1. Introduction to Financial Statement Analysis
Chapter 2
Introduction to Financial Statement Analysis

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
2.5 Other Financial Statement Information
2.6 Accounting Manipulation
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3. 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.
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4. 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.
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5. 2.1 Disclosure of Financial Information
Financial Statements
Firm-issued accounting reports with past performance information
Filed with the SEC
10Q
Quarterly
10K
Annual
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6. 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)
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7. 2.1 Disclosure of Financial Information (cont'd)
Types of Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholders’ Equity
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8. 2.2 Balance Sheet A snapshot in time of the firm’s financial position
The Balance Sheet Identity:
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9. 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
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10. 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
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11. 2.2 Balance Sheet (cont'd) Assets Long-Term Assets
Net Property, Plant, & Equipment
Book Value
Depreciation
Goodwill
Amortization
Other Long-Term Assets
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12. Table 2.1
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13. 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
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14. 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
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15. Table 2.1 (cont'd)
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16. 2.2 Balance Sheet (cont'd) Net Working Capital
Current Assets – Current Liabilities
For Global Conglomerate Corp. (2005)
= $57M - $48M = $9 Million
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17. 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
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18. Example 2.1
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19. 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
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20. 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?
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21. 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 ???
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22. 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
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23. 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
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24. Example 2.2
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25. Computing Enterprise Value (Cont.)
Enterprise Value = Market Cap (MC) + Debt – Cash
Market Cap = $36.87 * = $12.82B
[BV of] Debt = MC * Debt to Equity Ratio /Market to Book
MVE * BVD/BVE * BVE/MVE
= $12.82B * 1.80/4.93 =
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26. Computing Enterprise Value (Cont.)
Enterprise Value = Market Cap (MC) + Debt – Cash
Market Cap = $36.87 * = $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 = $ $ $1.08 = $16.42 B
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27. 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
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28. 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
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29. 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
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30. Table 2.2
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31. 2.3 Income Statement Total Sales orRevenues Cost of Sales Gross Profit
minus
Cost of Sales
equals
Gross Profit
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32. 2.3 Income Statement (cont'd)
Gross Profit
minus
Operating Expenses
Selling, General, and Administrative Expenses
R&D
Depreciation & Amortization
equals
Operating Income
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33. 2.3 Income Statement (cont'd)
Operating Income
Plus or minus
Other Income or Other Expenses
equals
Earnings Before Interest and Taxes (EBIT)
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34. 2.3 Income Statement (cont'd)
Earnings Before Interest and Taxes (EBIT)
Plus or minus
Interest Income or Interest Expense
equals
Pre-Tax Income
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35. 2.3 Income Statement (cont'd)
Pre-Tax Income
minus
Taxes
equals
Net Income
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36. 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:
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37. 2.3 Income Statement (cont'd)
Income Statement Analysis
Profitability Ratios (For Global =
Operating Margin
Net Profit Margin
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38. 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%)
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39. 2.3 Income Statement (cont'd)
Income Statement Analysis
Working Capital Days
Accounts Receivable Days
For Global = 18.5/.511 = 36 days
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40. 2.3 Income Statement (cont'd)
Income Statement Analysis
EBITDA = Earnings Before Interest Taxes Depreciation and Amortization
= EBIT + Depreciation and Amortization
For Global = = 11.6
It represents the cash available to pay the “claimants to that cash” i.e. Stockholders, bondholders and the Government
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41. 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
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42. 2.3 Income Statement (cont'd)
Income Statement Analysis
Investment Returns
ROA
Net Income / Total Assets
ROE
Valuation Ratios
P/E Ratio
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43. 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
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44. Example 2.3
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45. Example 2.3 Continued WMT TGT Operating Margin 5.90% 7.66%
Net Profit Margin % %
P/E Ratio % %
Enterprise Value (EV)
[EV/Operating Income]
[EV/Sales]
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46. 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
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48. 2.4 Statement of Cash Flows (cont'd)
Three Sections
Operating Activities
Investment Activities
Financing Activities
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49. 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.
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50. 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.
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51. 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
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52. Example 2.4
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53. Example 2.4 (cont'd)
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54. 2.5 Other Financial Statement Information
Management Discussion and Analysis
Off-Balance Sheet Transactions
Statement of Stockholders’ Equity
Notes to the Financial Statements
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55. 2.6 Accounting Manipulation
Enron
WorldCom
Sarbanes-Oxley Act (SOX)
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56. Questions?
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