M02 Berk6104037 02 CF C02

Chapter 2
Introduction
to Financial
Statement
Analysis
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter Outline
2.1 Firms’ Disclosure of Financial Information
2.2 The Balance Sheet
2.3 Balance Sheet Analysis
2.4 The Income Statement
2.5 Income Statement Analysis
2.6 The Statement of Cash Flows
2.7 Other Financial Statement Information
2.8 Financial Reporting in Practice
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Learning Objectives
1. List the four major financial statements required by the SEC for
publicly traded firms, define each of the four statements, and
explain why each of these financial statements is valuable.
2. Discuss the difference between book value of stockholders’ equity
and market value of stockholders’ equity; explain why the two
numbers are almost never the same.
3. Compute the following measures, and describe their usefulness in
assessing firm performance: the debt-equity ratio, the enterprise
value, earnings per share, operating margin, net profit margin,
accounts receivable days, accounts payable days, inventory days,
interest coverage ratio, return on equity, return on assets, price-
earnings ratio, and market-to-book ratio.
4. Discuss the uses of the DuPont identity in disaggregating ROE,
and assess the impact of increases and decreases in the
components of the identity on ROE.

Learning Objectives
5. Describe the importance of ensuring that valuation ratios are

consistent with one another in terms of the inclusion of debt in
the numerator and the denominator.
6. Distinguish between cash flow, as reported on the statement of
cash flows, and accrual-based income, as reported on the income
statement; discuss the importance of cash flows to investors,
relative to accrual-based income.
7. Explain what is included in the management discussion and
analysis section of the financial statements that cannot be found
elsewhere in the financial statements.
8. Explain the importance of the notes to the financial statements.
9. List and describe the financial scandals described in the text,
along with the new legislation designed to reduce that type of
fraud.

2.1 Disclosure of Financial
Information
• Financial Statements
– Firm-issued accounting reports with past
performance information
– Filed with the SEC
• 10Q
– Quarterly
• 10K
– Annual
– Must also send an annual report with financial
statements to shareholders

Information (cont'd)
• Preparation of Financial Statements
– Generally Accepted Accounting Principles
(GAAP)
– Auditor
• Neutral third party that checks a firm’s financial
statements

Information (cont'd)
• Types of Financial Statements
– Balance Sheet
– Income Statement
– Statement of Cash Flows
– Statement of Stockholders’ Equity

2.2 Balance Sheet
• A snapshot in time of the firm’s financial

position
• The Balance Sheet Identity:
Assets  Liabilities  Stockholders' Equity

2.2 Balance Sheet (cont'd)
• Assets
– What the company owns
• Liabilities
– What the company owes
• Stockholder’s Equity
– The difference between the value of the firm’s
assets and liabilities

• Assets
– Current Assets: Cash or expected to be turned
into cash in the next year
• Cash
• Marketable Securities
• Accounts Receivable
• Inventories
• Other Current Assets
– Example: Pre-paid expenses

• Assets
– Long-Term Assets
• Net Property, Plant, & Equipment
– Book Value = Acquisition cost
– Depreciation (and Accumulated Depreciation)
• Goodwill and intangible assets
– Amortization
• Other Long-Term Assets
– Example: Investments in Long-term Securities

Table 2.1 Global Conglomerate Corporation
Balance Sheet for 2009 and 2008

• Liabilities
– Current Liabilities: Due to be paid within the
next year
• Accounts Payable
• Short-Term Debt/Notes Payable
• Current Maturities of Long-Term Debt
• Other Current Liabilities
– Taxes Payable
– Wages Payable

• Net Working Capital

– Current Assets – Current Liabilities

• Liabilities
– Long-Term Liabilities
• Long-Term Debt
• Capital Leases
• Deferred Taxes

Table 2.1 (cont'd) Global Conglomerate
Corporation Balance Sheet for 2009 and 2008

• Equity
– Book Value of Equity
• Book Value of Assets – Book Value of Liabilities
– Could possibly be negative
– Market Value of Equity (Market Capitalization)

• Market Price per Share x Number of Shares
Outstanding
– Cannot be negative

Textbook Example 2.1

Textbook Example 2.1 (cont'd)

Alternative Example 2.1
• Problem
– Rylan Enterprises has 5 million shares
outstanding.
– The market price per share is $22.
– The firm’s book value of equity is $50 million.
– What is Rylan’s market capitalization?
– How does the market capitalization
compare to Rylan’s book value of equity?

• Solution
– Rylan’s market capitalization is $110 million
• 5 million shares × $22 share = $110 million.
• The market capitalization is significantly higher than
Rylan’s book value of equity of $50 million.

2.3 Balance Sheet Analysis
– Liquidation Value
• Value of the firm if all assets were sold and liabilities
paid
– Market-to-Book Ratio
Market Value of Equity
Market-to-Book Ratio 
Book Value of Equity
• Value Stocks
– Low M/B ratios
• Growth stocks
– High M/B ratios

2.3 Balance Sheet Analysis (cont'd)
• Debt-Equity Ratio
– Measures a firm’s leverage
Total Debt
Debt-Equity Ratio 
Total Equity
– Using Book Value versus Market Value
• Enterprise Value
Enterprise Value  Market Value of Equity  Debt  Cash



• Problem
– In January 2009, Rylan Corporation (from
Alternative Example 2.1) had a market
capitalization of 110 million, a market-to-book
ratio of 2.2, a book debt to equity ratio of 1.4,
and cash of $6.3 million. What was Rylan’s
enterprise value?

• Solution
– As stated in Alternative Example 2.1, Rylan’s
book value of equity was $50 million. Given a
book debt-equity ratio of 1.4, Rylan had total
debt of 1.4 X 50 = 70 million. Thus, Rylan’s
enterprise value was 110+70 – 6.3 = $173.7
million.

2.3 Balance Sheet Analysis (cont'd)
• Other Balance Sheet Information

– Current Ratio
• Current Assets / Current Liabilities
– Quick Ratio
• (Current Assets – Inventories) / Current Liabilities

2.4 Income Statement
• Total Sales/Revenues
– minus
• Cost of Sales
– equals
• Gross Profit

2.4 Income Statement (cont'd)
• Gross Profit
– minus
• Operating Expenses
• Selling, General, and Administrative Expenses
• R&D
• Depreciation & Amortization
– equals
• Operating Income

• Operating Income
– plus/minus
• Other Income/Other Expenses

– equals
• Earnings Before Interest and Taxes (EBIT)

• Earnings Before Interest and Taxes (EBIT)

– plus/minus
• Interest Income/Interest Expense

– equals
• Pre-Tax Income

• Pre-Tax Income
– minus
• Taxes
– equals
• Net Income

Income Statement Sheet for 2009 and 2008

• Earnings per Share

Net Income $2.0 million
EPS    $0.556 per share
Shares Outstanding 3.6 million shares
• Stock Options
• Convertible Bonds
• Dilution
– Diluted EPS

– Profitability Ratios
• Gross Margin
Gross Profit
Gross M arg in 
Sales
• Operating Margin
Operating Income
Operating M arg in 
Sales
• Net Profit Margin
Net Income
Net Profit Margin 
Total Sales

(cont'd)
• Working Capital Days
– Accounts Receivable Days
Accounts Receivable
Accounts Receivable Days 
Average Daily Sales
• EBITDA
– Reflects the cash a firm has earned from its
operations

(cont'd)
• Leverage Ratios/Interest Coverage Ratios
– EBIT / Interest Expense
– Operating Income / Interest Expense
– EBITDA / Interest Expense

(cont'd)
• Investment Returns
– ROA
Net Income
Return on Assets 
Total Assets
– ROE
Net Income
Return on Equity 
Book Value of Equity

(cont'd)
• The DuPont Identity
 Net Income   Sales   Total Assets 

ROE         
 Sales   Total Assets   Book Value of Equity 
Net Profit Margin Asset Turnover Equity Multiplier
Return On Assets


Textbook Example 2.3 (cont’d)

(cont'd)
– Valuation Ratios
• P/E Ratio
Market Capitalization Share Price
P / E Ratio  
Net Income Earnings per Share
• Enterprise Value to Operating Income

Market value of Equity  Debt  Cash
Enterprise Value to EBIT 
EBIT
• Enterprise Value to Sales

Market value of Equity  Debt  Cash
Enterprise Value to Sales 
Sales



Problem:
Consider the following data for the year ended Dec.
31, 2008 for Yahoo! and Google (in millions):
Yahoo! Google
Sales 7,209 21,796
Operating Income 12 6,632
Net Income 424 4,227
Market Capitalization 22,830 177,380
Cash 2,292 8,657
Debt 2,439 3,529
Compare Yahoo and Google’s operating margin, net
profit margin, P/E ratio, and the ratio of enterprise
value to operating income and sales.
Solution:
Yahoo! Had an operating margin of 12/7,209=0.17%, a net
profit margin of 424/7,209=5.88%, and a P/E ratio of
22,830/424=53.84. Its enterprise value was 22,830+2439-
2292=22,977 million, which has a ratio of
22,977/12=1914.75 to operating income and
22,977/7,209=3.19 to sales.
Google had an operating margin of 6,632/21,796=30.4%, a net
profit margin of 4,227/21,796=19.39%, and a P/E ratio of
177,380/4,227=41.96. Its enterprise value was
177,380+3,529-8,657=172,252 million, which has a ratio of
172,252/6,632=25.97 to operating income and
172,252/21,796=7.90 to sales.

• To summarize:
Ratio Yahoo! Google

Operating Margin .17% 30.4%
Net Profit Margin 5.88% 19.39%
P/E Ratio 53.84 41.96
Enterprise Value to 1914.75 25.97
Operating Income
Enterprise Value to Sales 3.19 7.90

Solution (cont’d):
Even though Yahoo! And Google are competitors,
their ratios look much different. Yahoo! has much
lower profit margins, yet their P/E ratio is higher
than Google’s. Their enterprise value to operating
income ratio is also higher, mostly because of low
operating income. Enterprise value to sales ratio is
lower than that of Google. The difference is
consistent with Yahoo!’s lower margins.

2.6 Statement of Cash Flows
• Net Income typically does NOT equal the

amount of Cash the firm has earned.
– Non-Cash Expenses
• Depreciation and Amortization
– Uses of Cash not on the Income Statement

• Investment in Property, Plant, and Equipment

(cont'd)
• Three Sections
– Operating Activities
– Investment Activities
– Financing Activities

(cont'd)
• Operating Activities
– Adjusts net income by all non-cash items
related to operating activities and changes in
net working capital
• Accounts Receivable – deduct the increases
• Accounts Payable – add the increases
• Inventories – deduct the increases

(cont'd)
• Investing Activities
– Capital Expenditures
– Buying or Selling Marketable Securities
• Financing Activities
– Payment of Dividends
• Retained Earnings = Net Income – Dividends
– Changes in Borrowings

Statement of Cash Flows for 2009 and 2008



2.7 Other Financial Statement
Information
• Management Discussion and Analysis
– Off-Balance Sheet Transactions
• Statement of Stockholders’ Equity

• Notes to the Financial Statements



• Problem
– Campbell Soup Company reported the following sales
revenues
by category:
2009 2008
U.S. Soup, Sauces and Beverages $ 3,257 $ 3,098
Baking and Snacking $ 1,747 $ 1,742
International Soup and Sauces $ 1,255 $ 1,227
Other $ 1,084 $ 1,005
Total $ 7,343 $ 7,072
– What was the percentage growth for each category?

– If Campbell’s has the same percentage growth from
2009 to 2010, what will its total revenues be in 2010?

• Solution
– U.S. Soup, Sauces and Beverages
• ($3,257 ÷ $3,098) − 1 = 5.13%
– Baking and Snacking
• ($1,747 ÷ $1,742) − 1 = 0.29%
– International Soup and Sauces
• ($1,255 ÷ $1,227) − 1 = 2.28%
– Other
• ($1,084 ÷ $1,005) − 1 = 7.86%
– Total
• ($7,343 ÷ $7,072 ) − 1 = 3.83%

• Solution (continued)
– Estimated 2007 Total Revenue
• $7,343 × (1 + 3.83%)
• $7,343 × 1.0383 = $7,624

2.8 Financial Reporting in Practice
• Even with safeguards, reporting abuses

still happen:
– Enron
– WorldCom
– Sarbanes-Oxley Act (SOX)

Discussion of Key Topic
• If either Ford or Microsoft’s P/E ratio is

lower than the industry average, do you
expect the stock price to go up? Could
there be reasons other than
undervaluation for a firm to have a low
P/E?

Chapter Quiz
1. The book value of a company’s assets usually does
not equal the market value of those assets. What are
some reasons for this difference?
2. What is a firm’s enterprise value?
3. What is the difference between a firm’s gross profit
and its net income?
4. What is the DuPont identity?
5. What are the components of the statement of cash
flows?
6. What information do the notes to the financial
statements provide?

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Chapter 2

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5. Describe the importance of ensuring that valuation ratios are

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– Statement of Cash Flows

– Statement of Stockholders’ Equity

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• A snapshot in time of the firm’s financial

Assets  Liabilities  Stockholders' Equity

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• Net Working Capital

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– Market Value of Equity (Market Capitalization)

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– Using Book Value versus Market Value

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• Other Balance Sheet Information

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• Other Income/Other Expenses

• Earnings Before Interest and Taxes (EBIT)

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• Earnings Before Interest and Taxes (EBIT)

• Interest Income/Interest Expense

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• Earnings per Share

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• Net Profit Margin

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 Net Income   Sales   Total Assets 

Net Profit Margin Asset Turnover Equity Multiplier

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• Enterprise Value to Operating Income

• Enterprise Value to Sales

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