Corporate

Finance
LECTURE 1
TOPIC 1: ACCOUNTING PRIMER
Financial Statements | Financial ratios | Comparing firms using |
financial ratios | Mini Case: Home Depot vs. Lowes

Chapters covered: 2

Big Picture
Dividend/Coupon
Payout

Cash Flows

Asset
1
Stocks
Demand
for goods

Equilibrium

Supply of
goods

Asset
2

Corporation

Raise
Capital

Capital Markets
Corporate
Bonds

Asset
3

Corporate
Investment

Consumers Investors

Portfolio
Allocation

Financial Statements

Financial statements are firm-issued accounting reports

with up-to-date performance information

Issued annually or quarterly

Public firms must file their financial statements with the

SEC on a quarterly basis (form 10-Q) or annual basis
(10-K)

Financial Statements

Financial statements reporting format follows the

GAAP standards (for public firms)

Public firms are required to hire third-party neutral

auditors to check on the format and informational
accuracy of financial statements

Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Stockholders Equity

Balance Sheet

Balance Sheet

Balance Sheet Identity:

Assets = Liabilities + Shareholders Equity

Types of Assets:

Current (e.g., cash, accounts receivables)

Long-Term (e.g.,net PPE, goodwill)

Balance Sheet

Types of Liabilities:

Current (e.g., accounts payables)

Long-term (e.g., long-term debt, capital leases)

Net Working Capital (NWC) is the difference between

Current Assets and Current Liabilities
NWC = Current Assets - Current Liabilities

Stockholders Equity or Book Value of Equity (BE)

BE = Total Assets - Total Liabilities

Book Value vs Market Value

Book Value of Equity (BE) or simply book equity is the

shareholders net worth from an accounting perspective

Market Value of Equity (ME) or simply market equity is the

amount shareholders are willing to pay (collectively) to own
the firms equity

ME is also known as Market Capitalization

ME = Price per Share * Number of Shares

Book Value vs Market Value

ME is the true net worth of the shareholders and it takes

into account the value of the firms existing assets as well
as the value of the firms future growth opportunities

ME is a forward-looking measure of the net worth of the

shareholders

BE reflects mostly the historical cost of the firms assets

BE is a backward-looking measure of the net worth of the

shareholders

ME and BE are usually very different

Book Value vs Market Value

Balance Sheet Analysis

Market-to-Book Ratio (ME/BE)

Market Equity
ME/BE =
Book Equity

ME/BE is a measure of the value of a firms assets to

shareholders, when put to use by the firm, relative to the
historical cost of acquiring these assets

Firms with low ME/BE (below 1) are called value firms

Firms with high ME/BE (far above 1) are called growth firms

Balance Sheet Analysis

Debt-to-Equity Ratio (D/E):

Total Debt
D/E =
Total Equity

D/E captures financial leverage

High D/E generally means that the firm relies heavily on

financing its assets with debt

We can compute Total Equity using either BE (book D/

E) or ME (market D/E)

Balance Sheet Analysis

Debt-to-Assets Ratio (D/A), also known as debt to

capital or simply as the leverage ratio

Total Debt
D/A =
Total Equity + Total Debt

D/A can be calculated using either book values (book

D/A) or market values (market D/A)

Net debt (ND) is simply total debt less excess cash and
cash equivalents

ND = Total Debt

Cash

Balance Sheet Analysis

Enterprise Value (EV)

EV = Market Equity + Net Debt

EV measures the market value of a firms operating

assets and is generally perceived as the cost of taking
over a business

Net Debt-to-Enterprise Value Ratio (ND/EV)

Net Debt
ND/EV =
Enterprise Value

Balance Sheet Analysis

Income Statement

Income Statement

Income Statement records a firms performance over a

period of time (quarter or year)

It reports the firms net income (NI) also known as

earnings or bottom line

Income Statement Analysis

Using the data in the income statement (and some on

the balance sheet) we can compute several important
ratios and rates

Profitability ratios

Capital activity ratios

Investment return rates

Income Statement Analysis

Profitability Ratios

Operating Income
Operating Margin =
Total Sales

EBITA
Operating Margin (Alt) =
Total Sales
Net Income
Net Profit Margin =
Total Sales

Profitability Ratios capture the fraction of sales that the

manager manages to keep in the firm

Income Statement Analysis

Capital

activity ratios:

Sales
Asset Turnover =
Total Assets
Sales
Capital Efficiency =
Invested Capital

Capital activity ratios capture the efficiency of a firms

assets

That is, the extent to which firm assets can generate sales

Income Statement Analysis

Invested Capital (IC) in the Capital Efficiency ratio is the

historical cost of a firms operating assets

IC can be computed as follows:

IC =Book Equity + Net Debt

Investment in Non-operating Assets

Non-operating assets are assets that are not involved

directly in production (e.g., perk apartment, corporate jet)

Income Statement Analysis

Return Rates

Net Income
ROA =
Total Assets
Net Income
ROE =
BE

NOPLAT
ROI =
Invested Capital

Investment return rates capture the net return on

investing directly in the operating assets of a firm

Income Statement Analysis

NOPLAT stands for net operating profit less adjusted tax

NOPLAT is defined approximately as

NOPLAT = (1

T) EBITA

T stands for the corporate tax rate

T*EBITA capture the taxes on the income generated by

the operating assets of the firm (so-called adjusted tax)

Income Statement Analysis

What do investment return rates really capture?

Useful decompositions:

NI
Sales
ROA =

Sales Total Assets

ROI = (1

EBITA
Sales
T)

Sales
Invested Capital

Income Statement Analysis

The

DuPont Identity

NI
Sales
Total Assets
ROE =

Sales Total Assets

BE
Net Profit Margin

Asset Turnover

Return on Assets (ROA)

Equity Multiplier

Income Statement Analysis

Return

on equity (ROE) captures 3 key concepts:

Net Profit Margin measures a firms profitability - that is, the

fraction of sales that the manager can turn into profits

Asset Turnover measures the efficiency of a firms assets that is, the ability of a firms assets to generate sales

Equity Multiplier measures a firms financial leverage - that

is, the extent to which a firm relies on debt to finance
assets

Income Statement Analysis

Income Statement Analysis

Relation between ROI and ROE

Suppose the firm has no excess cash (all cash is working

cash) and has no other long-term investments (e.g.,
financial assets)

ROE = ROI + ROI

After-tax Interest Exp Debt

Debt
BE

Statement of Cash Flows

Statement of Cash Flows

Statement of Cash Flows reports the sources and uses

of cash generated during a certain period of time (e.g.,
year)

It augments the Income Statement by adding back noncash entries and capital expenditures

Statement of Cash Flows

Statement of Cash Flows can be used to back out

retained earnings (RE)

RE are earnings reinvested back into the firm

RE = NI

Dividends

Dividends
Payout Ratio =
NI
RE
Plowback Ratio =
=1
NI

Payout Ratio

Statement of Cash Flows

Statement of Cash Flows Analysis

Working

Capital Ratios

Accounts Receivable
Acc. Rec. Days =
365
Sales
Accounts Payable
Acc. Pay. Days =
365
Cost of Goods Sold

Accounts receivable days captures the number of days it

takes to converge sales into cash, and accounts payable days
captures the number of days it takes to repay suppliers

Statement of Cash Flow Analysis

Liquidity Ratios

Current Assets
Current Ratio =
Current Liabilities
EBIT
Coverage Ratio =
Interest Expense

These ratios are used to asses whether a firm has

enough cash flows to meet its short-term financial
obligations

Valuation Multiples
NI
EPS =
Number of Shares

ME
Price per Share
P/E Ratio =
=
NI
EPS

EV
Enterprise/EBITDA Ratio =
EBITDA

Valuation multiples or ratios are used by analysts to

compare the market value of two or more firms

Valuation Multiples

Other Statements

Statement

of Stockholders Equity: Decomposes

Shareholders Equity on the Balance Sheet into
retained earnings and net new equity (new equity
issued net of retired equity)

Management

Discussion and Analysis (MD&A):

Preface to Financial Statements discussing recent
year performance