Valuation Fundamentals Workshop

TRACK A
Accounting and Finance Basics:
Key Characteristics in Analyzing
Distressed Companies

Prof. Jim Nolen, Presiding Officer

The University of Texas at Austin, McCombs School of Business
2015

Austin, Texas
Earn CLE credit on demand

Cutting-edge Insolvency Courses

With eLearning:
• Learn from leading insolvency professionals
• Access when and where you want—even on your mobile device
• Search consumer or business courses by topic or speaker
• Invest in employees and improve your talent pool

Expert Speakers, Affordable Prices

elearning.abi.org
ABI’s eLearning programs are presumptively approved for CLE credit in CA, FL, GA, HI, IL, NV, NJ, NY (Approved Jurisdiction Policy), RI and SC. Approval in
additional states may be available for some courses. Please see individual course listings at elearning.abi.org for a list of approved states.

66 Canal Center Plaza • Suite 600 • Alexandria, VA 22314-1583 • phone: 703.739.0800 • abi.org

Join our networks to expand yours:

© 2015 American Bankruptcy Institute. All Rights Reserved.
 Session 1 -
Accounting & Finance Basics
American Bankruptcy Institute

Jim Nolen
Department of Finance
McCombs School of Business
February 25, 2015
© University of Texas at Austin, 2015 1

7
8
Session Objectives
 To Improve financial acumen
 To discuss accounting and financial concepts
 To examine the balance sheet, income statement
and cash flow statement
 To use financial ratios to evaluate the financial
condition of the firm and pre-cursers to financial
VALCON 2015

distress
 To review the value drivers of a firm: growth, risk
management, profitability, asset efficiency and
leverage.
 To analyze the components of firm free cash flow as
an introduction into business valuation concepts

© University of Texas at Austin, 2015 2

 Accounting’s Role
 The role of the accounting function is to provide
information about the past performance to company
executives and investors.

 This information is communicated in the financial

statements
 Balance Sheet
 Income Statement
 Statement of Cash Flows
American Bankruptcy Institute

 Statement of Shareholders’ Equity

 Accountants are responsible for reporting,

controlling and budgeting activities.

9
© University of Texas at Austin, 2015 3
10
Finance’s Role
 The role of the finance function is to analyze
information about the past to make
investment, financing and operating
decisions that improve the company’s
performance in the future.
 Investment Decisions (Capital Budgeting) to maximize
return and includes: make vs. buy decisions, working
VALCON 2015

capital management, treasury operations and asset

acquisitions and divestitures.
 Financing Decisions to minimize the cost of capital and
includes: debt vs. equity financing, dividend policy and
share repurchases.
 Operating Decisions that improve efficiencies and includes:
pricing and product mix, purchasing and supply chain
decisions, controlling expenses and risk management.
© University of Texas at Austin, 2015 4
 Financial Management
 The goal of finance is to create wealth and maximize
firm value.
 Wealth is created by making economic profit - where
the rate of return on investments exceed the cost of
capital
 The cost of capital is a function of the risk.
 There are two kinds of risk: (1) business (market)
risk that affect the variability of future cash flows
and (2) financial risk from the source of capital used.
American Bankruptcy Institute

 Thus, finance is the study of the trade-offs between

risk and return. Firms compete for both customers
and capital and must produce risk adjusted returns
for investors to be able to attract and keep capital.

© University of Texas at Austin, 2015 5

11
12
Financial Management Decisions
The Accounting Balance Sheet
Assets Liabilities + SE
Short-term assets Short-term liabilities
Long-term assets Long-term liabilities
Stockholder equity
The Economic Balance Sheet
VALCON 2015

Exchange value of assets (A) Market value of debt (D)

Wealth created (W) Market value of equity (E)

Investment Decisions Financing Decisions

What projects to pursue Financing the asset
What assets to obtain purchases

© University of Texas at Austin, 2015 6

 Accrual vs Cash
 Two parallel views of the company’s
“flows”
Accrual Accounting Cash Basis Accounting

Resources Cash
Revenue Inflows
- Expense - Outflows
Profit Net Cash Flow
American Bankruptcy Institute

Accrual accounting records revenues when they are earned and expenses
are matched with the revenues as incurred. However, profits can be much
different than the cash flow of the company based on the cash received and
disbursed. The Statement of Cash Flows converts accrual accounting back
to cash flow.

© University of Texas at Austin, 2015 7

13
14
Revenue Recognition
 What is Revenue?
 Average Selling Price x Quantity Sold
 But when do we record it, when sold or paid?
 Revenues are recognized (recorded)
when they are both
 Earned – The goods and services have been
VALCON 2015

substantially provided
 Realized or Realizable – One of the following has
been received
 Cash
 A claim to cash (accounts receivable)
 Something that can be readily converted into cash
© University of Texas at Austin, 2015 8
 Revenue Recognition
 In some cases it can be difficult to determine
whether revenue has been sufficiently “earned” to
warrant recognition
 This presents an opportunity to exercise discretion
that can lead to aggressive recognition of revenue
 To reduce abuse of revenue recognition and to
narrow the variation in practice, in 1999 the SEC
issued Staff Accounting Bulletin No. 101 (SAB 101)
American Bankruptcy Institute

and modified it in December 2003 by issuing SAB

104.

© University of Texas at Austin, 2015 9

15
16
Revenue Recognition
 In this document, the SEC says that revenue
should not be recognized unless all of the
following occur
 Persuasive evidence of an arrangement exists
 Delivery has occurred or services have been
rendered
 The seller’s price to the buyer is fixed or determinable
VALCON 2015

 Collectability is reasonably assured

 A reserve for non-collectability of accounts

receivable (bad debt) is recorded at the time
of sale based on historical bad debt
percentage.
© University of Texas at Austin, 2015 10
 Expense Recognition
 When should an expenditure be written off?
 When Incurred?
 When Paid for?
 When Used?

 Why are some expenditures capitalized and put on the

balance sheet as an asset instead of expensing against
revenues?

 Why is inventory shown in current assets and not subject

American Bankruptcy Institute

to depreciation but new equipment is in long term assets

and depreciated?

 Who determines the length of time over which the

property is depreciated? And what is the difference
between depreciation, amortization and depletion?
© University of Texas at Austin, 2015 11

17
18
Expense Recognition
 Expenses are recognized (recorded)
 By matching
 Direct Materials, Direct Labor, Commissions
 In the period in which they occur
 Rent, Salaries
 By allocating over several periods
VALCON 2015

 Depreciation, Insurance, Warranty Expense

 An expenditure to buy fixed assets or to add to the

value of an existing fixed asset with a useful life that
extends beyond the taxable year is “capitalized” by
placing the asset on the balance sheet and
depreciating the asset over its economic life.
© University of Texas at Austin, 2015 12
 Revenue and Expense Recognition Summary
 Revenues are recognized as “earned”
 An arrangement exists
 Delivery has occurred
 Price is fixed
 Collectability is reasonably assured

 Expenses are recognized as “incurred”

 Contributed to revenue production this period
 Will not contribute to revenue production in future
American Bankruptcy Institute

 Matched, Period, Allocated

 Shared Expenses are usually pooled and then allocated

to profit centers based on the activity that created the
expense (headcount, sq. footage, etc.)
© University of Texas at Austin, 2015 13

19
20
Financial Statements

Balance Sheet Statement of Cash Flows

Assets Cash From Operations
- Liabilities +/- Cash From Investing
Owners’ Equity +/- Cash From Financing
Change in Cash
Beginning Cash Balance
Statement of Ending Cash Balance
Stockholders’ Equity
VALCON 2015

Beginning Balance
Income Statement
+ Net Income
Revenue (Sales)
+/- Other Comprehensive Inc
+ New Issues - Expense
- Cash Dividends +/- Gains/Losses
- Share Repurchases Net Income
Ending Balance

14
© University of Texas at Austin, 2015
 Balance Sheet
Assets (Investments)
Cash
Accounts Receivable
Inventory
Prepaid Expenses
Total Current Assets (Working Capital < 1 yr.)

Property Plant & Equipment (Fixed Assets/CAPEX)

Less: Accumulated Depreciation
Net Fixed Assets
American Bankruptcy Institute

Other Assets (Intangibles)

Total Assets

© University of Texas at Austin, 2015 15

21
22
Balance Sheet (continued)
Liabilities & Owner’s Equity
Accounts Payable (Vendor Credit)
Accrued Expenses (Taxes, etc.)
Short-term Debt (Lines of Credit)
Current Portion of Long-Term Debt
Total Current Liabilities (claims due < 1 yr.)

Long-Term Debt (claims due > 1 yr.)

Total Liabilities (Total Claims on Assets)
VALCON 2015

Owner’s Capital Includes: Common

Retained Earnings Stock, Paid-in-Capital
Preferred Stock,
Owner’s Equity (Net Worth or Stockholder’s Equity) Treasury Stock, Profits
Less Dividends Paid
Total Liabilities & Owner’s Equity

© University of Texas at Austin, 2015 16

 Income Statement
(Profit/Loss Statement)

Sales (Revenues or Turnover)

- Cost of Goods Sold (Variable Costs, Direct Costs)
Gross Profit (Gross Contribution)
- Operating Fixed Costs (SG&A, Overhead or OPEX)
Earnings Before Depreciation, Interest & Taxes (EBITDA)
- Depreciation & Amortization (Non-cash expenses)
Net Operating Income (NOI or EBIT)
-Interest Expense
Earnings Before Tax (EBT, PBT, NIBT, Taxable Income)
American Bankruptcy Institute

- Corporate Income Taxes

Earnings After Tax (EAT, NIAT, PAT) Common Adjustments to
Net Income:
Minority Interests
Non-Recurring Items

Dividends to Retained and

Shareholders Reinvested
© University of Texas at Austin, 2015 17

23
24
The Cash Flow Statement
 Operating Cash Flows
 Net Income After Taxes
 Plus: Depreciation/Amortization (Non-Cash Expenses)
 Plus: Non-Cash Operating Expenses (Options, Unrealized
(Gains)/Losses)
 Less: Change in Net Working Capital (Changes in Receivables,
Inventory, Payables and Accruals)
 Investing Cash Flows
VALCON 2015

 Less: Increase in Fixed Assets (CAPEX)

 Financing Cash Flows
 Borrowing and Repayment of Debt
 Issuance & Re-repurchase of Equities
 Dividend Payments

 Effects of Currency

= Change in Cash Position

© University of Texas at Austin, 2015 18
 Energy Future Holdings12/31/13
In millions USD Balance Sheet
Income Statement Cash & Mkt. Sec. $1,217 Statement of
Net Receivables 718
Revenue $5,899 Tax Def. Asset/Other 1,121
Cash Flows
COGS 2,848 Inventory 399 Net Income ($2,218)
Gross Profit $3,051 Other Cur. Assets 1,012 +Deprec. & Amort 1,512
GPM 51.7% + Operating Exp Adj. (1) 153
Total Current Assets $4,467
+/- Dec/(Inc) in NWC 50
Other Op. Exp. 1,010 Cash From Operations ($503)
Gross Fixed Assets 24,514
SG&A (OPEX) 747
Accum Deprec. (7,056) CAPEX (497)
Depr./Amort. 1,355
PP&E ,net $17,458 Other Invest Activity 500
Op. Inc. ( $61) Cash from Investing $3
OPM (1.03%)
Long-term Invest 5,961
Debt Repaid (187)
Net Interest. Exp. (2,703) Goodwill & Intangibles 3,952 Other Financing (9)
Income-Affiliates 335 Deferred Tax Assets 2,012 Cash From Financing $(196)
Other Non-Op Inc 8 Other Long-term Assets 2,590
American Bankruptcy Institute

Taxable Inc. (2,421) Total Assets $36,445 Net Change Cash ($696)
Unusual Exp. (1,175)
- Corp. Tax (1,271) Current Liabilities $43,506 Begin. Cash 1,913
Net Inc.–Company (2,325) Long term Debt 0
Other L-T Liabilities 6,195 Ending Cash $1,217
Minority Int. 107
Net Income ($2,218) Total Liabilities $49,701
NPM (37.6%)

EPS (fully diluted) ($1.33)

S/H Equity ($13,255)
$39,238MM in current liabilities is
# Shares – 1.67 Billion
the current maturities of Long-term
Liabilities & Equity $36,445 Debt
19

25
© University of Texas at Austin, 2015
26
Financial Analysis
 Historical Performance is analyzed over
three to five years using ratio analysis.
 Common Sized Statements
 Trend Analysis
 Benchmarking against industry/competitors

 This Historical Analysis is filtered

VALCON 2015

through:
 The current economic conditions
 The industry
 The competitive landscape
 The Company analysis
 Strengths, Weaknesses, Opportunities and Threats
 It’s Business Model and Strategy

20
© University of Texas at Austin, 2015
 EFH P&L History
Reclassified LTM
For the Fiscal Period Ending 12 months 12 months 12 months 12 months 12 months 12 months
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014
Currency USD USD USD USD USD USD

Revenue 9,546.0 8,235.0 7,040.0 5,636.0 5,899.0 6,058.0

Fuel & Purchased Power 2,878.0 4,371.0 3,396.0 2,816.0 2,848.0 2,929.0

Ops. and Maintenance 1,598.0 837.0 924.0 888.0 881.0 856.0

Selling General & Admin Exp. 1,068.0 751.0 742.0 674.0 747.0 747.0

Depreciation & d. 1,754.0 1,407.0 1,455.0 1,373.0 1,355.0 1,318.0

Other Operating Exp. (1,405.0) (2,060.0) (926.0) (309.0) 129.0 306.0

Total Operating Exp. 5,893.0 5,306.0 5,591.0 5,442.0 5,960.0 6,156.0

EBITDA 5,758.0 4,640.0 3,156.0 1,743.0 1,451.0 1,364.0

American Bankruptcy Institute

Operating Income 3,653.0 2,929.0 1,449.0 194.0 (61.0) (98.0)

Net Interest Exp. (2,867.0) (3,544.0) (4,292.0) (3,506.0) (2,703.0) (2,085.0)

Income/(Loss) from Affiliates - 277.0 286.0 270.0 335.0 356.0

Other Non-Operating Inc. (Exp.) 23.0 3.0 2.0 (274.0) 8.0 11.0

EBT Excl. Unusual Items 809.0 (335.0) (2,555.0) (3,316.0) (2,421.0) (1,816.0)

21

27
© University of Texas at Austin, 2015
28
EFH Unusual Items
Reclassified LTM
For the Fiscal Period Ending 12 months 12 months 12 months 12 months 12 months 12 months
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014
Currency USD USD USD USD USD USD

Total Merger & Rel. Restruct. Charges (7.0)- (5.0) - - - -

Impairment of Goodwill (90.0) (4,100.0) - (1,200.0) (1,000.0) (1,000.0)

Gain (Loss) on Sale of Invest. - 37.0 - - - -

Gain (Loss) On Sale Of Assets - 44.0 - (4.0) - 2.0

Asset Writedown (34.0) - (427.0) (70.0) (177.0) (147.0)

Total Insurance Settlements - 6.0 7.0 2.0 2.0 0

Total Legal Settlements (3.0) - - - - (519.0)

VALCON 2015

Other Unusual Items 100.0 1,930.0 (28.0) (4.0) - (720.0)

EBT Incl. Unusual Items 775.0 (2,423.0) (3,047.0) (4,592.0) (3,596.0) (4,200.0)

Income Tax Expense 367.0 389.0 (1,134.0) (1,232.0) (1,271.0) (1,176.0)

Earnings from Cont. Ops. 408.0 (2,812.0) (1,913.0) (3,360.0) (2,325.0) (3,024.0)

Minority Int. in Earnings (64.0) - - - 107.0 107.0

Net Income 344.0 (2,812.0) (1,913.0) (3,360.0) (2,218.0) (2,917.0)

© University of Texas at Austin, 2015 22

 EFH Balance Sheet (Assets)
Balance Sheet as of:
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014
Currency USD USD USD USD USD USD
ASSETS

Cash And Equivalents 1,189.0 1,534.0 826.0 1,913.0 1,217.0 3,606.0

Short Term Investments 425.0 - - - - -

Trading Asset Securities 60.0 95.0 142.0 134.0 67.0 -

Accounts Receivable 1,260.0 999.0 767.0 718.0 718.0 923.0

Other Receivables - - - - - -

Accounts Receivable, Total 1,260.0 999.0 767.0 718.0 718.0 923.0

Inventory 485.0 395.0 418.0 393.0 399.0 370.0

Deferred Tax Assets, Curr. 5.0 - - - 105.0 102.0

American Bankruptcy Institute

Restricted Cash 48.0 33.0 129.0 680.0 949.0 4.0

Other Current Assets 2,654.0 2,863.0 3,021.0 1,675.0 1,012.0 285.0

Total Current Assets 6,126.0 5,919.0 5,303.0 5,513.0 4,467.0 5,290.0

Gross Property, Plant & Equipment 36,311.0 23,558.0 23,910.0 24,281.0 24,514.0 26,161.0

Accumulated Depreciation (6,633.0) (3,545.0) (4,803.0) (5,937.0) (7,056.0) (9,100.0)

Net Property, Plant & Equipment 29,678.0 20,013.0 19,107.0 18,344.0 17,458.0 17,061.0

© University of Texas at Austin, 2015 23

29
30
EFH Balance Sheet (Continued) Reclassified LTM
For the Fiscal Period Ending 12 months 12 months 12 months 12 months 12 months 12 months
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014
Currency USD USD USD USD USD USD

Regulatory Assets 1,959.0 - - - - -

Goodwill 14,316.0 6,152.0 6,152.0 4,952.0 3,952.0 3,952.0

Other Intangibles 2,876.0 2,400.0 1,845.0 1,755.0 1,679.0 1,589.0

Long-term Investments 527.0 5,550.0 5,724.0 5,852.0 5,961.0 6,109.0

Other Long-Term Assets 3,750.0 6,001.0 5,626.0 4,193.0 2,596.0 1,883.0

Total Assets 59,662.0 46,388.0 44,077.0 40,970.0 36,446.0 35,884.0

LIABILITIES
VALCON 2015

Accounts Payable 896.0 681.0 574.0 394.0 401.0 446.0

Accrued Exp. 528.0 566.0 628.0 579.0 573.0 112.0

Short-term Borrowings 1,569.0 1,221.0 774.0 2,136.0 2,054.0 -

Curr. Port. of LT Debt 1,104.0 1,447.0 834.0 781.0 39,290.0 132.0

Def. Tax Liability, Curr. - 11.0 54.0 48.0 - -

Other Current Liabilities 2,967.0 2,677.0 2,750.0 1,330.0 1,188.0 584.0

Total Current Liabilities 7,064.0 6,603.0 5,614.0 5,268.0 43,506.0 1,274.0

© University of Texas at Austin, 2015 24
 EFH Balance Sheet (continued)
Reclassified LTM
For the Fiscal Period Ending 12 months 12 months 12 months 12 months 12 months 12 months
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014
Currency USD USD USD USD USD USD

Long-Term Debt 42,059.0 35,209.0 37,108.0 39,354.0 - 43,323.0

Pension & Other Post-Retire. Benefits 1,711.0 1,895.0 1,664.0 1,035.0 1,057.0 278.0

Def. Tax Liability, Non-Curr. 6,168.0 5,350.0 3,989.0 2,828.0 3,433.0 2,835.0

Other Non-Current Liab., Total 4,496.0 3,242.0 3,459.0 3,408.0 1,705.0 2,770.0

Total Liabilities 61,498.0 52,299.0 51,834.0 51,893.0 49,701.0 50,480.0

Common Stock 2.0 2.0 2.0 2.0 2.0 2.0

Additional Paid In Capital 7,914.0 7,937.0 7,947.0 7,959.0 7,962.0 7,969.0

Retained Earnings (10,854.0) (13,666.0) (15,579.0) (18,939.0) (21,157.0) (22,491.0)

American Bankruptcy Institute

Comprehensive Inc. and Other (309.0) (263.0) (222.0) (47.0) (63.0) (76.0)

Total Common Equity (3,247.0) (5,990.0) (7,852.0) (11,025.0) (13,256.0) (14,596.0)

Minority Interest 1,411.0 79.0 95.0 102.0 1.0 -

Total Equity (1,836.0) (5,911.0) (7,757.0) (10,923.0) (13,255.0) (14,596.0)

Total Liabilities And Equity 59,662.0 46,388.0 44,077.0 40,970.0 36,446.0 35,884.0

© University of Texas at Austin, 2015 25

31
32
EFH Cash Flow Statement
For the Fiscal Period Ending 12 months 12 months 12 months 12 months 12 months 12 months
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014

Net Income 344.0 (2,812.0) (1,913.0) (3,360.0) (2,218.0) (2,917.0)

Depreciation & Amort., Total 2,105.0 1,711.0 1,707.0 1,549.0 1,512.0 1,462.0

Other Amortization 275.0 228.0 380.0 270.0 270.0 207.0

(Gain) Loss On Sale Of Invest. (517.0) 213.0 836.0 (160.0) (1,49.0) (219.0)

Total Asset Writedown 149.0 4,100.0 471.0 1,271.0 1,177.0 1,147.0

(Income) Loss on Equity Invest. - (108.0) (170.0) (123.0) (122.0) (163.0)

Stock-Based Compensation 14.0 19.0 13.0 11.0 7.0 7.0

Provision & Write-off of Bad debts 113.0 108.0 56.0 26.0 33.0 40.0
VALCON 2015

Change in Acc. Receiv. (125.0) 258.0 176.0 21.0 (33.0) (33.0)

Sale/Securitization of Acc. Receivable (33.0) (383.0) - - - -

Change In Inventories (59.0) (6.0) (23.0) 19.0 (6.0) (6.0)

Change in Acc. Payable (141.0) (93.0) (120.0) (142.0) 11.0 11.0

Change in Other Net Operating Assets 105.0 (36.0) 543.0 (968.0) 45.0 125.0

Other Operating Activities (519.0) (2,093.0) (1,115.0) 768.0 (130.0) 372.0

Cash from Ops. 1,711.0 1,106.0 841.0 (818.0) (503.0) 33.0

© University of Texas at Austin, 2015 26

 EFH Cash Flow Statement (cont)
For the Fiscal Period Ending 12 months 12 months 12 months 12 months 12 months 12 months
Dec-31-2009 Dec-31-2010 Dec-31-2011 Dec-31-2012 Dec-31-2013 Sep-30-2014

Capital Expenditures (2,348.0) (838.0) (552.0) (664.0) (541.0) (378.0)

Sale of Property, Plant and Equipment 42.0 147.0 52.0 2.0 4.0 4.0

Purchase/Sale of Intangibles 0 (18.0) (7.0) (25.0) (16.0) (13.0)

Nuclear Fuel Expenditures (197.0) (106.0) (132.0) (213.0) (116.0) (133.0)

Cont. To Nuclear Decomm. Trust (3,080.0) (990.0) (2,436.0) (122.0) (191.0) (314.0)

Net Cash from Investments 142.0 - - - - -

Total Other Investing Activities 2,808.0 1,337.0 2,540.0 (446.0) 863.0 498.0

Cash from Investing (2,633.0) (468.0) (535.0) (1,468.0) 3.0 (336.0)

Total Debt Issued 854.0 1,121.0 1,758.0 3,652.0 - 4,899.0

American Bankruptcy Institute

Total Debt Repaid (396.0) (1,388.0) (1,925.0) (242.0) (187.0) (2,629.0)

Other Financing Activities (36.0) 3.0 (847.0) (37.0) (9.0) (177.0)

Cash from Financing 422.0 (264.0) (1,014.0) 3,373.0 (196.0) 2,093.0

Misc. Cash Flow Adj. - (29.0) - - - -

Net Change in Cash (500.0) 345.0 (708.0) 1,087.0 (696.0) 1,790.0

27

33
© University of Texas at Austin, 2015
34
Energy Future Holdings Cash Flow
VALCON 2015

The Blue Bar – Cash from Operations – is the lifeblood of the company
and what sustains the company’s ability to make CAPEX and cover
financing requirements.
© University of Texas at Austin, 2015 28
 The 13-Week Cash Flow Projection
 The primary tool of a restructuring firm is the
rolling 13-week cash flow projection.
American Bankruptcy Institute

© University of Texas at Austin, 2015 29

35
36
Financial Statement Analysis -
Financial Ratios
• Solvency & Risk measurements
VALCON 2015

• Profitability & Return measurements

• Efficiency & Productivity measurements
• Valuation & Market measurements

© University of Texas at Austin, 2015 30

 Financial Ratios:
Key Areas of Performance Measurement
 Performance in several key areas must be considered
when evaluating a firm’s prospects for the future
 Operational analysis
 Resource management
 Profitability and Productivity
 Investment returns
American Bankruptcy Institute

 Market indicators
 Risk - Liquidity, leverage, and debt service coverage

Source: Helfert, Erich A., “Techniques of Financial Analysis: A Guide to Value Creation,” 10 th
Edition, Irwin McGraw Hill, Burr Ridge IL, 2000.

31
© University of Texas at Austin, 2015

37
38
Common Size Statements
 Financial analysis is about pattern recognition.
You look for symptoms and then diagnose
causes. You need to convert data to information.

 It is often useful to compute common size

financial statements when analyzing a firm’s
financial performance
VALCON 2015

 Common Size financial statements

 Income statement: All items in the income statement
are restated as a percent of sales
 Balance sheet: All balance sheet items are restated as
a percent of assets
 Provide insights concerning trends in the firm’s
operating performance and financing

© University of Texas at Austin, 2015 32

 Financial Ratios
 Solvency & Risk Measurements
 Liquidity (Short-term Solvency)
 Leverage (Long-term Solvency)
 Debt Coverage (Ability to service financial obligations)

 Profitability & Return Measurements

 Profitability (Return on Sales – Profit Margins)
 Return (Profit Related to Investment)
American Bankruptcy Institute

 Efficiency & Productivity Measurements

 Asset Turnover (Asset Efficiency/Utilization)
 Cash Conversion Cycle
 Sales per employee or Sales per sq. ft.

Market & Valuation Measurements

 Earnings per share (EPS) , P/E Ratio, Enterprise Value/EBITDA

39
© University of Texas at Austin, 2015 33
40
Key Financial Terms
 Liquidity – The ability of the company to meet maturing
obligations. Current Assets relative to Current Liabilities.
 Leverage – Long-term solvency ratio. The amount of debt
capital used relative to equity (shareholder) capital. Debt to
Equity to Debt to Total Assets.
 Coverage – The ability of the cash flow from operations to
cover the annual debt service of the company. Cash Flow
divided by annual debt service or EBIT/Interest Expense
 Profitability – The return on each sales dollar (margin). After
VALCON 2015

the total costs of producing sales, how much money of left

over. Measured by profit margins (profit/net sales).
 Asset Turnover– Utilization (Asset Turnover) measurement.
Sales divided by Total Assets
 Rate of Return – some measure of profit divided by some
measure of the investment. Return on Assets Profit divided
by Assets.

© University of Texas at Austin, 2015 34

 Signs of Financial Distress
 Declining ROA and ROIC
 Decline in profit margins and/or
 Decline in asset turnover
 Plant and Equipment Utilization (Lower CAPEX)
 Working Capital Management
 Increase in Days Sales Outstanding (DSO)
 Increase in Days Sales Inventory (DSI)
 Increase in Days Payable Outstanding (DPO) followed by decline in DPO
(put on COD).

 Decline in Liquidity Ratios

 Current Ratio, Quick Ratio and Net Working Capital
American Bankruptcy Institute

 Increase in Leverage Ratios

 Debt to Assets, Debt to Equity, Debt to EBITDA
 Decrease in Coverage Ratios
 Times Interest Earned, EBITDA/(Interest/Capex)
 Decline in Operating Cash Flow
© University of Texas at Austin, 2015 35

41
42
Energy Future Holdings Profit Margins
VALCON 2015

© University of Texas at Austin, 2015 36

 Energy Future Holdings ROA & ROIC
American Bankruptcy Institute

© University of Texas at Austin, 2015 37

43
44
EFH Liquidity Ratios
VALCON 2015

Declining current and quick ratio is often a symptom. A ratio of less than
1.0 and no availability on credit lines is also common. Restructuring can
help liquidity (i.e. 2014)
© University of Texas at Austin, 2015 38
 EFH Cash Conversion Cycle
American Bankruptcy Institute

Lower days payable indicate company cannot leverage suppliers any more
and whose suppliers have power. Lower CCC due to days payable rising
indicate a company who can not pay suppliers who have no power over
company.
39

45
© University of Texas at Austin, 2015
46
EFH Leverage Ratios
VALCON 2015

Increased borrowing to cover negative cash flows are causing leverage ratios
to increase.

© University of Texas at Austin, 2015 40

 EFH Coverage Ratios

Equity Value < 0

American Bankruptcy Institute

Debt coverage ratios declining then deferring CAPEX to cover debt service.
Debt to EBITDA increasing. Enterprise values of companies range from 6 –
12X EBITDA and a 25x Debt to EBITDA ratio in 2012 make equity valueless.
© University of Texas at Austin, 2015 41

47
48
Measuring Performance
VALCON 2015

© University of Texas at Austin, 2015 42

 Business Performance
 How should we measure the performance of a
business?
 Revenue Growth?
 Market Share?
 Profitability?
 Earnings per share?
 Stock Price?

 Return on Equity (ROE) is a very common measure of

business performance (Return on Assets and Return
American Bankruptcy Institute

on Invested Capital are other metrics).

 It measures the amount investors receive per dollar
invested and is measured as:
Net Income Rev  Exp
ROE  
Owner' s Equity Assets  Liab
© University of Texas at Austin, 2015 43

49
50
Business Performance
 Managers can increase the firm’s value and it return
to shareholders:
Net Income Rev  Exp
ROE  
Owner' s Equity Assets  Liab
 By increasing Revenue (Profitability/Growth)
 Increasing Average Selling Price (ASP) and/or Volume (Q)
 Organic growth vs. acquisition ; New Products ; New Territories;
Customer Acquisition, Development & Retention; New Channels
VALCON 2015

 By decreasing Expenses (Profitability)

 Decrease Avg. Unit Cost (AUC) through Supply Chain Management,
Labor Productivity, OPEX control and Scaling Fixed Costs
 By decreasing Assets relative to Sales (Efficiency)
 Increasing Cash Conversion Cycle and Plant Utilization; Asset
Divestitures; Sales increases without Asset Increases
 By increasing Liabilities (Leverage/Risk – other people’s money)
 Higher returns come with higher financial risk if ROIC > Cost of Debt
© University of Texas at Austin, 2015 44
 Business Performance
 So ROE can be improved by managing:
 The Income Statement – Profitability and Growth
 The Balance Sheet – Efficiency and Leverage

But why is ROE so important?

 ROE is accounting’s way of measuring the value

created for the shareholders and can reveal the
American Bankruptcy Institute

financial strategy of the company. The first signs of

distress can be a declining ROE.

A firm’s sustainable growth rate is:

sustainable growth  ROE x Earnings Retention Rate
© University of Texas at Austin, 2015 45

51
52
VALCON 2015

Financial Strategies

© University of Texas at Austin, 2015 46

 Maximize Share Value
DuPont
Analysis

Growth (g) Return (ROE) Risk (r)

Profitability Efficiency Leverage

American Bankruptcy Institute

Operating Decisions Investing Decisions Financing Decisions

Customers Suppliers Asset Mix Terms of Trade Debt-Equity Mix
Products Pricing Liquidity, Cash Conversion Cycle Capital Structure Policy
Marketing Distribution
Controlling Expenses Plant Utilization, Make or Buy Dividend Policy

53
47
54
Market Value
Financial
Statements How can I
improve the
company’s
ROE?
Past Performance Future Performance
Return on Equity Return on Equity
Growth Growth
VALCON 2015

Risk Risk

DuPont
Company
Analysis
Manager
48
 Financial Strategy
 The financial goal (recognizing there are other
stakeholders) is to maximize shareholder wealth.
 This is accomplished by investing in projects that exceed the
firm’s cost of capital
 Cost of capital is a function of risk and opportunity costs

 Firms can create value by using its competitive advantage

in:
 Costs (power over suppliers, business model, OPEX
control)
 Pricing (power over customers)
American Bankruptcy Institute

 Asset Utilization
 Access and Cost of Capital
 Growth (branding, distribution channels, marcom)
 Risk Management (hedging, diversification, leverage)

© University of Texas at Austin, 2015 49

55
56
Financial Strategies
 Companies employ different strategies and
tactics to achieve the goal of maximizing
shareholder wealth.
 Some work off maximizing profit margins through
differentiation or intellectual property (Software/
Pharmaceuticals)
 Some work off scope (Proctor & Gamble, Wal-mart)
VALCON 2015

 Some work off scale (Frito Lay, McDonalds)

 Some work off efficient asset utilization (Airlines, Cable)
 Some work off leverage (Insurance, Financial Services)
 Combinations are possible
What is Cintra’s strategy and how does it generate it’s
returns?
© University of Texas at Austin, 2015 50
 DuPont Analysis

Inc Rev  Exp

ROE  
OE Assets  Liab

Inc Inc Sales Assets

  
OE Sales Assets OE
American Bankruptcy Institute

Profitability Asset Financial

on Sales Turnover Leverage
(Efficiency)

© University of Texas at Austin, 2015 51

57
58
DuPont Analysis
Inc Rev  Exp
ROE  
OE Assets  Liab
Return on
Assets (ROA)

Inc Inc Sales Assets

VALCON 2015

  
OE Sales Assets OE

Profitability Asset Turnover Financial

on Sales (Efficiency) Leverage

Note: The same factors affect ROC

© University of Texas at Austin, 2015 52

 DuPont Analysis
 Let’s compare some public companies in different
industries
 Let’s look at
 A Grocery Chain – Whole Foods
 A general merchandiser – Wal-Mart
 A software company – Microsoft
 A computer company – Apple
 A pharmaceutical (research) company – Johnson & Johnson
 A financial institution – Wells Fargo
 An insurance company – Progressive
American Bankruptcy Institute

 What would you expect the return on equity to be for each of

these companies given the risk of their industry to be able to
attract capital?
 How do you think they generate their return? Through profit
margins, asset efficiency or leverage

© University of Texas at Austin, 2015 53

59
60
DuPont Analysis
Last Twelve Months

Whole Wal- Wells Progressive

Foods Mart Microsoft Apple JNJ Fargo Insurance
ROE 15.1% 20.3% 26.2% 30.6% 23.7% 13.5% 17.2%

Profit Margin 4.1% 3.3% 25.4% 21.7% 23.3% 27.9% 6.2%

Turnover 2.5 2.37 0.55 0.9 0.60 0.051 0.75
Leverage 1.47 2.59 1.88 1.57 1.70 9.51 3.7

Note the different financial strategies the different companies take to produce
a risk adjusted return that allows they to attract capital.
VALCON 2015

• Whole Foods and Wal-Mart works off volume and efficient asset turnover while
leveraging their suppliers, but have small profit margins.
• Microsoft, Apple and JNJ have intellectual property and brand that enables
them to have higher profit margins, but they have relatively low asset turnover
(MSFT has $84B, Apple has $164B, & JNJ $33B in cash & investments).
• Financial Service companies like Progressive and Wells Fargo have huge
asset bases and low turnover, but work off other peoples money (leverage).
Low investment returns, catastrophic losses, bad loans can affect ROE.

© University of Texas at Austin, 2015 54

 Using Accounting Information for
Financial Decision-Making
American Bankruptcy Institute

© University of Texas at Austin, 2015 55

61
62
The Limitations of Profit-based thinking
 What are Profits?
Profits = Sales – Expenses
 Profits and Wealth
Wealth is the “value” added to the company by investment
decisions.
 Are accounting profits the best way to measure
wealth?
 What do accountants report or not report in the income
VALCON 2015

statement that might affect “value”?

 Interest is reported as an expense but where is the cost of
equity?
 Depreciation was recorded as an expense, but no check
was written
 That new equipment you bought on 12/31/13 required a
cash payment, but no expense was recorded on the P&L
 Some sales were reported but no cash was received
(receivable)
© University of Texas at Austin, 2015 56
 Operating Cash Flows
Operating Income= Revenues (R) – Costs (C) –
Depreciation (D)

Operating Cash Flow

OCF = R – C –Tax Payments (1)

Since depreciation is tax-deductible,

Tax Payments= (R-C-D) (Tax Rate) (2)
American Bankruptcy Institute

Substitute (2) into (1) and rearrange terms:

OCF = R-C-(R-C-D)(Tax Rate) (3)

This can be further rearranged two ways:

© University of Texas at Austin, 2015 57

63
64
Operating Cash Flows

OCF = (R-C-D)(1-Tax Rate) + D (4)

OR
VALCON 2015

OCF = (R-C)(1-Tax Rate) + D (Tax Rate) (5)

The second formulation illustrates the notion of a Depreciation Tax Shield

Why is interest expense not included as an operating expense?

© University of Texas at Austin, 2015 58

 The Firm’s Total or “Free” Cash Flows

Assets (LHS) = Claims to Assets (RHS)

Cash Flows from LHS Cash Flows from RHS
Operating Cash Flows Cash flows to Debt
(OCF) Interest
+ Debt retirement
CAPEX (purchases less – LT Debt Issues
American Bankruptcy Institute

sales of fixed assets) Cash flows to Equity

Dividends
+ Stock Repurchases
Additions to Net Working
– New Equity Issues
Capital (NWC)
+ Merger payoffs

59

65
© University of Texas at Austin, 2015
66
Applying the Past to the Future
 We can use our financial analysis of historical
operations to forecast the future free cash flows of
the business.
 Growth in revenues, expenses, operating margins and tax rates
to arrive at expected operating profits after tax.
 Depreciation expense
 Changes in working capital (receivables, inventory, and
payables) as revenues change
VALCON 2015

 Capital expenditures and capacity constraints

 We also have a feel for the variability of cash flows,
historical capital structure decisions, industry and
competitor information that will assist in determining
the appropriate discount rate (WACC) for the
riskiness of the cash flows

© University of Texas at Austin, 2015 60

 Discounted Free Cash Flow

The total value of a project or The free cash flows from the
business (firm), VF, equals the firm are calculated as follows:
present value of the project’s or
firm’s free cash flows (FFCF) that it Net Revenue
is expected to provide investors - COGS & Operating Expenses
(both debt and equity), discounted Earnings Before Interest, Taxes,
by the firm’s weighted average cost Deprec & Amort (EBITDA)
of capital (WACC). - Depreciation and Amortization
Operating Income (EBIT)
 x (1 - Average Tax Rate)
FCFFt
American Bankruptcy Institute

Net Operating Profit After Tax (NOPAT)

t
VF  
t 0 (1  WACC) + Depreciation and Amortization
where: - Capital Expenditures
t is the period in which the - Additions to Net Working Capital
cash flow is received. Free Cash Flows from the Firm (FCFF)

Free cash flow looks like a cash flow statement but is missing the financing
cash flows. Why?
© University of Texas at Austin, 2015 61

67
68
FCF and Firm Value
Our next session, led by Cesare Fracassi, will discussion business
valuation and will use our calculation of a firm’s free cash flow:

The value of a firm at time zero can be expressed

by the Free Cash Flow Model
FCF1 FCF2 FCF3 TVt
V0  1
 2
 3
 ...
(1  r ) (1  r ) (1  r ) (1  r )t
VALCON 2015

where
V0 = Value at time zero
TVt = Terminal Value at period t
r = Weighted Average Cost of Capital

Note: FCF is the Firm’s Free Cash Flows

© University of Texas at Austin, 2015 62
 Stock Price Maximization
Cash Flows have three dimensions which can
be exploited for stock price maximization:

 Magnitude
 The dollar amount of the cash flow
 Timing
 The time of inflow or outflow (today or in the future)
American Bankruptcy Institute

 Risk
 The likelihood of occurrence (variance).

© University of Texas at Austin, 2015 63

69
70
Accounting and Market Value

Good News – No News – No

Increase expected change in expected
FCF, ROE and FCF, ROE and
Stock Growth Growth
Price
VALCON 2015

Bad News – Decrease

expected FCF, ROE
and Growth

Time

© University of Texas at Austin, 2015 64

 The next session that will cover:

Valuation Basis
American Bankruptcy Institute

© University of Texas at Austin, 2015 65

71
72
Value Drivers

 Value Levers
 Growth
 Risk
 Profitability
 Asset Efficiency ROE
VALCON 2015

 Leverage
 Time

A sooner dollar and a safe dollar is worth more

than a later dollar and riskier dollar.

© University of Texas at Austin, 2015 66

 Business Valuation
Businesses are valued similar to a real estate appraisal.

 Cost Approaches
 Replacement cost of the assets – Value in Trade or Liquidation

 Market Value Approaches

 Precedent Transaction and Guideline Public Comparable company
multiples
 P/E ratio, Price/Book, Enterprise Value/Revenues, Enterprise Value/EBITDA
American Bankruptcy Institute

 Income or Discounted Cash Flow Approaches

 Present Value of the future Income or Free Cash Flow
 Leverage Buyout Value

67
© University of Texas at Austin, 2015

73
74
Reading List

• Finance and Accounting for Non-Financial Managers by William

Droms

• Financial Intelligence: A Manager's Guide to Knowing What the

Numbers Really Mean (Hardcover) by Karen Berman, Joe Knight &
John Case
VALCON 2015

• Corporate Financial Strategy (Paperback) (new edition due

12/2013) by Ruth Bender – UK author but good applied principles

© University of Texas at Austin, 2015 68

 Contact Information

Jim Nolen
McCombs School of Business
University of Texas at Austin
[email protected]
512-232-6834
American Bankruptcy Institute

© University of Texas at Austin, 2015 69

75