Introduction to Financial Statement Analysis Chapter 2 Introduction to Financial Statement Analysis

Chapter Outline 2.1 The Disclosure of Financial Information 2.2 The Balance Sheet 2.3 The Income Statement 2.4 The Statement of Cash Flows 2.5 Other Financial Statement Information 2.6 Accounting Manipulation Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Learning Objectives List the four major financial statements required by the SEC for publicly traded firms, define each of the four statements, and explain why each of these financial statements is valuable. Discuss the difference between book value of stockholders’ equity and market value of stockholders’ equity; explain why the two numbers are almost never the same. Compute the following measures, and describe their usefulness in assessing firm performance: the debt-equity ratio, the enterprise value, earnings per share, operating margin, net profit margin, accounts receivable days, accounts payable days, inventory days, interest coverage ratio, return on equity, return on assets, price- earnings ratio, and market-to-book ratio. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Learning Objectives (cont'd) Describe the importance of ensuring that valuation ratios are consistent with one another in terms of the inclusion of debt in the numerator and the denominator. Distinguish between cash flow, as reported on the statement of cash flows, and accrual-based income, as reported on the income statement; discuss the importance of cash flows to investors, relative to accrual-based income. Explain the importance of the notes to the financial statements. List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.1 Disclosure of Financial Information Financial Statements Firm-issued accounting reports with past performance information Filed with the SEC 10Q Quarterly 10K Annual Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.1 Disclosure of Financial Information (cont'd) Preparation of Financial Statements Generally Accepted Accounting Principles (GAAP) Auditor Neutral third party that checks a firm’s financial statements To obtain reasonable assurance about whether the financial statements are free of material misstatement Statements are in conformity with accounting principles generally accepted in the U.S. (GAAP) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.1 Disclosure of Financial Information (cont'd) Types of Financial Statements Balance Sheet Income Statement Statement of Cash Flows Statement of Stockholders’ Equity Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet A snapshot in time of the firm’s financial position The Balance Sheet Identity: Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Assets Liabilities Stockholder’s Equity What the company owns Liabilities What the company owes Stockholder’s Equity The difference between the value of the firm’s assets and liabilities Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Assets Current Assets: Cash or expected to be turned into cash in the next year Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Pre-paid expenses Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Assets Long-Term Assets Net Property, Plant, & Equipment Book Value Depreciation Goodwill Amortization Other Long-Term Assets Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Table 2.1 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Liabilities Current Liabilities: Due to be paid within the next year Accounts Payable Notes Payable/Short-Term Debt Current Maturities of Long-Term Debt Other Current Liabilities Taxes Payable Wages Payable Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Liabilities Long-Term Liabilities Long-Term Debt Capital Leases Long term leases on capital equipment Deferred Taxes Occur when the financial income differs from taxable income. Eventually the difference will have to be made up Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Table 2.1 (cont'd) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Net Working Capital Current Assets – Current Liabilities For Global Conglomerate Corp. (2005) = $57M - $48M = $9 Million Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Equity Book Value of Equity Book Value of Assets – Book Value of Liabilities Could possibly be negative Market Value of Equity (Market Capitalization) Market Price per Share Number of Shares Outstanding Cannot be negative Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.1 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.1 (cont'd) Market Capitalization = $14 X 3.6 million Book value of Equity = $22.2 million Market to Book Ratio = 50.4/22.2 = 2.27 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Alternative Example 2.1 Problem Rylan Enterprises has 5 million shares outstanding. The market price per share is $22. The firm’s book value of equity is $50 million. What is Rylan’s market capitalization? How does the market capitalization compare to Rylan’s book value of equity? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Alternative Example 2.1 Solution Rylan’s market capitalization is $110 million 5 million shares × $22 share = $110 million. The market capitalization is significantly higher than Rylan’s book value of equity of $50 million. Market to Book Ratio is ??? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Balance Sheet Analysis Liquidation Value Value of the firm if all assets were sold and liabilities paid Unless there is reason to believe otherwise, usually we assume the Book Value of Assets is the liquidation value of the firm Market-to-Book Ratio Value Stocks Low M/B ratios Growth stocks High M/B ratios Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Balance Sheet Analysis Debt-Equity Ratio Measures a firm’s leverage Using Book Value versus Market Value Enterprise Value Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Computing Enterprise Value (Cont.) Enterprise Value = Market Cap (MC) + Debt – Cash Market Cap = $36.87 * 347.6 = $12.82B [BV of] Debt = MC * Debt to Equity Ratio /Market to Book MVE * BVD/BVE * BVE/MVE = $12.82B * 1.80/4.93 = Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Computing Enterprise Value (Cont.) Enterprise Value = Market Cap (MC) + Debt – Cash Market Cap = $36.87 * 347.6 = $12.82B [BV of] Debt = MC * Debt to Equity Ratio /Market to Book MVE * BVD/BVE * BVE/MVE = $12.82B * 1.80/4.93 = $4.68B Cash = $1.08B Enterprise Value = $12.82 + $4.68 - $1.08 = $16.42 B Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Other Balance Sheet Information Current Ratio Current Assets / Current Liabilities For Global = Quick Ratio (Current Assets – Inventories) / Current Liabilities Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.2 Balance Sheet (cont'd) Other Balance Sheet Information Current Ratio Current Assets / Current Liabilities For Global = 1.19 Quick Ratio (Current Assets – Inventories) / Current Liabilities For Global = 0.87 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement Lists the firms revenues and expenses over time (in contrast to the balance sheet, it is a flow, not a stock or snapshot) Gives Net Income (bottom line) or Earnings over some period of time Sometimes referred to as P & L Statement Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Table 2.2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement Total Sales orRevenues Cost of Sales Gross Profit minus Cost of Sales equals Gross Profit Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Gross Profit minus Operating Expenses Selling, General, and Administrative Expenses R&D Depreciation & Amortization equals Operating Income Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Operating Income Plus or minus Other Income or Other Expenses equals Earnings Before Interest and Taxes (EBIT) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Earnings Before Interest and Taxes (EBIT) Plus or minus Interest Income or Interest Expense equals Pre-Tax Income Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Pre-Tax Income minus Taxes equals Net Income Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Earnings per Share Employee Stock Options Convertible Bonds Dilution Fully Diluted EPS E.g. suppose Global has 2 million shares in stock options outstanding and convertible bonds that can be converted to 1 million shares of stock, then fully diluted EPS is: 0.513 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis Profitability Ratios (For Global = Operating Margin Net Profit Margin Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis Profitability Ratios Operating Margin (For Global = 10.4/186.7 = 5.57%) Net Profit Margin (For Global = 2/186.7 = 1.07%) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis Working Capital Days Accounts Receivable Days For Global = 18.5/.511 = 36 days Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis EBITDA = Earnings Before Interest Taxes Depreciation and Amortization = EBIT + Depreciation and Amortization For Global = 10.4 + 1.2 = 11.6 It represents the cash available to pay the “claimants to that cash” i.e. Stockholders, bondholders and the Government Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis Leverage Ratios or Interest Coverage Ratios EBIT / Interest Expense Operating Income / Interest Expense EBITDA / Interest Expense Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis Investment Returns ROA Net Income / Total Assets ROE Valuation Ratios P/E Ratio Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.3 Income Statement (cont'd) Income Statement Analysis For Global Investment Returns ROA = 2/177.7 = 1.13% ROE = 2/22.2 = 9.01% PE Ratio = 14/1.25 = 17.5 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.3 Continued WMT TGT Operating Margin 5.90% 7.66% Net Profit Margin 3.47% 4.04% P/E Ratio 22.80% 23.68% Enterprise Value (EV) 255 53 [EV/Operating Income] 15.00 14.72 [EV/Sales] .89 1.13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.4 Statement of Cash Flows Net Income typically does NOT equal the amount of Cash the firm has earned. Non-Cash Expenses Depreciation and Amortization Uses of Cash not on the Income Statement Investment in Property, Plant, and Equipment Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.4 Statement of Cash Flows (cont'd) Three Sections Operating Activities Investment Activities Financing Activities Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.4 Statement of Cash Flows (cont'd) Operating Activities Adjusts net income by all non-cash items related to operating activities and changes in net working capital Accountants Depreciate fixed assets rather than account for them when they are actually paid for. So for example, a purchase of a machine of $1 million will “use” 1 million dollars in Cash, but this does not appear on the income statement. What does appear is the depreciation associated with passed purchases of fixed assets. So we must adjust net income for this Depreciation Expense that is not a cash expense, and the investment expense which is. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.4 Statement of Cash Flows (cont'd) Changes in Non-Cash Working Capital: =  Accounts Receivable –  Accounts Payable +  Inventory Notice that increases in Accounts Receivable means we did not get the cash that was recorded in sales (Decreasing Cash), increases in Accounts Payable means we did not pay the cost of goods sold (Increasing Cash), and increases in inventory means we recorded an expense (to create the inventory) but it was not part of Cost of Goods Sold (Deceasing Cash) So we must adjust Net Income by subtracting Changes in Non-Cash net working Capital. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.4 Statement of Cash Flows (cont'd) Investing Activities Capital Expenditures or Sales Buying or Selling Marketable Securities Financing Activities Changes in Borrowings or Equity Increases in Borrowing – Decreases in Borrowing + Equity Issue – Equity repurchases Payment of Dividends Retained Earnings Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Example 2.4 (cont'd) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.5 Other Financial Statement Information Management Discussion and Analysis Off-Balance Sheet Transactions Statement of Stockholders’ Equity Notes to the Financial Statements Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

2.6 Accounting Manipulation Enron WorldCom Sarbanes-Oxley Act (SOX) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Questions? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.