Topic 2: (Cont’d)

COMPANY ANALYSIS
 Objectives
Understand the information provided by financial statements

Differentiate between book and market values

Know the difference between accounting income and cash flow

Analyse and evaluate financial ratios of a company

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 Contents
Financial statements Financial ratios Self - study
Definition & types Overview Book & market values
Accounting income &
Balance sheet Financial ratios analysis
cash flow
Income statement Probability ratios Practice
Cash flow statement Performance ratios
Market ratios

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Financial statements

Definition & types

Balance sheet

Income statement

Cash flow statement

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Financial Statements – What are they?
• A set of documents that show your company's financial status at a
specific point of time.
• Include key data on what a company owns and owes and how much
money it has made and spent.

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Types of financial statements

Statement of
Income Cashflow
Financial Position
Statement Statement
(Balance Sheet)

Notes

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Where to find?

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Where to find?

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Where to find?

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Financial position/Balance sheet

❑ An accountant’s snapshot of the firm’s

accounting value at a specific point of time
❑ The Financial Position Identity is:

Assets ≡ Liabilities + Stockholder’s Equity

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Financial position/Balance sheet
The assets are listed in2010 order by
2009
2012 2011
Current assets: the length
Current Liabilities: of time it would
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 normally
Notes payable take a firm with 50ongoing
53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 operations to
Total current liabilitiesconvert them
$486 into
$455
Total current assets $761 $707 cash.
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation (550) (460) Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Clearly, cash is much more liquid
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
than property, plant, and
Capital surplus 347 327
Accumulated retained earnings 390 347
equipment.
Less treasury stock (26) (20)
Total assets $1,879 $1,742 Total equity $805 $725
Total liabilities and stockholder's equity $1,879 $1,742

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Financial position/Balance sheet
When analyzing a Financial Position, a person should be aware of
three concerns:
- Liquidity

- Debt versus equity

- Value versus cost

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Liquidity
Refers to the ease and quickness with which assets can be converted to
cash—without a significant loss in value
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely the firm is to experience
problems meeting short-term obligations.
Liquid assets frequently have lower rates of return than fixed assets.

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Debt versus Equity

Creditors generally receive the first claim on the firm’s cash flow.
Shareholder’s equity is the residual difference between assets and
liabilities.

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Value versus Cost
Under Generally Accepted Accounting Principles (GAAP), audited
financial statements of firms in the U.S. carry assets at cost.
Market value is the price at which the assets, liabilities, and equity could
actually be bought or sold, which is a completely different concept from
historical cost.

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The Income Statement

Measures financial performance over a specific period of time

The accounting definition of income is:

Revenue – Expenses ≡ Income

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The Income Statement
U.S.C.C. Income Statement
The operations Total operating revenues $2,262
Cost of goods sold 1,655
section of the Selling, general, and administrative expenses 327
income statement Depreciation 90
reports the firm’s Operating income $190
Other income 29
revenues and Earnings before interest and taxes $219
expenses from Interest expense 49
principal Pretax income $170
Taxes 84
operations. Current: $71
Deferred: $13
Net income $86

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The Income Statement
U.S.C.C. Income Statement
Total operating revenues $2,262
The non-operating Cost of goods sold 1,655
section of the Selling, general, and administrative expenses 327
Depreciation 90
income statement
Operating income $190
includes all Other income 29
financing costs, Earnings before interest and taxes $219
Interest expense 49
such as interest Pretax income $170
expense. Taxes 84
Current: $71
Deferred: $13
Net income $86

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The Income Statement
U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Usually a separate Interest expense 49
section reports Pretax income $170
Taxes 84
the amount of Current: $71
taxes levied on Deferred: $13
income. Net income $86

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The Income Statement
U.S.C.C. Income Statement
Total operating revenues $2,262
Cost of goods sold 1,655
Selling, general, and administrative expenses 327
Depreciation 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense 49
Net income is the Pretax income $170
“bottom line.” Taxes 84
Current: $71
Deferred: $13
Net income $86

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The Income Statement EPS & DPS

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The Income Statement EPS & DPS

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The Income Statement
There are two things to keep in mind when analyzing
an income statement:
1. Non-Cash Items
2. Time and Costs

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The Income Statement
Non-Cash Items
❑ Depreciation is the most apparent.
❑ Another non-cash item is deferred taxes, which does not
represent a cash flow.
❑ Thus, net income is not cash.

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The Income Statement

Time and Costs

❑ In the short-run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can vary such
inputs as labor and raw materials.
❑ In the long-run, all inputs of production (and hence costs) are
variable.
❑ Financial accountants do not distinguish between variable costs
and fixed costs. Instead, accounting costs usually fit into a
classification that distinguishes product costs from period costs.

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 Financial Cash Flow

In finance, the most important item that can be extracted

from financial statements is the actual cash flow of the
firm.
Since there is no magic in finance, it must be the case that
the cash flow received from the firm’s assets must equal
the cash flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)

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The Statement of Cash Flows
There is an official accounting statement called the statement of cash
flows.
This helps explain the change in accounting cash.
The three components of the statement of cash flows are:
◦ Cash flow from operating activities
◦ Cash flow from investing activities
◦ Cash flow from financing activities

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U.S.C.C. Cash Flow from Operations
Operations
To calculate cash flow Net Income $86
from operations, start Depreciation 90
Deferred Taxes 13
with net income, add
Changes in Assets and Liabilities
back non-cash items Accounts Receivable -24
like depreciation and Inventories 11
Accounts Payable 16
adjust for changes in Accrued Expenses 18
current assets and Other -8
liabilities (other than Total Cash Flow from Operations $202
cash).

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U.S.C.C. Cash Flow from Investing

Cash flow from Acquisition of fixed assets -$198

investing activities Sales of fixed assets 25
Total Cash Flow from Investing Activities -$173
involves changes in
capital assets:
acquisition of fixed
assets and sales of
fixed assets (i.e., net
capital expenditures).

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U.S.C.C. Cash Flow from Financing

Cash flows to and Retirement of debt (includes notes) -$73

from creditors and Proceeds from long-term debt sales 86
Change in notes payable -3
owners include Dividends -43
changes in equity and Repurchase of stock -6
debt. Proceeds from new stock issue 43

Total Cash Flow from Financing $4

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U.S.C.C. Statement of Cash Flows
Operations
Net Income $86
Depreciation 90
The statement of Deferred Taxes 13
Changes in Assets and Liabilities
cash flows is the Accounts Receivable -24
Inventories 11
addition of cash Accounts Payable
Accrued Expenses
16
18
flows from Other
Total Cash Flow from Operations
-8
$202
Investing Activities
operations, Acquisition of fixed assets -$198
Sales of fixed assets 25
investing, and Total Cash Flow from Investing Activities -$173
Financing Activities
financing. Retirement of debt (includes notes) -$73
Proceeds from long-term debt sales 86
Notes Payable -3
Dividends -43
Repurchase of stock -6
Proceeds from new stock issue 43
Total Cash Flow from Financing $4
Change in Cash (on the Financial Position) $33

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Quick Quiz
What is the difference between book value and market value? Which
should we use for decision making purposes?
What is the difference between accounting income and cash flow? Which
do we need to use when making decisions?
What is the difference between average and marginal tax rates? Which
should we use when making financial decisions?
How do we determine a firm’s cash flows? What are the equations, and
where do we find the information?

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Financial ratios

Overview

Financial ratios analysis

5 groups of ratios

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Overview
Aim:
Evaluate performance, profitability and potential growth of a business
taking into its objectives and strategies.

2 types:
- Analysing financial ratios
- Analysing cash flow

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 Financial ratios analysis
Value of a company is determined by
profitability and growth potentials
=> 4 policies:
- Operating
- Investment
- Finance
- Dividend
Aim to evaluate efficiency of 4 policies =>
Assess profitability and growth potentials
=> Base investment decisions

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Financial ratios analysis
Method of financial ratios analysis

Company A

Benchmark

Company B

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 Profitability evaluation
Gross (profit) margin: Gross profit / Net sales
Measure how much profit a business makes after the cost of goods and services compared to net sales.

Operating (profit) margin: Operating income / Net sales

Measure how much profit a company generates from net sales after accounting for the cost of goods sold and
operating expenses.
(Net) profit margin: Net income / Net sales
Measure how much profit a company finally generates from net sales after accounting for the cost of goods
sold, operating expenses, other expenses, tax, and interest.
Return on assets (ROA): Net income / Total assets
Determine how much profits they generate from total assets or resources, including current and noncurrent
assets.
Return on equity (ROE): Net income / Equity
Measures how much profit a business generates from shareholders’ equity.

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Profitability evaluation – Dupont analysis

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 Efficiency evaluation
Asset turnover: Net sales / Average total assets
Measures how much net sales are made from average assets.

Inventory turnover: COGS/ Average inventory

Measures how often inventory is used and replaced for operations.

Payables turnover: COGS ( or net credit purchases) / Accounts Payable

Calculates how quickly a business pays its suppliers and creditors.

Receivables turnover : Net credit sales / Average accounts receivable

Measure how quickly they turn customers’ invoices into cash.
…

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 Leverage ratios

Debt ratio: Debt / Assets

Debt to equity ratio: Debt / Equity
Asset to equity ratio: Assets/Equity
…

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 Liquid ratios
Current ratio: Current Assets / Current Liabilities
Measures how a business’s current assets, such as cash, cash equivalents, accounts receivable, and
inventories, are used to settle current liabilities such as accounts payable.

Quick ratio (Acid-test ratio): Current Assets – Inventories / Current Liabilities

Measures how a business’s more liquid assets, such as cash, cash equivalents, and accounts receivable can
cover current liabilities.

Cash ratio: Cash and cash equivalents / Current Liabilities

Measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities. This ratio shows
how quickly a company can settle current obligations.

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 Market related ratios
Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total
common shares outstanding
Calculates the per-share value of a company based on the equity available to shareholders

Dividend yield ratio = Dividend per share / Share price

Measures the amount of dividends attributed to shareholders relative to the market value per share

Earnings per share ratio = Net earnings / Total shares outstanding

Measures the amount of net income earned for each share outstanding

Price-earnings ratio = Share price / Earnings per share

Compares a company’s share price to its earnings per share

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