Financial Statement Structure

Financial Statement Structure

• Profit and Loss (P&L) or Net Income statement is reviewed over time.
• Sales equal revenue.
• Subtracting the cost of goods sold (COGS) from sales yields the gross profit.
• Subtracting selling, general, and administrative expenses (SG&A), depreciation, and other expenses from the gross profit equals earnings before interest and taxes (EBIT), which is the operating income.
• Subtracting interest from EBIT equals earnings before tax (pre-tax income).
• Net income is determined by subtracting tax from earnings before tax, which is also known as net profit.

Additional Financial Statement Considerations

• The balance sheet (BS) connection shows dividends (if any) and retained earnings.
• Earnings before interest, taxes, depreciation, and amortization (EBITDA) typically isn't included as part of the net income statement, equaling EBIT (operating income) + depreciation and amortization,.
• EBITDA is not a generally accepted accounting practice, but a basic proxy for a company's financial performance.
• EBITDA is capital structure independent since it adds back interest and taxes, and doesn't account for how leveraged a company is.
• Capital expenditures (CAPEX) do NOT appear on the income statement, and appears indirectly through depreciation.

Profitability Ratios

• Profitability ratios are connected to net income, and measured against revenues (sales denominator).
• Gross Profit Margin formula: (sales - cost of goods sold) / sales.
• Net Profit Margin formula: (profits after tax) / sales.
• Operating profit margin formula: (operating income) / revenue.
• Operating Leverage: Companies with high SG&A(airlines, utilities) expenses have high operating leverage, where revenue changes have a greater impact on operating profit.
• Microsoft has high operating leverage with mostly fixed costs for development/marketing, where additional sales contribute directly to profits once covered.
• Walmart has low operating leverage because of high variable costs: merchandise inventory is its largest expense, rising with sales, leading to a continuous increase in the cost of goods sold (COGS).

Cash vs Profit

• Cash flow can differ from recorded profit, where a company may have recorded profit, and if one is receiving payments later might have cash flow problems (cash squeeze).
• Starbucks records revenue but doesn't receive cash immediately (credit customers)

Balance Sheet

• The balance sheet is a snapshot in time: Assets = Liabilities + Equity, or Assets - Liabilities = Equity.

Assets

• Current Assets: accounts receivable (AR), inventory, cash, prepaid expenses, investments equal total current assets.
• Fixed Assets: land, buildings, equipment (minus accumulated depreciation), other assets (intangible assets) equal total assets.

Liabilities and Shareholder Equity

• Current Liabilities: accounts payable (AP), tax payable, bank overdraft and accrued expenses equal total current liabilities.
• Adding long term (LT) debt and bonds to current liabilities equals total debt.
• Shareholder's Equity: common stock, paid in capital, and +/- retained earnings. equal total equity + debt.
• Net Working Capital or Net Current Assets generally refers to the difference between current assets and current liabilities (CA-CL).
• Equity is the sum of common stock and share issuance, minus dividends paid and stock buybacks.

Cash Flow Statement - Changes Between Years

• To calculate net income add non-cash charges (depreciation and amortization).

Cash from Operations:

• Accounting for changes in accounts receivable (AR), accounts payable (AP) and inventory adjusts for cash
• Increase in AR = decrease in cash (vice versa)
• Increase in AP = increase in cash.
• Increase in inventory = decrease in cash.

Cash From Investing

• Includes capital expenditures, proceeds from sales of equipment and investments, and investments in subsidiaries to determine net cash after investment activities
• Also includes capital expenditures, proceeds from sales of equipment and investments, and investment in subsidiary.

Cash From Financing

• Includes payments of long-term debt where cash goes out.
• Includes proceeds from issuance of long-term debt (cash from loan/corporate bond) and common stock which increases cash.
• Includes dividend payments and purchase of treasury stock which are uses of cash.
• Net cash provided by financing activities = increase/decrease in cash.
• Opening Cash from BS + End of Cash flow statement = Closing Cash in BS

Linking Financial Statements

• Balance at bottom of cash flow statement equals balance sheet cash
• Changes in shareholders' equity equals positive or negative net income and result in less dividends
• Accumulated depreciation balance will equal depreciation charge in net income statement
• Working capital from the cash flow statement = current assets - current liabilities from the balance sheet

Important Principles

• Recognize sales when the good is delivered or service performed (assuming one has reasonable expectation of being paid.
• Revenue recognition may not be coincident with cash receipt (accounts receivable where the opposite is true (paid in advance – deferred revenue liability). Matching
• Determine the appropriate revenue recognition where the appropriate expense is matched in time to the expense incurred in the production of the associated good or service
• Matching may not be coincident with cash payment (Accounts payable)
• Revenue and associated expenses should be recorded within the same period

Accruals

• Idea of time apportionment denotation of consumption vs billing cycles or cash

Economic Entity

• Assumption that assets, liabilities and transactions of an incorporated business are separate from stakeholders

Materiality

• Purpose of a financial statement is to provide true of fair view in relation to accounting of insignificant monetary amount

Consistency

• When a business has fixed a method for accounting, similar items are accounted for in the exact same way in the future

Cash vs Income

• Capital expenditure can deplete cash while the depreciation or amortization charge associated with the expenditure increases net income over time
• Raising a loan or equity can increase cash with no material impact on net income
• A charge to AR in respect of debt debt impacts net income while cash in unaffected
• Revenue recognition is the fundamental record to sales revenue where net income is recorded despite not receiving cash.

Important Considerations Regarding Revenue Recognition

• Revenue recognition rules may indicate cash has been received for a sale that has yet to occur
• So long as there is no disagreement about the validity of a sales record, it may be recorded regardless of whether there has been any cash payment
• Cash may have also been received prior to contract or service compensation
• Cost of goods sold (COGS) can include large AP elements–income recognized but cash not yet paid
• Significant charges like restructuring or good will write off affect net income, but bleed in cash over time

GAAP vs Non-GAAP

• GAAP focuses on consistency where entities often report non-GAAP principles (must reconcile to GAAP).
• The SEC is the enforcer of GAAP for listed companies
• GAAP provides unifying frame work for financial reporting despite inevitable judgment that impacts financial statements

Policy Examples for FIFO and LIFO

• FIFO: during periods of inflation, FIFO results in lowest estimate of goods sold and highest net income
• LIFO: during periods of inflation, LIFO results in the highest estimate of goods sold and lowest net income

Firms and the LIFO approach

• Firms often adopt the LIFO approach for the tax benefits during periods of high inflation
• Reduces the reported taxable income and net income, while increasing cash flows
• Other important considerations include Depreciation accounting, AR / bad debt estimation, non-GAAP reconciliations

Analyzing Companies and Seeing Trends

• Growth rates and a common size analysis (express each line item as a % of the base amount for that period) allow for cross comparisons between companies of different sizes

Ratio Analysis: Profitabilty

• ROA: measure of the reutnr on total investment
• Formula: Net income/Assets =Net Income/Revenue *Revenue/Assets
• ROE: measure of the rate on stockholders investments/equity
• ROE = (Net Income/Assets) * (Assets/Equity)

Current Ratio and Liquidity

• Current Ratio: Extent to which claims of short-term creditors are covered by assets that are expected to be converted to cash in a period roughly corresponding to the maturity of the liabilities
• Formula: Current assets / current liabilities Acid Test Can Analyze "Long Term Statements"
• Measure of a firm’s ability to pay off short-term obligations without relying on the sale of its inventories
• Formula: (Current assets-Inventory)/ current liabilities = quick ratio, or (cash + marketable securities + net AR = quick ratio

Debt/Equity Ratio

• Both balance sheet and income type measures
• Time Interest Ratio Interest cover = (net income + net financial expense) / net financial expense = EBIT / Interest Expenses

Accounts Receivable and Asset Efficiency

• The outstanding invoices that a company has or the money that clients owe the company.
• AR turnover in Days formula: AR / (Total Sales / 365) = AR turnover in Days
• Days Sales Outstanding: = 365 / Receivable Turnover = Accounts Receivables / Net Credit SalesX Number of Days
• A low DSO means the business takes a few days to collect its receivables while a high DSO may lead to cash flow problems in the long run

Accounts Payable and Asset Efficiency

• The money owed by a business to its suppliers shown as a component on a balance sheet
• AP Turnover in Days: AP/(total sales/365) Days Payable Outstanding
• Average accounts Payable/ Costs of goods sold)*( Number of Days in the accounting period
• A high DPOMay cause suppliers to label the company with restrictions, while al ow may show that the company is not fully fully utilizing its cash position and may indicate an inefficiently operating company

Notion of Capital

• The difference between current assets and current liabilities.
• Helps determine the company’s needs and helps plan for future needs

Inventory

• Days Sales Inventory = (Inventory / Cost of Sales) x (No. of Days in the Period)

Measuring the Market and Stocks

• p/e ratio, or the market price per share dividend by earnings per share
• Beta measures expected correlation and variables

Market Risk Premium Calculations

• Calculate by observing he average historical risk premium of a broad portfolio of equities

Gross Profit Margin

• Indicating margin available to cover operating expenses and yield a profit using the formula( Sales-COGS)/Sales
• Operating Margin: idnicates profitability firm returns with out regard to intrest and capital by calculating EBIT/sales

Net Margin: Shows profit per dollar after taxes

Formula: Profits after Tax/ Sales = Net Profit or net income margin

Dupont/ Integrated analysis

Analyses margin , asset turnover and leverage which allows the investor to view relations across companies/industires

Asset Turnover

• Measure of productivity including assets and utility with sales/total assets

Debt Ratio

• Measures the extent to which borrowed funds have been used to finance operations by calculating total debt/ total assets

Long-term debt and equity ratio

Indicates if equity in in total debt or total shareholder equity

Measuring Time-and earned Interst

• Reveals earnings and what charges decline and prevent firms from being able to provide interest rates and taxes over total interest charges
• Analyze trends of cash flow over period Debt: learning lesson 2
• Learn the types and characteristics of current and long term contracts

Coupon and current yield

A. Aka coupon yield is the intrest rate on a bond when issued that remains the same for life B. current rates divided to current market price reveals yield

Short term yield

• Used to evaluate total future returns after maturity and shows annualized return rates while considering face values payments and the market.

Price of bond

Calculations: Pt= sum Ct/(1+1)^t

Yield Curve

• Reveals changes in bond yields and varied changes over the period

Inverted yield Curve

• Shows scenario of intrest rates where short term curves reveal higher intrest despite credit scores/ratings which is an excellent economic indication

Bond valuation and YTM

• Calculation: the bond's price along with its coupon rate and the remaining time to maturity determines the YTM

Risk free Rates and YTM

• Calculated over the risk-free rate and determines government bond't rate and IBM (should be close to 0)

Calculating Bond Yield

• The cause comes from a change in risk and price in relation to discounted rates based on investors

Ratings and information

• AAA: Aaa versus BBB/Baa1 for highest ratings
• Calculating gross redemption yield

Debt vs equity

Debt seniors in cash flow and contractual

why invest in bonds

Conservation and risk management A. Reduce risk and portfolio growth Equity:

• CAPM what are the main ideas? Calculates models over risk free rates equity Risk Premium (why hold a riskier asset for less prospective return, shares move together (with the market) and so what counts under CAPM is the way the stock moves in proportion to the market – beta)

What is Beta/ Calculation?

• a measure of a stock's risk (volatility of returns) reflected by measuring the fluctuation of its price changes relative to the overall market

Beta Statistical Measurements

• The lower the beta , the more likely securities will have a negative coreltaion will yield B of 1, B =01, B1

What are good beta stocks

Depends on the goal and risk tolerance of invesmtntts while considering the impacts

The Leveraged Unlevraged Beta is Different?

• leveraged/riskier companies have more betas

What compsnetns represent equity costs

Depend if shift in production Calculate as : E(R₁) = Rf + β¡*ERP, ERP = E(Rm) – Rf components: capital appreciation/depreciation and dividend yield Apple situation a few years ago:

Calculating Cost Debt and equity

WACC = Kd(1-t) *D/(D+E) + Ke * E/(D+E) → D+ E = 1 Kd = Kd (1 - t) → TAX DEDUCTIBLE Ke = Rf + B (Rm - Rf) → CAPM, Rm - Rf > 0

Why minimize WACC?

Reduces overall cost and improves efficiency

Opposing Forces

(lower risk (and hence lower cost of debt) plus tax shield vs expensive (risker and not tax-deductible equity) with ascending bankruptcy risk as leverage rises).

• How to lower tax benefits

High Risks Bankruptcy:

• What is capital budgeting?
• refer to the decision-making process that companies follow with regard to which capital-intensive projects they should pursue
• forward-looking because we must estimate future cash flows to value a project and is the application of metrics

Estimating Cash Flows

Estimating cash flows over product’s life cycle

Application of Capital Budgeting Metrics

• Net Present Value (NPV): NPV measures the difference between the present value of cash inflows and outflows associated with a project. A positive NPV indicates that the project is expected to generate returns higher than the cost of capital and is therefore considered financially viable.
• Internal Rate of Return (IRR): IRR represents the discount rate at which the NPV of a project is zero.
• It indicates the project's rate of return and helps assess its profitability relative to the cost of capital. Projects with IRR greater than the company's cost of capital are typically accepted.

Capital and financial Analysis

MIRR: •payback Period: payback period calculation pros and cons •Where applicable, what would be your approach to the determination of an appropriate discount ratethe best time is when discount has been fixed

EVA insight

• Economic Value Added: a measure based on residual income techniques, which measures the return generated which underlies when proftabiloty accuers over high yields and proejcts with the highest capital two problems with EVA