CHAPTER 2 INTRODUCTION
TO FINANCIAL STATEMENT
ANALYSIS
Zoubida SAMLAL - MBA , CFA Member,
PHD candidate for HBS program
LEARNING OBJECTIVES
1. List the four major financial statements required by the SEC
for publicly traded firms
2. Discuss the difference between book value of stockholders’
equity and market value of stockholders’ equity
3. Compute the measures that describe a firm’s performance
4. Discuss the uses of the DuPont identity in disaggregating
ROE, and assess the impact of increases and decreases in the
components of the identity on ROE.
LEARNING OBJECTIVES
5. Describe the importance of ensuring that valuation ratios are
consistent with one another.
6. Distinguish between cash flow, as reported on the statement
of cash flows, and accrual-based income, as reported on the
income statement
7. Explain what is included in the management discussion and
analysis section of the financial statements
8. Explain the importance of the notes to the financial
statements.
DISCLOSURE OF FINANCIAL INFORMATION
• Financial Statements
– Firm-issued accounting reports with past
performance information
– Filed with the SEC
• 10Q
– Quarterly
• 10K
– Annual
– Must also send an annual report with financial
statements to shareholders
DISCLOSURE OF FINANCIAL
INFORMATION
• Preparation of Financial Statements
– Generally Accepted Accounting Principles (GAAP)
– Auditor
• Neutral third party that checks a firm’s financial
statements
DISCLOSURE OF FINANCIAL
INFORMATION
• Types of Financial Statements
– Balance Sheet
– Income Statement
– Statement of Cash Flows
– Statement of Stockholders’ Equity
BALANCE SHEET
• A snapshot in time of the firm’s financial
position
• The Balance Sheet Identity:
Assets  Liabilities  Stockholders' Equity
BALANCE SHEET
• Assets
– What the company owns
• Liabilities
– What the company owes
• Stockholder’s Equity
– The difference between the value of the firm’s
assets and liabilities
BALANCE SHEET
• Assets
– Current Assets: Cash or expected to be turned into
cash in the next year
• Cash
• Marketable Securities
• Accounts Receivable
• Inventories
• Other Current Assets
– Example: Pre-paid expenses
BALANCE SHEET
• Assets
– Long-Term Assets
• Net Property, Plant, & Equipment
– Book Value = Acquisition cost
– Depreciation (and Accumulated Depreciation)
• Goodwill and intangible assets
– Amortization
• Other Long-Term Assets
– Example: Investments in Long-term Securities
GLOBAL CONGLOMERATE CORPORATION
BALANCE SHEET FOR 2009 AND 2008
BALANCE SHEET
• Liabilities
– Current Liabilities: Due to be paid within the next
year
• Accounts Payable
• Short-Term Debt/Notes Payable
• Current Maturities of Long-Term Debt
• Other Current Liabilities
– Taxes Payable
– Wages Payable
BALANCE SHEET
• Net Working Capital
– Current Assets – Current Liabilities
BALANCE SHEET
• Liabilities
– Long-Term Liabilities
• Long-Term Debt
• Capital Leases
• Deferred Taxes
GLOBAL CONGLOMERATE CORPORATION BALANCE
SHEET FOR 2009 AND 2008
BALANCE SHEET
• 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 x Number of Shares
Outstanding
– Cannot be negative
TEXTBOOK EXAMPLE
TEXTBOOK EXAMPLE
ALTERNATIVE EXAMPLE
• 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?
ALTERNATIVE EXAMPLE
• 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.
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
– Low M/B ratios
• Growth stocks
– High M/B ratios
Market Value of Equity
Book Value of Equity
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
TEXTBOOK EXAMPLE
TEXTBOOK EXAMPLE
ALTERNATIVE EXAMPLE
• Problem
– In January 2009, Rylan Corporation (from
Alternative Example 2.1) had a market
capitalization of 110 million, a market-to-book
ratio of 2.2, a book debt to equity ratio of 1.4, and
cash of $6.3 million. What was Rylan’s enterprise
value?
ALTERNATIVE EXAMPLE
• Solution
– As stated in Alternative Example 2.1, Rylan’s book
value of equity was $50 million. Given a book
debt-equity ratio of 1.4, Rylan had total debt of
1.4 X 50 = 70 million. Thus, Rylan’s enterprise
value was 110+70 – 6.3 = $173.7 million.
BALANCE SHEET ANALYSIS
• Other Balance Sheet Information
– Current Ratio
• Current Assets / Current Liabilities
– Quick Ratio
• (Current Assets – Inventories) / Current Liabilities
INCOME STATEMENT
• Total Sales/Revenues
– minus
• Cost of Sales
– equals
• Gross Profit
INCOME STATEMENT
• Gross Profit
– minus
• Operating Expenses
• Selling, General, and Administrative Expenses
• R&D
• Depreciation & Amortization
– equals
• Operating Income
INCOME STATEMENT
• Operating Income
– plus/minus
• Other Income/Other Expenses
– equals
• Earnings Before Interest and Taxes (EBIT)
INCOME STATEMENT
• Earnings Before Interest and Taxes (EBIT)
– plus/minus
• Interest Income/Interest Expense
– equals
• Pre-Tax Income
INCOME STATEMENT
• Pre-Tax Income
– minus
• Taxes
– equals
• Net Income
GLOBAL CONGLOMERATE CORPORATION
INCOME STATEMENT FOR 2009 AND 2008
INCOME STATEMENT ANALYSIS
• 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
INCOME STATEMENT ANALYSIS
Gross Profit
Gross M arg in 
Sales
Operating Income
Operating M arg in 
Sales
Net Income
Net Profit Margin 
Total Sales
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
INCOME STATEMENT ANALYSIS
• Leverage Ratios/Interest Coverage Ratios
– EBIT / Interest Expense
– Operating Income / Interest Expense
– EBITDA / Interest Expense
INCOME STATEMENT ANALYSIS
• Investment Returns
– ROA
Net Income
Return on Assets 
Total Assets
– ROE
Return on Equity 
Net Income
Book Value of Equity
INCOME STATEMENT ANALYSIS
• The DuPont Identity
 

Total Assets
 Net Income   Sales
ROE  
  

  
 Sales   Total Assets   Book Value of Equity 
Net Profit Margin
Asset Turnover
Return On Assets
Equity Multiplier
TEXTBOOK EXAMPLE
TEXTBOOK EXAMPLE
Valuation Ratios
P/E Ratio
Market Capitalization
Share Price
P / E Ratio 

Net Income
Earnings per Share
Enterprise Value to Operating Income
Market value of Equity  Debt  Cash
Enterprise Value to EBIT 
EBIT
Enterprise Value to Sales
Market value of Equity  Debt  Cash
Enterprise Value to Sales 
Sales
TEXTBOOK EXAMPLE
TEXTBOOK EXAMPLE
ALTERNATIVE EXAMPLE
Problem:
Consider the following data for the year ended Dec. 31, 2008 for
Yahoo! and Google (in millions):
Yahoo!
Google
7,209
21,796
Operating Income
12
6,632
Net Income
424
4,227
Market Capitalization
22,830
177,380
Cash
2,292
8,657
Debt
2,439
3,529
Sales
Compare Yahoo and Google’s operating margin, net profit margin,
P/E ratio, and the ratio of enterprise value to operating income
and sales.
ALTERNATIVE EXAMPLE
Solution:
Yahoo! Had an operating margin of 12/7,209=0.17%, a net profit
margin of 424/7,209=5.88%, and a P/E ratio of
22,830/424=53.84. Its enterprise value was 22,830+24392292=22,977 million, which has a ratio of 22,977/12=1914.75 to
operating income and 22,977/7,209=3.19 to sales.
Google had an operating margin of 6,632/21,796=30.4%, a net
profit margin of 4,227/21,796=19.39%, and a P/E ratio of
177,380/4,227=41.96. Its enterprise value was 177,380+3,5298,657=172,252 million, which has a ratio of
172,252/6,632=25.97 to operating income and
172,252/21,796=7.90 to sales.
ALTERNATIVE EXAMPLE
• To summarize:
Ratio
Yahoo!
Google
Operating Margin
.17%
30.4%
Net Profit Margin
5.88%
19.39%
P/E Ratio
53.84
41.96
1914.75
25.97
3.19
7.90
Enterprise Value to
Operating Income
Enterprise Value to Sales
ALTERNATIVE EXAMPLE
Solution
Even though Yahoo! And Google are competitors, their
ratios look much different. Yahoo! has much lower profit
margins, yet their P/E ratio is higher than Google’s. Their
enterprise value to operating income ratio is also higher,
mostly because of low operating income. Enterprise
value to sales ratio is lower than that of Google. The
difference is consistent with Yahoo!’s lower margins.
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
STATEMENT OF CASH FLOWS
• Three Sections
– Operating Activities
– Investment Activities
– Financing Activities
STATEMENT OF CASH FLOWS
• Operating Activities
– Adjusts net income by all non-cash items related
to operating activities and changes in net working
capital
• Accounts Receivable – deduct the increases
• Accounts Payable – add the increases
• Inventories – deduct the increases
STATEMENT OF CASH FLOWS
• Investing Activities
– Capital Expenditures
– Buying or Selling Marketable Securities
• Financing Activities
– Payment of Dividends
• Retained Earnings = Net Income – Dividends
– Changes in Borrowings
GLOBAL CONGLOMERATE CORPORATION
STATEMENT OF CASH FLOWS FOR 2009 AND 2008
TEXTBOOK EXAMPLE
TEXTBOOK EXAMPLE
OTHER FINANCIAL STATEMENT
INFORMATION
• Management Discussion and Analysis
– Off-Balance Sheet Transactions
• Statement of Stockholders’ Equity
• Notes to the Financial Statements
TEXTBOOK EXAMPLE
TEXTBOOK EXAMPLE
ALTERNATIVE EXAMPLE
• 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
$
$
$
$
2009
3,257
1,747
1,255
1,084
Total
$
7,343
$
$
$
$
2008
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 2009 to 2010,
what will its total revenues be in 2010?
ALTERNATIVE EXAMPLE
• Solution
– U.S. Soup, Sauces and Beverages
• ($3,257 ÷ $3,098) − 1 = 5.13%
– Baking and Snacking
• ($1,747 ÷ $1,742) − 1 = 0.29%
– International Soup and Sauces
• ($1,255 ÷ $1,227) − 1 = 2.28%
– Other
• ($1,084 ÷ $1,005) − 1 = 7.86%
– Total
• ($7,343 ÷ $7,072 ) − 1 = 3.83%
ALTERNATIVE EXAMPLE
• Solution (continued)
– Estimated 2007 Total Revenue
• $7,343 × (1 + 3.83%)
• $7,343 × 1.0383 = $7,624
Financial Reporting in Practice
• Even with safeguards, reporting abuses still
happen:
– Enron
– WorldCom
– Sarbanes-Oxley Act (SOX)
DISCUSSION OF KEY TOPIC
• If either Ford or Microsoft’s P/E ratio is lower
than the industry average, do you expect the
stock price to go up? Could there be reasons
other than undervaluation for a firm to have a
low P/E?