SESSION OBJECTIVES

At the end of this session participants should be able to:

Understand the FIO model

Understand the process of value creation

Identify the drivers of value

Identify links between financial statements

The Process of Value Creation

Creating economic value for the owners

Selecting and sourcing prudent funding options

Selecting and makingsound resource commitments

Operating resources in a competitive,

cost-effective manner

Operating resources in a competitive,

cost-effective manner

The three basic decisions made by management

Operating DecisionsOperating Decisions

Financing Decisions

Investment Decisions

The Three Basic Business Decisions

INCOME STATEMENT ANALYSIS

THE INCOME STATEMENT

• IT IS OF PRIME IMPORTANCE TO CEO

• IT IS A PERIOD STATEMENT

• IT IS BASED ON THE ‘MATCHING’ PRINCIPLE

• STATEMENT OF VALUE CREATION

REVENUE - EXPENSES = INCOME

INCOME STATEMENT CLASSIFICATIONS

SALES PRICE X VOLUMEREVENUE

EXPENSES PRODUCT VS. DIRECT VS. PERIOD COST INDIRECT COST

INCOME DIVIDENDS + RETAINED EARNINGS

-

= VARIABLE VS FIXED COST

INCOME STATEMENT ITEMS

REVENUE Price X Volume- COST OF GOODS SOLD Product Cost Direct Expense Fixed and Variable Expense- SELLING,GENERAL, AND ADMINISTRATIVE Period Cost, Indirect Expense, Fixed and Variable Cost - INTEREST Financing Cost- TAXES= NET INCOME

COMMON SIZED ANALYSIS

COMMON SIZE ANALYSIS CONVERTS EACH ITEM ON THE INCOME STATEMENT INTO A PERCENTAGE IN ORDER FOR ANALYSIS TO BE PERFORMED ON A COMMON BASIS. EACH ITEM IS EXPRESSED AS A PER CENT OF REVENUES.

• PERCENT OF TOTAL

• APPLES AND APPLES

• IDENTIFY TRENDS

COMMON SIZED ANALYSISTHE INCOME STATEMENT FACSIMILIE CO.

For the Period Ending 12/31/XXREVENUES $ 7523 100%

- COST OF GOODS SOLD 4849 65

= GROSS MARGIN 2674 35

- S.G.& A. 1524 20

= OPERATING INCOME 1150 15

- INTEREST EXPENSE 160 2

= NET INCOME BEFORE TAX 990 13

- TAXES ON INCOME 336 5

= NET INCOME 594 8

PERCENT ANALYSISALLOWS ONE TO TRACK CHANGES IN FINANCIAL STATEMENTS FROM ONE REPORTING PERIOD TO THE NEXT

CALCULATE THE CHANGE IN AN ITEM, THEN,

DIVIDE THAT BY PREVIOUS YEARS TOTAL

EXAMPLE: PERCENT CHANGE = (THIS YEAR - LAST YEAR) DIVIDED BY LAST YEAR

PERCENT CHANGE FOR COST OF GOODS:

(5625 - 4849) / 4849 = 16.0%

INCOME STATEMENT RATIOS

RETURN ON SALES Net Income / Total Sales

GROSS MARGIN Gross Margin / Total Sales

S. G. & A. RATIO S.G.&A. Expenses / Total Sales

INTEREST COVERAGE Operating Income / Interest Expense

OPERATING MARGIN Operating Income / Sales

NET MARGIN Net Income / Sales

INCOME STATEMENT- LINKS TO BALANCE SHEET

BALANCE SHEET INCOME STATEMENT

ACCOUNTS RECEIVABLE REVENUES

INVENTORY - COST OF GOODS

- OTHER EXPENSES

RETAINED EARNINGS =NET INCOME

LIMITATIONS OF INCOME STATEMENT

• EXPENSES ARE NOT DETAILED

• DEPRECIATION AND COST OF GOODS ARE UNDERSTATED IN INFLATIONARY PERIODS

• CAPITALIZATION VS. EXPENSING

• IGNORES THE COST OF EQUITY FINANCING

SUMMARY

• INCOME STATEMENT PROVIDES INFORMATION

REVENUES

EXPENSES

NET INCOME

• YOU HAVE LEARNED HOW TO CALCULATE AND ANALYZE THE INCOME STATEMENT USING:

COMMON SIZE ANALYSIS

PERCENT CHANGE ANALYSIS

• ANALYSIS DOES NOT SHOW UNDERLYING CAUSES

BALANCE SHEET ANALYSIS

THE BALANCE SHEET

• IT IS A SNAP SHOT SHOWING WHAT THE COMPANY OWNS AND OWES AT A POINT IN TIME

• HOW MUCH DID WE INVEST?

• HOW IS THE INVESTMENT FINANCED?

• WHAT ASSETS DO WE OWN?

TANGIBLE/ INTANGIBLE

SHORT TERM/ LONG TERM

• ASSETS = LIABILITIES + OWNERS’ EQUITY

• IT IS OF PRIME IMPORTANCE TO CFO

THE BALANCE SHEET

CURRENT ASSETS

FIXED ASSETS

CASH

A/R

INVEN-TORY

OTHER

NET P.&E.

OTHER

CURRENT LIABILITIES

LONG TERM LIABILITIES

OWNER’S EQUITY

=

ACCTS.PAYABLE

WAGES PAYABLE

ACCRUALS

LONG TERM DEBT

RETAINED EARNINGS

INVESTMENT IN FIXED ASSETS

DEPRECIATION EXPENSE

ACCUMULATED DEPRECIATION

DEPRECIATION METHODS

STRAIGHT LINE

ACCELERATED

BOOK VALUE

ECONOMIC VALUE

INVESTMENT IN WORKING CAPITAL

• WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

• MEASURES THE NET INVESTMENT IN OPERATING CASH CYCLE

• WORKING CAPITAL NECESSARY TO:

PRODUCE PRODUCT

MAINTAIN DAY-TO-DAY OPERATIONS

MAKE SALES

CAPITAL

• DEBT + OWNER’S EQUITY = INVESTED CAPITAL

• ANY INVESTMENT EARNING RETURNS IS CAPITAL

DEBT: INTEREST

EQUITY: DIVIDENDS & STOCK PRICE

• BALANCE SHOWS HOW ASSETS WERE FINANCED

• LEVERAGE: PROPORTION OF CAPITAL FROM DEBT

INVESTMENT

CAPITAL FROM INVESTMENT

SHORT TERM LOANS WORKING CAPITAL

LONG TERM DEBT = +

OWNER’S EQUITY FIXED ASSETS

THE RETURN TO THE PROVIDERS OF CAPITAL COMES FROM THE EARNINGS FROM INVESTMENTS

THE BALANCE SHEET AND MANAGEMENT ACTION

WORKING CAPITAL LONG TERM LIABILITIES

CREDIT POLICY DEBT POLICIES

PRODUCTION SCHEDULES PENSIONS

PAYMENT POLICY TAX DEFERMENT

FIXED ASSETS OWNER’S EQUITY

EQUIPMENT PURCHASES STOCK ISSUANCE

ACQUISITIONS REPURCHASE

LONG TERM INVESTMENTS DIVIDEND POLICY

BALANCE SHEET RATIOSQUICK RATIO

DEBT AS A PERCENT OF CAPITALIZATION

DEBT TO EQUITY

FINANCIAL LEVERAGE

DAY’S SALES O/S

INVENTORY TURNOVER

Current Assets - Inventories

Current Liabilities

Total Debt

Debt + Equity

Total DebtEquity

AssetsEquity

Accounts Receivable

Average Daily Credit Sales

Cost of Goods SoldAverage Inventory

BALANCE SHEET- LINKS TO THE INCOME STATEMENT

BALANCE SHEET INCOME STATEMENT

ACCOUNTS RECEIVABLE REVENUES

INVENTORY - COST GOODS

- OTHER EXPENSES

RETAINED EARNINGS = NET INCOME

LIMITATIONS OF THE BALANCE SHEET

• HISTORICAL COST RESULTS IN UNDERVALUED ASSETS SUCH AS REAL ESTATE

• SOME LIABILITIES NOT RECORDED (OFF BALANCE SHEET FINANCING)

• INTANGIBLE ASSETS MIS-PRICED

• BALANCE SHEET LOOKS BACKWARD

SUMMARYBALANCE SHEET PROVIDES KEY INFORMATION

• SIZE OF ACCOUNT BALANCES

• NEW INVESTMENTS

• FINANCING OF NEW INVESTMENTS

FINANCIAL TOOLS AVAILABLE TO ANALYZE BALANCE SHEET

• PERCENT CHANGE

• COMMON SIZE

• RATIO ANALYSIS

CASH FLOW STATEMENT

WHY EXAMINE CASH FLOW?

A COMPANY IS A COLLECTION OF PROJECTS EACH GENERATING CASH. CASH FLOW STATEMENTS TOTAL THE SOURCES AND USES OF CASH FOR ALL PROJECTS.

CASH FLOW STATEMENT ANALYSIS ALLOWS US TO DETERMINE:

• NEED FOR EXTERNAL FUNDING

• ABILITY TO PAY CASH RETURN TO INVESTORS

• RELATIONSHIP BETWEEN INVESTMENT AND GENERATION OF CASH

• IT IS OF PRIME IMPORTANCE TO COO

THE CASH FLOW CYCLE

FOUR STAGES

• FINANCING

• INVESTING

• OPERATING

• RETURNING

Financing

InvestingOperating

Return

ing

THE CASH CYCLE-FINANCING

(OWNER’S ) (LENDERS)

CASH

EQUITY LIABILITIES

THE CASH CYCLE-INVESTING

CASH

FIXED ASSETSLABOR, MATERIALS,

OVERHEAD,ETC.

INVENTORY

THE CASH CYCLE-OPERATING

INVENTORY

SALE

REVENUE

I.O.U.

ACCOUNTS RECEIVABLECASH

SG&A

THE CASH CYCLE- RETURNING

OWNERS LENDERS

EQUITY LIABILITIES

CASH

TAXES

THE CASH CYCLE

ACCOUNTS RECEIVABLECASH

TAXES

FIXED ASSETS

LAB, MTLS, ETC SG&A

INVENTORY REVENUE

EQUITY LIABILITIES

THE CASH FLOW STATEMENTRECONCILES THE BEGINNING AND ENDING CASH BALANCES

CATEGORIZES CASH FLOW BY ACTIVITY

• OPERATING

• INVESTING

• FINANCING

CASH FLOWS FROM OPERATIONS

CASH FLOWS FROM INVESTING

+

CASH FLOWS FROM FINANCING

+

NET CHANGE IN CASH

=