Chapter 2 – Introduction to Financial Statement Analysis

Chapter 2 – Introduction to Financial Statement Analysis
School of Natural and Social Sciences Department of Economics and Business, Lehman College Chapter 2 – Introduction to Financial Statement Analysis Alexander Núñez Torres, PhD Assistant Professor, Department of Economics and Business Unless otherwise noted, licensed under an Attribution-NonCommercial-ShareAlike 4.0 International.

Schedule Firms Disclosure of Financial Information The Balance Sheet
The Balance Sheet Identity Assets Liabilities Shareholder’s equity The Income Statement Earnings Calculations Earnings per share Earnings before interest, taxes, depreciation and amortization The Statement of Cash Flows Operating activity Investment activity Financial Investments Other Financial Statement Information Financial Statement Analysis Financial Reporting in Practice

Firms’ Disclosure of Financial Information
Financial statements are accounting written reports issued periodically to present business activities and past performance of a company. Investors, financial analysts, managers, and other interested parties such as creditors rely on financial statements to obtain reliable information about a corporation Public companies must file financial results with the Securities and Exchange Commission (SEC) On a quarterly basis (10-Q) An annual basis (10-K) The annual report with financial statements must be sent to their shareholders every year. The four main financial statements are Balance sheet, income statement, shareholders equity, and Cash Flows

The Balance Sheet Also called “Statement of Financial Position”
The balance sheet is a financial statement that reports the company situation with respect to the company’s assets, liabilities and shareholders’ equity Lists the firm’s assets and liabilities The report shows the information for a specific point in time.

The Balance Sheet – The Coca Cola Company

The two sides of the balance sheet must balance:
The Balance Sheet Identity The two sides of the balance sheet must balance: 𝐴𝑠𝑠𝑒𝑡𝑠=𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠+𝐸𝑞𝑢𝑖𝑡𝑦

The Balance Sheet Current Assets Cash and other marketable securities:
Short-term, low-risk investments Easily sold and converted to cash Accounts receivable: Amounts owed to the firm by customers who have purchased on credit Inventories: Raw materials, work-in-progress and finished goods; Other current assets: Includes items such as prepaid expenses, goodwills, and intangible assets

The Balance Sheet Long-term assets
Assets that produce benefits for more than one year Reduced through a yearly deduction called depreciation according to a schedule that depends on an asset’s life Depreciation is not an actual cash expense, but a way of recognizing that fixed assets wear out and become less valuable as they get older In accounting terms, the book value of an asset is its acquisition cost less its accumulated depreciation

The Balance Sheet Liabilities Current Liabilities
Accounts Payable: The amounts to payoff a short-term debt to its creditors and suppliers Notes payable and short-term debt: Loans that must be repaid within the next year. Accruals items: Items such as salary or taxes that are owed but have not yet been paid.

The Balance Sheet Liabilities Net Working Capital:
The capital of a business used in its day-to-day trading operation. It is a measure of a company’s operational efficiency. 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 −𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Long-term Liabilities: Are the loan or debt obligation maturing in more than a year

The Balance Sheet Stockholder’s equity Book Value
Net worth from an accounting perspective Assets – Liabilities = Equity True value of assets may be different from book value Market Capitalization Market price per share times number of shares Does not depend on historical cost of assets

The Balance Sheet Example 2.1 Market capitalization vs Book Value:
If Coca Cola has 4,268 million shares outstanding in December The price per share was $47.35 per share, what is Coca Cola’s market capitalization? How does the market capitalization compare to Coca cola’s book value of equity?

The Balance Sheet Solution: Process:
Market capitalization is equal to price per share times shares outstanding We can find Coca Cola’s book value of equity at the bottom of its balance sheet: $19,058 million for 2018

The Balance Sheet Solution: Computation:
Global’s market capitalization is: (4,299 million shares)  ($47.35/share) = $203, million This market capitalization is significantly higher than Coca Cola’s book value of equity: $22.2 million

The Balance Sheet Solution: Examine:
Coca Cola must have sources of value that do not appear on the balance sheet. These include: Opportunities for growth The quality of the management team Relationships with suppliers and customers, etc

The Balance Sheet Market-to-book ratio
The ratio of a firm’s market capitalization to the book value of stockholders’ equity: 𝑀𝑎𝑟𝑘𝑒𝑡−𝑡𝑜−𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜= 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 Also called Price-to-Book ratio Sometimes used to classify firms as a value firm (low M/B) or a growth firm (high M/B)

The Balance Sheet Enterprise value
is a comprehensive measure of a company’s total value, used in conjunction of market capitalization. It is the value of a company if an investor would like to acquire it. EV includes in its calculation the market capitalization of the company as well as the value of debt minus the value of cash. 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒=𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦+𝐷𝑒𝑏𝑡 −𝐶𝑎𝑠ℎ

The Balance Sheet Example 2.2 Computing Enterprise value:
In December 2018, Amazon. (AMZN) had a share price of $1,501.97, 500 million outstanding shares, a market-to-book ratio of 16.93, a book value of debt of $119,099 million, and cash of $41,250 million What was Amazon’s market capitalization (its market value of equity)? What was its enterprise value?

We will solve the problem using Enterprise Value Equation
The Balance Sheet Solution: Plan: Market capitalization is equal to price per share times shares outstanding Share price $1,501.97, Shares outstanding 500 million Cash $41.25 billion, Debt (book) $ billion We will solve the problem using Enterprise Value Equation

The Balance Sheet Solution: Compute:
Amazon had market capitalization of $1,  500 million shares = $750.5 billion Thus, Amazon’s enterprise value was 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒=𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦+𝐷𝑒𝑏𝑡 −𝐶𝑎𝑠ℎ 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒= – = $ billion

The Income Statement The income statement or profit and loss account (P&L) is a financial report that provides a summary of a company’s revenues, expenses, and profits/losses over a period of time. The last line of the income statement is usually the net income. Also called earnings, the Net income is a measure of the company’s profitability during the period.

The Income Statement Earnings Calculations Gross Profit
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 (𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠) − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 = 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 Operating Income 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 – 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 Earnings Before Interest and Taxes (EBIT) Operating Income +/- Other Income = Earnings Before Interest and Taxes Pretax and Net Income EBIT +/- Interest income (Expense) = Pretax Income Pretax Income – Taxes = Net Income

The Income Statement– Global Corporation

The Income Statement Earnings per share
Net income reported on a per-share basis 𝐸𝑃𝑆= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = $6,434 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 4,259 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 =$1.51 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

The Income Statement Earnings per share
Fully diluted EPS increases number of shares by: Stock options issued to employees: The right to buy a certain number of shares by a specific date at a specific price. Shares issued due to conversion of convertible bonds: Convertible bonds are corporate bonds with a provision that gives the bondholder an option to convert each bond into a fixed number of shares of common stock.

Income Statement EBITDA
Financial analysts often compute a firm’s earnings before interest, taxes, depreciation, and amortization, or EBITDA. Because depreciation and amortization are not cash flows, this subtotal reflects the cash a firm has earned from operations.

Statement of Cash Flows
The firm’s statement of cash flows uses the information from the income statement and balance sheet to determine: How much cash the firm has generated 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: Operating activities Investment activities Financing activities

Statement of Cash Flow – Global Corporation

Operating activity Use the following guidelines to adjust for changes in working capital: Accounts receivable: 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 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 Inventory: Finally, we deduct increases to inventory Increases to inventory are not recorded as an expense and do not contribute to net income However, the cost of increasing inventory is a cash expense for the firm and must be deducted We also add depreciation to net income, since it is not a cash outflow

Investment activity Subtract the actual capital expenditure that the firm made Also deduct other assets purchased or investments made by the firm, such as acquisitions

Financing activities The last section of the statement of cash flows shows the cash flows from financing activities Dividends paid Cash received from sale of stock or spent repurchasing its own stock Changes to short-term and long-term borrowing

The last line of the Statement of Cash Flows combines the cash flows from these three activities (Operating, Investment, Financing activities) to calculate the overall change in the firm’s cash balance over the time period.

Other Financial Statement Information
Statement of Stockholders’ Equity (SE) 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝐸=𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠+𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝐸=(𝑁𝐼 −𝐷𝑖𝑣)+(𝑆𝑡𝑜𝑐𝑘 𝑆𝑎𝑙𝑒𝑠−𝑅𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘)

Financial Statement Analysis
Investors often use accounting statements to: Compare the firm with itself by analyzing how the firm has changed over time (time series analysis) Compare the firm to other similar firms using a common set of financial ratios (Cross sectional analysis)

Profitability Ratios Gross Margin: How much a company earns from each dollar of sales after paying for the items sold 𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛= 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 = 𝑆𝑎𝑙𝑒𝑠 −𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑆𝑎𝑙𝑒𝑠

Profitability Ratios Operating Margin: How much a company earns before interest and taxes from each dollar of sales 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛= 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠

Profitability Ratios Net Profit Margin: The fraction of each dollar in revenues that is available to equity holders after the firms pays interest and taxes 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠

Liquidity Ratios Current Ratio: The Ratio of current assets to current liabilities. It measures a company's ability to pay short-term obligations 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Liquidity Ratios Quick Ratio: The Ratio of current assets other than inventory to current liabilities 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Liquidity Ratios Cash Ratio: The most stringent liquidity ratio 𝐶𝑎𝑠ℎ 𝑅𝑎𝑡𝑖𝑜= 𝐶𝑎𝑠ℎ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Asset Efficiency Asset Turnover: A first broad measure of efficiency is asset turnover 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟= 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Asset Efficiency Fixed Asset Turnover: Since total assets include assets that are not directly involved in generating sales, a manager might also look at fixed asset turnover 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟= 𝑆𝑎𝑙𝑒𝑠 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

Working Capital Ratios Accounts Receivable Days: The firm’s account receivable in terms of the numbers of days’ worth of sales that it represents 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠= 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠

Working Capital Ratios Inventory Days and Inventory Turnover Inventory days is the number of days’ cost of goods sold represented by inventory. Inventory Turnover tells how efficiently a company turns its inventory into sales 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Example 2.5 Computing Working Capital Ratios Compute Coca Cola’s Accounts receivable and payable days, inventory days and inventory turnover for 2018

Solution: Plan: Working Capital Ratios require information from both the balance sheet and the income statement For these ratios, we need inventory and accounts payable from the balance sheet and cost of goods sold from the income statement (often listed as cost of sales) 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦=2,766𝑀 𝑆𝑎𝑙𝑒𝑠=31,856𝑀 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒=8,932𝑀 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒=3,396𝑀 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 =11,700

Solution: Execute: 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠= 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠 = 3,396𝑀 31,856𝑀 365 =38.91 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠= 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠 = 8,932𝑀 31,856𝑀 365 =102.34 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠= 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 = 2,766𝑀 11,770𝑀 365 =85.78 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 11,770𝑀 2,766𝑀 =4.26

Solution: Examine: Assuming that Coca Cola’s accounts payable at year-end on its balance sheet is representative of the normal amount during the year, Coca Cola is able, on average, to take about days to pay its suppliers This compares with the days we calculated that it waits on average to be paid (its accounts receivable days)

Solution: Examine: Coca Cola typically takes days to sell its inventory Note that inventory turnover and inventory days tell us the same thing in different ways – if it takes Coca Cola about days to sell its inventory, then it turns over its inventory about 4.26 times per 365-day year

Interest Coverage Ratios Also known as times interest earned (TIE) TIE = Earnings divided by interest Can define earnings as operating income, EBIT, or EBITDA Assesses how easily a firm is able to cover its interest payments

Example 2.7 Computing Interest Coverage Ratios Assess Coca Cola’s ability to meet its interest obligations by calculating interest coverage ratios using both EBIT and EBITDA

Solution: Plan: Gather the EBIT, depreciation and amortization and interest expense for each year from Coca Cola’s income statement 2017 EBIT = 7,599.00M EBIT = 8,700.00M, EBITDA = 7,599.00M+1,260.00M, EBITDA = 8, ,086.00M, Interest expense = M Interest expense = M

Solution: Compute: 𝐸𝐵𝐼𝑇−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 2017= 7, =9.04 𝐸𝐵𝐼𝑇𝐷𝐴−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 2017= 8, =10.53 𝐸𝐵𝐼𝑇−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 2018= 8, =9.47 𝐸𝐵𝐼𝑇𝐷𝐴−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 2018= 9, =10.65

Solution: Examine: The coverage ratios indicate that Coca Cola is generating enough cash to cover its interest obligations Additionally, Coca Cola is increasing the interest coverage from 2017 to 2018

Leverage Ratios Debt-Equity Ratio The debt-equity ratio is a common ratio used to asses a firm’s leverage 𝐷𝑒𝑏𝑡−𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜= 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 This ratio can be calculated using book or market values

Leverage Ratios Debt-to-Capital Ratio The debt-to-capital ratio calculates the fraction of the firm financed by debt 𝐷𝑒𝑏𝑡−𝑡𝑜−𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜= 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦+𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 This ratio can also be calculated using book or market values

Leverage Ratios Net Debt While leverage increases risk to equity holders, firms may also hold cash reserves in order to reduce risk 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡=𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 −𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ & 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠

Leverage Ratios Debt-to-Enterprise Value Ratio 𝐷𝑒𝑏𝑡−𝑡𝑜−𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 𝑅𝑎𝑡𝑖𝑜= 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦+𝑁𝑒𝑡 𝐷𝑒𝑏𝑡

Valuation Ratios 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 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 earnings it can generate 𝑃/𝐸𝑅𝑎𝑡𝑖𝑜= 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Valuation Ratios PEG Ratio P/E ratios can vary widely across industries and tend to be higher for industries with higher growth rates. One way to capture the idea that a higher P/E ratio can be justified by higher expected earnings growth

Valuation Ratios PEG Ratio It is the ratio of the firm’s P/E to its expected earnings growth rate The higher the PEG ratio, the higher the price relative to growth, so some investors avoid companies with PEG ratios over 1

Example 2.8 Assessing two competing microprocessors companies Consider the following data about AMD and Intel for December 2018. Compare both companies operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales 2018 Information Advanced Micro Devices (AMD) Intel Corporation (INTC) Sales $ 6,475M 70,848M Operating Income $ 451M 23,316M Net Income $ 337M 21,053M Price $ 18.46 $ 46.93 Shares Outstanding 1.064B 4.701B Cash $ 1,078M 3,019M Debt $ 3,290M 26,359M

Solution: Plan: The table contains all of the raw data, but we need to compute the ratios using the inputs in the table. 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 / 𝑆𝑎𝑙𝑒𝑠 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 / 𝑆𝑎𝑙𝑒𝑠 𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜 = 𝑃𝑟𝑖𝑐𝑒 / 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐸𝑉 𝑡𝑜 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 =𝐸𝑉/ 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑉 𝑡𝑜 𝑆𝑎𝑙𝑒𝑠 =𝐸𝑉/ 𝑆𝑎𝑙𝑒𝑠

Solution: Compute: Advanced Micro Devices (AMD): 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 = 451𝑀 6,475𝑀 =6.97% 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 337 𝑀 6,475 𝑀 =5.20% 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 = $18.46 𝑥 1,064𝑀 337 𝑀 =57.28 𝐸𝑉 𝑡𝑜 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 = 21, 𝑀 451 𝑀 =48.46 𝐸𝑉 𝑡𝑜 𝑆𝑎𝑙𝑒𝑠 = 21, 𝑀 6,475 𝑀 = 34.26

Solution: Compute: Intel Corporation (INTC): 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 = 23,316𝑀 70,848 𝑀 =32.91% 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 21,053 𝑀 70,848 𝑀 =29.72% 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 = $46.93 𝑥 4,701𝑀 21,053 𝑀 =10.48 𝐸𝑉 𝑡𝑜 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 = 217, 𝑀 23,316 𝑀 =9.33 𝐸𝑉 𝑡𝑜 𝑆𝑎𝑙𝑒𝑠 = 217, 𝑀 70,848 𝑀 =3.07

Solution: Examine: INTEL has better profitability indicators. Additionally, AMD has the highest P/E ratio of the two

Operating Returns Return on Equity Evaluating the firm’s return on investment by comparing its income to its investment 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦

Operating Returns Return on Invested Capital After-tax profit generated by the business, excluding interest, compared to capital raised that has already been deployed 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙= 𝐸𝐵𝐼𝑇 (1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦+𝑁𝑒𝑡 𝐷𝑒𝑏𝑡

Example 2.9 Assessing Coca Cola Return on Assets Using Coca Cola’s using the income statement and Balance Sheet for 2018 and 2017, compute the Return on Equity, Return on Assets

Solution: Plan: Shareholder’s Equity 2017: $18,977.00 Shareholder’s Equity 2018: $19,058.00 Net Income 2017: $1, M Net Income 2018: $6, M Total Assets 2017: $83, M Total Assets 2018: $87, M

Solution: Compute: 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 2018= $ 6, 𝑀 $ 19, 𝑀 =33.76% 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 2017= $ 1, 𝑀 $ 18, 𝑀 =6.57% 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 2017= $ 1, 𝑀 83, 𝑀 =1.50% 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 2018= $ 6, 𝑀 87, 𝑀 =7.32%

Solution: Examine: In general terms, Coca Cola improved its Return on Equity and Return on Assets. Looking at the Revenues, it had a decline from one year to the next. The difference arises in the amount of taxes paid.

The 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 𝑅𝑂𝐸= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

The DuPont Identity 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 (equity multiplier 𝑅𝑂𝐸= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑅𝑂𝐸= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Example 2.10 Dupont Analysis The following table contains information about AMD and Intel Compute their respective ROEs 2018 Information Advanced Micro Devices (AMD) Intel Corporation (INTC) Profit Margin 5.20% 29.72% Asset Turnover 142.12% 55.37% Equity Multiplier 359.87% 171.62%

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 its profit margin, asset turnover, and equity multiplier

Solution: Execute: 𝑅𝑂𝐸= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑂𝐸 𝐴𝑀𝐷= 5.20% % % =26.61% 𝑅𝑂𝐸 𝐼𝑁𝑇𝐸𝐿= 29.72% % % =28.24%

References Berk, J.B., DeMarzo, P.M., & Harford, J.V.T. (2015). Fundamentals of Corporate Finance. (3rd ed.). Boston: Pearson Education. U.S. Securities and Exchange Commision. (2018). EDGAR Search Results: The Coca Cola Company CIK#: Retrieved from Yahoo! Finance. (2019). Intel corporation (INTC). Retrieved from Yahoo! Finance. (2019). Advanced Micro Devices, Inc. (AMD). Retrieved from srch

Chapter 2 – Introduction to Financial Statement Analysis
School of Natural and Social Sciences Department of Economics and Business, Lehman College Chapter 2 – Introduction to Financial Statement Analysis Alexander Núñez Torres, PhD Assistant Professor, Department of Economics and Business

Chapter 2 – Introduction to Financial Statement Analysis

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