FM - income statement analysis

balance sheet

A financial statement that summarizes a company's assets, liabilities, and shareholders' equity at a specific point in time, indicating its financial position.

income statement

A financial statement that reports a company's revenues, expenses, and profits over a period of time, showing its operational performance.

it computes the firm’s bottom line of net income, or earnings, over a given time interval

Cash flow statement

A financial statement that provides a summary of cash inflows and outflows from operating, investing, and financing activities over a specific period, indicating how cash is generated and used by the company.

GAAP

Generally Accepted Accounting Principles, the standard framework of guidelines for financial accounting used in the United States.

non-GAAP vs GAAP

A comparison between financial reporting methods that include non-GAAP measures, which can provide insight beyond standard GAAP metrics, often emphasizing metrics like EBITDA or adjusted earnings to reflect a company's financial performance more accurately.

Internally firms use financial statements for:

• Evaluating performance

• Understanding the levers of management control → the influence of operating decisions

GAAP ← → IFRS

A comparison between Generally Accepted Accounting Principles (GAAP) used in the U.S. and International Financial Reporting Standards (IFRS) used globally, highlighting differences in financial reporting and accounting practices.

Balance sheet identitty

TOTAL ASSETS = TOTAL LIABILITIES + EQUITY

Total assets

Current assets

• cash

• marketable securities

• accounts receivable

• inventories

Non-current assets

• net property, plant, and equipment

• goodwill and intangible assets

Total liabilities

Current liabilities

• account payable

• notes payable

• other short-term debt

Long-term liabilities

• deferred taxes

• capital leases

• long term debt

Shareholder equity

• stocks

• retained earnings

Amortisation

or impairment charge

If the firm assesses that the value of these intangible assets declined over time, it will reduce the amount listed on the balance sheet by an amortization or impairment charge that captures the change in value of the acquired assets.

not an actual cash expense

Depreciation

decrease in value over time

An asset’s accumulated depreciation is the total amount deducted over its life

not an actual cash expense that the firm pays; it is a way of recognizing that buildings and equipment wear out and thus become less valuable the older they get

Net income __ amount of cash earned

deos NOT equal (e.g. non-cash expenses such as depreciation)

Focus of cash flow statements

solvency → ensure that there is enough cash to pay bills as they come due

Operating activity

Adjusts net income by all non-cash items related to operating activities and changes in net working capital

• Depreciation – add the amount of depreciation

• Accounts Receivable – deduct the increases, add the decreases

• Accounts Payable – add the increases, deduct the decreases

• Inventories – deduct the increases, add the increases

• Operating cash flow = NI + Depreciation - increase in AR + increase in AP increase in INV

Investment activity:

• Capital Expenditures

• Buying or Selling Marketable Securities

• Adjustment of acquisition and sales (divestiture) of fixed assets

• Capital expenditures and acquisitions & other investing activities

• Also includes acquisitions of other firms

Financing activities

• Payment of dividends: Retained earnings = Net income – dividends

• Changes in borrowings

• Adjustment of issue and repurchase of equity, issue and repayment of debt and after dividend payments

• Financing cash flow = – dividends paid + sale (or – purchase) of shares + increase (or – decrease) in ST borrowing + increase (or – decrease) in LT borrowing

Rule of thumb for CF

The sum of CF from operating, investing, financing activities should equal change in cash and marketable securities

Financial Statement Analysis: What Do Investors Use It For?

• Compare the firm with itself by analyzing how the firm has changed over time (time series analysis)

• Compare the firm to other similar firms using a common set of financial ratios (Cross sectional analysis)

Two Most Frequently Used Techniques to Analyze Financial Statements

1. Common-size analysis

2. Financial ratio analysis

Common-Size Analysis

Common-size analysis is done by expressing financial data in the financial statements, in relation to a single financial statement item (vertical) or base year (horizontal).

a. Horizontal common-size analysis is useful when comparing growth of different accounts over time.

Highlights items that have changed unexpectedly or have unexpectedly remained unchanged.

b. Vertical common-size analysis highlights composition and identify what items are important.

Balance sheet: Aggregate amount is total assets.

Income statement: Aggregate amount is revenues or sales.

Financial Ratio Analysis

• net profit margin: dollars earned per sale? (47 min lecture recording)

• to increase the NP margin:

  • increase price or

  • decrease production cost

• Financial ratio analysis is the use of relationships among financial statement accounts to gauge the financial condition and performance of a company.

  • The ratio analysis enables comparative analysis: intracompany, intercompany, industry averages

BV of equity

BV of assets - BV of liabilities

MV of equity (market capitalisation)

number of shares outstanding x market price per share

MVA (market value added)

= MV of equity - BV of equity

Market-to-Book Ratio (price-to-book)

MV of equity / BV of equity

EV (enterprise value)

= market value of equity + debt - cash

• price of acquiring a company

ROE (return on equity)

= NI / Equity

• a measure of the efficiency with which a company employs owners’ capital

• a measure of company financial performance

DuPont Identity

ROE = Net profit margin x Asset turnover x Financial leverage (equity multiplier)

Net profit margin

= NI / sales

the earnings squeezed out of each dollar of sales (profit per dollar of sales)

asset turnover

= sales / assets

the sales generated from each dollar of assets employed (resources/assets required to support sales)

financial leverage

= assets / shareholders’ equity

the amount of equity used to finance assets (shareholders’ equity used to finance the assets)

The four required financial statements

the balance sheet

the income statement

the statement of cash flows

the statement of stockholders’ equity

US required reports

• 10K - annually

• 10Q - quarterly

• annual report with their financial statements to their shareholders each year

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.

Corporations are required to hire a neutral third party, known as an auditor, to check the annual financial statements, to ensure that the annual financial statements are reliable and prepared according to GAAP

net working capital

= currents assets - current liabilities

the capital available in the short term to run the business, is the difference between the firm’s current assets and current liabilities

Cash and other marketable securities

short-term, low-risk investments that can be easily sold and converted to cash (such as money market investments like government debt that matures within a year)

Accounts receivable

amounts owed to the firm by customers who have purchased goods or services on credit; Inventories, which are composed of raw materials as well as work-in-progress and finished goods

Other current assets

a catch-all category that includes items such as pre-paid expenses (such as rent or insurance paid in advance)

Long-Term Assets

• net property, plant, and equipment: these include assets such as real estate or machinery that produce tangible benefits for more than one year

• Other long-term assets can include such items as property not used in business operations, start-up costs in connection with a new business, investments in long-term securities, and property held for sale

The book value of an asset

the value shown in the firm’s financial statements, 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

accounts payable

the amounts owed to suppliers for products or services purchased with credit

Short-term debt or notes payable

long-term debt, which are all repayments of debt that will occur within the next year

Items such as salary or taxes that are owed but have not yet been paid, and deferred or unearned revenue

revenue that has been received for products that have not yet been delivered

Firms with low (or negative) net working capital

may face a shortage of funds unless they generate sufficient cash from their ongoing activities

value stocks

firms with low market-to-book ratios

growth stocks

high market-to-book ratios

operating income

equal to its revenues less its cost of goods sold and operating expenses. After adjusting for other, non-operating income or expenses, we have the firm’s earnings before interest and taxes, or EBIT

EPS (earnings per share)

net income / number of shares outstanding

gross profit

= sales revenues - the costs

Operating Expenses

• expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold

• they include administrative expenses and overhead, salaries, marketing costs, and research and development expenses

• depreciation and amortization

operating income

The firm’s gross profit net of operating expenses is called

diluted EPS

Firms disclose the potential for dilution by reporting diluted EPS, which computes earnings per share as though any in-the-money stock options, stock grants, or dilutive convertible debt had already been exercised or converted

Cash flow statement sections

1. operating activities

2. investment activities

3. financing activities

capital expenditures

Purchases of new property, plant, and equipment

firms recognize these expenditures over time as depreciation expenses

Statement of Stockholders’ Equity

The change in stockholders’ equity can be computed as retained earnings (net income less dividends) plus net sales of stock (new grants or issuances, net of repurchases)

The statement of stockholders’ equity breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing shares (par value plus paid-in capital) versus retained earnings

Because the book value of stockholders’ equity is not a useful assessment of value for financial purposes, financial managers use the statement of stockholders’ equity infrequently

Management Discussion and Analysis (MD&A)

• contains management’s overview of the firm’s performance, as well as disclosure of risks the firm faces, including those from off-balance sheet transactions

• they may also discuss the coming year, and outline goals, new projects, and future plans

• required to disclose any off-balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm’s future performance yet do not appear on the balance sheet

Notes to the Financial Statements / Footnotes

• generally contain important details regarding the numbers used in the main statements

• document important accounting assumptions that were used in preparing the statements

• Details of acquisitions, spin-offs, leases, taxes, debt repayment schedules, and risk management activities are also given

  • very important to fully interpret the firm’s financial statements

Financial ratios

• allow us to

  (i) compare the firm’s performance over time

  (ii) compare the firm to other similar firms

• Key financial ratios measure the firm’s

  • profitability

  • liquidity

  • working capital

  • interest coverage

  • leverage

  • valuation

  • operating returns

EBITDA

= EBIT + Depreciation and Amortization

measures the cash a firm generates before capital investments

Net debt

= Total Debt − Cash & Short-term Investments

measures the firm’s debt in excess of its cash reserves

A higher current or quick ratio

implies less risk of the firm experiencing a cash shortfall in the near future

Limit of liquidity ratios

if the firm is able to generate significant cash quickly from its ongoing activities, it might be highly liquid even if these ratios are poor

comparing net profit margins limits

While differences in net profit margins can be due to differences in efficiency, they can also result from differences in leverage, which determines the amount of interest expense, as well as differences in accounting assumptions

differences in profitability can result from corporate strategy

Turnover ratios

= total cost of sales / working capital account (inventory, assets,…)

higher turnover →

corresponds to shorter days, and thus a more efficient use of working capital

benchmark for EBIT / interest coverage

• creditors often look for an EBIT/Interest coverage ratio in excess of 5 × for high-quality borrowers

• When EBIT/Interest falls below 1.5, lenders may begin to question a company’s ability to repay its debts

leverage

the extent to which a firm relies on debt as a source of financing