UNDERSTANDING

FINANCIAL
STATEMENTS AND
FCF
CALCULATION

Presentation subtitle

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LESSONS GUIDEPOST

Understanding FS/Financial
Analysis

Valuation/

Financing Decision

Brigham and Ehrhardt, p.64

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 OBJECTIVES
 The stream of cash flows a firm is expected to
generate in the future determines its
fundamental value (also called intrinsic value).
 But how does an investor go about estimating
future cash flows, and how does a manager
decide which actions are most likely to increase
cash flows?
 Our first task is to understand the financial
statements, how to interpret them and how to
use them to assess firm’s performance and risks.
 Then we will focus on FCF, how it is
calculated based on the financial statements and
its meaning as it related to shareholder value

Note: Texts/tables/examples used in this ppt are the from

textbooks listed in Syllabus

TEACH A COURSE 3
 1 2 3 4 5
Balance sheet Income Cash Flow FCF Ratio Analysis
Statement Statement Calculation

OUTLINE

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IMPORTANCE OF FINANCIAL STATEMENTS ANALYSIS

 The financial statements (FS) report what actually happened net income relate to cash flows. Recall finance principle that
to assets, earnings, dividends, and cash flows during the past cash flows are the source of value. Firms can earn positive
few years. It is accompanied by a Management Discussions accounting earnings while hemorrhaging cash, and can have
section that explains why things happened the way they did. positive cash flow while reporting accounting losses. (see
 Understanding the financial health of a business by Titman p.40 for discussion)
reviewing its FS is important to the financial manager whose  Alternatively, one may take the perspective of a financial
goal is to determine how to increase the value of the firm. analyst who wants to know the firm’s financial performance
 Analyzing FS can help managers carry out three important in order to better make investment decisions. Should we buy
the stock of this company? Should we invest in the bond
tasks:
issued by this company – can it pay back principal at
 assess current performance and financial condition of the maturity?
firm as well as the risks
 monitor and control operations (e.g., to ascertain if debt
levels are within limits, comparison of costs vs. pricing)
 plan and forecast future expected value to be created
 A finance manager needs to understand how accounting’s

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 BALANCE SHEET
 represents a snapshot of the firm’s financial position as of
the report date (quartertly, annual)
 Parts:

Assets – things which the company owns, listed in order

of liquidity, or length of time it typically takes to convert
them to cash at fair market values
Liabilities - claims that various groups have against the
company’s value, listed in the order in which they must
be paid. Suppliers have claims called accounts payable
due within 30 days, banks have claims called notes
payable due within 90 days, and bondholders may have
claims that are not due for 20 years or more.
Stockholders’ equity - ownership;
 figures - are in book values since they are based on the
amounts recorded by bookkeepers when assets were
purchased or when liabilities were issued
 Rule: Assets = Total Liabilities + Equity

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Brigham & Ehrhardt
 INCOME STATEMENT
 shows a snapshot of a firm ‘s financial performance during a period
(e.g. for the year ending 2019)
Components:

Net sales - revenues less any discounts or returns

Cost of goods sold (COGS) - labor, raw materials, and other expenses
directly related to production in that period.
Depreciation and amortization - reflect the estimated costs of the
tangible assets that wear out in producing goods and services;
amortization refers to costs of intangible assets. If a company acquires
another company but pays more than the tangible assets, then the
difference is called goodwill. Intangible assets include patents,
copyrights, trademarks, and similar items.
Earnings before interest and taxes (EBIT) - earnings after subtracting
COGS, depreciation and other operating expenses
Net income – earnings after subtracting interest expense, tax,
preferred dividends
Brigham & Ehrhardt
Earnings per share (EPS) - net income divided by the number of shares
outstanding 7
 CASH FLOW STATEMENT

Is the firm generating enough cash to purchase additional

assets required for growth?
Is the firm generating any extra cash it can use to repay
debt or to invest in new products?
Net income is not a cash flow!

 The statement of cash flows shows the sources and uses of

cash

Parts: cash flows from operating, investing, and financing and the
ending cash balance
Operating Activities:
 Net income is adjusted to account for working capital movements
and noncash items since not all revenues and expenses in the income
statement are received or paid in cash. Depreciation is reported as
an expense but is not a cash flow; the cash flow occurred when the
asset was purchased.
Brigham & Ehrhardt
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 CASH FLOW STATEMENT

Adjustments in working capital:

increases in current assets other than cash (such as inventories and

accounts receivable) decrease cash, while decreases in these
accounts increase cash. If inventories increase, then the firm must
use cash to acquire such.
increases in current liabilities increase cash while decreases on
current liabilities decrease cash. If payables decrease, this means cash
was used to pay off its suppliers.
Investing Activities

Investing activities include transactions involving fixed assets or short-

term financial investments. If a company buys new IT infrastructure,
its cash goes down at the time of the purchase. On the other hand, if
it sells a building or a Treasury bond, its cash goes up.

Brigham & Ehrhardt

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CASH FLOW STATEMENT

Financing Activities
Financing activities include raising cash by issuing short-term
debt, long-term debt, or stock. Because dividend payments, stock
repurchases, and principal payments on debt reduce a company’s
cash, such transactions are included as negative cash flows.
Cash Balance at the end of the year
When all activities are totaled, MicroDrive’s cash outflows
exceeded cash inflows by $2 million, or -$2 million.
Should MicroDrive’s statement of cash flows worry its managers?
It had $5 billion in sales but generated only $163m from
operations, not enough to cover the $420m spent on fixed assets
and the $67m paid in dividends. Instead, borrowing and selling of
short-term investments were undertaken.
Not a tenable situation. What changes do managers have to
make?
Brigham & Ehrhardt
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 FREE CASH FLOW (FCF)
• the intrinsic value of a firm is determined by the
stream of cash flows that investors expect to
receive now and in the future, generated
through operations. Intrinsic value directly
related to the ability of a firm to generate FCF.
• FCF is the cash flow available for distribution to
all shareholders after all investments to sustain
operations are made.
• a key indicator of a company's financial health
• FCF = net operating profit after taxes minus net
investment in total net operating capital.
• Net operating working capital in Step 2 excludes
items not directly related to operations (short-
term investments and notes payable).
• Rule of thumb: a. if an asset pays interest, then
Brigham & Ehrhardt
it is not an operating asset
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 MICRODRIVE’S FCF)
Step 1
• NOPAT = $400(1 - 0.25) = $300 million
Step 2
• NOWC at end 2019
= Operating current assets - Operating
current liabilities
= (Cash + Accounts receivable +
Inventories) - (Accounts payable + Accruals)
= ($100 + $500 + $1,000) - ($200 + $400)
= $1,000 million
• NOWC at end 2018
= ($102 + $384 + $774) - ($180 + $370)
Brigham & Ehrhardt = $710 million
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 MICRODRIVE’S
FCF)
Step 3
At end 2019, only operating long-term assets was net
plant and equipment, thus,
Total net operating capital = $1,000 + $2,000
= $3,000 million
At end 2018,
Total net operating capital =$710 + $1,780
= $2,490 million
Step 4
Net investment in operating capital =$3,000-$2,490
= $510 million
FCF = $300 - ($3,000 - $2,490)
= $300 - $510
Brigham & Ehrhardt
= -$210 million
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FCF AND SHAREHOLDER VALUE/WEALTH

FCF and Shareholder Value

Good Uses for FCF
 Remember this basic concept: the
1. Pay off debt fundamental value of a company to its
2. Pay dividend to shareholders shareholders depends on the present
value of its expected future FCFs,
3. Buy back shares discounted at the company’s weighted
4. Buy short term investments average cost of capital (WACC).

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ANALYSIS OF FINANCIAL STATEMENTS

 Fundamental purpose is to determine the firm’s financial condition, value

and performance.
 For firms, the results of analysis are useful inputs to how it might improve
operations, competitive position, future plans and financial projections.
 Who undertakes financial analysis?
• Banks/lenders deciding whether to loan money to the firm
• Suppliers considering whether to grant credit to the firm
• Credit-rating agencies trying to determine the firm’s
creditworthiness
Professional analysts who work for investment companies
• Individual investors deciding whether to invest in the firm

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RATIO ANALYSIS

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PROFITABILITY RATIOS
Q: Has the firm earned adequate returns on its investments?
 Cost control

How well has the firm controlled its cost of goods sold, operating expenses, financing costs, and other expenses relative to each
dollar of sales?
 Efficiency of asset utilization.
How effective is the firm’s management at using the firm’s assets to generate sales?

1. Net Profit Margin (net income/Revenue)

 shows the profit per dollar of sales. It measures how many dollars are left after all expenses have been paid for each
dollar of sales made. The higher the net profit margin, the better.
2. Operating Profit Margin (EBIT/Revenue)
 shows how the operating profit per dollar of sales (before the impact of interest expenses is considered.) It reflects
efficiency of the firm and profitability of the business

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PROFITABILITY RATIOS

3. Return on Assets (Net Income/Total Assets)

 shows how much income is earned from the use of the firm’s assets (resources), how well the firm converts its
investments in assets into profits
4. Return on Equity (Net Income/Common Equity)
 shows shows how much profit each dollar of common stockholders' equity generates; shows how much money is
made based on the investors’ investment in the company
5. Return on Invested Capital (Net Operating Income After Tax/Total Net Operating Capital)
 shows how how effective a company is at turning its operating capital into profits; helps assess whether a company is
creating value with its investments. (Recall: FCF = NOPAT less net Investment in Operating Capital)

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PROFITABILITY RATIOS

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PROFITABILITY RATIOS

2019 2018 Peer

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LIQUIDITY RATIOS

Q: How liquid is the firm? Will

it be able to pay its bill as they
come due?
One way to analyze a firm’s
liquidity is by comparing the
firm’s current assets, which can
be converted quickly and easily
to cash, to the firm’s current
liabilities

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LIQUIDITY RATIOS

Q: How liquid is the firm? Will

it be able to pay its bill as they
come due?
The other way is by examining
the timeliness with which liquid
assets—accounts receivable and
inventory—are converted to
cash.

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LIQUIDITY RATIOS

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DEBT MANAGEMENT RATIOS

Q: How has the firm financed

the purchase of its assets?

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DEBT MANAGEMENT RATIOS

Q: How were assets financed? What is the leverage or gearing of

the company?
1. Debt to Equity Ratio (Total Debt/Shareholders Equity)
 shows how much of the assets was financed by creditors
compared to how much was funded by shareholders equity.
 a debt-to-equity ratio of 2 or 2.5 is generally considered good.
This means that for every dollar invested in the company,
about 66 cents come from debt, while the other 33 cents
come from the company’s equity.
 a high D/E ratio indicates heavy reliance of debt financing and
is viewed as high investment risk

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DEBT MANAGEMENT RATIOS

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 METHODS OF ANALYSIS
1. Percentage change analysis yoy (horizontal analysis)
2. Trend analysis (over a period of time)
3. Vertical analysis
4. Seasonal effects
5. Benchmark (peer comparison, industry average)
6. Look beyond the numbers (ref. Brigham books)
a. To what extent are the company’s revenues tied to one key customer or to one key product? To what extent
does the company rely on a single supplier? Reliance on single customers, products, or suppliers increases risk.
b. What percentage of the company’s business is generated overseas? Companies with a large percentage of
overseas business are exposed to risk of currency exchange volatility and political instability

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METHODS OF ANALYSIS

c. What are the probable actions of current competitors and the likelihood of additional competitors?

d. Do the company’s future prospects depend critically on the success of products currently in the
pipeline or on existing products?
e. How do the legal and regulatory environments affect the company?
7. Analyze according to the stage of the firm in the corporate life cycle

NB. FS are serious documents that are required by SEC and related regulatory bodies to be prepared by
CPAs and being reviewed for compliance with Philippines Financial Reporting Standards, tax laws and
other regulations

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 THE
CORPORATE
LIFE CYCLE*

Slides in this subsection taken from

Aswath Damodaran’s presentations

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