Introductory Corporate Finance: Financial Statement Analysis - Balance Sheet, Assets Liabilities Equity Liquidity Debt vs. Equity Financing

What This Is

A balance sheet is a financial statement that presents a company's financial position at a specific point in time. It consists of three main components: assets, liabilities, and equity. Assets represent what the company owns, liabilities represent what the company owes, and equity represents the company's net worth. For example, let's consider Tesla, Inc. (TSLA) as of 2022:

• Assets: $123.1 billion (cash, inventory, property, plant, and equipment)
• Liabilities: $63.4 billion (short-term debt, long-term debt, accounts payable)
• Equity: $59.7 billion (common stock, retained earnings)

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
• wd: weight of debt (proportion of debt in capital structure)
• rd: cost of debt (interest rate on debt)
• T: corporate tax rate
• wps: weight of preferred stock
• rps: cost of preferred stock
• we: weight of equity
• re: cost of equity (required rate of return on equity)
• DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage; measures EBIT sensitivity to sales.
• Q: sales volume
• P: price per unit
• V: variable costs per unit
• F: fixed costs
• DFL = EBIT / (EBIT + I) – debt-free leverage; measures EBIT sensitivity to interest expenses.
• EBIT: earnings before interest and taxes
• I: interest expenses
• ROE = Net Income / Total Equity – return on equity; measures profitability of equity.
• ROA = Net Income / Total Assets – return on assets; measures profitability of assets.
• Current Ratio = Current Assets / Current Liabilities – liquidity ratio; measures ability to pay short-term debts.
• Debt-to-Equity Ratio = Total Debt / Total Equity – capital structure ratio; measures proportion of debt in capital structure.
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – growth rate; measures maximum growth rate without external financing.

Step-by-Step Calculation

1. Compute free cash flow:
2. Free Cash Flow = EBIT + Depreciation - Capital Expenditures - Change in Working Capital
3. Example: EBIT = $10M, Depreciation = $2M, Capital Expenditures = $5M, Change in Working Capital = -$1M
4. Free Cash Flow = $10M + $2M - $5M - ($1M) = $6M
5. Calculate sustainable growth rate:
6. ROE = 15%
7. Retention Ratio = 40%
8. Sustainable Growth Rate = 15% × (1 - 40%) = 9%
9. Perform EBIT-EBITDA analysis:
10. EBIT = $10M, Interest Expenses = $2M, Tax Rate = 25%
11. EBITDA = EBIT + Interest Expenses = $10M + $2M = $12M
12. EBIT-EBITDA = EBIT - Interest Expenses = $10M - $2M = $8M
13. Compute debt-free leverage:
14. EBIT = $10M, Interest Expenses = $2M
15. DFL = $10M / ($10M + $2M) = 0.83

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
2. Correction: Use market value for WACC, as it reflects the current market price of the company's securities.
3. Counterexample: If a company's market value is $100M, but its book value is $50M, using book value would result in an incorrect WACC.
4. Mistake: Ignoring flotation costs when calculating WACC.
5. Correction: Include flotation costs in the WACC calculation, as they represent the costs associated with issuing new securities.
6. Counterexample: If a company issues $10M in new debt with a flotation cost of 2%, the correct WACC would be higher than if the flotation cost were ignored.
7. Mistake: Confusing sunk cost with opportunity cost.
8. Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs represent the benefits that could have been obtained by choosing an alternative option.
9. Counterexample: If a company has already invested $10M in a project, the sunk cost is $10M, but the opportunity cost is the potential benefit that could have been obtained by investing in an alternative project.

Exam / CFA Tips

1. Tip: Be careful when using the Modigliani-Miller (M&M) propositions, as they have specific assumptions and limitations.
2. Tip: Understand the difference between IRR and NPV, and when to use each.
3. Tip: Be aware of the dividend irrelevance theorem and its implications for capital structure decisions.

Quick Practice Problem

A company has EBIT of $10M, interest expenses of $2M, and a tax rate of 25%. Compute the debt-free leverage (DFL).

Answer: DFL = $10M / ($10M + $2M) = 0.83

Explanation: The debt-free leverage measures the sensitivity of EBIT to interest expenses, and in this case, it is 0.83, indicating that a 1% increase in interest expenses would result in a 0.83% decrease in EBIT.

Last-Minute Cram Sheet

1. WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital.
2. DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage.
3. DFL = EBIT / (EBIT + I) – debt-free leverage.
4. ROE = Net Income / Total Equity – return on equity.
5. ROA = Net Income / Total Assets – return on assets.
6. Current Ratio = Current Assets / Current Liabilities – liquidity ratio.
7. Debt-to-Equity Ratio = Total Debt / Total Equity – capital structure ratio.
8. Sustainable Growth Rate = ROE × (1 - Retention Ratio) – growth rate.
9. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
10. The dividend irrelevance theorem states that the value of a firm is independent of its dividend policy, but this is only true under certain assumptions.