Financial Statement Analysis EBinder
Financial Statement Analysis EBinder
Analysis
Accounting Fundamentals
Introduction
Uses of accounting information
Examples
• Profitability analysis
• Cash flow analysis
• Forecasting
• Corporate valuation
• Credit analysis
• Deal structuring (M&A, LBO, divestitures)
• Company profiles
Financial analysis
4
Company accounts
Annual report
Key contents
MD&A
Notes to the
financial statements
6
The financial statements
Financial statements
8
Financial statements: The balance sheet
Liabilities
Equity
10
Balance sheet liabilities
An example
Current liabilities
11
12
Transaction examples
Balance sheet
Equipment
13
Income statement
An example
Net sales $ 7,386,626
Costs and expenses:
Cost of sales 4,003,951
Selling, marketing and administrative 1,969,308
Goodwill and other intangible asset impairment changes 280,802
Business realignment charges 94,806
Total costs and expenses 6,348,867
Operating profit 1,037,759
Interest expense, net 105,773
Other (income) expense, net 30,139
Income before incomes taxes 901,847
Provision for income taxes 388,896
Net income $ 512,951
14
Transaction examples
Balance Sheet and Income Statement
Liabilities
15
16
Cash flow statement
An example
Investing Activities
Capital expenditure (329,707)
Capitalized software additions (27,103)
Proceeds from sales of property, plant and equipment 1,205
Proceeds from sale of business 32,408
Equity investments in tax credit qualifying partnerships (30,720)
Business acquisitions, net of cash and cash equivalents acquired (218,654)
Sale (purchase) of short-term investments 95,316
Net cash used in investing activities (477,255)
Financing Activities
Net increase in short-term debt 10,720
Long-term borrowings 599,031
Repayment of long-term debt (355,446)
Cash dividends paid (476,132)
Exercise of stock options 72,719
Excess tax benefits from stock-based compensation 24,839
Payment of contingent consideration (10,000)
Purchase of non-controlling interest (38,270)
Repurchase of common stock (582,623)
Net cash used in financing activities (755,162)
Effect of exchange rate changes on cash and cash equivalents (10,364)
(Decrease) increase in cash and cash equivalents (28,325)
17
18
Financial statements
Key links
Cash flow
statement
Cash Liabilities
Assets Equity
19
Liabilities
Assets & Equity
+ Dr - Cr - Dr + Cr
20
The Income Statement
Overview
• Revenue
• Costs
• Profit margins
• Tax expense
• Net income
• EPS
2
The income statement
Revenue x
Making / buying your product Cost of goods sold (COGS) (x)
Gross profit x
Supporting the business Sales, general and admin. (SG&A) (x)
Operating profit x
Financing the business Interest / finance cost (x)
Profit before taxes x
Paying the government Tax cost (x)
Profit after tax / Net income x
Revenue
Revenue recognition
6
Key revenue links
Cash
Deferred revenue
Expenses
The income statement
Expenses
Sales x
Making / buying your product Cost of goods sold (COGS) (x)
Gross profit x
Supporting the business Sales, general and admin. (SG&A) (x)
Operating profit x
Financing the business Interest / finance cost (x)
Profit before taxes x
Paying the government Tax cost (x)
Profit after tax / net income x
10
COGS example
• In the first year of operation, Co. A spent $100 on 10 units of production and sold 8 units at
$12 each.
• What is the Cost of Goods Sold (COGS) for the year?
Co A. Inventory and COGS calculations
Starting inventory (0 units) 0
Production Costs
- Materials 50
- Labor 40
- Other production overheads (incl. 10
depreciation) 100
Total Production Costs (10 units @ $10)
Cost of Goods Sold (8 units @ $10) 80
Ending inventory (2 units @ $10) 20
11
12
SG&A example
At the start of the year, Co. A buys an accounting software package, which is
expected to last for 3 years, for $12 cash.
Co. A SG&A illustration
Acquired software (start of year) 0
Cash payment for accounting software 12
SG&A income statement expenses for the year 4
Acquired software (end of year) 8
13
Profit margins
Profit measurements
Revenue x
Gross profit x
Operating profit x
15
Income Statement
Gross Margin
Sales 100 60/100=60%
COGS 40
Gross Profit 60
SG&A 15
Operating Profit (EBIT) 45
EBIT Margin
Net interest expense 5 45/100=45%
Profit before tax 40
Tax 10
Net Income 30
16
Profit margins: EBITDA
17
Income Statement
Sales 100
COGS 40
Gross Profit 60
SG&A 15 PBT Margin
40/100=40%
Operating Profit (EBIT) 45
Net interest expense 5
Profit before tax 40
Net Margin
Tax 10 30/100=30%
Net Income 30
18
Profit margins
Summary
19
Normalized profits
• ‘One off’ income or expenses are usually removed from profit calculations to
facilitate comparisons and forecasting
• Non-recurring items are not expected to occur in the future
• They must be examined case-by-case
• Examples:
– Asset Impairments
– Business restructuring costs
– Large gains and losses on the sale of businesses or assets
– Large litigation costs
20
Normalized EBIT and EBITDA
21
Tax expense
Tax expense
• P&L reports the tax expense related to the reported profits before tax
• Tax expense ≠ Tax paid (in cash) during the period
• Effective tax rate (ETR) = Tax expense / Profit before tax
– Average tax rate on the reported profit
– Based on accounting data
• Marginal tax rate (MTR) = Tax applicable to the additional unit of profit
– MTR measurement is based on assumptions
– Typically: statutory tax rate on corporate income in the relevant jurisdiction(s)
23
Income Statement
Sales 100
COGS 40
Gross Profit 60
SG&A 15
Operating Profit (EBIT) 45
Net interest expense 5 ETR
10/40=25%
Profit before tax 40
Tax 10
Net Income 30
24
Using the ETR and MTR
Examples
25
Assets
Reinvestment
Returns
Shareholders
Net
Income
27
28
Earnings Per Share (EPS)
29
Equity metrics
30
Working Capital
Overview
• Current assets
• Current liabilities
• Working capital
• Analyzing working capital
2
Current assets
Current assets
4
Current assets: examples
From the notes of company accounts
• Cash and cash equivalents
– The Company considers all highly liquid investments with the original maturity of three
months or less to be cash equivalents.
• Accounts receivable
– In the normal course of business, the Company extends credit to customers that satisfy
pre-defined credit criteria.
– Accounts receivable are net of allowances and anticipated discounts.
• Inventories
– Inventories consist of materials, labor and overhead associated with the production
process.
– Inventories are valued at cost on a last-in, first-out (LIFO) basis for U.S. associated
companies and at the lower of cost (principally first-in, first-out basis) or market for non-
U.S. associated companies.
Inventory
Valuation
Mix Maintenance
Depreciation
Sand / water
Limestone
Factory labor
Utilities
Inventory
Cost of goods
Deliveries
sold when
delivered
6
Inventory
Income statement and balance sheet
Inventories
purchased
Inventory
COGS
asset
Inventory
Change during the period
8
Inventory valuation methods
Inventory valuation
Example
• No opening inventory
• Purchased 700 units for $6 each and later purchased 600 units for $8 each
• Sells 1,000 units at a price of $10 each
Inventory and Profit calculations LIFO FIFO
Opening inventory 0 0
Add: Purchases (700 @ 6 + 600 @ 8) 9,000 9,000
Less: Cost of goods sold (COGS) 7,200 6,600
(600 @ 8 + 400 @ 6) (700 @ 6 + 300 @ 8)
= Closing inventory 1,800 2,400
(300 @ 6) (300 @ 8)
10
Current liabilities
Current liabilities
12
Examples of key types of current liabilities
• Short-term debt
– Interest-bearing debt due within one year and / or current portion of long-term debt
• Accounts payable
– Amounts owed to suppliers
• Accrued expenses
– Operating costs incurred during the year but not yet paid
• Dividends payable
– Dividends declared but not yet paid to shareholders
• Taxes payable
13
Current
Current
liabilities
assets
Non current
= liabilities
Non current
assets
Equity
15
Working capital
Current
Current
liabilities
assets
Non current
= liabilities
Non current
assets
Equity
Financial Current
assets operating
liabilities
Current
operating Non current
assets operating
= liabilities
Financial Current
assets operating
liabilities
Current
operating Non current
assets operating
liabilities
=
Non current Debt
operating
assets
Equity
18
Operating working capital
Example
19
Inventory
Accounts payable
20
Operating working capital
Example (2 of 4)
Inventory
Accounts payable
21
Inventory
Accounts payable
22
Operating working capital
Example (4 of 4)
Inventory
Accounts payable
23
Equity
Non current
assets
Resources Funding
24
Should OWC be positive or negative?
Debt
Non current
assets
Equity
Resources Funding
25
26
Understanding OWC and its link with cash flow
Examples 3 and 4
• Example 3
Year 1 Year 2
OWC (720) (680)
Impact on cash flow? - ?
• Example 4
Year 1 Year 2
OWC (440) (540)
Impact on cash flow? - ?
27
28
Analyzing working capital –
Ratios
Receive cash
from customers
0 21 30
days
Acquire Deliver 41
raw product 11 days funding
materials required
Pay
suppliers
30
The cash cycle for a home improvements retailer
31
32
Estimating OWC days
Analyzing OWC components
Ending receivables
Receivable days = x 365
Sales
Ending payables
Payable days = x 365
Cost of goods sold
Ending inventories
Inventory days = x 365
Cost of goods sold
These ratios can also be calculated using averages (rather than ending balances)
33
Solutions to exercises
Operating working capital
Example (1 of 4)
Inventory + 10
Accounts payable
35
Buy a widget on day 1 of the week for 10.0 on credit payable in 30 days. The
widget will be sold for 20 on day 7 in cash.
Inventory + 10
Accounts payable + 10
36
Operating working capital
Example (3 of 4)
Buy a widget on day 1 of the week for 10.0 on credit payable in 30 days. The
widget is sold for 20 on day 7 in cash.
Inventory + 10 – 10 = 0
Accounts payable + 10
37
Buy a widget on day 1 of the week for 10.0 on credit payable in 30 days. The
widget is sold for 20 on day 7 on credit, payable in 60 days.
Inventory + 10 – 10 = 0
Accounts payable + 10
38
Understanding OWC and its link with cash flow
Examples 3 and 4
• Example 3
Year 1 Year 2
OWC (720) (680)
Impact on cash flow? - (40)
– Negative cash flow impact of 40 during year 2 because increasing OWC requires more
funding
• Example 4
Year 1 Year 2
OWC (440) (540)
Impact on cash flow? - 100
– Positive cash flow impact of 100 during year 2 because decreasing OWC releases cash
39
Non-current Assets
Non-current assets
What are they?
2
Non-current assets
Presentation example
• A process that spreads the cost of an asset over its useful life
• Applied to PP&E (depreciation) and to intangibles (amortization)
Depreciable
Original cost “How many years value
of asset are we going to use
this asset for?”
Salvage
value
Year 1
Year 2
Depreciable “The asset will last
me five years” Year 3
value
Year 4
Year 5
6
Depreciation & amortization
Expense
Accelerated
(higher in the earlier years)
Straight-line (constant)
40
20
Time
8
Goodwill
Beginning amount
Subtractions Depreciation
Ending amount
11
Intangible assets
BASE analysis
Beginning amount
Subtractions Amortization
Ending amount
12
Ratio analysis
‘PP&E turnover’
Sales
What is the relationship between the
Net PP&E investment (PP&E) and the sales?
Capex
Is PP&E growing?
Depreciation
13
Debt and Equity
Equity Debt
2
Equity Financing
Equity
Provide funds
Shareholders Corporation
2
(May) receive
dividends
1) Equity investments do not have a maturity
2) Dividends are discretionary payments
4
Common stock
Number of Shares
6
Retained earnings
BASE analysis
Beginning amount
Subtractions Dividends
Ending amount
Equity
Balance sheet presentation
Par value of all shares
Common stock
issued
8
Preferred stock
• Preference shares
• Only some companies have them
• Ranks above common stock on liquidation
• Debt-like characteristics:
– No voting rights (usually)
– No maturity (usually)
– Regular dividend payments (like interest)
Debt Financing
Financial debt
Lend funds
1
Lenders 2
Pay interest Borrower
3
Repay funds
11
Debt
Key terms
12
Debt instruments
Examples
13
Debt metrics
14
Leverage illustration
House purchase
Debt Debt
Initial $2m $2m
house House
value value
$3m Equity increases Equity
$1m to increases
$4m to
(33%) $2m
(100%)
15
Return measures
Return on capital
Return
Return on
capital =
Capital
How much capital was
invested?
17
Net income
Return on
equity =
Shareholders’ equity
18
ROE decomposition (DuPont analysis)
19
20
ROIC Decomposition
21
Cash Flow Statement
4
Rules of cash flow
Summary
8
Cash flow categories
10
Categorising cash flows
Change
Year 1 Year 2 Category
in cash
Cash 50 55
Inventories 30 20 10 Operating
Net PP&E 40 45 (5) Operating & Investing
Debt 60 50 (10) Financing
Retained earnings 60 70 10 Operating & Financing
11
Beginning balance 40
CF
Subtractions Depreciation (3) O
Ending balance 45
12
Splitting the movement of retained earnings
Retained earnings BASE
Beginning balance 60
CF
Additions Net income 12 O
Ending balance 70
13
Cash reconciliation
The net cash flow shown in the cash flow statement must be reconciled with the
cash shown on balance sheet
16
The complete cash flow statement
Year 2
Net Income 12
Depreciation 3
Change in inventories 10
Cash flow from operations 25
Capital expenditure (8)
Cash flow from investing (8)
Change in debt (10)
Dividends paid (2)
Cash flow from financing (12)
Net cash flow 5
17