FINA5523 - Financial Statement

Analysis & Business Valuation

Week 2
Financial Statements
Objectives for Week 2

You should be able to:

– interpret data in financial statements

– explain the linkages between the four main financial statements

– calculate EBITDA, free cash flow (FCF) and free cash flow to
equity (FCFE), EPS and enterprise value (EV), from financial
statement data
Key Financial Statements

Analysts need to be able to read and understand financial statements

because they hold information useful for inferring fundamental value.

There are four primary financial statements:

• Balance Sheet
• Income Statement
• Cash Flow Statement
• Equity Statement

Financial statements are prepared according to accounting standards.

The two systems of accounting standards are International Financial
Reporting Standards (IFRS) and Australian Accounting Standards
issued by AASB.

AASB adopted IFRS in 2005 – the requirements of AASB Standards

are the same as those of IFRS.
The Balance Sheet

The Balance Sheet (aka Statement of Financial Position) shows what

assets the firm has and how those assets are financed at the end of the
accounting period.

The fundamental balance sheet equation:

Assets = Liabilities + Shareholders’ equity

Liabilities represent the claims of creditors. Shareholders’ equity

represents the shareholders’ residual claim on the firm’s assets.

Assets are classified in decreasing order of liquidity.

Liabilities are classified in increasing order of maturity.

The Balance Sheet:
Nike, Inc., 2010

2-5
Measurement - Balance Sheet

Assets are measured using several different bases:

• Cash – fair value
• Receivables – fair value
• Inventory – lower of cost or market value
• PPE (historical cost less accumulated depreciation)
• Brand assets – not recorded unless ‘acquired’

Absence of market values mean analyst must be careful interpreting

market/book ratios.
Income Statement

The Income Statement (aka Statement of Profit & Loss) reports how
shareholders’ equity increased or decreased during the accounting
period as a result of business activities.

The fundamental Income Statement equation:

Net Income = Revenues − Expenses

The Income Statement ‘groups’ like expenses in reporting components

of net income:
Net Revenue – Cost of Goods Sold = Gross Margin
Gross Margin – Operating Expenses = Operating Income (EBIT)
Operating Income – Interest Expense + Interest Income = Income before Taxes
Income before Taxes – Income Taxes = Income after Taxes and before
Extraordinary Items
Income before Extraordinary Items + Extraordinary Items = Net Income
Net Income – Preferred Dividends = Net Income Available to Common
Measurement – Income Statement

Income Statement is prepared used accrual accounting rather than

cash accounting.

There are two basic principles of accrual accounting:

– Realization principle: a revenue is recorded when the transaction

takes place, not when the cash is received

– Matching principle: an expense associated with a revenue is

recognized along with the revenue, not when paid

What is the benefit of doing so?

What if I don’t do this?
What if that product doesn’t produce any revenue? Can still capitalise the cost of goods?
Good v bad matching

Good matching:
• Cost of buying plant is not expensed at time of purchase but
“capitalized” on the balance sheet and depreciated over years when
the plant produces revenues. Depreciation is a method of matching the
cost of plant to the revenues the plant generates.

Bad matching:
• Research and development expenditures are expensed when
incurred, rather than matched to (subsequent) revenues they generate.
 The Income
Statement:
Nike, Inc., 2010

2-10
Cash Flow Statement

The Cash Flow Statement (aka Statement of Cash Flows) describes

how the firm generated and used cash during the accounting period.

Cash flows are divided into three types:

• Cash flow from operating activities
= NPAT + non-cash charges – increase in working capital
• Cash flow from investing activities
= fixed asset acquisitions – fixed asset sales
• Cash flow from financing activities
= new borrowings + new share issues – loan repayments
– dividends – share repurchases

Change in Cash = Cash flow from operating activities

+ Cash flow from investing activities
+ Cash flow from financing activities
The Cash Flow
Statement :
Nike, Inc., 2010

2-12
Equity Statement

The Equity Statement (aka Statement of Changes in Equity) shows

how equity changes over the period.

Shareholders’ equity is increased by a profit and decreased by the

payment of a dividend or repurchase of shares:
Ending equity = Beginning equity + Comprehensive income
– Net payout to shareholders
Comprehensive income = Net income + Other comprehensive income
Net payout to shareholders = Dividends + Share repurchases – Share issues
Just consider the direction of the cashflow

The practice of reporting income directly via ‘other comprehensive

income’ rather than though the ‘net income’ (ex Income Statement) is
referred to as ‘dirty surplus accounting’.
The Statement of
Shareholders’
Equity:
Nike, Inc., 2010

2-14
Fitting it all together

Beginning stocks Flows Ending stocks

Cash Flow Statement

Cash from operations

Beginning Balance Sheet Cash from investing Ending Balance Sheet

Cash from financing

Cash Net change in cash Cash

+ Other Assets + Other Assets

Statement of Shareholders’ Equity
Total Assets Total Assets
Investment and disinvestment by owners
- Liabilities - Liabilities
Net income and other comprehensive income

Owners’ equity Net change in owners’ equity Owners’ equity

Income Statement

Revenues

Expenses

Net income

2-15
 How Parts of the Financial Statements Fit Together
The Balance Sheet

Assets
− Liabilities
= Shareholders' Equity

The Income Statement

Net Revenue
− Cost of Goods Sold
= Gross Margin
− Operating Expenses
= Operating Income before Taxes (EBIT)
− Net Interest Expense
= Income Before Taxes
− Income Taxes
= Income After Tax and before Extraordinary Items
+ Extraordinary Items
= Net Income
− Preferred Dividends
= Net Income Available to Common

Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash Flow from Operations

+ Cash Flow from Investing
+ Cash Flow from Financing
= Change in Cash

Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income
Statement)
Dividends
Net Income + Share Repurchases
Beginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income ⎯⎯ = Comprehensive Income − Share Issues
− Net Payout to Shareholders ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ = Net Payout
= Ending Equity

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EBIT and EBITDA

EBIT and EBITDA are commonly-used measures of operating profit.

EBIT is defined as Earnings Before Interest and Tax.

EBITDA is defined as Earnings Before Interest, Tax, Depreciation and

Amortization.

EBIT and EBITDA are referred to as unlevered measures of profitability

because they are measured prior to interest payments and are not
affected by the firm’s capital structure.
 Free Cash Flow

Free cash flow (FCF) is a key input into the FCF valuation model.

FCF is a measure of the cash flow available to all suppliers of capital

i.e. lenders and shareholders.

FCF = EBIT(1–tc) + Depreciation & amortisation expense

– WCR – Net capital expenditure

FCF = Cash + Dividend + Net share repurchases

+ INT(1–tc) + Net debt repayments
Cash is the after all expense left in the business, others are cost of equity and debt (dividend, interests payment with tax shield), repayment of equity
and debt,
As free cash flow is cash flow available to all suppliers of capital, it is
not affected by the firm’s capital structure.

EBIT(1 – tc) aka NOPAT or NOPLAT

Free Cash Flow to Equity

Free cash flow to equity (FCFE) is a measure of the cash flow available
to equityholders or shareholders.

FCFE = NPAT + Depreciation & amortisation expense

– WCR – Net capital expenditure – Net debt repayments

FCFE = Cash + Dividend + Net share repurchases

Note that FCFE is affected by the level of interest payments and

changes in the level of debt i.e. it is affected by the firm’s capital
structure.
Earnings per share (EPS)

Earnings per (common) share) is defined as follows:

Net income available to common shareholders

EPS per common share =
Number of common shares

Net income − preferred dividends

=
Number of common shares

Preferred dividends are subtracted from net income before EPS can be
calculated because preferred shareholders have a prior claim on
income of the firm.

Preferred shares is more like a company bond, receiving coupon/dividend, which is different with the expected price change of
shares like common shareholder
Enterprise Value (EV)

Enterprise Value (EV) is defined as follows:

EV = Market value of common equity

+ Market value of preferred equity Net Debt

+ Market value of debt

- Market value of cash & cash equivalents

MV of debt and cash are usually proxied by their book values.

MV of common equity = common stock price x no. of common shares

MV of preferred equity = preferred stock price x no. of preferred shares

Debt is interest-bearing short-term and long-term liabilities.

Debt minus cash is aka ‘Net debt’.

Homework Exercises

Penman
Financial Statement Analysis and Security Valuation
5th Edition

Chapter 1: E1.1, E1.2, E1.5

Chapter 2: E2.1, E2.2, E2.4, E2.7, E2.11, E2.12

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