Workshop: A Review of Financial Statements with Analysis Professors Tom Byers and Randy Komisar Stanford University With special thanks to: Roma Jhaveri, Ben Hallen, Filipe Santos, Yosem Companys Copyright © 2008 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be reproduced for educational purposes only.

Goals of the Workshop Review main accounting documents and financial analysis Balance Sheet Income Statement (Statement of Operations) Statement of Cash Flows

How Does It All Add Up Income Expenses Assets Liabilities When you get paid for a product or service… Income Expenses When you buy something… Assets often generate income Liabilities often generate expenses Assets Liabilities The value of anything you own… The value of anything you borrow…

Some Accounting Principles Accounting items are classified into “accounts” according to their nature, translated into monetary units, and organized in statements Basic Accounting formula: Assets = Liabilities + Equity What the company owns How the ownership of assets was financed (By third parties or by the owners)

Accounting vs. Market Value Equity: Ownership of a company is divided in certificates called common shares Accounting Value (or Book Value) = Equity = Assets – Liabilities Accounting Value is different from Market Value !!! Market Value = Share Price * Number of Common Shares Outstanding

Income Statement Reports the economic results of a company over a time period. It shows the derivation of earnings or losses. Income Statement of XXX Corp. – year 2009 $ % Rev. + Revenues - Cost of Revenue (product cost or COGS) = Gross Margin Sales and Marketing General and Administrative Research & Development Depreciation and Amortization = Operating Income (EBIT) + Interest Income(expense) net = Net Income before Taxes - Income Tax Provision - Extraordinary Items = Net Income

Income Statement - Analysis When does a transaction affect income? - When it changes the economic value of the company for the owners Some Profitability Measures: Gross Margin (%) = Gross Profit / Sales Operating Margin = Operating Income / Sales Return on Sales = Net Income / Sales Return on Equity = Net Income / Shareholders’ Equity Other Important Measures Earnings Per Common Share (EPS) = Net Income / Common Shares Price Earnings Ratio (P/E) = Market Price / Earnings Per Share

Income Statement - Example The following information was taken from the 2009 financial statements of Wellogg Company. Dollar amounts are in millions. Cost of goods sold $ 4,128.5 Selling & admin. expenses 3,523.6 Interest expense 351.5 Other expense 54.0 Net sales 8,853.3 Income tax expense 322.1

Income Statement - Example WELLOGG COMPANY Income Statement For the Year Ended December 31, 2009 Net sales $ 8,853.3 Cost of goods sold 4,128.5 Gross Profit 4,724.8 Selling & admin. expense 3,523.6 Income from Operations 1,201.2 Interest expense 351.5 Other expense 54.0 Net Income Before Taxes 795.7 Income tax expense 322.1 Net Income $ 473.6

Balance Sheet It is a financial snapshot of a company at a given point in time Balance Sheet of XXX Corp. - 31 December of 2009 (in thousand $) Cash and Equivalents Accounts Receivable Inventories Accounts Payable Accrued Expenses Short Term debt Current Liabilities (payable in less than a year) Long-Term Liabilities (bonds issued, bank loans) Shareholders’ Equity Current Assets (liquid in less than a year) Fixed Assets Other Assets Property, plant and equipment (minus Depreciation) Common Stock Additional Paid-in Capital Retained Earnings Intangibles (minus depreciation) Investment Securities Total Assets = Total Liabilities + Shareholder’s Equity

Balance Sheet - Analysis Working Capital: measure of the amout of cash available in the short-term; Also, indication of the funds needed operate within a given business size = Current Assets – Current Liabilities Liquidity ratios: measures of the ability to meet short term financial obligations Current Ratio: Current Assets / Current Liabilities Acid-test: (Cash + Accounts receivable) / Current Liabilities Operational Efficiency Measures Inventory Turnover = Cost of Sales per year / Current Inventory Accounts Receivable Collection Period = accounts receivable / sales Accounts Payable Collection Period = accounts payable / cost of sales

Balance Sheet - Example These financial statement items are for Tweeter Entertainment Group at year-end on September 30, 2009. (in millions) Accounts payable $ 38.6 Property, plant & equipment 109.1 Receivables 31.3 Other current liabilities 23.3 Stockholders’ equity 332.4 Cash 3.3 Long-term debt 36.7 Inventories 129.2 Accrued expenses 38.9 Other current assets 7.5 Other liabilities 10.5 Other assets 200.0

Balance Sheet - Example TWEETER HOME ENTERTAINMENT GROUP Balance Sheet (in millions) September 30, 2009 Assets Current assets Cash $ 3.3 Receivables 31.3 Inventories 129.2 Other current assets 7.5 Total current assets 171.3 Property, plant & equipment 109.1 Other assets 200.0 Total assets $ 480.4 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $ 38.6 Accrued expenses 38.9 Other current liabilities 23.3 Total current liabilities 100.8 Long-term debt 36.7 Other liabilities 10.5 Total liabilities 148.0 Stockholders’ equity 332.4 Total liab. & stock. equity $ 480.4

Statement of Cash Flows The Statement of Cash Flows reports cash receipts and payments over a period, separating operational, investing and financing activities. Statement of Cash Flows of XXX Corp. – 2009 $ + Cash Flow from operating activities (reconciled from income statement) = income - net changes in working capital (except cash and equivalents) + depreciation and amortization + Cash Flow from investing activities + Cash Flow from financing activities = Net Change in Cash or Equivalents + Cash or Equivalents at beginning of period = Cash or Equivalents at end of period

Statement of Cash Flows - Analysis How is cash flow different from income? Income accrual is not necessarily linked to cash transactions (e.g., depreciation, sales by credit) Some activities affect cash flows but not income (e.g., investments in fixed assets, additional capital from shareholders) Growth often absorbs cash flow because of a higher need for working capital and fixed investments (Entrepreneurial firms with negative income and high growth can have a very fast cash burn rate)

Statement of Cash Flows - Example SIERRA CORPORATION Statement of Cash Flows For the Month Ended October 31, 2009 Cash flows from operating activities Cash receipts from operating activities $ 11,200 Cash payments for operating activities (5,500) Net cash provided by operating activities $ 5,700 Cash flows from investing activities Purchased office equipment (5,000) Net cash used by investing activities (5,000) Cash flows from financing activities Issuance of common stock 10,000 Issued note payable 5,000 Payment of dividend 500 Net cash provided by financing activities 14,500 Net increase in cash 15,200 Cash at beginning of period 0 Cash at end of period 15,200