Financial Statements

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Financial Statements
Lecturer: Adrian Euler

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What are the functions of financial
statements?
• Provide information to owners and creditors about the
firm’s current status and past financial performance
• Provide a convenient way for owners and creditors to set
performance targets and impose restrictions on
managers
• Provide a convenient way for a firm’s financial planning

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Types of financial statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows

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The Balance Sheet
• The balance sheet shows a firm’s assets (what it
owns) and liabilities (what it owes)
• The difference between a firm’s assets and
liabilities is the firm’s net worth
• For corporations, net worth is called
stockholder’s equity

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A typical balance sheet
Assets
Current Assets:
Cash & short term securities
Accounts Receivable
Inventory
Total Current Assets
Fixed (long-term) assets:
Property/plant/equipment
Investments
Other assets
Total Assets
Liabilities & Shareholder Equity
Current Liabilities:
Accounts payable
Short-term debt (due in one year)
Accrued expenses
Total Current Liabilities
Long-term Liabilities
Long-term debt
Total Liabilities
Shareholder Equity:
Common equity (paid in)
Retained earnings
Total liabilities & shareholder equity

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Do financial analysts disagree with
balance sheet information?
• Main issue: Book values (The net asset value of a company, calculated by total
assets minus intangible assets (patents, goodwill) and liabilities) vs. market values
• Balance sheets omit some economically significant
assets called intangible assets, such as R&D
• Intangible assets, such as goodwill, are not reported at
market values (the excess of the purchase price of a company over its book value which
represents the value of goodwill as an intangible asset for accounting purposes)
• Some economically significant liabilities are also omitted,
e.g. pending lawsuits (In American law, a lawsuit is a civil action brought before a court in
which the party commencing the action)

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The Income Statement
• The income statement presents in a summary form the
profitability of a firm over an annual period
• The income statement presents information on
– Revenues (sales)
– Cost of goods sold
– Operating expenses
– Financing costs of doing business
– Tax expenses

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A typical income statement
Sales revenue
- Cost of goods sold
= Gross margin
- Operating expenses
= EBITDA (Earnings before interest, taxes and depreciation)
- Depreciation & Amortization
= EBIT (Operating income)
- Interest payment
= Taxable income
- Taxes
= Net Income

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How is net income allocated?
• Dividends
• Change in retained earnings
• Earnings per share:
– Basic: Net income / shares of common stock
outstanding
– Diluted: Adjusts for stock options and convertible debt

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Accounting vs. economic measures
of earnings
• Accounting definition of earnings ignores
unrealized gains or losses in market value of
assets and liabilities
• Accrual (make provision for (a charge) at the end of a financial period)
accounting recognizes revenues and expenses
in the period that they take place, which does
not necessarily match the cash flows of a firm

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The firm’s expenses
• The firm’s expenses are separated into operating,
financing and capital
– Accounting depreciation does not attempt to measure
economic depreciation (loss in an asset’s value)
– Inconsistencies in the application of this categorization
of expenses (e.g., R&D is treated as an operating
expense)

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Statement of Cash Flows
• The statement of cash flows shows all the cash that
flows in and out of a firm during a specified period of
time
• Note that income statements show revenues and
expenses
• Cash flow statements are useful because
– They show a firm’s cash position over time
– They avoid accounting judgments about revenues and expenses
found in income statements

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A typical cash flow statement
Cash flow from operations
Net income
+ Depreciation
- Increase in accounts receivable
- Increase in inventories
+ Increase in accounts payable
Total cash flow from operations
Cash flow from investing activities
- Investment in plant and equipment
Cash flow from financing activities
- Dividends paid
+ Increase in short-term debt
Change in cash and marketable securities

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Financial Ratio Analysis: Evaluating
a firm’s performance
• Financial ratio analysis is a popular way of using
information from financial statements to evaluate
a firm’s performance
• Through the analysis of financial ratios, we can
easily identify the strengths and weaknesses of
a firm

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How are financial ratios used?
• Calculating financial ratios allows us to
– Examine the firm’s performance through time (e.g.
last five years) and identify trends
– Compare the firm’s performance with other
comparable firms (peer group) and identify the firm’s
competitive advantage
– Some financial ratios (e.g. price-earnings ratio,
market-to-book ratio) are useful in valuation analysis,
such as valuing private firms

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Classification of financial ratios
• Profitability ratios
• Liquidity ratios
• Efficiency ratios
• Financial leverage ratios
• Market value ratios
• Payout policy ratios

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Profitability Ratios
• After-tax operating margin: Measures the firm’s effectiveness in
generating profits from operations
(EBIT – taxes)/Sales
• Return on assets: Measures the firm’s operating effectiveness in
generating profits from its assets
(EBIT – taxes)/Average Assets

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Profitability Ratios
• Return on equity: Measures the firm’s profitability from the
perspective of the equity investor
Net Income/Stockholder’s Equity
• Return on capital: Measures the firm’s effectiveness in generating
profits from the capital invested in the firm
(EBIT – taxes)/(BV Debt + BV Equity)

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Liquidity Ratios
• Current ratio: Compares current assets (cash, inventory, accounts
receivable) to current liabilities (obligations due within one year)
Current Assets/Current Liabilities
• Quick or Acid Test ratio: Variant of current ratio that distinguishes
current assets that can be converted quickly into cash (cash,
marketable securities) from those that cannot (inventory, accounts
receivable)
(Cash + Marketable Securities)/Current Liabilities

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Efficiency Ratios
(Asset Management Ratios)
• Asset Turnover ratio: Indicates how efficiently the firm is using its
assets to generate sales
Sales/Average Total Assets
• Accounts Receivable Turnover ratio: Indicates how rapidly the firm is
collecting its credit, measured by how many times accounts
receivable are rolled over during a year
Sales/Average Accounts Receivable

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Efficiency Ratios
• Inventory Turnover ratio: Indicates the relative liquidity of
inventories, measured by how many times the firm’s inventories are
replaced during a year
Cost of Goods Sold/Average Inventory
• Days Receivable Outstanding, Days Inventory Held:
365/Receivable Turnover
365/Inventory Turnover

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Financial Leverage Ratios
• Times Interest Earned Ratio (Interest Coverage Ratio): Measures
the firm’s capacity to meet interest payments from pre-debt, pre-tax
earnings
EBIT/Interest Expenses
• Debt Capitalization ratio: Measures how much debt a firm is using
as a proportion of its total capital (total value of debt plus equity)
Debt/(Debt + Equity)

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Financial Leverage Ratios
• Debt to Equity Ratio: Measures debt as a proportion of the firm’s
equity
Debt/Equity
• The above two ratios can also be calculated by using only long-term
debt
• Moreover, these ratios must be calculated using market instead of
book values for debt and equity. Market-based debt ratios give a
better indication of a firm’s ability to borrow

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Market Value Ratios
• Price to Earnings ratio (P/E) and Market to Book ratio: Measure the
relation between the accounting measures (value) of the firm and its
market value
Price per Share/Earnings per Share
Price per Share/Book Value per Share

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Payout Policy Ratios
• Dividend Payout ratio: It relates dividends paid to the earnings of the
firm
Dividends/Earnings
• Dividend Yield ratio: It relates the dividend paid to the price of the
stock
Annual Dividends per Share/Price per Share

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The DuPont Analysis
• A useful way to understand the sources that drive a
firm’s ROA and ROE
• We can disaggregate ROA as follows:
ROA = (Net Profit Margin)  (Total Asset Turnover)

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The DuPont Analysis
• Asset turnover and net profit margin (return on sales) drive ROA
• If a firm can reduce working capital without hurting its competitiveness,
then asset turnover  and ROA 
• If a firm cuts back capital expenditures, then, in the short run, ROA 
because asset turnover  (due to total assets ) and return on sales 
(the latter because future depreciation  and, thus, net income )
• But, this strategy, will probably hurt the firm’s competitiveness and,
thus, ROA in the long run

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The DuPont Analysis
• Moreover, we can disaggregate ROE as follows:
ROE = (ROA)  (1 – Debt Ratio)
• As we see, ROE can increase through an increase in
ROA or the Debt Ratio

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The DuPont Analysis
• Financial analysts value more a firm that increases
its ROE through higher ROA
• A firm that increases ROE by taking on more debt
also increases the probability of being in financial
distress (bankruptcy)