|Working with Financial Statements||3|
THE PRICE OF A SHARE OF COMMON STOCK in cereal maker General Mills closed at about $49 on January 8, 2014. At that price, General Mills had a price–earnings (PE) ratio of 18. That is, investors were willing to pay $18 for every dollar in income earned by General Mills. At the same time, investors were willing to pay $105, $31, and $11 for each dollar earned by Adobe Systems, Google, and Ford, respectively. At the other extreme were Blackberry and Twitter. Both had negative earnings for the previous year, yet Blackberry was priced at about $9 per share and Twitter at about $59 per share. Because they had negative earnings, their PE ratios would have been negative, so they were not reported. At the time, the typical stock in the S&P 500 index of large company stocks was trading at a PE of about 16, or about 16 times earnings, as they say on Wall Street.
Price-to-earnings comparisons are examples of the use of financial ratios. As we will see in this chapter, there are a wide variety of financial ratios, all designed to summarize specific aspects of a firm’s financial position. In addition to discussing how to analyze financial statements and compute financial ratios, we will have quite a bit to say about who uses this information and why.
For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com.
After studying this chapter, you should understand:
|LO1||How to standardize financial statements for comparison purposes.|
|LO2||How to compute and, more importantly, interpret some common ratios.|
|LO3||The determinants of a firm’s profitability.|
|LO4||Some of the problems and pitfalls in financial statement analysis.|
In Chapter 2, we discussed some of the essential concepts of financial statements and cash flow. Part 2, this chapter and the next, continues where our earlier discussion left off. Our goal here is to expand your understanding of the uses (and abuses) of financial statement information.
Financial statement information will crop up in various places in the remainder of our book. Part 2 is not essential for understanding this material, but it will help give you an overall perspective on the role of financial statement information in corporate finance.
A good working knowledge of financial statements is desirable simply because such statements, and numbers derived from those statements, are the primary means of communicating financial information both within the firm and outside the firm. In short, much of the language of corporate finance is rooted in the ideas we discuss in this chapter.
Page 50Furthermore, as we will see, there are many different ways of using financial statement information and many different types of users. This diversity reflects the fact that financial statement information plays an important part in many types of decisions.
In the best of all worlds, the financial manager has full market value information about all of the firm’s assets. This will rarely (if ever) happen. So, the reason we rely on accounting figures for much of our financial information is that we are almost always unable to obtain all (or even part) of the market information we want. The only meaningful yardstick for evaluating business decisions is whether they create economic value (see Chapter 1). However, in many important situations, it will not be possible to make this judgment directly because we can’t see the market value effects of decisions.
We recognize that accounting numbers are often just pale reflections of economic reality, but they are frequently the best available information. For privately held corporations, notfor-profit businesses, and smaller firms, for example, very little direct market value information exists at all. The accountant’s reporting function is crucial in these circumstances.
Clearly, one important goal of the accountant is to report financial information to the user in a form useful for decision making. Ironically, the information frequently does not come to the user in such a form. In other words, financial statements don’t come with a user’s guide. This chapter and the next are first steps in filling this gap.
3.1 Cash Flow and Financial Statements: A Closer Look
At the most fundamental level, firms do two different things: They generate cash and they spend it. Cash is generated by selling a product, an asset, or a security. Selling a security involves either borrowing or selling an equity interest (shares of stock) in the firm. Cash is spent in paying for materials and labor to produce a product and in purchasing assets. Payments to creditors and owners also require the spending of cash.
In Chapter 2, we saw that the cash activities of a firm could be summarized by a simple identity:
Cash flow from assets = Cash flow to creditors + Cash flow to owners
This cash flow identity summarizes the total cash result of all transactions a firm engages in during the year. In this section, we return to the subject of cash flow by taking a closer look at the cash events during the year that lead to these total figures.
SOURCES AND USES OF CASH
Activities that bring in cash are called sources of cash. Activities that involve spending cash are called uses (or applications) of cash. What we need to do is to trace the changes in the firm’s balance sheet to see how the firm obtained and spent its cash during some period.
To get started, consider the balance sheets for the Prufrock Corporation in Table 3.1. Notice that we have calculated the change in each of the items on the balance sheets.
Looking over the balance sheets for Prufrock, we see that quite a few things changed during the year. For example, Prufrock increased its net fixed assets by $149 and its inventory by $29. (Note that, throughout, all figures are in millions of dollars.) Where did the money come from? To answer this and related questions, we need to first identify those changes that used up cash (uses) and those that brought cash in (sources).
A little common sense is useful here. A firm uses cash by either buying assets or making payments. So, loosely speaking, an increase in an asset account means the firm, on a net basis, bought some assets—a use of cash. If an asset account went down, then on a net basis, the firm sold some assets. This would be a net source. Similarly, if a liability account goes down, then the firm has made a net payment—a use of cash.
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sources of cash A firm’s activities that generate cash.
uses of cash A firm’s activities in which cash is spent. Also called applications of cash.
Given this reasoning, there is a simple, albeit mechanical, definition you may find useful. An increase in a left-side (asset) account or a decrease in a right-side (liability or equity) account is a use of cash. Likewise, a decrease in an asset account or an increase in a liability (or equity) account is a source of cash.
Looking again at Prufrock, we see that inventory rose by $29. This is a net use because Prufrock effectively paid out $29 to increase inventories. Accounts payable rose by $32. This is a source of cash because Prufrock effectively has borrowed an additional $32 payable by the end of the year. Notes payable, on the other hand, went down by $35, so Pru-frock effectively paid off $35 worth of short-term debt—a use of cash.
Based on our discussion, we can summarize the sources and uses of cash from the balance sheet as follows:
Company financial information can be found in many places on the Web, including finance.yahoo.com, finance.google.com, and money.msn.com.
The net addition to cash is just the difference between sources and uses, and our $14 result here agrees with the $14 change shown on the balance sheet.
This simple statement tells us much of what happened during the year, but it doesn’t tell the whole story. For example, the increase in retained earnings is net income (a source of funds) less dividends (a use of funds). It would be more enlightening to have these reported separately so we could see the breakdown. Also, we have considered only net fixed asset acquisitions. Total or gross spending would be more interesting to know.
To further trace the flow of cash through the firm during the year, we need an income statement. For Prufrock, the results for the year are shown in Table 3.2.
Notice here that the $242 addition to retained earnings we calculated from the balance sheet is just the difference between the net income of $363 and the dividends of $121.
THE STATEMENT OF CASH FLOWS
There is some flexibility in summarizing the sources and uses of cash in the form of a financial statement. However it is presented, the result is called the statement of cash flows.
We present a particular format for this statement in Table 3.3. The basic idea is to group all the changes into three categories: operating activities, financing activities, and investment activities. The exact form differs in detail from one preparer to the next.
Don’t be surprised if you come across different arrangements. The types of information presented will be similar; the exact order can differ. The key thing to remember in this case is that we started out with $84 in cash and ended up with $98, for a net increase of $14. We’re just trying to see what events led to this change.
Going back to Chapter 2, we note that there is a slight conceptual problem here. Interest paid should really go under financing activities, but unfortunately that’s not the way the accounting is handled. The reason, you may recall, is that interest is deducted as an expense when net income is computed. Also, notice that the net purchase of fixed assets was $149. Because Prufrock wrote off $276 worth of assets (the depreciation), it must have actually spent a total of $149 + 276 = $425 on fixed assets.
Once we have this statement, it might seem appropriate to express the change in cash on a per-share basis, much as we did for net income. Ironically, despite the interest we might have in some measure of cash flow per share, standard accounting practice expressly prohibits reporting this information. The reason is that accountants feel that cash flow (or some component of cash flow) is not an alternative to accounting income, so only earnings per share are to be reported.
As shown in Table 3.4, it is sometimes useful to present the same information a bit differently. We will call this the “sources and uses of cash” statement. There is no such statement in financial accounting, but this arrangement resembles one used many years ago. As we will discuss, this form can come in handy, but we emphasize again that it is not the way this information is normally presented.
statement of cash flows A firm’s financial statement that summarizes its sources and uses of cash over a specified period.
Page 53TABLE 3.3
Page 54Now that we have the various cash pieces in place, we can get a good idea of what happened during the year. Prufrock’s major cash outlays were fixed asset acquisitions and cash dividends. It paid for these activities primarily with cash generated from operations.
Prufrock also retired some long-term debt and increased current assets. Finally, current liabilities were not greatly changed, and a relatively small amount of new equity was sold. Altogether, this short sketch captures Prufrock’s major sources and uses of cash for the year.
3.1a What is a source of cash? Give three examples.
3.1b What is a use, or application, of cash? Give three examples.
3.2 Standardized Financial Statements
The next thing we might want to do with Prufrock’s financial statements is compare them to those of other similar companies. We would immediately have a problem, however. It’s almost impossible to directly compare the financial statements for two companies because of differences in size.
For example, Ford and GM are serious rivals in the auto market, but GM is bigger (in terms of market share), so it is difficult to compare them directly. For that matter, it’s difficult even to compare financial statements from different points in time for the same company if the company’s size has changed. The size problem is compounded if we try to compare GM and, say, Toyota. If Toyota’s financial statements are denominated in yen, then we have size and currency differences.
To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements. One common and useful way of doing this is to work with percentages instead of total dollars. In this section, we describe two different ways of standardizing financial statements along these lines.