UnderstandingFinancial Statements
Phil Drake (ASU) Tom Contiliano (Bloomberg)
A R I Z O N A S T A T EReynolds Business Journalism Week
• Welcome & Introduction– Speak the Language of FinanceTM
– Linking Business Decisions to Valuation
• The Accounting Equation
• Financial Statement Relations
• Ratio Puzzle Exercise
• Financial Statement Analysis
• Cash Flow Analysis aka “Follow the Money”
Agenda
When financial matters come up at work, you …
Can you read an annual report … with understanding?
How do they determine value so quickly?
Debt Providers
Equity Providers
Capital Markets
Customers
Suppliers
Financial
Assets & Liabilities
Operating
Assets & Liabilities
Product MarketsThe Firm
FCF
$
$
OI
OE
Financing Investing Operating
An Overview of the Marketplace
Essence of Valuation
Businesses invest in assets (people, ideas, equipment, and companies) that produce cash flows.
What is the right price to pay for (or, “fair value” to place on) an asset whose cash flows are expected in the future?
Three Behavioral Assumptions
Cash flows: want more rather than less• “greed”
Risk: want less rather more• “fear”
Timing: want now rather than later• “impatience”
Net Present Value of an Asset Formula
T
PV (asset) = Σt = 0
________1
(1 + r )t
CFt
Sum from now (t = 0) to a future time T
Present value of an asset
Cash flow at time t
Discount to the present
Behavioral assumptions captured in formula
Present value of an asset
“Greed”
“Fear” “Impatience”
PV (asset) = Σt = 0
________1
(1 + r )t
CFt
T
Financial Statements: The Link between Business Decisions and Valuation:
Seeing the World as an Accountant Does
INFORMATION
The Fundamental Accounting Equation
Assets = Liabilities + Shareholders’ Equity
In essence, everything that the firm owns (i.e., assets) it owes to it creditors (e.g., banks,
vendors, employees, bondholders) or it owners.
Everything You Need to Know About Accounting
• Balance Sheet– Reports the resources the firm controls at a point in
time and the claims against those resources.
The Financial Statements
Fundamental Accounting Equation
Assets = Liabilities + Shareholders’ Equity
• Balance Sheet– Reports the resources the firm controls at a point in
time and the claims against those resources.
• Income Statement– Reports revenues less expenses that result in net
income (or profits). The profits increase shareholders’ equity on the balance sheet.
The Financial Statements
Let’s Look at Amazon’s Financials
• Balance Sheet– Reports the resources the firm controls at a point in
time and the claims against those resources.
• Income Statement– Reports revenues less expenses that result in net
income (or profits). The profits increase shareholders’ equity on the balance sheet.
• Statement of Cash Flows– Explains the change in cash (from two balance sheets)
over a period of time, in terms of cash provided by or used for operating, investing, and financing activities.
The Financial Statements
• Assets– Probable future economic benefit– Obtained or controlled by the entity– As a result of past transactions
• Historical Cost vs. Fair Value (Mark to Market)
Definitions – Assets
• Cash• Accounts receivable• Inventory• Prepaid expenses• Property, plant and equipment• Investments• Goodwill & intangible assets
Example – Assets
• Liabilities– Probable future economic sacrifice– That is the responsibility of the entity– As a result of past transactions
• Parallels the asset definition
Definitions – Liabilities
• Accounts payable• Accrued expenses • Unearned revenues• Taxes payable• Bonds payable• Pensions• Capitalized leases
Example – Liabilities
• Equity is the owner’s contribution in the company. – Paid in Capital
• Common stock• Preferred stock• Treasury stock
– Retained earnings (undistributed profits)
– Other comprehensive income (items impacting the wealth of the shareholders, but not meeting the revenue or expense criteria)
Definitions – Shareholders’ Equity
• Assets listed in order of liquidity• Separation of current assets (liabilities)
and non-current assets (liabilities)• Assets on the left hand side (top) and
Liabilities and Equity on the right hand side (bottom)
The Balance Sheet – Typical Format
Definitions – Revenue
Revenue, generally, is realized or realizable and earned when all of the following criteria are meet:
1. There is persuasive evidence that an arrangement exists,2. Delivery has occurred or services have been rendered,3. The seller’s price to the buyer is fixed or determinable, and4. Collectability is reasonable assured.
Cash basis of accounting recognizes revenues when cash is received.
• Cost of goods and services used or consumed to generate the revenues recognized.
• Matching Concept – Expenses are recognized in the income statement their association with the revenues for which there incurred.
Definitions – Expenses
Typical Income Statement Format
Sales- Cost of goods sold
Gross margin- Operating expenses
Operating income+/- Other revenues (gains) /expenses (losses)
Income before taxes- Income tax expense
Net Income (loss)
Income Statement
For the Year Ended
Revenue- Expenses
Net Income
Statement of Retained Earnings
For the Year Ended
Beginning Retained Earnings
- Dividends Ending Retained Earnings
+ Net Income
Retained Earnings
Balance SheetAs of December 31
Assets Liabilities
Shareholder’s Equity
Paid-in Capital
Business Decisions in Financial Statements
“owns” “owes” others
“owes” owners
Investment FinancingOperations
Income Statement
Revenues
- Expenses
Net Income
employeessupplierslendersgovt.
customers
owners
Statement of Cash Flows• Purpose is provide information regarding the
sources and uses of cash.
• Summary of inflows and outflows of cash– Reconciles beginning and ending cash flows
• Segmented by activity– Operating
• Direct v. Indirect presentation
– Investing– Financing
Break
Financial Statement Analysis
Decomposition of Return on Common Equity
ROCE = Net income
Average Shareholders ' Equity
ROCE = Net incomeNet sales
xNet sales
Avg Total Assetsx
Avg Total Assets
Avg Shareholders ' Equity
ROCE can be rewritten into its drivers
Profit Margin Asset Turnover Leverage
Return on Assets
Return on Equity & Its Drivers
Add high margin sales; improve mix;
reduce costs per sales dollar
How much of each sales
dollar is retained as profit?
How many sales dollars are
generated by each $1 of
assets
Cut unproductive assets; manage receivables and
inventory
How well do we leverage equity with liabilities to
fund assets?
Borrow to increase leverage; manage
payables
ROCE = Net Income
Salesx
Sales
Ave. AssetsxAve. Assets
Ave. Equity
Ultimate goal: More output (income) for less input (equity).
Working Capital Management - Operating Cycle
Day 0PurchaseInventoryon credit
Day 30PayA/P
Day 75Sell
Inventoryon credit
Day 90Collect
A/R
Inventory Days ++ Receivable Days
Operating Cycle(75 + 15 = 90 days)
Working Capital Management - Cash-to-Cash Cycle
Day 0PurchaseInventoryon credit
Day 30PayA/P
Day 75Sell
Inventoryon credit
Day 90Collect
A/R
Inventory Days ++ Receivable Days
Cash-to-Cash Cycle(75 + 15 = 90 – 30 = 60 days)
AP Days
Breakout
Let’s work some examples!
Whew … It’s Over!!
No wait, it has just began!
Enjoy your Reynolds’ Week experience.