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Foundations of Finance Summary of Book "Principles of Corporate Finance"
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SUMMARY FINANCEChapter 28 – Financial Analysis
28.1 Financial Ratios
28.3 Home Depot's Financial Statements
The balance sheet provides a snapshot of the company's assets at the end of the year and the
sources of the money that was used to buy those assets.
The assets are listed in declining order of liquidity. Current assets: assets that are most likely to be
turned into cash in the near future:
- Cash
- Marketable securities and receivables
- Inventories of raw materials
- Work in process
- Finished goods
The remaining assets on the balance sheet are long-term, usually illiquid, assets such as:
- Warehouses
- Stores
, - Fixtures
- Vehicles
Balance sheet does not show up-to-date market values of the long-term assets but shows the
amount that each asset originally cost and deducts a fixed annual amount for depreciation of
buildings, plant, and equipment. Balance sheet does not include all company's assets, such as
intangible: reputation, skilled management, well-trained labour force.
Liabilities: the money owed by the company. Current liabilities that need to be paid off in the near
future, include: debts that are due to be repaid within the next year and payables (amounts owed by
the company to its suppliers).
Difference between current assets and current liabilities= net current assets or net working capital.
It roughly measures the company's potential reservoir of cash. Net working capital= current assets –
current liabilities
Long-term liabilities of the balance sheet show the sources of the cash that was used to acquire the
net working capital and fixed assets. Some of the cash has come from the issue of bonds and leases
that will not be repaid for many years. After all these long-term liabilities have been paid off, the
remaining assets belong to the common stockholders.
The equity is the total value of the net working capital and fixed assets less the long-term liabilities.
Part of this equity has come from the sale of shares to investors, and the remainder has come from
earnings that the company has retained and invested on behalf of the shareholders.
Income statements show how profitable the firm has been over the past year.
Earnings Before Interest and Taxes (EBIT)= total revenues – costs – depreciation
28.4 Measuring Home Depot's Performance
The book value measures shareholders’ cumulative investment in the company.
Market capitalization: refers to the total dollar market value of a company's outstanding shares of
stock. The investment community uses this figure to determine a company's size instead of sales or
total asset figures. The market value added: the difference between the market value of the firm's
shares and the amount of money that shareholders have invested in the firm. Financial managers
and analysts also like to calculate how much value has been added for each dollar that shareholders
have invested > the ratio of market value to book value. Market-to-book ratio= market value of
equity / book value of equity
,The market value performance measures in table 28.3 have three drawbacks:
1. The market value of the company's shares reflects investors’ expectations about future
performance. Investors pay attention to current profits and investment, of course, but
market-value measures can be noisy measures of current performance.
2. Measures of market performance are only a first step toward understanding the reasons for
the performance. Are the measures an indication of the manager's competence? Are they a
reflection of events that are outside the managers’ control, or do they just suggest
fluctuations in investor sentiment?
3. You can't look up the market value of privately owned companies whose shares are not
traded. Nor can you observe the market value of divisions or plants that are parts of larger
companies. You may use market values to satfisy yourself that the company as a whole has
performed well, but you can't use them to drill down to look at the performance of, say, its
overseas stores or particular U.S. stores. You need accounting measures of profitability.
Economic Value Added
To see whether the firm has truly created value, we need to measure whether it has earned a profit
after deducting all costs, including its cost of capital. The cost of capital is the minimum acceptable
rate of return on capital investment. It is an opportunity cost of capital, because it equals the
expected rate of return on investment opportunities open to investors in financial markets. The firm
creates value for investors only if it can earn more than its cost of capital, that is, more than its
investors can earn by investing on their own. The profit after deducting all costs, including the cost
of capital, is called the company's economic value added or EVA. The long-term capital, sometimes
called total capitalization, is the sum of long-term debt and shareholders’ equity. EVA= (after-tax
interest + net income) - (cost of capital x capital) or re-express EVA as:
The return on capital (ROC) is equal to the total profits that the company has earned for its debt-
and equity holders, divided by the amount of money that they have contributed. If the company
earns a higher return on its capital than investors require, EVA is positive.
, Accounting Rates of Return
EVA measures how many dollars a business is earning after deducting the cost of capital. Other
things equal, the more assets the manager has to work with, the greater the opportunity to generate
a larger EVA.
When comparing managers, it can be helpful to measure the firm's return per dollar of investment.
Three common return measures, all based on accounting information and are therefore known as
book rates of return:
1. Return on capital (ROC)
2. Return on equity (ROE)
3. Return on assets (ROA)
Return on Capital
The reason that we subtract the tax shield on debt interest is that we wish to calculate the income
that the company would have earned with all-equity financing. The tax advantages of debt financing
are picked up when we compare the company's return on capital with its weighted-average cost of
capital (WACC). WACC already includes an adjustment for the interest tax shield.
Return on Equity
We measure the return on equity as the income to shareholders per dollar invested. Has the
company provided an adequate return for shareholders? To answer this, we need to compare it with
the company's cost of equity.
Return on Assets
Measures the income available to debt and equity investors per dollar of the firm's total assets. Total
assets (which equal total liabilities plus shareholders’ equity) are greater than total capital because
total capital does not include current liabilities.
Problems with EVA and Accounting Rates of Return
Unlike market-value-based measures, they show current performance and are not affected by the
expectations about future events that are reflected in today's stock market prices. Rate of return
and economic value added can also be calculated for an entire company or for a particular plant or
division.
Both measures are based on book (balance sheet) values for assets. Debt and equity are also book
values. Accountants do not show every asset on the balance sheet, yet our calculations take
accounting data at face value (e.g. brand name)
The balance sheet does not show current market values of the firm's assets. The assets in a
company's books are valued at their original cost less any depreciation. Older assets may be grossly
undervalued in today's market conditions and prices. So a high return on assets indicates that the
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