Understanding Financial Statements Chris Droussiotis June 2011

2 Table of Contents Accounting Definitions, Terms and Concepts Using Financial Statements Financial Ratio Analysis These slides could be obtain via the Instructor’s Web page at

3 Accounting Definitions and Concepts A = L + NW A = Assets L = Liabilities NW = Net Worth OwnOweKeep (Value Creation) Similar Concepts in Other Areas of Finance: Consumer finance: Value of the House = Mortgage + Equity Corporation Value: Enterprise Value = Net Debt + Equity Investments: Value of the Investment: Margin Loan + Equity How did you pay for the Assets that you own

4 Accounting Definitions and Concepts Book Value Vs Market Value Book Value  Accounting  Fixed Assets  Corporate Taxation Market Value  Finance  Financial Assets  Investment Taxation

5 Accounting Definitions and Concepts Income Vs Cash The Perfect World: Every business is run like a lemonade Stand

6 Accounting Definitions and Concepts Income Vs Cash Not So Perfect World: The world of IOUs

7 Financial Statements – Other Terms  General Accepted Accounting Standards (GAPP)  Who Needs Financial Statements?  IRS and Tax Authorities  Public Investors ( regulated by Securities and Exchange Commission (SEC)  Financial Analysts – performance review  Banks and Financial Institutions  Management and Owners  Statements (Public Filing10K, 10Q)  Income Statement  Balance Sheet Statement  Cash Flow Statement

8 Income Statement  Measurement of Profit and Loss over a Period of Time  Top Line to Bottom Line  Revenue (Sales) Less Expenses = Profit or Loss

9 Income Statement

10 Balance Sheet Statement  It shows us on a snap shot the Wealth of the Company  The statement is set-up in Order of Liquidity

11 Balance Sheet Statement

12 Cash Flow Statement  It shows the Company’s Cash Inflow and Outflow over a period of time  Differences between Income Statement and Cash Flow Statement  Timing Differences (Working Capital Activities)  Capital Expenses Vs Operating Expenses (Investment Activities)  Financing Expenses not included in the Income Statement (Financing Activities)  Represents the changes from last Year’s Balance Sheet to this Year’s Balance Sheet  Asset goes Up = Cash Negative  Asset goes down = Cash Positive  Liability goes up = Cash Positive  Liability goes down = Cash Negative  Owner’s Equity goes up = Cash Positive  Owner’s Equity goes down = Cash Negative

13 Cash Flow Statement Adjusting Income to Cash

14 Cash Flow Statement Working Capital Activities

15 Cash Flow Statement Investment Activities

16 Cash Flow Statement Financing Activities

17 Cash Flow Statement Timing Differences (Working Capital Activities) Investment Activities Recap Financing Activities

18 Financial Analysis  Management Discussion and Analysis (MD&A)  Equity & Bond Research – Wall Street Analysts  The Financial Statements could be used by analysts to project the Company’s performance and valuation  For an effective performance of the Company, you need to ask the three following questions: 1. How is the Company doing versus Last Year 2. How is the Company doing versus its competitors / piers/ market 3. How is the Company doing versus expectations

19 Financial Ratio Analysis  Trend Analysis

20 Financial Ratio Analysis  Liquidity Ratio  How well the Company manages Cash

21 Financial Ratio Analysis  Solvency Ratio  How well the Company manages Debt

22 Financial Ratio Analysis  Activity and Operating Ratios  It measures productivity and efficiency for running the business Please note that there are a lot of ratios establish by specialization (i.e. for a Hotel company is Occupancy Rate or for a Cable company is revenue per subscriber)

23 Financial Ratio Analysis  Profitability Ratio  How profitable is the company