Understanding financial statements gentry

Understanding Financial Statements

Strictly Financials

Jan. 2, 2013

Strictly Financials 2

Donald W. Reynolds National Center for Business Journalism at Arizona State University


n  James K. Gentry, Ph.D. n  Clyde M. Reed Teaching Professor n  School of Journalism and Mass Communications n  University of Kansas n  [email protected]


Types of Companies n  Public n  Private

n  Financial statements conforming to public company statements

n  Nonprofits


Important Terms n  Unaudited n  Audited n  Accountants n  Certified Public Accountants (CPAs) n  GAAP, FASB, AICPA, PCAOB


Assessing a Company n  Context n  Trends n  Rules n  Outsiders n  Insiders


Annual Report,10-K n  10-K wrap n  Auditor’s report: Clean, qualified? n  MD&A or Management’s Discussion

and Analysis n  Financial statements and footnotes n  Management’s letter if annual report

Traditional Auditor’s Report n  Independent auditor’s opinion on whether

financial statements are presented fairly in all material respects, in accordance with GAAP: n  We looked at these statements n  They’re management’s responsibility; we’re just

here to express our opinion n  We followed the rules in our audits, and here’s

what an audit involves n  In our opinion, the statements fairly present the

company’s position.



Auditor’s Report by Category

n  Clean or Unqualified n  Qualified n  Disclaimer n  Adverse


New Auditor’s Report n  Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act


Sarbanes-Oxley Act of 2002

n  Response to abuses with Enron and WorldCom as catalysts

n  New responsibilities, resources for SEC n  Created PCAOB n  Major emphasis on “internal controls” n  More disclosure for public companies


Sarbanes-Oxley Act (SOX) n  Analysts must state potential conflicts of interest. n  Limited types of services accounting firms can

provide to public-company clients n  Companies disclose in 10-K the fees paid to auditors. n  Recent concerns

n  CEO, CFO attest to accuracy, completeness, fairness of financial statements.

n  Rigorous penalties for fraud, other misdeeds


Public Company Accounting Oversight Board n  Created by SOX to oversee accounting n  Began operating in 2003 n  SEC appoints five members to five-year

terms. n  Two members must be or have been CPAs. n  All members must be “financially literate.” n  In 2008, Supreme Court upheld PCAOB but

said SEC couldn’t remove board members.


PCAOB’s Duties

n  Set rules on “auditing, quality control, ethics, independence, and other standards…”

n  Conduct “inspections” of accounting firms

n  Conduct “investigations and disciplinary proceedings”

n  Enforce compliance with SOX


Section 404: Internal Controls n  “Management Assessment of Internal

Controls” n  Each 10-K must contain an “internal-control

report” that: n  States management is responsible for

internal-control structure and procedures n  Contains an assessment on effectiveness of

internal-control structure and procedures


Management on the Spot n  Section 404: Management must evaluate and

test internal controls over financial reporting, including anti-fraud programs, annually.

n  Management certifies that it does (or doesn’t) have adequate internal controls in place.

n  Independent board members easier to attract n  Auditor attests to adequacy of controls. n  Management to be forced to answer for

fraudulent activities, misconduct, etc.


Private Company Impact n  Banks, insurers requiring companies to

embrace SOX. n  Now most private firms have audited financial

statements. n  If private company owners want to sell to

public company, must be in compliance n  Private equity funds more willing to invest in

companies in compliance. n  Best outside directors


Nonprofit Impact n  Audit committees, independent members n  CEO, CFO attest to accuracy, completeness,

fairness of financial statements. n  Financial statements more accessible n  Codes of ethics n  Rules governing transactions with “insiders”

Goal of Accounting n  Record, classify and report financial

transactions. To provide managers across the organization with information that facilitates: n  Control of activities and expenditures n  Refinement of operational plans n  Accountability n  Reporting on project outcomes n  Writing of bids for new funds



Goal of Finance n  Maximize shareholder wealth as

reflected in market price of the stock n  Achieving this goal requires financial

manager to focus on economic profit, not accounting profit


Financial Decisions n  Long-term investment decisions

n  Capital budgeting n  Long-term financing decisions

n  Capital structure n  Working-capital management decisions

n  Net working capital


Financial Decisions n  Investing decisions: Types of assets

firm wants to hold. n  Financing decisions: Acquisition of

funds needed to support long-term investments.


Generally Accepted Accounting Principles n  Guidelines based on theory and

practice n  Evolved over time n  Procedures, concepts and standards


GAAP: Assumptions n  Periodicity n  Going concern n  Economic entity n  Monetary unit


GAAP: Principles n  Full disclosure n  Matching n  Historical cost n  Revenue realization n  Consistency


GAAP: Underlying Considerations n  Materiality n  Industry practices n  Conservatism


Specialized Industry GAAP n  Banking and thrift industries n  Benefit plans, including pension funds n  Broadcasting industry n  Cable television industry n  Computer software n  Finance companies n  Investment companies


Cash or Operating Cycle n  Cash n  Purchase inventory n  Produce product n  Sell product n  Cash


Cash or Operating Cycle (cont.) n  “Cash”

n  Cash n  Receivables n  Debt

n  Inventory n  Raw materials n  Work in progress n  Finished goods


Cash or Operating Cycle (cont.) n  Sell product

n  Accounts receivable n  Cash

n  Cash n  Collect receivables as cash

n  Pay off payables n  Start over


Accrual Method n  Records revenues when the “sale”

occurs n  Records expenses when the bill is

received n  That is, transactions enter the financial

records when they occur, not when cash changes hands

n  Accrual method, therefore, shows “scores,” not real spendable dollars


About These Numbers: They’re Squishy n  Goods will not necessarily be paid for. n  Goods are not necessarily going to be

kept. n  Inventory might be out of date, obsolete

or unsellable. n  Status of some inventory may be

uncertain n  Intangible assets are estimates


About These Numbers: They’re Squishy (cont.) n  Machinery or other fixed assets might

be obsolete or falling apart long before the so-called useful life is up.

n  Goodwill n  Accounting conventions n  Timing issues n  Bottom line: In many ways, statements

are a collection of estimates.


Because They’re Squishy n  You need to know the rules and

assumptions used to create the numbers.


Income Statement or ... n  Statement of earnings n  Statement of operations n  Statement of income and

comprehensive income


Income Statement n  Covers a period of time, typically a year

or quarter n  Reports income from ongoing activities n  Reports income from activities beyond

management’s control (comprehensive income)

n  Involves estimates


Basic Income Statement n  Sales or revenues n  Expenses n  Taxes n  Net income or profit


Income Statement n  Sales or revenues n  Cost of goods sold n  Gross profit n  Operating expenses

n  Sales, general and administrative n  Depreciation, amortization

n  Operating profit n  Other income/expenses n  Interest n  Income taxes n  Net income or profit


Cost of Goods Sold n  Expenses incurred in the cost of

manufacturing or creating or acquiring the product the company sells.


Cost of Goods Sold (CGS) n  Manufacturer: What the company pays

for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer.


Cost of Goods Sold

n  Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers.

n  Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS.


SGA n  Includes office expenses, accounting,

shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale.

n  Often includes depreciation and amortization.


Other Income/Expenses n  Discontinued items n  Unusual/extraordinary items n  Changes in accounting principle n  Impairment charge n  Sale of investment n  Minority interest


Thinking Inside the Box n  Revenues n  Minus cost of goods sold n  Equals gross profit n  Minus operating expenses n  Equals operating profit n  Minus or plus other expenses/income n  Minus or plus interest expenses/income n  Minus income taxes n  Net income


Inside the Box Earnings n  Sales or revenues n  Cost of goods sold n  Gross profit n  Operating expenses

n  Sales, general and administrative n  Depreciation, amortization

n  Operating profit


‘One-Time’ Gains That Reoccur n  Don’t be fooled by extraordinary items

that make the net income look better than it really is.

n  Extraordinary items should be both unusual in nature and infrequent in occurrence.

n  Examples: write-downs, restructurings, etc.


Earnings Per Share n  Basic earnings per share

(Bloomberg) n  Diluted earnings per share (Wall

Street Journal, fully diluted)

Calculating EPS n  Basic: Net income for period divided by

weighted average number shares outstanding.

n  Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments.


Dividend Payout n  Percentage of earnings paid to

shareholders in form of dividends n  Or:

Dividends Net Income

n  Or: Dividend per share per period EPS per period

Strictly Financials

49

P/E Ratio n  Company’s current share price compared to

its per-share earnings n  To calculate:

Market price per share Earnings per share

n  Share price of $43 and earnings of $1.95 for last 12 months would be P/E of $22.05.

n  Usually use last four quarters (“trailing P/E”)


P/E Ratio n  High P/E ratio means investors expect higher

earnings growth in future compared to companies with lower P/E.

n  Compare companies in same industry, to the market in general or historic P/E

n  Called “multiple” since shows how much investors willing to pay for dollar of earnings

n  Company with P/E of 20 means willing to pay $20 for $1 of current earning.


PEG Ratio n  A ratio used to determine a stock’s value

while considering likely earnings growth. n  Frequently indicator of stock's potential value.

Often favored over price/earnings ratio since also accounts for growth. Like P/E, lower PEG means stock is more undervalued.

n  To calculate: P/E

Annual EPS growth



Balance Sheet n  It balances n  Assets = Liabilities + Shareholders’

Equity


Assets n  Current assets

n  Cash and cash equivalents n  Accounts receivable n  Inventories n  Prepaids

n  Investments and other assets


Assets n  Property, plant and equipment, net

n  Land and improvement n  Buildings and improvements n  Equipment n  Less accumulated depreciation

n  Goodwill and other intangibles


Goodwill and Impairment n  Difference between what a business

pays to buy another company and the book value (total assets minus total liabilities) of that company


Liabilities n  Current liabilities

n  Accounts payable n  Accrued liabilities n  Income taxes n  Current maturity of long-term debt

n  Noncurrent liabilities n  Long-term debt n  Deferred income taxes

n  Commitments and contingencies


Shareholders’ Equity n  Capital stock

n  Preferred stock n  Common stock

n  Additional paid-in capital n  Retained earnings n  Treasury stock

n  Total shareholders’ equity n  Total L + OE


Statement of Cash Flows n  Record of cash provided by cash

sources and of cash consumed by cash uses.


Cash Flows (cont.) n  Information about use of cash n  Information about investing and

financing n  Ability to continue as a going concern n  Ability to generate future positive cash

flows n  Ability to meet obligations and pay

dividends


Cash Flows n  From operations n  From investing n  From financing


Flexibility n  Companies have some flexibility in

categories for entries. n  Total change in cash, however, will not

change. n  Overwhelming majority of all accounting

standards deal with balance sheet and income statement, not cash-flows statement.


Free Cash Flow n  Powerful tool for making a company

successful n  Powerful indicator for investors n  Cash that is left over after productive

capacity is maintained or expanded n  Permits expansion, paying down debt,

buying back shares, etc.


Free Cash Flow (cont.) n  Several ways to calculate it n  Companies create their own models. n  Gross way to do it:

n  Cash from operating activities n  Minus capital expenditures n  Equals free cash flow


American Standard Model

n  Cash from operating activities n  Minus capital expenditures n  Plus proceeds from disposal of property n  Plus proceeds from sale and

leasebacks n  Equals free cash flow

Free-Cash Models n  ‘Gross’ method n  American Standard method n  VF method

n  Cash from operating minus cash from investing


Keys to Looking at Cash n  Cash from operations n  Capital expenditures (cap ex) n  Free cash n  Cash and cash equivalents at the end

of the year



Looking at the Numbers n  Note changes in amounts year to year, especially

revenues and expenses. n  Note numbers that are significantly larger or smaller

than the previous period. n  Look at trend line for sales/revenues, operating

income and net income. Calculate percentage change for each.

n  Look at cash flow. n  Look at free cash flow. n  Tie the numbers to the footnotes.


Techniques n  Calculate percentage change n  Trend analysis n  Common size analysis n  Ratio analysis

Understanding financial statements gentry

Documents

n clyde

n response

n best

n james

n states management

n control of activities

n financing decisions

n rigorous penalties