Financial Management

CH02
Determinants of Intrinsic
Value: Calculating FCF
Stockholders come last, for two reasons.
First, their claim represents ownership (or
equity) and need never be “paid off.”
Second, they have a residual claim in the
sense that they may receive payments only
if the other claimants have already been
paid.

The Income Statement

Income statements can cover any period,
but they are usually prepared monthly,
Financial Statements and quarterly, and annually.
reports Unlike the balance sheet, which is a
snapshot of a firm at a point in time, the
The financial statements report what has income statement reflects performance
actually happened to assets, earnings, during the period.
dividends, and cash flows during the past
few years. Subtracting operating costs from net sales
but excluding depreciation and
The annual report presents four basic amortization results in EBITDA, which
financial statements—the balance sheet, stands for earnings before interest, taxes,
the income statement, the statement of depreciation, and amortization.
stockholders’ equity, and the statement
of cash flows. The net income available to common
shareholders, which is revenues less
Balance Sheets expenses, taxes, and preferred dividends is
generally referred to as net income,
The left side of a balance sheet lists assets,
although it is also called profit or
which are the “things” the company owns.
earnings, particularly in the news or
They are listed in order of “liquidity,” or
financial press.
length of time it typically takes to convert
them to cash at fair market values. STATEMENT OF
The right side lists the claims that various STOCKHOLDERS’ EQUITY
groups have against the company’s value,
listed in the order in which they must be Changes in stockholders’ equity during the
paid. accounting period are reported in the
statement of stockholders’ equity.
NET CASH FLOW to pay off its suppliers. Therefore,
increases in current liabilities such
A business’s net cash flow generally differs as accounts payable increase cash,
from its accounting profit because some of whereas decreases in current
the revenues and expenses listed on the liabilities decrease cash.
income statement were not received or 4. Investments. If a company invests
paid in cash during the year. The in fixed assets or short-term
relationship between net cash flow and net financial investments, this will
income is: reduce its cash position. On the
Net cash flow = Net income − Noncash revenues + other hand, if it sells some fixed
Noncash charges assets or short-term investments, this
will increase cash.
STATEMENT OF CASH 5. Security transactions and
FLOWS dividend payments. If a company
issues stock or bonds during the
Even if a company reports a large net year, the funds raised will increase
income during a year, the amount of cash its cash position. On the other hand,
reported on its year-end balance sheet may if the company uses cash to buy
be the same or even lower than its back outstanding stock or to pay off
beginning cash. The reason is that its net debt, or if it pays dividends to its
income can be used in a variety of ways, shareholders, this will reduce cash.
not just kept as cash in the bank.
1. Net income before preferred
dividends. Other things held Each of these five factors is reflected in the
constant, a positive net income will statement of cash flows. The statement
lead to more cash in the bank. separates activities into three categories,
However, as we shall discuss, other plus a summary section, as follows.
things generally are not held 1. Operating activities, which
constant. includes net income, depreciation,
2. Noncash adjustments to net changes in current assets and
income. To calculate cash flow, it is liabilities other than cash, short-term
necessary to adjust net income to investments, and short-term debt.
reflect noncash revenues and 2. Investing activities, which includes
expenses, such as depreciation and investments in or sales of fixed
deferred taxes. assets and short-term financial
3. Changes in working capital. investments.
Increases in current assets other than 3. Financing activities, which includes
cash, decrease cash, whereas raising cash by issuing short-term
decreases in these accounts increase debt, long-term debt, or stock. Also,
cash. On the other hand, if payables because dividend payments, stock
increase then the firm has received repurchases, and principal payments
additional credit from its suppliers, on debt reduce a company’s cash,
which saves cash, but if payables such transactions are included here.
decrease, this means it has used cash
MODIFYING Calculating Free Cash Flow

ACCOUNTING DATA FOR FCF = NOPAT – net investment in

operating capital
MANAGERIAL
Gross investment in operating capital
DECISIONS GIOC = NIOC + depreciation
Net Operating Profit after Taxes (NOPAT) Operation cash flow
Amount of profit a company would Operation cash flow = NOPAT +
generate if it had no debt and held no Depreciation
financial assets. NOPAT is defined as
follows: The uses of FCF
1. Pay interest to debtholders, keeping
in mind that the net cost to the
company is the after-tax interest
expense.
2. Repay debtholders; that is, pay off
some of the debt.
3. Pay dividends to shareholders.
4. Repurchase stock from shareholders.
5. Buy short-term investments or other
nonoperating assets.
The net amount of debt that is repaid is
NOPAT = EBIT (1- Tax Rate)
equal to the amount at the beginning of
the year minus the amount at the end of
the year. This includes notes payable and
long-term debt. If the amount of ending
debt is less than the beginning debt, the
Net Operating Working Capital company paid down some of its debt. But
if the ending debt is greater than the
Operating current assets minus operating beginning debt, the company borrowed
current liabilities. In other words, net additional funds from creditors. In that
operating working capital is the working case, it would be a negative use of FCF.
capital acquired with investor-supplied
funds.
NOWC = Operating current (assets- FCF and Corporate Value
liabilities) The fundamental value of a company to its
Total Net Operating Capital investors depends on the present value of
its expected future FCFs, discounted at the
The sum of NOWC and operating long- company’s weighted average cost of
term assets. capital.
TNOC = NOWC + operating long-term
assets
Evaluating FCF, NOPAT, and Operating THE FEDERAL INCOME
Capital
TAX SYSTEM
One way to determine whether growth is
profitable is by examining the return on The value of any financial asset, as well as
invested capital (ROIC), which is the ratio most real assets such as plants or even
of NOPAT to total operating capital. entire firms, depends on the after-tax
stream of cash flows produced by the asset.
If the ROIC exceeds the rate of return
required by investors, then a negative free Corporate Income Taxes
cash flow caused by high growth is nothing The marginal tax rate is the rate paid on
to worry about. the last dollar of income, while the
ROIC = NOPAT/Operating capital average tax rate is the average rate paid
on all income.
MVA and EVA
Market Value Added and Economic Value
Interest and Dividend Income Received
Added
by a Corporation. Is taxed as ordinary
MVA = Market value of stock − Equity income at regular corporate tax rates.
capital supplied by shareholders However, 70% of the dividends received
by one corporation from another is
= (Shares outstanding) (Stock price) -
excluded from taxable income, while the
Total common equity
remaining 30% is taxed at the ordinary tax
or rate.
MVA= Total market value - Total
investor-supplied capital
Interest and Dividends Paid by a
= (Market value of stock + Market value Corporation.
of debt) - Total investor-supplied capital
A firm’s operations can be financed with
either debt or equity capital. If the firm
uses debt, then it must pay interest on this
EVA = NOPAT – After tax dollar cost of
debt, but if the firm uses equity, then it is
capital used to support operations
expected to pay dividends to the equity
= EBIT (1-Tax rate) – (Total net investors (stockholders). The interest paid
operating capital) (WACC) by a corporation is deducted from its
or operating income to obtain its taxable
income, but dividends paid are not
EVA = (Operating capital) (ROIC – deductible.
WACC)

Corporate Capital Gains.

Corporations’ capital gains are taxed at the
same rates as their operating income.
Corporate Loss Carryback and
Carryforward.
Taxation of Small Businesses: S
Ordinary corporate operating losses can be Corporations
carried back (carryback) to each of the
If a corporation elects S corporation status
preceding 2 years and forward
for tax purposes, then all the business’s
(carryforward) for the next 20 years and
income is reported as personal income by
thus be used to offset taxable income in
its stockholders, on a pro rata basis, and
those years.
thus is taxed at the rates that apply to
individuals.
Improper Accumulation to Avoid This is an important benefit to the owners
Payment of Dividends. of small corporations in which all or most
of the income earned each year will be
Corporations could refrain from paying
distributed as dividends, because then the
dividends and this permit their
income is taxed only once, at the
stockholders to avoid personal income
individual level.
taxes on dividends. To prevent this, the Tax
Code contains an improper accumulation
provision that states that earnings
accumulated by a corporation are subject
to penalty rates if the purpose of the
accumulation is to enable stockholders to
avoid personal income taxes.

Consolidated Corporate Tax Returns.

If a corporation owns 80% or more of
another corporation’s stock, then it can
aggregate income and file one consolidated
tax return; thus, the losses of one company
can be used to offset the profits of another.

CH03

Financial Analysis
When we perform a financial analysis, we
conduct the following steps:
1. Gather Data
2. Examine the Statement of Cash
Flows
 3. Calculate and Examine the Return Evaluating Receivables: The Days Sales
on Invested Capital Outstanding
4. Begin Ratio Analysis
The DSO represents the average length of
Liquidity ratios time that the firm must wait after making a
sale before receiving cash, which is the
Current Ratio average collection period.
Current ratio = current assets/current DSO = Receivables/Average sales per
liabilities day
Current assets normally include cash, or
marketable securities, accounts receivable,
DSO = Receivables/ (Average sales per
and inventories.
year/365)
Current liabilities consist of accounts
payable, short-term notes payable, current
maturities of long-term debt, accrued taxes, Evaluating Fixed Assets: The Fixed Assets
and other accrued expenses. Turnover Ratio
The fixed assets turnover ratio measures
how effectively the firm uses its plant and
Quick Ratio
equipment.
Quick Ratio = (Current Assets –
FATR = Sales/Net fixed assets
Inventories)/Current liabilities

Evaluating Total Assets: The Total Assets

Assets management ratios Turnover Ratio

Asset management ratios measure how Total assets turnover ratio = sales/ total
effectively a firm is managing its assets. assets

If a company has excessive investments in DEBT MANAGEMENT

assets, then its operating capital will be
unduly high, which will reduce its free
RATIOS
cash flow and ultimately its stock price. The extent to which a firm uses debt
financing, or financial leverage, has three
On the other hand, if a company does not
important implications:
have enough assets, then it will lose sales,
which will hurt profitability, free cash flow, 1. By raising funds through debt,
and the stock price. stockholders can maintain control of
a firm without increasing their
Evaluating Inventories: The Inventory
investment.
Turnover Ratio
2. If the firm earns more on
Inventory turnover ratio = investments financed with
sales/inventories borrowed funds than it pays in
interest, then its shareholders’
returns are magnified, or
 “leveraged,” but their risks are also Often it is difficult to estimate the market
magnified. value of liabilities, so many analysts define
3. Creditors look to the equity, or the market debt ratio as
owner-supplied funds, to provide a
Market debt ratio = Total liabilities/
margin of safety, so the higher the
(Total liabilities + Market value of
proportion of funding supplied by
equity)
stockholders, the less risk
creditors face. Times-Interest-Earned Ratio
The ratio of total liabilities to total assets is Also called the interest coverage ratio.
called the debt ratio, or sometimes the total The TIE ratio measures the extent to which
debt ratio. It measures the percentage of operating income can decline before the
funds provided by current liabilities and firm is unable to meet its annual interest
long-term debt: costs. Failure to meet this obligation can
Debt ratio = total liabilities/total assets bring legal action by the firm’s creditors,
possibly resulting in bankruptcy.
Creditors prefer low debt ratios because
the lower the ratio, the greater the cushion TIE ratio = EBIT/ Interest expense
against creditors’ losses in the event of EBITDA Coverage Ratio
liquidation. Stockholders, on the other
hand, may want more leverage because it The EBITDA coverage ratio is most useful
magnifies their return. for relatively short-term lenders such as
banks, which rarely make loans for longer
Some sources report the debt-to-equity than about 5 years.
ratio, defined as:
Over a relatively short period,
Debt-to-equity ratio = Total liabilities/ depreciation-generated funds can be used
(Total assets − Total liabilities) to service debt.
The debt-to-equity ratio and the debt ratio Over a longer time, those funds must be
contain the same information but present reinvested to maintain the plant and
that information slightly differently. equipment.
Debt-to-equity = Debt ratio/ (1 - Debt Therefore, banks and other relatively short-
ratio) term lenders focus on the EBITDA
and coverage ratio, whereas long-term
bondholders focus on the TIE ratio.
Debt ratio = Debt-to-equity/ (1 + Debt-
to-equity) EBITDA coverage ratio = (EBITDA +
Lease payments)/
(Interest + Principal payments + Lease
Sometimes it is useful to express debt
payments)
ratios in terms of market values.
It is easy to calculate the market value of PROFITABILITY RATIOS
equity, which is equal to the stock price Profitability is the net result of a number of
multiplied by the number of shares. policies and decisions.
 ROA = Net income available to common
stockholders/Total assets
Net Profit Margin
Return on Common Equity
Also called the profit margin on sales.
The ratio of net income to common equity
Net profit margin = Net income
measures the return on common equity
available to common stockholders/Sales
(ROE):
Instead of just comparing net income to
ROE = Net income available to common
sales, many analysts also break the income
stockholders/Common equity
statement into smaller parts to identify the
sources of a low net profit margin. For MARKET VALUE RATIOS
example, the operating profit margin is
defined as Market value ratios relate a firm’s stock
price to its earnings, cash flow, and book
Operating profit margin = EBIT/Sales
value per share. Market value ratios are a
The operating profit margin identifies how way to measure the value of a company’s
a company is performing with respect to stock relative to that of another company.
its operations before the impact of interest
Price/Earnings Ratio
expenses is considered. Some analysts drill
even deeper by breaking operating costs The price/earnings (P/E) ratio shows how
into their components. For example, the much investors are willing to pay per
gross profit margin is defined as dollar of reported profits.
Gross profit margin = (Sales − Cost of (P/E) ratio = Price per share/Earnings
goods sold)/Sales per share
The gross profit margin identifies the gross Price/earnings ratios are higher for firms
profit per dollar of sales before any other with strong growth prospects, other things
expenses are deducted. held constant, but they are lower for riskier
firms.
Basic Earning Power (BEP) Ratio
Price/Cash Flow Ratio
This ratio shows the raw earning power of
the firm’s assets before the influence of Stock prices depend on a company’s ability
taxes and leverage, and it is useful for to generate cash flows. Consequently,
comparing firms with different tax investors often look at the price/cash flow
situations and different degrees of financial ratio, where cash flow is defined as net
leverage. income plus depreciation and amortization:
BEP ratio = EBIT/Total assets Price/cash flow ratio = Price per
share/Cash flow per share
Return on Total Assets
The price/EBITDA ratio is similar to the
The ratio of net income to total assets
price/cash flow ratio, except the price/
measures the return on total assets (ROA)
EBITDA ratio measures performance
after interest and taxes.
before the impact of interest expenses and
taxes, making it a better measure of
operating performance.
Market/Book Ratio TYING THE RATIOS
The ratio of a stock’s market price to its TOGETHER: THE DU
book value gives another indication of how
investors regard the company. Companies PONT EQUATION
with relatively high rates of return on In ratio analysis, it is sometimes easy to
equity generally sell at higher multiples of miss the forest for all the trees. The Du
book value than those with low returns. Pont equation provides a framework that
Book value per share = Common ties together a firm’s profitability, asset
equity/Shares outstanding efficiency, and use of debt.

M/B = Market price per share/Book ROA = Profit margin × Total assets
value per share turnover
= (Net income/Sales) × (Sales/Total
assets)
To find the return on equity (ROE),
TREND ANALYSIS, multiply the ROA by the equity multiplier,
COMMON SIZE which is the ratio of assets to common
equity:
ANALYSIS, AND
Equity multiplier = Total
PERCENTAGE CHANGE assets/Common equity
ANALYSIS Firms that have a lot of leverage have a
Trends give clues as to whether a firm’s high equity multiplier because the assets
financial condition is likely to improve or are financed with a relatively smaller
deteriorate. amount of equity. Therefore, the return on
equity (ROE) depends on the ROA and the
To do a trend analysis, you examine a use of leverage:
ratio over time.
ROE = ROA × Equity multiplier
In a common size analysis, all income
statement items are divided by sales and all = (Net income/Total assets) × (Total
balance sheet items are divided by total assets/Common equity)
assets.
The advantage of common size analysis is ROE = (Profit margin) (Total assets
that it facilitates comparisons of balance turnover) (Equity multiplier)
sheets and income statements over time
and across companies. = (Net income/Sales) × (Sales/Total
assets) × (Total assets/Common equity)
In percentage change analysis, growth
rates are calculated for all income The insights provided by the Du Pont
statement items and balance sheet accounts model are valuable, and the model can be
relative to a base year. used for “quick and dirty” estimates of the
impact that operating changes have on
returns.
COMPARATIVE RATIOS
AND BENCHMARKING
Ratio analysis involves comparisons. A
company’s ratios are compared with those
of other firms in the same industry—that
is, with industry average figures.
This technique is called benchmarking,
and the companies used for the comparison
are called benchmark companies.
Many companies also benchmark various
parts of their overall operation against top
companies, whether they are in the same
industry or not.

USES AND LIMITATIONS

OF RATIO ANALYSIS
Ratio analysis provides useful information
concerning a company’s operations and
financial condition, but it has limitations
that necessitate care and judgment.
Conducting ratio analysis in a mechanical,
unthinking manner is dangerous, but when
ratio analysis is used intelligently and with
good judgment, it can provide useful
insights into a firm’s operations and
identify the right questions to ask.