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Chapter 2
Introduction to
Financial
Statement
Analysis
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Chapter Outline
2.1 Firms Disclosure of Financial Information
2.2 The Balance Sheet
2.3 Balance Sheet Analysis
2.4 The Income Statement
2.5 Income Statement Analysis
2.6 The Statement of Cash Flows
2.7 Other Financial Statement Information
2.8 Financial Reporting in Practice
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Learning Objectives
Know why the disclosure of financial information
through financial statements is critical to investors
Understand the function of the balance sheet
Use the balance sheet to analyze a firm
Understand how the income statement is used
Analyze a firm through its income statement, including
using the DuPont Identity
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Learning Objectives (contd)
Interpret a statement of cash flows
Know what managements discussion and analysis and
the statement of stockholders equity are
Analyze the role of accounting manipulation in the
Enron and WorldCom bankruptcies
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2.1 Firms Disclosure of Financial
Information
Financial statements are accounting reports that
a firm issues periodically to describe its past
performance.
Investors, financial analysts, managers, and
other interested parties such as creditors rely on
financial statements to obtain reliable
information about a corporation.
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2.1 Firms Disclosure of Financial
Information
Financial Statements
The four required financial statements are
! The balance sheet,
! The income statement,
! The statement of cash flows, and the
! The statement of stockholders equity
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2.1 Firms Disclosure of Financial
Information
GAAP
! In the United States, the Financial Accounting
Standards Board (FASB) establishes Generally
Accepted Accounting Principles (GAAP) to
provide a common set of rules and a standard format
for public companies to use when they prepare their
reports.
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2.1 Firms Disclosure of Financial
Information
Audited Statements
! Investors also need some assurance that the
financial statements are prepared accurately.
Corporations are required to hire a neutral third
party, known as an auditor, to check the annual
financial statements, ensure they are prepared
according to GAAP, and provide evidence to
support that the information is reliable.
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2.2 The Balance Sheet
The balance sheet shows the current financial
position (assets, liabilities, and stockholders
equity) of the firm at a single point in time.
Stockholders equity is the book value of the
firms equity. It differs from the market value of
the firms equity, its market capitalization,
because of the way assets and liabilities are
recorded for accounting purposes.
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Table 2.1 Global Corporation Balance
Sheet for 2007 and 2006
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The Balance Sheet Identity
The two sides of the balance sheet must balance
Assets = Liabilities + Stockholders Equity (Eq. 2.1)
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2.2 The Balance Sheet
Current Assets
! Cash and other marketable securities, which are short-term,
low-risk investments that can be easily sold and converted to
cash like government debt that matures within a year
! Accounts receivable, which are 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, which is a catch-all category that
includes items such as prepaid expenses
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2.2 The Balance Sheet
Long-Term Assets
! Assets like real estate or machinery that produce
tangible benefits for more than one year
! Reduced by the value recorded for this equipment
through a yearly deduction called depreciation
according to a depreciation schedule that depends on
an assets life span
! Other long-term assets can include such items as
property not used in business operations
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2.2 The Balance Sheet
Current Liabilities
! Accounts payable, the amounts owed to suppliers for
products or services purchased with credit
! Notes payable, loans that must be repaid in the next year.
Any repayment of long-term debt that will occur within the
next year would also be listed here as current maturities of
long-term debt
! Accrual items, such as salary or taxes that are owed but have
not yet been paid, and deferred or unearned revenue
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Net Working Capital
The difference between current assets and
current liabilities is the firms net working
capital, the capital available in the short term to
run the business.
Net Working Capital = Current Assets Current Liabilities
(Eq. 2.2)
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2.2 The Balance Sheet
Long-Term Liabilities
! 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. That loan would
appear on the balance sheet as long-term debt,
which is any loan or debt obligation with a maturity
of more than a year.
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2.2 The Balance Sheet
Stockholders Equity
! Book value of equity: represents the net worth of
the firm from an accounting perspective aka Equity
(this is located in the balance sheet under owners
equity or stockholders equity)
! Market capitalization: the total market value of a
firms equity equals the market price per share times
the number of shares
market price per share x the number of shares
If Global has 3.6 million shares outstanding, and these shares are trading
for a price of $10 per share, what is Globals market capitalization? How
does the market capitalization compare to Globals book value of equity?
Problem
What we know
Market capitalization is equal to price per share times shares outstanding.
(3.6 million shares) ! ($10/share) = $36 million
We can find Globals book value of equity at the bottom of the right side
of its balance sheet.
Book Value
=
$22.2 million
Global must have sources of value that do not appear on
the balance sheet. These include potential opportunities
for growth, the quality of the management team,
relationships with suppliers and customers, etc.
Evaluate
Ron Johnson help shape Targets
image, Apples Stores, and now
JC Pennys Sales Floor
Mortorola stock prices
increase when Google
announced it will acquire
the company
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2.3 Balance Sheet Analysis
We can also learn a great deal of useful
information from a firms balance sheet that
goes beyond the book value of the firms equity
by analyzing the balance sheet to assess the
firms value, its leverage, and its short-term cash
needs
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Market-to-Book Ratio
The ratio of a firms market capitalization to the
book value of stockholders equity:
(Eq. 2.3)
note:
book value of equity = equity = stockholders/owners equity
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Figure 2.1
Market-to-Book Ratios in 2006
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Debt-Equity Ratio
The debt-equity ratio is a common ratio used to
assess a firms leverage
(Eq. 2.4)
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Enterprise Value
The enterprise value of a firm assesses the
value of the underlying business assets,
unencumbered by debt and separate from any
cash and marketable securities
Enterprise Value = Market Value of Equity + Debt Cash (Eq. 2.4)
In October 2007, H.J. Heinz Co. (HNZ) had a share price
of $46.78, 319.1 million shares outstanding, a market-to-
book ratio of 8.00, a book debt-equity ratio of 2.62, and
cash of $576 million. What was Heinzs market
capitalization? What was its enterprise value?
What we know
Share Price
$46.78
Shares outstanding
319.1 million
Market-to-book
8.00
Cash
$576 million
D e b t - t o - e q u i t y
(book)
2.62
Enterprise value = Market capitalization + Debt Cash
Enterprise value = Market capitalization + Debt $576 million
What we know
Share Price
$46.78
Shares outstanding
319.1 million
Market-to-book
8.00
Cash
$576 million
D e b t - t o - e q u i t y
(book)
2.62
Enterprise value = Market capitalization + Debt $576 million
Market capitalization =
$46.78 x 319.1 million
Enterprise value =
Share Price x Shares Outstanding
$14.93 billion
$14.93 billion + Debt $576 million
What we know
Share Price
$46.78
Shares outstanding
319.1 million
Market-to-book
8.00
Cash
$576 million
D e b t - t o - e q u i t y
(book)
2.62
Enterprise value = $14.93 billion + Debt $576 million
Debt
equity
2.62 =
8.0
Market Value
Book Value
=
1. we know that the debt divided by the equity equals 2.62
2. we also know that the
market value divided by the
book value equals 8.0
What else do we know?
3. we know
that the equity
and book
value are one
in the same
4. we can find know the market value
by multiplying share price times shares
outstanding: $46.78 x 319.1M = 14.93B
5. So market value equals
$14.93B
we can begin to solve the
rest of the puzzle.
What we know
Share Price
$46.78
Shares outstanding
319.1 million
Market-to-book
8.00
Cash
$576 million
D e b t - t o - e q u i t y
(book)
2.62
Enterprise value = $14.93 billion + Debt $576 million
Debt
equity
2.62 =
8.0
Market Value
Book Value
=
What else do we know?
solve for book
value
8.0
$14.93B
Book Value
=
=
8.0
$14.93B
Book Value
=
8.0
$14.93B
Book Value
=
Book Value Book Value
1 1
8.0 $14.93B = (Book Value)
8.0 8.0
1.86B = Book Value
( ) ( )
now that you have the
book value (aka
equity) you can use it
find the debt
Debt
equity
2.62 =
Debt
1.86B
2.62 =
=
Now you have all the information to find the
enterprise value.
4.87B
1.86M
2.62 = =
Enterprise value = Market capitalization + Debt Cash
Market Capitalization 14.93B
Debt 4.90B
Cash .576B
Enterprise Value =14.93 + 4.90 .576 = $19.254 billion.
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Current Ratio
The ratio of current assets to current liabilities
(Eq. 2.6)
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Quick Ratio (Acid-Test Ratio)
The ratio of current assets other than inventory
to current liabilities.
(Eq. 2.6)
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Table 2.2 Balance Sheet Ratios
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2.4 The Income Statement
The income statement lists the firms revenues
and expenses over a period of time. The last or
bottom line of the income statement shows the
firms net income, which is a measure of its
profitability during the period. The income
statement is sometimes called a profit and loss,
or P&L, statement and the net income is also
referred to as the firms earnings.
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Table 2.3 Global Corporations Income
Statement Sheet for 2007 and 2006
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Earnings Per Share
Net income reported on a per-share basis
(Eq. 2.8)
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2.5 Income Statement Analysis
The income statement provides very useful
information regarding the profitability of a
firms business and how it relates to the value of
the firms shares. We now discuss several ratios
that are often used to evaluate a firms
performance and value.
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2.5 Income Statement Analysis
Profitability Ratios
! Gross Margin
! Operating Margin
! Net Profit Margin
Asset Efficiency
Working Capital Ratios
EBITDA
Leverage Ratios
Investment Returns
The DuPont Identity
Valuation Ratios
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Example 2.1a EBITDA
Problem:
JH Metals recently reported $9,000 of sales, $6,000 of
operating costs other than depreciation, and $1,500 of
depreciation. The company had no amortization
charges and no non-operating income. It had issued
$4,000 of bonds that carry a 7% interest rate, and its
federal-plus-state income tax rate was 40%. What was
the firm's operating income, or EBITDA?
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Example 2.1a EBITDA
Solution:
Plan:
Using the structure of the Income Statement, subtract the proper
items from sales. Because interest expense is not needed for the
calculation of EBITDA, we can ignore it for this problem.
Sales
$9,000
Operating Costs
$6,000
Depreciation
$1,500
Outstanding Bonds (7%)
$4,000
Tax Rate
40%
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Example 2.1a EBITDA
Execute:
Sales $9,000
Operating costs excluding depreciation $6,000
Depreciation $1,500
Operating income (EBIT) $1,500
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Example 2.1a EBITDA
Evaluate:
Operating Income (EBITDA) represents funds
generated by the business model and does not include
the subtraction of interest, which is a cost identified
separately as the cost of using debt.
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Operating Margin
The operating margin reveals how much a
company earns before interest and taxes from
each dollar of sales
(Eq. 2.10)
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Net Profit Margin
(Eq. 2.11)
The net profit margin shows the fraction of each
dollar in revenues that is available to equity
holders after the firm pays interest and taxes
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(Eq. 2.12)
Asset Efficiency: Asset Turnover
A first broad measure of efficiency is asset
turnover
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Asset Efficiency: Fixed Asset Turnover
Since total assets includes assets like cash that
are not directly involved in generating sales,
Globals manager might also look at Globals
fixed asset turnover
(Eq. 2.13)
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(Eq. 2.14)
Working Capital Ratios: Accounts
Receivable Days
The firms accounts receivable in terms of the
number of days worth of sales that it represents
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(Eq. 2.15)
Working Capital Ratios: Inventory
Turnover
How efficiently we turn our inventory into sales
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(Eq. 2.16)
Investment Returns
Evaluating the firms return on investment by
comparing its income to its investment
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(Eq. 2.17)
DuPont Identity
This expression says that ROE can be thought of
as net income per dollar of sales (profit margin)
times the amount of sales per dollar of equity
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(Eq. 2.18)
DuPont Analysis
This final expression says that ROE is equal to
net income per dollar of sales (profit margin)
times sales per dollar of assets (asset turnover)
times assets per dollar of equity (a measure of
leverage called the equity multiplier).
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Profit
Margin
Asset
Turnover
Equity
Multiplier
Wal-Mart
3.6% 2.4 2.6
Nordstrom
7.7% 1.7 2.4
Example 2.3 DuPont Analysis
Problem:
The following table contains information about Wal-Mart (WMT)
and Nordstrom (JWN). Compute their respective ROEs and then
determine how much Wal-Mart would need to increase its profit
margin in order to match Nordstroms ROE.
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Example 2.3 DuPont Analysis
Solution:
Plan:
The table contains all the relevant information to use the DuPont
Identity to compute the ROE. We can compute the ROE of each
company by multiplying together its profit margin, asset turnover,
and equity multiplier. In order to determine how much Wal-Mart
would need to increase its margin to match Nordstroms ROE, we
can set Wal-Marts ROE equal to Nordstroms, keep its turnover
and equity multiplier fixed, and solve for the profit margin.
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Example 2.3 DuPont Analysis
Execute:
Using the DuPont Identity, we have:
!
ROE
WMT
= 3.6% x 2.4 x 2.6 = 22.5%
!
ROE
JWN
= 7.7% x 1.7 x 2.4 = 31.4%
Now, using Nordstroms ROE, but Wal-Marts asset
turnover and equity multiplier, we can solve for the
margin that Wal-Mart needs to achieve Nordstroms
ROE:
! 31.4% = Margin x 2.4 x 2.6
! Margin = 31.4% / 6.24 = 5.0%
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Example 2.3 DuPont Analysis
Evaluate:
Wal-Mart would have to increase its profit
margin from 3.6% to 5% in order to match
Nordstroms ROE. It would be able to achieve
Nordstroms ROE even with a lower margin
than Nordstrom (5.0% vs. 7.7%) because of its
higher turnover and slightly higher leverage.
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Valuation Ratio
Analysts and investors use a number of ratios to gauge
the market value of the firm. The most important is the
firms price-earnings ratio (P/E): The P/E ratio is a
simple measure that is used to assess whether a stock is
over- or under-valued based on the idea that the value
of a stock should be proportional to the level of
earnings it can generate for its shareholders.
(Eq. 2.19)
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Example 2.4
Computing Profitability and Valuation Ratios
Problem:
Consider the following data from 2006 for Wal-Mart Stores and Target
Corporation ($ billions):
Compare Wal-Mart and Targets operating margin, net profit margin, P/E ratio,
and the ratio of enterprise value to operating income and sales.
Wal-Mart Stores (WMT)
Target Corporation (TGT)
Sales 345 60
Operating Income 19 5
Net Income 11 3
Market Capitalization 190 49
Cash 7 1
Debt 36 10
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Example 2.4
Computing Profitability and Valuation Ratios
Solution
Plan:
The table contains all of the raw data, but we need to
compute the ratios using the inputs in the table.
! Operating Margin = Operating Income / Sales
! Net Profit Margin = Net Income / Sales
! P/E ratio = Price / Earnings
! Enterprise value to operating income = Enterprise Value /
Operating Income
! Enterprise value to sales = Enterprise Value / Sales
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Example 2.4
Computing Profitability and Valuation Ratios
Execute:
Wal-Mart had an operating margin of 19/345 = 5.5%, a net
profit margin of 11/345 = 3.2%, and a P/E ratio of 190/11 =
17.3. Its enterprise value was 190 + 36 7 = $219 billion, which
has a ratio of 219/19 = 11.5 to operating income and 219/345 =
0.64 to sales.
Target had an operating margin of 5/60 = 8.3%, a net profit
margin of 3/60 = 5.0%, and a P/E ratio of 49/3 = 16.3. Its
enterprise value was 49 + 10 1 = $58 billion, which has a ratio
of 58/5 = 11.6 to operating income and 58/60 = 0.97 to sales.
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Example 2.4
Computing Profitability and Valuation Ratios
Evaluate:
Note that despite their large difference in size, Target
and Wal-Marts P/E and enterprise value to operating
income ratios were very similar. Targets profitability
was somewhat higher than Wal-Marts, however, this
explains the difference in the ratio of enterprise value to
sales.
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Table 2.4 Income Statement Ratios
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Table 2.4 Income Statement Ratios
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2.6 The Statement of Cash Flows
The firms statement of cash flows utilizes the
information from the income statement and
balance sheet to determine how much cash the
firm has generated, and how that cash has been
allocated, during a set period. Cash is important
because it is needed to pay bills and maintain
operations and is the source of any return of
investment for investors.
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2.6 The Statement of Cash Flows
The statement of cash flows is divided into three
sections which roughly correspond to the three
major jobs of the financial manager:
! Operating activities
! Investment activities
! Financing activities
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Table 2.5 Global Corporations Statement of
Cash Flows for 2007 and 2006
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2.6 The Statement of Cash Flows
Operating Activity
Use the following guidelines to adjust for changes in
working capital:
! Accounts receivable: When a sale is recorded as part of net
income, but the cash has not yet been received from the
customer, we must adjust the cash flows by deducting the
increases in accounts receivable. This increase represents
additional lending by the firm to its customers and it reduces
the cash available to the firm.
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2.6 The Statement of Cash Flows
Operating Activity (contd)
! Accounts payable: Similarly, we add increases in
accounts payable. Accounts payable represents
borrowing by the firm from its suppliers. This
borrowing increases the cash available to the firm.
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2.6 The Statement of Cash Flows
Operating Activity (contd)
! Inventory: Finally, we deduct increases to inventory.
Increases to inventory are not recorded as an
expense and do not contribute to net income (the
cost of the goods are only included in net income
when the goods are actually sold). However, the cost
of increasing inventory is a cash expense for the firm
and must be deducted.
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2.6 The Statement of Cash Flows
Investment Activity
! Subtract the actual capital expenditure that the firm
made. Similarly, also deduct other assets purchased
or investments made by the firm, such as
acquisitions.
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2.6 The Statement of Cash Flows
Financing Activity
! The last section of the statement of cash flows shows
the cash flows from financing activities. Dividends
paid and the difference between a firms net income
and the amount it spends on dividends, which is
referred to as the firms retained earnings for that
year.
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Example 2.4a Analyzing a Statement of
Cash Flows
Problem:
Smithson, Inc. had $75,000 in cash at the end of 2004. At year-
end 2005, the company had $155,000 in cash. We know cash
flow from operating activities totaled $1,250,000 and cash flow
from long-term investing activities totaled -$1,000,000.
Furthermore, Smithson issued $250,000 in long-term debt last
year to fund new projects, increase liquidity, and to buy back
some common stock. If dividends paid to common stockholders
equaled $25,000, how much common stock did Smithson
repurchase last year? (Assume that the only financing activities
in which Smithson engaged involved long-term debt, payment of
common dividends, and common stock.)
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Example 2.4a Analyzing a Statement of
Cash Flows
Smithson, Inc.
Beginning Cash
$75,000
Ending Cash
$155,000
Cash from Operations
$1,250,000
Cash from Investing
-$1,000.000
Long Term Debt Issued
$250,000
Dividends Paid
$25,000
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Example 2.4a Analyzing a Statement of
Cash Flows
Solution:
Plan:
Calculate the change in cash for the year.
Solve for CF from financing using the following formula:
! CF from operations + CF from investing + CF from financing = " in cash
We have been given the cash flows from two of the three
financing activities, so we can calculate the amount of stock that
was repurchased using:
! "L-T debt + "Common stock Pmt. of common dividends = CF from
financing
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Example 2.4a Analyzing a Statement of
Cash Flows
Execute:
Cash at the end of the year $155,000
Cash at the beginning of the year -75,000
Change in cash $ 80,000
$1,250,000 + (-$1,000,000) + CF from financing = $ 80,000
CF from financing = -$170,000.
$250,000 + "Common stock - $25,000 = -$170,000
"Common stock = -$395,000.
The negative change in common stock tells us that the firm repurchased
$395,000 worth of its common stock.
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Example 2.4a Analyzing a Statement of
Cash Flows
Evaluate:
The negative change in common stock tells us that the
firm used cash to buy back $395,000 worth of its
common stock, known as Treasury Stock, and is a use
of cash, shown on the Cash Flow Statement.
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Payout Ratio and Retained Earnings
(Eq. 2.21)
Retained Earnings = Net IncomeDividends (Eq. 2.20)
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Example 2.5
The Impact of Depreciation on Cash Flow
Problem:
Suppose Global had an additional $1 million
depreciation expense in 2007. If Globals tax rate on
pretax income is 26%, what would be the impact of
this expense on Globals earnings? How would it
impact Globals cash at the end of the year?
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Example 2.5
The Impact of Depreciation on Cash Flow
Solution:
Plan:
Depreciation is an operating expense, so Globals operating
income, EBIT, and pretax income would be affected. With a tax
rate of 26%, Globals tax bill will decrease by 26 cents for every
dollar that pretax income is reduced. In order to determine how
Globals cash would be impacted, we have to determine the
effect of the additional depreciation on cash flows. Recall that
depreciation is not an actual cash outflow, even though it is
treated as an expense, so the only effect on cash flow is through
the reduction in taxes.
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Example 2.5
The Impact of Depreciation on Cash Flow
Execute:
Globals operating income, EBIT, and pretax income would fall by $1 million
because of the $1 million in additional operating expense due to depreciation.
This $1 million decrease in pretax income would reduce Globals tax bill by
26% ! $1 million = $0.26 million. Therefore, net income would fall by 1
0.26 = $0.74 million.
On the statement of cash flows, net income would fall by $0.74 million, but
we would add back the additional depreciation of $1 million because it is not
a cash expense. Thus, cash from operating activities would rise by 0.74 + 1 =
$0.26 million. Thus, Globals cash balance at the end of the year would
increase by $0.26 million, the amount of the tax savings that resulted from the
additional depreciation deduction.
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Example 2.5
The Impact of Depreciation on Cash Flow
Evaluate:
The increase in cash balance comes completely from
the reduction in taxes. Because Global pays $0.26
million less in taxes even though its cash expenses have
not increased, it has $0.26 million more in cash at the
end of the year.
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2.7 Other Financial Statement
Information
Other pieces of information contained in the
financial statements:
! Management Discussion and Analysis
! Statement of Stockholders Equity
! Notes to the Financial Statements
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2.8 Financial Reporting in Practice
Even with safeguards such as GAAP and
auditors, though, financial reporting abuses
unfortunately do take place. Two of the most
infamous recent examples:
! Enron
! WorldCom
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2.8 Financial Reporting in Practice
The Sarbanes-Oxley Act
In 2002, Congress passed the Sarbanes-Oxley Act (SOX). While
SOX contains many provisions, the overall intent of the
legislation was to improve the accuracy of information given to
both boards and to shareholders. SOX attempted to achieve this
goal in three ways:
! Overhauling incentives and independence in the auditing process
! Stiffening penalties for providing false information
! Forcing companies to validate their internal financial control processes.
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Chapter Quiz
What is the role of an auditor?
What is depreciation designed to capture?
What does a firms high debt-to-equity ratio tell
you?
How do you use the price-earnings (P/E) ratio to
gauge the market value of a firm?
Why does a firms net income not correspond to
cash earned?
