CORPORATE FINANCE

Financial Analysis
S1
Sebastian Sandoval
Types of Firms
USA
- Sole proprietorships
The most common.
- Partnerships – May be limited
General Partners and Limited Partners • Sociedades en comandita
- Limited Companies
All are limited partners
- Corporation
Anyone can be a shareholder.
Colombia
• Persona natural
• Empresa unipersonal
• Sociedad colectiva
• Sociedad limitada
• Sociedad anónima
• Sociedad por acciones simplificada
• Empresa asociativa de trabajo
Types of Firms
Property Vs Control

Example: Tesla
Financial Management Functions
Investment decisions: Define where to invest such as adopting new projects.
Where to invest resources?
Financing decisions: Define how you are going to pay for those investments.
Sometimes you must look for other sources of money in addition to your
available cash. Where to get the resources?
• Cash handling: Ensure that the firm has enough cash to sustain its day-to-
day operations. Working capital!
• The CEO, like the CFO, must meet the expectations of the firm's owners
(shareholders). What are those expectations?
Some related topics are Benefit Corporation and the Agency Problems.
Stock Markets
Stock Markets
A firm's ownership is divided into units of value called shares.
If the firm is listed on a stock exchange, it is said to have a public equity and its
shares have liquidity.
There are two types of markets:
- Primary market.
- Secondary market.
For an exchange to work, an intermediation mechanism is required that connects
buyers with sellers.
This role is developed by market makers who are the ones who set a Bid price and
an Ask price where they indirectly charge for an intermediation which is called the
bid-ask spread.
Assessing a company’s financial health
Financial statements are the primary tool for evaluating different elements of a
company. Each accounting report gives us different clues about the state of the
company.
- Balance Sheet: Report what the firm has and where the money came from to
get it.
- Income Statement: Reports what the firm generated in income during a
period of time.
- Cash flow: Report where the money comes from and where it ends up going.
Example: Ecopetrol
They must follow accounting and reporting standards (GAAP, IFRS).
Balance Sheet
Market Value Vs Book Value
• Market value of equity

• Equity book value

• Firm value
Market Value Vs Book Value
The book value of equity is not equal to that of the market mainly because
the valuation of intangible assets is not incorporated, for example:
- Some assets are recorded in the financial statements in a different way than
the market such as the real estate market.
- It does not incorporate the expectations of the firm's future plans or assets
that are difficult to quantify as the quality of the staff.
The value of the company (EV) seeks to quantify how much the entire
company is worth, not just what the shareholders own.
Income
Statement
Net Income is not Cash
The income statement generates a report of accounts according to the
responsibilities that the firm has assumed, but it does not discriminate which
ones reflect effective movements of money.
Example of this:
- Depreciation and amortization.
- Capital purchases are not reported, such as the purchase of a building.
- Some sales may have been made on credit.
- Transactions of the firm to its shareholders like dividend payments.
Cash Flow
Statement
Summary of some
financial ratios
Financial Ratios
With financial statements, two main types of analysis can be performed:
1. Compare the firm with itself by reviewing changes over time.
2. Compare the firm with similar ones using financial ratios.
The idea is to evaluate the performance of the firm (vertical analysis) and its
evolution over time (horizontal analysis).
Financial ratios:
- Liquidity.
- Activity.
- Profitability.
- Market.
Profitability Ratios
They measure the company's performance in relation to its sales, assets and
equity. Of great interest if you want to invest in the firm.
Gross margin: Measures the profitability of the company after sales costs. It
is expressed as a percentage.

The higher the better because it indicates how expensive the firm can sell its
products in relation to its production costs.
Profitability Ratios
Operating margin: Measures the profitability of the company after operating
expenses. It's a measure of productivity. It is expressed as a percentage.

The higher the better because it indicates how much the firm has left after
covering all its production and operating costs.
Margins EBIT
Profitability Ratios
• Net Margin: Measures the profitability of the company after operating
expenses, expenses and non-operating income and after paying taxes. It is
expressed as a percentage.

The higher the better because it indicates that much is left of the sales to its
shareholders.
Profitability Ratios
Return on equity (ROE): Profit generated by the company for each dollar
invested by the partners (owners). It is expressed as a percentage.

The higher the better because it indicates how much the firm is returning to
shareholders based on what they have contributed. Also, It may indicate that it
can have attractive investment opportunities.
Sensitive to the level of leverage. Higher leverage, higher ROE.
This return can be decomposed, revise the DuPont identity.
Profitability Ratios
Return on assets (ROA): Measures the return generated by each dollar
invested in assets.

Since it measures the profitability of the company, this indicator would be

expected to be increasing.
Sensitive to working capital. Less sensitive to leverage than ROE.
Profitability Ratios
Return on investment capital (ROIC): Measures the return generated by
each peso invested after taxes.

Since it measures the profitability of the company, this indicator would be

expected to increase.
It is a widely used and useful profitability indicator since it is not affected by
the company’s leverage.
Profitability Ratios
EBITDA (Earnings Before interest, taxes, depreciation and amortization):
It is one of the most used profitability results. It measures the profitability of
the company's operation without counting depreciation, amortization, how it is
financed, and taxes.

It is expected to increase year by year.

Profitability Ratios
EBITDA margin: Measures operating profitability without discounting
depreciation, amortization and taxes

x100

It is expected to increase year by year.

Having a low EBITDA margin is a red flag, but it depends on the financial
capabilty of the firm.
Liquidity Ratios
They measure the company's ability to meet its short-term obligations. Of
great interest to those who want to lend to the firm.
Working capital (expressed in $):

If , the company has liquidity.

If , the company is illiquid.
It is preferred that it be increased year after year.
Liquidity Ratios
Current Ratio (expressed in times):

If , the company has liquidity.

If , the company is illiquid.
Example: A company with a current ratio of 1.3 in year t and with a current
ratio of 0.8 in year t-1. It is said that the company regained his ability to pay.
The higher it is, the less likely the firm is to have difficulty paying its short-
term obligations.
Liquidity Ratios
Quick Ratio (expressed in times):

There are current assets that are not easily convertible into cash, these are
subtracted from current assets to determine if removing these assets, the
company still can pay in the short term.
Example: The current ratio of a company is 1.2, and its quick ratio (without
inventories) is 0.6.
In the example, if the company could not convert its inventories into cash in
the short term, and was required to pay its short-term debts, the company
would be illiquid.
Liquidity Ratios
Cash ratio (expressed in times):

It is the most demanding liquidity test because it only considers the firm's most
liquid asset, cash.
These ratios don't necessarily measure a firm's ability to generate cash.
 Activity Ratios
They measure the effectiveness of the company to manage its working capital. It
combines information from the Balance Sheet and the Income Statement. Of great
interest for the management.
Accounts Receivable Turnover (expressed in times and days): Determines the speed
at which credit sales turn into cash.

It is preferred that it increases when calculated in times, that is, collect more times in a
year. When calculated in days, it is preferred that it decreases, that is, collect in shorter
periods of time.
Activity Ratios
Inventory Turnover: Identifies the times inventory is converted into money in
a year. It can be expressed in times or days.

It is preferred that it increases when calculated in times, that is, inventory is

sold more times in a year. When calculated in days, it is preferred that it
decreases, that is, to turn inventories to sales in shorter periods of time.
Activity Ratios
Accounts Payable Turnover: Determines the speed at which bills are paid
with providers on credit. It can be expressed in times or days.

It is preferred that it goes down when calculated in times, that is, pay fewer
times in the year. When calculated in days, it is preferred that it increases,
that is, taking longer and longer periods to make payments.
Leverage Ratios
They allow to know the capital structure of the firm, that is, who and how
much they are putting in resources to finance the firm.
Capital structure (debt-to-equity ratio): Measures the ratio of debt to
owners.

0.4 1 1,4
For each dollar of For every dollar For each dollar of
contribution from the contributed by the contribution from the
partners, 0.4 dollars is partners, one dollars is partners, 1.4 dollars is
owed to third parties. owed to third parties. owed to third parties.
Leverage Ratios
Debt-to-Enterprise Value Ratio: Measures the percentage of assets financed
by borrowing.

It cannot be estimated that a rise or fall is good in advance. It depends on the

company’s situation, the cost of debt, the cost of equity, the behavior of the
sector's indebtedness, etc.
Leverage Ratios
Equity-to-Enterprise Value Ratio: Measures the proportion of assets
financed by owners. When added to the debt-to-value ratio the result must be
100%.

It cannot be estimated that a rise or fall is good in advance. It depends on the

company’s situation, the cost of debt, the cost of equity, the behavior of the
sector's indebtedness, etc.
Leverage Ratios
Interest Coverage Ratio: Measures the ability to pay financial costs through
operating income. It is measured in times:

It is estimated that it is better to have interest coverage greater than one.

EBIT/I (less than 1.5 generates concerns, greater than 5 is safe). EBITDA/I can
also be used.
Market Ratios
They are ratios that measure the market value of the company depending on
certain accounting parameters.
Earnings Per Share: Measures the profitability of each share according to the
accounting result.

Because it is a profitability ratio, it is expected to increase.

Razones de Mercado
Price-earnings ratio: Measures how many times investors are willing to pay
for every dollar in profits.

Because it is a profitability ratio, it is expected to increase.

It is sensitive to leverage, so it is used more to compare firms within the same
industry and leverage.
It is also known as the Market-to-Book Ratio. It allows a classification of
stocks between value stocks (<1) and growth stocks (>1).
DuPont Analysis
The ROE rate of return can be broken down to better understand the origin of
shareholder profitability as follows:

Decomposition:
Net margin: Measures the profits generated to shareholders.
Asset turnover: Measures the ability of assets to generate sales.
Equity multiplier: Measures what asset value corresponds to each dollar in
equity. The higher, the more leveraged the firm.