1 Introduction to Financial Statement Analysis smartwomansecurities October 25, 2006 Carolyn Clark Harvard Business School These materials are made for

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Introduction to Financial Statement Analysis

smartwomansecuritiesOctober 25, 2006

Carolyn ClarkHarvard Business School

These materials are made for educational purposes and should not be distributed. All materials are for SWS members’ use only

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Announcements

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Announcements

• Industry Teams– Meet your team members; talk about your

company’s business and its competitors

• Industry Mentors– Your Industry Mentor will be emailed to

you this week; correspondence with Industry Mentors should be made as a group. For more details about Industry Mentors, check out the Mentor sheet you received last week!

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Senior Mentors• Senior Mentors

– Senior Mentors are another optional resource for SWS members.

– We currently have several Senior Mentors that we want to pair up with interested members; Senior Mentors are senior-level executives and professionals that have been highly successful in their various fields.

– We will send out information about Senior Mentors in an email after this seminar; in order to get a Senior Mentor, you will have to write a short paragraph detailing why you would like to have that person as your Senior Mentor.

– Depending on demand, we will likely only have 1-2 mentees per Senior Mentor.

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Senior Mentors

• Jodi Tan, Chief Financial Officer, Chimay Capital Management

• Emily Grimes Wood, Financial Advisor, Grimes and Company

• Eva Valentine, Principal Executive Officer, Aegis Financial Strategies– We will email you the bios of these women

after the seminar in order for you to get a better sense of what they do.

– We will update you as more opportunities to get Senior Mentors arise!

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Accounting and Financial Statements

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Financial Accounting• Why is accounting useful?

– Translates activities into objective numbers• Allows comparability across time, firms and

industries

– Enables the assessment of:• Performance• Problems• Prospects

– Informs the decisions of:• Managers of the company• Internal and external auditors• Investors and creditors

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Accessing Financial Statements

• How do investors get access to financial statements?– A public company’s financial statements

MUST be available to the public (further requirements as mandated by Sarbanes-Oxley, an act passed by Congress in 2002 to fight fraud in corporations)

– Look at your company’s website and find their 10K (annual report) or 10-Q (quarterly report) – this is usually found under “SEC Filings” or something similar

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Accessing Financial Statements

• Public Companies: www.sec.gov/edgar

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Financial Statements

• Annual Reports (10-K)– Company overview & business description– Accounting policies (GAAP)– Financial statements (and footnotes!)– Management discussion and analysis (MD&A)– Directors and executive officers’ bios– Executive compensation

• Quarterly Reports (10-Q)– Financial statements– MD&A

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Financial Statements

• What do investors look at?– Balance Sheet– Income Statement– Statement of Cash Flows– Footnotes

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Balance Sheet

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Balance Sheet

• Financial snapshot at a single point in time• Assets (what the company owns)

– economic resources that are expected to benefit future activities of the organization

• Liabilities (what the company owes) – the entity’s economic obligations to non-owners

• Owners’ equity (whatever is left)– the excess of the assets over the liabilities (also

called “stockholder’s/shareholder’s equity”) – Homeowner example

• Assets = Liabilities + Owner’s Equity

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Balance Sheet: Its Components

Assets: A company’s resources

Liabilities: Claims against the company’s resources

Owner’s Equity: Remaining Claims accruing to owners

Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

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Assets

Assets generate probable future economic benefits (value) for the company

• Examples: Cash, Accounts Receivable, Supplies, Inventory, Property and Equipment, Furniture, etc.

• Current Assets: Assets that can be converted to cash within one year or the operating cycle, whichever is longer (ie. cash, receivables, inventory)

• Non-Current Assets: Assets that are not expected to be converted to cash within that time period: property, plants, equipment, investments and funds


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Liabilities

Liabilities are obligations to deliver something of value (usually cash or services) in the future

• Examples: Accounts Payable, Salaries Payable, Interest Payable, Note Payable

• Current Liabilities: Obligations that are expected to be paid within one year (ie. notes payable, accounts payable, etc)

• Non-Current Liabilities: Obligations that are not expected to be paid within one year or the operating cycle, whichever is longer (ie. bonds payable, long-term notes payable, pension liabilities, capital leases)


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Shareholder’s Equity

Equity is the residual interest in the assets of an entity that remains after its liabilities are deducted

• Stock and Paid-in Capital• Retained Earnings• Treasury Stock• Other


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How we can read balance sheets

• Its usefulness– Gives information about the liquidity of a

company– Long-term solvency information (the ability of a

corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth)

• Its limitations– Assets are recorded at historical cost rather than

at market value (what you paid, not what it’s “worth”)

– Resources such as employee skills and reputation are NOT recorded on balance sheet

Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001; Investopedia.com

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An investor’s look at balance sheets

• Current Ratio: a measure of short-term liquidity risk

• Current Assets/Current Liabilities– Want to see a Current Ratio > 1 (ideally

between 1.5 and 2)• A ratio less than 1 means that a company

can’t pay its bills! • Anything over 2 means that the company

can easily fund its current liabilities, but may be keeping cash for other purposes.

Sources: What is a “Strong” Balance Sheet, Chris Cather, Motley Fool, fool.com, February 2, 2005

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• Return on Equity: Measure of the efficiency with which a company employs its owners’ capital

• Net Income / Owners’ Equity– Measures the percentage return to

owners on their investment (earnings per dollar invested)

– Helps managers and investors gauge where to allocate their capital

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• Debt-to-Equity: This ratio measures the amount of long-term debt financing relative to equity in a firm’s capital structure

• Long-term Debt / Owners’ Equity– Firms typically have a target debt-to-equity

ratio; the degree of leverage varies across industries

• Note: Don’t try to compare debt-to-equity ratios across different industries; in order to truly understand this ratio, must look at close peers to the company you’re covering

Sources: What is a “Strong” Balance Sheet, Chris Cather, Motley Fool, fool.com, February 2, 2005

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Example: Balance Sheet (AEOS)

American Eagle OutfittersIn Millions of USD (except for per share items) 2Q06 1Q06 4Q05

Cash & Equivalents 331.36 168.57 130.53

Short Term Investments 482.73 602.80 620.99

Cash and Short Term Investments 814.09 771.37 751.52

Accounts Receivable - Trade, Net 13.29 30.64 29.15

Total Receivables, Net 13.29 30.64 29.15

Total Inventory 267.39 195.31 210.74

Prepaid Expenses 33.95 33.35 30.11

Other Current Assets, Total 36.97 34.13 55.27

Total Current Assets 1,165.69 1,064.81 1,076.78

Property/Plant/Equipment, Total - Gross 752.03 689.87 667.02

Goodwill, Net 9.95 9.95 9.95

Long Term Investments 117.29 153.72 145.77

Other Long Term Assets, Total 39.24 32.17 27.63

Total Assets 1,736.57 1,617.26 1,605.65

Accounts Payable 175.93 121.03 139.20

Accrued Expenses 101.87 109.78 143.60

Notes Payable/Short Term Debt 0.00 0.00 0.00

Other Current liabilities, Total 60.83 63.74 68.69

Total Current Liabilities 338.63 294.56 351.49

Total Long Term Debt 0.00 0.00 0.00

Total Debt 0.00 0.00 0.00

Other Liabilities, Total 104.55 99.60 98.61

Total Liabilities 443.18 394.16 450.10

Common Stock, Total 1.70 1.62 1.61

Additional Paid-In Capital 403.75 387.66 370.62

Retained Earnings (Accumulated Deficit) 1,087.01 1,031.80 978.86

Treasury Stock - Common -224.13 -223.66 -216.51

Other Equity, Total 25.05 25.68 20.99

Total Equity 1,293.39 1,223.10 1,155.55

Total Liabilities & Shareholders' Equity 1,736.57 1,617.26 1,605.65

Total Common Shares Outstanding 149.40 148.93 147.93 From Google Finance

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Income Statement

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Income Statement• “Flow” in a given period (vs. a given

point in time)• Basic equation:

Net Income = Revenues – Expenses– Revenues: sources of income– Expenses: uses of income

• Net Income = “earnings” to be divided among the firm’s shareholders (EPS)

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Revenues and Expenses• Revenues are inflows of resources as a

result of providing goods or services to customers– Examples: Sales, interest income, gain on

sale of plant assets

• Expenses are outflows of resources incurred in generating revenues– Examples: Cost of goods sold, selling

expenses, general and administrative expenditures, depreciation, interest, income taxes

Source: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

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How we can read income statements

• Its usefulness– Summarizes sales and profits over a period of time– Lets us look at changes in key line items and ratios across

time to see whether operations have been changing

• Its limitations– Difficult to compare some ratios for companies in

different industries– Revenues reported don’t always equal cash collected, and

expenses reported aren’t always equal to cash paid, so income usually IS NOT EQUAL to the change in cash for the period

– There are many components in income statements; make sure you read the footnotes so that you’re getting the whole story!

Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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An investor’s look at income statements• Gross Profit = Revenue – Cost of Goods Sold (“COGS”)• Gross Margin = Gross Profit/Revenue• Operating Profit = Revenues – COGS – Remaining costs

involved in operations (ie. employee compensation, advertising, expenses, etc.)

• Operating Margin = Operating Profit/Revenue– Operating margin measures the proportion of a company’s

revenue that is left over after paying for costs of operating, such as labor, raw materials, etc.)

– A healthy gross margin is important for a company to pay its operating costs. The higher the margin the better!

• Note: Margins vary widely by industry. For example, software companies (ie, Microsoft) tend to have high margins, whereas retailers (ie, Wal-Mart) tend to have low margins

– Why? (Hint: think about the “value-add” each company offers its customers. How replicable are the goods/services each company is offering?)

• Lower-margin companies like Wal-Mart can still be very profitable because they make up for their margins through selling large volumes of products

Sources: Foolish Fundamentals: The Income Statement, Motley Fool, fool.com, August 25, 2006; Investopedia

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Income Statement (AEOS)In Millions of USD (except for per share items) 2Q06 1Q06 4Q05

Revenue 602.33 522.43 764.37

Other Revenue, Total - - -

Total Revenue 602.33 522.43 764.37

Cost of Revenue, Total 327.79 268.61 410.12

Gross Profit 274.53 253.82 354.24

Selling/General/Admin. Expenses, Total 143.58 135.76 160.87

Research & Development - - -

Depreciation/Amortization 21.70 19.23 19.15

Total Operating Expense 493.07 423.61 590.14

Operating Income 109.25 98.82 174.23

Other, Net 8.97 7.54 4.38

Income Before Tax 118.22 106.36 178.60

Income After Tax 72.10 64.16 107.14

Net Income Before Extra. Items 72.10 64.16 107.14

Net Income 72.10 64.16 107.54

Preferred Dividends - - -

Income Available to Common Excl. Extra Items 72.10 64.16 107.14

Income Available to Common Incl. Extra Items 72.10 64.16 107.54

Basic Weighted Average Shares - - -

Basic EPS Excluding Extraordinary Items 0.48 0.43 0.72

Basic EPS Including Extraordinary Items 149.20 148.48 151.60

Dilution Adjustment 0.00 0.00 0.00

Diluted Weighted Average Shares 152.81 152.26 151.46

Diluted EPS Excluding Extraordinary Items 0.47 0.42 0.71

Diluted EPS Including Extraordinary Items - - -

Dividends per Share - Common Stock Primary Issue 0.11 0.07 0.07

Diluted Normalized EPS 0.47 0.42 0.71

From Google Finance

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Statement of Cash Flows

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Cash Flows• Statement of cash flows provides relevant

information about a company’s cash inflows and outflows

• Net Income ≠ Cash!!– Net income is an accounting concept (GAAP

rules); cash is king

• Cash flows help investors (and creditors) assess– Future funding needs– Liquidity (cash to run daily/annual operations)– Long-term solvency (ability to pay bills and

service debt)Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

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Cash Flows

• Cash flows come from – Operating Activities

• How much cash do the firm’s core operations generate?

– Investing Activities • Buying and selling non-current assets

– Financing Activities• How does the company buy its assets and

pay its debts?

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Cash Flows from Operating Activities• Inflows

– Cash received from customers– Interest income on receivables– Dividends from investments

• Outflows– Purchasing inventory– Salaries, wages, and other operating

expenses– Interest on debt– Income taxes


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Cash Flows from Investing Activities• Inflows

– Cash received from sales of PP&E– Sale of investments

• Outflows– Purchasing long-term assets (PP&E)– Purchasing investments– Acquisitions of other companies,

divisions, etc.


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Cash Flows from Financing Activities• Inflows

– Cash received from sale of equity securities

– Cash received from borrowing, through bonds, loans, mortgages, etc.

• Outflows– Repaying debt– Paying out dividends to shareholders– Repurchasing stock in the market


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How we can read cash flow statements

• Its usefulness– You can actually see where cash is going;

can fill in the gaps between balance sheets– Get a better understanding of a company’s

investing and financing activities• Its limitations

– There are different methods to report cash flows that may vary across firms; it is often difficult to fully reconcile all of the cash inflows and outflows• Remember that competitors can read your

financial statements, too!!Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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An investor’s look at cash flows• Net Operating Cash Flow: This represents the

company’s true cash profit.• Net Investing Cash Flow: Investing activities let us

know what a company may to aiming to do in the future; high investing outflow means a company may be expanding to grow a business.

• Free Cash Flow = Operating Cash Flow – Capital Expenditures (represents the cash that a company is able to generate after laying out the money required to maintain/expand its basset base)

• Net Financing Cash Flow: Financing activities let us know what a company is doing to get more cash.

• Note: It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.

Sources: Vince Hanks, Motley Fool, fool.com; Investopedia

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Cash Flows (AEOS)In Millions of USD (except for per share

items) 2Q06 1Q06 4Q05

Net Income/Starting Line 72.10 64.16 107.54 Depreciation/Depletion 21.71 19.23 19.15 Amortization - - - Deferred Taxes -10.68 3.12 -5.13 Non-Cash Items 10.04 11.49 5.20 Changes in Working Capital 180.15 -43.75 142.01 Cash from Operating Activities 273.31 54.26 268.77 Capital Expenditures -71.44 -31.71 -21.79 Other Investing Cash Flow Items, Total -27.61 22.93 -247.15 Cash from Investing Activities -99.05 -8.78 -268.94 Financing Cash Flow Items 2.62 3.24 - Total Cash Dividends Paid -16.88 -11.21 -11.14 Issuance (Retirement) of Stock, Net 4.35 -1.71 -19.94 Issuance (Retirement) of Debt, Net -0.30 -0.17 -0.19 Cash from Financing Activities -10.20 -9.86 -31.27 Foreign Exchange Effects -1.27 2.42 1.62 Net Change in Cash 162.79 38.04 -29.83 Cash Interest Paid, Supplemental - - - Cash Taxes Paid, Supplemental 56.46 43.16 46.09

From Google Finance

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Key Takeaways

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Key Points

• Use balance sheets to assess a company’s financial position at a point in time– Look at key ratios to analyze a company’s

business

• Income statements measure performance– Look at the company’s performance over time in

terms of profits, margins, etc.

• Use statement of cash flows to follow the money– Look at where cash is going; free cash flow is a

key metric!

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Q&A

Documents

1 Introduction to Financial Statement Analysis smartwomansecurities October 25, 2006 Carolyn Clark Harvard Business School These materials are made for