Financial Statements and Analysis

In chapter 2, we investigate the timeliness of the statements, the components of the financial statements, why they are important, and what information can be divulged from them.

TIMLINESS
Financial Statementsare usually done quarterly or annually. These are documents that showcase a firm’s past performance and a snapshot of its assets and how it finances those assets. These statements are sent out to shareholders in the form of annual reports. This report allows shareholders to personally see how their investments are paying off.

FOUR TYPES OF STATEMENTS
There are four statements that all public companies are required to produce in their financial statement: the balance sheet, income statement, statement of cash flows, and statement of stockholder’s equity. These statements are created through a common set of rules called generally accepted accounting principles (GAAP)that set a standard format for all public companies to follow. This allows any analysis done of a firm to be compared with any other in the same industry or between different years.

THE BALANCE SHEET
The balance sheetis a complete list of a firm’s assets and liabilities at a given point in time. Assetscan be split into current and long-term. Current assetsare cash and marketable securitiesthat can be turned into cash in a relatively short period of time (usually one year). This can include cash,accounts receivable, and inventory. Long-term assetsare those assets that cannot be turned into cash quickly: property, plants, and equipment. These long term assets are depreciatedover there useful life. The book valueof an asset is equal to its acquisition cost less any accumulated depreciation.Liabilitiesare also divided into current and long-term. Current liabilitiesare short-term obligations that have to be repaid within about one year: accounts payableand notes payable (short term debt).Long-term liabilitiesare obligations that the firm will hold for over a year. Stockholder’s equityorbook value of equityis the last part of the balance sheet and is the difference between assets and liabilities. This is a measure of a firm’s net worth. The total market value of a firm's equity equals the market price per share times the number of outstanding shares. This is referred to as the company's market capitalization.

Due to the way the balance sheet is set up, the balance sheet identityis:

Assets=Liabilities + Stockholder’s Equity


To see a sample balance sheet follow: http://vitago.org/wp-content/uploads/2007/10/sample-balance-sheet2.gif

BALANCE SHEET ANALYSIS
The balance sheet gives a book value of a firm. This value is not a good indication of the true value of the firm but can give an indication of the liquidation value. The liquidation valueis the value of the firm after all assets are sold and all liabilities are paid. Other information the balance sheet can give is a firm’s value, its leverage, and its short-term cash needs.

MARKET-TO-BOOK RATIO
Market to Book= Market value of equity/book value of equity
This ratio, also called
the
price to book (P/B) ratio, gives a firm’s market capitalization in terms of its book value. In most successful firms, this ratio should be 1 or greater. Analysis tend to call firms with low MTB value stocks, and firms with high MTB growth stocks.

DEBT-TO-EQUITY RATIO
Debt to Equity
= Total debt/Total equity
This ratio is used to assess a firm’s
leverage
, which is the measure of how much a firm relies on debt as a source of financing. The higher this number climbs, the more a firm uses debt to finance its activities.

ENTERPRISE VALUE
Enterprise Value
= Market value of equity +Debt - Cash
This measures the underlying value of a firm. This is usually considered the cost to takeover a firm.

CURRENT AND QUICK RATIOS
Current Ratio
= Current assets/Current liabilities
Quick Ratio
= Current assets-Inventory/Current liabilities
These are two ratios that creditors use to assess whether the firm has sufficient working capital to meet short-term needs. A higher ratio in these two implies that there is less risk of a firm experiencing a cash shortfall in the near future.

INCOME STATEMENT
The income statementis the bottom line of a firm, it lists all revenues and expenses over a period of time. The “bottom line” of the IS gives the firm’s net incomeor earnings, which is the measure of income over a period of tie.

To see a sample income statement follow: http://www.whatisvat.com/images/income-statement.jpg
INCOME STATEMENT ANALYSIS

GROSS PROFIT
Gross Profit= Total sales - Cost of goods sold.
This first two lines of the IS list revenues from sales and cost of goods sold. The difference between these two gives the gross profit.


OPERATING INCOME
Operating Income= Gross profit-Operating expenses
Operating expenses are those that are incurred normally in the course of running the business. This can include administrative expenses, research and development, and depreciation expense.


EARNINGS BEFORE INTEREST AND TAX
EBIT= Operating income + Other income-Other expenses
EBIT is simply income before taxes but after other income and expenses are taken into account. These expenses arise from activities that are not central to a firms business. Financial analysts often compute a firm's earnings before interest, taxes, depreciation, and amortization. This is known as
EBITDA.This reflects the cash a firm has earned from operations.

NET INCOME
NI=EBIT ± Interest income(expenses) * Tax rate
The net income is the bottom line of the firms operating and financing activities. This represents the total earning of a firm’s equity holders.


EARNINGS PER SHARE
EPS= Net income / Shares outstanding
Earnings per share are what a shareholder can expect to receive from the shares they hold of a firm.
Stock optionsgive holders the right to buy a certain number of shares by a specific date at a specific price. The number of shares may also increase with the issuance of convertible bonds,a form of debt that can be converted to shares of common stock. Growth in the number of shares is referred to as dilution. Diluted EPSshows the earnings per share the company would have if the stock options were exercised.

PROFITABILITY RATIOS

GROSS MARGIN
Gross Margin= Gross profit/Sales
This reflects the ability of the firm to sell a product for more than the direct costs of making it. This ratio must cover all other costs incurred while making the product in order for it to be profitable.


OPERATING MARGIN
Operating Margin= Operating income/Total sales
This shows how much a firm earns before interest and taxes from each dollar of sales. Comparing this ratio gives insight to how efficiently a firm’s operations are.


NET PROFIT MARGIN
Net Profit Margin= Net income/Total sales
This shows the fraction of each dollar earned that is available to shareholders after the firm pays its expenses, interest, and taxes


ASSET EFFICIENCY
These ratios gauge how efficiently the firm is utilizing its assets.

ASSET TURNOVER
Asset Turnover= Sales/Total sales
This gives how much revenue is generated per dollar of assets.


FIXED ASSET TURNOVER
Fixed Asset Turnvoer= Sales/Fixed assets
This gives how much revenue is generated per dollar of assets without volatile assets, such as cash.


WORKING CAPITAL RATIOS
These ratios show how efficiently the firm is managing its net working capital.

ACCOUNTS RECEIVABLE DAYS
Account Receivable Days= Accounts receivable/Average daily sales
This gives the average length of time it takes a firm to collect cash from account receivable sales. The lower this number the quicker cash is received. This is also known as the
average collection periodordays sales outstanding.

INVENTORY TURNOVER
Inventory Turnover= Sales/Inventory
This shows how long it takes a firm to turn its inventory into cash earning sales. The lower this number the quicker inventory converts to sales.


Leverage Ratios
TIE= Earnings/Interest

Lenders assess a firm's leverage by computed an interest coverage ratio or times interest earned (TIE) ratio.

Investment Returns

RETURN ON EQUITY
Return on Equity= Net income/Book value of equity
This gives a percentage return that a firm receives on its past investments. A high ROE rate indicates the invest opportunity the firm found was very profitable.


Return on Assets
Return on Assets= Net Income/Total Assets

Valuation Ratios

PRICE-EARNINGS RATIO
P/E Ratio= Share price/Earnings per share
This assesses whether a firms stock prices are over- or under-valued. These ratios tend to be higher in firms with higher growth rates.


STATEMENT OF CASH FLOWS
The cash flow statementshows how a firm has earned and used the cash it earned during a set period. It is broken down into three sections: operating activities, investment activities, and financing activities.

To see a sample statement of cash flows follow: http://i.investopedia.com/inv/articles/site/Cash_Flow_Example.gif

OPERATING ACTIVITIES
This section adjusts net income by all non-cash items related to operating activity. Anything that is not an actual cash expense is taken out of net income in this section. Some things that are fixed in this section are depreciation, accounts receivable, accounts payable, and inventory.

INVESTMENT ACTIVITIES
This section shoes the cash required for investment activities during the period. Purchases of plant, property, and equipment are known as capital expenditures. This expenditure is subtracted out so that the cash spent on it is reflected in the cash flow statement.

FINANCING ACTIVITIES
This is cash flows from how the firm finances its activities. Some things that are in this section are dividends, retained earnings, changes in short or long-term borrowing, and stock sales. Retained Earningsequal the net income minus dividends.The Payout Ratio= Dividends/Net Income

OTHER INFORMATION INCLUDED WITH THE STATEMENTS
There are sections of the financial statements that give more of an overview of what the firm is doing or plans on doing then the hard facts of the statements. Management Discussion and analysis (MD&A)is a preface in which the firm’s management discusses the recent period. This provides the reader a background in the firm and any significant events that may have occurred, and also outlines goals and new projects. Management must also disclose off balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm's future performance yet do not appear on the balance sheet.

NOTES TO THE STATEMENTS
This is where additional details on the information provided in the statements is given. This documents the accounting principles used when creating the statements. This section also gives information on any and all of the firm’s subsidiaries or its separate product lines. This is often is very important to gain a full interpretation of the firm’s financial statements.

LEGISLATION
After numerous scandals in the accounting industry, Enron being the most well-known, Congress passed the Sarbanes Oxlet Act (SOX)in 2002. This new legislation was intended to improve the accuracy of financial information given to both boards and to shareholders. In essence, SOX is trying to improve the transparency of all public firms and make more people personally liable for mistakes are fraud committed on the financial statements. This act also forces firms to have their statements audited by a third party not connected with the firm. An auditoris another way to check a firm’s annual statements to ensure all information is true and accurate.