Chapter 2: Introduction to Financial Statement Analysis Flashcards
Balance Sheet
The statement of the financial position of the company. Shows the value of assets, liabilities, and equity at a particular point in time.
Basic equation of the balance sheet
Stockholder’s Equity = Assets - Liabilities. This is an accounting measure of the firm’s net worth, not the market value
Market Capitalization
The current market value of the firm as measured by what investors are willing to pay for a share of stock. This value is your future earnings potential, not your current bank balance
Formula for market capitalization
Share price * Number of shares
Book Value
An accounting measure of what you now own (your assets) - what you owe now (your liabilities). It’s your “bank balance.”
Market to Book Ratio (formula)
Market Cap./Book Value of Equity
Net Working Capital
This is the amount of money available to run the firm in the short run.
Formula of Net Working Capital
Current Assets - Current Liabilities
Current Ratio (formula)
Current Assets/Current Liabilities
Debt/Equity Ratio (formula)
Debt/Market Cap.
Debt/Capital Ratio (formula)
Debt/(Equity + Debt)
Income Statement
Statement of financial performance which shows the revenues and costs for a particular time period
Basic equation of income statement
Net Income = Revenue - Cost
Net Income
The “bottom line” so the total income after all the revenues and expenses
Gross Profit
The income or profit remaining after the production costs have been subtracted from the revenue. We can see this in the 3rd line of the income statement
Formula of Gross Profit
Gross Revenue - Cost of Revenue
Gross Margin (formula)
Gross Profit/Revenues
Operating Income
The income from operations, so the gross profit for running the firm minus the operating expenses. Located below the gross profit stuff
Operating Margin (formula)
Operating Income/Revenue
Non-Operating Income and Expenses
Income and expenses from activities not central to running the firm, such as income from investments or interest expense. This is located under the operating income line
Interest Coverage Ratio (formula)
EBIT (Earnings before Interest and Taxes)/Interest Expenses
Earnings Per Share (formula)
Net Income/# of shares
Price to Earnings Ratio (formula)
Market Cap./Net Income or Price Per Share/Earnings Per Share
Return on Equity (ROE)
Net Income/Avg. Book Value of Equity
Cash Flow Statement
Shows change in cash position for a particular time period
Basic formula for cash flows
Cash (End) - Cash (Beginning) = Change in Cash
Cash from (used by) Operations
Start with net income and adjust for non-cash items
Cash from (used by) Investing Activities
Purchases of new property, plants, and equipment
Cash from (used by) Financing Activities
Shows if a firm issued new debt or paid off debt
Enterprise Value
Total amount of money needed to take over 100% of the company. This value is higher if the future profitability and future earnings growth is higher
Differences between shareholder’s equity, market cap., and enterprise value
One measures the company’s net worth so the amount returned if the company was liquidated, another is the amount of outstanding shares of stock, and one is the total value
The 10-Q and 10-K financial reports are produced under what accounting standards?
Generally Accepted Accounting Principles – more commonly known as GAAP accounting
Why is the Management Discussion and Analysis (MD&A) important?
In the MD&A, management of a firm discusses significant events and results and, importantly, it discusses significant risks and issues facing the firm. Management may discuss future plans or projects. It also discloses off-balance sheet items (e.g. market value of derivatives), which are shown in the footnotes to the financial statements.
What legislation was passed by Congress in 2002 after the Enron and WorldCom financial scandals? What is its significance?
The Sarbanes-Oxley Act requires that Chief Executive officers (CEOs) and Chief Financial Officers (CFOs) certify the accuracy and appropriateness of the firm’s financial statements, and increases the penalties against them if the financial statements later prove to be fraudulent. This is significant because it provides a powerful incentive for executives to monitor their financial statements and assure their accuracy
What are the roles of board of directors and financial managers?
The board of directors set the risk tolerances that the financials managers have to be aware of when trying to maximize the value of the firm.
How is book value of equity determined?
Determined from the balance sheet, and is an accounting measure of the firm’s net worth at a particular point in time. Does not reflect expectations of future sales or profit.
How does market capitalization differ from book value of equity?
- Balance sheet is based on GAAP accounting
- Balance sheet gives no value to intangible assets, such as quality of management or future sales
Enterprise value relationship with market cap.
EV = Market Cap. + Debt - Cash
What are the two accounting standards?
GAAP and Statutory
GAAP
Rule-based system used by all corporations in a standard format. It is used by investors to compare the financial results of the firm with itself
Statutory Rules
Prescribed by the statute by the insurance regulators of 50 states. They are used by regulators to assess financial strength and claims paying ability of the insurance companies, so that they can be sure that the insurers have enough reserves and capital to pay the benefits promised to policyholders
How are GAAP and statutory different?
- Statutory rules are more conservative than GAAP (resulting in higher reserves).
- GAAP uses best estimate for future assumptions, statutory uses prudent best estimate assumptions.
As determined in class, the Price/Earnings ratio for Amazon on 12/31/23 is 51.9. On the same date, the price/earnings ratio for Kroger supermarkets was about 15. What might account for the differences in P/E ratios for Amazon and Kroger?
If investors think future earnings will grow significantly, and therefore future dividends will also grow, then the P/E ratio, which is usually calculated on the past 12 months earnings, will be high. That is the case for Amazon as of this date. Conversely, investors may not think a chain of supermarkets, like Kroger has the same opportunity to grow future earnings and dividends so greatly. In that case, the P/E ratio will be lower.
