Relying entirely on a firm’s statement of cash flows while ignoring its income statement is

Robert C. Higgins

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

Analysis for Financial Management

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

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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

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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In memory of my son

STEVEN HIGGINS

1970–2007

vi

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

xi

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

st

Di vid

end s

Inventory

Accounts receivable

Fixed assets

Cash salesP ro

du cti

on

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

g

In ve

st in

g

Fi na

nc in

g

Equity at end

Balance sheets

Cash flow statement

Income statement

E xp

en se

s

R ev

en ue

s

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

© Stryker.

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.