Chapter 2 Introduction to Financial Statement Analysis Chapter

Chapter 2 Introduction to Financial Statement Analysis

Chapter Outline 2.1 Firms’ Disclosure of Financial Information 2.2 The Balance Sheet 2.3 Balance Sheet Analysis 2.4 The Income Statement 2.5 Income Statement Analysis 2.6 The Statement of Cash Flows 2.7 Other Financial Statement Information 2.8 Financial Reporting in Practice

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. Discuss the uses of the DuPont identity in disaggregating ROE, and assess the impact of increases and decreases in the components of the identity on ROE.

Learning Objectives 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 what is included in the management discussion and analysis section of the financial statements that cannot be found elsewhere in the financial statements. 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.

2.1 Disclosure of Financial Information Financial Statements Firm-issued accounting reports with past performance information Filed with the SEC 10Q Quarterly 10K Annual Must also send an annual report with financial statements to shareholders

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

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

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

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

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 Example: Pre-paid expenses

2.2 Balance Sheet (cont'd) Assets Long-Term Assets Net Property, Plant, & Equipment Book Value = Acquisition cost Depreciation (and Accumulated Depreciation) Goodwill and intangible assets Amortization Other Long-Term Assets Example: Investments in Long-term Securities

Table 2.1 Global Conglomerate Corporation Balance Sheet for 2009 and 2008

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

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

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

Table 2.1 (cont'd) Global Conglomerate Corporation Balance Sheet for 2009 and 2008

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 x Number of Shares Outstanding Cannot be negative

Textbook Example 2.1

Textbook Example 2.1 (cont'd)

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?

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.

2.3 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

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

Textbook Example 2.2

Textbook Example 2.2 (cont'd)

Alternative Example 2.2 Problem In January 2009, Rylan Corporation (from Alternative Example 2.1) had a market capitalization of 110 million, a market-to-book ratio of 2.2, a book debt to equity ratio of 1.4, and cash of $6.3 million. What was Rylan’s enterprise value?

Alternative Example 2.2 Solution As stated in Alternative Example 2.1, Rylan’s book value of equity was $50 million. Given a book debt-equity ratio of 1.4, Rylan had total debt of 1.4 X 50 = 70 million. Thus, Rylan’s enterprise value was 110+70 – 6.3 = $173.7 million.

2.3 Balance Sheet Analysis (cont'd) Other Balance Sheet Information Current Ratio Current Assets / Current Liabilities Quick Ratio (Current Assets – Inventories) / Current Liabilities

2.4 Income Statement Total Sales/Revenues minus Cost of Sales equals Gross Profit

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

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

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

2.4 Income Statement (cont'd) Pre-Tax Income minus Taxes equals Net Income

Table 2.2 Global Conglomerate Corporation Income Statement Sheet for 2009 and 2008

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

2.5 Income Statement Analysis Profitability Ratios Gross Margin Operating Margin Net Profit Margin

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

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

2.5 Income Statement Analysis (cont'd) Investment Returns ROA ROE

2.5 Income Statement Analysis (cont'd) The DuPont Identity Net Profit Margin Asset Turnover Equity Multiplier Return On Assets

Textbook Example 2.3

Textbook Example 2.3 (cont’d)

2.5 Income Statement Analysis (cont'd) Valuation Ratios P/E Ratio Enterprise Value to Operating Income Enterprise Value to Sales

Textbook Example 2.4

Textbook Example 2.4 (cont'd)

Alternative Example 2.4 Problem: Consider the following data for the year ended Dec. 31, 2008 for Yahoo! and Google (in millions): Compare Yahoo and Google’s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales.

Alternative Example 2.4 Solution: Yahoo! Had an operating margin of 12/7,209=0.17%, a net profit margin of 424/7,209=5.88%, and a P/E ratio of 22,830/424=53.84. Its enterprise value was 22,830+2439-2292=22,977 million, which has a ratio of 22,977/12=1914.75 to operating income and 22,977/7,209=3.19 to sales. Google had an operating margin of 6,632/21,796=30.4%, a net profit margin of 4,227/21,796=19.39%, and a P/E ratio of 177,380/4,227=41.96. Its enterprise value was 177,380+3,529-8,657=172,252 million, which has a ratio of 172,252/6,632=25.97 to operating income and 172,252/21,796=7.90 to sales.

Alternative Example 2.4 To summarize:

Alternative Example 2.4 Solution (cont’d): Even though Yahoo! And Google are competitors, their ratios look much different. Yahoo! has much lower profit margins, yet their P/E ratio is higher than Google’s. Their enterprise value to operating income ratio is also higher, mostly because of low operating income. Enterprise value to sales ratio is lower than that of Google. The difference is consistent with Yahoo!’s lower margins.

2.6 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

2.6 Statement of Cash Flows (cont'd) Three Sections Operating Activities Investment Activities Financing Activities

2.6 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 Accounts Receivable – deduct the increases Accounts Payable – add the increases Inventories – deduct the increases

2.6 Statement of Cash Flows (cont'd) Investing Activities Capital Expenditures Buying or Selling Marketable Securities Financing Activities Payment of Dividends Retained Earnings = Net Income – Dividends Changes in Borrowings

Table 2.3 Global Conglomerate Corporation Statement of Cash Flows for 2009 and 2008

Textbook Example 2.5

Textbook Example 2.5 (cont'd)

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

Textbook Example 2.6

Textbook Example 2.6 (cont'd)

Alternative Example 2.6 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 2009 to 2010, what will its total revenues be in 2010?

Alternative Example 2.6 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%

Alternative Example 2.6 Solution (continued) Estimated 2007 Total Revenue $7,343 × (1 + 3.83%) $7,343 × 1.0383 = $7,624

2.8 Financial Reporting in Practice Even with safeguards, reporting abuses still happen: Enron WorldCom Sarbanes-Oxley Act (SOX)

Discussion of Key Topic If either Ford or Microsoft’s P/E ratio is lower than the industry average, do you expect the stock price to go up? Could there be reasons other than undervaluation for a firm to have a low P/E?

Chapter Quiz The book value of a company’s assets usually does not equal the market value of those assets. What are some reasons for this difference? What is a firm’s enterprise value? What is the difference between a firm’s gross profit and its net income? What is the DuPont identity? What are the components of the statement of cash flows? What information do the notes to the financial statements provide?