Summary Financial Statement Analysis
and Security Valuation
,Contents
Lecture 1: Introduction and Key Financial Statements................................................................... 5
Introduction to Financial Statements .......................................................................................... 5
The Balance Sheet....................................................................................................................... 6
Assets ...................................................................................................................................... 6
Equity and Liabilities .............................................................................................................. 8
Lecture 2: Key Financial Statements .............................................................................................. 9
Income Statement........................................................................................................................ 9
Equity Statement ....................................................................................................................... 10
Comprehensive Income Statement ............................................................................................11
Cash Flow Statement .................................................................................................................11
Lecture 3: Profitability Analysis ................................................................................................... 12
Operating Return ....................................................................................................................... 12
NOPAT .................................................................................................................................. 12
NOA ...................................................................................................................................... 13
RNOA ................................................................................................................................... 13
Nonoperating Return ................................................................................................................. 14
Financial Leverage (FLEV) .................................................................................................. 14
Spread ................................................................................................................................... 14
Lecture 4: Credit Risk Analysis (Solvency Analysis) ................................................................... 16
Credit Risk Concept .................................................................................................................. 16
Credit Risk Analysis – Solvency ratios ..................................................................................... 16
Liabilities-to-Equity .............................................................................................................. 16
Book leverage ....................................................................................................................... 16
Market leverage .................................................................................................................... 17
Times interest earned ............................................................................................................ 17
Debt-to-EBITDA .................................................................................................................. 18
Net Debt-to-EBITDA............................................................................................................ 18
Accounting in Debt Contracts (role of covenants) ................................................................... 18
Credit ratings ............................................................................................................................. 19
Lecture 5: Operating Income ........................................................................................................ 20
2
, Income statement ...................................................................................................................... 20
Revenues ................................................................................................................................... 21
Unearned/deferred revenues ................................................................................................. 21
Research and development expenses .................................................................................... 22
Selling, general and administrative expenses ....................................................................... 22
Non-controlling interests ...................................................................................................... 23
Earnings per share ................................................................................................................. 23
Lecture 6: Current Assets (Liquidity Analysis) ............................................................................ 23
Inventories and Cost of Sales .................................................................................................... 23
Accounting for inventories ................................................................................................... 24
Inventory costing methods .................................................................................................... 24
Accounts receivable .................................................................................................................. 25
Operating current liabilities ...................................................................................................... 27
Liquidity................................................................................................................................ 27
Lecture 7: Long-Term Assets ........................................................................................................ 29
Property, Plant and Equipment ................................................................................................. 29
Intangible Assets ....................................................................................................................... 30
Goodwill ................................................................................................................................... 30
Joint Ventures ............................................................................................................................ 31
Fair value assets + examples ..................................................................................................... 31
Leased Assets ............................................................................................................................ 32
Valuation part 1: Valuation basics ................................................................................................. 34
Making accounting adjustments ............................................................................................... 34
Forecasting financial statements – 4 step procedure................................................................. 35
Concepts of valuation ............................................................................................................... 35
Valuation part 2: Cash flow based valuation................................................................................. 38
DDM – Dividend Discount Model ........................................................................................... 38
DCF – Discounted Cash Flow Model ....................................................................................... 39
Valuation part 3: Operating income based valuation .................................................................... 41
Residual Operating Income Model (ROPI) .............................................................................. 41
Valuation process .................................................................................................................. 41
3
, ROPI vs DCF ........................................................................................................................ 42
Valuation part 4: Market based valuation ..................................................................................... 43
Types of multiples ..................................................................................................................... 43
Earnings multiples ................................................................................................................ 43
Book value multiples ............................................................................................................ 44
Conclusions on Multiples ......................................................................................................... 44
Lecture Wizecap............................................................................................................................ 45
Rationales behind M&A ........................................................................................................... 45
Valuations .................................................................................................................................. 45
M&A advisory services............................................................................................................. 47
4
,Lecture 1: Introduction and Key Financial Statements
Introduction to Financial Statements
Who is interested in the financial statements of a company? – Demand & Supply
Demand for financial information by (especially for stock listed companies):
• Shareholders
• Investment Analysts
• Lenders and bondholders => solvency (credit risk)
• Employees
• Customers, suppliers, and other partners
• Regulators and Tax authorities
Supply of financial information
• Compliance with public market regulation (financial regulation – expressed in EUR;
unlike ESG)
• Benefits of disclosure:
o Lower cost of equity
o Lower cost of debt
=> Both used for DCF calculation; WACC which represents the volatility/risk:
1. Operating risk
2. Financial risk
3. Information = financial information does not represent the
correct situation
• Disclosing information also involves costs
o Preparation and dissemination
o Competitive disadvantages
What documents are included in the financial statements of a company?
1. Balance sheet (= the accounting equation: Assets = Liabilities + Equity)
2. Income Statement: reports on operation activities – from sales to net income
3. Equity Statement: reports on changes in the book value of equity
It has 2 main components:
• Contributed capital (from stock issuance)
• Earned capital (retained earnings or reserves built up from previous periods)
4. Cash Flow statement: reports on cash flows for operating, investing and financing
activities of the fiscal year
5. (Comprehensive income statement)
5
,The Balance Sheet
Remember Assets = Liabilities + Equity
Assets
What are the reporting rules on including a certain asset on the BS?
1. The asset must be owned or controlled by the company
2. The company possesses expected future economic benefits
Assets are listed in order of liquidity, with the most liquid assets being the Current Assets (= can
be converted to cash within a year), and the least liquid are the Long-term Assets (= are not
expected to be converted to cash within a year)
Current Assets
• Cash and Cash Equivalents: currency, bank deposits, and investments with an
original maturity of 90 days or less
• Marketable securities: short-term investments that can be quickly sold to raise cash,
typically with a maturity between 3 and 12 months
• Accounts receivable, net: amounts due to the company from customers arising from
the sale of products and services on credit
• Inventories: goods purchased or produced for sale to customers, including raw
materials and work-in-progress
• Prepaid expenses: costs paid in advance for rent, insurance, advertising or other
services
Long-Term Assets (non current)
• Property, plant and equipment (PPE), net: land, factory buildings, warehouses,
office buildings, machinery, motor vehicles, office equipment and other items used in
operating activities (“net” refers to subtraction of accumulated depreciation)
• Leased assets: all leased assets must be shown on the balance sheet
• Intangible and other assets: assets without physical substance, such as patents,
trademarks, franchise rights and other costs the company incurred that provide future
benefits
• Goodwill: the premium on top of the book/market value paid in acquisition activities
• Long-term investments (=non current marketable securities): investments
(usually in equity and bonds) which are not intended to be sold within a year
6
,Notes with the examples:
Important to notice is that half of the BS is pure cash management and thus has nothing to do with
operations. A direct implication of this is that the ROA ratio is not relevant because the assets also
contain investments in other companies (non current marketable securities) which are not part of
the operations.
Vendor non-trade receivables = amount of money a business expects to receive from a vendor that
is not related to the normal buying and selling of goods or services
If a company has Goodwill, it means that they engage in M&A (non organic growth).
Sometimes changes in IFRS rules can influence the BS to a great extent which could lead to wrong
conclusions. (see SAS example)
Pernod Ricard’s inventories are very high, but this entails no problem because alcohol has to ripe,
imagine if this would have been Mercedes, in that case it would be bad.
How are assets being incorporated? – asset recognition
• Principle of historical cost (amortized cost) = recording the value of the asset at the
historical cost price. This principle is often used, as it is objective, verifiable, and
predictable.
Book value = historical cost – depreciation
• Fair value accounting = instead of using the historical cost, use the current value of
an asset
It is important to only include items that can be sufficiently reliably measured, this means
that a considerable amount of ‘economic assets’ may not be reflected on a BS.
(for ex. A strong management team, customer satisfaction, …)
Notes with the examples:
The Disney character Mickey Mouse is not included in the intangible assets because it is not
sufficiently measurable because it is internally generated. Iron man tough is included because it
is part of Marvel, which was acquired by Disney, so can be found in Goodwill.
For LVMH we can find a decomposition of the intangible assets, including brand names, trade
names, licences etc. These brands are valued at historical cost according to the explanation.
7
, Equity and Liabilities
Equity consists of:
• Contributed capital: cash raised from the issuance of shares with current and new
shareholders
• Earned capital: Retained earnings or capital reserves built up from prior fiscal periods
o Retained earnings calculated as follows:
Beginning retained earnings
+ Net income
- Dividends
= Ending Retained earnings
Company with highest book value = BS Hathaway
Liabilities consist of:
Current liabilities
• Accounts payable: amounts owed to suppliers for purchases on credit (< 1 year)
• Accrued liabilities: obligations for expenses that have been incurred but not yet paid;
examples are wages payable, interest payable, tax payable
• Unearned revenues: obligations created when the company accepts payment in
advance for goods or services it will deliver in the future
• Short-term debt: short-term debt to banks or other creditors
• Current maturities of long-term debt: principal portion of long-term debt that is
due to be paid within one year
Long-term liabilities
• Long-term debt: borrowings from creditors to be repaid more than one year from
now, including bank loans, bonds, and other loans
• Operating long-term liabilities: Obligations, such as accounts payable, pensions and
provisions, that are expected to be settled a year or more from now.
Notes with the examples:
Why do companies like apple that have a lot of cash still have debt => is efficient because they
can get very low interest rates thanks to their great cash position (leverage). Big companies like
apple can also use their power to obtain lots of credit with their suppliers resulting in rather large
amounts of accounts payable. Apple also has no retained earnings despite being profitable.
8
and Security Valuation
,Contents
Lecture 1: Introduction and Key Financial Statements................................................................... 5
Introduction to Financial Statements .......................................................................................... 5
The Balance Sheet....................................................................................................................... 6
Assets ...................................................................................................................................... 6
Equity and Liabilities .............................................................................................................. 8
Lecture 2: Key Financial Statements .............................................................................................. 9
Income Statement........................................................................................................................ 9
Equity Statement ....................................................................................................................... 10
Comprehensive Income Statement ............................................................................................11
Cash Flow Statement .................................................................................................................11
Lecture 3: Profitability Analysis ................................................................................................... 12
Operating Return ....................................................................................................................... 12
NOPAT .................................................................................................................................. 12
NOA ...................................................................................................................................... 13
RNOA ................................................................................................................................... 13
Nonoperating Return ................................................................................................................. 14
Financial Leverage (FLEV) .................................................................................................. 14
Spread ................................................................................................................................... 14
Lecture 4: Credit Risk Analysis (Solvency Analysis) ................................................................... 16
Credit Risk Concept .................................................................................................................. 16
Credit Risk Analysis – Solvency ratios ..................................................................................... 16
Liabilities-to-Equity .............................................................................................................. 16
Book leverage ....................................................................................................................... 16
Market leverage .................................................................................................................... 17
Times interest earned ............................................................................................................ 17
Debt-to-EBITDA .................................................................................................................. 18
Net Debt-to-EBITDA............................................................................................................ 18
Accounting in Debt Contracts (role of covenants) ................................................................... 18
Credit ratings ............................................................................................................................. 19
Lecture 5: Operating Income ........................................................................................................ 20
2
, Income statement ...................................................................................................................... 20
Revenues ................................................................................................................................... 21
Unearned/deferred revenues ................................................................................................. 21
Research and development expenses .................................................................................... 22
Selling, general and administrative expenses ....................................................................... 22
Non-controlling interests ...................................................................................................... 23
Earnings per share ................................................................................................................. 23
Lecture 6: Current Assets (Liquidity Analysis) ............................................................................ 23
Inventories and Cost of Sales .................................................................................................... 23
Accounting for inventories ................................................................................................... 24
Inventory costing methods .................................................................................................... 24
Accounts receivable .................................................................................................................. 25
Operating current liabilities ...................................................................................................... 27
Liquidity................................................................................................................................ 27
Lecture 7: Long-Term Assets ........................................................................................................ 29
Property, Plant and Equipment ................................................................................................. 29
Intangible Assets ....................................................................................................................... 30
Goodwill ................................................................................................................................... 30
Joint Ventures ............................................................................................................................ 31
Fair value assets + examples ..................................................................................................... 31
Leased Assets ............................................................................................................................ 32
Valuation part 1: Valuation basics ................................................................................................. 34
Making accounting adjustments ............................................................................................... 34
Forecasting financial statements – 4 step procedure................................................................. 35
Concepts of valuation ............................................................................................................... 35
Valuation part 2: Cash flow based valuation................................................................................. 38
DDM – Dividend Discount Model ........................................................................................... 38
DCF – Discounted Cash Flow Model ....................................................................................... 39
Valuation part 3: Operating income based valuation .................................................................... 41
Residual Operating Income Model (ROPI) .............................................................................. 41
Valuation process .................................................................................................................. 41
3
, ROPI vs DCF ........................................................................................................................ 42
Valuation part 4: Market based valuation ..................................................................................... 43
Types of multiples ..................................................................................................................... 43
Earnings multiples ................................................................................................................ 43
Book value multiples ............................................................................................................ 44
Conclusions on Multiples ......................................................................................................... 44
Lecture Wizecap............................................................................................................................ 45
Rationales behind M&A ........................................................................................................... 45
Valuations .................................................................................................................................. 45
M&A advisory services............................................................................................................. 47
4
,Lecture 1: Introduction and Key Financial Statements
Introduction to Financial Statements
Who is interested in the financial statements of a company? – Demand & Supply
Demand for financial information by (especially for stock listed companies):
• Shareholders
• Investment Analysts
• Lenders and bondholders => solvency (credit risk)
• Employees
• Customers, suppliers, and other partners
• Regulators and Tax authorities
Supply of financial information
• Compliance with public market regulation (financial regulation – expressed in EUR;
unlike ESG)
• Benefits of disclosure:
o Lower cost of equity
o Lower cost of debt
=> Both used for DCF calculation; WACC which represents the volatility/risk:
1. Operating risk
2. Financial risk
3. Information = financial information does not represent the
correct situation
• Disclosing information also involves costs
o Preparation and dissemination
o Competitive disadvantages
What documents are included in the financial statements of a company?
1. Balance sheet (= the accounting equation: Assets = Liabilities + Equity)
2. Income Statement: reports on operation activities – from sales to net income
3. Equity Statement: reports on changes in the book value of equity
It has 2 main components:
• Contributed capital (from stock issuance)
• Earned capital (retained earnings or reserves built up from previous periods)
4. Cash Flow statement: reports on cash flows for operating, investing and financing
activities of the fiscal year
5. (Comprehensive income statement)
5
,The Balance Sheet
Remember Assets = Liabilities + Equity
Assets
What are the reporting rules on including a certain asset on the BS?
1. The asset must be owned or controlled by the company
2. The company possesses expected future economic benefits
Assets are listed in order of liquidity, with the most liquid assets being the Current Assets (= can
be converted to cash within a year), and the least liquid are the Long-term Assets (= are not
expected to be converted to cash within a year)
Current Assets
• Cash and Cash Equivalents: currency, bank deposits, and investments with an
original maturity of 90 days or less
• Marketable securities: short-term investments that can be quickly sold to raise cash,
typically with a maturity between 3 and 12 months
• Accounts receivable, net: amounts due to the company from customers arising from
the sale of products and services on credit
• Inventories: goods purchased or produced for sale to customers, including raw
materials and work-in-progress
• Prepaid expenses: costs paid in advance for rent, insurance, advertising or other
services
Long-Term Assets (non current)
• Property, plant and equipment (PPE), net: land, factory buildings, warehouses,
office buildings, machinery, motor vehicles, office equipment and other items used in
operating activities (“net” refers to subtraction of accumulated depreciation)
• Leased assets: all leased assets must be shown on the balance sheet
• Intangible and other assets: assets without physical substance, such as patents,
trademarks, franchise rights and other costs the company incurred that provide future
benefits
• Goodwill: the premium on top of the book/market value paid in acquisition activities
• Long-term investments (=non current marketable securities): investments
(usually in equity and bonds) which are not intended to be sold within a year
6
,Notes with the examples:
Important to notice is that half of the BS is pure cash management and thus has nothing to do with
operations. A direct implication of this is that the ROA ratio is not relevant because the assets also
contain investments in other companies (non current marketable securities) which are not part of
the operations.
Vendor non-trade receivables = amount of money a business expects to receive from a vendor that
is not related to the normal buying and selling of goods or services
If a company has Goodwill, it means that they engage in M&A (non organic growth).
Sometimes changes in IFRS rules can influence the BS to a great extent which could lead to wrong
conclusions. (see SAS example)
Pernod Ricard’s inventories are very high, but this entails no problem because alcohol has to ripe,
imagine if this would have been Mercedes, in that case it would be bad.
How are assets being incorporated? – asset recognition
• Principle of historical cost (amortized cost) = recording the value of the asset at the
historical cost price. This principle is often used, as it is objective, verifiable, and
predictable.
Book value = historical cost – depreciation
• Fair value accounting = instead of using the historical cost, use the current value of
an asset
It is important to only include items that can be sufficiently reliably measured, this means
that a considerable amount of ‘economic assets’ may not be reflected on a BS.
(for ex. A strong management team, customer satisfaction, …)
Notes with the examples:
The Disney character Mickey Mouse is not included in the intangible assets because it is not
sufficiently measurable because it is internally generated. Iron man tough is included because it
is part of Marvel, which was acquired by Disney, so can be found in Goodwill.
For LVMH we can find a decomposition of the intangible assets, including brand names, trade
names, licences etc. These brands are valued at historical cost according to the explanation.
7
, Equity and Liabilities
Equity consists of:
• Contributed capital: cash raised from the issuance of shares with current and new
shareholders
• Earned capital: Retained earnings or capital reserves built up from prior fiscal periods
o Retained earnings calculated as follows:
Beginning retained earnings
+ Net income
- Dividends
= Ending Retained earnings
Company with highest book value = BS Hathaway
Liabilities consist of:
Current liabilities
• Accounts payable: amounts owed to suppliers for purchases on credit (< 1 year)
• Accrued liabilities: obligations for expenses that have been incurred but not yet paid;
examples are wages payable, interest payable, tax payable
• Unearned revenues: obligations created when the company accepts payment in
advance for goods or services it will deliver in the future
• Short-term debt: short-term debt to banks or other creditors
• Current maturities of long-term debt: principal portion of long-term debt that is
due to be paid within one year
Long-term liabilities
• Long-term debt: borrowings from creditors to be repaid more than one year from
now, including bank loans, bonds, and other loans
• Operating long-term liabilities: Obligations, such as accounts payable, pensions and
provisions, that are expected to be settled a year or more from now.
Notes with the examples:
Why do companies like apple that have a lot of cash still have debt => is efficient because they
can get very low interest rates thanks to their great cash position (leverage). Big companies like
apple can also use their power to obtain lots of credit with their suppliers resulting in rather large
amounts of accounts payable. Apple also has no retained earnings despite being profitable.
8
