Daniel FotinichAndy Zhao

Berkeley Investment Group:Financial Statements and Modeling Workshop

Importance of Financial Statements

Supplement our qualitative judgments about a company

Predict future financial performance

Calculate what we believe is the firm’s fair value

Financial StatementsWhat are the three financial statements?

– Income Statement– Balance Sheet– Statement of Cash Flows

Where do we find them?– Yahoo/ Google/ Morningstar– http://www.sec.gov/edgar.shtml– Company’s investor relations webpage

Which is the most important?– All of them are useful for analysis

10-k, 10-Q

Case Study: Chipotle

The Income Statement

A Bare-bones Income Statement

Revenue $a

Cost of Goods Sold (COGS) b

Gross Profit a-b

Operating Expenses c

Operating Income a-b-c

Interest Expense d

Income Tax e

Net Income $a-b-c-d-e

“topline”

“bottom line”

Actual Income Statement

Revenue, Cost of Goods Sold, Gross Profit

Revenue – money generated from sales of products and/or services within a given time frame

COGS – cost of materials directly related to goods/services sold

Gross Profit – profit directly related to producing the good/service

Gross margins: Gross profit/Revenue

Operating Expenses & Operating Income

OpEx – Indirect costs of operating the business

Gross Profit

Operating Income –profit received from company’s core operations

Operating margins: Operating Profit/Revenue

Interest, Taxes, Net Income

Interest Payments – interest on company debt

Net Income – “earnings”, how much total profit a company makes

Operating Income

Taxes – Tax rate * (Income Before Taxes)

Net Margins: Net Income/Revenue

Fixed vs. Variable CostFixed Cost Variable Cost

• Costs that don’t directly vary with incremental increases in production

• Costs that directly vary with incremental increases in production

Production

Costs

Fixed CostVariable Cost

• Examples: Factories, Management • Examples: Labor, input costs

• Step-function • Linear Function

Operating Leverage

% of costs as fixed

0%

Op. Income

Revenue

50%

• Total expenses increase at a rate less than that of revenue• Occurs when there are fixed costs in the business• The greater the % of costs as fixed costs, the greater the operating leverage

Understanding Gross Profit

A

BHow do these two businesses differ from one another?

Company A has 16% GMs, Company B has 81% GMs

Understanding Gross Profit

Certain types of businesses have far lower gross margins than others, and it is important to recognize these

Operating costs: The Great Equalizer

Ford has 2x the revenue of Pfizer, but 2x less “operating costs”

Analyzing Income Statement Trends (I)

What trends do you notice in this income statement?

Analyzing Income Statement Trends (I)

• Steep sales decline from 2011o 40% decline in 2013

• Huge decline in gross and operating marginso GMs: 44% → 31% in 2 yearso OMs: 23% → -11%

• R&D spending flat in 2013, even as sales collapseo Due to the BlackBerry 10

• Net loss in 2013

Analyzing Income Statement Trends (II)

What trends do you notice in this income statement?

Analyzing Income Statement Trends (II)

• Annual revenue growth has averaged 17% since 2009

• SG&A has increased far less than revenue has in 2012-13o Lots of operating leverage!

• Net income up 103% since 2009

• Restaurant count has increased by ~100 per yearo “Same-store sales” up 4%

The Balance Sheet

A Bare-bones Balance Sheet

Assets

Current Assets a

Non-Current Assets b

Total Assets a+b

Liabilities

Short-term Liabilities c

Long-term Liabilities d

Total Liabilities c+d

Shareholders’ Equity

Total Shareholders’ Equity e

How to Think about the B/S

What are the two methods for paying for a house?

ASSET

LIABILIT

Y

EQUITY

Therefore…

ASSETS = LIABILITIES + EQUITY

The “balance sheet equation”

Assets Cash and Cash Equiv.

Receivables – IOUs from customers

Inventory – goods that have been produced but not sold

PP&E– capital goods used to make products

Liabilities

Accounts Payable – IOUs to suppliers

Long-term Debt – debt to be paid off in more than a year (bonds)

Equity

Additional paid-in capital – total value of all issued stock

Retained earnings – the sum of all the earnings of the business since

day 1

What’s the point?

Debt/EBITDA• A higher D/EBITDA means more aggressive financing and is different for every industry• Companies with significant debt usually trade at a discount to companies with less debt

Return on Assets: Net Earnings / Total Assets

• An indicator for how efficiently the firm uses its assets• Generally the higher the better• Why do airlines have lower ROAs than biotechnology companies?

The balance sheet is useful to investors in two ways: • How efficiently the company is using its capital• Solvency of the company (whether or not it’ll be able to pay back debt

One Type of Business

What do you notice on this balance sheet?

$20 Billion in PP&E!

One Type of Business

The Venetian is “necessary capital” for Las Vegas Sands to provide its product

Another Type of Business

What do you notice on this balance sheet?

Another Type of Business

“NIKE, Inc., together with its subsidiaries, engages in the design, development, marketing, and sale of athletic footwear, apparel, equipment, and accessories”

The Cash Flow Statement

What happens when the company makes money?

Assume the company makes $1MM

earnings in 2013 (all cash)

Pay back $100k debt

Distribute $200k to Shareholders

Reinvest rest in co

• ↓ LT-Liabilities by 100k • ↓ Cash by 100k

• ↓ cash by $200k

• Capital expenditures

• Keep cash on balance sheet

• ↑ cash by $1MM

Cash flow from financing

Cash Flow from investing

Remaining cash flow

Statement of Cash Flows

From Operating Activities• See appendix

for detailed explanation

From Investing Activities

From Financing Activities• Dividends• Debt paydowns

Why does Cash Flow matter?

• As investors, we are entitled to the assets of the company and cash is the most liquid asset

• Not all of a company’s earnings are in cash

• Chronically negative cash flow could result in increased leverage or eventual default

What’s the problem here?

Appendix

“Cash Rules Everything Around Me” - Wu Tang Clan

• Not all financial statements are created equal– IS tells us the earnings and costs of doing business– BS tells us the financial health of the company– CS tells us how much CASH is coming in every year and ties together the two

• Cash is what investors want the most (cash = value)– High income doesn’t necessarily = High cash flow– The cash flow statement tells us how much value the company is generating

Investors

Lenders

Non-Cash Items and AdjustmentsNon-cash items are line items included in earnings but don’t represent cash inflows or outflows for the company.

Expenses (additions to earnings):• Depreciation and Amortization – Accounting method for recognizing capitalized

expenses over time (non-cash)• Change in Accounts Payable – IOUs to suppliers (didn’t spend the cash)

Revenue (deduction from earnings):• Change in Accounts Receivable – IOUs from customers (didn’t give you cash)

But you did spend cash on something else… Capital expenditures

Capex is not recognized on the income statement, but is a major use of cash

Free Cash Flow

Proxy for FCF: • EBITDA (EBIT + D&A)

Free Cash Flow: cash the company generates in a given year to pay off lenders and give value to investors

The Equation…

Free Cash Flow = Operating Cash Flow – Capex

Strong free cash flow is a good indicator of a firm’s value

The Beauty of the Statements

BS IS

CSNet Incom

e, D&ANW

C, Is

sued

Deb

t

Chan

ge in

Cas

h

Net Income (becomes retained earnings)