Investment is based on plans for committing existing or new
funds to three main areas:
- Working Capital
- Physical Assets
- Major Spending Programs, such as R&D, Product Development,
Acquisitions, etc.
If an investment is not working out, then it is necessary to
disinvest. Yardsticks, such as Net Present Value are used
in making investment decisions.
Once the investments are made, it is necessary to operate the
resulting projects efficiently. Decisions such as the appropriate
level of operating leverage, on the production side; and the choice
of price/marketing strategy on the sales side are involved in
the operating process.
The profits from the operations of the firm feed into the third
process, the financing process. Here dividend payout decisions
have to be made, as well as the appropriate sourcing of funds
from a variety of sources, both equity-based and debt-based.
In order to take the proper decisions, it is necessary for the
manager to have access to the right information. Information
related to the investment and the funding process can be found
in the balance sheet, while information related to the operating
process can be found primarily in the Income Statement.
The Statement of Retained Earnings provides more details regarding
the disposition of the equity account. The Statement of
Cash Flows provides more detail regarding the sources and uses
of cash, which can help in a proper analysis of the operations
of the firm.
We will now discuss these four financial statements in a little
more detail.
The Balance Sheet
The balance sheet is a snapshot of the firm; it is a means of organizing
and summarizing what a firm owns (its assets) and what it owes (its
liabilities). Here is an example of a balance sheet.
Example
| Assets |
|
|
Liabilities |
|
|
| |
1993 |
1994 |
|
1993 |
1994 |
| Current Assets |
|
|
Current Liabilities |
|
|
| Receivables |
1200 |
1250 |
Payables |
1229 |
1149 |
| Inventories |
1400 |
1683 |
|
|
|
| Cash |
1987 |
2087 |
|
|
|
| Total Current Assets |
4587 |
5020 |
Total Current Liabilities |
1229 |
1149 |
| |
|
|
Working Capital =Current Assets- Current Liabilities |
3358 |
3871 |
| Fixed Assets |
|
|
Long-term debt |
3475 |
4300 |
| Tangible Fixed Assets |
5106 |
5315 |
|
|
|
| Intangible Fixed Assets |
3000 |
3000 |
|
|
|
| Total assets |
12693 |
13335 |
Total liabilities |
4704 |
5449 |
| |
|
|
Shareholders' equity = |
|
|
| |
|
|
Owner's Equity |
|
|
| |
|
|
Common Stock and Paid-in Surplus |
2000 |
1476 |
| |
|
|
Retained Earnings |
5989 |
6410 |
| |
|
|
Total liabilities and shareholders' equity |
12693 |
13335 |
Damodaran presents a convenient way of categorizing the items
in a balance sheet:
| Assets |
Liabilities |
| Long Lived Real Assets |
Fixed Assets |
Current Liabilities |
Short-term Liabilities of the firm |
| Short-lived Assets |
Current Assets |
Debt |
Debt Obligations of the firm |
| Investments in securities and assets of other
firms |
Financial Investments |
Other Liabilities |
Other long-term Obligations |
| Assets which are not physical, like patents
& trademarks |
Intangible Assets |
Equity |
Equity Investment in Firm |
Important Concepts Pertaining to the Balance Sheet:
Net Working Capital: The difference between current assets
and current liabilities. This represents the amount of capital
that the firm is using for the short-run needs of the business.
Shareholders’ Equity: The difference between what
the business owns and what it owes, i.e. the shareholder’s
wealth in the firm.
Liquidity: This refers to the speed and ease with which
an asset can be converted to cash. Assets are normally listed
on the balance sheet in order of liquidity.
Market Value versus Book Value: The Book Value of an asset
is based on accounting concepts, which are often linked up with
historical cost. This need not be the same as market value. In
addition, assets such as managerial talent and liabilities such
as potential product liability suits are often not represented
on the balance sheet. Finance is usually interested in market
value, rather than in book value.
The rule that assets are valued at book rather than market, in
financial statements is generally true. However, financial
investments are not always subject to this rule, since, often,
dependable market values can be obtained from liquid markets.
The rules that apply in this case are, in summary form, as follows:
| Majority |
Minority |
| Active Investment |
Active Investment |
Passive Investment |
| > 50% ownership of asset |
20% to 50% ownership of asset |
Between 0% and 20%
ownership of asset |
| |
|
Investments held to maturity |
Investments available for sale |
Trading Investments |
The accounting treatment:
The balance sheets of the two firms are consolidated,
with the assets and the liabilities of the two firms being
merged and shown together. The ownership stake of the
minority shareholders is shown in the balance sheet as a liability. |
The accounting treatment:
The investment is carried at historical acquisition cost;
a proportional amount of the income of the firm is added to
the book value of the investment, while dividends paid are
deducted from the book value. The proportional income
is reported in the income statement, but the receipt of dividends
is not recognized in the income statement. However,
the concomitant increase in cash is recorded. |
The accounting treatment:
Shown at historical value, with interest/dividends shown
in the income statement |
The accounting treatment:
Valued at market, but unrealized gains and losses are
shown as part of equity in the balance sheet and not in the
income statement. |
The accounting treatment:
Valued at market and unrealized gains/losses are shown
in the income statement. |
My interpretation:
Essentially treated as a subsidiary, except that minority
holdings in the owned firm are shown on the liabilities side;
the same is done in the Income Statement as well. |
My interpretation:
Equity approach:
Recorded at book value just like any other asset; except that
income and dividends are treated as adjustments to the book
value (dividends in this case are comparable to depreciation
in the usual fixed asset case, except that there will be cash
implications in our situation).
The regular income of the firm would show up on the liabilities
side, as an addition to retained earnings, while in our case,
it is treated as a reduction on the assets side. |
My interpretation:
Recorded at book value, just like any other asset; however,
this approach differs from the equity approach in terms of
how income is treated. |
My interpretation:
Since these assets are traded in a liquid market, there
is a reliable price available for them, and there is an intention
to use this market (since the assets are considered available
for sale); in this case, this price trumps acquisition cost
as an accounting measure of value. Unrealized
gains-and-losses are shown on the liabilities side, and not
on the assets side as in the equity approach. |
My interpretation:
For the same reasons as in the case of investments available
for sale, these are valued at market. Their treatment
can be compared to the treatment of inventory, but even unsold
"inventory" is considered "sold," because
they are so liquid and saleable. |
Intangible assets, such as patents, if they are generated internally
through research and development don't even show up as assets in
the balance sheet since they are simply expensed. If they
are acquired from other parties, then they are shown at historical
value. Goodwill is an example of such an intangible asset.
It is created when a firm acquires another firm where the purchase
price is greater than the book value of tangible assets or intangible
assets such as patents and trade names; the excess price is called
goodwill. Hence it is simply a reflection of the difference
between the book value of assets and the market value of the acquired
firm that owned the assets.
Income Statement
An Income Statement provides information about a firm's operating
activities over a specified time period. The main categories
are shown in the table below:
| Gross Revenues from sale of products and
services |
Revenues |
| Expenses associated with generating revenues |
- Operating Expenses |
| Operating Income for the period |
= Operating Income |
| Expenses associated with borrowing and
other financing |
- Financial Expenses |
| Taxes due on taxable income |
- Taxes |
| Earnings to Common and Preferred Equity
for current period |
= Net Income before Extraordinary Items |
| Profits and Losses not associated with
operations |
-(+) Extraordinary Losses (Profits) |
| Profits or losses associated with changes
in accounting rules |
- Income Changes caused by changes in
accounting methods |
| Dividends paid to preferred stockholders |
- Preferred Dividends |
| |
= Net Income to Common Stockholders |
Example: Rasputin Corporation
| Income Statement (in Millions of
Dollars) |
1993 |
1994 |
| Sales |
1745 |
1990 |
| Cost of Goods Sold |
690 |
770 |
| Depreciation |
184 |
184 |
| EBIT |
871 |
1036 |
| Interest |
122 |
148 |
| Taxable Income |
749 |
888 |
| Taxes (34%) |
255 |
302 |
| Net Income |
494 |
586 |
| Dividends |
150 |
165 |
| Addition to Retained Earnings |
344 |
421 |
Shares Outstanding = 125 million
Earnings per share for 1993= Net Income/# shares = 494/125 =
$3.95
Dividend per share for 1993= Total Dividends/# shares = 150/125
= $1.20
An Income Statement is a record of the revenues and expenses
of a firm over a particular period of time using GAAP, rather
than the actual cash flows.
Let us consider a balance sheet. We know that GAAP rules are
used to make up the balance sheet; and these are tilted towards
recording the past. However, the financial analyst is interested
in what the balance sheet can tell him about the future. When
a financial analyst looks at a balance sheet for purposes of valuation
or for purposes of analyzing the firm's capital structure, he might
like to see a balance sheet that looks somewhat like this:
| Assets |
Liabilities |
Existing Investments
Generate
Cashflows today
Includes long lived (fixed) and
short-lived (working capital) assets |
Assets-in-place |
Debt |
Fixed Claim on cashflows
Little or no role in management
Fixed
Maturity
Tax Deductible |
| Expected value that will be created by future
investments |
Growth Assets |
Equity |
Residual Claim on cashflows
Significant role in management
Perpetual
Lives |
The Assets side of
the picture
Given the discussion of valuation principles above, we see that
it is not easy to generate values for assets-in-place and growth
assets from the traditional balance sheet information. For
example, intangible assets are given short shrift in the traditional
accounting methodology. One way to do this would be to take
the research and development expenses from the Income Statement
and to capitalize them.
In order to do this, we would first need to get an estimate of
the amount of time that it takes for research and development
to be converted into commercial products. This is called
the amortizable life of the product. This would be long
for a pharmaceutical company, but shorter for a software company.
Suppose, for example, that the amortizable life is six years.
We then collect the annual R&D expenses for the company.
Assuming that the amortization is uniform over time, R&D expenses
from six years ago and more, would have been fully amortized.
R&D expenses from five years ago would only have one-sixth
of their value unamortized; R&D from four years ago, would
be two-sixths unamortized, and so on. These unamortized
values are then added together to obtain an estimate of the value
of R&D as an asset, following accounting principles similar
to that used with Property, Plant and equipment.
This approach would, first of all, give us a better idea of the
market value of the firm; secondly, by looking at the ratio of
such "growth" assets to the total value of all assets,
we can get a better estimate of the growth rate. In addition,
the greater the proportion of such "growth" assets,
the lower the proportion, we would expect, of debt in the capital
structure of the firm, as will be explained in the notes
on Capital Structure.
Capitalization of R&D:
For example, SmithKline Beecham (SBH) report on their website
Research and Development expenses for the last five years:
| Year |
R & D expense (in £) |
Unamortized proportion |
Unamortized Value |
| 1999 |
1018 |
1 |
1018 |
| 1998 |
910 |
0.8 |
728 |
| 1997 |
843 |
0.6 |
505.8 |
| 1996 |
764 |
0.4 |
305.6 |
| 1995 |
653 |
0.2 |
130.6 |
Suppose we assume that the amortizable life is five years.
Then, if we are computing the value of R&D asset in 1999,
none of the £1018 incurred this year will have been amortized;
all of it will be added into the value of R&D asset.
For 1998, 20% of that (or one-fifth) will be amortized, and the
remaining 80% (0.8 times £910) will be included in the value of
R&D asset. Proceeding thus, we have a value of £2688
for the R&D asset as of 1999.
Of course, if we capitalize R&D expenses to create a new
asset, we will have to adjust Operating Income as well.
We will add back R&D expenses, but then subtract the amortization
of the R&D asset. Hence:
Adjusted Operating Income = Operating Income + R&D expenses
- Amortization of the R&D asset
Adjusted Net Income = Net Income + R&D expenses - Amortization
of the R&D asset
Another example:
Apple Inc (AAPL)
From
the information submitted to the SEC by Apple Inc. on 9/29/2007
(Source: http://phx.corporate-ir.net/phoenix.zhtml?c=107357&p=irol-SECText&TEXT=aHR0cDovL2NjYm4uMTBrd2l6YXJkLmNvbS94bWwvZmlsaW5nLnhtbD9yZXBvPXRlbmsmaXBhZ2U9NTI4NjAzNSZhdHRhY2g9T04%3d)
Company Background
Apple Inc. and its wholly-owned subsidiaries (collectively "Apple"
or the "Company") design, manufacture, and market personal
computers, portable digital music players, and mobile communication
devices and sells a variety of related software, services, peripherals,
and networking solutions. The Company sells its products worldwide
through its online stores, its retail stores, its direct sales
force, and third-party wholesalers, resellers, and value-added
resellers. In addition, the Company sells a variety of third-party
Macintosh ("Mac"), iPod and iPhone compatible products,
including application software, printers, storage devices, speakers,
headphones, and various other accessories and peripherals through
its online and retail stores. The Company sells to education,
consumer, creative professional, business, and government customers.
The Company's fiscal year is the 52 or 53-week period that ends
on the last Saturday of September. Unless otherwise stated, all
information presented in this Form 10-K is based on the Company's
fiscal calendar.
The
following financial statements information has been obtained from
Disclosure (the financial data from 2003 to 2007 are obtained
from Mergent Online):
Balance Sheet
(in millions of dollars)
|
As Reported Annual
Balance Sheet |
9/29/07
|
9/30/06
|
9/24/05
|
9/25/04
|
9/27/03
|
| Cash & cash equivalents |
9,352
|
6,392
|
3,491
|
2,969
|
3,396
|
| Short-term investments |
6,034
|
3,718
|
4,770
|
2,495
|
1,170
|
| Accounts receivable, gross |
1,684
|
1,304
|
941
|
821
|
815
|
| Allowances |
47
|
52
|
46
|
47
|
49
|
| Accounts receivable, net |
1,637
|
1,252
|
895
|
774
|
766
|
| Purchased parts |
NA
|
NA
|
NA
|
1
|
2
|
| Work in process |
NA
|
NA
|
NA
|
NA
|
4
|
| Finished goods |
NA
|
NA
|
NA
|
100
|
50
|
| Inventories |
346
|
270
|
165
|
101
|
56
|
| Deferred tax assets |
782
|
607
|
331
|
231
|
190
|
| Vendor non-trade receivables |
2,392
|
1,593
|
417
|
276
|
NA
|
| NAND flash memory prepayments |
417
|
208
|
NA
|
NA
|
NA
|
| Other current assets |
996
|
469
|
231
|
209
|
NA
|
| Other current assets |
3,805
|
2,270
|
648
|
485
|
NA
|
| Other current assets, net |
NA
|
NA
|
NA
|
NA
|
309
|
| Total current assets |
21,956
|
14,509
|
10,300
|
7,055
|
5,887
|
| Land & buildings |
762
|
626
|
361
|
351
|
350
|
| Machinery, equipment, & internal-use software |
954
|
595
|
494
|
422
|
393
|
| Office furniture & equipment |
106
|
94
|
81
|
79
|
74
|
| Leasehold improvements |
1,019
|
760
|
545
|
446
|
357
|
| Property, plant & equipment, gross |
2,841
|
2,075
|
1,481
|
|
