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Interpreting Financial Statements

ObjectiveContrast Economic and

Accounting Models<=>

Value of Accounting Information

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ContentsContents

• Functions of Financial Functions of Financial StatementsStatements

• Review of Financial Review of Financial StatementsStatements

• Analysis Using Financial Analysis Using Financial Ratios Ratios

• Working CapitalWorking Capital

• Constructing a Financial Constructing a Financial Planning ModelPlanning Model

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Functions of Financial Statements• Financial Statements:

– Provide information to the owners & creditors of a firm about the current status and past performance

– Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm

– Provide a convenient templates for financial planning

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Review of Financial Statements

•Balance Sheet

•Income Statement

•Statement of Cash Flow

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The Balance Sheet• Summarizes a firms assets, liabilities, and

owner’s equity at a moment in time

• Prepared according to GAAP, Generally Accepted Accounting Principles– GAAP modified occasionally by the Financial

Accounting Standards Board

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The Balance Sheet

• Major Divisions:– Assets

• Current assets (less than a year)

• Long-term assets (longer than a year– Depreciation

– Liabilities and Stockholder’s Equity• Liabilities

– Current Liabilities– Long-term debt

• Equity

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GPC Balance Sheet at Dec 31, 2xx1

2xx0 2xx1 ChangeAssetsCash & mkt'ble secs 100.0 120.0 20.0 Receivables 50.0 60.0 10.0 Inventories 150.0 180.0 30.0 *Current assets 300.0 360.0 60.0

Pp&e 400.0 490.0 90.0 Acc depreciation (100.0) (130.0) (30.0) *Net pp&e 300.0 360.0 60.0

**Total Assets 600.0 720.0 120.0

Liabilities & EquityAccounts payable 60.0 72.0 12.0 Short-term debt 90.0 184.6 94.6 *Current liabilities 150.0 256.6 106.6

Long-term debt 150.0 150.0 - **Total liabilities 300.0 406.6 106.6

Paid-in capital 200.0 200.0 - Retained earnings 100.0 113.4 13.4 *Shareholders equ 300.0 313.4 13.4

Liab + Shareholder 600.0 720.0 120.0

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The Income Statement• Summarizes the profitability of a

company during a time period

• Major Divisions:– Revenue & cost of goods sold

» Gross margin

– General administrative and selling expenses (GS&A)

» Operating income

– Debt service » Taxable income

– Corporate Taxes » Net income

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GPC Income Statement for Year Ending 2xx1

Sales revenues 200.0 Cost of goods sold (110.0) *Gross margin 90.0

Gen sell, & admin exp (30.0) *Operating income 60.0

Interest expense (21.0) *Taxable income 39.0

Income tax (15.6) *Net income 23.4

Allocation to divs (10.0) *Chg retained earn 13.4

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The Cash-Flow Statement

• Show the cash that flowed into and from a firm in during a time period– Focuses attention on a firm’s cash situation

• A firm may be profitable and short of cash

– Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods • The IRS uses accounting income to compute

tax, so accounting rules have a second order effect on cash flows through taxes

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GPC Cash Flow Statement, forthe Year ending Dec 31, 2xx0

Net income 23.4 + Depreciation 30.0 - Increase in acc rec (10.0) - Increase in invent (30.0) + Increase in acc rec 12.0 *Total cash from operations 25.4

- Invest in new ppe (90.0) *Cash flow invest' activities (90.0)

-Div paid (10.0) + Inc short-term debt 94.6 *Cash flow from financing 84.6

**Chng cash & mkt securities 20.0

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GPC Balance Sheet at Dec 31, 2xx1

2xx0 2xx1 ChangeAssetsCash & mkt'ble secs 100.0 120.0 20.0 Receivables 50.0 60.0 10.0 Inventories 150.0 180.0 30.0 *Current assets 300.0 360.0 60.0

Pp&e 400.0 490.0 90.0 Acc depreciation (100.0) (130.0) (30.0) *Net pp&e 300.0 360.0 60.0

**Total Assets 600.0 720.0 120.0

Liabilities & EquityAccounts payable 60.0 72.0 12.0 Short-term debt 90.0 184.6 94.6 *Current liabilities 150.0 256.6 106.6

Long-term debt 150.0 150.0 - **Total liabilities 300.0 406.6 106.6

Paid-in capital 200.0 200.0 - Retained earnings 100.0 113.4 13.4 *Shareholders equ 300.0 313.4 13.4

Liab + Shareholder 600.0 720.0 120.0

GPC Income Statement for Year Ending 2xx1

Sales revenues 200.0 Cost of goods sold (110.0) *Gross margin 90.0

Gen sell, & admin exp (30.0) *Operating income 60.0

Interest expense (21.0) *Taxable income 39.0

Income tax (15.6) *Net income 23.4

Allocation to divs (10.0) *Chg retained earn 13.4

GPC Cash Flow Statement, forthe Year ending Dec 31, 2xx0

Net income 23.4 + Depreciation 30.0 - Increase in acc rec (10.0) - Increase in invent (30.0) + Increase in acc pay 12.0 *Total cash from operations 25.4

- Invest in new ppe (90.0) *Cash flow invest' activities (90.0)

-Div paid (10.0) + Inc short-term debt 94.6 *Cash flow from financing 84.6

**Chng cash & mkt securities 20.0

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Financial Ratios• Return Ratios

• Profitability Ratios

• Liquidity Ratios

• Shareholder Ratios

• Leverage Ratios

• Activity Ratios

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Examples: Return Ratios

%6.72/4.313300

4.23

sEquityr'StockHolde

NetIncome (RoE)Equity on Return

%1.92/720600

60

alAssetsAverageTot

EBIT (RoA) Assetson Return

%30200

60Sales

EBIT (RoS) Saleson Return

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Examples: Activity Ratios

Times 3.02/720600

200

Assets Total Average

Sales Turnover Asset

Times 7.02/180150

110

Inventory Average

Sold Goods ofCost Turnover Inventory

Times 6.32/6050

200

sReceivable Average

Sales Turnover sReceivable

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Example: Financial Leverage

Times 3.14.313

6.406

Equity

Debt Total Equity Debt to

%57720

6.406Assets Total

Debt Total Assets Debt to

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Examples: Liquidity Ratios

Times 7.06.256

180360sLiabilitieCurrent

Inventory - AssetsCurrent RatioQuick

Times 4.16.256

360sLiabilitieCurrent

AssetsCurrent RatioCurrent

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Examples: Shareholder Ratios

0.84.23

2.187

income)(net Earnings

tionCapitalizaMarket Earnings toPrice

See Yahoo Finance for Additional Shareholder Ratios

Market Capitalization = Share Price x Shares Outstanding

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Ratio Comparisons• Establish Your Perspective

• Shareholder

• employee, Management, or Union

• Creditor

• Predator, Customer, Supplier, Competitor, Trade Association

• Establish Benchmarks• Other companies ratios

• The firm’s historical ratios

• Data extracted from financial markets

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Working Capital• Represents the amount of day-by-day operating

liquidity available to a business

• Working Capital = Current Assets – Current Liabilities

• Example: Working Capital = 360 – 256.6 = 103.4

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Year's Sales)

Year xxx0 xxx1 xxx2 xxx3 xxx1 xxx2 xxx3

Income StatementSales 200 240 288 100.0% 100.0% 100.0%Cost of goods sold 110 132 158 55.0% 55.0% 55.0%Gross margin 90 108 130 45.0% 45.0% 45.0%Selling, general & admin. expenses 30 36 43 15.0% 15.0% 15.0%EBIT 60 72 86 30.0% 30.0% 30.0%Interest expences 30 45 64 15.0% 18.8% 22.2%Taxes 12 11 9 6.0% 4.5% 3.1%Net income 18 16 13 9.0% 6.7% 4.7%Dividends 5 5 4 2.7% 2.0% 1.4%Change in shareholder's equity 13 11 9 6.3% 4.7% 3.3%

Balance SheetAssets: Cash & equivalents 10 12 14 17 6.0% 6.0% 6.0% Receivables 40 48 58 69 24.0% 24.0% 24.0% Inventories 50 60 72 86 30.0% 30.0% 30.0% Property, Plant & equipment 500 600 720 864 300.0% 300.0% 300.0% Total Assets 600 720 864 1037 360.0% 360.0% 360.0%Liabilities: Payables 30 36 43 52 18.0% 18.0% 18.0% Short-term debt 120 221 347 502 110.7% 144.6% 174.2% Long-term debt 150 150 150 150 75.0% 62.5% 52.1% Total Liabilities 300 407 540 704 203.7% 225.1% 244.3%Shareholder's equity 300 313 324 333 156.3% 134.9% 115.7%

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(Nearest $ Million) Year xxx0 xxx1 xxx2 xxx3

Income StatementSales 200 240 288Cost of goods sold 110 132 158Gross margin 90 108 130Selling, general & admin. expenses 30 36 43EBIT 60 72 86Interest expences 30 45 64Taxes 12 11 9Net income 18 16 13Dividends 5 5 4Change in shareholder's equity 13 11 9

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Balance SheetAssets: Cash & equivalents 10 12 14 17 Receivables 40 48 58 69 Inventories 50 60 72 86 Property, Plant & equipment 500 600 720 864 Total Assets 600 720 864 1037Liabilities: Payables 30 36 43 52 Short-term debt 120 221 347 502 Long-term debt 150 150 150 150 Total Liabilities 300 407 540 704Shareholder's equity 300 313 324 333

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(Percent of Year's Sales)Year xxx1 xxx2 xxx3

Income StatementSales 100.0% 100.0% 100.0%Cost of goods sold 55.0% 55.0% 55.0%Gross margin 45.0% 45.0% 45.0%Selling, general & admin. expenses15.0% 15.0% 15.0%EBIT 30.0% 30.0% 30.0%Interest expences 15.0% 18.8% 22.2%Taxes 6.0% 4.5% 3.1%Net income 9.0% 6.7% 4.7%Dividends 2.7% 2.0% 1.4%Change in shareholder's equity6.3% 4.7% 3.3%

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Balance SheetAssets: Cash & equivalents 6.0% 6.0% 6.0% Receivables 24.0% 24.0% 24.0% Inventories 30.0% 30.0% 30.0% Property, Plant & equipment 300.0% 300.0% 300.0% Total Assets 360.0% 360.0% 360.0%Liabilities: Payables 18.0% 18.0% 18.0% Short-term debt 110.7% 144.6% 174.2% Long-term debt 75.0% 62.5% 52.1% Total Liabilities 203.7% 225.1% 244.3%Shareholder's equity 156.3% 134.9% 115.7%

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million)

Year xxx0 xxx1 xxx2 xxx3 xxx4

Income StatementSales 200 240 288 346Cost of goods sold 110 132 158 190Gross margin 90 108 130 156Selling, general & admin. expenses 30 36 43 52EBIT 60 72 86 104Interest expences 30 45 64 87Taxes 12 11 9 7Net income 18 16 13 10Dividends 5 5 4 3Change in shareholder's equity 13 11 9 7

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GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million)

Year xxx0 xxx1 xxx2 xxx3 xxx4

Balance SheetAssets: Cash & equivalents 10 12 14 17 21 Receivables 40 48 58 69 83 Inventories 50 60 72 86 104 Property, Plant & equipment 500 600 720 864 1037 Total Assets 600 720 864 1037 1244Liabilities: Payables 30 36 43 52 62 Short-term debt 120 221 347 502 692 Long-term debt 150 150 150 150 150 Total Liabilities 300 407 540 704 904Shareholder's equity 300 313 324 333 340