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Financial Metrics: Part 1 smartwomansecurities October 31, 2006 SPEAKER Company Name These materials are made for educational purposes and should not be.

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Presentation on theme: "Financial Metrics: Part 1 smartwomansecurities October 31, 2006 SPEAKER Company Name These materials are made for educational purposes and should not be."— Presentation transcript:

1 Financial Metrics: Part 1 smartwomansecurities October 31, 2006 SPEAKER Company Name These materials are made for educational purposes and should not be distributed. All materials are for SWS members’ use only

2 Announcements

3 What Happened in the Market Last Week

4 Why Financial Metrics are Important From last week, you have been able to formulate a list of stocks you are interested in –Based on trends, industry position, Porter’s Five Forces, etc. How can you tell these companies are financially stable? –Can they cover their debts? –What are their prospects for growth? –Will their stock price appreciate? Or are they about to crash? Financial statement analysis and understanding ratios is an integral part of doing the research behind making investments –Allows us to make comparisons between similar companies

5 In This Seminar: Read financial statements and understand what they mean –Balance Sheet –Income Statement –Cash Flows (next week) Learn important ratios Be able to compare similar stocks on the basis of financial strength Pare down your list of stocks even more, based on financial metrics

6 intro to financial statements

7 Financial Accounting –Translates activities into objective numbers Allows comparability across time, firms and industries –Enables the assessment of: Performance Problems Prospects –Informs the decisions of: Managers of the company Internal and external auditors Investors and creditors ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Every public company has to disclose financial statements. Thus, understanding financial statements offer us a good point of comparison, as well as an indication of a company’s relative financial strength

8 Accessing Financial Statements How do investors get access to financial statements? –A public company’s financial statements MUST be available to the public (further requirements as mandated by Sarbanes-Oxley, an act passed by Congress in 2002 to fight fraud in corporations) –Look at your company’s website and find their 10K (annual report) or 10-Q (quarterly report) – this is usually found under “SEC Filings” or something similar

9 Accessing Financial Statements Public Companies:

10 Financial Statements Annual Reports (10-K) –Company overview & business description –Accounting policies (GAAP) –Financial statements (and footnotes!) –Management discussion and analysis (MD&A) –Directors and executive officers’ bios –Executive compensation Quarterly Reports (10-Q) –Financial statements –MD&A

11 Financial Statements What do investors look at? –Balance Sheet –Income Statement –Statement of Cash Flows –Footnotes

12 A Note on Ratios Most of the financial metrics investors use are given in the form of ratios found in financial statements –PE Ratio, Price to Book, Quick Ratio, etc. This is so that comparisons can be made across two different stocks It is important to note that ratios tell you nothing by themselves; we can only judge something in comparison to others. Oftentimes we compare companies that are in the same industry or have similar business models (ie. Pepsi vs. Coke), or we compare a company to its industry as a whole (ie. Coke to the beverage industry). These are still imperfect comparisons, but it is important to note that because industries are so different, it does not make sense to compare a Coke to Microsoft, or compare a single stock to another industry. comparing ratios

13 Balance Sheet

14 Financial snapshot at a single point in time Assets (what the company owns) –economic resources that are expected to benefit future activities of the organization Liabilities (what the company owes) –the entity’s economic obligations to non-owners Owners’ equity (whatever is left) –the excess of the assets over the liabilities (also called “stockholder’s/shareholder’s equity”) –Homeowner example Assets = Liabilities + Owner’s Equity ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

15 Balance Sheet: Its Components Assets: A company’s resources Liabilities: Claims against the company’s resources Owner’s Equity: Remaining Claims accruing to owners Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

16 Assets Assets generate probable future economic benefits (value) for the company Examples: Cash, Accounts Receivable, Supplies, Inventory, Property and Equipment, Furniture, etc. Current Assets: Assets that can be converted to cash within one year or the operating cycle, whichever is longer (ie. cash, receivables, inventory) Non-Current Assets: Assets that are not expected to be converted to cash within that time period: property, plants, equipment, investments and funds Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

17 Liabilities Liabilities are obligations to deliver something of value (usually cash or services) in the future Examples: Accounts Payable, Salaries Payable, Interest Payable, Note Payable Current Liabilities: Obligations that are expected to be paid within one year (ie. notes payable, accounts payable, etc) Non-Current Liabilities: Obligations that are not expected to be paid within one year or the operating cycle, whichever is longer (ie. bonds payable, long-term notes payable, pension liabilities, capital leases) Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

18 Shareholder’s Equity Equity is the residual interest in the assets of an entity that remains after its liabilities are deducted Stock and Paid-in Capital Retained Earnings Treasury Stock Other Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

19 How We Can Read Balance Sheets Its usefulness –Gives information about the liquidity of a company –Long-term solvency information (the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth) Its limitations –Assets are recorded at historical cost rather than at market value (what you paid, not what it’s “worth”) –Resources such as employee skills and reputation are NOT recorded on balance sheet Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001; Investopedia.com

20 An Investor’s Look at Balance Sheets Current Ratio: a measure of short-term liquidity risk = Current Assets/Current Liabilities Return on Equity: Measure of the efficiency with which a company employs its owners’ capital = Net Income / Owners’ Equity Return on Assets: Measure of the efficiency with which a company employs its assets = Net Income / Assets Debt-to-Equity: This ratio measures the amount of long-term debt financing relative to equity in a firm’s capital structure = Long-term Debt / Owners’ Equity Sources: What is a “Strong” Balance Sheet, Chris Cather, Motley Fool, fool.com, February 2, 2005

21 Other Balance Sheet Ratios Price to Book Price to Sales

22 Example: Balance Sheet (AEOS) American Eagle Outfitters In Millions of USD (except for per share items) 2Q061Q064Q05 Cash & Equivalents Short Term Investments Cash and Short Term Investments Accounts Receivable - Trade, Net Total Receivables, Net Total Inventory Prepaid Expenses Other Current Assets, Total Total Current Assets 1, , , Property/Plant/Equipment, Total - Gross Goodwill, Net 9.95 Long Term Investments Other Long Term Assets, Total Total Assets 1, , , Accounts Payable Accrued Expenses Notes Payable/Short Term Debt 0.00 Other Current liabilities, Total Total Current Liabilities Total Long Term Debt 0.00 Total Debt 0.00 Other Liabilities, Total Total Liabilities Common Stock, Total Additional Paid-In Capital Retained Earnings (Accumulated Deficit) 1, , Treasury Stock - Common Other Equity, Total Total Equity 1, , , Total Liabilities & Shareholders' Equity 1, , , Total Common Shares Outstanding From Google Finance

23 Income Statement

24 “Flow” in a given period (vs. a given point in time) Basic equation: Net Income = Revenues – Expenses –Revenues: sources of income –Expenses: uses of income Net Income = “earnings” to be divided among the firm’s shareholders (EPS)

25 Revenues and Expenses Revenues are inflows of resources as a result of providing goods or services to customers –Examples: Sales, interest income, gain on sale of plant assets Expenses are outflows of resources incurred in generating revenues –Examples: Cost of goods sold, selling expenses, general and administrative expenditures, depreciation, interest, income taxes Source: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

26 How We Can Read Income Statements Its usefulness –Summarizes sales and profits over a period of time –Lets us look at changes in key line items and ratios across time to see whether operations have been changing Its limitations –Difficult to compare some ratios for companies in different industries –Revenues reported don’t always equal cash collected, and expenses reported aren’t always equal to cash paid, so income usually IS NOT EQUAL to the change in cash for the period –There are many components in income statements; make sure you read the footnotes so that you’re getting the whole story! Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

27 An Investor’s Look at Income Statements Gross Profit = Revenue – Cost of Goods Sold (“COGS”) Gross Margin = Gross Profit/Revenue Operating Profit = Revenues – COGS – Remaining costs involved in operations (ie. employee compensation, advertising, expenses, etc.) Operating Margin = Operating Profit/Revenue –Operating margin measures the proportion of a company’s revenue that is left over after paying for costs of operating, such as labor, raw materials, etc.) –A healthy gross margin is important for a company to pay its operating costs. The higher the margin the better! Sources: Foolish Fundamentals: The Income Statement, Motley Fool, fool.com, August 25, 2006; Investopedia Note: Margins vary widely by industry. For example, software companies (ie, Microsoft) tend to have high margins, whereas retailers (ie, Wal-Mart) tend to have low margins - Why? (Hint: think about the “value-add” each company offers its customers. How replicable are the goods/services each company is offering?) Lower-margin companies like Wal-Mart can still be very profitable because they make up for their margins through selling large volumes of products

28 Earnings From the income statement, we can determine the company’s earnings –The company can do two things with earnings: pay it out in the form of dividends, or re-invest in the company (known as “retained earnings”) Earnings per share (EPS) –How much a stock earned per share (or, net income divided by number of shares outstanding) During “earnings” season, companies have to report how well they did in the previous quarter. Oftentimes you might hear about a company “missing earnings”… this means that the company did poor compared to the consensus (from research analysts) from the Street.

29 PE Ratio One of the most important earnings ratios is the PE ratio: also called PE multiple, price-to-earnings ratio, the multiple, etc. This is often the first means of comparison between companies. –Tell whether a company is overvalued or undervalued –Reflects how much times earnings investors are willing to pay for a company –PE ratios are generally low for slow growers, high for fast growers; but at the same time, you could see it as being low for undervalued companies, or high for overvalued companies Company PE ratios can be compared to other similar companies, as well as with the market PE –The current market PE ratio is –EDIT-. Historically it has ranged from around –EDIT-

30 Income Statement (AEOS) In Millions of USD (except for per share items)2Q06 1Q064Q05 Revenue Other Revenue, Total Total Revenue Cost of Revenue, Total Gross Profit Selling/General/Admin. Expenses, Total Research & Development Depreciation/Amortization Total Operating Expense Operating Income Other, Net Income Before Tax Income After Tax Net Income Before Extra. Items Net Income Preferred Dividends Income Available to Common Excl. Extra Items Income Available to Common Incl. Extra Items Basic Weighted Average Shares Basic EPS Excluding Extraordinary Items Basic EPS Including Extraordinary Items Dilution Adjustment 0.00 Diluted Weighted Average Shares Diluted EPS Excluding Extraordinary Items Diluted EPS Including Extraordinary Items Dividends per Share - Common Stock Primary Issue Diluted Normalized EPS From Google Finance

31 Key Takeaways

32 Key Points Use balance sheets to assess a company’s financial position at a point in time –Look at key ratios to analyze a company’s business Income statements measure performance –Look at the company’s performance over time in terms of profits, margins, etc.

33 Key Ratios Important ratios vary from industry to industry, depending on the type of business –For example, pharmaceutical companies put a big focus on --- vs. retail companies which care about --? Some generally important ratios across the board: –PE Ratio –Price to Book –Return on Equity, Return on Assets –Current Ratio Ratios only tell us something about potential investments when compared to other similar companies

34 Next Seminar Week 6: More on financial statements –Cash Flows –Case study –Actually applying these ratios and looking more in- depth to balance sheet, income statement, etc.

35 Q&A


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