In the Financial Statement Analysis chapter, we will cover five primary topic areas: Financial statements
are formal records of the financial activities of a business. For a corporation with publicly traded securities, there are three primary financial statements that must be reported quarterly (4 times per year): These financial statements all aim to provide an overview
of a business’s performance and position, either over time, or at a given point in time. They are highly interrelated and must tie together perfectly. For example, in the Statement of Cash Flows, a detailed account of the change in a company’s Cash balances is given. This change must exactly match the change in Cash balances listed on the beginning and ending Balance Sheets for the Company. Similarly, many items in the Income Statement directly reflect changes in Balance
Sheet accounts over time, and must match the changes there. More discussion of this concept can be found at the end of this chapter. Financial statements are issued by companies and reviewed by the Securities & Exchange Commission (SEC). The SEC requires publicly-traded companies to file quarterly and annual results of operations. These are the summarized financial results of the company, and they are the backbone of financial modeling, company profiles and
pitch book presentations. Without financial statements, most valuation work would be difficult or nearly impossible. All publicly-traded companies are required by the SEC to file quarterly and annual reports. Private companies are not required to file financial reports, although some may have to if they have publicly traded debt. Company filings are found on the SEC’s
EDGAR website. Annual reports are filed as 10-Ks with the SEC and must be filed within 60 days of the company’s fiscal year end. 10-Ks
are much more detailed than quarterly reports (10-Qs, discussed below), and contain information such as the company’s Business Overview, Risk Factors, Financial Data (Income Statement, Balance Sheet, and Statement of Cash Flows), Management Discussion & Analysis, and other important disclosures. Quarterly reports are filed as 10-Qs with the SEC and have to be filed within 40 days of the end of the fiscal quarter. 10-Qs are less detailed than annual form 10-Ks but do provide helpful detail around the quarterly Financial Data (Income Statement, Balance Sheet, and Cash Flow), Management Discussion & Analysis, and other Company disclosures. Income StatementThe Income Statement shows how much Revenue (i.e., sales) is being generated by a business, and also accounts for Costs, Expenses, Interest, Taxes and other items. The main purpose of this statement is to show the company’s level of profitability. The Income Statement represents items over a period of time, usually over a quarter (3 months) or a year. This statement is also referred to as the Profit and Loss Statement (P&L). Income Statement: Key Line Items
Calculating Earnings Per Share (EPS)EPS equals Net Income (after dividends on preferred stock) divided by the company’s Weighted Average Shares Outstanding. Shares Outstanding will typically be found either on the Income Statement, below Net Income, or on the first page of the most recent 10-Q or 10-K. It can also be calculated as the average of the number of common shares outstanding at the beginning of the period and end of the period (from the company’s Balance Sheet). EPS is an extremely important metric of a company’s value: it represents the profit generated by the company for each shareholder. It will be used extensively when working through valuation techniques such as Comparable Company Analysis and Precedent Transaction Analysis. Here is an example of an Income Statement, showing all of the discussed line items, from Amazon at the end of 2010 (Ticker AMZN): Balance SheetThe Balance Sheet provides a snapshot of a company’s financial position at the end of a period (either quarterly or annually). The balance sheet lists company Assets, Liabilities, and Shareholders’ Equity as of a specific point in time. An important rule is that the Balance Sheet for a company must balance. In other words: Balance Sheet Golden Rule: Assets = Liabilities + Shareholders’ EquityThis may seem like an obvious statement, but in producing financial models it is easy to make an error wherein the balance sheet does not properly balance, which will lead to serious problems with financial projection. Always make sure your balance sheet balances! As demonstrated above, the difference between Assets and Liabilities is Shareholders’ Equity. In other words, the value of a company’s equity is equal to the value of its assets net of the outstanding obligations it has to other entities. This is, from an accounting (or “book”) perspective, what the value of a company’s shareholders positions “should be.” As we have seen, there are many reasons why a company’s equity will trade at a different valuation in the market than that derived from the Balance Sheet (usually, and hopefully, at a higher valuation than Book Value). From the perspective of a financial analyst, the most important Balance Sheet line items fall into the following categories:
Note that the difference between Current Assets and Current Liabilities is referred to as “Working Capital” or “Net Working Capital,” while the difference between Operating Assets and Operating Liabilities is referred to as “Operating Working Capital.” Working Capital is an important consideration in financial modeling—this is particularly true of Operating Working Capital. This concept will be discussed in further detail later in this training course. Here is an example of a Balance Sheet, showing all of the discussed line items, from Amazon at the end of 2010 (Ticker AMZN): Statement of Cash FlowsThe Statement of Cash Flows, or Cash Flow Statement (CFS), provides an accounting of the Cash being generated by a business, and the uses of that Cash, over a period of time. The CFS shows how Net Income (from the Income Statement) and changes in Balance Sheet items affect a company’s Cash balance. Generally speaking the CFS will provide a clear view of the short-term viability of a business and its ability to pay its debts. If the business is not generating enough Cash from its operations to service its obligations, it should be evident from its CFS. The bottom line, therefore, is that the CFS reflects a company’s liquidity, solvency, and ongoing viability. Three Parts of a Cash Flow StatementAll Cash flows can be broken down into one of the important categories:
The SCF is greatly affected by the change in Balance Sheet line items. When Assets on the Balance Sheet fall, Cash typically rises. For example: if “Accounts Receivable” (an Operating Current Asset on the Balance Sheet) falls, this is because a customer had paid its bill and hence Cash increases. Simultaneously, the Accounts Receivable line item decreases by the same amount. By contrast, when Liabilities and Equity rise, typically so does Cash. For example, if a company issues Debt (a Liability on the Balance Sheet), Cash will rise by the same amount as the value of the loan taken out. Similarly, if a Company repurchases common shares outstanding, Cash will decrease by the same amount as the value of the Equity being retired in the transaction. In summary, Assets are uses of Cash while Liabilities and Equity are sources of Cash. This important concept will come into play directly in building financial models that help determine a company’s value. Here is an example of a Statement of Cash Flows, showing all of the discussed line items, from Amazon at the end of 2010 (Ticker AMZN): How Financial Statements Tie TogetherNow that you are familiar with the three main Financial Statements, we can ascertain how they all tie together. In short, the Financial Statements are interconnected in many places. In particular, practically every line item on the SCF is connected to one of the two other statements. Connected Line Items on the Financial StatementsWhile this list is not exhaustive, it covers most of the basic interconnections across a company’s Financial Statements:
How Does Depreciation Affect the Financial Statements?Depreciation is an especially tricky line item because it affects all three Financial Statements, but is often not broken out directly in the Income Statement even though it is an annual expense. Here is a summary of how Depreciation affects all three Statements (a similar description also applies to Amortization):
←Valuation Techniques OverviewComparable Company Analysis→ Where is amortization on the balance sheet?Presentation of Accumulated Amortization
Accumulated amortization is recorded on the balance sheet as a contra asset account, so it is positioned below the unamortized intangible assets line item; the net amount of intangible assets is listed immediately below it.
How do you calculate depreciation and amortization on financial statements?How do you calculate depreciation and amortization? Calculating amortization and depreciation using the straight-line method is the most straightforward. You can calculate these amounts by dividing the initial cost of the asset by the lifetime of it.
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