5/1/23, 10:10 AM Financial Statement Analysis | Street Of Walls

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FINANCIAL STATEMENT ANALYSIS

of Investment Banking Technical Training

In the Financial Statement Analysis chapter, we will cover five primary topic areas:

Financial Statement Overview

Income Statement

Balance Sheet Statement

Cash Flow Statement

How Financial Statements Tie Together

Financial Statement Overview

WHAT ARE FINANCIAL STATEMENTS, WHY ARE THEY IMPORTANT, AND WHY DO FINANCIAL
ANALYSTS USE THEM?

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):

Income Statement: Reports a snapshot of a company’s business performance over a period of

time. This statement indicates how much revenue (sales) is generated by a business, and also

accounts for direct product costs, general expenses, Interest on Debt, Taxes, and other expense

items. The purpose of this statement is to show the company’s level of profitability, which is

equal to a company’s Revenue net of its expenses.

Balance Sheet Statement: Reports a snapshot of a company’s outstanding balances in

various accounts at a specific point in time. The purpose of this statement is to demonstrate a

business’s financial heath at any given time, by enumerating it assets as well as the claims

against them (liabilities and equity).

Statement of Cash Flows: Reports on all of the company’s activities that affect its cash

position over a period of time. These activities are broken down into three primary categories:

Operating, Investing, and Financing. The purpose of this statement is to give a detailed

reconciliation of how the company’s Cash is being used (and how much Cash is being generated).

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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.

LOCATING FINANCIAL STATEMENTS

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.

PRIMARY INFORMATION FOUND IN FINANCIAL STATEMENTS (FORMS 10-K & 10-Q)

Management Discussion & Analysis

Income Statement
Balance Sheet Statement

Statement of Cash Flows

Notes and Exhibits to Financial Statements

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.

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Income Statement

The 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

Revenue represents the sales brought in from selling a product or performing a service.

Cost of Goods Sold (COGS) represents direct costs of producing goods and services that the
business has sold, such as material costs and direct labor.

Selling, General, & Administrative Expense (SG&A) represents expenses associated with
selling products and managing the business. This will include salaries, shipping, insurance,

utilities, rent, compensation for executives, etc.

Depreciation & Amortization (D&A) represents the expenses associated with fixed assets

and intangible assets that have been capitalized on the Balance Sheet. D&A that is directly
related to production will generally be included in COGS and will be separated out on the

Statement of Cash Flows (more on this later).

Net Interest Expense represents the total Interest paid on Debt liabilities, net of the total

Interest received on Cash assets.

Tax Expense represents the amount of taxes paid.

Net Income represents the company’s profit, which is Revenue minus all of the aforementioned
costs and expenses.

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.

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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 Sheet

The 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’ EQUITY

This 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

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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:

Cash (Asset): Money owned by the company. For accounting purposes, Cash generally includes

currency and coins on hand, checking account balances, and undeposited customer checks.
Current Assets: Assets whose value is expected to translate into Cash in the near future
(generally within one year). Cash is a Current Asset. Most Current Assets besides Cash are
classified as “Operating Assets,” or Assets generated by the company as part of the functioning of

its business operations.

Other or Long-term Assets: Assets whose value will not translate into Cash in the near future
(outside of one year). Most Long-term Assets are classified as “Operating Assets,” or Assets
required by the company as part of the functioning of its business operations.

Debt (Liability): An obligation (almost always interest-bearing) that represents borrowed

money that the company must repay. Debt is usually part of Long-Term Liabilities (see below),
although any portion of Debt which must be repaid within the next year will be classified as a
Current Liability.

Current Liabilities: Liabilities that a company must meet (via payment) in the near future
(generally within one year). Most Current Liabilities (other than Debt) are classified as
“Operating Liabilities,” or Liabilities generated by the company as part of the functioning of its
business operations.

Other or Long-term Liabilities: Liabilities that do not need to be met (via payment) in the
near future (outside of one year). Most Long-term Liabilities are classified as Debt, although
some qualify as “Operating Liabilities,” or Liabilities generated by the company as part of the
functioning of its business operations.
Shareholders’ Equity: The difference between Assets and Liabilities. This represents the

value of the company’s assets after all outstanding obligations have been paid off. This value
accrues directly to the company’s owners, or Shareholders.

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.

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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 Flows

The 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 STATEMENT

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All Cash flows can be broken down into one of the important categories:

Operating Activities: The Cash generated/used by a company’s business operations. This

includes earnings delivered by the company as well as payments collected from its customers. In
its simplest form, Cash Flow from Operating Activities (CFO) will equal Net Income +
Depreciation & Amortization – changes in Operating Working Capital.
Investing Activities: The cash generated/used by a company’s investment in assets. Cash Flow

from Investing Activities (CFI) includes the purchases of Fixed (long-term) Assets and
maintenance of those Assets (Capital Expenditures), payments made for M&A activities (usually
acquisitions of other companies), or Cash generated by Marketable Securities or other non-
operating uses of Cash.
Financing Activities: The Cash generated/used by a company’s financing of its operations.
Cash Flow from Financing Activities (CFF) includes the Cash inflows from shareholders and
lenders as well as the outflows of dividends or sales of stock. Items found in this line item will
include: Dividends Paid, Cash raised via the sale of Common Stock, Cash proceeds from

Borrowings (Debt), and repayment of Debt obligations.

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):

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How Financial Statements Tie Together

Now 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 STATEMENTS

While this list is not exhaustive, it covers most of the basic interconnections across a company’s
Financial Statements:

Income Statement:
Depreciation: Fixed Long-term Assets (Balance Sheet) are depreciated over a period of
time; this is expensed on the Income Statement.

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Amortization: Some other Long-term Assets (Balance Sheet) are amortized (similar to
being depreciated) over a period of time; this is expensed on the Income Statement.

Balance Sheet:
Cash: Ending Cash on the Cash Flow Statement flows into Cash within Current Assets on
the Balance Sheet.
Shareholder’s Equity: Net Income (Earnings from the Income Statement) after
Dividends Paid flow into Retained Earnings in Shareholder’s Equity.

Cash Flow Statement:

Beginning Cash: This is equal to the previous period’s ending Cash balance on the
Company’s Balance Sheet.
Net Income (CFO): Equals Net Income found on the Income Statement.
Depreciation (CFO): Depreciation is a (generally unlisted) component of COGS and
other expense items found on the Income Statement; it is added back because it is a non-
Cash expense. In other words, the company did not actually spend the money being
represented by Depreciation during the period—that Cash expense was recorded as a

Capital Expenditure in a prior period. That value is allocated over a long time horizon, and
Depreciation in any given year represents that year’s ascribed value of the Assets being
used.
Amortization (CFO): Amortization is a (generally unlisted) component of COGS and
other expense items found on the Income Statement; like Depreciation, it is added back
because it is a non-Cash expense. The Cash was generally spent in a prior period, usually
as part of an acquisition.
Capital Expenditures (CFI): This is money spent on Long-term (Fixed) Assets on the

Balance Sheet. The change in these Assets should equal Capital Expenditures minus the
year’s Depreciation on these Assets.
Repayments of and Proceeds from Long-term Debt (CFF): This is money raised
from, or used to repay, Long-term Debt obligations (Liabilities) on the Balance Sheet.
(Note that mandatory Debt repayments coming due in the near future are moved from
Long-Term Liabilities to Current Liabilities on the Balance Sheet as their repayment dates
draw near.)
Ending Cash: This is equal to the current period’s ending Cash balance on the
Company’s Balance Sheet.

HOW DOES DEPRECIATION AFFECT THE FINANCIAL STATEMENTS?

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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):

Income Statement: Depreciation is an expense on the Income Statement (often buried inside
displayed line items such as COGS). Increasing Depreciation will increase expenses, thereby
decreasing Net Income.
Cash Flow Statement: Because Depreciation is incorporated into Net Income, it must be
added back in the SCF, because it is a non-cash expense and therefore does not decrease Cash
when it is expensed.
Balance Sheet: Net Fixed Assets (generally Plant, Property, and Equipment) is reduced by the
amount of the Depreciation. This reduces Fixed Assets. It also reduces Net Income and therefore
Retained Earnings (Shareholders’ Equity) as well. As discussed previously, Depreciation is a

non-Cash expense. Therefore, increases or decreases to Depreciation will not impact Cash
directly.

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