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Seminar 6


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Understanding financial statements (II)

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Seminar 6

  1. 1. Understanding Financial Statements II Speaker Position Company smart woman securities © 2010 Smart Woman Securities. Materials are for SWS members’ use only. All rights reserved. Date
  2. 2. Announcements <ul><li>Please enter any SWS related announcements here. </li></ul>
  3. 3. Last Seminar Recap <ul><li>Financials paint a picture about a company and industry – they’re more than just numbers! </li></ul><ul><li>Use balance sheets to assess a company’s financial position at a point in time </li></ul><ul><li>Assets are what a company owns. Liabilities are what a company owes. </li></ul><ul><li>Accounts within each category help you understand more about the business operations. </li></ul>
  4. 4. Tonight’s Agenda <ul><li>Income Statement </li></ul><ul><li>Statement of Cash Flows </li></ul>
  5. 5. This Week’s Seminar <ul><li>After this, you should be able to: </li></ul><ul><ul><li>Be familiar with the three financial statements (balance sheet, income statement, cash flow statement) </li></ul></ul><ul><ul><li>Understand why you look at each statement </li></ul></ul><ul><ul><li>Understand the income statement accounts, what they mean, and how to read them </li></ul></ul><ul><ul><li>Understand the three main sections of the cash flow statements and what they mean </li></ul></ul>
  6. 6. Market Update <ul><li>Have speaker comment on what happened in the markets for past week. </li></ul><ul><li>We encourage speakers to create a slide of important occurrences (see next slide for example). </li></ul>
  7. 7. Market Update Example Slide <ul><li>There were mixed technology results as Apple & Microsoft posted solid positive third quarter earnings; raising concerns about semiconductor valuations </li></ul><ul><li>Merrill Lynch wrote down $7.9b in losses from subprime losses, which adds more wariness around the health of the housing market. </li></ul><ul><li>Bank of America announced 3,000 job cuts, which adds concern to the state of the economy. </li></ul><ul><li>Crude oil futures climbed above $92; analysts expect it to surpass $100, a strong sign for the economy. </li></ul><ul><li>S&P500 gained 2.3% on the week; DJIA was up 2.1% while the NASDAQ was up 2.9% as investors seemed less concerned about risks in the credit markets. </li></ul>
  8. 8. Review: Stock Picking <ul><li>#1: Finding ideas through trends </li></ul><ul><ul><li>Newspapers, TV, roommates, internet, everyday life </li></ul></ul><ul><ul><li>Wall Street Journal, New York Times </li></ul></ul><ul><ul><li>Come up with preliminary list of companies </li></ul></ul><ul><li>#2: Research the company </li></ul><ul><ul><li>What industry does it belong in? What trends impact that industry? </li></ul></ul><ul><ul><li>Company website, financial filings (MD&A section), talk to company mgmt, listen to conference calls </li></ul></ul><ul><ul><li>Porter’s 5 forces tell you if it’s a good business (customer power, supplier power, barriers to entry, threat of substitutes, rivalry) </li></ul></ul><ul><li>#3: Determine how sustainable trends are (this is subjective, no easy answer) </li></ul><ul><ul><li>Talk to company mgmt, think independently (what makes sense?) </li></ul></ul><ul><ul><li>Remember trends drive revenues, and revenues drive earnings (aka EPS)! </li></ul></ul>
  9. 9. Next Up: Valuation <ul><li>#4: Use valuation to determine if a trends are priced into the stock </li></ul><ul><li>#5: Use valuation to determine future stock price </li></ul><ul><li>But, before we can do this, we must learn about the financial statements </li></ul><ul><ul><li>Balance Sheet </li></ul></ul><ul><ul><li>Income Statement </li></ul></ul><ul><ul><li>Statement of Cash Flows </li></ul></ul>
  10. 10. Income Statement
  11. 11. Income Statement <ul><li>Tells us about the profitability of a company over a 3-month or 1-year period vs. point in time (balance sheet) </li></ul><ul><li>Basic equation: </li></ul><ul><li> revenues – expenses = net income </li></ul><ul><ul><li>Revenues: what the firm gets paid for selling goods (sometimes also called sales) </li></ul></ul><ul><ul><li>Expenses: costs firm incurs to create those goods </li></ul></ul><ul><ul><li>Analysis of net income (& other measures of profitability) tell us how profitable the firm is </li></ul></ul><ul><li>Net Income = “earnings” </li></ul>
  12. 12. Revenues and Expenses <ul><li>Revenues are typically = price x volume. </li></ul><ul><ul><li>Price per widget x # of widgets </li></ul></ul><ul><li>Expenses are the costs incurred in generating revenues </li></ul><ul><ul><li>Cost of goods sold </li></ul></ul><ul><ul><li>Selling, general and administrative expenditures </li></ul></ul><ul><ul><li>Depreciation </li></ul></ul><ul><ul><li>Interest </li></ul></ul><ul><ul><li>Income taxes </li></ul></ul><ul><ul><li>Source: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001 </li></ul></ul>
  13. 13. Income Statement Example <ul><li>Revenues = # of loaves of bread sold x price per loaf </li></ul><ul><li>Cost of Good Sold = cost of ingredients & cost of using the plant to produce the bread, cost of labor </li></ul><ul><li>Gross Profit = amount of money left over after paying for the cost of the items sold </li></ul><ul><li>Selling General & Administrative Costs = costs to run your headquarters, your salaries </li></ul>
  14. 14. Income Statement Example <ul><li>Operating Profit (also called Earnings Before Interest and Taxes (EBIT)) = the amount of profit you have left after paying for all of the operations of the business </li></ul><ul><li>Interest expense = cost of taking on debt </li></ul><ul><li>Taxes = what you owe the government </li></ul><ul><li>Net Income = the amount of profits you have left over </li></ul><ul><li>EPS = net income divided by shares outstanding </li></ul><ul><li>Diluted Shares Outstanding = number of shares (always use diluted!) </li></ul>
  15. 15. Earnings <ul><li>From the income statement, we can determine the company’s earnings </li></ul><ul><ul><li>The company can do three things with earnings </li></ul></ul><ul><ul><ul><li>Pay dividends (returning money to shareholders) </li></ul></ul></ul><ul><ul><ul><li>Repurchase shares (returning money to shareholders) </li></ul></ul></ul><ul><ul><ul><li>Re-invest in the company (known as “retained earnings”) </li></ul></ul></ul><ul><li>Earnings per share (EPS) </li></ul><ul><ul><li>How much a stock earned per share (or, net income divided by number of shares outstanding </li></ul></ul><ul><ul><li>During “earnings” season (4x a year), companies have to report how well they did in the previous quarter. Oftentimes you might hear about a company “missing earnings”… this means that the company reported EPS below consensus </li></ul></ul>
  16. 16. Earnings <ul><li>Quarterly earnings </li></ul><ul><ul><li>How much profit a company made or lost during the past quarter </li></ul></ul><ul><ul><li>Given in EPS </li></ul></ul><ul><ul><ul><li>Usually company also holds an earnings call where they discuss their earnings and company financial performance </li></ul></ul></ul><ul><li>Earnings seasons </li></ul><ul><ul><li>Differ by company, but typically they come in the month after the end of the quarter </li></ul></ul><ul><li>Earnings vs. consensus </li></ul><ul><ul><li>Consensus from Wall Street analysts on what EPS will be </li></ul></ul><ul><ul><li>If the company beats estimates, the stock tends to go up </li></ul></ul><ul><ul><li>If the company falls short, the stock tends to go down </li></ul></ul><ul><ul><ul><li>However, other aspects may also cause stock to move (management earnings call, announcement about part of the business, etc.) </li></ul></ul></ul>
  17. 17. Income Statement (CL)
  18. 18. Income Statement Detail (CL) <ul><li>Usually companies give more detail regarding revenues, either by region or by product </li></ul>
  19. 19. How We Can Read Income Statements <ul><li>Its usefulness </li></ul><ul><ul><li>Summarizes sales and profits and losses (P&L) over a period of time – hence why it is often called a P&L statement! </li></ul></ul><ul><ul><li>Lets us look at changes in key line items and ratios across time to see whether operations have been changing and in what direction </li></ul></ul><ul><li>Its limitations </li></ul><ul><ul><li>Difficult to compare some ratios for companies in different industries </li></ul></ul><ul><ul><li>Management teams have lots of options for accounting practices </li></ul></ul><ul><ul><li>Revenues reported don’t always equal cash collected, and expenses reported aren’t always equal to cash paid, so income usually IS NOT EQUAL to the change in cash for the period </li></ul></ul><ul><ul><li>There are many components in income statements; make sure you read the footnotes so that you’re getting the whole story! </li></ul></ul><ul><ul><li>Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton </li></ul></ul>
  20. 20. Statement of Cash Flows
  21. 21. Cash Flows <ul><li>Statement of cash flows provides relevant information about a company’s cash inflows and outflows </li></ul><ul><li>Net Income ≠ Cash generated!! </li></ul><ul><ul><li>Net income is a function of accrual accounting which smoothes cash flow </li></ul></ul><ul><ul><li>Cash can’t be manipulated </li></ul></ul><ul><li>Cash flows help investors (and creditors) assess </li></ul><ul><ul><li>Future funding needs </li></ul></ul><ul><ul><li>Liquidity (cash to run daily/annual operations) </li></ul></ul><ul><ul><li>Long-term solvency (ability to pay bills and service debt) </li></ul></ul><ul><ul><li>Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001 </li></ul></ul>
  22. 22. Income Statement vs. Cash Flows <ul><li>Income statement uses accrual accounting to smooth cash flow, which tends to be lumpy. </li></ul><ul><ul><li>Revenue recognition </li></ul></ul><ul><ul><ul><li>Does a company recognize revenue when end product has been produced, when it’s shipped, when customer receives it? Orders often placed at end of the quarter. </li></ul></ul></ul><ul><ul><li>Cost recognition </li></ul></ul><ul><ul><ul><li>Does a company recognize cost when the end product has been produced, when it receives payment for the product? </li></ul></ul></ul><ul><ul><li>There is a LOT of discretion by the CFO in terms of how s/he can account for items in the income statement </li></ul></ul><ul><li>Cash flow is literally the cash being generated and used by the company over a certain period of time </li></ul>
  23. 23. Cash Flows <ul><li>3 sections of the cash flow statements </li></ul><ul><ul><li>Operating Activities </li></ul></ul><ul><ul><ul><li>How much cash do the firm’s core operations generate? </li></ul></ul></ul><ul><ul><li>Investing Activities </li></ul></ul><ul><ul><ul><li>How much cash firm is spending on long term assets to grow (capex) or on acquisitions </li></ul></ul></ul><ul><ul><li>Financing Activities </li></ul></ul><ul><ul><ul><li>How much cash firm is spending to finance its growth (debt borrowed & equity issued) </li></ul></ul></ul><ul><ul><ul><li>How much cash firm is returning to shareholders (dividends, share repurchases) </li></ul></ul></ul>
  24. 24. Cash Flows from Operating Activities <ul><li>Inflows </li></ul><ul><ul><li>Cash received from customers (remember accounts receivables) </li></ul></ul><ul><li>Outflows </li></ul><ul><ul><li>Buying inventory (remember accounts payables) </li></ul></ul><ul><ul><li>Paying salaries and wages </li></ul></ul><ul><ul><li>Paying suppliers (also accounts payable) </li></ul></ul><ul><ul><li>Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001 </li></ul></ul>
  25. 25. Net Income and Operating Cash Flow <ul><li>Operating cash flow statement takes Net Income and makes adjustments so investors can see how much cash the business generated </li></ul>
  26. 26. Cash Flows from Operating Activities
  27. 27. Cash Flows from Investing Activities <ul><li>Inflows </li></ul><ul><ul><li>Cash received from sales of PP&E (selling an plant the firm doesn’t need anymore). Pretty infrequent. </li></ul></ul><ul><li>Outflows </li></ul><ul><ul><li>Purchasing long-term assets (PP&E) = capital expenditures (aka capex) (building a new plant) </li></ul></ul><ul><ul><li>Acquisitions of other companies </li></ul></ul><ul><ul><li>Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001 </li></ul></ul>
  28. 28. Cash Flows from Investing Activities
  29. 29. Cash Flows from Financing Activities <ul><li>Inflows </li></ul><ul><ul><li>Cash received from borrowing (i.e. firms borrow cash from banks to make acquisitions) </li></ul></ul><ul><ul><li>Cash received from issuing stock (i.e. firm issues shares to raise money) </li></ul></ul><ul><li>Outflows </li></ul><ul><ul><li>Repaying debt (i.e. firms eventually have to pay back what they borrowed from the bank) </li></ul></ul><ul><ul><li>Paying dividends to shareholders </li></ul></ul><ul><ul><li>Repurchasing stock </li></ul></ul><ul><ul><li>Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001 </li></ul></ul>
  30. 30. Cash Flows from Financing Activities
  31. 31. Cash Flows (CL)
  32. 32. How To Read Cash Flow Statements <ul><li>Its usefulness </li></ul><ul><ul><li>You can actually see where cash is going and how the company spends it </li></ul></ul><ul><ul><li>Changes in the B/S can be explained by looking at CF statement </li></ul></ul><ul><ul><li>Get a better understanding of a company’s investing and financing activities because these aren’t obvious in the I/S </li></ul></ul><ul><li>Its limitations </li></ul><ul><ul><li>When companies make acquisitions, it is often difficult to fully reconcile all of the cash inflows and outflows w/ the B/S </li></ul></ul><ul><ul><li>Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton </li></ul></ul>
  33. 33. Free Cash Flow: Important Metric <ul><li>Free Cash Flow (FCF) is the most important metric from the statement of cash flows </li></ul><ul><li>FCF represents the cash that a company has left over after paying money required to maintain/expand its asset base </li></ul><ul><li>It isn’t given to you, but it’s easy to calculate from the cash flow statement. The most basic way is: </li></ul><ul><ul><li>Free Cash Flow = </li></ul></ul><ul><ul><li>Operating Cash Flow – Capital Expenditures </li></ul></ul>
  34. 34. What is Free Cash Flow? <ul><li>Free cash flow is what a company has left over at the end of the year - or quarter - after paying all its employees' salaries, its bills, its interest on debt, and its taxes, and after making capital expenditures to expand the business </li></ul><ul><li>Investors often refer to this as the “cash” that the company is producing. The company can decide what they want to do with the cash (expand, pay a dividend, pay down debt). Like with most things, the more cash you have, the more options you have. </li></ul>
  35. 35. Free Cash Flow Example <ul><li>For our, CL example, you take 1,821.5 (cash from operations) and add 476.4 (capex) and you get 1,345.1in FCF. </li></ul><ul><li>So in 2006, CL had $1.3 billion in FCF. Now, that’s serious cash! </li></ul>
  36. 36. Seminar Recap <ul><li>Income statements measure profitability over a certain time period </li></ul><ul><ul><li>Revenues are what a company makes, expenses are its costs, and profit or earnings are what it takes home at the end. </li></ul></ul><ul><li>Cash flow statements help to show you were cash has been used in the business and has three important parts: </li></ul><ul><ul><li>Operating - cash going in/out for business operations </li></ul></ul><ul><ul><li>Investing - cash going in/out for growth and investment </li></ul></ul><ul><ul><li>Financing - cash going in/out to finance operations or growth or to return cash to shareholders /bondholders </li></ul></ul>
  37. 37. <ul><li>Week 7: </li></ul><ul><li>Understanding important financial metrics </li></ul><ul><li>Calculating financial ratios </li></ul><ul><li>Analyzing what ratios mean about a company or industry </li></ul><ul><li>Week 8: </li></ul><ul><li>Understanding how an investment recommendation works </li></ul><ul><li>Putting it all together with an investment recommendation </li></ul><ul><li>Seeing a real world example of an investment recommendation </li></ul><ul><li>Weeks 9-10: </li></ul><ul><li>Guest lectures/presentations </li></ul>Coming Up