2) Financial Statement Analysis

What are financial statements

Accounting reports presenting past performance, and a snapshot of the business’s assets and financing.

They are used by managers, analysts, investors, etc

What are the four main financial statements

Balance Sheet

Income statement

Statement of Cashflow

Statement of changes in equity (including retained earnings)

What are the advantages and disadvantages of financial statements

ADV:

• Reliable

• Easily available at little cost

DISADV:

• Based on past information

• Differing standards across countries

• Potential conflicts of interest (Shareholders vs Lenders, Management vs Shareholders, etc)

What is a Balance Sheet

A snapshot of the businesses financial position, measuring how they manage debt and equity

What is the key principle balance sheets are based on

Assets = Liabilities + Shareholder Equity

Assets are on the left, Liabilities and Equity on the Right

What are the two types of Assets

Current:

• Turned into cash within a year

• Bank balance, inventories, prepaid expenses, etc

Non-Current:

• Expected to take over a year to be turned into cash

• Property, cars, trademarks, etc

What are the two types of Liabilities

Current:

• Paid within a year

• Accounts payable, short term debt, credit debt, etc

Non-Current:

• Paid in over a year

• Long term debt, bank loans, mortgages, capital leases, deferred taxes, etc

What is depreciation

The loss in value of a non-current asset over time

Not an actual expense, but the estimate of costs that arise from wear and tear, loss in market value, etc

How is depreciation shown in financial statements

Balance Sheet:

• The book value of an asset equals its purchase cost minus accumulated depreciation

Income Statement:

• Depreciation is treated as an operating expense

Statement of cashflows

• Depreciation is added to net income to estimate total cash from operating activities

Net Working Capital

NWC = Current Assets - Current Liabilities

Shows the liquid money a company has, and their ability to pay off short term debts

Book vs Market Value of Shareholder Equity

Book Value:

• Book Value of Assets - Book Value of Liabilities

Market Value:

• Shares Outstanding x Share Price

• Often differs from the book value, based on investor expectations of future risk and return

Market to Book ratio, and it’s meaning

Market Value / Book Value

High M/B:

• Indicates growth shares, and that investors are hopeful for the future

Low M/B:

• Indicate value shares, and that they’re undervalued

Debt-Equity Ratio

Total Debt (liabilities) / Total Equity

Used to asses a firms leverage

• Above 1 means the company runs more on debt and is a higher risk

• Less than 1 indicates the company can easily pay off it’s debt

• The ideal range is between 1 and 2

Enterprise Value

The underlying value of a firm, separate from cash and market securities

EV = Market Value of Equity + Debt - Cash

What are Income Statements

Income statements (Profit Loss statements) show the flow of revenue and expense

This shows the profitability of the firm

Income statement layout

In the form of a list:

• List of income and values

• List of expenses and values

• Bottom Line is the Net Profit / Net Income

The statement can features multiple lists alongside each other for different years

Earnings per Share (EPS)

EPS = Net Income / Shares Outstanding

Finds the profit per share invested

Return on Equity (ROE)

ROE = Net Income / Book Value of Equity

Compares the cost on an investment to it’s returns

Return on Assets (ROA)

ROA = Net Operating Profit / Total Assets

Compares the company’s asset investment to it's net profit

Price-Earnings Ratio

Most valuable ratio in evaluating a company’s share price

Share price should be proportional to the earnings it could generate

Formulae:

• P/E = Market Value / Net Profit

• P/E = Share price / Earning per Share

Statement of Cashflows

Uses information from both the balance sheet, and income statement to determine:

• Amount of cash generated

• How the cash was allocated during a set period

Three sections of a Cash Flow Statement

Operating Activity

Investing Activity

Financing Activity

Operating Activity

Tracks the cash moving in and out daily from core company operation (Operating Cash Flow OCF), mostly income statement items

(Direct Method) OCF = Gross Cash Received - Gross Cash Payments

(Indirect Method) OCF = Net Income + Non-Cash Expenses (depreciation, amortisation, etc) - Changes in working capital

Investing Activity

Tracks cashflow of long-term assets, mostly balance sheet items'

Calculated by the values of buying/selling non-current assets

Financing Activity

Tracks cashflow of long term liabilities and equity, mostly balance sheet items

Calculated by the values of issuing/repurchasing non-current liabilities (including dividend payments)

Statement of changes in equity

Explains how/why a company’s equity changed over a year

Compares 3 main sources of equity

• Share capital (money invested)

• Retained equity (Money kept by a business to reinvest)

• Reserves (Tracks other adjustments, such as loss/gain from exchange rates and valuation of long term assets)

Financial Ratios

Ratios are used to evaluate the performance of a business in different aspects (profitability, liquidity, efficiency, valuation, etc)

Profitability Ratios

Shows how profitable a business is

• Return on Equity

• Return on Assets

• Net Profit Margin (Net Income / Total Sales)

Leverage/Gearing Ratios

Shows how much as business relies on debt

• Debt to equity ratio

• Quick Ratio ((Current Assets - Cash) / Current Liabilities)

Valuation Ratio

Price-Earning Ratio (Market Value / Net income) or (Share Price / Earnings per Share)

Efficiency Ratios

Inventory Turnover (COGS / Average inventory)

Accounts Receivable Days (Average Accounts Receivable / Average quantity of sales) or (365 x Average Accounts receivable / revenue)

Interpretive Issues with Ratios

When comparing ratios, it is essential they were calculated using the same definitions or classifications

Ratios can be calculated against previous history, or other companies, but context is key

Ratios don’t provide answers, rather questions. A bad ratio is more informative than a “normal“ one

How the Australian Tax Works

The share is initially taxed, creating a franking credit

You are then taxed the full initial amount, but you subtract the franking credit from tax paid. With the system you should only pay at your tax rate.

(Imagine $100 share, 30% Corporate tax, 45% Personal Tax)

• 100 × 0.3 = $30 franking credit and $70 left

• 100 × 0.45 = $45 tax (without credit)

• 45 - 30 = $15 tax to actually pay

• 70 - 15 = $55 Amount left after tax