There are three primary financial statements: income statement, balance sheet, and the statement of cash flows. We need all three statements to properly understand and evaluate financial performance. However, the fi- nancial statements provide only limited insight into a company’s perfor- mance and must be combined with key ratios and ultimately an understanding of the company’s market, competitive position, and strategy, before evaluating a company’s current performance and value.
Financial statements are based on generally accepted accounting princi- ples (GAAP). A key objective of financial statements prepared under GAAP is to match revenues and expenses. Two significant conventions arise from this objective: the accrual method of accounting and depreciation. These two conventions are significant in our intended use of financial statements for economic evaluation and valuation purposes, since they result in differ- ences between accounting income and cash flow.
Accrual Accounting
Financial statements record income when earned and expenses when in- curred. For example, the accrual basis of accounting will record sales when the terms of the contract are fulfilled, usually prior to collection of cash.
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Abbreviation P&L EBIT EBIAT EBITDA EP
Sales $100,000 $100,000 $100,000 $100,000 $100,000
Cost of Goods Sold COGS 50,000 50,000 50,000 50,000 50,000
Gross Margin GM 50,000 50,000 50,000 50,000 50,000
% of Sales 50.0% 50.0% 50.0% 50.0% 50.0%
Research & Development R&D 5,000 5,000 5,000 5,000 5,000
Selling, General, & Administrative
Expenses SG&A 15,000 15,000 15,000 15,000 15,000
Depreciation and Amortization D&A 10,000 10,000 10,000 — 10,000
Operating Profit OP 20,000 20,000 20,000 30,000 20,000
% of Sales 20.0% 20.0% 20.0% 30.0% 20.0%
Interest Expense 3,000
Profit Before Tax PBT 17,000
Income Tax 35.0% 5,950 7,000 7,000
Net Income (Profit After Tax) PAT $ 11,050
% 11.1%
Earnings Before Interest and Taxes EBIT $ 20,000
Earnings Before Interest AfterTaxes EBIAT $ 13,000 13,000
Earnings Before Interest, Taxes, EBITDA $ 30,000
Depreciation, and Amortization
Capital Charge 10,000
Economic Profit EP $ 3,000
Similarly, expenses are recorded when service is performed rather than when paid for.
Depreciation
Generally accepted accounting principles require that an expenditure for such things as property, plant, and equipment with long lives be recorded as an asset and depreciated over the expected useful life of the asset. As a result, when a firm spends cash to purchase equipment, it records it as an asset on the balance sheet and depreciates the cost of that asset each year on the income statement.
Income Statement (aka Profit and Loss)
The income statement, or what is frequently referred to as the profit and loss (P&L) statement, is a summary of all transactions completed during the period (year, quarter, etc.). Typical captions and math logic for a basic income statement include:
Sales + $1,000
Cost of goods sold – 500
Gross margin = 500
Operating expenses – 200 Operating income = 300 Income tax expense – 100
Net income = 200
Many different measures, terms, and acronyms are used in practice to describe various elements of the P&L. Table 2.1 illustrates how some of these common measures are determined as well as how they relate to one another.
Following are definitions of some key terms used in Table 2.1:
■ Net income. Residual of income over expense. Sometimes referred to as profit after tax (PAT).
■ Earnings before interest and taxes (EBIT). This measure reflects the income generated by operating activities (generally equals or approxi- mates operating income) before subtracting financing costs (interest) and income tax expense.
■ Earnings before interest after taxes (EBIAT). Also known as net operating profit after taxes (NOPAT) or operating profit after taxes (OPAT), this measure estimates the after-tax operating earnings. It
excludes financing costs but does reflect income tax expense. It is use- ful in comparing and evaluating the operational performance of firms, excluding the impact of financing costs.
■ Earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA adjusts EBIT (operating income) by adding back noncash charges, depreciation, and amortization. This measure is used in valuation and financing decisions, since it approximates cash generated by the operation. It does not reflect capital require- ments such as working capital and expenditures for property and equipment.
■ Economic profit (EP). Economic profit measures, including Economic Value Added (EVATM) developed by Stern Stewart & Company,1sub- tract a capital charge from the earnings to arrive at an economic profit.
The capital charge is computed based on the level of capital employed in the business.
Balance Sheet
The balance sheet is a critical financial report. It is a summary of the com- pany’s assets, liabilities, and owner’s equity and represents a snapshot of all open transactions as of the reporting date. For example, the inventory bal- ance represents all materials delivered to the company, work in process, and finished goods not yet shipped to customers. Accounts payable repre- sents open invoices due vendors that have not been paid as of the balance sheet date.
The balance sheet can be a good indicator of the efficiency of an oper- ation. A firm with a very effective manufacturing process will have lower inventory levels than a similar firm with less effective practices.
The balance sheet is constructed as shown in Table 2.2.
Another way to look at the balance sheet is to reorder the tradi- tional format (Table 2.2) to identify the net operating assets and the sources of capital provided to the organization. This presentation is more useful in understanding the dynamics of the balance sheet. The net operating assets are those assets that are required to operate and support the business. The net operating assets must be funded (or provided to the firm) by investors, either bondholders or shareholders, as illustrated in Table 2.3.
12 CREATING CONTEXT AND COVERING THE BASICS
1EVA is a registered trademark of Stern Stewart & Company.
Statement of Cash Flows
The statement of cash flows (SCF) summarizes the cash generated and uti- lized by the enterprise during the specific period (year, quarter, etc.). Since cash flow will be a focus of our economic valuation and is an important business measure, we will pay particular interest to cash flows in the VPF framework. The statement of cash flows starts with the net income gener- ated by the company over the period, as reported on the income statement.
Since net income is based on various accounting conventions, such as the matching principle, the SCF identifies various adjustments to net in- come to arrive at cash flow. In addition, we also will have to factor in vari- ous cash flow items that are not reflected in net income, such as working capital requirements, dividends, and purchases of equipment.
A simplified format for a statement of cash flows is shown in Table 2.4.
TABLE 2.2 Balance Sheet: Assets = Liabilities + Shareholders’ Equity
Assets Liabilities and Equity
Cash $150 Accounts Payable $100
Receivables 200 Accrued Liabilities 100
Inventories 200 Debt 200
Fixed Assets, Net 50 Total Liabilities 400
Stockholders’ Equity 200
Total Assets $600 Total Liabilities and Equity $600
TABLE 2.3 Net Operating Assets/Invested Capital Illustration
Net Assets Sources of Capital
Cash $150
Receivables 200
Inventories 200
Fixed Assets, Net 50
Debt $200
Total Assets $600
Less Operating Liabilities Shareholders’ Equity 200 Accounts Payable –100
Accrued Liabilities –100
Net Assets $400 Total Invested Capital $400
The three primary financial statements just discussed are interre- lated. Understanding these relationships is critical to evaluating business performance and valuation and is presented in Figure 2.1. For example, net income (or PAT) flows from the income statement to increase share- holders’ equity in the balance sheet. Net income for the period is also the starting point for the statement of cash flows. Other elements on the statement of cash flows are the result of year-to-year changes in vari- ous balance sheet accounts, including capital expenditures, changes in working capital, and reductions or increases in borrowings. Finally, fi-
14 CREATING CONTEXT AND COVERING THE BASICS
TABLE 2.4 Cash Flow Statement
Net Income $200
Depreciation and Amortization 10 (Increase) Decrease in Working Capital –25 Purchases of Property and Equipment –25
Operating Cash Flow $160
Dividends 0
Debt Repayments –60
Cash Flow $100
FIGURE 2.1 Financial Statement Interrelationships
Income Statement Change Cash Flow
Sales $100 Net Income
Gross Margin 500 425 75 +Depreciation
Operating Expenses 200 190 10 –Capital Expenditures – 25 Operating Profit 300 235 65
– 25
Net Income $200 $157 $ 43 Operating Cash Flow 160
Financing – 60
Cash Flow $100
Balance Sheet
Cash $50 $100
Receivables 200 150 50
Ratio Analysis
Inventories 200 150 50
PP&E: Cost 100 75 25
Profitability 20%
PP&E: Accumulated
Depreciation – 50 –40 –10
Total Assets $215 Days Sales Outstanding 73.0
Accounts Payable 100
Asset Turnover 1.67
Accrued Liabilities 100
Debt 200 260 – 60
Return on Assets: Net Income 33%
Equity 200 0 200
Assets Liabilities and Equity $600 $385 $215
Year 2 Year 1 Year 2
$1,000 $900
(Increase) Decrease in Operating Capital
$600
$150
$385
$200 10
25 50 75 50
nancial ratios look at the relationship of various line items both within each financial statement and across all financial statements (e.g., return on assets).