CH.

1: FRAMEWORK
BALANCE SHEET EQUATION
A = L + SE
INCOME STATEMENT EQUATION
REV EXPENSES = NET INCOME
SE STATEMENT
END RE = BEG RE + NET INC DIV
CF STATEMENT

Examples: NOT operating items: financial items (interest exp, interest income, dividend
income, investment gains/losses, income from minority investments, income from disc.
operations

Form: NOPAT = Operating profit x (1- tax rate) *USE EBIT AS PROXY
Form (book): NOPAT= NOPBT[Tax exp + (Pretax net nonop exp x stat. tax rate)
NOA (Net Operating Assets)
Def: Assets used in operating activities
Examples: (A) Receivs, inventories, prepaid exp, PPE (L) accts payable, income tax, pensions
NOT examples: (A) ST/LT invest in market securities, fin. invest (L) bonds pay, bank loans

OCF+ICF+FCF=NET INC. IN CASH

Form: Operating Assets Operating Liabilities

Form: NOA = NNO + SE

FCF = Cash flow from Op Capex

Cash Asset + Noncash Assets = L + Cont. Cap + Earned Cap (R-Exp=Net
Inc)
CH. 3: PROFITABILITY ANALYSIS
ROE
Def: Measures return earned by SH

Net income for common

=
Av . SE
Net incomePref . Stock Dividends
Av . SE

NNO (Net Nonoperating Obligations)

Form: Nonoperating Liabilities Nonoperating Assets
NNE (Net Nonoperating Expenses, Interest Cost)
Def: Diff bw net income and NOPAT; counterpart to ATI
Form: NNE = Net income - NOPAT
RNOA =

Form: ROE =

ROA (Return on Assets)

NNEP (Net Nonoperating Expense cost, Financing Cost)

Def: Measurement of firms cost of debt

NNE
Av . NNO

Form: NNEP =

Def: Performance eval for c (not just EH)

ROA = NOPAT / Av. NOA

DUPONT ANALYSIS (Percentages)

Form: ROA =

Net income+ Interest exp(1Tax Rate )

Av .Total Assets
PRE-TAX ROA

ROA = NOPM x NOAT (Profitability and productivity)

ROA = NOPAT / Av. NOA

Net income+ ATI

NOPAT
=
Sales
Sales
Sales
Revenues
=
Av .Total A
Av . NOA

NOPM =

Form: ROA =

EBIT (Earningsbefore interesttax)

Av . Total Assets
AFTER-TAX ROA
Form: ROA = Pretax ROA x (1-tax rate)
Form: ROA =

( Net income+ NNE)

Av . NOA

EBIT (1Tax rate)

Av .Total Asset s

ATI (After Tax Interest)

Def: Net int. cost after taking into acct income tax ben from deduct int. expense
Form: Interest Expense x (1-Tax rate)
ATIP (Av. Financing Cost, Cost of Debt)
Def: Av. financing cost of company

ATI
Form: ATIP =
=
Average L
Interest exp (1tax rate)
Av . Liabilities

NOAT =

LEVERAGE (Decimals)
FL (Financial Leverage)
Form: FL =

Av .Total A
Av .Total SE

Debt-Equity Ratio
Form:

L
SE

Debt-Total Asset Ratio

Form:

L
A

Cap Structure Leverage

Form:

Total A
SE

RNOA (Return on Net Operating Assets) Percentage

Def: Matching op. income with op. assets (corollary to ROA)

NOPAT
=
Av . NOA
Operating profit ( 1tax rate )
Net Operating ANet Operating L

Form: RNOA =

*USE EBIT AS PROXY FOR OP PROFIT BT

Form: RNOA =

( Net income+ NNE)

Av . NOA

NOPAT (Net Operating Profit After Tax)

Def: Rather than just net income, what net profit would be taking out nonop exp.

RETURN SPREAD
Def: Earnings positive economic profit (EP)
Form: ROA WACC (Weighted av. cost of capital)
Form: EP = Av. Total A x (ROA WACC)
FINANCING SPREAD
Def: Difference between what firm earns on investments and the cost of financing
Form: ATIP (After-tax cost of financing) = ATI / Avg. L
Form: Financing Spread: ROA ATIP
After-tax cost of financing: NNEP = NNE / Av. NNO
Financing Spread = RNOA - NNEP
When ROAT ATIP is positive, ROA greater than ROA and using debt well

TOTAL ACCRUALS (Total Operating accruals)

CH. 4: CREDIT RISK ANALYSIS

Accruals from operating A and L

Examples: Inventory, accts receivable, accts payable, income tax payable, deferred income tax, pension liability

Accruals from investment A

PROFITABILITY RATIOS

Examples: Depreciation, write-off, restructuring charges, gains and losses on asset sale, other changes in
investment

RNOA = NOPM X NOAT = NOPAT / AV. NOA

Form: Total Accruals = Net Income Cash Flow from Operations

COVERAGE RATIOS
TIMES INTEREST EARNED (Interest Cov. Ratio)

M-SCORE MANIPULATION VARIABLES

Earnings before income tax ( EBIT )

Interest Expense

Days Sales in Receivables (DSRI)

Receivables/Sales

Gross Margin Index (GMI)

Gross profit/Sales

Asset Quality Index (AQI)

1-((Current A +PPE)/(Total A)

EBITDA COVERAGE RATIO

Sales Growth Index (SGI)

Sales

Def: Exclusion of dep and amort since not cash

Depreciation Index (DEPI)

Depreciation/(Depreciation+PPE)

SG&A Expenses Index

SG&A Expense/Sales

Leverage Index

(LT Debt+Current L)/Total A

Total Accruals to Total Assets

Current operating accruals/Total A

Form: TIE =

Form: EBITDA Cov =

EBIT + Interest Expense + Dep+ Amort

Interest Expense

FCF to TOTAL DEBT (Free Operating Cash Flow to Total Debt)

Def: Measurements using free cashexcess after capex spending
Form:

Cash

OperationsCapex
Debt +ST Debt

LIQUIDITY RATIOS

Moodys Credit Analysis

EBITA/Av. Assets
EBITA/Interest Expense
EBITA Margin

EBITA/Net Revenue

Operating Margin

Operating Profit/Net Revenue

(FFO+Interest Exp)/Interest Exp (Funds from Ops + Interest Expense) / Interest Expense

CURRENT RATIO
Def: Comparing cash inflow to outflow in short term
Form: CURRENT RATIO =

Current Assets
Current Liabilities

FFO/Debt

Funds from Ops/(ST debt + LT debt)

RCF/Debt

(FFO-PrefDiv-Common Div-Minority Div)/(ST and LT debt)

Debt/EBITDA
Debt/Book Capitalization
Interest + Book Equity)

(ST and LT debt)/(ST and LT debt + Deferred taxes +Minority

QUICK RATIO

CAPEX/Depreciation Exp Capital expenditures/depreciation expense

Def: Focus on quick assets, excluding inventory and prepaid A, ability to meet
current Ls without liquidating

FFO = Net income from continuing operations plus dep, amort, deferred income taxes, other
noncash items

Form: QUICK RATIO =

Cash+ Market Sec+ Acct Receiv

Current Liabilities

Operating Activities
Net Income

Adjustments to reconcile net income to operating cash flow

SOLVENCY RATIOS
LIABILITIES TO EQUITY RATIO
Def: How reliant a c is on creditor financing (v. equity)
Form: L-E RATIO =

CASH FLOW STATEMENT

Total Liabilities
SE

Depreciation

Accts receivable

Prepaid expense

Accts payable

Wages payable

X
X (Added adjustments)

TOTAL DEBT TO EQUITY RATIO

Net cash provided from op activities

Def: Distinguishing operating creditors and debt obligations

Form:

Cash used in Investing Activities

Total Liabilities
SE

Cash from financing activities __

Net change in cash

ALTMAN Z SCORE (5 Variables) 1.8 < x < 3.0

Form: [1.2 x Work cap/total A] + [1.4 x RE/Total A] +[3.3 x EBIT/Total A]
+ [0.6 x Market Val. Equity/BV of Total L] + [0.99 x Sales/Total A]
PIOTROSKI F SCORE (9 Variables) 0-2 < x < 7-9
Net income is positive

Profitable

Operating cash flow is positive

Generates cash

Operating cash flow > net income

Earnings quality good

Return on assets increased

Improving business (Net inc b4 ext.items/begyr t.a. x100%)

Gross margin improved

Improving profitability

(gross profit/sales)x100%

Asset turnover improved

Improving efficiency

(Total sales/beg yr total A)

LT Debt/Total assets decreased

Declining risk (LT debt + Current portion LT debt)/Av. total A)

Current ratio improved

Improving liquidity

No new equity issuance

No equity dilution risk

CH. 5: ACCRUALS AND EARNINGS QUALITY

Cash, beginning year

__

Cash, ending year

INCOME STATEMENT
Revenue

Cost of Revenue

Gross Margin

Operating expenses
SG&A

R&D expense

Total op exp

Interest exp

Income bef. Inc. tax

Income tax exp

Net income

Cash Flows from Operations under Indirect Method

Def: Remove accruals from net income
To Use: Add back expenses and losses that did not use cash, and deduct rev and gains that
did not produce cash
Adjustments to current A and current L in operating:
Accts receivable, inventory, accts payable
o
Add decreases in CA and increases in CL, subtract increases in CA and
decreases in CL
Adjustments related to no-current A and non-current L in operating:
o
Depreciation, gains and losses from sale of assets, changes in deferred tax A&L,
pension L

Prepaid expenses

Cash Flows from Ops Using Direct Method

Cash collected from customers
o
Sales Increase in accts receivable
Cash paid to suppliers and employees
o
COGS (excluding deprec) + Inc. in inventory Increase in accts payable
Increase in wages pay
Interest paid
o
Interest exp Increase in interest payable dec. in bond discount (or + decrease
in bond premium)
Other operating cash paid
o
SG&A exp + Increas in prepaid exp increase in accrued L
Income taxes paid
o
Tax exp=increase in tax payable-increase in deferred tax L (or increase in def. tax
asset)

Equity method investments

Red Flags Analysis

1.
Operations risk
2.
Governance and management control risks
3.
Aggressive accounting and misstatement risks
Examples:
Cash flow from op less than net income
CFO down for year compared to last year but net income up
Large unexplained changes in inventory, receivables, etc.
Large one-time items such as impairment charges, g/l from asset sales
Cash flow from op negative for several quarters but positive for the full year
Capex is greater than cash flow from ops (i.e., FCF is negative)
Dividends and stock repurchases exceed free cash flow
Large non-cash acquisitions

Current liabilities of discontinued operations

OPERATING/NONOPERATING ITEMS IN BALANCE SHEET

Current Assets
Cash and cash equivalents
ST investments
Accts receivable
Inventories

Deferred income tax assets

Other current assets
Current Assets of discontinued operations
LT Assets
LT investments in securities
PPE, net
Caplease
Natural resources
Goodwill and intangible assets
Deferred income tax assets
Other longterm assets
LT assets of discontinued operations
Current Liabilities
ST notes and interest payable
Current maturities of LT debt
Accts payable
Accrued L
Unearned revenue
Deferred income tax liabilities

LT Liabilities
Bonds and notes payable
Cap lease obligations
Pension and other post-employment liabilities
Deferred income tax liabilities
LT liabilities of discontinued operations
SE
All equity accounts
Noncontrolling (minority) interest
FINANCING SPREAD EXAMPLE
Firm has 1000 of equity, and borrows 600 at 10% interest rate (7% after-tax interest rate). It
uses the funds to acquire A yielding 15% pre-tax ROA (10.5% after-tax ROA). (Income tax rate
= 30%).
Av. total A = 1000 equity + 600 liabilities = 1600
Net income = 0.7 (1600x0.15-600x0.10)=126
AT profits from A financed with equity = 1000 x 10.5% = 105
AT Profits from A financed with debt = 600 x (10.5-7%0 = 21
ROA numerator = Net income + aftertax itnerst = 126 + 42 = 168
ROA = 168 / 1600 = 10.5% ROE = 126 / 1000 = 12.6%
ROE > ROA, benefiting from positive financing spread of 3.5%
Note: Using formula ROE = ROA + (Financing spread x L/SE),
ROE = 10.5% + [(10.5-7%)x600/1000]=12.6%
Glamour stocks are defined as stocks with high price to book (P/B) values and Value stocks
as having low price to book ratios.