You are on page 1of 31

Chapter 2

Introduction to
Financial
Statement
Analysis

Copyright © 2012 Pearson Education.


Chapter Outline

2.1 Firms’ Disclosure of Financial Information


2.2 The Balance Sheet
2.3 Balance Sheet Analysis

Copyright © 2012 Pearson Education.


2-2
Learning Objectives
• Know why the disclosure of financial information
through financial statements is critical to investors
• Understand the function of the balance sheet
• Use the balance sheet to analyze a firm
• Understand how the income statement is used
• Analyze a firm through its income statement, including
using the DuPont Identity
• Interpret a statement of cash flows
• Know what management’s discussion and analysis and
the statement of stockholders equity are
• Understand the main purpose and aspects of the
Sarbanes-Oxley reforms following Enron and other
financial scandals.
Copyright © 2012 Pearson Education.
2-3
2.1 Firms’ Disclosure of Financial
Information
• Financial statements are accounting reports issued
periodically to present past performance and a snapshot
of the firm’s assets and the financing of those assets.
• Investors, financial analysts, managers, and other
interested parties such as creditors rely on financial
statements to obtain reliable information about a
corporation.
• Public companies must file financial results with the
Securities and Exchange Commission (SEC)
– on a quarterly basis (10-Q)
– and an annual basis (10-K)
• The annual report with financial statements must be
sent to their shareholders every year.

Copyright © 2012 Pearson Education.


2-4
2.1 Firms’ Disclosure of Financial
Information
• The four financial statements required by
the SEC are:
– The balance sheet,
– The income statement,
– The statement of cash flows, and the
– The statement of stockholders’ equity

Copyright © 2012 Pearson Education.


2-5
2.2 The Balance Sheet
• Also called “Statement of Financial Position”
• Lists the firm’s assets and liabilities
• Provides a snapshot of the firm’s financial
position at a given point in time.

Copyright © 2012 Pearson Education.


2-6
Table 2.1 Nokia Consolidated
Statements of Financial Position Prepared According to
IFRS (Reformatted) in € millions

Copyright © 2012 Pearson Education.


2-7
2.2 The Balance Sheet

• The Balance Sheet Identity


– The two sides of the balance sheet must
balance

Assets = Liabilities + Stockholders’ (Eq. 2.1)


Equity

Copyright © 2012 Pearson Education.


2-8
2.2 The Balance Sheet

• Current Assets
– Cash and other marketable securities
• short-term, low-risk investments
• easily sold and converted to cash
– Accounts receivable
• amounts owed to the firm by customers who have
purchased on credit
– Inventories
• raw materials, work-in-progress and finished goods;
– Other current assets
• includes items such as prepaid expenses

Copyright © 2012 Pearson Education.


2-9
2.2 The Balance Sheet

• Long-Term Assets
– Assets that produce benefits for more than one
year
– Reduced through a yearly deduction called
depreciation according to a schedule that
depends on an asset’s life.
• Depreciation is not an actual expense, but a way of
recognizing that fixed assets wear out and become
less valuable as they get older.

Copyright © 2012 Pearson Education.


2-10
2.2 The Balance Sheet

• Long-Term Assets
– The book value of an asset is its acquisition
cost less its accumulated depreciation.
– Other assets can include such items as
property not used in business operations, start-
up costs in connection with a new business,
trademarks and patents, and property held for
sale

Copyright © 2012 Pearson Education.


2-11
2.2 The Balance Sheet

• Current Liabilities
– Accounts payable
• the amounts owed to suppliers purchases made on
credit
– Notes payable
• loans that must be repaid in the next year
• repayment of long-term debt that will occur within the
next year
– Accrual items
• Items such as salary or taxes that are owed but have
not yet been paid, and deferred or unearned revenue

Copyright © 2012 Pearson Education.


2-12
2.2 The Balance Sheet

• Net working capital


– The capital available in the short term to run
the business:

Net Working Capital = Current Assets – Current


Liabilities
(Eq. 2.2)
• Long-Term Liabilities
– Long-term debt
• a loan or debt obligation maturing in more than a
year.
Copyright © 2012 Pearson Education.
2-13
2.2 The Balance Sheet

• Stockholders’ Equity
– Book value of equity
• Net worth from an accounting perspective
• Assets – Liabilities = Equity
• True value of assets may be different from book value
– Market capitalization
• Market price per share times number of shares
• Does not depend on historical cost of assets.

Copyright © 2012 Pearson Education.


2-14
Example 2.1
Market versus Book Value
Problem:
• If Global has 3.6 million shares outstanding, and these
shares are trading for a price of $10 per share, what is
Global’s market capitalization?
• How does the market capitalization compare to Global’s
book value of equity?

Copyright © 2012 Pearson Education.


2-15
Example 2.1
Market versus Book Value (cont’d)
Solution:
Plan:
• Market capitalization is equal to price per share times
shares outstanding.
• We can find Global’s book value of equity at the bottom of
the right side of its balance sheet.
Execute:
• Global’s market capitalization is:
– (3.6 million shares)  ($10/share) = $36 million
• This market capitalization is significantly higher than
Global’s book value of equity:
– $22.2 million
Copyright © 2012 Pearson Education.
2-16
Example 2.1
Market versus Book Value (cont’d)
Evaluate:
• Global must have sources of value that do not appear on
the balance sheet.
• These include
– opportunities for growth
– the quality of the management team
– relationships with suppliers and customers, etc.

Copyright © 2012 Pearson Education.


2-17
Table 2.1 Nokia Consolidated
Statements of Financial Position Prepared According to
IFRS (Reformatted) in € millions

Copyright © 2012 Pearson Education.


2-18
2.3 Balance Sheet Analysis

• Book value of equity is sometimes used to


estimate liquidation value
• We can learn a great deal from a firm’s
balance sheet to assess:
– The firm’s value
– Its leverage
– Its short-term cash needs

Copyright © 2012 Pearson Education.


2-19
2.3 Balance Sheet Analysis

Market to Book Ratio


• The ratio of a firm’s market capitalization
to the book value of stockholders’ equity:
Market Value of Equity
Market-to-Book Ratio 
Book Value of Equity (Eq. 2.3)

• Also called Price-to-Book ratio.


• Sometimes used to classify firms as value
(low M/B) or growth (high M/B).

Copyright © 2012 Pearson Education.


2-20
Figure 2.1 Market-to-Book Ratios in
2010

Copyright © 2012 Pearson Education.


2-21
2.3 Balance Sheet Analysis

Debt-Equity Ratio
• The debt-equity ratio is a common ratio
used to assess a firm’s leverage

Total Debt
Debt-Equity Ratio  (Eq. 2.4)
Total Equity

Copyright © 2012 Pearson Education.


2-22
2.3 Balance Sheet Analysis

Enterprise value
– Assesses the value of the underlying business
assets, unencumbered by debt and separate
from cash and marketable securities

Enterprise Value = Market Value of Equity + Debt – Cash

(Eq. 2.4)

Copyright © 2012 Pearson Education.


2-23
Example 2.2
Computing Enterprise Value
Problem:
• In April 2010, H.J. Heinz Co. (HNZ) had a share price of
$46.15, 316.2 million shares outstanding, a market-to-book
ratio of 7.99, a book debt-equity ratio of 2.64, and cash of
$562.3 million.
• What was Heinz’s market capitalization?
• What was its enterprise value?

Copyright © 2012 Pearson Education.


2-24
Example 2.2
Computing Enterprise Value (cont’d)
Solution:
Plan:
Share Price $46.15
Shares outstanding 316.2 million
Market-to-book 7.99
Cash $562 million
Debt-to-equity (book) 2.64

We will solve the problem using Eq. 2.5:


Enterprise value = Market capitalization + Debt –
Cash
Copyright © 2012 Pearson Education.
2-25
Example 2.2
Computing Enterprise Value (cont’d)
Execute:
• We can compute the market capitalization by
multiplying the share price by the shares
outstanding.
• We are given the amount of cash.
• We are not given the debt directly, but we are
given the book debt-to-equity ratio.
• Since we can compute the market value of equity
(market capitalization) and we have the market-
to-book ratio, we can compute the book value of
equity.

Copyright © 2012 Pearson Education.


2-26
Example 2.2
Computing Enterprise Value (cont’d)
Execute (cont’d):
• Heinz had market capitalization of $46.15  316.2
million shares = $14.59 billion.
– Since Heinz’s market-to-book = 7.99 = $14.59
billion / book equity, then book equity = $14.59
billion / 7.99 = $1.83 billion.
– Given that book equity is $1.83 billion and book
debt-to-equity ratio is 2.64,
– the total value of Heinz’s debt is $1.83 billion 
2.64 = $4.83 billion.
Evaluate:
• Thus, Heinz’s enterprise value was
14.59 + 4.83 – .562 = $18.858 billion.
Copyright © 2012 Pearson Education.
2-27
Table 2.1 Nokia Consolidated
Statements of Financial Position Prepared According to
IFRS (Reformatted) in € millions

Copyright © 2012 Pearson Education.


2-28
2.3 Balance Sheet Analysis

Current Ratio
• The ratio of current assets to current
liabilities

Current Assets
Current Ratio = (Eq. 2.6)
Current Liabilities

Copyright © 2012 Pearson Education.


2-29
2.3 Balance Sheet Analysis

Quick Ratio
• The ratio of current assets other than
inventory to current liabilities.

Current Assets - Inventory (Eq. 2.7)


Quick Ratio =
Current Liabilities

Copyright © 2012 Pearson Education.


2-30
Table 2.2 Balance Sheet Ratios

Copyright © 2012 Pearson Education.


2-31