Chapter 2 Introduction to Financial Statement Analysis

2-2 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

Disclosure of Financial Information Financial Statements  Firm-issued accounting reports with past performance information  Filed with the SEC 10Q (Quarterly) 10K (Annual) Other – 8K, proxy statements Preparation of Financial Statements  Generally Accepted Accounting Principles (GAAP)  Auditor -- Neutral third party that checks a firm’s financial statements

Disclosure of Financial Information (cont'd) Types of Financial Statements  Balance Sheet  Income Statement  Statement of Cash Flows  Statement of Stockholders’ Equity

Balance Sheet A snapshot in time of the firm’s financial position The Balance Sheet Identity:

Balance Sheet (cont'd) Assets  What the company owns Liabilities  What the company owes Stockholder’s Equity  The difference between the value of the firm’s assets and liabilities

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

Balance Sheet (cont'd) Assets  Long-Term Assets Net Property, Plant, & Equipment  Book Value  Depreciation Goodwill  Amortization Other Long-Term Assets

2-9 Table 2.1

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

Balance Sheet (cont'd) Liabilities  Long-Term Liabilities Long-Term Debt Capital Leases Deferred Taxes

2-12 Table 2.1 (cont'd)

Balance Sheet (cont'd) Net Working Capital  Current Assets – Current Liabilities

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

2-15 Example 2.1

2-16 Example 2.1 (cont'd)

2-17 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?

2-18 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.

Balance Sheet (cont'd) Balance Sheet Analysis  Liquidation Value Value of the firm if all assets were sold and liabilities paid  Market-to-Book Ratio Value Stocks  Low M/B ratios Growth stocks  High M/B ratios

Balance Sheet (cont'd) Balance Sheet Analysis  Debt-Equity Ratio Measures a firm’s leverage Using Book Value versus Market Value  Enterprise Value

2-21 Example 2.2

2-22 Example 2.2 (cont'd)

Balance Sheet (cont'd) Other Balance Sheet Information  Current Ratio Current Assets / Current Liabilities  Quick Ratio (Current Assets – Inventories) / Current Liabilities

Income Statement Total Sales/Revenues - Cost of Sales = Gross Profit Gross Profit - Operating Expenses = Operating Income Operating Expenses: Selling, General, and Administrative Expenses R&D Depreciation & Amortization

Income Statement (cont'd) Operating Income - Other Income/Expenses = Earnings Before Interest and Taxes (EBIT) EBIT - Interest Expense = Pre-Tax Income Pre-Tax Income – Taxes = Net Income

2-26 Table 2.2

Income Statement (cont'd) Earnings per Share

Income Statement (cont'd) Income Statement Analysis Gross Margin = Gross Profit / Total Sales Operating Margin Net Profit Margin

Income Statement (cont'd) Asset Turnover = Total Revenue / Total Assets Accounts Receivable Days

Income Statement (cont'd)  Interest Coverage Ratios EBIT / Interest Expense Operating Income / Interest Expense EBITDA / Interest Expense

Income Statement (cont'd)  Investment Returns ROA  Net Income / Total Assets ROE  Valuation Ratios P/E Ratio

2-32 Example 2.3

2-33 Example 2.3 (cont'd)

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

Statement of Cash Flows (cont'd) Three Sections  Operating Activities  Investment Activities  Financing Activities

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 An increase in current assets is a use of funds A decrease in current assets is a source of funds An increase in current liabilities is a source of funds A decrease in current liabilities is a use of funds

Statement of Cash Flows (cont'd) Investing Activities  Capital Expenditures  Buying or Selling Marketable Securities Financing Activities  Changes in Borrowings  Payment of Dividends and Retained Earnings

2-38

2-39 Example 2.4

2-40 Example 2.4 (cont'd)