Financial Statements
Gitman/Madura Chapter 8
Lecture notes 8
Why Read or Care?
• Investment strategies
– Growth
• Use accounting numbers to estimate growth
– Value
• Compare accounting numbers to price
Goals
• Accounting statements
• Financial ratios
• Ratios and valuation
Accounting Statements
•
•
•
•
Income statement
Balance sheet
Statement of retained earnings
Statement of cash flows
Income Statement
• Flow variables
• Revenues – Cost of goods sold
Income Statement Example
• Total revenues $50
• Labor and other operating expenses $-25
– (for goods sold)
•
•
•
•
•
•
Advertising + Admin. expenses $-5
Depreciation $-5
Interest payments $-5
Taxes $-5
Earnings 50-25-5-5-5-5 = $5
EBIT = Earnings before interest and taxes
– = 50-25-10 = $15
Balance Sheet
Accounting Value of the Firm
• Assets (things firm owns)
• Liabilities (Loans)
• Stockholders’ equity
– (Assets - Liabilities)
– Also called
• Book value
• Net worth
Assets
•
•
•
•
•
Cash
Accounts receivable
Inventories
Land
Plant and equipment
– Less: Depreciation
Liabilities
• Accounts payable
• Notes payable (short term debt)
• Long term debt
Balance Sheet
• Assets
– Cash $5
– Plant and equipment $100
• Liabilities
– Accounts payable $1
– Long term debt $75
• Stockholder equity 105-76 = $29
Retained Earnings Statement
• Cumulative sums of retained earnings
• RE = retained earnings
• New RE = Old RE + Earnings - Dividends
Cash Flow
• Pure measure of incoming - outgoing cash
• Differences with income statement
– No depreciation
– No accounts payable/receivable
– Inventories (account for costs of producing and
putting in inventory)
Cash Flow Parts
• Operating Activities
• Investment Activities
• Financial Activities
Operating Cash Flow
• Earnings = $5
– Adjust to get to cash flow
• Depreciation : +5
– Why? Remove depreciation adjustments
• Increase in accounts payable: +5
– Why? Haven’t paid this yet.
• Increase in accounts receivable: -2
– Why? Haven’t received this yet.
• Increase in inventories: -10
– Production costs reflect only goods sold.
– Adjustment: 5+5+5-2-10 = 3 = operating cash flow
Investment Cash Flow
• Increase in gross fixed assets
• Purchases of new plant and equipment
• -30 million : New office building
• Total investment cash flow = -30 million
Finance Cash Flow
• Increase in long term debt:
• +50 million of incoming funds
• Dividends:
• -20 million payout of divs
• Total finance cash flow = +30 million
Goals
• Accounting statement
• Financial Ratios
• Ratios and valuation
Financial Ratios
• Ratios of various financial variables
• Uses
– Analyze financial well being of a firm
– Compare different stocks in terms of current
values
• “Find good investments”
Ratios
•
•
•
•
Profitability ratios
Market ratios
Debt ratios
Other ratios
– Why skipping many in book
Profitability:
Gross Profit Margin
Sales  Cost of goodssold

Sales
Gross profits

Sales

Profitability:
Earnings for Shareholders
• Earnings available for common shareholders
– Revenues minus
•
•
•
•
•
Costs of goods sold (production)
Operating expenses
Interest
Taxes
Preferred dividends
• Final earnings left for shareholders (earnings)
Profitability:
Net profit margin
Earnings

Sales

Profitability:
Earnings per Share (EPS)
• Key ratio!!!
Earnings
EPS 
Shares of common stock

Return on Total Assets (ROA)
Earnings
ROA 
Totalassets

Return on Common Equity
(ROE)
• Common stock holder Equity
– Balance sheet book value assigned to common
stock
– Net worth – preferred stock (valued at par)
Earnings
ROE 
Common stock equity

Market Ratios
• Share price versus accounting value
• Very important
• Examples
– Price/Earnings ratio
– Market/Book (M/B) ratio
Price Earnings Ratio
P/E Ratio
Market price per share
P / E Ratio 
Earnings per share

Price Earnings Ratio
• Price per earnings
• Example:
– Microsoft
• About 30
• $30 per $1 of earnings
Compare to Earnings Growth
• P = y(1+g)/(k-g)
• P/E = (1+g)/(k-g)
• Try
– k = 0.07 (close to average real return)
– g = 0.02 (close to average real growth of
economy)
– gives P/E for stock
– 20
High Flying P/E’s
• AOL (1999) near 600
• Dell Computer (1999) 100
• These require higher growth rates, but
maybe not much higher
– 1/(0.07-0.06) = 100
– 6% growth forever is pretty big
• For many dot com’s no P/E since earnings
are zero
Market to Book Ratio (M/B)
Market price per share
M /B
Book value per share

Market to Book Ratio
• Market value of the firm relative to its
accounting value
• Key tool for “value investors”
• Extensive academic evidence that low
market to book firms do better on average
Debt Ratio
Totalliabilities

Totalassets

Dividend Payout
• Net Income
– Dividends
– Retained Earnings
• Dividend Payout ratio = Divs/Earnings
Problems for Other Ratios
• Might vary a lot across industries
• Example:
– Total asset turnover
– Think about consulting firm versus a steel mill
Sales
Totalasset turnover 
Totalassets

Goals
• Accounting statement
• Financial Ratios
• Ratios and valuation
Fundamental Analysis
• Use information about firm to evaluate
stock price
• Growth
– Estimate earnings growth and future prospects
• Value
– Find “undervalued” stocks
Ratio Analysis
• Many methods
• Compare ratios to appropriate comparison
set
• Example:
– P/E ratio for a pharmaceutical firm
– Compare to industry
– If low -> buy
Problems With Accounting
Information
• Misses “intangibles”
– Knowledge base (patents)
– Customer base
• Sometimes numbers are zero
– Dot coms often have zero earnings
More Problems with Accounting
Information
• There are many ways to derive accounting
numbers
• Large “fudge factors”
• Can clever accountants make things look
better?
Accounting “Tricks”
• Off balance sheet items
– Enron
– Stock options
• Capital depreciation tricks
– Worldcom
– AOL
• Taking over low p/e firms
Fundamental Analysis
Weaknesses
• Bad data
• Bad interpretation of data (growth rates)
• Market efficiency:
– Semi-strong efficiency: Prices should reflect
all public information
• Market inefficiency (prices may not adjust
to where they should go)
Goals
• Accounting statement
• Financial Ratios
• Ratios and valuation