L2 Refined Corporate finance: financial statements:

Financial statements:

Are financial reports containing past performance information that firm must publish annually/quarterly and follow unified worldwide accounting rules (IRFS) to protect small investors, or GAAP (US) and China.

Financial statements traits

-        Filed with the appropriate regulatory agency (SEC in US)

-        These must always be sent to shareholders.

-        Clear and not complex to confuse investors

-        Honest an reliable

-        Checked by auditors

Types of financial statements

• Balance sheet: Acts as a snapshot in time of a firm's financial position. It follows the identity Assets = Liabilities + Stockholders’ Equity.

• The Income Statement (Profit and loss statement): Measures profitability over a period by listing revenues and expenses.

• Cash flow statement:

Assets

Include current assets (cash, accounts receivable, and inventory) and long-term assets like property and machinery.

Current assets

o   (converted to cash within one year): E.g. Cash & Marketable Securities, Accounts Receivables (credit to customers), Inventories (raw material, work in progress..) and Pre-paid expenses.

Long-term assets:

o   Include assets such as real estate or machinery that produce tangible benefits for more than one year.

§  Net Property, Plant, and Equipment: Book Value = Acquisition Cost – Accumulated Depreciation

§  Goodwill & intangible assets (brand, reputation, network, customer base, employees):

·       Paid–book value

·       Amortization = Reflects the gradual loss of value of these assets

• Investment in long-term securities.

• Depreciation

Depreciation

•   Is loss of value of the assets due to wear and tear or outdated. Not a cash expense but an accounting method to acknowledge that an asset’s value decreases as it gets older.

Accumulated depreciation:

Total depreciation amount deducted from the asset’s original cost over its life.

Liabilities:

-        Represent what the company owes e.g. loans, bonds and accounts payable, divided into current (due within a year) and long-term debt.

Current liabilities: Due to be paid in one year e.g.:

§  Accounts Payable = credit to firm by suppliers

§  Short-Term Debt/Notes Payable

§  Current Maturities of Long-Term Debt

§  Taxes payable

§  Wages payable

Long-term liabilities: Extend beyond one year.

• Long-Term Debt: Any loan or debt obligation with a maturity of more than a year.

·       When a firm needs to raise funds to purchase an asset or make an investment, it may borrow those funds through a long-term loan.

§  Capital Leases: long-term lease contracts where firm must make payments to use an asset. E.g. firm lease a building for corporate headquarter.

§  Deferred Taxes: taxes that are owed but have not yet been paid

Stockholders' Equity

Firm’s networth and book value fo equity. Asset - Liabilities. -        fails to capture intangible assets like expertise or appropriate current values for real estate.

The Income Statement (Profit and loss statement):

Measures profitability over a period by listing revenues and expenses.

Probability metrics include:

-        EBIT (Earnings Before Interest and Taxes), EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and Earnings Per Share (EPS).

EPS and diluted EPS:

-        Earnings Per Share (EPS): Earnings are often reported as EPS, calculated as Net Income divided by Shares Outstanding.

-        Diluted EPS is also used to adjust for potential increases in shares from items like convertible bonds.

Net income is not the same as earned cash because of:

-        Non-cash expenses in Income statement like depreciation and amortization. (It is a cost and decreases the result but it isn’t an expense for the company yet.)

-        Cash uses that cannot be seen in the income statement e.g. investments in property, plant & equipment.

Cash flow statement:

Shows the cash flows over a specific period by tracking actual cash movements. Help show where cash comes from, where it’s spent. E.g. in BS we can only see whether the cash has gone up and down BUT not how the cash came into the business or what it has been spent on.

Note: There are two different moments — when the trade is recorded (accrual accounting) and when the cash is actually transacted.

It categorizes cash movement into:

Operating, investment and financing activities.

Operating Activities:

How cash flows from their operations and whether they can sustain itself without external financing. Inflows like revenue, interest and dividens. Outflows like suppliers, wages and rent.

Operating Activities: Adjustments

-        Adjusts net income by adding back depreciation and accounting for changes in working capital (e.g., deducting increases in accounts receivable or inventory).

o   Add depreciation in the cash flow statement because it has been deducted in the income statement but doesn’t affect the cash flow.

o   Depreciation is added - It is a non-cash expense

o   Increases in Accounts Receivables are deducted - Sales are recorded, but cash has not yet been received

o   Increases in Accounts Payable are added - Expenses are recorded, but cash has not yet been paid

o   Increases in Inventories are deducted - Cash is spent to buy inventory before it is sold.

Investment Activities

-        Tracks long term investments that affect company growth. Including Capital Expenditures (CapEx) on long-term assets and the buying/selling of marketable securities.

Capital expenditures:

Cash spent on long-term assets e.g. buildings and machinery are expensed in the income statement through depreciation. This is adjusted in the Cash flow statement to reflect the actual cash outflow when the investment made.

Buying/selling of marketable:

§  Cash used to purchase financial investments

§  Cash received from selling financial investments

§  These transactions affect cash but not operating profit

Financing Activities

How company raises and repays capital through debt and equity financing. Covers transactions such as retained earnings (profits not paid as dividends), issuing or buying back equity, and changes in borrowing.

Retained Earnings

§  Retained earnings = Net income − Dividends

§  Portion of profits kept in the firm rather than paid out to shareholders

o   Equity Transactions

§  Cash raised from issuing new shares

§  Cash paid to buy back the firm’s own equity

o   Changes in Borrowing

§  Cash received from new debt

§  Cash used to repay existing debt

Market Capitalization:

The Market Value of Equity and is the total worth of company’s shares in the stock market. Calculated as the share price multiplied by the number of shares. It can be substantially different from the book value and cannot be negative.

Market-to-Book Ratio

Measures market valuation of a firm compared to book value. A ratio higher than 1 indicates the market values the firm's assets more than their net assets (higher than their historical cost).

Growth and value stocks:

-        Growth Stocks (strong expectations, high valued by market, can be overvalued).

-        Value Stocks (low market to book value, lower expectations, viewed as undervalued).

Enterprise value:

Measures the value of the business itself, calculated as: EV = Market Value of Equity + Debt – Cash.

Profitability Ratios:

These measure efficiency by showing how much a firm earns on every dollar of sales. They reflect a company's pricing power and cost control.

Operating Returns:

These metrics indicate how efficiently assets and equity are used to generate profits and capture the firm’s ability to find profitable investment opportunities. They essentially combine profitability with asset use and financing choices.

The DuPont Identity:

Expresses Return on Equity (ROE) as a product of three distinct factors for analysts to determine whether a firm’s returns are driven by high margins, efficient use of assets, or the use of debt to finance assets.

1.     Net Profit Margin (Profitability): Net Income divided by Sales.

2.     Asset Turnover (Asset Efficiency): Sales divided by Total Assets.

3.     Equity Multiplier (Leverage): Total Assets divided by the Book Value of Equity.

Liquidity Ratios:

These indicate short-term financial health by measuring how well a firm can meet its short-term obligations. However, these ratios might not capture firms that generate cash very quickly from ongoing activities.

Leverage ratios:

How much a firm relies on debt as source for funding. While higher leverage indicates higher financial risk, it also amplifies both returns and losses. The Equity Multiplier specifically captures the amplification of returns resulting from this leverage.

Interest Coverage Ratios:

Measure a firm's ability to pay interest on its debt.

-        A high coverage (>5x) suggests a strong ability to service debt, marking a high-quality borrower.

-        Low coverage (<1.5x) is a warning sign of financial distress, indicating a limited margin for economic downturns.

Valuation ratios:

Help investors determine how much they are paying for a firm’s earnings.

P/E Ratio (Price to Earnings):

This measures the firm's value in relation to its earnings and indicates what investors are willing to pay for each dollar of earnings.

-        Analysts must be careful with this ratio because it can be impacted by leverage and earnings volatility; using ratios based on Enterprise Value can help avoid these limitations.

Forward vs. Trailing PE

Calculated using the current price divided by upcoming quarterly consensus estimates. A Trailing PE uses the current price divided by the sum of the four most recently reported quarterly earnings

The Cash Conversion Cycle (CCC):

Measures how long cash is tied up in operations: A/R Days + Inventory Days - A/P Days.

The operating cycle:

Tracks time from buying inventory to collecting cash from sales.

Cash cycle

How long it takes a company to convert its investments in inventory and other resources into cash from sales.

Working capital:

“Capital that is working for the project” and include cash, inventory, receivables and payables. It includes cash needed for daily operations and meeting short-term obligations and not excess cash that can be used as investments as part of firm’s capital structure, offsetting firm debt.

-        Increases in net working capital representing investment. Reduces the available cash => alters a firm’s value.

Working capital ratios:

How firms can handle it’s working capital is through. Show how many days of sales or costs are tied up in different parts of the business.

Cash Conversion Cycle (CCC). Tracks how long a firm's cash is "tied up" in its operations before it is recovered. It is calculated as:

-        Accounts Receivable Days (time to get paid by customers) + Inventory Days (time items sit in stock) – Accounts Payable Days (time the firm takes to pay its own bills)

Strategies for managing money customers owe and the physical goods a company keeps on hand:

Receivable Management:

-        Firms must establish a credit policy by setting standards for who gets credit, what the terms are, and how they will collect the money

-        Using aging schedule: They can monitor those accounts by categorizing unpaid bills based on how long they have been outstanding. Looking at the payment patterns can help see what percentage of sales are collected each month.

Inventory management:

It’s about balancing between the benefits of holding stocks (inventory) (to e.g. prevent stock-outs and meet seasonal demands) and the costs of keeping it (storage, insurance, spoilage and opportunity costs).

Instead of regular inventory management use:

-        Instead focus on Just-in-Time Inventory management: where a firm acquires stock exactly when needed so the balance stays near zero.

Cash management:

Cash is important but the liquidity has a cost because holding cash do provide security but costs potential growth e.g. cash earns. Not converting less liquid can make higher-return assets give transaction costs or price losses.

Despite these costs, firms are motivated to hold cash for three main reasons:

1.     Transaction Balance: To meet daily needs and pay bills (often measured by the quick ratio).

2.     Precautionary Balance: To act as a safety net against uncertainty in future cash flows.

3.     Compensating Balance: To satisfy bank requirements to ensure the firm continues to receive funding and services