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Understanding Financial Statements
Strictly Financials
Jan. 2, 2013
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Donald W. Reynolds National Center for Business Journalism at Arizona State University
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n James K. Gentry, Ph.D. n Clyde M. Reed Teaching Professor n School of Journalism and Mass Communications n University of Kansas n [email protected]
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Types of Companies n Public n Private
n Financial statements conforming to public company statements
n Nonprofits
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Important Terms n Unaudited n Audited n Accountants n Certified Public Accountants (CPAs) n GAAP, FASB, AICPA, PCAOB
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Assessing a Company n Context n Trends n Rules n Outsiders n Insiders
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Annual Report,10-K n 10-K wrap n Auditor’s report: Clean, qualified? n MD&A or Management’s Discussion
and Analysis n Financial statements and footnotes n Management’s letter if annual report
Traditional Auditor’s Report n Independent auditor’s opinion on whether
financial statements are presented fairly in all material respects, in accordance with GAAP: n We looked at these statements n They’re management’s responsibility; we’re just
here to express our opinion n We followed the rules in our audits, and here’s
what an audit involves n In our opinion, the statements fairly present the
company’s position.
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Auditor’s Report by Category
n Clean or Unqualified n Qualified n Disclaimer n Adverse
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New Auditor’s Report n Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act
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Sarbanes-Oxley Act of 2002
n Response to abuses with Enron and WorldCom as catalysts
n New responsibilities, resources for SEC n Created PCAOB n Major emphasis on “internal controls” n More disclosure for public companies
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Sarbanes-Oxley Act (SOX) n Analysts must state potential conflicts of interest. n Limited types of services accounting firms can
provide to public-company clients n Companies disclose in 10-K the fees paid to auditors. n Recent concerns
n CEO, CFO attest to accuracy, completeness, fairness of financial statements.
n Rigorous penalties for fraud, other misdeeds
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Public Company Accounting Oversight Board n Created by SOX to oversee accounting n Began operating in 2003 n SEC appoints five members to five-year
terms. n Two members must be or have been CPAs. n All members must be “financially literate.” n In 2008, Supreme Court upheld PCAOB but
said SEC couldn’t remove board members.
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PCAOB’s Duties
n Set rules on “auditing, quality control, ethics, independence, and other standards…”
n Conduct “inspections” of accounting firms
n Conduct “investigations and disciplinary proceedings”
n Enforce compliance with SOX
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Section 404: Internal Controls n “Management Assessment of Internal
Controls” n Each 10-K must contain an “internal-control
report” that: n States management is responsible for
internal-control structure and procedures n Contains an assessment on effectiveness of
internal-control structure and procedures
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Management on the Spot n Section 404: Management must evaluate and
test internal controls over financial reporting, including anti-fraud programs, annually.
n Management certifies that it does (or doesn’t) have adequate internal controls in place.
n Independent board members easier to attract n Auditor attests to adequacy of controls. n Management to be forced to answer for
fraudulent activities, misconduct, etc.
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Private Company Impact n Banks, insurers requiring companies to
embrace SOX. n Now most private firms have audited financial
statements. n If private company owners want to sell to
public company, must be in compliance n Private equity funds more willing to invest in
companies in compliance. n Best outside directors
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Nonprofit Impact n Audit committees, independent members n CEO, CFO attest to accuracy, completeness,
fairness of financial statements. n Financial statements more accessible n Codes of ethics n Rules governing transactions with “insiders”
Goal of Accounting n Record, classify and report financial
transactions. To provide managers across the organization with information that facilitates: n Control of activities and expenditures n Refinement of operational plans n Accountability n Reporting on project outcomes n Writing of bids for new funds
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Goal of Finance n Maximize shareholder wealth as
reflected in market price of the stock n Achieving this goal requires financial
manager to focus on economic profit, not accounting profit
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Financial Decisions n Long-term investment decisions
n Capital budgeting n Long-term financing decisions
n Capital structure n Working-capital management decisions
n Net working capital
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Financial Decisions n Investing decisions: Types of assets
firm wants to hold. n Financing decisions: Acquisition of
funds needed to support long-term investments.
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Generally Accepted Accounting Principles n Guidelines based on theory and
practice n Evolved over time n Procedures, concepts and standards
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GAAP: Assumptions n Periodicity n Going concern n Economic entity n Monetary unit
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GAAP: Principles n Full disclosure n Matching n Historical cost n Revenue realization n Consistency
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GAAP: Underlying Considerations n Materiality n Industry practices n Conservatism
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Specialized Industry GAAP n Banking and thrift industries n Benefit plans, including pension funds n Broadcasting industry n Cable television industry n Computer software n Finance companies n Investment companies
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Cash or Operating Cycle n Cash n Purchase inventory n Produce product n Sell product n Cash
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Cash or Operating Cycle (cont.) n “Cash”
n Cash n Receivables n Debt
n Inventory n Raw materials n Work in progress n Finished goods
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Cash or Operating Cycle (cont.) n Sell product
n Accounts receivable n Cash
n Cash n Collect receivables as cash
n Pay off payables n Start over
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Accrual Method n Records revenues when the “sale”
occurs n Records expenses when the bill is
received n That is, transactions enter the financial
records when they occur, not when cash changes hands
n Accrual method, therefore, shows “scores,” not real spendable dollars
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About These Numbers: They’re Squishy n Goods will not necessarily be paid for. n Goods are not necessarily going to be
kept. n Inventory might be out of date, obsolete
or unsellable. n Status of some inventory may be
uncertain n Intangible assets are estimates
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About These Numbers: They’re Squishy (cont.) n Machinery or other fixed assets might
be obsolete or falling apart long before the so-called useful life is up.
n Goodwill n Accounting conventions n Timing issues n Bottom line: In many ways, statements
are a collection of estimates.
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Because They’re Squishy n You need to know the rules and
assumptions used to create the numbers.
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Income Statement or ... n Statement of earnings n Statement of operations n Statement of income and
comprehensive income
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Income Statement n Covers a period of time, typically a year
or quarter n Reports income from ongoing activities n Reports income from activities beyond
management’s control (comprehensive income)
n Involves estimates
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Basic Income Statement n Sales or revenues n Expenses n Taxes n Net income or profit
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Income Statement n Sales or revenues n Cost of goods sold n Gross profit n Operating expenses
n Sales, general and administrative n Depreciation, amortization
n Operating profit n Other income/expenses n Interest n Income taxes n Net income or profit
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Cost of Goods Sold n Expenses incurred in the cost of
manufacturing or creating or acquiring the product the company sells.
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Cost of Goods Sold (CGS) n Manufacturer: What the company pays
for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer.
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Cost of Goods Sold
n Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers.
n Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS.
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SGA n Includes office expenses, accounting,
shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale.
n Often includes depreciation and amortization.
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Other Income/Expenses n Discontinued items n Unusual/extraordinary items n Changes in accounting principle n Impairment charge n Sale of investment n Minority interest
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Thinking Inside the Box n Revenues n Minus cost of goods sold n Equals gross profit n Minus operating expenses n Equals operating profit n Minus or plus other expenses/income n Minus or plus interest expenses/income n Minus income taxes n Net income
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Inside the Box Earnings n Sales or revenues n Cost of goods sold n Gross profit n Operating expenses
n Sales, general and administrative n Depreciation, amortization
n Operating profit
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‘One-Time’ Gains That Reoccur n Don’t be fooled by extraordinary items
that make the net income look better than it really is.
n Extraordinary items should be both unusual in nature and infrequent in occurrence.
n Examples: write-downs, restructurings, etc.
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Earnings Per Share n Basic earnings per share
(Bloomberg) n Diluted earnings per share (Wall
Street Journal, fully diluted)
Calculating EPS n Basic: Net income for period divided by
weighted average number shares outstanding.
n Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments.
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Dividend Payout n Percentage of earnings paid to
shareholders in form of dividends n Or:
Dividends Net Income
n Or: Dividend per share per period EPS per period
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P/E Ratio n Company’s current share price compared to
its per-share earnings n To calculate:
Market price per share Earnings per share
n Share price of $43 and earnings of $1.95 for last 12 months would be P/E of $22.05.
n Usually use last four quarters (“trailing P/E”)
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P/E Ratio n High P/E ratio means investors expect higher
earnings growth in future compared to companies with lower P/E.
n Compare companies in same industry, to the market in general or historic P/E
n Called “multiple” since shows how much investors willing to pay for dollar of earnings
n Company with P/E of 20 means willing to pay $20 for $1 of current earning.
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PEG Ratio n A ratio used to determine a stock’s value
while considering likely earnings growth. n Frequently indicator of stock's potential value.
Often favored over price/earnings ratio since also accounts for growth. Like P/E, lower PEG means stock is more undervalued.
n To calculate: P/E
Annual EPS growth
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Balance Sheet n It balances n Assets = Liabilities + Shareholders’
Equity
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Assets n Current assets
n Cash and cash equivalents n Accounts receivable n Inventories n Prepaids
n Investments and other assets
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Assets n Property, plant and equipment, net
n Land and improvement n Buildings and improvements n Equipment n Less accumulated depreciation
n Goodwill and other intangibles
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Goodwill and Impairment n Difference between what a business
pays to buy another company and the book value (total assets minus total liabilities) of that company
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Liabilities n Current liabilities
n Accounts payable n Accrued liabilities n Income taxes n Current maturity of long-term debt
n Noncurrent liabilities n Long-term debt n Deferred income taxes
n Commitments and contingencies
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Shareholders’ Equity n Capital stock
n Preferred stock n Common stock
n Additional paid-in capital n Retained earnings n Treasury stock
n Total shareholders’ equity n Total L + OE
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Statement of Cash Flows n Record of cash provided by cash
sources and of cash consumed by cash uses.
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Cash Flows (cont.) n Information about use of cash n Information about investing and
financing n Ability to continue as a going concern n Ability to generate future positive cash
flows n Ability to meet obligations and pay
dividends
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Cash Flows n From operations n From investing n From financing
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Flexibility n Companies have some flexibility in
categories for entries. n Total change in cash, however, will not
change. n Overwhelming majority of all accounting
standards deal with balance sheet and income statement, not cash-flows statement.
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Free Cash Flow n Powerful tool for making a company
successful n Powerful indicator for investors n Cash that is left over after productive
capacity is maintained or expanded n Permits expansion, paying down debt,
buying back shares, etc.
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Free Cash Flow (cont.) n Several ways to calculate it n Companies create their own models. n Gross way to do it:
n Cash from operating activities n Minus capital expenditures n Equals free cash flow
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American Standard Model
n Cash from operating activities n Minus capital expenditures n Plus proceeds from disposal of property n Plus proceeds from sale and
leasebacks n Equals free cash flow
Free-Cash Models n ‘Gross’ method n American Standard method n VF method
n Cash from operating minus cash from investing
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Keys to Looking at Cash n Cash from operations n Capital expenditures (cap ex) n Free cash n Cash and cash equivalents at the end
of the year
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Looking at the Numbers n Note changes in amounts year to year, especially
revenues and expenses. n Note numbers that are significantly larger or smaller
than the previous period. n Look at trend line for sales/revenues, operating
income and net income. Calculate percentage change for each.
n Look at cash flow. n Look at free cash flow. n Tie the numbers to the footnotes.
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Techniques n Calculate percentage change n Trend analysis n Common size analysis n Ratio analysis