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Chapter 2
Introduction to Financial
Statement Analysis
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2-2
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
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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, price-earnings ratio, and market-to-book ratio.
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Learning Objectives (cont'd)
4. 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.
5. 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.
6. Explain the importance of the notes to the financial statements.
7. List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud.
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2.1 Disclosure of Financial Information
• Financial Statements
Firm-issued accounting reports with past performance information
Filed with the SEC• 10Q
Quarterly
• 10K Annual
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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
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2.1 Disclosure of Financial Information (cont'd)
• Types of Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholders’ Equity
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2.2 Balance Sheet
• A snapshot in time of the firm’s financial position
• The Balance Sheet Identity:
Assets Liabilities Stockholders' Equity
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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
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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
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2.2 Balance Sheet (cont'd)
• Assets
Long-Term Assets
• Net Property, Plant, & Equipment Book Value Depreciation
• Goodwill Amortization
• Other Long-Term Assets
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Table 2.1
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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
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2.2 Balance Sheet (cont'd)
• Liabilities
Long-Term Liabilities
• Long-Term Debt
• Capital Leases
• Deferred Taxes
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Table 2.1 (cont'd)
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2.2 Balance Sheet (cont'd)
• Net Working Capital
Current Assets – Current Liabilities
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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
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Example 2.1
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Example 2.1 (cont'd)
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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
Market - to - Book Ratio Market Value of Equity
Book Value of Equity
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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
Debt - Equity Ratio Total Debt
Total Equity
Enterprise Value Market Value of Equity Debt Cash
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Example 2.2
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Example 2.2 (cont'd)
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2.2 Balance Sheet (cont'd)
• Other Balance Sheet Information
Current Ratio• Current Assets / Current Liabilities
Quick Ratio• (Current Assets – Inventories) / Current Liabilities
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2.3 Income Statement
• Total Sales/Revenues minus
• Cost of Sales equals
• Gross Profit
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2.3 Income Statement (cont'd)
• Gross Profit minus
• Operating Expenses• Selling, General, and Administrative Expenses• R&D• Depreciation & Amortization
equals
• Operating Income
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2.3 Income Statement (cont'd)
• Operating Income plus/minus
• Other Income/Other Expenses equals
• Earnings Before Interest and Taxes (EBIT)
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2.3 Income Statement (cont'd)
• Earnings Before Interest and Taxes (EBIT) plus/minus
• Interest Income/Interest Expense equals
• Pre-Tax Income
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2.3 Income Statement (cont'd)
• Pre-Tax Income minus
• Taxes equals
• Net Income
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Table 2.2
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2.3 Income Statement (cont'd)
• Earnings per Share
• Stock Options
• Convertible Bonds
• Dilution Diluted EPS
EPS Net Income
Shares Outstanding
$2.0 million
3.6 million shares $0.556 per share
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Profitability Ratios
• Operating Margin
• Net Profit Margin
Operating Margin Operating Income
Total Sales
Net Profit Margin Net Income
Total Sales
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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
Accounts Receivable Days Accounts Receivable
Average Daily Sales
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Leverage Ratios/Interest Coverage Ratios
• EBIT / Interest Expense
• Operating Income / Interest Expense
• EBITDA / Interest Expense
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2.3 Income Statement (cont'd)
• Income Statement Analysis
Investment Returns
• ROA Net Income / Total Assets
• ROE
Valuation Ratios
• P/E Ratio
Return on Equity Net Income
Book Value of Equity
P / E Ratio Market Capitalization
Net Income
Share Price
Earnings per Share
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Example 2.3
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Example 2.3 (cont'd)
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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
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2.4 Statement of Cash Flows (cont'd)
• Three Sections
Operating Activities
Investment Activities
Financing Activities
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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
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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
Retained Earnings Net Income Dividends
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Example 2.4
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Example 2.4 (cont'd)
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2.5 Other Financial Statement Information
• Management Discussion and Analysis Off-Balance Sheet Transactions
• Statement of Stockholders’ Equity
• Notes to the Financial Statements
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Example 2.5
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Example 2.5 (cont'd)
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2.6 Accounting Manipulation
• Enron
• WorldCom
• Sarbanes-Oxley Act (SOX)
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Questions?