Chapter 2
Introduction to Financial Statement Analysis
Chapter Outline
2.1 The Disclosure of Financial Information
2.2 The Balance Sheet
2.3 The Income Statement
2.4 The Statement of Cash Flows
2.5 Other Financial Statement Information
2.6 Accounting Manipulation
2
Learning Objectives
1.
2.
3.
List the four major financial statements required by the SEC
for publicly traded firms, define each of the four statements,
and explain why each of these financial statements is
valuable.
Discuss the difference between book value of stockholders’
equity and market value of stockholders’ equity; explain why
the two numbers are almost never the same.
Compute the following measures, and describe their
usefulness in assessing firm performance: the debt-equity
ratio, the enterprise value, earnings per share, operating
margin, net profit margin, accounts receivable days, accounts
payable days, inventory days, interest coverage ratio, return
on equity, return on assets, price-earnings ratio, and marketto-book ratio.
3
Learning Objectives (cont'd)
4.
Describe the importance of ensuring that valuation ratios are
consistent with one another in terms of the inclusion of debt
in the numerator and the denominator.
5.
Distinguish between cash flow, as reported on the statement
of cash flows, and accrual-based income, as reported on the
income statement; discuss the importance of cash flows to
investors, relative to accrual-based income.
6.
Explain the importance of the notes to the financial
statements.
7.
List and describe the financial scandals described in the text,
along with the new legislation designed to reduce that type of
fraud.
4
2.1 Disclosure of Financial Information

Financial Statements

Firm-issued accounting reports with past
performance information

Filed with the SEC

10Q


Quarterly
10K

Annual
5
2.1 Disclosure of Financial Information
(cont'd)

Preparation of Financial Statements

Generally Accepted Accounting Principles (GAAP)

Auditor

Neutral third party that checks a firm’s financial
statements
6
2.1 Disclosure of Financial Information
(cont'd)

Types of Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Stockholders’ Equity
7
2.2 Balance Sheet

A snapshot in time of the firm’s financial
position

The Balance Sheet Identity:
Assets  Liabilities  Stockholders' Equity
8
2.2 Balance Sheet (cont'd)

Assets


Liabilities


What the company owns
What the company owes
Stockholder’s Equity

The difference between the value of the firm’s
assets and liabilities
9
2.2 Balance Sheet (cont'd)

Assets

Current Assets: Cash or expected to be turned
into cash in the next year

Cash

Marketable Securities

Accounts Receivable

Inventories

Other Current Assets

Pre-paid expenses
10
2.2 Balance Sheet (cont'd)

Assets

Long-Term Assets

Net Property, Plant, & Equipment



Goodwill


Book Value
Depreciation
Amortization
Other Long-Term Assets
11
Table 2.1
12
2.2 Balance Sheet (cont'd)

Liabilities

Current Liabilities: Due to be paid within the next
year

Accounts Payable

Notes Payable/Short-Term Debt

Current Maturities of Long-Term Debt

Other Current Liabilities


Taxes Payable
Wages Payable
13
2.2 Balance Sheet (cont'd)

Liabilities

Long-Term Liabilities

Long-Term Debt

Capital Leases

Deferred Taxes
14
Table 2.1 (cont'd)
15
2.2 Balance Sheet (cont'd)

Net Working Capital

Current Assets – Current Liabilities
16
2.2 Balance Sheet (cont'd)

Equity

Book Value of Equity

Book Value of Assets – Book Value of Liabilities


Could possibly be negative
Market Value of Equity
(Market Capitalization)


Market Price per Share
Outstanding

Number of Shares
Cannot be negative

17
Example 2.1
18
Example 2.1 (cont'd)
19
Alternative Example 2.1

Problem

Rylan Enterprises has 5 million shares
outstanding.

The market price per share is $22.

The firm’s book value of equity is $50 million.

What is Rylan’s market capitalization?

How does the market capitalization compare
to Rylan’s book value of equity?
20
Alternative Example 2.1

Solution

Rylan’s market capitalization is $110 million

5 million shares × $22 share = $110 million.

The market capitalization is significantly higher than
Rylan’s book value of equity of $50 million.
21
2.2 Balance Sheet (cont'd)

Balance Sheet Analysis

Liquidation Value


Value of the firm if all assets were sold and liabilities
paid
Market-to-Book Ratio
Market-to-Book Ratio 

Value Stocks


Market Value of Equity
Book Value of Equity
Low M/B ratios
Growth stocks

High M/B ratios
22
2.2 Balance Sheet (cont'd)

Balance Sheet Analysis

Debt-Equity Ratio

Measures a firm’s leverage
Debt-Equity Ratio 


Total Debt
Total Equity
Using Book Value versus Market Value
Enterprise Value
Enterprise Value  Market Value of Equity  Debt  Cash
23
Example 2.2
24
Example 2.2 (cont'd)
25
2.2 Balance Sheet (cont'd)

Other Balance Sheet Information

Current Ratio


Current Assets / Current Liabilities
Quick Ratio

(Current Assets – Inventories) / Current Liabilities
26
2.3 Income Statement

Total Sales/Revenues


Cost of Sales


minus
equals
Gross Profit
27
2.3 Income Statement (cont'd)

Gross Profit


minus
Operating Expenses





Selling, General, and Administrative Expenses
R&D
Depreciation & Amortization
equals
Operating Income
28
2.3 Income Statement (cont'd)

Operating Income


Other Income/Other Expenses


plus/minus
equals
Earnings Before Interest and Taxes (EBIT)
29
2.3 Income Statement (cont'd)

Earnings Before Interest and Taxes (EBIT)


Interest Income/Interest Expense


plus/minus
equals
Pre-Tax Income
30
2.3 Income Statement (cont'd)

Pre-Tax Income


Taxes


minus
equals
Net Income
31
Table 2.2
32
2.3 Income Statement (cont'd)

Earnings per Share
Net Income
$2.0 million
EPS 

 $0.556 per share
Shares Outstanding
3.6 million shares

Stock Options

Convertible Bonds

Dilution

Diluted EPS
33
2.3 Income Statement (cont'd)

Income Statement Analysis

Profitability Ratios


Operating Margin
Operating Income
Operating Margin 
Total Sales
Net Profit Margin
Net Profit Margin 
Net Income
Total Sales
34
2.3 Income Statement (cont'd)

Income Statement Analysis

Working Capital Days

Accounts Receivable Days
Accounts Receivable Days 

Accounts Receivable
Average Daily Sales
EBITDA

Reflects the cash a firm has earned from its operations
35
2.3 Income Statement (cont'd)

Income Statement Analysis

Leverage Ratios/Interest Coverage Ratios

EBIT / Interest Expense

Operating Income / Interest Expense

EBITDA / Interest Expense
36
2.3 Income Statement (cont'd)

Income Statement Analysis

Investment Returns

ROA



Net Income / Total Assets
ROE
Return on Equity 
Net Income
Book Value of Equity
Valuation Ratios

P/E Ratio Market Capitalization
P / E Ratio 
Net Income

Share Price
Earnings per Share
37
Example 2.3
38
Example 2.3 (cont'd)
39
2.4 Statement of Cash Flows

Net Income typically does NOT equal the
amount of Cash the firm has earned.

Non-Cash Expenses


Depreciation and Amortization
Uses of Cash not on the Income Statement

Investment in Property, Plant, and Equipment
40
2.4 Statement of Cash Flows (cont'd)

Three Sections

Operating Activities

Investment Activities

Financing Activities
41
2.4 Statement of Cash Flows (cont'd)

Operating Activities

Adjusts net income by all non-cash items related
to operating activities and changes in net working
capital
42
2.4 Statement of Cash Flows (cont'd)


Investing Activities

Capital Expenditures

Buying or Selling Marketable Securities
Financing Activities

Changes in Borrowings

Payment of Dividends

Retained Earnings
Retained Earnings
 Net Income  Dividends
43
44
Example 2.4
45
Example 2.4 (cont'd)
46
2.5 Other Financial Statement Information

Management Discussion and Analysis

Off-Balance Sheet Transactions

Statement of Stockholders’ Equity

Notes to the Financial Statements
47
Example 2.5
48
Example 2.5 (cont'd)
49
Alternative Example 2.5

Problem

Campbell Soup Company reported the following sales
revenues
by category:
U.S. Soup, Sauces and Beverages
Baking and Snacking
International Soup and Sauces
Other
Total


$
$
$
$
$
2006
3,257
1,747
1,255
1,084
7,343
$
$
$
$
$
2005
3,098
1,742
1,227
1,005
7,072
What was the percentage growth for each category?
If Campbell’s has the same percentage growth from 2006
to 2007, what will its total revenues be in 2007?
50
Alternative Example 2.5

Solution

U.S. Soup, Sauces and Beverages


Baking and Snacking


($1,255 ÷ $1,227) − 1 = 2.28%
Other


($1,747 ÷ $1,742) − 1 = 0.29%
International Soup and Sauces


($3,257 ÷ $3,098) − 1 = 5.13%
($1,084 ÷ $1,005) − 1 = 7.86%
Total

($7,343 ÷ $7,072 ) − 1 = 3.83%
51
Alternative Example 2.5

Solution (continued)

Estimated 2007 Total Revenue

$7,343 × (1 + 3.83%) =

$7,343 × 1.0383 = $7,624
52
2.6 Accounting Manipulation

Enron

WorldCom

Sarbanes-Oxley Act (SOX)
53