Financial Statement Analysis. Financial statements: A reminder

Financial Statement Analysis Financial statements: A reminder The Balance Sheet Income statement Cash flow statement Fahmi Ben Abdelkader Required Reading 10/4/2017 11:56 AM 1 Overview of financial statements Revenues and expenses Gains and losses Equity Cash inflows and outflows Income statement Statement of comprehensive income Balance sheet Cash flow statement 2

A reminder of financial statements Balance sheet Income statement Cash flow statement 3 The Balance Sheet The Balance Sheet Identity Lists the firm s assets and liabilities Provides a snapshot of the firm s financial position at a given point in time. The Balance sheet does not reflect the firm s financial position during the year Employments (uses of funds) What does the money get spent on? and Shareholders equity Financial Resources Where does the money come from? Total + Shareholders equity An accounting measure of a firm s net worth 4

The Balance Sheet Liquidity And maturity dates A condensed presentation of the Balance Sheet and Shareholders equity Long-lived (physical or intangible) that produce benefits for more than one year Shareholders equity Investment of Shareholders and accumulated reinvested profits Asset liquidity Inventories Accounts receivable Cash and marketable securities Items held for sale or used in the manufacture of products that will be sold amounts owed to the firm by customers who have purchased on credit short-term investments easily sold and converted to cash Long-Term Financial Debt Short-Term Financial Debt Accounts Payable Loan or debt obligation with maturities beyond one year Loan that must be repaid in one year Amounts owed to suppliers purchases made on credit Maturity dates Total + Shareholders equity 5 The Balance Sheet Liquidity And maturity dates Example: JIT : Just-In-Time Computer Services Consolidated Statements of Financial Position Prepared According to IFRS in millions N+1 N and Shareholders' Equity N+1 N Goodwill 0,0 0,0 Intellectual property rights, brands and other intangible assets 41,0 14,0 Net Property, Plant and Equipment 78,7 66,9 Financial (Equity in Joint ventures, investments in shares and participations, deferred tax assets, etc.) 1,0 0,0 Total Shareholders' Equity 32,2 31,2 Long-term financial debt 106,0 61,8 Total non-current assets 120,7 80,9 Non-current liabilities 106,0 61,8 Inventories 15,3 14,3 Accounts receivables 18,5 13,2 Other current assets 0,0 0,0 Short-term financial debt 9,0 11,0 Accounts payable 30,5 24,9 Asset liquidity Short-term investments 2,0 1,0 Cash and cash equivalents 21,2 19,5 Current liabilities 39,5 35,9 Maturity dates Total current assets 57,0 48,0 TOTAL NET ASSETS 177,7 128,9 TOTAL LIABILITIES AND EQUITY 177,7 128,9 6

The Balance Sheet Long-Term (or Non-Current or Fixed) assets that produce benefits for more than one year Reduced through a yearly deduction called depreciation according to a schedule that depends on an asset s life. Depreciation is not an actual expense, but a way of recognizing that fixed assets wear out and become less valuable as they get older. The book value (or carrying amount) of an asset is its acquisition cost less its accumulated depreciation 7 The Balance Sheet Tangible versus Intangible assets Tangible Machinery and equipment Buildings Land Have physical substance Intangible assets Patents Copyrights Brand Names Franchises Goodwill: Arises when one company acquires another company for a price in excess of the book value of the net identifiable assets acquired 8

The Balance Sheet Depreciation Fixed assets other than land are depreciated over the period of time they benefit the firm. The process of depreciation is a method of allocating the cost of long-lived assets. Original cost less estimate residual value is spread over the asset s expected life Two main methods: 1. Straight-line method allocates an equal amount of expense to each year of the depreciation period. 2. Accelerated method apportions larger amounts of expense to earlier years of the asset s depreciable life 9 The Balance Sheet Depreciation versus Amortization Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent, with each portion being recorded as an expense on the company's income statement. Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before it becomes run down and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year. Depreciation is applicable only on Fixed & Tangible which depends on useful life of that assets that may be expected accurately but Amortization is applicable on Intangible whose life is very critical to be measured 10

The Balance Sheet Current Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12 months Inventories Items held for sale or used in the manufacture of products that will be sold Industry is critical Retail Company (one type of inventory): Finished goods Manufacturing Company (three types of inventory) raw materials, work-in-progress and finished goods held for eventual sale; Accounts receivable amounts owed to the firm by customers who have purchased on credit Cash and marketable securities short-term and low-risk investments (investments in cash that is not needed) easily sold and converted to cash Ex. U.S. Treasury bills, bonds, commercial paper, etc. 11 The Balance Sheet Current Zoom on Deferred Tax Asset (=Deferred Income Tax) Deferred Tax Deferred tax assets are created due to taxes paid or carried forward but not yet recognized in the income statement. This asset helps in reducing the company s future tax liability deferred tax asset will only be recognized when the difference between the loss-value or depreciation of the asset is expected to offset future profit For example (from: www.investopedia.com/), a computer manufacturing company estimates based on previous lines of production that the probability a computer will be sent back for warranty repairs in the next year is 2% out of the total production. If the company's total revenue in year 1 is $3,000 and the warranty expense is $60 (2% * $3,000) then the company's taxable income is $2,940. However most tax authorities do not allow companies to deduct expenses based on expected warranties, thus the company would actually require to pay taxes on the full $3,000. If the tax rate for the company is 30% then: The difference of $18 ($900 - $ 882) between the taxes payable in the income statement and the taxes payable to the tax authority is considered the deferred tax asset. 12

The Balance Sheet Accounts Receivable and Allowance for doubtful accounts Customer balances outstanding on credit sales Reported on the balance sheet at net realizable value: actual amount less an allowance for doubtful accounts Affect balance sheet valuation and bad debt expense on income statement Can be crucial in assessing earnings quality Should reflect volume of credit sales, past experience with customers, customer base, credit policies, collections practices, and economic conditions Example: Accounts Receivable and Allowance for doubtful accounts of the World Company (Million) 2009 2010 Growth rate Net Sales $153.0 $215.6 40.9% Accounts receivable $ 8.7 $ 9.4 7.3% Allowance for doubtful accounts $ 0.41 $ 0.44 7.4% 13 The Balance Sheet Inventory Accounting Methods Valuation is based on an assumption regarding the flow of goods, not the actual order in which products are sold. Three cost flow assumptions most frequently used by U.S. companies FIFO (First In, First Out) LIFO (Last In, First Out) Average cost Disclosure of inventory cost flow assumption is in the notes. Inventory reported on balance sheet mast be at the lower of cost or market. Companies may use more than one method for inventories in the U.S Accounting Method FIFO LIFO Average Cost Cost of Goods Sold (Income Statement) first purchases last purchases (close to current cost) average of all purchases Inventory Valuation (Balance Sheet) last purchases (close to current cost) first purchases average of all purchases 14

The Balance Sheet Inventory Accounting Methods Qucik Check Problem: A new company in its first year of operations purchases five products for sale in the order and at the prices shown. The company sells three of these items. Item Purchase Price Cost flow assumptions for each method : #1 $5 #2 $7 #3 $8 #4 $9 #5 $11 Effect on the income statement and balance sheet: Accounting Method Cost of Goods Sold (Income Statement) Inventory Valuation (Balance Sheet) FIFO $20 $20 LIFO $28 $12 Average Cost $24 $16 15 The Balance Sheet Long-Term A loan or debt obligation with maturities beyond one year long-term debt, capital lease obligations, postretirement benefits other than pensions, commitments and contingencies, hybrid securities Obligations 16

The Balance Sheet Current Must be repaid in one year or one operating cycle Accounts Payable Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services Account is eliminated when bill is satisfied Increase and decrease depending on credit policies, economic conditions, and cyclical nature of operations Short-Term Debt (or Notes Payable) Short-term obligations in the form of promissory notes Lines of credit to suppliers or financial institutions Current maturities of long-term debt: Portion of the principal of long-term debt that will be repaid during the upcoming year Accrual items Items such as salary or taxes that are owed but have not yet been paid, and deferred or unearned revenue 17 The Balance Sheet The book value of The book value of a firm s equity Shareholders equity = Total assets - An accounting measure of a firm s net worth Residual interest in assets that remains after deducting liabilities Two main components: share capital + retained earning = the book value of shareholders ownership claims Retained Earnings Sum of every dollar a company has earned since its inception, less any payments made to shareholders Funds a company has elected to reinvest in the operations of the business rather than pay out in stock = Measurement of all undistributed earnings Beginning Net Ending retained ± income Dividends = retained earnings (loss) earnings 18

The Balance Sheet The market value of The market value of a firm s equity: a company s Market Capitalization Market Capitalization = Market Price per Share x Number of Shares Outstanding Cannot be negative Does not depend on historical cost of assets Often differs substantially from book value It depends on what investors expect those assets to produce in the future 19 FAQ. 1 Deferred Taxes Deferred taxes are taxes that are owed but have not yet been paid. Firms generally keep two sets of financial statements: one for financial reporting and one for tax purposes. Occasionally, the rules for the two types of statements differ. Deferred tax liabilities generally arise when the firm s financial income exceeds its income for tax purposes. Because deferred taxes will eventually be paid, they appear as a liability on the balance sheet. A firm may also have deferred tax assets related to tax credits it has earned that it will receive in the future. Source: Berk Jonathan et DeMarzo Peter (2017), Corporate Finance, Pearson Education. 20

A reminder of financial statements Balance sheet Income statement Cash flow statement 21 The Income Statement The Income Statement: An Overview By Nature Versus By Function From Sales to Net Income The Income Statement: Also called the Profit and Loss Statement, or P&L The Statement of Comprehensive Income (IFRS) lists the items that positively or negatively affect a company s wealth Revenues and expenses (or charges or costs) over a period of time. Revenues Charges Gross additions to wealth gross deductions to wealth = Earnings = net additions to wealth (deductions to) Only charges that affect wealth are recorded in the income statement Operating charges Depreciation and amortization (Investment cycle charges) Financial charges (net of financial income) Non-recurring items Tax charges Investments in fixed assets (Machinary, building, etc.) are not directly recorded in the income statement Operating charges are consumed, so reduce wealth fixed assets are used without being destroyed directly 22

The Income Statement The Income Statement: An Overview By Nature vs By Function From Sales to Net Income Earnings Quality A typical Income Statement in a condensed form Revenue (Net Sales) Operating cycle charges Investment cycle charges Financial cycle charges - Operating Expenses = EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) - Depreciation and amortization charges = EBIT (or Operating Income) (Earnings Before Interest and Taxes) - Financial expense net of financial income = EBT (or Pretax Income) (Earnings Before Taxes and non-recurring items) can be grouped differently: By Nature By Function +/ Non-recurring items - Corporate income tax = Net Earnings (or Profit, or Income) 23 The Income Statement The Income Statement: An Overview By Nature vs By Function From Sales to Net Income Earnings Quality Income Statement by Nature vs Function Revenue (Net Sales) + Other income (Changes in inventories of finished goods and work in progress) - Purchase of raw materials - Services (other operating expenses) - Employee benefits expenses - Taxes other than corporate taxes = EBITDA -Depreciation, amortization and impairment losses on fixed assets = EBIT (or Operating Income) - Financial expense net of financial income = EBT (or Pretax Income) +/ Non-recurring items - Corporate income tax = Net Earnings BY NATURE Revenue (Net Sales) - Cost of Sales (The costs incurred to produce and sell products) = Gross Profit - Operating expenses not directly related to producing the goods being sold, including: Selling and marketing expenses General and administrative expenses (including salaries) Research and development expenses = EBIT (Operating Income) = EBT - Financial expense net of financial income +/ Non-recurring items - Corporate income tax = Net Earnings BY FUNCTION 24

The Income Statement The Income Statement: An Overview By Nature vs By Function From Sales to Net Income Earnings Quality Income Statement by Nature vs Function Revenue (Net Sales) + Other income - Purchase of raw materials - Services (other operating expenses) - Employee benefits expenses - Taxes other than corporate taxes = EBITDA BY NATURE -Depreciation, amortization and impairment losses on fixed assets Financial cycle charges Non-recurring items impact Tax effect Operating cycle charges Investment cycle charges = EBIT (or Operating Income) - Financial expense net of financial income = EBT (or Pretax Income) +/ Non-recurring items - Corporate income tax Revenue (Net Sales) - Cost of Sales = Gross Profit BY FUNCTION - Operating expenses not directly related to producing the goods being sold: Selling and marketing expenses, General and administrative expenses (including salaries), Research and development expenses = EBITDA (new trend) -Depreciation, amortization and impairment losses on fixed assets = Net Earnings 25 The Income Statement The Income Statement: An Overview By Nature vs By Function From Sales to Net Income Earnings Quality Income Statement by Nature vs Function Income Statement by Nature vs Function in some countries (from Vernimmen, Corporate Finance Theory and Practice) Vernimmen, Corporate Finance Theory and Practice Section 3.2 DIFFERENT INCOME STATEMENT FORMATS 26

The Income Statement The Income Statement: An Overview By Nature versus By Function From Sales to Net Income Earnings Quality Income Statement by Function Example: JIT : Just-In-Time Computer Services Income Statement Year ended December 31 - in millions Year 2 Year 1 Net Sales 186,7 176,1 - Cost of Sales 89,7 81,0 Gross Profit 97,0 95,1 - Selling, general and administrative expenses 73,0 75,2 - Research and development 12,4 11,7 + Other Operating Income 0,0 0,3 EBITDA 11,6 8,5 - Depreciation, amortization and impairment losses on fixed assets 1,2 1,1 EBIT 10,4 7,4 - Financial expense 7,7 4,6 + Financial income 0,0 0,0 Earnings Before Taxes 2,7 2,8 + Non-recurring items 0,3 0,0 Pretax Income 3,0 2,8 - Corporate income tax 1,0 0,9 Net Earnings 2,0 1,9 27 The Income Statement The Income Statement: An Overview By Nature Versus By Function From Sales to Net Income Earnings Quality From Net Sales to Net Income Revenue (Net Sales) - Cost of Sales Growth of wealth analysis Price effect (don t neglect inflation) vs Volume effect? Successful commercialization of a new product? Dependence on one or a few customers? Aggressive growth strategy (discount policy) vs upmarket positioning? = Gross Profit Indicate a firm s capacity to generate income after costs of goods sold - Operating expenses not directly related to producing the goods being sold, including: = EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) -Depreciation, amortization and impairment losses on fixed assets = EBIT (Operating Income) (Earnings Before Interest and Taxes) - Financial expense net of financial income = EBT (or Pretax Income) +/ Non-recurring items - Corporate income tax = Net Earnings (or Net Income) Crucial indicator to assess a firm s capacity to generate wealth thanks to its core business Is not altered by : investment policy, accounting choices (depreciation method), financial debt, taxes and non-recurring items represents the earnings generated by investment and operating cycles for a given period represents the earnings generated by investment and operating cycles after debt expenses Net additions (deductions) to wealth Need to assess the quality of Earnings 28

A reminder of financial statements Balance sheet Income statement Cash flow statement 29 The Statement of Cash Flows Cash-flow statement The firm s statement of cash flows provides users of financial statements the basis for assessing: A company s ability to generate cash: How much cash the firm has generated? How that cash has been allocated during a set of period? December 31, year 0 December 31, year 1 Income Statement Net Income Cash flows from operations (I) Cash Flow Statement + Cash flows from investments (II) + Cash flows from financing (III) Balance Sheet Cash Beginning of period (I)+(II)+(III) Increase/decrease in cash Cash End of period 30

The Statement of Cash Flows A typical Cash Flow Statement Example: Nike Inc. Statement of Cash Flows (in $ thousands) - Source: http://finance.yahoo.com/ 31 The Statement of Cash Flows Income Statement Versus Cash-flow statement Earnings are an opinion, cash is a fact 32

The Statement of Cash Flows Income Statement Versus Cash-flow statement Net Income typically does NOT equal the amount of cash the firm has earned Non-cash items (e.g. Amortization and Depreciation) Accruals (e.g. Unrealized revenues) Uses of Cash not on the Income Statement Investment in Property, Plant, and Equipment The purpose of Cash-flow statement Adjustments to reconcile net income to cash (cf. appendix) 33 The Statement of Cash Flows Income Statement Versus Cash-flow statement Example: JIT : Just-In-Time Computer Services Income Statement Year ended December 31 - in millions N+1 N Net Sales 186,7 176,1 - Cost of Sales 89,7 81,0 Gross Profit 97,0 95,1 - Selling, general and administrative expenses 73,0 75,2 - Research and development 12,4 11,7 + Other Operating Income 0,0 0,3 EBITDA 11,6 8,5 - Depreciation, amortization and impairment losses on fixed assets 1,2 1,1 EBIT 10,4 7,4 - Financial expense 7,7 4,6 + Financial income 0,0 0,0 Earnings Before Taxes 2,7 2,8 + Non-recurring items 0,3 0,0 Pretax Income 3,0 2,8 - Corporate income tax 1,0 0,9 Net Earnings 2,0 1,9 34

The Statement of Cash Flows Income Statement Versus Cash-flow statement Example: Just-In-Time Computer Services- Statement of Cash Flows Year ended December 31 - in M N+1 Net Earnings 2,0 + Depreciation and amortization 1,2 + Other adjustments to reconcile net income to cash -1,2 Cash effect of changes in operating net assets: - Accounts receivable 5,3 - Inventories 1,0 + Accounts payable 5,6 - Increase in working capital 0,7 = Cash From Operating Activities (I) 1,3 - Capital expenditures 39,8 - Acquisitions and other investing activity 0,0 + Sales of property, plant and equipment 0,0 + Divestments of subsidiaries and other operations 0,0 = Cash From Investing Activities (II) -39,8 - Dividends paid 1,0 + Sale or purchase of shares 0,0 + Increase/decrease in short-term borrowing -2,0 + Increase/decrease in long-term borrowing 44,2 = Cash From Financing Activities (III) 41,2 Change in cash and cash equivalents = I+II+III 2,7 35 The Statement of Cash Flows Adjustments to reconcile net income to cash Adjustment of net income by adding back all non-cash items Non-cash items: e.g. Amortization and Depreciation Other adjustments: e.g. Deferred taxes N+1 Net Earnings 2,0 + Depreciation and amortization 1,2 + Other adjustments to reconcile net income to cash -1,2 Cash effect of changes in operating net assets: - Accounts receivable 5,3 - Inventories 1,0 + Accounts payable 5,6 - Increase in working capital 0,7 = Cash From Operating Activities (I) 1,3 36

The Statement of Cash Flows Adjustments to reconcile net income to cash: operating activities Operating activities: adjust for changes in Accounts Receivable Accrual accounting recognizes a transaction at the time when a sale is made rather than when cash is received from the customer a sale is recorded as part of net income, but the cash has not yet been received from the customer adjust the cash flows by deducting the increases in accounts receivable N+1 Net Earnings 2,0 + Depreciation and amortization 1,2 + Other adjustments to reconcile net income to cash -1,2 Cash effect of changes in operating net assets: - Accounts receivable 5,3 - Inventories 1,0 + Accounts payable 5,6 - Increase in working capital 0,7 Balance Sheet N+1 N Accounts receivables 18,5 13,2 = Cash From Operating Activities (I) 1,3 This increase represents additional lending by the firm to its customers 37 The Statement of Cash Flows Adjustments to reconcile net income to cash: operating activities Operating activities: adjust for changes in Inventories Increases to inventory are not recorded as an expense and do not contribute to net income However, the cost of increasing inventory is a cash expense for the firm adjust the cash flows by deducting the increases in inventories N+1 Net Earnings 2,0 + Depreciation and amortization 1,2 + Other adjustments to reconcile net income to cash -1,2 Cash effect of changes in operating net assets: - Accounts receivable 5,3 - Inventories 1,0 + Accounts payable 5,6 - Increase in working capital 0,7 Balance Sheet N+1 N Inventories 15,3 14,3 = Cash From Operating Activities (I) 1,3 38

The Statement of Cash Flows Adjustments to reconcile net income to cash: operating activities Operating activities: adjust for changes in Accounts Payable Accrual accounting recognizes a transaction at the time when a purchase is made rather than when cash is paid to suppliers Accounts payable represents borrowing by the firm from its suppliers adjust the cash flows by adding the increases in accounts payable N+1 Net Earnings 2,0 + Depreciation and amortization 1,2 + Other adjustments to reconcile net income to cash -1,2 Cash effect of changes in operating net assets: - Accounts receivable 5,3 - Inventories 1,0 + Accounts payable 5,6 - Increase in working capital 0,7 Balance Sheet Current N+1 N Accounts payable 30,5 24,9 = Cash From Operating Activities (I) 1,3 This increase represents additional cash available to the firm 39 The Statement of Cash Flows Adjustments to reconcile net income to cash: operating activities Adjust for changes in operating activities = adjust for changes in Working Capital Accounts receivable + Inventories - Accounts payable = Working Capital If Working Capital > 0 Increase in expenses = reduces cash available N+1 Net Earnings 2,0 + Depreciation and amortization 1,2 + Other adjustments to reconcile net income to cash -1,2 Cash effect of changes in operating net assets: - Accounts receivable 5,3 - Inventories 1,0 + Accounts payable 5,6 - Increase in working capital 0,7 = 5.3 + 1-5.6= +0.7 = Cash From Operating Activities (I) 1,3 This increase in working capital represents additional expenses for the firm and must be deduced 40

The Statement of Cash Flows Cash from Investment Activities Shows the cash required for investment activities The income statement spreads the capital expenditure charge over the entire life of the asset (through depreciation), while the cash flow statement records it only in the period in which it is purchased. capital expenditures have a direct impact on cash available to the firm N+1 - Capital expenditures 39,8 - Acquisitions and other investing activity 0,0 + Sales of property, plant and equipment 0,0 + Divestments of subsidiaries and other operations 0,0 = Cash From Investing Activities (II) -39,8 41 The Statement of Cash Flows Cash from Financing Activities Shows cash inflows (new borrowings, capital increases, etc.) and outflows (e.g. dividends) related to the financing cycle Outflows representing a return on invested capital may be analyzed as either expenses (e.g. interest) or a distribution of wealth created by the company among its equity capital providers (e.g. dividends). N+1 - Dividends paid 1,0 + Sale or purchase of shares 0,0 + Increase/decrease in short-term borrowing -2,0 + Increase/decrease in long-term borrowing 44,2 = Cash From Financing Activities (III) 41,2 Change in cash and cash equivalents = I+II+III +2,7 Cash surplus despite substantial investment outflows: These outflows have been covered by an increase in longterm debt Cash Beginning of period + Change in cash and cash equivalents = Cash End of period Balance Sheet N+1 N Cash and cash equivalents 21,2 19,5 19.5 + 2.7 = 21.2 42