1. Chapter 2 Introduction to Financial Statement Analysis

2. Chapter Outline 2.1 The Disclosure of Financial Information
2.2 The Balance Sheet
2.3 The Income Statement
2.4 The Statement of Cash Flows
2.5 Other Financial Statement Information
2.6 Accounting Manipulation

3. Learning Objectives
List the four major financial statements required by the SEC for publicly traded firms, define each of the four statements, and explain why each of these financial statements is valuable.
Discuss the difference between book value of stockholders’ equity and market value of stockholders’ equity; explain why the two numbers are almost never the same.
Compute the following measures, and describe their usefulness in assessing firm performance: the debt-equity ratio, the enterprise value, earnings per share, operating margin, net profit margin, accounts receivable days, accounts payable days, inventory days, interest coverage ratio, return on equity, return on assets, price-earnings ratio, and market- to-book ratio.

4. Learning Objectives (cont'd)
Describe the importance of ensuring that valuation ratios are consistent with one another in terms of the inclusion of debt in the numerator and the denominator.
Distinguish between cash flow, as reported on the statement of cash flows, and accrual-based income, as reported on the income statement; discuss the importance of cash flows to investors, relative to accrual-based income.
Explain the importance of the notes to the financial statements.
List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud.

5. 2.1 Disclosure of Financial Information
Financial Statements
Firm-issued accounting reports with past performance information
Filed with the SEC
10Q
Quarterly
10K
Annual

6. 2.1 Disclosure of Financial Information (cont'd)
Preparation of Financial Statements
Generally Accepted Accounting Principles (GAAP)
Auditor
Neutral third party that checks a firm’s financial statements

7. 2.1 Disclosure of Financial Information (cont'd)
Types of Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholders’ Equity

8. 2.2 Balance Sheet A snapshot in time of the firm’s financial position
The Balance Sheet Identity:

9. 2.2 Balance Sheet (cont'd) Assets Liabilities Stockholder’s Equity
What the company owns
Liabilities
What the company owes
Stockholder’s Equity
The difference between the value of the firm’s assets and liabilities

10. 2.2 Balance Sheet (cont'd) Assets
Current Assets: Cash or expected to be turned into cash in the next year
Cash
Marketable Securities
Accounts Receivable
Inventories
Other Current Assets
Pre-paid expenses

11. 2.2 Balance Sheet (cont'd) Assets Long-Term Assets
Net Property, Plant, & Equipment
Book Value
Depreciation
Goodwill
Amortization
Other Long-Term Assets

12. Table 2.1

13. 2.2 Balance Sheet (cont'd) Liabilities
Current Liabilities: Due to be paid within the next year
Accounts Payable
Notes Payable/Short-Term Debt
Current Maturities of Long-Term Debt
Other Current Liabilities
Taxes Payable
Wages Payable

14. 2.2 Balance Sheet (cont'd) Liabilities Long-Term Liabilities
Long-Term Debt
Capital Leases
Deferred Taxes

15. Table 2.1 (cont'd)

16. 2.2 Balance Sheet (cont'd) Net Working Capital
Current Assets – Current Liabilities

17. 2.2 Balance Sheet (cont'd) Equity Book Value of Equity
Book Value of Assets – Book Value of Liabilities
Could possibly be negative
Market Value of Equity (Market Capitalization)
Market Price per Share Number of Shares Outstanding
Cannot be negative

18. Example 2.1

19. Example 2.1 (cont'd)

20. Alternative Example 2.1 Problem
Rylan Enterprises has 5 million shares outstanding.
The market price per share is $22.
The firm’s book value of equity is $50 million.
What is Rylan’s market capitalization?
How does the market capitalization compare to Rylan’s book value of equity?

21. Alternative Example 2.1 Solution
Rylan’s market capitalization is $110 million
5 million shares × $22 share = $110 million.
The market capitalization is significantly higher than Rylan’s book value of equity of $50 million.

22. 2.2 Balance Sheet (cont'd) Balance Sheet Analysis Liquidation Value
Value of the firm if all assets were sold and liabilities paid
Market-to-Book Ratio
Value Stocks
Low M/B ratios
Growth stocks
High M/B ratios

23. 2.2 Balance Sheet (cont'd) Balance Sheet Analysis Debt-Equity Ratio
Measures a firm’s leverage
Using Book Value versus Market Value
Enterprise Value

24. Example 2.2

25. Example 2.2 (cont'd)

26. 2.2 Balance Sheet (cont'd) Other Balance Sheet Information
Current Ratio
Current Assets / Current Liabilities
Quick Ratio
(Current Assets – Inventories) / Current Liabilities

27. 2.3 Income Statement Total Sales/Revenues Cost of Sales Gross Profit
minus
Cost of Sales
equals
Gross Profit

28. 2.3 Income Statement (cont'd)
Gross Profit
minus
Operating Expenses
Selling, General, and Administrative Expenses
R&D
Depreciation & Amortization
equals
Operating Income

29. 2.3 Income Statement (cont'd)
Operating Income
plus/minus
Other Income/Other Expenses
equals
Earnings Before Interest and Taxes (EBIT)

30. 2.3 Income Statement (cont'd)
Earnings Before Interest and Taxes (EBIT)
plus/minus
Interest Income/Interest Expense
equals
Pre-Tax Income

31. 2.3 Income Statement (cont'd)
Pre-Tax Income
minus
Taxes
equals
Net Income

32. Table 2.2

33. 2.3 Income Statement (cont'd)
Earnings per Share
Stock Options
Convertible Bonds
Dilution
Diluted EPS

34. 2.3 Income Statement (cont'd)
Income Statement Analysis
Profitability Ratios
Operating Margin
Net Profit Margin

35. 2.3 Income Statement (cont'd)
Income Statement Analysis
Working Capital Days
Accounts Receivable Days
EBITDA
Reflects the cash a firm has earned from its operations

36. 2.3 Income Statement (cont'd)
Income Statement Analysis
Leverage Ratios/Interest Coverage Ratios
EBIT / Interest Expense
Operating Income / Interest Expense
EBITDA / Interest Expense

37. 2.3 Income Statement (cont'd)
Income Statement Analysis
Investment Returns
ROA
Net Income / Total Assets
ROE
Valuation Ratios
P/E Ratio

38. Example 2.3

39. Example 2.3 (cont'd)

40. 2.4 Statement of Cash Flows
Net Income typically does NOT equal the amount of Cash the firm has earned.
Non-Cash Expenses
Depreciation and Amortization
Uses of Cash not on the Income Statement
Investment in Property, Plant, and Equipment

41. 2.4 Statement of Cash Flows (cont'd)
Three Sections
Operating Activities
Investment Activities
Financing Activities

42. 2.4 Statement of Cash Flows (cont'd)
Operating Activities
Adjusts net income by all non-cash items related to operating activities and changes in net working capital

43. 2.4 Statement of Cash Flows (cont'd)
Investing Activities
Capital Expenditures
Buying or Selling Marketable Securities
Financing Activities
Changes in Borrowings
Payment of Dividends
Retained Earnings

45. Example 2.4

46. Example 2.4 (cont'd)

47. 2.5 Other Financial Statement Information
Management Discussion and Analysis
Off-Balance Sheet Transactions
Statement of Stockholders’ Equity
Notes to the Financial Statements

48. Example 2.5

49. Example 2.5 (cont'd)

50. Alternative Example 2.5 Problem
Campbell Soup Company reported the following sales revenues by category:
What was the percentage growth for each category?
If Campbell’s has the same percentage growth from 2006 to 2007, what will its total revenues be in 2007?

51. Alternative Example 2.5 Solution U.S. Soup, Sauces and Beverages
($3,257 ÷ $3,098) − 1 = 5.13%
Baking and Snacking
($1,747 ÷ $1,742) − 1 = 0.29%
International Soup and Sauces
($1,255 ÷ $1,227) − 1 = 2.28%
Other
($1,084 ÷ $1,005) − 1 = 7.86%
Total
($7,343 ÷ $7,072 ) − 1 = 3.83%

52. Alternative Example 2.5 Solution (continued)
Estimated 2007 Total Revenue
$7,343 × ( %) =
$7,343 × = $7,624

53. 2.6 Accounting Manipulation
Enron
WorldCom
Sarbanes-Oxley Act (SOX)