LEARN HOW TO READ FINANCIALS AND CALCULATE

IMPORTANT RATIOS!

Financial Statement Analysis

Financial Statements Overview

Financial statements convey the results and financial position of a business

We use them to evaluate sales, profitability, cash flow, and other metrics

In the U.S. financial statements are prepared on a quarterly and annual basis

Financial Statements Overview

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Stockholder’s Equity

Balance Sheet

The Balance Sheet presents a Company’s assets, liabilities, and shareholder’s equity at a point in time

Assets represent future economic benefits i.e. office building, patents, or even inventory

Liabilities represent future economic sacrifices i.e. bank loans, accounts payable to suppliers

Balance Sheet

Equity represents capital contributions to the business + cumulative retained profits (earnings)

Under the accounting equation:

Assets = Liabilities + Equity

Balance Sheet

Current assets/current liabilities Assets/liabilities that will be consumed (or paid

off/settled) within the next year i.e. accounts receivable, inventory, or accounts

payable

Non-current assets/non-current liabilities Assets/liabilities that will not be consumed (or paid

off/settled) within the next year i.e. production equipment, long-term bank obligation

Income Statement

The Income Statement summarizes the profit generating activities of a business

Most companies report a multiple-step income statement

Income Statement

JC. Co. Income Statement For The Year Ended 12/31/16Revenue $100,000

Cost of goods sold ($50,000)Gross Profit $50,000

Operating expenses:Selling expenses ($10,000)

General and administrative ($10,000)Research & development ($5,000)

Operating Income $25,000Other income (expense)

Interest income $500Interest expense ($500)

Income before taxes $25,000Income tax expense ($10,000)

Net income $15,000

Statement of Cash Flows

The Statement of Cash Flows shows how a company’s cash balance changed over a period

The statement classifies cash transactions into 3 categories:

Operating Activities

Investing Activities

Financing Activities

Operating Activities

Operating activities represent cash inflows and outflows related to a Company’s main business activities

Inflows include: cash received from customers for the sale of goods/services, interest income, and dividends from investments

Outflows include: inventory, salaries/wages, other operating expenses, interest on debt, and income taxes

Investing Activities

Investing activities include cash inflows/outflows related to the purchase and sale of non-current assets

Examples:

Purchase/sale of long-lived assets used in the business

Purchase/sale investments in stocks and bonds

Acquisition or disposition of businesses

Financing Activities

Financing activities relate to the external financing of the Company (debt + equity)

Inflows: (1) shares issued to owners (2) borrowing money

Outflows: (1) dividends, (2) acquisition of shares, (3) repayment of debt principal

Earnings-Per-Share (EPS)

Shares are units of ownership in a business that provide for an equal distribution of profit or dividends

All public companies have shares that are traded on stock exchanges

Earnings-Per-Share (EPS)

Basic shares outstanding = the number of shares outstanding

Sometimes companies issue stock options or other equity awards to executives as compensation. This represents “dilution” to current shareholders

Diluted shares outstanding = the number of shares outstanding + any potential claims on common shares

Earnings-Per-Share (EPS)

Earnings-Per-Share (EPS) = Net Income / Shares Outstanding Represents how much profit the Company generates

per share outstanding

Basic EPS = Net Income / Basic Shares Outstanding

Diluted EPS = Net Income / Diluted Shares Outstanding

Profitability Analysis

Gross Margin = Gross Profit / Revenue

Operating Margin = Operating Profit / Revenue

Net Margin (Profit Margin) = Net Income / Revenue

Profitability Analysis

Analysts typically compare ratio metrics relative to: (1) prior year results or (2) a peer company (i.e. a competitor)

A basis point represents 1/100th of a percent .01% = 1 basis point 1% = 100 basis points

Activity/Turnover Analysis

Turnover ratios are important because they gauge a company’s ability to convert assets into cash

Asset Turnover = Sales / Average Total Assets

Asset Turnover shows how efficiently a business utilizes its assets to generate revenue!

Activity/Turnover Analysis

Receivables Turnover Ratio = Sales / Average Accounts Receivable

Receivables Turnover measures the number of times during the period that the average accounts receivable balance is collected

Activity/Turnover Analysis

Days Sales Outstanding (DSO) = # of days in period / Receivables Turnover Ratio

DSO represents the average collection period for a Company’s accounts receivables

Activity/Turnover Analysis

Inventory Turnover = Cost of Goods Sold / Average Inventory

Inventory Turnover measures the number of times the average inventory balance is sold during a period

Activity/Turnover Analysis

Days Sales of Inventory (DSI) = # of days in the period / Inventory Turnover Ratio

DSI measures the number of days it takes for a business to sell its inventory

Activity/Turnover Analysis

Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable

Accounts Payable Turnover measures how many times the average payable balance is paid during a period

Activity/Turnover Analysis

Days Payable Outstanding (DPO) = # of days in the period / Payable Turnover Ratio

DPO measures how long it takes a business to pay its suppliers

Activity/Turnover Analysis

Days Inventory Outstanding (DSI)

Days Sales Outstanding (DSO)

Days Payable Outstanding (DPO)

Cash Conversion Cycle = DSI + DSO - DPO

Liquidity Ratio Analysis

Liquidity refers to the ease of ability in converting assets to cash.

Current Ratio = Current Assets / Current Liabilities The higher the current ratio, the more capable the

Company is of paying short-term obligations

Acid-Test Ratio (Quick Ratio) = Quick Assets / Current Liabilities

Leverage Analysis

Leverage analysis is used to assess a company’s ability to repay its long-term debt

Interest Coverage Ratio = (Net Income + Interest Expense + Income Taxes) / (Interest Expense)

Interest Coverage measures how easily a business can pay interest on outstanding debt.

Leverage Analysis

Debt to Equity Ratio = Debt / Equity

Debt to Equity ratio measures how much debt is used to finance assets relative to equity

All else equal, the higher the ratio, the higher the risk of bankruptcy

Leverage Analysis

Debt-to-EBITDA ratio = Debt / EBITDA Very commonly used by credit agencies

EBITDA = earnings before interest, taxes, depreciation expense, and amortization expense

Different industries use leverage differently!

Valuation Ratios

“Valuation is an art, not science”

In finance/accounting, valuation refers to the calculation of a security’s value

Valuation ratios are used to assess how “cheap” or “expensive” a company is

Valuation Ratios

Price-to-Earnings Ratio (P/E Ratio) = Stock Price / EPS

P/E measures how much you are paying for a business relative to its earnings (profits)

Forward P/E ratio: Stock Price / Forecasted Future Earnings

Valuation Ratios

Price-to-Cash Flow Ratio (P/CF) = Market Capitalization / Cash from Operating Activities

Market capitalization = share price * shares outstanding

This ratio measures how much you are paying for a business relative to its cash flow generation capability

Valuation Ratios

Price/Sales Ratio (P/S): Market Capitalization / Sales

Measures how much you are paying for a company’s revenue

Typically used in start ups, high growth technology companies, or businesses without profits

Valuation Ratios

Book Value (BV) represents the net assets of a business.

Book Value = Total Assets – Total Liabilities

BV per-share = Book Value / Diluted Share Count

Valuation Ratios

Price-to-Book Value (P/B) = Share Price / Book Value per-share

P/B measures how much you are paying for the net assets of a business.

P/B is most appropriate for businesses with high tangible assets (i.e. a bank or insurance company) It is less appropriate for companies that have large

intangible assets (i.e. biotech/pharmaceuticals or technology companies)

Valuation Ratios

Market Capitalization = Shares Outstanding x Share Price

Enterprise Value is a more comprehensive measure of a company’s value

Enterprise Value (EV) = Market Capitalization + Preferred Shares + Debt + Minority Interest - Cash

Valuation Ratios

Enterprise Value-to-EBITDA (EV/EBITDA) = Enterprise Value / EBITDA

EV/EBITDA measures the multiple a potential acquirer would pay for a business

How To Read Financial Statements

ALL public companies are required to file documents with the U.S. Securities and Exchange Commission (SEC) on a regular basis

A public company’s SEC filings are available to the public for FREE at:https://www.sec.gov/

Key SEC Filings

10-K: An annual report filed with the SEC detailing a company’s financial performance

10-Q: A comprehensive quarterly report

8-K: A broad form utilized to inform shareholders of key events

DEF-14A: A Company’s annual Proxy statement

Form 4: A filing detailing executives’ buys/sales of shares

10-K

Large companies ($700M+) must file their 10-K 60 days after their fiscal year ends

The 10-K is required reading for any serious investor!

Warren Buffett reportedly reads over 500 pages a day!

10-K

A 10-K is a public company’s annual report with the SEC detailing its business performance

A 10-K IS NOT the same thing as a company’s Annual Report to Shareholders!

“All else being equal, invest in the company with the fewest color photographs in the annual report.”—Peter Lynch

10-K Reading Tips

Don’t read it all in one sitting

Take many breaks!

The best way to read a 10-K is side-by-side with the prior year filing

10-K: Business Section

The Business Section describes the ‘who’ and ‘what’ of the company

The business section typically describes the company’s products/services, its operating segments, competition, goals, employees, and market dynamics

It may also include recent events, regulation, labor issues, or potential lawsuits

10-K: Risk Factors Section

The Risk Factors section describes key risks the Company faces i.e. employee strikes, dependence on a customer,

increased industry competition

Risk factors are often drafted by lawyers so the language can be ‘boilerplate’

10-K Risk Factors Section

Key risk factors to watch out for:

Changes in competition Customer concentration (large customers) New/pending regulation Any important lawsuits Commentary about debt levels Dependence on certain products Dependence on certain suppliers or manufacturers

10-K: Unresolved Staff Comments

This section requires companies to explain comments it received from SEC staff on previously filed reports that have not been resolved after an extended period of time

Any comments should be taken as a red flag!

10-K: Properties

This section discloses information about a company’s significant properties

i.e. headquarters, manufacturing plants, store base, square footage, etc.

10-K: Legal Proceedings

This section describes all of the Company’s important legal proceedings

The language may be boilerplate, but can identify key risks to watch out for!

10-K: Item 5

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity

Item 5 essentially summarizes information about the company’s shares i.e. share price highs/lows, volume, dividends, and

share repurchases

10:K Selected Financial Data

The selected financial data section provides financial information about a company for the past 5 years.

Most companies will disclose important income statement and balance sheet data, along with other key performance metrics

10-K: MD&A (Highlights + Strategy)

Management’s Discussion of Analysis of Financial Condition and Results of Operations

The MD&A section typically begins with a discussion of highlights from the most recent year and the company’s strategy

10-K: MD&A (Results Discussion)

The MD&A will include certain financial metrics over the past 3 years

The Company will also discuss income statement results over the past 3 years on a ‘line-by-line’ basis

10K: MD&A (Results Discussion)

MD&A commentary varies, but typically includes:

why revenue increased/decreased

why profit increased/decreased

any one-time expenses

discussion on taxes

10-K: MD&A (Liquidity & Capital Resources)

The next section of the MD&A focuses on ‘liquidity and capital resources

Here, the company discusses the significant sources and uses of cash This will include a discussion of (1) cash from operating

activities, (2) cash from investing activities, and (3) cash from financing activities

The final section of liquidity and capital resources discusses the company’s available credit resources

10-K: MD&A (Contractual Obligations)

Under “Contractual Obligations”, the company will list a timeline of its obligations

These obligations may include: Debt, purchase obligations, and leases among others

10-K: MD&A (Critical Accounting Policies)

At the end of every MD&A section, the company will discuss its critical accounting policies

These policies typically include: Revenue recognition Inventory valuation Impairment analysis Taxes

10-K: Item 7A

Quantitative and Qualitative Disclosures about Market Risk

The SEC requires the company to discuss market risks such as: Interest rates Foreign currency Commodity prices

The company may also discuss how it mitigates these risks

10-K: Financial Statements

Item 8 is the part of the 10-K that discloses the company’s financial statements

Item 8 also includes the auditor opinion and financial footnotes

10-K: Financial Statements

All public companies must have an auditor Most select the “Big 4”—EY, PwC, Deloitte, KPMG

In the 10-K, company’s must release their independent auditor’s opinion

10-K: Financial Statements

The audit report will contain the auditor’s opinion about the fairness of the financials presented and opinion the company’s internal control

Internal control represents the processes put in place to ensure integrity of accounting and financial information presented

10-K: Financial Statements

Most companies receive an “unqualified opinion” on their audit

It is important to watch out for internal control weaknesses!

10-K: Financial Statements

Balance Sheet for the past 2 years

Income Statement for the past 3 years

Statement of stockholder’s equity for the past 3 years

Statement of Cash Flows for the past 3 years

10-K: Footnotes

The footnotes are presented after the financial statements and include a variety of details about the company’s accounts and policies

Footnotes are often the most important part of the financials to read!

10-K: Footnotes

Key sections to read:

Revenue recognition

Accounts receivable

Inventory

PP&E

Debt

Acquisitions

Taxes

10-K: Footnotes

Other important footnote disclosures:

Segment Reporting

Geographic information

Remember: reading the footnotes is incredibly important!

10-Q: Quarterly Report

Large companies ($700M+) must file their 10-Q 40 days after the end of the quarter

A quarterly report is an abbreviated filing with the SEC detailing financial results from the quarter

10-Q: Financial Statements

The financial statements are presented first

Footnotes are presented after the financial statements

The 10-Q is much more abbreviated than the 10-K and contains fewer disclosures

10-Q: MD&A

The 10-Q also contains a “Management’s Discussion and Analysis” section

The MD&A starts with an overview of recent financial performance before discussing detailed performance

8-K: Current Report

Form 8-K is the “current report” public companies must file with the SEC to announce major events shareholders should know about

8-K: Current Report

A company should issue an 8-K for:

Acquiring another business

Asset sales

Quarterly results

Issuing debt and/or equity

8-K: Current Report

A company should issue an 8-K for:

Restructuring plans

Change in accountants

Senior officer changes

Director elections/departures

DEF-14A: Proxy Statement

All public companies need to file a proxy statement (DEF-14A) ahead of the annual shareholder’s meeting

Key disclosures include: voting procedure, background about directors and management, and compensation

DEF-14A Proxy Statement

Notice of Annual Meeting of Shareholders

Details the who, what, where, and when of the meeting

DEF-14A: Proxy Statement

Solicitation of the proxy: details what is being voted on and the board’s recommendation

Election of Directors Will include a background of each director

DEF-14A: Proxy Statement

Board Committees:

Audit Committee

Nominating Committee

Compensation Committee

DEF-14A: Beneficial Ownership

All proxy statements include:

a section disclosing significant (5%+) shareholders

Directors’ and Officers’ beneficial ownership

DEF-14A: Director Compensation

As analysts, we want to know how much and how directors are being compensated

Directors are typically paid through a combination of retainer (cash) and equity

DEF-14A: Executive Compensation

Executive compensation is the most important part of the proxy statement!

A company typically discusses: Compensation philosophy Role of the Compensation Committee Elements of compensation

DEF-14A: Executive Compensation

Elements of Executive Compensation: Base Salary Cash Bonus Equity (options, RSUs, performance-based shares,

etc.) Others/perquisites

Summary Compensation Table

Form 4

All directors, officers, and 10%+ shareholders must file documents (the Form 4) for changes in share holdings

A Form 4 MUST be filed before the end of the second business day following a change in ownership

Form 4: Codes

P: Open market or private purchase of shares

S: Open market or private sale of shares

A: grant, award, or other acquisition of shares from the company

Form 4: Codes

D: Sale or transfer of shares back to the company

F: Payment of exercise price or tax liability using portion of securities received from the company

M: Exercise or conversion of security received from the company

G: Gift (i.e. donation) of securities by the insider

Form 4: Insider Buying / Selling

How many insiders are buying/selling?

Were the purchases/sales significant?

Conference Calls (CCs)

Conference Calls are used my almost all public companies to report quarterly results

CCs are typically scheduled in advance via press release

Many CCs are also accompanied with presentations

Conference Calls (CCs)

Conference Calls may also be held for:

Acquisitions/mergers/dispositions

Monthly sales calls

Significant corporate events

Many others

Quarterly Results Overview

Public companies in the U.S. report results on a quarterly basis

Companies typically set reporting dates in advance

Keep an eye out for the 8-K or press release!

Guidance

Some (but not all) companies provide guidance

Companies may provide guidance on: Revenue Margins Profit Store openings/closings Capital expenditures …and much more!

Guidance

Guidance is not required by SEC reporting standards–it is entirely voluntary

Stocks can trade off guidance so pay attention!

Key Performance Indicators (KPIs)

As analysts, we must identify a company’s key performance indicators

KPIs are typically disclosed and discussed in earnings releases, conference calls, and the MD&A section of reports

Some industries have very specific KPIs

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