CPChap 2
CPChap 2
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TCH321
CORPORATE FINANCE
Nguyễn Mạnh Hiệp
2020
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CHAPTER 2
FINANCIAL STATEMENT ANALYSIS
Nguyen Manh Hiep
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In this chapter
• FINANCIAL STATEMENTS AND COMPANY’S
I. ACTIVITIES
• FINANCIAL RATIOS
III
• FINANCIAL FORECASTING
IV
• HOMEWORK
V
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I. FIN. STATEMENTS VS
ACTIVITIES
Production-Investment Cycles
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I. FIN. STATEMENTS VS
ACTIVITIES
Underlying Assumptions in Financial Statements
Accrual accounting: Transaction recorded when
it takes place / incurs, not when the actual cash
payment are made.
Going concern: Company will continue
operations in a foreseeable future.
If cash flows are so important why do people use accrual accounting but not cash-basic
accounting, i.e., recognizing revenues and expenses when there are actual flows of cash?
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I. FIN. STATEMENTS VS
ACTIVITIES
Accrual Accounting
Example: Tuan Bach Corp. sells VND100 million
stationary to Mai Linh Book Store on 30-day
credit. Cost of production is VND70 million. On the
day of delivery Tuan Bach records:
A. Nothing.
B. A 70 mil increase in sales.
C. A 100 mil increase in liabilities.
D. A 70 mil decrease in inventory and 100 mil
increase in receivables.
There’s reasonable assurance ML will pay back 8
I. FIN. STATEMENTS VS
ACTIVITIES
Accrual Accounting
Example: December 15th, 2018 Tuan Bach Inc.
makes a payment of Euro 120k to Mai Linh Estate
to pay for office rent for the year 2019. On the day
of payment Mai Linh records:
A. Nothing.
B. A 120k increase in revenue.
C. A 120k increase in liabilities (unearned revenue)
D. A 120k increase in cash.
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II. FINANCIAL REPORTING
FRAMEWORK
A Set of Financial Statements
Balance Sheet.
Income Statement/Profit and Loss Statement.
Cash Flow Statement.
Notes to the Financial Statements.
Others.
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II. FINANCIAL REPORTING
FRAMEWORK
Qualities of Financial Statements
Relevance (Materiality, Timeliness,…)
Faithful representation (complete, neutral, free
from error)
Comparability.
Verifiability.
Understandability.
(IASB: Conceptual Framework for Financial Reporting 2010)
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II. FINANCIAL REPORTING
FRAMEWORK
Example: History shows that Tuan Bach Co.’s
uncollectable accounts from customers are on
average 2% of sales revenue. Should Tuan Bach
Co. accordingly record an estimated expense
reflecting this potential loss simultaneously when
recording sales revenue?
A. Yes, because this information provide relevant
information and faithfully represents the
economic event.
B. No, because this information is non-verifiable
until a later period. 12
II. FINANCIAL REPORTING
FRAMEWORK
The Elements of Financial Statements
Elements of financial statements:
o Assets, Liabilities, Equity.
o Revenue, Expenses.
An element should be recognized when it is
probable and can be measured with reliability.
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II. FINANCIAL REPORTING
FRAMEWORK
Measurement of Financial Statement Elements
Historical cost.
Amortized cost.
Current cost.
Realizable/Settlement value.
Present value.
Fair value.
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II. FINANCIAL REPORTING
FRAMEWORK
Assets = Liabilities + Equity
Equity = Assets – Liabilities
Assets 1566
Liabilities 1147
Contributed Capital 257
Retained Earnings 162
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II. FINANCIAL REPORTING
FRAMEWORK
The Relationship between BS and IS
1566 = 1147 + 257 + 162
∆Assets = ∆Liabilities + ∆Con. Capital+ ∆Ret. Earn.
Or:
∆Assets = ∆Sources of Capital
Change in use of fund = change in sources of fund
And:
346 = 184 + 162
Net Income = Dividends + ∆ Ret. Earnings. 18
II. FINANCIAL REPORTING
FRAMEWORK
The Relationship between BS and IS
Example: Mai Linh Inc. records an expense related
to research and development. How does this
action affect the balance sheet?
A. Increases assets.
B. Decreases liabilities.
C.Reduce net income.
D.Increases equity.
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II. FINANCIAL REPORTING
FRAMEWORK
Balance Sheet
A statement of financial condition/position at a
point in time.
Used to assess a firm’s liquidity, solvency, and
ability to make distributions to shareholders.
Three elements: assets, liabilities, equity.
Assets Liabilities Stockholders' Equity
Assets and liabilities are classified as current and
non-current.
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II. FINANCIAL REPORTING
FRAMEWORK
The Balance Sheet: An Example
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II. FINANCIAL REPORTING
FRAMEWORK
The Balance Sheet
Example: What would happen to Mai Linh Corp.’s
balance sheet when it tightens sales policy,
specifically, it stops allowing sales on credit?
A.A decrease in receivables.
B. A decrease in payables.
C.An increase in sales revenue.
D.An increase in net income.
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II. FINANCIAL REPORTING
FRAMEWORK
The Balance Sheet
Example: Tuan Bach, CEO of Tuan Bach Corp. has
found an excellent method of inventories
management that will help to coordinate
production and selling process more efficiently
and significantly reduce the levels inventories the
firm must maintain to guarantee smooth operation.
How will this invention affect the balance sheet of
the company?
Reduction in inventory 23
II. FINANCIAL REPORTING
FRAMEWORK
The Balance Sheet
Example: Mai Linh Commercial is a chain of retail
supermarkets. Tuan Bach Corp. is a real estate
company which owns, trades and rents buildings,
offices, apartments, houses… How would you
expect their balance sheet to be different?
ML: More short-term loan, lower inventory, high
inventory cycle, lower receivables
TB: More long-term loan, high inventory cost, low
inventory cycle, higher receivables, high debt level
Business model determines how balance 24
II. FINANCIAL REPORTING
FRAMEWORK
Balance Sheet: Some Notes
WC= CA– CL.
Strictly speaking, WC does not include current
financial assets and liabilities (for instance, excess
cash, short-term debts,…).
Operating (current) liabilities should not be viewed
as parts of firm’s financial activities.
Cash is usually viewed as negative debt. (Although
some economists would not agree. See Acharya et. al (2007), “Is cash a
negative debt? A hedging perspective on corporate financial policies”,
Journal of Financial Intermediation)
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II. FINANCIAL REPORTING
FRAMEWORK
Income Statement
Reports the revenues and expenses of the firm
over a period.
The Income Statement: An example.
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II. FINANCIAL REPORTING
FRAMEWORK
Income Statement: General Format
Revenue
- Cost of goods sold
Gross profit
+ Other recurring income
- Other recurring expense
Income from continuing operations
+/- Other non-recurring income/expense
Income before tax
- Taxes
Net income
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II. FINANCIAL REPORTING
FRAMEWORK
Example: Tuấn Bách Company:
Revenue 4 bil
CoGS 3 bil
Other operating expense 0.5 bil
Interest expense 0.1 bil
Provision for income tax 0.12 bil
Gross profit = ?
Operating income = ?
EBIT = ?
Net income = ? 28
II. FINANCIAL REPORTING
FRAMEWORK
Income Statement
Example: In order to prepare for Tuan Bach Inc.’s share
offerings next year, Tuan Bach, CFO wants to inflate
earnings. The company is installing a new machine which
costs euro 5 million and have economic life of 5 years.
The accounting standards allow Tuan Bach some
discretion in the estimation of assets life. He could:
A. Lengthen the estimate of asset’s life to 7 years, record a
lower depreciation expense each year and record an
impairment loss after 5 years.
B. Shorten the estimate of asset’s life to 3 years, record a
lower depreciation expense each year and write-up the
asset after 5 years.
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II. FINANCIAL REPORTING
FRAMEWORK
Income Statement
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II. FINANCIAL REPORTING
FRAMEWORK
Income Statement
Example: Is higher EPS good or bad?
Does the choice between debt and equity funding
affect EPS?
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II. FINANCIAL REPORTING
FRAMEWORK
Inventory
Recorded at the lower of either cost or fair value.
COGS = Beginning Inventory + Purchases-
Ending Inventory
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II. FINANCIAL REPORTING
FRAMEWORK
Inventory Systems
Periodic inventory system.
Perpetual inventory system (more common).
Valuation Methods
FIFO.
LIFO.
Weighted Average Cost.
Specific Identification.
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II. FINANCIAL REPORTING
FRAMEWORK
Example: 3 units from beginning inventory and 5 units
from Jan 7’s purchase are taken for sales on Jan 15.
Calculate revenue and CoGS in January and ending
inventory on January 31 under Specific Identification,
FIFO, LIFO, and weighted average cost methods in
periodic and perpetual system.
Unit Price Value
Jan 1 (Beginning inventory) 5 $5 $25
Jan 7 purchase 10 $6 $60
Jan 15 sell 8 $9 $72
Jan 22 purchase 6 $7 $42
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II. FINANCIAL REPORTING
FRAMEWORK
Example: Under which method is CoGS (inventory)
the best approximation of current CoGS
(inventory)?
Example: Assuming inflation and stable or
increasing quantities of inventory, compare LIFO
to FIFO with regard to:
Inventory, working capital, non-current assets,
liabilities, equity.
Sales, CoGS, taxes, net income, dividend.
Cash flows.
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II. FINANCIAL REPORTING
FRAMEWORK
Example:
In 2014, An Giang Sao Mai (ASM) issues stock warrants
for employees with exercise price of VND10
thousand. Market price was VND15 thousand per
share.
In 2020 Thien Long (TLG) repurchased 1.5 million
shares at VND30 thousand per share. Few days after,
TLG sold these treasury shares to employees at
VND10 thousand per share.
Do these operations impose any costs/losses to the
company and the shareholders? How do accountants
record these costs/losses? 38
II. FINANCIAL REPORTING
FRAMEWORK
Example: Which of the following statements is most likely incorrect?
A. To operating executives, a company's income statement is interesting
because the income statement measures operating performance or
profitability.
B. To financial executives, when planning for future financing requirements, a
projected balance sheet shows how much external financing will need to be
raised because it forecasts future uses of funds (i.e., assets) and sources of
funds (i.e., liabilities plus equity).
C. As the income statement and balance sheet are prepared under accrual
accounting, financial executives need to prepare cash budgets, which list
projected cash receipts and disbursements over a forecast period for the
purpose of anticipating future cash shortages or surpluses.
D. If a firm has seasonal financing requirements, such as in some seasonal
industries the financial executive should make monthly or quarterly
forecasts rather than annual ones.
E. Receivables and inventory can be used to pay liabilities.
F. Equity can be used to pay liabilities. 39
II. FINANCIAL REPORTING
FRAMEWORK
Cash Flow Statement
Information about a company actual cash inflows
and outflows.
Cash flows are more reliable than earnings
because it is less affected by management
discretion and estimates. (Do you agree?)
Empirical research shows that cash flows
component of earnings are more persistent than
accrual component.
Net Cash Flow = Ending Cash – Beginning Cash.
Net Cash Flow = CFO + CFI + CFF. 40
II. FINANCIAL REPORTING
FRAMEWORK
Cash Flow Statement
Example:
Na Ri Hamico (KSS): Positive earnings 9 years in a
row but Negative CFOs. May 2015: arrest of
CEO, Chairman and Chief Accountant.
Machinco (SMA): Always had positive earnings but
negative cash flows in 2011-2013. Dividend
payment for 2011, 2012 and 2013 was postponed
for years until 2015 (2011’s dividend was
postponed 11 times).
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II. FINANCIAL REPORTING
FRAMEWORK
Cash Flow Statement: An example
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II. FINANCIAL REPORTING
FRAMEWORK
Cash Flow Statement
CFO calculation: direct methods
o Add/Subtract cash receipts and cash payments
from operation, or
o Readjust revenue and cost for:
Non-cash charges or income.
Non-operation cash-flow.
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II. FINANCIAL REPORTING
FRAMEWORK
Cash Flow Statement
CFO indirect calculation: adjust net income (or
income before tax) for
o Non-cash income (-), non-cash charges (+).
o Non-operation income or charges.
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II. FINANCIAL REPORTING
FRAMEWORK
Example: What type of cash flow are these:
A. Repurchase shares CFF
B. Pay interest CFO (VN) / CFF or CFO (IFRS) /
CFO (GAAP)
C. Receive dividend / bond interest CFI (VN) / CFI
or CFO (IFRS) / CFO (GAAP)
D. Provide loan to business partner CFI
E. Pay salary CFO
F. Buy materials on 3-month credit CFO
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G. Convert bonds into stock No change
II. FINANCIAL REPORTING
FRAMEWORK
Example: Predict what happens to Tuan Bach
Corp.’s financial statements in short-term and in
long-term in the following cases.
A. Tuan Bach Corp. makes it easier for customers to
buy on credit. Revenue increases, equity
increases, but CFO doesn’t change cuz no
change in CF from sales. Sometimes, CFO
can decrease cuz over-inventory cost…
B. Tuan Bach Corp. produces too much more
products than it can sell. (higher productivity)
CFO decreases cuz cost of over-inventory,
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fixed cost lower due to economy of scale
II. FINANCIAL REPORTING
FRAMEWORK
Free Cash-Flow to the Firm (FCFF)
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III. RATIO ANALYSIS
Uses of Ratio Analysis
Evaluate a firm’s ability to meet obligations.
Evaluate a firm’s ability to growth.
Assess management’s performance.
III. RATIO ANALYSIS
Limitation of Ratio Analysis
Financial ratios are only useful when compared to
those of other comparable firms or historical ratios.
Companies that operate in multiple industries or
using different accounting standards… are difficult
to compare.
Requires some range of acceptable values rather
than a single target value.
III. RATIO ANALYSIS
Receivables
Tax turnover Interest
coverage
Fixed-assets
Common-size
turnover Debt payment
income statement
coverage…
Common-size
balance sheet
III. RATIO ANALYSIS
Cautions on the use of ROE
Timing problem: Numbers that we use to calculate
ROE and its components are all historical data
Think whether they will reflect the future or not.
Value problem:
III. RATIO ANALYSIS
Liquidity Ratios Current assets
Current ratio =
Current liabilities
Cash + Receivables +
Marketable securities (held to maturity – record at h
, trading secu – recorded at fair value)
Quick ratio =
Current liabilities
Cash
Cash ratio =
Current liabilities
III. RATIO ANALYSIS
Example: Tuan Bach Inc., producer of TubaPhone,
want to hedge the risk of supply constraints that
existed in the past. Tuan Bach maintains high levels
of inventory and entered long-term contracts for
certain components. Now that there is a significant
decrease in demand for TubaPhone, inventory
levels exceed requirements based on new sales
forecasts. Excess inventory is not expected to be
used in the foreseeable future. Tuan Bach, CEO,
decides to record a $3 billion provision for inventory.
How will the recognition of inventory charge affect
the firm’s liquidity ratios?
III. RATIO ANALYSIS
Solvency Ratios
Total debt
Debt-to-equity=
Total equity
Total assets
Financial leverage=
(Equity multiplier) Total equity
III. RATIO ANALYSIS
Interest Coverage Ratios
EBIT
Interest coverage=
Interest payments
EBITDA
Debt Service =
Coverage ratio
Interest Pmt(1-tax)+Principal Pmt
III. RATIO ANALYSIS
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III. RATIO ANALYSIS
Example: Which of the following will most likely
increase total asset turnover?
A. Investment in new PP&E.
B. Share repurchases.
C. Debt repayment.
D. Impairment write-downs of fixed assets.
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III. RATIO ANALYSIS
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IV. FINANCIAL
FORECASTING
Financial forecast and planning can be either for
specialized department/individual project or
company-wide.
For company-wide forecasting, future financial
statements are projected, from which problems are
pointed out. Solving these problem means financial
planning.
Examples of problems: funding needs, trends in
costs, treasury management…
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IV. FINANCIAL
FORECASTING
Forecasting is usually based on Percentage-of-
sales method.
- Forecast sales.
- Determine the financial accounts that vary with
sales using past data.
- Forecast the financial statements.
- Scenario analysis.
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IV. FINANCIAL
FORECASTING
Example: In order to meet the market’s increasing
demand for the current bestseller muscle-building drug,
Tuan Bach Inc. is considering expanding the current
production facility. As a result, fixed assets will increase.
Working capital will also increase to support increased
production and sales. Total increase in assets is
estimated to be VND300 bil. However, liabilities are
forecasted to be unchanged, and equity to increase
VND50bil due to the increase in retained earnings.
How may Tuan Bach solve the shortage in funding?
- By financing activities?
- By operating activities, i.e. free cash flows? 73
V. HOMEWORK
Financial model using Excel: An Example
Read the excel file “Financial model – Training
material.xlsx”.
Note: This file is confidential and intended for the sole
and exclusive and personal use of the intended learner
of this course. Any other use, dissemination,
distribution, copying or storing of the file is strictly
prohibited.
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V. HOMEWORK