MBA/ Financial Analysis

Lecture #1
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 What is Money?
• The quantification of value
• We assign monetary value for goods and
services
• The level of that value depends on supply and
demand for them
• Money shows the value of scarce resources
and factors of production (land, labor and
capital)

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Different types of business
The Corporation: A distinct legal entity
• Articles of incorporation
• Set of bylaws
• Key players: The shareholders, the Board of directors
and the top management.

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Different types of business
The Corporation: Key characteristics
• Ownership represented by shares of stock
• Easily transfer of ownership – unlimited life (on going
concern)
• Limited liability of shareholders.
• Access to capital markets- Easy to raise equity
• Separate corporate tax – Double taxation on dividend
shareholders get
• Define Dividend:
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 Business and Finance

• Define Finance: Part of the economic theory that

studies money matters.
• What is the role of business in society?
• We are called to make financial decisions about:
• Our personal life. E.g. loans, pension schemes, etc
• The role of finance in business decisions
• Money is the common language between
departments in a firm
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 Objectives of the firm

Stockholders wealth maximization = maximizing the price of the firm’s

common stock

Maximizing wealth by all means?

Reject the notion “end justifies the means”.
Why? Social responsibility
• Social responsibility comes at a cost. Cost prevents high profits.
• Co-operation between Industry and Government
• Establish rules of corporate behavior.
• Monitor firm’s performance
• Enforce the rules

• Business Ethics
Commitment to obey the laws and regulations relating to business
activity and the firm’s role to society.

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 What is Accounting?
• Accounting is the science (and the art for
some) of recording, organizing, reporting and
analyzing the financial data and results of
firms and other organizations

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 Accounting as a source of information:
The language of Business

• Internal use of information:

- Regular reports on accounting information e.g. monthly
sales
- Ad hoc reports providing info for decision making e.g. the
decision to buy or lease a piece of equipment

• External use of information:

- Financial statements produced by the firm providing
information to the firm’s various stakeholders

Define Stakeholders:

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 The Corporation as a separate economic entity
The corporation is distinct from its investors

Define investors:
Shareholders provide the firm with equity
Creditors provide the firm with loans

There are two basic elements in describing the corporation in accounting

terms:

1. What resources (total assets) the firm uses

2. And who has invested money to get these assets (total claims)

So on one hand we see what is owned by the firm but on the other we also
have to see the claims various investors have towards the firm . These two
must balance and the statement that shows them is called balance sheet.

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 Assets
• What does the term “assets” mean?
• Why a firm needs to have assets?
• Some examples of assets:

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 The accounting recording of assets

Different duration of assets: Fixed versus

Current assets
• Fixed assets : The firm uses these assets
beyond the current year
• Current assets: Those assets that are renewed
within the year

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 Some examples of fixed assets

• Land
• Building facilities: Offices, Warehouses,
factory plants
• Machinery production installations
• Vehicles
• Furniture, fixtures and other equipment

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 Some examples of current assets

• Inventories: Raw Materials, finished goods,

goods in process
• Debtors or Accounts Receivable: Money that
customers owe to the firm
• Prepayments that the firm made to suppliers
• Cash or cash equivalents

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 Total claims
• What does the term “claims” mean?
• Why a firm needs to investors?
• Some examples of claims from investors:

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 The accounting recording of claims

Two basic categories:

1. Debt
• Short term: to be paid within the year: short loans,
accounts payable (money the company owes to its
suppliers)
• Long term: the repayment period exceeds one year
long term bank loans, bonds, etc

2. Equity
• Common equity shares
• Preferred equity shares

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 The basic accounting cycle 1/2

• The firm obtains production resources (assets) that

are financed by the investors (shareholders and
creditors)
• The production resources are used by the firm to
operate and do business
• As a result of operating, the firm generates revenues
as well as expenses

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 The basic accounting cycle 2/2

• The expenses include interest which reflects the cost

of borrowing and is paid to the company’s creditors
• And the end profit belongs to whom? To common
Shareholders
• How the firm handles the profit it made? Two
options: Dividends and Retained earnings
• And finally, retained earnings belong to whom? Again
to common shareholders

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How the Accounting cycle works

(1) Investment and financing

Assets = Creditors + Shareholders
↓
(2) Assets put in operation
Profit = Revenues - Expenses
↓
(3) Distribution of company profits

Dividends Retained Earnings

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 Balance Sheet
• It is like a “photo” of the firm
• It shows total assets and total claims

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Balance sheet of ALFA corp 2011 2010

Current Assets
Cash and Cash equivalents 45.400 40.000
Accounts Receivables (debtors) 122.000 110.000
Inventories 133.000 120.000
Prepaid expenses 3.000 5.000
303.400 275.000
Fixed Assets
Land 100.000 80.000
Buildings 180.000 130.000
Accumulated Depreciation Buildings (33.000) (30.000)
Factory equipment 190.000 170.000
Accumulated Depreciation F. equipment (55.000) (40.000)
382.000 310.000
Total Assets 685.400 585.000

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CLAIMS 2011 2010

Short term liabilities or obligations

Accounts Payable (creditors) 78.600 75.000
Notes Payable 22.000 30.000
Prepayments from customers 41.600 31.400
142.200 136.400
Long term Liabilities
Mortgages and bank loans 250.000 210.000

Equity
Common Share capital 220.000 200.000
Retained Earnings 73.200 38.600

Total claims 685.400 585.000

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Income Statement (US) or Profit and
Loss Account, P&L (UK)
• It is like a video of the company’s operations
during a year
• Shows the results from operations, i.e.
Revenues – Expenses
• What is the difference between an investment
and an expense?
• How do we allocate the cost of an investment
over time?

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Income Statement 2011

Net Sales 1.280.000

Cost of goods sold (692.000)
Gross Profit 588.000

Operating expenses except depreciation (510.000)

Depreciation (18.000)
Earnings before interest and taxes (EBIT) 60.000

Interest Expense (7.000)

Extraordinary losses (4.000)
Profit Before taxes 49.000
Corporate tax (29%) (14.400)

Net Profit 34.600

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 Statement of Cash Flows
• Why do we need a separate statement?
• What is the difference between accounting
profit and cash flows?
• Where do the cash flow come from?
Operating activities
Investing activities
Financing activities

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 Examples of cash flows
• An Increase in Accounts receivable means that we
made sales without receiving cash; thus, other things
held constant, cash level falls.
• An Increase in Accounts payable, notes Payable,
Accruals, or long term debt means that we made
expenses or investments without paying in cash;
thus, other things held constant, cash level rises.
 Examples of cash flows
• When Inventories increase, means that we
spent cash to buy more stock; thus, other
things held constant, the cash level falls.
• The same applies when there is an increase in
fixed assets
 Factors that determine the
level of cash in a company
Operating activities (other things being equal)
Net Income  Cash ?
Depreciation  Cash ?

Acc. Receivable  Cash ?

Payables  Cash ?
Inventories  Cash ?
Defer taxes  Cash ?
 Factors that determine the
level of cash of a company
Investing activities (other things being equal)
Fixed Assets  Cash ?

Financing activities (other things being equal)

Long term debt  Cash ?
Short term debt  Cash ?
Common Stock  Cash ?
Preferred stock  Cash ?
Dividends  Cash ?
 Statement of cash flows 2011

Operating activities
Net Profit 34.600
Depreciation 18.000
Increase in Accounts Receivable (12.000)
Increase in Inventories (13.000)
Decrease in prepaid expenses 2.000
Increase in Accounts Payable 3.600
Increase of prepayments from customers 10.200
Cash flows from operations 43.400 .(1)

Investing activities
Increase in Land (20.000)
Increase in Buildings (50.000)
Increase in machinery and equipment (20.000)
Cash Flows from investments (90.000) .(2)

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Financing activities
Decrease in Notes payable (8.000)
Increase in bank loans 40.000
Increase in common equity 20.000
Cash flows from financing activities 52.000 .(3)

Net cash flows for 2011

(1)+(2)+(3) = 5.400
Cash balance in 2010 40.000
Cash balance in 2011 45.400

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 Modifying Accounting Data
for Managerial Decisions
• Net Operating Profit after Taxation (NOPAT)
• Net Operating Working Capital (NOWC)
• Total Operating capital or capital employed
• Free Cash Flow, (FCF)
• Economic Value Added (EVA)
 NOPAT (Net Operating Profit after Taxation)

• NOPAT = net operating profit after tax

• NOPAT11 =

• What is the meaning of the above formula?

• How do we use it?

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 Net Operating Working Capital, (NOWC)

• NOWC = Current operating assets – Short term operating

liabilities

• NOWC11 =

• NOWC10 =

• What it means?

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 Operating capital or capital employed
• Operating capital = NOWC + fixed operating assets

• Operating Capital11 =

• Operating Capital10=

• Change in operating capital =

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 Free Cash Flow, (FCF)

• FCF = NOPAT – net change in operating capital

• FCF =

• What it means?
• Is a negative FCF always a bad sign?

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 Economic Value Added, (EVA)

• EVA = NOPAT – cost of capital

• What is cost of capital? Weighted Average Cost of Capital
(WACC) Assume 20%
• EVA = NOPAT – (Operating Capital * WACC)

• EVA =

• What it means?

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 Some comments on Ratio
Analysis
• Liquidity: high values not always good
• Efficiency: Be careful of the depreciation – ageing of
assets
• Debt Management: Different levels of tolerance
• Profitability: consistency between results and claims
• Market value: Be aware of excessive optimism
 Explain the Du Pont System

Profit TA Equity
( margin
)( turnover
)( multiplier
) = ROE

NI Sales TA
Sales x TA x CE = ROE.
The Du Pont system focuses on:
• Expense control (PM)
• Asset utilization (TATO)
• Debt utilization (EM)

It shows how these factors combine to determine the ROE.

What are some potential problems and
limitations of financial ratio analysis?

• Comparison with industry averages is

difficult if the firm operates many
different divisions.
• “Average” performance is not necessarily
good.
• Seasonal factors can distort ratios.
(More…)
• Window dressing techniques can make
statements and ratios look better.
• Different accounting and operating practices
can distort comparisons.
• Sometimes it is difficult to tell if a ratio value is
“good” or “bad.”
• Often, different ratios give different signals, so
it is difficult to tell, on balance, whether a
company is in a strong or weak financial
condition.
 What are some qualitative factors
analysts should consider when evaluating
a company’s likely future financial
performance?

• Are the company’s revenues tied to a single

customer?
• To what extent are the company’s revenues
tied to a single product?
• To what extent does the company rely on a
(More…)
single supplier?
• What percentage of the company’s
business is generated overseas?
• What is the competitive situation?
• What does the future have in store?
• What is the company’s legal and
regulatory environment?
Introduction to Costing: A basic taxonomy
A. Direct and Indirect Costs

Direct: Costs exclusively made for a specific product or service

Examples include raw materials, direct labor

General or Indirect or overheads: Costs made to support the

firm’s production process. Examples include Administrative
costs, Marketing expenses, etc

The challenge for accountants: How should they allocate the

general costs to specific products or services?

The General costs should be allocated according some activity

or measurable variable which is directly related to the
production of a specific product or (cost drivers).
Introduction to Costing: A basic taxonomy
A. Direct and Indirect Costs

Variable: Costs that rise as output increases. Usually depend

on production / sales output.

Fixed: Costs that remain unchanged regardless of the level of

sales

Define profit:
Profit = (Revenue) – (total variable costs) – (fixed costs)
Profit = (P*Q) – (Q*VC) – FC
 Break Even Analysis

• Break Even Sales: We refer to that level of sales on which the company
produces zero profit or loss.
• Example:
Selling price, P, per unit €200
Variable , VC cost per unit (raw materials, direct labor, transportation, etc) €150
Fixed costs, FC(admin. expenses, rent, salaries of permanent staff, etc) €5.000

The Break Even Formula BEP = FC/ (P-VC)

If we also require a target profit of €1,000 the new level of sales will be: