Fincancial statements and measures

Since the wealth of the shareholders depends on the investment decisions the firm makes, financial managers need to take into account for example how those investments are profitable when compared to the company’s cost of capital. However, in the previous lectures we also showed how the wealth of the shareholders depends on the financing decisions the firm makes. Financial managers need this time to take into account whether the funds already available are sufficient and, if not, how can the company get the additional funds in the way that most suites the company.

THE FINANCIAL STATEMENT AND ITS COMPONENTS

When a company prepares annual financial statements, it files them to the Securities and Exchange Commision (SEC) with the code 10-K. Conversely, if the company prepares financial statements quarterly they are filed as 10-Q. While you are reading a financial statement, you need to remember that each company prepares its own and that the accountants of each company enjoy some freedom when preparing them. This means that, for example, that they can choose the depreciation method. Financial statements are composed by two parts: the balance sheet and the income statement.

WHAT IS THE BALANCE SHEET

A balance sheet is a document providing a view of the assets that the company possesses at the end of the period and from where the company got the money to acquire them. A balance sheet presents the data from the present and the previous year. In the left part of the balance sheet are listed the assets of the company listed from the most liquid ones like cash to the ones that require more time to be transformed in liquidity. Assets that can be easily turned into liquidity are: account receivables or marketable securities or inventories. Conversely, assets which are harder to be turned in liquidity are long term ones like plants or machinery. It is important to stress that in the balance sheet everything is reported in book and not in market values. This means that assets are not registered as how much they really cost today according to market values but are registered according to their original cost minus the depreciation costs estimated by the accountant. A balance sheet includes only the tangible assets while all the intangible ones like the brand name, the human resources and reputation are not considered in it. The right part of the balance sheet gives the reader information about which sources of capital the firm has employed to finance its activities. The liabilities comprehend all the money the company owes to other agents. The first liabilities to be listed are the ones which will be paid back in a short period of time. Those liabilities are called current liabilities. Example of current liabilities are the account payables the firm owes to its suppliers. The net working capital or net current assets is simply the difference between current assets and current liabilities. The part of the balance sheet below them refers to all the sources of money that are generally related to the acquisition of fixed assets and components of the net working capital. The items included in this category are for example long term bonds. In the lowest part are indicated the amounts related to equity. In the equity are listed the money coming from the acquisition of the firm’s share by investors and from the revenues from the retained earnings of previous years.

WHAT IS THE INCOME STATEMENT

An income statement is a document showing how much the company has been profitable over the last period. It takes into account a lot of factors other than simple revenues and costs. Examples of those factors are indirect expenses like depreciation, interest expenses, taxes dividends and also the part of the profits that the company keeps as retained earnings.

HOW TO MEASURE PERFORMANCE

The market capitalization of a firm is defined as the number of shares of that firm available on the market times their price. The book value presented in the financial statement indicates how much shareholders invested in the company. The difference between the market value of those shares and how much the shareholders contributed in the beginning is called the market value added. If the firm increased the value of the shares the market value added is positive while if the shares of the firm lost value the market value added is negative. If you want to calculate how much value the firm has added to shares per dollar invested by the shareholders you can calculate the market to book ratio:

You can in this way calculate how much the firm has multiplied the investments of its shareholders. Remember however that the market values of the company’s stocks are based on the expectations of investors about the future performance of the firm. Furthermore, the market is constantly fluctuating making it impossible to understand really how the firm is performing by only looking at the market values. Obviously you can not calculate this ratio when considering companies that are not publicly traded.

NEVER FORGET THE OPPORTUNITY COSTS

Accountant take into account various kind of costs but they never consider the cost of capital because it is not a real cash-out for the company. The cost of capital is rate of return demanded by investors and it is equal in a perfect market to the rate of return they would get by investing independently in the market. Investors are happy with the firm performance only if it is at least equal to market returns. The profit that takes into account also he cost of capital is called the economic value added (EVA). The sum of all the company’s long term debt and equity is called total capitalization. If the firm achieves a return higher than the one demanded by investors, the EVA is positive. The formula to calculate the EVA is the following:

EVA = (after tax interest + net income) – (cost of capital x capital)

Or equivalently:

EVA = (return on capital – cost of capital) x total capital

The return on capital (ROC) is defined as the amount of money the firm has earned with respect to the capital that both bond and stock holders gave to the firm. The ROC is calculated as follows:

OTHER RATES

In general, if a manager has a large number of assets, it will be able to generate a high economic value added for its security holders. When comparing managers administrating a different number of assets, it is better to use the return per dollar of investment than using the EVA. We will consider three ratios: the return on capital (ROC), the return on equity (ROE) and the return on assets (ROA). Because all of those ratios are computed using accounting information, they are called book rates of return. We already introduced the ROC, so let’s start with the return on equity. The ROE is simply a measure of how many dollars the firm has earned per dollar invested.

The return on assets (ROA) instead is considering the income of the firm compared to the total assets the firm possesses. Remember that total assets (liabilities + equity) are greater than the firm’s capital because capital does not include liabilities.

TURNOVERS

The asset turnover ratio, also called sales to asset ratio, is a measure of how many dollars of sales have been generated per dollar of assets. So we can think of it as a measure for the assets’ productivity.

If you want to be more precise you should compute it using the average value of assets the firm possessed during last period.

The inventory turnover is a measure of how the sales of the company during last period compare with the inventories possessed by the firm.

Firms generally get rid of inventories as soon as possible. So you can calculate which is the time the firm needs to get completely rid of them. This measure is called the inventory period and it is computed as follows:

The money the firm has to receive from customers or other third parties are called receivables and you can measure how the firm’s sales compare with the receivable it had when the period started. This ratio is called receivables turnover and you an calculate it using the following formula:

A high receivables turnover ratio is an indication of an efficient payment system, while a low ratio indicates that the firm is delaying the money it should receive. As we did with the inventories we can calculate the time needed for customers to pay the firm using the account receivable period:

RETURN ON ASSETS ACCORDING TO THE DU PONT SYSTEM

When measuring if a company is successful, we can compute the proportion of sales that represent the real profits of the firm. We can calculate that using the profit margin:

If we want to adjust this measure by taking into account the debt employed by the firm, we can do so by modifying the formula in:

According to Du Pont the returns on assets depend on how many sales the company generates considering its assets (which is the asset turnover) and the profits earned per dollars of sales (which is the operating profit margin). The following formula is therefore called the Du Pont Method:

Thanks to this formula we can identify the constraints of a firm: businesses like fast foods have high levels of assets turnovers but low profit margins while luxury restaurants have high profit margins but low asset turnovers. The formula explains also why, when firms try to improve their return on assets by acquiring supplier do not succeed. Acquiring a supplier gives the firm higher profit margins but, at the same time, because the assets of the firm increased, the asset turnover decreases thus leaving the return on assets unchanged.