Chapter 2 Introduction to Financial Statement Analysis

1
Chapter 2Introduction to Financial Statement
Analysis
2
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

3
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,
   price-earnings ratio, and market-to-book ratio.

4
Learning Objectives (cont'd)

1. 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.
2. 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.
3. Explain the importance of the notes to the
   financial statements.
4. List and describe the financial scandals
   described in the text, along with the new
   legislation designed to reduce that type of fraud.

5
2.1 Disclosure of Financial Information

• Financial Statements
• Firm-issued accounting reports with past
  performance information
• Filed with the SEC
• 10Q
• Quarterly
• 10K
• Annual

6
2.1 Disclosure of Financial Information (cont'd)

• Preparation of Financial Statements
• Generally Accepted Accounting Principles (GAAP)
• Auditor
• Neutral third party that checks a firms
  financial statements

7
2.1 Disclosure of Financial Information (cont'd)

• Types of Financial Statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Stockholders Equity

8
2.2 Balance Sheet

• A snapshot in time of the firms financial
  position
• The Balance Sheet Identity

9
2.2 Balance Sheet (cont'd)

• Assets
• What the company owns
• Liabilities
• What the company owes
• Stockholders Equity
• The difference between the value of the firms
  assets and liabilities

10
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

11
2.2 Balance Sheet (cont'd)

• Assets
• Long-Term Assets
• Net Property, Plant, Equipment
• Book Value
• Depreciation
• Goodwill
• Amortization
• Other Long-Term Assets

12
Table 2.1
13
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

14
2.2 Balance Sheet (cont'd)

• Liabilities
• Long-Term Liabilities
• Long-Term Debt
• Capital Leases
• Deferred Taxes

15
Table 2.1 (cont'd)
16
2.2 Balance Sheet (cont'd)

• Net Working Capital
• Current Assets Current Liabilities

17
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

18
Example 2.1
19
Example 2.1 (cont'd)
20
Alternative Example 2.1

• Problem
• Rylan Enterprises has 5 million shares
  outstanding.
• The market price per share is 22.
• The firms book value of equity is 50 million.
• What is Rylans market capitalization?
• How does the market capitalization compare to
  Rylans book value of equity?

21
Alternative Example 2.1

• Solution
• Rylans market capitalization is 110 million
• 5 million shares 22 share 110 million.
• The market capitalization is significantly higher
  than Rylans book value of equity of 50 million.

22
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
• Value Stocks
• Low M/B ratios
• Growth stocks
• High M/B ratios

23
2.2 Balance Sheet (cont'd)

• Balance Sheet Analysis
• Debt-Equity Ratio
• Measures a firms leverage
• Using Book Value versus Market Value
• Enterprise Value

24
Example 2.2
25
Example 2.2 (cont'd)
26
2.2 Balance Sheet (cont'd)

• Other Balance Sheet Information
• Current Ratio
• Current Assets / Current Liabilities
• Quick Ratio
• (Current Assets Inventories) / Current
  Liabilities

27
2.3 Income Statement

• Total Sales/Revenues
• minus
• Cost of Sales
• equals
• Gross Profit

28
2.3 Income Statement (cont'd)

• Gross Profit
• minus
• Operating Expenses
• Selling, General, and Administrative Expenses
• RD
• Depreciation Amortization
• equals
• Operating Income

29
2.3 Income Statement (cont'd)

• Operating Income
• plus/minus
• Other Income/Other Expenses
• equals
• Earnings Before Interest and Taxes (EBIT)

30
2.3 Income Statement (cont'd)

• Earnings Before Interest and Taxes (EBIT)
• plus/minus
• Interest Income/Interest Expense
• equals
• Pre-Tax Income

31
2.3 Income Statement (cont'd)

• Pre-Tax Income
• minus
• Taxes
• equals
• Net Income

32
Table 2.2
33
2.3 Income Statement (cont'd)

• Earnings per Share
• Stock Options
• Convertible Bonds
• Dilution
• Diluted EPS

34
2.3 Income Statement (cont'd)

• Income Statement Analysis
• Profitability Ratios
• Operating Margin
• Net Profit Margin

35
2.3 Income Statement (cont'd)

• Income Statement Analysis
• Working Capital Days
• Accounts Receivable Days
• EBITDA
• Reflects the cash a firm has earned from its
  operations

36
2.3 Income Statement (cont'd)

• Income Statement Analysis
• Leverage Ratios/Interest Coverage Ratios
• EBIT / Interest Expense
• Operating Income / Interest Expense
• EBITDA / Interest Expense

37
2.3 Income Statement (cont'd)

• Income Statement Analysis
• Investment Returns
• ROA
• Net Income / Total Assets
• ROE
• Valuation Ratios
• P/E Ratio

38
Example 2.3
39
Example 2.3 (cont'd)
40
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

41
2.4 Statement of Cash Flows (cont'd)

• Three Sections
• Operating Activities
• Investment Activities
• Financing Activities

42
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

43
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

44
(No Transcript)
45
Example 2.4
46
Example 2.4 (cont'd)
47
2.5 Other Financial Statement Information

• Management Discussion and Analysis
• Off-Balance Sheet Transactions
• Statement of Stockholders Equity
• Notes to the Financial Statements

48
Example 2.5
49
Example 2.5 (cont'd)
50
Alternative Example 2.5

• Problem
• Campbell Soup Company reported the following
  sales revenues by category
• What was the percentage growth for each category?
• If Campbells has the same percentage growth from
  2006 to 2007, what will its total revenues be in
  2007?

51
Alternative Example 2.5

• 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

52
Alternative Example 2.5

• Solution (continued)
• Estimated 2007 Total Revenue
• 7,343 (1 3.83)
• 7,343 1.0383 7,624

53
2.6 Accounting Manipulation

• Enron
• WorldCom
• Sarbanes-Oxley Act (SOX)