CorporateFinanceFifthEditionChapter2IntroductiontoFinancialStatementAnalysisCopyright?2020,2017,2014PearsonEducation,Inc.

AllRightsReservedChapterOutline2.1

Firms’DisclosureofFinancialInformation

2.2TheBalanceSheet2.3

TheIncomeStatement2.4TheStatementofCashFlows2.5

OtherFinancialStatementInformation2.6

FinancialStatementAnalysis2.7

FinancialReportinginPracticeLearningObjectives(1of5)ListthefourmajorfinancialstatementsrequiredbytheS

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Cforpubliclytradedfirms,defineeachofthefourstatements,andexplainwhyeachofthesefinancialstatementsisvaluable.Discussthedifferencebetweenbookvalueofstockholders’equityandmarketvalueofstockholders’equity;explainwhythetwonumbersarealmostneverthesame.LearningObjectives(2of5)Computethefollowingmeasures,anddescribetheirusefulnessinassessingfirmperformance:thedebt-equityratio,theenterprisevalue,earningspershare,operatingmargin,netprofitmargin,accountsreceivabledays,accountspayabledays,inventorydays,interestcoverageratio,returnonequity,returnonassets,price-earningsratio,andmarket-to-bookratio.LearningObjectives(3of5)DiscusstheusesoftheDuPontidentityindisaggregatingR

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E,andassesstheimpactofincreasesanddecreasesinthecomponentsoftheidentityonR

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E.Describetheimportanceofensuringthatvaluationratiosareconsistentwithoneanotherintermsoftheinclusionofdebtinthenumeratorandthedenominator.LearningObjectives(4of5)Distinguishbetweencashflow,asreportedonthestatementofcashflows,andaccrual-basedincome,asreportedontheincomestatement;discusstheimportanceofcashflowstoinvestors,relativetoaccrual-basedincome.Explainwhatisincludedinthemanagementdiscussionandanalysissectionofthefinancialstatementsthatcannotbefoundelsewhereinthefinancialstatements.LearningObjectives(5of5)Explaintheimportanceofthenotestothefinancialstatements.Listanddescribethefinancialscandalsdescribedinthetext,alongwiththenewlegislationdesignedtoreducethattypeoffraud.2.1Firms’DisclosureofFinancialInformationFinancialStatementsFirm-issuedaccountingreportswithpastperformanceinformationFiledwiththeS

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C10QQuarterly10KAnnualMustalsosendanannualreportwithfinancialstatementstoshareholdersPreparationofFinancialStatementsGenerallyAcceptedAccountingPrinciples(G

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P)AuditorNeutralthirdpartythatchecksafirm’sfinancialstatementsTypesofFinancialStatementsBalanceSheetIncomeStatementStatementofCashFlowsStatementofStockholders’Equity2.2BalanceSheet(1of2)Asnapshotintimeofthefirm’sfinancialpositionTheBalanceSheetIdentity:2.2BalanceSheet(2of2)AssetsWhatthecompanyownsLiabilitiesWhatthecompanyowesStockholder’sEquityThedifferencebetweenthevalueofthefirm’sassetsandliabilitiesAssets(1of2)CurrentAssets:CashorexpectedtobeturnedintocashinthenextyearCashMarketableSecuritiesAccountsReceivableInventoriesOtherCurrentAssetsExample:Pre-paidexpensesAssets(2of2)Long-TermAssetsNetProperty,Plant,andEquipmentDepreciation(andAccumulatedDepreciation)

GoodwillandintangibleassetsAmortizationOtherlong-termassetsExample:InvestmentsinLong-TermSecuritiesTable2.1GlobalConglomerateCorporationBalanceSheet

(1of2)Liabilities(1of3)CurrentLiabilities:DuetobepaidwithinthenextyearAccountsPayableShort-TermDebt/NotesPayableCurrentMaturitiesofLong-TermDebtOtherCurrentLiabilitiesTaxesPayableWagesPayableLiabilities(2of3)NetWorkingCapital

Liabilities(3of3)Long-TermLiabilitiesLong-TermDebtCapitalLeasesDeferredTaxesTable2.1GlobalConglomerateCorporationBalanceSheet(2of2)Stockholder’sEquityBookValueofEquity

CouldpossiblybenegativeManyofthefirm’svaluableassetsmaynotbecapturedonthebalancesheetMarketValueVersusBookValue(1of2)MarketValueofEquity(MarketCapitalization)

CannotbenegativeOftendifferssubstantiallyfrombookvalueMarketValueVersusBookValue(2of2)Market-to-BookRatioakaPrice-to-BookRatioValueStocksLowM/BratiosGrowthstocksHighM/BratiosEnterpriseValueakaTotalEnterpriseValue(T

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V)TextbookExample2.1(1of2)MarketVersusBookValueProblemIfGlobalhas3.6millionsharesoutstanding,andthesesharesaretradingforapriceof$14pershare,whatisGlobal’smarketcapitalization?HowdoesthemarketcapitalizationcomparetoGlobal’sbookvalueofequityin2018?TextbookExample2.1(2of2)MarketVersusBookValueSolutionGlobal’smarketcapitalizationisThismarketcapitalizationissignificantlyhigherthanGlobal’sbookvalueofequityof$22.2million.Thus,investorsarewillingtopaytheamountGlobal’ssharesare“worth”accordingtotheirbookvalue.AlternativeExample2.1(1of2)ProblemRylanEnterpriseshas5millionsharesoutstanding.Themarketpricepershareis$108.Thefirm’sbookvalueofequityis$50million.WhatisRylan’smarketcapitalization?WhatisRylan’sMarket-to-Bookratio?AlternativeExample2.1(2of2)SolutionRylan’smarketcapitalizationis$490million

TheMarket-to-Bookratiois2.3IncomeStatementakathe“statementoffinancialperformance”akathe“bottomline”EarningsCalculations(1of6)TotalSales/RevenuesminusCostofSalesequalsGrossProfitEarningsCalculations(2of6)GrossProfitminusOperatingExpensesSelling,General,andAdministrativeExpensesRandDDepreciationandAmortizationequalsOperatingIncomeEarningsCalculations(3of6)OperatingIncomeplus/minusOtherIncome/OtherExpensesequalsEarningsBeforeInterestandTaxes(E

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T)EarningsCalculations(4of6)EarningsBeforeInterestandTaxes(E

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T)plus/minusInterestIncome/InterestExpenseequalsPre-TaxIncomeEarningsCalculations(5of6)Pre-TaxIncomeminusTaxesequalsNetIncomeTable2.2GlobalConglomerateCorporationIncomeStatementSheetEarningsCalculations(6of6)EarningsperShareStockOptionsConvertibleBondsDilutionDilutedE

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S2.4StatementofCashFlows(1of2)NetIncometypicallydoesN

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Tequaltheamountofcashthefirmhasearned.Non-CashExpensesDepreciationandAmortizationUsesofCashNotontheIncomeStatementInvestmentinProperty,Plant,andEquipment2.4StatementofCashFlows(2of2)ThreeSectionsOperatingActivityInvestmentActivityFinancingActivityOperatingActivityAdjustsnetincomebyallnon-cashitemsrelatedtooperatingactivitiesandchangesinnetworkingcapitalDepreciation–addtheamountofdepreciationAccountsReceivable–deducttheincreasesAccountsPayable–addtheincreasesInventories–deducttheincreasesInvestmentActivityCapitalExpendituresBuyingorSellingMarketableSecuritiesFinancingActivityPaymentofDividends

ChangesinBorrowingsTable2.3GlobalConglomerateCorporationStatementofCashFlowsTextbookExample2.2(1of2)TheImpactofDepreciationonCashFlowProblemSupposeGlobalhadanadditional$1milliondepreciationexpensein2018.IfGlobal’staxrateonpretaxincomeis26%,whatwouldbetheimpactofthisexpenseonGlobal’searnings?HowwoulditimpactGlobal’scashbalanceattheendoftheyear?TextbookExample2.2(2of2)SolutionDepreciationisanoperatingexpense,soGlobal’soperatingincome,E

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T,andpretaxincomewouldfallby$1million.ThisdecreaseinpretaxincomewouldreduceGlobal’staxbillbymillion.Therefore,netincomewouldfallbyOnthestatementofcashflows,netincomewouldfallby$0.74million,butwewouldaddbacktheadditionaldepreciationof$1millionbecauseitisnotacashexpense.Thus,cashfromoperatingactivitieswouldrisebyThus,Global’scashbalanceattheendoftheyearwouldincreaseby$0.26million,theamountofthetaxsavingsthatresultedfromtheadditionaldepreciationexpense.AlternativeExample2.2(1of2)ProblemIn2019,RylanEnterprises’netincomeincreasedby$1.5millionwhileitsdepreciationexpensedecreasedby$750,000,accountsreceivableincreasedby$5,000,000andaccountspayableincreasedby$3,000,000.Rylan’stotalcorporatetaxrateis40%.HowdidthedeclineinRylan’sdepreciationexpenseimpactitsend-of-yearcashbalance?AlternativeExample2.2(2of2)SolutionThedecreaseindeprecationexpenseincreasesRylan’spre-taxincomeby$750,000.ThisincreasesRylan’staxobligationby:

Rylanmustpay$300,000moreintaxesduetothedeclineindepreciationexpense.Thus,itsend-of-yearcashbalanceis$300,000lowerasadirectresultofthelowerdepreciationexpense.2.5OtherFinancialStatementInformationSeveralotherpiecesofinformationcontainedinthefinancialstatementswarrantmention:Thestatementofstockholders’equityThemanagementdiscussionandanalysisNotestothefinancialstatementsStatementofStockholders’EquityManagementDiscussionandAnalysisOff-BalanceSheetTransactionsTransactionsorarrangementsthatcanhaveamaterialimpactonthefirm’sfutureperformanceyetdonotappearonthebalancesheetNotestotheFinancialStatementsInadditiontothefourfinancialstatements,companiesprovideextensivenoteswithfurtherdetailsontheinformationprovidedinthestatements.Forexample,thenotesdocumentimportantaccountingassumptionsthatwereusedinpreparingthestatements.TextbookExample2.3(1of2)ProblemIntheSegmentResultssectionofitsfinancialstatements,HormelFoodsCorp(H

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L)reportedthefollowingsalesrevenuesbyreportablesegment/productcategory($million):Blank20172016GroceryProducts$1,761$1,684RefrigeratedFoods4,4044,647Jennie-OTurkeyStore1,6631,741SpecialtyFoods795939InternationalandOther545511Whichcategoryshowedthehighestpercentagegrowth?IfHormelhasthesamepercentagegrowthbycategoryfrom2017to2018,whatwillitstotalrevenuesbein2018?TextbookExample2.3(2of2)SolutionThepercentagegrowthinthesalesofgroceryproductswasSimilarly,growthinRefrigeratedFoodswasJennie-OTurkeyStorewasSpecialtyFoodswasandInternationalandOthercategorieswere6.7%.Thus,InternationalandOthercategoryshowedthehighestgrowth.Ifthesegrowthratescontinueforanotheryear,salesofGroceryProductswillbeandtheothercategorieswillbe$4,173million,$1,589million,$672million,and$581million,respectively,fortotalrevenuesof$8.9billion,a3.4%decreasefrom2017.AlternativeExample2.3(1of4)ProblemApplereportedthefollowingnetsales(inmillions)byoperatingsegment:Blank20182017Americas$112,093$96,600Europe$62,420$54,938GreaterChina$51,942$44,764Japan$21,733$17,733RestofAsiaPacific$17,407$15,199Total$265,595$229,234Whichoperatingsegmenthadthelargestpercentchange?Thelargestdollarchange?AlternativeExample2.3(2of4)SolutionAmericas

Europe

GreaterChina

AlternativeExample2.3(3of4)Solution(continued)Americas

RestofAsiaPacific

Japanhadthelargestpercentchangewitha22.6%increase.AlternativeExample2.3(4of4)Solution(continued)TheAmericashadthelargestdollarchangewitha$15.493billionincrease.Blank20182017ChangeAmericas$112,093$96,600$15,493Europe$62,420$54,938$7,482GreaterChina$51,942$44,764$7,178Japan$21,733$17,733$4,000RestofAsiaPacific$17,407$15,199$2,2082.6FinancialStatementAnalysisUsedto:ComparethefirmwithitselfovertimeComparethefirmtoothersimilarfirmsProfitabilityRatios(1of2)GrossMarginOperatingMarginProfitabilityRatios(2of2)E

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TMarginNetProfitMarginFigure2.1EB

ITMarginsforFiveU.S.AirlinesSource:

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QLiquidityRatiosCurrentRatioQuickRatioCashRatioTextbookExample2.4(1of2)ComputingLiquidityRatiosProblemCalculateGlobal’squickratioandcashratio.Basedonthesemeasures,howhasitsliquiditychangedbetween2017and2018?TextbookExample2.4(2of2)SolutionIn2017,Global’squickratiowasanditscashratiowasIn2018,theseratioswererespectively.Thus,Global’scashratioremainedstableoverthisperiod,whileitsquickratioimprovedslightly.Butalthoughtheseliquiditymeasureshavenotdeteriorated,amoreworrisomeindicatorforinvestorsregardingGlobal’sliquiditymightbeitsongoingnegativecashflowfromoperatingandinvestingactivities,showninthestatementofcashflows.AlternativeExample2.4(1of4)ProblemBasedonthedataonthefollowingslide,calculateRylanCorporation’squickratioandcashratio.Basedonthesemeasures,howhasitsliquiditychangedbetween2017and2018?AlternativeExample2.4(2of4)ProblemBalanceSheetAssets20182017Cash$20,00,000$40,00,000Short-TermInvestments$70,00,000$60,00,000AccountsReceivable$2,00,00,000$1,50,00,000Inventory$2,60,00,000$2,30,00,000OtherCurrentAssets$1,00,00,000$90,00,000TotalCurrentAssets$6,50,00,000$5,70,00,000Long-TermAssets$5,00,00,000$4,50,00,000TotalAssets$11,50,00,000$10,20,00,000AlternativeExample2.4(3of4)BalanceSheetLiabilities20182017AccountsPayable$1,00,00,000$70,00,000Short-TermDebt$2,50,00,000$2,00,00,000TotalCurrentLiabilities$3,50,00,000$2,70,00,000Long-TermDebt$3,00,00,000$3,00,00,000TotalLiabilities$6,50,00,000$5,70,00,000TotalEquity$5,00,00,000$4,50,00,000TotalLiabilitiesandEquity$11,50,00,000$10,20,00,000AlternativeExample2.4(4of4)SolutionQuickRatio2018:2017:CashRatio2018:2017:Usingeithermeasure,Rylan’sliquidityhasdeteriorated.WorkingCapitalRatios(1of2)AccountsReceivableDaysAccountsPayableDaysInventoryDaysWorkingCapitalRatios(2of2)AccountsReceivableTurnoverAccountsPayableTurnoverInventoryTurnoverInterestCoverageRatiosEBIT/InterestEBITDA/Interest

TextbookExample2.5(1of2)ComputingInterestCoverageRatiosProblemAssessGlobal’sabilitytomeetitsinterestobligationsbycalculatinginterestcoverageratiosusingbothEBITandEBITDA.TextbookExample2.5(2of2)SolutionIn2017and2018,Globalhadthefollowinginterestcoverageratios:InthiscaseGlobal’slow—anddeclining—interestcoveragecouldbeasourceofconcernforitscreditors.AlternativeExample2.5(1of2)Problem

AssessRylan’sabilitytomeetitsinterestobligationsbycalculatinginterestcoverageratiosusingbothE

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A.IncomeStatementBlank20182017Revenues$50,00,00,000$45,00,00,000Less:CostofGoodsSold$22,50,00,000$20,00,00,000GrossProfit$27,50,00,000$25,00,00,000Less:OperatingExpenses$15,00,00,000$14,00,00,000EBITDA$12,50,00,000$11,00,00,000Less:Depreciation$2,50,00,000$2,25,00,000EBIT$10,00,00,000$8,75,00,000Less:InterestExpense$1,00,00,000$90,00,000EBT$9,00,00,000$7,85,00,000Less:Taxes(40%)$3,60,00,000$3,14,00,000NetIncome$5,40,00,000$4,71,00,000AlternativeExample2.5(2of2)SolutionE

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/Interest2018:2017:E

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A/Interest2018:2017:Usingeithermeasure,Rylan’sabilitytomeetitsobligationisverygoodandimproving.LeverageRatios(1of2)Debt-EquityRatioDebt-to-CapitalRatioLeverageRatios(2of2)NetDebtTotalDebt+ExcessCashandShort-TermInvestmentsDebt-to-EnterpriseValueEquityMultiplierValuationRatiosP/ERatioEnterpriseValuetoE

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TEnterpriseValuetoSalesTextbookExample2.6(1of3)ComputingProfitabilityandValuationRatiosProblemConsiderthefollowingdataasofFebruary2017forWalmartandTargetCorporation(in$billion):BlankWalmart(WMT)Target(TGT)Sales485.969.5EBIT22.85.0DepreciationandAmortization10.12.3NetIncome13.62.7MarketCapitalization213.237.1Cash6.92.5Debt46.612.7CompareWalmart’sandTarget’sE

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Tmargins,netprofitmargins,P/Eratios,andtheratioofenterprisevaluetosales,E

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A.TextbookExample2.6(2of3)SolutionWalmarthadanE

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TMarginofanetprofitmarginofandaP/EratioofItsenterprisevaluewaswhichhasaratiooftoE

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T,andTextbookExample2.6(3of3)SolutionTargethadanEBITmarginofanetprofitmarginofandaP/EratioofItsenterprisevaluewaswhichhasaratioofE

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T,andNotethatdespitethelargedifferenceinthesizeofthetwofirms,theirvaluationmultiplesarecomparable.Walmarttradesatasomewhathigherearningsmultiple,whereasTargettradesatahighermultipleofsales(likelyduetoitshigherprofitmargin).AlternativeExample2.6(1of2)ProblemUsingthebalancesheetinAlternativeExample2.4andtheincomestatementinAlternativeExample2.5,calculateRylanCorporation’sOperatingMargin,NetProfitMargin,P/ERatio,andEnterpriseValuefor2018.AlternativeExample2.6(2of2)Solution

Recall,Rylan’smarketcapitalizationwaspreviouslycalculatedtobe$490million.

OperatingReturnsReturnonEquityReturnonAssetsReturnonInvestedCapitalTextbookExample2.7

(1of3)ComputingOperatingReturnsProblemAssesshowGlobal’sabilitytouseitsassetseffectivelyhaschangedinthelastyearbycomputingthechangeinitsreturnoninvestedcapital.TextbookExample2.7(2of3)SolutionIn2018,Global’sR

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Ain2017ofTocomputethereturnoninvestedcapital,weneedtocalculateafter-taxE

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T,whichrequiresanestimateofGlobal’staxrate.BecausewecanestimateTextbookExample2.7(3of3)SolutionTocomputeinvestedcapital,notefirstthatGlobal’snetdebtwasin2017andin2018.Thus,R

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Cin2018wascomparedwithin2017.TheimprovementinGlobal’sR

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Cfrom2017to2018suggeststhatGlobalwasabletouseitsassetsmoreeffectivelyandincreaseitsreturnoverthisperiod.AlternativeExample2.7(1of2)ProblemUsingthebalancesheetinAlternativeExample2.4andtheincomestatementinAlternativeExample2.5,assesshowRylan’sabilitytouseitsassetseffectivelyhaschangedinthelastyearbycomputingitsreturnonassetsandreturnoninvestedcapital.AlternativeExample2.7(2of2)SolutionReturnonAssetsR

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Aimprovedalittle,indicatingaslightlymoreefficientuseofitsassets.TheDuPontIdentityExpressestheR

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Eintermsofthefirm’sprofitability,assetefficiency,andleverageTextbookExample2.8(1of3)DeterminantsofR

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EProblemFortheyearendedJanuary2017,Walmart(W

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T)hadsalesof$485.9billion,netincomeof$13.6billion,assetsof$198.8billion,andabookvalueofequityof$77.8billion.Forthesameperiod,Target(T

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T)hadsalesof$69.5billion,netincomeof$2.7billion,totalassetsof$37.4billion,andabookvalueofequityof$11billion.Comparethesefirms’profitability,assetturnover,equitymultipliers,andreturnonequityduringthisperiod.IfTargethadbeenabletomatchWalmart’sassetturnoverduringthisperiod,whatwoulditsR

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Ehavebeen?TextbookExample2.8(2of3)SolutionWalmart’snetprofitmargin(fromExample2.6)waswhichwasbelowTarget’snetprofitmarginofOntheotherhand,Walmartuseditsassetsmoreefficiently,wit