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Financial Statements
Economics 71a
Gitman/Madura Chapter 8
WSJ 54-59
Lecture notes 8
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Why Read or Care?
• Investment strategies– Growth
• Use accounting numbers to estimate growth
– Value• Compare accounting numbers to price
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Goals
• Accounting statements
• Financial ratios
• Ratios and valuation
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Accounting Statements
• Income statement
• Balance sheet
• Statement of retained earnings
• Statement of cash flows
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Income Statement
• Flow variables
• Revenues – Cost of goods sold
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Income Statement Example
• Total revenues $50• Labor and other operating expenses $-25
– (for goods sold)
• Advertising + Admin. expenses $-5• Depreciation $-5• Interest payments $-5• Taxes $-5• Earnings 50-25-5-5-5-5 = $5• EBIT = Earnings before interest and taxes
– = 50-25-10 = $15
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Balance SheetAccounting Value of the Firm
• Assets (things firm owns)
• Liabilities (Loans)
• Stockholders’ equity– (Assets - Liabilities)– Also called
• Book value
• Net worth
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Assets
• Cash
• Accounts receivable
• Inventories
• Land
• Plant and equipment– Less: Depreciation
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Liabilities
• Accounts payable
• Notes payable (short term debt)
• Long term debt
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Balance Sheet
• Assets– Cash $5– Plant and equipment $100
• Liabilities– Accounts payable $1– Long term debt $75
• Stockholder equity 105-76 = $29
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Retained Earnings Statement
• Cumulative sums of retained earnings
• RE = retained earnings
• New RE = Old RE + Earnings - Dividends
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Cash Flow
• Pure measure of incoming - outgoing cash
• Differences with income statement– No depreciation– No accounts payable/receivable– Inventories (account for costs of producing and
putting in inventory)
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Cash Flow Parts
• Operating Activities
• Investment Activities
• Financial Activities
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Operating Cash Flow
• Earnings = $5– Adjust to get to cash flow
• Depreciation : +5– Why? Remove depreciation adjustments
• Increase in accounts payable: +5– Why? Haven’t paid this yet.
• Increase in accounts receivable: -2– Why? Haven’t received this yet.
• Increase in inventories: -10– Production costs reflect only goods sold.
– Adjustment: 5+5+5-2-10 = 3 = operating cash flow
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Investment Cash Flow
• Increase in gross fixed assets• Purchases of new plant and equipment
• -30 million : New office building
• Total investment cash flow = -30 million
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Finance Cash Flow
• Increase in long term debt: • +50 million of incoming funds
• Dividends: • -20 million payout of divs
• Total finance cash flow = +30 million
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Goals
• Accounting statement
• Financial Ratios
• Ratios and valuation
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Financial Ratios
• Ratios of various financial variables
• Uses– Analyze financial well being of a firm– Compare different stocks in terms of current
values• “Find good investments”
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Ratios
• Profitability ratios
• Market ratios
• Debt ratios
• Other ratios– Why skipping many in book
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Profitability: Gross Profit Margin
Sales-Cost of goods sold
SalesGrossprofits
Sales
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Profitability:Earnings for Shareholders
• Earnings available for common shareholders– Revenues minus
• Costs of goods sold (production)
• Operating expenses
• Interest
• Taxes
• Preferred dividends
• Final earnings left for shareholders (earnings)
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Profitability:Net profit margin
Earnings
Sales
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Profitability:Earnings per Share (EPS)
• Key ratio!!!
EarningsEPS
Sharesof commonstock
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Return on Total Assets (ROA)
EarningsROA
Total Assets
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Return on Common Equity (ROE)
• Common stock holder Equity– Balance sheet book value assigned to common
stock– Net worth – preferred stock (valued at par)
EarningsROE
Common Stock Equity
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Market Ratios
• Share price versus accounting value
• Very important
• Examples– Price/Earnings ratio– Market/Book (M/B) ratio
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Price Earnings Ratio
Market price per shareP/E Ratio =
Earnings per share
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Price Earnings Ratio
• Price per earnings
• Example:– Microsoft
• About 30
• $30 per $1 of earnings
– S&P 500 • About 30
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Compare to Earnings Growth
• P = y(1+g)/(k-g)• P/E = (1+g)/(k-g)• Try
– k = 0.07 (close to average real return)– g = 0.02 (close to average real growth of
economy)– gives P/E for stock– 20
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High Flying P/E’s
• AOL (1999) near 600• Dell Computer (1999) 100• These require higher growth rates, but
maybe not much higher– 1/(0.07-0.06) = 100 – 6% growth forever is pretty big
• For many dot com’s no P/E since earnings are zero
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Market to Book Ratio (M/B)
Market price per shareM/B =
Book value per share
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Market to Book Ratio
• Market value of the firm relative to its accounting value
• Key tool for “value investors”
• Extensive academic evidence that low market to book firms do better on average
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Debt Ratios
Total LiabilitiesDebt Ratio =
Total Assets
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Dividend Payout
• Net Income– Dividends– Retained Earnings
• Dividend Payout ratio = Divs/Earnings
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Problems for Other Ratios
• Might vary a lot across industries
• Example:– Total asset turnover– Think about consulting firm versus a steel mill
SalesTotal Asset Turnover =
Total assets
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Goals
• Accounting statement
• Financial Ratios
• Ratios and valuation
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Fundamental Analysis
• Use information about firm to evaluate stock price
• Growth– Estimate earnings growth and future prospects
• Value– Find “undervalued” stocks
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Ratio Analysis
• Many methods
• Compare ratios to appropriate comparison set
• Example: – P/E ratio for a pharmaceutical firm– Compare to industry– If low -> buy
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Problems With Accounting Information
• Misses “intangibles” – Knowledge base (patents)– Customer base
• Sometimes numbers are zero– Dot coms often have zero earnings
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More Problems with Accounting Information
• There are many ways to derive accounting numbers
• Large “fudge factors”
• Can clever accountants make things look better?
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Accounting “Tricks”
• Off balance sheet items– Enron– Stock options
• Capital depreciation tricks – Worldcom– AOL
• Taking over low p/e firms
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Fundamental Analysis Weaknesses
• Bad data
• Bad interpretation of data (growth rates)
• Market efficiency: – Semi-strong efficiency: Prices should reflect
all public information
• Market inefficiency (prices may not adjust to where they should go)
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Goals
• Accounting statement
• Financial Ratios
• Ratios and valuation