Chapter 2 Introduction to Financial Statement Analysis

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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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -2

Learning Objectives 1. 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. 2. 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. 3. 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, priceearnings ratio, and market-to-book ratio. 4. Discuss the uses of the Du. Pont identity in disaggregating ROE, and assess the impact of increases and decreases in the components of the identity on ROE. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -3

Learning Objectives 5. 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. 6. 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. 7. Explain what is included in the management discussion and analysis section of the financial statements that cannot be found elsewhere in the financial statements. 8. Explain the importance of the notes to the financial statements. 9. List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -4

2. 1 Disclosure of Financial Information • Financial Statements – Firm-issued accounting reports with past performance information – Filed with the SEC • 10 Q – Quarterly • 10 K – Annual – Must also send an annual report with financial statements to shareholders Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -5

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -6

2. 1 Disclosure of Financial Information (cont'd) • Types of Financial Statements – Balance Sheet – Income Statement – Statement of Cash Flows – Statement of Stockholders’ Equity Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -7

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -9

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -10

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -11

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -13

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -17

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? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -20

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. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -21

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -22

2. 3 Balance Sheet Analysis (cont'd) • Debt-Equity Ratio – Measures a firm’s leverage – Using Book Value versus Market Value • Enterprise Value Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -23

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? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -26

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. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -27

2. 3 Balance Sheet Analysis (cont'd) • Other Balance Sheet Information – Current Ratio • Current Assets / Current Liabilities – Quick Ratio • (Current Assets – Inventories) / Current Liabilities Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -28

2. 4 Income Statement (cont'd) • Gross Profit – minus • Operating Expenses • Selling, General, and Administrative Expenses • R&D • Depreciation & Amortization – equals • Operating Income Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -30

2. 4 Income Statement (cont'd) • Operating Income – plus/minus • Other Income/Other Expenses – equals • Earnings Before Interest and Taxes (EBIT) Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -31

2. 4 Income Statement (cont'd) • Earnings Before Interest and Taxes (EBIT) – plus/minus • Interest Income/Interest Expense – equals • Pre-Tax Income Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -32

2. 5 Income Statement Analysis (cont'd) • Working Capital Days – Accounts Receivable Days • EBITDA – Reflects the cash a firm has earned from its operations Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -37

2. 5 Income Statement Analysis (cont'd) • Leverage Ratios/Interest Coverage Ratios – EBIT / Interest Expense – Operating Income / Interest Expense – EBITDA / Interest Expense Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -38

2. 5 Income Statement Analysis (cont'd) – Valuation Ratios • P/E Ratio • Enterprise Value to Operating Income • Enterprise Value to Sales Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -43

Alternative Example 2. 4 Problem: Consider the following data for the year ended Dec. 31, 2008 for Yahoo! and Google (in millions): Yahoo! Google 7, 209 21, 796 Operating Income 12 6, 632 Net Income 424 4, 227 Market Capitalization 22, 830 177, 380 Cash 2, 292 8, 657 Debt 2, 439 3, 529 Sales Compare Yahoo and Google’s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -46

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+24392292=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. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -47

Alternative Example 2. 4 • To summarize: Ratio Yahoo! Google Operating Margin . 17% 30. 4% Net Profit Margin 5. 88% 19. 39% P/E Ratio 53. 84 41. 96 1914. 75 25. 97 3. 19 7. 90 Enterprise Value to Operating Income Enterprise Value to Sales Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -48

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. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -49

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -50

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -52

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -53

2. 7 Other Financial Statement Information • Management Discussion and Analysis – Off-Balance Sheet Transactions • Statement of Stockholders’ Equity • Notes to the Financial Statements Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -57

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? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -60

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% Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -61

2. 8 Financial Reporting in Practice • Even with safeguards, reporting abuses still happen: – Enron – World. Com – Sarbanes-Oxley Act (SOX) Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -63

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? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -64

Chapter Quiz 1. 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? 2. What is a firm’s enterprise value? 3. What is the difference between a firm’s gross profit and its net income? 4. What is the Du. Pont identity? 5. What are the components of the statement of cash flows? 6. What information do the notes to the financial statements provide? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2 -65