Financial Statement Analysis and Security Valuation Stephen H. Penman

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

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Financial Statement Analysisand Security Valuation

Stephen H. Penman

Financial Statement Analysisand Security Valuation

Stephen H. Penman

Prepared by

Peter D. Easton and Gregory A. SommersFisher College of Business

The Ohio State University

With contributions by

Stephen H. Penman – Columbia University

Luis Palencia – University of Navarra, IESE Business School

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Part II

The Analysis of

Financial Statements

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Chapter 7The business activities

- Financing

- Investing

- Operating

and the financial statements

Chapter 11The Analysis of Profitability

Layout of Part II

Chapter 8The Statement of Stockholders’ Equity

Chapter 9The Balance Sheet and Income Statement

Chapter 10The Statement of Cash Flows

Operating assets/liabilities

Financing assets/liabilities

Operating income/expense

Financing income/expenseChapter 12The Analysis of Growth and Sustainable Earnings

Part IIPage 208

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Business Activities andFinancial Statements

Chapter 7

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Chapter 7 Page 211What You Will Learn in This Chapter

• How businesses are organized to generate value for shareholders

• The difference between operating and financing aspects of a business

• How business activities are reported in financial statements

• How financial statements are organized to highlight value added

• How business activities articulate and how financial statements articulate

• The four cash flows of a business and how they relate to each other

• Why free cash flow does not affect value added

• How accrual accounting captures value added

• A set of accounting relations that summarize how business activities drive financial statements

• A template for how we will reformulate and articulate the financial statements

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Business Activities:All the Stocks & Flows

• Ch.1 - Firm has 3 activities– Financing– Operating– Investing

• Ch. 2 - Financial Statements record– Stocks– Flows

Product and Input Markets

Customers

Suppliers

The FirmCapital Markets

Debt Holders

or Issuers

Share

Holders

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d


NetFinancial

Assets

(NFA)

Chapter 7 Page 212

Figure 7.1Cash Flows Between the Firm and Claimants in the Capital Market

• F is net cash flow to debt holders (or issuers)

• d is net dividend to shareholders

Share

Holders

Debt Holders

or Issuers

F

Financing Activities

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I

C

Business Activities:ALL THE CASH FLOWS

• C is net cash (flow) from operations

Operating Activities Financing Activities

• I is net cash invested in operating assets

• C-I is “free cash flow”

• If NFA are negative, they are Net Financial Obligations (NFO)

Chapter 7 Page 214

Figure 7.2


Debt Holders

or Issuers

Share

Holders

NetFinancial

Assets

(NFA)

NetOperating

Assets

(NOA)

(NFO)

F

d

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A fundamental accounting identity:

• C = Net cash from operations• I = Net cash outflow for investing (purchases, divestments)• C - I = Free cash flow• d = Net dividends to shareholders (including common dividends, stock

issues...)• F = Net cash outflow for debt financing (principal + interest)

The treasurer’s rule:– If C - I - i > d : lend or buy down own debt– If C - I - i < d : borrow or reduce lending

i is net interest paid

CCEFdIC

Chapter 7 Pages 213-215The Cash Conservation Equation

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Financial Activities:Stocks & Flows

The cash flows flow into/out of the financial assets: their change must be explained by the four flows components of the equation.

For Financial Assets (FA)

For financial obligations (FO)

(it is interest paid)

For given interest payments and net dividends, cash flow from operations (C) reduces borrowing and cash investment (I) increases it

tttt1tt diICFAFA

tttt1tt diICFOFO

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Chapter 7Page 215

Reformulated Statementof Cash Flows

Cash flows from operations C

Cash investment in operations (I)

Free cash flow from operations C - I

Equity financing flows:

Dividends and share repurchases XX

Share issues (XX) d

Debt financing flows:

Net purchase of financial assets XX

Interest on financial assets (XX)

Net issue of debt (XX)

Interest on debt XX F

Total financing flows d + F

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I

C

Business Activities:ALL THE CASH FLOWS

• C is net cash (flow) from operations

• I is net cash invested in operating assets

• C-I is “free cash flow”

• If NFA are negative, they are Net Financial Obligations (NFO)

Chapter 7 Page 214

Figure 7.2


Debt Holders

or Issuers

Share

Holders

NetFinancial

Assets

(NFA)

NetOperating

Assets

(NOA)

(NFO)


F

d

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Chapter 7Page 216Balance Sheet

Assets

Operating assets OA

Financial assets FA

Total Assets OA + FA

Equities

Operating liabilities OL

Financial obligations FO

Common stockholders’ equity CSE

Total Equities OL + FO + CSE

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Chapter 7Page 216Balance Sheet Reformulated

Operating AssetsOperating assets OAOperating liabilities (OL)

Net operating assets NOA

Financial Obligations & Owners’ EquityFinancial liabilities FOFinancial assets (FA)

Net financial obligations NFOCommon equity CSE

Total NFO & Equity NFO + CSENOA = OA - OLNFA = FA - FOCSE = NOA + NFA (Usually NFA is negative: NFO)CSE = NOA - NFO

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• OR is operating revenue

• OE is operating expense

• NFI is net financial income

OR - OE = OI

OR

OE

Chapter 7 Page 218

Figure 7.3

• indicates change

• NFA can be negative (NFO)


OI - NOA = C - IC - I = NFA - NFI + d


Customers

Suppliers

I

C


Debt Holders

or Issuers

Share

Holders

NetFinancial

Assets

(NFA)

NetOperating

Assets

(NOA)

F

d

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• NFI is net financial income

OR - OE = OI

OR

OE

Chapter 7 Page 218

Figure 7.3




OI - NOA = C - IC - I - NFA + NFI = d


Customers

Suppliers

I

C


Debt Holders

or Issuers

Share

Holders

NetFinancial

Assets

(NFA)

NetOperating

Assets

(NOA)

F

d

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• NFE is net financial expense

OR - OE = OI

OR

OE

Chapter 7 Page 218

Figure 7.3




OI - NOA = C - IC - I + NFO - NFE = d


Customers

Suppliers

I

C


Debt Holders

or Issuers

Share

Holders

NetFinancialObligat’ns

(NFO)

NetOperating

Assets

(NOA)

F

d

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Income Statement

The difference between operating revenue and operating expense is called operating income:

OI = OR - OE

Net financing expense can be negative (net financial income)

Chapter 7 Page 217

Income Statement

Operating income

Operating revenue OR

Operating expense (OE) OI

Net financing expense

Interest expense XX

Interest revenue (XX) (NFE)

Comprehensive incomeEarnings

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Business Activities and theFinancial Statements

Chapter 7 Summary

Net Operating Assets Net Financial Obligations

BALANCESHEET

NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt

CSEt = CSEt-1 + OIt - NFEt - dt

INCOMESTATEMENT

earnt = OIt - NFEt

CASH FLOWSTATEMENT

Ct - It = dt + Ft

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Stocks & Flows:Operating Activities

• The change in NFO is given by

• The change in NOA is given by

• Operating income in the income statement flows to net operating assets in the balance sheet.

• Free cash flow reduces NOA and reduces NFO (increases NFA). Free cash flow can be seen as a dividend paid from operating to financial activities

ttt1tt ICOINOANOA

tttt1tt dFENICNFONFO

Chapter 7 Pages 220-221

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Tying it Together:What Generates Value?

• From the balance sheet equation

ttt NFONOACSE

Chapter 7 Page 222

• For this to be true, however, accounting must be Clean Surplus.

• Free cash flow drops out in the previous equation: Free cash flow (C - I) does not add value to shareholders.

• What generates value is the profit from operating and financing activities.

• By the way NOA and NFO are calculated,

which is the stocks and flows equation.

ttt

tttt-t

ttttt-ttttt

dearnCSE

dNFEOINFONOA

dNFEICNFOICOINOACSE

1

11

11

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Value Added and Accrual Accounting

OI and NFE are accounting measures and so are determined by accounting principles

NI = (C - I) + i + I + new accruals

OI = (C - I) + I + new operating accruals

= C + new operating accruals

NFE = i + new financing accruals

Chapter 7 Page 223

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Accruals and the Balance Sheet

NOAt = NOAt-1 + It + new operating accrualst

NFOt = NFOt-1 - (Ct - It) + it + new financial accrualst + dt

and

CSEt = CSEt-1 + NOAt - NFOt

Chapter 7 Page 223

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Separating operating and financing activities in the Income Statement identifies profit flows

Comparison of these flows with their asset base yields the corresponding rates of return:

Return on Net Operating Assets

Return on Net Financial Assets

If there are NFO rather than NFA, net borrowing cost

Forecasting ROCE (at the heart of the valuation model) involves both the forecast of RNOA and RNFA (or NBC)

1tt21

tt NOANOAOIRNOA

1tt21

tt NFANFAFINRNFA

1tt21

tt NFONFOFENNBC

Chapter 7Page 224

Stocks & Flows Ratios:Business Profitability

Documents

Financial Statement Analysis and Security Valuation Stephen H. Penman