Financial Statements
Economics 98 / 198
Spring 2008
Copyright 2008 Lawrence Wu
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LECTURE CONTENT
Today’s Lecture
• Trading Psychology
• Financial Statements introduction
– Income Statement
– Balance Sheet
– Cash Flow Statement
– Earning Season
• Ratio Analysis
TRADING
PSYCHOLOGY
Trading Psychology
Emotions severely impair your judgment
in deciding whether to buy or sell stocks
HOPE
FEAR
GREED
PRIDE
Psychology & The Stock Market
• Emotions can wreak havoc on your
results and decisions
• Need to take emotion out of investing
• Do this by developing a system with
rules to follow with discipline
Trading Psychology
“Your biggest enemy, when trading, is
within yourself. Success will only come
when you learn to control your
emotions”
- Edwin Lefevre
Accounting 101:
Financial Statements
Reporting Financial Statements
• Public companies required to publish 10K
and 10Q and file with the SEC
– 10K = Annual financial reports (audited)
– 10Q = Quarterly financial reports (unaudited)
Income Statement
Balance Sheet
Statement of Cash Flows
• Why do we care about these reports?
The Income Statement
• Shows how much a company earned or
lost during that specific period
• Considered the most analyzed
statement for investors
• Divulges into a company’s profitability
IS THE COMPANY MAKING PROFITS?
Income Statements
• Generally, 3 Major Parts
– Revenues
– Expenses
– Net Income
Income = Revenues - Expenses
• Earnings Per Share (EPS)
= Profits / Shares Outstanding
• Investors pay very close attention to
profits (earnings) and revenue (sales)
Income Statement
 Expenses
 Cost of Goods Sold (COGS)
– other than raising the prices of its products, there is
little management can do to keep a large increase in
COGS from cutting into profits
 Selling, General, and
Administrative Expenses (SG&A)
– includes Depreciation/Amortization
– good measure of management’s
efficiency at controlling costs
 Research and Development (R&D)
 Taxes, interest payments
Income Statement
 Net Income (“bottom line”)
= Revenue – Expenses
 Gross Income = Revenue – COGS
 Operating Income = Revenue – (COGS + SG&A)
 Profit Margin = Net Income / Revenue
 Gross Income Margin = Gross Income / Revenue
 Operating Margin = Operating Income / Revenue
 Earnings can be increasing, while profit margins are
shrinking
 Earnings Per Share (EPS)
= Profits / Shares Outstanding
Balance Sheet
• Summarizes company’s assets, liabilities,
and shareholders’ equities at specific time
Assets = Liabilities + Shareholder’s Equity
• How do we analyze this statement?
• We use ratios and changes in trends to analyze
the information
Balance Sheet
Assets
– Current Assets: life span of 1 year or less
– Non-Current assets
Liabilities
– Current Liabilities
– Non-current liabilities
Shareholder’s Equity
– Common / Preferred Stock
– Retained Earnings
Balance Sheet
 Assets
 Current Assets: items that are
converted to cash within a year
– Cash and cash equivalents
– Inventory
‫ ﮦ‬Inventory Turnover = Sales / Inventory
‫ ﮦ‬low turnover indicates poor sales and excess inventory
– Accounts Receivable
‫ ﮦ‬the less money tied up as receivables, the better
 Non-Current Assets: items that are more permanent
– Property, Plant, and Equipment (PP&E)
– Intangibles: intellectual property, deferred charges,
goodwill
Balance Sheet
 Liabilities
 Current Liabilities: obligations
due within a year
– Accounts Payable
‫ ﮦ‬the longer a company can stretch out the collection
period for its payables, the better
– Quick Ratio
= (Current Assets – Inventory) / Current Liabilities
‫ ﮦ‬quick ratio of 1 or higher indicates company is able to
meet its short-term obligations
 Non-Current Liabilities: obligations due
beyond a year
 typically bank and bondholder debt
Balance Sheet
 Shareholders’ Equity
 Retained Earnings
– investors should be aware of how a company puts retained
capital to use and what return is produced
 Preferred Stock, Common Stock, Paid-in Capital
 Debt/Equity Ratio
= Total Liabilities / Shareholders’ Equity
– low debt/equity ratio indicates less risk and less volatile
earnings, generated primarily from shareholders’ investment,
as opposed to borrowed money
 Return on Equity (ROE)
= Net Income / Shareholders’ Equity
– high ROE shows management makes good use of money
invested by shareholders
Statement of Cash Flows
• Shows how much money coming in (inflows)
and going out (outflows)
– Cash flow from operations
– Cash flow from investing
– Cash flow from financing
• Shows if company having trouble with cash
– Profitable companies can have low cash flows. Why?
• Cash is king! Pays for bills and funds
operations!
Statement of Cash Flows
 reconciles Income Statement and Balance
Sheet by recording company’s cash
transactions (inflows and outflows)
 shows how much actual cash company
made over a specific period of time (gets
rid of “accounting noise”)
 Profitable ≠ Positive Cash Flow,
and vice versa
Statement of Cash Flows
 Cash from Operations (CFO)
 cash transactions regarding core
business operations
– outflows: buy inventory, pay operating
costs, pay interest on debt, pay taxes
– inflows: make sales
 changes in CFO are usually a
preview of future changes in net income
Statement of Cash Flows
 Cash from Investing (CFI)
 cash transactions regarding purchase/sale of incomeproducing assets
– outflows: buy assets (PP&E)
– inflows: divest of assets
 large investments can lead to negative net cash flow, but
may pay off in the long run
 Cash from Financing (CFF)
 cash transactions between company
and its owners and creditors
– outflows: pay dividend
– inflows: sell equity, issue debt
 negative CFF usually means company is taking on debt,
but could also mean it is making dividend payments and
stock repurchases, which could be good for shareholders
Other Important Sections in Financial Filings
 Management Discussion and Analysis
(MD&A)
 Auditor’s Report, a.k.a. Report of
Independent Accountants
 Notes to Financial Statements
Earnings Season
• Companies release quarterly reports and
annual reports
– “Financial Report Cards”
• Stock analysts issue earnings estimate
– Consensus earnings estimates
• Earnings surprise is a good thing
– Meeting / beating / missing expectations
– If below estimates, then stock usually plummets!
Understanding Earnings
• Actual earnings value is important, but
so is the growth of these earnings
• Compare EPS / Revenue?
– Do we compare them to last quarter?
– Do we compare them to the same quarter
last year?
EPS % Growth: Google
Source: MSN Money Stock Quotes
EPS growth calculated
comparing Q2 2007 to
Q2 2006
Q2 2007EPS Growth
2007 Q2 EPS
2006 Q2 EPS
$2.98 / sh
$2.39 / sh
=25%
Q2 2007
Why do Investors Care About
Earnings?
• Strong earnings or expectations of strong
earnings drive stock prices. Why?
– Potential for greater reinvestment, and
greater earnings
– Passing the money to shareholders in various
forms (dividends, buybacks, etc.)
• Ultimately, earnings provide a return on
the investment for shareholders
Ratio Analysis
Ratio Analysis
• Used to gain idea of valuation and
financial performance
• Compared to competitors and historical
values to gain understanding about
company’s value
– Is it undervalued? Overvalued?
– How is it performing?
Profit Margins
Profit Margins
• = net income / net sales (revenue)
– Measures how much out of every dollar of sales a company
actually keeps in earnings
• High profit margins indicates that management
efficient at controlling costs
– Increased earnings are good, but if costs are increasing
faster than sales, leads to lower profit per sale
• Good sign if company has growing profit margins
Profit Margins: Example
Company has a net income of $10 million from sales
of $100 million, giving it a profit margin of 10%
($10 million/$100 million)
If in the next year net income rose to $15 million on
sales of $200 million.
Would its profit margins be growing or diminishing?
What does this mean?
Price to Earnings Ratio (P/E)
P/E Ratio
• = Price per share / Earnings per share
– Look at company’s earnings relative to its price
• Most basic valuation method of company
– How do you we use it?
• Ex. If BIG OIL co. has P/E ratio of 15 and has solid
fundamentals, and the industry average is 40, then
the BIG OIL would be considered undervalued
Price to Earnings Ratio (P/E)
• Use as a guide, not a guarantee in your analysis
• Sometimes, there is a reason for high or low P/E ratios
(understanding business and industry is important)
– High P/E ratios: investors may be willing to pay
more for less earnings because its expect higher
growth rates in the future
– Low P/E ratios: may seem like a bargain, but low
ratio may signal questionable future prospects
Return on Equity (ROE)
Return on Equity (ROE)
• = Net Income / Shareholder’s Equity
– how much profit a company can generate with the money
shareholders have invested
– Is it a profit-making machine or an inefficient clunker?
• Useful for comparing profitability and efficiency of a
company to other firms in same industry
– can indicate whether a company is growing without pouring
new capital into business
• Growing ROE also shows management making
better use of money invested by shareholders
Debt-to-Equity Ratios
Debt / Equity Ratio
• = Total Liabilities / Shareholder’s Equity
– Proportion of equity and debt to finance assets
• High ratio: aggressive debt, potential for higher earnings
per share but at more risk
– More volatile earnings and larger interest expenses
• Compare this similar companies
• Warren Buffet preferred to see lower ratio so that
earnings growth is generated by investors rather than
borrowed money
Google Example
2004
2005
2006
2007
Profit Margin
13%
24%
29%
25%
ROE
14%
15.6%
18.1%
18.5%
Debt/Equity
0.13
0.09
0.08
0.00
261%
198%
134%
EPS Growth
Other Relevant Ratios
• Current Ratio
• Return on Assets
• Inventory Turnover
• Interest Coverage
More on Ratio Analysis / Financial Statement Analysis:
http://www.investopedia.com/university/ratios/ratios1.asp
http://www.investopedia.com/university/financialstatements/
UGBA 102A: Introduction to Financial Accounting
Reading
• Motley Fool. “Analyzing Stocks”
• Recommended:
Investopedia. “Valuation”