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Chapter 2: Introduction to Financial Statement Analysis

Firms’ Disclosure of Financial Information

Financial Statements: Periodic reports (quarterly, annual) that present a company’s past financial performance and its current financial position.

Users: Investors, creditors, analysts, and managers use financial statements for decision-making.

Regulatory Requirement:

  • Public companies in Canada must file their reports with provincial securities regulators.
  • They must send annual reports to shareholders.

GAAP (Generally Accepted Accounting Principles):

  • Common set of accounting rules and formats for preparing financial statements.
  • Ensures consistency and comparability across companies.
  • Requires firms to hire an independent auditor.

Auditor: Independent entity that verifies financial statements are prepared according to GAAP and are reliable.

IFRS (International Financial Reporting Standards):

  • A global accounting framework, mandatory in Canada since Jan 1, 2011 for public companies.
  • Focuses on fair value accounting, unlike US GAAP which relies more on historical cost.

The Statement of Financial Position (Balance Sheet)

Purpose: Reports the firm’s financial position at a specific point in time, showing what it owns and owes.

Balance Sheet Identity

Assets = Liabilities + Shareholders' Equity

Key Components

Assets

  • Current Assets: Cash, accounts receivable, inventory, marketable securities (expected to be used within 1 year).
  • Long-Term Assets: Equipment, property, intangible assets (expected to provide benefit for more than 1 year).
    • Depreciated over time.
    • Book value of an asset = Purchase price − accumulated depreciation.

Depreciation is the process of allocating the cost of a tangible asset over its useful life.

Liabilities

  • Current Liabilities: Accounts payable, short-term debt, accrued expenses (due within 1 year).
  • Long-Term Liabilities: Long-term debt, obligations due after 1 year.

Shareholders’ Equity

  • Book Value of Equity = Assets − Liabilities.
  • Represents owners' residual claim on assets after debts are paid.

Net Working Capital

Net Working Capital = Current Assets − Current Liabilities

Measures liquidity or short-term financial health.

Market Capitalization

Market Capitalization = Share Price × Number of Shares Outstanding
  • Book value of equity ≠ true (market) value of the firm.
  • It reflects past costs, not future potential.
  • But in a worst-case scenario (liquidation), it can give a rough sense of what might be left for shareholders after debts are paid.

Market-to-Book Ratio

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

  • 1 → firm is valued more highly by the market than its book value (growth firms).

  • <1 → may indicate undervaluation or weak performance (value firms).

Enterprise Value

Enterprise Value = Market Value of Equity + Debt − Cash
  • Measures the value of a firm’s core business operations.
  • Excludes excess cash and includes debt obligations.

Liquidation Value: Estimate of what shareholders would receive if all assets were sold and liabilities paid — may differ from book equity because assets are valued at market/fire-sale prices.

The Income Statement

Purpose: Measures a firm’s financial performance over a period (quarter/year).

Income Statement Flow

Revenues
− Cost of Sales = Gross Profit
− Operating Expenses = Operating Income
+/- Other Income = EBIT (Earnings Before Interest & Taxes)
+/- Interest = Pretax Income
− Taxes = Net Income
  • Gross Profit: Sales minus direct costs of goods sold.
  • Operating Income: Profit from core business activities.
  • EBIT: Includes non-operating gains/losses.
  • Net Income: Final profit after all expenses — represents profitability.

Earnings per Share (EPS)

EPS = Net Income / Shares Outstanding

Diluted EPS: Adjusted for potential shares (options, convertibles).

Stock Option: Right to buy a firm’s stock at a predetermined price.

Convertible Bond: Bond that can be converted into a fixed number of company shares.

The Statement of Cash Flows

Purpose: Shows actual cash inflows and outflows, categorized into:

  1. Operating Activities: From core business (e.g., net income adjusted for working capital changes).
    • Increase in A/R (accounts receivable) → subtract
    • Increase in A/P (account payable) → add
    • Increase in inventory → subtract
    • Depreciation → add back (non-cash expense)
  2. Investing Activities: Purchase/sale of assets (e.g., equipment, investments). —> subtract
  3. Financing Activities: Issuing stock, repurchasing shares, paying dividends, borrowing.

Key Formulas

Payout Ratio = Dividends / Net Income
Retained Earnings = Net Income - Dividends

Payout Ratio: shows how much profit is paid to shareholders as dividends.

High payout → company returns more to shareholders, less reinvestment.

Low payout → company keeps more to grow (R&D, expansion).

Retained Earnings: The total profits kept in the company over time (not paid out).

Other Financial Statement Information

  • Statement of Shareholders' Equity: Breaks equity into new share capital and retained earnings.
  • Management Discussion and Analysis (MD&A): Management’s narrative of company performance, strategy, and risks. Must disclose off-balance sheet transactions (e.g., leasing, guarantees).
  • Notes to Financial Statements: Provide details on accounting policies and additional breakdowns of line items.

Financial Statement Analysis

Profitability Ratios

Gross Margin = Gross Profit / Sales
Operating Margin = Operating Income / Sales
Net Profit Margin = Net Income / Sales

Liquidity Ratios

Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets − Inventory) / Current Liabilities

Current Ratio

1 → Company has more current assets than current liabilities → liquid

< 1 → May struggle to cover short-term obligations → risk of liquidity issues

Quick Ratio: More conservative than current ratio—excludes inventory (which is harder to turn into cash quickly)

< 1.0 → May not meet obligations quickly

1.0 – 1.5 → Reasonably healthy

1.5 → Very liquid, possibly under-leveraged

Efficiency Ratios

Asset Turnover = Sales / Total Assets
Fixed Asset Turnover = Sales / Fixed Assets
Accounts Receivable Days = Accounts Receivable / Average Daily Sales
Inventory Turnover = Cost of Goods Sold / Inventory

Asset Turnover: measures how efficiently a company uses its assets to generate sales.

A higher ratio means the company is using its assets more efficiently to generate revenue.

A lower ratio suggests inefficiency or underutilized assets.

Asset Turnover includes assets that are not directly involved in generating sales.

Accounts Receivable Days: how long it takes, on average, for a company to collect payment after a sale.

Lower AR Days = Customers are paying quickly → better cash flow

Higher AR Days = Customers take longer to pay → potential cash flow or credit control issues

Inventory Turnover

Higher turnover = selling inventory quickly → efficient

Higher inventory days = slower movement, potential cash tied up

Interest Coverage

Times Interest Earned = EBIT(or EBITDA, Operating Income) / Interest Expense

When this ratio is high, it indicates that the firm is earning much more than is necessary to meet its required interest payments.

Leverage Ratios

Debt-to-Equity = Total Debt / Total Equity
Debt-to-Capital = Total Debt / (Total Debt + Total Equity)
Net Debt = Total Debt − Cash and Short-Term Investments
Debt-to-Enterprise Value = Net Debt / (Net Debt + Market Equity) = Net Debt / Enterprise Value
Equity Multiplier = Total Assets / Book Value of Equity

Debt-to-Equity Ratio

High ratio → greater return potential, but higher bankruptcy risk.

Low ratio → financially stable, but possibly slower growth.

Debt-to-Capital: measures the proportion of a company’s total capital (debt + equity) that comes from debt financing.

Higher ratio → more reliance on debt → higher financial risk.

Lower ratio → more reliance on equity → lower risk, more flexibility.

Debt-to-Enterprise: measures how much of a company’s total value is financed through debt.

Higher ratio = More of the company’s total value is funded by debt → more leverage, higher risk

Lower ratio = More of the value is funded by equity or the company holds a lot of cash → lower financial risk

Equity Multiplier: shows how much of a company’s assets are financed by equity versus debt

Higher multiplier = more leverage (company is using more debt relative to equity)

Lower multiplier = company is relying more on equity, less on debt

Valuation Ratios

P/E Ratio = Share Price / EPS = Market Cap / Net Income
PEG Ratio = P/E Ratio / Earnings Growth Rate

P/E ratio measures how much investors are willing to pay per dollar of earnings

High P/E → investors expect high future growth

Low P/E → company may be undervalued or have slow/no growth

The higher the PEG ratio, the higher the price relative to growth, so some investors avoid companies with PEG ratios over 1

Return Ratios

Return on Equity (ROE) = Net Income / Book Value of Equity
Return on Assets (ROA) = Net Income / Total Assets
Return on Invested Capital (ROIC) = EBIT × (1 − Tax Rate) / (Book Equity + Net Debt)

Return on Equity: measures how effectively a company is using shareholders’ equity to generate net profit

higher means for strong return, but may be due to high debt (small equity base)

Return on Assets: measures how efficiently a company uses all its assets to generate net income

Higher ROA → better efficiency in using assets to generate profit

Lower ROA → less efficient, or possibly asset-heavy (e.g., manufacturing, utilities)

DuPont Identity

ROE = (Net Income / Sales) × (Sales / Assets) × (Assets / Equity) = Profit Margin × Asset Turnover × Equity Multiplier

Financial Reporting in Practice

Sarbanes-Oxley Act (SOX):

  • US law passed in 2002 after Enron/WorldCom scandals.
  • CEOs and CFOs must certify financial statements.
  • Increases penalties for misreporting and mandates auditor independence.

Key Definitions for Exam

  • Book Value of Equity: Accounting value of shareholders’ claim.
  • Market Capitalization: Market value of equity = price × shares.
  • Enterprise Value: Total value of business assets excluding cash.
  • EBIT: Earnings before interest and taxes.
  • EPS: Net income per share.
  • Liquidation Value: Estimated cash after assets sold and liabilities paid.
  • Off-Balance Sheet Transaction: Financial commitment not shown on balance sheet (e.g., lease guarantees).
  • Diluted EPS: EPS if all options/convertibles exercised.