Financial Statements

1. Financial Statements Economics 71a Gitman/Madura Chapter 8 WSJ 54-59 Lecture notes 8

2. Why Read or Care? • Investment strategies • Growth • Use accounting numbers to estimate growth • Value • Compare accounting numbers to price

3. Goals • Accounting statements • Financial ratios • Ratios and valuation

4. Accounting Statements • Income statement • Balance sheet • Statement of retained earnings • Statement of cash flows

5. Income Statement • Flow variables • Revenues – Cost of goods sold

6. 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

7. Balance SheetAccounting Value of the Firm • Assets (things firm owns) • Liabilities (Loans) • Stockholders’ equity • (Assets - Liabilities) • Also called • Book value • Net worth

8. Assets • Cash • Accounts receivable • Inventories • Land • Plant and equipment • Less: Depreciation

9. Liabilities • Accounts payable • Notes payable (short term debt) • Long term debt

10. Balance Sheet • Assets • Cash $5 • Plant and equipment $100 • Liabilities • Accounts payable $1 • Long term debt $75 • Stockholder equity 105-76 = $29

11. Retained Earnings Statement • Cumulative sums of retained earnings • RE = retained earnings • New RE = Old RE + Earnings - Dividends

12. 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)

13. Cash Flow Parts • Operating Activities • Investment Activities • Financial Activities

14. 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

15. 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

16. 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

17. Goals • Accounting statement • Financial Ratios • Ratios and valuation

18. 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”

19. Ratios • Profitability ratios • Market ratios • Debt ratios • Other ratios • Why skipping many in book

20. Profitability: Gross Profit Margin

21. 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)

22. Profitability:Net profit margin

23. Profitability:Earnings per Share (EPS) • Key ratio!!!

24. Return on Total Assets (ROA)

25. Return on Common Equity (ROE) • Common stock holder Equity • Balance sheet book value assigned to common stock • Net worth – preferred stock (valued at par)

26. Market Ratios • Share price versus accounting value • Very important • Examples • Price/Earnings ratio • Market/Book (M/B) ratio

27. Price Earnings Ratio

28. Price Earnings Ratio • Price per earnings • Example: • Microsoft • About 30 • $30 per $1 of earnings • S&P 500 • About 30

29. 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

30. 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

31. Market to Book Ratio (M/B)

32. 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

33. Debt Ratios

34. Dividend Payout • Net Income • Dividends • Retained Earnings • Dividend Payout ratio = Divs/Earnings

35. Problems for Other Ratios • Might vary a lot across industries • Example: • Total asset turnover • Think about consulting firm versus a steel mill

36. Goals • Accounting statement • Financial Ratios • Ratios and valuation

37. Fundamental Analysis • Use information about firm to evaluate stock price • Growth • Estimate earnings growth and future prospects • Value • Find “undervalued” stocks

38. Ratio Analysis • Many methods • Compare ratios to appropriate comparison set • Example: • P/E ratio for a pharmaceutical firm • Compare to industry • If low -> buy

39. Problems With Accounting Information • Misses “intangibles” • Knowledge base (patents) • Customer base • Sometimes numbers are zero • Dot coms often have zero earnings

40. More Problems with Accounting Information • There are many ways to derive accounting numbers • Large “fudge factors” • Can clever accountants make things look better?

41. Accounting “Tricks” • Off balance sheet items • Enron • Stock options • Capital depreciation tricks • Worldcom • AOL • Taking over low p/e firms

42. 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)

43. Goals • Accounting statement • Financial Ratios • Ratios and valuation