# A Crash Course in Financial Statement Analysis

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```							                           A Crash Course in Financial Statement Analysis
(This material is taken from Chapter 10 of Riggs, Financial and Cost Analysis for Engineering and Technology
Management and Chapter 2 of Higgins, Analysis for Financial Management. For further information, see the texts.)

What are the primary questions to be answered:
 How sound is the company’s financial position?
 How well is the company performing in earning returns on the capital employed?

Readers of financial statements are concerned primarily with the company’s progress in satisfying these dual
objectives of (1) earning profits and (2) maintaining a sound financial position.

The Financial Statements
Balance Sheet         Sometimes referred to as the “Statement of Financial Position.” Provides a
snapshot of the Assets, Liabilities and Owner’s Equity of the corporation at a
particular point in time. Used primarily to gauge the capital structure of the
company.

Income Statement        Provides a measure of performance during a period of time. Shows how net
income is derived from the difference between revenues and expenses of the
company.

Cash Flow Statement     Reconciles the beginning and ending balance of the cash account for a given
period of time. Separates out the effects of operating, investing, and financing
activities of the firm on cash flow.

Statement of Changes    Reconciles the activity in the equity section of the balance sheet from one period
to Owner’s Equity       to another. These changes generally result from profits or losses, dividends and/or
stock issuances.

One can assess the progress of a company in meeting its goals by examining the relationships between amounts on
the income statement and balance sheet.

The Balance Sheet
Is a statement of financial condition at a particular point in time.
 Is a snapshot of the company’s financial position at one particular date or point in time.
 Shows the capital structure of the company. Capital Structure is how the company has distributed its debt
(liabilities) and equity.
 Takes the form of the Accounting Equation.

The Accounting Equation:       Assets = Liabilities + Owner’s Equity

Key Observations about the Accounting Equation:
 LHS ( Assets )                         = What the company owns
 RHS ( Liabilities + Owner’s Equity)    = How the ownership of these assets was financed

Basic Accounting Definitions (relevant to Balance Sheet)
Examples: Accounts Receivable, Prepaid Expenses, Patents and Trademarks.
Examples: Accounts Payable, Notes Payable, Interest Payable.
Equity      The claims held by the owners of the business.
Examples: Common Stock, Preferred Stock, Retained Earnings

E140A - Workshop B                                                                                         1
What is Owner’s Equity?

      The difference between assets (what the company owns) and liabilities (what the company owes) is a measure
of the company’s accounting value or worth (owner’s equity).              Accounting Value of the company
= Owner’s Equity = Assets – Liabilities

      Owner’s Equity is

Increased when…                                          Decreased when…
The owners raise more capital and invest it              The owners take money out of the company (for
example, dividend payments)
The company makes a profit                               The company incurs a revenue loss

Owner’s Equity = (Investments + Profits) – (Losses + Pay to owners)

      Owners Equity = Invested capital – Retained Earnings
Retained Earnings = Cumulative Profits earned since the company started
– Cumulative losses incurred since the company started
– Cumulative Dividends paid to shareholders since the company started

      In a corporation Owner’s Equity is also called shareholder’s equity or net worth

      Myth #1 : Owner’s Equity is a pile of cash (liquid funds) available to spend
NOPE. Cash is an asset NOT owner’s equity

      Myth # 2 : Owner’s Equity = Accounting Value of the company = Market value of the company.
NOPE. Wrong again. Market Value, Market capitalization, or the “Market Cap” of a company is
not reflected in the financial statements of a company in the balance sheet.

Market Value = current price of a share of stock * number of shares outstanding
THIS IS NOT EQUAL TO
Accounting Value = Book Value = Owner’s Equity = Assets – Liabilities

The number of shares outstanding is the number of share currently being traded in public markets.

Key terms on the Balance Sheet:

Term                                  Definition
Accounts Receivable (asset)           Amount owed by the company’s customers for services
or products

Accounts Payable (liability)          money the company owes someone else for services or
products the company used
Current Assets                        assets the can be made liquid within 12 months (i.e.:
Cash, Accounts Receivable)
Fixed Assets                          Assets with a useful life of more than one year

Current Liabilities:                  liabilities that will be due within the next 12 months
(i.e.: Accounts payable)
Working Capital                       Current Assets – Current Liabilities; represents the
available resources to keep the company running

E140A - Workshop B                                                                                          2
Common Stock (equity)                 Shares issued by the corporation with no special rights
or privileges attached

Preferred Stock                       Stock that is issued with the promise of paid dividends.
Preferred shareholders are given preference over
common shareholders in the event of liquidation (i.e:
bankruptcy)
Retained Earnings                     Retained earnings from last year + (Net income – paid
dividends)

The Income Statement
 A.K.A. “Profit and Loss Statement”, P& L, operating statement, earnings statement
 Records operating results for the a period of time (usually a year) between balance sheets; a “moving picture of
what happened during a period (usually a year)
 Is a statement of financial performance, show where net income is derived.
 Matches the revenues earned with the costs/expenses incurred to run the company to derive net income (A.K.A.
profit or earnings)
 Expands on the retained earnings portion of the Balance Sheet: from one balance sheet to the next retained
earnings increase by the amount of the net income – paid dividends.

Key Terms on the Income Statement:

Term                  Definition
Revenue (Sales)       Primarily: money generated from the sale of products
and/or services
Secondarily: money generated from interest
COGS                  “Cost of Goods Sold”: expenses that can be traced
DIRECTLY to the products and services provided to
customers.

A.K.A. “Cost of Sales” (COS) (especially seen in
EBIT                  Earning Before Interest and Taxes
Depreciation          A non-cash expense that represents the decline in value
of a fixed asset over its useful life.

Net Income = Sales
– COGS
= Gross Profit
– SG&A ( Sales, General, & Administrative Expenses )
– R&D ( Research & Development )
= EBIT
– Interest
= Pre-tax Income
– Taxes

Cash Flow Statement
 Cash Flow Is More Important Than Your Mother: CFIMITYM
 The only way bills get paid, and employees get compensated is with cash
 Therefore, If a company runs out of cash the game is over.
 Free Cash Flow = EBIT – Depreciation – Working Capital – Interest

E140A - Workshop B                                                                                       3
Analyzing the Financial Statements using Ratios

Ratio analysis is the fundamental tool for analyzing financial statements. It is particularly helpful when justifying
statements in a case analysis or assessing a company in general. There are a lot of ratios out there, but generally
there are 5 categories of information they provide:

1.   Liquidity
Liquidity ratios help asses how able a company is in meeting it’s financial obligations
2.   Working Capital Utilization
Working Capital Utilization ratios help assess how efficiently a company I using is assets and liabilities.
3.   Capital Structure
Capital Structure ratios help clarify what the companies sources of capital are, and determine how “leveraged” a
company is. A lot of debt indicates a highly leveraged company.
4.   Profitability
Profitability ratios help asses how profitable a company is in light of its sales and invested capital.
5.   Market
Market ratios asses the company as it is viewed by the public equity markets

Using Financial Ratios

Experienced financial statement analysts instinctively think in terms of ratios. However, not every ratio provides
useful information in every situation. Furthermore, judging the appropriateness of a particular ratio is not easy.
However there are two techniques which can be particularly helpful for this assessment:
1. Reviewing trends in the ratios over time.
2. Comparing the ratios with those of similar companies in the same industry.

E140A - Workshop B                                                                                            4
Examples of Financial Ratios (and Other Measures)

Liquidity
Measures to evaluate the company’s ability to meet its short-term obligations.
Current Ratio
Measures the company’s ability to pay current liabilities with
current assets. A company prefers to have a high current ratio,                Current assets
which means that the business has plenty of current assets to                 Current liabilities
pay current liabilities.

Acid-Test (or Quick Ratio)
Indicates whether the company could pay all its current
liabilities if they came due immediately. Inventory and prepaid   cash + cash equiv. + accounts receivable
expenses are not included in the acid-test ratio because these               current liabilities
are the least liquid of the current assets.

Working Capital Utilization
Measures of the efficiency of the company in using its assets.
Working Capital
The amount of cash available for immediate use.                       Current assets – Current liabilities

Accounts Receivable Collection Period (days)
Is a measure of how promptly customers are paying.                          accounts receivable
total sales ÷ 365

Inventory Turnover (times per year)
Is a measure of the number of times a company sells its average         cost of sales (COS) per year
level of inventory during a year.                                        cost of current inventory

Inventory Flow Period (days)
An alternative to Inventory Turnover. Indicates how frequently                       1
a company fully replenishes its inventory.                               inventory turnover ÷ 365

Accounts Payable Payment Period (days)
Is a measure of how long it takes the company to pay its                     accounts payable
suppliers.                                                               cost of sales (COS) ÷ 365

Working Capital Turnover (time per year)
Summarizes the efficiency with which a company is using its                         sales
working capital. It shows the dollars of sales achieved per                average working capital
dollar of working capital invested.

Asset Turnover
Measures the sales generated per dollar of assets. Again, an                       sales
efficiency measure.                                                                assets

E140A - Workshop B                                                                                     5
Capital Structure (Solvency)
Show how the company is financed; financial riskiness; ability to meet long-term obligations.
Total Debt to Owner’s Equity Ratio
The relative contribution of creditors and owners to the                            total liabilities
company’s financing.                                                          total shareholder’s equity

Total Debt to Total Assets Ratio
Indicates the proportion of a company’s assets that are financed                   total liabilities
with debt. The ratio measures a business’s ability to pay both                       total assets
current debt and long-term debts.

Profitability
Used to assess the profitability of the business with respect to sales or invested capital.
Percentage Relationships on Income Statement
How do each of the product or service lines contribute to total income as a percentage?

Return on Equity
Tells you the number of \$ earned by the company for each \$                          Net income
invested by the shareholders. Of course, the higher the ratio,                  Shareholders’ equity
the better.

Return on Assets
How efficiently the firm uses its assets. The higher that rate of                    Net income
return, the more net sales dollars are providing income to the                       Total assets
business and the fewer net sales dollars are being absorbed by
expenses.

Return on Sales                                                                        Net income
Quick assessment of the profitability of total operations.                            Net sales

Gross Margin
Another indication of the profitability of the business, based on                    Gross profit
the gross profit. Therefore, it does not factor the operating                         Net sales
expenses, etc.

Profit Margin
Tells you the % of the company’s sales that are profits. Gives                       Net income
you one indication of the level of profitability of the business.                      Sales

Earnings per Share
Yet another indication of profitability based on the share price                     Net income
of the firm                                                           Avg. # shares common stock outstanding

E140A - Workshop B                                                                                           6
Market Ratios
Measure “market worth” of a share of stock; indicates return.
Price/Earnings (P/E) Ratio
Helps the investor to analyze the price of the stock. Generally          Current market share price
used in comparison to the industry as a whole.                              Earnings per share

Dividend Yield Ratio
Measures the percentage of a stock’s market value that is                   Dividend per share
returned annually as dividends. Preferred stock-holders who              Current market share price
invest primarily to receive dividends pay particular attention to
this ratio.

Return on Equity
net income
ROE         =      shareholders’
equity

net income                            sales                    assets
=           sales               x             assets        x       shareholders’
equity

=      profit margin            x       asset turnover      x    financial leverage

E140A - Workshop B                                                                                      7

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