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Financial Statement Analysis P.V. Viswanath Based on Damodaran’s Corporate Finance Questions we would like answered… As financial analysts… Assets Liabilities What are the assets in place? How valuable are these assets? Assets in Place How risky are these assets? What are the growth assets? Growth Assets How valuable are these assets? Debt Equity What is the value of the debt? How risky is the debt? What is the value of the equity? How risky is the equity? However, the information we have comes from the firm’s financial statements… P.V. Viswanath 2 Basic Financial Statements The balance sheet, which summarizes what a firm owns and owes at a point in time. The income statement, which reports on how much a firm earned in the period of analysis The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis P.V. Viswanath 3 The Balance Sheet Figure 4.1: The Balance Sheet Assets Liabilities Fixed Assets Current Liabilties Current Assets Debt Debt obligations of firm Investments in securities & assets of other firms Financial Investments Other Liabilities Other long-term obligations Assets which are not physical, like patents & trademarks Intangible Assets Equity Equity investment in firm Long Lived Real Assets Short-lived Assets Short-term liabilities of the firm This is what we can see from the firm’s balance sheet… P.V. Viswanath 4 An example : Maxwell Shoe Company, Inc Maxwell Shoe Company Inc. designs, develops and markets casual and dress footwear for women and children under multiple brand names, each of which is targeted to a distinct segment of the footwear market. The Company offers casual and dress footwear for women in the moderately priced market segment under the Mootsies Tootsies brand name, in the upper moderately priced market segment under the Sam & Libby and Dockers Khakis Footwear For Women brand names and in the better market segment under the Anne Klein 2 and A Line Anne Klein brand names. It also sells moderately priced and upper moderately priced children's footwear under both the Mootsies Tootsies and Sam & Libby brand names. In addition, it designs and develops private label footwear for selected retailers under the retailers' own brand names. Maxwell has licensed the J.G. Hook trademark to source and develop private label products for retailers who require brand identification. P.V. Viswanath 5 An example of an Accountant’s Balance Sheet Maxwell Shoe Company, Inc. As of October 31, 2000 (In ‘000s) ASSETS Current assets: Cash and cash equivalents Accounts receivable, trade Inventory, net Prepaid expenses Prepaid income taxes Deferred income taxes.... Total current assets........ Property and equipment, net. Trademarks, net.. Other assets..... $48,074 34,244 12,036 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable......... Accrued expenses......... Deferred income taxes..... Current portion of Capital lease obligations 536 1,478 798 97,166 Total current liabilities... Long-term deferred income $6,605 taxes........ 15,479 Stockholders' equity Additional paid-in 185 capital.......... Deferred compensation.... Retained earnings........ Total stockholders' equity.. $119,435 P.V. Viswanath $1,863 7,254 479 102 9,698 1,540 88 43,112 -251 65,248 108,197 $119,435 6 Notes on the Maxwell Balance Sheet Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are created when future taxable income is expected to exceed pretax income, while deferred tax liabilities occur in the reverse case. If more deductions have been taken in the current period for reporting purposes, then tax payable (according to the GAAP income statement) will be lower than the actual tax paid. Hence it will seem like taxes have been prepaid. This is reflected in the balance sheet as an asset. Deferred tax assets ($798) reflect allowance for doubtful accounts, stock option compensation, inventory capitalization, and inventory reserve. Deferred tax liabilities ($479) reflect amortization of trademarks (long-term) and depreciation of property and equipment (short-term). P.V. Viswanath 7 A Financial Analyst’s Balance Sheet Assets Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments Liabilities Assets in Place Debt Growth Assets Equity Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible Residual Claim on cash flows Significant Role in management Perpetual Lives This is what we would like to see… P.V. Viswanath 8 The Income Statement Figure 4.2: Income Statement Gross revenues from sale of products or services Revenues Expenses associates with generating revenues - Operating Expenses Operating income for the period = Operating Income Expenses associated with borrowing and other financing - Financial Expenses Taxes due on taxable income - Taxes Earnings to Common & Preferred Equity for Current Period = Net Income before extraordinary items Profits and Losses not associated with operations - (+) Extraordinary Losses (Profits) Profits or losses associated with changes in accounting rules - Income Changes Associated with Accounting Changes Dividends paid to preferred stockholders - Preferred Dividends = Net Income to Common Stockholders P.V. Viswanath 9 The Income Statement Maxwell Shoe Company, Inc. For the year ended October 31, 2000 (In ‘000s) Net sales.... Cost of sales Gross profit. Operating expenses: Selling. General and administrative.. Operating income.. Other expenses (income) Interest income, net... Amortization of trademarks.. Other, net... Income before income taxes.. Income taxes. Net income... P.V. Viswanath $158,205 116,991 41,214 11,584 16,141 27,725 13,489 -3,039 367 -310 -2,982 16,471 6,589 $9,882 10 The Income Statement The Income Statement provides us with information about changes in the balance sheet from one year to another. Hence it is crucial to creating the financial balance sheet that we want. However, the income statement is prepared according to GAAP. Underlying GAAP are certain principles, such as revenue recognition when the service for which the firm is being paid has been performed substantially, the matching principle governing recognition of expenses, a historical cost-based approach, and a basic conservatism in the recognition of assets. This leads to certain accounting practices that need to be corrected, from a financial analyst’s point of view… P.V. Viswanath 11 P.V. Viswanath 12