 Cash collections: the principle cash inflow component of CFO
 = Sales + Decrease (or - increase) in Accounts Receivable
 Cash payment: the principle cash outflow component in CFO
 = cost of goods sold + increase (or - decrease) in inventory + decrease (or -
increase) in accounts payable
 Cash payments for operating expenses = operating expenses + increase (or -
decrease) in prepaid expenses + decrease (or - increase) in accrued liabilities
 Cash interest = interest expense - increase (or + decrease) interest payable
 Cash payments for income taxes
= income taxes + decrease (or - increase) in income taxes payable
Statement of Cash flows
 Cash flow from investing and financing are
computed the same way it was calculated under the
indirect method.
 Though the methods used differ, the results are
always the same.
Considerations When Using Financial
Ratios
 What aspect of the firm or its operations are we attempting to analyze?
 Firm performance can be measured along “dimensions”

 What goes into a particular ratio?

 Historical cost? Market values? Accounting conventions?

 What is the unit of measurement?

 Dollars? Days? Turns?

 What would a desirable ratio value be? What is the benchmark?

 Time-series analysis? Cross-sectional analysis?

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Cautions About Using Financial Ratios

 Ratio Analysis may point the analyst in the right direction, but it does not
provide the answers.

 The better question for the analyst

 Not “what are” the ratios, but “why” are these the ratios?
 Are the ratios consistent with the company’s story?

 Bottom Line – Ratio analysis leads to questions not answers.

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Cautions About Using Financial Ratios
 Difficult to establish appropriate benchmarks
 By Industry?
 By Size?
 Inconsistency In Accounting Procedures
 Significant differences in inventories, securities, etc.
 Seasonality
 Inconsistent reporting periods
 Operational differences
 Different strategies (low cost, high quality, …)
 Growth rates
 Financing strategies

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Ratio Analysis
 The purpose of Financial Statement Analysis is to understand how
changes in the operations of the firm and the external environment
effect financial success of the firm.
 Ratio Analysis is not Financial Analysis
 Ratios help us compare periods or firms, but merely lead us to
questions not answers.
 Ratios can be used to identify trends and changes in the firm, which
leads to questions about the cause of the trends and their likely
persistence.
 Ratios can be used to check the reasonableness of our financial
projections.
 Getting to Cashflow
 Finance practitioners must understand accounting methods
in order to interpret the impact accounting practices have on
the cash position and future cashflow.

 To value the future activity a a firm you will often be

required to forecast the future cashflows that a firm’s
projects will generate.