Chapter 2: Introduction to Financial Statement Analysis

Question 1

Balance Sheet

Answer 1

The statement of the financial position of the company. Shows the value of assets, liabilities, and equity at a particular point in time.

Question 2

Basic equation of the balance sheet

Answer 2

Stockholder’s Equity = Assets - Liabilities. This is an accounting measure of the firm’s net worth, not the market value

Question 3

Market Capitalization

Answer 3

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

Question 4

Formula for market capitalization

Answer 4

Share price * Number of shares

Question 5

Book Value

Answer 5

An accounting measure of what you now own (your assets) - what you owe now (your liabilities). It’s your “bank balance.”

Question 6

Market to Book Ratio (formula)

Answer 6

Market Cap./Book Value of Equity

Question 7

Net Working Capital

Answer 7

This is the amount of money available to run the firm in the short run.

Question 8

Formula of Net Working Capital

Answer 8

Current Assets - Current Liabilities

Question 9

Current Ratio (formula)

Answer 9

Current Assets/Current Liabilities

Question 10

Debt/Equity Ratio (formula)

Answer 10

Debt/Market Cap.

Question 11

Debt/Capital Ratio (formula)

Answer 11

Debt/(Equity + Debt)

Question 12

Income Statement

Answer 12

Statement of financial performance which shows the revenues and costs for a particular time period

Question 13

Basic equation of income statement

Answer 13

Net Income = Revenue - Cost

Question 14

Net Income

Answer 14

The “bottom line” so the total income after all the revenues and expenses

Question 15

Gross Profit

Answer 15

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

Question 16

Formula of Gross Profit

Answer 16

Gross Revenue - Cost of Revenue

Question 17

Gross Margin (formula)

Answer 17

Gross Profit/Revenues

Question 18

Operating Income

Answer 18

The income from operations, so the gross profit for running the firm minus the operating expenses. Located below the gross profit stuff

Question 19

Operating Margin (formula)

Answer 19

Operating Income/Revenue

Question 20

Non-Operating Income and Expenses

Answer 20

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

Question 21

Interest Coverage Ratio (formula)

Answer 21

EBIT (Earnings before Interest and Taxes)/Interest Expenses

Question 22

Earnings Per Share (formula)

Answer 22

Net Income/# of shares

Question 23

Price to Earnings Ratio (formula)

Answer 23

Market Cap./Net Income or Price Per Share/Earnings Per Share

Question 24

Return on Equity (ROE)

Answer 24

Net Income/Avg. Book Value of Equity

Question 25

Cash Flow Statement

Answer 25

Shows change in cash position for a particular time period

Question 26

Basic formula for cash flows

Answer 26

Cash (End) - Cash (Beginning) = Change in Cash

Question 27

Cash from (used by) Operations

Answer 27

Start with net income and adjust for non-cash items

Question 28

Cash from (used by) Investing Activities

Answer 28

Purchases of new property, plants, and equipment

Question 29

Cash from (used by) Financing Activities

Answer 29

Shows if a firm issued new debt or paid off debt

Question 30

Enterprise Value

Answer 30

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

Question 31

Differences between shareholder’s equity, market cap., and enterprise value

Answer 31

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

Question 32

The 10-Q and 10-K financial reports are produced under what accounting standards?

Answer 32

Generally Accepted Accounting Principles – more commonly known as GAAP accounting

Question 33

Why is the Management Discussion and Analysis (MD&A) important?

Answer 33

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.

Question 34

What legislation was passed by Congress in 2002 after the Enron and WorldCom financial scandals? What is its significance?

Answer 34

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

Question 35

What are the roles of board of directors and financial managers?

Answer 35

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.

Question 36

How is book value of equity determined?

Answer 36

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.

Question 37

How does market capitalization differ from book value of equity?

Answer 37

• Balance sheet is based on GAAP accounting
• Balance sheet gives no value to intangible assets, such as quality of management or future sales

Question 38

Enterprise value relationship with market cap.

Answer 38

EV = Market Cap. + Debt - Cash

Question 39

What are the two accounting standards?

Answer 39

GAAP and Statutory

Question 40

GAAP

Answer 40

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

Question 41

Statutory Rules

Answer 41

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

Question 42

How are GAAP and statutory different?

Answer 42

• Statutory rules are more conservative than GAAP (resulting in higher reserves).
• GAAP uses best estimate for future assumptions, statutory uses prudent best estimate assumptions.

Question 43

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?

Answer 43

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.