Financial Accounting Greg Gleeson, CPA, CFA Chief Operating Officer- GROW Partners, LLC firstname.lastname@example.org
Why are Financial Statements Important? • Financial Health of Company • Track Record of Management • Independently Audited & Objective • Ease of Comparison Across Companies • Valuation of Company • Starting point for all Financial Analysis
Why are Financial Statements Limited? • Backward Looking • Highly Summarized • Typically “cost basis” vs. “market value” • Accrual Basis • Non Cash Items (“Stock Options”) • Subjective “One-Time” Charges • Accounting Elections can Make Comparisons Difficult
Do you need CPA to Review and Understand Financial Statements? • Financial Data Providers have Distilled (Bloomberg, Factset, Reuters) many important facts • Financial Ratios provide important information and details, without having to read financials themselves • There are many analysts out there who review info for you …however… • Strong fundamental research requires in-depth review/knowledge of accounting • Ability to review/examine/digest financial statements is a growing area of need in money management (e.g., forensic accounting research, fraud specialization)
Financial Statement Components • Auditors Report • Must read, if other than unqualified, look out! • Balance Sheet • The net worth of the company at a point in time • Income Statement • The results of operations for a period of time (accrual basis) • Statement of Cash Flows • Operations on a cash basis, plus other changes in cash • Statement of Changes in Equity & Retained Earnings • Did company issue equity/debt, at what price? • Footnotes • Must read, the only color in the report (which is audited)
Auditors Report • Was an Audit Even Done? • Audit is different from an compilation, examination/attestation, agreed upon procedures, or other reports • Who are the Auditors? • Are they national/reputable? PCAOB? • Was it Prepared in Accordance with GAAP? • Is the Report Unqualified (i.e., Clean) • Is the report Qualified • Why? Read very carefully! • Has the Firm Changed Audit Firms in Recent Years?
Balance Sheet • Assets • Is it a company spinning of cash or burning cash? • Is it a company that is capitally intensive? • Is it a company that holds inventory? How old is inventory? Accounting? • Is it a company that holds intangibles? • Liabilities • Can the company pay their bills? • Does the company have long term debt? Interest rate sensitive? • Does the company have unionize labor? Long term liabilities? • Are their contingencies on the books? Why? • Equity • Who bought equity at what price? • Are the senior equity or debt holders ahead of you? • Why is company raising capital? • Can the company pay a dividend?
Income Statement • Revenues • What is the revenue recognition policy? • How do they collect their revenues? • Does the company offer terms “Accounts Receivable”? • How does company account for “Cost-of-Goods Sold”? LIFO/FIFO? • Expenses • What is in G&A? Is it tight-ship? • What are cash versus non-cash expenses (such as depreciation, stock options)? • How levered is the business model? • Other (One-time) • Why does the company have one-time charges? • Are “one-time” charges routine at this company?
Statement of Cash Flows • Cash Flow From Operations • Translates Accrual Basis to Cash Basis • Eliminates “Non Cash” items such as depreciation, unrealized gains or losses • Gives a better estimate of what the company is generating on operating basis • Cash Flow from Investing Activities • Accounts for “big ticket” items that are typically capitalized • Shows you what the company is really spending on equipment and long lived items • Gives you an idea of how successful the company is at selling equipment • Cash From Financing Activities • Shows the sources of capital raising activities during the period • Shows distributions to shareholders
Statement of Changes in Equity & Retained Earnings: • Drills Down the Equity Section of the Balance Sheet • Shows the net income that made it to shareholders • Show new issuances of stock, amounts, and price • Shows retirement of stock, amounts, and price • Shows distribution of earnings to shareholders • Shows conversions of debt to equity
Footnotes: Devil’s in the Details… • “Minimum” Color Required by GAAP • Audited • Provides Critical Information to Understand Financial Statements Such As: • Earnings-per-share • Details of taxes provisions • Details of pension obligations • Valuation of Investments such as derivatives • Off balance sheet items, contingencies
Ratios: Accounting Shorthand • Reader’s Digest of Financial Statements • Derived from Financial Statements but Audited • Objective view. However, Subjective to Accounting Distortions • Allows for Quick Comparisons against Prior Periods and Peers • Allows Stock Pickers to Screen Companies Quickly • Widely Used Ratios can Measure Many Dimensions of Financial Reporting: • Valuation: P/E, P/S, P/B • Profitability: Margin %, ROA, ROE • Efficiency: Rev/Employee; A/R Turnover • Liquidity: Current Ratio, Quick Ratio • Credit: Debt/Equity; Debt/Earnings
Other Information: MD&A • Additional Color Provided by Management • Can be Forward Looking • Unaudited • Can Highlight Items Not in the Financial Statements
Case Study: Cisco (CSCO) Key Statistics Key Statistics Has underperformed over past 5 years versus S&P 500
Case Study: YTD Performance Key Statistics Key Statistics
Case Study: Cisco - Balance Sheet Almost $47B in Cash Low A/R (falling) Leases (increasing) Purchased Companies since last July Took Cash, Haven’t Booked Revs 25% of Company Leveraged Cumulatively, Have Been Profitable Has Healthy Equity
Case Study: Cisco – Income Statement Grew 5% over past year (increasing) Grew 6% over past year (decreasing) Grew 2% over past year (decreasing) Grew 7.5% over past year (increasing) Grew 10% over past 3 years Increasing Dividend
Case Study: Cisco – Stmt of Cash Flow Collecting Slower than in Past Extending more Credit (leases) More Profitable than P&L Shows Bought a Company ($5B for NDS Group) Slowed down Purchasing Own Stock Increasing Dividend
Case Study: Cisco – Footnotes (40 pages worth) Leases grew by 6% in 1 year, Faster than revenues…. Past Due Increased by 20% in 1 year
Case Study: Cisco – MD&A (Un-Audited) Provides warning about When Revenues Booked
CSCO--- Accounting Observations • Generally…Low Valuation in Relation to Other Large Companies (even after recent run) • Cash Cow …However… • Sales Not Growing Very Fast • Net Margins are Not Terrific • Their Cash Flow May decline it they Continue to Lease • Don’t seem to know what to do with their Cash, have repurchased stock and declared dividends