1. Financial Statements & Analysis
Resa Lundkvist
Former Financial Analyst, Standard & Poor’s
Retired Managing Director, JP Morgan
Adjunct Professor, Finance, SNHU

2. Brady Inc. Balance Sheet as of 12/31/13
Assets = Liabilities + Stockholders Equity
Cash $ Accounts Payable $300
Accounts Receivable Notes Payable
Inventory Current portion LTD
Current Assets Current Liabilities
Equipment, net of Dep’n Long-Term Debt
Property Total Liabilities ,300
Noncurrent Assets , Common Stock
Retained Earnings
Stockholders Equity ,500
Total Assets , Total Liab. & SE ,800
↓ ↓
Company’s Economic Resources Company’s Sources of Financing

3. Balance Sheet The B/S is a financial snapshot on a specific date
The B/S doesn’t reflect amounts for which assets could currently be sold (an asset’s market value). Instead, balance sheets report book values less any accumulated depreciation.
Assets are listed in order of liquidity (closeness to cash)
Current assets will be turned into cash in < 1 year
Noncurrent assets will be turned into cash > 1 year
Inventory is included as a Current Asset regardless of how long its cycle to cash
Liabilities are listed in order of maturity, so obligations due within the next year are classified as current liabilities

4. Key Liquidity Tests
Why is liquidity so important?
Because cash is king. You can’t repay debt with equipment or property – you need cash! A company can’t meet its ST obligations if all its assets are tied up long-term. Companies have failed more often for liquidity problems than for solvency problems. A profitable company that can’t meet its payroll obligations has liquidity problems.
So, keep an eye on:
Net working capital = current assets – current liabilities
Current ratio = current assets/current liabilities

5. Debt vs. Equity and Capital Structure
Debt/equity - describes a company’s capital structure. Long-term asset purchases are financed either by debt capital, supplied by creditors, or by equity capital, supplied by owners. A company’s particular mix of debt and equity is called its capital structure. The capital structure is how a firm finances its operations and growth by using different sources of funds.
Debt is typically a cheaper source of funding than equity, but debt has a major drawback:
it has to be serviced and repaid in full and on time. Debt payments place a burden on the company that must be met, regardless of the company’s profitability. There is no flexibility.
Equity is a permanent and more flexible source of funding

6. Brady Inc. Income Statement (P&L) FYE 12/31/13
Sales $3,000
Cost of Goods Sold (COGS) ,000
Gross Profit ,000
Selling, General, & Admin Expenses (SG&A)
Depreciation Expense
Earnings before Interest & Taxes (EBIT) ,300
Interest Expense
Pretax Income ,200
Income taxes (25%)
Net Income ↓
Dividends +/or Retained Earnings

7. Income Statement (P&L)
If the B/S is a snapshot, then the P&L is a video, recording all of the company’s transactions
Net Income is allocated to dividends (shows up in cash flow statement) +/or retained earnings (shows up in Stockholders’ Equity section of B/S)
Good example of how the 3 main financial statements are connected and explains why all 3 have to be calculated to have a complete financial picture of a company

8. P&L Analysis Ratios focus on operating or “core” profitability
How much of each $1 of sales is turned into gross profit or EBIT?
Gross Profit Margin = Gross Profit/Sales
EBIT Margin = EBIT/Sales
How much Net Income are the company’s assets or equity generating (return on invested capital)?
Return on Assets = Net Income/Total Assets
Return on Equity = Net Income/Equity
Ratios are industry specific: identify correct peer group

9. P&L Analysis (#2)
Depreciation – a non-cash allocation of an asset’s cost over its estimated useful life.
Note that interest expense is deducted below core profitability measures, because it’s a consequence of capital structure, not operations.
Interest expense is tax-deductible, thus reducing tax expense. No flexibility, but lower-cost.
Dividends, however, are after-tax payments. More flexibility but also more expensive.
Payout Ratio = Dividends/Net Income
Plowback Ratio = Retained Earnings added/Net Income

10. Cash Flow Statement
Cash Flow Statement is the summation of all the company’s transactions that had a direct impact on cash. It explains the change in the Cash account on the B/S from 1 year to the next. A giant Cash T-account.
Cash from Operations – start with Net Income … then adjust
+/- Cash from Investing Activities – transactions with an operational nature, like buying a new equipment, opening a new factory, closing a factory or selling land
+/- Cash from Financing Activities – transactions related to capital structure, such as selling new shares, paying dividends, borrowing new debt, or repaying loans
--> Change in Cash on B/S from last year

11. My income statement says I made money, so why doesn’t my bank account agree?
OR: Why isn’t net income = cash from operations?
2 reasons: 1 easy, 1 not-so-easy
Depreciation is a non-cash expense that has been deducted on the P&L but doesn’t affect cash, and must be added back.
The P&L doesn’t capture changes in current assets and current liabilities that result from accrual accounting and cause changes in cash.
Example: Reported revenues don’t always equal cash collected from customers because some sales may be on credit, causing Accounts Receivable, a current asset, to increase. To calculate cash from operations, this increase must be deducted from Net Income. If a CA ↑, deduct from NI. If a CL ↑, add to NI.

12. Example: Calculating Cash from Operations
Brady Inc.’s Net Income = $900 & Depreciation = $200
2013 A/R = $200 & 2012 A/R = $150, using cash
2013 A/P = $300 & 2012 A/P = $100, releasing cash
To calculate CFO:
Start with Net Income $900
Add back Depreciation
Subtract ↑ in Current Assets (A/R)
Add ↑ in Current Liabilities (A/P)
Cash from Operations $800