Notes on Understanding Financial Statements

Understanding Financial Statements

• Learning objectives summary:

  • Describe the financial statement and its elements

  • Analyze balance sheet and income statement through financial ratios

  • Determine and evaluate a company’s past performance via financial ratios

  • Interpret changes in the company’s financial structure

  • Discuss operating, investing, and financing activities

  • Construct the cash flow statement

• Introduction

  • The financial manager aims to optimize investors’ funds by maintaining the present value of the stock.

  • The belief that managers should simply inflate the firm’s funds via impressive reports is a misconception; reports influence stock price and must be accurate.

  • Accounting information is presented in financial statements and is vital for analyzing past performance and future outlook.

• What is the financial statement?

  • It is the presentation of data on assets, liabilities, and equities, including the balance sheet and the income statement’s revenues and expenses.

  • Its goal is to provide substantial information about the firm’s financial position, operating results, and cash flow to aid decision making for a broad set of recipients.

Components of Financial Statements

• The major components:
  1) Balance sheet
  2) Income statement
  3) Statement of stockholders’ equity

  • Balance sheet overview:

  • Shows financial position at a point in time; assets, liabilities, and stockholders’ equity.

  • Current assets: cash and items that can be converted to cash within one year (e.g., accounts receivable, inventories, prepaid expenses).

  • Non-current assets: long-term assets such as land, buildings, machinery, equipment, furniture, fixtures, vehicles, etc.

  • Liabilities: current and non-current liabilities.

  • Stockholders’ equity: net worth of the residual interest; includes par value stock, additional paid-in capital, and retained earnings.

  • Retained earnings represent cumulative earnings reinvested in the firm.

• Example components from MGM Enterprises (illustrative balance sheet):

  • Current assets include: Cash, Accounts receivable, Marketable securities, Inventory, Prepaid expenses

  • Total current assets: shown to reconcile with total assets

  • Non-current assets: Plant assets

  • Liabilities: Current liabilities and Long-term liabilities

  • Stockholders’ equity: Common stock (par value), Retained earnings

  • Balance sheet totals: Total assets = Total liabilities and stockholders’ equity = 450,000

• The income statement (operation results for a period):

  • Shows revenue (net sales) and expenses during the operating period.

  • Broad classes of expense include:

  • Cost of Goods Sold (COGS): direct costs of producing goods sold

  • General and Administrative expenses (G&A): overhead, salaries, advertising, other operating costs not directly tied to production

  • Interest expense

  • Taxes

• Statement of stockholders’ equity (required basic statement):

  • Shows movements in equity components, including:

  • Issuance of stock and related items

  • Retained earnings

  • Declaration and payment of cash dividends

  • Distribution of stock dividends (affecting retained earnings)

  • Purchase and sale of treasury stock (treasury stock increases stockholders’ equity when sold; decreases when purchased)

  • Accumulated other comprehensive income (unrealized gains/losses on available-for-sale investments and foreign currency translation adjustments)

  • Correction of errors (restatements from past years)

• The income statement example (MGM Enterprises, year ended 2019):

  • Sales:

  • Less: sales returns and allowances

  • Net sales

  • Less: cost of goods sold

  • Gross profit

  • Less: Operating expenses (selling, general)

  • Income from operations

  • Add: non-operating income

  • Income before interest and taxes

  • Less: Interest expense

  • Income before tax expense

  • Less: income taxes (35%)

  • Net income

• Financial statement quality and purpose

  • Financial statements are used by managers, creditors, investors, and other users to assess financial strength, liquidity, profitability, and future prospects.

  • They support decisions such as financing, investing, and dividend policies.

Financial Statement Analysis

• Definition

  • The comparison of past and present activities and forecasting future performance using numbers from income statements and balance sheets.

  • Purpose: identify deficiencies and guide actions to improve performance.

• Role in decision making

  • Ratios indicate financial strength, liquidity, investment safety, management efficiency, and profitability growth.

  • They help assess creditworthiness and investment potential.

  • Analysts should understand the company’s business, objectives, products/services, market, and customers; review footnotes for accounting practices; compare against industry data and trend lines.

• Common tools and techniques
  1) Horizontal analysis (trend analysis)
  2) Vertical analysis (common-size statements)
  3) Financial ratios

• Horizontal analysis

  • Compares financial data across two or more years to show increases/decreases and trend behavior.

  • Formula (percent change):
    $ext{Percentage change}= rac{ ext{Later year} - ext{Base year}}{ ext{Base year}} imes 100\%$

  • Example illustrates how a large relative change can be accompanied by a small absolute change, and vice versa; both pesos and percentages should be reported.

• Vertical analysis (Common-size statements)

  • Uses a base figure for a major item; all other items are expressed as a percentage of that base.

  • For the balance sheet:

  • Base: Total assets; each asset as a percentage of total assets.

  • Liabilities and stockholders’ equity also expressed as a percentage of total liabilities and stockholders’ equity (i.e., total liabilities + equity = 100%).

  • For the income statement:

  • Base: Net sales; all other items as a percentage of net sales.

  • Purpose: reveal internal structure and resource allocation; help compare with competitors and identify potential improvements.

• Financial ratios (two types of comparison)

  • Industry comparison: compare a firm’s ratios to industry averages.

  • Trend analysis: compare ratios over multiple years to assess performance trajectory.

  • Five major classifications:
    1) Liquidity ratios
    2) Activity (asset utilization) ratios
    3) Leverage (solvency) ratios
    4) Profitability ratios
    5) Market value ratios

• Liquidity ratios

  • Purpose: assess ability to meet short-term obligations and cash needs.

  • Key considerations: liquidity supports operations during shocks (labor strikes, price shocks, etc.). Greater liquidity supports borrowing capacity but may reduce potential returns.

  • Example metrics (definitions):

  • Current ratio:
    $ext{Current ratio}= rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

  • Quick ratio (acid-test): excludes inventories from current assets:
    $ext{Quick ratio}= rac{ ext{Cash}+ ext{Marketable securities}+ ext{Accounts receivable}}{ ext{Current Liabilities}}$

  • Cash position ratio (cash-focused liquidity):
    $ext{Cash position ratio}= rac{ ext{Cash}+ ext{Marketable securities}}{ ext{Current Liabilities}}$

• Activity (Asset Utilization) ratios

  • Measure how efficiently a firm uses assets to generate sales or cash.

  • Key measures include:

  • Accounts receivable turnover:
    $ext{Accounts receivable turnover}= rac{ ext{Net credit sales}}{ ext{Average accounts receivable}}$

  • Average collection period:
    $ext{Average collection period}= rac{360}{ ext{Accounts receivable turnover}}$

  • Inventory turnover:
    $ext{Inventory turnover}= rac{ ext{Cost of goods sold}}{ ext{Average inventory}}$

  • Average age of inventory:
    $ext{Average age of Inventory}= rac{360}{ ext{Inventory turnover}}$

  • Operating cycle:
    $ext{Operating cycle}= ext{Average collection period} + ext{Average age of inventory}$

  • Fixed asset turnover:
    $ext{Fixed Asset Turnover}= rac{ ext{Sales}}{ ext{Average net fixed assets}}$

  • Total asset turnover:
    $ext{Total asset turnover}= rac{ ext{Net sales}}{ ext{Average total assets}}$

• Leverage (Solvency) ratios

  • Assess a firm’s long-term financial risk and capital structure.

  • Key measures:

  • Debt ratio:
    $ext{Debt ratio}= rac{ ext{Total liabilities}}{ ext{Total assets}}$

  • Debt-to-equity ratio:
    $ext{Debt-to-equity ratio}= rac{ ext{Total liabilities}}{ ext{Stockholders' equity}}$

  • Times interest earned (TTI):
    $ext{Times interest earned}= rac{ ext{Earnings before interest and taxes (EBIT)}}{ ext{Interest expense}}$

• Profitability ratios

  • Evaluate how effectively a firm earns profits relative to sales, assets, and equity.

  • Key measures:

  • Gross profit margin:
    $ext{Gross profit margin}= rac{ ext{Gross profit}}{ ext{Net Sales}}$

  • Profit margin:
    $ext{Profit margin}= rac{ ext{Net income after taxes}}{ ext{Net Sales}}$

  • Return on assets (ROA):
    $ext{ROA}= rac{ ext{Net income}}{ ext{Average total assets}}$

  • Return on equity (ROE):
    $ext{ROE}= rac{ ext{Net income after taxes}- ext{Preferred stock dividends}}{ ext{Average stockholders' equity}- ext{Preferred stock}}$

  • Equity multiplier (DuPont):
    $ext{Equity multiplier}= rac{ ext{Average total assets}}{ ext{Average stockholders' equity}}$

  • DuPont relationship:$ext{ROE}= ext{ROA} imes ext{Equity multiplier}$

• Market value ratios

  • Reflect investor perceptions of the firm’s value and growth prospects.

  • Key measures:

  • Earnings per share (EPS):
    $ext{EPS}= rac{ ext{Net income after taxes}- ext{Preferred stock dividends}}{ ext{Common shares outstanding}}$

  • Price/earnings (P/E) ratio:
    $ext{P/E ratio}= rac{ ext{Market price per share}}{ ext{Earnings per share (EPS)}}$

  • Book value per share (BVPS):
    $ext{BVPS}= rac{ ext{Total stockholders' equity}- ext{Preferred stock}}{ ext{Common shares outstanding}}$

  • Market-to-book value ratio:
    $ext{Market-to-book value ratio}= rac{ ext{Market price per share}}{ ext{Book value per share}}$

  • Dividend yield:
    $ext{Dividend yield}= rac{ ext{Dividend per share}}{ ext{Market price per share}}$

  • Dividend payout ratio:
    $ext{Dividend payout ratio}= rac{ ext{Dividend per share}}{ ext{Earnings per share (EPS)}}$

• Summary of ratios (conceptual view)

  • Liquidity: how well the firm can meet short-term obligations.

  • Activity: how efficiently assets are converted to sales or cash.

  • Leverage: how much the firm is financed by debt.

  • Profitability: how effectively the firm generates earnings.

  • Market value: investor valuation and expected growth.

Practical MGM Enterprises Ratios (Illustrative numbers)

• Balance sheet snapshot (illustrative):

  • Total assets = 450,000; Total liabilities = 280,800; Stockholders’ equity = 194,200.

  • Current assets components and current liabilities are listed; non-current assets include long-term assets; equity includes common stock and retained earnings.

• Key ratio observations from the MGM example (values shown in the source):

  • Current ratio, 2017–2019:
    $ext{Current ratio}<em>{2019} = rac{ ext{Current Assets}</em>{2019}}{ ext{Current Liabilities}<em>{2019}} = 2.21$ $ext{Current ratio}</em>{2018} = 2.10 ext{ (approx.)}$
    $ext{Current ratio}_{2017} = 1.97$

  • Quick ratio (2019, 2018, 2017):
    $ext{Quick ratio} = rac{ ext{Cash}+ ext{Marketable securities}+ ext{Accounts receivable}}{ ext{Current liabilities}}$

  • Accounts receivable turnover (2019, 2018):
    $ext{AR turnover}_{2019}= rac{ ext{Net credit sales}}{ ext{Avg AR}} <br>ightarrow 4.27\% ext{ (approx.)}$

  • Average collection period (2019, 2018):
    $ext{ACP}<em>{2019}= rac{360}{ ext{AR turnover}</em>{2019}} <br>ightarrow 84.31 ext{ days}$

  • Inventory turnover (2019, 2018):
    $ext{Inventory turnover}_{2019}= rac{ ext{COGS}}{ ext{Avg Inventory}} <br>ightarrow 1.11\, ext{times}$

  • Average age of inventory (2019, 2018):
    $ext{Average age}= rac{360}{ ext{Inventory turnover}} <br>ightarrow 281.25 ext{ days (2019)}$

  • Operating cycle:
    $ext{Operating cycle} = ext{ACP} + ext{Average age of inventory} <br>ightarrow 408.63 ext{ days (2019)}$

  • Fixed asset turnover (2019, 2018):
    $ext{Fixed Asset Turnover}= rac{ ext{Sales}}{ ext{Avg Net Fixed Assets}} <br>ightarrow ext{(values shown)}$

  • Total asset turnover (2019, 2018):
    $ext{Total Asset Turnover}= rac{ ext{Net sales}}{ ext{Avg total assets}} <br>ightarrow 0.3879 ext{ (2019)}, 0.5068 ext{ (2018)}$

  • Debt ratio (2019, 2018, 2017):
    $ext{Debt ratio}= rac{ ext{Total liabilities}}{ ext{Total assets}} <br>ightarrow 60.85\% ext{ (2019)}, 65.79\% ext{ (2018)}, 65.07\% ext{ (2017)}$

  • Debt-to-equity ratio (2019, 2018, 2017):
    $ext{Debt-to-equity}= rac{ ext{Total liabilities}}{ ext{Stockholders' equity}} <br>ightarrow 1.72, 2.15, 2.09$

  • Times interest earned (TTI) (2019, 2018, 2017):
    $ext{TTI}= rac{ ext{EBIT}}{ ext{Interest expense}} <br>ightarrow 10 imes,\, 11.10 imes,\ 9.17 imes$

  • Profitability: Gross profit margin (2019, 2018, 2017):
    $ext{Gross profit margin}= rac{ ext{Gross profit}}{ ext{Net Sales}} <br>ightarrow 56.25\%, 53.71\%, 78.72\%$

  • Profit margin (2019, 2018, 2017):
    $ext{Profit margin}= rac{ ext{Net income after taxes}}{ ext{Net Sales}} <br>ightarrow 14.87\%, 12.64\%, 17.36\%$

  • Return on assets (ROA) (2019, 2018):
    $ext{ROA}= rac{ ext{Net Income}}{ ext{Average Total Assets}} <br>ightarrow 5.76\%, 6.19\%$

  • Return on equity (ROE) (2019, 2018):
    $ext{ROE}= rac{ ext{Net income after taxes}- ext{Preferred dividends}}{ ext{Average equity}} <br>ightarrow 15.65\%, 17.92\%$

  • EPS (2019, 2018, 2017):
    $ext{EPS}= rac{ ext{Net income after taxes}- ext{Preferred dividends}}{ ext{Common shares outstanding}} <br>ightarrow 1.19, 1.16, 0.81$

  • P/E ratio (2019, 2018, 2017):
    $ext{P/E}= rac{ ext{Market price per share}}{ ext{EPS}} <br>ightarrow 23.13, 14.70, 13.00$

  • Book value per share (BVPS) (2019, 2018, 2017):
    $ext{BVPS}= rac{ ext{Total equity}- ext{Preferred stock}}{ ext{Common shares outstanding}} <br>ightarrow 10.21, 8.00, 8.05$

  • Market-to-book value ratio (2018, 2019):
    $ext{Market-to-book}= rac{P_0}{BVPS} <br>ightarrow 1.61 ext{ (2018)}, 1.26 ext{ (2019)}$

  • Dividend yield (example values):
    $ext{Dividend yield}= rac{ ext{Dividend per share}}{ ext{Market price per share}} <br>ightarrow 0.52 ext{ (2018)}, 0.50 ext{ (2019)}$

  • Dividend payout ratio (example values):
    $ext{Dividend payout ratio}= rac{ ext{Dividend per share}}{ ext{EPS}} <br>ightarrow 3.82 ext{ (2018)}, 3.84 ext{ (2019)}$

• Limitations of ratio analysis (key points from Cabrera, 2013)

  • Variation in accounting principles across firms can distort ratio comparability (e.g., different depreciation methods).

  • Ratios are static estimates and may not capture true performance; true performance emerges on liquidation and over time.

  • Inflation is not reflected in historical cost-based statements.

  • Financial statements do not include all significant facts; consider notes, context, and industry conditions.

  • Industry averages may be difficult to apply due to diversification and differences across sectors.

  • A single ratio can be misleading without considering its composition (e.g., high current ratio with obsolete inventory).

• Cash flow statement (purpose and structure)

  • Represents the firm’s cash receipts and payments during a period.

  • Important uses:

  • Compare cash flow from operations to net income to assess “quality” of earnings (operating cash flow versus accruals).

  • Identify cash sources and uses to assess dividends, debt repayment, share buybacks, acquisitions, etc.

  • Main sections:

  • Cash flows from operating activities (CFO)

  • Cash flows from investing activities (CFI)

  • Cash flows from financing activities (CFF)

• Cash flows from operating activities (CFO)

  • CFO reflects cash effects of operating activities; includes inflows from customers and other operating receipts, and outflows for payments to suppliers, employees, taxes, and interest.

  • Example CFO calculation (illustrative):

  • Net income, non-cash adjustments (depreciation, amortization), and changes in working capital are used to derive CFO.

  • Typical CFO formula illustrated:
    ext{Net cash provided by operating activities} = ext{Net income} + ext{Non-cash expenses (e.g., depreciation, amortization)} + ext{Other adjustments} \

    ext{(adjustments for changes in working capital)}

• Cash flows from investing activities (CFI)

  • Reflects cash flows from the purchase and sale of long-term assets and investments (e.g., property, plant & equipment; acquisition of investments; proceeds from sale of assets).

  • Example items: receipts from sale of available-for-sale securities, sale of equipment, purchase of equipment, loans granted, purchases of debt or equity securities.

• Cash flows from financing activities (CFF)

  • Reflects cash flows from borrowing and repayments, equity financing, and payments to owners (dividends and share repurchases).

  • Examples: proceeds from issuing bonds or equity, repayments of debt, payment of dividends, repurchase of treasury stock, redemption of preferred stock.

• Relationship to other statements

  • The cash flow statement complements the balance sheet and income statement by showing liquidity and cash management over the period.

  • The cash flow statement is governed by standards (e.g., Philippine Accounting Standards No. 7 in the course material).

MGM Enterprises: Integrated Cash Flow Example (2019)

• Given balance sheet data (2018 and 2019) and additional information, the exercise is to prepare the cash flow statement for the year ended 2019.

  • Balance sheet similarity points (examples): cash, marketable securities, accounts receivable, merchandise inventory, prepaid insurance, land/buildings/equipment, accumulated depreciation, accounts payable, salaries payable, notes payable, bonds payable, common stock, retained earnings.

  • Additional information includes:

  • Sale of available-for-sale securities (cost 87,750; sale price 90,000)

  • Sale of equipment (cost 18,750; book value 3,750; sale price 4,500)

  • Bond payable at par (310,125)

  • Purchase of computers (310,125 cash)

  • Dividends paid (22,500)

  • Net income for 2019 (45,000)

  • Proceeds from notes payable used for operating purposes

• MGM Enterprises – Statement of Cash Flows (Year Ended 12/31/2019) – Key figures

  • Cash flows from operating activities:

  • Net income: 100,000 (example in the narrative)

  • Adjustments:

    • Gain on sale of available-for-sale securities: $(2,250)$

    • Gain on sale of equipment: $(750)$

    • Depreciation expense: 75,000

    • Change in working capital items (e.g., accounts receivable, inventory, prepaid insurance, accounts payable, salaries payable, notes payable): net effect $(158,250)$

  • Net cash used in operating activities: $(113,250)$ (negative)

  • Cash flows from investing activities:

  • Proceeds from sale of available-for-sale securities: 90,000

  • Proceeds from sale of equipment: 4,500

  • Purchase of equipment: $(310,125)$

  • Net cash used in investing activities: $(215,625)$

  • Cash flows from financing activities:

  • Proceeds from bond issuance: 375,000

  • Dividends paid: $(22,500)$

  • Net cash provided by financing activities: 352,500

  • Net increase in cash: 23,625

  • Beginning cash: 63,750

  • Ending cash: 142,375

• Additional detailed explanation (about the cash flow logic):

  • Net cash from operating activities is derived from net income adjusted for non-cash items and changes in working capital.

  • Gains from sales of securities and equipment reduce cash from operations because they are investing activities and do not provide cash from operating activities.

  • Depreciation is added back because it is a non-cash expense.

  • The change in working capital (accounts receivable, inventory, prepaid expenses, accounts payable, salaries payable, notes payable) affects cash flow positively or negatively depending on whether they increase or decrease.

Practical Notes and Implications

• Cash flow statements provide insight into the quality of earnings (CFO vs net income) and the firm’s ability to generate cash to fund dividends, debt repayments, and investments.

• A firm can show high profitability but weak cash flow if working capital grows or if non-cash revenue is high; conversely, strong CFO can support greater flexibility for dividends and investments.

• Ratio analysis and cash flow analysis should be used together with footnotes and management discussion to gain a complete view of the firm’s financial health.

• Ethical and practical considerations:

  • Financial reporting should reflect true performance; misrepresentation can mislead investors and regulators.

  • Analysts should consider accounting policy differences and industry benchmarks before making cross-firm comparisons.

  • Economic context, inflation effects, and long-term sustainability should be weighed beyond raw numbers.

Quick Formulas Recap (LaTeX-ready)

• Current ratio: $ext{Current ratio}= rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

• Quick ratio: $ext{Quick ratio}= rac{ ext{Cash}+ ext{Marketable securities}+ ext{Accounts receivable}}{ ext{Current Liabilities}}$

• Cash position ratio: $ext{Cash position ratio}= rac{ ext{Cash}+ ext{Marketable securities}}{ ext{Current Liabilities}}$

• Accounts receivable turnover: $ext{AR turnover}= rac{ ext{Net credit sales}}{ ext{Average accounts receivable}}$

• Average collection period: $ext{ACP}= rac{360}{ ext{AR turnover}}$

• Inventory turnover: $ext{Inventory turnover}= rac{ ext{COGS}}{ ext{Average inventory}}$

• Average age of inventory: $ext{Average age of Inventory}= rac{360}{ ext{Inventory turnover}}$

• Operating cycle: $ext{Operating cycle}= ext{ACP}+ ext{Average age of Inventory}$

• Fixed asset turnover: $ext{Fixed Asset Turnover}= rac{ ext{Sales}}{ ext{Average net fixed assets}}$

• Total asset turnover: $ext{Total Asset Turnover}= rac{ ext{Net sales}}{ ext{Average total assets}}$

• Debt ratio: $ext{Debt ratio}= rac{ ext{Total liabilities}}{ ext{Total assets}}$

• Debt-to-equity: $ext{Debt-to-equity}= rac{ ext{Total liabilities}}{ ext{Stockholders' equity}}$

• Times interest earned: $ext{TTI}= rac{ ext{EBIT}}{ ext{Interest expense}}$

• Gross profit margin: $ext{Gross profit margin}= rac{ ext{Gross profit}}{ ext{Net Sales}}$

• Profit margin: $ext{Profit margin}= rac{ ext{Net income after taxes}}{ ext{Net Sales}}$

• ROA: $ext{ROA}= rac{ ext{Net income}}{ ext{Average total assets}}$

• ROE: $ext{ROE}= rac{ ext{Net income after taxes}- ext{Preferred stock dividends}}{ ext{Average stockholders' equity}- ext{Preferred stock}}$

• Equity multiplier: $ext{Equity multiplier}= rac{ ext{Average total assets}}{ ext{Average stockholders' equity}}$

• ROE (DuPont): $ext{ROE}= ext{ROA} imes ext{Equity multiplier}$

• EPS: $ext{EPS}= rac{ ext{Net income after taxes}- ext{Preferred stock dividends}}{ ext{Common shares outstanding}}$

• P/E: $ext{P/E}= rac{ ext{Market price per share}}{ ext{EPS}}$

• BVPS: $ext{BVPS}= rac{ ext{Total stockholders' equity}- ext{Preferred stock}}{ ext{Common shares outstanding}}$

• Market-to-book: $ext{Market-to-book}= rac{P_0}{BVPS}$

• Dividend yield: $ext{Dividend yield}= rac{ ext{Dividend per share}}{ ext{Market price per share}}$

• Dividend payout ratio: $ext{Dividend payout ratio}= rac{ ext{Dividend per share}}{ ext{EPS}}$

• Cash flow statement structure (high level): CFO, CFI, CFF; CFO formula example (illustrative):
  $ext{CFO} = ext{Net income} + ext{Non-cash expenses} + ext{Changes in working capital}$

If you want, I can tailor these notes to a specific chapter page or focus more on a subset (e.g., only ratios or only cash flow) for faster study.