CH 2

Chapter 2
Introduction
to Financial
Statement
Analysis
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Chapter Outline
2.1 Firms Disclosure of Financial Information
2.2 The Balance Sheet
2.3 Balance Sheet Analysis
2.4 The Income Statement
2.5 Income Statement Analysis
2.6 The Statement of Cash Flows
2.7 Other Financial Statement Information
2.8 Financial Reporting in Practice
2-2
Learning Objectives
1. List the four major financial statements required by the SEC for
publicly traded firms, define each of the four statements, and
explain why each of these financial statements is valuable.
2. Discuss the difference between book value of stockholders equity
and market value of stockholders equity; explain why the two
numbers are almost never the same.
3. Compute the following measures, and describe their usefulness in
assessing firm performance: the debt-equity ratio, the enterprise
value, earnings per share, operating margin, net profit margin,
accounts receivable days, accounts payable days, inventory days,
interest coverage ratio, return on equity, return on assets, priceearnings ratio, and market-to-book ratio.
4. Discuss the uses of the DuPont identity in disaggregating ROE,
and assess the impact of increases and decreases in the
components of the identity on ROE.
2-3
Learning Objectives
5. Describe the importance of ensuring that valuation ratios are
consistent with one another in terms of the inclusion of debt in
the numerator and the denominator.
6. Distinguish between cash flow, as reported on the statement of
cash flows, and accrual-based income, as reported on the income
statement; discuss the importance of cash flows to investors,
relative to accrual-based income.
7. Explain what is included in the management discussion and
analysis section of the financial statements that cannot be found
elsewhere in the financial statements.
8. Explain the importance of the notes to the financial statements.
9. List and describe the financial scandals described in the text,
along with the new legislation designed to reduce that type of
fraud.
2-4
2.1 Disclosure of Financial

Information
Financial Statements
Firm-issued accounting reports with past
performance information
Filed with the SEC
10Q
Quarterly
10K
Annual
Must also send an annual report with financial

statements to shareholders
2-5

Information (cont'd)
Preparation of Financial Statements
Generally Accepted Accounting Principles
(GAAP)
Auditor
Neutral third party that checks a firms financial
statements
2-6

Information (cont'd)
Types of Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholders Equity
2-7
2.2 Balance Sheet

A snapshot in time of the firms financial
position
The Balance Sheet Identity:
Assets Liabilities Stockholders' Equity
2-8
2.2 Balance Sheet (cont'd)

Assets
What the company owns
Liabilities
What the company owes
Stockholders Equity
The difference between the value of the firms
assets and liabilities
2-9

Assets
Current Assets: Cash or expected to be turned
into cash in the next year
Cash
Marketable Securities
Accounts Receivable
Inventories
Other Current Assets
Example: Pre-paid expenses
2-10

Assets
Long-Term Assets
Net Property, Plant, & Equipment
Book Value = Acquisition cost
Depreciation (and Accumulated Depreciation)
Goodwill and intangible assets

Amortization
Other Long-Term Assets

Example: Investments in Long-term Securities
2-11
Table 2.1 Global Conglomerate Corporation

Balance Sheet for 2009 and 2008
2-12

Liabilities
Current Liabilities: Due to be paid within the
next year
Accounts Payable
Short-Term Debt/Notes Payable
Current Maturities of Long-Term Debt
Other Current Liabilities
Taxes Payable
Wages Payable
2-13

Net Working Capital
Current Assets Current Liabilities
2-14

Liabilities
Long-Term Liabilities
Long-Term Debt
Capital Leases
Deferred Taxes
2-15
Table 2.1 (cont'd) Global Conglomerate

Corporation Balance Sheet for 2009 and 2008
2-16

Equity
Book Value of Equity
Book Value of Assets Book Value of Liabilities
Could possibly be negative
Market Value of Equity (Market Capitalization)

Market Price per Share x Number of Shares
Outstanding
Cannot be negative
2-17
Textbook Example 2.1
2-18
Textbook Example 2.1 (cont'd)
2-19
Alternative Example 2.1

Problem
Rylan Enterprises has 5 million shares
outstanding.
The market price per share is $22.
The firms book value of equity is $50 million.
What is Rylans market capitalization?
How does the market capitalization
compare to Rylans book value of equity?
2-20

Solution
Rylans market capitalization is $110 million
5 million shares $22 share = $110 million.
The market capitalization is significantly higher than
Rylans book value of equity of $50 million.
2-21
2.3 Balance Sheet Analysis

Liquidation Value
Value of the firm if all assets were sold and liabilities
paid
Market-to-Book Ratio
Market-to-Book Ratio
Market Value of Equity

Value Stocks
Low M/B ratios
Growth stocks
High M/B ratios
2-22
2.3 Balance Sheet Analysis (cont'd)

Debt-Equity Ratio
Measures a firms leverage
Total Debt
Debt-Equity Ratio
Total Equity
Using Book Value versus Market Value
Enterprise Value
Enterprise Value Market Value of Equity Debt Cash
2-23
2-24
2-25

Problem
In January 2009, Rylan Corporation (from
Alternative Example 2.1) had a market
capitalization of 110 million, a market-to-book
ratio of 2.2, a book debt to equity ratio of 1.4,
and cash of $6.3 million. What was Rylans
enterprise value?
2-26

Solution
As stated in Alternative Example 2.1, Rylans
book value of equity was $50 million. Given a
book debt-equity ratio of 1.4, Rylan had total
debt of 1.4 X 50 = 70 million. Thus, Rylans
enterprise value was 110+70 6.3 = $173.7
million.
2-27
2.3 Balance Sheet Analysis (cont'd)

Other Balance Sheet Information
Current Ratio
Current Assets / Current Liabilities
Quick Ratio
(Current Assets Inventories) / Current Liabilities
2-28
2.4 Income Statement

Total Sales/Revenues
minus
Cost of Sales
equals
Gross Profit
2-29
2.4 Income Statement (cont'd)

Gross Profit
minus
Operating Expenses
Selling, General, and Administrative Expenses
R&D
Depreciation & Amortization
equals
Operating Income
2-30

Operating Income
plus/minus
Other Income/Other Expenses

equals
Earnings Before Interest and Taxes (EBIT)
2-31

Earnings Before Interest and Taxes (EBIT)
plus/minus
Interest Income/Interest Expense

equals
Pre-Tax Income
2-32

Pre-Tax Income
minus
Taxes
equals
Net Income
2-33

Income Statement Sheet for 2009 and 2008
2-34

Earnings per Share
Net Income
$2.0 million
EPS
$0.556 per share

Shares Outstanding
3.6 million shares
Stock Options
Convertible Bonds
Dilution
Diluted EPS
2-35

Profitability Ratios
Gross Margin
Gross M arg in
Gross Profit
Sales
Operating Margin
Operating M arg in
Operating Income
Sales
Net Profit Margin

Net Profit Margin
Net Income
Total Sales
2-36

(cont'd)
Working Capital Days
Accounts Receivable Days
Accounts Receivable Days
Accounts Receivable
Average Daily Sales
EBITDA
Reflects the cash a firm has earned from its
operations
2-37

(cont'd)
Leverage Ratios/Interest Coverage Ratios
EBIT / Interest Expense
Operating Income / Interest Expense
EBITDA / Interest Expense
2-38

(cont'd)
Investment Returns
ROA
Net Income
Return on Assets
Total Assets
ROE
Return on Equity
Net Income
2-39

(cont'd)
The DuPont Identity

Total Assets
Net Income Sales
ROE

Sales Total Assets Book Value of Equity
Net Profit Margin
Asset Turnover
Equity Multiplier
Return On Assets
2-40
2-41
Textbook Example 2.3 (contd)
2-42

(cont'd)
Valuation Ratios
P/E Ratio
P / E Ratio
Market Capitalization
Share Price
Net Income
Earnings per Share
Enterprise Value to Operating Income

Enterprise Value to EBIT
Market value of Equity Debt Cash

EBIT
Enterprise Value to Sales

Market value of Equity Debt Cash

Sales
2-43
2-44
2-45

Problem:
Consider the following data for the year ended Dec.
31, 2008 for Yahoo! and Google (in millions):
Yahoo!
Google
7,209
21,796
Operating Income
12
6,632
Net Income
424
4,227
Market Capitalization
22,830
177,380
Cash
2,292
8,657
Debt
2,439
3,529
Sales
Compare Yahoo and Googles operating margin, net

profit margin, P/E ratio, and the ratio of enterprise
value to operating income and sales.
2-46

Solution:
Yahoo! Had an operating margin of 12/7,209=0.17%, a net
profit margin of 424/7,209=5.88%, and a P/E ratio of
22,830/424=53.84. Its enterprise value was 22,830+24392292=22,977 million, which has a ratio of
22,977/12=1914.75 to operating income and
22,977/7,209=3.19 to sales.
Google had an operating margin of 6,632/21,796=30.4%, a net
profit margin of 4,227/21,796=19.39%, and a P/E ratio of
177,380/4,227=41.96. Its enterprise value was
177,380+3,529-8,657=172,252 million, which has a ratio of
172,252/6,632=25.97 to operating income and
172,252/21,796=7.90 to sales.
2-47

To summarize:
Ratio
Yahoo!
Google
Operating Margin
.17%
30.4%
Net Profit Margin
5.88%
19.39%
P/E Ratio
53.84
41.96
1914.75
25.97
3.19
7.90
Enterprise Value to
Operating Income
2-48

Solution (contd):
Even though Yahoo! And Google are competitors,
their ratios look much different. Yahoo! has much
lower profit margins, yet their P/E ratio is higher
than Googles. Their enterprise value to operating
income ratio is also higher, mostly because of low
operating income. Enterprise value to sales ratio is
lower than that of Google. The difference is
consistent with Yahoo!s lower margins.
2-49
2.6 Statement of Cash Flows

Net Income typically does NOT equal the
amount of Cash the firm has earned.
Non-Cash Expenses
Depreciation and Amortization
Uses of Cash not on the Income Statement

Investment in Property, Plant, and Equipment
2-50

(cont'd)
Three Sections
Operating Activities
Investment Activities
Financing Activities
2-51

(cont'd)
Operating Activities
Adjusts net income by all non-cash items
related to operating activities and changes in
net working capital
Accounts Receivable deduct the increases
Accounts Payable add the increases
Inventories deduct the increases
2-52

(cont'd)
Investing Activities
Capital Expenditures
Buying or Selling Marketable Securities
Financing Activities
Payment of Dividends
Retained Earnings = Net Income Dividends
Changes in Borrowings
2-53

Statement of Cash Flows for 2009 and 2008
2-54
2-55
2-56
2.7 Other Financial Statement

Information
Management Discussion and Analysis
Off-Balance Sheet Transactions
Statement of Stockholders Equity

Notes to the Financial Statements
2-57
2-58
2-59

Problem
Campbell Soup Company reported the following sales
revenues
by category:
U.S. Soup, Sauces and Beverages
Baking and Snacking
International Soup and Sauces
Other
$
$
$
$
2009
3,257
1,747
1,255
1,084
Total
7,343
$
$
$
$
2008
3,098
1,742
1,227
1,005
7,072
What was the percentage growth for each category?

If Campbells has the same percentage growth from
2009 to 2010, what will its total revenues be in 2010?
2-60

Solution
U.S. Soup, Sauces and Beverages
($3,257 $3,098) 1 = 5.13%
Baking and Snacking

($1,747 $1,742) 1 = 0.29%
International Soup and Sauces

($1,255 $1,227) 1 = 2.28%
Other
($1,084 $1,005) 1 = 7.86%
Total
($7,343 $7,072 ) 1 = 3.83%
2-61

Solution (continued)
Estimated 2007 Total Revenue
$7,343 (1 + 3.83%)
$7,343 1.0383 = $7,624
2-62
2.8 Financial Reporting in Practice

Even with safeguards, reporting abuses
still happen:
Enron
WorldCom
Sarbanes-Oxley Act (SOX)
2-63
Discussion of Key Topic

If either Ford or Microsofts P/E ratio is
lower than the industry average, do you
expect the stock price to go up? Could
there be reasons other than
undervaluation for a firm to have a low
P/E?
2-64
Chapter Quiz
1. The book value of a companys assets usually does
not equal the market value of those assets. What are
some reasons for this difference?
2. What is a firms enterprise value?
3. What is the difference between a firms gross profit
and its net income?
4. What is the DuPont identity?
5. What are the components of the statement of cash
flows?
6. What information do the notes to the financial
statements provide?
2-65

CH 2

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Chapter 2

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

2.1 Disclosure of Financial

Must also send an annual report with financial

2.1 Disclosure of Financial

Copyright 2011 Pearson Prentice Hall. All rights reserved.

2.1 Disclosure of Financial

Copyright 2011 Pearson Prentice Hall. All rights reserved.

2.2 Balance Sheet

Assets Liabilities Stockholders' Equity

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2.2 Balance Sheet (cont'd)

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2.2 Balance Sheet (cont'd)

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2.2 Balance Sheet (cont'd)

Goodwill and intangible assets

Other Long-Term Assets

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Table 2.1 Global Conglomerate Corporation

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2.2 Balance Sheet (cont'd)

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2.2 Balance Sheet (cont'd)

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2.2 Balance Sheet (cont'd)

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Table 2.1 (cont'd) Global Conglomerate

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2.2 Balance Sheet (cont'd)

Market Value of Equity (Market Capitalization)

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Textbook Example 2.1

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Textbook Example 2.1 (cont'd)

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Alternative Example 2.1

Alternative Example 2.1

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2.3 Balance Sheet Analysis

Market Value of Equity

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2.3 Balance Sheet Analysis (cont'd)

Using Book Value versus Market Value

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Textbook Example 2.2

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Textbook Example 2.2 (cont'd)

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Alternative Example 2.2

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Alternative Example 2.2

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2.3 Balance Sheet Analysis (cont'd)

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2.4 Income Statement

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2.4 Income Statement (cont'd)

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2.4 Income Statement (cont'd)

Other Income/Other Expenses