Chapter 2: Introduction to Financial Statement Analysis: Key Concepts and Applications

Introduction to Financial Statement Analysis

Overview

Financial statement analysis is a fundamental process in financial accounting, enabling users to interpret and evaluate a company's financial health and performance. This topic covers the types of financial statements, their users, methods of analysis, and practical applications using real-world data.

Types of Financial Statements

Main Financial Statements in a 10-K Filing

• Balance Sheet: Presents a company's assets, liabilities, and shareholders' equity at a specific point in time.

• Income Statement: Shows revenues, expenses, and profits over a period.

• Statement of Cash Flows: Details cash inflows and outflows from operating, investing, and financing activities.

• Statement of Shareholders' Equity: Explains changes in equity accounts over time.

These statements are audited and must comply with GAAP (Generally Accepted Accounting Principles) to ensure accuracy and reliability.

Users of Financial Statements

Categories of Users and Their Interests

• Investors: Assess profitability, risk, and potential returns.

• Creditors: Evaluate liquidity and solvency to determine creditworthiness.

• Managers: Use data for strategic planning and performance evaluation.

• Regulators: Ensure compliance with laws and regulations.

• Suppliers and Customers: Assess financial stability for business relationships.

Example: Stockholders use statements to assess a firm's profitability and ability to make future dividend payments.

Finding Financial Statements

Sources for Public Company Financial Statements

• Company's investor relations website

• SEC EDGAR database

• Financial data platforms (e.g., MarketWatch, Yahoo Finance)

Analyzing Financial Statements

Key Analytical Questions

• How much cash does a company have at year-end?

• What are the total assets and liabilities?

• What is the book value of equity?

• What is the market capitalization?

• What is the enterprise value?

• What is the market-to-book ratio?

Important Formulas

• Book Value of Equity: $\text{Book Value of Equity} = \text{Total Assets} - \text{Total Liabilities}$

• Market Capitalization: $\text{Market Cap} = \text{Share Price} \times \text{Shares Outstanding}$

• Enterprise Value: $\text{Enterprise Value} = \text{Market Cap} + \text{Total Debt} - \text{Cash}$

• Market-to-Book Ratio: $\text{Market-to-Book Ratio} = \frac{\text{Market Cap}}{\text{Book Value of Equity}}$

Practical Applications and Case Studies

Example: Analyzing Qualcomm and Costco

• Locate 10-K filings to find cash, total assets, liabilities, and equity.

• Calculate ratios such as current ratio, debt-to-equity, and market-to-book.

• Interpret changes in financial metrics over time to assess performance.

Example: Impact of Operating Expenses and Capital Expenditures

• Operating expenses reduce net income in the year incurred.

• Capital expenditures are depreciated over time, affecting net income gradually.

• Depreciation Formula: $\text{Annual Depreciation} = \frac{\text{Capital Expenditure}}{\text{Useful Life}}$

Financial Statement Data and Stock Price Table

Purpose

Tables in financial statement analysis are used to compare key metrics across years, such as revenues, net income, profit margins, and stock prices.

Year	Revenue ($M)	Net Income ($M)	Profit Margin (%)	Stock Price ($)
2016	4,043	445	11.0	24.50
2017	4,456	476	10.7	26.00
2018	4,890	509	10.4	28.50
2019	5,200	540	10.4	30.00

Additional info: Table values are inferred for illustration; actual values may differ.

Advanced Topics

EBIT and Net Income Calculations

• EBIT (Earnings Before Interest and Taxes): $\text{EBIT} = \text{Revenue} - \text{Operating Expenses}$

• Net Income: $\text{Net Income} = \text{EBIT} - \text{Interest Expense} - \text{Taxes}$

Effects of Marketing Campaigns and Capital Structure

• Changes in sales, operating margin, and capital expenditures impact EBIT and net income.

• Share repurchases affect shares outstanding and earnings per share (EPS).

• EPS Formula: $\text{EPS} = \frac{\text{Net Income}}{\text{Shares Outstanding}}$

Summary

Financial statement analysis is essential for understanding a company's financial position and making informed decisions. By mastering the interpretation of key statements, ratios, and metrics, students can evaluate real-world companies and apply these skills in professional contexts.