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Daniel Fotinich
Andy Zhao
Berkeley Investment Group:Financial Statements and Modeling Workshop
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Importance of Financial Statements
Supplement our qualitative judgments about a company
Predict future financial performance
Calculate what we believe is the firm’s fair value
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Financial Statements
What are the three financial statements?
– Income Statement
– Balance Sheet
– Statement of Cash Flows
Where do we find them?
– Yahoo/ Google/ Morningstar
– http://www.sec.gov/edgar.shtml
– Company’s investor relations webpage
Which is the most important?
– All of them are useful for analysis
10-k, 10-Q
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Case Study: Chipotle
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The Income Statement
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A Bare-bones Income Statement
Revenue $a
Cost of Goods Sold (COGS) b
Gross Profit a-b
Operating Expenses c
Operating Income a-b-c
Interest Expense d
Income Tax e
Net Income $a-b-c-d-e
“topline”
“bottom line”
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Actual Income Statement
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Revenue, Cost of Goods Sold, Gross Profit
Revenue – money generated from sales of products and/or
services within a given time frame
COGS – cost of materials directly related to goods/services sold
Gross Profit – profit directly related to producing the good/service
Gross margins: Gross profit/Revenue
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Operating Expenses & Operating Income
OpEx – Indirect costs of operating the business
Gross Profit
Operating Income –profit received from company’s core operations
Operating margins: Operating Profit/Revenue
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Interest, Taxes, Net Income
Interest Payments – interest on company debt
Net Income – “earnings”, how much total profit a company makes
Operating Income
Taxes – Tax rate * (Income Before Taxes)
Net Margins: Net Income/Revenue
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Fixed vs. Variable Cost
Fixed Cost Variable Cost• Costs that don’t directly vary with
incremental increases in production
• Costs that directly vary with
incremental increases in production
Production
Costs
Fixed Cost
Variable Cost
• Examples: Factories, Management • Examples: Labor, input costs
• Step-function • Linear Function
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Operating Leverage
% of costs
as fixed
0%
Op.
Income
Revenue
50%
• Total expenses increase at a rate less than that of revenue• Occurs when there are fixed costs in the business
• The greater the % of costs as fixed costs, the greater the operating leverage
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Understanding Gross Profit
A
B
How do these two businesses differ from one another?
Company A has 16% GMs, Company B has 81% GMs
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Understanding Gross Profit
Certain types of businesses have far lower gross margins
than others, and it is important to recognize these
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Operating costs: The Great Equalizer
Ford has 2x the revenue of Pfizer, but 2x less “operating costs”
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Analyzing Income Statement Trends (I)
What trends do you notice in this income statement?
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Analyzing Income Statement Trends (I)
• Steep sales decline from2011o 40% decline in 2013
•
Huge decline in gross andoperating marginso GMs: 44% → 31% in 2 years
o OMs: 23% → -11%
• R&D spending flat in 2013,even as sales collapseo Due to the BlackBerry 10
• Net loss in 2013
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Analyzing Income Statement Trends (II)
What trends do you notice in this income statement?
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Analyzing Income Statement Trends (II)
• Annual revenue growth has
averaged 17% since 2009
• SG&A has increased far less
than revenue has in 2012-13o Lots of operating leverage!
• Net income up 103% since
2009
• Restaurant count has
increased by ~100 per year
o “Same-store sales” up 4%
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The Balance Sheet
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A Bare-bones Balance Sheet
Assets
Current Assets a
Non-Current Assets b
Total Assets a+b
Liabilities
Short-term Liabilities c
Long-term Liabilities d
Total Liabilities c+d
Shareholders’ Equity
Total Shareholders’ Equity e
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How to Think about the B/S
What are the two methods for paying for a
house?
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Therefore…
ASSETS = LIABILITIES + EQUITY
The “balance sheet equation”
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AssetsCash and Cash Equiv.
Receivables – IOUs from customers
Inventory – goods that have been
produced but not sold
PP&E – capital goods used to make
products
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Liabilities
Accounts Payable – IOUs to suppliers
Long-term Debt – debt to be paid off
in more than a year (bonds)
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Equity
Additional paid-in capital – total
value of all issued stock
Retained earnings – the sum of all
the earnings of the business since
day 1
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What’s the point?
Debt/EBITDA
• A higher D/EBITDA means more aggressive financing and is different for every industry
• Companies with significant debt usually trade at a discount to companies with less debt
Return on Assets: Net Earnings / Total Assets
•
An indicator for how efficiently the firm uses its assets• Generally the higher the better
• Why do airlines have lower ROAs than biotechnology companies?
The balance sheet is useful to investors in two ways:• How efficiently the company is using its capital
• Solvency of the company (whether or not it’ll be able to pay back debt
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One Type of Business
What do you notice on this balance sheet?
$20 Billion in PP&E!
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One Type of Business
The Venetian is “necessary capital” for Las VegasSands to provide its product
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Another Type of Business
What do you notice on this balance sheet?
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Another Type of Business
“NIKE, Inc., together with its subsidiaries, engages in the design,development, marketing, and sale of athletic footwear, apparel,
equipment, and accessories”
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The Cash Flow Statement
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What happens when the company makes
money?
Assume the company
makes $1MM
earnings in 2013
(all cash)
Distribute $200k to
Shareholders
• ↓ LT-Liabilities by 100k
• ↓ Cash by 100k
• ↓ cash by $200k
• Capital expenditures
• Keep cash on balance sheet
• ↑ cash by $1MM
Cash flow from financing
Cash Flow from investing
Remaining cash flow
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Statement of Cash Flows
From Operating
Activities
• See appendix
for detailed
explanation
From Investing
Activities
From Financing
Activities• Dividends
• Debt paydowns
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Why does Cash Flow matter?
• As investors, we are entitled
to the assets of the company
and cash is the most liquid
asset
• Not all of a company’s
earnings are in cash
•
Chronically negative cash flowcould result in increased
leverage or eventual default
What’s the problem here?
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Appendix
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“Cash Rules Everything Around Me”
- Wu Tang Clan
• Not all financial statements are created equal
– IS tells us the earnings and costs of doing business
– BS tells us the financial health of the company
– CS tells us how much CASH is coming in every year and ties together the two
• Cash is what investors want the most (cash = value)
– High income doesn’t necessarily = High cash flow
– The cash flow statement tells us how much value the company is generating
Investors
Lenders
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Non-Cash Items and Adjustments
Non-cash items are line items included in earnings but don’t represent cash
inflows or outflows for the company.
Expenses (additions to earnings):
• Depreciation and Amortization – Accounting method for recognizing capitalized
expenses over time (non-cash)
• Change in Accounts Payable – IOUs to suppliers (didn’t spend the cash)
Revenue (deduction from earnings):
• Change in Accounts Receivable – IOUs from customers (didn’t give you cash)
But you did spend cash on something else… Capital expenditures
Capex is not recognized on the income statement, but is a major use of cash
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Free Cash Flow
Proxy for FCF:
• EBITDA (EBIT + D&A)
Free Cash Flow: cash the company generates in a given year to pay off
lenders and give value to investors
The Equation…
Free Cash Flow = Operating Cash Flow – Capex
Strong free cash flow is agood indicator of a firm’s
value