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.