chapter 2 introduction to financial statement analysis

Chapter 2

Introduction to Financial

Statement Analysis

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-2

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


Learning Objectives

1. 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.

2. 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.

3. 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.


Learning Objectives (cont'd)

4. 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.

5. 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.

6. Explain the importance of the notes to the financial statements.

7. List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud.


2.1 Disclosure of Financial Information

• Financial Statements

Firm-issued accounting reports with past performance information

Filed with the SEC• 10Q

Quarterly

• 10K Annual


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)


2.1 Disclosure of Financial Information (cont'd)

• Types of Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Stockholders’ Equity


2.2 Balance Sheet

• A snapshot in time of the firm’s financial position

• The Balance Sheet Identity:

Assets Liabilities Stockholders' Equity


2.2 Balance Sheet (cont'd)

• Assets What the company owns

• Liabilities What the company owes

• Stockholder’s Equity The difference between the value of the firm’s assets

and liabilities



• 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



• Assets

Long-Term Assets

• Net Property, Plant, & Equipment Book Value Depreciation

• Goodwill Amortization

• Other Long-Term Assets


Table 2.1



• 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



• 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


Table 2.1 (cont'd)



• Net Working Capital

Current Assets – Current Liabilities

• For Global Conglomerate Corp. (2005)

= $57M - $48M = $9 Million



• 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


Example 2.1


Example 2.1 (cont'd)

• Market Capitalization = $14 X 3.6 million

= $50.4 million

• Book value of Equity = $22.2 million

• Market to Book Ratio = 50.4/22.2 = 2.27


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?


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 ???



• 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

Market Value of EquityMarket-to-Book Ratio




• Balance Sheet Analysis

Debt-Equity Ratio

• Measures a firm’s leverage

• Using Book Value versus Market Value

Enterprise Value

Total DebtDebt-Equity Ratio

Total Equity

Enterprise Value Market Value of Equity Debt Cash


Example 2.2


Computing Enterprise Value (Cont.)

• Enterprise Value = Market Cap (MC) + Debt – Cash

Market Cap = $36.87 * 347.6 = $12.82B [BV of] Debt = MC * Debt to Equity Ratio /Market to Book

MVE * BVD/BVE * BVE/MVE


= $12.82B * 1.80/4.93 =


Computing Enterprise Value (Cont.)

• Enterprise Value = Market Cap (MC) + Debt – Cash

Market Cap = $36.87 * 347.6 = $12.82B [BV of] Debt = MC * Debt to Equity Ratio /Market to Book



= $12.82B * 1.80/4.93 = $4.68B Cash = $1.08B

• Enterprise Value = $12.82 + $4.68 - $1.08 = $16.42 B



• Other Balance Sheet Information

Current Ratio• Current Assets / Current Liabilities

For Global =

Quick Ratio• (Current Assets – Inventories) / Current Liabilities

For Global =



• 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


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


Table 2.2


2.3 Income Statement

• Total Sales orRevenues minus

• Cost of Sales equals

• Gross Profit


2.3 Income Statement (cont'd)

• Gross Profit minus

• Operating Expenses• Selling, General, and Administrative Expenses• R&D• Depreciation & Amortization

equals

• Operating Income



• Operating Income Plus or minus

• Other Income or Other Expenses equals

• Earnings Before Interest and Taxes (EBIT)



• Earnings Before Interest and Taxes (EBIT) Plus or minus

• Interest Income or Interest Expense equals

• Pre-Tax Income



• Pre-Tax Income minus

• Taxes equals

• Net Income



• 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: 0.513

Net Income $2.0 millionEPS $0.556 per share

Shares Outstanding 3.6 million shares



• Income Statement Analysis

Profitability Ratios (For Global =

• Operating Margin

Operating IncomeOperating Margin

Total Sales

Net IncomeNet Profit Margin

Total Sales

Net Profit Margin




Profitability Ratios

• Operating Margin (For Global = 10.4/186.7 = 5.57%)

Operating IncomeOperating Margin

Total Sales

Net IncomeNet Profit Margin

Total Sales

Net Profit Margin (For Global = 2/186.7 = 1.07%)




Working Capital Days

• Accounts Receivable Days

For Global = 18.5/.511 = 36 days

Accounts ReceivableAccounts Receivable Days

Average Daily Sales




EBITDA = Earnings Before Interest Taxes Depreciation and Amortization

= EBIT + Depreciation and Amortization

For Global = 10.4 + 1.2 = 11.6

It represents the cash available to pay the “claimants to that cash” i.e. Stockholders, bondholders and the Government

Accounts ReceivableAccounts Receivable Days

Average Daily Sales




Leverage Ratios or Interest Coverage Ratios

• EBIT / Interest Expense

• Operating Income / Interest Expense

• EBITDA / Interest Expense




Investment Returns

• ROA Net Income / Total Assets

• ROE

Valuation Ratios

• P/E Ratio

Net IncomeReturn on Equity


Market Capitalization Share PriceP / E Ratio

Net Income Earnings per Share



• 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


Example 2.3


Example 2.3 Continued

WMT TGT

Operating Margin 5.90% 7.66%

Net Profit Margin 3.47% 4.04%

P/E Ratio 22.80% 23.68%

Enterprise Value (EV) 255 53

[EV/Operating Income] 15.00 14.72

[EV/Sales] .89 1.13


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


2.4 Statement of Cash Flows (cont'd)

• Three Sections

Operating Activities

Investment Activities

Financing Activities



• 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.



• Changes in Non-Cash Working Capital: = Accounts Receivable

– Accounts Payable + InventoryNotice 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.



• 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

Retained Earnings Net Income Dividends


Example 2.4


Example 2.4 (cont'd)


2.5 Other Financial Statement Information

• Management Discussion and Analysis Off-Balance Sheet Transactions

• Statement of Stockholders’ Equity

• Notes to the Financial Statements


2.6 Accounting Manipulation

• Enron

• WorldCom

• Sarbanes-Oxley Act (SOX)


Questions?

chapter 2 introduction to financial statement analysis

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