Financial Statement Analysis 1 Financial Statement Analysis objectives

Financial Statement Analysis 1

Financial Statement Analysis (objectives) v. A good working knowledge of financial statement is desirable because such a statement and number derived from those statement are primary means of communicating financial information both with the firm and out side the firm. 2

Financial Statement Analysis (objectives) v. Financial statement analysis is performance by: § Stockholders : to measure management’s performance. § Creditors : to make their investment decisions. § Management: to plan and control operation. § And it is also an important tool for accountants and financial analysts to use to better understand their company's competitive position. 3

Financial Statement Analysis (objectives) • Financial statements can be analyzed to identify: – Trends in key financial data. – Compare financial performance across companies. – Calculate financial ratios which can be used to assess a company's current performance as well as its prospects for the future. • Financial statement users should be able to find and interpret information to answer questions about a company. 4

Financial Statement Analysis v Annual reports contain four basic financial statements: Balance Sheet. • Statement of Stockholders’ Equity. • Income Statement or Earnings Statement. • Statement of Cash Flows. • 5

The Financial Statements The Balance Sheet • Also called the statement of condition or the statement of financial position. • Shows the financial condition or financial position of a company on a particular date. – Prepared on a particular date at the end of an accounting period – End of accounting period can be the end of a calendar year, fiscal year, or interim period such as a year, a quarter, etc. • Summarizes what the firm owns and what the firm owes to outsiders and to internal owners. 6

The Financial Statements The Balance Sheet • Assets = Liabilities + Stockholders’ equity – Assets are what the firm owns. – Liabilities are what the firm owes to outsiders. – Stockholders’ equity is what the firm owes to internal owners. 7

Financial Statement : Balance Sheet Assets Current Assets Liabilities Current Liabilities Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity 8

Financial Statement : Balance Sheet Assets A. Current Assets: Include cash and assets expected to be converted to cash within one year or one operating cycle. Assets that are continually 1. Cash • • 2. Marketable Securities • • 3. Cash awaiting deposit Cash in a bank account Short-term investments of cash that is not needed. Treasury bills, certificates, notes, bonds, commercial paper Accounts Receivable • Customer balances outstanding on credit sales. 9

Financial Statement : Balance Sheet Assets 4. Inventories § § 5. Items held for sale or used in the manufacture of products that will be sold. Manufacturing Company (three types of inventory): ü Raw materials ü Work-in-process ü Finished goods Prepaid Expenses § Expenses paid in advance. Included in current assets if they expire within one year or one operating cycle: ü insurance ü rent ü utilities 10

Financial Statement : Balance Sheet Assets A. Fixed Assets 1)Tangible: • Have physical substance. long-lived – – • Fixed assets other than land are “depreciated” over the period of time they benefit the firm. – • Not used up during annual operations. Produce economic benefits for more than one year. Straight-line method allocates an equal amount of expense to each year of the depreciation period. Land refers to property used in business, not investment property. 11

Financial Statement : Balance Sheet Assets 2. Intangible • • • Goodwill recognized in business combinations Patents Trademarks Copyrights Brand Names Franchises 12

Financial Statement (Balance Sheet) Liabilities v Represent claims against assets and include Current Liabilities & Non current liabilities. A. Current liabilities must be satisfied in one year or one operating cycle and include. 1. Accounts payable Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services. Account is eliminated when bill is satisfied. 2. Notes payable Short-term obligations in the form of promissory notes. Lines of credit to suppliers or financial institutions. 3. Accrued liabilities 4. Result from recognition of an expense prior to actual payment of cash. Unearned revenue Result from payments received in advance for services or products. 13

Financial Statement (Balance Sheet) Liabilities B. Long–term liabilities: Obligations with maturities beyond one year. 1. Long-term debt : Bonds, Long-Term Notes Payable. 2. Deferred Taxes: Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income. 14

Financial Statement (Balance Sheet) Stockholders’ Equity v Stockholders’ Equity: Final section of balance sheet Also called shareholders’ equity Residual interest in assets that remains after deducting liabilities A. Common Stock Shareholders • • • Do not ordinarily receive a fixed return. Have voting privileges in proportion to ownership interest. Can benefit through price appreciation. Can suffer through price depreciation. Dividends are declared at the discretion of a company’s board of directors. 15

Financial Statement (Balance Sheet) Stockholders’ Equity B. Additional paid-in capital : Reflects the amount by which the original sales price of the stock shares exceeded par value. C. Retained Earnings: Funds a company has elected to reinvest in the operations of the business rather than pay out in stock. D. Preferred stock : Carries a fixed annual dividend payments Carries no voting rights. 16

Financial Statement : Balance Sheet Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets Fixed assets: Property, plant, and equipment Less accumulated depreciation Net property, plant, and equipment Intangible assets and other Total fixed assets Total assets 2007 $140 294 269 58 $761 2006 $107 270 280 50 $707 $1, 423 $1, 274 (550) (460) 873 814 245 221 $1, 118 $1, 035 $1, 879 $1, 742 2006 The assets are listed in 2007 order by Current Liabilities: the length Accounts payable of time it would $213 $197 Notes payable 50 53 normally take a firm with Accrued expenses 223 205 Total current liabilities $486 $455 ongoing operations to convert Long-term liabilities: them into cash. Deferred taxes $117 $104 Long-term debt Total long-term liabilities Stockholder's equity: Preferred stock Common stock ($1 per value) Capital surplus Accumulated retained earnings Less treasury stock Total equity Total liabilities and stockholder's equity 471 $588 458 $562 $39 55 32 347 327 390 347 (26) (20) $805 $725 $1, 879 $1, 742 17 Clearly, cash is much more liquid than property, plant, and equipment.

The Financial Statements The Income Statement v Also called the earnings statement Presents the results of operations for the accounting period. revenues • expenses • net income • earnings per share • v Reveals management’s ability to translate sales dollars into profits. 18

The Financial Statements The Income Statement • Sales (operating revenues) are the major revenue source for most companies. • Cost of Goods Sold: Cost to seller of products or services sold to customers. • Operating Expenses: Selling and administrative, Advertising. • Depreciation Cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the asset’s service life. 19

The Financial Statements The Income Statement • Operating Profit (Operating income) Also called earnings before interest and taxes (EBIT) – Measures overall performance of company’s operations: sales revenue less expenses associated with generating sales. – Provides a basis for assessing success of a firm apart from financing and investing activities and separate from tax considerations. 20

The Financial Statements The Income Statement • Other Income (Expense) Revenues and costs other than from operations such as • • • dividend and interest income interest expense investment gains (losses) equity earnings (losses) gains (losses) from sale of fixed assets 21

Financial Statement : Income Statement The operations section of the income statement reports the firm’s revenues and expenses from principal operations. Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings Dividends: $2, 262 ( 1, 655) ( 327) ( 90) $190 29 $219 ( 49) $170 ( 84) $86 $43 22

Financial Statement : Income Statement The non-operating section of the income statement includes all financing costs, such as interest expense. Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings: Dividends: $2, 262 1, 655 327 90 $190 29 $219 49 $170 84 $86 $43 23

Financial Statement : Income Statement Usually a separate section reports the amount of taxes levied on income. Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Addition to retained earnings: Dividends: $2, 262 1, 655 327 90 $190 29 $219 49 $170 84 $86 $43 24

Financial Statement : Income Statement Net income is the “bottom line. ” Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Retained earnings: Dividends: $2, 262 1, 655 327 90 $190 29 $219 49 $170 84 $86 $43 25

Short-Term Asset Management Current Assets Fixed Assets 1 Tangible 2 Intangible Current Liabilities Net Working Capital How should short -term assets be managed and financed? Long-Term Debt Shareholders’ Equity 26

Financial Statement : Balance Sheet $252 m = $707 - $455 2007 Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets $140 294 269 58 $761 2006 $107 270 280 50 $707 Fixed assets: Property, plant, and equipment $1, 423 $1, 274 Less accumulated depreciation (550) (460 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1, 118 $1, 035 $275 m = $761 m- $486 m 2007 Current Liabilities: Accounts payable Notes payable Accrued expenses Total current liabilities $1, 879 $1, 742 $213 50 223 $486 $197 53 205 $455 Long-term liabilities: Deferred taxes Long-term debt Total long-term liabilities Here we see NWC grow $117 to $104 471 458 $275 million in 2006 from $588 $562 $252 million in 2005. Stockholder's equity: Preferred stock $39 $23 million Common stock ($1 par value) 55 32 Capital surplus 347 327 This increase of $23 million is Accumulated retained earnings 390 347 Lessinvestment treasury stock (26) (20) an of the firm. Total equity Total assets 2006 $805 $725 Total liabilities and stockholder's equity $1, 879 $1, 742 27

The Financial Statements The Statement of Cash Flows v. Provides information about the cash inflows and outflows during an accounting period Operating activities • Financing activities • Investing activities • 28

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 Operating Cash Flow: EBIT -173 -23 $42 $36 Depreciation $219 $90 Current Taxes -$71 OCF $238 6 $42 29

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 Capital Spending -173 -23 $42 Purchase of fixed assets $198 Sales of fixed assets -$25 Capital Spending $173 $36 6 $42 30

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 -173 -23 $42 $36 NWC grew from $275 million in 2007 from $252 million in 2006. This increase of $23 million is the addition to NWC. 6 $42 31

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 -173 -23 $42 $36 6 $42 32

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total Cash Flow to Creditors $238 -173 Interest $49 Retirement of debt -23 $42 $36 6 73 Debt service 122 Proceeds from new debt sales -86 Total $36 $42 33

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 Cash Flow to Stockholders -173 -23 $42 $36 6 Dividends $43 Repurchase of stock 6 Cash to Stockholders 49 Proceeds from new stock issue -43 Total $6 $42 34

Financial Statement : Financial Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 -173 The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders: -23 $42 $36 6 $42 35

Financial Statement : Financial Cash Flow (Cash Flow from Operations) To calculate cash flow from operations, start with net income, add back non-cash items like depreciation and adjust for changes in current assets and liabilities (other than cash). Operations Net Income $86 Depreciation 90 Deferred Taxes 13 Changes in Assets and Liabilities Accounts Receivable -24 Inventories 11 Accounts Payable 16 Accrued Expenses 18 Notes Payable -3 Other -8 Total Cash Flow from Operations $199 36

Financial Statement : Financial Cash Flow (Cash Flow from Investing) Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i. e. , net capital expenditures). Acquisition of fixed assets Sales of fixed assets Total Cash Flow from Investing Activities -$198 25 -$173 37

Financial Statement : Financial Cash Flow (Cash Flow from Financing) Cash flows to and from creditors and owners include changes in equity and debt. Retirement of debt (includes notes) -$73 Proceeds from long-term debt sales 86 Dividends -43 Repurchase of stock -6 Proceeds from new stock issue 43 Total Cash Flow from Financing $7 38

Financial Statement : Financial Cash Flow Operations Net Income Depreciation Deferred Taxes Changes in Assets and Liabilities Accounts Receivable Inventories Accounts Payable Accrued Expenses Notes Payable Other The statement of cash flows is the addition of cash flows from operations, investing, Total Cash Flow from Operations Investing Activities Acquisition of fixed assets and financing. Sales of fixed assets Total Cash Flow from Investing Activities Financing Activities Retirement of debt (includes notes) Proceeds from long-term debt sales Dividends Repurchase of stock Proceeds from new stock issue Total Cash Flow from Financing Change in Cash (on the balance sheet) $86 90 13 -24 11 16 18 -3 -8 $199 -$198 25 -$173 -$73 86 -43 -6 43 $7 $33 39

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