Strategic Capital Group Workshop #5: Financial Statement Analysis

AgendaTypes of Accounts

The Balance Sheet

The Income Statement

The Statement of Cash Flows

Looking at health and profitability

The Balance Sheet

A snapshot of the business at a point in time, shows values of assets, liabilities, and equity

accounts.

Types of AccountsWe have 3 types of accounts in the

balance sheet:

Assets: Resources of the business we will use to generate revenues

Liabilities: Money we owe to creditors or “debt-holders” that have funded our business

Equity: Money we got from people who bought stock from the company in return for voting power and a share of the profits

Assets = Liabilities + Owner’s Equity

Value of resources in the business = Money we got from creditors + money we got from shareholders

In other words, everything in the business was either bought with money from shareholders or creditors.

The Accounts Within: AssetsCash

Accounts Receivable(Short term IOU’S)

Investments

Land

Buildings

Equipment

“Property, Plant, and Equipment” or PP&EInventory

Stepping to the side:

Depreciation and Amortization, what are they?When you buy a car for $50,000 and try to sell it a year later, you can’t get the same value you paid for it, you get less.

Accountants adjust the value of the long term assets the company is holding at the end of every period to reflect what they believe is the new value.

We call this “depreciation” for physical assets and “amortization” for intangible assets (like patents)

The Accounts Within: Liabilities

Accounts Payable (short term debt to

suppliers)

Bank Loans

Bonds Payable

Unearned Revenue (prepaid sandwiches)

The Accounts Within: Equity

Common Stock

Preferred Shares

Retained Earnings

Additional Paid-In Capital

Treasury Stock

Exercise

Assets Liabilities Equity

Companies have a lot of funky names for their accounts, so based on your

knowledge of the base accounts and what each category is, what is each account

classified under?

Cash and Cash Equivalents

Certificates of Deposit (CD’s)

Raw MaterialsConstruction in Progress

Intangible Assets (Patents)

Short Term Borrowings

Dividends PayableTrade

Receivables

Earnings Employed in the business

Common Stock Held in

Treasury

Form of the Balance SheetAssets:Current Assets:Cash

$50Inventory

$75Long Term Assets:PP&E

$800Total Assets:

$925Liabilities:Current Liabilities $40Long term Liabilities $324

Total Liabilities:$364

Equity:Common Stock $1Add. PIC

$360Retained Earnings $200

Total Equity:$561

Total L + E$925

The Income Statement

Tells us the revenue generating and expense generating activities of the

business over the course of the reporting period (year or quarter)

Two Classifications to Know

Revenues: Dollar value of sales a company generates

Expenses: Costs associated with generating the revenue.

After all expenses have been taken out of our pool of revenue, what’s left is taxed.

The form of the Income StatementRevenue/Sales$1200-Cost of Goods Sold $300Gross Profit$900

Gross margin75%

-Operating Expenses $150Operating Income $750

Operating Margin62.5%-Interest Expense $125Income Before taxes $625-Taxes$187.50Net Income$437.50

Profit Margin34.6%

So at the end, 34.6% of every dollar in sales becomes profit available to shareholders

Depreciation Expense

Remember back a few slides…Every period we wrote down the value of our

long-term assets to reflect what they were worth (given that they’ve been used a little and

they’re not longer brand new)

This adjustment is recorded as “depreciation expense” even though no cash was paid out.

We record depreciation expense under operating expenses

Cost of Goods SoldValue of the inputs that are directly involved in the

process of making a product or getting it “ready for sale”

This includes the cost of sandwich meat, bread,

lettuce, tomatoes, sauce (direct materials)

Also includes cost of labor that is directly assembling the

sandwiches and delivering them (direct labor)

Includes cost of rent and utilities of the sandwich

shop or assembly factory(overhead)

Does not include the cost of rent of our New York Headquarters,

salaries of the CEO, salaries of our accountants, or supply costs.

These costs are not necessary to make and prepare the sandwich

for sale.

Gross Profit

So Gross Profit is essentially how much it would money we would make if we got rid of corporate

(though there are still a couple necessary expenses we’d have to add back in)

Operating Expenses-Salaries of people not associated with the production of sandwiches-Rent on NY HQ-R&D Expenses for developing ultra-modern sandwiches-General expenses like cost of paper clips for the office, utilities for the office, etc.

Most of the time this is all covered under “Selling, General, and Administrative Expenses” or SG&A.

Interest Expense

An important thing to notice is that interest expense is taken out of our Earnings before we take out taxes, why is this significant?

Because this means interest is tax-deductible, meaning that if we pay less taxes on our earnings if we

pay more in interest. This is one of the benefits of funding your operations through debt, you end up

paying a lower tax rate and a lower total tax expense.

Earnings: what does it mean?

Earnings is the profit left after all suppliers (COGS), creditors (interest expense), and the government (taxes)

have been paid off, so the only person left to have the money go to is the shareholders.

But if the sandwich company makes $400 in earnings, not all of it goes into the shareholders’ pockets, some of it is distributed back to

shareholders in the form of dividends that are checks to shareholders as a sort of “thank you” for risking your money by investing in the

company. The rest is deposited into retained earnings and recycled back into the business to grow.

The Uselessness of the Income Statement

• Typically, investors don’t use Operating income to a profit measurement, we have EBITDA, EBIT, EBT, and E.

Earnings Before Interest Taxes Depreciation and Amortization

How we get to Earnings

Revenue-Cost of Goods SoldGross Profit-Selling, General, and Admin Expense-Other Expenses+Depreciation and AmortizationEBITDA-Depreciation and AmortizationEBIT-InterestEBT-TaxesEarnings

Most of the time, this is the same as Operating Income

Most of the time D&A is already looped in with COGS or in Expenses

Why is our method important?

EBITDA is what we’re really trying to get at here (not EBIT, that’s just Operating Income so we can find that already). EBITDA is our operating income before non-cash expenses are incurred (depreciation), which makes our earnings number closer to the amount of cash we made.

Where does the account belong?Income Statement Balance Sheet

Net Income

Common Stock

CashAccounts

Receivable

Selling, General, and Administrative Expenses

EBITDA

Equipment

Interest Expense

Accounts PayableLong-Term

DebtTotal

Depreciation

Unearned Revenue

Statement of Cash Flows

Tell us about where we earned and spent cash during the reporting period, as well as our cash

balances.

Important because a company can earn billions of dollars in revenue but through the usage of

accounts receivable, never see a dollar. This can be a problem because you have to pay debts

with cash not another IOU.

This statement will be our best friend during DCF modeling in a few lessons.

Form of the Statement of Cash Flows

Beginning Cash$100

Net Income$437.50

+Net Cash Flows from Operations $550

+Net Cash Flows from Investing -$50

+Net Cash Flows from Financing $400

+Net Cash Flows$900

Ending Cash$1000

Idea Behind it:

We want to take our net income and add back any cash generating activities, then take back out any cash using activities to find how much cash was

generated by the business.

We like cash because finance people think accountants can manipulate numbers (they can) so cash gives us the clearest picture of the reality

of the business.

Cash Flows from Operating Activities

Cash generated or used up from the everyday activities of the business like:

Cash collections from Accounts ReceivablesCash SalesCash ExpendituresChanges in Current AssetsChanges in Current LiabilitiesAdd back Depreciation and Amortization

Depreciation and Amortization are already in Net income, so to get to cash, we need to add it back (remember, we don’t actually pay any cash on D&A), it’s an accounting gimmick.

Essentially how much cash you take in minus your bills.

Cash Flows from Investing ActivitiesCovers purchases and sales of long-term assets and investments.

What we see in the statement:

Buying a building is a cash outflowSelling land is a cash inflow

Buying Investments is a cash outflowSelling investments is a cash inflow

Important to remember that you’re dealing with cash, so buying assets will decrease your cash and vice versa

We refer to the acquisition of long-term assets as “Capital Expenditures”

Cash Flows from FinancingCovers cash flows that are related to raising capital for the business, both by

debt and equity.

Paying interest is a cash outflowPaying back principal of a loan is a cash outflow

Receiving a loan’s funds is a cash inflowReceiving funds from a issuance of stock is a cash inflow

Having a positive number in cash flows from financing means you are taking on more debt or issuing stock faster than you are paying it back.

So if we go back…Beginning Cash

$100

Net Income$437.50

+Net Cash Flows from Operations $550

+Net Cash Flows from Investing -$50

+Net Cash Flows from Financing $400

+Net Cash Flows$900

Ending Cash$1000

Cash in - Bills

Buying/Selling LT Assets

Taking in/paying off capital from investors and creditors

How does all this apply to picking better stocks and valuation?

Eyes on the prize: This is all leads to DCF modeling and valuation.

Although balance sheets and cash flow statements alone can’t tell you how much a

company is worth, we can look at it to see if the company is “healthy”.

Is this company healthy?Statement of Cash Flows

Net Income $150

CFOperations:-$100

CFInvesting:-$200

CFFinancing: $600

Net CF: $300

I would argue no here- the company has a positive net cash flow, but it is getting its money

mainly from financing and is losing money in the CFO category, which should be positive almost always.

Statement of Cash Flows

Net Income $150

CFOperations: $600

CFInvesting:-$800

CFFinancing:-$100

Net CF: -$300

As long as the investing activities are a one-time deal, this company

has healthy CF generation from strong CFO and low CFF.

Assessing Balance Sheet HealthWe can assess debt health by looking at a couple ratios:

Current ratio = Current Assets/ Current LiabilitiesIf we were to use up our current assets by turning them into cash, would

it cover everything we owe this year?Quick Ratio = (Current Assets – Inventory)/Current Liabilities

If we use our most liquid assets we have on hand right now, can we pay off the debt we owe this year?

Ideally, we want these ratios to be greater than 1 which means we can pay all the debts we owe this year and more. A healthy company has consistent liquidity ratios greater than 1.

Assessing Balance Sheet HealthWe can also assess company health by looking at the debt coming due in the future:

Sources like FactSet and the 10K will disclose how much debt comes due and at what interest rate at specified years, we want to invest companies that can cover any debt obligations that come due. We can assess the company’s ability to cover future obligations by looking at historical Operating Cash Flow trends, forecasting what we expect OCF to be in the next few years, then verifying it is greater than

the amount of debt coming due.

Relationships between the StatementsIt’s important to understand how each of the statements relate to each other:

Revenue/Sales-Cost of Goods SoldGross Profit

Gross margin-Operating ExpensesOperating Income

Operating Margin-Interest ExpenseIncome Before taxes-TaxesNet Income

Profit Margin

Tied to Inventory on the Balance Sheet (Change in

Inventory = COGS)

First line item of Statement of Cash Flows

Depreciation Expense is tied to Total

Depreciation of PP&E on the Balance Sheet

Relationships between the Statements

Beginning Cash$100

Net Income$437.50

+Net Cash Flows from Operations $550

+Net Cash Flows from Investing -$50

+Net Cash Flows from Financing $400

+Net Cash Flows$900

Ending Cash$1000

Includes Depreciation and Amortization

from Income Statement

From Income Statement

Tied to PP&E

Tied to changes in LT Liabilities

Covers changes in current assets and liabilities

Cash

Common Interview Question

What is the impact of $10 of extra depreciation in each of the statements given a tax rate of 30%?

Revenue-COGSOperating Income-ExpensesEBIT-InterestEBT-TaxesEarnings

+$10-$10

-$10

-$7

Net Income

Beginning CashCFOCFICFFNetEnding Cash

-$7

+$10 (add back D&A)

+$3+$3

Interview Question, Cont.

Assets:Cash

+$3PP&E -Accum. Depr +$10Net PP&E

-$10Total Assets:

-$7

Liabilities:

Equity:Retained Earnings

-$7

Follow-up Interview Question

But if depreciation is a non-cash expense, how did we generate $3 in extra cash?

Revenue-COGSOperating Income-ExpensesEBIT-InterestEBT-TaxesEarnings

+$10-$10

-$10

-$7

Net Income

Beginning CashCFOCFICFFNetEnding Cash

-$7

+$10 (add back D&A)

+$3+$3

By having an extra $10 in depreciation, we saved $3 in taxes,

which ends up in cash.