Financial Statements
Download as PPT, PDF0 likes5,852 views
1. Financial statements provide information to owners and creditors about a firm's financial performance and position. The three main statements are the balance sheet, income statement, and statement of cash flows. 2. The balance sheet outlines a firm's assets, liabilities, and equity. The income statement shows revenues, expenses, and profits over a period of time. The statement of cash flows displays all cash inflows and outflows. 3. Financial analysts use ratio analysis to evaluate a firm's performance in areas like profitability, liquidity, efficiency, and financial leverage by calculating ratios from the information in the financial statements.
Financial Statements
- 2. 2 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
- 3. 3 Types of financial statements • Balance Sheet • Income Statement • Statement of Cash Flows
- 4. 4 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
- 5. 5 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
- 6. 6 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)
- 7. 7 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
- 8. 8 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
- 9. 9 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
- 10. 10 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
- 11. 11 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)
- 12. 12 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
- 13. 13 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
- 14. 14 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
- 15. 15 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
- 16. 16 Classification of financial ratios • Profitability ratios • Liquidity ratios • Efficiency ratios • Financial leverage ratios • Market value ratios • Payout policy ratios
- 17. 17 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
- 18. 18 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)
- 19. 19 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
- 20. 20 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
- 21. 21 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
- 22. 22 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)
- 23. 23 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
- 24. 24 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
- 25. 25 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
- 26. 26 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)
- 27. 27 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
- 28. 28 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
- 29. 29 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)