1. Financial Statements Gitman/Madura Chapter 8 Lecture notes 8

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

3. Goals Accounting statements Financial ratios Ratios and valuation

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

5. Income Statement Flow variables Revenues – Cost of goods sold

6. 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 50-25-5-5-5-5 = $5 EBIT = Earnings before interest and taxes –= 50-25-10 = $15

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

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

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

10. Balance Sheet Assets –Cash $5 –Plant and equipment $100 Liabilities –Accounts payable $1 –Long term debt $75 Stockholder equity 105-76 = $29

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

12. 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)

13. Cash Flow Parts Operating Activities Investment Activities Financial Activities

14. 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: 5+5+5-2-10 = 3 = operating cash flow

15. 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

16. 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

17. Goals Accounting statement Financial Ratios Ratios and valuation

18. 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”

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

20. Profitability: Gross Profit Margin

21. 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)

22. Profitability: Net profit margin

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

24. Return on Total Assets (ROA)

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

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

27. Price Earnings Ratio P/E Ratio

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

29. 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

30. High Flying P/E’s AOL (1999) near 600 Dell Computer (1999) 100 These require higher growth rates, but maybe not much higher –1/(0.07-0.06) = 100 –6% growth forever is pretty big For many dot com’s no P/E since earnings are zero

31. Market to Book Ratio (M/B)

32. 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

33. Debt Ratio

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

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

36. Goals Accounting statement Financial Ratios Ratios and valuation

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

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

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

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

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

42. 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)

43. Goals Accounting statement Financial Ratios Ratios and valuation