Chapter 2

Chapter 2

Introduction to Financial

Statement Analysis

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-2

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


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.


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.


2.1 Disclosure of Financial Information

• Financial Statements

Firm-issued accounting reports with past performance information

Filed with the SEC• 10Q

Quarterly

• 10K Annual


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


2.1 Disclosure of Financial Information (cont'd)

• Types of Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Stockholders’ Equity


2.2 Balance Sheet

• A snapshot in time of the firm’s financial position

• The Balance Sheet Identity:

Assets Liabilities Stockholders' Equity


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



• 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



• Assets

Long-Term Assets

• Net Property, Plant, & Equipment Book Value Depreciation

• Goodwill Amortization

• Other Long-Term Assets


Table 2.1



• 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



• Liabilities

Long-Term Liabilities

• Long-Term Debt

• Capital Leases

• Deferred Taxes


Table 2.1 (cont'd)



• Net Working Capital

Current Assets – Current Liabilities



• 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


Example 2.1


Example 2.1 (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

Market - to - Book Ratio Market Value of Equity




• Balance Sheet Analysis

Debt-Equity Ratio

• Measures a firm’s leverage

• Using Book Value versus Market Value

Enterprise Value

Debt - Equity Ratio Total Debt

Total Equity

Enterprise Value Market Value of Equity Debt Cash


Example 2.2





• Other Balance Sheet Information

Current Ratio• Current Assets / Current Liabilities

Quick Ratio• (Current Assets – Inventories) / Current Liabilities


2.3 Income Statement

• Total Sales/Revenues minus

• Cost of Sales equals

• Gross Profit


2.3 Income Statement (cont'd)

• Gross Profit minus

• Operating Expenses• Selling, General, and Administrative Expenses• R&D• Depreciation & Amortization

equals

• Operating Income



• Operating Income plus/minus

• Other Income/Other Expenses equals

• Earnings Before Interest and Taxes (EBIT)



• Earnings Before Interest and Taxes (EBIT) plus/minus

• Interest Income/Interest Expense equals

• Pre-Tax Income



• Pre-Tax Income minus

• Taxes equals

• Net Income


Table 2.2



• Earnings per Share

• Stock Options

• Convertible Bonds

• Dilution Diluted EPS

EPS Net Income

Shares Outstanding

$2.0 million

3.6 million shares $0.556 per share



• Income Statement Analysis

Profitability Ratios

• Operating Margin

• Net Profit Margin

Operating Margin Operating Income

Total Sales

Net Profit Margin Net Income

Total Sales




Working Capital Days

• Accounts Receivable Days

EBITDA

• Reflects the cash a firm has earned from its operations

Accounts Receivable Days Accounts Receivable

Average Daily Sales




Leverage Ratios/Interest Coverage Ratios

• EBIT / Interest Expense

• Operating Income / Interest Expense

• EBITDA / Interest Expense




Investment Returns

• ROA Net Income / Total Assets

• ROE

Valuation Ratios

• P/E Ratio

Return on Equity Net Income


P / E Ratio Market Capitalization

Net Income

Share Price

Earnings per Share


Example 2.3




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


2.4 Statement of Cash Flows (cont'd)

• Three Sections

Operating Activities

Investment Activities

Financing Activities



• Operating Activities

Adjusts net income by all non-cash items related to operating activities and changes in net working capital



• Investing Activities Capital Expenditures

Buying or Selling Marketable Securities

• Financing Activities Changes in Borrowings

Payment of Dividends• Retained Earnings

Retained Earnings Net Income Dividends



Example 2.4




2.5 Other Financial Statement Information

• Management Discussion and Analysis Off-Balance Sheet Transactions

• Statement of Stockholders’ Equity

• Notes to the Financial Statements


Example 2.5




2.6 Accounting Manipulation

• Enron

• WorldCom

• Sarbanes-Oxley Act (SOX)


Questions?

Chapter 2

Economy & Finance

balance sheet identity

net income

operating income

market value enterprise

firms assets

income plusminus

firms financial statements

learning objectives