Interpretation of financial statements Flashcards by Jason Adjei

We concluded last lecture that valuation is all about forecasting future returns, we have 2 accounting rates of return which are?

ROCE
RNOA

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Do firms create value more from operating or fianancing activities?

Operating activities except for a few expections
1) Fricitions in capital market allow firms to make money from fiancing activities
2) Firms that operate in the financial sector ( e.g. banks a lot of operating activities is to do with fiancing things.)

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What are the formulas for RNOAt and ROCEt( means how well company is generating profit from capital ( so high means good for shareholders) ?

So t-1 is the beginning of the period or the end of last period.

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What is a problem of just looking at these two Ratios?

1) Ratios may hide underlying trends.
2) Ratios are less relevant if looked at in isolation. ( need to have a benchmark e..g industry or previous years)
3) We have implicitly made the assumption that financial leverage doesn’t affect value.

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So what do we use to make ratios more meaning?

Advanced/ DuPont analysis, is a useful technique used to decompose the different drivers of return on capital employed. ( ROCE)

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So what is another way to write RNOA

PM X AT
if there is no _b balance then it means that its a t balance.
Hence using the OI/NOA_b doesn’t allow us to decompose what causes RNOA and affects forecast.

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What does RNOA mean?
What does profit margin tell you?
What does AT turn over tell you?

RNOA = measure of our return on operating assets.
PM = how many cents per dollar it generates per sale.
AT = measures the efficiency of a company’s assets in generating revenue or sales.

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Does any effect on interest expenses get measured in profit margin?

No, originally if we borrowed money the interest expense will lower our profit margin, hence this fixes it, so profit margin will only change our operating activities.

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How are we defining NOA and NFO? And then what is the fundamental balance sheet equation?

NOA = ( OA - OL) ( assumes OA> OL, if not then its either negative NOA or NOL)
NFO = ( FL - FA) ( same here)
NOA = NFO + CSE. ( this always holds)

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What is advanced Dupont analysis of ROCE ( skipping all the algebra )?

ROCE = RNOA + FLEV*SPREAD

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So we know that ROCE = ROCE = RNOA + FLEV*SPREAD which splits ROCE into the rate of return of operating activities and rate of return of non-operating activities what are the formulas for each component. What does FLEV mean for equity holders?

RNOA = OI/NOA_b
FLEV = NFO/CSE
SPREAD = RNOA - NFE/NFO_b
If a firm uses some debt, then this will increase return for equity holders, you want to take more leverage if RNOA > NFE/NFO_b

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What does spread mean? RNOA - NFE/NFO_b

Basically tells us if you are generating return on assets to cover the interest you paying for borrowing, if you are the more you want to borrow as ROCE increases.

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No we have to reformulate them.

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What is a stock variable and what is a flow variable?

flow variable is measured over a period of time ( IS and CS)
stock variable is measured at a specific point in time.( balance sheet)

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Now we are going to look at the stock and flow equation for equity? Now what is the clean surplus relation?

The clean surplus states that the difference between earnings and dividends equals the change in book value. Or the beginning book value of equity + CI for the period - dividends for the period show equal the the book value of equity at end of period.
CI from income statement is NI + OCI = CI
d = Net dividends ( so company pays dividends but they can also receive income ( e.g. share repurchases) but here is assuming the company paying dividends pay more than what company receives. BE CAREFUL WITH SIGNS

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What is the aim of reformulating financial statements?

To create a distinction between operating and financing activities and focus on operating due to our assumption that firms do not revalue based on Fiancing activities.

There are 2 ways in which you can work out to do a reformulated balance sheet. What is the first way we will do it? ( hint its about splitting)

What are operating assets?
What are operating liabilities?

OA = Means used directly in operations. you do not receive or pay interest
OL = those expenses companies pay to support their operations. you DONT get a return of interest or you DONT pay interest.

We are going to do some classifications of the current and non current assets to test understanding of OA and OL.
1) Trade & other receivables
2) Inventories
3) Trade & other payables
4) Provisions ( a provision is an account that records a present liability of an entity. )
5) Current tax liabilities
6) Current tax assets
7) Cash & cash equivalents
8) Post employment benefit obligations ( Most post-employment plans consist of a deferred salary but also may include other benefits like healthcare )
9) Deferred tax assets
10) Assets of the disposal group & non current assets classified as held for sale
11) Liabilities of the disposal group classified as held for sale.
12) Goodwill, software & other intangible assets
13) Right of use of lease assets
14) Income tax receivable
15) Prepaid expenses
16) current portion of deferred taxes
17) Pension liabilities)
18) Any intangible asset
19) Remeasurement of defined benefit plans
20) Foreign currency translation adjustment
21) Non controlling interest

1) OA
2) OA
3) OL
4) OL
5) OL
6) OA
7) Can be a OA and FA ( must make an assumption or it may say in the question)
8) OL ( you not paying interest)
9) OA
10) OA
11) OL
12) OA
13) OA
14) OA
15) OA
16) OA
17) OL
18) OA
19) OA
20) OA
21) OL ( its not going to be CSE as its separate, so its either OL or OA and its more intuitive to think OL)

What is a financial asset?
What is a financial obligation/liability?

FA = a non-physical asset whose value is derived from a contractual claim.
FL/FO= A financial liability can be a contractual obligation, a payment involving an equity settlement, or a settlement of a derivative.

Classify these into FA or OA
1) Cash and deposits
2) Marketable securities
3) Current portion of bonds ( the amount of unpaid principal from long-term debt that has accrued in a company’s normal operating cycle)
4) Investment securities
5) Bonds
6) Long term borrowing
7) Lease obligations
8) Commercial paper
9) Other investments & other assets
10) Share acquisition rights
11) commitment and contingencies
12) Preferred stock (a different type of equity that represents ownership of a company and the right to claim income from the company’s operations)

1) Depends on specification of question but FA.
2) FA
3) FL
4) FA
5) FL
6) FL
7) FL
8) FO
9) FA
10) FL
11) FO
12) FO

So we can find CSE by doing NOA - NFO or we can literally identify CSE by identifying CSE values.
What are these?
Also Treasury shares
Capital surplus

ALL CSE except Preffered stock

What does accure mean, what does accure interest mean?

Acculumate over time, so interest will accumulate over time.

What are all of these?

Now we are going to look at another way of calculating Reformulated balance sheet, whats the first step?

We have to restate CSE + CSE from balance sheet - Preferred stock ( its a liability for shareholders, if it says redeemable preferred stock, don't touch) - Non controlling( or minority ) interest : a liability for shareholders - Unearned ( or deferred compensation( for employees): an asset (OA) + Dividend payable

Now we are going to look at another way of calculating Reformulated balance sheet, whats the second step?

You need to find NFO which is FO - FA so identify financial obligations Then financial assets Take them away from each other then from there you know NFO + CSE = NOA.

How do we reformulate the Equity statement?

So we have seen that reformulated balance sheet is quite straightforward whatever of the 2 ways we go. How do we check if we have the correct NOA using the 2nd method we used?

We use the NOA we have found in second case ( from adding NFO + CSE) and take away from ( ALL THE OA - OL) AND IF it equals 0 then we have got it correct)

We are going to look at Reformulated income statement which is a bit more difficult to do. What is Net financial expense ( same as interest expense) ? What is the first step?

NFE = Net Financial Expenses means Interest expenses minus Interest income. We need to find NFE after tax. + Interest expense - Interest revenue ( its literally minus even if positive) +/- Realised losses and gains on financial assets + Payment to preferred stock ( remember PS is a FO) =NFE before tax -Tax benefit from NFO ( NFE before tax * 1-Tax rate ) =NFE( after tax)

We are going to look at Reformulated income statement which is a bit more difficult to do. How do we find Comprehensive income

To get CI we use the equity stock and flow equation. What is d + Cash dividends ( dividends declared - changes in dividends payable) + Share repurchases - Share issues

What is another approach to work out CI?

An alternative approach is to identify all items in Other Comprehensive Income (OCI). This allows you to get CI = NI + OCI.

So we have NFE now and CI, how can we work out OI? How do we check for OI?

NFE + CI = OI Original OI - ( sales - COGS - all the expenses ( not including Amoritisation) and if = 0 then we know its correct.

Its important we understand that there are 2 ways of calculating CI, so calculate CI using the second way whether you identify all items in OCI, to get CI = NI + OCI?

Net income (loss) attributable to parent -291 ( key we look at parent and not anything else like NCI which is a liability and also excludes OCI + OCI ( key here that it is Acculumated Other comprehensive income, so we find difference which is C34 - D43. So CI = -291 + ( C43 - D43)

So what are the 3 fundamental stock and flow equations for Equity, Assets and Liabilities? Using the one for liabilities how do we calculate F

F = NFEt - (NFOt - NFOt-1) ( : Cash flow to debt holders)

Finally lets look at reformulated cash flow statement? So we want to find FCF? There is another way but don't worry

We are going to look at an example to do reformulated B/S, the formate should be NOA, NFO and CSE; a reformulated income statement with the following items: OI, NFE and CI; and finally F and d. We are going doing 2017 and 2016 We are going to make some assumptions 1) Tax benefit 35%. 2) 50% of cash & cash equivalents is for financing activities 3) We are dividing all numbers by 1000. First of all work out the reformulated B/S?

As we have a lot of items here i will not bother to do the classification of OA and OL and FA and FL.

Notice that F + d = FCF as well

What are all the formulas for ROCE RNOA FLEV SPREAD PM AT using stock and flow variables.

EASY