Corporate Finance

Chapter 2
Introduction to Financial Statement
Analysis
 Learning Objectives
• LO-1review the four main types of financial
statements, present examples of these statements for a
firm.
• LO-2 discuss where an investor or manager might
find various types of information about the company
• LO-3 discuss some of the financial ratios that
investors and analysts use to assess a firm’s
performance and value.
• LO-4 close the chapter with a look at a few highly
publicized financial reporting abuses
 Discussion Points of Chapter
• Firms’ Disclosure of Financial Information
• The Balance Sheet
• The Income Statement
• The Statement of Cash Flow
• Other Financial Statement Information
• Financial Statement Analysis
• Financial Reporting in Practice
 Introductions
• Although the corporate organizational structure
greatly facilitates the firm’s access to investment
capital, it also means that stock ownership is most
investors’ sole tie to the company.
• How, then, do investors learn enough about a
company to know whether or not they should invest
in it?
• How can financial managers assess the success of
their own firm and compare it to the performance of
competitors?
• One way firms evaluate their performance and
communicate this information to investors is through
their financial statement.
 Firms’ Disclosure of Financial
Information
• Financial statements are accounting reports with past
performance information that a firm issues
periodically (usually quarterly and annually).
• U.S. public companies are required to file their
financial statements with the U.S.
• They must also send an annual report with their
financial statements to their shareholders each year.
• Private companies often prepare financial statements
as well, but they usually do not have to disclose these
reports to the public.
 Firms’ Disclosure of Financial
Information (Cont,)
• Reports about a company’s performance must be
understandable and accurate.
• Generally Accepted Accounting Principles (GAAP)
provide a common set of rules and a standard format
for public companies to use when they prepare their
reports.
• This standardization also makes it easier to compare
the financial results of different firms.
• Investors also need some assurance that the financial
statements are prepared accurately.
 Firms’ Disclosure of Financial
Information (Cont,)
• Corporations are required to hire a neutral third party,
known as an auditor, to check the annual financial
statements, to ensure that the annual financial
statements are reliable and prepared according to
GAAP.
 Types of Financial Statement
• Every public company is required to produce four
financial statements:
 the balance sheet,
 the income statement,
 the statement of cash flows &
 the statement of equity
 Balance Sheet

• The Balance Sheet Identity

• Assets = Liabilities + Stockholders> Equity
 Balance Sheet (Cont,)
 Assets
• Current assets are either cash or assets that could be
converted into cash within one year. This category
includes the following:
 Cash and other marketable securities
 Accounts receivable
 Inventories
 Other current assets (such as prepaid expenses )
Balance Sheet (Cont,)
 Balance Sheet (Cont,)

• Current assets are either cash or assets that could be

converted into cash within one year. This category
includes the following:
 Cash and other marketable securities
 Accounts receivable
 Inventories
 Other current assets (such as prepaid expenses )
 Balance Sheet (Cont,)

 Liabilities
• Current Liabilities. Liabilities that will be satisfied
within one year are known as current liabilities. They
include the following:
 Accounts payable
 Short-term debt or notes payable, and current
maturities of long-term debt
 Other current liabilities (Tax Payable , wage Payable)
 The difference between current assets and current
liabilities is the firm’s net working capital
 Balance Sheet (Cont,)
Long-Term Liabilities
 Long-term liabilities are liabilities that extend beyond
one year. The main types as follows:
1. Long-term debt
2. Capital leases
3. Deferred taxes
Shareholder equity
 The difference between the firm’s assets and
liabilities is the stockholders’ equity;
 it is also called the book value of equity.
 Balance Sheet (Cont,)
Market Value versus Book Value
 The total market value of a firm’s equity equals the
number of shares outstanding times the firm’s market
price per share:
 Market Value of Equity = Shares outstanding *
Market price per share
 The market value of equity is often referred to as the
company’s market capitalization (or “market
cap”)
 Balance Sheet (Cont,)
Market Value versus Book Value
 Market-to-Book Ratio. (also called the price-to-book
[P/B] ratio.

 low market-to-book ratios as value stocks,

 high market-to-book ratios as growth stocks.
 Balance Sheet (Cont,)
Enterprise Value
 A firm’s market capitalization measures the market
value of the firm’s equity, or the value that remains
after the firm has paid its debts. But what is the value
of the business itself?
 The enterprise value of a firm (also called the total
enterprise value or TEV)

Enterprise Value = Market Value of Equity + Debt - Cash .

 Income Statement
 The income statement or statement of financial
performance lists the firm’s revenues and expenses
over a period of Times.
 The income statement is sometimes called a profit
and loss, or “P&L” statement, and the net income is
also referred to as the firm’s earnings.
 Income Statement (Cont,)
 Gross Profit
 The first two lines of the income statement list the
revenues from sales of products and the costs
incurred to make and sell the products.
 Cost of sales shows costs directly related to
producing the goods or services being sold, such as
manufacturing costs.
 Other costs such as administrative expenses, research
and development, and interest expenses are not
included in the cost of sales.
 The third line is gross profit, which is the difference
between sales revenues and the costs
 Income Statement (Cont,)
 Operating Expenses
 The next group of items is operating expenses. These are
expenses from the ordinary course of running the business
that are not directly related to producing the goods or
services being sold.
 They include administrative expenses and overhead,
salaries, marketing costs, and research and development
expenses.
 The third type of operating expense, depreciation and
amortization, is not an actual cash expense but represents an
estimate of the costs that arise from wear and tear or
obsolescence of the firm’s assets.
 The firm’s gross profit net of operating expenses is called
operating income
 Income Statement (Cont,)
 Earnings before Interest and Taxes
 Earnings before Interest and Taxes. We next include
other sources of income or expenses that arise from
activities that are not the central part of a company’s
business.
 Income from the firm’s financial investments is one
example of other income that would be listed here.
 After we have adjusted for other sources of income or
expenses, we have the firm’s earnings before interest
and taxes, or EBIT
 Income Statement (Cont,)
 Pretax & Net Income
 From EBIT, we deduct the interest expense related to
outstanding debt to compute Global’s pretax income,
and then we deduct corporate taxes to determine the
firm’s net income.
 Net income represents the total earnings of the firm’s
equity holders. It is often reported on a per-share
basis as the firm’s earnings per share (EPS), which
we compute by dividing net income by the total
number of shares outstanding:
 Income Statement (Cont,)
 Stock options that give the holder the right to buy a
certain number of shares by a specific date at a
Specific price.
 Convertible bonds, a form of debt that can be
converted to shares.
 There will be more total shares to divide the same
earnings, this growth in the number of shares is
referred to as dilution.
 Diluted EPS, which represents earnings per share
for the company calculated as though, for exmple, in-
the-money stock options or other stock-based
compensation had been exercised or dilutive
convertible debt had been converted.
 The Statement of Cashflow
 The income statement provides a measure of the
firm’s profit over a given time period.
 However, it does not indicate the amount of cash the
firm has generated.
 There are two reasons that net income does not
correspond to cash earned.
 First, there are noon the income statement, such as
depreciation and amortization.
 Second, certain uses of cash, such as the purchase of
a building or expenditures on inventory, are not
reported on the income statement
 The Statement of Cashflow (Cont,)
 The firm’s statement of cash flows utilizes the
information from the income statement and balance
sheet to determine how much cash the firm has
generated, and how that cash has been allocated,
during a set period.
 As we will see, from the perspective of an investor
attempting to value the firm, the statement of cash
flows provides what may be the most important
information of the four financial statements.
 The Statement of Cashflow (Cont,)
 Three Sections
1. Operating activity( net income from the income
statement. It then adjusts this number by adding
back all non-cash entries related to the firm’s
operating activities)
2. Investment activity (lists the cash used for
investment)
3. financing activity (shows the flow of cash between
the firm and its investors)
 Other Financial Information
 Several other pieces of information contained in the
financial statements warrant brief mention: the
statement of stockholders’ equity, the management
discussion and analysis, and notes to the financial
statements.
 Change in Stockholders Equity
= Retained Earnings + Net sales of stock
= Net Income - Dividends + Sales of stock -
Repurchases of stock
 Other Financial Information
 The management discussion and analysis (MD&A)
is a preface to the financial statements in which the
company’s management discusses the recent year (or
quarter), providing a background on the company and
any significant events that may have occurred.
 Management may also discuss the coming year, and
outline goals, new projects, and future plans.
 Management is also required to disclose any off
balance sheet transactions, which are transactions or
arrangements that can have a material impact on the
firm’s future performance yet do not appear on the
balance sheet.
 Other Financial Information
 In addition to the four financial statements, companies
provide extensive notes with further details on the
information provided in the statements.
 For example, the notes document important accounting
assumptions that were used in preparing the statements.
 They often provide information specific to a firm’s
subsidiaries or its separate product lines.
 They show the details of the firm’s stock-based
compensation plans for employees and the different types of
debt the firm has outstanding.
 Details of acquisitions, spin-offs, leases, taxes, debt
repayment schedules, and risk management activities are
also given. The information provided in the notes is often
very important to interpret fully the firm’s financial
statement.
Solution
 The percentage growth in the sales of grocery products was
1761/1684 - 1 = 4.6%.
 Similarly, growth in Refrigerated Foods was -5.2%, Jennie-O
Turkey Store was -4.5%, Specialty Foods was -15.4%, and
International and Other categories were 6.7%.
 Thus, International and Other categories showed the highest
growth.
 If these growth rates continue for another year, sales of Grocery
Products will be 1761 *1.046 = $1842 million, and the other
categories will be $4173 million, $1589 million, $672 million,
and $581 million, respectively, for total revenues of $8.9 billion,
a 3.4% decrease from 2017.
 Financial Statement Analysis
 Financial Statement Analysis Financial ratios allow us to (i)
compare the firm’s performance over time, and (ii) compare
the firm to other similar firms.
 Key financial ratios measure the firm’s profitability,
liquidity, working capital, interest coverage, leverage,
valuation, and operating returns. See Table 2.4 for a
summary.
 EBITDA measures the cash a firm generates before capital
investments:
EBITDA = EBIT + Depreciation and Amortization
 Net debt measures the firm’s debt in excess of its cash
reserves:
Net Debt = Total Debt - Excess Cash & Short term Investments
 Financial Reporting in Practice
 The various financial statements we have examined
are of critical importance to investors and financial
managers alike.
 Even with safeguards such as GAAP and auditors,
though, financial reporting abuses unfortunately do
take place.
 Take assignment to study the Text Book Example
(Enron & Worldcom Case at page 84 & 85)
 In an attempt to improve the reliability of financial
reporting and corporate governance, Congress passed
the Sarbanes-Oxley Act (SOX) in 2002.
 Financial Reporting in Practice
(Cont)
 In an attempt to improve the reliability of financial
reporting and corporate governance, Congress passed
the Sarbanes-Oxley Act (SOX) in 2002.
 . SOX attempted to achieve this goal in three ways:
(1) by overhauling incentives and the independence
in the auditing process, (2) by stiffening penalties for
providing false information, and (3) by forcing
companies to validate their internal financial control
processes
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