# Net Income

Berkeley Investment Group:
Financial Statements and Modeling Workshop
Daniel Fotinich
Andy Zhao
Importance of Financial Statements
Supplement our qualitative judgments about a company
Predict future financial performance
Calculate what we believe is the firm’s fair value
Financial Statements
What are the three financial statements?
– Income Statement
– Balance Sheet
– Statement of Cash Flows
Where do we find them?
– http://www.sec.gov/edgar.shtml
– Company’s investor relations webpage
Which is the most important?
– All of them are useful for analysis
10-k, 10-Q
Case Study: Chipotle
The Income Statement
A Bare-bones Income Statement
“topline”
Revenue
Cost of Goods Sold (COGS)
Gross Profit
Operating Expenses
Operating Income
\$a
b
a-b
c
a-b-c
Interest Expense
d
Income Tax
e
Net Income
\$a-b-c-d-e
“bottom line”
Actual Income Statement
Revenue, Cost of Goods Sold, Gross Profit
Revenue – money generated from sales of products and/or
services within a given time frame
COGS – cost of materials directly related to goods/services sold
Gross Profit – profit directly related to producing the good/service
Gross margins: Gross profit/Revenue
Operating Expenses & Operating Income
Gross Profit
OpEx – Indirect costs of operating the business
Operating Income –profit received from company’s core operations
Operating margins: Operating Profit/Revenue
Interest, Taxes, Net Income
Operating Income
Interest Payments – interest on company debt
Taxes – Tax rate * (Income Before Taxes)
Net Income – “earnings”, how much total profit a company makes
Net Margins: Net Income/Revenue
Fixed vs. Variable Cost
Fixed Cost
Variable Cost
• Costs that don’t directly vary with
incremental increases in production
• Examples: Factories, Management
• Costs that directly vary with
incremental increases in production
• Examples: Labor, input costs
• Step-function
• Linear Function
Costs
Variable Cost
Fixed Cost
Production
Operating Leverage
Op.
Income
Revenue
% of costs
as fixed
50%
0%
• Total expenses increase at a rate less than that of revenue
• Occurs when there are fixed costs in the business
• The greater the % of costs as fixed costs, the greater the operating leverage
Understanding Gross Profit
A
B
How do these two businesses differ from one another?
Company A has 16% GMs, Company B has 81% GMs
Understanding Gross Profit
Certain types of businesses have far lower gross margins
than others, and it is important to recognize these
Operating costs: The Great Equalizer
Ford has 2x the revenue of Pfizer, but 2x less “operating costs”
Analyzing Income Statement Trends (I)
What trends do you notice in this income statement?
Analyzing Income Statement Trends (I)
• Steep sales decline from
2011
o 40% decline in 2013
• Huge decline in gross and
operating margins
o GMs: 44% → 31% in 2 years
o OMs: 23% → -11%
• R&D spending flat in 2013,
even as sales collapse
o Due to the BlackBerry 10
• Net loss in 2013
Analyzing Income Statement Trends (II)
What trends do you notice in this income statement?
Analyzing Income Statement Trends (II)
• Annual revenue growth has
averaged 17% since 2009
• SG&A has increased far less
than revenue has in 2012-13
o Lots of operating leverage!
• Net income up 103% since
2009
• Restaurant count has
increased by ~100 per year
o “Same-store sales” up 4%
The Balance Sheet
A Bare-bones Balance Sheet
Assets
Current Assets
a
Non-Current Assets
b
Total Assets
a+b
Liabilities
Short-term Liabilities
c
Long-term Liabilities
d
Total Liabilities
c+d
Shareholders’ Equity
Total Shareholders’ Equity
e
How to Think about the B/S
What are the two methods for paying for a
house?
Therefore…
ASSETS = LIABILITIES + EQUITY
The “balance sheet equation”
Assets
Cash and Cash Equiv.
Receivables – IOUs from customers
Inventory – goods that have been
produced but not sold
PP&E– capital goods used to make
products
Liabilities
Accounts Payable – IOUs to suppliers
Long-term Debt – debt to be paid off
in more than a year (bonds)
Equity
value of all issued stock
Retained earnings – the sum of all
the earnings of the business since
day 1
What’s the point?
The balance sheet is useful to investors in two ways:
• How efficiently the company is using its capital
• Solvency of the company (whether or not it’ll be able to pay back debt
Return on Assets: Net Earnings / Total Assets
•
•
•
An indicator for how efficiently the firm uses its assets
Generally the higher the better
Why do airlines have lower ROAs than biotechnology companies?
Debt/EBITDA
•
•
A higher D/EBITDA means more aggressive financing and is different for every industry
Companies with significant debt usually trade at a discount to companies with less debt
What do you notice on this balance sheet?
\$20 Billion in PP&E!
The Venetian is “necessary capital” for Las Vegas
Sands to provide its product
What do you notice on this balance sheet?
“NIKE, Inc., together with its subsidiaries, engages in the design,
development, marketing, and sale of athletic footwear, apparel,
equipment, and accessories”
The Cash Flow Statement
What happens when the company makes
money?
• ↓ LT-Liabilities by 100k
• ↓ Cash by 100k
Cash flow from financing
Assume the company
makes \$1MM
earnings in 2013
(all cash)
• ↑ cash by \$1MM
Distribute \$200k to
Shareholders
• ↓ cash by \$200k
Cash Flow from investing
• Capital expenditures
• Keep cash on balance sheet
Remaining cash flow
Statement of Cash Flows
From Operating
Activities
• See appendix
for detailed
explanation
From Investing
Activities
From Financing
Activities
•
•
Dividends
Debt paydowns
Why does Cash Flow matter?
• As investors, we are entitled
to the assets of the company
and cash is the most liquid
asset
• Not all of a company’s
earnings are in cash
• Chronically negative cash flow
could result in increased
leverage or eventual default
What’s the problem here?
Appendix
“Cash Rules Everything Around Me”
- Wu Tang Clan
•
Not all financial statements are created equal
– IS tells us the earnings and costs of doing business
– BS tells us the financial health of the company
– CS tells us how much CASH is coming in every year and ties together the two
• Cash is what investors want the most (cash = value)
– High income doesn’t necessarily = High cash flow
– The cash flow statement tells us how much value the company is generating
Investors
Lenders
Non-cash items are line items included in earnings but don’t represent cash
inflows or outflows for the company.
• Depreciation and Amortization – Accounting method for recognizing capitalized
expenses over time (non-cash)
• Change in Accounts Payable – IOUs to suppliers (didn’t spend the cash)
Revenue (deduction from earnings):
• Change in Accounts Receivable – IOUs from customers (didn’t give you cash)
But you did spend cash on something else… Capital expenditures
Capex is not recognized on the income statement, but is a major use of cash
Free Cash Flow
Free Cash Flow: cash the company generates in a given year to pay off
lenders and give value to investors
The Equation…
Free Cash Flow = Operating Cash Flow – Capex
Proxy for FCF:
•
EBITDA (EBIT + D&A)
Strong free cash flow is a
good indicator of a firm’s
value
The Beauty of the Statements
CS
BS
Net Income (becomes retained earnings)
IS