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Understanding
Financial Statements

Business Journalism Professors
Jan. 4, 2014
Donald W. Reynolds National Center
For Business Journalism
At Arizona State University

Strictly Financials
2
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James K. Gentry, Ph.D.
Clyde M. Reed Teaching Professor
School of Journalism and Mass Communications
...
Types of Statements
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Public
Private
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Financial statements conforming to public
company statements

Non-pr...
Important Terms
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Unaudited
Audited
Accountants
Certified Public Accountants (CPAs)
GAAP, FASB, AICPA, ...
Assessing a Company
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Context
Trends
Rules
Outsiders
Insiders

Strictly Financials
6
Annual Report,10-K
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Annual report,10-K wrap, 10-K
Auditor’s report: Clean, qualified?
MD&A or Managem...
Traditional Auditor’s Report
n 

Independent auditor’s opinion on whether
financial statements are presented fairly in al...
Auditor’s Report by Category
n 
n 
n 
n 

Clean or Unqualified
Qualified
Disclaimer
Adverse

Strictly Financials
9
New Auditor’s Report
n 

Combines traditional report with
“internal controls” requirement of
Sarbanes-Oxley Act

Strictly...
Sarbanes-Oxley Act of 2002
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n 
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Response to abuses with Enron and
WorldCom as catalysts
New responsibilit...
Sarbanes-Oxley Act
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Analysts must state potential conflicts of interest
Limited types of services accounting firms...
Public Company Accounting
Oversight Board
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Created by SOX to oversee accounting
Began operating i...
PCAOB’s Duties
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n 

n 

n 

Set rules on “auditing, quality control,
ethics, independence, and other
standards…”
Co...
Section 404: Internal Controls
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“Management Assessment of Internal
Controls”
Each 10-K must contain an ...
Management on the Spot
n 

n 

n 
n 
n 

Section 404: Management must evaluate and
test internal controls over financ...
Private Company Impact
n 
n 

n 
n 

n 

Banks, insurers requiring companies to
embrace SOX.
Now most private firms h...
Non-Profit Impact
n 
n 

n 
n 
n 

Audit committees, independent members
CEO, CFO attest to accuracy, completeness,
f...
Goal of accounting
n 

Record, classify and report financial
transactions. To provide managers across the
organization wi...
Goal of Finance
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n 

Maximize shareholder wealth as
reflected in market price of the stock
Achieving this goal requir...
Financial Decisions
n 

n 

Investing decisions: Types of assets
firm wants to hold.
Financing decisions: Acquisition of...
Generally Accepted
Accounting Principles
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n 
n 

Guidelines based on theory and
practice
Evolved over time
Procedure...
GAAP
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n 

Periodicity
Going concern
Economic entity
Monetary unit
Full disclosure
Historical cost
...
GAAP
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n 

Materiality
Industry practices
Conservatism

Strictly Financials
24
Specialized Industry GAAP
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Banking and thrift industries
Benefit plans, including pension fund...
Cash or Operating Cycle
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Cash
Purchase inventory
Produce product
Sell product
Cash

Strictly Financial...
Cash or Operating Cycle
(cont.)
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“Cash”
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n 

Cash
Receivables and payables
Debt

Inventory
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n 
n 

R...
Cash or Operating Cycle
(cont.)
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Sell product
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n 

Cash
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n 
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Accounts receivable
Cash
Collect receiv...
Accrual Method
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n 

n 

Records revenues when the the “sale”
occurs
Records expenses when the bill is
received
...
About These Numbers:
They’re Squishy
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n 

n 

n 

n 

Goods will not necessarily be paid for
Goods are not necessar...
About These Numbers:
They’re Squishy (cont.)
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n 
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n 

Machinery or other fixed assets might
be obsolete or fa...
Because They’re Squishy
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You need to know the rules and
assumptions used to create the
numbers

Strictly Financials
32
Income Statement or ...
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Statement of earnings
Statement of operations
Statement of income and
comprehensive i...
Income Statement
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n 

Covers a period of time, typically a year
or quarter
Reports income from ongoing activ...
Basic Income Statement
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Sales or revenues
Expenses
Taxes
Net income or profit

Strictly Financials
35
Income Statement
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Sales or revenues
Cost of goods sold
Gross profit
Operating expenses
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n 
n 
n...
Cost of Goods Sold
n 

Expenses incurred in the cost of
manufacturing or creating or acquiring
the product the company se...
Cost of Goods Sold
n 

Manufacturer: What the company pays
for inventory, i.e. raw materials and
supplies used to make it...
Cost of Goods Sold
n 

n 

Retailer: What the company pays
suppliers for the products it sells on its
shelves. Only the ...
SGA
n 

n 

Includes office expenses, accounting,
shipping department, advertising, R&D,
depreciation and other expenses...
Other Income/Expenses
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n 
n 
n 
n 

Discontinued items
Unusual/extraordinary items
Changes in accounting princi...
Thinking Inside the Box

n 

Revenues
Minus cost of goods sold
Equals gross profit
Minus operating expenses
Equals operat...
Inside the Box Earnings
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Sales or revenues
Cost of goods sold
Gross profit
Operating expenses
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n ...
‘One-Time’ Gains That
Reoccur
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n 

n 

Don’t be fooled by extraordinary items
that make the net income look better
t...
Earnings Per Share
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Basic earnings per share
(Bloomberg)
Diluted earnings per share (Wall
Street Journal, fully d...
Calculating EPS
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Basic: Net income for period divided by
weighted average number shares
outstanding.
Diluted: Net...
Dividend
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Company’s board of directors decides to
distribute a portion of a company's net income
to a class of its sha...
Dividend Payout Ratio
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The percentage of a company’s net
income that is paid to shareholders in
dividends.

Strictly F...
Dividend Payout Ratio
Dividend per share
Earnings per share
Dividend payout
Net Income for same period

Strictly Financial...
Dividend Yield
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How much a company pays out in dividends
each year in relation to its stock price.
A way to measu...
Dividend Yield
Dividend
Stock price
$1
$20
5%

vs.

$1
$40
2.5%
Strictly Financials
51
Looking at Dividends
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In general, investors react poorly to a
decrease in dividends, and the stock price
usually ...
Balance Sheet
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It balances
Assets = Liabilities + Shareholders’
Equity

Strictly Financials
53
Assets
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Current assets
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Cash and cash equivalents
Accounts receivable
Inventories
Prepaids

Inves...
Assets
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Property, plant and equipment, net
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Land and improvement
Buildings and improvements
Equip...
Goodwill and Impairment
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Difference between what a business
pays to buy another company and the
book value (total asse...
Liabilities
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Current liabilities
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Noncurrent liabilities
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Accounts payable
Accrued l...
Shareholders’ Equity
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Capital stock
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Preferred stock
Common stock

Additional paid-in capital
Ret...
Statement of Cash Flows
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Record of cash provided by cash
sources and of cash consumed by cash
uses.

Strictly Financia...
Cash Flows (cont.)
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Information about use of cash
Information about investing and
financing
Ability ...
Cash Flows
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From operations
From investing
From financing

Strictly Financials
61
Flexibility
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Companies have some flexibility in
categories for entries.
Total change in cash, however, will ...
Free Cash Flow
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Powerful tool for making a company
successful
Powerful indicator for investors
Cash that...
Free Cash Flow (cont.)
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Several ways to calculate it
Companies create their own models
Gross way to do it:
n ...
American Standard Model
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Cash from operating activities
Minus capital expenditures
Plus proceeds from...
Free Cash Models
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‘Gross’ method
American Standard method
VF method
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Cash from operating minus cash from
i...
Keys to Looking at Cash
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Cash from operations
Capital expenditures (cap ex)
Free cash
Cash and cash equiva...
Looking at the Numbers
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Note changes in amounts year to year, especially
revenues and expenses
...
Techniques
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Calculate percentage change
Trend analysis
Common size analysis
Ratio analysis

Strictly Finan...
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Business Journalism Professors 2014: Teaching Financial Statements by Jimmy Gentry

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Jimmy Gentry presents "Teaching Financial Statements" during the Reynolds Center for Business Journalism's annual Business Journalism Week, Jan. 4, 2014. Gentry is the Clyde M. Reed Teaching Professor at the University of Kansas' School of Journalism and Mass Communications.

The annual event features two concurrent seminars, Business Journalism Professors and Strictly Financials for journalists.

For more information about business journalism training, please visit http://businessjournalism.org.

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Transcript of "Business Journalism Professors 2014: Teaching Financial Statements by Jimmy Gentry"

  1. 1. Understanding Financial Statements Business Journalism Professors Jan. 4, 2014
  2. 2. Donald W. Reynolds National Center For Business Journalism At Arizona State University Strictly Financials 2
  3. 3. n  n  n  n  n  James K. Gentry, Ph.D. Clyde M. Reed Teaching Professor School of Journalism and Mass Communications University of Kansas jgentry@ku.edu Strictly Financials 3
  4. 4. Types of Statements n  n  Public Private n  n  Financial statements conforming to public company statements Non-profits Strictly Financials 4
  5. 5. Important Terms n  n  n  n  n  Unaudited Audited Accountants Certified Public Accountants (CPAs) GAAP, FASB, AICPA, PCAOB Strictly Financials 5
  6. 6. Assessing a Company n  n  n  n  n  Context Trends Rules Outsiders Insiders Strictly Financials 6
  7. 7. Annual Report,10-K n  n  n  n  n  Annual report,10-K wrap, 10-K Auditor’s report: Clean, qualified? MD&A or Management’s Discussion and Analysis Financial statements and footnotes Management’s letter if annual report Strictly Financials 7
  8. 8. Traditional Auditor’s Report n  Independent auditor’s opinion on whether financial statements are presented fairly in all material respects, in accordance with GAAP: n  n  n  n  We looked at these statements They’re management’s responsibility; we’re just here to express our opinion We followed the rules in our audits and here’s what an audit involves In our opinion, the statements fairly present the company’s position Strictly Financials 8
  9. 9. Auditor’s Report by Category n  n  n  n  Clean or Unqualified Qualified Disclaimer Adverse Strictly Financials 9
  10. 10. New Auditor’s Report n  Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act Strictly Financials 10
  11. 11. Sarbanes-Oxley Act of 2002 n  n  n  n  n  Response to abuses with Enron and WorldCom as catalysts New responsibilities, resources for SEC Created PCAOB Major emphasis on “internal controls” More disclosure for public companies Strictly Financials 11
  12. 12. Sarbanes-Oxley Act n  n  Analysts must state potential conflicts of interest Limited types of services accounting firms can provide to public company clients n  n  n  n  n  n  Companies disclose in 10-K the fees pay to auditors Recent concerns Consulting CEO, CFO attest to accuracy, completeness, fairness of financial statements Rigorous penalties for fraud, other misdeeds Clawbacks Strictly Financials 12
  13. 13. Public Company Accounting Oversight Board n  n  n  n  n  n  Created by SOX to oversee accounting Began operating in 2003 SEC appoints five members to five-year terms Two members must be or have been CPAs All members must be “financially literate” In 2008, Supreme Court upheld PCAOB but said SEC couldn’t remove board members Strictly Financials 13
  14. 14. PCAOB’s Duties n  n  n  n  Set rules on “auditing, quality control, ethics, independence, and other standards…” Conduct “inspections” of accounting firms Conduct “investigations and disciplinary proceedings” Enforce compliance with SOX Strictly Financials 14
  15. 15. Section 404: Internal Controls n  n  n  n  “Management Assessment of Internal Controls” Each 10-K must contain an “internal control report” that: States management is responsible for internal control structure and procedures Contains an assessment on effectiveness of internal control structure and procedures Strictly Financials 15
  16. 16. Management on the Spot n  n  n  n  n  Section 404: Management must evaluate and test internal controls over financial reporting, including anti-fraud programs, annually. Management certifies that it does (or doesn’t) have adequate internal controls in place. Independent board members easier to attract Auditor attests to adequacy of controls. Management to be forced to answer for fraudulent activities, misconduct, etc. Strictly Financials 16
  17. 17. Private Company Impact n  n  n  n  n  Banks, insurers requiring companies to embrace SOX. Now most private firms have audited financial statements If private company owners want to sell to public company, must be in compliance Private equity funds more willing to invest in companies in compliance Best outside directors Strictly Financials 17
  18. 18. Non-Profit Impact n  n  n  n  n  Audit committees, independent members CEO, CFO attest to accuracy, completeness, fairness of financial statements Financial statements more accessible Codes of ethics Rules governing transactions with “insiders” Strictly Financials 18
  19. 19. Goal of accounting n  Record, classify and report financial transactions. To provide managers across the organization with information that facilitates: n  n  n  n  n  Control of activities and expenditures Refinement of operational plans Accountability Reporting on project outcomes Writing of bids for new funds Strictly Financials 19
  20. 20. Goal of Finance n  n  Maximize shareholder wealth as reflected in market price of the stock Achieving this goal requires financial manager to focus on economic profit, not accounting profit Strictly Financials 20
  21. 21. Financial Decisions n  n  Investing decisions: Types of assets firm wants to hold. Financing decisions: Acquisition of funds needed to support long-term investments. Strictly Financials 21
  22. 22. Generally Accepted Accounting Principles n  n  n  Guidelines based on theory and practice Evolved over time Procedures, concepts and standards Strictly Financials 22
  23. 23. GAAP n  n  n  n  n  n  n  Periodicity Going concern Economic entity Monetary unit Full disclosure Historical cost Consistency Strictly Financials 23
  24. 24. GAAP n  n  n  Materiality Industry practices Conservatism Strictly Financials 24
  25. 25. Specialized Industry GAAP n  n  n  n  n  n  n  Banking and thrift industries Benefit plans, including pension funds Broadcasting industry Cable television industry Computer software Finance companies Investment companies Strictly Financials 25
  26. 26. Cash or Operating Cycle n  n  n  n  n  Cash Purchase inventory Produce product Sell product Cash Strictly Financials 26
  27. 27. Cash or Operating Cycle (cont.) n  “Cash” n  n  n  n  Cash Receivables and payables Debt Inventory n  n  n  Raw materials Work in progress Finished goods Strictly Financials 27
  28. 28. Cash or Operating Cycle (cont.) n  Sell product n  n  n  Cash n  n  n  Accounts receivable Cash Collect receivables as cash Pay off payables Start over Strictly Financials 28
  29. 29. Accrual Method n  n  n  n  Records revenues when the the “sale” occurs Records expenses when the bill is received IE, transactions enter the financial records when they occur, not when cash changes hands Accrual method, therefore, shows “scores,” not real spendable dollars Strictly Financials 29
  30. 30. About These Numbers: They’re Squishy n  n  n  n  n  Goods will not necessarily be paid for Goods are not necessarily going to be kept Inventory might be out of date, obsolete or unsellable Status of some inventory may be uncertain Intangible assets are estimates Strictly Financials 30
  31. 31. About These Numbers: They’re Squishy (cont.) n  n  n  n  n  Machinery or other fixed assets might be obsolete or falling apart long before the so-called useful life is up Goodwill Accounting conventions Timing issues Bottom line: In many ways, statements are a collection of estimates. Strictly Financials 31
  32. 32. Because They’re Squishy n  You need to know the rules and assumptions used to create the numbers Strictly Financials 32
  33. 33. Income Statement or ... n  n  n  Statement of earnings Statement of operations Statement of income and comprehensive income Strictly Financials 33
  34. 34. Income Statement n  n  n  n  Covers a period of time, typically a year or quarter Reports income from ongoing activities Reports income from activities beyond management’s control (comprehensive income) Involves estimates Strictly Financials 34
  35. 35. Basic Income Statement n  n  n  n  Sales or revenues Expenses Taxes Net income or profit Strictly Financials 35
  36. 36. Income Statement n  n  n  n  Sales or revenues Cost of goods sold Gross profit Operating expenses n  n  n  n  n  n  n  Sales, general and administrative Depreciation, amortization Operating profit Other income/expenses Interest Income taxes Net income or profit Strictly Financials 36
  37. 37. Cost of Goods Sold n  Expenses incurred in the cost of manufacturing or creating or acquiring the product the company sells. Strictly Financials 37
  38. 38. Cost of Goods Sold n  Manufacturer: What the company pays for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer. Strictly Financials 38
  39. 39. Cost of Goods Sold n  n  Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers. Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS. Strictly Financials 39
  40. 40. SGA n  n  Includes office expenses, accounting, shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale. Often includes depreciation and amortization. Strictly Financials 40
  41. 41. Other Income/Expenses n  n  n  n  n  n  Discontinued items Unusual/extraordinary items Changes in accounting principle Impairment charge Sale of investment Minority interest Strictly Financials 41
  42. 42. Thinking Inside the Box n  Revenues Minus cost of goods sold Equals gross profit Minus operating expenses Equals operating profit Minus or plus other expenses/income Minus or plus interest expenses/income Minus income taxes n  Net income n  n  n  n  n  n  n  Strictly Financials 42
  43. 43. Inside the Box Earnings n  n  n  n  Sales or revenues Cost of goods sold Gross profit Operating expenses n  n  n  Sales, general and administrative Depreciation, amortization Operating profit Strictly Financials 43
  44. 44. ‘One-Time’ Gains That Reoccur n  n  n  Don’t be fooled by extraordinary items that make the net income look better than it really is Extraordinary items should be both unusual in nature and infrequent in occurrence Examples: Writedowns, restructurings, etc. Strictly Financials 44
  45. 45. Earnings Per Share n  n  Basic earnings per share (Bloomberg) Diluted earnings per share (Wall Street Journal, fully diluted) Strictly Financials 45
  46. 46. Calculating EPS n  n  Basic: Net income for period divided by weighted average number shares outstanding. Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments. Strictly Financials 46
  47. 47. Dividend n  Company’s board of directors decides to distribute a portion of a company's net income to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). Strictly Financials 47
  48. 48. Dividend Payout Ratio n  The percentage of a company’s net income that is paid to shareholders in dividends. Strictly Financials 48
  49. 49. Dividend Payout Ratio Dividend per share Earnings per share Dividend payout Net Income for same period Strictly Financials 49
  50. 50. Dividend Yield n  n  How much a company pays out in dividends each year in relation to its stock price. A way to measure how much cash flow you are getting for each dollar invested in an equity position. Investors who require a minimum stream of cash flows from their investments can secure this by investing in stocks paying relatively high, stable dividend yields. Strictly Financials 50
  51. 51. Dividend Yield Dividend Stock price $1 $20 5% vs. $1 $40 2.5% Strictly Financials 51
  52. 52. Looking at Dividends n  n  In general, investors react poorly to a decrease in dividends, and the stock price usually declines as investors seek other dividend-paying stocks. A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors. Strictly Financials 52
  53. 53. Balance Sheet n  n  It balances Assets = Liabilities + Shareholders’ Equity Strictly Financials 53
  54. 54. Assets n  Current assets n  n  n  n  n  Cash and cash equivalents Accounts receivable Inventories Prepaids Investments and other assets Strictly Financials 54
  55. 55. Assets n  Property, plant and equipment, net n  n  n  n  n  Land and improvement Buildings and improvements Equipment Less accumulated depreciation Goodwill and other intangibles Strictly Financials 55
  56. 56. Goodwill and Impairment n  Difference between what a business pays to buy another company and the book value (total assets minus total liabilities) of that company Strictly Financials 56
  57. 57. Liabilities n  Current liabilities n  n  n  n  n  Noncurrent liabilities n  n  n  Accounts payable Accrued liabilities Income taxes Current maturity of long-term debt Long-term debt Deferred income taxes Commitments and contingencies Strictly Financials 57
  58. 58. Shareholders’ Equity n  Capital stock n  n  n  n  n  Preferred stock Common stock Additional paid-in capital Retained earnings Treasury stock n  n  Total shareholders’ equity Total L + OE Strictly Financials 58
  59. 59. Statement of Cash Flows n  Record of cash provided by cash sources and of cash consumed by cash uses. Strictly Financials 59
  60. 60. Cash Flows (cont.) n  n  n  n  n  Information about use of cash Information about investing and financing Ability to continue as a going concern Ability to generate future positive cash flows Ability to meet obligations and pay dividends Strictly Financials 60
  61. 61. Cash Flows n  n  n  From operations From investing From financing Strictly Financials 61
  62. 62. Flexibility n  n  n  Companies have some flexibility in categories for entries. Total change in cash, however, will not change. Overwhelming majority of all accounting standards deal with balance sheet and income statement, not cash flows statement. Strictly Financials 62
  63. 63. Free Cash Flow n  n  n  n  Powerful tool for making a company successful Powerful indicator for investors Cash that is left over after productive capacity is maintained or expanded Permits expansion, paying down debt, buying back shares, etc. Strictly Financials 63
  64. 64. Free Cash Flow (cont.) n  n  n  Several ways to calculate it Companies create their own models Gross way to do it: n  n  n  Cash from operating activities Minus capital expenditures Equals free cash flow Strictly Financials 64
  65. 65. American Standard Model n  n  n  n  n  Cash from operating activities Minus capital expenditures Plus proceeds from disposal of property Plus proceeds from sale and leasebacks Equals free cash flow Strictly Financials 65
  66. 66. Free Cash Models n  n  n  ‘Gross’ method American Standard method VF method n  Cash from operating minus cash from investing Strictly Financials 66
  67. 67. Keys to Looking at Cash n  n  n  n  Cash from operations Capital expenditures (cap ex) Free cash Cash and cash equivalents at the end of the year Strictly Financials 67
  68. 68. Looking at the Numbers n  n  n  n  n  n  Note changes in amounts year to year, especially revenues and expenses Note numbers that are significantly larger or smaller than the previous period Look at trend line for sales/revenues, operating income and net income. Calculate percentage change for each. Look at cash flow Look at free cash flow Tie the numbers to the footnotes. Strictly Financials 68
  69. 69. Techniques n  n  n  n  Calculate percentage change Trend analysis Common size analysis Ratio analysis Strictly Financials 69
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