smartwomansecurities
October 25, 2006
Introduction to Financial
Statement Analysis
Carolyn Clark
Harvard Business School
These materials are made for educational
purposes and should not be distributed.1 All
materials are for SWS members’ use only
Announcements
2
Announcements
• Industry Teams
– Meet your team members; talk about your company’s
business and its competitors
• Industry Mentors
– Your Industry Mentor will be emailed to you this
week; correspondence with Industry Mentors should
be made as a group. For more details about Industry
Mentors, check out the Mentor sheet you received
last week!
3
Senior Mentors
• Senior Mentors
– Senior Mentors are another optional resource for SWS members.
– We currently have several Senior Mentors that we want to pair
up with interested members; Senior Mentors are senior-level
executives and professionals that have been highly successful in
their various fields.
– We will send out information about Senior Mentors in an email
after this seminar; in order to get a Senior Mentor, you will have
to write a short paragraph detailing why you would like to have
that person as your Senior Mentor.
– Depending on demand, we will likely only have 1-2 mentees per
Senior Mentor.
4
Senior Mentors
• Jodi Tan, Chief Financial Officer, Chimay
Capital Management
• Emily Grimes Wood, Financial Advisor,
Grimes and Company
• Eva Valentine, Principal Executive Officer,
Aegis Financial Strategies
– We will email you the bios of these women after the seminar
in order for you to get a better sense of what they do.
– We will update you as more opportunities to get Senior
Mentors arise!
5
Accounting and Financial
Statements
6
Financial Accounting
• Why is accounting useful?
– Translates activities into objective numbers
• Allows comparability across time, firms and industries
– Enables the assessment of:
• Performance
• Problems
• Prospects
– Informs the decisions of:
• Managers of the company
• Internal and external auditors
• Investors and creditors
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
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Accessing Financial Statements
• How do investors get access to
financial statements?
– A public company’s financial statements MUST be
available to the public (further requirements as
mandated by Sarbanes-Oxley, an act passed by
Congress in 2002 to fight fraud in corporations)
– 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
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Accessing Financial Statements
• Public Companies: www.sec.gov/edgar
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Financial Statements
• Annual Reports (10-K)
–
–
–
–
–
–
Company overview & business description
Accounting policies (GAAP)
Financial statements (and footnotes!)
Management discussion and analysis (MD&A)
Directors and executive officers’ bios
Executive compensation
• Quarterly Reports (10-Q)
– Financial statements
– MD&A
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Financial Statements
• What do investors look at?
–
–
–
–
Balance Sheet
Income Statement
Statement of Cash Flows
Footnotes
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Balance Sheet
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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 organization
• Liabilities (what the company owes)
– the entity’s economic obligations to non-owners
• Owners’ equity (whatever is left)
– the excess of the assets over the liabilities (also called
“stockholder’s/shareholder’s equity”)
– Homeowner example
• Assets = Liabilities + Owner’s Equity
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
13
Balance Sheet: Its Components
Assets: A company’s
resources
Liabilities: Claims
against the company’s
resources
Owner’s Equity:
Remaining Claims
accruing to owners
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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Assets
Assets generate probable future economic benefits
(value) for the company
• Examples: Cash, Accounts Receivable, Supplies, Inventory,
Property and Equipment, Furniture, etc.
• Current Assets: Assets that can be converted to cash within
one year or the operating cycle, whichever is longer (ie. cash,
receivables, inventory)
• Non-Current Assets: Assets that are not expected to be
converted to cash within that time period: property, plants,
equipment, investments and funds
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
15
Liabilities
Liabilities are obligations to deliver something of
value (usually cash or services) in the future
• Examples: Accounts Payable, Salaries Payable, Interest
Payable, Note Payable
• Current Liabilities: Obligations that are expected to be paid
within one year (ie. notes payable, accounts payable, etc)
• Non-Current Liabilities: Obligations that are not expected
to be paid within one year or the operating cycle, whichever is
longer (ie. bonds payable, long-term notes payable, pension
liabilities, capital leases)
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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Shareholder’s Equity
Equity is the residual interest in the
assets of an entity that remains after
its liabilities are deducted
•
•
•
•
Stock and Paid-in Capital
Retained Earnings
Treasury Stock
Other
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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How we can read balance sheets
• Its usefulness
– Gives information about the liquidity of a company
– Long-term solvency information (the ability of a
corporation to meet its long-term fixed expenses
and to accomplish long-term expansion and growth)
• Its limitations
– Assets are recorded at historical cost rather than at
market value (what you paid, not what it’s “worth”)
– Resources such as employee skills and reputation are
NOT recorded on balance sheet
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Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001; Investopedia.com
An investor’s look at balance sheets
• Current Ratio: a measure of shortterm liquidity risk
• Current Assets/Current Liabilities
– Want to see a Current Ratio > 1 (ideally between 1.5
and 2)
• A ratio less than 1 means that a company can’t pay its
bills!
• Anything over 2 means that the company can easily
fund its current liabilities, but may be keeping cash for
other purposes.
Sources: What is a “Strong” Balance Sheet, Chris Cather, Motley Fool, fool.com, February 2, 2005
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An investor’s look at balance sheets
• Return on Equity: Measure of the
efficiency with which a company
employs its owners’ capital
• Net Income / Owners’ Equity
– Measures the percentage return to owners on their
investment (earnings per dollar invested)
– Helps managers and investors gauge where to
allocate their capital
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An investor’s look at balance sheets
• Debt-to-Equity: This ratio measures the
amount of long-term debt financing relative
to equity in a firm’s capital structure
• Long-term Debt / Owners’ Equity
– Firms typically have a target debt-to-equity ratio; the degree
of leverage varies across industries
• Note: Don’t try to compare debt-to-equity ratios across different
industries; in order to truly understand this ratio, must look at close
peers to the company you’re covering
Sources: What is a “Strong” Balance Sheet, Chris Cather, Motley Fool, fool.com, February 2, 2005
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Example: Balance Sheet (AEOS)
American Eagle Outfitters
In Millions of USD (except for per share items)
1Q06
4Q05
Cash & Equivalents
331.36
168.57
130.53
Short Term Investments
482.73
602.80
620.99
Cash and Short Term Investments
814.09
771.37
751.52
Accounts Receivable - Trade, Net
13.29
30.64
29.15
Total Receivables, Net
13.29
30.64
29.15
Total Inventory
267.39
195.31
210.74
Prepaid Expenses
33.95
33.35
30.11
Other Current Assets, Total
Total Current Assets
Property/Plant/Equipment, Total - Gross
Goodwill, Net
Long Term Investments
Other Long Term Assets, Total
36.97
34.13
55.27
1,165.69
1,064.81
1,076.78
752.03
689.87
667.02
9.95
9.95
9.95
117.29
153.72
145.77
39.24
32.17
27.63
1,736.57
1,617.26
1,605.65
Accounts Payable
175.93
121.03
139.20
Accrued Expenses
101.87
109.78
143.60
Total Assets
Notes Payable/Short Term Debt
0.00
0.00
0.00
Other Current liabilities, Total
60.83
63.74
68.69
Total Current Liabilities
338.63
294.56
351.49
Total Long Term Debt
0.00
0.00
0.00
Total Debt
0.00
0.00
0.00
Other Liabilities, Total
104.55
99.60
98.61
Total Liabilities
443.18
394.16
450.10
Common Stock, Total
1.70
1.62
1.61
403.75
387.66
370.62
Retained Earnings (Accumulated Deficit)
1,087.01
1,031.80
978.86
Treasury Stock - Common
-224.13
-223.66
-216.51
25.05
25.68
20.99
Total Equity
1,293.39
1,223.10
1,155.55
Total Liabilities & Shareholders' Equity
1,736.57
1,617.26
1,605.65
149.40
148.93
147.93
Additional Paid-In Capital
Other Equity, Total
From Google Finance
2Q06
Total Common Shares Outstanding
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Income Statement
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Income Statement
• “Flow” in a given period (vs. a given
point in time)
• Basic equation:
Net Income = Revenues – Expenses
– Revenues: sources of income
– Expenses: uses of income
• Net Income = “earnings” to be divided
among the firm’s shareholders (EPS)
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Revenues and Expenses
• Revenues are inflows of resources as a
result of providing goods or services to
customers
– Examples: Sales, interest income, gain on sale of plant
assets
• Expenses are outflows of resources
incurred in generating revenues
– Examples: Cost of goods sold, selling expenses, general
and administrative expenditures, depreciation, interest,
income taxes
Source: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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How we can read income statements
• Its usefulness
– Summarizes sales and profits over a period of time
– Lets us look at changes in key line items and ratios across time to
see whether operations have been changing
• Its limitations
– Difficult to compare some ratios for companies in different
industries
– 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
26
An investor’s look at income statements
• Gross Profit = Revenue – Cost of Goods Sold (“COGS”)
• Gross Margin = Gross Profit/Revenue
• Operating Profit = Revenues – COGS – Remaining costs
involved in operations (ie. employee compensation,
advertising, expenses, etc.)
• Operating Margin = Operating Profit/Revenue
– Operating margin measures the proportion of a company’s revenue that is left
over after paying for costs of operating, such as labor, raw materials, etc.)
– A healthy gross margin is important for a company to pay its operating costs.
The higher the margin the better!
• Note: Margins vary widely by industry. For example, software companies (ie,
Microsoft) tend to have high margins, whereas retailers (ie, Wal-Mart) tend to
have low margins
– Why? (Hint: think about the “value-add” each company offers its customers. How
replicable are the goods/services each company is offering?)
• Lower-margin companies like Wal-Mart can still be very profitable because
they make up for their margins through selling large volumes of products
Sources: Foolish Fundamentals: The Income Statement, Motley Fool, fool.com, August 25, 2006; Investopedia
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Income Statement (AEOS)
In Millions of USD (except for per share items)
2Q06
1Q06
Revenue
Other Revenue, Total
Total Revenue
Cost of Revenue, Total
Gross Profit
Selling/General/Admin. Expenses, Total
Research & Development
Depreciation/Amortization
Total Operating Expense
Operating Income
Other, Net
Income Before Tax
Income After Tax
Net Income Before Extra. Items
Net Income
Preferred Dividends
Income Available to Common Excl. Extra Items
Income Available to Common Incl. Extra Items
Basic Weighted Average Shares
Basic EPS Excluding Extraordinary Items
Basic EPS Including Extraordinary Items
Dilution Adjustment
Diluted Weighted Average Shares
Diluted EPS Excluding Extraordinary Items
Diluted EPS Including Extraordinary Items
Dividends per Share - Common Stock Primary Issue
Diluted Normalized EPS
602.33
602.33
327.79
274.53
143.58
21.70
493.07
109.25
8.97
118.22
72.10
72.10
72.10
72.10
72.10
0.48
149.20
0.00
152.81
0.47
0.11
0.47
522.43
522.43
268.61
253.82
135.76
19.23
423.61
98.82
7.54
106.36
64.16
64.16
64.16
64.16
64.16
0.43
148.48
0.00
152.26
0.42
0.07
0.42
From Google Finance
4Q05
764.37
764.37
410.12
354.24
160.87
19.15
590.14
174.23
4.38
178.60
107.14
107.14
107.54
107.14
107.54
0.72
151.60
0.00
151.46
0.71
0.07
0.71 28
Statement of Cash Flows
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Cash Flows
• Statement of cash flows provides relevant
information about a company’s cash inflows
and outflows
• Net Income ≠ Cash!!
– Net income is an accounting concept (GAAP rules); cash is king
• 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
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Cash Flows
• Cash flows come from
– Operating Activities
• How much cash do the firm’s core operations generate?
– Investing Activities
• Buying and selling non-current assets
– Financing Activities
• How does the company buy its assets and pay its debts?
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Cash Flows from Operating Activities
• Inflows
– Cash received from customers
– Interest income on receivables
– Dividends from investments
• Outflows
–
–
–
–
Purchasing inventory
Salaries, wages, and other operating expenses
Interest on debt
Income taxes
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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Cash Flows from Investing Activities
• Inflows
– Cash received from sales of PP&E
– Sale of investments
• Outflows
– Purchasing long-term assets (PP&E)
– Purchasing investments
– Acquisitions of other companies, divisions, etc.
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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Cash Flows from Financing Activities
• Inflows
– Cash received from sale of equity securities
– Cash received from borrowing, through bonds, loans,
mortgages, etc.
• Outflows
– Repaying debt
– Paying out dividends to shareholders
– Repurchasing stock in the market
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
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How we can read cash flow statements
• Its usefulness
– You can actually see where cash is going; can fill in the
gaps between balance sheets
– Get a better understanding of a company’s investing
and financing activities
• Its limitations
– There are different methods to report cash flows that
may vary across firms; it is often difficult to fully
reconcile all of the cash inflows and outflows
• Remember that competitors can read your financial
statements, too!!
Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
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An investor’s look at cash flows
• Net Operating Cash Flow: This represents the company’s
true cash profit.
• Net Investing Cash Flow: Investing activities let us know
what a company may to aiming to do in the future; high investing
outflow means a company may be expanding to grow a business.
• Free Cash Flow = Operating Cash Flow – Capital
Expenditures (represents the cash that a company is able to
generate after laying out the money required to maintain/expand
its basset base)
• Net Financing Cash Flow: Financing activities let us know
what a company is doing to get more cash.
• Note: It is important to note that negative free cash flow is not bad in itself.
If free cash flow is negative, it could be a sign that a company is making
large investments. If these investments earn a high return, the strategy has
the potential to pay off in the long run.
Sources: Vince Hanks, Motley Fool, fool.com; Investopedia
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Cash Flows (AEOS)
In Millions of USD (except for per share items)
2Q06
1Q06
4Q05
Net Income/Starting Line
Depreciation/Depletion
Amortization
Deferred Taxes
72.10
21.71
-10.68
64.16
19.23
3.12
107.54
19.15
-5.13
Non-Cash Items
Changes in Working Capital
Cash from Operating Activities
10.04
180.15
273.31
11.49
-43.75
54.26
5.20
142.01
268.77
Capital Expenditures
Other Investing Cash Flow Items, Total
-71.44
-27.61
-31.71
22.93
-21.79
-247.15
Cash from Investing Activities
-99.05
-8.78
-268.94
Financing Cash Flow Items
Total Cash Dividends Paid
Issuance (Retirement) of Stock, Net
2.62
-16.88
4.35
3.24
-11.21
-1.71
-11.14
-19.94
Issuance (Retirement) of Debt, Net
-0.30
-0.17
-0.19
Cash from Financing Activities
-10.20
-9.86
-31.27
Foreign Exchange Effects
Net Change in Cash
Cash Interest Paid, Supplemental
Cash Taxes Paid, Supplemental
-1.27
162.79
56.46
2.42
38.04
43.16
1.62
-29.83
46.09
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From Google Finance
Key Takeaways
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Key Points
• 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 performance
– Look at the company’s performance over time in terms of
profits, margins, etc.
• Use statement of cash flows to follow the
money
– Look at where cash is going; free cash flow is a key metric!
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Q&A
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