Understanding and using financial stament

• 1. Understanding and Using Financial Statements

2. Agenda

• Review of financial statement relationships

• • Plumbing

• • Reporting conventions

• • Producing reports

• Financial analysis

• • Ratios

• • Reverse engineering

Robert Magee, Kellogg School of Management 2008 3. The Balance Sheet

• Snapshot at a point in time

• Levelsof Assets

• • Resources listed by type

• Levelsof Liabilities and Shareholders Equity

• • Claims on resources

• • Fixed claims (liabilities)

• • Flexible claims (shareholders equity)

Robert Magee, Kellogg School of Management 2008 4. The Income Statement

• Flows of resources(net assets)

• • Over a period of time

• • Resulting from operations

• Revenues reflectinflowsof resources

• Expenses reflectoutflowsof resources

• Try to separate ongoing amounts from infrequent amounts

Robert Magee, Kellogg School of Management 2008 5. The Statement of Cash Flows

• Flows of Cash

• • Over a period of time

• • Three classifications

• • • Operations

• • • Investing

• • • Financing

• Two methods of presentation for Operations

• • Direct easy to understand

• • Indirect what everyone reports!

Robert Magee, Kellogg School of Management 2008 6. The Accounting Model (BS) Robert Magee, Kellogg School of Management 2008 7. The Accounting Model (BS+IS) Robert Magee, Kellogg School of Management 2008 8. The Accounting Model (BS+IS+SCF) Robert Magee, Kellogg School of Management 2008 9. Accounting Measurement Principles

• Timing of revenue recognition

• • Revenue must have been earned

• • Amount to be received can be estimated with reasonable certainty

• Timing of expense recognition

• • Match expenses with the revenues they produce

• • Occasional conflict with accountings conservatism in the recognition of assets and liabilities

Robert Magee, Kellogg School of Management 2008 10. The Sage Company: Start Robert Magee, Kellogg School of Management 2008 11. The Sage Company: 1-6 Robert Magee, Kellogg School of Management 2008 12. The Sage Company: 7-12 Robert Magee, Kellogg School of Management 2008 13. The Sage Company Robert Magee, Kellogg School of Management 2008 SCF I/S 14. Financial Statements (flows) Robert Magee, Kellogg School of Management 2008 Statement of Cash Flows Operations: Cash receipts from customers $3,500 Less: Payments to suppliers 1,100 Payments to employees 730 Payments for rent 600 Payments for interest 16 Cash from operations $ 1,054 Investing: Proceeds from disposals $10 New fixtures and equipment (800) Cash from investing ($ 790) Financing: Loan repayment (1,600) Proceeds from new loan 2,000 Shareholder dividends (80) Cash from financing $320 Net change in cash $584 Beginning cash balance 600 Ending cash balance $ 1,184 Income Statement Revenue $ 3,800 Expenses: Cost of goods sold 1,800 Salaries and wages 700 Rent 200 Depreciation 150 2,850 Operating income $ 950 Interest expense 16 Income before taxes $ 934 Tax expense 374 Net income $ 560 15. The Sage Company: Close Robert Magee, Kellogg School of Management 2008 16. Balance Sheet (levels) Robert Magee, Kellogg School of Management 2008 Assets Liabilities and shareholders equity Cash $1,184 Accounts payable $ 3,100 Accounts receivable 6,800 Salaries and wages payable70 Inventory 1,800 Tax payable 374 Prepaid rent 400 Current Liabilities $ 3,544 Current Assets $ 10,184 Long-term loan 2,000 Fixtures and equipment at cost 2,620 Common Stock, $1 par 300 Accumulated depreciation (880) Additional paid-in-capital 4,300 Plant and equipment, net 1,740 Retained earnings 1,780 Total Assets $ 11,924 Total liabilitiesand shareholders equity $ 11,924 Balance Sheet July 31, 2000 17. Reconcile Cash Flow and Income Robert Magee, Kellogg School of Management 2008 Statement of Cash Flows-Indirect Operations: Net income $560 Adjustments: Depreciation addback 150 Less: A/R increase (300) Prepaid rent increase (400) Wages Payable decrease (30) Plus: Inventory decrease 600 A/P increase 100 Tax payable increase 374 Cash from operations $ 1,054 Statement of Cash Flows Operations: Cash receipts from customers $3,500 Less: Payments to suppliers 1,100 Payments to employees 730 Payments for rent 600 Payments for interest 16 Cash from operations $ 1,054 Investing: Proceeds from disposals $10 New fixtures and equipment (800) Cash from investing ($ 790) Financing: Loan repayment (1,600) Proceeds from new loan 2,000 Shareholder dividends (80) Cash from financing $320 Net change in cash $584 Beginning cash balance 600 Ending cash balance $ 1,184 18. Key to Reading Financial Reports Robert Magee, Kellogg School of Management 2008 Understanding the real activities and how they are reflected in financial reports is the key to effective reading of the reports. ORGANIZATION Financial FinancingReporting Collections PurchasingB/S ProductionI/S PaymentsSCF SellingFns Financial Statement Analysis 19. The Current Ratio Robert Magee, Kellogg School of Management 2008 The Current Ratio compares the pool of resources that are expected to become cash within the year to the obligations that must be met within the year. Current Assets Current Ratio= Current Liabilities Walgreens Current Ratios 20072006 20. Other Liquidity Ratios Robert Magee, Kellogg School of Management 2008 Quick ratio = (Current assets inventory) Current liabilities A/R turnover = Sales revenue Average A/R Days receivables = Average A/R (Sales revenue 365) Inventory turnover = Cost of goods sold Average inventory Days inventory = Average inventory (Cost of goods sold 365) A/P turnover = Cost of goods sold Average A/P Days payables = Average A/P (Cost of goods sold 365) Cash operating cycle = Days receivables + Days inventory Days payables Days to flame-out = (Cash + Marketable securities) (-Free cash flow 365) 21. The Total Debt to Total Equity Ratio Robert Magee, Kellogg School of Management 2008 One measure of the firms ability to meet its long-term fixed commitments relates the size of the fixed obligations (liabilities) to the size of the shareholders residual claim. Total Liabilities Debt to Equity Ratio= Shareholders Equity Walgreens D/E Ratios 20072006 22. Return on Common Shareholders Equity Robert Magee, Kellogg School of Management 2008 Profitability measures often use a return on investment notion so that the accomplishments (profits) are related to the resources provided (investment). Net Profit to Common 1 Return on Shareholders Equity = Average Common Shareholders Equity Walgreens ROE 20071Net profit to common equals net income minus any dividends to outstanding preferred stock. 23. Other Profitability Ratios Robert Magee, Kellogg School of Management 2008 Earnings per share = Net profit to common Average common shares outstanding Gross margin = Gross profit Sales revenue Return on sales (Profit margin) = Net income Sales revenue Total asset turnover = Sales revenue Average total assets Return on assets (pre-tax) = EBIT 1 Average total assets Return on assets = {Net income + (1-tax rate)*Interest expense} Average assets 1 EBIT is defined as earnings before interest and tax expense. 24. Ratios Tell A Story: 2005

• Airline company

• Automobile manufacturer

• Pharmaceutical company

• Commercial bank

• Computer and office equipment manufacturer

• Discount general-merchandise store chain

• Electric utility

• Fast-food chain

• Wholesale food distributor

• Supermarket chain

• Internet retailer

• Specialized staffing services company

• Software development company

25. Ratios Tell A Story - Two Lessons

• Ratios are only meaningful when compared to an appropriate benchmark. Comparing ratios of firms from the same industry, with similar strategies, is useful. A firm can provide its own comparison using prior periods if there have been no significant changes in its operations or policies.

• What we have done is to picture how a particular type of company (e.g., a grocery chain or an electric utility) would be reflected in its financial statements. The next step is to picture how a well-run company would be reflected in its financial statements, relative to a poorly-run company.

26. What Happens When Hide Trouble?

• Standard Red Flags 1

• • Net income much higher than operating cash flow

• • Big differences between tax income and book income

• • Unsustainable sales

• • Reserves

• • Asset overstatements (a.k.a. Deferred expenses)

• • Purchased profits

• • Growing inventory and/or receivables

• • Write-offs

• • Cutbacks in soft investments

27. Reverse Engineering Exercise 28. Financial Reporting Issues

• Revenue recognition timing product characteristics

• Accounts receivable valuation use of estimates

• Inventory margin and operating analysis

• Noncurrent operating assets intellectual property

• Financial assets multiple methods

• Liabilities

• Leases off-balance-sheet financing

• Shareholders equity options

• Regulatory changes movement to IFRS