Strategic Capital Group Workshop #5: Financial Statement Analysis

Agenda
Types of Accounts
The Balance Sheet The Income Statement The Statement of Cash Flows Looking at health and profitability

The Balance Sheet

A snapshot of the business at a point in time, shows values of assets, liabilities, and equity accounts.

Types of Accounts
We have 3 types of accounts in the balance sheet: Assets: Resources of the business we will use to generate revenues Liabilities: Money we owe to creditors or debt-holders that have funded our business Equity: Money we got from people who bought stock from the company in return for voting power and a share of the profits Assets = Liabilities + Owners Equity
Value of resources in the business = Money we got from creditors + money we got from shareholders In other words, everything in the business was either bought with money from shareholders or creditors.

The Accounts Within: Assets

Cash
Land

Accounts Receivable (Short term IOUS)

Buildings

Investments

Equipment

Inventory

Property, Plant, and Equipment or PP&E

Stepping to the side:

Depreciation and Amortization, what are they?
When you buy a car for $50,000 and try to sell it a year later, you cant get the same value you paid for it, you get less. Accountants adjust the value of the long term assets the company is holding at the end of every period to reflect what they believe is the new value. We call this depreciation for physical assets and amortization for intangible assets (like patents)

The Accounts Within: Liabilities

Accounts Payable (short term debt to suppliers)

Bank Loans

Bonds Payable

Unearned Revenue (prepaid sandwiches)

The Accounts Within: Equity

Common Stock Additional Paid-In Capital

Preferred Shares

Treasury Stock Retained Earnings

Exercise
Companies have a lot of funky names for their accounts, so based on your knowledge of the base accounts and what each category is, what is each account classified under?

Assets
Earnings Employed in the business Certificates of Deposit (CDs)

Liabilities
Cash and Cash Equivalents

Equity

Raw Materials Construction in Progress Dividends Payable Short Term Borrowings Intangible Assets (Patents) Common Stock Held in Treasury

Trade Receivables

Form of the Balance Sheet

Assets: Current Assets: Cash Inventory Long Term Assets: PP&E Total Assets: Liabilities: Current Liabilities Long term Liabilities Total Liabilities: Equity: Common Stock Add. PIC Retained Earnings Total Equity: Total L + E $50 $75 $800 $925 $40 $324 $364 $1 $360 $200 $561 $925

The Income Statement

Tells us the revenue generating and expense generating activities of the business over the course of the reporting period (year or quarter)

Two Classifications to Know

Revenues: Dollar value of sales a company generates Expenses: Costs associated with generating the revenue.

After all expenses have been taken out of our pool of revenue, whats left is taxed.

The form of the Income Statement

Revenue/Sales -Cost of Goods Sold Gross Profit Gross margin -Operating Expenses Operating Income Operating Margin -Interest Expense Income Before taxes -Taxes Net Income Profit Margin $1200 $300 $900 75% $150 $750 62.5% $125 So at the end, 34.6% of every $625 dollar in sales becomes profit $187.50 available to shareholders $437.50 34.6%

Depreciation Expense
Remember back a few slides
Every period we wrote down the value of our long-term assets to reflect what they were worth (given that theyve been used a little and theyre not longer brand new)

This adjustment is recorded as depreciation expense even though no cash was paid out. We record depreciation expense under operating expenses

Cost of Goods Sold

Value of the inputs that are directly involved in the process of making a product or getting it ready for sale Also includes cost of labor that is directly assembling the sandwiches and delivering them (direct labor) Does not include the cost of rent of our New York Headquarters, salaries of the CEO, salaries of our accountants, or supply costs. These costs are not necessary to make and prepare the sandwich for sale.

This includes the cost of sandwich meat, bread, lettuce, tomatoes, sauce (direct materials)

Includes cost of rent and utilities of the sandwich shop or assembly factory (overhead)

Gross Profit
So Gross Profit is essentially how much it would money we would make if we got rid of corporate (though there are still a couple necessary expenses wed have to add back in)

Operating Expenses
-Salaries of people not associated with the production of sandwiches -Rent on NY HQ -R&D Expenses for developing ultra-modern sandwiches -General expenses like cost of paper clips for the office, utilities for the office, etc.

Most of the time this is all covered under Selling, General, and Administrative Expenses or SG&A.

Interest Expense
An important thing to notice is that interest expense is taken out of our Earnings before we take out taxes, why is this significant?
Because this means interest is tax-deductible, meaning that if we pay less taxes on our earnings if we pay more in interest. This is one of the benefits of funding your operations through debt, you end up paying a lower tax rate and a lower total tax expense.

Earnings: what does it mean?

Earnings is the profit left after all suppliers (COGS), creditors (interest expense), and the government (taxes) have been paid off, so the only person left to have the money go to is the shareholders.

But if the sandwich company makes $400 in earnings, not all of it goes into the shareholders pockets, some of it is distributed back to shareholders in the form of dividends that are checks to shareholders as a sort of thank you for risking your money by investing in the company. The rest is deposited into retained earnings and recycled back into the business to grow.

The Uselessness of the Income Statement

Typically, investors dont use Operating income to a profit measurement, we have EBITDA, EBIT, EBT, and E.
Earnings Before Interest Taxes Depreciation and Amortization

How we get to Earnings

Revenue -Cost of Goods Sold Gross Profit -Selling, General, and Admin Expense -Other Expenses +Depreciation and Amortization EBITDA -Depreciation and Amortization EBIT -Interest EBT -Taxes Earnings

Most of the time D&A is already looped in with COGS or in Expenses Most of the time, this is the same as Operating Income

Why is our method important?

EBITDA is what were really trying to get at here (not EBIT, thats just Operating Income so we can find that already). EBITDA is our operating income before non-cash expenses are incurred (depreciation), which makes our earnings number closer to the amount of cash we made.

Where does the account belong?

Income Statement Balance Sheet

EBITDA

Net Income
Cash Common Stock Unearned Revenue Total Depreciation

Selling, General, and Administrative Expenses Accounts Receivable Equipment

Interest Expense

Long-Term Debt

Accounts Payable

Statement of Cash Flows

Tell us about where we earned and spent cash during the reporting period, as well as our cash balances.

Important because a company can earn billions of dollars in revenue but through the usage of accounts receivable, never see a dollar. This can be a problem because you have to pay debts with cash not another IOU. This statement will be our best friend during DCF modeling in a few lessons.

Form of the Statement of Cash Flows

Beginning Cash Net Income +Net Cash Flows from Operations +Net Cash Flows from Investing +Net Cash Flows from Financing +Net Cash Flows Ending Cash $100 $437.50 $550 -$50 $400 $900 $1000

Idea Behind it:

We want to take our net income and add back any cash generating activities, then take back out any cash using activities to find how much cash was generated by the business. We like cash because finance people think accountants can manipulate numbers (they can) so cash gives us the clearest picture of the reality of the business.

Cash Flows from Operating Activities

Cash generated or used up from the everyday activities of the business like:
Cash collections from Accounts Receivables Cash Sales Cash Expenditures Changes in Current Assets Changes in Current Liabilities Add back Depreciation and Amortization Essentially how much cash you take in minus your bills.

Depreciation and Amortization are already in Net income, so to get to cash, we need to add it back (remember, we dont actually pay any cash on D&A), its an accounting gimmick.

Cash Flows from Investing Activities

Covers purchases and sales of long-term assets and investments.

What we see in the statement:

Buying a building is a cash outflow Selling land is a cash inflow Buying Investments is a cash outflow Selling investments is a cash inflow Important to remember that youre dealing with cash, so buying assets will decrease your cash and vice versa We refer to the acquisition of long-term assets as Capital Expenditures

Cash Flows from Financing

Covers cash flows that are related to raising capital for the business, both by debt and equity. Paying interest is a cash outflow Paying back principal of a loan is a cash outflow Receiving a loans funds is a cash inflow Receiving funds from a issuance of stock is a cash inflow Having a positive number in cash flows from financing means you are taking on more debt or issuing stock faster than you are paying it back.

So if we go back
Beginning Cash Net Income +Net Cash Flows from Operations +Net Cash Flows from Investing +Net Cash Flows from Financing +Net Cash Flows Ending Cash $100 $437.50 $550 Cash in - Bills -$50 Buying/Selling LT Assets

$400 Taking in/paying off capital from investors $900 and creditors $1000

How does all this apply to picking better stocks and valuation?
Eyes on the prize: This is all leads to DCF modeling and valuation. Although balance sheets and cash flow statements alone cant tell you how much a company is worth, we can look at it to see if the company is healthy.

Is this company healthy?

Statement of Cash Flows Net Income CFOperations: CFInvesting: CFFinancing: Net CF: $150 -$100 -$200 $600 $300 Statement of Cash Flows Net Income CFOperations: CFInvesting: CFFinancing: Net CF: $150 $600 -$800 -$100 -$300

I would argue no here- the company has a positive net cash flow, but it is getting its money mainly from financing and is losing money in the CFO category, which should be positive almost always.

As long as the investing activities are a one-time deal, this company has healthy CF generation from strong CFO and low CFF.

Assessing Balance Sheet Health

We can assess debt health by looking at a couple ratios: Current ratio = Current Assets/ Current Liabilities If we were to use up our current assets by turning them into cash, would it cover everything we owe this year? Quick Ratio = (Current Assets Inventory)/Current Liabilities If we use our most liquid assets we have on hand right now, can we pay off the debt we owe this year? Ideally, we want these ratios to be greater than 1 which means we can pay all the debts we owe this year and more. A healthy company has consistent liquidity ratios greater than 1.

Assessing Balance Sheet Health

We can also assess company health by looking at the debt coming due in the future: Sources like FactSet and the 10K will disclose how much debt comes due and at what interest rate at specified years, we want to invest companies that can cover any debt obligations that come due. We can assess the companys ability to cover future obligations by looking at historical Operating Cash Flow trends, forecasting what we expect OCF to be in the next few years, then verifying it is greater than the amount of debt coming due.

Relationships between the Statements

Its important to understand how each of the statements relate to each other: Revenue/Sales -Cost of Goods Sold Gross Profit Gross margin -Operating Expenses Operating Income Operating Margin -Interest Expense Income Before taxes -Taxes Net Income Profit Margin Tied to Inventory on the Balance Sheet (Change in Inventory = COGS) Depreciation Expense is tied to Total Depreciation of PP&E on the Balance Sheet First line item of Statement of Cash Flows

Relationships between the Statements

Beginning Cash Net Income

Covers changes in current assets and liabilities

$100 $437.50

Includes Depreciation and Amortization from Income Statement

+Net Cash Flows from Operations

+Net Cash Flows from Investing +Net Cash Flows from Financing +Net Cash Flows Ending Cash

$550
-$50 $400 $900 $1000

From Income Statement Tied to PP&E Tied to changes in LT Liabilities

Cash

Common Interview Question

What is the impact of $10 of extra depreciation in each of the statements given a tax rate of 30%?
Revenue -COGS Operating Income -Expenses +$10 -$10 EBIT -Interest -$10 EBT -Taxes Earnings -$7

Net Income

-$7

Beginning Cash CFO +$10 (add back D&A) CFI CFF Net +$3 Ending Cash +$3

Interview Question, Cont.

Assets: Cash +$3 PP&E -Accum. Depr +$10 Net PP&E -$10 Total Assets: -$7 Liabilities: Equity: Retained Earnings

-$7

Follow-up Interview Question

But if depreciation is a non-cash expense, how did we generate $3 in extra cash? By having an extra
Revenue -COGS Operating Income -Expenses +$10 -$10 EBIT -Interest -$10 EBT -Taxes Earnings -$7

Net Income

-$7

$10 in depreciation, we saved $3 in taxes, which ends up in cash.

Beginning Cash CFO +$10 (add back D&A) CFI CFF Net +$3 Ending Cash +$3