Financial Statements

Economics 71a

Gitman/Madura Chapter 8

WSJ 54-59

Lecture notes 8

Why Read or Care?

• Investment strategies– Growth

• Use accounting numbers to estimate growth

– Value• Compare accounting numbers to price

Goals

• Accounting statements

• Financial ratios

• Ratios and valuation

Accounting Statements

• Income statement

• Balance sheet

• Statement of retained earnings

• Statement of cash flows

Income Statement

• Flow variables

• Revenues – Cost of goods sold

Income Statement Example

• Total revenues $50• Labor and other operating expenses $-25

– (for goods sold)

• Advertising + Admin. expenses $-5• Depreciation $-5• Interest payments $-5• Taxes $-5• Earnings 50-25-5-5-5-5 = $5• EBIT = Earnings before interest and taxes

– = 50-25-10 = $15

Balance SheetAccounting Value of the Firm

• Assets (things firm owns)

• Liabilities (Loans)

• Stockholders’ equity– (Assets - Liabilities)– Also called

• Book value

• Net worth

Assets

• Cash

• Accounts receivable

• Inventories

• Land

• Plant and equipment– Less: Depreciation

Liabilities

• Accounts payable

• Notes payable (short term debt)

• Long term debt

Balance Sheet

• Assets– Cash $5– Plant and equipment $100

• Liabilities– Accounts payable $1– Long term debt $75

• Stockholder equity 105-76 = $29

Retained Earnings Statement

• Cumulative sums of retained earnings

• RE = retained earnings

• New RE = Old RE + Earnings - Dividends

Cash Flow

• Pure measure of incoming - outgoing cash

• Differences with income statement– No depreciation– No accounts payable/receivable– Inventories (account for costs of producing and

putting in inventory)

Cash Flow Parts

• Operating Activities

• Investment Activities

• Financial Activities

Operating Cash Flow

• Earnings = $5– Adjust to get to cash flow

• Depreciation : +5– Why? Remove depreciation adjustments

• Increase in accounts payable: +5– Why? Haven’t paid this yet.

• Increase in accounts receivable: -2– Why? Haven’t received this yet.

• Increase in inventories: -10– Production costs reflect only goods sold.

– Adjustment: 5+5+5-2-10 = 3 = operating cash flow

Investment Cash Flow

• Increase in gross fixed assets• Purchases of new plant and equipment

• -30 million : New office building

• Total investment cash flow = -30 million

Finance Cash Flow

• Increase in long term debt: • +50 million of incoming funds

• Dividends: • -20 million payout of divs

• Total finance cash flow = +30 million

Goals

• Accounting statement

• Financial Ratios

• Ratios and valuation

Financial Ratios

• Ratios of various financial variables

• Uses– Analyze financial well being of a firm– Compare different stocks in terms of current

values• “Find good investments”

Ratios

• Profitability ratios

• Market ratios

• Debt ratios

• Other ratios– Why skipping many in book

Profitability: Gross Profit Margin

Sales-Cost of goods sold

SalesGrossprofits

Sales

Profitability:Earnings for Shareholders

• Earnings available for common shareholders– Revenues minus

• Costs of goods sold (production)

• Operating expenses

• Interest

• Taxes

• Preferred dividends

• Final earnings left for shareholders (earnings)

Profitability:Net profit margin

Earnings

Sales

Profitability:Earnings per Share (EPS)

• Key ratio!!!

EarningsEPS

Sharesof commonstock

Return on Total Assets (ROA)

EarningsROA

Total Assets

Return on Common Equity (ROE)

• Common stock holder Equity– Balance sheet book value assigned to common

stock– Net worth – preferred stock (valued at par)

EarningsROE

Common Stock Equity

Market Ratios

• Share price versus accounting value

• Very important

• Examples– Price/Earnings ratio– Market/Book (M/B) ratio

Price Earnings Ratio

Market price per shareP/E Ratio =

Earnings per share

Price Earnings Ratio

• Price per earnings

• Example:– Microsoft

• About 30

• $30 per $1 of earnings

– S&P 500 • About 30

Compare to Earnings Growth

• P = y(1+g)/(k-g)• P/E = (1+g)/(k-g)• Try

– k = 0.07 (close to average real return)– g = 0.02 (close to average real growth of

economy)– gives P/E for stock– 20

High Flying P/E’s

• AOL (1999) near 600• Dell Computer (1999) 100• These require higher growth rates, but

maybe not much higher– 1/(0.07-0.06) = 100 – 6% growth forever is pretty big

• For many dot com’s no P/E since earnings are zero

Market to Book Ratio (M/B)

Market price per shareM/B =

Book value per share

Market to Book Ratio

• Market value of the firm relative to its accounting value

• Key tool for “value investors”

• Extensive academic evidence that low market to book firms do better on average

Debt Ratios

Total LiabilitiesDebt Ratio =

Total Assets

Dividend Payout

• Net Income– Dividends– Retained Earnings

• Dividend Payout ratio = Divs/Earnings

Problems for Other Ratios

• Might vary a lot across industries

• Example:– Total asset turnover– Think about consulting firm versus a steel mill

SalesTotal Asset Turnover =

Total assets

Goals

• Accounting statement

• Financial Ratios

• Ratios and valuation

Fundamental Analysis

• Use information about firm to evaluate stock price

• Growth– Estimate earnings growth and future prospects

• Value– Find “undervalued” stocks

Ratio Analysis

• Many methods

• Compare ratios to appropriate comparison set

• Example: – P/E ratio for a pharmaceutical firm– Compare to industry– If low -> buy

Problems With Accounting Information

• Misses “intangibles” – Knowledge base (patents)– Customer base

• Sometimes numbers are zero– Dot coms often have zero earnings

More Problems with Accounting Information

• There are many ways to derive accounting numbers

• Large “fudge factors”

• Can clever accountants make things look better?

Accounting “Tricks”

• Off balance sheet items– Enron– Stock options

• Capital depreciation tricks – Worldcom– AOL

• Taking over low p/e firms

Fundamental Analysis Weaknesses

• Bad data

• Bad interpretation of data (growth rates)

• Market efficiency: – Semi-strong efficiency: Prices should reflect

all public information

• Market inefficiency (prices may not adjust to where they should go)

Goals

• Accounting statement

• Financial Ratios

• Ratios and valuation