Financial Statements according to GAAP

1. Financial Statements according to GAAP • Income Statement (Statement of Operations) • Shows profitability for a period of time • A summary statement of revenues, expenses, gains, and losses • Must follow GAAP (financial accounting standards) • Subject to much judgment by management and CPAs • Traditionally, bottom-line earnings from income statements represented primary stock price drivers • Currently, the move is on in the accounting profession to distinguish appropriately between earnings and “quality” earnings

2. The Balance Sheet (Financial Position) • Determines Solvency Position of an organization on a given date • Assets (Resources): Future economic value owned or controlled by the organization • Current:--Cash and near cash assets • Non-current—Relatively permanent assets used to generate revenue • Liabilities (Debts): Future claims by outsiders on assets of the organization • Current—Due in the near future • Long-term—Due at least one year from the balance sheet date • Stockholders’ Equity—Owners’ claim to organization resources

3. Statement of Cash Flows • Summarizes cash inflows and (outflows) for a period of time • Includes all cash inflows (outflows) regardless of source or use • Categories of cash flows • Operating Activities: Shows cash flows from operating income (from income statement) • Investing Activities: Shows cash flows to investments and from sales of investments • Financing Activities: Shows cash flows from borrowing and sales of original equity issues and subsequent pay back of loans, equity re-acquisitions, and dividends

4. Sources of Financial Analysis Tools • Finance and Accounting Texts • Dess-Lumpkin Text pp 98-117 • Stickney-Brown Text (5th Ed) • Handout Link in your tentative schedule (Best Source) • Uses averages instead of end-of-year figures where appropriate and cost of goods sold instead of sales in inventory turnover calculations • Emphasizes DuPont Model for R.O.I. calculations • More cash flow analyses included

5. Financial Statement Analysis • Profitability Analysis • Return on Investment (ROI) • Return / Average Investment • DuPont Model • Return / Sales X Sales / Average Investment • Sales Margin X Asset Turnover • Return on Equity (ROE) • Return / Average Stockholders’ Equity • Others: PE Ratio; Dividend Yield; Dividend Payout • Also be sure to compare your company stock price trend with some of the major price indices.

6. Why We Use Averages in Denominators • Assume Total Assets at Beginning of Year = $500 • At July 1, we acquire $500 in new plant assets • Net income (return on investment) for year is $50 • If we use asset value at end of year • ROI = .05 ($50/ $1,000) • If we use average asset value • ROI = .067 ($50/ ($500 + 1,000)/2 • Use of average assets gives a more accurate annual return on your investment (The $50 was earned during the last six months of the year)

7. Advantage of Using DuPont Model • Identifies cause of change in ROI from year to year • Uses the product of two intermediate calculations for sales margin (efficiency measure) and asset turnover (effective utilization of assets to generate revenue) • Assume the following information as an example Year 01: Net Income-$50; Average Assets-$800; Sales-$1,000 Year 02: Net Income-$50; Average Assets-$1,000; Sales-$2,000

8. Calculation of ROI Both Methods • Year 01Year 02 • Regular $50/$800 = .0625 $50/$1,000= .05 • DuPont • 50/1,000 * 1,000/800 50/2,000 * 2000/1000 • .05 * 1.25 = .025 * 2 = • .0625 .05

9. Liquidity Analysis • Working Capital • Working Capital =$Current Assets –$ Current Liabilities • Current Ratio = Current Assets / Current Liabilities • Acid Test Ratio = Cash, Temporary Investments and Receivables / Current Liabilities • Cash and Equivalents • Cash Flow Adequacy • Debt Coverage (Debt Payback) • Operations Index • Others include Reinvestment ratio, cash flow to sales, and cash flow return on average assets

10. Activity and Efficiency Measures • Property-Plant-Equipment Turnover • Inventory Turnover (Day’s sales in inventory) • Accounts Receivable Turnover (Days sales in accounts receivable)

11. Financial Leverage Analysis • Debt Ratio • Debt to Equity Ratio • Times Interest Earned • Times Interest Covered by Cash Flow from Operating Activities • Wisely used outside capital injections greatly improve owners’ return on equity • Unwise use of outside capital adds burdensome fixed costs and contribute to increased risk of the organization

12. WHY FINANCIAL ANALYSIS? • Solvency Evaluation (Short-range and Long-range) • Changes in Company Value (Owner’s net worth) • Earnings and Quality of Earnings Trend • Management Efficiency • Utilization and Control of Organization Resources (Assets) • Cash Generation Efficiency of Organization • Risk Assessment