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
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Learning Objectives
1.
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.
2.
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.
3.
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, priceearnings ratio, and market-to-book ratio.
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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.
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2.1 Disclosure of Financial Information
• Financial Statements
Firm-issued accounting reports with past
performance information
Filed with the SEC
• 10Q
Quarterly
• 10K
Annual
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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
To obtain reasonable assurance about whether the financial
statements are free of material misstatement
Statements are in conformity with accounting principles
generally accepted in the U.S. (GAAP)
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2.1 Disclosure of Financial
Information (cont'd)
• Types of Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholders’ Equity
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2.2 Balance Sheet
• A snapshot in time of the firm’s financial position
• The Balance Sheet Identity:
Assets Liabilities Stockholders' Equity
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2.2 Balance Sheet (cont'd)
• 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
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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
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2.2 Balance Sheet (cont'd)
• Assets
Long-Term Assets
• Net Property, Plant, & Equipment
Book Value
Depreciation
• Goodwill
Amortization
• Other Long-Term Assets
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Table 2.1
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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
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2.2 Balance Sheet (cont'd)
• Liabilities
Long-Term Liabilities
• Long-Term Debt
• Capital Leases
Long term leases on capital equipment
• Deferred Taxes
Occur when the financial income differs from taxable income.
Eventually the difference will have to be made up
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Table 2.1 (cont'd)
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2.2 Balance Sheet (cont'd)
• Net Working Capital
Current Assets – Current Liabilities
• For Global Conglomerate Corp. (2005)
= $57M - $48M = $9 Million
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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 Number of Shares Outstanding
Cannot be negative
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Example 2.1
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Example 2.1 (cont'd)
• Market Capitalization = $14 X 3.6 million
= $50.4 million
• Book value of Equity = $22.2 million
• Market to Book Ratio = 50.4/22.2 = 2.27
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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?
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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.
• Market to Book Ratio is ???
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2.2 Balance Sheet (cont'd)
• Balance Sheet Analysis
Liquidation Value
• Value of the firm if all assets were sold and liabilities paid
• Unless there is reason to believe otherwise, usually we assume
the Book Value of Assets is the liquidation value of the firm
Market-to-Book Ratio
Market Value of Equity
Market-to-Book Ratio
Book Value of Equity
• Value Stocks
Low M/B ratios
• Growth stocks
High M/B ratios
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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
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Example 2.2
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Computing Enterprise Value (Cont.)
• Enterprise Value = Market Cap (MC) + Debt –
Cash
Market Cap = $36.87 * 347.6 = $12.82B
[BV of] Debt = MC * Debt to Equity Ratio /Market to Book
MVE * BVD/BVE * BVE/MVE
MVE * BVD/BVE * BVE/MVE
= $12.82B * 1.80/4.93 =
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Computing Enterprise Value (Cont.)
• Enterprise Value = Market Cap (MC) + Debt –
Cash
Market Cap = $36.87 * 347.6 = $12.82B
[BV of] Debt = MC * Debt to Equity Ratio /Market to Book
MVE * BVD/BVE * BVE/MVE
MVE * BVD/BVE * BVE/MVE
= $12.82B * 1.80/4.93 = $4.68B
Cash
= $1.08B
• Enterprise Value = $12.82 + $4.68 - $1.08 = $16.42 B
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2.2 Balance Sheet (cont'd)
• Other Balance Sheet Information
Current Ratio
• Current Assets / Current Liabilities
For Global =
Quick Ratio
• (Current Assets – Inventories) / Current Liabilities
For Global =
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2.2 Balance Sheet (cont'd)
• Other Balance Sheet Information
Current Ratio
• Current Assets / Current Liabilities
For Global = 1.19
Quick Ratio
• (Current Assets – Inventories) / Current Liabilities
For Global = 0.87
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2.3 Income Statement
• Lists the firms revenues and expenses over time
(in contrast to the balance sheet, it is a flow, not a
stock or snapshot)
• Gives Net Income (bottom line) or Earnings over
some period of time
• Sometimes referred to as P & L Statement
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Table 2.2
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2.3 Income Statement
• Total Sales orRevenues
minus
• Cost of Sales
equals
• Gross Profit
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2.3 Income Statement (cont'd)
• Gross Profit
minus
• Operating Expenses
• Selling, General, and Administrative Expenses
• R&D
• Depreciation & Amortization
equals
• Operating Income
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2.3 Income Statement (cont'd)
• Operating Income
Plus or minus
• Other Income or Other Expenses
equals
• Earnings Before Interest and Taxes (EBIT)
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2.3 Income Statement (cont'd)
• Earnings Before Interest and Taxes (EBIT)
Plus or minus
• Interest Income or Interest Expense
equals
• Pre-Tax Income
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2.3 Income Statement (cont'd)
• Pre-Tax Income
minus
• Taxes
equals
• Net Income
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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
• Employee Stock Options
• Convertible Bonds
• Dilution
Fully Diluted EPS
• E.g. suppose Global has 2 million shares in stock options
outstanding and convertible bonds that can be converted to
1 million shares of stock, then fully diluted EPS is: 0.513
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Profitability Ratios
(For Global =
• Operating Margin
Operating Margin
Operating Income
Total Sales
Net Profit Margin
Net Profit Margin
Net Income
Total Sales
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Profitability Ratios
• Operating Margin
Operating Margin
(For Global = 10.4/186.7 = 5.57%)
Operating Income
Total Sales
Net Profit Margin (For Global = 2/186.7 = 1.07%)
Net Profit Margin
Net Income
Total Sales
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Working Capital Days
• Accounts Receivable Days
Accounts Receivable Days
Accounts Receivable
Average Daily Sales
For Global = 18.5/.511 = 36 days
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2.3 Income Statement (cont'd)
• Income Statement Analysis
EBITDA = Earnings Before Interest Taxes Depreciation and
Amortization
= EBIT + Depreciation and Amortization
Accounts Receivable Days
Accounts Receivable
Average Daily Sales
For Global = 10.4 + 1.2 = 11.6
It represents the cash available to pay the “claimants to that cash”
i.e. Stockholders, bondholders and the Government
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Leverage Ratios or Interest Coverage Ratios
• EBIT / Interest Expense
• Operating Income / Interest Expense
• EBITDA / Interest Expense
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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
P / E Ratio
Market Capitalization
Share Price
Net Income
Earnings per Share
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2.3 Income Statement (cont'd)
• Income Statement Analysis For Global
Investment Returns
• ROA = 2/177.7 = 1.13%
• ROE = 2/22.2 = 9.01%
• PE Ratio = 14/1.25 = 17.5
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Example 2.3
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Example 2.3 Continued
WMT
Operating Margin
5.90%
Net Profit Margin
3.47%
P/E Ratio
22.80%
Enterprise Value (EV) 255
[EV/Operating Income] 15.00
[EV/Sales]
.89
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TGT
7.66%
4.04%
23.68%
53
14.72
1.13
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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
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2.4 Statement of Cash Flows (cont'd)
• Three Sections
Operating Activities
Investment Activities
Financing Activities
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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
Accountants Depreciate fixed assets rather than
account for them when they are actually paid for. So
for example, a purchase of a machine of $1 million will
“use” 1 million dollars in Cash, but this does not appear
on the income statement. What does appear is the
depreciation associated with passed purchases of fixed
assets. So we must adjust net income for this
Depreciation Expense that is not a cash expense, and
the investment expense which is.
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2.4 Statement of Cash Flows (cont'd)
• Changes in Non-Cash Working Capital: =
Accounts Receivable
– Accounts Payable
+ Inventory
Notice that increases in Accounts Receivable means we
did not get the cash that was recorded in sales
(Decreasing Cash), increases in Accounts Payable means
we did not pay the cost of goods sold (Increasing Cash),
and increases in inventory means we recorded an
expense (to create the inventory) but it was not part of
Cost of Goods Sold (Deceasing Cash)
So we must adjust Net Income by subtracting Changes in
Non-Cash net working Capital.
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2.4 Statement of Cash Flows (cont'd)
• Investing Activities
Capital Expenditures or Sales
Buying or Selling Marketable Securities
• Financing Activities
Changes in Borrowings or Equity
Increases in Borrowing – Decreases in Borrowing +
Equity Issue – Equity repurchases
Payment of Dividends
• Retained Earnings
Retained Earnings
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Net Income Dividends
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Example 2.4
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Example 2.4 (cont'd)
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2.5 Other Financial Statement Information
• Management Discussion and Analysis
Off-Balance Sheet Transactions
• Statement of Stockholders’ Equity
• Notes to the Financial Statements
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2.6 Accounting Manipulation
• Enron
• WorldCom
• Sarbanes-Oxley Act (SOX)
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Questions?
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