Introduction to Financial Reporting & Analysis
These notes were taken at Rice University in a Management program held in May 2011, that was conducted by Dr Karen Nelson, PHD.
· US Security and Exchange Commission - SEC ( www.sec.gov )
The congress delegated to the SEC the control of the Accounting Standards. They make the Auditing Standards. They look for problems in the financial statements (Fraud, Inside trading, etc…)
Companies Information: http://www.sec.gov/edgar.shtml (Filings & Forms)
Publicly traded Companies have to follow the SEC
There is one US FASB
· For International Companies:
IASB - International Accounting Standard Board (www.iasb.org )
IFRS – International Financial Reporting Standard
In the US they can use LIFO (Last In First Out) Inventory system. (You use the highest cost as expense.) All energy Co use this method to Lower tax. Tech Companies all use FIFO, as prices in technology are expected to go Down!
IFRS: Does NOT allow to use LIFO. You must use FIFO (First In / First Out )
Wal-Mart Annual report:
1) Letter to the shareholders: Its like a holiday card, positively focused.
Read Waren Buffet Letter to shareholders. They are DIFFERENT. Very detailed. You can see them in the Internet.
2) MD&A (Management Discussion and Analysis – Managers’ view) will narrate in the Managers words and points of views, the Financial Statements, very useful for the non financial people. Read it with Ecepticism!. Read the SUMMARY OF CRITICAL ACCOUNTING POLICIES.
3) Financial Statements
4) Auditors Report: Guideline on how to read the financial information.
If a company switches an accounting Method (ie LIFO to FIFO), they do not need to re-state their financial statements. You only re-state the accounting statements when there was something WRONG (Fraud, …)
Forms:
· 10K : End of the Year (annual Filing)
· 10Q: Quarterly Filling
· 8K: Every time you have an event (Buy/Sell company, change auditors)
· Form 4: Insider trader (Top executives) Must report within two days of the transaction.
Voluntary Disclosures:
· Corporate Press Releases
· Management Forecast (Usually done at companies, when the analysts expect a higher / better results than what the company is expecting)
· Conference Call (If you do it in once, then the market expects you do it again, if not, people get paranoid!)
Accounting Equation:
Assets: (ordered based on the liquidity)
· Cash
· Account Receivables: In the balance is shown only the Account Receivables that I expect to collect. There is a Provision of bad Debts. In a recession, the BAD DEBT can not go down! You have to sniff the balances
· Inventory: Should not reflect damaged inventory, or obsolete… Only Inventory that can be sold
· Property, Plants & Equipment (PP&E)
Liabilities:
· Account payables
· Long term debt
Equity:
· Owners (shareholders) residual interest (Residual is what is left after paying liabilities)
Contributed Capital + Retained Earnings!
How much the company is worth?
Total Assets? Wal-mart: 163.429 Million
Total Equity? Wal-mart: 65.285 Millions (Books) ***
Market Value is Nr. Shares x Today’s value!
Market to book ratio; 165 / 65 = 2,5
The higher Off Books (out of balance) the higher the Market to Book ratio:
Technology, Pharmaceuticals (High R&D, Brands, Patents, leases…) High Ratio
Agriculture, Utilities: Low Ratio
Goodwill is the last, the most intangible!. Goodwill are the things that I could not identify and separate when I buy a company (I identify patents, inventory…). Goodwill is a “squishy” asset. It’s a “Synergy” thing!
Other causes of Book Value being different of Market value:
o Historical Costs is used for most items. In the US you do not increase the value. Things are valued at OLD costs. (Ie. Buying a property is reflected at historical costs)
o Fair value (market Value) is used for financial Instruments
Leases in the US do NOT need to be reflected in the balance. You can decide if you want a lease to be OFF BALANCE! Continental Airlines has all their fleet in leases not reflected in the balance. They have it as a note.
In US: You must put the capital leases in a balance. Are you using the leased asset for 75% if their life. If YES is Capital lease, if shorter (74,99% is done by many companies), they have it as operational leases. It has a Huge impact in the balance (Higher liabilities => Riskier company)
Ratios:
Useful to benchmark against previous years & Competitors!
Liquidity:
· Current Ratio = Current Assets / Current Liabilities
A high current ratio could be BAD: Too many account receivables or too much inventory!!
· Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Solvency:
Debt to Equity: Debt / Equity
Long Term Debt: Long Term Debt / (Long Term Debt + Equity)
Wal-Mart
| Ac | 48949 | 0,883715472 |
| PC | 55390 | |
| | | |
| | | |
| Quick | 11180 | 0,201841488 |
| | 55390 | |
| | | |
| Debt | 98144 | 1,503316229 |
| equity | 65285 | |
| | | |
| Long Term Debt (Does NOT incluye Minorities interest or Differed Income) | 34.549 | 0,386064467 |
| LTD + E | 99834 | |
| | | |
| Capital Structure | 98144 | 60% |
| | 163429 | |
Retailers end on January 31st. Because on December is their strongest month. Q4 ending on Jan 31 is their strongest quarter. They want to concentrate on sales! Then on January you have many returns. So it makes sense to pick Jan 31st.
Biggest Assets: Property & Inventory.
Most of Wal-Mart Inventory is owned by their supplier!
WalMart D/E = 1,5.
Mirage Resorts and Casinos has 18 Debt/Equity Ratio
Relationship between Balance Sheet and Income statement:
Shareholders Equity = Contributed Capital + Retained Earnings (Beginning) + Net Income (Income Statement) – Dividends
NET INCOME = Change in Sockholders Equity = Change on Assets – Change in Liabilities
Sell Inventory
Up Cash - Revenue (Increase in Stockholder Equity)
Down Inventory – Expense (Decrease in Stockholder Equity)
Land DOES NOT get depreciated. You leave it at your book at historical cost. You realize the utility at the moment you sell it. CONSTUCTION IN PROGRESS is NOT depreciated!
The Income Statement “links” two periods of the Balance Sheet! Initial and ending Balance.
In accounting you reflect the losses NOW. If there is a oil exploration project, and at the end is not viable, you need to take it out of Assets (Property…) and put it on expenses reflecting the loose.
Net Income = Revenues – Expenses + Gains – Losses
Gains and Losses are occasional (ie: Sale of a production machine)
Accruals (accumulation of something) let us bridge a transaction, registering in our accounting at the moment it happens, but also clarifying when is paid: Salaries 14.000 $, but paying 13.000 now and 1.000 in the next period.
· The balance has to reflect EPS (Earnings per Shares)
· Diluted Earnings per Share: Is Worst Case Scenario (If all share that could become common stock, would all converted to common stock). Example: There might be debt, stock options or preferred stock, that are convertible to common stock.
In Walmart: EPS = 3,36, Diluted EPS = 3,35
Profitability:
Gross Margin: S-C/S (S = Sales)
Net Margin: NI/Sales
Return on Investment:
· ROA = Net Income (NI) / Net ASSETS
· ROE = NI / Net Equity
We use NET Assets or Equity, as we are analyzing a period, not a moment.
Rules of tax returns (IRS) not similar to (GAAP) Pretax Income. These diference of differed taxes are to stimulate the economy!
Walmart:
Effective Tax = 34,19% = Income Tax Expense 7,145 / Pretax Income 20,898 (From Income Statement)
The important question is What is your effective Tax Rate.
Liquidity:
It has to be evaluated more than only from the Balance Sheet!
Operating Cycle:
· Aquiring Raw Materials, Plant..
· Period of Production
· Sales
· Period Holding Receivables
· Collecting Cash
Operating Cycle:
Days Of Inventory + Days AR (Account Receivables)
· Inventory Turnover= Cost Of Goods Sold COGS / Average Inventory
· Account Receivables Turnover= Net Credit Sales / Average Net Account Receivables
Days Inventory = 365 / Inventory Turnover
Days AR = 365 / AR Turnover
Net Trade Cycle (Cash to cash cycle)
= Days Inventory held + Days AR Oustanding – Days AP Oustanding
Account Pay Turnover = Purchases / A.Payable (Compras / CxP)
Days Acc Pay Outsanding = 365 / AP Turnover
Wallmart:
Operating Cycle:
Days Inventory: 41,5
Days A/R 3,4 (Credit Cards)
Operating Cycle: 44,9 days!
Days A/P 35,4 days (It take wallmart 35 days to pay suppliers)
Net trade cycle: 9,4 days (They need 10 days of financing! Cash in hand before paying suppliers)
Amazon:
Inventory: 31,8 days
AR 14,6 days
Operating Cycle: 46,4
AP 77,2 payment terms (It takes 77 days to pay partners)
Net Trade Cicle: (30,8 days They are staying with the cash for 30 days! )
Revenue is recorded when:
1) It has been earned (Delivery of goods or services have been rendered). Example Magazines do not realize the revenues at the moment of the subscription payment. They recognize month by month when delivering each magazine. They classify this as “Differed revenue”
2) Payment is realized or realizable (you have an invoice)
3) Price is fixed
4) Collection is reasonably assured
Expense recognition:
1) Match costs with benefits. By using accrued accounting its easy to accomplish this. Prepaid rent.
2) Product costs
3) Period costs. Selling, General & Administrative Costs (SG&A).
Maintenance vs Improvement: Maintenance is expense. Improvement is capitalized.
Common-Sized Income Statement: Everything reflected as a percentage of sales!
| | | | | | | | |
| Wallmart | | 2009 | | 2008 | | 2007 | |
| | | | | | | | |
| Sales | | 401.244,00 | | 374.307,00 | | 344.759,00 | |
| Sales Increase | 7,20% | | 8,57% | | | | |
| | | | | | | | |
| Cost of Sales | -306.158,00 | | -286.350,00 | | -263.979,00 | | |
| Cost Increase | 6,92% | | 8,47% | | | | |
| | | | | | | | |
| Gross Profit Margin | 95.086,00 | - | 87.957,00 | - | 80.780,00 | | |
| | | 23,70% | | 23,50% | | 23,43% | |
| | | | | | | | |
| Net Income | | 13.400,00 | | 12.731,00 | | 11.284,00 | |
| | | 3,34% | | 3,40% | | 3,27% | |
| | | | | | | | |
Returns
ROA: 13.400 / (163514+163429)/2 = 8,2 %
ROE : 13400 / (65.285 + 64.608)/2 = 20,6 %
What is the best measure of profitability?
There are some: NI (Net Income), ROE, ROA, Trend analisis.
Statements of Cash Flow
1) CFO - Cash Flow from Operating Activities (Changes in Current Asets and Current Liabilities). In : Collections from customers, dividends received, interest received //out: payment to suppliers, employees, tax payments, Interest payments.
2) CFI - Cash Flow from Investing Activities (In: Sales of Fixed Assets, Sell Investment in Securities, Collections of Notes // Out: Purchase of Fixed Assets (Capital expenditures), Investments, Lending Money. Usually is negative unless you are selling part of your assets…
3) CFF - Cash Flow from Financing Activities: Change in Long term Liabilities and Stockholders equity (In: Issuance of debt and equity securities // out: Share repurchases, debt repayments (principal only), dividend payments (Negative: You are paying back your debt)
Worldcomm (MCI) fraud was based in this statement: They were classifying wrongly to improve the Operating Cashflow.
Direct Method is not frequently used:
Operating, Investing, Financing.
How is usually done in the US? FASB requires companies to use indirect method
A = L + E
Indirect metod of CashFlows!
CFO: Var Current Liab - Var Current Assets + Var Net Income
CFI: - Var Long Term Asset
CFF: + Long Term Liab + Transaction with Owners
CFO = Net Income + Var Current Liabilities – Var Current Assets
Operating Cash Flow vs Net Income
Note: We must add (Adjust) the non- cash expenses: (ie. Depreciation, Amortization (ie Patents) , Stock based compensation, Loss on disposals of property)
Other Measures of Cash Flow:
EBITDA: Earnings Before Interest, Taxes, Depreciation & Amortization (Ignores changes in Working Capital)
Free Cash Flow: GAAP Cash of Operations minus Capital expenditures.
There are variations:
Key Finantial Ratios
ROE = NI / Average Equity
DuPont Analisys:
ROE = (Net Income / Average Assets) x (Aver. Assets / Aver. Equity )
ROE = ROA x ( Assets / Equity )
Assets / Equity = Leverage
Example:
1) No Debt: ROE = ROA
Assets = Equity = 100
2) A = 100 , D = 20 , E = 80
If I% = 10% => Interest = 2
ROA: Si ROA = 10% = ROE
Si ROA < 10% ROE < ROA
Si ROA > 10% ROE > ROA
Dupont:
ROE = NI / Av Equity =
Return on Sales (ROS) x Asset TurnOver x Leverage
ROE = (NI/Sales) x (Sales / Av Assets) x (Av Assets / Av Equity)
In Sears the ROE is similar from Walmart. Comes from Leverage (More than double than Walmart).
Sears: Days Inventory 73 Vs Walmart 47
Days receivables: Sears 315 days vs 3 days Walmart
Earnings Managements:
Investors and Bankers focus on earnings!
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