Financial Statement Basics

1. Financial Statement Basics Fin 341 Prepared by Keldon Bauer

2. Financial Statement Fundamentals • Publicly traded companies must file an annual (10-K) report with the SEC. • The purpose of the 10-K is to report to owners on the status of their investment. • The 10-K report contains both verbal and quantitative information about the performance of the firm.

3. Financial Statement Fundamentals • Income Statement (usually 3 years) • Balance Sheet (usually 2 years) • Statement of Retained Earnings • Statement of Cash Flows • Key operating statistics for 5-10 years • The purpose is both informative and marketing Financial Sections Include:

4. Financial Misrepresentation • Some firms go far in misrepresenting their financial statements. • If they become fiction, then shareholders can sue. • Stanford Law School maintains a clearinghouse website for securities class actions, most of which involve managers allegedly misrepresenting their financial statements.

5. Financial Misrepresentation • Trust is a very important asset in the financial market. • Those playing games with their financial credibility may never regain market value that they once had. • Typically, new leadership is required to reestablish it – the CEO must go!

6. Importing Financial Statements • The Securities and Exchange Commission (SEC) posts firms’ financial filings online on EDGAR. • To access these filings go to this link and type in the company’s name. • Then click find companies. • Filings are listed chronologically from most recent to most ancient.

7. Importing Financial Statements • Annual income statements are usually found in the firm’s 10-k report (annual report). • The report type is listed on the left side of the screen. • Most of these files have follow-up links. • Use the link to 10-k, annual report, or sometimes exhibit 13.

8. Importing Financial Statements • Once the annual report is loaded in the browser, the quickest way to the financials is usually under Edit and Find (or ctl-f). • Then type in the words “balance sheet.” • Balance sheet is a better term because it is found next to the income statement and not all firms call the income statement the same thing. • You may have to hit find a couple of times to get to the actual balance sheet.

9. Importing Financial Statements • Click and drag over the whole income statement. • Copy to the clip-board. • Go to Excel and put the cell-pointer in the upper-left corner of where you want to put the statement. • Then paste.

10. Importing Financial Statements • There are two general types of EDGAR filings. • Those in HTML format. • Those in text format. • If the numbers are mostly in their own cells, then you probably have one in HTML format. • You will still have to clean it up. • Reformat it to look nice. • Watch for negatives where only one bracket is in the right cell!

11. Importing Financial Statements • If it was a text file, then Excel put all data from each line in the first column, and you need to break them into individual columns. • Highlight all lines (just the column with the data). • Data • Text to Columns • Use the fixed widths option, and use the arrows to point to where the breaks should be. • Double click an arrow to make it go away.

12. The Balance Sheet • The balance sheet gives a conservative estimate of the current status of sources and uses of investment funds. • Each side of the balance sheet is organized in order of decreasing liquidity. • The further a line is from the top, the less liquid, and the less likely it represents the current market value. • Liabilities do equal the current outstanding balance.

13. Income Statement • The income statement show the basis whereby equity is adjusted on the balance sheet over time. • This is its primary function. • The bottom-line income is then used to declare a dividend, or increase the equity on the balance sheet (retained earnings).

14. Creating Common Size Statements • The key to creating common size financial statements is the use of relative versus absolute addresses. • Excel interprets an address as relative (in position) to another address in a formula, unless you specify otherwise. • A1 is a relative address. • To specify an absolute address you simply use a $ in front of the absolute portion. • $A$1 means always A1. • The F4 key allows you to cycle through all options.

15. Creating Common Size Statements • The item that is the basis for the common size, then typically gets an absolute address. • For example if sales are in C4, then creating a common size income statement would require you to punch in: • C4/C$4. • Then copying that formula down will create the common size income statement.

16. Creating Custom Views • You might want to, (but you don’t have to) use the custom view to create the common size statements. • To use a custom view, first get the spreadsheet to display what you want it to display. • Then choose View and Custom Views. • Then just add the new view.

17. Cash Flow Statements • There are two types of cash flow statements possible: • Indirect • Starts with net income a reconciles the change in cash position of the company by making adjustments. • Direct • Looks like an income statement, but deals only with cash items, and ends up showing the change in cash position of the company.

18. Cash Flow Statements • Companies may disclose either type of cash flow statement as long as they disclose and indirect statement. • If they choose to use a direct statement, they must also use an indirect. • Therefore, only indirect statements are used.

19. Indirect Cash Flow Statement • The indirect cash flow statement starts with net income disclosed on the income statement. • Cash adjustments are then made for operating revenues and expenses. • Then cash adjustments are made for assets and liabilities.

20. Indirect Cash Flow Statement • Then categories are covered that don’t exist on the income statement. • First, the cash income is adjusted for investing activities. • Buying/selling subsidiaries, assets, etc. • Second, the cash income is adjusted for financing activities. • Both activities that bring in funds, or cost funds.

21. What is free cash flow (FCF)? Why is it important? • FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends upon the amount of FCF it can generate.

22. What are the five uses of FCF? 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

23. What are operating current assets? • Operating current assets (OCA) are the current assets needed to support operations. • Operating current assets include: cash, inventory, receivables. • Operating current assets exclude: short-term investments, because these are not a part of operations.

24. What are operating current liabilities? • Operating current liabilities (OCL) are the current liabilities resulting as a normal part of operations. • Operating current liabilities include: accounts payable and accruals. • Operating current liabilities exclude: notes payable, because this is a source of financing, not a part of operations.

25. Important Operating Measures • Net Operating Working Capital (NOWC): • NOWC = OCA - OCL • Total Net Operating Capital (TNOC): • TNOC = NOWC + Net Fixed Assets • Net Operating Profit After Tax (NOPAT): • NOPAT = EBIT(1-Tax Rate) • EBIT = Earnings Before Interest and Taxes

26. Important Operating Measures • Free Cash Flow (FCF): • FCF = NOPAT - Net investment in operating capital • Return on Invested Capital (ROIC): • ROIC = NOPAT / TNOC • Economic Value Added (EVA): • EVA = NOPAT- (WACC)(TNOC)

27. Market Value Added • Market Value Added (MVA): • Market Value of Firm - Book Value of Firm • If the market value of debt is close to the book value of debt, then MVA is: • MVA = Market value of equity – book value of equity