FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 5 – The analysis of Financial Statements (1)
What You Will Learn in This Chapter
• How businesses are set up to generate value
• How the financial statements are organized to reveal value added for shareholders
• Why reformatting financial statements is necessary for analysis
• How operating, investing, and financing activities are depicted in reformatted financial
statements
• The four types of cash flows in a business and how they relate to each other
• How reformulated statements tie together as a set of stocks and flows
• Why free cash flow is a dividend from operating activities to the financing activities
• Why free cash flow does not affect the accounting for value added
• What is reported in “other comprehensive income” and where it is reported
• What “dirty-surplus” items appear in the statement of shareholders’ equity
• How stock options work to compensate employees
• How management can create value (and losses) for shareholders with share
transactions
The Big Picture for This Chapter
This chapter provides the template for reformulating financial statements in a
way that readies them for analysis

Sound financial statement analysis requires

1. A distinction between the operating and financing aspects of the business

2. A reformulation of the financial statements into a form that makes this
distinction clear

A sharper picture of the business is drawn with reformulated financial

statements
Cash Flows Between the Firm and Claimants in the
Capital Market
Cash received from debtholders and shareholders is (temporarily) invested in financial assets. Cash payments to
debtholders and shareholders are made by liquidating financial assets (that is, selling debt). Net financing assets are
debt purchased from issuers, net of debt issued to debtholders. Net financing assets can be negative (that is, debt sold
to debtholders is greater than debt purchased).
Capital
The Firm Markets

F Debt
Holders or
Issuers
Net
Financial
Assets
d Share
(NFA) Holders

Financing Activities
Key: F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
NFA = net financial assets = financial assets – financial liabilities
Business Activities: All Cash Flows
Cash generated from operations is invested in net financial assets (that is, it is used to buy financial assets or to
reduce financial liabilities). Cash investment in operations is made by reducing net financial assets (that is, by
liquidating financial assets or issuing financial obligations). Cash from operations and cash investment may be
negative (such that, for example, cash can be generated by liquidating an operating asset and investing the
proceeds in a financial asset).
Capital
The Firm Markets

F Debt
Holders or
C Issuers
Net Net
Operating Financial
Assets I Assets
d Share
(NOA) (NFA) Holders

Operating Activities Financing Activities

Key: F = net cash flow to debtholders and issuers

d = net cash flow to shareholders
C = cash flow from operations
I = cash investment
NFA = net financial assets
NOA = net operating assets = operating assets – operating liabilities
The Cash Conversion Equation
A fundamental accounting identity:

C = Net cash from operations

I = Net cash outflow for investing
C-I = Free cash flow
d = Net dividends (common dividends + share repurchases – share issues)
F = Net cash outflow to debtholders and debt issuers (the net cash flow from
borrowing and lending)
= Net principal payments + net interest paid (i)

The treasurer’s rule:

If C − I −i  d : lend or buy down own debt

If C − I −i  d : borrow or reduce lending

Applying the Treasurer’s Rule: Microsoft
Applying the Treasurer’s Rule: General Electric
 Reformulated Statement of Cash Flows
C–I=d+F
Cash flows from operations C
Cash investment (I)
Free cash flow C-I
Equity financing flows:
Dividends and share repurchases XX
Share issues (XX) d

Debt financing flows:

Net purchases of financial assets XX
Interest on financial assets (XX)
Net issue of debt (XX)
Interest on debt XX F

Total financing flows d+F

Reformulated Cash Flow Statements: Microsoft
Reformulated Cash Flow Statement: General Electric
Reformulated Balance Sheet
Assets
Operating assets OA
Financial assets FA
Total Assets OA + FA

Liabilities and Equity

Operating liabilities OL
Financial obligations FO
Common stockholders’ equity CSE
Total OL + FO + CSE
Balance Sheet Restated Operating Assets
Operating assets OA
Operating liabilities (OL)
Net operating assets NOA

Financial Obligations & Owners’ Equity

Financial liabilities FO
Financial assets (FA)
Net financial obligations NFO
Common equity CSE
Total NFO & Equity NFO + CSE
Business Activities: All the Stocks & Flows
Product and
input markets The firm Capital markets
Net operating assets are
employed in operations to

ue t s
iss deb lder
generate operating

s
er
OR C F

or tho
revenue (by selling goods

Net Operating

eb
to

Net Financial
Assets (NOA)

rs
Assets (NFA)
us

D
and services to customers)

C
and incur operating
expenses (by buying inputs
from suppliers).

rs
∆ indicates changes.

de
rs

ol
lie

eh
OE d

pp

ar
I

Sh
Su OR-OE=OI
Key:
F = net cash flow to debtholders and issuers OI -DNOA=C-I
d = net cash flow to shareholders
C = cash flow from operations C-I -DNFA+NFI=d
I = cash investment
NFA = net financial assets
NOA = net operating assets Operating Financing
OR = operating revenue Activities Activities
OE = operating expense
OI = operating income
NFI = net financial income
Reformulated Income Statement
Business Activities and the Financial Statements: The Big Picture
This figure shows how
reformulated income
statements, balance sheets, and
the cash flow statements report
the operating and financing
activities of a business, and
how the stocks and flows are
uncovered in the financial
statements. Operating income
increases net operating assets
and net financial expense
increases net financial
obligations. Free cash flow is a
“dividend” from the operating
activities to the financial
activities: free cash flow
reduces net operating assets
and also reduces net financial
obligations. Net dividends to
shareholders are paid out of net
financial obligations.
How the Balance Sheet Evolves Over Time: Operating Activities
• The change in Net Operating Assets is given by

NOAt = NOAt −1 + OIt − (Ct − I t )

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

• Free cash flow reduces NOA.

How the Balance Sheet Evolves Over Time:
Financing Activities
•The change in Net Financial Obligations is given by

NFOt = NFOt −1 + NFEt − (Ct − I t ) + d t

•Net financial expense increases indebtedness

•Free cash reduces indebtedness, after paying out net

dividends from the free cash flow

•If the firm has net financial assets rather than NFO

NFAt = NFAt-1 + NFIt + (Ct – It) – dt

Free Cash Flows and Dividends: How They are Explained
1. As ΔNOA = OI – (C - I)
then
C - I = OI - ΔNOA
Free cash flow is what’s left over from OI after adding to the balance sheet, ΔNOA

2. As ΔNFO = NFE – (C –I ) + d
then
C - I = NFE – ΔNFO + d
Free cash flow is applied to pay NFE, reduce NFO and pay dividends

3. As ΔNFO = NFE – (C - I) + d
then
d = (C - I) – NFE + ΔNFO
Net dividend is the cash left over from free cash flow, after paying NFE and reducing debt
The Reformulated Statements:
Nike, Inc., 2010
Free Cash Flow for Nike, Inc., 2010
C - I = OI ‒ ΔNOA
= 1,814 ‒ (5,514 – 6,346)
= 2,646

Nike generated $1,814 million in operating income and reduced its investment
in the balance sheet by $832 million, so generated
$2, 646 million in free cash flow
Tying it Together: What Generates Value?
• From the balance sheet equation
CSE t = NOA t − NFO t

Given the way that NOA and NFO are calculated,

CSE t = NOA t −1 + OIt − ( Ct − It ) − NFOt-1 + ( Ct − It ) − NFEt − d t
= NOA t −1 − NFOt-1 + OIt − NFE t − d t
= CSE t −1 + Earn t − d t

which is the stocks and flows equation.

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

• Free cash flow drops out in this calculation: Free cash flow (C - I) does not add value to shareholders. Free
cash flow is a dividend from the operating activities to the financing activities

• What generates value for shareholders is the income from operating and financing activities.
Week 5 – The analysis of Financial Statements (2)
GAAP Statement of Shareholders’ Equity
___________________________________________________________________
Opening book value of equity (common, preferred, and noncontrolling equity)

+ Net share transactions with common stockholders

+ Capital contributions (paid in capital from share issues)

- Share repurchases (into treasury stock or against paid-in
capital)

+ Net share transactions with preferred shareholders

+ Capital contributions (share issues)

- Share redemptions

+ Change in retained earnings

+ Net income – including noncontrolling interest income
- Common dividends
- Preferred dividends
- Some share repurchases
+ Accumulated other comprehensive income
+ Earnings restatements due to change in accounting
+ Increase in equity from issuing stock options

Closing book value of equity (common, preferred, and noncontrolling equity)

The Governing Accounting Relation

Book value, beginning of period

+ Comprehensive income

- Net payout to shareholders

= Book value, end of period

Reformulated Statement of Common Stockholders’ Equity
Opening book value if common equity (CSEt-1)

+ Net transactions with common shareholders

+ Capital contributions (share issues)
- Share repurchases

- Common dividends

+ Comprehensive income to common shareholders

+ Net income – Noncontrolling interest income
+ Other comprehensive income

- Preferred dividends

Closing book value of common equity (CSEt)

Note that preferred equity and noncontrolling interest

are taken out of the common shareholders' equity
statement (and treated as obligations to others).
Reformulation: The Steps
1. Restate beginning and ending balances for items incorrectly included in or excluded from
common equity
– Preferred stock
– Noncontrolling interest reported within equity
+ Dividends payable

2. Calculate net transactions with shareholders

Cash dividends + share repurchases – share issues

(Cash dividends = Dividends declared – change in dividends payable)

3. Calculate comprehensive income

= Net income + “Other comprehensive income”
– Earnings from accounting changes
– Preferred dividends
– Noncontrolling interest in earnings
– Hidden dirty-surplus losses
The GAAP Statement: Nike, Inc., 2010
Nike: The Reformulated Statement

Cash dividends = Dividends declared – Change in dividends payable

= $514.8 – (130.7 – 121.4)
= $505.5
Dirty-Surplus Accounting: The Most Common Items
• Currency translation gains and losses

• Unrealized gains and losses on securities (debt and equity)

• Gains and losses on derivative instruments

Dirty Surplus Accounting in the US: A Complete List
 Ratio Analysis

Payout and Retention Ratios

Dividends
Dividend Payout =
Comprehensive Income

Dividends + Stock Repurchases

Total Payout Ratio=
Comprehensive Income

Dividends
Dividends-to-Book Value=
Book Value of CSE +Dividends +Stock Repurchases

Dividends+StockRepurchses
Total Payout-to-Book Value=
Book Value of CSE + Dividends + StockRepurchases

Comprehensive Income - Dividends

Retention Ratio= =1- Dividend Payout Ratio
Comprehensive Income
Ratio Analysis (continued)
Shareholder Profitability Ratio
Comprehensive Earningst
ROCE t =
1
( CSEt +CSEt-1 )
2
Growth Ratios

Transactions with shareholders

Net Investment Rate=
Beginning Book Value of CSE

Change in CSE Comprehensive Income+Net Transactions with Shareholders

Growth Rate of CSE= =
Beginning CSE Beginning CSE
Hidden Dirty Surplus
• Shareholders lose when shares are issued at less than the market price (e.g.
exercise of options)

• This loss, however, is not recorded as expense under GAAP and IFRS.

• What is the nature of this loss? If options are part of a compensation package,
this loss is an employee compensation expense. If from a conversion of a
bond, preferred stock or warrants, the loss is a financing expense.

• What is the amount of the loss?

Market price - exercise price.
Measuring the Loss from Exercise of Stock Options
Method 1 (Nike)
Expense is implied from the tax benefit*:
(Tax rate is 36.3%)

Stock option expense $58.5/0.363 $ 161.1

Tax benefit at 36.3% (58.5)

Stock option expense, after tax $ 102.6

*From financing section of the cash flow statement; sometimes reported separately in
the equity statement
Measuring The Loss from Exercise of Stock Options:
Method 2 (Nike)
Calculate difference between average stock price and
exercise price:

Estimate market value of shares issued: 8.6 mill x $64 $ 550.4

Exercise (issue) price, from equity statement 321.1*

Stock option expense, before tax 229.3

Tax benefit at 36.3% 83.2

Stock option expense, after tax $ 146.1

*From equity statement ($379.6) less tax benefit of $58.5 that has been added to
issue price in equity statement

Use this method when tax benefit is not reported, or for incentive
options (where there is no tax benefit).
Should Loss from Exercise of Options be Included
in Comprehensive Income?
• In principle, YES

• But….as grant date expense has already been recorded, we would be double
counting to some extent

• Two alternatives:
1. Unravel GAAP accounting and recognize just the exercise date expense that has
not already been recognized in prior years at grant dates (too difficult!)
2. Recognize loss on exercise of stock options, but reduce by “stock-based
compensation” recognized in the current year.
Alternative 2 is an expediency,
though not strictly correct.
Is “Stock-based Compensation Equity”
or is it Liability?
• It’s a liability! Shareholders have a (contingent) liability to issue stock at less
than market price.

• Yet GAAP and IFRS treat it as equity

• GAAP and IFRS make it look like issuing stock options increases equity.
• How can “payment” for wages increase equity?

• But…unraveling the GAAP accounting is too difficult. So treat stock-based

compensation as a net against loss or exercise of stock options (as an
expediency).
The Reformulated Equity Statement:
Including Loss on Exercise of Stock Options
The Option Overhang
The option overhang is the value of the options not yet exercised. This
(contingent) liability is the estimate of the amount of value that shareholders
will give up at exercise date.

A rough estimate of the option overhang:

Market value of stock to be issued XXX

Strike price of options XXX
Tax benefit (if any) XXX
Contingent liability for options XXX

(This is a floor valuation: ignores option value)

The Option Overhang: Nike Inc.
At the end of 2010, Nike had 36.0 million employee stock
options outstanding at a weighted average exercise price of
$46.60. Nike’s stock traded at $72.38 at fiscal-year end.

Floor valuation of Nike’s overhang:

(In millions)
Market price of shares: 36.0 × $72.38 $2,606
Exercise price: 36.0 × $46.60 1,678
928
Tax benefit (at 36.3%) 337
Contingent liability 591

(This is $1.22 per share)

Hidden Losses on Put Options: Dell Inc.
From the 2002 equity statement (see Chapter 2):
Shares Amount

Repurchase of common shares (millions) 68 $3,000

The Loss:

Market price of shares repurchased $24 x 68 million $1,632 million

Amount paid for shares repurchased 3,000

Loss on exercise of put options $1,368 million

Put Option Overhang: Dell
At the end of 2002, Dell had 51 million put options outstanding at a strike
price of $45. The market price of the shares was $25.

Estimate of option overhang:

Market price of shares $25
Strike price 45
Loss per share $20
× 51mill.
Overhang $1,020 mill.

This overhang is a contingent liability that has not been booked to the balances sheet

(The estimate is a floor: no option value added)

Losses on Convertible Securities
Loss = Market price of common issued -
Book value of convertible surrendered

The market value method vs. the book value method

• The market value method recognizes losses on conversion

• The book value method records the shares at the book value of the
convertible securities, with no loss recognized

Almost all firms use the book value method.

Accounting Quality Watch
Accounting Item The Quality Problem
• Dividends payable GAAP treats dividends payable as a liability. Rather, it is part of
shareholders’ equity. Shareholders have a claim to these dividends
that have been declared but not paid. They do not owe them to
others.
• Unrealized gains and Unrealized gains and losses on available-for-sale debt and equity
losses on securities securities are reported as part of other comprehensive income in
the equity statement rather than in the income statement. Thus the
full performance of an investment portfolio is not reported in the
income statement. Worse, as firms report realized gains and
losses in the income statement, they can “cherry pick” gains into
the income statement (and earnings per share) by selling
securities that have appreciated in value while holding those on
which they have experienced losses and reporting those
unrealized losses in the equity statement.
• Translation gains The gain or loss from holding assets and liabilities in foreign
gains and losses currencies when exchange rate change is not recognized in the
income statement. (The effect is booked to equity in the equity
statement, bypassing the income statement.)
• Preferred dividends Preferred dividends are treated as a distribution of equity rather
than a cost to (common) shareholders.
• Minority Interest The claim on the minority shareholders are incorrectly included in the
shareholders’ equity

(continued)
Accounting Quality Watch (Cont.)
• Stock compensation GAAP recognizes deferred compensation from grant of stock
credits to equity options as a credit to equity, as if shareholders’ equity increase by
compensating employees. This is a liability – to give up value on
the exercise of options – not an increase in equity.

• Grant-date stock GAAP recognizes stock option compensation at option grant date.
option accounting However, the expense (to the shareholder) is incurred at exercise date
as shares are issued for less than market price. If granted options are
not exercised, GAAP overstates wages expense. If options are
exercised, GAAP typically understates wages expense.

• Accounting for GAAP does not report the loss to shareholders when warrants and
warrants and options (call and put) options on the firms stock are exercised and shares
are issued or repurchased at prices differing from market price.

• Accounting for GAAP converts these claims to equity at their book value. Thus
convertible bonds no loss in recognized on the conversion.
and preferred stock

• Omitted borrowing As losses are not recognized on conversion of non-equity

costs financing instruments (like convertible bonds) into equity,
borrowing costs are understated.

• Omitted (off-balance Outstanding obligations to issue shares at less than market price
sheet) liabilities are not recognized on the balance sheet. These include the option
overhang from outstanding stock options.
QUESTIONS?