Introduction to Financial Statements Analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 2

Introduction to Financial Statement Analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-

Chapter Outline

2.1 Firms’ Disclosure of Financial Information 2.2 The Balance Sheet 2.3 Balance Sheet Analysis 2.4 The Income Statement 2.5 Income Statement Analysis 2.6 The Statement of Cash Flows 2.7 Other Financial Statement Information 2.8 Financial Reporting in Practice


Learning Objectives

• Know why the disclosure of financial information through financial statements is critical to investors

• Understand the function of the balance sheet • Use the balance sheet to analyze a firm • Understand how the income statement is used • Analyze a firm through its income statement, including

using the DuPont Identity


Learning Objectives (cont’d)

• Interpret a statement of cash flows • Know what management’s discussion and analysis and

the statement of stockholders equity are • Analyze the role of accounting manipulation in the

Enron and WorldCom bankruptcies


2.1 Firms’ Disclosure of Financial Information

• Financial statements are accounting reports that a firm issues periodically to describe its past performance.

• Investors, financial analysts, managers, and other interested parties such as creditors rely on financial statements to obtain reliable information about a corporation.



• Financial Statements • The four required financial statements are

w The balance sheet, w The income statement, w The statement of cash flows, and the w The statement of stockholders’ equity



• GAAP w In the United States, the Financial Accounting

Standards Board (FASB) establishes Generally Accepted Accounting Principles (GAAP) to provide a common set of rules and a standard format for public companies to use when they prepare their reports.



• Audited Statements w Investors also need some assurance that the

financial statements are prepared accurately. Corporations are required to hire a neutral third party, known as an auditor, to check the annual financial statements, ensure they are prepared according to GAAP, and provide evidence to support that the information is reliable.


2.2 The Balance Sheet

• The balance sheet shows the current financial position (assets, liabilities, and stockholders’ equity) of the firm at a single point in time.

• Stockholders’ equity is the book value of the firm’s equity. It differs from the market value of the firm’s equity, its market capitalization, because of the way assets and liabilities are recorded for accounting purposes.


Table 2.1 Global Corporation Balance Sheet for 2007 and 2006


The Balance Sheet Identity

• The two sides of the balance sheet must balance

Assets = Liabilities + Stockholders’ Equity (Eq. 2.1)



• Current Assets w Cash and other marketable securities, which are short-term,

low-risk investments that can be easily sold and converted to cash like government debt that matures within a year

w Accounts receivable, which are amounts owed to the firm by customers who have purchased goods or services on credit;

w Inventories, which are composed of raw materials as well as work-in-progress and finished goods;

w Other current assets, which is a catch-all category that includes items such as prepaid expenses



• Long-Term Assets w Assets like real estate or machinery that produce

tangible benefits for more than one year w Reduced by the value recorded for this equipment

through a yearly deduction called depreciation according to a depreciation schedule that depends on an asset’s life span

w Other long-term assets can include such items as property not used in business operations



• Current Liabilities w Accounts payable, the amounts owed to suppliers for

products or services purchased with credit w Notes payable, loans that must be repaid in the next year.

Any repayment of long-term debt that will occur within the next year would also be listed here as current maturities of long-term debt

w Accrual items, such as salary or taxes that are owed but have not yet been paid, and deferred or unearned revenue


Net Working Capital

• The difference between current assets and current liabilities is the firm’s net working capital, the capital available in the short term to run the business.

Net Working Capital = Current Assets – Current Liabilities

(Eq. 2.2)



• Long-Term Liabilities w When a firm needs to raise funds to purchase an

asset or make an investment, it may borrow those funds through a long-term loan. That loan would appear on the balance sheet as long-term debt, which is any loan or debt obligation with a maturity of more than a year.



• Stockholders’ Equity w Book value of equity: represents the net worth of

the firm from an accounting perspective aka Equity (this is located in the balance sheet under owner’s equity or stockholder’s equity)

w Market capitalization: the total market value of a firm’s equity equals the market price per share times the number of shares

market price per share x the number of shares

If Global has 3.6 million shares outstanding, and these shares are trading for a price of $10 per share, what is Global’s market capitalization? How does the market capitalization compare to Global’s book value of equity?

Problem

What we know• Market capitalization is equal to price per share times shares outstanding.

(3.6 million shares) × ($10/share) = $36 million • We can find Global’s book value of equity at the bottom of the right side

of its balance sheet.

Book Value =

$22.2 million

Global must have sources of value that do not appear on

the balance sheet. These include potential opportunities

for growth, the quality of the management team,

relationships with suppliers and customers, etc.

Evaluate

Ron Johnson help shape Target’s image, Apple’s Stores, and now JC Penny’s Sales Floor

Mortorola stock prices increase when Google announced it will acquire the company


2.3 Balance Sheet Analysis

• We can also learn a great deal of useful information from a firm’s balance sheet that goes beyond the book value of the firm’s equity by analyzing the balance sheet to assess the firm’s value, its leverage, and its short-term cash needs


Market-to-Book Ratio

• The ratio of a firm’s market capitalization to the book value of stockholders’ equity:

(Eq. 2.3)

note: book value of equity = equity = stockholders/owners equity


Figure 2.1 Market-to-Book Ratios in 2006


Debt-Equity Ratio

• The debt-equity ratio is a common ratio used to assess a firm’s leverage

(Eq. 2.4)


Enterprise Value

• The enterprise value of a firm assesses the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities

Enterprise Value = Market Value of Equity + Debt – Cash (Eq. 2.4)

In October 2007, H.J. Heinz Co. (HNZ) had a share price of $46.78, 319.1 million shares outstanding, a market-to-book ratio of 8.00, a book debt-equity ratio of 2.62, and

cash of $576 million. What was Heinz’s market capitalization? What was its enterprise value?

What we know!Share Price !$46.78!Shares outstanding !319.1 million!Market-to-book !8.00!Cash !$576 million!D e b t - t o - e q u i t y (book)

!2.62

Enterprise value = Market capitalization + Debt – Cash

Enterprise value = Market capitalization + Debt – $576 million


!2.62

Enterprise value = Market capitalization + Debt – $576 million

Market capitalization =

$46.78 x 319.1 million

Enterprise value =

Share Price x Shares Outstanding

$14.93 billion

$14.93 billion + Debt – $576 million


!2.62

Enterprise value = $14.93 billion + Debt – $576 million

Debt

equity2.62=

8.0Market ValueBook Value =

1. we know that the debt divided by the equity equals 2.62

2. we also know that the market value divided by the book value equals 8.0

What else do we know?

3. we know that the equity and book value are one in the same

4. we can find know the market value by multiplying share price times shares outstanding: $46.78 x 319.1M = 14.93B

5. So market value equals $14.93B

we can begin to solve the rest of the puzzle.


!2.62

Enterprise value = $14.93 billion + Debt – $576 million

Debt

equity2.62=

8.0Market ValueBook Value =

What else do we know?

solve for book value

8.0$14.93B

Book Value=

=

8.0$14.93B

Book Value =

8.0$14.93B

Book Value=

Book Value Book Value

1 1

8.0$14.93B = (Book Value)

8.08.0

1.86B = Book Value

( ) ( )

now that you have the book value (aka

equity) you can use it find the debt

Debt

equity2.62=

Debt

1.86B2.62==

Now you have all the information to find the enterprise value.

4.87B

1.86M2.62==

Enterprise value = Market capitalization + Debt – Cash

Market Capitalization 14.93B

Debt 4.90B

Cash .576B

Enterprise Value =14.93 + 4.90 – .576 = $19.254 billion.


Current Ratio

• The ratio of current assets to current liabilities

(Eq. 2.6)


Quick Ratio (“Acid-Test” Ratio)

• The ratio of current assets other than inventory to current liabilities.

(Eq. 2.6)


Table 2.2 Balance Sheet Ratios


2.4 The Income Statement

• The income statement lists the firm’s revenues and expenses over a period of time. The last or “bottom” line of the income statement shows the firm’s net income, which is a measure of its profitability during the period. The income statement is sometimes called a profit and loss, or “P&L,” statement and the net income is also referred to as the firm’s earnings.


Table 2.3 Global Corporation’s Income Statement Sheet for 2007 and 2006


Earnings Per Share

• Net income reported on a per-share basis

(Eq. 2.8)


2.5 Income Statement Analysis

• The income statement provides very useful information regarding the profitability of a firm’s business and how it relates to the value of the firm’s shares. We now discuss several ratios that are often used to evaluate a firm’s performance and value.


2.5 Income Statement Analysis

• Profitability Ratios w Gross Margin w Operating Margin w Net Profit Margin

• Asset Efficiency • Working Capital Ratios • EBITDA • Leverage Ratios • Investment Returns • The DuPont Identity • Valuation Ratios


Example 2.1a EBITDA

Problem: • JH Metals recently reported $9,000 of sales, $6,000 of

operating costs other than depreciation, and $1,500 of depreciation. The company had no amortization charges and no non-operating income. It had issued $4,000 of bonds that carry a 7% interest rate, and its federal-plus-state income tax rate was 40%. What was the firm's operating income, or EBITDA?


Example 2.1a EBITDA

Solution: Plan: • Using the structure of the Income Statement, subtract the proper

items from sales. Because interest expense is not needed for the calculation of EBITDA, we can ignore it for this problem.

!Sales !$9,000!Operating Costs !$6,000!Depreciation !$1,500!Outstanding Bonds (7%) !$4,000!Tax Rate !40%


Example 2.1a EBITDA

Execute: Sales $9,000Operating costs excluding depreciation $6,000Depreciation $1,500Operating income (EBIT) $1,500


Example 2.1a EBITDA

Evaluate: • Operating Income (EBITDA) represents funds

generated by the business model and does not include the subtraction of interest, which is a cost identified separately as the cost of using debt.


Operating Margin

• The operating margin reveals how much a company earns before interest and taxes from each dollar of sales

(Eq. 2.10)


Net Profit Margin

(Eq. 2.11)

• The net profit margin shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes


(Eq. 2.12)

Asset Efficiency: Asset Turnover

• A first broad measure of efficiency is asset turnover


Asset Efficiency: Fixed Asset Turnover

• Since total assets includes assets like cash that are not directly involved in generating sales, Global’s manager might also look at Global’s fixed asset turnover

(Eq. 2.13)


(Eq. 2.14)

Working Capital Ratios: Accounts Receivable Days

• The firm’s accounts receivable in terms of the number of days’ worth of sales that it represents


(Eq. 2.15)

Working Capital Ratios: Inventory Turnover

• How efficiently we turn our inventory into sales


(Eq. 2.16)

Investment Returns

• Evaluating the firm’s return on investment by comparing its income to its investment


(Eq. 2.17)

DuPont Identity

• This expression says that ROE can be thought of as net income per dollar of sales (profit margin) times the amount of sales per dollar of equity


(Eq. 2.18)

DuPont Analysis

• This final expression says that ROE is equal to net income per dollar of sales (profit margin) times sales per dollar of assets (asset turnover) times assets per dollar of equity (a measure of leverage called the equity multiplier).


!Profit !Margin!Asset !Turnover

!Equity !Multiplier!!Wal-Mart 3.6% 2.4 2.6

!!!Nordstrom 7.7% 1.7 2.4

Example 2.3 DuPont Analysis

Problem: • The following table contains information about Wal-Mart (WMT)

and Nordstrom (JWN). Compute their respective ROEs and then determine how much Wal-Mart would need to increase its profit margin in order to match Nordstrom’s ROE.



Solution: Plan: • The table contains all the relevant information to use the DuPont

Identity to compute the ROE. We can compute the ROE of each company by multiplying together its profit margin, asset turnover, and equity multiplier. In order to determine how much Wal-Mart would need to increase its margin to match Nordstrom’s ROE, we can set Wal-Mart’s ROE equal to Nordstrom’s, keep its turnover and equity multiplier fixed, and solve for the profit margin.



Execute: • Using the DuPont Identity, we have:

w ROEWMT = 3.6% x 2.4 x 2.6 = 22.5% w ROEJWN = 7.7% x 1.7 x 2.4 = 31.4%

• Now, using Nordstrom’s ROE, but Wal-Mart’s asset turnover and equity multiplier, we can solve for the margin that Wal-Mart needs to achieve Nordstrom’s ROE: w 31.4% = Margin x 2.4 x 2.6 w Margin = 31.4% / 6.24 = 5.0%



Evaluate: • Wal-Mart would have to increase its profit

margin from 3.6% to 5% in order to match Nordstrom’s ROE. It would be able to achieve Nordstrom’s ROE even with a lower margin than Nordstrom (5.0% vs. 7.7%) because of its higher turnover and slightly higher leverage.


Valuation Ratio

• Analysts and investors use a number of ratios to gauge the market value of the firm. The most important is the firm’s price-earnings ratio (P/E): The P/E ratio is a simple measure that is used to assess whether a stock is over- or under-valued based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders.

(Eq. 2.19)


Example 2.4Computing Profitability and Valuation Ratios

Problem: • Consider the following data from 2006 for Wal-Mart Stores and Target

Corporation ($ billions):

• Compare Wal-Mart and Target’s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales.

!Wal-Mart Stores (WMT)

!Target Corporation (TGT)

Sales 345 60Operating Income 19 5Net Income 11 3Market Capitalization 190 49Cash 7 1Debt 36 10



Solution Plan: • The table contains all of the raw data, but we need to

compute the ratios using the inputs in the table. w Operating Margin = Operating Income / Sales w Net Profit Margin = Net Income / Sales w P/E ratio = Price / Earnings w Enterprise value to operating income = Enterprise Value /

Operating Income w Enterprise value to sales = Enterprise Value / Sales



Execute: • Wal-Mart had an operating margin of 19/345 = 5.5%, a net

profit margin of 11/345 = 3.2%, and a P/E ratio of 190/11 = 17.3. Its enterprise value was 190 + 36 – 7 = $219 billion, which has a ratio of 219/19 = 11.5 to operating income and 219/345 = 0.64 to sales.

• Target had an operating margin of 5/60 = 8.3%, a net profit margin of 3/60 = 5.0%, and a P/E ratio of 49/3 = 16.3. Its enterprise value was 49 + 10 – 1 = $58 billion, which has a ratio of 58/5 = 11.6 to operating income and 58/60 = 0.97 to sales.



Evaluate: • Note that despite their large difference in size, Target

and Wal-Mart’s P/E and enterprise value to operating income ratios were very similar. Target’s profitability was somewhat higher than Wal-Mart’s, however, this explains the difference in the ratio of enterprise value to sales.


Table 2.4 Income Statement Ratios


Table 2.4 Income Statement Ratios


2.6 The Statement of Cash Flows

• The firm’s statement of cash flows utilizes the information from the income statement and balance sheet to determine how much cash the firm has generated, and how that cash has been allocated, during a set period. Cash is important because it is needed to pay bills and maintain operations and is the source of any return of investment for investors.



• The statement of cash flows is divided into three sections which roughly correspond to the three major jobs of the financial manager: w Operating activities w Investment activities w Financing activities


Table 2.5 Global Corporation’s Statement of Cash Flows for 2007 and 2006



• Operating Activity • Use the following guidelines to adjust for changes in

working capital: w Accounts receivable: When a sale is recorded as part of net

income, but the cash has not yet been received from the customer, we must adjust the cash flows by deducting the increases in accounts receivable. This increase represents additional lending by the firm to its customers and it reduces the cash available to the firm.



• Operating Activity (cont’d) w Accounts payable: Similarly, we add increases in

accounts payable. Accounts payable represents borrowing by the firm from its suppliers. This borrowing increases the cash available to the firm.



• Operating Activity (cont’d) w Inventory: Finally, we deduct increases to inventory.

Increases to inventory are not recorded as an expense and do not contribute to net income (the cost of the goods are only included in net income when the goods are actually sold). However, the cost of increasing inventory is a cash expense for the firm and must be deducted.



• Investment Activity w Subtract the actual capital expenditure that the firm

made. Similarly, also deduct other assets purchased or investments made by the firm, such as acquisitions.



• Financing Activity w The last section of the statement of cash flows shows

the cash flows from financing activities. Dividends paid and the difference between a firm’s net income and the amount it spends on dividends, which is referred to as the firm’s retained earnings for that year.


Example 2.4a Analyzing a Statement of Cash Flows

Problem: • Smithson, Inc. had $75,000 in cash at the end of 2004. At year-

end 2005, the company had $155,000 in cash. We know cash flow from operating activities totaled $1,250,000 and cash flow from long-term investing activities totaled -$1,000,000. Furthermore, Smithson issued $250,000 in long-term debt last year to fund new projects, increase liquidity, and to buy back some common stock. If dividends paid to common stockholders equaled $25,000, how much common stock did Smithson repurchase last year? (Assume that the only financing activities in which Smithson engaged involved long-term debt, payment of common dividends, and common stock.)



Smithson, Inc. !Beginning Cash ! $75,000!Ending Cash ! $155,000!Cash from Operations ! $1,250,000!Cash from Investing !-$1,000.000!Long Term Debt Issued ! $250,000!Dividends Paid ! $25,000



Solution: Plan: • Calculate the change in cash for the year. • Solve for CF from financing using the following formula:

w CF from operations + CF from investing + CF from financing = Δ in cash

• We have been given the cash flows from two of the three financing activities, so we can calculate the amount of stock that was repurchased using: w ΔL-T debt + ΔCommon stock – Pmt. of common dividends = CF from

financing



Execute: Cash at the end of the year $155,000 Cash at the beginning of the year -75,000 Change in cash $ 80,000 $1,250,000 + (-$1,000,000) + CF from financing = $ 80,000 CF from financing = -$170,000.

$250,000 + ΔCommon stock - $25,000 = -$170,000 ΔCommon stock = -$395,000. • The negative change in common stock tells us that the firm repurchased

$395,000 worth of its common stock.



Evaluate: • The negative change in common stock tells us that the

firm used cash to buy back $395,000 worth of its common stock, known as Treasury Stock, and is a use of cash, shown on the Cash Flow Statement.


Payout Ratio and Retained Earnings

(Eq. 2.21)

Retained Earnings = Net Income–Dividends (Eq. 2.20)


Example 2.5The Impact of Depreciation on Cash Flow

Problem: • Suppose Global had an additional $1 million

depreciation expense in 2007. If Global’s tax rate on pretax income is 26%, what would be the impact of this expense on Global’s earnings? How would it impact Global’s cash at the end of the year?



Solution: Plan: • Depreciation is an operating expense, so Global’s operating

income, EBIT, and pretax income would be affected. With a tax rate of 26%, Global’s tax bill will decrease by 26 cents for every dollar that pretax income is reduced. In order to determine how Global’s cash would be impacted, we have to determine the effect of the additional depreciation on cash flows. Recall that depreciation is not an actual cash outflow, even though it is treated as an expense, so the only effect on cash flow is through the reduction in taxes.



Execute: • Global’s operating income, EBIT, and pretax income would fall by $1 million

because of the $1 million in additional operating expense due to depreciation. • This $1 million decrease in pretax income would reduce Global’s tax bill by

26% × $1 million = $0.26 million. Therefore, net income would fall by 1 – 0.26 = $0.74 million.

• On the statement of cash flows, net income would fall by $0.74 million, but we would add back the additional depreciation of $1 million because it is not a cash expense. Thus, cash from operating activities would rise by –0.74 + 1 = $0.26 million. Thus, Global’s cash balance at the end of the year would increase by $0.26 million, the amount of the tax savings that resulted from the additional depreciation deduction.



Evaluate: • The increase in cash balance comes completely from

the reduction in taxes. Because Global pays $0.26 million less in taxes even though its cash expenses have not increased, it has $0.26 million more in cash at the end of the year.


2.7 Other Financial Statement Information

• Other pieces of information contained in the financial statements: w Management Discussion and Analysis w Statement of Stockholders’ Equity w Notes to the Financial Statements


2.8 Financial Reporting in Practice

• Even with safeguards such as GAAP and auditors, though, financial reporting abuses unfortunately do take place. Two of the most infamous recent examples: w Enron w WorldCom


2.8 Financial Reporting in Practice

• The Sarbanes-Oxley Act • In 2002, Congress passed the Sarbanes-Oxley Act (SOX). While

SOX contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders. SOX attempted to achieve this goal in three ways: w Overhauling incentives and independence in the auditing process w Stiffening penalties for providing false information w Forcing companies to validate their internal financial control processes.


Chapter Quiz

• What is the role of an auditor? • What is depreciation designed to capture? • What does a firm’s high debt-to-equity ratio tell

you? • How do you use the price-earnings (P/E) ratio to

gauge the market value of a firm? • Why does a firm’s net income not correspond to

cash earned?

Introduction to Financial Statements Analysis

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