ITP Fall 2014: Financial Statements

September 28, 2014

What are financial statements?

Definition:
A formal record of the financial activities of a business

Remember the SEC?

Primary agency for regulating the securities industry and enforcing
securities law
Insider trading, fraud (Madoff) etc.
Financial Reporting

Financial Reporting
U.S. GAAP
Generally Accepted Accounting Principles
The rules that all companies must follow

SEC Reporting
Public companies are required to disclose their financial statements
Most common: Form 10-K and Form 10-Q
EDGAR Database

Accounting
Definition:
The process of communicating financial information about a business to
shareholders, investors, managers etc., generally through the use of
financial statements

Financial Auditing:
The verification, by accountants, of the financial statements of a company.
Designed to provide a reasonable assure that the financial statements are
presented fairly in all material respects

The Big Four Accounting Firms

PricewaterhouseCoopers
Deloitte Touche Tohmatsu
Ernst & Young
KPMG

SEC Form 10-K

The Three Statements

Balance Sheet
A snapshot at a moment in time
What the company owns (assets)
What the company owes to others (liabilities)
What remains accrues to owners (equity)

Income Statement
A report of flows
How much money the company brings in (revenues)
How much it costs to bring that money in (expenses)
How much money is left over (profit)

Statement of Cash Flows

A report of flows
What cash has come in or out, and for what purposes

Balance Sheet
Assets = Liabilities + Shareholders Equity
Assets:
A resource with economic value that an individual, corporation, or country
owns or controls with the expectation that it will provide future benefit

Liabilities:
A companys legal debts or obligations that arise during the course of
business operations. Liabilities are settled over time through the transfer of
economic benefits including money, goods, or services

Shareholders Equity:
A firms total assets minus its total liabilities; the money left over to the
owners of a company

Examples
Assets:

Cash
Buildings
Inventory
Accounts Receivable

Liabilities:

Debt
Accounts Payable
Rent Payable
Salary Payable

10

Balance Sheet
Assets

Liabilities & Equity

($mm)

2012

($mm)

2012

Cash & Equivalents

Accounts Receivable
Inventory
Other Current Assets
TOTAL CURRENT ASSETS

250.4
183.2
59.0
14.1
506.7

Accounts Payable
Short Term Debt
Accrued Interest Payable
Other Current Liabilities
TOTAL CURRENT LIABILITIES

147.5
33.0
12.9
88.8
282.2

PP&E
Other Long Term Assets
TOTAL LONG TERM ASSETS

934.6
25.0
959.6

Long Term Debt

Other Long Term Liabilities
TOTAL LONG TERM LIABILITIES

766.6
14.3
780.9

TOTAL ASSETS

1,466.3

TOTAL LIABILITIES

1063.1

Stockholder's Equity

403.2

TOTAL LIABILITIES & EQUITY

1,466.3

11

Balance Sheet
Assets:
The Asset side of the balance sheet reflects the operations of the firm
Note the distinction between current assets (some of which can be
liquidated immediately) and longer-term, fixed, and intangible assets. Why
is this distinction important?

Liabilities:
Liabilities and equity reflect the financing aspect of the firm
What type of financial instrument might be included in long-term debt?
Note that these are book values, and may not equal the firms market value

12

Balance Sheet
Its usefulness:
Gives us information about the liquidity of the company
Tells us how asset intensive a company is or how many assets (buildings,
machines, equipment) are necessary
Tells us about the ability of a company to meet its long-term fixed expenses
and to accomplish long-term growth

Its limitations:
Assets are recorded at historical cost rather than at market value
What you paid, not what it is worth or the price at which you could sell the asset

Resources such as employee skills and firm reputation are NOT recorded

13

Income Statement
A financial statement that measures a companys financial
performance over a specific accounting period
Financial performance is assessed by giving a summary of how the
business incurs its revenues and expenses through both operating and
non-operating activities. It also shows the net profit or loss incurred
over a specific accounting period, typically over a fiscal quarter or year

14

Income Statement
Its usefulness:
Summarizes sales and profits and losses (P&L) over a period of time
Lets us look at changes in key line items and ratios across time to see
whether operations have been changing and in what direction

Its limitations:
Difficult to compare some ratios for companies in different industries
Management teams have lots of options for accounting practices within the
income statement
Revenues reported dont always equal cash collected, and expenses
reported dont always equal cash paid, so net income is not the same as
cash flow for the period

15

Income Statement and Simple Cash Flow Calculation

Income Statement

Cash Flow Reconciliation

($mm)

2012

($mm)

Revenues
COGS
Gross Profit
SG&A Expense
EBITDA
D&A
EBIT
Interest Expense
Pre-Tax Income
Taxes
NET INCOME

938.5
334.0
604.5
234.4
370.1
25.0
345.1
6.9
338.2
118.4
219.8

NET INCOME
D&A
in Working Capital
CapEx
FCF

2012
219.8
25.0
(16.3)
(45.8)
182.7

16

Statement of Cash Flows

Provides aggregate data regarding all cash inflows a company receives
from both its ongoing operations and external investment sources, as
well as all cash outflows that pay for business activities and
investments during a given quarter or year
Note:
Differences between income and cash

17

Statement of Cash Flows

Operating:
Cash from what the company actually does
Sell widgets

Financing:
Cash brought in from financing sources
Take out a loan

Investing:
Cash from investments
Store excess cash in U.S. Treasury bonds

18

Statement of Cash Flows

Free cash flow is what a company has left over at the end of the year or
the quarter after paying all of its employees salaries, its bills, its
interest on its debt, and its taxes, and after making capital expenditures
to expand the business
Investors often refer to this as the cash that the company is
producing. The company can then decide what to do with the cash
(expand, pay down debt, pay a dividend etc.)

19

Statement of Cash Flows

Statement of Cash Flows
($mm)

2012

Operating Activities
Cash recevied from customers
Cash paid to suppliers
Interest Paid
Taxes Paid

721.9
324.1
(6.9)
(118.4)

Net Cash from Operating Activities

920.7

Investing Activities
Proceeds from sale of building
Returns on Treasury investments

120.5
43.7

Net Cash from Operating Activities

164.2

Financing Activities
Dividends paid
Loan from bank
Net Cash from Operating Activities

(100.0)
200.0
100.0
20

Attendance

21

Attendance Quiz URL

http://tinyurl.com/rForrestr

Which is the most important?

Classic interview questions:
If you could only have access to one of the three statements, which would
it be and why?
If you could only have access to two of the three statements, which ones
would they be and why?
Walk me through how a 10 dollar rise in depreciation flows through the
three financial statements.

23

Why do we care about accounting and financial statements?

Complete diagnostic of a company
Warren Buffet looks at the same statements we do

Foundation of fundamental research

Source for vast majority of valuation inputs
Historical data

24

Want to learn more?

Econ 174: Financial Accounting
Professor C.J. Skender
Learn how the three statements work and fit together

25

Unofficial Homework
Go look up any companys 10-K on the SEC EDGAR database or the
companys Investor Relations website
Example: Microsoft (MSFT)
http://www.microsoft.com/investor/SEC/default.aspx
http://www.sec.gov/Archives/edgar/data/789019/000119312513310206/d
527745d10k.htm

26