Welcome to Class 16
Research: Financial Domain &
Case Studies – Part 2
Chapter 8
Key Financial Statements
A Review for non-Accountants
The Balance Sheet
Reports the financial condition of a corporation on the
last day of its fiscal year.
(Assets, Debts, and Equity)
The Balance Sheet (Cont)
Assets = tangible and intangible valuables that have an
assignable numerical value)
Debts = financial obligations to creditors and others
Equity = the residual after deducting debts from assets
Remember: Organizations have other important resources that
do not have an assignable numerical value – e.g. people
Balance
Sheet
Assets
Liabilities
Equity
Current
Current
Paid-in
Noncurrent
Noncurrent
Earned
Important Note about Stockholders Equity, Retained
Earnings, & Deficits!
STOCKHOLDERS EQUITY: is comprised of a variety of subcategories
however; each of these originates from one of two basic sources:
(1) Profits* (earnings/gains)
(2) Paid-in (sales of the corporation’s stock)
* The term “Profits” is used as a proxy for any increase in stockholders equity that is not a result of
additional investments by shareholders.
The Income Statement
Reports a firm’s revenues, expenses, net income, and related
items for the current fiscal year (plus two or more prior years).
Corporate net income =
total net revenue + other income - expenses and other deductions
The Income Statement (Cont)
Revenue may appear by many other names such as:
Sales, Fees, Commissions, Turnover, etc.
The after tax net income less dividends is added to
Stockholders Equity in the "earned capital" section, generally
called retained earnings.
If the company experienced a loss the amount of the loss plus
any dividends declared will be subtracted from equity.
Revenue
Costs
Gross
Profit
Expenses
Net
Income
The Statement of Cash Flows
Most businesses report their Income Statements and Balance
Sheets using the accrual basis of accounting.
Consequence :
Lack of information related to how cash is generated and
used by a firm.
Solution:
The statement of cash flows provides this information.
The Statement of Cash Flows bridges the informational gaps
between accounting reports and finance reports.
The Statement of Cash Flows (Cont)
Divides business activities into three (3) segments and
examines the cash flow through these
Each will indicate whether cash has been
“used in” or “provided by”
The three segments are:
(1) Operating Activities
(2) Investing Activities
(3) Financing Activities
Cash
Flow
Operating
Activities
Investing
Activities
Financing
Activities
Operating Activities
“Operating Activities” include cash used in or provided by:
 The routine process of day to day business activities.
NOT included in
“OPERATING” ACTIVITIES:
 Buying or selling equipment, facilities, patents, etc.
 Transactions with stockholders and long-term creditors
Investing Activities
“Investing Activities” include cash used
in or provided by:
 Acquiring subsidiary companies
 Selling subsidiary companies
 Investing in other companies
 Selling investments in other companies
 Buying or selling property, plant, and equipment
 Buying or selling other fixed, productive and/or
intangible assets, etc.
Financing Activities
“Financing Activities” include cash used in or provided by:
 Selling or repurchasing a company’s own stock
 Issuing corporate notes or bonds
 Borrowing money from other institutions (banks,
insurance companies, etc.)
 Debt repayment
 Payment of dividends, etc.
Cost of Capital/Interest Rate Terms:
1. Euribor = Euro interbank offered rate
2. Libor = London interbank offered rate
3. Prime Rate = Interest rate charged by commercial
banks to their most credit-worthy customers
4. Fed Funds Rate = Overnight rate that banks charge
each other
5. Discount Rate* = Interest rate charged to commercial
banks by the Federal Reserve
* Also is a term used in discounted cash flow (DCF) analyses
to determine the present value of future cash flows
The Statement of Cash Flows,
The Income Statement, &
The Balance Sheet …
Need to be “Common-sized” and
organized into financial categories
The Financial Four
Common-sizing financial data:
1. Translates financial data to allow comparison of different size firms
2. Converts currency data into percentages
3. Enables firms with different currencies to be compared
4. Facilitates grouping of various categories of performance into
those that are closely related – the Financial Four.
The Financial Four are:
1) Profit, Equity, & Share Value Management
2) Debt Management
3) Cash Management
4) Asset Management
1) Profit, Equity, & Share Value Management
 Continuously expanding profitability
 Increasing equity balances
 Strengthening the value of traded shares
… are interrelated and tied closely to a firm’s ability to:
 Achieving and sustaining a competitive advantages
 Yielding above average returns for stockholders
2) Debt Management
Financial leverage is important to most (not all) firms.
The degree of leverage and the proper configuration
(long-term and short-term) are crucial considerations.
Debt levels should be sufficient to satisfy current financial
requirements, amplify shareholder returns, and facilitate
corporate growth and expansion.
BUT, caution is important since excessive levels of debt
can shift corporate decision-making from TMTs to creditors.
3) Cash Management
Inadequate funds can lead to:
 Lost purchasing discounts (2% 10, n 30 = 36% apr)
 Missed business opportunities
 Alienation of suppliers, etc.
Excessive funds can lead to:
 Lack of financial productivity
 Render the firm highly prone to hostile takeover bids
4) Asset Management
An appropriate level , type, and configuration of Assets is
essential to the health of a corporation.
It is possible for a firm to have:
Too much invested in non-current assets = unproductive
Too little invested in non-current assets = unproductive
Outdated non-current assets (need to upgrade) = unproductive
Slow payment by customers = unproductive
Slow sales of Inventory = unproductive
Primary Techniques
for Studying
Financial Statements
The A-B-Cs of studying financial statements:
A – Preparing a list of performance questions
B – Commonsizing the financial data
C – Utilizing analysis methods, including:
1. Vertical analysis
2. Horizontal analysis
3. Cross-sectional analysis
4. Time-series analysis
A – Performance Questions
 Have revenues increased?
 Has gross margin improved?
 Has net income increased?
 Has EPS increased?
 Has the share price increased?
 Has total shareholder equity increased?
 Has retained earnings increased?
 Is return on equity adequate compared to a benchmark?
 How does return on assets compare to the benchmark?
 Is cash flow from operations positive (provided by) or
negative (used in)?
 Does "times interest earned" (cost of capital) look appropriate?
 What does the independent auditor (Certified Public
Accounting firm) say about the financial data?
B – Common-sizing
Common-sizing is the process of converting all
items on the financial statements to a percentage.
Advantages of common-sizing:
 Allows the comparison of a small corporation to a
large corporation
 Allows the comparison of two corporations
reporting in different currencies e.g. Yen vs.
Dollar
C – Analysis Methods
1. Vertical Analysis
Each line item is divided by a base number
Income Statement
Revenue as the divisor for all other items on the Income Statement
Balance Sheet
Total Assets as the divisor for everything on the Balance Sheet
This allows the measurement of deviation from acceptable norm.
2. Horizontal Analysis
(partial Time-Series)
Each line item is divided by its corresponding number
from the budget or from a previous period.
For example:
On both the Income Statement & the Balance Sheet
Each line item is divided by its counterpart from last year
and then 100% is subtracted to compute the % of change.
This allows the measurement of variance by category.
3. Cross-Sectional Analysis
{also called Target/Benchmark analysis}
The Cross-Sectional Analysis is a comparison of the
target company to the benchmark company.
It involves the comparison of common-sized
financial statement analyses (Balance Sheet and
Income Statement) of both companies.
4. Time-series Analysis
Time-series analysis is a combination of other analyses.
Time series analyses normally begin with a horizontal analysis, which is
a “sideways” line-item summary of period-over-period changes in
revenue, expenses, assets, debts, and equity.
Example: If a firm spent 20% more (or less) on advertising than it did in the
previous period, this would be revealed by this analysis.
Time-series analyses also include two vertical analyses. Comparing the
two vertical analyses reveals the extent to which individual
categorical activities have changed as a percentage of a base
number.
Example: The firm may have spent 4% of Sales on advertising during the
current period whereas in the previous period, 10% of Sales was
spent on advertising. Even though the absolute amount spent on
advertising may have increased the relative commitment has been
reduced. The example above represents a 6% relative reduction in
advertising.
Look for Red Flags
These are potential signs of trouble
The Red Flags
The Red Flags
1) Management bonuses or stock options increase when profits decrease or are
level
2) Acquisition of a competitor for a significant premium (Paying too much?)
3) Diversifications appear nonsensical – (unrelated or new ventures that appear
to lack the opportunity for synergy)
4) Reverse stock splits
5) Dividends are declared even though the firm is losing money
6) Off Balance Sheet Financing
7) Debt Refinancing
8) Restructuring, reengineering, downsizing, rightsizing, resizing, and
related euphemisms
9) Significant increases in Treasury Stock
10) Public statements about stock value or performance such as: “We know of
no better investment than our own company so we will be reacquiring
stock.”
11) Erratic or inconsistent decisions, actions, or achievements
The Red Flags
12) Disgruntled Board of Directors
13) Financial Statements that look a little too good or perhaps slightly
incongruent when compared to other data
14) Unusual financial arrangements or joint-ventures that appear strangely
complex
15) Assets that seem relatively too high or too low when compared by
percentage to the benchmark
16) Rapid changes in assets or debts – (Unusual increases or decreases in
Inventory, Receivables, Short-term Debt, etc.)
17) Restatement of earnings
18) Investigation by the SEC
The Red Flags
19) Changes in reported Net Income that seem inconsistent with changes in
Cash position – (e.g. Net Income up significantly while Cash is down
significantly)
20) Large or unusual non-operating expenses or income
21) Footnotes (endnotes) that seem unclear or ambiguous
22) Golden parachutes for executives that appear a little too generous
23) Extraordinary compensation packages for top management
24) The firm's independent auditors (CPAs) express a "reservation" in their
opinion section of the annual report
Addendum
Revenue
Income
Statement
Costs
Gross Profit
Operating Expenses
Other Expenses
Other Income
Net Income
Annual Reports can be difficult for the uninitiated to
read because they lack standardization.
Some degree of standardization my be on the horizon
with the advent of the XBRL system.
XBRL is a semi-standardized language that may offer future help
to readers of financial reports. This acronym stands for
eXtensible Business Reporting Language.
XBRL is a language for the electronic communication of business
and financial data that is meant to simplify the preparation
of financial data and to improve communication.
It originally began as a project by the American Institute of
Certified Public Accountants (AICPA) and now there are
multiple companies selling products (mostly software and
books) and services to assist with the implementation of
XBRL.
More information see – http://www.xbrl.org/Home/
The annual report contains separate segments, each with
unique and valuable data and these typically include:
 Chair's report
 CEO's report
 Auditor's report on corporate governance
 Mission Statement
 Compliance statement (Corporate Governance)
 Statement of Directors responsibilities
 Auditor's report on the financial statements
 Selected Financial Highlights
 Statement of Financial Position (Balance Sheet)
 Statement of Retained Earnings
 Statement of Revenues and Expenses (Income Statement)
 Statement of Cash Flows
 Notes to the Financial Statements
 Accounting Policies
Another important document
required by the SEC is the
Proxy Statement
The SEC requires that shareholders of a company
whose securities are registered under Section 12 of the
Securities Exchange Act of 1934 receive a proxy statement
prior to a shareholder meeting, whether an annual or special
meeting.
The information contained in the statement must be
filed with the SEC before soliciting a shareholder vote on the
election of directors and the approval of other corporate
action. Solicitations, whether by management or
shareholders, must disclose all important facts about the
issues on which shareholders are asked to vote.*
*Data directly from SEC website
Proxy Statements (cont)
Information included:
 Voting procedures
 Background information about the company's nominated directors (history
with the company or industry, positions on other corporate boards, and potential
conflicts in interest)
 Compensation received by Board Members
 TMT compensation, (salary, bonus, non-equity compensation, stock awards,
options, and deferred compensation).
 Data related to perks (personal use of company vehicles, aircraft, travel)
 Golden parachutes (payout packages to TMTs upon leaving the firm)
 Who is on the audit committee and detail about fees for both audit and nonaudit fees paid to CPA firm.
Abbreviations Related to Financial Documents
MRQ:
Most Recent Quarter
TTM:
Trailing Twelve Months
Enough!!
YOY:
Year Over Year
LFY:
Last Fiscal Year
FYE:
Fiscal Year Ending
End, Research: Financial Domain & Case Studies – Part 2