Analysis for Financial Management

Robert C. Higgins

Analysis for Financial Management E l e v en t h Ed i t i o n

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate

Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

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Analysis for Financial Management

Eleventh Edition

ROBERT C. HIGGINS Marguerite Reimers

Emeritus Professor of Finance The University of Washington

with

JENNIFER L. KOSKI John B. and Delores L. Fery

Faculty Fellow Associate Professor of Finance The University of Washington

and

TODD MITTON Ned C. Hill Professor of Finance Brigham Young University

ANALYSIS FOR FINANCIAL MANAGEMENT, ELEVENTH EDITION

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In memory of my son

STEVEN HIGGINS

1970–2007

Preface xi

PART ONE Assessing the Financial Health of the Firm 1

1 Interpreting Financial Statements 3

2 Evaluating Financial Performance 39

PART TWO Planning Future Financial Performance 79

3 Financial Forecasting 81 4 Managing Growth 115

PART THREE Financing Operations 141

5 Financial Instruments and Markets 143

6 The Financing Decision 195

PART FOUR Evaluating Investment Opportunities 237

7 Discounted Cash Flow Techniques 239

8 Risk Analysis in Investment Decisions 289

9 Business Valuation and Corporate Restructuring 343

GLOSSARY 393 SUGGESTED ANSWERS TO

ODD-NUMBERED PROBLEMS 405 INDEX 437

Brief Contents

Preface xi

PART ONE ASSESSING THE FINANCIAL HEALTH OF THE FIRM 1

Chapter 1 Interpreting Financial Statements 3 The Cash Flow Cycle 3 The Balance Sheet 6

Current Assets and Liabilities 11 Shareholders’ Equity 12

The Income Statement 12 Measuring Earnings 12

Sources and Uses Statements 17 The Two-Finger Approach 18

The Cash Flow Statement 19 Financial Statements and the

Value Problem 24 Market Value vs. Book Value 24 Economic Income vs. Accounting Income 27 Imputed Costs 28

Summary 31 Additional Resources 32 Problems 33

Chapter 2 Evaluating Financial Performance 39 The Levers of Financial Performance 39 Return on Equity 40

The Three Determinants of ROE 40 The Profit Margin 42 Asset Turnover 44 Financial Leverage 49

Is ROE a Reliable Financial Yardstick? 55 The Timing Problem 56 The Risk Problem 56

The Value Problem 58 ROE or Market Price? 59

Ratio Analysis 62 Using Ratios Effectively 62 Ratio Analysis of Stryker Corporation 63

Summary 71 Additional Resources 72 Problems 73

PART TWO PLANNING FUTURE FINANCIAL PERFORMANCE 79

Chapter 3 Financial Forecasting 81 Pro Forma Statements 81

Percent-of-Sales Forecasting 82 Interest Expense 88 Seasonality 89

Pro Forma Statements and Financial Planning 89

Computer-Based Forecasting 90 Coping with Uncertainty 94

Sensitivity Analysis 94 Scenario Analysis 95 Simulation 96

Cash Flow Forecasts 98 Cash Budgets 99 The Techniques Compared 102 Planning in Large Companies 103 Summary 105 Additional Resources 106 Problems 108

Chapter 4 Managing Growth 115 Sustainable Growth 116

The Sustainable Growth Equation 116 vii

Contents

viii Contents

Too Much Growth 119 Balanced Growth 119 Under Armour’s Sustainable Growth Rate 121 “What If” Questions 122

What to Do When Actual Growth Exceeds Sustainable Growth 122

Sell New Equity 123 Increase Leverage 125 Reduce the Payout Ratio 125 Profitable Pruning 126 Outsourcing 127 Pricing 127 Is Merger the Answer? 127

Too Little Growth 128 What to Do When Sustainable Growth

Exceeds Actual Growth 129 Ignore the Problem 130 Return the Money to Shareholders 130 Buy Growth 131

Sustainable Growth and Pro Forma Forecasts 132

New Equity Financing 132 Why Don’t U.S. Corporations Issue More

Equity? 135 Summary 136 Additional Resources 137 Problems 138

PART THREE FINANCING OPERATIONS 141

Chapter 5 Financial Instruments and Markets 143 Financial Instruments 144

Bonds 145 Common Stock 152 Preferred Stock 156

Financial Markets 158 Venture Capital Financing 158 Private Equity 160 Initial Public Offerings 162

Seasoned Issues 163 Issue Costs 168

Efficient Markets 169 What Is an Efficient Market? 170 Implications of Efficiency 172

Appendix Using Financial Instruments to Manage Risks 174

Forward Markets 175 Speculating in Forward Markets 176 Hedging in Forward Markets 177 Hedging in Money and Capital Markets 180 Hedging with Options 180 Limitations of Financial Market Hedging 183 Valuing Options 185

Summary 188 Additional Resources 189 Problems 191

Chapter 6 The Financing Decision 195 Financial Leverage 197 Measuring the Effects of Leverage on a

Business 201 Leverage and Risk 203 Leverage and Earnings 206

How Much to Borrow 208 Irrelevance 208 Tax Benefits 210 Distress Costs 211 Flexibility 215 Market Signaling 217 Management Incentives 220 The Financing Decision and Growth 221

Selecting a Maturity Structure 224 Inflation and Financing Strategy 225

Appendix The Irrelevance Proposition 225

No Taxes 226 Taxes 228

Summary 230 Additional Resources 231 Problems 232

Contents ix

PART FOUR EVALUATING INVESTMENT OPPORTUNITIES 237

Chapter 7 Discounted Cash Flow Techniques 239 Figures of Merit 240

The Payback Period and the Accounting Rate of Return 241

The Time Value of Money 242 Equivalence 247 The Net Present Value 248 The Benefit-Cost Ratio 250 The Internal Rate of Return 250 Uneven Cash Flows 254 A Few Applications and Extensions 255 Mutually Exclusive Alternatives and Capital

Rationing 259 The IRR in Perspective 260

Determining the Relevant Cash Flows 260

Depreciation 262 Working Capital and Spontaneous

Sources 264 Sunk Costs 265 Allocated Costs 266 Cannibalization 267 Excess Capacity 268 Financing Costs 270

Appendix Mutually Exclusive Alternatives and

Capital Rationing 272 What Happened to the Other

$578,000? 273 Unequal Lives 274 Capital Rationing 277 The Problem of Future Opportunities 278 A Decision Tree 279

Summary 280 Additional Resources 281 Problems 282

Chapter 8 Risk Analysis in Investment Decisions 289 Risk Defined 291

Risk and Diversification 293 Estimating Investment Risk 295

Three Techniques for Estimating Investment Risk 296

Including Risk in Investment Evaluation 297 Risk-Adjusted Discount Rates 297

The Cost of Capital 298 The Cost of Capital Defined 299 Cost of Capital for Stryker Corporation 301 The Cost of Capital in Investment Appraisal 308 Multiple Hurdle Rates 309

Four Pitfalls in the Use of Discounted Cash Flow Techniques 311

The Enterprise Perspective versus the Equity Perspective 312

Inflation 314 Real Options 315 Excessive Risk Adjustment 321

Economic Value Added 322 EVA and Investment Analysis 323 EVA’s Appeal 325

A Cautionary Note 326 Appendix Asset Beta and Adjusted Present

Value 326 Beta and Financial Leverage 327 Using Asset Beta to Estimate Equity

Beta 328 Asset Beta and Adjusted Present Value 329

Summary 332 Additional Resources 333 Problems 335

Chapter 9 Business Valuation and Corporate Restructuring 343 Valuing a Business 345

Assets or Equity? 346

x Contents

Dead or Alive? 346 Minority Interest or Control? 348

Discounted Cash Flow Valuation 349 Free Cash Flow 350 The Terminal Value 351 A Numerical Example 354 Problems with Present Value Approaches to

Valuation 357 Valuation Based on Comparable Trades 357

Lack of Marketability 361 The Market for Control 362

The Premium for Control 362 Financial Reasons for Restructuring 364

The Empirical Evidence 372 The Cadbury Buyout 374 Appendix The Venture Capital Method of

Valuation 376 The Venture Capital Method—One

Financing Round 377

The Venture Capital Method—Multiple Financing Rounds 380

Why Do Venture Capitalists Demand Such High Returns? 382

Summary 384 Additional Resources 385 Problems 386

Glossary 393 Suggested Answers to

Odd-Numbered Problems 405 Index 437

Preface

Like its predecessors, the eleventh edition of Analysis for Financial Man- agement is for nonfinancial executives and business students interested in the practice of financial management. It introduces standard techniques and recent advances in a practical, intuitive way. The book assumes no prior background beyond a rudimentary, and perhaps rusty, familiarity with financial statements—although a healthy curiosity about what makes business tick is also useful. Emphasis throughout is on the managerial im- plications of financial analysis.

Analysis for Financial Management should prove valuable to individuals interested in sharpening their managerial skills and to executive program participants. The book has also found a home in university classrooms as the sole text in Executive MBA and applied finance courses, as a compan- ion text in case-oriented courses, and as a supplementary reading in more theoretical finance courses.

Analysis for Financial Management is my attempt to translate into another medium the enjoyment and stimulation I have received over the past four decades working with executives and college students. This experience has convinced me that financial techniques and concepts need not be abstract or obtuse; that recent advances in the field such as agency theory, market sig- naling, market efficiency, capital asset pricing, and real options analysis are important to practitioners; and that finance has much to say about the broader aspects of company management. I also believe that any activity in which so much money changes hands so quickly cannot fail to be interesting.

Part One looks at the management of existing resources, including the use of financial statements and ratio analysis to assess a company’s finan- cial health, its strengths, weaknesses, recent performance, and future prospects. Emphasis throughout is on the ties between a company’s oper- ating activities and its financial performance. A recurring theme is that a business must be viewed as an integrated whole and that effective financial management is possible only within the context of a company’s broader operating characteristics and strategies.

The rest of the book deals with the acquisition and management of new resources. Part Two examines financial forecasting and planning with par- ticular emphasis on managing growth and decline. Part Three considers the financing of company operations, including a review of the principal security types, the markets in which they trade, and the proper choice of security type by the issuing company. The latter requires a close look at fi- nancial leverage and its effects on the firm and its shareholders.

Part Four addresses the use of discounted cash flow techniques, such as the net present value and the internal rate of return, to evaluate invest- ment opportunities. It also deals with the difficult task of incorporating risk into investment appraisal. The book concludes with an examination of business valuation and company restructuring within the context of the ongoing debate over the proper roles of shareholders, boards of directors, and incumbent managers in governing America’s public corporations.

An extensive glossary of financial terms and suggested answers to odd- numbered, end-of-chapter problems follow the last chapter.

Changes in the Eleventh Edition Readers familiar with earlier editions of Analysis for Financial Management will notice a number of changes here. Most important, two talented young teachers and scholars have joined me in preparing the eleventh edition. Jennifer Koski, a colleague at the University of Washington, and Todd Mitton, at Brigham Young University, have done yeomen’s work ushering the book into the digital era. I much appreciate their many contributions. You should expect their responsibilities to grow in any future editions.

A second noteworthy change is the book’s partnership with McGraw- Hill’s Connect. As the following section explains in more detail, Connect is the lynchpin of the publisher’s digital initiative. Combining elements of computerized instruction and electronic publishing, it promises signifi- cant benefits to readers and instructors alike. I am anxious to watch McGraw-Hill turn this promise into reality. There will undoubtedly be bumps along the way, but I am confident we are on the right path.

Other more conventional changes and refinements in the eleventh edi- tion include:

• An introductory discussion of crowdfunding and its possible future. • A new treatment of present value calculations, gracefully introducing

computer spreadsheets as the principal means for solving present value problems, while eliminating reference to present value tables.

• Explicit discussion of present value problems involving uneven cash flows. • Enhanced ‘recommended resources’ at the end of each chapter,

including two-dimensional bar codes (QR codes) and recommended mobile apps for Android and iOS devices.

• Added discussion of payout policy, illustrated by Apple Inc.’s recent experience.

• Updated details on the impact of U.S. regulation on financial manage- ment, including the Dodd-Frank Act and the JOBS Act of 2012.

• Better integration of T-accounts and financial statements. • Use of Stryker Corporation, a leading medical technology company, as

an extended example throughout the book.

xii Preface

McGraw-Hill’s Connect connect.mheducation.com

McGraw-Hill’s Connect® is an online assess- ment solution that connects students with the

tools and resources they’ll need to achieve success. Connect allows faculty to create and deliver exams easily with selectable test bank items. Instruc- tors can also build their own questions into the system for homework or practice. Readers have access to the student resources that accompany this text, as well as McGraw-Hill’s adaptive self-study technology in Learn- Smart and Smartbook.

Connect supports this book in several important ways. The student re- sources include:

• Excel spreadsheets referenced in end-of-chapter problems. • Supplementary chapter problems and suggested answers. • Complimentary software programs described in Additional Resources

at the end of several chapters.

If you are not enrolled in a course using Connect, you can access these stu- dent resources with a free trial by following the instructions accompanying the access code acquired with the book. I encourage you to download these items now for later use. If you are enrolled in a Connect course, ask your instructor for your Connect course URL to access the course resources.

Intended primarily for instructor use, the Connect Instructor Library houses, among other things: • A test bank. • PowerPoint presentations. • An annotated list of suggested cases to accompany the book. • Suggested answers to even-numbered problems.

To access the Instructor Library, log in to your Connect course, select the “Library” tab, and then select “Instructor Resources.”

Connect’s adaptive learning resources, LearnSmart and Smartbook, promise to speed and enrich your mastery of the book by creating a per- sonalized, flexible program of study.

For more information about Connect, LearnSmart, or Smartbook, go to connect.mheducation.com, or contact a McGraw-Hill sales representative. For 24-hour support you can e-mail a Product Specialist or search Frequently Asked Questions at mhhe.com/support. Or for a human, call 800-331-5094.

A word of caution: Analysis for Financial Management emphasizes the ap- plication and interpretation of analytic techniques in decision making. These techniques have proved useful for putting financial problems into perspective and for helping managers anticipate the consequences of their

Preface xiii

actions. But techniques can never substitute for thought. Even with the best technique, it is still necessary to define and prioritize issues, to mod- ify analysis to fit specific circumstances, to strike the proper balance be- tween quantitative analysis and more qualitative considerations, and to evaluate alternatives insightfully and creatively. Mastery of technique is only the necessary first step toward effective management.

I am indebted to Andy Halula of Standard & Poor’s for providing timely updates to Research Insight. The ability to access current Compustat data on CD continues to be a great help in providing timely examples of current practice. I also owe a large thank you to the following people for their in- sightful reviews of the 10th edition and their constructive advice. They did an excellent job; any remaining shortcomings are mine not theirs.

Bruce Campbell Franklin University Charles Evans Florida Atlantic University, Boca Raton Jaemin Kim San Diego State University, San Diego Inayat Ullah Mangla Western Michigan University, Kalamazoo

John Strong College of William & Mary Andy Terry University of Arkansas, Little Rock Marilyn Wiley University of North Texas Jaime Zender University of Colorado, Boulder

I appreciate the exceptional direction provided by Chuck Synovec, Noelle Bathurst, Melissa Caughlin, Dheeraj Chahal, and Mary Jane Lampe of McGraw-Hill on the development, design, and editing of the book. Bill Alberts, David Beim, Dave Dubofsky, Bob Keeley, Jack McDonald, George Parker, Megan Partch, Larry Schall, and Alan Shapiro have my continuing gratitude for their insightful help and support throughout the book’s evolu- tion. Thanks go as well to my daughter, Sara Higgins, for writing and editing the accompanying software. Finally, I want to express my appreciation to students and colleagues at the University of Washington, Stanford University, IMD, The Pacific Coast Banking School, The Koblenz Graduate School of Management, The Gordon Institute of Business Science, The Swiss International Business School ZfU AG, Boeing, and Microsoft, among others, for stimulating my continuing interest in the practice and teaching of financial management.

I envy you learning this material for the first time. It’s a stimulating intellectual adventure.

Robert C. (Rocky) Higgins Marguerite Reimers Emeritus Professor of Finance

Foster School of Business University of Washington

rhiggins@uw.edu

xiv Preface

P A R T O N E

Assessing the Financial

Health of the Firm

C H A P T E R O N E

Interpreting Financial Statements

Financial statements are like fine perfume; to be sniffed but not swallowed. Abraham Brilloff

Accounting is the scorecard of business. It translates a company’s diverse activities into a set of objective numbers that provide information about the firm’s performance, problems, and prospects. Finance involves the in- terpretation of these accounting numbers for assessing performance and planning future actions.

The skills of financial analysis are important to a wide range of people, including investors, creditors, and regulators. But nowhere are they more important than within the company. Regardless of functional specialty or company size, managers who possess these skills are able to diagnose their firm’s ills, prescribe useful remedies, and anticipate the financial conse- quences of their actions. Like a ballplayer who cannot keep score, an op- erating manager who does not fully understand accounting and finance works under an unnecessary handicap.

This and the following chapter look at the use of accounting information to assess financial health. We begin with an overview of the accounting prin- ciples governing financial statements and a discussion of one of the most abused and confusing notions in finance: cash flow. Two recurring themes will be that defining and measuring profits is more challenging than one might ex- pect, and that profitability alone does not guarantee success, or even survival. In Chapter 2, we look at measures of financial performance and ratio analysis.

The Cash Flow Cycle

Finance can seem arcane and complex to the uninitiated. However, a comparatively few basic principles should guide your thinking. One is that a company’s finances and operations are integrally connected. A company’s

activities, method of operation, and competitive strategy all fundamentally shape the firm’s financial structure. The reverse is also true: Decisions that appear to be primarily financial in nature can significantly affect company operations. For example, the way a company finances its assets can affect the nature of the investments it is able to undertake in future years.

The cash flow–production cycle shown in Figure 1.1 illustrates the close interplay between company operations and finances. For simplicity, suppose the company shown is a new one that has raised money from owners and creditors, has purchased productive assets, and is now ready to begin operations. To do so, the company uses cash to purchase raw mate- rials and hire workers; with these inputs, it makes the product and stores it temporarily in inventory. Thus, what began as cash is now physical in- ventory. When the company sells an item, the physical inventory changes back into cash. If the sale is for cash, this occurs immediately; otherwise, cash is not realized until some later time when the account receivable is collected. This simple movement of cash to inventory, to accounts receiv- able, and back to cash is the firm’s operating, or working capital, cycle.

4 Part One Assessing the Financial Health of the Firm

FIGURE 1.1 The Cash Flow–Production Cycle

Cash

Ch ang

es in

equ ity

Ch ang

es in

lia bil

itie s

Ta xes

Int ere

Di vid

end s

Inventory

Accounts receivable

Fixed assets

Cash salesP ro

du cti

Collection of credit sales

D epreciation

In ve

stm ent

Cre dit

sa les

Another ongoing activity represented in Figure 1.1 is investment. Over a period of time, the company’s fixed assets are consumed, or worn out, in the creation of products. It is as though every item passing through the business takes with it a small portion of the value of fixed assets. The accountant rec- ognizes this process by continually reducing the accounting value of fixed assets and increasing the value of merchandise flowing into inventory by an amount known as depreciation. To maintain productive capacity and to fi- nance additional growth, the company must invest part of its newly received cash in new fixed assets. The object of this whole exercise, of course, is to ensure that the cash returning from the working capital cycle and the investment cycle exceeds the amount that started the journey.

We could complicate Figure 1.1 further by including accounts payable and expanding on the use of debt and equity to generate cash, but the fig- ure already demonstrates two basic principles. First, financial statements are an important window on reality. A company’s operating policies, production techniques, and inventory and credit-control systems fundamentally de- termine the firm’s financial profile. If, for example, a company requires payment on credit sales to be more prompt, its financial statements will reveal a reduced investment in accounts receivable and possibly a change in its revenues and profits. This linkage between a company’s operations and its finances is our rationale for studying financial statements. We seek to understand company operations and predict the financial consequences of changing them.

The second principle illustrated in Figure 1.1 is that profits do not equal cash flow. Cash—and the timely conversion of cash into inventories, ac- counts receivable, and back into cash—is the lifeblood of any company. If this cash flow is severed or significantly interrupted, insolvency can occur. Yet the fact that a company is profitable is no assurance that its cash flow will be sufficient to maintain solvency. To illustrate, suppose a company loses control of its accounts receivable by allowing customers more and more time to pay, or suppose the company consistently makes more mer- chandise than it sells. Then, even though the company is selling mer- chandise at a profit in the eyes of an accountant, its sales may not be generating sufficient cash soon enough to replenish the cash outflows re- quired for production and investment. When a company has insufficient cash to pay its maturing obligations, it is insolvent. As another example, suppose the company is managing its inventory and receivables carefully, but rapid sales growth is necessitating an ever-larger investment in these assets. Then, even though the company is profitable, it may have too little cash to meet its obligations. The company will literally be “growing broke.” These brief examples illustrate why a manager must be concerned at least as much with cash flows as with profits.

Chapter 1 Interpreting Financial Statements 5

To explore these themes in more detail and to sharpen your skills in using accounting information to assess performance, we need to review the basics of financial statements. If this is your first look at financial ac- counting, buckle up because we will be moving quickly. If the pace is too quick, take a look at one of the accounting texts recommended at the end of the chapter.

The Balance Sheet

The most important source of information for evaluating the financial health of a company is its financial statements, consisting principally of a balance sheet, an income statement, and a cash flow statement. Although these statements can appear complex at times, they all rest on a very sim- ple foundation. To understand this foundation and to see the ties among the three statements, let us look briefly at each.

A balance sheet is a financial snapshot, taken at a point in time, of all the assets the company owns and all the claims against those assets. The basic relationship, and indeed the foundation for all of accounting, is

Assets � Liabilities � Shareholders’ equity

It is as if a herd (flock? column?) of accountants runs through the busi- ness on the appointed day, making a list of everything the company owns, and assigning each item a value. After tabulating the firm’s assets, the ac- countants list all outstanding company liabilities, where a liability is simply an obligation to deliver something of value in the future—or more collo- quially, some form of an “IOU.” Having thus totaled up what the com- pany owns and what it owes, the accountants call the difference between the two shareholders’ equity. Shareholders’ equity is the accountant’s estimate of the value of the shareholders’ investment in the firm just as the value of a homeowner’s equity is the value of the home (the asset), less the mort- gage outstanding against it (the liability). Shareholders’ equity is also known variously as owners’ equity, stockholders’ equity, net worth, or simply equity.

It is important to realize that the basic accounting equation holds for individual transactions as well as for the firm as a whole. When a firm pays $1 million in wages, cash declines $1 million and shareholders’ equity falls by the same amount. Similarly, when a company borrows $100,000, cash rises $100,000, as does a liability named something like loans outstanding. And when a company receives a $10,000 payment from a customer, cash rises while another asset, accounts receivable, falls by the same figure. In each instance the double-entry nature of accounting guarantees that the basic accounting equation holds for each transaction, and when summed across all transactions, it holds for the company as a whole.

6 Part One Assessing the Financial Health of the Firm

To see how the repeated application of this single formula underlies the creation of company financial statements, consider Worldwide Sports (WWS), a newly founded retailer of value-priced sporting goods. In Jan- uary 2014, the founder invested $150,000 of his personal savings and added another $100,000 borrowed from relatives to start the business. After buying furniture and display fixtures for $60,000 and merchandise for $80,000, WWS was ready to open its doors.

The following six transactions summarize WWS’s activities over the course of its first year.

• Sell $900,000 of sports equipment, receiving $875,000 in cash, with $25,000 still to be paid.

• Pay $190,000 in wages, including the owner’s salary.

• Purchase $380,000 of merchandise at wholesale, with $20,000 still owed to suppliers, and $30,000 worth of product still in WWS’s inven- tory at year-end.

• Spend $210,000 on other expenses, such as utilities and rent.

• Depreciate furniture and fixtures by $15,000.

• Pay $10,000 interest on WWS’s loan from relatives and another $40,000 in income taxes to the government.

Table 1.1 shows how an accountant would record these transactions. WWS’s beginning balance, the first line in the table, shows cash of $250,000, a loan of $100,000, and equity of $150,000. But these numbers change quickly as the company buys fixtures and an initial inventory of mer- chandise. And they change further as each of the listed transactions occurs.

Chapter 1 Interpreting Financial Statements 7

TABLE 1.1 Worldwide Sports Financial Transactions 2014 ($ thousands)

Assets � Liabilities � Equity

Accounts Fixed Accounts Loan from Owners’ Cash Receivable Inventory Assets � Payable Relatives Equity

Beginning Balance 1/1/14 $ 250 � $100 $ 150 Initial purchases (140) 80 60 � Sales 875 25 � 900 Wages (190) � (190) Merchandise purchases (360) 30 � 20 (350) Other expenses (210) � (210) Depreciation (15) � (15) Interest payment (10) � (10) Income tax payment (40) � (40)

Ending Balance 12/31/14 $ 175 $25 $110 $ 45 � $20 $100 $ 235

Abstracting from the accounting details, there are two important things to note here. First, the basic accounting equation holds for each transaction. For every line in the table, assets equal liabilities plus owners’ equity. Second, WWS’s year-end balance sheet across the bottom of the table is just its be- ginning balance sheet plus the cumulative effect of the individual transac- tions. For example, ending cash on December 31, 2014 is the beginning cash of $250,000 plus or minus the cash involved in each transaction. Incidentally, WWS’s first year appears to have been a decent one: Owner’s equity is up $85,000 over the year, on top of whatever the owner paid himself in salary.

To further convince you that the bottom row of Table 1.1 really is a balance sheet, the table below presents the same information in a more conventional format.

Worldwide Sports Balance Sheet, December 31, 2014 ($ thousands)

Cash $175 Accounts payable $ 20 Accounts receivable 25 Total current liabilities 20 Inventory 110 Loan from relatives 100

Total current assets 310 Equity 235 Fixed assets 45 Total liabilities and

Total asssets $355 Shareholders’ equity $355

If a balance sheet is a snapshot in time, the income statement and the cash flow statement are videos, highlighting changes in two especially im- portant balance sheet accounts over time. Business owners are naturally interested in how company operations have affected the value of their in- vestment. The income statement addresses this question by partitioning the recorded changes in owners’ equity into revenues and expenses, where revenues increase owners’ equity and expenses reduce it. The difference between revenues and expenses is earnings, or net income.

Looking at the right-most column in Table 1.1, WWS’s 2014 income statement looks like this. Note that the $85,000 net income appearing at the bottom of the statement equals the change in shareholders’ equity over the year.

Worldwide Sports Income Statement, 2014 ($ thousands)

Sales $900 Wages 190 Merchandise purchases 350 Depreciation 15

Gross profit $345 Other expenses 210 Interest expense 10

Income before tax $125 Income taxes 40

Net income $ 85

8 Part One Assessing the Financial Health of the Firm

Chapter 1 Interpreting Financial Statements 9

The focus of the cash flow statement is solvency, having enough cash in the bank to pay bills as they come due. The cash flow statement provides a detailed look at changes in the company’s cash balance over time. As an organizing principle, the statement segregates changes in cash into three broad categories: cash provided, or consumed, by operating activities, by investing activities, and by financing activities. Figure 1.2 is a simple schematic diagram showing the close conceptual ties among the three principal financial statements.

To illustrate the techniques and concepts presented throughout the book, I will refer whenever possible to Stryker Corporation. If you or a relative have ever contemplated a hip or knee replacement, you probably know Stryker. The firm is a leading medical technology company with an especially strong position in orthopedic products. It derives about 60 per- cent of its revenue from the sale of hip and knee replacements and 40 per- cent from medical and surgical equipment—known in the trade as “medsurg.” The company competes in over 100 countries and produces almost 60,000 products and services in 29 facilities throughout the globe.

Headquartered in Kalamazoo, Michigan, with annual sales of over $9 billion, Stryker trades on the New York Stock Exchange and is a mem- ber of the Standard & Poor’s 500 Stock Index. The firm was founded in 1946 by Homer Stryker, a practicing orthopedist, and was originally known as The Orthopedic Frame Company, changing its name to Stryker Corporation in 1964. In 1979, Stryker went public and commenced an extended period of remarkably rapid growth. Beginning in 1976, Stryker’s average compound growth rate in earnings per share exceeded 20 percent per annum for over 30 years, and its corporate mantra became “20 per- cent growth forever.” Recent years have been more challenging, how- ever, as maturing products, the financial crisis, and the medical device excise tax tied to ObamaCare have taken their toll.

FIGURE 1.2 Ties among Financial Statements

Assets at beginning

Cash Shareholders’ Equity

= +Liabilities at beginning Equity at beginning

Assets at end = +Liabilities at end

O pe

ra tin

In ve

st in

Fi na

nc in

Equity at end

Balance sheets

Cash flow statement

Income statement

E xp

en se

R ev

en ue

See stryker.com. Follow Investors > Financial informa- tion for financial statements.

Tables 1.2 and 1.3 present Stryker’s balance sheets and income state- ments for 2012 and 2013. If the precise meaning of every asset and liability category in Table 1.2 is not immediately apparent, be patient. We will discuss many of them in the following pages. In addition, all of the accounting terms used appear in the glossary at the end of the book.

Stryker Corporation’s balance sheet equation for 2013 is

Assets � Liabilities � Shareholders’ equity $15,743 million � $6,696 million � $9,047 million

10 Part One Assessing the Financial Health of the Firm

See nysscpa.org/ glossary for an exhaustive glossary of accounting terms.

TABLE 1.2 Stryker Corporation, Balance Sheets ($ millions)*

December 31 Change in 2012 2013 Account

Assets Cash $ 1,395 $ 1,339 $ (56) Marketable securities 2,890 2,641 (249) Accounts receivable, less reserve for possible losses 1,430 1,518 88 Inventories 1,265 1,422 157 Other current assets 1,168 1,415 247

Total current assets 8,148 8,335

Gross property, plant, and equipment 2,232 2,497 265 Less accumulated depreciation and amortization 1,284 1,416 132

Net property, plant, and equipment 948 1,081 133

Goodwill and intangible assets, net 3,566 5,833 2,267 Other assets 544 494 (50)

Total assets $13,206 $15,743

Liabilities and Shareholders’ Equity Long-term debt due in one year 16 25 9 Taxes payable 70 131 61 Trade accounts payable 288 314 26 Accrued compensation 467 535 68 Accrued expenses 1,035 1,652 617

Total current liabilities 1,876 2,657

Long-term debt 1,746 2,739 993 Other long-term liabilities 987 1,300 313

Total liabilities 4,609 6,696

Common stock 38 38 Additional paid-in capital 1,098 1,160 Retained earnings 7,461 7,849

Total shareholders’ equity 8,597 9,047 450

Total liabilities and shareholders’ equity $13,206 $15,743

*Totals may not add due to rounding.

Current Assets and Liabilities By convention, U.S. accountants list assets and liabilities on the balance sheet in order of decreasing liquidity, where liquidity refers to the speed with which an item can be converted to cash. Thus among assets cash, marketable securities, and accounts receivable appear at the top, while land, plant, and equipment are toward the bottom. Similarly on the liabil- ities side, short-term loans and accounts payable are toward the top, while shareholders’ equity is at the bottom.

Accountants also arbitrarily define any asset or liability that is expected to turn into cash within one year as current and all others assets and liabil- ities as long term. Inventory is a current asset because there is reason to believe it will be sold and will generate cash within one year. Accounts payable are short-term liabilities because they must be paid within one year. Note that over half of Stryker’s assets are current, a fact we will say more about in the next chapter.

Chapter 1 Interpreting Financial Statements 11

TABLE 1.3 Stryker Corporation, Income Statements ($ millions)

January 1 to December 31

2012 2013

Net sales $8,657 $9,021 Cost of goods sold 2,604 2,762

Gross profit 6,053 6,259

Selling, general, and administrative expenses 3,501 4,077 Research, development, and engineering expenses 471 536 Depreciation and amortization 277 307

Total operating expenses 4,249 4,920

Operating income 1,804 1,339

Interest expense 63 83 Other nonoperating expense 36 44

Total nonoperating expenses 99 127

Income before income taxes 1,705 1,212 Provision for income taxes 407 206

Net income $1,298 $1,006

A Word to the Unwary Nothing puts a damper on a good financial discussion (if such exists) faster than the suggestion that if a company is short of cash, it can always spend some of its shareholders’ equity. Equity is on the liabilities side of the balance sheet, not the asset side. It represents owners’ claims against existing assets. In other words, that money has already been spent.

Shareholders’ Equity A common source of confusion is the large number of accounts appearing in the shareholders’ equity portion of the balance sheet. Stryker has three, beginning with common stock and ending with retained earnings (see Table 1.2). Unless forced to do otherwise, my advice is to forget these dis- tinctions. They keep accountants and attorneys employed, but seldom make much practical difference. As a first cut, just add up everything that is not an IOU and call it shareholders’ equity.

The Income Statement

Looking at Stryker’s operating performance in 2013, the basic income statement relation appearing in Table 1.3 is

Revenues � Expenses � Net income

Cost of Operating Nonoperating Net Net sales � goods sold � expenses � expenses � Taxes � income

$9,021 � $2,762 � $4,920 � $127 � $206 � $1,006

Net income records the extent to which net sales generated during the accounting period exceeded expenses incurred in producing the sales. For variety, net income is also commonly referred to as earnings or profits, frequently with the word net stuck in front of them; net sales are often called revenues or net revenues; and cost of goods sold is labeled cost of sales. I have never found a meaningful distinction between these terms. Why so many words to say the same thing? My personal belief is that accountants are so rule-bound in their calculations of the various amounts that their creativ- ity runs a bit amok when it comes to naming them.

Income statements are commonly divided into operating and nonoper- ating segments. As the names imply, the operating segment reports the results of the company’s major, ongoing activities, while the nonoperating segment summarizes all ancillary activities. In 2013 Stryker reported oper- ating income of $1,339 million and nonoperating expenses of $127 million, consisting largely of interest expense.

Measuring Earnings This is not the place for a detailed discussion of accounting. But because earnings, or lack of same, are a critical indicator of financial health, several technical details of earnings measurement deserve mention.

12 Part One Assessing the Financial Health of the Firm

Chapter 1 Interpreting Financial Statements 13

Accrual Accounting The measurement of accounting earnings involves two steps: (1) identify- ing revenues for the period and (2) matching the corresponding costs to revenues. Looking at the first step, it is important to recognize that revenue is not the same as cash received. According to the accrual principle (a cruel principle?) of accounting, revenue is recognized as soon as “the ef- fort required to generate the sale is substantially complete and there is a reasonable certainty that payment will be received.” The accountant sees the timing of the actual cash receipts as a mere technicality. For credit sales, the accrual principle means that revenue is recognized at the time of sale, not when the customer pays. This can result in a significant time lag between the generation of revenue and the receipt of cash. Looking at Stryker, we see that revenue in 2013 was $9,021 million, but accounts re- ceivable increased $88 million. We conclude that cash received from sales during 2013 was only $8,933 million ($9,021 � $88 million). The other $88 million still awaits collection.

Depreciation Fixed assets and their associated depreciation present the accountant with a particularly challenging problem in matching. Suppose that in 2015, a company constructs for $50 million a new facility that has an expected productive life of 10 years. If the accountant assigns the entire cost of the facility to expenses in 2015, some weird results follow. Income in 2015 will appear depressed due to the $50 million expense, while income in the fol- lowing nine years will look that much better as the new facility contributes to revenue but not to expenses. Thus, charging the full cost of a long-term asset to one year clearly distorts reported income.

The preferred approach is to spread the cost of the facility over its ex- pected useful life in the form of depreciation. Because the only cash outlay associated with the facility occurs in 2015, the annual depreciation listed as a cost on the company’s income statement is not a cash outflow. It is a noncash charge used to match the 2015 expenditure with resulting revenue. Said differently, depreciation is the allocation of past expenditures to future time periods to match revenues and expenses. A glance at Stryker’s income statement reveals that in 2013, the company included a $307 million non- cash charge for depreciation and amortization among their operating ex- penses. In a few pages, we will see that during the same year, the company spent $195 million acquiring new property, plant, and equipment.

To determine the amount of depreciation to take on a particular asset, three estimates are required: the asset’s useful life, its salvage value, and the method of allocation to be employed. These estimates should be based on economic and engineering information, experience, and any other objective

data about the asset’s likely performance. Broadly speaking, there are two methods of allocating an asset’s cost over its useful life. Under the straight- line method, the accountant depreciates the asset by a uniform amount each year. If an asset costs $50 million, has an expected useful life of 10 years, and has an estimated salvage value of $10 million, straight-line depreciation will be $4 million per year ([$50 million � $10 million]�10).

The second method of cost allocation is really a family of methods known as accelerated depreciation. Each technique charges more deprecia- tion in the early years of the asset’s life and correspondingly less in later years. Accelerated depreciation does not enable a company to take more depreciation in total; rather, it alters the timing of the recognition. While the specifics of the various accelerated techniques need not detain us here, you should recognize that the life expectancy, the salvage value, and the al- location method a company uses can fundamentally affect reported earn- ings. In general, if a company is conservative and depreciates its assets rapidly, it will tend to understate current earnings, and vice versa.

Taxes A second noteworthy feature of depreciation accounting involves taxes. Most U.S. companies, except very small ones, keep at least two sets of fi- nancial records: one for managing the company and reporting to share- holders and another for determining the firm’s tax bill. The objective of the first set is, or should be, to accurately portray the company’s financial performance. The objective of the second set is much simpler: to mini- mize taxes. Forget objectivity and minimize taxes. These differing objec- tives mean the accounting principles used to construct the two sets of books differ substantially. Depreciation accounting is a case in point. Re- gardless of the method used to report to shareholders, company tax books will minimize current taxes by employing the most rapid method of de- preciation over the shortest useful life the tax authorities allow.

This dual reporting means that actual cash payments to tax authorities usu- ally differ from the provision for income taxes appearing on a company’s in- come statement, sometimes trailing the provision and other times exceeding it. To illustrate, Stryker’s $206 million provision for income taxes appearing on its 2013 income statement is the tax payable according to the accounting techniques used to construct the company’s published statements. But be- cause Stryker used different accounting techniques when reporting to the tax authorities, taxes actually paid in 2013 were lower than this amount. To confirm this fact, note that Stryker has a tax account on the liabilities side of its balance sheet labeled “taxes payable,” a short-term liability. The liability reflects tax obligations incurred in past periods but not yet paid. The net change in this balance sheet account during 2013 indicates that

14 Part One Assessing the Financial Health of the Firm

Stryker’s tax liability rose $61 million over the year, so that taxes paid must have been $61 million less than the provision for taxes appearing on the income statement. Stryker’s aggressive deferral of tax obligations incurred during the year resulted in a 2013 tax payment less than the tax obligation appearing on its income statement. Here is the detailed accounting with figures in millions:

Provision for income taxes $206 − Increase in taxes payable 61____

Taxes paid $145

At the end of 2013, Stryker’s net tax liability appearing on its balance sheet was $131 million. This sum represents money Stryker must pay tax authorities in future years, but in the meantime can be used to finance the business. Tax deferral techniques create the equivalent of interest-free loans from the government. In Japan and other countries which do not allow the use of separate accounting techniques for tax and reporting purposes, these complications never arise.

Research and Marketing Now that you understand how accountants use depreciation to spread the cost of long-lived assets over their useful lives to better match revenues and costs, you may think you also understand how they treat research and marketing expenses. Because research and development (R&D) and mar- keting outlays promise benefits over a number of future periods, it is only logical that an accountant would show these expenditures as assets when they are incurred and then spread the costs over the assets’ expected use- ful lives in the form of a noncash charge such as depreciation. Impecca- ble logic, but this isn’t what accountants do, at least not in the United States. Because the magnitude and duration of the prospective payoffs from R&D and marketing expenditures are difficult to estimate, ac- countants typically duck the problem by forcing companies to record the entire expenditure as an operating cost in the year incurred. Thus, al- though a company’s research outlays in a given year may have produced technical breakthroughs that will benefit the firm for decades to come, all of the costs must be shown on the income statement in the year incurred. The requirement that companies expense all research and marketing ex- penditures when incurred commonly understates the profitability of high-tech and high-marketing companies and complicates comparison of American companies with those in other nations that treat such expendi- tures more liberally.

Chapter 1 Interpreting Financial Statements 15

16 Part One Assessing the Financial Health of the Firm

Defining Earnings Creditors and investors look to company earnings for help in answering two fundamental questions: How did the company do last period, and how might it do in the future? To answer the first question it is important to use a broad-based measure of income that includes everything affecting the com- pany’s performance over the accounting period. However, to answer the second question we want a narrower income measure that abstracts from all unusual, nonrecurring events to focus strictly on the company’s steady state, or ongoing, performance.

The accounting profession and the Securities and Exchange Commission obligingly provide two such official measures, known as net income and operating income, and require companies to report them on their financial statements.

Net income, or net profit, is the proverbial “bottom line,” defined as total revenue less total expenses. Operating income is profit realized from day-to-day operations excluding taxes, interest income

and expense, and what are known as extraordinary items. An extraordinary item is one that is both unusual in nature and infrequent in occurrence.

For a variety of sometimes-legitimate reasons, corporate executives and business analysts have increasingly argued that these official income measures are inadequate or inappropriate for their purposes and have encouraged a whole cottage industry devoted to creating and promoting new, improved earnings measures. Here are some of the more popular ones:

Pro forma earnings, also known as adjusted earnings, core earnings, or ongoing earnings, are total revenues less total expenses, omitting any and all expenses the company believes might cloud investor perceptions of the true earning power of the business. If this sounds vague, it is. Each company has license to decide what expenses are to be ignored, and to change its mind from year to year. The SEC requires only that the company reconcile its preferred earnings measure with the closest official number in its annual report. In the first three quarters of 2001, during the depths of the dot-com bust, the 100 largest firms traded on the NASDAQ stock exchange reported aggregate pro forma earnings of $20 billion. For the same period, they reported losses according to Generally Accepted Accounting Principles of $82 billion.a In the recent financial crisis, S&P 500 companies reported aggregate 2008 pro forma earnings per share of over $60, while the corresponding figure under GAAP was below $20.b In 2013, our featured company, Stryker Corporation, highlighted “adjusted” net earnings of $1.6 billion, some 60 percent above the comparable GAAP figure, due principally to large product liability claims which the company chose to consider nonrecurring.

EBIT (pronounced E-bit) is earnings before interest and taxes, a useful and widely used measure of a business’s income before it is divided among creditors, owners, and the taxman.

EBITDA (pronounced E-bit-da) is earnings before interest, taxes, depreciation, and amortization. EBITDA has its uses in some industries, such as broadcasting, where depreciation charges may routinely overstate true economic depreciation. However, as Warren Buffett notes, treating EBITDA as equivalent to earnings is tantamount to saying that a business is the commercial equivalent of the pyramids—forever state-of-the-art, never needing to be replaced, improved, or refurbished. In Buffett’s view, EBITDA is a number favored by investment bankers when they cannot justify a deal based on EBIT.

EIATBS (pronounced E-at-b-s) is earnings ignoring all the bad stuff, which is the earnings concept too many executives and analysts appear to prefer.

a “A Survey of International Finance,” The Economist, May 18, 2002, p. 20. b “Chart of the Day: Here’s How You Should Think About ‘Adjusted’ Earnings.” Sam Ro, Business Insider, December 26,

2013, Businessinsider.com/gaap-vs-non-gaap-earnings-eps-2013-12.

Chapter 1 Interpreting Financial Statements 17

Sources and Uses Statements

Two very basic but valuable things to know about a company are where it gets its cash and how it spends the cash. At first blush, it might appear that the income statement will answer these questions because it records flows of resources over time. But further reflection will con- vince you that the income statement is deficient in two respects: It includes accruals that are not cash flows, and it lists only cash flows associated with the sale of goods or services during the accounting period. A host of other cash receipts and disbursements do not appear on the income statement. Thus, Stryker Corporation increased its investment in accounts receivable by $88 million in 2013 (Table 1.2) with little or no trace of this buildup on its income statement. Stryker also increased long-term debt by almost $1 billion with little effect on its income statement.

To gain a more accurate picture of where a company got its money and how it spent it, we need to look more closely at the balance sheet or, more precisely, two balance sheets. Use the following two-step procedure. First, place two balance sheets for different dates side by side, and note all of the changes in accounts that occurred over the pe- riod. The changes for Stryker in 2013 appear in the rightmost column of Table 1.2. Second, segregate the changes into those that generated cash and those that consumed cash. The result is a sources and uses statement.

Here are the guidelines for distinguishing between a source and a use of cash:

• A company generates cash in two ways: by reducing an asset or by increasing a liability. The sale of used equipment, the liquidation of inventories, and the reduction of accounts receivable are all reductions in asset accounts and are all sources of cash to the company. On the liabilities side of the balance sheet, an increase in a bank loan and the sale of common stock are increases in liabilities, which again generate cash.

• A company also uses cash in two ways: to increase an asset account or to reduce a liability account. Adding to inventories or accounts receivable and building a new plant all increase assets and all use cash. Conversely, the repayment of a bank loan, the reduction of accounts payable, and an operating loss all reduce liabilities and all use cash.

Because it is difficult to spend money you don’t have, total uses of cash over an accounting period must equal total sources.

Table 1.4 presents a 2013 sources and uses statement for Stryker Corporation. It reveals that the company got over one-third of its cash from increased long-term borrowing and, in turn, used almost 80 percent of the cash to increase net goodwill and intangible assets, reflecting size- able acquisitions, as we will soon discuss further.

The Two-Finger Approach I personally do not spend a lot of time constructing sources and uses state- ments. It might be instructive to go through the exercise once or twice just to convince yourself that sources really do equal uses. But once beyond this point, I recommend using a “two-finger approach.” Put the two

18 Part One Assessing the Financial Health of the Firm

TABLE 1.4 Stryker Corporation, Sources and Uses Statement, 2013 ($ millions)*

Sources

Reduction in cash 56 Reduction in marketable securities 249 Reduction in other assets 50 Increase in long-term debt due in one year 9 Increase in taxes payable 61 Increase in trade accounts payable 26 Increase in accrued compensation 68 Increase in accrued expenses 617 Increase in long-term debt 993 Increase in other long-term liabilities 313 Increase in total shareholders’ equity 450

Total sources $2,892

Uses

Increase in accounts receivable 88 Increase in inventories 157 Increase in other current assets 247 Increase in net property, plant, and equipment 133 Increase in net goodwill and intangible assets 2,267

Total uses $2,892

*Totals may not add due to rounding.

How Can a Reduction in Cash Be a Source of Cash? One potential source of confusion in Table 1.4 is that the reduction in cash and marketable securities in 2013 appears as a source of cash. How can a reduction in cash be a source of cash? Simple. It is the same as when you withdraw money from your checking account. You reduce your bank balance but have more cash on hand to spend. Conversely, a deposit into your bank account increases your balance but reduces spendable cash in your pocket.

Chapter 1 Interpreting Financial Statements 19

balance sheets side by side, and quickly run any two fingers down the columns in search of big changes. This should enable you to quickly observe that the majority of Stryker’s cash came from long-term debt, retained earnings, and increased accrued expenses and most of it went to finance new acquisitions. In 30 seconds or less, you have the essence of a sources and uses analysis and are free to move on to more stimulating activities. The other changes are largely window dressing of more interest to accountants than to managers.

The Cash Flow Statement

Identifying a company’s principal sources and uses of cash is a useful skill in its own right. It is also an excellent starting point for considering the cash flow statement, the third major component of financial statements along with the income statement and the balance sheet.

In essence, a cash flow statement just expands and rearranges the sources and uses statement, placing each source or use into one of three broad cate- gories. The categories and their values for Stryker in 2013 are as follows:

Category Source (or Use) of Cash

($ millions)

1. Cash flows from operating activities $1,886 2. Cash flows from investing activities ($2,217) 3. Cash flows from financing activities $275

Double-entry bookkeeping guarantees that the sum of the cash flows in these three categories equals the change in cash balances over the accounting period.

Table 1.5 presents a complete cash flow statement for Stryker Corpora- tion in 2013. The first category, “cash flows from operating activities,” can be thought of as a rearrangement of Stryker’s financial statements to elimi- nate the effects of accrual accounting on net income. First, we add all non- cash charges, such as depreciation and amortization, back to net income, recognizing that these charges did not entail any cash outflow. Then we add the changes in current assets and liabilities to net income, acknowledging, for instance, that some sales did not increase cash because customers had not yet paid, while some expenses did not reduce cash because the company had not yet paid. Changes in other current assets and liabilities, such as in- ventories, appear here because the accountant, following the matching prin- ciple, ignored these cash flows when calculating net income. Interestingly, the cash generated by Stryker’s operations was over 80 percent more than

the firm’s income. A principal reason for the difference is that the income statement includes a $43.4 million noncash charge for depreciation.

If cash flow statements were just a reshuffling of sources and uses statements, as many textbook examples suggest, they would be redun- dant, for a reader could make his own in a matter of minutes. A chief at- traction of cash flow statements is that companies reorganize their cash flows into new and sometimes revealing categories. To illustrate, Stryker’s cash flow statement in Table 1.5 reveals that during 2013 it paid dividends of $401 million, repurchased $317 million of its common

20 Part One Assessing the Financial Health of the Firm

TABLE 1.5 Stryker Corporation, Cash Flow Statement, 2013 ($ millions)*

Cash Flows from Operating Activities Net income $ 1,006 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization 307 Deferred income taxes 23 Stock-based compensation expense 76 Restructuring charges 50 Changes in assets and liabilities:

Increase in accounts receivables (89) Increase in inventories (77) Increase in accounts payable 1 Increase in accrued expenses and other liabilities 657 Decrease in accrued income taxes (124) Other 56

Net cash provided by operating activities 1,886

Cash Flows from Investing Activities Capital expenditures (195) Acquisitions (2,320) Net decline in investments 298 Net cash used by investing activities (2,217)

Cash Flows from Financing Activities Repurchase of common stock (317) Dividends paid (401) Long-term debt issuance, net of retirements 1,005 Other financing activities 13 Effect of exchange rate changes on cash (25) Net cash provided by financing activities 275

Net increase (decrease) in cash (56) Cash at beginning of year 1,395 Cash and marketable securities at end of year $ 1,339

*Totals may not add due to rounding.

Chapter 1 Interpreting Financial Statements 21

stock, and invested $195 million in new capital expenditures. This is the only place in its financial statements where these basic activities are even mentioned.

A second attraction of a cash flow statement is that it casts a welcome light on firm solvency by highlighting the extent to which operations are generating or consuming cash. Stryker’s cash flow statement in 2013 in- dicates that cash flow from operating activities exceeded net income by a hearty 80 percent, due principally to an increase in something called “accrued expenses and other liabilities.” This is a lot of money for such an innocuous sounding account. Additional digging reveals that the in- crease reflects additions to a reserve account to honor anticipated prod- uct liability claims. In mid-2012, Stryker voluntarily recalled several hip replacement products due to their tendency to cause metal ion poison- ing in some patients. Used in about 20,000 people, remedial treatment requires replacing the failed hip. A year later, with the number of law- suits climbing above 900, Stryker announced it was adding some $600 million to the reserve. From an accounting perspective, this involves adding $600 million to selling, general, and administrative expenses and increasing accrued expenses and liabilities by a like amount. Because this build-up is a noncash charge until patient claims are actually paid, it does not diminish cash flow from operations and must thus be added back to net income.

Why Are The Numbers Different? Stryker’s sources and uses statement in Table 1.4 tells us that inventories rose $157 million in 2013; yet its cash flow statement in Table 1.5 says that inventories increased only $77 million over the same period. Nor is this an isolated example. Many of the apparently identical quantities differ from one statement to the other. Why the difference?

Here are two possible answers. Companies often divide changes in current assets and liabilities into two parts: those attributable to existing activities, and those due to newly acquired businesses, with the first appearing in cash flows from operating activities and the second in cash flows from in- vesting activities. By pushing as much of the increase into investing activities as possible, Stryker enhances its recorded cash generated by operating activities—an appealing outcome. The second answer involves exchange rates. Stryker has assets and liabilities of various types scattered all over the world. To construct a consolidated balance sheet, its accountants translate the company’s foreign-denominated accounts into U.S. dollars at the then prevailing exchange rates. As a result, the balance sheet changes we observe on their consolidated statements are due at least in part to changing currency values. However, because the currency-induced changes are not cash flows until the assets or liabilities are brought home, Stryker omits them from the numbers appearing on its cash flow statement.

Are these answers complicated? Yes. Do the manipulations described add to our understanding of Stryker’s performance? I doubt it.

Another noteworthy entry on Stryker’s cash flow statement is “stock- based compensation expense,” which contributed $76 million to cash flow from operations in 2013. After a long and bitter battle among businesses, Congress, and accounting regulators, employee stock options are finally, and correctly, classified as an expense. However, they are not a cash flow, neither when they are given to the employee nor when she converts them into company stock. So they too must be added back to net income when calculating cash flow from operations. If you are wondering how stock op- tions can be an expense when the firm never seems to have to pay any cash to anyone, the answer is that they are a cost to shareholders, who see their ownership percentage diluted as employees acquire shares without paying full value for them.

Some analysts maintain that net cash provided by operating activi- ties, appearing on the cash flow statement, is a more reliable indicator of firm performance than net income. They argue that because net in- come depends on myriad estimates, allocations, and approximations, devious managers can easily manipulate it. Numbers appearing on a company’s cash flow statement, on the other hand, record the actual movement of cash, and are thus seen to be more objective measures of performance.

There is certainly some merit to this view, but also two problems. First, low or even negative net cash provided by operating activities does not necessarily indicate poor performance. Rapidly growing businesses in particular must customarily invest in current assets, such as accounts receivable and inventories, to support increasing sales. And although such investments reduce net cash provided by operating activities, they do not in any way suggest poor performance. Second, cash flow state- ments turn out to be less objective, and thus less immune to manipula- tion than might be supposed. Here’s a simple example. Suppose two companies are identical except that one sells its product on a simple open account, while the other loans its customers money enabling them to pay cash for the product. In both cases, the customer has the product and owes the seller money. But the increase in accounts receivable recorded by the first company on each sale will lower its cash flows from operating activities relative to the second, which can report the cus- tomer loan as part of investing activities. Because the criteria for appor- tioning cash flows among operating, investing, and financing activities are ambiguous, subjective judgment must be used in the preparation of cash flow statements.

Much of the information contained in a cash flow statement can be gleaned from careful study of a company’s income statement and balance sheet. Nonetheless, the statement has three principal virtues. First, accounting

22 Part One Assessing the Financial Health of the Firm

neophytes and those who do not trust accrual accounting have at least some hope of understanding it. Second, the statement provides more accurate in- formation about certain activities, such as share repurchases and employee stock options than one can infer from income statements and balance sheets alone. Third, it casts a welcome light on cash generation and solvency.

Chapter 1 Interpreting Financial Statements 23

What Is Cash Flow? So many conflicting definitions of cash flow exist today that the term has almost lost its meaning. At one level, cash flow is very simple. It is the movement of money into or out of a cash account over a period of time. The problem arises when we try to be more specific. Here are four common types of cash flow you are apt to encounter.

Net cash flow � Net income � Noncash items

Often known in investment circles as cash earnings, net cash flow is intended to measure the cash a business generates, as distinct from the earnings—a laudable objective. Applying the formula to Stryker’s 2013 figures (Table 1.5), net cash flow was $1,462 million, equal to net income plus depreci- ation, and other noncash charges.

A problem with net cash flow as a measure of cash generation is that it implicitly assumes a busi- ness’s current assets and liabilities are either unrelated to operations or do not change over time. In Stryker’s case, the cash flow statement reveals that changes in a number of current assets and lia- bilities contributed $424 million in cash. A more inclusive measure of cash generation is therefore cash flow from operating activities as it appears on the cash flow statement.

Cash flow from operating activities � Net cash flow ± Changes in current assets and liabilities

A third, even more inclusive measure of cash flow, popular among finance specialists is

Total cash available for distribution to owners and creditors Free cash flow �

after funding all worthwhile investment activities

Free cash flow extends cash flow from operating activities by recognizing that some of the cash a business generates must be plowed back into the business, in the form of capital expenditures, to support growth. Abstracting from a few technical details, free cash flow is essentially cash flow from operating activities less capital expenditures. As we will see in Chapter 9, free cash flow is a fundamental determinant of the value of a business. Indeed, one can argue that the principal means by which a company creates value for its owners is to increase free cash flow.

Yet another widely used cash flow is

A sum of money today having the same value Discounted cash flow �

as a future stream of cash receipts and disbursements

Discounted cash flow refers to a family of techniques for analyzing investment opportunities that take into account the time value of money. A standard approach to valuing investments and busi- nesses uses discounted cash flow techniques to calculate the present value of projected free cash flows. This is the focus of the last three chapters of this book.

My advice when tossing cash flow terms about is to either use the phrase broadly to refer to a general movement of cash or to define your terms carefully.

24 Part One Assessing the Financial Health of the Firm

Financial Statements and the Value Problem

To this point, we have reviewed the basics of financial statements and grappled with the distinction between earnings and cash flow. This is a valuable start, but if we are to use financial statements to make informed business decisions, we must go further. We must understand the extent to which accounting numbers reflect economic reality. When the accountant tells us that Stryker Corporation’s total assets were worth $15,743 million on December 31, 2013, is this literally true, or is the number just an artifi- cial accounting construct? To gain perspective on this issue, and in anticipa- tion of later discussions, I want to conclude by examining a recurring problem in the use of accounting information for financial decision making.

Market Value vs. Book Value Part of what I will call the value problem involves the distinction between the market value and the book value of shareholders’ equity. Stryker’s 2013 balance sheet states that the value of shareholders’ equity is $9,047 million. This is known as the book value of Stryker’s equity. However, Stryker is not worth $9,047 million to its shareholders or to anyone else, for that matter. There are two reasons. One is that financial statements are largely transactions based. If a company purchased an asset for $1 million in 1950, this transaction provides an objective measure of the asset’s value, which the accountant uses to value the asset on the company’s balance sheet. Unfortunately, it is a 1950 value that may or may not have much relevance today. To further confound things, the accountant attempts to reflect the gradual deterioration of an asset over time by periodically sub- tracting depreciation from its balance sheet value. This practice makes sense as far as it goes, but depreciation is the only change in value an American accountant customarily recognizes. The $1 million asset pur- chased in 1950 may be technologically obsolete and therefore virtually worthless today; or, due to inflation, it may be worth much more than its original purchase price. This is especially true of land, which can be worth several times its original cost.

It is tempting to argue that accountants should forget the original costs of long-term assets and provide more meaningful current values. The prob- lem is that objectively determinable current values of many assets do not exist, and it is probably not wise to rely on incumbent mangers to make the necessary adjustments. Faced with a choice between relevant but subjective current values and irrelevant but objective historical costs, accountants opt for irrelevant historical costs. Accountants prefer to be precisely wrong than approximately right. This means it is the user’s responsibility to make any adjustments to historical-cost asset values she deems appropriate.

For more of fair value account- ing and many other account- ing topics, see cfo.com.

Prodded by regulators and investors, the Financial Accounting Stan- dards Board, accounting’s principal rule-making organization, increas- ingly stresses what is known as fair value accounting, according to which certain assets and liabilities must appear on company financial statements at their market values instead of their historical costs. Such “marking to market” applies to selected assets and liabilities that trade actively on fi- nancial markets, including many common stocks and bonds. Proponents of fair value accounting acknowledge it will never be possible to eliminate his- torical- cost accounting entirely, but maintain that market values should be used whenever possible. Skeptics respond that mixing historical costs and market values in the same financial statement only heightens confusion, and that periodically revaluing company accounts to reflect changing mar- ket values introduces unwanted subjectivity, distorts reported earnings, and greatly increases earnings volatility. They point out that under fair value accounting, changes in owners’ equity no longer mirror the results of com- pany operations but also include potentially large and volatile gains and losses from changes in the market values of certain assets and liabilities. The gradual movement toward fair value accounting was initially greeted with howls of protest, especially from financial institutions concerned that the move would increase apparent earnings volatility and, more menac- ingly, might reveal that some enterprises are worth less than historical-cost financial statements suggest. To these firms the appearance of benign sta- bility is apparently more appealing than the hint of an ugly reality.

To understand the second, more fundamental reason Stryker is not worth $9,047 million, recall that equity investors buy shares for the future income they hope to receive, not for the value of the firm’s assets. Indeed, if all goes according to plan, most of the firm’s existing assets will be con- sumed in generating future income. The problem with the accountant’s measure of shareholders’ equity is that it bears little relation to future in- come. There are two reasons for this. First, because the accountant’s num- bers are backward-looking and cost-based, they often provide few clues about the future income a company’s assets might generate. Second, com- panies typically have a great many assets and liabilities that do not appear on their balance sheets but affect future income nonetheless. Examples in- clude patents and trademarks, loyal customers, proven mailing lists, supe- rior technology, and, of course, better management. It is said that in many companies, the most valuable assets go home to their spouses in the evening. Examples of unrecorded liabilities include pending lawsuits, in- ferior management, and obsolete production processes. The accountant’s inability to measure assets and liabilities such as these means that book value is customarily a highly inaccurate measure of the value perceived by shareholders.

Chapter 1 Interpreting Financial Statements 25

It is a simple matter to calculate the market value of shareholders’ equity when a company’s shares are publicly traded: Simply multiply the market price per share by the number of common shares outstanding. On December 31, 2013, Stryker’s common shares closed on the New York Stock Exchange at $75.14. With 378 million shares outstanding, this yields a value of $28,403 million, or 3.1 times the book value ($28,403/$9,047 million). This figure is the market value of Stryker’s equity, often known as its market capitalization or market cap.

Table 1.6 presents the market and book values of equity for 15 repre- sentative companies. It demonstrates clearly that book value is a poor proxy for market value.

Goodwill There is one instance in which intangible assets, such as brand names and patents, find their way onto company balance sheets. It occurs when one company buys another at a price above book value. Suppose an acquiring firm pays $100 million for a target firm and the target’s assets have a book value of only $40 million and an estimated replacement value of only $60 million. To record the transaction, the accountant will allocate $60 million of the acquisition price to the value of the assets acquired and assign the remaining $40 million to a new asset commonly known as

26 Part One Assessing the Financial Health of the Firm

Fair Value Accounting and the Financial Crisis of 2008 The financial crisis of 2008 revealed several quirks and problems with fair value accounting. Among the quirks is fair value’s treatment of company liabilities. Many financial institutions saw the market value of their publicly traded debt plummet during the crisis as investors lost faith in the institutions’ ability to honor their obligations—clearly bad news. Yet fair value accounting forced the organiza- tions to report this drop in value as a gain on the theory that it would now cost them that much less to repurchase and retire the debt. Similarly, when the crisis eased and debt values rose, the same institutions found themselves recording losses as the cost of repurchase went up. As one example, investment bank Morgan Stanley reported a $5.5 billion gain in 2008 on declining debt values, fol- lowed in 2009 by a $5.4 billion loss as the price of their debt recovered.

More worrisome, some observers maintain that fair value accounting may actually have con- tributed to the crisis. They argue that panic selling during the collapse made observed market prices more an indicator of investor fears than of asset values. Moreover, they claim that reliance on these distressed prices to value assets set in motion a vicious cycle whereby falling prices prompted cred- itors to demand payment of the debt, increased collateral, or increased equity relative to debt, all of which forced the debtors into more panic selling. While not abandoning fair value accounting, this criticism has forced accountants and regulators to allow managers some discretion in estimating fair values in distressed markets.c

cFor more on this topic, see Christian Laux and Christian Leuz “The Crisis of Fair Value Accounting: Making Sense of the Recent Debate,” Accounting, Organizations and Society, April 2009. Available at ssrn.com/abstract=1392645.

“goodwill.” The acquiring company paid a handsome premium over the fair value of the target’s recorded assets because it places a high value on its unrecorded, or intangible, assets. But not until the acquisition creates a piece of paper with $100 million written on it is the accountant willing to acknowledge this value.

Looking at Stryker Corporation’s balance sheet in Table 1.2 under the heading “goodwill and intangible assets, net,” we see that the company has $5,833 million of goodwill, its largest single asset and 37 percent of total assets. To put this number in perspective, the median ratio of good- will and intangible assets to total assets among Standard & Poor’s 500 in- dustrial companies—a diversified group of large firms—was 22 percent in 2013. Express Scripts Holding Company, a health care management com- pany, topped the list with a ratio of 81 percent.1

Economic Income vs. Accounting Income A second dimension of the value problem is rooted in the accountant’s dis- tinction between realized and unrealized income. To anyone who has not

Chapter 1 Interpreting Financial Statements 27

TABLE 1.6 The Book Value of Equity Is a Poor Surrogate for the Market Value of Equity, December 31, 2013

Value of Equity Ratio, Market ($ millions) Value to

Company Book Market Book Value

Aetna Inc. 14,026 27,154 1.9 Apache Corp. 33,396 32,829 1.0 Coca-Cola Co. 33,173 170,181 5.1 Delta Air Lines Inc. 11,643 29,502 2.5 Duke Energy Corp. 41,330 50,281 1.2 Facebook Inc. 15,470 153,431 9.9 General Motors Co. 39,498 51,630 1.3 Google Inc. 87,309 374,288 4.3 Harley-Davidson Inc. 3,009 14,651 4.9 Hewlett-Packard Co. 27,269 61,452 2.3 Intel Corp. 58,256 128,218 2.2 Stryker Corp. 9,047 28,403 3.1 Tesla Motors Inc. 667 25,658 38.5 United States Steel Co. 3,348 3 ,995 1.2 Walmart Stores Inc. 76,255 247,098 3.2

1For many years, accounting authorities required companies to write goodwill off as a noncash expense against income over a number of years. Now they acknowledge that most goodwill is not necessarily a wasting asset and only requires a write-down when there is evidence the value of goodwill has declined. There is no offsetting provision requiring the write-up of goodwill when values appear to have risen. If this sounds vague and capricious, I agree.

studied too much accounting, income is what you could spend during the period and be as well off at the end as you were at the start. If Mary Siegler’s assets, net of liabilities, are worth $100,000 at the start of the year and rise to $120,000 by the end, and if she receives and spends $70,000 in wages during the year, most of us would say her income was $90,000 ($70,000 in wages � $20,000 increase in net assets).

But not the accountant. Unless Mary’s investments were in marketable securities with readily observable prices, he would say Mary’s income was only $70,000. The $20,000 increase in the value of assets would not qual- ify as income because the gain was not realized by the sale of the assets. Be- cause the value of the assets could fluctuate in either direction before the assets are sold, the gain is only on paper, and accountants generally do not recognize paper gains or losses. They consider realization the objective evidence necessary to record the gain, despite the fact that Mary is proba- bly just as pleased with the unrealized gain in assets as with another $20,000 in wages.

It is easy to criticize accountants’ conservatism when measuring in- come. Certainly the amount Mary could spend, ignoring inflation, and be as well off as at the start of the year is the commonsense $90,000, not the accountant’s $70,000. Moreover, if Mary sold her assets for $120,000 and immediately repurchased them for the same price, the $20,000 gain would become realized and, in the accountant’s eyes, become part of income. That income could depend on a sham transaction such as this is enough to raise suspicions about the accountant’s definition.

However, we should note three points in the accountant’s defense. First, if Mary holds her assets for several years before selling them, the gain or loss the accountant recognized on the sale date will equal the sum of the annual gains and losses we nonaccountants would recognize. So it’s really not total income that is at issue here but simply the timing of its recognition. Second, accountants’ increasing use of fair value accounting, where at least some as- sets and liabilities are revalued periodically to reflect changes in market value, reduces the difference between accounting and economic income. Third, even when accountants want to use fair value accounting, it is ex- tremely difficult to measure the periodic change in the value of many assets and liabilities unless they are actively traded. Thus, even if an accountant wanted to include “paper” gains and losses in income, she would often have great difficulty doing so. In the corporate setting, this means the accountants frequently must be content to record realized rather than economic income.

Imputed Costs A similar but subtler problem exists on the cost side of the income statement. It involves the cost of equity capital. Stryker’s accountants acknowledge that

28 Part One Assessing the Financial Health of the Firm

in 2013 the company had use of $9,047 million of shareholders’ money, measured at book value. They would further acknowledge that Stryker could not have operated without this money and that this money is not free. Just as creditors earn interest on loans, equity investors expect a return on their in- vestments. Yet if you look again at Stryker’s income statement (Table 1.3), you will find no mention of the cost of this equity; interest expense appears, but a comparable cost for equity does not.

While acknowledging that equity capital has a cost, the accountant does not record it on the income statement because the cost must be imputed, that is, estimated. Because there is no piece of paper stating the amount of money Stryker is obligated to pay owners, the accoun- tant refuses to recognize any cost of equity capital. Once again, the ac- countant would rather be reliably wrong than make a potentially inaccurate estimate. The result has been serious confusion in the minds of less knowledgeable observers and continuing “image” problems for corporations.

Following is the bottom portion of Stryker’s income statement as pre- pared by its accountant and as an economist might prepare it. Observe that while the accountant shows earnings of $1,006 million, the economist records a profit of only $101 million. These numbers differ because the economist includes a $905 million charge as a cost of equity capital, while the accountant pretends equity is free. (We will consider ways to estimate a company’s cost of equity capital in Chapter 8. Here, for illustrative purposes only, I have assumed a 10 percent annual equity cost and applied it to the book value of Stryker’s equity [$905 million � 10% � $9,047 million].)

($ millions) Accountant Economist

Operating income $1,339 $1,339 Interest expense 83 83 Other nonoperating expenses 44 44 Cost of equity 905 Income before taxes 1,212 307 Provision for taxes 206 206

Accounting earnings $1,006 Economic earnings $ 101

The distinction between accounting earnings and economic earnings might be only a curiosity if everyone understood that positive accounting earnings are not necessarily a sign of superior or even commendable per- formance. But when many labor unions, Occupy Wall Streeters, and politicians view accounting profits as evidence that a company can afford higher wages, higher taxes, or more onerous regulation, and when most

Chapter 1 Interpreting Financial Statements 29

managements view such profits as justification for distributing handsome performance bonuses, the distinction can be an important one. Keep in mind, therefore, that the right of equity investors to expect a competitive return on their investments is every bit as legitimate as a creditor’s right to interest and an employee’s right to wages. All voluntarily contribute scarce resources, and all are justified in expecting compensation. Remember too that a company is not shooting par unless its economic profits are zero or

30 Part One Assessing the Financial Health of the Firm

International Financial Reporting Standards A danger inherent in any cross-country comparison of accounting numbers is that accountants in different countries may not keep score by the same rules. Happily, this problem has diminished greatly over the past decade or so, and what optimists might call international accounting standards are emerging. The European Union took the lead in this initiative as part of its much broader effort to hammer out a common, integrated marketplace among member countries. After some 30 years of study, debate, and political wrangling, the accounting initiative became a reality on January 1, 2005, when all 7,000 publicly traded companies in Europe dumped their national accounting rules in favor of the newly designated International Financial Reporting Standards (IFRS). Today, over 100 coun- tries on six continents have adopted IFRS, either directly or by aligning national rules to the interna- tional standards. Conspicuously absent from the earlier adopters have been the United States and Japan who are, nonetheless, working at their own pace to join the club, or at least become affiliate members.

For many years, U.S. accounting authorities viewed American accounting rules as the gold stan- dard to which other countries could only aspire, and their approach to international accounting standards was to invite the rest of the world to adopt theirs. But accounting scandals in the early 2000s and the ensuing collapse of the accounting firm Arthur Andersen have made Americans a bit more humble about their accounting rules and a bit more willing to compromise.

A major barrier to greater transatlantic cooperation on accounting standards has been differing philosophical perspectives on the role such standards should play. The European philosophy is to articulate broad accounting principles and to charge accountants and executives to prepare com- pany accounts consistent with the spirit of those principles. Concerned that principles alone would leave too much room for manipulation, the American approach has been to lay down voluminous, detailed rules defining how each transaction is to be recorded and to demand strict conformance to the letter of those rules. Ironically, this rules-based philosophy seems to have backfired, for rather than limiting manipulation, the American “bright-line” approach appears to have encouraged it by shifting some executives’ focus from preparing fair and accurate statements to figuring out how best to beat the rules. The argument “we didn’t break any rules, so we must be innocent” appears to have been an enticing one.

One response to the breakdown in U.S. accounting standards was passage of the Sarbanes- Oxley Act of 2002, which among other changes requires chief executives and chief financial officers to personally attest to the appropriateness of their company’s financial reports. Another was to take the European, broad-brush approach more seriously. Indeed, there was a time some 10 years ago when it appeared that U.S. regulators and accounting authorities were about to name a date-certain when the United States would adopt IFRS. Today this no longer appears likely. Instead, U.S. and in- ternational accounting authorities appear intent on integrating the two standards on a piecemeal basis over an extended period. Not a single standard perhaps, but at least a workable compromise.

Chapter 1 Interpreting Financial Statements 31

greater. By this criterion, Stryker had a decent but not fantastic year in 2013. On closer inspection, you will find that many companies reporting apparently large earnings are really performing like weekend duffers when the cost of equity is included.

We will look at the difference between accounting and economic prof- its again in more detail in Chapter 8 under the rubric of economic value added, or EVA. In recent years, EVA has become a popular yardstick for assessing company and managerial performance.

In sum, those of us interested in financial analysis eventually develop a love-hate relationship with accountants. The value problem means that financial statements typically yield distorted information about company earnings and market value. This limits their applicability for many impor- tant managerial decisions. Yet financial statements frequently provide the best information available, and if we bear their limitations in mind, they can be a useful starting point for analysis. In the next chapter, we consider the use of accounting data for evaluating financial performance.

SUMMARY

1. The cash flow cycle • Describes the flow of cash through a company. • Illustrates that profits and cash flow are not the same. • Reminds a manager she must be at least as concerned with cash flows

Analysis for Financial Management

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