Welcome to Class 17Welcome to Class 17

Research: Financial Domain & Research: Financial Domain & Case Studies – Part 2Case Studies – Part 2

Chapter 8

Key Financial Statements

A Review for non-AccountantsA Review for non-Accountants

The Balance SheetThe Balance Sheet

Reports the financial condition of a corporation on the last day of its fiscal year.

(Assets, Debts, and Equity)

AssetsAssets = tangible and intangible valuables that have an that have an assignable numerical valueassignable numerical value)

DebtsDebts = financial obligations to creditors and others

EquityEquity = = the residual after deducting debts from assets

The Balance Sheet The Balance Sheet (Cont)

Remember: Organizations have other important resources that Remember: Organizations have other important resources that do not have an assignable numerical value do not have an assignable numerical value – e.g. people– e.g. people

Important Note about Stockholders Equity, Retained Important Note about Stockholders Equity, Retained Earnings, & Deficits!Earnings, & Deficits!

STOCKHOLDERS EQUITY: is comprised of a variety of subcategories however; each of these originates from one of two basic sources:

(1) Profits* (earnings/gains) (2) Paid-in (sales the corporation’s stock)

* * The term “Profits” is used as a proxy for any increase in stockholders equity that is not a result of The term “Profits” is used as a proxy for any increase in stockholders equity that is not a result of additional investments by shareholders.additional investments by shareholders.

RETAINED EARNINGS: RETAINED EARNINGS: The PSC reflects two categories for retained

earnings: Retained Earnings REPORTEDREPORTED (directly off the firm’s balance

sheet) and …..Retained Earnings NETNET.

The two will rarely be the same since the NET category is meant to provide a larger perspective of individual categories.

Not combining these categories is analogous to trying to understand what a building looks like by studying the individual doors and windows. This provides a precise picture of these individual items but how helpful is it to understanding how the building looks as a whole? You must stand back for a broader perspective.

DEFICIT: It is possible for a Deficit to appear in Retained Earnings – NET even though the Retained Earnings – REPORTED by the corporation does not reflect a Deficit.

If this is the case, it is a RED FLAG. It does not mean the company is in immediate financial trouble but is COULD be a harbinger of potential problems in the future.

It suggests researching further and PROCEEDING WITH CAUTION!

CAUTION!CAUTION!

The Income StatementThe Income Statement

Reports a firm’s revenues, expenses, net income, and related items for the current fiscal year (plus two or more prior years).

Corporate net income = total net revenue + other income - expenses and other deductionstotal net revenue + other income - expenses and other deductions

Revenue may appear by many other names such as:Sales, Fees, Commissions, Turnover, etc. Sales, Fees, Commissions, Turnover, etc.

The after tax net income less dividends is added to Stockholders Equity in the "earned capital" section, generally

called retained earnings.

If the company experienced a loss the amount of the loss plus any dividends declared will be subtracted from equity.

The Income Statement The Income Statement (Cont)

The Statement of Cash FlowsThe Statement of Cash FlowsMost businesses report their Income Statements and Balance Sheets using the accrual basisaccrual basis of accounting.

Consequence : Consequence : Lack of information related to how cash is generated and

used by a firm.

Solution:Solution:The statement of cash flows provides this information.

The Statement of Cash Flows bridges the informational gaps The Statement of Cash Flows bridges the informational gaps between accounting reports and finance reports.between accounting reports and finance reports.

Divides business activities into three (3) segments and examines the cash flow through these

Each will indicate whether cash has been “used inused in” or “provided byprovided by”

The three segments are:

(1) Operating Activities (1) Operating Activities (2) Investing Activities(2) Investing Activities(3) Financing Activities(3) Financing Activities

The Statement of Cash Flows The Statement of Cash Flows (Cont)

Operating Activities Operating Activities

““Operating Activities” Operating Activities” include cash used in or provided byprovided by:

The routine processroutine process of buying and selling products or providing services.

NOTNOT included AS OPERATING included AS OPERATING ACTIVITIES:ACTIVITIES:

Buying or selling productive assets or other noncurrent assets

Transactions with stockholders and long-term creditors

Investing Activities Investing Activities

““Investing Activities” Investing Activities” include cash used in or provided by:

Acquiring subsidiary companies

Selling subsidiary companies

Investing in other companies

Selling investments in other companies

Buying or selling property, plant, and equipment

Buying or selling other fixed, productive and/or intangible assets, etc.

Financing Activities Financing Activities

““Financing Activities” Financing Activities” include cash used in or provided by:

Selling or repurchasing a company’s own stock

Issuing corporate notes or bonds

Borrowing money from other institutions (banks, insurance companies, etc.)

Debt repayment

Payment of dividends, etc.

Cost of Capital/Interest Rate Terms:Cost of Capital/Interest Rate Terms:

1.1. EuriborEuribor = = Euro interbank offered rate2.2. LiborLibor = = London interbank offered rate3.3. Prime Rate Prime Rate = = Interest rate charged by commercial

banks to their most credit-worthy customers4.4. Fed Funds Rate Fed Funds Rate = = Overnight rate that banks charge

each other5.5. Discount RateDiscount Rate** = = Interest rate charged to commercial

banks by the Federal Reserve

* Also is a term used in discounted cash flow (DCF) analyses Also is a term used in discounted cash flow (DCF) analyses to determine the present value of future cash flows to determine the present value of future cash flows

The Statement of Cash Flows, The Statement of Cash Flows, The Income Statement, The Income Statement, &&

The Balance Sheet …The Balance Sheet …

Need to be “Need to be “Common-sizedCommon-sized” and ” and organized into financial categoriesorganized into financial categories

The Financial Four are:

1) Profit, Equity, & Share Value Management

2) Debt Management

3) Cash Management

4) Asset Management

The Financial FourThe Financial FourCommon-sizing financial data:Common-sizing financial data:

1. Translates financial data to allow comparison of different size firms

2. Converts currency data into percentages

3. Enables firms with different currencies to be compared

4. Facilitates grouping of various categories of performance into those that are closely related – the Financial Four.

1) Profit, Equity, & Share Value Management 1) Profit, Equity, & Share Value Management

Continuously expanding profitability Increasing equity balances Strengthening the value of traded shares

… are interrelated and tied closely to a firm’s ability to:Achieve and sustain a competitive advantagesYields above average returns for stockholders

2) Debt Management 2) Debt Management

Financial leverage is important to most (not all) firms.Financial leverage is important to most (not all) firms.

The degree of leverage andand the proper configuration (long-term and short-term) are crucial considerations.

Debt levels should be sufficient to satisfy current financial requirements, amplify shareholder returns, and facilitate corporate growth and expansion.

BUT, caution is important since excessive levels of debt can shift corporate decision-making from TMTs to creditors.

3) Cash Management 3) Cash Management

Inadequate funds can lead to: Lost purchasing discounts (2% 10, n 30 = 36% apr36% apr)Missed business opportunitiesAlienation of suppliers, etc.

Excessive funds can lead to: Lack of financial productivityRender the firm highly prone to hostile takeover bids

4) Asset Management4) Asset Management

An appropriate level , type, and configuration of Assets is An appropriate level , type, and configuration of Assets is essential to the health of a corporation. essential to the health of a corporation.

It is possible for a firm to have:1.Too much invested in productive assets2.Too little invested in productive assets3.Outdated productive assets (need to upgrade)4.Slowly turning Accounts Receivable (long collection period)5.Slowly turning Inventory

Primary Techniques Primary Techniques for Studying for Studying

Financial StatementsFinancial Statements

The A-B-Cs of studying financial statements: A – Preparing a list of performance questions

B – Commonsizing the financial data

C – Utilizing analysis methods, including:1. Vertical analysis2. Horizontal analysis3. Cross-sectional analysis4. Time-series analysis

A – Performance Questions Have revenues increased? Has gross margin improved? Has net income increased? Has EPS increased? Has the share price increased? Has total shareholder equity increased? Has retained earnings increased? Is return on equity adequate compared to a benchmark? How does return on assets compare to the benchmark? Is cash flow from operations positive (provided by) or

negative (used in)? Does "times interest earned" look appropriate? What does the independent auditor (Certified Public

Accounting firm) say about the financial data?

B – Common-sizingB – Common-sizing

Common-sizing is the process of converting all items on the financial statements to a percentage.

Advantages of common-sizing:

Allows the comparison of a small corporation to a large corporation

Allows the comparison of two corporations reporting in different currencies e.g. Yen vs. Dollar

1. Vertical Analysis1. Vertical Analysis

Each line item is divided by a base number

Income StatementIncome Statement

Revenue as the divisor for all other items on the Income Statement

Balance SheetBalance Sheet

Total Assets as the divisor for everything on the Balance Sheet

This allows the measurement of deviation from acceptable norm.

C – Analysis MethodsC – Analysis Methods

2. Horizontal Analysis 2. Horizontal Analysis (partial Time-Series) (partial Time-Series)

Each line item is divided by its corresponding number from the budget or from a previous period.

For example:

On both the Income Statement & the Balance Sheet

Each line item is divided by its counterpart from last year and then 100% is subtracted to compute the % of change.

This allows the measurement of variance by category.

3. Cross-Sectional Analysis3. Cross-Sectional Analysis{{also called Target/Benchmark analysisalso called Target/Benchmark analysis}}

The Cross-Sectional Analysis is a comparison of the target company to the benchmark company.

It involves the comparison of common-sized financial statement analyses (Balance Sheet and

Income Statement) of both companies.

4. Time-series Analysis4. Time-series AnalysisTime-series analysis is a combination of other analyses.Time-series analysis is a combination of other analyses.

Time series analyses normally begin with a horizontal analysis, which is a “sideways” line-item summary of period-over-period changes in revenue, expenses, assets, debts, and equity.

Example: If a firm spent 20% more (or less) on advertising than it did in the previous period, this would be revealed by this analysis.

Time-series analyses also include two vertical analyses. Comparing the two vertical analyses reveals the extent to which individual

categorical activities have changed as a percentage of a base number. Example: Example: The firm may have spent 4% of Sales on advertising during the The firm may have spent 4% of Sales on advertising during the

current period whereas in the previous period, 10% of Sales was current period whereas in the previous period, 10% of Sales was spent on advertising. Even though the absolute amount spent on spent on advertising. Even though the absolute amount spent on advertising may have increased the relative commitment has been advertising may have increased the relative commitment has been reduced. The example above represents a 6% relative reduction in reduced. The example above represents a 6% relative reduction in advertising.advertising.

Look for Red FlagsLook for Red FlagsThese are potential signs of troubleThese are potential signs of trouble

The Red Flags

1) Management bonuses or stock options increase when profits decrease or are level2) Acquisition of a competitor for a significant premium (Paying too much?)3) Diversifications appear nonsensical – (unrelated or new ventures that appear

to lack the opportunity for synergy)4) Reverse stock splits5) Dividends are declared even though the firm is losing money6) Off Balance Sheet Financing7) Debt Refinancing8) Restructuring, reengineering, downsizing, rightsizing, resizing, and related euphemisms9) Significant increases in Treasury Stock10) Public statements about stock value or performance such as: “We know of

no better investment than our own company so we will be reacquiring stock.”

11) Erratic or inconsistent decisions, actions, or achievements

The Red Flags

12) Disgruntled Board of Directors13) Financial Statements that look a little too good or perhaps slightly incongruent when compared to other data14) Unusual financial arrangements or joint-ventures that appear strangely

complex15) Assets that seem relatively too high or too low when compared by percentage to the benchmark16) Rapid changes in assets or debts – (Unusual increases or decreases in Inventory, Receivables, Short-term Debt, etc.)17) Restatement of earnings18) Investigation by the SEC

The Red Flags

19) Changes in reported Net Income that seem inconsistent with changes in Cash position – (e.g. Net Income up significantly while Cash is down significantly)20) Large or unusual non-operating expenses or income21) Footnotes (endnotes) that seem unclear or ambiguous22) Golden parachutes for executives that appear a little too generous23) Extraordinary compensation packages for top management24) The firm's independent auditors (CPAs) express a "reservation" in their

opinion section of the annual report

The Red Flags

Every student READ THIS!Every student READ THIS!

Go to Page 247 in your online textbook “Management: Strategy & Performance”

There are several large, global, publicly–traded companies in your text..

Team Presidents Team Presidents YOU should select one (1) of the companies and IMMEDIATELY notify your team of the company name. Every member of the team MUSTMUST then review it carefully and discuss it

at the team meeting – Team Class 2

Team secretaries:Team secretaries: In your report to the professor you should name each team participant and include the exact comment each member of your team had relative to the company in the team meeting.

Members not commenting will LOSE 25 POINTS!Members not commenting will LOSE 25 POINTS!

End, Research: Financial Domain & Case Studies – Part 2

Prepare for Team Class 2 including the two assignments:Prepare for Team Class 2 including the two assignments:The one detailed above, andThe one detailed above, andThe Team Culture ExerciseThe Team Culture Exercise

Link to Team Class 2 Details

Important!!! Important!!! Go to the Addendum below – Go to the Addendum below –

Information on these slides may help you with your…Information on these slides may help you with your…

TEST!TEST!

AddendumAddendum

Income Income StatementStatement

RevenueRevenue

CostsCosts

Gross ProfitGross Profit

Operating ExpensesOperating Expenses

Other ExpensesOther Expenses

Net IncomeNet Income

Other IncomeOther Income

Annual Reports can be difficult for the uninitiated to read because they lack standardization.

Some degree of standardization my be on the horizon with the advent of the XBRL system.

XBRL is a semi-standardized language that may offer future help to readers of financial reports. This acronym stands for

eXtensible Business Reporting Language.

XBRL is a language for the electronic communication of business and financial data that is meant to simplify the preparation of financial data and to improve communication.

It originally began as a project by the American Institute of Certified Public Accountants (AICPA) and now there are multiple companies selling products (mostly software and books) and services to assist with the implementation of XBRL.

More information see – http://www.xbrl.org/Home/http://www.xbrl.org/Home/

The annual report contains separate segments, each with unique and valuable data and these typically include:

Chair's report CEO's report Auditor's report on corporate governance Mission Statement Compliance statement (Corporate Governance) Statement of Directors responsibilities Auditor's report on the financial statements Selected Financial Highlights Statement of Financial Position (Balance Sheet) Statement of Retained Earnings Statement of Revenues and Expenses (Income Statement) Statement of Cash Flows Notes to the Financial Statements Accounting Policies

Another important document required by the SEC is the

Proxy StatementProxy StatementThe SEC requires that shareholders of a company

whose securities are registered under Section 12 of the Securities Exchange Act of 1934 receive a proxy statement prior to a shareholder meeting, whether an annual or special meeting.

The information contained in the statement must be filed with the SEC before soliciting a shareholder vote on the election of directors and the approval of other corporate action. Solicitations, whether by management or shareholders, must disclose all important facts about the issues on which shareholders are asked to vote.*

*Data directly from SEC website

Proxy Statements (cont)Information included:Information included:

Voting procedures

Background information about the company's nominated directors (history with the company or industry, positions on other corporate boards, and potential conflicts in interest)

Compensation received by Board Members

TMT compensation, (salary, bonus, non-equity compensation, stock awards, options, and deferred compensation).

Data related to perks (personal use of company vehicles, aircraft, travel)

Golden parachutes (payout packages to TMTs upon leaving the firm)

Who is on the audit committee and detail about fees for both audit and non-audit fees paid to CPA firm.

Abbreviations Related to Financial Documents 

MRQ:Most Recent Quarter

 TTM:

Trailing Twelve Months 

YOY:Year Over Year

 LFY:

Last Fiscal Year 

FYE:Fiscal Year Ending

Enough!!