Citibank: basic of corporate finance
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1-24 FINANCIAL STATEMENT ANALYSIS
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Income Statement
There are two accounts in the Income Statement that represent
sources of cash. The first, NET INCOME BEFORE PREFERRED DIVIDEND, is
the cash generated by the sale of the product or services that the
company has available for discretionary expenditures. We are
assuming that the costs and expenses related to production, interest,
and taxes are all non-discretionary expenses. For XYZ Corporation,
we will use the line:
Net Income Before Preferred Dividend $9.9 million
The other account we include in the Cash Flow Statement as a source of
cash is DEPRECIATION. Remember, depreciation is deducted as an operating
expense in the Income Statement. Since depreciation is
not actually a cash outflow, we must add XYZ's 1993 DEPRECIATION figure
of $8.9 million into the Cash Flow Statement so that the cash flow sources
are accurate.
Uses
Balance Sheet:
decreased
liabilities;
increased assets
As with the sources, there are two simple rules for calculating the
uses of cash in a company.
1. A decrease in a liability or equity account is a use of funds.
Paying off a loan is one example. In our XYZ Corporation
example, the OTHER CURRENT LIABILITIES account decreased by
$700,000 (from $5.6 million in 1992 to $4.9 million
in 1993). This means that XYZ paid off $700,000 of short-term
liabilities.
2. An increase in an asset account is a use of cash.
The increase indicates that funds were used to purchase
additional assets. XYZ purchased $22.6 million worth of FIXED
ASSETS during 1992 (from $136.2 million in 1992 to $158.8
million in 1993).
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Financing Activities
Buying and
selling of capital
Financing activities are related to the buying and selling of capital.
Remember, a company has two alternatives for raising capital: debt
and equity. This section of the Cash Flow Statement is a summary of
the equity raised and the debt borrowed and paid off. Usually, only the
net changes of each account are listed.
Cash flow –
net increase /
(decrease)
For example, XYZ Corporation's LONG-TERM BONDS account was
$102.7 million in 1992 and $107.4 million in 1993. The company
may have paid off $25 million in bonds and issued $29.7 million in
new bonds, but the Cash Flow Statement will only show the net
increase of $4.7 million.
With that brief explanation about the sources and uses of funds, let's
take a look at XYZ Corporation's Cash Flow Statement.
XYZ Corporation
December 31, 1993
(In Millions $)
OPERATING ACTIVITIES:
Sources:
Net Income Before Preferred Dividends 9.9
Depreciation 8.9
Incr. in Accounts Payable 2.5
Incr. in Accrued Wages and Taxes 0.2
Incr. in Other Current Liabilities (0.7)
Total Sources from Operations 20.8
Uses:
Incr. in Accounts Receivable (0.7)
Incr. in Inventories (3.7)
Incr. in Prepaid Expenses 0.8
Incr. in Other Current Assets 0.1
Incr. in Gross Fixed Assets 22.6
Total Uses from Operations 18.9
FINANCING ACTIVITIES:
Incr. in Notes Payable 1.9
Incr. in Long-term Bonds 4.7
Incr. in Preferred Stock 0.1
Incr. of Common Stock 0.0
Net Funds from Financing 6.7
Total Funds from Operations and Financing 8.6
Less Common and Preferred Dividends 7.7
Incr. (Decr.) in Cash and Mkt Sec. 0.9
Figure 1.5: XYZ Corporation Cash Flow Statement
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As you can see, the Cash Flow Statement is divided into OPERATING
ACTIVITIES, Sources and Uses, and FINANCING ACTIVITIES. The final
calculation is the NET INCREASE or DECREASE IN CASH AND MARKETABLE
SECURITIES. Let's see how we get there.
Operating
activities:
Sources
NET INCOME BEFORE PREFERRED DIVIDENDS ($9.9 million) and the
$8.9 million DEPRECIATION charge are taken directly from the 1993
Income Statement.
The current liabilities from the Balance Sheet are listed individually
(INCREASE IN ACCOUNTS PAYABLE, INCREASE IN ACCRUED WAGES AND TAXES,
INCREASE IN OTHER CURRENT LIABILITIES) with their net change from 1992
to 1993. TOTAL SOURCES FROM OPERATIONS ($20.8 million) is the sum of
these sources.
Operating
activities:
Uses
Next, the net change in each asset account except CASH and MARKETABLE
SECURITIES is listed: INCREASE IN ACCOUNTS RECEIVABLE, INCREASE IN
INVENTORIES, INCREASE IN PREPAID EXPENSES, INCREASE IN OTHER CURRENT
ASSETS, INCREASE IN GROSS FIXED ASSETS. GROSS FIXED ASSETS is used
instead of NET FIXED ASSETS because we have already adjusted for
DEPRECIATION and we do not want to double count. TOTAL USES FROM
OPERATIONS is the sum of these changes.
Financing
activities
Finally, we summarize the financing activities by listing each net change
from 1992 to 1993 for the potential sources of capital:
INCREASE IN NOTES PAYABLE, INCREASE IN LONG-TERM BONDS, INCREASE IN
PREFERRED STOCK, INCREASE OF COMMON STOCK. NET FUNDS FROM
FINANCING is the sum of the financing activities.
Total funds from
operations and
financing
TOTAL FUNDS FROM OPERATIONS AND FINANCING is calculated by
subtracting the uses from the sources and adding to that number the NET
FUNDS FROM FINANCING. In our XYZ example, that calculation is:
Total operating sources $20.8 million
- Total operating uses 18.9 million
+ Net financing sources 6.7 million
____________________________________________________________
Total funds from operations and financing $ 8.6 million
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Increase
(Decrease) in
cash and
marketable
securities
Finally, we subtract the total value of the COMMON and PREFERRED
DIVIDENDS (from the Income Statement) to arrive at the net INCREASE
or DECREASE in CASH and MARKETABLE SECURITIES.
$8.6 million - $7.7 million = $0.9 million
Our check to make sure that the calculation is correct is to calculate the
net change in the Balance Sheet accounts for CASH and MARKETABLE
SECURITIES.
($5.7 million + $6.3 million) - ($6.2 million + $4.9 million) = $0.9 million
For our XYZ Corporation, we have calculated the sources and uses of
cash correctly.
Summary
The Cash Flow Statement is a summary of the sources and uses of cash
for a specified period of time. Different formats for presenting the
information have other names, such as "Statement of Changes in Financial
Position." Regardless of the format, the basic rules for calculating cash
flow remain the same. Any basic finance or accounting text will give
additional information on these other formats. The unit of the bank in
which you work will have specific instructions on the format you should
use for your analysis.
You have completed the "Cash Flow Statement" section of Financial Statement Analysis.
Please complete Progress Check 1.3, then continue to the next section that covers "Financial
Ratios." If you answer any questions incorrectly, please review the appropriate text.
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þ PROGRESS CHECK 1.3
Directions: Use the Balance Sheet and Income Statement information presented below
to answer the questions. Calculate the answer to each question, then check
your solution with the Answer Key on the next page.
Fruit Packing, Inc. — Balance Sheet
December 31, 1993 (In Millions $)
ASSETS 1992 1993 LIABILITIES AND EQUITY 1992 1993
Cash
Marketable Securities
Accounts Receivable
Raw Goods Inventory
Finished Goods Inventory
Prepaid Expenses
Other Current Assets
Total Current Assets
6.7
0.0
22.4
19.2
22.3
1.2
0.8
72.6
7.4
0.6
23.7
19.5
22.4
1.5
0.8
75.9
Accounts Payable - Fruit
Accounts Payable - Material
Notes Payable
Accrued Wages and Taxes
Other Current Liabilities
Total Current Liabilities
9.6
9.2
21.8
1.5
0.7
42.8
10.2
9.6
23.0
1.7
0.6
45.1
Gross Fixed Assets
Less Depreciation
Net Fixed Assets
97.5
16.8
80.7
101.2
19.9
81.3
Long-term Debt
Preferred Stock
Total Long-term Liabilities
46.1
7.8
96.7
45.1
7.8
98.0
Common Stock
Retained Earnings
Total Common Equity
15.1
41.5
56.6
15.1
44.1
59.2
Total Assets 153.3 157.2 Total Liabilities and Equity 153.3 157.2
Fruit Packing, Inc. — Income Statement
December 31, 1993 (In Millions $)
Net Sales 150.6
Operating Expenses 101.2
Depreciation 3.1
EBIT 46.3
Interest Expense 11.5
Earnings Before Taxes 34.8
Taxes (@ 40%) 13.9
Net Income to Shareholders 20.9
Preferred Dividends 6.3
Net Income to Common 14.6
Common Dividends 12.0
Earnings Retained 2.6
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PROGRESS CHECK 1.3
(Continued)
Assume you are building a Cash Flow Statement for Fruit Packing, Inc.
9. How much is the total cash SOURCE from operations?
_____a) $19.9 million
_____b) $23.6 million
_____c) $24.6 million
_____d) $25.1 million
_____e) $44.7 million
10. How much is the total cash USE from operations?
_____a) $0.3 million
_____b) $0.4 million
_____c) $1.3 million
_____d) $2.0 million
_____e) $5.7 million
11. What is the total of net funds from FINANCING?
_____a) ($1.0) million
_____b) $0.2 million
_____c) $1.0 million
_____d) $1.2 million
_____e) $1.3 million
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ANSWER KEY
9. How much is the total cash SOURCE from operations?
d) $25.1 million
(in millions $)
NET SALES 20.9
DEPRECIATION 3.1
INCREASE ACCOUNTS PAYABLE 1.0
INCREASE ACCRUED WAGES AND TAXES 0.2
INCREASE OTHER CURRENT LIABILITIES (0.1)
TOTAL SOURCES FROM OPERATIONS 25.1
10. How much is the total cash USE from operations?
e) $5.7 million
(in millions $)
INCREASE IN ACCOUNTS RECEIVABLE 1.3
INCREASE IN INVENTORIES 0.4
INCREASE IN PREPAID EXPENSES 0.3
INCREASE IN OTHER CURRENT ASSETS 0.0
INCREASE IN GROSS FIXED ASSETS 3.7
TOTAL USES FROM OPERATIONS 5.7
11. What is the total of net funds from FINANCING?
b) $0.2 million
(in millions $)
INCREASE IN NOTES PAYABLE 1.2
INCREASE IN LONG-TERM BONDS (1.0)
INCREASE IN COMMON STOCK 0.0
INCREASE IN PREFERRED STOCK 0.0
TOTAL FUNDS FROM FINANCING 0.2
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FINANCIAL RATIOS
Financial
statements used to
predict future
earnings
So far, we have seen how the Balance Sheet reports a company's
position at a point in time, how the Income Statement reports a
company's operations over a period of time, and how the Cash Flow
Statement reports a company's sources and uses of funds over that
period. The real value of financial statement analysis is to use these
statements to forecast a firm's future earnings.
From an investor's point of view, forecasting the future is the main
purpose of financial statement analysis. From a manager's viewpoint,
financial statement analysis is useful as a way to anticipate future
conditions and, most important, as a starting point for developing
strategies that influence a company's future course of business.
Ratios highlight
relationships
between accounts
An important step toward achieving these goals is to analyze the firm's
financial ratios. Ratios are designed to highlight relationships between
the financial statement accounts. These relationships begin to reveal
how well a company is doing in its primary goal of creating value for
its shareholders.
Useful with
application of
analytical
techniques
The ratios, alone, usually give the analyst very little information. There
are two ratio analysis techniques that provide additional insight into a
company. The first technique is to compare the ratios of one company
with other similar companies within the same industry. The second
technique is to observe trends of the ratios over a period of time.
These trends give clues about a company's performance.
Five ratio
categories
The most common financial ratios can be grouped into five broad
categories:
• Liquidity Ratios
• Asset Management Ratios
• Debt Management Ratios
• Profitability Ratios
• Market Value Ratios
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