UNDERSTANDING FINANCIAL STATEMENTS

UNDERSTANDING FINANCIAL STATEMENTSWHITNEY TILSON WTILSON@KASELEARNING.COMGLENN TONGUE GLENNT@KASELEARNING.COM

FINANCIAL STATEMENTS ARE AMIXTURE OF ART & SCIENCE Accounting requires many judgments andestimations by management Rules allow for significant variation in how toprepare and present results It is critical to understand incentives ofmanagement and accountantsNot enough to just follow the rules.Financial statements must “ fairly present thefinancial position of the company”2“Regardless of howour businesses mightbe doing, [we] could –quite legally – causenet income in anygiven period to bealmost any number wewould like ”– W A R R E N B UFFE T T ,LETTER TO BERKSHIRE HATHAWAYSH A R E H O L DE R S,FE B R UA R Y 2011

ACCRUAL VS. CASH ACCOUNTING All accounting youwill see is accrual3

FINANCIAL FILINGS CONTAIN MORE THAN JUSTFINANCIAL STATEMENTS Financial Statements ManagementDiscussion & Analysis(MD&A) Audit Reports Footnotes4

INFORMATION IS PRESENTED THROUGHTHREE FINANCIAL STATEMENTSINCOME STATEMENTBALANCE SHEET5STATEMENT OFCASH FLOWS

THE INCOME STATEMENTTELLS THE STORY FOR A CERTAIN PERIODREVENUE(WHAT THE COMPANY SOLDTO CUSTOMERS)-EXPENSES(WHAT IT COSTTO RUN THE COMPANY) NET INCOME(PROFIT, EARNINGS,THE BOTTOM LINE)(WHAT'S LEFT OVERFOR OWNERS)Tells what happened to the company over a certain period of time6

MATCHING PRINCIPLES Revenues are reported when the service is performed or the goods aredelivered– Not when payment is received Associated expenses are recognized alongside the revenues– Not when expenses are paid Example: a lawyer does 5,000 of work in December, bills the clientin January, and the client pays the bill in February. The 5,000 inrevenue and associated expenses appear on the December incomestatement.7

THE INCOME STATEMENTEvery company isdifferent but followssame general format -SALES (REVENUE OR THE “TOP LINE”)COST OF SALES (COGS)-GROSS PROFITSG&A, R&D, MARKETING EXPENSES, ETCOPERATING INCOME /- INTEREST EXPENSE / INCOME-PRE-TAX INCOMETAXNET INCOME (“BOTTOM LINE”)8DIRECT COSTOF GOODSPROVIDED TOCUSTOMERS

Apple, Inc.IncomeStatement9

FINANCIAL STATEMENT ANALYSISFinancial statement analysisis based on comparisons10RATIO ANALYSISCOMPARISON WITHSIMILAR COMPANIESComparestwo or moreline itemsProvides insightsconcerning acompany’s relativeperformance

INDICATORS, NOT ABSOLUTES Ratios will vary because of thecompany’s industry characteristics,nature of operations, size, growthrates, macro economic factors,international dynamics, accountingpolicies, etc.11Ratiospoint outareas toquestion

COMPONENT ANALYSIS: MARGINS The gross margin (gross profit / revenues) shows how much of a mark-upabove its costs a company takes The difference between the gross and operating margin (operating profit /revenues) reveals a company’s cost structure and how well it controls costs The net margin (net income / revenues) is most important, as it shows acompany’s ability to generate a profit12

COMPONENT ANALYSIS: GROWTH RATES Calculating growth rates over time of revenues and net income shows acompany’s rate and consistency of top-line growth, and whether and howthat is translating into profits Calculated by dividing current period vs. prior one– Revenues growing from 10 to 12 is 20% growth, calculated as follows:12/10 1.2, drop the 1 .2, move the decimal place 20%13

EXERCISE For both Apple and Costco, calculate:– Current period gross margin (gross profit divided by revenue) In the case of Costco, must first calculate gross profit by subtracting“Merchandise costs” from revenues– Current period net margin (net profit divided by revenue)– Year-over-year revenue growth– Year-over-year net income growth14

AppleIncomeStatement15

CostcoIncomeStatement16

BALANCE SHEET IS A SNAPSHOT OF WHERE ACOMPANY IS AT A PARTICULAR INSTANT IN TIMEASSETS-LIABILITIES(WHAT YOU OWN) (WHAT YOU OWE)EQUITY(WHAT YOU ARE “WORTH”)The balance sheet must always balanceIf: A – L Ethen: A L EAt any single point in time17AL E

BALANCE SHEET ITEMS18 Assets: economic resources of a business that are expected to benefit future operations Liabilities: obligations of the business (monetary or nonmonetary)– Trade related– Debt Stockholders’ Equity represents the equity stake of a firm's equity investors– Paid-in capital: equity invested by owners– Retained earnings: accumulated profits– Equity is reduced by net income losses and when capital is paid out to owners in theform of dividends and share repurchases

AppleBalanceSheet:Assets19

AppleBalanceSheet:Liabilities andShareholders’Equity20

RATIO ANALYSIS BASICSRatio analysis is used to measure company’s ability to: Generate a healthy return on capital Manage assets Meet short-term obligations (liquidity) Meet long-term obligations (solvency)21

TESTS OF LIQUIDITY Current Ratio Quick Ratio22Tests of liquidity focuson the relationshipbetween currentassets and currentliabilities as well asinterest payments.Measures the company’sability to meet its shortterm obligations.

CURRENT RATIO CURRENT RATIO2016Current RatioCurrent AssetsCURRENT LIABILITIES2017 106,869 128,645Current Liabilities 79,006 100,814Current Ratio23CURRENT ASSETS1.351.28This ratio measures the abilityof the company to pay currentdebts as they become due.

QUICK RATIO (ACID TEST)QUICK RATIO CURRENT LIABILITIES2016Quick Ratio242017Quick Assets 97,182 110,072Current Liabilities 79,006 100,8141.231.09Quick RatioQUICK ASSETSQUICK ASSETS CASHS/T INVESTMENTSACCOUNTSRECEIVABLEThis ratio measures thecompany’s immediate abilityto pay debts, so it excludesinventory.

TESTS OF SOLVENCY Debt to Equity25Tests ofsolvency measurea company’sability to meetits long-termobligations.

DEBT/EQUITY RATIO DEBT/EQUITY RATIO2016Debt to Equity DebtEquityDebt to Equity26DEBT SHAREHOLDER EQUITY201787,032 115,680 128,249 134,0470.680.86This ratio measures the amount ofdebt that exists for each 1 investedby the owners.Typically this measures structureddebt.

RETURN ON EQUITYNET INCOME RETURN ON EQUITYSTOCKHOLDER’S EQUITY2016Apple’sNet Income ROEEquity 128,249 134,04735.6%36.1%ROE2745,6872017 48,351This measure indicates howmuch income was earnedfor every dollar of equityinvested by the owners.

BASIC CALCULATIONS Net cash or debt: all cash (including marketable securities) minus all debt(short and long term) Debt to equity ratio (net debt / equity) Net cash or debt growth Inventory growth rate (compare to revenue growth) Current ratio: current assets / current liabilities Quick ratio: (current assets – inventory) / current liabilities Return on equity (net income / equity)28

EXERCISE For both Apple and Costco, calculate:– Net cash or debt– Debt to equity ratio– Net debt growth rate– Inventory growth rate– Current ratio– Quick ratio– Return on equity29

AppleBalanceSheet30

CostcoBalanceSheet31

FIVE COMPANY EXERCISE32

THE CASH FLOW STATEMENT TRACKS ALL CASH GOINGINTO AND OUT OF A COMPANY Captures elements of both theincome statement and balancesheet Inflows and outflows of cash over acertain period of time Allocates all cash going in and outof a company into three categories:operating, investing, and financingactivities33

THE CASH FLOW STATEMENT DETAILS CASHFLOWS FROM ALL THREE AREAS OF A BUSINESS34 Operating– Cash generated by a company’s operating activities– Cash the company pays out related to its operating activities (e.g., payments tosuppliers and employees) Investing– Capital expenditures (cap ex)– Acquisitions– Purchase and sale of investment securities, property Financing– Proceeds from issuance of debt and equity– Cash spent on share repurchases and dividends

Balance Sheetshows whereI am nowBalanceSheet showswhere I wasAssets(incl.cash)INCOME STATEMENT TELLS THE STORYOF WHAT HAPPENEDAssets(incl.cash)Income StatementLiabilities&Equity35Liabilities&Equity

THE CASH FLOW STATEMENT:CASH GENERATED BY OPERATING ACTIVITIES 36Apple

THE CASH FLOW STATEMENT:CASH GENERATED BY INVESTING ACTIVITIES 37Apple

THE CASH FLOW STATEMENT:CASH GENERATED BY FINANCING ACTIVITIES 38Apple

ANALYZING FINANCIALSTATEMENTS

“VALUE” OF THE COMPANY Stockholders’ equity book value– Book value is stated on the balance sheet and is determined byGenerally Accepted Accounting Principles (GAAP) Book value market value– Market value (market capitalization) # of shares x price per share Book value true valuation of the company– A company’s true value is based on many variables, including: expectedfuture cash flows of the firm, market position, size, growth potential,risk, competition, and employee and management quality40

RETURN ON EQUITY: THE DUPONT FORMULAThere are three ways to improve ROE:higher profit margin, faster asset turnover, or higher leverageROEAPPLE’S ROEAPPLE’S ROE41 NET 2.80

MEDIAN RATIO OF LIABILITIES TO EQUITY FORSELECTED INDUSTRIES2.52.01.51.00.5042Data Source: Compustat Research Insight

MEASURING CASH FLOWS EBIT EBITDA Free cash flow43Cash flows arethe life blood ofany organization– and there aremany ways tocalculate them.

EBIT: EARNINGS BEFORE INTEREST AND TAXESFor many companies, this is simply operating income.2016EBIT442017Net Income 45,687 48,351Taxes 15,685 15,738Interest (net) 2,543 EBIT 63,915 66,9672,878

EBITDA: EARNINGS BEFORE INTEREST, TAXES,DEPRECIATION & AMORTIZATIONA very common measure of cash flow – yet very flawed,primarily because it adds back depreciation but ignores cap ex.2016EBITDA452017Net Income 45,687 48,351Taxes 15,685 15,738Interest (net) 2543 D&A 10,505 10,157EBITDA 74,420 77,1242878

DEPRECIATION AND AMORTIZATION Depreciation– 46Depreciation is an accounting method of allocating the cost of a tangible asset over itsuseful life and is used to account for declines in value over time. Businesses depreciatelong-term assets for both tax and accounting purposes.Amortization–Amortization is an accounting technique used to incrementally lower the cost value ofan intangible asset through scheduled charges to income.–Amortization is also the paying off of debt with a fixed repayment schedule in regularinstallments over a period of time for example with a mortgage or a car loan.They are both non-cash charges – but usually represent very real cash expenses

FREE CASH FLOWThere are many ways to measure this, but a common way is cash flow fromoperations minus maintenance cap ex(depreciation is often a good measure of maintenance cap ex)2016Free Cash Flow47CFFO2017 65,824 63,598Maint cap ex 10,505 10,157FCF 53,441 55,319

VALUATION RATIOS Market capitalization Enterprise value P/E ratio Enterprise value/EBITDA P/S ratio P/B ratio48Investors usemany toolsto valuecompanies.

MARKET CAPITALIZATIONThe value the market places on the company’s shares.MARKET CAPAPPLEMARKET CAP49 DILUTED SHARESOUTSTANDING4.9151 billionXSHAREPRICEX 188.58 926.9 billion

ENTERPRISE VALUEMarket cap adjusted for cash and debtENTERPRISE VALUEAPPLEENTERPRISE VALUE50 MARKET CAP 926.9 DEBT-CASH 121.8- 267.2 781.5 billion

P/E (PRICE TO EARNINGS) RATIOCompares a company’s share price to its earnings per share.The most commonly used valuation measure.P/E RATIOAPPLEP/E RATIO SHAREPRICE/EARNINGSPER SHARE* 188.58/ 10.41 18.12x* Some people use trailing 12-month EPS, others use current year estimates, others use next 12 month estimates, while still others use thenext calendar year. There is no right answer. For the purposes of this example, let’s use actual trailing 12-month earnings of 10.41.51

EV/EBITDA RATIOSort of like the P/E ratio, but it compares a company’s enterprise value(which includes debt) with its EBITDA (which is a measure of cash flowbefore interest payments on debt). A commonly used valuationmeasure in the buyout business.52EV/EBITDA RATIO ENTERPRISE VALUEAPPLEEV/EBITDA RATIO 781.5/EBITDA/ 76.4 10.2x

P/S (PRICE TO SALES) RATIOCompares a company’s share price to its revenues per share.Can be useful in comparing companies in the same industry.P/S RATIO SHARE PRICE REVENUES PER SHAREAPPLEP/S RATIO53 926.9 billionMARKET CAPREVENUES/ 247.4 billion 3.8x