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Project1ReviewandPracticeGuide.pdf
UMGC MBA 620: Financial
Decision Making
Project 1: Review and
Practice Guide
Project 1: Review and
Practice Guide
Analyzing Financial Statements
Contents The Basics of Financial Statements ............................................................................................................... 3
Purpose of Financial Statements .............................................................................................................. 3
Who Can Use Financial Statements? ........................................................................................................ 3
Generally Accepted Accounting Principles (GAAP) ................................................................................... 3
Annual Report ........................................................................................................................................... 3
Key Financial Statements .......................................................................................................................... 3
The Balance Sheet ......................................................................................................................................... 4
Two Sides of Balance Sheet ...................................................................................................................... 4
The accounting equation: ..................................................................................................................... 4
Net Working Capital .................................................................................................................................. 4
Order of Items on the Balance Sheet ........................................................................................................ 4
Income Statements ....................................................................................................................................... 4
The Income Statement .............................................................................................................................. 4
Profit and Loss: Four Key Equations .......................................................................................................... 4
Profit and Loss Statement ..................................................................................................................... 4
Income Statement: Depreciation .............................................................................................................. 5
Income Statement: Amortization ............................................................................................................. 5
Income Statement: EBITDA & EBIT ........................................................................................................... 5
Statement of Cash Flows .............................................................................................................................. 6
Cash Flow Statement ................................................................................................................................ 6
Cash Flow Statement: Organization.......................................................................................................... 6
Cash Flows ................................................................................................................................................. 6
Financial Statements Analysis ....................................................................................................................... 7
Financial Ratios and Company Performance ............................................................................................ 7
Liquidity ratios....................................................................................................................................... 7
Efficiency ratios ..................................................................................................................................... 7
Leverage (debt) ratios ........................................................................................................................... 8
Profitability ratios ................................................................................................................................. 8
Market value ratios ............................................................................................................................... 8
DuPont Equation ....................................................................................................................................... 8
Problems/Exercises ....................................................................................................................................... 9
Chapter 3 ............................................................................................................................................... 9
Chapter 4 ............................................................................................................................................... 9
Solutions ....................................................................................................................................................... 9
Questions and Problems, Intermediate, 3.18 ....................................................................................... 9
Questions and Problems, Intermediate, 3.21 ..................................................................................... 10
Questions and Problems, Intermediate, 3.26 ..................................................................................... 10
Questions and Problems, Advanced, 4.31 .......................................................................................... 11
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The Basics of Financial Statements
Purpose of Financial Statements To provide a foundation for evaluating the financial health of a company
Who Can Use Financial Statements? • customers
• general public
• government/regulators
• suppliers
• creditors
• employees
• management
• stockholders
Generally Accepted Accounting Principles (GAAP) • Rules developed by the Financial Accounting Standards Board (FASB) that public companies
must abide by in developing financial statements and reporting results
• Authorized by the Securities and Exchange Commission (SEC)
Annual Report • A summary of an organization's performance over the course of a fiscal year
• Usually includes three parts: o a discussion of the business and its properties, risk factors, and legal proceedings o equity-related issues, an analysis of the organization's performance, market-risk exposure,
and audited financial statements o corporate governance
Key Financial Statements • Balance sheet—snapshot of a company's assets and funding at a point in time
• Income statement—a statement showing a company's profitability for a specific reporting
period (month, quarter, etc.)
• Cash flow statement—summarizes the cash inflows and outflows from a company's operations,
investments, and financing activities during a specific period
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The Balance Sheet
Two Sides of Balance Sheet • Left side—assets a firm owns and uses to generate revenue
• Right side—sources of the funds used to acquire assets
Net Working Capital net working capital = total current assets − total current liabilities
Order of Items on the Balance Sheet • Assets listed in order of liquidity
• Liabilities listed in order in which they are due to be paid
• Stockholders' equity listed last
o Common stockholders are entitled to assets remaining after all other providers of funds
are paid.
Income Statements
The Income Statement Shows a company's profitability during a specific reporting period (month, quarter, etc.)
net income = revenue − expenses
o Revenue—includes both cash and credit sales of a company's products and/or services
o Expenses—costs of producing or providing products and services, as well as
depreciation and amortization of assets used
Profit and Loss: Four Key Equations
• Profitability
net income = revenue − cost of goods sold − expenses − taxes
assets = liabilities + owners' (stockholders') equity
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• Revenue
revenue − cost of goods sold = gross profit (gross margin)
• Expenses
gross profit − expenses = operating income
• Net Income
operating income − taxes = net income
Income Statement: Depreciation The cost of a physical asset like a plant or machinery written off over the lifetime of the asset.
Depreciation is a noncash expense.
Two methods of depreciation
▪ straight-line
▪ accelerated
A company may choose one method for internal documentation and the other for tax purposes or
publicly available reports.
Income Statement: Amortization A noncash expense associated with intangible assets
• Examples
o Goodwill
o Patents
o Licenses
Income Statement: EBITDA & EBIT • Earnings before interest, taxes, depreciation, and amortization (EBITDA)
o income from selling goods and services minus the cost of providing them
• Earnings before interest and taxes (EBIT)
o EBITDA minus depreciation and amortization
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Statement of Cash Flows
Cash Flow Statement • Operating activities, investing activities, and financing activities generate cash flows.
• The cash flow statement summarizes cash flows in and out of a company during a specified
period:
net cash flow = cash inflows − cash outflows
Cash Flow Statement: Organization • Cash at the beginning of the period
• Operating activities
• Investing activities
• Financing activities
• Cash at the end of the period
Cash Flows • Statement of Cash Flows organization
o Operating Activities
▪ cash inflows
❑ sell goods and services
▪ cash outflows
❑ raw materials
❑ inventory
❑ salaries and wages
❑ utilities
❑ rent
o Investing Activities
▪ cash outflows and inflows from
❑ buying and selling long-term assets such as plant and equipment
❑ buying and selling bonds and stocks issued by other companies
o Financing Activities
▪ cash inflows
❑ issue debt
❑ issue equity
❑ borrow money
▪ cash outflows
❑ pay interest or dividends
❑ repay loan principal
❑ purchase treasury stock
Net increase or
decrease in cash
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Financial Statements Analysis
Financial Ratios and Company Performance • Categories of Common Financial Ratios
o Liquidity
o Efficiency
o Leverage
o Profitability
o Market value
o Indicate a firm's ability to pay short-term obligations with short-term assets without
endangering the company. In general, higher ratios are a favorable indicator.
Current Ratio = Current assets
Current liabilities
Quick Ratio = Current assets - Inventory
Current liabilities
o Indicate a firm's ability to use assets to produce sales. These are also called turnover
ratios. In general, higher numbers are a favorable indicator.
Inventory Turnover = Cost of Goods Sold
Inventory
Total Asset Turnover = Net Sales
Total Assets
o For the efficiency ratio below, a lower number is generally a positive signal.
Days Sales in Inventory = 365 Days
Inventory Turnover
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o Indicate whether a firm is using the appropriate amount of debt financing. In general,
higher ratios indicate greater potential return and greater bankruptcy risk.
Total Debt Ratio = Total Debt
Total Assets
Debt-to-Equity = Total Debt
Total Equity
o Indicate whether a company is generating adequate profit from its assets. In general,
higher ratios indicate better performance.
Net Profit Margin = Net Income
Net Sales
Return on Assets = Net Income
Total Assets
Return on Equity = Net Income
Total Equity
o Indicate how the market is valuing the firm's equity. Higher ratios indicate greater
shareholder wealth.
Price-Earnings Ratio = Price Per Share
Earnings Per Share
Market-to-Book = Price Per Share
Book Value of Equity Per Share
DuPont Equation • Return on Equity (ROE)
ROE = Net Income
Net Sales ×
Net Sales
Total Assets ×
Total Assets
Total Equity
= Net Profit Margin x Total Asset Turnover x Equity Multiplier
Shows that return-on-equity is driven by profitability, operating efficiency, and amount of leverage
(debt)
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Problems/Exercises
• Self-study problems
• Questions and Problems, Intermediate, 3.18 (Balance sheet)
• Questions and Problems, Intermediate, 3.21 (Income statement)
• Questions and Problems, Intermediate, 3.26 (Cash flows)
• Self-study problems 4.1–4.5
• Questions and Problems, Advanced, 4.31
Solutions
Blackwell Automotive Inc.
Balance Sheet as of December 31
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Nimitz Rental Company
Income Statement as of March 31
Amount
Revenues $878,412
General and administrative expenses 352,666
Leasing expenses 108,195
EBITDA $417,551
Depreciation expenses 131,455
EBIT $286,096
Interest expenses 78,122
EBT $207,974
Taxes (34%) 70,711
Net income $137,263
Cash flow: Refer to the information in Problem 3.21
Cash flow from operations = Net income + Depreciation = $137,263 + $131,45
= $268,718
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Ratio Industry Average Nederland
Current ratio 2.05 0.77
Quick ratio 0.78 0.57
Gross margin 23.9% 51.2%
Net Profit margin 12.3% 12.6%
Debt ratio 0.23 0.70
Long-term debt to equity 0.98 0.73
Interest coverage 5.62 20.6
ROA 5.3% 11.4%
ROE 18.8% 37.5%
Source: Based on information in Parrino, Kidwell, & Bates (2012)
Now that you have read this Review and Practice Guide and completed the problems and exercises, you are ready to participate in the discussion in Step 3.
