Investment Club Training Program Fall 2019

Lesson 4: Financial Statements

September 29th, 2019

Announcements / Reminders
§ Finance Journal: Reminder to submit! Please do so before midnight
tonight!

§ Participation quiz answers will be sent out afterwards

§ Office Hours scheduled and by appointment:

§ Alex Yu: Mondays 8:45-10:00pm, Perkins 110
§ Alex Sanfilippo: Tuesdays 7:00-8:00pm, Perkins 128
§ Michael Li: Thursdays 6:00-7:15pm, Perkins 110

§ Any questions?

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ITP Curriculum

1. Introduction to Markets, Economics, and a Career in Finance (Week 1; 9/8)

2. Equities, Debt, and Other Investments (Week 2; 9/15)
3. Fundamentals of Investing (Week 3; 9/22)
4. Financial Statements (Week 4; 9/29)
5. Valuation (Week 5; 10/13)
6. Discounted Cash Flow Analysis (Week 6; 10/20)
7. Discounted Cash Flow Workshop (Week 7; 10/27)
8. Interview Questions and Mastering the Statements (Week 8; 11/3)
9. Sample Stock Pitch + Working Day (Week 9; 11/10)
10. Stock Pitches (Week of 11/17)
11. Final Exam (Week 10; 11/24*)

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What happened in the
markets this week?
Discuss with the person next to you!

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Background
What Are Financial Statements?
§ Definition:
§ Records that convey the business activities and financial performance of
a company
§ Why do they matter?

Three Financial
Statements

Income Cash Flow Balance

Statement Statement Sheet

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Securities and Exchange Commission (SEC)
§ Established by the Securities Exchange Act of 1934
§ Primary agency for regulating the securities industry and enforcing
securities law
§ Protects against insider trading, financial fraud, and market
manipulation
§ Enforces financial reporting
§ EDGAR; BamSEC
§ Goal is to ensure that all investors in public companies have an even
playing field

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Financial Reporting
§ Accounting: The process of communicating financial information about a
business to the public and/or government through the use of financial
statements
§ U.S. “GAAP”
§ Generally Accepted Accounting Principles set by the Financial Accounting Standards
Board (FASB)
§ The rules that all companies must follow when presenting their financial statements
§ Follows accrual-basis rather than cash-basis rules
§ SEC Reporting
§ Public companies are required to disclose their financial statements
§ Most common:
§ Form 10-K – Annual Reports
§ Form 10-Q – Quarterly Reports
§ All forms can be found on EDGAR, BamSEC, or company website

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Why Do We Care about Accounting and Financial Statements?
§ Complete “diagnostic” of a company
§ Sophisticated investors look at the same statements we do

§ Foundation of fundamental research

§ An understanding of the statements is the first tool necessary for identifying
winners and losers

§ Source for vast majority of valuation inputs

§ Historical data informs projections

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SEC Form 10-K
Use the following link:
https://investors.nike.com/investors/news-events-and-
reports/default.aspx

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The Three Statements
Income Statement
The Three Statements
§ Income Statement
§ A report of flows over a period of time
§ How much money the company brings in (revenues)
§ How much it costs to bring that money in (expenses)
§ How much money is left over (profit)

§ Statement of Cash Flows

§ A report of flows over a period of time
§ What cash has come in or out, and for what purposes

These statements are connected

§ Balance Sheet to and dependent on each other!
§ A snapshot at a moment in time Stay tuned…
§ What the company owns (assets)
§ What the company owes to others (liabilities)
§ What remains accrues to owners (equity) 13
Income Statement
§ What: A statement that measures a
company’s financial performance
over a specific accounting period Income Statement Examples

Revenue: $20.61bn
§ Why: Facilitates analysis of a Net Income: $10.3bn
company’s growth prospects, cost Revenue: $24.9bn
structure, and profitability Net Income: $1.1bn

Revenue: $21.5bn
§ How: Financial performance assessed Net Income: $(1.1bn)

by summarizing revenues and

Revenue: $3.3bn
expenses through operating and non- Net Income: $483.8mm
operating activities
§ “Line items” map to “Net Income” or What would you want to own
“Net Loss” based on this? What might be
missing…
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Income Statement Breakdown
Revenue
– COGS “Top-line”
= Gross Profit

– Operating Expenses
= *EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
– Depreciation and Amortization
= EBIT (Earnings Before Interest and Taxes)

+ Other Income
+/ – Non-Operating Gains/Losses
– Interest Expense
= Pre-Tax Income

– Taxes
“Bottom-line”
= Net Income
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*EBITDA is a non-GAAP measure and generally not found on official financial statements
Income Statement Terminology

Revenue Represents the amount of money collected from a business’ primary operating activities

Cost of Goods The “variable cost” associated with the collection of revenue; direct cost of a good or
Sold service

= Revenue – COGS
Gross Profit Represents a business’ operating profitability only accounting for variable costs

Operating Fixed costs of managing a company that must be paid regardless of revenue; typically
Expenses includes marketing, R&D, and Selling, General, and Administrative (SG&A)

= Gross Profit – Operating Expenses

EBITDA Represents a business’ overall operating profitability that does not include the impact of
financing (interest) or accounting technicalities (depreciation)

Depreciation is a non-cash accounting technicality used to expense the cost of hard assets
Depreciation &
(PP&E) over time by gradually reducing their book value; Amortization is equivalent but
Amortization for intangible assets (IP)

= EBITDA – D&A
EBIT Represents the profits generated by the core business’ operating activities

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Income Statement Terminology
Other Income Income (or expenses) generated from secondary activities that differ from the primary
(Losses) revenue source

Non-Operating Adjustments to the value of a company’s Assets or Liabilities unrelated to the core
Gains (Losses) operating activities that affect overall profitability

Interest Expense
Costs associated with borrowing
(Income)

= EBIT + Other Income +/– Non-Operating Gains/Losses – Interest Expense

Pre-Tax Income Profitability before accounting for taxes

A portion of earnings that a company pays to a government, calculated as a percentage of

Taxes Pre-Tax Income

= Pre-Tax Income – Taxes

Net Income The overall profitability of a business - usually called “Earnings”

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Income Statement Example: AAPL
§ Any reactions?

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Income Statement
Usefulness Limitations
§ Summarizes P&L over a period of § Management teams have lots of
time options for accounting practices
within the income statement
§ Shows changes in key line items
and ratios across time to see § Because of the accrual system,
whether operations have been revenues and expenses reported
changing, and in which direction may not reflect the cash position
of a company
§ Essential for forecasting
§ It does not evaluate non-revenue
factors for success

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Cash Flow Statement
Cash Flow Statement
§ Reflects cash inflows and outflows to show
changes in a company’s cash over a period of
time

§ Management judgement lead to a potentially

misleading or even manipulated Income
Statement
§ Case 1: Profitable company with significant non-
cash revenues
§ Case 2: Company with low or negative
profitability and major non-cash D&A expenses

§ The CFS translates net income into an actual

change in cash balance over a period of time
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Cash Flow Statement Sections
§ Cash from Operations (CFO):
§ Cash flows from what the company actually does
§ Revenues and expenses are baked into net income
§ Add back non-cash expenses such as D&A
§ Subtract changes in current assets, add changes in current liabilities

§ Cash from Investing Activities (CFI):

§ Cash flows from any investment activity
§ Capital Expenditures (Purchases of Property, Plant, and Equipment)
§ Purchases and sales of assets or debt / equity securities

§ Cash from Financing Activities (CFF):

§ Cash brought in from and paid out to financing sources
§ Issuance / repayment of debt
§ Issuance / repurchase of stock
§ Payment of a dividend 22
Statement of Cash Flows

Cash from
Operations

Cash from
Investing

Cash from
Financing

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Cash Flow Statement
§ Cash Flow (CF) vs. Free Cash Flow
(FCF)
§ CF: The net amount of cash
equivalents being transferred into
out out of a company
§ FCF: Cash left over after a company
has paid its operating expenses and
capital expenditures

§ Investors often refer to FCF as the

“cash” that the company is
producing
§ Company decides what to do with
the free cash flow (expand, pay
down debt, pay a dividend, etc.)
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Cash Flow Statement Transactions
§ Classify the following activities as operating, investing, or financing
activities and as inflows or outflows:
§ $100 equity injection and $100 debt raising with 5% interest
§ $100 purchase of a food truck
§ $60 purchase of raw denim to manufacture jeans

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Balance Sheet
Balance Sheet

Assets = Liabilities + Shareholders’ Equity

Operations Financing

§ Assets: what the company owns

§ Resources with quantifiable economic value that will provide future benefit
§ Examples: Cash, Accounts Receivable, Inventory, Property Plants & Equipment
(PP&E), etc.

§ Liabilities: what the company owes

§ Company’s debts or obligations to be paid back in the future in some form
§ Examples: Debt, Accounts Payable, Accrued Expenses, etc.

§ Shareholders’ (Owners’) Equity: what the company shareholders own

§ Money left over for the company owners
§ Examples: Common Stock, Preferred Stock, Retained Earnings, etc.

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Balance Sheet Example

“Current” assets
examples

Long-term assets
examples

“Current” liabilities
examples

Long-term liabilities
examples

Shareholders’ equity
examples

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Pros and Cons of the Balance Sheet
§ Why is it useful?
§ Gives us information about the operations and liquidity of the company at
any moment in time
§ Understand how “asset intensive” a company is or how many assets are necessary
to operate
§ Reveals information about company’s financial health and leverage profile

§ What are its limitations?

§ Assets are recorded at historical cost (“book value”) rather than at market
value
§ What company paid, not what it is “worth” or the price at which one could sell the
asset
§ Some current assets are valued on estimated basis
§ Doesn’t include important non-monetary “intangible” assets
§ Examples: employee skills, brand awareness, firm reputation, etc.

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Financial Ratios
What are Financial Ratios?
§ Snapshot-in-time relationships determined from a company’s
financial information
§ Gives investors various metrics on which to compare companies
§ Tracking ratios over time can be effective for identifying trends in their
early stages

§ The company perspective:

§ Ratios may affect ability to obtain debt or equity financing
§ “Covenants” on borrowing

§ Measures:
§ Profitability
§ Leverage
§ Liquidity
§ Efficiency
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Profitability
§ How profitable is the company?

§ Gross Margin: Gross Profit / Revenue

§ EBITDA Margin: EBITDA / Revenue

§ Operating Margin: Operating Profit / Revenue

§ Return on Assets (ROA): Net Income / Avg. Total Assets

§ Return on Equity (ROE): Net Income / Shareholders’ Equity

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Leverage
§ How levered is the company?

§ Total Debt vs. Net Debt

§ Net Debt = Total Debt – Cash

§ Debt-to-EBITDA: Net Debt / EBITDA

§ Interest Coverage: EBIT / Interest Expense

§ Debt-to-Equity: Total Debt / Total Equity

§ Debt-to-Assets: Total Debt / Total Assets

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Liquidity
§ How easily can the company convert assets to cash?
§ Liquidity Ratios
§ Working Capital: Current Assets – Current Liabilities
§ Current Ratio: Current Assets / Current Liabilities
§ Quick Ratio: (Current Assets – Inventory) / Current Liabilities

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Efficiency
§ How well does a company use its financial assets and liabilities?
§ Ratios:
§ Inventory Turnover: Cost of Goods Sold / Avg. Inventory
§ Accounts Receivable Turnover: Revenue / Avg. Accounts Receivable
§ Accounts Payable Turnover: Cost of Goods Sold / Avg. Accounts Payable

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Three Statement Example: Nike
Nike: Income Statement
§ Revenue: Alex and Alex buy Michael some Nike Elites for his birthday
§ Revenue recorded regardless of payment method!

§ Cost of Goods Sold: Nike purchases the thread and polyester fabrics for
its Dri-FIT goods

Consider this photo. How would

costs be broken down for Nike?
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Nike: Income Statement
§ Operating Expenses: Nike runs an advertising campaign with Cristiano
Ronaldo to improve cleat sales
§ Depreciation: “Depreciation and amortization of assets used in
manufacturing, warehousing and product distribution are recorded in Cost
of Sales. Depreciation and amortization of all other assets are recorded in
Operating overhead expense” – Nike 10-K
§ This is valuable information! Why?

“Capital Expenditure”

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Nike: Income Statement
§ Other Income (Expense): Nike sells many more cleats in Europe
because everyone loves Ronaldo. They have to convert the revenues in
Euros to USD. But the Euro’s value against the dollar plummets after
the purchase of those cleats because of a hard Brexit. What happens?
§ “Net beneficial change in foreign currency conversion gains” – Nike 10-K

Where is the Euro / USD right now?

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Nike: Income Statement
§ Interest Expense: Nike takes out a loan due November 1, 2045 with an
interest rate of 3.88%
§ Taxes: Nike pays the US Government as well as “numerous foreign
jurisdictions”
§ 2019 Effective Tax Rate: 16.1%
§ Corporate Tax Rate: 21% - what’s going on here?
§ Per Nike, “Portions of our operations are subject to a reduced tax rate or are free
of tax under various tax holidays and rulings”

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Statement of Cash Flows

Cash from
Operations

Cash from
Investing

Cash from
Financing

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Nike: Cash Flow Statement
§ Operating Activities:
§ Accounts Receivable decreased $187 million, primarily due to improved
collection, compared to an increase of $426 million in fiscal 2017
§ Accrual of $1.17 billion transition tax under the Tax Act, which will be paid in
cash over an eight-year period (increase in DTLs)

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Nike: Cash Flow Statement
§ Investing Activities:
§ Planned to continue investing in infrastructure to support future growth, including
corporate facilities, digital capabilities, and new NIKE Direct stores (approximately 3-
4% of revenues)
§ During fiscal 2018, there was a cash inflow of $1.33 billion from the winding down of
short-term investments

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Nike: Cash Flow Statement
§ Financing Activities:
§ Purchased 69.7 million shares of NIKE’s Class B Common Stock for $4.3
billion in fiscal 2018

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Nike: Balance Sheet

“Current” assets
examples

Long-term assets
examples

“Current” liabilities
examples

Long-term liabilities
examples

Shareholders’ equity
examples

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 Current
Asset
Nike: Balance Sheet (Assets)
§ Cash and Equivalents: The amount of cash or highly
liquid securities (treasury bills, commercial paper,
etc.) the company has on-hand

§ Accounts Receivable: Any payments owed to a

company expected to be collected
§ Linked to revenues on income statement
§ Example: Customer buys Nike LeBron 16 shoes with
credit card, credit card company hasn’t paid Nike yet

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 Current
Asset
Nike: Balance Sheet (Assets)
§ Inventory: Goods that have not yet been sold or delivered to
customer
§ Usually equivalent to the cost of making that good (COGS) or how
much the inventory item was purchased for
§ Flows over to income statement as COGS expense when sold
§ Example: Unsold shoes on the display racks and storage room at Nike
stores

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 Current
Asset
Nike: Balance Sheet (Assets)
§ Prepaid Expense: A payment that has been made in advance for
an expense that has not yet occurred
§ Asset because company has paid for the rights to use future services
§ Often includes insurance, rent, utilities, etc.
§ Example: Signing LeBron James to a lifetime endorsement contract to
use him in future advertisements (expense)

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 Non-
Current
Nike: Balance Sheet (Assets) Asset

§ Property, Plant & Equipment (PP&E): Factories, buildings, land,

equipment, and other fixed assets that last for over a year used in the
production / manufacturing of company’s core business
§ Reported as a net of accumulated depreciation
§ New purchases of PP&E are called “capital expenditures”
§ Example: Factories, machines, and other equipment used to produce Nike
products; Nike retail stores and corporate offices

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 Current
Liability
Nike: Balance Sheet (Liabilities)
§ Debt: The collective amount a company has borrowed that it has yet
to pay back
§ “Short-Term Debt”: Due within one year (current)
§ “Long-Term Debt”: Due in more than one year (non-current)

§ Accounts Payable: Any payments that a company owes, such as

those to a supplier
§ Example: Nike receives rubber and polyester from their raw materials
suppliers and will pay them back at the end of the month

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 Current
Liability
Nike: Balance Sheet (Liabilities)
§ Accrued Liabilities: Expenses that have already been incurred but
not yet paid
§ Typically include wages, insurance, rent, taxes, royalties, etc.
§ Example: Nike corporate office employees aren’t paid for their work until
end of the month (“salaries payable”)

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 Current
Liability
Nike: Balance Sheet (Liabilities)
§ Deferred (Unearned) Revenue: Revenue received in advance for
products/services not yet provided
§ Recognized as actual revenue once delivered
§ Especially prevalent with subscription model companies
§ Example: Customer pre-orders Nike LeBron 17 shoes but Nike hasn’t
released them yet
§ Example: Alex gives me a $50 Nike gift card that I haven’t redeemed yet

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 Owners’
Equity
Nike: Balance Sheet (Owners’ Equity)
§ Retained Earnings: Net income left over (“retained”) for business
after paying dividends
§ Connection between income statement and balance sheet
§ All income on income statement increases retained earnings
§ All expenses on income statement decreases retained earnings

Retained Retained
Net Income Dividends
Earnings + (During Year)
– (During Year) = Earnings
(Start of Year) (End of Year)

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 Owners’
Equity
Nike: Balance Sheet (Owners’ Equity)
§ Common Stock: Equity with voting rights
§ Nike has Class A and Class B common stocks (different voting rights)

§ Preferred Stock: Equity with no voting rights

§ Nike has not issued preferred stock

§ Treasury Stock: Shares repurchased by company

§ Nike announced $15bn in stock buybacks in 2019

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3 Statement Flow

Cash Flow Statement Balance Sheet

Income Statement
Cash Flows from Operating Activities
= Net Income
Revenue (Sales) Assets
+ Depreciation and Amortization
– COGS = Cash
+/– Non-Operating Losses/Gains
– Change in Net Working Capital + Current Assets (Inventory)
= Gross Profit + Non-Current Assets (PP&E)
– SG&A
+
= EBITDA =
– Depreciation and Amortization Cash Flows from Investing Activities
= Purchases of PP&E (CapEx) Liabilities
= EBIT (Operating Income) = Current Liabilities (Accounts Payable)
+/– Non-Operating Gains/Losses + Non-Current Liabilities (Debt)
+
– Interest Expense
+
= Pre-Tax Income Cash Flows from Financing Activities
– Taxes = Debt or Equity In/Outflows
– Dividend Payments Shareholders’ Equity
= Retained Earnings (Net Income –
= Net Income Dividend Payments)
= Free Cash Flow

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Want to Learn More?
§ Econ 174: Financial Accounting
§ Professor C.J. Skender
§ Highly recommended to take before recruiting for the junior year internship

Look at that
flow!

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Participation Quiz
Participation Quiz

www.tinyurl.com/fall19q4

No class next week – have a great Fall Break!

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