Financial Statements Gitman/Madura Chapter 8 Lecture notes 8

Why Read or Care? Investment strategies –Growth Use accounting numbers to estimate growth –Value Compare accounting numbers to price

Goals Accounting statements Financial ratios Ratios and valuation

Accounting Statements Income statement Balance sheet Statement of retained earnings Statement of cash flows

Income Statement Flow variables Revenues – Cost of goods sold

Income Statement Example Total revenues $50 Labor and other operating expenses $-25 –(for goods sold) Advertising + Admin. expenses $-5 Depreciation $-5 Interest payments $-5 Taxes $-5 Earnings = $5 EBIT = Earnings before interest and taxes –= = $15

Balance Sheet Accounting Value of the Firm Assets (things firm owns) Liabilities (Loans) Stockholders’ equity –(Assets - Liabilities) –Also called Book value Net worth

Assets Cash Accounts receivable Inventories Land Plant and equipment –Less: Depreciation

Liabilities Accounts payable Notes payable (short term debt) Long term debt

Balance Sheet Assets –Cash $5 –Plant and equipment $100 Liabilities –Accounts payable $1 –Long term debt $75 Stockholder equity = $29

Retained Earnings Statement Cumulative sums of retained earnings RE = retained earnings New RE = Old RE + Earnings - Dividends

Cash Flow Pure measure of incoming - outgoing cash Differences with income statement –No depreciation –No accounts payable/receivable –Inventories (account for costs of producing and putting in inventory)

Cash Flow Parts Operating Activities Investment Activities Financial Activities

Operating Cash Flow Earnings = $5 –Adjust to get to cash flow Depreciation : +5 –Why? Remove depreciation adjustments Increase in accounts payable: +5 –Why? Haven’t paid this yet. Increase in accounts receivable: -2 –Why? Haven’t received this yet. Increase in inventories: -10 –Production costs reflect only goods sold. –Adjustment: = 3 = operating cash flow

Investment Cash Flow Increase in gross fixed assets Purchases of new plant and equipment -30 million : New office building Total investment cash flow = -30 million

Finance Cash Flow Increase in long term debt: +50 million of incoming funds Dividends: -20 million payout of divs Total finance cash flow = +30 million

Goals Accounting statement Financial Ratios Ratios and valuation

Financial Ratios Ratios of various financial variables Uses –Analyze financial well being of a firm –Compare different stocks in terms of current values “Find good investments”

Ratios Profitability ratios Market ratios Debt ratios Other ratios –Why skipping many in book

Profitability: Gross Profit Margin

Profitability: Earnings for Shareholders Earnings available for common shareholders –Revenues minus Costs of goods sold (production) Operating expenses Interest Taxes Preferred dividends Final earnings left for shareholders (earnings)

Profitability: Net profit margin

Profitability: Earnings per Share (EPS) Key ratio!!!

Return on Total Assets (ROA)

Return on Common Equity (ROE) Common stock holder Equity –Balance sheet book value assigned to common stock –Net worth – preferred stock (valued at par)

Market Ratios Share price versus accounting value Very important Examples –Price/Earnings ratio –Market/Book (M/B) ratio

Price Earnings Ratio P/E Ratio

Price Earnings Ratio Price per earnings Example: –Microsoft About 30 $30 per $1 of earnings

Compare to Earnings Growth P = y(1+g)/(k-g) P/E = (1+g)/(k-g) Try –k = 0.07 (close to average real return) –g = 0.02 (close to average real growth of economy) –gives P/E for stock –20

High Flying P/E’s AOL (1999) near 600 Dell Computer (1999) 100 These require higher growth rates, but maybe not much higher –1/( ) = 100 –6% growth forever is pretty big For many dot com’s no P/E since earnings are zero

Market to Book Ratio (M/B)

Market to Book Ratio Market value of the firm relative to its accounting value Key tool for “value investors” Extensive academic evidence that low market to book firms do better on average

Debt Ratio

Dividend Payout Net Income –Dividends –Retained Earnings Dividend Payout ratio = Divs/Earnings

Problems for Other Ratios Might vary a lot across industries Example: –Total asset turnover –Think about consulting firm versus a steel mill

Goals Accounting statement Financial Ratios Ratios and valuation

Fundamental Analysis Use information about firm to evaluate stock price Growth –Estimate earnings growth and future prospects Value –Find “undervalued” stocks

Ratio Analysis Many methods Compare ratios to appropriate comparison set Example: –P/E ratio for a pharmaceutical firm –Compare to industry –If low -> buy

Problems With Accounting Information Misses “intangibles” –Knowledge base (patents) –Customer base Sometimes numbers are zero –Dot coms often have zero earnings

More Problems with Accounting Information There are many ways to derive accounting numbers Large “fudge factors” Can clever accountants make things look better?

Accounting “Tricks” Off balance sheet items –Enron –Stock options Capital depreciation tricks –Worldcom –AOL Taking over low p/e firms

Fundamental Analysis Weaknesses Bad data Bad interpretation of data (growth rates) Market efficiency: –Semi-strong efficiency: Prices should reflect all public information Market inefficiency (prices may not adjust to where they should go)

Goals Accounting statement Financial Ratios Ratios and valuation