Session 4: Financial Statements Analysis Flashcards
What is the balance sheet equation, and what do its components represent?
The fundamental balance sheet equation is:
Assets = Liabilities + Stockholder’s Equity
- Assets: What the company owns
- Liabilities: What the company owes
- Stockholder’s Equity: The difference between the firm’s assets and liabilities
What are current assets, and what are some examples?
Current assets are assets expected to be turned into cash within the next year. Examples include:
- Cash
- Marketable Securities (e.g., money market investments)
- Accounts Receivable (amounts not yet collected from customers)
- Inventories (raw materials, work in process, and finished goods)
- Other Current Assets
- Pre-paid Expenses (e.g., rent or insurance paid in advance)
What are long-term (fixed or non-current) assets, and what do they include?
Long-term assets are assets that provide value beyond one year.
They include:
Property, Plant, & Equipment (PP&E) (e.g., real estate, machinery)
Book Value = Acquisition Cost - Accumulated Depreciation
Depreciation: Recognizing loss of value over time
Goodwill (difference between book and fair value of assets)
Amortization: Recognizing loss of value over time
Other Long-Term Assets
Tangible (e.g., unused property)
Intangible (e.g., patents, trademarks)
What are the two main types of liabilities on a balance sheet, and what do they include?
Liabilities represent what a company owes and are classified into:
Current Liabilities (Due within the next year):
- Accounts Payable (amount owed to suppliers for products/services purchased on credit)
- Notes Payable / Short-Term Debt / Current Maturities of Long-Term Debt (debt repayment due within 12 months)
- Other Current Liabilities (e.g., Taxes Payable, Wages Payable)
Long-Term Liabilities:
- Long-Term Debt
- Capital Leases (regular lease payments in exchange for asset use)
- Deferred Taxes (taxes owed but not yet paid)
What is Net Working Capital
Net Working Capital (NWC) = Current Assets – Current Liabilities
How does liquidity impact financial decisions?
- Liquidity: Ease of converting assets to cash without significant loss.
- Conversion Speed vs. Value Loss: Liquid assets convert quickly with minimal loss; illiquid assets (e.g., real estate, machinery) take time and may sell at a discount.
- Liquidity & Financial Distress: Holding liquid assets helps meet short-term obligations but may reduce long-term investment profits.
- Liquidation Value: The amount available if all assets were sold and liabilities settled, depending on asset liquidity.
How are assets ordered by liquidity on financial statements?
Assets are listed in order of decreasing liquidity:
- Cash & Cash Equivalents – Most liquid, already in cash form.
- Marketable Securities – Stocks, bonds, or other investments that can be quickly sold with minimal loss.
- Accounts Receivable – Money owed by customers, expected to be collected soon.
- Inventory – Physical goods for sale; may take time to convert into cash.
- Property, Plant, & Equipment (PP&E) – Long-term assets that are harder to sell and may lose value in the process.
- Intangible Assets (e.g., patents, goodwill) – Valuable but not easily sold or converted into cash.
What is the Book Value of Equity, and what does it indicate?
Book Value of Equity = (Book) Value of Assets – (Book) Value of Liabilities
- Represents the net worth of a company according to its accounting records.
- Can be negative, meaning the company has more liabilities than assets.
- A negative book value is not always bad—successful firms may have high borrowing capacity to finance growth beyond their book assets.
What is the Market Value of Equity, and how is it different from the Book Value of Equity?
Market Value of Equity = Market Price per Share × Number of Shares Outstanding
- Also known as Market Capitalization.
- Represents the total market valuation of a company based on stock prices and investor perception.
- Unlike book value, it cannot be negative, since stock prices and share quantities cannot be negative.
What is the purpose of the income statement, and how is income calculated?
- The income statement provides an overview of a firm’s financial performance over a specific period.
- It focuses on profits and losses using the formula:
Revenues – Expenses = Income - Companies first report revenues (sales or other income sources) and then subtract expenses incurred during the period.
- Also includes non-cash expenses like depreciation and amortization.
What is the Matching Principle, and how does it relate to accrual accounting?
- Accrual Accounting: Revenue is recorded when earned, not necessarily when cash is received.
- Expenses must be recorded in the same period as the revenue they help generate.
Example:
If a company delivers a product in December but gets paid in January, the revenue is recorded in December, not January.
What are the key steps in calculating net income on the income statement?
What is Earnings Per Share (EPS), and how is it calculated?
- EPS represents net income on a per-share basis.
- The number of shares may grow due to stock options or convertible bonds.
- Diluted EPS reports EPS if all options were exercised.
What are the three main sections of the cash flow statement, and how do they contribute to the net change in cash balance?
The Statement of Cash Flows tracks how cash moves in and out of a business over a period. It consists of three main sections:
Cash Flow from Operations:
- Cash generated from core business activities (after taxes and interest).
- Includes revenues, operating expenses, and changes in working capital.
Cash Flow from Investing:
- Cash spent on acquiring or selling physical assets (capital expenditure).
- Buying or selling financial investments.
Cash Flow from Financing:
- Issuing or repurchasing equity (stocks).
- Raising or repaying debt.
- Paying dividends to shareholders.
OperatingCashFlow + InvestingCashFlow + FinancingCashFlow = NetChangeinCashBalance
Why is profit (net income) different from cash flow?
- Operating cash flow measures cash generated from operations and should generally be positive over time.
- Total cash flow (Net Change in Cash Balance) includes adjustments for capital expenditures and financing activities and may be negative.
Profit ≠ Cash Flow because:
- Non-cash expenses (e.g., depreciation and amortization) reduce net income but do not involve actual cash outflows.
- Cash is used in ways not reflected on the income statement (e.g., investment in property, plant, and equipment).
What is Cash Flow from Assets (CFFA), and why is it important?
- CFFA (also called Free Cash Flow to the Firm - FCFF) measures how much cash a company generates and where it goes.
- Represents cash available for creditors (lenders) and stockholders (owners).
- Definition: The cash a business generates from its operations after accounting for investments in long-term assets and working capital.
What is the formula for Cash Flow from Assets (CFFA), and what does it represent?
Shows how much cash remains after a company:
- Earns from operations (Operating Cash Flow).
- Invests in fixed assets (Net Capital Spending).
- Invests in short-term assets like inventory or accounts receivable (Change in Net Working Capital).
The remaining cash can be distributed to creditors (debt repayment) or stockholders (dividends/stock buybacks).
Cash Flow from Assets (CFFA)
What is Operating Cash Flow (OCF), and why is depreciation added back?
- Represents money generated by a business’s daily operations.
- Depreciation is added back because it is a non-cash expense—it reduces book asset values, but no actual money leaves the company.
Cash Flow from Assets (CFFA)
What is Net Capital Spending (CapEx), and how does it affect cash flow?
- Represents cash spent on new investments in machinery, buildings, or technology.
- Buying new assets reduces available cash for distribution to creditors or shareholders.
Cash Flow from Assets (CFFA)
How does a change in Net Working Capital (NWC) affect cash flow?
- NWC = Current Assets - Current Liabilities
- If NWC increases (e.g., more inventory or accounts receivable), cash decreases (more money is tied up).
- If NWC decreases (e.g., faster collections or lower inventory), cash increases.
- If a company increases inventory or delays customer payments, it uses more cash and reduces CFFA.
How is Cash Flow from Assets (CFFA) distributed, and what is the fundamental cash flow identity?
CFFA is the cash a firm generates after investments, distributed to:
- Creditors (interest & loan repayments)
- Stockholders (dividends & buybacks)
Fundamental Identity:
CFFA = CashFlowtoCreditors + CashFlowtoStockholders
Formulas:
Cash Flow to Creditors = Interest Paid - Net New Borrowing
- Borrowing > Repayments → Cash inflow
- Repayments > Borrowing → Cash outflow
Cash Flow to Stockholders = Dividends Paid - Net New Equity Raised
- Issuing stock → Cash inflow
- Buybacks → Cash outflow
What does a positive or negative Cash Flow from Assets (CFFA) indicate?
Positive CFFA:
- The company generates more cash than it spends on operations and investments.
- Excess cash can be distributed to creditors and stockholders.
Negative CFFA:
- The company is spending more on investments than it generates.
- Could be a bad sign (poor cash flow) or a good sign (heavy reinvestment for future growth).
- Growing corporations may have negative CFFA because they raise more money through borrowing and stock sales than they pay out to creditors and stockholders.
Short-term Solvency & Liquidity Measures
What are liquidity measures, and why are they important?
- Liquidity analysis evaluates a company’s ability to pay short-term debts.
- Current assets and liabilities typically have similar book and market values, making liquidity ratios useful financial tools.
- However, since these values fluctuate, liquidity ratios have low predictive power for long-term stability.
Short-term Solvency & Liquidity Measures
What is the Current Ratio, and how is it interpreted?
- Creditors’ perspective: Higher is better—it indicates a firm can cover short-term liabilities.
- Firm’s perspective: Too high may indicate inefficient resource use (e.g., excess inventory or idle cash).
- If Current Ratio < 1: Indicates negative net working capital—potential liquidity problems.
- Can be artificially improved if a company borrows long-term debt to pay short-term liabilities.
Short-term Solvency & Liquidity Measures
What is the Quick Ratio, and why is it considered a stricter liquidity measure?
- Similar to Current Ratio, but excludes inventory (since inventory can be difficult to liquidate).
- A more strict measure of liquidity—shows how well a firm can meet obligations with only its most liquid assets.
- Higher Quick Ratio = Better liquidity, as it highlights whether a company may struggle to collect receivables or sell inventory.
Short-term Solvency & Liquidity Measures
What is the Cash Ratio, and why is it the most conservative liquidity measure?
- The most conservative liquidity measure—it only considers cash and near-cash assets.
- High Cash Ratio: May indicate the firm isn’t using assets efficiently.
- Low Cash Ratio: Could signal liquidity risk, especially in a credit crisis when short-term borrowing is difficult.
Short-term Solvency & Liquidity Measures
What does Net Working Capital (NWC) indicate, and how is it related to liquidity risk?
- Measures how much of a company’s assets are tied up in working capital.
- Higher NWC: Suggests reliance on short-term assets.
- Lower NWC: Indicates efficient asset utilization but may suggest liquidity risk.
What is the Total Debt Ratio, and what does it measure?
- Measures the proportion of a company’s assets financed by debt.
- A higher ratio means the company relies more on debt financing, which could increase financial risk.
Long-term Solvency Measures
What is the Debt-to-Equity Ratio, and what does it indicate?
- Measures the relative proportion of debt and equity used for financing.
- A higher ratio means the company is more leveraged and relies heavily on debt.
Long-term Solvency Measures
What is the Equity Multiplier, and how does it reflect financial leverage?
- Reflects financial leverage—how much of a company’s assets are financed by shareholders’ equity.
- Higher ratio means more reliance on debt financing.
Long-term Solvency Measures
What is the Times Interest Earned (TIE) Ratio, and what does it measure?
- Evaluates how well a company can cover its interest payments using operating profit (EBIT).
- Higher ratio = stronger ability to meet interest obligations
Long-term Solvency Measures
What is the Cash Coverage Ratio, and why is it more accurate than TIE?
- Includes non-cash expenses (depreciation & amortization) for a more accurate measure of a company’s ability to cover interest costs.
- Higher ratio = better ability to handle interest payments.
Asset Management or Turnover Measures
What is the Inventory Turnover ratio, and what does it measure?
- Measures how frequently inventory is sold and replaced.
- Higher ratio = more efficient inventory management.
Asset Management or Turnover Measures
What is Days’ Sales in Inventory, and what does it indicate?
- Reflects how many days it takes to sell the entire inventory.
- Lower days indicate faster inventory turnover.
Asset Management or Turnover Measures
What is the Receivables Turnover ratio, and what does it measure?
- Measures how efficiently a company collects receivables.
- Higher ratio = faster collection of accounts receivable
Asset Management or Turnover Measures
What is Days’ Sales in Receivables, and what does it represent?
- Shows the average time taken to collect outstanding receivables.
- Also called the Average Collection Period (ACP).
Asset Management or Turnover Measures
What is the Total Asset Turnover ratio, and what does it indicate?
- Indicates how efficiently assets generate revenue.
- Higher ratio = better asset utilization.
Asset Management or Turnover Measures
What does Capital Intensity measure?
- Inverse of Total Asset Turnover—shows how much capital is needed per unit of sales.
Asset Management or Turnover Measures
What does NWC Turnover measure?
- Measures how efficiently working capital is used to generate revenue.
Profitability Measures
What is the Operating Margin, and what does it measure?
- Shows how much a company earns before interest and taxes from each € of sales.
- Higher margin = better operational efficiency.
Profitability Measures
What is the Profit Margin, and why does it vary across industries?
- Represents the portion of revenue available to shareholders after interest and tax payments.
- Higher margins are desirable, but lower margins may result from strategic pricing to increase sales volume.
- Margins vary by industry due to efficiency, strategy, and financial leverage.
Profitability Measures
What is Return on Assets (RoA), and what does it indicate?
- Measures profit earned per unit of assets.
- Indicates how efficiently a company generates profits from its assets.
Profitability Measures
What is Return on Equity (RoE), and why is it important?
- Reflects how well shareholders’ investments are performing.
- A high RoE means the firm successfully finds profitable investment opportunities.
- RoE interpretation can be challenging due to variations in book value of equity.
How does financial leverage impact the difference between ROA and ROE?
- ROE is higher than ROA when a company uses debt financing.
- The greater the financial leverage (more debt relative to equity), the bigger the gap between ROA and ROE.
- Too much debt increases financial risk, as interest payments must be met even in tough times.
- Important: ROA and ROE are accounting rates of return and should not be directly compared with market rates of return.
- Profitability varies by industry, strategy, and leverage levels.
Market Value Measures
What is the Price-to-Earnings (P/E) Ratio, and what does it measure?
- Can also be calculated as Market Capitalization / Net Income.
- Measures how much investors are willing to pay for each € of earnings.
- High P/E Ratio: May indicate high growth expectations but can be misleading if earnings are low.
Market Value Measures
What is the Price-to-Sales Ratio, and when is it useful?
- Useful for evaluating start-ups or companies with negative earnings, where P/E is not meaningful.
- Helps assess valuation based on revenue rather than profitability.
Market Value Measures
What is Earnings Per Share (EPS), and what does it indicate?
Indicates how much profit is earned per outstanding share.
Market Value Measures
What is the Market-to-Book Ratio, and what does it indicate?
- Measures how the market values a firm’s equity relative to its accounting value.
- Low ratio: May indicate an undervalued “value stock”.
- High ratio: Suggests a “growth stock”.
Market Value Measures
What is Tobin’s Q Ratio, and what does it measure?
- Compares a company’s market valuation to the cost of replacing its assets.
- Ratio above 1: The company is valued above the cost of its assets, implying strong market confidence.
Market Value Measures
What is Enterprise Value (EV), and why is it important?
- Represents the total cost to acquire a company, including both equity and debt.
- Important for evaluating takeover targets and determining true company valuation.
What are the two key approaches to benchmarking in financial analysis?
- Time Trend Analysis – Examines financial ratios over multiple years to identify trends, improvements, or deteriorations.
- Peer Group Analysis – Compares a company’s financial ratios with similar firms in the same industry using SIC codes.
What are two key considerations in benchmarking for financial analysis?
- Inappropriate Peers – Some firms operate in multiple industries, making direct comparisons difficult. Differences in accounting standards can also distort comparisons.
- Aspirant Analysis – Compares a firm with the best companies in the industry to set goals and identify best practices.
What are two key sources of financial information for benchmarking?
- Financial Websites – Examples include Yahoo! Finance, Reuters, FT.com, ADVFN.com, and Motley Fool.
- Company Accounts – Can be downloaded from official company websites.
