Chapter 2
Introduction to Financial
Statement Analysis
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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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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.
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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.
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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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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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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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2.2 Balance Sheet
• A snapshot in time of the firm’s financial position
• The Balance Sheet Identity:
Assets Liabilities Stockholders' Equity
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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
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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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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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Table 2.1
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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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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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Table 2.1 (cont'd)
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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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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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Example 2.1
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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
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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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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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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
Market Value of EquityMarket-to-Book Ratio
Book Value of Equity
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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
Total DebtDebt-Equity Ratio
Total Equity
Enterprise Value Market Value of Equity Debt Cash
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Example 2.2
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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
MVE * BVD/BVE * BVE/MVE
= $12.82B * 1.80/4.93 =
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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
MVE * BVD/BVE * BVE/MVE
= $12.82B * 1.80/4.93 = $4.68B Cash = $1.08B
• Enterprise Value = $12.82 + $4.68 - $1.08 = $16.42 B
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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
For Global =
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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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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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Table 2.2
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2.3 Income Statement
• Total Sales orRevenues minus
• Cost of Sales equals
• Gross Profit
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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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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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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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2.3 Income Statement (cont'd)
• Pre-Tax Income minus
• Taxes equals
• Net Income
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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: 0.513
Net Income $2.0 millionEPS $0.556 per share
Shares Outstanding 3.6 million shares
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Profitability Ratios (For Global =
• Operating Margin
Operating IncomeOperating Margin
Total Sales
Net IncomeNet Profit Margin
Total Sales
Net Profit Margin
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2.3 Income Statement (cont'd)
• Income Statement Analysis
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%)
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Working Capital Days
• Accounts Receivable Days
For Global = 18.5/.511 = 36 days
Accounts ReceivableAccounts Receivable Days
Average Daily Sales
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2.3 Income Statement (cont'd)
• Income Statement Analysis
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
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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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2.3 Income Statement (cont'd)
• Income Statement Analysis
Investment Returns
• ROA Net Income / Total Assets
• ROE
Valuation Ratios
• P/E Ratio
Net IncomeReturn on Equity
Book Value of Equity
Market Capitalization Share PriceP / E Ratio
Net Income Earnings per Share
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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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Example 2.3
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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
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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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2.4 Statement of Cash Flows (cont'd)
• Three Sections
Operating Activities
Investment Activities
Financing Activities
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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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2.4 Statement of Cash Flows (cont'd)
• 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.
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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
Retained Earnings Net Income Dividends
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Example 2.4
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Example 2.4 (cont'd)
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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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2.6 Accounting Manipulation
• Enron
• WorldCom
• Sarbanes-Oxley Act (SOX)
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Questions?