Session 2 –

Financial Statements: from

Accounting to Finance
 IMPORTANT QUESTIONS
Managers, shareholders, creditors and other interested groups
seek answers to the following important questions about a firm:
• What is the financial position of the firm at a given point of
time?
• How has the firm performed financially over a given period of
time?
• What have been the sources and uses of cash over a period of
time?
Determinants of Intrinsic Value: Calculating FCF
Sales revenues
EBIT (1-T)
− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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Balance Sheet
• Snapshots of financial position on the last day of each year(financial
year).
• List out things “What company Own”- Assets AND “What company
Owe”- Liabilities
General Rule of Balance Sheet

A= L+E
 Current and Non-Current Classification
• The Company presents assets and liabilities in the Balance Sheet based on
Current/ Non-Current classification.
• An asset is treated as Current when it is –
- Expected to be realised or intended to be sold or consumed in normal operating cycle;
- Held primarily for the purpose of trading;
- Expected to be realised within twelve months after the reporting period, or
- Cash or cash equivalent unless restricted from being exchanged or used to settle a
liability for at least twelve months after the reporting period.

• All other assets are classified as non-current.

• A liability is current when:
- It is expected to be settled in normal operating cycle;
- It is held primarily for the purpose of trading;
- It is due to be settled within twelve months after the reporting
period, or
- There is no unconditional right to defer the settlement of the
liability for at least twelve months after the reporting period.
• All other liabilities are classified as non-current.
BALANCE SHEET
(Dollars in millions, except per share amount)
Balance Sheet As at 31st March, 2021
(₹ in crore)

RIL
Balance Sheet
As at 31st
March, 2021
Statement of Profit and Loss For the year ended 31st March, 2021
Income Statement or SOPL- 3M
 What is free cash flow (FCF)?
Why is it important?
• FCF is the amount of cash available from operations
for distribution to all investors (including
stockholders and debtholders) after making the
necessary investments to support operations.
• A company’s value depends on the amount of FCF it
can generate.

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 Calculating Free Cash Flow in 5 Easy Steps
Step 1
Earning before interest and taxes
X (1 − Tax rate)
Net operating profit after taxes
Step 5
Net operating profit after taxes
− Net investment in operating capital
Free cash flow
Step 2
Operating current assets
− Operating current liabilities
Net operating working capital
Step 3
Net operating working capital
+ Operating long-term assets
Total net operating capital
Step 4
Total net operating capital this year
− Total net operating capital last year
Net investment in operating capital
Exercise Micro Drive Inc
Compute the following
• NOPAT = net operating profit after tax
• Net operating working capital
• Operating Current Assets
• Operating Current Liabilities
• Computing Total Operating capital
• Computing Free Cash Flow (FCF)
• Uses of Free Cash Flow
What are the five uses of FCF?
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy-back stocks/shares.
5. Buy nonoperating assets (e.g., marketable securities,
investments in other companies, etc.)
What are operating current assets?
• Operating current assets are the CA needed to support operations.
• Op CA include: cash, inventory, receivables.
• Op CA exclude: short-term investments, because these are not a
part of operations.

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What are operating current liabilities?
• Operating current liabilities are the CL resulting as a normal
part of operations.
• Op CL include: accounts payable and accruals.
• Op CL exclude: notes payable, because this is a source of
financing, not a part of operations.

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 Return on Invested Capital (ROIC)

ROIC = NOPAT / operating capital

Reflect on MicroDrive Inc NOPAT and FCF ?

Is negative FCF is always bad?
Compare ROIC with WACC and comment?

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 The firm’s cost of capital is 11%. Did the growth
add value?
• No. The ROIC of 1.16% is less than the WACC of 11%. Investors did not
get the return they require.
• Note: High growth usually causes negative FCF (due to investment in
capital), but that’s ok if ROIC > WACC.

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Issue with Accounting Numbers/ metrics?
• Fails to incorporate Stock prices, even though primary goal is
maximization of firm’s intrinsic stock price.

• So, we need a measure that consider and attempt to compare

intrinsic measure with market measures.
 Market Value Added (MVA)
• Market Value Added is the difference between the market value of stock and
the amount of equity capital supplied by shareholders.
When firm don’t have any Debt

MVA= Market value of the stock- Equity capital

When firm has debt
MVA = Market Value of the Firm - Book Value of the Firm
• Market Value = (# shares of stock)(price per share) + Value of debt
• Book Value = Total common equity including preference capital+ Value of debt
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MVA (Continued)
• If the market value of debt is close to the book value of debt,
then MVA is:

• MVA = Market value of equity – book value of equity

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MVA (Assume market value of debt = book value
of debt.)

2013 MVA = Stock price x # of shares - Total common equity

= $27.00 x 50 - $1,470
= $1,350 - $1,470
2013 MVA = -$120

2012 MVA = Stock price x # of shares - Total common equity

= $40.00 x 50 - $1,300
= $2,000 - $1,300
2012 MVA = $700
Economic Value Added (EVA)
• MVA measures the effects of managerial actions since the inception of
a company, Economic Value Added (EVA) focuses on managerial
effectiveness in a given year.
• Economic Value Added is an estimate of a business’s true economic
profit for the year, and it differs sharply from accounting profit.
• EVA represents the residual income that remains after the cost of all
capital, including equity capital, has been deducted, whereas
accounting profit is determined without imposing a charge for equity
capital.

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• EVA = NOPAT- (WACC)(Total net operating Capital)

WACC= WACC is weighted average cost of capital

NOPAT = EBIT (1-T)
Economic Value Added measures the extent to which the firm has increased
shareholder value.
Therefore, if managers focus on EVA, they will more likely operate in a manner
consistent with maximizing shareholder wealth.
EVA can be determined for divisions as well as for the company as a whole, so it
provides a useful basis for determining managerial performance at all levels
Exercise MicroDrice Inc
• Compute MVA
• Compute EVA and
• Comment on the MicroDrive Inc.
HUL Financial over a Decade!