Financial Statement Analysis

P.V. Viswanath

Based on Damodaran’s Corporate Finance

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Questions we would like answered…

Assets Liabilities

Assets in Place Debt

Equity

What is the value of the debt?How risky is the debt?

What is the value of the equity?How risky is the equity?

Growth Assets

What are the assets in place?How valuable are these assets?How risky are these assets?

What are the growth assets?How valuable are these assets?

As financial analysts…

However, the information we have comes from the firm’s financial statements…

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Basic Financial Statements

The balance sheet, which summarizes what a firm owns and owes at a point in time.

The income statement, which reports on how much a firm earned in the period of analysis

The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis

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The Balance Sheet

Assets Liabilities

Fixed Assets

Debt

Equity

Short-term liabilities of the firm

Intangible Assets

Long Lived Real Assets

Assets which are not physical,like patents & trademarks

Current Assets

Financial InvestmentsInvestments in securities &assets of other firms

Short-lived Assets

Equity investment in firm

Debt obligations of firm

Current Liabilties

Other Liabilities Other long-term obligations

Figure 4.1: The Balance Sheet

This is what we can see from the firm’s balance sheet…

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An example : Maxwell Shoe Company, Inc

Maxwell Shoe Company Inc. designs, develops and markets casual and dress footwear for women and children under multiple brand names, each of which is targeted to a distinct segment of the footwear market. The Company offers casual and dress footwear for women in the moderately priced market segment under the Mootsies Tootsies brand name, in the upper moderately priced market segment under the Sam & Libby and Dockers Khakis Footwear For Women brand names and in the better market segment under the Anne Klein 2 and A Line Anne Klein brand names.

It also sells moderately priced and upper moderately priced children's footwear under both the Mootsies Tootsies and Sam & Libby brand names. In addition, it designs and develops private label footwear for selected retailers under the retailers' own brand names. Maxwell has licensed the J.G. Hook trademark to source and develop private label products for retailers who require brand identification.

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An example of an Accountant’s Balance Sheet

Maxwell Shoe Company, Inc.As of October 31, 2000 (In ‘000s)

ASSETSLIABILITIES AND STOCKHOLDERS' EQUITY

Current assets: Current liabilities:Cash and cash equivalents $48,074 Accounts payable......... $1,863Accounts receivable, trade 34,244 Accrued expenses......... 7,254Inventory, net 12,036 Deferred income taxes..... 479

Prepaid expenses 536Current portion of Capital lease obligations 102

Prepaid income taxes 1,478Deferred income taxes.... 798Total current assets........ 97,166 Total current liabilities... 9,698

Property and equipment, net. $6,605Long-term deferred income taxes........ 1,540

Trademarks, net.. 15,479 Stockholders' equity 88

Other assets..... 185Additional paid-in capital.......... 43,112Deferred compensation.... -251Retained earnings........ 65,248Total stockholders' equity.. 108,197

$119,435 $119,435

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Notes on the Maxwell Balance Sheet

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are created when future taxable income is expected to exceed pretax income, while deferred tax liabilities occur in the reverse case.

If more deductions have been taken in the current period for reporting purposes, then tax payable (according to the GAAP income statement) will be lower than the actual tax paid. Hence it will seem like taxes have been prepaid. This is reflected in the balance sheet as an asset.

Deferred tax assets ($798) reflect allowance for doubtful accounts, stock option compensation, inventory capitalization, and inventory reserve. Deferred tax liabilities ($479) reflect amortization of trademarks (long-term) and depreciation of property and equipment (short-term).

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A Financial Analyst’s Balance Sheet

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

This is what we would like to see…

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The Income Statement

Figure 4.2: Income Statement

RevenuesGross revenues from sale of products or services

- Operating ExpensesExpenses associates withgenerating revenues

= Operating IncomeOperating income for theperiod

- Financial ExpensesExpenses associated withborrowing and other financing

- TaxesTaxes due on taxable income

= Net Income before extraordinary itemsEarnings to Common & Preferred Equity forCurrent Period

- (+) Extraordinary Losses (Profits)Profits and Losses notassociated with operations

- Income Changes Associated with Accounting ChangesProfits or losses associatedwith changes in accountingrules

- Preferred DividendsDividends paid to preferredstockholders

= Net Income to Common Stockholders

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The Income Statement

Net sales.... $158,205Cost of sales 116,991Gross profit. 41,214Operating expenses:Selling. 11,584General and administrative.. 16,141

27,725Operating income.. 13,489

Other expenses (income)Interest income, net... -3,039Amortization of trademarks.. 367Other, net... -310

-2,982Income before income taxes.. 16,471

Income taxes. 6,589Net income... $9,882

Maxwell Shoe Company, Inc.For the year ended October 31, 2000 (In ‘000s)

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The Income Statement

The Income Statement provides us with information about changes in the balance sheet from one year to another. Hence it is crucial to creating the financial balance sheet that we want.

However, the income statement is prepared according to GAAP.

Underlying GAAP are certain principles, such as revenue recognition when the service for which the firm is being paid has been performed substantially, the matching principle governing recognition of expenses, a historical cost-based approach, and a basic conservatism in the recognition of assets.

This leads to certain accounting practices that need to be corrected, from a financial analyst’s point of view…

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