5 a framework for reformulating financial statements
15 likes27,869 views
The document discusses key concepts related to analyzing financial statements. It explains: 1) The relationship between a firm's operating and financing activities and how cash flows between these activities and capital markets. 2) How to reformulate traditional financial statements into an operating and financing framework to better analyze a firm's profitability and value generation. 3) Key metrics like return on net operating assets, return on net financial assets, and net borrowing cost that can be used to assess a firm's performance when statements are presented in the reformulated format.
![Value generation & business profitability
• Separating operating and financing activities in the income statement identifies
profit flows
• Comparison of these flows with their balance sheet base yields the
corresponding rates of return:
Return on Net Operating Assets RNOA t = OI t [ ( NOA
1
+ NOA t −1 ) ]
2 t
Return on Net Financial Assets RNFA t = NFI t [ ( NFA
1
2 + NFA t −1 ) ]
t
If there are NFO rather than NFA, net borrowing cost is given by
NBC t = NFE t [ ( NFO
1
2 t + NFO t −1 ) ]
• Value is generated by operating activities => analysts should focus on RNOA
7-17](https://image.slidesharecdn.com/5-aframeworkforreformulatingfinancialstatements-130417075627-phpapp01/85/5-a-framework-for-reformulating-financial-statements-17-320.jpg)
5 a framework for reformulating financial statements
- 1. Lecture 5 Ch. 7 and 8 from Penman For a brief review of the principals of presentation of Financial Statements see: http://www.docstoc.com/docs/15908274/IFRS-Presentation-of-Financial-Statements
- 2. Analysis of financial statement Learning objectives: • Relationship between capital market and the firm. • The difference between operating and financing aspects. • Interrelationship between the three financial statements: income statement, statement of financial position (B/S) & Cash flow statement. • Why reformulation of the statements is necessary? 7-2
- 3. The Firm, Its Claimants & the Capital Market The firm The capital market Net cashflow to debtholders (F) C Interest payment Debtholders Cash from debt Dividend payment I Shareholders ti v t c a g n t ar ep O ti v t c a g n c na n F Cash from share issues i ti v t c a g n t s ev n I i NOA NFA Net cashflow to s/holders (d) i i i i Operating activities Financing activities i i 7-3
- 4. Flows of cash between the firm and the providers of capital The firm Capital markets •Cash received from debtholders and shareholders is ue bt rs iss de lde (temporarily) invested in F or tho financial assets. eb rs Net Financial Assets (NFA) D •Cash payments to debtholders and shareholders are made by rs de liquidating financial assets ol eh d ar Sh •Net financial assets are debt purchased from issuers, net of debt issued to debtholders. Financing Activities •Net financial assets can be negative, i.e. Net financial F=net cash flow to debtholders and issuers obligation, when debt issued to d=net cash flow to shareholders debtholders is greater than debt NFA=net financial assets= financial assets – purchased. financial liabilities 7-4
- 5. Business Activities: All Cash Flows The firm Capital markets • Cash investment in ue bt rs i ss de lde operations is made by o r tho C F Net Operating Assets (NOA) Net Financial Assets (NFA) reducing net financial rs eb D assets (i.e. by liquidating financial assets or issuing rs de financial obligations). ol eh d ar I Sh • Cash generated from operations is invested in Operating Financing net financial assets (i.e. it Activities Activities is used to buy financial assets or to reduce F= net cash flow to debtholders and issuers financial liabilities). d= net cash flow to shareholders C= cash flow from operations • Cash from operations I= cash investment and cash investment may NFA= net financial assets be negative NOA= net operating assets = operating assets – operating liabilities 7-5
- 6. The Cash Conservation Equation A fundamental accounting identity: C −I ≡d +F C = Net cash from operations I = Net cash outflow for investing C-I = Free cash flow d = Net dividends (common dividends + share repurchases – share issues) F = Net cash outflow to debtholders and debt issuers = Net borrowing principal payments + net interest paid i = Net interest cash outflow The treasurer’s rule: If C− I−i> d => lend the cash or repay own debt If C− I −i< d => issue debt or reduce lending 7-6
- 7. Applying the Treasurer’s Rule: Microsoft 2nd Quarter, 2004 2nd Quarter, 2005 In millions In millions Cash flow from operations $4,236 $3,377 Cash investment in operations 172 177 Free cash flow 4,064 3,200 Cash interest received (after tax) 338 242 Cash available for shareholders 4,402 3,442 Net dividend: Cash dividend $1,729 $33,498 Share repurchases 730 969 Share issues (189) 2,270 (795) 33,672 Purchase of financial assets, $2,132 $(30,230) or redemption of own bonds/debt (sale of financial assets, or issue debt/bonds) 7-7
- 8. Reformulated Statement of Cash Flows to match the cash conservation equation Cash flows from operations C Cash investment (I) Free cash flow C-I Equity financing flows: Dividends and share repurchases XX Share issues (XX) d Debt financing flows: Net purchases of financial assets XX Interest on financial assets (XX) F Net issue of debt (XX) Interest on debt XX Total financing flows: d+F 7-8
- 9. Reformulated Cash Flow Statements: Microsoft 2Q, 2004 2Q, 2005 Cash flow from operations (C) $4,236 $3,377 Cash investment (I) (172) (177) Free cash flow (C – I) 4,064 3,200 Equity financing flows (d): Dividends and share repurchases $2,459 $34,467 Share issues (189) 2,270 (795) 33,672 Debt financing flows (F): Net purchase of financial assets 2,132 (30,230) Interest on financial assets (after tax) (338) (242) 7-9
- 10. The Reformulated Balance Sheet • Published balance sheets list items classified into current & long-term categories – useful for credit analysis •Reformulation of BS into operating and financial assets(liabilities) makes it useful for equity investors Assets Operating assets OA Financial assets FA Total Assets OA + FA Liabilities and Equity Operating liabilities OL Financial obligations FO Common stockholders’ equity CSE Total Liab. & Equity OL + FO + CSE 7-10
- 11. The Reformulated Balance Sheet Operating Assets Operating assets OA Operating liabilities (OL) Net operating assets NOA Financial Obligations & Owners’ Equity Financial liabilities FO Financial assets (FA) Net financial obligations NFO Common equity CSE Total NFO & Equity NFO + CSE ⇒NOA – NFO = CSE note that CSE is simply the book value of equity (i.e., BV) 7-11
- 12. Reformulated Income Statement The difference between operating revenue and operating expense is called operating income: OI = OR – OE Income Statement Operating revenue OR Operating expense (OE) Operating income * OI Financial expense (FE) Financial revenue FI Net financial (expense) income* (NFE) or NFI Earnings Earn * OI and NFI should be after tax 7-12
- 13. Stocks & flows in business activities Product and input markets The firm Capital markets Net operating assets ue bt rs iss de lde s are employed in er or tho OR C F m Net Operating Assets (NOA) Net Financial Assets (NFA) eb to rs operations to us D C generate operating revenue (by selling rs de goods and services to rs ol lie eh pp OE d ar customers) and incur I Sh Su operating expenses (by buying inputs OR- OE=OI OI - ∆ NOA=C-I from suppliers). C-I - ∆ NFA+NFI=d Operating and investment Financing Activities Activities F=net cash flow to debtholders and issuers NOA=net operating assets d=net cash flow to shareholders OR=operating revenue C=cash flow from operations OE=operating expense I=cash investment OI=operating income NFA=net financial assets NFI=net financial income 7-13
- 14. Creation and disposition of FCF The source of FCF FCF is created from cash income (OI) generated by operations after reinvesting part of it in net operating assets (ΔNOA): C – I = OI – ΔNOA The utilisation (disposition) of FCF Utilisation of FCF depends on whether the firm is a net lender (i.e. has NFA) or a net borrower (i.e. has NFO), and whether it is a net payer of interest (NFE) or a net receiver of interest (NFI). E.g.: If the firm is a net lender and net receiver of interest, the FCF along with NFI is used to invest in NFA and pay net dividends: C – I + NFI = ΔNFA + d C – I = ΔNFA – NFI + d E.g.: If the firm is a net debtor and net payer of interest, the free cash flow is be used to reduce NFO, pay NFE net dividends: C – I = NFE – ΔNFO + d
- 15. The drivers of Dividends Re-arranging the above equations for a ‘net lender’ firm gives: d = (C – I) + NFI – ΔNFA i.e. Net dividends are paid out of FCF and interest earned on fin. assets, and by selling fin. assets Similarly, re-arranging the equation for a ‘net debtor’ firm gives: d = (C – I) – NFE + ΔNFO i.e. Dividends are paid out of FCF after servicing interest and by increasing borrowing = > dividends might be a poor indicator of value generation
- 16. Articulation of Reformulated Financial Statements Income Statement NIt = OIt -NFEt Balance Sheet Net operating assets Net financial obligations NOAt = NOA t -1 + OIt - (Ct-It) NFOt = NFOt-1 + NFEt – (Ct-It) + dt Common stockholders equity CSEt = CSEt-1 + OIt – NFEt - dt Cashflow Statement FCF or Ct-It = dt + Ft
- 17. Value generation & business profitability • Separating operating and financing activities in the income statement identifies profit flows • Comparison of these flows with their balance sheet base yields the corresponding rates of return: Return on Net Operating Assets RNOA t = OI t [ ( NOA 1 + NOA t −1 ) ] 2 t Return on Net Financial Assets RNFA t = NFI t [ ( NFA 1 2 + NFA t −1 ) ] t If there are NFO rather than NFA, net borrowing cost is given by NBC t = NFE t [ ( NFO 1 2 t + NFO t −1 ) ] • Value is generated by operating activities => analysts should focus on RNOA 7-17
- 18. Analysis of the statement of shareholder equity • Provides summary of all transactions that affect shareholder equity • Provides reconciliation of beginning and ending owners’ equity • Because earnings reported in the income statement is not comprehensive, analysis of shareholder equity is necessary. => Should be in the focus of the equity analysts
- 19. A typical statement of shareholders’ Equity: Opening book value of equity (ordinary and preferred) + Net share transactions with common stockholders + Capital contributions (paid in capital from share issues) - Share repurchases (into treasury stock or against paid-in capital) + Net share transactions with preferred shareholders + Capital contributions (share issues) - Share redemptions + Change in retained earnings + Net income - Common dividends - Preferred dividends - Some share repurchases + Accumulated other comprehensive income + Earnings restatements due to change in accounting + Increase in equity from issuing stock options Closing book value of equity (ordinary and preferred) 8-19
- 20. The Governing Accounting Relation Book value, end of period = Book value, beginning of period + Comprehensive income - Net payout to shareholders Investors are interested in book value for ordinary (common) shareholders. ⇒ Need to reformulate the equity statement to exclude items that are not part of ordinary shareholders’ equity, and include items that are part of ordinary shareholders’ equity. 8-20
- 21. Reformulated Statement of Stockholders’ Equity Opening book value if common equity (CSEt-1) + Net transactions with common shareholders + Capital contributions (share issues) - Share repurchases - Common dividends + Comprehensive income to common shareholders + Net income + Other comprehensive income - Preferred dividends Closing book value of common equity (CSEt) Note that preferred equity is taken out of the common shareholders' equity statement. Preferred equity should be treated as a liability. 8-21
- 22. Benefits of reformulation • Gives a clear picture of the growth in common equity over time • Distinguishes clearly between sources growth: – From new investment or disinvestment by the owners – Additions to equity from running the business (income) • distinguishes the creation of value from its distribution
- 23. Reformulation: The Steps 1. Restate beginning and ending balances for items incorrectly included in or excluded from common equity – Preferred stock – Minority interest reported within equity + Dividends payable to common shareholders (if excluded initially) – Equity from stock-based compensation 2. Calculate net transactions with shareholders Cash dividends + share repurchases – share issues (Cash dividends = Dividends declared – change in dividends payable) 3. Calculate comprehensive income = Net income + “Other comprehensive income” – Earnings from accounting changes – Preferred dividends – Hidden dirty-surplus losses 8-23
- 24. Nike Equity Statement for 2008 8-24
- 25. Note: Footnotes to the 10-K indicate Nike had $112.9 million in dividends payable at the end of 2008 and $92.9 million at the end of 2007.
- 26. Nike: The Reformulated Statement Balances: 2008 2007 Reported $7,825.3 7,025.4 Dividends payable 113.0 92.9 Stock-based compensation (141.0) Restated balance $7,797.3 $7,118.3 8-26
- 27. Useful ratios for analysing the statement of shareholders’ equity Payout and Retention Ratios Dividends Dividend Payout = Comprehensive Income Dividends + Stock Repurchases Total Payout Ratio= Comprehensive Income Dividends Dividends-to-Book Value= Book Value of CSE +Dividends +Stock Repurchases Dividends+StockRepurchses Total Payout-to-Book Value= Book Value of CSE + Dividends + StockRepurchases Comprehensive Income - Dividends Retention Ratio= =1- Dividend Payout Ratio Comprehensive Income 8-27
- 28. Ratio Analysis (continued) Shareholder Profitability Ratio Growth Ratios Transactions with shareholders Net Investment Rate= Beginning Book Value of CSE Change in CSE Comprehensive Income+Net Transactions with Shareholders Growth Rate of CSE= = Beginning CSE Beginning CSE 8-28
- 29. Hidden Dirty Surplus • Shareholders lose when shares are issued at less than the market price (e.g. exercise of options) • This loss, however, is not recorded as expense. • What is the nature of this loss? If options are part of a compensation package, this loss is an employee compensation expense. If from a conversion of a bond, preferred stock or warrants, the loss is a financing expense. • What is the amount of the loss? Market price - exercise price. 8-29