smartwomansecurities
Date
Understanding Financial
Statements
Speaker
Position
Company
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Tonight’s Agenda
• Introduction to Financial Statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
This Week’s Seminar
• After this, you should be able to:
– Be familiar with the three financial statements
(balance sheet, income statement, statement of cash
flows)
– Understand why you look at each statement
– Understand what accounts in each statement you
want to focus on if you have limited time
Market Update
• Have speaker comment on what
happened in the markets for past
week.
• We encourage speakers to create a
slide of important occurrences (see
next slide for example).
Market Update Example Slide
• S&P200 gained 2.3% on the week; DJIA was up 2.1%
while the NASDAQ was up 2.9% as investors seemed
less concerned about risks in the credit markets
• There were mixed technology results as Apple &
Microsoft posted solid positive Q3 earnings; rising
concerns about semiconductor valuations
• Merrill Lynch wrote down $7.9b in losses from
subprime losses, although the stock rallied on reports
that CEO Stan O’Neal would be ousted
• Bank of America announced 3,000 job cuts in the
corporate & investment banking division
• Crude oil futures climbed above $92; some analysts
expect it to surpass $100
Review: Stock Picking
• #1: Finding ideas through trends
– Newspapers, TV, roommates, internet, everyday life
– Wall Street Journal, New York Times
– Come up with preliminary list of companies
• #2: Research the company
– What industry does it belong in? What trends impact that industry?
– Company website, financial filings (MD&A section), talk to company
mgmt, listen to conference calls
– Porter’s 5 forces tell you if it’s a good business (customer power, supplier
power, barriers to entry, threat of substitutes, rivalry)
• #3: Determine how sustainable trends are (this is
subjective, no easy answer)
– Talk to company mgmt, think independently (what makes sense?)
– Remember trends drive revenues, and revenues drive earnings (aka EPS)!
Next Up: Valuation
• #4: Use valuation to determine if a trends are
priced into the stock
• #5: Use valuation to determine future stock price
• But, before we can do this, we must learn about the
financial statements
– Balance Sheet
– Income Statement
– Statement of Cash Flows
Introduction to Financial
Statements
Financial Statements are Critical
• Helps investors determine the financial health
of the company. This is REALLY important.
–
–
–
–
–
How fast have revenues grown?
How profitable is the company?
How efficiently are they growing EPS?
How are they financing that growth (debt & equity)?
Do they have adequate liquidity?
• Once we learn about the financial statements,
you can calculate ratios and compare them
across different companies
Financial Accounting
• Translates activities into objective numbers
– Allows comparability across time, firms and industries
• Helps us evaluate:
– Historical financial performance
– Future prospects
– Potential problems
• Every public company has to disclose
financial statements.
– Understanding financial statements offer us a good point of
comparison, as well as an indication of a company’s relative
financial strength
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Accessing Financial Statements
• How do investors get access to
financial statements?
– Public company’s financial statements MUST be
available to the public
– Look at your company’s website and find their 10K
(annual report) or 10-Q (quarterly report) – this is
usually found under “SEC Filings” or something
similar
Accessing Financial Statements
• Public Companies: www.sec.gov/edgar.shtml
Company Reports
• Annual Reports (10-K)
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–
–
–
–
–
–
Company overview & business description
Accounting policies (GAAP)
Financial statements (and footnotes!)
Management discussion and analysis (MD&A)
Directors and executive officers’ bios
Executive compensation
Update on recent merger/acquisition activity
• Quarterly Reports (10-Q)
– Financial statements
– MD&A
Financial Statements
• The Three Main Statements
– Balance Sheet
• Allows you to understand the assets and liabilities of the
company at any given point in time
– Income Statement
• Provides you the revenue and expenses a company has incurred
over a certain period of time
– Statement of Cash Flows
• Explains how cash has changed over a period of time.
Financial Statements
• Other Important Components
– Management Discussion and Analysis (MD&A)
• Management explains the business and what has taken place
over the past year. It helps to hear it in their words.
– Footnotes (they explain changes in these statements
• Footnotes are particularly important as they will often help
investors interpret the numbers, make necessary adjustments
and gain a better understanding of the business functioning
Balance Sheet
Balance Sheet
• Financial snapshot at a single point in time
• Assets (what the company owns)
– economic resources that are expected to benefit future
activities of the company
• Liabilities (what the company owes)
– the company’s economic obligations
• Shareholders’ equity (whatever is left)
– the excess of the assets over the liabilities (also called
“stockholders’ equity”)
• Assets = Liabilities + Shareholders’ Equity
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Balance Sheet: Its Components
Assets: Resources
that generate future
value for the
company
Liabilities: Obligations
the company has to
deliver something of
value (usually cash or
services) in the future
Shareholders’ Equity:
Remaining claims
accruing to owners
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Assets
Resources that generate future value for the
company
• Current Assets: Assets that can be converted to cash within
one year
– Cash = money company has today
– Accounts Receivables = money owed to the company by its customers
– Inventory = assets that will be turned into products that the company
will sell for money in future
• Non-Current Assets: Assets that are not expected to be
converted to cash within that time period: property, plants,
equipment, patents, goodwill
– Property Plant & Equipment = assets that are used to produce products
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Assets (CL)
Liabilities
Obligations the company has to deliver something of
value (usually cash or services) in the future
• Current Liabilities: Obligations that are expected to be paid
within one year
– Accounts Payable = money the company owes its suppliers
– Salaries Payable = money the company owes its workers
– Short term debt = money the company owes the bank to be paid in the
next year
• Non-Current Liabilities: Obligations that are not expected
to be paid within one year or the operating cycle, whichever is
longer
– Long term debt = money the company owes the bank to paid after 1 year
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Liabilities (CL)
Shareholders’ Equity
Equity is the remaining claims accruing to
shareholders, also the difference between
assets and liabilities
• Stock and Paid-in Capital
– Securities representing equity ownership in a corporation
• Retained Earnings
– Earnings not paid out as dividends but reinvested in the core
business or used to pay off debt
• Treasury Stock
– Stock that the company reacquires that can be retired
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Shareholder’s Equity (CL)
Balance Sheet Example
• You & your roommates decide after
graduating you want to start a bread
company.
• You need money to start up the
company
– Borrow money from your parents?
– Go to the bank to borrow money?
– Go to mutual fund company like Fidelity to borrow
money?
Balance Sheet Example cont’d
• You borrow $500M from the bank and
sell shares in the public market for
another $500M
ASSETS
Cash: $1B
LIABILITIES & EQUITY
Debt: $500M
Shareholders’ Equity: $500M
Total Assets: $1B
Total Liabilities & Equity: $1B
Balance Sheet Example cont’d
• Use cash to buy stuff to help you
make bread: a bread plant, ingredients
(flour, eggs), an office, etc
ASSETS
LIABILITIES & EQUITY
Current Assets:
Cash: $100M
Inventory: $200M
Debt: $500M
Shareholders’ Equity: $500M
Long Term Assets:
Property Plant & Equipment: $700M
Total Assets: $1B
Total Liabilities & Equity: $1B
Example: Balance Sheet (CL)
How We Can Read Balance Sheets
• Its usefulness
– Gives information about the liquidity of a company
– Tells us how “asset intensive” a company is
– Tells us about the ability of a company to meet its long-term
fixed expenses and to accomplish long-term growth
• Its limitations
– Assets are recorded at historical cost rather than at market
value (what you paid, not what it’s “worth” or the price at
which you could sell the asset)
– Resources such as employee skills and reputation are NOT
recorded on balance sheet
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001; Investopedia.com
Income Statement
Income Statement
• Tells us about the profitability of a company
over a 3-month or 1-year period vs. point in
time (balance sheet)
• Basic equation:
revenues – expenses = net income
– Revenues: what the firm gets paid for selling goods (sometimes
also called sales)
– Expenses: costs firm incurs to create those goods
– Analysis of net income (& other measures of profitability) tell us
how profitable the firm is
• Net Income = “earnings”
Revenues and Expenses
• Revenues are typically = price x volume.
– Price per widget x # of widgets
• Expenses are the costs incurred in
generating revenues
–
–
–
–
–
Cost of goods sold
Selling, general and administrative expenditures
Depreciation
Interest
Income taxes
Source: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Income Statement Example
• Revenues = # of loaves of bread
sold x price per loaf
• Cost of Good Sold = cost of
ingredients & cost of using the
plant to produce the bread, cost
of labor
• Gross Profit = amount of money
left over after paying for the cost
of the items sold
• Selling General & Administrative
Costs = costs to run your
headquarters, your salaries
INCOME STATEMENT (in Millions $)
Revenues
- Cost of Goods Sold
Gross Profit
- Selling General & Administrative Expenses
Operating Profit
-Interest
- Taxes
Net Income
EPS
Diluted Shares Outstanding
$
$
$
$
$
$
$
$
$
250
175
75
25
50
6
15
29
1.43
20
Income Statement Example
• Operating Profit (also called
Earnings Before Interest and
Taxes (EBIT)) = the amount of
profit you have left after paying
for all of the operations of the
business
INCOME STATEMENT (in Millions $)
Revenues
- Cost of Goods Sold
Gross Profit
- Selling General & Administrative Expenses
• Interest expense = cost of taking
Operating Profit
on debt
-Interest
- Taxes
• Taxes = what you owe the
government
Net Income
EPS
• Net Income = the amount of
Diluted Shares Outstanding
profits you have left over
• EPS = net income divided by
shares outstanding
$
$
$
$
$
$
$
$
$
250
175
75
25
50
6
15
29
1.43
20
• Diluted Shares Outstanding =
number of shares (always use
diluted!)
Earnings
• From the income statement, we can
determine the company’s earnings
– The company can do three things with earnings
• Pay dividends (returning money to shareholders)
• Repurchase shares (returning money to shareholders)
• Re-invest in the company (known as “retained earnings”)
• Earnings per share (EPS)
– How much a stock earned per share (or, net income divided
by number of shares outstanding
– During “earnings” season (4x a year), companies have to
report how well they did in the previous quarter.
Oftentimes you might hear about a company “missing
earnings”… this means that the company reported EPS
below consensus
Earnings
• Quarterly earnings
– How much profit a company made or lost during the past quarter
– Given in EPS
• Usually company also holds an earnings call where they discuss their
earnings and company financial performance
• Earnings seasons
– Differ by company, but typically they come in the month after the
end of the quarter
• Earnings vs. consensus
– Consensus from Wall Street analysts on what EPS will be
– If the company beats estimates, the stock tends to go up
– If the company falls short, the stock tends to go down
• However, other aspects may also cause stock to move (management
earnings call, announcement about part of the business, etc.)
Income Statement (CL)
Income Statement Detail (CL)
• Usually companies give more detail
regarding revenues, either by region or by
product
How We Can Read Income Statements
• Its usefulness
– Summarizes sales and profits and losses (P&L) over a period of time –
hence why it is often called a P&L statement!
– Lets us look at changes in key line items and ratios across time to see
whether operations have been changing and in what direction
• Its limitations
– Difficult to compare some ratios for companies in different industries
– Management teams have lots of options for accounting practices
– Revenues reported don’t always equal cash collected, and expenses
reported aren’t always equal to cash paid, so income usually IS NOT
EQUAL to the change in cash for the period
– There are many components in income statements; make sure you read the
footnotes so that you’re getting the whole story!
Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Statement of Cash Flows
Cash Flows
• Statement of cash flows provides relevant
information about a company’s cash inflows
and outflows
• Net Income ≠ Cash generated!!
– Net income is a function of accrual accounting which smoothes
cash flow
– Cash can’t be manipulated
• Cash flows help investors (and creditors)
assess
– Future funding needs
– Liquidity (cash to run daily/annual operations)
– Long-term solvency (ability to pay bills and service debt)
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Income Statement vs. Cash Flows
• Income statement uses accrual accounting to
smooth cash flow, which tends to be lumpy.
– Revenue recognition
• Does a company recognize revenue when end product has been
produced, when it’s shipped, when customer receives it? Orders
often placed at end of the quarter.
– Cost recognition
• Does a company recognize cost when the end product has been
produced, when it receives payment for the product?
– There is a LOT of discretion by the CFO in terms of how s/he can
account for items in the income statement
• Cash flow is literally the cash being generated and
used by the company over a certain period of time
Cash Flows
• 3 sections of the cash flow statements
– Operating Activities
• How much cash do the firm’s core operations generate?
– Investing Activities
• How much cash firm is spending on long term assets to grow (capex)
or on acquisitions
– Financing Activities
• How much cash firm is spending to finance its growth (debt
borrowed & equity issued)
• How much cash firm is returning to shareholders (dividends, share
repurchases)
Cash Flows from Operating Activities
• Inflows
– Cash received from customers (remember accounts
receivables)
• Outflows
– Buying inventory (remember accounts payables)
– Paying salaries and wages
– Paying suppliers (also accounts payable)
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Reconciling Net Income and
Operating Cash Flow
Operating cash flow statement takes Net Income and
makes adjustments so investors can see how much
cash the business generated
INCOME STATEMENT
Revenues
- CGS (includes Depreciation & Amortization)
Gross Profit
- Selling, General & Administrative Costs
- Research & Development
- Other Operating Expenses
Operating Income
- Interest Expense
-Taxes
Net Income
Earnings Per Share
Diluted Shares Outstanding
CASH FLOW STATEMENT
Operating Cash Flows:
Net Income
+ Depreciation & Amortization
+ Amortization on Research & Development
+ Changes in A/R, Inventory, A/P
Operating Cash Flow
Cash Flows from Operating Activities
Cash Flows from Investing Activities
• Inflows
– Cash received from sales of PP&E (selling an plant the
firm doesn’t need anymore). Pretty infrequent.
• Outflows
– Purchasing long-term assets (PP&E) = capital
expenditures (aka capex) (building a new plant)
– Acquisitions of other companies
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Cash Flows from Investing Activities
Cash Flows from Financing Activities
• Inflows
– Cash received from borrowing (i.e. firms borrow cash
from banks to make acquisitions)
– Cash received from issuing stock (i.e. firm issues shares
to raise money)
• Outflows
– Repaying debt (i.e. firms eventually have to pay back
what they borrowed from the bank)
– Paying dividends to shareholders
– Repurchasing stock
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Cash Flows from Financing Activities
Cash Flows
(CL)
How To Read Cash Flow Statements
• Its usefulness
– You can actually see where cash is going and how the company
spends it
– Changes in the B/S can be explained by looking at CF statement
– Get a better understanding of a company’s investing and
financing activities because these aren’t obvious in the I/S
• Its limitations
– When companies make acquisitions, it is often difficult to fully
reconcile all of the cash inflows and outflows w/ the B/S
Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Most Important Metric from CF
statement: Free Cash Flow
• Free Cash Flow = Operating Cash Flow
– Capital Expenditures: Represents the cash that a
company has left over after paying money required to
maintain/expand its asset base
INCOME STATEMENT
Revenues
- CGS (includes Depreciation & Amortization)
Gross Profit
- Selling, General & Administrative Costs
- Research & Development
- Other Operating Expenses
Operating Income
- Interest Expense
-Taxes
Net Income
Earnings Per Share
Diluted Shares Outstanding
Sources: Vince Hanks, Motley Fool, fool.com; Investopedia
CASH FLOW STATEMENT
Operating Cash Flows:
Net Income
+ Depreciation & Amortization
+ Amortization on Research & Development
+ Changes in A/R, Inventory, A/P
Operating Cash Flow
- Capital Expenditures
FREE CASH FLOW
Seminar Recap
• Use balance sheets to assess a company’s
financial position at a point in time
– Look at key ratios to analyze a company’s business
• Income statements measure profitability
over a certain time period
– Look at the company’s sales growth, operating profit growth,
gross & operating margins, etc.
• Statements of cash flows help to show you
were cash has been used in the business
– Understand the difference between operating, investing, and
finanancing
Coming Up
• Week 6:
– Important financial metrics
– How to calculate financial ratios
– How to understand what financial ratios mean
• Week 7:
– Putting it all together to form an investment recommendation