Financial Statement Analysis

Financial Statement
Analysis
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FINANCIALS AND
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IMPORTANT RATIOS!
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Financial Statements Overview
 Financial statements convey the results and financial

position of a business
 We use them to evaluate sales, profitability, cash

flow, and other metrics
 In the U.S. financial statements are prepared on a

quarterly and annual basis
Financial Statements Overview
 Balance Sheet
 Income Statement
 Statement of Cash Flows
 Statement of Stockholder’s Equity
Balance Sheet
 The Balance Sheet presents a Company’s assets,

liabilities, and shareholder’s equity at a point in time
 Assets represent future economic benefits

 i.e. office building, patents, or even inventory
 Liabilities represent future economic sacrifices

 i.e. bank loans, accounts payable to suppliers
Balance Sheet
 Equity represents capital contributions to the

business + cumulative retained profits (earnings)
 Under the accounting equation:
Assets = Liabilities + Equity
Balance Sheet
 Current assets/current liabilities

 Assets/liabilities that will be consumed (or paid off/settled)
within the next year
 i.e. accounts receivable, inventory, or accounts payable
 Non-current assets/non-current liabilities

 Assets/liabilities that will not be consumed (or paid
off/settled) within the next year
 i.e. production equipment, long-term bank obligation
Income Statement
 The Income Statement summarizes the profit

generating activities of a business
 Most companies report a multiple-step income

statement
Income Statement
JC. Co. Income Statement For The Year Ended 12/31/16

Revenue $100,000
Cost of goods sold ($50,000)
Gross Profit $50,000
Operating expenses:
Selling expenses ($10,000)
General and administrative ($10,000)
Research & development ($5,000)
Operating Income $25,000
Other income (expense)
Interest income $500
Interest expense ($500)
Income before taxes $25,000
Income tax expense ($10,000)
Net income $15,000
Statement of Cash Flows
 The Statement of Cash Flows shows how a

company’s cash balance changed over a period
 The statement classifies cash transactions into 3

categories:
 Operating Activities
 Investing Activities
 Financing Activities
Operating Activities
 Operating activities represent cash inflows and

outflows related to a Company’s main business
activities
 Inflows include: cash received from customers for

the sale of goods/services, interest income, and
dividends from investments
 Outflows include: inventory, salaries/wages, other

operating expenses, interest on debt, and income
taxes
Investing Activities
 Investing activities include cash inflows/outflows

related to the purchase and sale of non-current
assets
 Examples:
 Purchase/sale of long-lived assets used in the business
 Purchase/sale investments in stocks and bonds
 Acquisition or disposition of businesses
Financing Activities
 Financing activities relate to the external

financing of the Company (debt + equity)
 Inflows: (1) shares issued to owners (2) borrowing

money
 Outflows: (1) dividends, (2) acquisition of shares,

(3) repayment of debt principal
Earnings-Per-Share (EPS)
 Shares are units of ownership in a business that

provide for an equal distribution of profit or
dividends
 All public companies have shares that are traded on

stock exchanges
 Basic shares outstanding = the number of shares

outstanding
 Sometimes companies issue stock options or other

equity awards to executives as compensation. This
represents “dilution” to current shareholders
 Diluted shares outstanding = the number of

shares outstanding + any potential claims on
common shares
 Earnings-Per-Share (EPS) = Net Income /

Shares Outstanding
 Represents how much profit the Company generates per share
outstanding
 Basic EPS = Net Income / Basic Shares

Outstanding
 Diluted EPS = Net Income / Diluted Shares

Outstanding
Profitability Analysis
 Gross Margin = Gross Profit / Revenue
 Operating Margin = Operating Profit / Revenue
 Net Margin (Profit Margin) = Net Income /

Revenue
Profitability Analysis
 Analysts typically compare ratio metrics relative to:

 (1) prior year results or
 (2) a peer company (i.e. a competitor)
 A basis point represents 1/100th of a percent

 .01% = 1 basis point
 1% = 100 basis points
Activity/Turnover Analysis
 Turnover ratios are important because they gauge

a company’s ability to convert assets into cash
 Asset Turnover = Sales / Average Total Assets
 Asset Turnover shows how efficiently a business

utilizes its assets to generate revenue!
 Receivables Turnover Ratio = Sales / Average

Accounts Receivable
 Receivables Turnover measures the number of

times during the period that the average accounts
receivable balance is collected
 Days Sales Outstanding (DSO) = # of days in

period / Receivables Turnover Ratio
 DSO represents the average collection period for a

Company’s accounts receivables
 Inventory Turnover = Cost of Goods Sold /

Average Inventory
 Inventory Turnover measures the number of

times the average inventory balance is sold during a
period
 Days Sales of Inventory (DSI) = # of days in the

period / Inventory Turnover Ratio
 DSI measures the number of days it takes for a

business to sell its inventory
 Accounts Payable Turnover = Cost of Goods

Sold / Average Accounts Payable
 Accounts Payable Turnover measures how many

times the average payable balance is paid during a
period
 Days Payable Outstanding (DPO) = # of days in

the period / Payable Turnover Ratio
 DPO measures how long it takes a business to pay

its suppliers
 Days Inventory Outstanding (DSI)
 Days Sales Outstanding (DSO)
 Days Payable Outstanding (DPO)
 Cash Conversion Cycle = DSI + DSO - DPO
Liquidity Ratio Analysis
 Liquidity refers to the ease of ability in converting

assets to cash.
 Current Ratio = Current Assets / Current

Liabilities
 The higher the current ratio, the more capable the Company is
of paying short-term obligations
 Acid-Test Ratio (Quick Ratio) = Quick Assets /

Current Liabilities
Leverage Analysis
 Leverage analysis is used to assess a company’s

ability to repay its long-term debt
 Interest Coverage Ratio = (Net Income + Interest

Expense + Income Taxes) / (Interest Expense)
 Interest Coverage measures how easily a business

can pay interest on outstanding debt.
Leverage Analysis
 Debt to Equity Ratio = Debt / Equity
 Debt to Equity ratio measures how much debt is

used to finance assets relative to equity
 All else equal, the higher the ratio, the higher the risk of
bankruptcy
Leverage Analysis
 Debt-to-EBITDA ratio = Debt / EBITDA

 Very commonly used by credit agencies
 EBITDA = earnings before interest, taxes,

depreciation expense, and amortization expense
 Different industries use leverage differently!
Valuation Ratios
 “Valuation is an art, not science”
 In finance/accounting, valuation refers to the

calculation of a security’s value
 Valuation ratios are used to assess how “cheap” or

“expensive” a company is
Valuation Ratios
 Price-to-Earnings Ratio (P/E Ratio) = Stock

Price / EPS
 P/E measures how much you are paying for a

business relative to its earnings (profits)
 Forward P/E ratio: Stock Price / Forecasted

Future Earnings
Valuation Ratios
 Price-to-Cash Flow Ratio (P/CF) = Market

Capitalization / Cash from Operating Activities
 Market capitalization = share price * shares

outstanding
 This ratio measures how much you are paying for a

business relative to its cash flow generation
capability
Valuation Ratios
 Price/Sales Ratio (P/S): Market Capitalization /

Sales
 Measures how much you are paying for a company’s

revenue
 Typically used in start ups, high growth technology

companies, or businesses without profits
Valuation Ratios
 Book Value (BV) represents the net assets of a

business.
 Book Value = Total Assets – Total Liabilities
 BV per-share = Book Value / Diluted Share Count
Valuation Ratios
 Price-to-Book Value (P/B) = Share Price / Book

Value per-share
 P/B measures how much you are paying for the net
assets of a business.
 P/B is most appropriate for businesses with high

tangible assets (i.e. a bank or insurance company)
 It is less appropriate for companies that have large
intangible assets (i.e. biotech/pharmaceuticals or
technology companies)
Valuation Ratios
 Market Capitalization = Shares Outstanding x

Share Price
 Enterprise Value is a more comprehensive measure

of a company’s value
 Enterprise Value (EV) = Market Capitalization +

Preferred Shares + Debt + Minority Interest - Cash
Valuation Ratios
 Enterprise Value-to-EBITDA (EV/EBITDA) =

Enterprise Value / EBITDA
 EV/EBITDA measures the multiple a potential

acquirer would pay for a business
How To Read Financial Statements
 ALL public companies are required to file

documents with the U.S. Securities and Exchange
Commission (SEC) on a regular basis
 A public company’s SEC filings are available to the

public for FREE at:
https://www.sec.gov/
Key SEC Filings
 10-K: An annual report filed with the SEC detailing a

company’s financial performance
 10-Q: A comprehensive quarterly report
 8-K: A broad form utilized to inform shareholders of key

events
 DEF-14A: A Company’s annual Proxy statement
 Form 4: A filing detailing executives’ buys/sales of

shares
10-K
 Large companies ($700M+) must file their 10-K 60

days after their fiscal year ends
 The 10-K is required reading for any serious

investor!
 Warren Buffett reportedly reads over 500 pages a

day!
10-K
 A 10-K is a public company’s annual report with the

SEC detailing its business performance
 A 10-K IS NOT the same thing as a company’s

Annual Report to Shareholders!
 “All else being equal, invest in the company with the fewest color
photographs in the annual report.”—Peter Lynch
10-K Reading Tips
 Don’t read it all in one sitting
 Take many breaks!
 The best way to read a 10-K is side-by-side with the

prior year filing
10-K: Business Section
 The Business Section describes the ‘who’ and

‘what’ of the company
 The business section typically describes the company’s

products/services, its operating segments, competition, goals,
employees, and market dynamics
 It may also include recent events, regulation, labor issues, or

potential lawsuits
10-K: Risk Factors Section
 The Risk Factors section describes key risks the

Company faces
 i.e. employee strikes, dependence on a customer, increased industry
competition
 Risk factors are often drafted by lawyers so the

language can be ‘boilerplate’
10-K Risk Factors Section
 Key risk factors to watch out for:
 Changes in competition
 Customer concentration (large customers)
 New/pending regulation
 Any important lawsuits
 Commentary about debt levels
 Dependence on certain products
 Dependence on certain suppliers or manufacturers
10-K: Unresolved Staff Comments
 This section requires companies to explain

comments it received from SEC staff on previously
filed reports that have not been resolved after an
extended period of time
 Any comments should be taken as a red flag!
10-K: Properties
 This section discloses information about a company’s

significant properties
 i.e. headquarters, manufacturing plants, store base, square

footage, etc.
10-K: Legal Proceedings
 This section describes all of the Company’s

important legal proceedings
 The language may be boilerplate, but can identify key

risks to watch out for!
10-K: Item 5
 Market for Registrant’s Common Equity, Related

Stockholder Matters and Issuer Purchases of Equity
 Item 5 essentially summarizes information about the

company’s shares
 i.e. share price highs/lows, volume, dividends, and share
repurchases
10:K Selected Financial Data
 The selected financial data section provides

financial information about a company for the past 5
years.
 Most companies will disclose important income

statement and balance sheet data, along with other
key performance metrics
10-K: MD&A (Highlights + Strategy)
 Management’s Discussion of Analysis of Financial

Condition and Results of Operations
 The MD&A section typically begins with a discussion

of highlights from the most recent year and the
company’s strategy
10-K: MD&A (Results Discussion)
 The MD&A will include certain financial metrics over

the past 3 years
 The Company will also discuss income statement

results over the past 3 years on a ‘line-by-line’ basis
10K: MD&A (Results Discussion)
 MD&A commentary varies, but typically includes:
 why revenue increased/decreased
 why profit increased/decreased
 any one-time expenses
 discussion on taxes
10-K: MD&A (Liquidity & Capital Resources)
 The next section of the MD&A focuses on ‘liquidity

and capital resources
 Here, the company discusses the significant sources

and uses of cash
 This will include a discussion of (1) cash from operating
activities, (2) cash from investing activities, and (3) cash from
financing activities
 The final section of liquidity and capital resources

discusses the company’s available credit resources
10-K: MD&A (Contractual Obligations)
 Under “Contractual Obligations”, the company will

list a timeline of its obligations
 These obligations may include:

 Debt, purchase obligations, and leases among others
10-K: MD&A (Critical Accounting Policies)
 At the end of every MD&A section, the company will

discuss its critical accounting policies
 These policies typically include:

 Revenue recognition
 Inventory valuation
 Impairment analysis
 Taxes
10-K: Item 7A
 Quantitative and Qualitative Disclosures about

Market Risk
 The SEC requires the company to discuss market

risks such as:
 Interest rates
 Foreign currency
 Commodity prices
 The company may also discuss how it mitigates these

risks
10-K: Financial Statements
 Item 8 is the part of the 10-K that discloses the

company’s financial statements
 Item 8 also includes the auditor opinion and

financial footnotes
 All public companies must have an auditor

 Most select the “Big 4”—EY, PwC, Deloitte, KPMG
 In the 10-K, company’s must release their

independent auditor’s opinion
 The audit report will contain the auditor’s opinion

about the fairness of the financials presented and
opinion the company’s internal control
 Internal control represents the processes put in place

to ensure integrity of accounting and financial
information presented
 Most companies receive an “unqualified opinion” on

their audit
 It is important to watch out for internal

control weaknesses!
 Balance Sheet for the past 2 years
 Income Statement for the past 3 years
 Statement of stockholder’s equity for the past 3 years
 Statement of Cash Flows for the past 3 years
10-K: Footnotes
 The footnotes are presented after the financial

statements and include a variety of details about the
company’s accounts and policies
 Footnotes are often the most important part

of the financials to read!
10-K: Footnotes
 Key sections to read:
 Revenue recognition
 Accounts receivable
 Inventory
 PP&E
 Debt
 Acquisitions
 Taxes
10-K: Footnotes
 Other important footnote disclosures:
 Segment Reporting
 Geographic information
 Remember: reading the footnotes is

incredibly important!
10-Q: Quarterly Report
 Large companies ($700M+) must file their 10-Q 40

days after the end of the quarter
 A quarterly report is an abbreviated filing with the

SEC detailing financial results from the quarter
10-Q: Financial Statements
 The financial statements are presented first
 Footnotes are presented after the financial

statements
 The 10-Q is much more abbreviated than the 10-

K and contains fewer disclosures
10-Q: MD&A
 The 10-Q also contains a “Management’s Discussion

and Analysis” section
 The MD&A starts with an overview of recent

financial performance before discussing detailed
performance
8-K: Current Report
 Form 8-K is the “current report” public companies

must file with the SEC to announce major events
shareholders should know about
8-K: Current Report
 A company should issue an 8-K for:
 Acquiring another business
 Asset sales
 Quarterly results
 Issuing debt and/or equity
8-K: Current Report
 A company should issue an 8-K for:
 Restructuring plans
 Change in accountants
 Senior officer changes
 Director elections/departures
DEF-14A: Proxy Statement
 All public companies need to file a proxy statement

(DEF-14A) ahead of the annual shareholder’s
meeting
 Key disclosures include: voting procedure,

background about directors and management, and
compensation
DEF-14A Proxy Statement
 Notice of Annual Meeting of Shareholders
 Details the who, what, where, and when of the meeting
 Solicitation of the proxy: details what is being voted

on and the board’s recommendation
 Election of Directors
 Will include a background of each director
 Board Committees:
 Audit Committee
 Nominating Committee
 Compensation Committee
DEF-14A: Beneficial Ownership
 All proxy statements include:
 a section disclosing significant (5%+) shareholders
 Directors’ and Officers’ beneficial ownership
DEF-14A: Director Compensation
 As analysts, we want to know how much and how

directors are being compensated
 Directors are typically paid through a combination of

retainer (cash) and equity
DEF-14A: Executive Compensation
 Executive compensation is the most important part

of the proxy statement!
 A company typically discusses:

 Compensation philosophy
 Role of the Compensation Committee
 Elements of compensation
DEF-14A: Executive Compensation
 Elements of Executive Compensation:

 Base Salary
 Cash Bonus
 Equity (options, RSUs, performance-based shares, etc.)
 Others/perquisites
 Summary Compensation Table
Form 4
 All directors, officers, and 10%+ shareholders must

file documents (the Form 4) for changes in share
holdings
 A Form 4 MUST be filed before the end of the

second business day following a change in ownership
Form 4: Codes
 P: Open market or private purchase of shares
 S: Open market or private sale of shares
 A: grant, award, or other acquisition of shares from

the company
Form 4: Codes
 D: Sale or transfer of shares back to the company
 F: Payment of exercise price or tax liability using

portion of securities received from the company
 M: Exercise or conversion of security received from

the company
 G: Gift (i.e. donation) of securities by the insider
Form 4: Insider Buying / Selling
 How many insiders are buying/selling?
 Were the purchases/sales significant?
Conference Calls (CCs)
 Conference Calls are used my almost all public

companies to report quarterly results
 CCs are typically scheduled in advance via press

release
 Many CCs are also accompanied with presentations
Conference Calls (CCs)
 Conference Calls may also be held for:
 Acquisitions/mergers/dispositions
 Monthly sales calls
 Significant corporate events
 Many others
Quarterly Results Overview
 Public companies in the U.S. report results

on a quarterly basis
 Companies typically set reporting dates in advance
 Keep an eye out for the 8-K or press release!
Guidance
 Some (but not all) companies provide guidance
 Companies may provide guidance on:

 Revenue
 Margins
 Profit
 Store openings/closings
 Capital expenditures
 …and much more!
Guidance
 Guidance is not required by SEC reporting

standards–it is entirely voluntary
 Stocks can trade off guidance so pay

attention!
Key Performance Indicators (KPIs)
 As analysts, we must identify a company’s key

performance indicators
 KPIs are typically disclosed and discussed in

earnings releases, conference calls, and the MD&A
section of reports
 Some industries have very specific KPIs
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Financial Statement

 Financial statements convey the results and financial

 We use them to evaluate sales, profitability, cash

 In the U.S. financial statements are prepared on a

 Statement of Cash Flows

 Statement of Stockholder’s Equity

 The Balance Sheet presents a Company’s assets,

 Assets represent future economic benefits

 Liabilities represent future economic sacrifices

 Equity represents capital contributions to the

 Under the accounting equation:

Assets = Liabilities + Equity

 Current assets/current liabilities

 Non-current assets/non-current liabilities

 The Income Statement summarizes the profit

 Most companies report a multiple-step income

JC. Co. Income Statement For The Year Ended 12/31/16

 The Statement of Cash Flows shows how a

 The statement classifies cash transactions into 3

 Operating activities represent cash inflows and

 Inflows include: cash received from customers for

 Outflows include: inventory, salaries/wages, other

 Investing activities include cash inflows/outflows

 Purchase/sale of long-lived assets used in the business

 Purchase/sale investments in stocks and bonds

 Acquisition or disposition of businesses

 Financing activities relate to the external

 Inflows: (1) shares issued to owners (2) borrowing

 Outflows: (1) dividends, (2) acquisition of shares,

 Shares are units of ownership in a business that

 All public companies have shares that are traded on

 Basic shares outstanding = the number of shares

 Sometimes companies issue stock options or other

 Diluted shares outstanding = the number of

 Earnings-Per-Share (EPS) = Net Income /

 Basic EPS = Net Income / Basic Shares

 Diluted EPS = Net Income / Diluted Shares

 Gross Margin = Gross Profit / Revenue

 Operating Margin = Operating Profit / Revenue

 Net Margin (Profit Margin) = Net Income /

 Analysts typically compare ratio metrics relative to:

 (2) a peer company (i.e. a competitor)

 A basis point represents 1/100th of a percent

 1% = 100 basis points

 Turnover ratios are important because they gauge

 Asset Turnover = Sales / Average Total Assets

 Asset Turnover shows how efficiently a business

 Receivables Turnover Ratio = Sales / Average

 Receivables Turnover measures the number of

 Days Sales Outstanding (DSO) = # of days in

 DSO represents the average collection period for a

 Inventory Turnover = Cost of Goods Sold /

 Inventory Turnover measures the number of

 Days Sales of Inventory (DSI) = # of days in the

 DSI measures the number of days it takes for a

 Accounts Payable Turnover = Cost of Goods

 Accounts Payable Turnover measures how many

 Days Payable Outstanding (DPO) = # of days in

 DPO measures how long it takes a business to pay