In part one of Corporate Finance, I covered Capital Budgeting which helps a company make future investment decisions based on previous Financial Statements as a past reference. To effectively evaluate a company’s Financial Statements we must first calculate the company’s Income Statement. To do this we must start by subtracting Cost of Goods Sold (COGS) by Sales which equates to our Gross Profit. We then calculate in our expenses, which in the case of Corporate Finance would typically include: Research and Development (R&D) expenses, Selling, General and Administrative (SG&A) expenses, Depreciation and Amortization, Goodwill, add other income which would be written off as an expense, and altogether would equate to Earnings Before Interest and Taxes (EBIT). We’d then subtract Interest and Taxes which calculates into our Earnings After Tax (EAT) or Net Income. After this the Finance Manager may ration a percentage of this income back to shareholders in the form of dividends and the difference would make up our Retained Earnings.
We’ll also have to calculate our Balance Sheet’s Assets, Liabilities and Equity. We’ll start with Assets, we must first gather the sum of Cash, Accounts/Receivable (A/R), Inventory and other current assets to establish our Total Current Assets. We’d then add the long term assets such as Long Term Securities, Net Fixed Assets, Goodwill and other long term assets to establish our Total Long Term Assets which together with Total Current Assets equate to our Total Assets. We’ll do the same for Liabilities, add up our Short Term Debt, Accounts/Payable (A/P) and other current liabilities to establish our Total Current Liabilities. We’ll accumulate our Long Term Debt and other long term liabilities to establish our Total Long Term Liabilities which with our Total Current Liabilities make up our Total Liabilities. To calculate our Equity, we just add the sum of Common Stock, accumulated Retained Earnings, and other stockholders equity to make up our Total Stockholders Equity which with Total Liabilities make up our Total Liabilities and Equity. With our given information, a Finance Manager can calculate the ratios of the Income Statement and Balance Sheet such as Inventory Turnover, Total Debt to Equity, Dividend Payout Ratio and Return on Equity and Assets. We may also forecast future performance, which we’ll do for Microsoft in part 3.
Now that we’ve covered the Income Statement and Balance Sheet, we’ll now cover Working Capital which is essentially Current Assets minus Current Liabilities. The Working Capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates a negative W/C ratio, meanwhile 2 and above means that the company is not investing excess assets. A proper W/C ratio is believed to be somewhere between 1.2 and 2. With Working Capital established, we can calculate our Free Cash Flow (FCF) which measures financial performance of the company.
As a Finance Manager, we focus on deciphering the Financial Statements to focus on future expected cash flows and it’s inherent market value. Assessing a company’s Balance Sheet will allow the Finance Manager to evaluate the company’s cash flow from its assets to its creditors and stockholders. A company will receive their cash flow from assets or Free Cash Flow (FCF) by means of Operating Cash Flow (OCF), Net Capital Spending (NCS) and Change in Net Working Capital (ΔNWC). OCF is calculated from the sum of EBIT and depreciation deducted by taxes; NCS is the company’s net fixed assets subtracted by their beginning net fixed assets and in addition to depreciation; ΔNet Working Capital is simply the ending NWC minus the beginning NWC. Overall the formula for FCF = OCF – NCS – ΔNWC, which I’ll use to calculate Microsoft’s valuation.
From Free Cash Flow we can then calculate our Weighted Average Cost of Capital (WACC), which derives from the Capital Structure where the Value of a company is comprised of Equity and Debt. WACC = (Equity/Value) x Rate of Equity + (Debt/Value) x Rate of Debt x (1 – T). The (1 – T) constitutes the tax shield for those claiming allowed deductions such as a mortgage, depreciation or donations. The WACC takes into account the contrast between a company’s debt to equity ratio which is an important concept of Capital Structure. The major theory of Capital Structure emphasizes whether a company benefits more from leveraging Debt, Equity or both. For example, Apple is a company that leverages Equity as they do not incur either short term or long term debt, whereas Microsoft incurs such debt.
In the next and final lesson in this series I’ll cover Microsoft’s Pro Forma Forecasting and Valuation, following Microsoft’s earnings call.
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