The Four Financial Statements 1. Balance Sheet 2. Income Statement 3. Cash Flow Statement 4. Statement of Shareholders’ Equity 2-1 The Form of the Balance Sheet Assets = Liabilities + Shareholders’ Equity or Shareholders’ Equity = Assets – Liabilities Compare to: Value of Equity = Value of Firm – Value of Debt 2-2 The Form of the Income Statement Net Revenue – Cost of Goods Sold = Gross Margin Gross Margin – Operating Expenses = Earnings before Interest and Tax (ebit) Earning Before Interest and Tax – Interest Expense + Interest Income = Income before Taxes Income before Taxes – Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income – Preferred Dividends = Net Income Available to Common 2-3 The Form of the Cash Flow Statement Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing 2-4 The Stocks and Flow Equation Ending equity = Beginning equity + Total (comprehensive) income – Net payout to shareholders Comprehensive income = Net income + Other comprehensive income Net payout to shareholders = Dividends + Share repurchases -Share issues 2-5 The Articulation of the Financial Statements Beginning stocks Flows Ending stocks Cash Flow Statement Cash from operations Beginning Balance Sheet Cash from investing Ending Balance Sheet Cash from financing Cash Net change in cash Cash + Other Assets Other Assets + Statement of Shareholders’ Equity Total Assets Total Assets Investment and disinvestment by owners - Liabilities - Liabilities Net income and other earnings Owners’ equity Net change in owners’ equity Owners’ equity Income Statement Revenues Expenses Net income 2-6 Intrinsic Value and Book Value • Intrinsic Premium: Intrinsic Value of Equity – Book Value of Equity • Market Premium: Market Value of Equity – Book Value of Equity • Intrinsic Price-to-Book Ratio: Intrinsic Value of Equity Book Value of Equity • Price-to-Book Ratio: Market Value of Equity Book Value of Equity 2-7 Percentiles of P/B Ratios for U.S. Firms, 1963-2003 8 p10 p25 median p75 p90 7 5 4 3 2 1 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 1973 1971 1969 1967 1965 0 1963 Price-to-book ratio 6 Source: Calculated from Standard & Poors’ COMPUSTAT data. 2-8 Measurement in the Balance Sheet • Historical Cost Accounting • Fair Value Accounting Box 2.2 explains how each item of assets and liabilities is measured 2-9 Measuring Value Added Value added = Ending Value – Beginning Value + Dividend Stock Return = Pt Pt 1 d t Accounting value added = Ending book value – Beginning book value + Net dividend = Comprehensive earnings 2-10 Principles of Earnings Measurement • Recognize only value added from sales to customers Revenue recognition principles Add value when it has been earned (usually when a sale is made) Matching principle Match expenses against revenue for which they are incurred • Accounting value added (earnings) = Revenue – Expenses 2-11 Good Matching • Only costs of good sold are matched to sales revenue, not the full costs of producing or buying inventory during the period. • Costs for goods not sold are reported in the balance sheet, as inventory, to be matched with revenue in future. • Costs of buying plant are not expensed when incurred. Rather, the cost is “capitalized” on the balance sheet and depreciated over years when the plant produces revenues. • Employee pension costs are recorded as an expense in the period that employees generate revenues, not when they are paid (in retirement). 2-12 Poor Matching • Research and development expenditures are expensed when incurred, rather than matched to (subsequent) revenues they generate • Advertising and promotion costs are expensed when incurred, rather than matched to (subsequent) revenues they generate • Estimating useful lives for plant assets that are too long: Depreciation is understated 2-13 Percentiles of P/E Ratios for U.S. Firms, 1963-2003 70 p10 p25 median p75 p90 50 40 30 20 10 Source: Calculated from Standard & Poors’ COMPUSTAT data. 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 1973 1971 1969 1967 1965 0 1963 Price-to-earnings ratio 60 Numerator: Price forecasts future earnings Denominator: Current earnings 2-14 Guiding Principles for Recognizing Accounting Value Added • The fundamentalist creed: Don’t mix what you know with speculation • The accountant’s restatement of the creed (the reliability criterion): Accounting numbers should be based on objective evidence, free of opinion and bias. Go to Accounting Clinic I 2-15