1

Three basic accounting statements:• Income statement – provides information on the

revenues and expenses of the firm, and the resulting income made by the firm, during a period.

• Balance sheet – summarizes the assets owned by a firm, the value of these assets, and the mix of financing used to finance these assets at a point in time.

• Statement of cash flows – specifies the sources and uses of cash to the firm from operating, investing, and financing activities during a period.

2

Typical financial statements we encounter in the classroom

Income Statement

SalesCost of Goods SoldGross ProfitSelling, General, & Administrative ExpensesEarnings Before Interest and TaxesIncome Tax ExpenseNet Income

3

RevenueCost of goods soldGross profitOperating expenses Selling, general and adminstrative expensesEBITDADepreciation and amortizationEBIT Interest Interest expense Interest incomeEBTIncome tax expenseNet income before non-recurring events and non-controlling interestsNon-recurring events Discontinued operationsNet income after non-recurring eventsDistributions Income attributable to non-controlling interestsNet income

Usually part of CGS or SG&A. Make sure that if you break it out this way, that you subtract it from CGS or SG&A

Make sure these are really non-recurring. If they always appear think about whether it should be included as part of operations.

4

Measures of profitability from operating activities

SalesNetIncome

SalestEBIT

SalesEBITDA

SalesCGSSales

Margin IncomeNet

1Margin Operating

MarginEBITDA

MarginProfit Gross

One way to generate these ratios is to construct common-size Income Statements.

Quick review: common-size financial statements are financial statements expressed in percentage terms. For example, common-size Income Statements would express line items as a percentage of sales; common-size Balance Sheets would express line items as a percentage of Total Assets

5

Typical financial statements we encounter in the classroom

Cash Accounts PayableAccounts Receivable Notes PayableInventory Accrued LiabilitiesOther Current Assets Total Short-term LiabilitiesTotal Current Assets Long-Term DebtProperty, Plant & Equipment Capital LeasesIntangible Assets Total LiabilitiesGoodwill Stockholders' EquityTotal Assets Total Liabilities & Stockholders' Equity

Balance Sheet

6

Measures of Profitability• Return on Equity – examines profitability from the

equity investor’s perspective

– DuPont Identity – shows the components of ROE; useful for tracking down the sources of profitability from a shareholders’ perspective

BVEquityNetIncomeROE

BVEquityNetIncome

BVEquitysTotalAsset

sTotalAssetSales

SalesNetIncomeROE

7

• Asset turnover – measures how effectively a company utilizes its capital.

• Equity multiplier – another measure of leverage

BVEquitysTotalAssetiplierEquityMult

sTotalAssetSalesverAssetTurno

8

• Return on capital – measures the profitability of the overall firm

• Return on Assets – measures operating efficiency in generating profits from assets, before the effects of financing

sTotalAssettEBITROA

1

BVEquityBVDebt

tEBITBVCapital

tEBITROC

11

9

Measures of Financial Stability

• Debt refers to interest-bearing debt: S/T debt + Current portion of L/T debt + L/T debt + Capital leases. It does not include payments to suppliers such as Accounts Payable

• We can use book values or market values when calculating the ratios above. In most instances, we will be using market values.

EquityDebtDebt Ratio Capital Debt to

EquityDebt RatioEquity Debt to

10

• Gearing – this ratio shows how much net debt is covered by shareholders’ equity

• Capex ratio – measures how much capital investments are needed to generate profits

Operating cash flows = EBIT(1- tax rate) + depreciation

EquityrsShareholdetshEquivalenCashAndCasDebtGearing

'

ashFlowOperatingCendituresCapitalExpCapexRatio

11

• Goodwill ratio – this can be used as a measure of “latent” impairments that could significantly affect the balance sheet (impairments reduce total assets and shareholders’ equity)

EquityrsShareholdeGoodwilltioGoodwillRa

'

sTotalAssetGoodwilltioGoodwillRa

12

A note on “Comprehensive Income” and dirty surplus accounting

• Comprehensive income = net income + other comprehensive income• Dirty surplus items are items that are allowed under GAAP to bypass

the income statement and be reported directly either into shareholders’ equity or as a footnote to the financial statements or in a separate statement

• These items are gains and/or losses that have not yet been realized (usually changes in assets or liabilities, arising from changes in market prices. See items on next slide). Once they are realized (e.g., sale of securities, subsidiaries), these items are moved to net income.

• These items are usually collectively labeled as – Accumulated other comprehensive income/loss– Other comprehensive income/loss– Accumulated non-owner equity account changes

13

• Dirty surplus items allowed under GAAP– Unrealized fair value gains and losses on available-

for-sale investment securities– Foreign currency translation gains and losses– Changes in assets and liabilities related to

pensions and postemployment benefits– Effects of cash flow hedges

14

• Sources:

– Damodaran, Investment Valuation, 2nd ed.– Palepu and Healy, Business Analysis and Valuation Using Financial

Statements, 4th ed.– Schmidlin, The Art of Company Valuation and Analysis– Wahlen, Baginski, and Bradshaw, Financial Reporting, Financial

Statement Analysis, and Valuation