Understanding Financial Statements PDF

UNDERSTANDING FINANCIAL STATEMENTS WHITNEY TILSON | [email protected] GLENN TONGUE| [email protected]  FINANCIAL STATEMENTS ARE A “Regardless of how MIXTURE OF ART & SCIENCE our businesses might...

UNDERSTANDING FINANCIAL STATEMENTS WHITNEY TILSON | [email protected] GLENN TONGUE| [email protected]  FINANCIAL STATEMENTS ARE A “Regardless of how MIXTURE OF ART & SCIENCE our businesses might be doing, [we] could – Accounting requires many judgments and quite legally – cause estimations by management net income in any Rules allow for significant variation in how to given period to be prepare and present results almost any number we It is critical to understand incentives of would like…” management and accountants – W A R R E N B UFFE T T , LETTER TO BERKSHIRE HATHAWAY SH A R E H O L DE R S, FE B R UA R Y 2011 Not enough to just follow the rules. Financial statements must “…fairly present the financial position of the company” 2  ACCRUAL VS. CASH ACCOUNTING All accounting you will see is accrual 3  FINANCIAL FILINGS CONTAIN MORE THAN JUST FINANCIAL STATEMENTS Financial Statements Management Discussion & Analysis (MD&A) Audit Reports Footnotes 4  INFORMATION IS PRESENTED THROUGH THREE FINANCIAL STATEMENTS INCOME STATEMENT BALANCE SHEET STATEMENT OF CASH FLOWS 5  THE INCOME STATEMENT TELLS THE STORY FOR A CERTAIN PERIOD REVENUE - EXPENSES = NET INCOME (WHAT THE COMPANY SOLD (WHAT IT COST (PROFIT, EARNINGS, TO CUSTOMERS) TO RUN THE COMPANY) THE BOTTOM LINE) (WHAT'S LEFT OVER FOR OWNERS) Tells what happened to the company over a certain period of time 6  MATCHING PRINCIPLES Revenues are reported when the service is performed or the goods are delivered – Not when payment is received Associated expenses are recognized alongside the revenues – Not when expenses are paid Example: a lawyer does $5,000 of work in December, bills the client in January, and the client pays the bill in February. The $5,000 in revenue and associated expenses appear on the December income statement. 7  THE INCOME STATEMENT Every company is SALES (REVENUE OR THE “TOP LINE”) DIRECT COST OF GOODS different but follows - COST OF SALES (COGS) PROVIDED TO same general format… CUSTOMERS GROSS PROFIT - SG&A, R&D, MARKETING EXPENSES, ETC OPERATING INCOME +/- INTEREST EXPENSE / INCOME PRE-TAX INCOME - TAX NET INCOME (“BOTTOM LINE”) 8  Apple, Inc. Income Statement 9  FINANCIAL STATEMENT ANALYSIS Financial statement analysis is based on comparisons COMPARISON WITH RATIO ANALYSIS SIMILAR COMPANIES Provides insights Compares concerning a two or more company’s relative line items performance 10  INDICATORS, NOT ABSOLUTES Ratios Ratios will vary because of the point out company’s industry characteristics, nature of operations, size, growth areas to rates, macro economic factors, international dynamics, accounting question policies, etc. 11  COMPONENT ANALYSIS: MARGINS The gross margin (gross profit / revenues) shows how much of a mark-up above its costs a company takes The difference between the gross and operating margin (operating profit / revenues) reveals a company’s cost structure and how well it controls costs The net margin (net income / revenues) is most important, as it shows a company’s ability to generate a profit 12  COMPONENT ANALYSIS: GROWTH RATES Calculating growth rates over time of revenues and net income shows a company’s rate and consistency of top-line growth, and whether and how that is translating into profits Calculated by dividing current period vs. prior one – Revenues growing from $10 to $12 is 20% growth, calculated as follows: 12/10 = 1.2, drop the 1 =.2, move the decimal place = 20% 13  EXERCISE For both Apple and Costco, calculate: – Current period gross margin (gross profit divided by revenue) In the case of Costco, must first calculate gross profit by subtracting “Merchandise costs” from revenues – Current period net margin (net profit divided by revenue) – Year-over-year revenue growth – Year-over-year net income growth 14  Apple Income Statement 15  Costco Income Statement 16  BALANCE SHEET IS A SNAPSHOT OF WHERE A COMPANY IS AT A PARTICULAR INSTANT IN TIME ASSETS (WHAT YOU OWN) - LIABILITIES (WHAT YOU OWE) = EQUITY (WHAT YOU ARE “WORTH”) The balance sheet must always balance If: A – L = E then: A = L + E At any single point in time A L+E 17  BALANCE SHEET ITEMS Assets: economic resources of a business that are expected to benefit future operations Liabilities: obligations of the business (monetary or nonmonetary) – Trade related – Debt Stockholders’ Equity represents the equity stake of a firm's equity investors – Paid-in capital: equity invested by owners – Retained earnings: accumulated profits – Equity is reduced by net income losses and when capital is paid out to owners in the form of dividends and share repurchases 18  Apple Balance Sheet: Assets 19  Apple Balance Sheet: Liabilities and Shareholders’ Equity 20  RATIO ANALYSIS BASICS Ratio analysis is used to measure company’s ability to: Generate a healthy return on capital Manage assets Meet short-term obligations (liquidity) Meet long-term obligations (solvency) 21  Tests of liquidity focus TESTS OF LIQUIDITY on the relationship between current Current Ratio assets and current liabilities as well as Quick Ratio interest payments. Measures the company’s ability to meet its short term obligations. 22  CURRENT RATIO CURRENT ASSETS CURRENT RATIO = CURRENT LIABILITIES 2016 2017 This ratio measures the ability Current Ratio Current Assets $ 106,869 $ 128,645 of the company to pay current Current Liabilities $ 79,006 $ 100,814 debts as they become due. Current Ratio 1.35 1.28 23  QUICK RATIO (ACID TEST) QUICK ASSETS QUICK ASSETS QUICK RATIO = CASH S/T INVESTMENTS ACCOUNTS CURRENT LIABILITIES RECEIVABLE 2016 2017 This ratio measures the Quick Ratio Quick Assets $ 97,182 $ 110,072 company’s immediate ability Current Liabilities $ 79,006 $ 100,814 to pay debts, so it excludes Quick Ratio 1.23 1.09 inventory. 24  TESTS OF SOLVENCY Tests of solvency measure Debt to Equity a company’s ability to meet its long-term obligations. 25  DEBT/EQUITY RATIO DEBT DEBT/EQUITY RATIO = SHAREHOLDER EQUITY 2016 2017 This ratio measures the amount of Debt to Equity Debt $ 87,032 $ 115,680 debt that exists for each $1 invested by the owners. Equity $ 128,249 $ 134,047 Typically this measures structured Debt to Equity 0.68 0.86 debt. 26  RETURN ON EQUITY NET INCOME RETURN ON EQUITY = STOCKHOLDER’S EQUITY 2016 2017 This measure indicates how Apple’s Net Income $ 45,687 $ 48,351 much income was earned ROE Equity $ 128,249 $ 134,047 for every dollar of equity invested by the owners. ROE 35.6% 36.1% 27  BASIC CALCULATIONS Net cash or debt: all cash (including marketable securities) minus all debt (short and long term) Debt to equity ratio (net debt / equity) Net cash or debt growth Inventory growth rate (compare to revenue growth) Current ratio: current assets / current liabilities Quick ratio: (current assets – inventory) / current liabilities Return on equity (net income / equity) 28  EXERCISE For both Apple and Costco, calculate: – Net cash or debt – Debt to equity ratio – Net debt growth rate – Inventory growth rate – Current ratio – Quick ratio – Return on equity 29  Apple Balance Sheet 30  Costco Balance Sheet 31  FIVE COMPANY EXERCISE 32  THE CASH FLOW STATEMENT TRACKS ALL CASH GOING INTO AND OUT OF A COMPANY Captures elements of both the income statement and balance sheet Inflows and outflows of cash over a certain period of time Allocates all cash going in and out of a company into three categories: operating, investing, and financing activities 33  THE CASH FLOW STATEMENT DETAILS CASH FLOWS FROM ALL THREE AREAS OF A BUSINESS Operating – Cash generated by a company’s operating activities – Cash the company pays out related to its operating activities (e.g., payments to suppliers and employees) Investing – Capital expenditures (cap ex) – Acquisitions – Purchase and sale of investment securities, property Financing – Proceeds from issuance of debt and equity – Cash spent on share repurchases and dividends 34  Balance Sheet Balance shows where Sheet shows I am now where I was Assets Assets (incl. cash) (incl. cash) INCOME STATEMENT TELLS THE STORY OF WHAT HAPPENED Income Statement Liabilities Liabilities & & Equity Equity 35  THE CASH FLOW STATEMENT: CASH GENERATED BY OPERATING ACTIVITIES Apple 36  THE CASH FLOW STATEMENT: CASH GENERATED BY INVESTING ACTIVITIES Apple 37  THE CASH FLOW STATEMENT: CASH GENERATED BY FINANCING ACTIVITIES Apple 38 ANALYZING FINANCIAL STATEMENTS  “VALUE” OF THE COMPANY Stockholders’ equity = book value – Book value is stated on the balance sheet and is determined by Generally Accepted Accounting Principles (GAAP) Book value ≠ market value – Market value (market capitalization) = # of shares x price per share Book value ≠ true valuation of the company – A company’s true value is based on many variables, including: expected future cash flows of the firm, market position, size, growth potential, risk, competition, and employee and management quality 40  RETURN ON EQUITY: THE DUPONT FORMULA There are three ways to improve ROE: higher profit margin, faster asset turnover, or higher leverage NET INCOME REVENUES ASSETS ROE = REVENUES X ASSETS X EQUITY 48,351 229,234 375,319 APPLE’S ROE = 229,234 X 375,319 X 134,047 APPLE’S ROE = 0.21 X 0.61 X 2.80 = 35.9% 41  MEDIAN RATIO OF LIABILITIES TO EQUITY FOR SELECTED INDUSTRIES 2.5 2.0 1.5 1.0 0.5 0 42 Data Source: Compustat Research Insight  MEASURING CASH FLOWS Cash flows are the life blood of EBIT any organization EBITDA – and there are Free cash flow many ways to calculate them. 43  EBIT: EARNINGS BEFORE INTEREST AND TAXES For many companies, this is simply operating income. 2016 2017 EBIT Net Income $ 45,687 $ 48,351 Taxes $ 15,685 $ 15,738 Interest (net) $ 2,543 $ 2,878 EBIT $ 63,915 $ 66,967 44  EBITDA: EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION & AMORTIZATION A very common measure of cash flow – yet very flawed, primarily because it adds back depreciation but ignores cap ex. 2016 2017 EBITDA Net Income $ 45,687 $ 48,351 Taxes $ 15,685 $ 15,738 Interest (net) $ 2543 $ 2878 D&A $ 10,505 $ 10,157 EBITDA $ 74,420 $ 77,124 45  DEPRECIATION AND AMORTIZATION Depreciation – Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value over time. Businesses depreciate long-term assets for both tax and accounting purposes. Amortization – Amortization is an accounting technique used to incrementally lower the cost value of an intangible asset through scheduled charges to income. – Amortization is also the paying off of debt with a fixed repayment schedule in regular installments over a period of time for example with a mortgage or a car loan. They are both non-cash charges – but usually represent very real cash expenses 46  FREE CASH FLOW There are many ways to measure this, but a common way is cash flow from operations minus maintenance cap ex (depreciation is often a good measure of maintenance cap ex) 2016 2017 Free Cash Flow CFFO $ 65,824 $ 63,598 Maint cap ex $ 10,505 $ 10,157 FCF $ 55,319 $ 53,441 47  VALUATION RATIOS Investors use Market capitalization many tools Enterprise value to value P/E ratio Enterprise value/EBITDA companies. P/S ratio P/B ratio 48  MARKET CAPITALIZATION The value the market places on the company’s shares. DILUTED SHARES SHARE MARKET CAP = OUTSTANDING X PRICE APPLE MARKET CAP = 4.9151 billion X $188.58 = $926.9 billion 49  ENTERPRISE VALUE Market cap adjusted for cash and debt ENTERPRISE VALUE = MARKET CAP + DEBT - CASH APPLE ENTERPRISE VALUE = $926.9 + $121.8 - $267.2 = $781.5 billion 50  P/E (PRICE TO EARNINGS) RATIO Compares a company’s share price to its earnings per share. The most commonly used valuation measure. SHARE EARNINGS P/E RATIO = PRICE / PER SHARE* APPLE P/E RATIO = $188.58 / $10.41 = 18.12x * Some people use trailing 12-month EPS, others use current year estimates, others use next 12 month estimates, while still others use the next calendar year. There is no right answer. For the purposes of this example, let’s use actual trailing 12-month earnings of $10.41. 51  EV/EBITDA RATIO Sort of like the P/E ratio, but it compares a company’s enterprise value (which includes debt) with its EBITDA (which is a measure of cash flow before interest payments on debt). A commonly used valuation measure in the buyout business. ENTERPRISE VALUE EV/EBITDA RATIO = / EBITDA APPLE EV/EBITDA RATIO = $781.5 / $76.4 = 10.2x 52  P/S (PRICE TO SALES) RATIO Compares a company’s share price to its revenues per share. Can be useful in comparing companies in the same industry. SHARE PRICE MARKET CAP P/S RATIO = = REVENUES PER SHARE REVENUES APPLE = $926.9 billion / $247.4 billion = 3.8x P/S RATIO 53  P/B (PRICE TO BOOK) RATIO Compares a company’s share price to its equity. Is most often used to value financial companies, which tend to more liquid, easier to value assets. SHARE PRICE MARKET CAP P/B RATIO = = EQUITY PER SHARE EQUITY APPLE = $926.9 billion / $134.1 billion = 6.9x P/B RATIO 54