The Analysis of Financial Statements

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The Analysis of Financial Statements
PART II
2
The Analysis of Financial Statements
3
Chapter 7
Business Activities and Financial Statements
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Business Activities and Financial Statements
Link to Previous Chapters
Chapter 1 introduced the
firms operating, investing and
financing activities. Chapter
2 introduced the financial
statements. Chapters 5 and 6 outlined
valuation models that
anchor on those financial statements.
This Chapter
How are the
How are
How are
What
This chapter shows how the
operating and
operating and
measures
cash flows of a
three business activities are
financing
capture the
business
financing assets
depicted in the financial
identified in
and liabilities
income
operating and
statements. It also shows how
identified in the
identified in the
financing
the cash flow
statement ?
balance sheet?
income
profitability ?
the statements are redesigned
statement?
to highlight these activities and
to prepare the statements for
applying the valuation models
in Chapter 5 and 6.
Link to Next Three Chapters
Chapters 8, 9 and 10
reformulate statements
according to the design
developed in this chapter.
Link to Web Page
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What you will learn in this chapter

• How businesses are organized to generate value
  for shareholders
• The difference between operating and financing
  aspects of a business
• How business activities are reported in financial
  statements
• How financial statements are organized to
  highlight operating and financing activities
• How business activities articulate and how
  financial statements articulate
• The four cash flows of a business and how they
  relate to each other
• Why free cash flow does not affect value added
• A set of accounting relations that summarize how
  business activities drive financial statements

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Cash Flows Between the Firm and Claimants in the
Capital Market
Cash received from debtholders and shareholders
is (temporarily) invested in financial assets.
Cash payments to debtholders and shareholders are
made by liquidating financial assets (that is,
selling debt). Net financing assets are
debt purchased from issuers, net of debt issued
to debtholders. Net financing assets can be
negative (that is, debt sold to debtholders is
greater than debt purchased).
Key F net cash flow to debtholders and
issuers d net cash flow to shareholders
NFA net financial assets financial assets
financial liabilities
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Business Activities All Cash Flows
Cash generated from operations is invested in net
financial assets (that is, it is used to buy
financial assets or to reduce financial
liabilities). Cash investment in operations is
made by reducing net financial assets (that is,
by liquidating financial assets or issuing
financial obligations). Cash from operations and
cash investment may be negative (such that, for
example, cash can be generated by liquidating an
operating asset and investing the proceeds in a
financial asset).
Key F net cash flow to debtholders and
issuers d net cash flow to shareholders C
cash flow from operations I cash investment
NFA net financial assets
NOA net operating assets operating
assets operating liabilities
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The Cash Conservation Equation

• A fundamental accounting identity
• C Net cash from operations
• I Net cash outflow for investing (expenditures
  less divestments)
• C - I Free cash flow
• d Net dividends (common dividends, stock
  repurchases, less stock issues)
• F Net cash outflow to debtholders and debt
  issuers (principal interest)
• The treasurers rule
• If lend or buy down
  own debt
• If borrow or reduce
  lending

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Statement of Cash Flows
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Balance Sheet
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Balance Sheet Restated
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Business ActivitiesAll the Stocks Flows
Net operating assets are employed in operations
to generate operating revenue (by selling goods
and services to customers) and incur operating
expenses (by buying inputs from suppliers). ?
indicates changes.
Key F net cash flow to debtholders and
issuers d net cash flow to
shareholders C cash flow from
operations I cash investment
NFA net financial assets NOA
net operating assets OR
operating revenue OE operating
expense OI operating income
NFI Net financial income
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Income Statement

• The difference between operating revenue and
  operating expense is called operating income
• Net financial expense can be negative (net
  financial income)

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Business Activities and the Financial Statements
This figure shows how reformulated income
statements, balance sheets, and the cash flow
statements report the operating and financing
activities of a business, and how the stocks and
flows are uncovered in the financial statements.
Operating income increases net operating assets
and net financial expense increases net financial
obligations. Free cash flow is a dividend from
the operating activities to the financial
activities free cash flow reduces net operating
assets and also reduces net financial
obligations. Net dividends to shareholders are
paid out of net financial obligations.
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Stocks FlowsOperating and Financing Activities

• The change in NFO is given by
• The change in NOA is given by
• Operating income in the income statement flows to
  net operating assets in the balance sheet.
• Free cash flow reduces NOA and reduces NFO
  (increases NFA).
• If the firm has net financial assets rather than
  NFO,
• NFAt NFAt-1 (Ct It) NFIt dt

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Tying it TogetherWhat Generates Value?

• From the balance sheet equation
• Given the way that NOA and NFO are calculated,
• which is the stocks and flows equation.
• For this to be true, however, accounting must be
  Clean Surplus.
• Free cash flow drops out in this calculation
  Free cash flow (C - I) does not add value to
  shareholders. Free cash flow is a dividend from
  the operating activities to the financing
  activities
• What generates value is the profit from operating
  and financing activities.

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Stocks Flows RatiosBusiness 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
• Return on Net Financial Assets
• If there are NFO rather than NFA, net borrowing
  cost
• Forecasting ROCE involves both the forecast of
  RNOA and RNFA (or NBC)