Lecture 2: Financial Statements

1. Lecture 2: Financial Statements C. L. Mattoli (C) Red Hill Capital Corp., Delaware, USA

2. Intro • To begin financial analysis, we need financial information. • One of the most common forms of financial information is the financial statements of companies or other businesses. • The three important financial statements are: income statement, balance sheet and cash flow statements, which show how one period’s balance sheet flows into the next. (C) Red Hill Capital Corp., Delaware, USA

3. Intro • Remember, again, that finance is not accounting, so we will need to use financial information in the proper manner. • Moreover, as we study how to properly use financial data, it will help you to understand accounting even better. • It will also help you to understand the limitations of accounting and how it differs from finance. (C) Red Hill Capital Corp., Delaware, USA

4. Intro • In particular, you should understand the difference between income and cash flow and accounting value versus market value • To those ends, we will discuss financial statements. Then, we will pick them apart to see what we can use for financial analysis. And finally, we will look at financial analytical systems. (C) Red Hill Capital Corp., Delaware, USA

5. The Balance Sheet (BS) (C) Red Hill Capital Corp., Delaware, USA

6. Balance sheet • The first statement that you can prepare for a business, is the balance sheet or statement of financial position. • The balance sheet (BS) gives a picture of what the company owns (assets) and owes (liabilities). • The difference between them: owner’s equity (equity) at a given point of time. • Assets,left-hand side; liabilities and equity are on the right. In an abstract equation we can write A = L + E. • It is published quarterly; in accounting, it is kept current on a day-to-day basis. (C) Red Hill Capital Corp., Delaware, USA

7. Abstract Basic Balance Sheet Net WC = CA - CL Current Assets Cash A/R Inventory Current Liabilities Accrued Expenses A/P SR Debt Non-current liabilities, including Long term debt Long term assets Tang. fixed assets Intangibles E = A - L Equity (C) Red Hill Capital Corp., Delaware, USA

8. Assets • First break assets down into current assets and fixed assets. • Current assets have a life of less than a year. • Examples are cash (and equivalents), inventory, and A/R (accounts receivable = money owed from customers for credit sales). • Fixed assets two sub-types: tangible (physically real), like machinery or a building, and intangible, like patents or trademarks. (C) Red Hill Capital Corp., Delaware, USA

9. Liabilities • Liabilities: current liabilities and long-term (LT) liabilities. • Current liabilities (CL) come due for payment within a year. • Include short-term (ST) loans, current portion of LT debt due for repayment, A/P (accounts payable to, e.g., suppliers), accrued expenses. • LT liabilities are LT debts, such as LT bank loans and bond and debenture securities. (C) Red Hill Capital Corp., Delaware, USA

10. Equity • Other portion of the right-hand side of the balance sheet is shareholders’ or owners’ equity. • Equity is the difference between assets and liabilities. • Usually, breakdown of equity into initial equity that was contributed to start the firm and retained earnings (RE), which represents the profits that the firm has made and reinvested in the business. (C) Red Hill Capital Corp., Delaware, USA

11. Equity • Accounting value of the firm may or may not have anything to do with actual value. • If you sold all of the assets (at their value on the balance sheet) and you used that money to liquidate all of the company’s debts, what would be leftover would belong to the owners. (C) Red Hill Capital Corp., Delaware, USA

12. Working Capital (WC) • Some further definitions for the balance sheet have to do with ST items. • Both CA and CL are part of working capital (WC). • We also define net WC as CA – CL. • We use Net WC as a first measure of the company’s financial health. (C) Red Hill Capital Corp., Delaware, USA

13. Working Capital (WC) • Since CL must be paid within a year, and CA are expected to be liquidated within a year, a positive NWC is a preliminary indication of the company’s viability. • If NWC is negative, it would appear that the firm will not be able to make it through the year. (C) Red Hill Capital Corp., Delaware, USA

14. Liquidity • We used the term “liquidate”, in the last few slides. • The word, liquid, means something, like water or milk, which are called liquids. • In finance, the term liquidity refers to how fast and how easily an asset can be converted to cash. • When we say “easy” that means, basically, without loss of value in the sale. (C) Red Hill Capital Corp., Delaware, USA

15. Liquidity • Anything can be sold at a reduced price, but when we say that an asset is liquid, then, we mean that it can be sold quickly without a big loss in value. • Things, like securities, saving accounts, and precious metals, like gold and silver, are fairly liquid assets. • Things, like real estate or a large piece of used specialty equipment are probably not very liquid. (C) Red Hill Capital Corp., Delaware, USA

16. The importance of liquidity • One of the things that we will study is WC management, so you might guess that liquidity is important. • The greater the liquidity of the company, the more likely that it will be able to pay off its debts and take on new assets. • The importance of liquidity is even recognized in the actual set-up of the balance sheet. • The balance sheet is constructed, on both sides, in decreasing order of liquidity. (C) Red Hill Capital Corp., Delaware, USA

17. The importance of liquidity • Thus the most liquid assets and liabilities are at the top, then, the next most liquid, etc. • Beyond the simple fact that we want to be able to meet our short term debts and have short term assets to do our business, well, there is another reason that we have to manage WC: profit. • Short-term assets tend to earn low or no return, like cash. • Short-term liabilities can be costly, like an emergency loan to meet current shortfalls in revenue. (C) Red Hill Capital Corp., Delaware, USA

18. Table 2.1 OZ Company Balance Sheet • Below, we show an excerpt from the text book, showing a basic balance sheet. • Notice that items appear on the BS in decreasing order of liquidity, down the sheet. (C) Red Hill Capital Corp., Delaware, USA

19. Debt compared to Equity • Since debt and equity (common plus preferred) make up the firm’s capital, it is worth looking at them, both, in greater detail. • Under most, if not all, laws around the world, creditors stand at the front of the line, in liquidation of the firm. As we mentioned, in last week’s lecture, debt is senior to equity with finer gradations for debt and equity. • By liquidation, we mean any type of winding up of the business, including forced liquidation (bankruptcy) or voluntary. (C) Red Hill Capital Corp., Delaware, USA

20. Debt compared to Equity • Logically, from a legal perspective, if you borrow money from someone, you should be legally liable for the repayment. • So, debt should be repaid, in any event, before the owner of the business can walk away with his leftovers: equity. • Also, the debt holders are, somehow, taking less of the risk in the business than the equity holder owners, which is as it should be. (C) Red Hill Capital Corp., Delaware, USA

21. Debt compared to Equity • That has one advantage, debt holders will demand less of a profit on their money than those who put money into the firm as owners. • However, there is also a downside to debt: payments on debt, including interest, the charge for borrowing, and eventual payment of the principal (the amount borrowed, in the first place), must be made in the ordinary course of business. (C) Red Hill Capital Corp., Delaware, USA

22. Debt compared to Equity • Affect on profit, since interest is an ongoing expense against income, but, debtors can sue, in court, if the debtor is in default of his contractual payments. • The amount of payment that the plaintiff sues for is what will be awarded by the court. • However, consider that there could be a “domino effect” from a default and a lawsuit, which might force the company into involuntary liquidation. (C) Red Hill Capital Corp., Delaware, USA

23. Debt compared to Equity • The equity entitles the owners to what is left after selling all assets and liquidating liabilities. • Equity holders are also entitled to all of the net cash flows that are leftover, each period, after everyone else is paid. • Out of that excess CF, the firm might make cash payments to equity holders, called dividend payments. The rest of the money will be reinvested in the firm as the RE portion of equity, and the firm will grow in accounting value. (C) Red Hill Capital Corp., Delaware, USA

24. Financial Leverage • The use of debt in the capital mix is referred to as financial leverage. • We speak of financial leverage because the use of debt can, therefore, magnify gains and losses. • As we shall learn later in this module, finance likes to look at things in terms of ratios of one financial number to another. (C) Red Hill Capital Corp., Delaware, USA

25. Financial Leverage • One of the fundamental ratios in finance is called a rate of return. • If I say I earned $1,000 on an investment, your first questions should be: how much did you invest to get that income? • The rate of return on in vestment (ROI) is the ratio of income from investment to initial investment: Inc/II. (C) Red Hill Capital Corp., Delaware, USA

26. Leverage • Why do we call it leverage? Because there is a magnification effect, like when we use a lever to lift something • For example, assume that you have $10 million (your equity), and that you can make a 10% return on money. With only your money, you would make $1 million (10%x$10 million). …….. (C) Red Hill Capital Corp., Delaware, USA

27. Leverage • Next, assume that you borrow $90 million (debt) for 5% interest. Then, you make $10 million (10% x $100 million), pay $4.5 million for the debt (5%x$90 million), so net income is $5.5 million ($10-$4.5 million). • Our return on equity is quite enhanced, levered. It is, now, $5.5 million/$10 million = 55% instead of the un-levered 10% return. (C) Red Hill Capital Corp., Delaware, USA

28. Market value vs. book (acctg) value • The true value of something is what you could sell it for (in, e.g., a market): market value. • The numbers shown in a BS are the book values of the firms assets and liabilities. • Under Australian Accounting Standards (AAS), assets are usually carried on the books at historical cost, no matter when the asset was acquired and what it is actually worth. (C) Red Hill Capital Corp., Delaware, USA

29. Market value vs. book (acctg) value • For CA, the book value should be close to market value. • Oh the other hand, a piece of old machinery that has been depreciated over the years will probably have a book value different from the actual value in the market for old machinery. • However, assets that are expected to appreciate in value, like real estate, must be periodically revalued. (C) Red Hill Capital Corp., Delaware, USA

30. Market value vs. book (acctg) value • Any adjustments to value are recorded in an Asset Revaluation Reserve Account (ARRA), on the books, and that ARRA is another sub-part of the owner’s equity account (E). • Investors and managers are interested in knowing market values, not book. • First of all, as we discussed, book value may not be representative of market value. (C) Red Hill Capital Corp., Delaware, USA

31. Market value vs. book (acctg) value • In addition, many of true assets are not even listed on the BS. These are things, like brand name, management/employee skill, and reputation. • Some people have said that the value of the names, Microsoft, Coca Cola and IBM, alone, are worth $50 billion. • Moreover, since owner’s equity is a residual, A – L, its book value will differ from market. • In finance, when we speak of value, we are usually referring to market value (economic). (C) Red Hill Capital Corp., Delaware, USA

32. Example 2.2: Market vs. Book We show a sample comparison of book (accounting) value and market (economic) values in the example, below. (C) Red Hill Capital Corp., Delaware, USA

33. The Income Statement (IS) (C) Red Hill Capital Corp., Delaware, USA

34. The income statement • The income statement reveals financial performance over some extended period of time, usually, a quarter, half, or whole year. • In a simple abstract equation: Income = Revenue – Expense (Inc = Rev – Exp). • We show a basic income statement in the next slide. (C) Red Hill Capital Corp., Delaware, USA

35. Textbook Table 2.2 (C) Red Hill Capital Corp., Delaware, USA

36. Income Statement • The first items on an income statement are revenues. • The next item is expenses against income. • Then, we include financing charges, like interest expense. • From that, we get taxable income (pre-tax income, PTI). • Then, calculate taxes, subtract them out to get net income (after-tax income, ATI). (C) Red Hill Capital Corp., Delaware, USA

37. Income Statement • Companies usually also report earnings per share (EPS), which is ATI/number of shares. • Out of income, some cash dividends might be paid out to shareholders (owners), and the rest of it goes to retained earnings (RE). • In looking at the IS, we must be aware of: AAS, cash versus non-cash items (like depreciation), time and cost. (C) Red Hill Capital Corp., Delaware, USA

38. AAS and the IS • According to AAS, revenue is recorded when it accrues (revenue recognition principle): when the earnings process is virtually completed and the value of the transaction is known. • In practice, that means at the time of sale, which may not be the same as when payment is made. • Expenses are based on a matching principle:costs associated with the sale are subtracted on the IS. • As a result, the income statement will not necessarily represent the actual cash flows that have occurred during the period. (C) Red Hill Capital Corp., Delaware, USA

39. Non-cash Items • A major reason that accounting income differs from actual cash flows is that accounting income statements include non-cash items. • Depreciation is one of the most common non-cash charges. • You buy equipment for $1 million that will be used for 10 years of production, instead of deducting all of it now, accounting will depreciate the cost over 10 years. (C) Red Hill Capital Corp., Delaware, USA

40. Non-cash Items • Thus, each year, $1 million/10 years = $100,000 depreciation (called straight-line depreciation because it is the same each year),will be expensed against revenues. • The depreciation charge is not an actual cash flow. After all, you spent the money for the machinery (actual cash outflow) when you bought it. (C) Red Hill Capital Corp., Delaware, USA

41. Non-cash Items • Depreciation arises in accounting, again, based on a matching principle of allocating costs to revenues, matching costs with benefits. • As we shall discover in future modules, the financial managers is critically interested in the actual timing of cash flows (time value), in order to come up with proper values of things. (C) Red Hill Capital Corp., Delaware, USA

42. Time & Costs • We have been dividing up things into LT and ST. The difference between the two, in economics, is that in the LT all business costs are variable costs. • In the short run, some costs, like interest payments and office rent, are fixed, while others, like production costs, are variable. • In finance, it is sometimes important to be able to break out fixed and variable costs for analysis. (C) Red Hill Capital Corp., Delaware, USA

43. Time & Costs • A problem is that accounting tends to group costs as product costs and period costs. • Product costs will be things associated with production, like materials, labor, and manufacturing overhead: some, fixed; some variable. • Period costs will include things, like selling, general, and administrative (SG&A), again, including some fixed and variable costs. (C) Red Hill Capital Corp., Delaware, USA

44. Earnings management? • Because of the leeway in accounting rules, companies have choices about how to account for expenses and revenues. • Given that, they can actually manipulate the numbers that lead to net income on their income statements. • Such discretion allows companies to engage in earnings management. • Sometimes, the notes to financial statement are helpful to understand all of the numbers on a more objective level. (C) Red Hill Capital Corp., Delaware, USA

45. Taxation (C) Red Hill Capital Corp., Delaware, USA

46. Intro • Taxes will be an important aspect of earnings for both individuals and corporations. • First of all, you only get to keep income after taxes. • Tax rates, around the world, can range from 10% or less to more than 50%, so they can be a large slice of the pie. • We look at taxes in Australia for corporations and people. (C) Red Hill Capital Corp., Delaware, USA

47. Corporate Taxes • The current corporate tax rate, in Australia, is a flat-rate of 30% on all income. • In a flat-rate tax, there is only one tax rate, a percentage of income that is owed as taxes. • Thus, if income before tax is $1 million, then, taxes are 30% x $1 million = $300,000, and net income AT = $700,000 = $1 million - $300,000 = $1 million x (1 – tax rate) = $1 million x 70% = $700,000. (C) Red Hill Capital Corp., Delaware, USA

48. Personal Tax rates • The personal taxation system, in Australia is called a graduated, or progressive, tax system. • In a graduated tax system, different tax rates, marginal tax rates, are applied to different portions of income. • For the first $6,000, the marginal tax rate is 0%. • If you earn between $6,000 and $25,000, you will owe 0% on the first $6,000 and 15% on the income above $6,000. • For example, if your earnings were $25,000, then, your tax would be 0% x $6,000 + 15% x $19,000 = $2,850. (C) Red Hill Capital Corp., Delaware, USA

49. Personal Tax rates • Your marginal tax rate on your next dollar of income would be 30% of the extra income. • We can also talk of your average tax rate, which is just equal to your total taxes paid as a percentage of pre-tax income. • Thus, in the present case, your average tax rate would be = $2,850/$25,000 = 11.4%, which is below your marginal rates. • In the next slide we show current marginal rates for individuals, in Australia. (C) Red Hill Capital Corp., Delaware, USA

50. Marginal tax rates (C) Red Hill Capital Corp., Delaware, USA