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Inventories 905 5
Prepaid taxes and other expenses 570 3

Total current assets $ 4,604 25%
Property, plant, and equipment (net of depreciation) $ 5,438 30%
Net intangible assets 4,485 24
Other assets 3,812 21

Total assets $18,339 100%

Liabilities and stockholders™ equity
Current liabilities
Loans payable $ 72 0%
Accounts payable and other current liabilities 3,815 21
Income taxes due 48 0
Total current liabilities 3,935 21
Long-term debt 2,346 13
Deferred income taxes 1,361 7
Other long-term liabilities 3,448 19

Total liabilities $11,090 60%
Stockholders™ equity
Common stock, par value $ 29 0%
Additional paid-in capital 955 5
Retained earnings 15,448 84
Cumulative foreign currency adjustments (1,263) (7)
Treasury stock (at cost) (7,920) (43)

Total stockholders™ equity $ 7,249 40%
Total liabilities and stockholders™ equity $18,339 100%


Note: Column sums subject to rounding error.
Source: PepsiCo Annual Report, 2000.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




454 Part FOUR Security Analysis


or book value of the firm. Stockholders™ equity is divided into par value of stock, capital sur-
plus (additional paid-in capital), and retained earnings, although this division is usually unim-
portant. Briefly, par value plus capital surplus represents the proceeds realized from the sale
of stock to the public, while retained earnings represent the buildup of equity from profits
plowed back into the firm. Even if the firm issues no new equity, book value will increase each
year by reinvested earnings.
The first column of numbers in the balance sheet in Table 13.2 presents the dollar value of
each asset. To make it easier to compare firms of different sizes, analysts sometimes present
each item on the balance sheet as a percentage of total assets. This is called a common-size
balance sheet and is presented in the last column of the table.



The Statement of Cash Flows
The statement of cash flows replaces what used to be called the statement of changes in fi-
statement of
nancial position or flow of funds statement. It is a report of the cash flow generated by the
cash flows
firm™s operations, investments, and financial activities. This statement was mandated by the
A financial statement
Financial Accounting Standards Board in 1987 and is sometimes called the FASB Statement
showing a firm™s cash
No. 95.
receipts and cash
payments during While the income statement and balance sheets are based on accrual methods of account-
a specified period. ing, which means revenues and expenses are recognized when incurred even if no cash has yet
been exchanged, the statement of cash flows recognizes only transactions in which cash
changes hands. For example, if goods are sold now, with payment due in 60 days, the income
statement will treat the revenue as generated when the sale occurs, and the balance sheet will
be immediately augmented by accounts receivable, but the statement of cash flows will not
recognize the transaction until the bill is paid and the cash is in hand.
Table 13.3 is the 2000 statement of cash flows for PepsiCo. The first entry listed under cash
flows from operations is net income. The entries that follow modify that figure by components
of income that have been recognized but for which cash has not yet changed hands. Increases
in accounts receivable, for example, mean income has been claimed on the income statement,
but cash has not yet been collected. Hence, increases in accounts receivable reduce the cash
flows realized from operations in this period. Similarly, increases in accounts payable mean
expenses have been incurred, but cash has not yet left the firm. Any payment delay increases
the company™s net cash flows in this period.
Another major difference between the income statement and the statement of cash flows in-
volves depreciation, which accounts for a substantial addition in the adjustment section of the
statement of cash flows in Table 13.3. The income statement attempts to “smooth” large cap-
ital expenditures over time to reflect a measure of profitability not distorted by large, infre-
quent expenditures. The depreciation expense on the income statement is a way of doing this
by recognizing capital expenditures over a period of many years rather than at the specific
time of those expenditures.
The statement of cash flows, however, recognizes the cash implication of a capital expen-
diture when it occurs. It will ignore the depreciation “expense” over time but will account for
the full capital expenditure when it is paid.
Rather than smooth or allocate expenses over time, as in the income statement, the state-
ment of cash flows reports cash flows separately for operations, investing, and financing ac-
tivities. This way, any large cash flows such as those for big investments can be recognized
explicitly as nonrecurring without affecting the measure of cash flow generated by operating
activities.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




455
13 Financial Statement Analysis


Cash flows from operating activities
TA B L E 13.3 Net income $ 2,183
Consolidated Adjustments to reconcile net income to net cash
statement of cash
provided by operating activities:
flows for PepsiCo,
Depreciation and amortization $960
Inc., for the year
Other 250
ended December 31,
Changes in operating assets and liabilities:
2000 (figures in
Decrease (increase) in accounts receivable (15)
millions)
Decrease (increase) in inventories (26)
Increase (decrease) in accounts payable 245
Decrease (increase) in other current assets 0
Increase (decrease) in taxes payable 314
Total adjustments $ 1,728
Net cash provided by operating activities $ 3,911
Cash flows from investing activities
Cash provided (used) for additions to
(disposal of) property, plant, and equipment $(1,014)
Acquisitions of businesses (65)
Short-term investments (634)
Net cash provided (used) in investing activities $(1,713)
Cash flow from financing activities
Proceeds from exercise of stock option
and purchase plans $559
Proceeds from issuance of long-term debt 130
Repayment of long-term debt (795)
Increase (decrease) in loans payable 0
Dividends paid (796)
Share repurchases (1,430)
Other 34
Net cash provided by (used in) financing activities $(2,298)
Effect of exchange rate changes 0
Net increase (decrease) in cash and cash equivalents $ (100)

Note: Column sums subject to rounding error.
Source: PepsiCo Annual Report, 2000.


The second section of the statement of cash flows is the accounting of cash flows from in-
vesting activities. These entries are investments in the capital stock necessary for the firm to
maintain or enhance its productive capacity.
Finally, the last section of the statement lists the cash flows realized from financing activi-
ties. Issuance of securities will contribute positive cash flows, and redemption of outstanding
securities will use up cash. For example, Pepsi repurchased $1,430 million of outstanding
shares during 2000, which was a use of cash. However, it issued new long-term debt amount-
ing to $130 million, which was a source of cash. The $796 million it paid in dividends reduced
net cash flow. Notice that while dividends paid are included in the cash flows from financing,
interest payments on debt are included with operating activities, presumably because, unlike
dividends, interest payments are not discretionary.
The statement of cash flows provides evidence on the well-being of a firm. If a company
cannot pay its dividends and maintain the productivity of its capital stock out of cash flow
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




456 Part FOUR Security Analysis


from operations, for example, and it must resort to borrowing to meet these demands, this is a
serious warning that the firm cannot maintain payout at its current level in the long run. The
statement of cash flows will reveal this developing problem when it shows that cash flow from
operations is inadequate and that borrowing is being used to maintain dividend payments at
unsustainable levels.

13.2 ACCOUNTING VERSUS ECONOMIC EARNINGS
We™ve seen that stock valuation models require a measure of economic earnings or sustainable
cash flow that can be paid out to stockholders without impairing the productive capacity of the
firm. In contrast, accounting earnings are affected by several conventions regarding the val-
accounting
uation of assets such as inventories (e.g., LIFO versus FIFO treatment) and by the way some
earnings
expenditures such as capital investments are recognized over time (as depreciation expenses).
Earnings of a firm
We will discuss problems with some of these accounting conventions in greater detail later in
as reported on its
the chapter. In addition to these accounting issues, as the firm makes its way through the busi-
income statement.
ness cycle, its earnings will rise above or fall below the trend line that might more accurately
reflect sustainable economic earnings. This introduces an added complication in interpreting
economic
net income figures. One might wonder how closely accounting earnings approximate eco-
earnings
nomic earnings and, correspondingly, how useful accounting data might be to investors at-
The real flow of cash
tempting to value the firm.
that a firm could pay
In fact, the net income figure on the firm™s income statement does convey considerable in-
out forever in the
absence of any formation concerning a firm™s products. We see this in the fact that stock prices tend to in-
change in the firm™s crease when firms announce earnings greater than market analysts or investors had
productive capacity.
anticipated. There are several studies to this effect. We showed you one such study in Chapter
8, Figure 8.5, which documented that firms that announced accounting earnings in excess of
market expectations enjoyed increases in stock prices, while shares of firms that announced
below-expected earnings fell in price.

13.3 RETURN ON EQUITY
Past versus Future ROE
We noted in Chapter 12 that return on equity (ROE) is one of the two basic factors in deter-
return on equity
mining a firm™s growth rate of earnings. Sometimes it is reasonable to assume that future ROE
(ROE)
will approximate its past value, but a high ROE in the past does not necessarily imply a firm™s
The ratio of
future ROE will be high. A declining ROE, on the other hand, is evidence that the firm™s new
net profits to
investments have offered a lower ROE than its past investments. The vital point for a security
common equity.
analyst is not to accept historical values as indicators of future values. Data from the recent
past may provide information regarding future performance, but the analyst should always
keep an eye on the future. Expectations of future dividends and earnings determine the intrin-
sic value of the company™s stock.


Financial Leverage and ROE
An analyst interpreting the past behavior of a firm™s ROE or forecasting its future value must
pay careful attention to the firm™s debt“equity mix and to the interest rate on its debt. An ex-
ample will show why. Suppose Nodett is a firm that is all-equity financed and has total assets
of $100 million. Assume it pays corporate taxes at the rate of 40% of taxable earnings.
Table 13.4 shows the behavior of sales, earnings before interest and taxes, and net profits
under three scenarios representing phases of the business cycle. It also shows the behavior of
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




457
13 Financial Statement Analysis


Sales EBIT ROA Net Profit ROE
TA B L E 13.4 Scenario ($ millions) ($ millions) (% per year) ($ millions) (% per year)
Nodett™s profitability
Bad year $ 80 $5 5% $3 3%
over the
business Normal year 100 10 10 6 6
cycle Good year 120 15 15 9 9



Nodett Somdett
TA B L E 13.5
ROE†
EBIT Net Profits ROE Net Profits*
Impact of financial
Scenario ($ millions) ($ millions) (%) ($ millions) (%)
leverage on ROE

Bad year $5 $3 3% $1.08 1.8%
Normal year 10 6 6 4.08 6.8
Good year 15 9 9 7.08 11.8

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