CHAPTER 3: FINANCIAL STATEMENTS, CASH FLOWS, AND TAXES ANNUAL REPORT Most important report Two sections: o Verbal o Financial Statements Balance Sheet – shows the assets that the company owns and who has claims on those assets as of a given date Income Statement – shows the firm’s sales and costs Statement of Cash Flows – how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash Statement of Shareholders’ Equity – shows the amount of equity the shareholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year Can be used to help forecast future earnings and dividends investors SHAREHOLDERS’ EQUITY Paid-in Capital + Retained Earnings Total Assets – Total Liabilities Cumulative total of all the earnings the company has earned during its life NOTES ABOUT BALANCE SHEET Common stock is more risky than bonds Only the cash and equivalents account represents actual spendable money Assets can be financed by current liabilities, long term debt, and common equity Liquidation current liabilities long term debt common equity (only if there is money left) Accounting numbers are different from what the assets would sell for if they were put up for sale A balance sheet is a snapshot of the firm’s financial position at a point in time WORKING CAPITAL o Current assets because they are used and then replaced throughout the year o NET WORKING CAPITAL Current Assets – Current Liabilities o NET OPERATING WORKING CAPITAL Current Assets – Current Liabilities – Notes Payable DEPRECIATION o Internal Revenue Service Accelerated Depreciation Taxes o GAAP Straight Line Depreciation Investors
Balance sheet is snapshot of the firm’s financial position at a point in time WORKING CAPITAL o Current assets because they are used and then replaced throughout the year o NET WORKING CAPITAL Current Assets – Current Liabilities o NET OPERATING WORKING CAPITAL Current Assets – Current Liabilities – Notes Payable DEPRECIATION o Internal Revenue Service Accelerated Depreciation Taxes o GAAP Straight Line Depreciation Investors
NOTES ON INCOME STATEMENT A report summarizing a firm’s revenue, expenses and profits during a reporting period, generally a quarter or a year EARNINGS PER SHARE o The Bottom Line Denoting all that of all items on the income statement Financial analysts and managers need to differentiate between operating and non-operating income o OPERATING INCOME (EBIT OR EARNINGS BEFORE INTEREST AND TAXES) Derived from the firm’s regular core business Calculated before deducting interest expenses and taxes (non-operating costs) Sales Revenues – Operating Costs If you want to compare two companies’ operating performances, it is best to focus on their operating income o EBITDA (EARNINGS BEFORE INTERESTS, TAXES, DEPRECIATION AND AMORTIZATION) DEPRECIATION (Annual charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were depleted in the production process) AND AMORTIZATION (Represents the decline in value of intangible assets such as patents, copyrights, trademarks, and goodwill) Important components of operating costs Write off or allocate the costs of assets over their useful lives Not cash expenses Income statements report operations over a period of time Quarterly and annual statements investors Monthly statements Internal Managers Planning and control Tied to the balance sheet through the retained earnings account Net income in the Income Statement – Dividends Paid = Retained Earnings for the Year
Retained Earnings for the Year + Cumulative Retained Earnings = YearEnd Balance for Retained Earnings Retained earnings for the year is also reported in the statement of stockholders’ equity
NOTES ON STATEMENT OF CASH FLOWS Management’s goal is to maximize the price of the firm’s stock, and the value of any asset, including a share of stock, is based on the cash flows the asset is expected to produce An accounting report that shows how much cash the firm is generating OPERATING ACTIVITIES – items that occur as part of normal ongoing operations o NET INCOME – first source of cash o DEPRECIATION AND AMORTIZATION – added back to net income o INCREASE IN INVENTORIES – any increase in inventories requires the use of cash o INCREASE IN ACCOUNTS RECEIVABLE – considered as an outflow since the company has to replace the inventory it sold o INCREASE IN ACCOUNTS PAYABLE – increase in cash o INCREASE IN ACCRUED WAGES AND TAXES – increase in cash o NET CASH PROVIDED BY OPERATING ACTIVITIES – normal operations that arise as a result of doing business LONG-TERM INVESTING ACTIVITES – involves long-term assets o ADDITIONS TO PROPERTY, PLANT, AND EQUIPMENT – considered as an outflow o NET CASH USED IN INVESTING ACTIVITES FINANCING ACTIVITIES o INCREASE IN NOTES PAYABLE – cash inflow o INCREASE IN BONDS (LONG-TERM DEBT) – issuing bonds in exchange of cash inflow o PAYMENT OF DIVIDENDS TO STOCKHOLDERS – dividends are paid in cash o NET CASH PROVIDED BY FINANCING ACTIVITIES – used to help pay for investing activities and cover for deficits resulting from operations SUMMARY – summarizes the change in cash and cash equivalents over the year o NET DECREASE IN CASH – the sum of the operating activities, investing activities, and financing activities o CASH AND EQUIVALENTS AT THE BEGINNING OF THE YEAR o CASH AND EQUIVALENTS AT THE END OF THE YEAR IDEAL CONDITION o Operating Activities POSITIVE
o Long-Term Investing Activities Expenditure on Fixed Assets = Depreciation Charges + Additional Expenditures to Provide Growth o Financing Activities Some Net Borrowing + “Reasonable” Amount of Dividends o Summary Stable Year-To-Year Cash Balance NOTES ON STATEMENT OF STOCKHOLDERS’ EQUITY Changes in stockholders’ equity during the accounting period Retained earnings represents a claim against assets Stockholders allowed management to retain earnings and reinvest them in the business additions to plant and equipment, inventories, etc Retained earnings as reported on the balance sheet do not represent cash and are not available for dividends or anything else CHAPTER 4: ANALYSIS OF FINANCIAL STATEMENTS GENERAL NOTES Management Maximize a firm’s value Take advantage of the firm’s strengths and correct its weaknesses Ratios help us evaluate financial statements ROE tends to be the focal point High ROE = Stable Liquidity + Efficient Asset Management + Proper Use of Debt LIQUIDITY RATIOS Idea of the firm’s ability to pay off debts that are maturing within a year Necessary if the firm is to continue operating LIQUID ASSET – one that trades in an active market and thus can be quickly converted to cash at the going market price CURRENT RATIO o Current Assets divided by Current Liabilities o If current liabilities is rising faster than current assets then the current ratio will fall A SIGN OF POSSIBLE TROUBLE o A deviation from the industry average is a signal for the analyst to check further o HIGH CURRENT RATIO Generally indicates a very strong, safe liquidity position Might also mean that the firm has too much old inventory that will have to be written off and too many old accounts receivable that may turn into bad debts The firm has too much cash, receivables, and inventory relative to its sales ASSETS ARE NOT MANAGED PROPERLY QUICK OR ACIT TEST RATIO o (Current Assets – Inventories) / Current Liabilities o Inventories
The least liquid of the firm’s current assets Where losses are most likely to occur in the event of liquidation o Measures the ability of the firm to pay off its short-term obligations without relying on the sale of inventories
ASSET MANAGEMENT RATIOS Idea of how efficiently the firm is using its assets Necessary for the firm to keep its costs low and thus the net income high Too many assets Cost of capital is too high Depress profits Too low assets Profitable sales are lost INVENTORY TURN OVER RATIO o Show how many times the particular asset is “turned over” during the year o Sales divided by inventories o If the turnover ratio is too high holding too much assets o Sales occur for the entire year while inventory is stocked up at a particular time AVERAGE INVENTORY DAYS SALES OUTSTANDING o Average collection period o Accounts Receivables / Average Sales Per Day o Average length of time the firm must wait after making a sale before receiving cash o Compared to both the industry average and the credit terms FIXED ASSETS TURNOVER RATIO o Sales / Net Fixed Assets o Higher than the industry average Firm is using its fixed assets at least as intensively as other firms in the industry o Inflation has caused the value of many assets that were purchased in the past to be seriously understated Old firms will probably have higher fixed assets turnover More reflective of the age of the assets than the inefficiency on the part of the new firm TOTAL ASSETS TURNOVER RATIO o Measures the turnover of all of the firm’s assets o Sales divided by total assets o Below the industry average Firm is not generating enough sales given its total assets DEBT MANAGEMENT RATIOS Idea of how the firm has financed its assets as well as the firm’s ability to repay its long-term debt Indicates how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders The use of debt will increase or “leverage up” a firm’s ROE if the firm earns more on its assets than the interest rate it pays on debt Debt exposes the firm to more risks
Two Reasons for the Leveraging Effect o Interest is deductible, so the use of debt lowers the tax bill and leaves more of the firm’s operating income available to its investors o If the rate of return on assets exceeds the interest rate on debt, a company can use debt to acquire assets, pay the interest on the debt and have something left over as a bonus to stockholders High debt ratios Higher expected returns (when the economy is normal) Lower returns and possibly bankruptcy (if there is recession) Two procedures that analysts use to examine the firm debt o Check the balance sheet to determine the proportion of total funds represented by debt o Review the income statement to see the extent to which interests is covered by operating activities TOTAL DEBT TO TOTAL ASSETS o Total Debt divided by Total Assets o Measures the percentage of funds provided by creditors o Total debt includes all current liabilities and long-term debt o Creditors Low Debt Ratios The lower the ratio, the greater the cushion against creditors’ losses in the event of liquidation o Stockholders More leverage Magnify expected earnings TIMES INTEREST EARNED RATIO o Earnings before interest and taxes divided by interest charges o Measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs o Failure to pay interest will bring legal action by the firm’s creditors and probably result in bankruptcy o The firm’s ability to pay current interest is not affected by taxes
PROFITABILITY RATIOS Idea of how profitably the firm is operating and utilizing its assets Asset Management + Debt Management + Effects on Return On Equity OPERATING MARGIN o Operating Income (EBIT) divided by sales o Measures the operating profit per dollar of sales o If below the industry Operating costs are too high Consistent with low inventory turnover and high days’ sales outstanding ratios PROFIT MARGIN o Net Income divided by sales o Interest charges pull net income down Constant sales Relatively low profit margin for the firm with more debt o Higher debt ratio Lower profit margin RETURN ON TOTAL ASSETS o Net income divided by total assets o It is better to have a higher return o Low ROA Result from a conscious decision to use a great deal of debt High interest expense Low net income
BASIC EARNING POWER RATIO o Operating income (EBIT) divided by total assets RETURN ON COMMON EQUITY o Most important THE BOTTOM LINE o Stockholders expect to earn a return on their money, and this ratio tells how well they are doing in an accounting sense
MARKET VALUE RATIOS Idea of what investors think about the firm and its future prospects Relates the stock price to earnings and book value price Previous ratios are looking good Market value ratios are high (if it will look good in the future) Stock price is high Management is doing well Three primary uses of market value ratios o Investors Buy or sell stocks o Investment bankers Setting the share price for a new stock issue o Firms How much to offer for another firm in a potential merger PRICE/EARNINGS RATIO o How much investors are willing to pay per dollar of reported profits o Price per share divided by earnings per share o High Strong growth prospects + Little risk o Low Slowly growing + Risky firms MARKET/BOOK RATIO o How investors regard the company o Companies that are well regarded by investors Low risk + High growth High M/B ratios o Book value per share = Common Equity / Shares Outstanding o Market/Book Ratio = Market Price per Share / Book Value per Share o M/B ratios typically exceed 1.0 investors are willing to pay more for stocks than the accounting book values of the stocks THE DuPONT EQUATION A formula that shows the rate of return on equity o ROE = ROA x Equity Multiplier o ROE = Profit Margin x Total Assets Turnover x Equity Multiplier o ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Common Equity) PROFIT MARGIN – How much the firm earns on its sales TOTAL ASSETS TURNOVER – A multiplier that tells us how many times the profit margin is earned each year (ROA must be adjusted upward to obtain the ROE) EQUITY MULTIPLER – The adjustment factor DuPont equation helps us see why the ROE is low or high
