CHAPTER 2: INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
2.1. Firms’ Disclosure of Financial Information
Financial statements are accounting reports with past performance information that a firm issues
periodically (usually quarterly and annually).
Private companies also prepare financial statements, but they do not have to disclose these to the
public.
Preparation of Financial Statements.
- Generally Accepted Accounting Principles (GAAP) provide a common set of rules and a standard
format for public companies to use when they prepare their reports.
- Neutral third party: auditor: checking the annual financial statements, to ensure that the annual
financial statements are reliable and prepared according to GAAP.
Types of Financial Statements
- Four financial statements: the balance sheet, the income statement, the statement of cash flows,
and the statement of stockholders’ equity.
2.2 The Balance Sheet
The balance sheet (or statement of financial position) lists the firm’s assets and liabilities,
providing a snapshot of the firm’s financial position at a given point in time.
The balance sheet is divided into two parts: the assets on the left side (cash, inventory, property,
plant, and equipment, and other investments the company has made); the liabilities on the right
(the firm’s obligations to creditors)
Also with the liabilities is the stockholders’ equity: the difference between the firm’s assets and
liabilities, in an accounting measure of the firm’s net worth.
The left and right sides must balance: Assets = Liabilities + Stockholders’ Equity
Assets
- Current assets are either cash assets that could be converted into cash within one year
Cash and other marketable securities
Accounts receivable
Inventories
Other
- Long-term assets
Net property, plant, and equipment
The company will reduce the value recorded for this each year by deducting a depreciation
expense. An asset’s accumulated depreciation is the total amount deducted over its life.
The book value of an asset is equal to its acquisition cost less accumulated depreciation.
The difference between the price paid for the company and the book value assigned to its
tangible assets is recorded separately as goodwill and intangible assets.
If the value of these intangible assets declined over time, the firm will reduce the amount
listed on the balance sheet by an amortization or impairment charge.
Property not used in business operations, start-up costs, investments in the long-term, and
property held for sale.
, Liabilities
Current liabilities: liabilities that will be satisfied within one year.
Accounts payable
Short-term debt or notes payable
Items such as salary or taxes have not yet been paid.
- The difference between current assets and current liabilities is the firm’s net working capital, the
capital available in the short term to run the business.
Long-term liabilities: Liabilities that extend beyond one year.
Long-term debt with a maturity of more than a year
Capital leases are long-term lease contracts
Deferred taxes are taxes that are owed but have not yet been paid
Stockholders’ Equity
- The difference between the firm’s assets and liabilities (also called the book value of equity)
Market value versus book value
- The book value of equity is an inaccurate assessment of the true value of the firm’s equity.
Market value of equity = Shares outstanding * Market price per share
- The market value of equity is referred to as market capitalization. The market value of a stock
does not depend on the historical cost, it depends on what investors expect those assets to produce
in the future.
- Firms with low market-to-book ratio: value stocks, firms with high market-to-book ratio: growth
stocks.
Enterprise value
- (also called the total enterprise value or TEV) assesses the value of the underlying business
assets.
Enterprise value = market value of equity + debt – cash
2.3. The income statement
(or statement of financial performance) lists the firm’s revenues and expenses over a period of
time
Net income: measure profitability (also earnings)
Earnings Calculations
- Gross profit: the difference between sales revenues and the costs
- Operating expenses: expenses from the ordinary course of running the business that are not
directly related to producing the goods or services. The firm’s gross profit net of operating
expenses is called operating income.
- Earnings before interest and taxes (EBIT): other sources of income or expenses that arise from
activities that are not the central part of a company’s business
- Pretax and net income
,2.4. The Statement of Cash Flows
The firm’s statement of cash flows utilizes the information from the income statement and
balance sheet to determine how much cash the firm has generated, and how that cash has been
allocated, during a set period.
Are divided into three sections: operating activity (starts with net income from the income
statement), investment activity (cash used for investment), and financing activity (the flow of
cash between the firm and investors).
Operating Activity
- First, adjusting net income by all non-cash items related to operating activity
- Next, adjusting for changes to net working capital that arise from changes to accounts receivable,
accounts payable, or inventory.
Account Receivable: If the cash has not yet been received from the customer, we must adjust
the cash flows by deducting the increases in accounts receivable.
Account Payable: Adding increases in accounts payable, representing borrowing by the firm
from suppliers.
Inventory: Deduct increases to inventory.
Other: Deducting the increase in any other current assets net of liabilities, excluding cash and
debt.
Investment Activity
- Purchases of new property, plant, and equipment are referred to as capital expenditures.
- Firms recognize these expenditures over time as depreciation expenses.
Financing Activity
- The difference between a firm’s net income and the amount it spends on dividends is retained
earnings for that year.
Retained Earnings = Net income – Dividends
2.5. Other Financial Statement Information
Statement of Stockholders’ Equity
- The statement of stockholders’ equity breaks down the stockholders’ equity computed on the
balance sheet into the amount that came from issuing shares versus retained earnings.
- Financial managers use this infrequently.
Change in Stockholders’ equity = Retained Earnings + Net sales of stock = Net income –
dividends + Sales of stock – Repurchases of stock
Management Discussion and Analysis
- (MD&A) is a preface to the financial statement, providing a background on the company and
significant events that may have occurred.
- Off-balance sheet transactions: Transactions or arrangements that can have a material impact on
the firm’s future performance but do not appear on the balance sheet.
, 2.6. Financial Statement Analysis
Compare the firm with itself
Compare the firm to other similar firms
Profitability Ratios
- Reflecting a firm’s ability to sell a product for more than the cost of producing it.
- Revealing how much a company earns before interest in taxes from each dollar of sales.
- Accessing the relative efficiency of the firms’ operations.
- Showing the fraction of each dollar in revenues that are available to equity holders after the firm
pays interest and taxes.
Liquidity Ratios
- Quick ratio: compares only cash and “near cash” assets to current liabilities.
- A higher current or quick ratio implies less risk of the firm in the near future.
Working Capital Ratios
- Account receivable days: the number of days’ worth of sales accounts receivable.
2.1. Firms’ Disclosure of Financial Information
Financial statements are accounting reports with past performance information that a firm issues
periodically (usually quarterly and annually).
Private companies also prepare financial statements, but they do not have to disclose these to the
public.
Preparation of Financial Statements.
- Generally Accepted Accounting Principles (GAAP) provide a common set of rules and a standard
format for public companies to use when they prepare their reports.
- Neutral third party: auditor: checking the annual financial statements, to ensure that the annual
financial statements are reliable and prepared according to GAAP.
Types of Financial Statements
- Four financial statements: the balance sheet, the income statement, the statement of cash flows,
and the statement of stockholders’ equity.
2.2 The Balance Sheet
The balance sheet (or statement of financial position) lists the firm’s assets and liabilities,
providing a snapshot of the firm’s financial position at a given point in time.
The balance sheet is divided into two parts: the assets on the left side (cash, inventory, property,
plant, and equipment, and other investments the company has made); the liabilities on the right
(the firm’s obligations to creditors)
Also with the liabilities is the stockholders’ equity: the difference between the firm’s assets and
liabilities, in an accounting measure of the firm’s net worth.
The left and right sides must balance: Assets = Liabilities + Stockholders’ Equity
Assets
- Current assets are either cash assets that could be converted into cash within one year
Cash and other marketable securities
Accounts receivable
Inventories
Other
- Long-term assets
Net property, plant, and equipment
The company will reduce the value recorded for this each year by deducting a depreciation
expense. An asset’s accumulated depreciation is the total amount deducted over its life.
The book value of an asset is equal to its acquisition cost less accumulated depreciation.
The difference between the price paid for the company and the book value assigned to its
tangible assets is recorded separately as goodwill and intangible assets.
If the value of these intangible assets declined over time, the firm will reduce the amount
listed on the balance sheet by an amortization or impairment charge.
Property not used in business operations, start-up costs, investments in the long-term, and
property held for sale.
, Liabilities
Current liabilities: liabilities that will be satisfied within one year.
Accounts payable
Short-term debt or notes payable
Items such as salary or taxes have not yet been paid.
- The difference between current assets and current liabilities is the firm’s net working capital, the
capital available in the short term to run the business.
Long-term liabilities: Liabilities that extend beyond one year.
Long-term debt with a maturity of more than a year
Capital leases are long-term lease contracts
Deferred taxes are taxes that are owed but have not yet been paid
Stockholders’ Equity
- The difference between the firm’s assets and liabilities (also called the book value of equity)
Market value versus book value
- The book value of equity is an inaccurate assessment of the true value of the firm’s equity.
Market value of equity = Shares outstanding * Market price per share
- The market value of equity is referred to as market capitalization. The market value of a stock
does not depend on the historical cost, it depends on what investors expect those assets to produce
in the future.
- Firms with low market-to-book ratio: value stocks, firms with high market-to-book ratio: growth
stocks.
Enterprise value
- (also called the total enterprise value or TEV) assesses the value of the underlying business
assets.
Enterprise value = market value of equity + debt – cash
2.3. The income statement
(or statement of financial performance) lists the firm’s revenues and expenses over a period of
time
Net income: measure profitability (also earnings)
Earnings Calculations
- Gross profit: the difference between sales revenues and the costs
- Operating expenses: expenses from the ordinary course of running the business that are not
directly related to producing the goods or services. The firm’s gross profit net of operating
expenses is called operating income.
- Earnings before interest and taxes (EBIT): other sources of income or expenses that arise from
activities that are not the central part of a company’s business
- Pretax and net income
,2.4. The Statement of Cash Flows
The firm’s statement of cash flows utilizes the information from the income statement and
balance sheet to determine how much cash the firm has generated, and how that cash has been
allocated, during a set period.
Are divided into three sections: operating activity (starts with net income from the income
statement), investment activity (cash used for investment), and financing activity (the flow of
cash between the firm and investors).
Operating Activity
- First, adjusting net income by all non-cash items related to operating activity
- Next, adjusting for changes to net working capital that arise from changes to accounts receivable,
accounts payable, or inventory.
Account Receivable: If the cash has not yet been received from the customer, we must adjust
the cash flows by deducting the increases in accounts receivable.
Account Payable: Adding increases in accounts payable, representing borrowing by the firm
from suppliers.
Inventory: Deduct increases to inventory.
Other: Deducting the increase in any other current assets net of liabilities, excluding cash and
debt.
Investment Activity
- Purchases of new property, plant, and equipment are referred to as capital expenditures.
- Firms recognize these expenditures over time as depreciation expenses.
Financing Activity
- The difference between a firm’s net income and the amount it spends on dividends is retained
earnings for that year.
Retained Earnings = Net income – Dividends
2.5. Other Financial Statement Information
Statement of Stockholders’ Equity
- The statement of stockholders’ equity breaks down the stockholders’ equity computed on the
balance sheet into the amount that came from issuing shares versus retained earnings.
- Financial managers use this infrequently.
Change in Stockholders’ equity = Retained Earnings + Net sales of stock = Net income –
dividends + Sales of stock – Repurchases of stock
Management Discussion and Analysis
- (MD&A) is a preface to the financial statement, providing a background on the company and
significant events that may have occurred.
- Off-balance sheet transactions: Transactions or arrangements that can have a material impact on
the firm’s future performance but do not appear on the balance sheet.
, 2.6. Financial Statement Analysis
Compare the firm with itself
Compare the firm to other similar firms
Profitability Ratios
- Reflecting a firm’s ability to sell a product for more than the cost of producing it.
- Revealing how much a company earns before interest in taxes from each dollar of sales.
- Accessing the relative efficiency of the firms’ operations.
- Showing the fraction of each dollar in revenues that are available to equity holders after the firm
pays interest and taxes.
Liquidity Ratios
- Quick ratio: compares only cash and “near cash” assets to current liabilities.
- A higher current or quick ratio implies less risk of the firm in the near future.
Working Capital Ratios
- Account receivable days: the number of days’ worth of sales accounts receivable.
