1. ©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

2. ©Cambridge Business Publishers, 2013 Overview of Business Activities and Financial Statements Module 2:

3. ©Cambridge Business Publishers, 2013 Four Main Financial Statements Balance Sheet Balance Sheet Income Statement Income Statement Statement of Stockholders’ Equity Statement of Stockholders’ Equity Statement of Cash Flows Statement of Cash Flows

4. ©Cambridge Business Publishers, 2013 Balance Sheet Mirrors the Accounting Equation Mirrors the Accounting Equation Assets = Liabilities + Equity Assets = Liabilities + Equity Uses of funds = Sources of funds Uses of funds = Sources of funds Assets are listed in order of liquidity Assets are listed in order of liquidity Liabilities are listed in order of maturity Liabilities are listed in order of maturity Equity consists of Contributed Capital and Retained Earnings Equity consists of Contributed Capital and Retained Earnings

5. ©Cambridge Business Publishers, 2013 Assets To be reported on a balance sheet, an asset must 1. Be owned (or controlled) by the company 2. Must possess expected future economic benefits Assets are listed in order of liquidity Current assets comprise assets that can be converted to cash within a year Current assets comprise assets that can be converted to cash within a year Long-term assets cannot be easily converted to cash within a year. Long-term assets cannot be easily converted to cash within a year.

6. ©Cambridge Business Publishers, 2013 Examples of Current Assets Cash—currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents); Cash—currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents); Marketable securities—short-term investments that can be quickly sold to raise cash; Marketable securities—short-term investments that can be quickly sold to raise cash; Accounts receivable, net—amounts due to the company from customers arising from the sale of products and services on credit (“net” refers to uncollectible accounts explained in Module 6); Accounts receivable, net—amounts due to the company from customers arising from the sale of products and services on credit (“net” refers to uncollectible accounts explained in Module 6); Inventory—goods purchased or produced for sale to customers; Inventory—goods purchased or produced for sale to customers; Prepaid expenses—costs paid in advance for rent, insurance, advertising or other services. Prepaid expenses—costs paid in advance for rent, insurance, advertising or other services.

7. ©Cambridge Business Publishers, 2013 Examples of Long-term Assets Property, plant and equipment (PPE), net—land, factory buildings, warehouses, office buildings, machinery, motor vehicles, office equipment and other items used in operating activities (“net” refers to subtraction of accumulated depreciation, the portion of the assets’ cost that has been transferred from the balance sheet to the income statement, which is explained in Module 6); Property, plant and equipment (PPE), net—land, factory buildings, warehouses, office buildings, machinery, motor vehicles, office equipment and other items used in operating activities (“net” refers to subtraction of accumulated depreciation, the portion of the assets’ cost that has been transferred from the balance sheet to the income statement, which is explained in Module 6); Long-term investments—investments that the company does not intend to sell in the near future; Long-term investments—investments that the company does not intend to sell in the near future; Intangible and other assets—assets without physical substance, including patents, trademarks, franchise rights, goodwill and other costs the company incurred that provide future benefits. Intangible and other assets—assets without physical substance, including patents, trademarks, franchise rights, goodwill and other costs the company incurred that provide future benefits.

8. ©Cambridge Business Publishers, 2013 Apple’s Assets

9. ©Cambridge Business Publishers, 2013 Cisco Systems, Inc. Assets

10. ©Cambridge Business Publishers, 2013 Assets are Reported at Historical Cost Historical Cost is Historical Cost is Objective Objective Verifiable Verifiable “Relevance vs. Reliability” “Relevance vs. Reliability” Only include items that can be reliably measured. Only include items that can be reliably measured. Considerable amount of “assets” may not be reflected on a balance sheet Considerable amount of “assets” may not be reflected on a balance sheet Strong management team, a well-designed supply chain, or superior technology Strong management team, a well-designed supply chain, or superior technology

11. ©Cambridge Business Publishers, 2013 Knowledge Based Assets are not Reflected on the Balance Sheet NOTE: While resources expended for research and development reflect and economic asset, they generally are expensed as incurred. NOTE: While resources expended for research and development reflect and economic asset, they generally are expensed as incurred. INSIGHT: Pharmaceutical firms do not have assets reflecting the full amount of money that they have spent developing drugs. These amounts, for the most part, have been expensed in the past and serve to reduce retained earnings. Internally developed trade marks are also economic assets, but may not show up on the balance sheet. [The purchase of externally developed trademarks are treated as assets.] INSIGHT: Pharmaceutical firms do not have assets reflecting the full amount of money that they have spent developing drugs. These amounts, for the most part, have been expensed in the past and serve to reduce retained earnings. Internally developed trade marks are also economic assets, but may not show up on the balance sheet. [The purchase of externally developed trademarks are treated as assets.]

12. ©Cambridge Business Publishers, 2013 Disney’s Assets Where’s Mickey? The market value of the Mickey Mouse trademark does not explicitly show up here.

13. ©Cambridge Business Publishers, 2013 Apple’s Liabilities and Equity

14. ©Cambridge Business Publishers, 2013 Examples of Current Liabilities Accounts payable —amounts owed to suppliers for goods and services purchased on credit. Accounts payable —amounts owed to suppliers for goods and services purchased on credit. Accrued liabilities —obligations for expenses that have been incurred but not yet paid; examples are accrued wages payable (wages earned by employees but not yet paid), accrued interest payable (interest that is owing but has not been paid), and accrued income taxes (taxes due). Accrued liabilities —obligations for expenses that have been incurred but not yet paid; examples are accrued wages payable (wages earned by employees but not yet paid), accrued interest payable (interest that is owing but has not been paid), and accrued income taxes (taxes due). Unearned revenues —obligations created when the company accepts payment in advance for goods or services it will deliver in the future; also called advances from customers, customer deposits, or deferred revenues. Unearned revenues —obligations created when the company accepts payment in advance for goods or services it will deliver in the future; also called advances from customers, customer deposits, or deferred revenues. Short-term notes payable —short-term debt payable to banks or other creditors. Short-term notes payable —short-term debt payable to banks or other creditors. Current maturities of long-term debt —principal portion of long-term debt that is due to be paid within one year. Current maturities of long-term debt —principal portion of long-term debt that is due to be paid within one year.

15. ©Cambridge Business Publishers, 2013 Cisco systems, Inc. Current Liabilities

16. ©Cambridge Business Publishers, 2013 Net Working Capital Net working capital = Current assets – Current liabilities

17. ©Cambridge Business Publishers, 2013 Operating Cycle

18. ©Cambridge Business Publishers, 2013 Examples of Noncurrent Liabilities Long-term debt — amounts borrowed from creditors that are scheduled to be repaid more than one year in the future; any portion of long-term debt that is due within one year is reclassified as a current liability called current maturities of long-term debt. Long-term debt includes bonds, mortgages, and other long-term loans. Long-term debt — amounts borrowed from creditors that are scheduled to be repaid more than one year in the future; any portion of long-term debt that is due within one year is reclassified as a current liability called current maturities of long-term debt. Long-term debt includes bonds, mortgages, and other long-term loans. Other long-term liabilities — various obligations, such as pension liabilities and long-term tax liabilities, that will be settled a year or more into the future. We discuss these items in later modules. Other long-term liabilities — various obligations, such as pension liabilities and long-term tax liabilities, that will be settled a year or more into the future. We discuss these items in later modules.

19. ©Cambridge Business Publishers, 2013 Cisco Systems, Inc. Long-term Liabilities

20. ©Cambridge Business Publishers, 2013 Equity Equity consists of: Contributed Capital (cash raised from the issuance of shares) Contributed Capital (cash raised from the issuance of shares) Earned Capital (retained earnings). Retained Earnings is updated each period as follows: Earned Capital (retained earnings). Retained Earnings is updated each period as follows:

21. ©Cambridge Business Publishers, 2013 Examples of Equity Accounts Common stock —par value received from the original sale of common stock to investors. Common stock —par value received from the original sale of common stock to investors. Preferred stock —value received from the original sale of preferred stock to investors; preferred stock has fewer ownership rights compared to common stock. Preferred stock —value received from the original sale of preferred stock to investors; preferred stock has fewer ownership rights compared to common stock. Additional paid-in capital —amounts received from the original sale of stock to investors in addition to the par value of common stock. Additional paid-in capital —amounts received from the original sale of stock to investors in addition to the par value of common stock. Treasury stock —amount the company paid to reacquire its common stock from shareholders. Treasury stock —amount the company paid to reacquire its common stock from shareholders. Retained earnings —accumulated net income (profit) that has not been distributed to stockholders as dividends. Retained earnings —accumulated net income (profit) that has not been distributed to stockholders as dividends. Accumulated other comprehensive income or loss — accumulated changes in equity that are not reported in the income statement (explained in Module 9). Accumulated other comprehensive income or loss — accumulated changes in equity that are not reported in the income statement (explained in Module 9).

22. ©Cambridge Business Publishers, 2013 Cisco Systems, Inc. Stockholders’ Equity

23. ©Cambridge Business Publishers, 2013 Income Statement

24. ©Cambridge Business Publishers, 2013 Apple’s Income Statement

25. ©Cambridge Business Publishers, 2013 Cisco Systems, Inc. Income Statement

26. ©Cambridge Business Publishers, 2013 When are Revenues and Expenses Recognized? Revenue Recognition Principle—recognize revenues when earned Revenue Recognition Principle—recognize revenues when earned Matching Principle—recognize expenses when incurred Matching Principle—recognize expenses when incurred

27. ©Cambridge Business Publishers, 2013 Profit vs. Cash Net Income does not necessarily correspond to a net cash flow. A firm could have “good income” but “poor cash flow” or vice versa (i.e., there are two dimensions to consider). Net Income does not necessarily correspond to a net cash flow. A firm could have “good income” but “poor cash flow” or vice versa (i.e., there are two dimensions to consider). We have previously summarized the mechanics of the balance sheet with the expanded accounting equation: We have previously summarized the mechanics of the balance sheet with the expanded accounting equation:

28. ©Cambridge Business Publishers, 2013 Operating vs. Nonoperating Operating expenses are the usual and customary costs that a company incurs to support its main business activities Operating expenses are the usual and customary costs that a company incurs to support its main business activities Nonoperating expenses relate to the company’s financing and investing activities Nonoperating expenses relate to the company’s financing and investing activities

29. ©Cambridge Business Publishers, 2013 Transitory Items in the Income Statement

30. ©Cambridge Business Publishers, 2013 Transitory Items Discontinued operations Gains or losses (and net income or loss) from business segments that are being sold or have been sold in the current period. Discontinued operations Gains or losses (and net income or loss) from business segments that are being sold or have been sold in the current period. Extraordinary items Gains or losses from events that are both unusual and infrequent. Extraordinary items Gains or losses from events that are both unusual and infrequent.

31. ©Cambridge Business Publishers, 2013 Accrual Accounting Accrual accounting refers to the recognition of revenue when earned (even if not received in cash) and the matching of expenses when incurred (even if not paid in cash).

32. ©Cambridge Business Publishers, 2013 Statement of Stockholders’ Equity Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’ equity accounts. Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’ equity accounts. Main equity categories are: Main equity categories are: Contributed capital Contributed capital Retained earnings (including Other Comprehensive Income or OCI) Retained earnings (including Other Comprehensive Income or OCI) Treasury stock Treasury stock

33. ©Cambridge Business Publishers, 2013 Apple’s Statement of Stockholders’ Equity

34. ©Cambridge Business Publishers, 2013 Statement of Cash Flows Statement of cash flows (SCF) reports cash inflows and outflows Statement of cash flows (SCF) reports cash inflows and outflows Cash flows are reported based on the three business activities of a company: Cash flows are reported based on the three business activities of a company: Cash flows from operating activities - Cash flows from the company’s transactions and events that relate to its operations. Cash flows from operating activities - Cash flows from the company’s transactions and events that relate to its operations. Cash flows from investing activities - Cash flows from acquisitions and divestitures of investments and long-term assets. Cash flows from investing activities - Cash flows from acquisitions and divestitures of investments and long-term assets. Cash flows from financing activities - Cash flows from issuances of and payments toward borrowings and equity. Cash flows from financing activities - Cash flows from issuances of and payments toward borrowings and equity.

35. ©Cambridge Business Publishers, 2013 Apple’s Statement of Cash Flows

36. ©Cambridge Business Publishers, 2013 Cisco Systems Statement of Cash Flows

37. ©Cambridge Business Publishers, 2013 Relation of SCF to Income Statement and Balance Sheet

38. ©Cambridge Business Publishers, 2013 General Coding of Balance sheet Changes

39. ©Cambridge Business Publishers, 2013 Working Capital Accounts

40. ©Cambridge Business Publishers, 2013 Articulation of Financial Statements Financial statements are linked within and across time – they articulate. Financial statements are linked within and across time – they articulate. Balance sheet and income statement are linked via retained earnings. Balance sheet and income statement are linked via retained earnings.

41. ©Cambridge Business Publishers, 2013 Apple’s Retained Earnings Reconciliation

42. ©Cambridge Business Publishers, 2013

43. Recording transactions – Pay $100 Wages in Cash ■Cash assets are reduced by $100, and wage expense of $100 is reflected in the income statement, which reduces income and retained earnings by that amount. ■All transactions incurred by the company during the accounting period are recorded similarly.

44. ©Cambridge Business Publishers, 2013 Adjusting Accounts

45. ©Cambridge Business Publishers, 2013 Prepaid Rent

46. ©Cambridge Business Publishers, 2013 Unearned Revenue

47. ©Cambridge Business Publishers, 2013 Accrual of Wages

48. ©Cambridge Business Publishers, 2013 Accrual of Revenue

49. ©Cambridge Business Publishers, 2013 Exercise: The Ice Cream Store, Inc. The Ice Cream Store, Inc. incurred the following start-up costs: 1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 in cash by the owners. 2. Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations. 3. Purchased equipment for $25,000 cash on October 2. 4. Acquired a building at a cost of $80,000. It was financed by making a $20,000 down-payment and obtaining a mortgage for the balance. The transaction occurred on October 2. 5. On October 2, the President of the United States publicly declared that she will eat (and plug) our ice cream while entertaining guests in the White House. Prepare a transaction analysis of 1. – 5. using the financial statement effects template.

50. ©Cambridge Business Publishers, 2013 Balance Sheet Income Statement TransactionCash Asset+ Noncash Assets = Liabi -lities + Contrib. capital + Retained Earnings Revenues– Expenses 1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 by the owners. +90 2. Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations. +35 N/P 3. Purchased equipment for $25,000 cash on October 2. -25 +25 Equip 4. Acquired a building at a cost of $80,000. It was financed by making a $20,000 down- payment and obtaining a mortgage for the balance. The transaction occurred on October 2. -20 +80 Bldg. +60 M/P 5. The President of the United States agreed to eat (and plug) our ice cream while entertaining guests in the White House on Oct. 2.

51. ©Cambridge Business Publishers, 2013 ASSETS Cash $80,000 Equipment 25,000 Building 80,000 Total Assets $185,000 LIABILITY AND STOCKHOLDERS' EQUITY Liabilities: Note Payable $35,000 Mortgage Payable 60,000 Total Liabilities 95,000 Stockholders Equity: Capital Stock 90,000 Total Liabilities and Stockholders Equity $185,000 Ice Cream Shop Balance Sheet:

52. ©Cambridge Business Publishers, 2013 Ice Cream Shop – Additional Transactions 6. On October 4, purchased merchandise inventory (i.e., ice cream) at a cost of $15,000 by paying $5,000 cash and receiving short-term credit for the remainder from the supplier. 7. Immediately returned some of the ice cream because some of the flavors delivered were not ordered. The cost of the inventory returned was $3,000. 8. Sales of ice cream for the month of October, 20XX, totaled $8,000. All sales were for cash. The ice cream cost $3,500. 9. For all of October, total employee wages and salaries earned/paid were $3,000. continued

53. ©Cambridge Business Publishers, 2013 Ice Cream Shop – Additional Transactions continued 10. As of the end of October, one month's depreciation on the equipment and building was recognized -- $383 for the building and $167 for the equipment. 11. $450 interest expense on the note and mortgage was due and paid on October 31. Assume that the principal amounts ($35,000 + $60,000) of the note and mortgage remain unchanged. Prepare a transaction analysis of 6. -11. using the balance sheet/income statement template presented above.

54. ©Cambridge Business Publishers, 2013 Balance Sheet Income Statement Transaction Cash Asset +Noncash Assets= Liabi- lities + Contrib. capital + Retained Earnings Revenues– Expenses 6. -5 +15 Inv. +10 A/P 7. -3 Inv. -3 A/P 8. +8 -3.5 Inv. +4.5 +8 Sales -3.5 COGS 9. -3. Wage exp. 10. -.383 Bldg., net -.167 Equip., net -.550 Dep. exp. 11. -.450 Int. Exp. Prepare the following financial statements (ignore income taxes): (i) an updated Balance Sheet as of October 31, 20XX; and (ii) an Income Statement for the month of October 20XX.

55. ©Cambridge Business Publishers, 2013 Cash ($80,000 -5,000 +8,000 -3,000 -450) $79,550. Merchandise Inventory ($0 + 15,000 -3,000 -3,500) 8,500. Equipment ($25,000 ) 25,000. Less: Accumulated Depreciation (383) Building ($80,000) 80,000. Less: Accumulated Depreciation(167) Total Assets $192,500. Accounts Payable ($0 + 10,000 – 3,000) $7,000. Note Payable ($35,000 principal is unchanged) 35,000. Mortgage Payable (60,000 principal is unchanged) 60,000. 102,000. Stockholders' Equity: Capital Stock 90,000. Retained Earnings 500. 90,500. Total Liabilities and Stockholders' Equity $192,500.

56. ©Cambridge Business Publishers, 2013 REVENUES: Sales of Ice Cream $8,000 Cost of Sales 3,500 GROSS PROFIT:4,500 Payroll Expense 3,000 Depreciation Expense550 INCOME FROM OPERATIONS950 Interest Expense450 NET INCOME$500 Note: Assume no income taxes.

57. ©Cambridge Business Publishers, 2013 Preparing the Financial Statements

58. ©Cambridge Business Publishers, 2013 Balance Sheet and Income Statement

59. ©Cambridge Business Publishers, 2013 Statement of Cash Flows

60. ©Cambridge Business Publishers, 2013 Statement of Stockholders’ Equity

61. ©Cambridge Business Publishers, 2013 Additional Sources of Information Form 10-K Form 10-K Item 1, Business; Item 1A. Risk Factors; Item 1, Business; Item 1A. Risk Factors; Item 2, Properties; Item 2, Properties; Item 3, Legal Proceedings; Item 3, Legal Proceedings; Item 4, Submission of Matters to a Vote of Security Holders; Item 4, Submission of Matters to a Vote of Security Holders; Item 5, Market for Registrant’s Common Equity and Related Stockholder Matters; Item 5, Market for Registrant’s Common Equity and Related Stockholder Matters; Item 6, Selected Financial Data; Item 6, Selected Financial Data; Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations; Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations; Item 7A, Quantitative and Qualitative Disclosures About Market Risk; Item 7A, Quantitative and Qualitative Disclosures About Market Risk; Item 8, Financial Statements and Supplementary Data; Item 8, Financial Statements and Supplementary Data; Item 9, Changes in and Disagreements With Accountants on Accounting and Financial Disclosure; Item 9, Changes in and Disagreements With Accountants on Accounting and Financial Disclosure; Item 9A, Controls and Procedures. Item 9A, Controls and Procedures.

62. ©Cambridge Business Publishers, 2013 Additional Sources of Information Form 8-K Form 8-K Entry into or termination of a material definitive agreement (including petition for bankruptcy) Entry into or termination of a material definitive agreement (including petition for bankruptcy) Exit from a line of business or impairment of assets Exit from a line of business or impairment of assets Change in the company’s certified public accounting firm Change in the company’s certified public accounting firm Change in control of the company Change in control of the company Departure of the company’s executive officers Departure of the company’s executive officers Changes in the company’s articles of incorporation or bylaws Changes in the company’s articles of incorporation or bylaws

63. ©Cambridge Business Publishers, 2013 Global Accounting Balance Sheet The most visible difference is that the typical IFRS- based balance sheet is presented in reverse order of liquidity. Balance Sheet The most visible difference is that the typical IFRS- based balance sheet is presented in reverse order of liquidity. Income Statement The most visible difference is that GAAP requires three years’ data on the income statement whereas IFRS requires only two. Income Statement The most visible difference is that GAAP requires three years’ data on the income statement whereas IFRS requires only two. Statement of Cash Flows One of the more apparent differences between GAAP and IFRS is that a GAAP-based statement of cash flows classifies interest expense, interest revenue, and dividend revenue as operating cash flows, and dividends paid as financing cash flows. IFRS allows firms to choose from between the following two options: Statement of Cash Flows One of the more apparent differences between GAAP and IFRS is that a GAAP-based statement of cash flows classifies interest expense, interest revenue, and dividend revenue as operating cash flows, and dividends paid as financing cash flows. IFRS allows firms to choose from between the following two options: 1. Classify interest expense, dividends paid, interest revenue, and dividend revenue as operating cash flows, or 2. Classify interest expense and dividends paid as financing cash flows, and interest revenue and dividend revenue as investing cash flows.

64. ©Cambridge Business Publishers, 2013 Analyst Reports

65. ©Cambridge Business Publishers, 2013 Credit and Data Services Credit Analysis Credit Analysis Standard & Poor’s (StandardAndPoors.com) Standard & Poor’s (StandardAndPoors.com) Moody’s Investors Service (Moodys.com) Moody’s Investors Service (Moodys.com) Fitch Ratings (FitchRatings.com) Fitch Ratings (FitchRatings.com) Data Services Data Services Thomson Corporation (Thomson.com) Thomson Corporation (Thomson.com) First Call - summary of analysts’ earnings forecasts First Call - summary of analysts’ earnings forecasts Compustat database - individual data items for all publicly traded companies or for any specified subset of companies. Compustat database - individual data items for all publicly traded companies or for any specified subset of companies.

66. ©Cambridge Business Publishers, 2013 End Module 2