Corporate Finance I: Measuring and Promoting Value Creation

Professors Stefan Zeume & Heitor Almeida

Module 1: The Objective and Language of Corporate Finance

Table of Contents
Module 1: The Objective and Language of Corporate Finance ................................................. 1
Module 1: The Objective and Language of Corporate Finance ..........................................................2
Lesson 1-1.0: Module Objectives and Overview ................................................................................................... 2
Lesson 1-1.1: Why Maximizing the Stock Price Is a Reasonable Goal for a Company? ........................................ 8
Lesson 1-1.2: Conflicts Between Shareholder Value Maximization and Society ................................................ 17
Lesson 1-1.3: The Agency Problem and Corporate Governance ........................................................................ 25
Lesson 1-1.4.1: Balance Sheet Ratios: Introduction ............................................................................................ 31
Lesson 1-1.4.2: Balance Sheet Ratios: Liquidity .................................................................................................. 36
Lesson 1-1.4.3: Balance Sheet Ratios: Solvency .................................................................................................. 48
Lesson 1-1.5: Income Statement Ratios: Profitability ......................................................................................... 59
Lesson 1-1.6: Cash Flow Statement Ratios.......................................................................................................... 70
Lesson 1-1.7: Valuation Ratios ............................................................................................................................ 82
Lesson 1-1.8: Module 1 Review........................................................................................................................... 91
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Module 1: The Objective and Language of Corporate Finance

Lesson 1-1.0: Module Objectives and Overview

This first module is about the goals and the language of corporate finance. Heitor is from Brazil,
I'm from Germany. So we thought we would start the course with a football or soccer ball
depending on where you come from. Unfortunately, though the language of
corporate finance is not Portuguese or German like Heitor and I learned when we were kids.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

The language of corporate finance happens to be accounting. What we will learn in this module
is how to use financial statements and how to use accounting data to really understand what's
going on inside companies. We are going to use financial ratios to measure concepts like
liquidity, profitability or leverage. And we are going to try to understand how companies are
generating and spending cash using the cash flow statement.

In terms of the goal, the important thing is that in corporate finance we are going to be studying
investment decisions that are made by companies as opposed to studying investment decisions
made by people. We are shifting our focus and we talk about companies. Before we can think
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
about the financial investment decisions, we have to discuss the objective of the corporation.
What is the goal of the company? What are firms maximizing when they make a financial
investment decision?

In this module we are going to discuss this really important idea of shareholder value, the
concept of shareholder value maximization. Okay? We will discuss why it makes sense to
maximize shareholder value and we will discuss the problem with maximizing shareholder value
as well, the potential problems that companies may encounter when they solely focus on
maximizing shareholder value.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Specifically, we will discuss why maximizing the stock price is a reasonable goal for companies
and better than alternatives such as maximizing their current profits. But we are also going to
talk about the potential problems that this may create. For instance, there are conflicts between
the stock price maximization on the one hand and social responsibility, employees, the
government on the other side, okay? And we're going to talk about those.

Finally, we are going to talk about agency problems. The fact that managers may not
necessarily maximize shareholder value and how corporate governance practice can help with
that problem. In fact, this last part, the problem with shareholder value maximization is so
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
important that we will get back to it in the very last module of the second MOOC of this course,
but only once we understand the language of finance much better, okay?

Next, in this first module, we are going to move on and talk and learn about the language of
finance. We will learn how to use information from the accounting statements to measure key
corporate finance concepts such as liquidity and solvency. Then we are going to look at the
income statement to measure profitability.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
We are going to look at the income statement to measure profitability and we are going to look
at the cash flow statement to understand how companies generate and spend their cash.

Finally, we are going to talk about valuation ratios from a corporate finance point of view. We
will talk about valuation ratios such as market to book, and we will calculate these ratios and
discuss what they mean.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.1: Why Maximizing the Stock Price Is a Reasonable Goal for a Company?

In this course, we will talk about many corporate decisions. Investment decisions
financing decisions, acquisition decisions. At this point, it's very important for us to discuss what
is the objective of the firm. What is the objective of the company. If they're making these
decisions, which variables are the companies maximizing. Which variables are they looking at?
You know, an idea seems to make sense is that since companies are owned by shareholders,
they should be maximizing shareholder wealth, or in other words, maximizing the stock price.
Maximizing the stock price is the objective of the corporation. What I want to do now it, is to
really discuss his idea with you and think about whether that makes sense or not.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

The first thing that you might be thinking is that maximizing a stock price seems to be a little bit
shortsighted. The stock price is a current measure; it's a measure of the current value of the
firm, whereas, if you are concerned about shareholder wealth, you might also be worried about
the future. What's going to happen in the future? If we maximize the current stock price,
perhaps we are not maximizing shareholder wealth. The think about the following: what
determines the stock price? This is something that you might have covered in a previous course
or if not, that's the right time for us to discuss this. It's a very important idea in finance. The stock
price should be that discounted sum of all future cash flows. The stock price of a company today
should depend of everything that is going to happen in the future. The stock price should reflect
all the consequences of any decision that a company takes today. It's the forward-looking
measure. That is why if you think about it, you know, even though it's a current measure, it also
reflects the future. It makes more sense once you think of stock prices as the discounted sum of
future cash flows, it starts making more sense that companies can look at stock price.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Let's think about this idea. Do stock prices really reflect information about the future? That is the
idea we just posed. Is there a way we can look at data to see that? A very useful example to
consider is the market reaction to merger announcements. Let me give an example here that is
an example were going to talk about more in our Module Four when we discuss acquisitions. On
September 4 of 2001, Hewlett-Packard announced it was going to buy Compaq. It's an
announcement. It announces to the financial press; to analysts that this merger is going to
happen. The merger hasn't happened yet. In fact, this merger was highly contested. The
shareholders of Hewlett-Packard were not happy about that merger. And the merger ended up
being completed almost a year later. But check this graph. Right on September 4, when the
merger was announced, this is what happened to stock price.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

This is the date of our September 4. The stock price immediately dropped. It is a current
measure, but the moment that this new information came into the market, the stock price
reacted to that. Why did the stock price drop? The stock price drop because, as we just
discussed, shareholders did not like the merger. They thought that the merger was not going to
add to the value of the company. With the market does is the market reacts immediately to that
piece of information. They are not waiting for future profits to come in, the markets not waiting to
try to figure out what's happened, you're immediately reacting to any corporate decision. This is
the support this idea that stock prices really reflect future, and it's a variable that managers
should be looking at.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

An important notion here is the role of efficient markets. This idea that we just posed that the
stock price reflects all consequences of any decision that a company takes today, it relies on the
assumption that markets are efficient. If the market is efficient than the stock price should be
exactly equal to that. Of course, markets are not perfectly efficient. The stock price is not always
going to be a perfect measure of shareholder value. There is going to be a discrepancy between
stock prices and shareholder wealth. At this point, we have to think about, are there good
alternatives? Is there something else we can look at?
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Let's talk about earnings-per-share. This is a commonly reported measure of profitability for
companies. What it is, it's just the current earnings; the current net income of the company
divided by the number of shares outstanding. You are looking at current profits and dividing
current profits by shares outstanding. And the question I want you to think about is, can it that
replace a stock price? Will maximizing earnings per share maximize current shareholder wealth
or not? Or are there problems with earnings-per-share?

If you think about this for a while, you will see that the answer is no. Now were going to have a
problem of short-term. Earnings-per-share are only going to measure current profits. If you're
maximizing current earnings-per-share, then you are completely ignoring the future. There's no
way you can capture future profits just by looking at earnings-per-share. Later in this module,
we are going to talk about profitability measures. One concept that going to learn is that there
may even be better measures of profitability. There are problems with earnings-per-share that
make it in my view, that make it a problematic measure of profitability. On top of this problem
that it ignores future, EPS is also problematic as a measure of profit. So it’s definitely not, as
you know, an adequate alternative.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Here is an interesting example from the merger world. That's a more recent merger on July
2015, the Celgene, which is a biotech company, announced a deal to buy another company
called Receptos. This deal was welcomed by the market, and the market liked this one. The
stock market reacted positively to the deal; Celgene stock price went up substantially, $115 to
135, but at the same time, the management announced that the deal was going to reduce
earnings-per-share. For four years, it would take four years for this deal to generate profit. Still,
the stock price went up. What does that mean? It means that the market really is considering
this long-term effect of the merger in order to figure out whether this merger is adding value to
the company or not. The fact that EPS is going to go down now, seems to not matter as much
when the stock market is trying to estimate the value of this deal. That's an example of situation
where stock prices and EPS are really departing from each other.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Another alternative you might think about is the book value per share. The book value of equity,
you know, one advantage may be that this is an accounting value. It goes to all the things. It's a
number that is easy to verify okay. The problem is going to be similar to earnings-per-share.
The book value of equity does not reflect future profits. The book value equity reflects mostly
what happened in the past not the future so if we maximize the book value of equity, again, we
are going to be completely missing this future, you know, it's going to leave the short term, it
might lead to wrong decisions.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Bottom line is that you know, maximizing stock prices is the lesser evil even if markets are not
perfectly efficient, at least you have a hope that the stock price is capturing information about
the future. That doesn't mean the stock price is a perfect measure, as were going to
talk now, there are problems. These problems arise mostly because maximizing shareholder
wealth may not be come patentable with the welfare of society as a whole and other
stakeholders in the firm. So that's the next topic we're going to discuss.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.2: Conflicts Between Shareholder Value Maximization and Society

Let us now think about potential conflicts between firms and society. We just discussed the
notion of maximizing the stock price to make shareholders happy. But what about society as a
whole? The first issue that we can talk about is social responsibility. Before we get into the
problems, let's talk about a few actions that companies may take that could be socially
responsible. Think about investing in human capital, for instance, if an employee works in a
company for a very long time, well that employee learns new skills. The company might even
pay for that employee to learn new skills. These skills have value, but the value of these skills is
not just captured by the company. The value is captured by the employee who takes them home
and might use them to benefit society. Investment into human capital is something that may
benefit society, not just the company. Sustainability is another issue. Many companies are
trying to develop products that are better for the environment, that make the environment
more sustainable. Again, that's an example of a socially responsible corporate action.
Philanthropy is another one. Many companies make donations and act to benefit the
communities and society as a whole. These are all examples of socially responsible corporate
actions.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

But of course, that doesn't always happen. There is a flip side to this. There are conflicts as
well, and it's easy to think of a situation where maximizing shareholder wealth may not be
consistent with social responsibility.

For example, there are some products that are simply bad for our health. Some companies
produce tobacco, junk food. It is well known that these are not great for people, but people value
them. Companies create profits by selling these products. This is good for shareholders, but it
may not be ideal for society.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

There is a conflict between maximizing shareholder value and society. Pollution is another
classic example. Companies have incentives to reduce costs and to produce things as cheaply
as possible to increase profits and therefore shareholder value. But this might not be exactly in
the best interests of the environment. Technologies that are cheap but pollute the environment
are not going to be great for society. Another example you might think of is outsourcing of labor.
Hiring employees and other countries is of course, going to be great for those countries but it
might not be ideal for local labor markets. This is another hotly debated topic anytime of the day.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

One issue that you might not have thought about is the example of conflicts when it comes to
taxation. Should companies minimize their tax burden? The answer seems to be obvious.
Minimizing taxes increases profits and therefore should increase stock prices. If taxes go down,
both your current and your future profits will be higher. But there's a flip side to this. Minimizing
taxes is also going to reduce tax collection. The government is going to receive less money. The
government will have less money to invest in infrastructure, to invest in social projects, and so
on. When firms minimize their tax bill, this might reduce the government budget. Corporate tax
reduction might not be best for society.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

One example that the financial press keeps coming back to is how much cash US firms hold
abroad. Turns out that up to 2018, US multinational companies were holding huge amounts of
cash in countries that are outside of the US, especially in so-called tax havens. On this slide,
you will see a chart to look at. You can see that Apple, for instance, hold 252 billion
of its 285 billion in cash abroad and mostly in tax havens. That's a huge amount of cash held
abroad and it's also very large fraction of Apple's cash holdings, it's almost 90% that they hold
abroad.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

You might have heard about this before and so let's look at how this is related to taxes.

Up to 2017, the huge cash holdings were mostly explained by the notion of repatriation taxes.
Take Apple as an example. Apple may have had operations in Ireland back then. The corporate
tax rate in Ireland is just about 10% so if Apple generates a billion in profits, they will generate a
tax bill of roughly $100 million. That's the Irish tax. Now the US corporate tax rate back in the
day was much higher than it is now, it used to be 35%. Apple in this case, would have to pay an
extra $250 million to bring back the cash to the US from Ireland, and guess what? The cash
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
didn't return to the US, it stayed abroad. Many companies would keep their cash abroad in order
to avoid this repatriation tax. Maybe waiting for repatriation tax break, and that reduced tax
collection for the US government.

All this has changed a little bit, thanks mostly to the Tax Cuts and Jobs Creation Act of 2017, so
that act reduced the repatriation tax to a flat 15.5% on foreign cash and eight% on foreign non-
cash assets. Relative to the repatriation tax paid prior to this act, firms now have a much greater
incentive to repatriate and they pay the tax. As you might imagine, this resulted in repatriation of
foreign cash, and that cash was then used to repurchase shares, repay debt, but also to invest.
It's hard to estimate how much cash has been repatriated due to the Tax Cuts Act, but some
estimates range into the 600 billion. Mode of course, that the Tax Cuts Act or the Tax Cuts and
Jobs Creation Act also reduced the corporate tax rate to a flat rate of 21%. It's likely that overall
tax revenues to the government went down.
Overall, I'm not trying to say that companies should not have hold cash abroad, and I'm not
trying to say that they should not keep holding cash abroad. The more general point here is that
there are situations where the government may come into regulation to intervene in order to
improve the situation. Pollution is an example by regulation as possible. Outsourcing of labors
another example here also regulation by the government is possible, and so there is a potential
role for the government here.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Next topic. Let's think about conflicts between shareholder wealth and other stakeholders. This
is related to what we've been talking about, but now let's think very specifically about
stakeholders like employees, suppliers, debt holders. Does a high stock price also benefit these
other stakeholders? That's a question that I would like you to think about for just a little bit, and
then we will talk about it very briefly. The answer seems to be yes, there isn't necessarily a
conflict if you think about it in the following way. A more valuable company, a company with a
higher stock price, is going to be able to pay higher wages, it's going to be able to improve
career prospects and so on, so high stock price could indeed be good for employees. A high
stock price is also good for debt holders because it makes the company much more stable, so it
lowers the risk for debt holders so there it is. There are many potential reasons why a high stock
price can be good for other stakeholders.
The problem, of course, is that this congruence does not always hold, so one commonly
discussed example of potential conflicts is mergers and acquisitions, which we discussed to
some extent already. M&As might increase the stock price, but they might also make some jobs
obsolete, so if two companies merge, some jobs may not make sense anymore, and there's
indeed some evidence that M&As are related to employment cuts. If you work for a company
that has undergone some M&A activity, you will know that this can be very stressful for the
employees. In the name of improving operating efficiency, it is common that M&As will result in
lower employment. There is another aspect of M&As that we are not going to talk about too
much in this course. Well, there is, in fact, an M&A course that we'll talk about this. You might
have heard that some M&As are financed with large amounts of debt, these are leveraged
buyouts. The new issuance of debt can of course hurt existing bondholders. If you hold a bond
and accompany that undergo such leveraged buyout, it's quite possible that the value of your
bond is going to go down just because leverage is increasing so much. This is just another
example, where maximizing the stock price doesn't necessarily benefit stakeholders.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.3: The Agency Problem and Corporate Governance

Let us talk now about corporate governance. The idea then that we've been discussing is that
companies should try to maximize shareholder wealth. The problem is that companies are
managed by managers. Managers must make these decisions. Shareholders may not be able
to make the decisions on their own. They must rely on managers. And the problem is that
managers of course are going to maximize their own wealth. Managers' incentives may not be
to always maximize shareholder's wealth. And there is a name for this in corporate finance. We
call this the agency problem, okay, managers, the fact that there may be a conflict between
what managers are maximizing and what shareholder's want. This is a different problem. Notice
that this has nothing to do with social responsibility or stakeholders. It really is a problem that
belongs to the company. It's a conflict between managers and shareholders.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

What's sort of a conflict are we thinking about here? For example, stealing, you know stealing is
not in a developed economy like the U.S., but it does happen, right? Even in the U.S. and it
happens in other countries as well. Sometimes managers steal from companies. Employing
family members, right a family member may not necessarily be the best manager. But if you are
a CEO you probably have a lot of power to decide who you are going to employ, especially if
you own the company as a whole, right? If you own a lot of stock in the company and you are
the CEO you might decide to employ a family member instead of hiring a manager in the labor
market that might be a better manager. That's going to be bad for shareholders but it's going to
be good for the CEO. Not working hard enough is another problem. Shareholders of course
want managers to work hard, create value but managers may be lazy and not want to put on the
hours, right? And overspending the company's money, right which is sort of related to stealing
but a softer version of stealing. You know one issue that we talk about is corporate jets. A
corporate jet might make sense but, in some cases, a corporate jet might be, the usage of a
corporate jet may be a little bit excessive and not be great for shareholder value. These are
some general examples of what with we think of as agency problem.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

How do companies’ slow agency problems? So how can you align incentives of managers and
shareholders? The answer is very simple. It's probably something that you have thought about
before. It's compensation. If you want managers to maximize the value of the stock, the easy
way to do it is to give stock to managers. That is why you know that managers own so much
stock in companies. Stock managers like CEOs, CFOs, you know the top five to ten managers
of a company would typically be owning a significant chunk of the stock. And if you think about
this practice it does make sense, right because if you want managers to maximize the stock
price. It's a good way for, this is a good way to do it because even if managers are maximizing
their own wealth they are going to end up maximizing the stock price.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

This is the idea, however, this practice of giving stock to managers has been the object of a very
heated debate recently. There are many observers, analysts, academics who claim that stock
compensation might have gone too far. This is just some data for you to think about. CEO pay in
the U.S. has grown by a lot more than the average pay of an employee, right, so the average
pay of an employee in the U.S. in the period of 1982 to 2004 which is in this graph hasn't grown
by much, whereas you know this CEO pay has grown by 8.5% a year, okay? It's also higher
than the GDP growth rate and higher than the growth rate in corporate profits which is 2.9%.
This kind of data you know we know that executives get paid a lot, CEO pay has also increased
a lot in recent years so this kind of data has generated this debate, you know, on whether top
executives are paid too much or not.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

There are two sides in this debate. Some of them exclaim that you know this is a market of
outcome. We shouldn't mess with it. Companies want to pay, if companies want to pay a lot to
hire a CEO, they should be able to do it. High pay is just the consequence of a demand for
talent. But on the other hand, the people who want to curb CEO pay what they claim is that this
argument doesn't really work because pay is determined by the board of directors and the board
of directors does not always work independently from the CEO. The board of directors may be
composed of people who are friends of the CEO, who are not truly independent and that may
lead to the CEO to get paid too much.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
A possible solution for this problem is to rely on corporate governance. To rely on other
governance mechanisms other than compensation. We think of corporate governance as any
sort of mechanisms that companies have to solve this conflict between managers and its
shareholders. For example, having a truly independent board of directors may help. If the
problem is that the board of directors is not really independent from the CEO what companies
can do is to get some independent directors. A very common and recent trend in the U.S. is the
role of institutional investors. Institutional investors have larger stake in firms, and they can
come, you know people who own a lot of stock in firms can come and try to change corporate
practice like CEO compensation. And finally, there is pressure from M&A market again. M&A
matters a lot, mergers and acquisitions. If a company is in inefficient, if you're paying the CEO
too much and profits are going down, shareholder value is going down you know, you might
eventually die out, either be swallowed by your competitors or disappear, go bankrupt. There
are ways to control this problem.

There may be a role for the government as well. The last observation here following the recent
financial crisis of 2007-2009, the U.S. government introduced a new law. According to it,
shareholders now have to vote to approve executive compensation. This law is being
implemented now, slowly being implemented so it may be a little bit too early to figure out
whether this law has had an effect on compensation or not. Academics are currently studying
this issue. What we see so far is that in a vast majority of cases the shareholders ended up
approving the compensation that was proposed by the board. Perhaps this means that the
compensation packages we are not wrong, were not excessive, okay or perhaps it means
something else. It's a little bit early for us to say. I think we have to wait a little to be able to
figure out whether "Say on Pay" is going to have an effect on executive compensation or not.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.4.1: Balance Sheet Ratios: Introduction

As we discussed in the introduction to this module, accounting is the language of corporate

finance. In this lesson, we will use accounting to calculate and interpret financial ratios. We will
use these financial ratios to measure key corporate finance concepts.

We will have to deal with the major financial statements, the balance sheet, the income
statement, and the cash flow statement. But in the end, we will be able to put life into these
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
financial statements. We will be able to discuss how firms did over time and how they did
compare to other companies. We will realize that we can learn a lot from just looking at financial
statements.

Let's start with balance sheets. That's going to be the first set of financial statements that we will
be looking at. We will spend quite a bit of time thinking about balance sheets. Are you ready?
Before we get into a real-world example, which is really how I want to do this, I want to start with
a very simplified example where we are comparing three companies. We have company A,
company B, and company C. There you can see all of their balance sheets. A railroad balance
sheet, of course, would be more complicated. But here we just have the basic items. Assets,
liabilities and assets and liabilities are split into current and non-current. And we also have
information equity, which is the difference between assets and liabilities. Now, ask yourself,
what kind of information we can get by just looking at these balance sheets? The first thing you
will notice is that the balance sheet will give you information on the size of the company. How
many assets does the company have? In this case, all of these three companies have 500,000
in assets. And then we can look at the liability side where we notice that there are some
differences. If you look at company A, for instance, that company has 200,000 in current
liabilities. Company B only has 50,000. Both companies have the same amount of total
liabilities, but company A has more current liabilities. In this lesson, we shall figure out what that
means. What does it mean for the liquidity of these companies that they have different current
liabilities?
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Next, let's look at company C. The main difference between Company C and the other two
companies is that company C has fewer liabilities. In this lesson, we will talk about solvency and
what it means for these companies.

These are the key concepts really that we're going to be talking about. Liquidity on the one side
and solvency. And rather than using the simplified and very dry example from before, I would
really like to introduce and discuss free real-world companies just to illustrate these concepts.
We will take two companies that are in roughly the same industry. They are almost competitors.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

The first one is Altice, a telecommunications company with roughly 5 million customers. These
customers are mostly in the US and in Canada. The company provides mostly broadband video,
telephony and mobile services.

The second company is Dish Network Operations, which we will just call Dish to save some
time. This company offers video and wireless services along with paid TV, and they have
roughly 10 million customers in the US.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

And for reasons that we will understand soon. We will also talk about a third company in a very
different industry. You will all know that this company designs, develops, sells services,
airplanes, among other things. They are a leading aerospace manufacturer and they are a
defense contractor. Of course, it's a completely different company. In a moment, you will see
why we include this in our analysis. Those are the three companies we are going to analyze.
Now, we're really going to try to get into the financial ratios and see what we can learn about
these companies by reading their financial statements.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.4.2: Balance Sheet Ratios: Liquidity

We will start by looking at liquidity ratios. Those are ratios that allow us to measure how liquid
the balance sheet of the company is. The first liquidity ratio that we're going to compute and
analyze is what we call the current ratio. The current ratio is really very simple. It's just the ratio
of current assets divided by current liabilities. As a way of illustration, let's just compute this ratio
for Altice and Boeing.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

We will start by looking Let's go here to the balance sheet. We have the real balance sheet for
Altice for three years. We will focus on the most recent year, but if you enjoy doing this, if you
want to practice, if you really want to see how this company did over time, you may want to
calculate everything for the other two years as well. Here we go. We would like to compute the
current ratio, so we have here the data of the most recent current assets, and the data for the
most recent current liabilities. The current ratio is simply the ratio of current assets to current
liabilities. It's 790 divided by 2,745. This is in millions. Altice has 790 million in current assets
and 2.7 billion in current liabilities. The current ratio is approximately equal to 0.3. Altice has
$0.30 in current assets for every dollar of current liabilities.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Let's move to Boeing. Here's the same information. You have the balance sheet for the last
three years. Here you have information on the current assets and current liabilities. Again, we
can compute the current ratio by dividing the current assets by the current liabilities. They have
108.7 billion in current assets, and 82 billion in current liabilities. Our current ratio here
is approximately 1.33. That's the calculation. Now let's think about this. Boeing seems to have
much larger current ratio than Altice has. It's 1.33, so it's significantly larger than 0.3. Does that
mean that Boeing has more liquidity than Altice? Well, the simple answer is yes, Boeing is more
liquid. But we must think about the details a little bit. We will soon realize that the main reason
why Boeing has a high liquidity ratio is because they have quite a bit of inventory. You can see
this here. Out of the 108.7 billion in current assets, they have 78.8 billion in inventory.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Let's take this information and think about it. Boeing seems to be more liquid, but this is largely
driven by their high inventory. Inventory, I mean, does this really measure liquidity? Is inventory
a really liquid asset or not? That's going to be our question. Does this calculation really mean
that Boeing has more liquidity than Altice? What we need to think about is, what does liquidity
really mean? What are we trying to measure when we measure liquidity? It turns out that this
notion of liquidity is really very important in finance. Liquidity measures how easy it is to turn
assets into cash.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

So how fast can we generate cash from an asset? How easy is it? How much cash are we
going to get for that asset? That's the notion of liquidity. Really, what we're trying to understand
is whether a company like Boeing has sufficient current assets to cover their current liabilities.

For instance, is inventory really a liquid asset? Well, think about that. Of course, companies can
always just sell their inventory. If you run into a liquidity problem, you could just sell some
inventory, raise some cash that way. But of course, there might be problems, so liquidating your
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
inventory in order to raise cash is going to disrupt the business, for instance. Think about
Boeing. The reason they have this inventory is because they have to keep engines, and seats,
and all the likes. They need the aircraft engines and seats and all of that in order to build
airplanes. If they have to liquidate inventory, well that's going to disrupt their business. So in
addition, the company may not really get a good price when they try to sell the inventory. Their
inventory might be very specific to a particular aircraft, and if they tried to sell it, they might not
get all that cash for it. Actually, there is some evidence in the corporate finance literature about
exactly this.

There's a very interesting paper by Berger, Ofek, and Swary, which was published many years
ago, but the results are still there, they still hold. What these authors did is they gathered
information on how much money companies could raise when they sold their current assets.
When they had to sell assets because they were discontinuing operations. These are
companies that went bankrupt later. What the authors did is they looked at how much these
companies got for their current assets.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Intuitively cash is one of these assets, if you sell a dollar of cash, you get a dollar. For
receivables, these companies got roughly 72 cents on the dollar. What this number tells you is
for every dollar in receivables, you are able to raise 72% of that. If you had 100 million
in receivables, you would raise 72 million in cash. Inventory was the lowest. Inventory only
generated roughly 55 million in cash for every 100 million in inventory, so 55%. Inventory is
somewhat liquid, but not perfectly liquid.

This is why we have to think about additional liquidity ratios. We need liquidity ratios that take
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
the liquidity of inventory into account. There are two ratios that we're going to be looking at. The
first one is called the quick ratio. It only uses cash and receivables. The other one is the cash
ratio, and it only uses cash. Both ratios ignore inventory and the cash ratio also ignores
receivables, since receivables are not perfectly liquid.

Let's calculate all ratios for DISH. This is DISH's balance sheet right here. What we would do to
calculate the quick ratio is we just take the first two numbers, cash plus receivables, and we
divide the sum by total current liabilities. We are ignoring everything else. That is in this balance
sheet. We are assuming everything else is not liquid. We only take the assets that we know are
going to be generating some liquidity. That's the idea.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Here's what you should find if you just took cash and receivables and divided by current
liabilities. DISH quick ratio should be about 0.97. DISH has 97% of their current liabilities in cash
and receivables. Later, we're going to talk about what this exactly means. Below on this slide
are all the calculations using the data and I encourage you to do this on your own just to check
and make sure that you can get to the same numbers. We have the cash ratio, the quick ratio,
and the current ratio for all three companies. Now let's compare the two companies that are in
the same industry. You can see that if you look at the comparison, it's easy to see that DISH
has a much higher liquidity ratios, so DISH is much more liquid than Altice. If Altice had to cover
its current liabilities on the spot right now, they might be in big trouble. We discussed that
Boeing looks liquid, just looking at the current ratio, 1.3 feet, so we have $1.43 in current assets
for every dollar in current liabilities. But look at the quick ratio and at the cash ratio. Once we
ignore inventory, Boeing looks much less liquid. If inventory is indeed a liquid, if it fetches like
cents on the dollar, they may be in trouble just like the other company.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Let's move one step further and think about the following question. What is a good liquidity
ratio? Remember, the question we are asking is, can the company pay for its short-term
liabilities without relying on cash flow? What that means is that one might be a quite reasonable
standard to look at. Current ratios should be above one. That means you have more current
assets than current liabilities. Quick ratios should also be at least close to one. Why is that?
Well, because we don't want to rely too much on having to sell inventory. Selling inventory can
be tricky, so we conclude that quick ratios should also be close to one. Ideally, you don't want
your quick ratio to fall too much below one. That's another way of putting it. How large the cash
ratio needs to be is a more complicated question. It depends on how liquid the receivables are,
but also on some other considerations. We will talk about short-term cash management a bit
more in the second module of this class. The general idea will remain that high cash ratios are a
good thing in terms of liquidity, but perhaps they don't have to be exactly one.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Lastly, let's understand how liquidity can deteriorate. How can a company become less liquid? If
you think about it, liquidity is all about comparing your short-term liabilities to your short-term
assets. One way the company can reduce their liquidity is by increasing short-term debt in order
to invest in long-term assets. That will reduce your liquidity. If you like math, you can go back to
the formulas. You are keeping constant at your numerator, and you are increasing your
denominator. If you don't like math, just trust that slide.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

The bottom line really is that if you take some of your cash to invest in capital expenditures,
you're going to lower your liquidity. This is an issue that we will talk about in Module 2.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.4.3: Balance Sheet Ratios: Solvency

Now we will talk about solvency ratios or leverage ratios. Those two are synonyms. You can use
either of them. There are several debt ratios out there. You see three of them on the slide and
we will talk about each of them. One of them, the first one is very commonly used, but I will
explain why I recommend not to use it.

The free ratios we will talk about in this class are debt/assets, debt/debt+equity and
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
liabilities/assets. Every time we use the term debt, you should think of that as the sum short-
erm and long-term. We're considering both short-term and long-term debt. Let's try to
understand the difference between these ratios and particularly let's try to understand the
difference between debt and liabilities. You see that some of these ratios use debt and others
use liabilities.

The best way to understand the differences is to look at a very simplified balance sheet,
which is what we have here. On the slide, this is a balance sheet we see that, we see other
liabilities on the right-hand side and assets on the left-hand side. Let's focus on the liability side.
Notice that total liabilities of the company are going to be the sum of debt, which you can think
of as financial liability plus other liabilities like pensions and accounts payable. There are other
liabilities on the balance sheet. It's not just financial debt. One way to think about this is
that total assets on the left-hand side are equal to debt plus other liabilities plus equity.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

You can immediately see one problem with the first ratio. The first ratio uses debt. The problem
with ratio number one is that it ignores other liabilities such as pension obligations, but other
liabilities are part of assets. Okay, so assets equal that plus other liabilities plus equity. But
we're not including other liabilities in the numerator. What does this mean? That over assets
may underestimate leverage for some companies, especially those that have a lot of accounts
payable or those that owe pensions to their employees. We might end up underestimating
leverage and we might be overestimating the solvency of these companies if we use the first
ratio. This is exactly why I usually prefer to look at ratios 2 and 3. So in the second ratio we
divide debt by debt plus equity. We essentially ignore the other liabilities but both in the
numerator and the denominator. And in the third ratio we include everything. We divide total
liabilities by total assets. So other liabilities are included in both the numerator and the
denominator.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

My recommendation is that we look at ratios number two and number three. But I wanted to
discuss that over assets because that ratio is commonly used, and you might encounter it when
you read beyond this course. I thought it was important that we discussed that first ratio but we
will focus on ratios number two and three.

Before let's try to calculate these leverage ratios using data from real world companies. Okay.
And let's focus on Altice first, let's figure out how much leverage this company actually has. You
see all the data on the slide, it's taken from capital like you. On the left, you have data on the
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
current capitalization of Altice, that's data on the current stock price and the current market
capitalization and that's really the market value of equity. You also have data on total debt and
on the right, I provided you with a simplified version of the balance sheet of the company where
we have assets and total liabilities. The first thing you will notice here is that Altice has more
liabilities than assets. Please look at this for all years that we have here Altice ends up having
more liabilities than assets.

Let's talk about that. Isn't there something strange here? Altice seems to have more debt than
assets. They have negative assets if you like. Their liabilities are greater than their assets. So
here's the question for you to think about, can a company have negative equity?
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

It turns out that the answer is no. A company that has negative equity, a company that has more
liabilities than assets is effectively bankrupt. That means you don't have sufficient assets to pay
for your liabilities. It's not a stable situation and it means that this company should actually
disappear. It should be sold off. Something should happen. But if you look at the data, you will
see that Altice actually not bankrupt. They exist and they have a positive market value, they are
trading, this is an operating company.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
What's going on here? The problem is book equity. it turns out that we can't use book equity in
order to calculate these leverage ratios. The reason is something that we actually discussed in
one of the previous lessons in this module. We discussed that the book value of equity doesn't
reflect the future. I remember we said that the book value of equity does not include future cash
flows. The book value of equity depends only on things that happened up to today. It only
includes what happens in the past. It doesn't include the sum of discounted future cash flows.
But if you want to know whether a company is solvent or not, you need to think about
the entire value of the company, not just about book equity, but also about the future.

To measure leverage, all we really need to do is use the market value of equity rather that the
book value of equity. And when we think about market value of equity, we're going to be
thinking about the stock price, times shares outstanding. But just one way that you can compute
the market value of equity for a company. It's publicly traded.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

The Altice example shows very nicely the importance of calculating leverage ratios based on
market values. Our answer wouldn't make any sense if we use book values. On this slide you
find the ratios that we are actually going to calculate. Instead of using book value of equity, we
are going to use the market value of equity. It's going to be debt divided by debt plus the market
value of equity and total liabilities divided by the market value of assets. And what's the
definition of market value of assets? We'll adjust with some of total liabilities and the market
value of equity. Notice that I already discovered our very first ratio, the one that ignores other
liabilities in the numerator. So that one is gone. There are two ratios left now.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Here is an example here is the data for Dish. Again, we have the market capitalization for Dish
on the left. That is the current market value of equity for this company. You also find data on
total debt on the left. And there's data on total liabilities on the right. Let's calculate the leverage
ratios then. As we did for the liquidity ratios, let's do these calculations using the most recent
data. For leverage ratios it really makes sense to use the most recent data because we're using
data on the market value of equity. We need current data that reflects the value of this company
as of today. So here on the bottom you have the calculations, the market value of equity which
we are pulling out directly from the data. Okay, and then the market value of assets which is just
the sum of total liabilities and the market value of equity.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

With those numbers it should be fairly simple to compute the leverage ratios, you can check on
your own but here are my results for both Altice and Dish. For example the liabilities over assets
would be 0.74. All you need to do is divide the liabilities from the balance sheet by the market
value of assets that be calculated in the previous slide. And you can do a very similar
calculation for Altice and you would get these ratios.

What's a good leverage ratio then as we just discussed definitely below one, so leverage ratio
that is higher than one just means the company is effectively bankrupt. A company cannot really
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
have leveraged greater than one. A company like that might actually just disappear. The
average leverage ratio in US companies is between 25% and 30%. But how much leverage
should a specific company have? Well that's a very important topic in corporate finance and we
will not discuss it in this course. It's a topic that really goes beyond what we can cover in this
course. Let's just keep these numbers in mind when we think about leverage ratios 25-30%.
Let's remember that leverage cannot be greater than one and shouldn't get too close to one.

Lastly, let's discuss how leverage can get high. As we discussed with the liquidity, it's important
to understand what decisions would increase leverage. First off, every time a company issues
debt to do something, you're running the risk that your leverage will increase. If you issue that
probably to repurchase equity, that's a decision that will increase your leverage. Second, if you
issue debt to invest in projects, then that might increase your leverage. Remember we are using
the market value of equity to compute leverage ratios. If you invest into a good project with your
new debt, the market value of equity will increase. So that's something we're going to talk about
and model free so you leverage ratio might go up or down. But if the market value of assets
doesn't increase that much then you leverage ratio may end up higher. Third and finally poor
performance is always a good reason why leverage might increase. If your company does
poorly, equity values go down, the stock price goes down and the leverage ratio is going to
increase very mechanically because your denominator goes down. So poor performance again
is a reason why leverage might get too high.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.5: Income Statement Ratios: Profitability

Now we're going to look at the income statement to measure the profitability of our company. So
here you have an example. It is the income statement for Dish for the last two years. We have
the 12-month December 2020 to 12-month December 2021. And then at the end you also have
what we call the latest 12-month income statement that covers a period of the last 12 months.
So that's kind of the last data that we have when we recorded these videos. Remember that
some line items are omitted. We don't have every single item that appears. If you download the
income statement from capital RQ or another source, there may be other items there. But that's
basically what the income state has. Here you have revenues and profits etc. It allows you to
measure a company's profitability, right? So that is really the key information that we're going to
focus on, in this lesson is how to measure profitability.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

To measure profitability and cooperate finance, we use three different ratios that I'm going to
focus on here. The first one is what we call the asset turnover ratio with revenues divided by
assets. Then we have the net profit margin, which is OPAT divided by revenues and then we
have return on assets which is OPAT divided by assets. OPAT, which is going to be an
important metric in our class is defined as operating income minus taxes. So that's why the
name OPAT means operating profits after taxes.

It is important for us to understand what the difference between OPAT and net income is. You
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
might have heard before that the bottom of the income statement that summarizes the
company's profitability in that year is called net income. And in corporate finance, we do not use
net income to measure profitability. For example, for December 2021 for Altice. That the other
company we're looking at, we're comparing Altice. You start from operating income or the at the
top of the statement. You see there the operating income is 2, 541.8 million. And then you find
the income tax expense in that year. In the case of Alt is 295 million. And then you deduct one
from the other, OPAT is in this case 2,246.8 million. So that's going to be our measure of
profitability. It is very different from net income. You can see that the company's net income in
2021 is about $1 billion.

What's the difference and why are we using your OPAT? So, the idea is that we want to
measure profitability for the company as a whole. We want to measure profitability for the
business and net income doesn't do that. Net income measures profitability from the
perspective of shareholders. And the easy way to see this is to notice that even going back to
the outside statement, if you want to do the calculation. Net income is approximately the
difference between OPAT and interest payments. OPAT is a measure of profits that is before
interest, we're not deducting interest expense as a cost. Net income is after interest and
that is the difference. And in corporate finance is actually important for us to use OPAT because
we want to measure business profitability. You can and think of interest payments as a payment
that is made to providers of capital. You have banks, you have bondholder who invest in the
company and in exchange they get interest payments. We do not treat interest
expense as a cost. That means you should not add income as a measure of profitability. There
are other reasons, it's not only because I think really the most important reason is this idea of
measuring business profits. But the other problem is that net income if you notice, it's at the
bottom of the income statement. What that means is that net income is going to be affected by
anything that happens in the company in that year. Onetime items such as revaluation of assets
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
and goodwill changes, etc. And situations in which really don't affect ongoing business
profitability are going to affect net income. It's also subject to accounting manipulation. It's much
easier to manipulate net income because of this onetime item. And manipulating operating
income, which is at the top of the statement. OPAT and ROA really are better measures of
profitability.

Here's the other question. Actually, it's a question for you to think about, okay? We already
talked about the fact that when we measure leverage, when we measure solvency ratios, we
use market values. It's important to use market values. Here we have, for example, ROA, right?
ROA is going to be OPAT divided by assets. Here's a question for you, should we use the
market value of assets in the denominator when we compute profitability ratios? And the answer
is, here you actually want to use book values. The idea is that you want to compare the
company's profitability to the capital invested in the company. In a sense, the assets that you're
using this ratio is a measure of how much capital has been invested in the company. The
market value of the company is a measure of the company's total value. And if you think about
it, the total value of the company depends a lot on future profits.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

If you use market value in the denominator, really what you're going to be doing is you're going
to be dividing current profits by future profits. A company that has a lot of future profits is going
to have a low profitability ratio. That doesn't seem to make much sense. The company is
expected to be profitable. In this case, it's important to use book values.

With this analysis, we can compute profitability ratios for Altice and DISH. I include here the
information on total assets for December 2020, 2021 the latest 12 months. For example,
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
if you take the December 2021 data, we already calculated OPAT, the assets are 33,215
million. That means the ROA is 7%, 0.07.

We can do the calculation for both companies. We could do for different years as well. But here,
what I'm doing here in this slide is showing you the three different ratios for our two companies
in the same time period. This is using data for December 2021, which is the latest complete
annual data that we had when we recorded these videos. These assets in December 2021 or 48
billion. And you can see here, if you compare the ratios, which by the way you should try to
calculate and make sure you can get these numbers. You see that Altice is basically more
profitable. It has higher net profit margin. It generates more profits out of revenue and it also
generates more profits out of assets. The ROA is higher. Dish does have higher asset turnover.
Dish creates more and more revenues, but the costs are significantly higher. And the company
has a lot more assets. In the end of the day, the conclusion is that Altice, at least in 2021 is a
more profitable company. That's how you can use these ratios to compare two or more
companies and analyze profitability. You might be wondering if we haven't even talked about
earnings per share. If you follow financial news, if you follow financial newspaper, that is a very
common measure of profitability. And it turns out that in corporate finance, we don't really use
earnings per share to measure profits.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

One problem with earnings per share is that it uses net income. We already talked about this,
we don't like net income because it's not a measure of business profits and it's subject to
manipulation. It's subject to onetime items. So that's the reason not to use earnings per share.
But the other reason is the denominator, earnings per share is profits divided by shares
outstanding. And it turns out that shares outstanding is actually a very bad denominator.

It's an additional problem. The number of shares outstanding can be easily manipulated. For
example, using stock splits. The company splits once talking to chew. This is going to change
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
the number of shares outstanding. EPS is going to change, but really nothing substantial
happened. Share repurchases is a more interesting example. Later in the course, we're going to
talk about share repurchase and pay out. And we're going to learn that share repurchase can
affect earnings per share, but it's sort of a mechanical effect as well, okay? The bottom line is
that my recommendation is not to use earnings per share to compare profitability across firms.
Okay, so just forget about EPS at least for the point of view of corporate finance, forget about
EPS. It's not a good measure of profit.

There is one viable alternative that I want to talk about. Our profitability ratios are based on
OPAT, but in the real world, in practice it's very common to focus on EBITDA instead of OPAT,
okay? The difference is that EBITDA is before depreciation. The operating income is essentially
EBITDA minus depreciation and amortization. If you start from EBITDA, you're starting from a
measure of profits that is before depreciation.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

There is a tradeoff, depreciation is not a cash expenses, is an accounting item. If you see
depreciation in the income statement, that doesn't mean the company is spending cash. It's just
a measure of the depreciation in the value of the assets or the amortization of the value of the
assets. Some analysts, practitioners like EBITDA better because it is a better measure of cash
profit. If you look at EBITDA, this is going to tell you with more precision how much cash the
company is generating in that year. However, the depreciation does capture what you can think
of as a useful concept. The depreciation captures the implicit cost of using the company's
assets to generate profits. The company has assets, these assets are used to generate profits.
The value of the assets depreciates over time. It kind of makes sense to treat depreciation of
the cost.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

There is a tradeoff and really what we can do to accommodate this tradeoff is to use both
measures. You can use EBITDA minus taxes instead of OPAT. Rather than starting from
operating income, you can also compute profitability ratios that start from EBITDA.

The asset turnover doesn't matter because it starts from revenue, but the net profit margin can
be calculated using EBITDA minus taxes. The ROA can be calculated using EBITDA minus
taxes as well.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Here is an example for Altice, we have operating income and EBITDA here for December 2021.
The difference of course is depreciation and amortization. EBITDA is always going to be a
bigger number, right? Because you're not deducting depreciation, you can see here for Altice is
a quite substantial number. Is close to $1.8 billion. What we can do is we can compute
profitability ratios using both operating income and EBITDA. Here's what you have here for both
of our companies for December 2021. And really the conclusion doesn't change. The Altice is
more profitable. Both using OPAT and EBITDA. What is interesting though is the differences in
profitability look even larger when we examine EBITDA. For example, the ROA based on
EBITDA is 12% for Altice and 7% for Dish. That's a bigger difference than when we focus on
operating income. But qualitatively, you kind of get the same picture. And what you're going to
find out with different examples is that this is typically going to be the case. When you compare
two different companies, that the comparison should not change if you go from operating
income to EBITDA. But I think it's a good idea to look at both of these measures.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.6: Cash Flow Statement Ratios

Now we're going to talk about the statement of cash flows. The statement of cash flows has
three major sections that tell you cash, how much cash the company is generated from
operating activities, how much cash the company is generating from investing activities, and
how much cash the company is generating from financing activities. And as you're going to see
in this in this lesson, the statement of cash flow can be very useful to tell you what is going on
with the company is probably my favorite statement to look at here.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

For example, you have this Dish cash flow statement for the same period that we're focusing on.
2020, and 2021 the latest 12 months, the structure of the cash flow statement is that it starts
from net income. You start from the bottom of the income statement and then what the casual
statement does, it adds and subtracts items to get to a measure of cash profitability. For
example, there is depreciation here. If we look at the December 2021 for example, we're adding
depreciation because depreciation is a non-cash cost. Then we are we are adding and
subtracting working capital items in module two, we're going to talk more about working capital
and that gets you to cash from operations, then you have investment cash flow as you see here
capital expenditures for example, and then we have cash from financing. So in the cash from
financing, what you see is how much debt the company is issuing, for example have debt
issues. You have stock repurchases. That are recorded here in dividends. This part of the cash
flow statement captures cash that is coming from investors or cash that the company is
returning to investors. And then at the end of the cash flow statement, you have the net change
in cash. Which is telling you how much cash the company generated in that year after taking
everything into account operations, investment and finance.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

In the cash flow statement, there is a very important convention that you should always
remember. This is extremely useful, which is that the sign has a meaning. If you see a positive
sign in the cash flow statement, it means that cash is coming to the company. If you see a
negative sign, it means that cash is being paid out.

For example, and in the cash flow statement, I just show you there is a capital expenditure of
minus $1,185.6. And capital expenditures could be both investments but can also be negative.
They can also, the company could be selling assets for example. You might be getting cash
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
from capital expenditures by selling assets. But in this case, because the number is negative, it
means that the company is spending cash. It means that the company spent $1.185 billion
2021. Okay, so you can use this convention for any type of item for all the items in the cash flow
statement.

As I said in the beginning, the cash flow statement contains a lot of information about what is
going on with the company. So, let me give you an example we have here. This is not the dish.
This is a made-up example. Just to show you this point, you have to four different companies A,
B, C and D. Okay. And you have the basic items in the cash flow statement that we just talked
about cash from operations, from investments, from financing and the net change in cash. And
here's a question for you using the convention that we just learn right negative means cash out
positive means cash in. Which of these companies is likely to be a startup? Think about it for a
while.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

It turns out that if you look at the data company C is the one that is most likely to be a startup.
Why? Because it's generating negative cash. That's common for startups. They are not really
producing cash while they are in the young in the growth phase, they have negative operating
cash flows. But they are investing, those are growth companies. They are they are, you know,
despite being unprofitable, they're still investing in the business. Why can't they do that?
Because they are raising money from investors. If you look at cash from investment,
the cash from investments is positive. There's cash coming to the company to finance the
negative cash going out and the investment that the company is making. So, for example, for
comparison, there is company B. That that company B is a mature company that is downsizing.
Why do we know that? Because they have positive cash flow from investments. That means
you're selling assets to generate cash and the company is using this cash to pay back investors.
Payments to investors are negative in the cash flow statement, meaning that cash is going
back. This is just an example, what you should try to do going forward is to use the cash flow
statement to try to understand what is going on with the company. You can also talk about A
and D. A Company is a profitable company. That is that is, despite being profitable, it is getting
financing from investors and company D has a negative change in cash. That's the difference
between D and the other one, is that cash the company lost cash in in that year. And then, you
know what will happen to, right, using our accounting knowledge, what you can figure out is
that since the company is reducing generated negative cash in that year, the company’s total
cash from the balance sheet should decrease. It has to be the case that that the company had
more cash to start with, right, in order to finance this, this cash drawdown that happened in
there.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

So now going from the fictitious from the simple example to the real world where I'm bringing all
this cash flow statement for us to analyze. Right? So, here you have cash from operations.
Cash from investment and cash from finance. If you look at this statement, all this clearly has
positive cash from operations of the company's is generating cash. Every year. We really only
have two years here, right? Because the latest 12 months, it's mostly 2021.

But you can see that the company is generating cash, right? The company is also investing in
the business. Why do we know that? Because we have the negative capital expenditure. That
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
means the company is investing. Okay. And then we have in the financing items. For example,
you see that the company did a very large stock repurchase in 2020. There was a significantly
negative cash from financing in 2020, mostly due to the stock repurchase. Here is the summary
that we talked about this this company is returning cash to investors, right? Because the cash
from investing is negative. You're not really issuing new finance to finance investment. In 2020,
if you look at the income statement, you'll see that the company did issue that. But the objective
in 2020 was, we are not 100% sure that this is the case. Because you only see the debt
issuance there. But it looks as if what the company did in that year is to issue the debt to help
fund the stock repurchase program.

There is a lot of information about what's going on with the companies in the cash flow
statement. Here is Dish. That's how you know what we're doing in this module is comparing
artists and Dish is very similar in the cash from operations. The company is generating a
significant amount of cash in the, in the two years and a half. That we're looking at for two years
and a quarter right that we're looking at here. The company is also investing in the business.
The difference here is as you can see this is issuing a lot of finance. The cash from financing is
positive. That means the company is bringing cash from investors. And if you look at the details,
it's, there's a little bit of stock issuance, but not very significant later on in the cost where we're
going to learn that us companies are very reluctant to issue equity and we're going to learn why.
There is not a lot of repurchase, either. Most of the action is in debt financing. The company is
issuing a lot of that in 2020 and 2021. It's also repaying that, but it is issuing debt in the net
basis. There is cash coming in from investors. So this is the summary here, right? There is
significant debt issuance the company's generating cash invested in the business. It is not really
paying out cash to investors, right?
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

And that raises a follow-up question. And when you look at cash flow statement, it's going to be
common that you're going to, you're going to get curious, this is going to generate interest
because some items might not be obvious in the case of Dish. The, the interesting not obvious
item here is that the company is spending a lot of cash on investments, but it's not capital
expenditures. Capital expenditures are significant, but the big item are really the other. It's
called other. And of course, other doesn't mean anything. If you want to understand what you're
going on, you must open the other box.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

This is what I'm doing here for you, is to get more details on the cash flow statement of Dish.
For example, if we look at 2020, there was a significant capital expenditure, but there is a cash
acquisition. The company spent a lot of cash $1.3 billion dollars to acquire another company.
And then there is also a purchase of an intangible asset. Right. That's a significant negative
number here. That is kind of going on to the other years in the latest 12 months, March 2022.
You see there is a very large number. It must be the case that dish made a big purchase of an
intangible asset in the beginning of 2022. That's a reasonable analysis. But then you can even
get more curious. What kind of, what is the, what are these investments? What is the
acquisition, what are the intangible assets that the company is buying? And then of course you
can do more, you can do, you know, you can go to the databases to do more research. For
example, I use the capital IQ here, you can try to use the internet, and you'll probably be able to
find this even using like a Google search or very basic tool.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

In terms of the cash acquisition, what happened is that Dish acquired a part of Sprint right there.
You know, Sprint is another company in the same in the same business. And what happened is
that Dish acquired Sprint’s boosted mobile and branded prepaid mobile services for that price of
$1.4 billion. This is a massive acquisition. It's not that it bought the entire company Sprint. In
fact, what happened in this case is that this deal was motivated by the merger of Sprint with T
Mobile. The Department of Justice of the United States actually forces Sprint to sell some
assets to approve the merger between Sprint and T Mobile that happened in 2019. This deal
closed in July of 2020. So that's why it's recorded in the casual statement in 2020.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

And then in terms of the purchase of intangible assets, you actually have to do quite a bit of
research to figure out it wasn't obvious just by looking at the cash flow statement. What I did
here is, I went to the annual report to read it and try to understand what's going on and here you
have the write-up. What happened in that case is that the company is investing approximately
$20 billion dollars to acquire wireless spectrum licenses.

This is basically the strategy of the company now is to deploy as you can read here a 5G
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
broadband network capable of serving large portions of the US population. And there are some
deadlines etc. The company is essentially in a big investment strategy here right to try to
upgrade its 5G broad, this 5G network and this is of course, this is not a general example. This
is, this is specific company, but I think this, this example shows you how much information you
can get from the cash flow statement, right. If we hadn't looked at the casual statement, we
wouldn't have had any clue that this was going through this, to this big change in how the
company operates.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.7: Valuation Ratios

So we’ve done a lot of work. We computed liquidity ratios, leverage ratios, profitability ratios, we
looked at cash flow statements. And if you think about it, we really learned a lot about what's
going on with Altice and DISH. And of course, you can do a similar exercise if you want to think
about any public company. Here's our summary for what we discovered for all Altice and for
DISH. Altice has higher leverage and has been more profitable in recent years. DISH, on the
other hand, is more liquid. And when we look at the cash flow statements, we saw that both of
the companies are generating cash from operations and are consistently investing into their
business. DISH also spends cash on acquisitions.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

How have these companies performed in recent years? Well, let's look at their stock prices, as
we discussed earlier in this module, the stock price really is the key summary statistic of
shareholder value. And it should be somewhat related to these ratios. Let's look at the stock
price performance for Altice and Dish over the last almost three years. What you see is that
neither company performed particularly well, but overall Dish performed somewhat less poorly.
You can also see that Dish was down quite a bit during this so called Covid dip in March 2020.
But since then, since March 2020, they've done a lot better. I mean, their stock prices basically
unchanged since March 2020. Well, the stock price for Altice has gone down quite a bit. In fact,
it appears that Altice has been doing poorly only in the last year on this graph on the slide. All
this is somewhat consistent with our analysis. Altice was more profitable in the past years, but
also, they are just much more leverage and much more liquid. Remember their current ratio is
0.3. Even that they could sell off all of their payables and inventory without a discount, they
could pay for only 30% of their current liabilities, using current assets. And their cash ratios even
lower, it's 0.07, so they are not very solvent to say the very least. We will also see in the later
module that their high leverage in combination with the liquidity may contribute to this poor
performance in recent months.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Since we are looking at stock prices, this is a very good time for us to think about valuation
ratios, and this is the last set of financial ratios that we're going to discuss in this module. And
these ratios, they are ratios that summarize the company's current market valuation. We're
going to look at two ratios, but both are going to use market values in the numerator. The
market value is going to be in the numerator. And then in the denominator of these ratios, we're
going to have either book value or profits, current profits in this case. And we've learned already
that the market value of a company is a measure of everything. Current but also future cash
flows. The market value should reflect all the cash flows, so really what you're doing is dividing
the future by today. This tells us how we should interpret the valuation ratios. They measure the
future relative to today.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Let's first talk about the market to book ratio. It's a ratio that uses book values in the
denominator. This ratio can be based either on assets or an equity. There are two versions of
this ratio, we can use the market value of assets and the book value of assets. Or we can use
the market value of equity and the book value of equity.

But we already saw in this module that book equity can be a very problematic measure. For
example, for Altice, you would not be able to compute this market to book ratio based on equity,
because the company has negative book equity. That's why I think it's better to use assets to
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
compute market to book ratios. Instead of using equity, I prefer assets and I will show you one
example in just a second.

In terms of value over profits, again we can do this either based off assets or based of equity.
We learned already that OPAT is a measure of profits for the company as a whole. So operating
profit after taxes measures profits for the company as a whole. Net income on the other hand,
measures profits for shareholders. The ratio number one divides the market value of assets, the
entire company by profits, current profits for the company as a whole. Ratio number two, which
is the well-known price to earnings ratio looks at equity only, it's a market value of equity divided
by net income. These ratios capture very similar information, right? Because you're dividing
market values by current profits. But you might guess at this point which ratio I will prefer.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

I really prefer to look at ratio number one. That's because it's based on asset values and profits
for the entire company. We are looking at the entire company, not just that equity, and we avoid
using net income. Remember the key difference between OPAT and net income is that OPAT is
at the top of the income statement, net income is at the bottom. So net income is a number that
is easily manipulated. My recommendation is that we focus mostly on assets over OPAT instead
of the price to earnings ratio, when we analyze companies.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Let's look at these ratios. All we need for the ratios are these three numbers – book value of
assets, OPAT, and market value of assets. And all were computed before, so I just copied them.
It should be easy to calculate the ratios from this point on. For example, the market to book ratio
should be just the market value of assets divided by the book value of assets. You can see that
this ratio is going to be a bit above one for Altice, and a little bit below one for Dish. But
remember we prefer the other ratio; you prefer market value over OPAT.

Let's look at that and the answer is here on the slide. These are the ratios for Altice and Dish
using our numbers. Dish has a higher value of a current OPAT, and their stock price performed
better in recent times over the last year. That actually makes sense. OPAT has past year
performance after all. Of course you might say that the market to book ratio disagrees with this,
Dish has a lower market to book ratio and Altice has a higher market to book value, even
though their stock price did more poorly over the last two years. Let's think about that next.
Altice did more poorly in terms of stock price, but they have a higher market to book value. Is
this finding consistent with the stock price? For starters you might say it's fine. At least value
over OPAT is consistent and we might prefer that measure. But there is another reason why
these ratios might disagree with the stock price. And that's what I would like to talk about next.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

We found that Altice has a higher market to book ratio but poorer stock price performance. Is
this consistent?

The answer is yes, this can easily be consistent. Well first off this is real data so it has to be
consistent, but also remember what valuation ratios measure. They measure the future over the
presenter even the future over the past. In this case, Altice did more poorly recently and their
value over OPAT ratio reflects exactly that. And this makes sense because OPAT captures their
present performance. Market to book value on the other hand, might not capture the recent poor
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
performance, because book value is the denominator, and book values do not just reflect the
presence. It's based on what happened in the past. Anything can happen in this case and this
book value of assets could even be massaged.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida
Lesson 1-1.8: Module 1 Review

This module was all about the objective and the language of corporate finance. In terms of the
objective, we talked about why maximizing the stock price is a reasonable objective for
companies. And by using the stock price is better than the alternatives, such as earnings per
share or the book value of equity. However reasonable doesn't make perfect. Therefore, we
also discussed some of the problems, such as conflicts that may arise between stock price
maximization and social responsibility. Or other stakeholders like employees and the
government.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

And finally we talked about agency problems, the fact that managers may not maximize
shareholder value, and how corporate governance might help in all of this.

Then we started talking about the language of corporate finance, the fact that we can use
information from the accounting statements to learn a lot about these companies. We made
comparisons across specific companies. We used information from the balance sheet to
measure liquidity and solvency and be used information from the income statement to measure
profitability.
 Corporate Finance I: Measuring and Promoting Value Creation
Professors Stefan Zeume & Heitor Almeida

Then we looked at the cash flow statement. The cash flow statement allowed us to understand
how companies are generating and expanding their cash. And finally, we look at valuation ratios
such as the market to book ratio. We calculated and we discussed the meaning of valuation
ratios.

We concluded the very important idea that valuation ratios measure the future divided by the
present or the past.