chapter 2 introduction to financial statement analysis chapter 2 author berk / demarzo subject...

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 2

Introduction to Financial Statement Analysis

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-2

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


Learning Objectives

1. List the four major financial statements required by the SEC for publicly traded firms, define each of the four statements, and explain why each of these financial statements is valuable.

2. Discuss the difference between book value of stockholders’ equity and market value of stockholders’ equity; explain why the two numbers are almost never the same.

3. Compute the following measures, and describe their usefulness in assessing firm performance: the debt-equity ratio, the enterprise value, earnings per share, operating margin, net profit margin, accounts receivable days, accounts payable days, inventory days, interest coverage ratio, return on equity, return on assets, price-earnings ratio, and market-to-book ratio.

4. Discuss the uses of the DuPont identity in disaggregating ROE, and assess the impact of increases and decreases in the components of the identity on ROE.


Learning Objectives

5. Describe the importance of ensuring that valuation ratios are consistent with one another in terms of the inclusion of debt in the numerator and the denominator.

6. Distinguish between cash flow, as reported on the statement of cash flows, and accrual-based income, as reported on the income statement; discuss the importance of cash flows to investors, relative to accrual-based income.

7. Explain what is included in the management discussion and analysis section of the financial statements that cannot be found elsewhere in the financial statements.

8. Explain the importance of the notes to the financial statements.

9. List and describe the financial scandals described in the text, along with the new legislation designed to reduce that type of fraud.


2.1 Disclosure of Financial Information

• Financial Statements

– Firm-issued accounting reports with past performance information

– Filed with the SEC

• 10Q

– Quarterly

• 10K

– Annual

– Must also send an annual report with financial statements to shareholders


2.1 Disclosure of Financial Information (cont'd)

• Preparation of Financial Statements

– Generally Accepted Accounting Principles (GAAP)

– Auditor

• Neutral third party that checks a firm’s financial statements


2.1 Disclosure of Financial Information (cont'd)

• Types of Financial Statements

– Balance Sheet

– Income Statement

– Statement of Cash Flows

– Statement of Stockholders’ Equity


2.2 Balance Sheet

• A snapshot in time of the firm’s financial position

• The Balance Sheet Identity:

Assets Liabilities Stockholders' Equity


2.2 Balance Sheet (cont'd)

• Assets

– What the company owns

• Liabilities

– What the company owes

• Stockholder’s Equity

– The difference between the value of the firm’s assets and liabilities



• Assets

– Current Assets: Cash or expected to be turned into cash in the next year

• Cash

• Marketable Securities

• Accounts Receivable

• Inventories

• Other Current Assets

– Example: Pre-paid expenses



• Assets

– Long-Term Assets

• Net Property, Plant, & Equipment

– Book Value = Acquisition cost

– Depreciation (and Accumulated Depreciation)

• Goodwill and intangible assets

– Amortization

• Other Long-Term Assets

– Example: Investments in Long-term Securities


Table 2.1 Global Conglomerate Corporation Balance Sheet for 2009 and 2008



• Liabilities

– Current Liabilities: Due to be paid within the next year

• Accounts Payable

• Short-Term Debt/Notes Payable

• Current Maturities of Long-Term Debt

• Other Current Liabilities

– Taxes Payable

– Wages Payable



• Net Working Capital

– Current Assets – Current Liabilities



• Liabilities

– Long-Term Liabilities

• Long-Term Debt

• Capital Leases

• Deferred Taxes


Table 2.1 (cont'd) Global Conglomerate Corporation Balance Sheet for 2009 and 2008



• Equity

– Book Value of Equity

• Book Value of Assets – Book Value of Liabilities

– Could possibly be negative

– Market Value of Equity (Market Capitalization)

• Market Price per Share x Number of Shares Outstanding

– Cannot be negative


Textbook Example 2.1


Textbook Example 2.1 (cont'd)


Alternative Example 2.1

• Problem

– Rylan Enterprises has 5 million shares outstanding.

– The market price per share is $22.

– The firm’s book value of equity is $50 million.

– What is Rylan’s market capitalization?

– How does the market capitalization compare to Rylan’s book value of equity?



• Solution

– Rylan’s market capitalization is $110 million

• 5 million shares × $22 share = $110 million.

• The market capitalization is significantly higher than Rylan’s book value of equity of $50 million.


2.3 Balance Sheet Analysis

– Liquidation Value

• Value of the firm if all assets were sold and liabilities paid

– Market-to-Book Ratio

• Value Stocks

– Low M/B ratios

• Growth stocks

– High M/B ratios

Market Value of EquityMarket-to-Book Ratio

Book Value of Equity


2.3 Balance Sheet Analysis (cont'd)

• Debt-Equity Ratio

– Measures a firm’s leverage

– Using Book Value versus Market Value

• Enterprise Value

Total DebtDebt-Equity Ratio

Total Equity

Enterprise Value Market Value of Equity Debt Cash



• Problem

– In January 2009, Rylan Corporation (from Alternative Example 2.1) had a market capitalization of 110 million, a market-to-book ratio of 2.2, a book debt to equity ratio of 1.4, and cash of $6.3 million. What was Rylan’s enterprise value?



• Solution

– As stated in Alternative Example 2.1, Rylan’s book value of equity was $50 million. Given a book debt-equity ratio of 1.4, Rylan had total debt of 1.4 X 50 = 70 million. Thus, Rylan’s enterprise value was 110+70 – 6.3 = $173.7 million.


2.3 Balance Sheet Analysis (cont'd)

• Other Balance Sheet Information

– Current Ratio

• Current Assets / Current Liabilities

– Quick Ratio

• (Current Assets – Inventories) / Current Liabilities


2.4 Income Statement

• Total Sales/Revenues

– minus

• Cost of Sales

– equals

• Gross Profit


2.4 Income Statement (cont'd)

• Gross Profit

– minus

• Operating Expenses • Selling, General, and Administrative Expenses

• R&D

• Depreciation & Amortization

– equals

• Operating Income



• Operating Income

– plus/minus

• Other Income/Other Expenses

– equals

• Earnings Before Interest and Taxes (EBIT)



• Earnings Before Interest and Taxes (EBIT)

– plus/minus

• Interest Income/Interest Expense

– equals

• Pre-Tax Income



• Pre-Tax Income

– minus

• Taxes

– equals

• Net Income


Table 2.2 Global Conglomerate Corporation Income Statement Sheet for 2009 and 2008



• Earnings per Share

• Stock Options

• Convertible Bonds

• Dilution

– Diluted EPS

Net Income $2.0 millionEPS $0.556 per share

Shares Outstanding 3.6 million shares


2.5 Income Statement Analysis

– Profitability Ratios

• Gross Margin

• Operating Margin

• Net Profit Margin

Net IncomeNet Profit Margin

Total Sales

Sales

ProfitGrossinargMGross

Sales

IncomeOperatinginargMOperating


2.5 Income Statement Analysis (cont'd)

• Working Capital Days

– Accounts Receivable Days

• EBITDA

– Reflects the cash a firm has earned from its operations

Accounts ReceivableAccounts Receivable Days

Average Daily Sales



• Leverage Ratios/Interest Coverage Ratios

– EBIT / Interest Expense

– Operating Income / Interest Expense

– EBITDA / Interest Expense



• Investment Returns

– ROA

– ROE

Net Income

Return on Equity Book Value of Equity

AssetsTotal

IncomeNetAssetsonReturn



• The DuPont Identity

EquityofValueBook

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNetROE

Net Profit Margin Asset Turnover Equity Multiplier

Return On Assets


Textbook Example 2.3 (cont’d)



– Valuation Ratios

• P/E Ratio

• Enterprise Value to Operating Income

• Enterprise Value to Sales

Market Capitalization Share PriceP / E Ratio

Net Income Earnings per Share

EBIT

CashDebtEquityofvalueMarketEBITtoValueEnterprise

Sales

CashDebtEquityofvalueMarketSalestoValueEnterprise



Problem:

Consider the following data for the year ended Dec. 31, 2008 for Yahoo! and Google (in millions):

Compare Yahoo and Google’s operating margin, net profit margin, P/E ratio, and the ratio of enterprise value to operating income and sales.

Yahoo! Google

Sales 7,209 21,796

Operating Income 12 6,632

Net Income 424 4,227

Market Capitalization 22,830 177,380

Cash 2,292 8,657

Debt 2,439 3,529



Solution:

Yahoo! Had an operating margin of 12/7,209=0.17%, a net profit margin of 424/7,209=5.88%, and a P/E ratio of 22,830/424=53.84. Its enterprise value was 22,830+2439-2292=22,977 million, which has a ratio of 22,977/12=1914.75 to operating income and 22,977/7,209=3.19 to sales.

Google had an operating margin of 6,632/21,796=30.4%, a net profit margin of 4,227/21,796=19.39%, and a P/E ratio of 177,380/4,227=41.96. Its enterprise value was 177,380+3,529-8,657=172,252 million, which has a ratio of 172,252/6,632=25.97 to operating income and 172,252/21,796=7.90 to sales.



• To summarize:

Ratio Yahoo! Google

Operating Margin .17% 30.4%

Net Profit Margin 5.88% 19.39%

P/E Ratio 53.84 41.96

Enterprise Value to

Operating Income

1914.75 25.97

Enterprise Value to Sales 3.19 7.90



Solution (cont’d):

Even though Yahoo! And Google are competitors, their ratios look much different. Yahoo! has much lower profit margins, yet their P/E ratio is higher than Google’s. Their enterprise value to operating income ratio is also higher, mostly because of low operating income. Enterprise value to sales ratio is lower than that of Google. The difference is consistent with Yahoo!’s lower margins.


2.6 Statement of Cash Flows

• Net Income typically does NOT equal the amount of Cash the firm has earned.

– Non-Cash Expenses

• Depreciation and Amortization

– Uses of Cash not on the Income Statement

• Investment in Property, Plant, and Equipment


2.6 Statement of Cash Flows (cont'd)

• Three Sections

– Operating Activities

– Investment Activities

– Financing Activities



• Operating Activities

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

• Accounts Receivable – deduct the increases

• Accounts Payable – add the increases

• Inventories – deduct the increases



• Investing Activities

– Capital Expenditures

– Buying or Selling Marketable Securities

• Financing Activities

– Payment of Dividends

• Retained Earnings = Net Income – Dividends

– Changes in Borrowings


Table 2.3 Global Conglomerate Corporation

Statement of Cash Flows for 2009 and 2008


2.7 Other Financial Statement Information

• Management Discussion and Analysis

– Off-Balance Sheet Transactions

• Statement of Stockholders’ Equity

• Notes to the Financial Statements



• Problem

– Campbell Soup Company reported the following sales revenues by category:

– What was the percentage growth for each category?

– If Campbell’s has the same percentage growth from 2009 to 2010, what will its total revenues be in 2010?

2009 2008

U.S. Soup, Sauces and Beverages 3,257$ 3,098$

Baking and Snacking 1,747$ 1,742$

International Soup and Sauces 1,255$ 1,227$

Other 1,084$ 1,005$

Total 7,343$ 7,072$



• Solution

– U.S. Soup, Sauces and Beverages • ($3,257 ÷ $3,098) − 1 = 5.13%

– Baking and Snacking • ($1,747 ÷ $1,742) − 1 = 0.29%

– International Soup and Sauces • ($1,255 ÷ $1,227) − 1 = 2.28%

– Other • ($1,084 ÷ $1,005) − 1 = 7.86%

– Total • ($7,343 ÷ $7,072 ) − 1 = 3.83%



• Solution (continued)

– Estimated 2007 Total Revenue

• $7,343 × (1 + 3.83%)

• $7,343 × 1.0383 = $7,624


2.8 Financial Reporting in Practice

• Even with safeguards, reporting abuses still happen:

– Enron

– WorldCom

– Sarbanes-Oxley Act (SOX)


Discussion of Key Topic

• If either Ford or Microsoft’s P/E ratio is lower than the industry average, do you expect the stock price to go up? Could there be reasons other than undervaluation for a firm to have a low P/E?


Chapter Quiz

1. The book value of a company’s assets usually does

not equal the market value of those assets. What are

some reasons for this difference?

2. What is a firm’s enterprise value?

3. What is the difference between a firm’s gross profit

and its net income?

4. What is the DuPont identity?

5. What are the components of the statement of cash

flows?

6. What information do the notes to the financial

statements provide?

chapter 2 introduction to financial statement analysis chapter 2 author berk / demarzo subject...

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