Ema Ge Berk CF 2GE SG 02
Ema Ge Berk CF 2GE SG 02
Introduction to Financial
Statement Analysis
Chapter Synopsis
2.1 Firms’ Disclosure of Financial Information
Publicly listed companies around the world are required to file their financial statements with
the relevant listing authorities. For example, U.S. companies with publicly traded securities are
required to file financial statements with the Securities and Exchange Commission (SEC).
Firms must also include financial statements in the annual report provided for shareholders.
The statements must conform to Generally Accepted Accounting Principles (GAAP) or
accounting standards and be audited by an independent third-party accounting firm.
Investors, financial analysts, managers, and other interested parties such as creditors rely on
financial statements to obtain reliable information about a corporation.
The production of financial statements to satisfy reporting requirements is called financial
reporting. Firms may also produce different financial statements for the taxation authorities
in what is known as tax reporting. For financial reporting, companies are required to produce
four financial statements: the balance sheet, the income statement, the statement of cash
flows, and the statement of changes in shareholders’ (or stockholders’) equity.
not an actual cash expense but reduces an asset’s book value (or carrying amount),
which equals the price paid for the assets minus accumulated depreciation from prior
years.
Total assets = total current assets + book value of long-term assets. The liabilities and
shareholders’ equity side of the balance sheet shows the firm’s obligations to creditors as
well as shareholders’ equity; it includes:
Current liabilities are obligations that will be paid within one year, such as accounts
payable, notes payable, and deferred expenses. Net working capital is the difference
between current assets and current liabilities.
Long-term liabilities include loans longer than one year and capital leases that obligate a
firm to make payments to use a long-term asset.
Shareholders’ equity, also known as book value of equity or net worth, is defined as the
difference between total assets and total liabilities in the balance sheet equation:
The Balance Sheet Equation
Assets = Liabilities + Shareholders’ Equity
The book value of equity is distinct from the market value of equity, or stock market
capitalization, which equals the current share price times the number of shares
outstanding. The market value of equity is generally different because the book value of
assets does not perfectly match the market value of the assets and because many of the
firm’s intangible assets are not captured on the balance sheet at all, such as its ability to
manufacture a proprietary software product.
ROE = ⎛⎜
Net Income ⎞ ⎛ Sales ⎞ × ⎛ Total Assets ⎞
⎟×⎜ ⎟ ⎜ ⎟
⎝144 2443⎠ ⎝144
Sales Assets3⎠ ⎝ Total Equity ⎠
Total244
1442443
Net Profit Margin Asset Turnover Equity Multiplier
The first term in the DuPont Identity is the firm’s net profit margin, which measures its overall
profitability. The second term is the firm’s asset turnover, which measures how efficiently the
firm is utilizing its assets to generate sales. The final term is a measure of leverage called the
equity multiplier, which indicates the value of assets held per euro or dollar of shareholder
equity. The equity multiplier will be higher the greater the firm’s reliance on debt financing.
Analysts use a number of ratios to gauge the market value of the firm. The most common is
the firm’s price-earnings ratio (P/E).
Market Capitalization Share Price
P/E Ratio = =
Net Income Earnings per Share
The P/E ratio is used to assess whether a stock is over- or undervalued based on the idea
that the value of a stock should be proportional to the level of earnings it can generate for its
shareholders. P/E ratios tend to be higher for firms with high growth rates.
Shareholders’ equity, the difference between the firm’s assets and liabilities, is an
accounting measure of the firm’s net worth. The two sides of the balance sheet must balance
according to the balance sheet equation: assets = liabilities + shareholder’s equity.
Book Value
The book value (or carrying amount) of a long-term asset is equal to its acquisition cost less
accumulated depreciation. Depreciation is not an actual cash expense; it is a way of
recognizing that buildings and equipment wear out and thus become less valuable as they
get older. For example, net property, plant, and equipment is equal to the total book value of
a firm’s long-term assets after subtracting the total depreciation from previous years. The
book value of equity, also known as shareholders’ equity or net worth, is defined as the
difference between total assets and total liabilities in the balance sheet identity.
Short-term Debt
Debt that will be repaid within one year.
Market Capitalization
Also known as the total market value of equity, it equals the market price per share times the
number of shares. The market capitalization does not depend on the historical cost of the
firm’s assets; instead, it depends on what investors expect those assets to produce in the
future. The book value of equity should not be confused with the market value of equity: The
market value of equity may be different because the book value of assets does not perfectly
match the market value of the assets and because many of the firm’s intangible assets are
not captured on the balance sheet.
Enterprise Value
The enterprise value of a firm assesses the value of the underlying business assets,
unencumbered by debt and separate from any cash and marketable securities. It can be
expressed as:
Enterprise Value = Market Value of Equity + Debt − Cash
Asset Turnover
A measure of how efficiently the firm is utilizing its assets to generate sales, which is
calculated as Sales/Total Assets.
Equity Multiplier
A measure of leverage that indicates the value of assets held per euro or dollar of
shareholder equity; it is calculated as Total Assets/Total Equity. The equity multiplier will be
higher the greater the firm’s reliance on debt financing.
DuPont Identity
A measurement that summarizes the determinants of a firm’s ROE and is calculated as
ROE= ⎛⎜
Net Income ⎞ ⎛ Sales ⎞ × ⎛ Total Assets ⎞ .
⎟×⎜ ⎟ ⎜ ⎟
1444 ⎝ 24443⎠ ⎝1442443⎠ ⎝ Total Equity ⎠
Sales Total Assets
1442443
Net Profit Margin Asset Turnover Equity Multiplier
EBIT Margin
A measure of profitability calculated as EBIT/Sales.
Gross Margin
A measure of profitability calculated as Gross Profit/Sales.
Intangible Assets
The balance sheet item that equals the difference between the price paid for the company
and the book value assigned to its tangible assets.
Impairment Charge
A reduction in the amount listed on the balance sheet that reflects the change in value of
previously acquired intangible assets.
Inventory Days
A measure of how long inventory is held and is calculated as Inventory/Average Daily Cost of
Sales.
ROE= ⎛⎜
Net Income ⎞ ⎛ Sales ⎞ × ⎛ Total Assets ⎞ .
⎟×⎜ ⎟ ⎜ ⎟
1444 ⎝ 2444
Sales 3⎠ ⎝144 Assets3⎠ ⎝ Total Equity ⎠
Total244
1442443
Net Profit Margin Asset Turnover Equity Multiplier
2.5.2. How do you use the price-earnings (P/E) ratio to gauge the market value of a firm?
The P/E ratio is the ratio of the value of equity to the firm’s earnings per share. It is used to
assess whether a share is over- or undervalued based on the idea that the value of a share
should be proportional to the level of earnings it can generate for its shareholders. P/E
ratios tend to be higher for firms with high growth rates.
2.6.1. Why does a firm’s net income not correspond to cash generated?
There are two reasons why net income does not correspond to cash earned. First, there are
non-cash expenses on the income statement, such as depreciation and amortization.
Second, certain uses of cash, such as purchasing a building, are not reported on the
income statement.
2.6.2. What are the components of the statement of cash flows?
The statement of cash flows is divided into three sections: operating activities, investment
activities, and financing activities.
2.7.1. Where do off-balance sheet transactions appear in a firm’s financial statements?
Management is required to disclose any off-balance sheet transactions in the management
discussion and analysis (MD&A) or business and operating review. Even though off-balance
sheet transactions do not appear on the balance sheet, they can have a material impact on
the firm’s future performance.
2.7.2. What information do the notes to financial statements provide?
The notes to financial statements provide additional information that is very important in
fully interpreting the firm’s financial statements. For example, the notes show accounting
assumptions that were used in preparing the statements. Details of acquisitions, spin-offs,
leases, taxes, and risk management activities are also given.
2.8.1. Describe the transactions Enron used to increase its reported earnings.
Enron sold assets at inflated prices to other firms, together with the promise to buy back
those assets at even higher future prices. Thus, Enron received cash today in exchange for
a promise to pay more cash in the future. But Enron recorded the incoming cash as
revenue, and then hid the promises to buy back the assets in a variety of ways.
2.8.2. What is the Sarbanes-Oxley Act?
In the United States in 2002, Congress passed the Sarbanes-Oxley Act, which requires,
among other things, that CEOs and CFOs certify the accuracy and appropriateness of their
firm’s financial statements and increases the penalties against them if their financial
statements later prove to be fraudulent.
Examples
1. Your firm is considering purchasing a machine for $2.5 million, which would be depreciable
straight line over 5 years. The machine will allow you to sell products that increase sales by
$5 million per year. The cost of goods sold would increase by 50% of sales, but other costs
would not change. If the firm has 1 million shares outstanding and pays 35% in taxes, what
affect would this project have on earnings per share in each of the next 5 years?
Step 1. Determine what financial statements would be affected and what statement(s) need
to be forecasted to answer the question.
The question asks for the effect on earnings per share, which depends on net income, so the
incremental income statements must be forecasted each year.
Step 2. Forecast the income statements for years 1 through 5 using the fact that
depreciation would be $2.5 million / 5 = $500,000 million per year.
1 2 3 4 5
Sales revenue 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000
- Cost of goods sold 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000
= Gross profit 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000
- Depreciation 500,000 500,000 500,000 500,000 500,000
= EBT 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
- Taxes 700,000 700,000 700,000 700,000 700,000
= Net income 1,300,000 1,300,000 1,300,000 1,300,000 1,300,000
At time 0, book value of equity will increase by $2.5 million, the amount of the new stock
issued.
Beginning in year 1, book value of equity will increase each year by $800,000.
3. Your firm is considering purchasing the machine in problem 1 for $2.5 million, which would
be depreciable straight line over 5 years. To finance the purchase, you will issue $2.5 in new
shares. Working capital would not change. How would the purchase of the machine affect
how much cash the firm has in years 1–5?
Step 1. Determine what financial statements would be affected and what statement(s) need
to be forecasted to answer the question.
The statement of cash flows can be forecasted to determine the change in cash. [Note that
you could also just use the information on the income statements and balance sheets to
measure the same change.]
Step 2. Forecast the statement of cash flows.
Depreciation 500,000 500,000 500,000 500,000 500,000
Cash from operating activities 1,800,000 1,800,000 1,800,000 1,800,000 1,800,000
Investment activities
Capital expenditures -2,500,000 0 0 0 0
Cash from investing activities -2,500,000 0 0 0 0
Financing activities
Dividends paid 0 0 0 0 0
Sale or purchase of stock 2500000 0 0 0 0
Increase in borrowing 0 0 0 0 0
Cash from financing activities 2500000 0 0 0 0
[B] Depreciation of $20 million would appear each year as an operating expense. Thus, net
income would change each of the next 5 years by − $20(0.40)= − $8 million
4. Earnings per share will increase by $2.60 in each of the next three years.
1 2 3
Sales revenue 10,000,000 10,000,000 10,000,000
- Cost of goods sold 5,000,000 5,000,000 5,000,000
= Gross profit 5,000,000 5,000,000 5,000,000
- Depreciation 1,000,000 1,000,000 1,000,000
= EBT 4,000,000 4,000,000 4,000,000
- Taxes 1,400,000 1,400,000 1,400,000
= Net income 2,600,000 2,600,000 2,600,000
Number of shares 1,000,000 1,000,000 1,000,000
Earnings per share $2.60 $2.60 $2.60
5. Book value of equity will increase from $3 million at date 0, to $3.9 million at the end of
year 3.
0 1 2 3
Assets
Cash 0 1,300,000 2,600,000 3,900,000
Total current assets 0 1,300,000 2,600,000 3,900,000
Long-term assets 3,000,000 3,000,000 3,000,000 3,000,000
Less: Accumulated depr. 0 1,000,000 2,000,000 3,000,000
Net Long-term assets 3,000,000 2,000,000 1,000,000 0
Total Assets 3,000,000 3,300,000 3,600,000 3,900,000