1. Strategic Capital Group Workshop #5: Financial Statement Analysis

2. Agenda Types of Accounts The Balance Sheet The Income Statement The Statement of Cash Flows Looking at health and profitability

3. The Balance Sheet A snapshot of the business at a point in time, shows values of assets, liabilities, and equity accounts.

4. Types of Accounts We have 3 types of accounts in the balance sheet: Assets: Resources of the business we will use to generate revenues Liabilities: Money we owe to creditors or “debt-holders” that have funded our business Equity: Money we got from people who bought stock from the company in return for voting power and a share of the profits Assets = Liabilities + Owner’s Equity Value of resources in the business = Money we got from creditors + money we got from shareholders In other words, everything in the business was either bought with money from shareholders or creditors.

5. The Accounts Within: Assets Cash Accounts Receivable (Short term IOU’S) Investments Land Buildings Equipment “Property, Plant, and Equipment” or PP&E Inventory

6. Stepping to the side: Depreciation and Amortization, what are they? When you buy a car for $50,000 and try to sell it a year later, you can’t get the same value you paid for it, you get less. Accountants adjust the value of the long term assets the company is holding at the end of every period to reflect what they believe is the new value. We call this “depreciation” for physical assets and “amortization” for intangible assets (like patents)

7. The Accounts Within: Liabilities Accounts Payable (short term debt to suppliers) Bank Loans Bonds Payable Unearned Revenue (prepaid sandwiches)

8. The Accounts Within: Equity Common Stock Preferred Shares Retained Earnings Additional Paid-In Capital Treasury Stock

9. Exercise AssetsLiabilitiesEquity Companies have a lot of funky names for their accounts, so based on your knowledge of the base accounts and what each category is, what is each account classified under? Cash and Cash Equivalents Certificates of Deposit (CD’s) Raw Materials Construction in Progress Intangible Assets (Patents) Short Term Borrowings Dividends Payable Trade Receivables Earnings Employed in the business Common Stock Held in Treasury

10. Form of the Balance Sheet Assets: Current Assets: Cash$50 Inventory$75 Long Term Assets: PP&E$800 Total Assets:$925 Liabilities: Current Liabilities$40 Long term Liabilities$324 Total Liabilities:$364 Equity: Common Stock$1 Add. PIC$360 Retained Earnings$200 Total Equity:$561 Total L + E$925

11. The Income Statement Tells us the revenue generating and expense generating activities of the business over the course of the reporting period (year or quarter)

12. Two Classifications to Know Revenues: Dollar value of sales a company generates Expenses: Costs associated with generating the revenue. After all expenses have been taken out of our pool of revenue, what’s left is taxed.

13. The form of the Income Statement Revenue/Sales$1200 -Cost of Goods Sold$300 Gross Profit$900 Gross margin75% -Operating Expenses$150 Operating Income$750 Operating Margin62.5% -Interest Expense$125 Income Before taxes$625 -Taxes$187.50 Net Income$437.50 Profit Margin34.6% So at the end, 34.6% of every dollar in sales becomes profit available to shareholders

14. Depreciation Expense Remember back a few slides… Every period we wrote down the value of our long-term assets to reflect what they were worth (given that they’ve been used a little and they’re not longer brand new) This adjustment is recorded as “depreciation expense” even though no cash was paid out. We record depreciation expense under operating expenses

15. Cost of Goods Sold Value of the inputs that are directly involved in the process of making a product or getting it “ready for sale” This includes the cost of sandwich meat, bread, lettuce, tomatoes, sauce (direct materials) Also includes cost of labor that is directly assembling the sandwiches and delivering them (direct labor) Includes cost of rent and utilities of the sandwich shop or assembly factory (overhead) Does not include the cost of rent of our New York Headquarters, salaries of the CEO, salaries of our accountants, or supply costs. These costs are not necessary to make and prepare the sandwich for sale.

16. Gross Profit So Gross Profit is essentially how much it would money we would make if we got rid of corporate (though there are still a couple necessary expenses we’d have to add back in)

17. Operating Expenses -Salaries of people not associated with the production of sandwiches -Rent on NY HQ -R&D Expenses for developing ultra-modern sandwiches -General expenses like cost of paper clips for the office, utilities for the office, etc. Most of the time this is all covered under “Selling, General, and Administrative Expenses” or SG&A.

18. Interest Expense An important thing to notice is that interest expense is taken out of our Earnings before we take out taxes, why is this significant? Because this means interest is tax-deductible, meaning that if we pay less taxes on our earnings if we pay more in interest. This is one of the benefits of funding your operations through debt, you end up paying a lower tax rate and a lower total tax expense.

19. Earnings: what does it mean? Earnings is the profit left after all suppliers (COGS), creditors (interest expense), and the government (taxes) have been paid off, so the only person left to have the money go to is the shareholders. But if the sandwich company makes $400 in earnings, not all of it goes into the shareholders’ pockets, some of it is distributed back to shareholders in the form of dividends that are checks to shareholders as a sort of “thank you” for risking your money by investing in the company. The rest is deposited into retained earnings and recycled back into the business to grow.

20. The Uselessness of the Income Statement Typically, investors don’t use Operating income to a profit measurement, we have EBITDA, EBIT, EBT, and E. Earnings Before Interest Taxes Depreciation and Amortization

21. How we get to Earnings Revenue -Cost of Goods Sold Gross Profit -Selling, General, and Admin Expense -Other Expenses +Depreciation and Amortization EBITDA -Depreciation and Amortization EBIT -Interest EBT -Taxes Earnings Most of the time, this is the same as Operating Income Most of the time D&A is already looped in with COGS or in Expenses

22. Why is our method important? EBITDA is what we’re really trying to get at here (not EBIT, that’s just Operating Income so we can find that already). EBITDA is our operating income before non-cash expenses are incurred (depreciation), which makes our earnings number closer to the amount of cash we made.

23. Where does the account belong? Income StatementBalance Sheet Net Income Common Stock Cash Accounts Receivable Selling, General, and Administrative Expenses EBITDA Equipment Interest Expense Accounts Payable Long-Term Debt Total Depreciation Unearned Revenue

24. Statement of Cash Flows Tell us about where we earned and spent cash during the reporting period, as well as our cash balances. Important because a company can earn billions of dollars in revenue but through the usage of accounts receivable, never see a dollar. This can be a problem because you have to pay debts with cash not another IOU. This statement will be our best friend during DCF modeling in a few lessons.

25. Form of the Statement of Cash Flows Beginning Cash$100 Net Income$437.50 +Net Cash Flows from Operations$550 +Net Cash Flows from Investing-$50 +Net Cash Flows from Financing$400 +Net Cash Flows$900 Ending Cash$1000

26. Idea Behind it: We want to take our net income and add back any cash generating activities, then take back out any cash using activities to find how much cash was generated by the business. We like cash because finance people think accountants can manipulate numbers (they can) so cash gives us the clearest picture of the reality of the business.

27. Cash Flows from Operating Activities Cash generated or used up from the everyday activities of the business like: Cash collections from Accounts Receivables Cash Sales Cash Expenditures Changes in Current Assets Changes in Current Liabilities Add back Depreciation and Amortization Depreciation and Amortization are already in Net income, so to get to cash, we need to add it back (remember, we don’t actually pay any cash on D&A), it’s an accounting gimmick. Essentially how much cash you take in minus your bills.

28. Cash Flows from Investing Activities Covers purchases and sales of long-term assets and investments. What we see in the statement: Buying a building is a cash outflow Selling land is a cash inflow Buying Investments is a cash outflow Selling investments is a cash inflow Important to remember that you’re dealing with cash, so buying assets will decrease your cash and vice versa We refer to the acquisition of long-term assets as “Capital Expenditures”

29. Cash Flows from Financing Covers cash flows that are related to raising capital for the business, both by debt and equity. Paying interest is a cash outflow Paying back principal of a loan is a cash outflow Receiving a loan’s funds is a cash inflow Receiving funds from a issuance of stock is a cash inflow Having a positive number in cash flows from financing means you are taking on more debt or issuing stock faster than you are paying it back.

30. So if we go back… Beginning Cash$100 Net Income$437.50 +Net Cash Flows from Operations$550 +Net Cash Flows from Investing-$50 +Net Cash Flows from Financing$400 +Net Cash Flows$900 Ending Cash$1000 Cash in - Bills Buying/Selling LT Assets Taking in/paying off capital from investors and creditors

31. How does all this apply to picking better stocks and valuation? Eyes on the prize: This is all leads to DCF modeling and valuation. Although balance sheets and cash flow statements alone can’t tell you how much a company is worth, we can look at it to see if the company is “healthy”.

32. Is this company healthy? Statement of Cash Flows Net Income $150 CFOperations:-$100 CFInvesting:-$200 CFFinancing: $600 Net CF: $300 I would argue no here- the company has a positive net cash flow, but it is getting its money mainly from financing and is losing money in the CFO category, which should be positive almost always. Statement of Cash Flows Net Income $150 CFOperations: $600 CFInvesting:-$800 CFFinancing:-$100 Net CF: -$300 As long as the investing activities are a one-time deal, this company has healthy CF generation from strong CFO and low CFF.

33. Assessing Balance Sheet Health We can assess debt health by looking at a couple ratios: Current ratio = Current Assets/ Current Liabilities If we were to use up our current assets by turning them into cash, would it cover everything we owe this year? Quick Ratio = (Current Assets – Inventory)/Current Liabilities If we use our most liquid assets we have on hand right now, can we pay off the debt we owe this year? Ideally, we want these ratios to be greater than 1 which means we can pay all the debts we owe this year and more. A healthy company has consistent liquidity ratios greater than 1.

34. Assessing Balance Sheet Health We can also assess company health by looking at the debt coming due in the future: Sources like FactSet and the 10K will disclose how much debt comes due and at what interest rate at specified years, we want to invest companies that can cover any debt obligations that come due. We can assess the company’s ability to cover future obligations by looking at historical Operating Cash Flow trends, forecasting what we expect OCF to be in the next few years, then verifying it is greater than the amount of debt coming due.

35. Relationships between the Statements It’s important to understand how each of the statements relate to each other: Revenue/Sales -Cost of Goods Sold Gross Profit Gross margin -Operating Expenses Operating Income Operating Margin -Interest Expense Income Before taxes -Taxes Net Income Profit Margin Tied to Inventory on the Balance Sheet (Change in Inventory = COGS) First line item of Statement of Cash Flows Depreciation Expense is tied to Total Depreciation of PP&E on the Balance Sheet

36. Relationships between the Statements Beginning Cash$100 Net Income$437.50 +Net Cash Flows from Operations$550 +Net Cash Flows from Investing-$50 +Net Cash Flows from Financing$400 +Net Cash Flows$900 Ending Cash$1000 Includes Depreciation and Amortization from Income Statement From Income Statement Tied to PP&E Tied to changes in LT Liabilities Covers changes in current assets and liabilities Cash

37. Common Interview Question What is the impact of $10 of extra depreciation in each of the statements given a tax rate of 30%? Revenue -COGS Operating Income -Expenses EBIT -Interest EBT -Taxes Earnings +$10 -$10 -$7 Net Income Beginning Cash CFO CFI CFF Net Ending Cash -$7 +$10 (add back D&A) +$3

38. Interview Question, Cont. Assets: Cash +$3 PP&E -Accum. Depr +$10 Net PP&E -$10 Total Assets: -$7 Liabilities: Equity: Retained Earnings-$7

39. Follow-up Interview Question But if depreciation is a non-cash expense, how did we generate $3 in extra cash? Revenue -COGS Operating Income -Expenses EBIT -Interest EBT -Taxes Earnings +$10 -$10 -$7 Net Income Beginning Cash CFO CFI CFF Net Ending Cash -$7 +$10 (add back D&A) +$3 By having an extra $10 in depreciation, we saved $3 in taxes, which ends up in cash.