Asw

ath Dam

odaran1

Financial S

tatement A

nalysis

Asw

ath Dam

odaran2

Questions w

e would like answ

ered…

Assets

Liabilities

Assets in Place

Debt

Equity

What is the value of the debt?

How

risky is the debt?

What is the value of the equity?

How

risk y is the equity?G

rowth A

ssets

What are the assets in place?

How

valuable are these assets?H

ow risk y are these assets?

What are the grow

th assets?H

ow valuable are these assets?

Asw

ath Dam

odaran3

Basic F

inancial Statem

ents

The balance sheet, w

hich summ

arizes what a firm

owns and ow

es at apoint in tim

e.

The incom

e statement, w

hich reports on how m

uch a firm earned in

the period of analysis

The statem

ent of cash flows, w

hich reports on cash inflows and

outflows to the firm

during the period of analysis

Asw

ath Dam

odaran4

The B

alance Sheet

Assets

Liabilities

Fixed Assets

Deb t

Equity

Short-term liabilities of the firm

Intangible Assets

Lon g L

ived Real A

ssets

Assets w

hich are not physical,like patents &

trademarks

Current A

ssets

Financial Investments

Investments in securities &

assets of other firms

Short-lived Assets

Equity investm

ent in firm

Debt obligations of firm

Current

Liabilties

Other

Liabilities

Other long-term

obligations

Figure 4.1: The B

alance Sheet

Asw

ath Dam

odaran5

A F

inancial Balance S

heet

Assets

Liabilities

Assets in Place

Debt

Equity

Fixed Claim

on cash flows

Little or N

o role in managem

entF

ixed Maturity

Tax Deductible

Residual C

laim on cash flow

sSignificant R

ole in managem

entP

erpetual Lives

Grow

th Assets

Existing Investm

entsG

enerate cashflows today

Includes long lived (fixed) and short-lived(w

orking capital) assets

Expected V

alue that will be

created b y future investments

Asw

ath Dam

odaran6

The Incom

e Statem

ent

Figure 4.2: Incom

e Statement

Revenues

Gross revenues from

sale of products or services

- Operating E

xpensesE

xpenses associates with

generating revenues

= Operating Incom

eO

perating income for the

period

- Financial Expenses

Expenses associated w

ithborrow

ing and other financing

- Taxes

Taxes due on taxable incom

e

= Net Incom

e before extraordinary items

Earnings to C

omm

on &

Preferred Equity for

Current Period

- (+) Extraordinary Losses (P

rofits)Profits and L

osses notassociated w

ith operations

- Income C

hanges Associated w

ith Accounting C

hangesProfits or losses associatedw

ith changes in accountingrules

- Preferred Dividends

Dividends paid to preferred

stockholders

= Net Incom

e to Com

mon Stockholders

Asw

ath Dam

odaran7

Modifications to Incom

e Statem

ent

There are a few

expenses that consistently are miscategorized in

financial statements.In particular,

•O

perating leases are considered as operating expenses by accountants butthey are really financial expenses

•R

&D

expenses are considered as operating expenses by accountants butthey are really capital expenses.

The degree of discretion granted to firm

s on revenue recognition andextraordinary item

s is used to manage earnings and provide m

isleadingpictures of profitability.

Asw

ath Dam

odaran8

Dealing w

ith Operating Lease E

xpenses

Debt V

alue of Operating L

eases = PV

of Operating L

ease Expenses at

the pre-tax cost of debt

This now

creates an asset - the value of which is equal to the debt

value of operating leases. This asset now

has to be depreciated overtim

e.

Finally, the operating earnings has to be adjusted to reflect thesechanges:•

Adjusted O

perating Earnings =

Operating E

arnings + O

perating Lease

Expense - D

epreciation on the leased asset

•If w

e assume that depreciation =

principal payment on the debt value of

operating leases, we can use a short cut:

Adjusted O

perating Earnings =

Operating E

arnings + D

ebt value ofO

perating leases * Cost of debt

Asw

ath Dam

odaran9

Exam

ples: Operating Leases at B

oeing andT

he Hom

e Depot in 1998

Boeing

Hom

e Depot

Year

Operating L

ease Expense

Present Value at

5.5%

Operating

Lease E

xpense

Present Value

at 5.8%

1 $ 205

$ 194.31 $ 294

$ 277.88

2 $ 167

$ 150.04 $ 291

$ 259.97

3 $ 120

$ 102.19 $ 264

$ 222.92

4 $ 86

$ 69.42 $ 245

$ 195.53

5 $ 61

$ 46.67 $ 236

$ 178.03

Yr 6 -15

$ - $ -

$ 270 $ 1,513.37

PV of O

perating Lease E

xpenses $ 562.64

$ 2,647.70

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ath Dam

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Imputed Interest E

xpenses on Operating

LeasesBoeing

The H

ome D

epotP

V of O

perating Leases

$ 562.64$ 2647.70

Interest rate on Debt

5.50%5.80%

Imputed interest expense on P

V of operating leases

$ 30.95$ 153.57

Asw

ath Dam

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The E

ffects of �C

apitalizing Operating Leases

Debt : w

ill increase, leading to an increase in debt ratios used in thecost of capital and levered beta calculation

Operating incom

e: will increase, since operating leases w

ill now be

before the imputed interest on the operating lease expense

Net incom

e: will be unaffected since it is after both operating and

financial expenses anyway

Return on C

apital will generally decrease since the increase in

operating income w

ill be proportionately lower than the increase in

book capital invested

Asw

ath Dam

odaran12

R&

D E

xpenses: Operating or C

apital Expenses

Accounting standards require us to consider R

&D

as an operatingexpense even though it is designed to generate future grow

th. It ism

ore logical to treat it as capital expenditures.

To capitalize R

&D

,•

Specify an amortizable life for R

&D

(2 - 10 years)

•C

ollect past R&

D expenses for as long as the am

ortizable life

•Sum

up the unamortized R

&D

over the period. (Thus, if the am

ortizablelife is 5 years, the research asset can be obtained by adding up 1/5th of theR

&D

expense from five years ago, 2/5th of the R

&D

expense from four

years ago...:

Asw

ath Dam

odaran13

Exam

ple: Capitalizing R

&D

Expenses: B

oeing

Year

R&D

Unam

ortizedPo

rtion

Value

19

89

$7

54

0.1

0$

75

19

90

$8

27

0.2

0$

16

51

99

1$

1,4

17

0.3

0$

42

5

19

92

$1

,84

60

.40

$7

38

19

93

$1

,66

10

.50

$8

31

19

94

$1

,70

40

.60

$1

,02

21

99

5$

1,3

00

0.7

0$

91

0

19

96

$1

,63

30

.80

$1

,30

61

99

7$

1,9

24

0.9

0$

1,7

32

19

98

$1

,89

51

.00

$1

,89

5C

apitalized Value of R

& D

Expenses =$

9,1

00

Asw

ath Dam

odaran14

Boeing’s C

orrected Operating Incom

e

Boeing

Operating Incom

e$1,720

+ R

esearch and Developm

ent Expenses

$1,895 - A

mortization of R

esearch Asset

$1,382 + Im

puted Interest Expense on O

peratingL

eases $ 31

= Adjusted O

perating Income

$2,264

Asw

ath Dam

odaran15

The E

ffect of Capitalizing R

&D

Operating Incom

e will generally increase, though it depends upon

whether R

&D

is growing or not. If it is flat, there w

ill be no effectsince the am

ortization will offset the R

&D

added back. The faster

R&

D is grow

ing the more operating incom

e will be affected.

Net incom

e will increase proportionately, depending again upon how

fast R&

D is grow

ing

Book value of equity (and capital) w

ill increase by the capitalizedR

esearch asset

Capital expenditures w

ill increase by the amount of R

&D

;D

epreciation will increase by the am

ortization of the research asset;For all firm

s, the net cap ex will increase by the sam

e amount as the

after-tax operating income.

Asw

ath Dam

odaran16

The S

tatement of C

ash Flow

s

Cash Flow

s From O

perations

+ C

ash Flows From

Investin g

+ Cash Flow

s from Financing

Net cash flow

from operations,

after taxes and interest expenses

Includes divestiture and acquisitionof real assets (capital expenditures)and disposal and purchase of financial assets. A

lso includes acquisitions of other firm

s.

Net cash flow

from the issue and

repurchase of equity, from the

issue and repayment of debt and afte r

dividend payments

= Net C

hange in Cash B

alance

Figure 4.3: Statem

ent of Cash F

lows

Asw

ath Dam

odaran17

The F

inancial perspective on cash flows

In financial analysis, we are m

uch more concerned about

•C

ash flows to the firm

or operating cash flows, w

hich are before cashflow

s to debt and equity)

•C

ash flows to equity, w

hich are after cash flows to debt but prior to cash

flows to equity