Understanding and Using Financial Statements

Mini-MBA Robert P. Magee 8 September 2008

Robert Magee, Kellogg School of Management 2008

Agenda
Review of financial statement relationships
Plumbing Reporting conventions Producing reports

Financial analysis
Ratios Reverse engineering
Robert Magee, Kellogg School of Management 2008

The Balance Sheet

Snapshot at a point in time Levels of Assets
Resources listed by type

Levels of Liabilities and Shareholders Equity

Claims on resources Fixed claims (liabilities) Flexible claims (shareholders equity)

Robert Magee, Kellogg School of Management 2008

The Income Statement

Flows of resources (net assets)
Over a period of time Resulting from operations

Revenues reflect inflows of resources Expenses reflect outflows of resources Try to separate ongoing amounts from infrequent amounts

Robert Magee, Kellogg School of Management 2008

The Statement of Cash Flows

Flows of Cash
Over a period of time Three classifications
Operations Investing Financing

Two methods of presentation for Operations

Direct easy to understand Indirect what everyone reports!
Robert Magee, Kellogg School of Management 2008

The Accounting Model (BS)

ASSETS Cash A/R Inv PPE,net = = LIAB'S A/P + SHAREHOLDERS EQUITY Contr'd Ret'd Capital Earnings

Robert Magee, Kellogg School of Management 2008

The Accounting Model (BS+IS)

ASSETS Cash A/R Inv PPE,net = = LIAB'S A/P + SHAREHOLDERS' EQUITY Contr'd Ret'd Capital Earnings Revenue Expense

Robert Magee, Kellogg School of Management 2008

The Accounting Model (BS+IS+SCF)

ASSETS Opns Invstg Fincg Cash A/R Inv PPE,net = = LIAB'S + SHAREHOLDERS' EQUITY Contr'd Ret'd A/P Capital Earnings Revenue Expense

Robert Magee, Kellogg School of Management 2008

Accounting Measurement Principles

Timing of revenue recognition
Revenue must have been earned Amount to be received can be estimated with reasonable certainty

Timing of expense recognition

Match expenses with the revenues they produce Occasional conflict with accountings conservatism in the recognition of assets and liabilities
Robert Magee, Kellogg School of Management 2008

The Sage Company: Start

ASSETS Ppd Opns Invstg Fincg Cash 600 A/R 6500 Inv 2400 Rent PPE 1900 Acm Dep -800 = = A/P 3000 W/P 100 STDt 1600 Tx/P LTDt = LIABILITIES + SHAREHOLDERS' EQUITY Con'd Ret'd Cap 4600 Earn 1300 Rev Exp

Robert Magee, Kellogg School of Management 2008

The Sage Company: 1-6

ASSETS Ppd Opns Invstg Fincg Cash 600 A/R 6500 3800 -1800 3500 -1100 -730 -600 400 -3500 (3) (4) (5) (6) -1100 -30 -700 -200 Inv 2400 1200 Rent PPE 1900 Acm Dep -800 = = (1) (2) A/P 3000 1200 3800 -1800 W/P 100 STDt 1600 Tx/P LTDt = LIABILITIES + SHAREHOLDERS' EQUITY Con'd Ret'd Cap 4600 Earn 1300 Rev Exp

Robert Magee, Kellogg School of Management 2008

The Sage Company: 7-12

ASSETS Ppd Opns Invstg Fincg Cash 600 A/R 6500 3800 -1800 3500 -1100 -730 -600 -800 10 2000 -16 -1600 (11) -80 (12) 400 800 -80 -3500 (3) (4) (5) (6) (7) 70 (8) -150 (9) (10) -1600 374 -80 2000 -16 -374 -150 -1100 -30 -700 -200 Inv 2400 1200 Rent PPE 1900 Acm Dep -800 = = (1) (2) A/P 3000 1200 3800 -1800 W/P 100 STDt 1600 Tx/P LTDt = LIABILITIES + SHAREHOLDERS' EQUITY Con'd Ret'd Cap 4600 Earn 1300 Rev Exp

Robert Magee, Kellogg School of Management 2008

The Sage Company

ASSETS Ppd Opns Invstg Fincg Cash 600 A/R 6500 3800 -1800 3500 -1100 -730 -600 -800 10 2000 -16 -1600 (11) -80 (12) 400 800 -80 -3500 (3) (4) (5) (6) (7) 70 (8) -150 (9) (10) -1600 374 -80 2000 -16 -374 -150 -1100 -30 -700 -200 Inv 2400 1200 Rent PPE 1900 Acm Dep -800 = = (1) (2) A/P 3000 1200 3800 -1800 W/P 100 STDt 1600 Tx/P LTDt = LIABILITIES + SHAREHOLDERS' EQUITY Con'd Ret'd Cap 4600 Earn 1300 Rev Exp

SCF

Robert Magee, Kellogg School of Management 2008

I/S

Financial Statements (flows)

Statement of Cash Flows
Operations: Cash receipts from customers Less: Payments to suppliers Payments to employees Payments for rent Payments for interest Cash from operations Investing: Proceeds from disposals New fixtures and equipment Cash from investing Financing: Loan repayment Proceeds from new loan Shareholder dividends Cash from financing Net change in cash Beginning cash balance Ending cash balance $ 3,500 1,100 730 600 16 $ 1,054 $10 (800) ($ 790) (1,600) 2,000 (80) $ 320 $ 584 600 $ 1,184

Income Statement
Revenue Expenses: Cost of goods sold 1,800 Salaries and wages 700 Rent 200 Depreciation 150 Operating income Interest expense Income before taxes Tax expense Net income $ 3,800

2,850 $ 950 16 $ 934 374 $ 560

Robert Magee, Kellogg School of Management 2008

The Sage Company: Close

ASSETS Ppd Opns Invstg Fincg Cash 600 A/R 6500 3800 -1800 3500 -1100 -730 -600 -800 10 2000 -16 -1600 (11) -80 1184 6800 1800 400 2620 -880 (12) CL = 3100 70 0 374 2000 4600 1780 400 800 -80 -3500 (3) (4) (5) (6) (7) 70 (8) -150 (9) (10) -1600 374 -80 2000 -16 -374 -150 -1100 -30 -700 -200 Inv 2400 1200 Rent PPE 1900 Acm Dep -800 = = (1) (2) A/P 3000 1200 3800 -1800 W/P 100 STDt 1600 Tx/P LTDt = LIABILITIES + SHAREHOLDERS' EQUITY Con'd Ret'd Cap 4600 Earn 1300 Rev Exp

Robert Magee, Kellogg School of Management 2008

Balance Sheet (levels)

Balance Sheet July 31, 2000
Assets Cash $ 1,184 Accounts receivable 6,800 Inventory 1,800 Prepaid rent 400 Current Assets $ 10,184 Fixtures and equipment at cost 2,620 Accumulated depreciation (880) Plant and equipment, net 1,740 Total Assets $ 11,924 Liabilities and shareholders equity Accounts payable $ 3,100 Salaries and wages payable 70 Tax payable 374 Current Liabilities $ 3,544 Long-term loan 2,000 Common Stock, $1 par 300 Additional paid-in-capital 4,300 Retained earnings 1,780 Total liabilities and shareholders equity $ 11,924

Robert Magee, Kellogg School of Management 2008

Reconcile Cash Flow and Income

Statement of Cash Flows
Operations: Cash receipts from customers Less: Payments to suppliers Payments to employees Payments for rent Payments for interest Cash from operations Investing: Proceeds from disposals New fixtures and equipment Cash from investing Financing: Loan repayment Proceeds from new loan Shareholder dividends Cash from financing Net change in cash Beginning cash balance Ending cash balance $ 3,500 1,100 730 600 16 $ 1,054 $10 (800) ($ 790) (1,600) 2,000 (80) $ 320 $ 584 600 $ 1,184

Statement of Cash Flows-Indirect

Operations: Net income Adjustments: Depreciation addback Less: A/R increase Prepaid rent increase Wages Payable decrease Plus: Inventory decrease A/P increase Tax payable increase Cash from operations $ 560 150 (300) (400) (30) 600 100 374 $ 1,054

Robert Magee, Kellogg School of Management 2008

Key to Reading Financial Reports

ORGANIZATION Financing Collections Purchasing Production Payments Selling Financial Reporting B/S I/S SCF Fns Financial Statement Analysis
Understanding the real activities and how they are reflected in financial reports is the key to effective reading of the reports.
Robert Magee, Kellogg School of Management 2008

The Current Ratio

The Current Ratio compares the pool of resources that are expected to become cash within the year to the obligations that must be met within the year. Current Assets Current Ratio = Current Liabilities Walgreens Current Ratios 2007 2006

Robert Magee, Kellogg School of Management 2008

Other Liquidity Ratios

Quick ratio = (Current assets inventory) Current liabilities A/R turnover = Sales revenue Average A/R Days receivables = Average A/R (Sales revenue 365) Inventory turnover = Cost of goods sold Average inventory Days inventory = Average inventory (Cost of goods sold 365) A/P turnover = Cost of goods sold Average A/P Days payables = Average A/P (Cost of goods sold 365) Cash operating cycle = Days receivables + Days inventory Days payables Days to flame-out = (Cash + Marketable securities) (-Free cash flow 365)
Robert Magee, Kellogg School of Management 2008

The Total Debt to Total Equity Ratio

One measure of the firms ability to meet its long-term fixed commitments relates the size of the fixed obligations (liabilities) to the size of the shareholders residual claim. Total Liabilities Debt to Equity Ratio = Shareholders Equity Walgreens D/E Ratios 2007 2006

Robert Magee, Kellogg School of Management 2008

Return on Common Shareholders Equity

Profitability measures often use a return on investment notion so that the accomplishments (profits) are related to the resources provided (investment). Net Profit to Common1 Return on Shareholders Equity = Average Common Shareholders Equity Walgreens ROE 2007

Net profit to common equals net income minus any dividends to outstanding preferred stock.
Robert Magee, Kellogg School of Management 2008

Other Profitability Ratios

Earnings per share = Net profit to common Average common shares outstanding Gross margin = Gross profit Sales revenue Return on sales (Profit margin) = Net income Sales revenue Total asset turnover = Sales revenue Average total assets Return on assets (pre-tax) = EBIT1 Average total assets Return on assets = {Net income + (1-tax rate)*Interest expense} Average assets
1

EBIT is defined as earnings before interest and tax expense.

Robert Magee, Kellogg School of Management 2008

Ratios Tell A Story: 2005

Airline company Automobile manufacturer Pharmaceutical company Commercial bank Computer and office equipment manufacturer Discount generalmerchandise store chain Electric utility Fast-food chain Wholesale food distributor Supermarket chain Internet retailer Specialized staffing services company Software development company

Robert Magee, Kellogg School of Management 2008

1 Year-end Cash Receivables Inventory Other current assets Total current assets Net plant and equip Goodw ill Other Total assets Accts payable Short-term debt Other Total current liabilities Long-term debt Other Total liabilities Preferred stock Com m on Stock Treasury stock Retained earnings Total ow ners' equity Total liab. and equity Return on sales Asset turnover Return on assets Financial leverage Return on equity Current ratio Receivable collection Inventory turnover Gross m argin Dividend payout Revenue grow th R&D ratio Dec 2.4 2.2 17.6 1.3 23.5 57.7 15.2 3.5 100.0 13.7 4.5 8.9 27.1 35.6 6.1 68.8 -22.0 -24.7 33.9 31.2 100.0 1.5% 2.44 3.6% 3.20 11.4% 0.87 3 9.9 28.9% 8.0% 7.2% NA

2 Jun 69.7 7.1 -5.5 82.3 4.3 4.9 8.6 100.0 1.7 -18.0 19.7 -3.9 23.6 -55.3 -95.2 116.3 76.4 100.0 30.7% 0.81 24.7% 1.31 32.3% 0.04 32 NA 95.3% 0.5% 17.9% 18.6%

3 Dec 14.2 4.5 2.0 2.1 22.9 63.0 -14.1 100.0 2.6 0.6 18.1 21.3 64.9 54.6 140.9 2.1 11.4 -7.7 -46.7 -40.9 100.0 -20.8% 0.94 -19.5% NA NA 1.07 18 NA NA NA 8.9% NA

4 Dec 34.7 34.2 -8.2 77.1 8.4 12.6 1.9 100.0 6.7 0.1 18.7 25.5 0.2 0.6 26.4 -66.4 -7.2 73.6 100.0 7.1% 2.53 18.0% 1.36 24.5% 0.03 49 NA 41.1% 20.2% 24.7% NA

5 Dec 3.8 3.8 9.5 20.1 37.2 35.2 0.9 26.7 100.0 7.2 18.1 17.5 42.8 22.0 17.0 81.9 -5.4 -12.7 18.1 100.0 1.9% 0.74 1.4% 5.53 7.8% 0.87 19 6.4 17.9% 55.3% 5.4% 3.8%

6 Jan 4.6 1.4 24.5 1.5 32.0 57.0 9.0 2.0 100.0 18.0 6.5 11.2 35.7 19.7 3.6 58.9 -2.4 -38.7 41.1 100.0 3.6% 2.40 8.5% 2.43 20.8% 0.90 2 7.5 22.9% 21.6% 11.3% NA

7 Dec 54.1 7.4 15.3 2.4 79.2 9.4 4.3 7.0 100.0 37.0 0.1 15.2 52.2 41.2 -93.3 -61.4 --54.7 6.7 100.0 4.2% 2.30 9.7% 15.02 145.9% 1.52 12 11.4 24.0% 0.0% 22.7% NA

8 Oct 18.2 15.6 9.1 13.0 55.8 9.1 20.8 14.3 100.0 13.0 2.6 24.7 40.3 3.9 6.5 50.6 -28.6 -20.8 49.4 100.0 2.3% 1.13 2.6% 2.03 5.3% 1.39 50 7.6 23.2% 50.0% 8.8% 4.0%

9 Dec 35.9 6.7 3.6 2.2 48.0 4.0 31.4 4.5 15.7 2.2 6.7 20.0 28.9 11.1 20.0 60.0 -15.8 -60.2 84.4 40.0 100.0 22.7% 0.49 11.2% 2.48 27.8% 1.66 50 3.1 77.3% 60.0% -4.3% 17.5%

10 Feb 7.4 7.5 16.4 2.6 33.9 35.1 25.9 5.1 100.0 17.7 1.6 6.7 26.0 25.2 8.9 60.0 -4.2 -4.9 40.7 40.0 100.0 2.0% 3.11 6.1% 2.50 15.4% 1.30 9 16.2 14.6% 20.7% -3.3% NA

11 Dec 25.6 65.7 0.0 0.5 91.9 1.8 2.1 4.3 100.0 64.1 4.0 7.1 75.2 14.5 1.3 91.0 -3.0 -1.2 7.2 9.0 100.0 31.0% 0.05 1.5% 11.14 16.4% 1.22 5055 NA NA 51.3% 21.4% NA

12 Jan 11.4 4.4 1.8 4.4 22.0 67.6 3.8 6.7 100.0 5.5 0.3 11.2 16.9 17.9 5.3 40.2 -12.2 -8.7 56.3 59.8 100.0 5.9% 1.10 6.5% 1.67 1.1% 1.30 14 31.8 33.9% 29.5% 4.1% NA

13 Dec 0.3 5.2 1.5 4.2 11.2 72.2 -16.6 100.0 4.8 2.5 5.1 12.4 28.8 27.4 68.6 1.0 11.0 -4.5 23.9 31.4 100.0 7.5% 0.44 3.3% 3.18 10.4% 0.91 44 15.4 47.6% 54.8% 15.8% NA

Ratios Tell A Story - Two Lessons

Ratios are only meaningful when compared to an appropriate benchmark. Comparing ratios of firms from the same industry, with similar strategies, is useful. A firm can provide its own comparison using prior periods if there have been no significant changes in its operations or policies. What we have done is to picture how a particular type of company (e.g., a grocery chain or an electric utility) would be reflected in its financial statements. The next step is to picture how a well-run company would be reflected in its financial statements, relative to a poorly-run company.
Robert Magee, Kellogg School of Management 2008

What Happens When Hide Trouble?

Standard Red Flags1

1

Net income much higher than operating cash flow Big differences between tax income and book income Unsustainable sales Reserves Asset overstatements (a.k.a. Deferred expenses) Purchased profits Growing inventory and/or receivables Write-offs Cutbacks in soft investments

G. Morgensen. When a Rosy Picture Should Raise a Red Flag New York Times July 18, 1999.
Robert Magee, Kellogg School of Management 2008

Reverse Engineering Exercise

Robert Magee, Kellogg School of Management 2008

Financial Reporting Issues

Revenue recognition timing product characteristics Accounts receivable valuation use of estimates Inventory margin and operating analysis Noncurrent operating assets intellectual property Financial assets multiple methods Liabilities Leases off-balance-sheet financing Shareholders equity options Regulatory changes movement to IFRS
Robert Magee, Kellogg School of Management 2008