MACC 594: LECTURE NOTES, MODULE I: INTRODUCTION TO ANALYSIS AND REVIEW OF BASIC CONCEPTS PART I. A. REVIEW OF FINANCIAL STATEMENTS ANALYZING THE BALANCE SHEET • The balance sheet lists the firm’s assets, liabilities and equity accounts and their balances at the end of the period. • What does the balance sheet reveal about a firm? • Size of the company (total assets or net assets) • Major assets owned and proportion of current vs. noncurrent assets: - Is the mix of assets consistent with norms in the industry? - Is it likely that any large assets are overstated (warn of future writedowns)? • Major liabilities and proportion of current vs. noncurrent liabilities: - Is it likely that any liabilities are understated? • Identify trends or abrupt changes in major assets, liabilities and equity during period. Attempt to explain cause of any abrupt changes.
ANALYZING THE BALANCE SHEET--CONTINUED
• How are assets financed? Compare proportions of financing from different sources: • Internal financing: earned capital / total assets • External financing from shareholders: contributed capital / total assets • External financing from suppliers and creditors: total liabilities / total assets (and total debt / total assets)
• Examine equity and identify major components and red flags: • Retained deficits (i.e., negative retained earnings) and negative stockholders equity are red flags • Has the firm spent exorbitant amounts of money repurchasing shares? Compare treasury stock to contributed capital and earned capital.
• Use balance sheet to assess liquidity and solvency. • Highly leveraged firms (high debt) with problems on the asset side (overstated assets) are likely to have problems. Some problems appear on the balance sheet before they reduce net income.
ANALYZING THE BALANCE SHEET -- CONTINUED
Limitations (weaknesses) of the balance sheet:
For many assets and liabilities, book value is far below market value; therefore, the balance sheet understates the value of these items. E.g., land. Some assets and liabilities are not recognized on the balance sheet. E.g., research and development, intangible assets developed within the firm, operating leases. Classification scheme is not meaningful Partitioning: operating vs. financing is more useful for equity analysis than current vs. noncurrent.
ANALYZING THE INCOME STATEMENT
• The “bottom line”: net income Is the firm profitable (or reporting losses)? Consider size and trends. Is growth from sustainable sources?
The “top line”: sales revenue Consider size and trends; sustainable growth in net income is from revenue growth Income from operations -- is it growing? why? Cutting costs is not a sustainable source of growth. How is the firm generating most of its income and growth in income? Source: operating activities, nonoperating activities, or earnings management? Sustainability: recurring or nonrecurring items?
• What largest expenses? What are largest sources of income? Identify trends and explain abrupt changes.
ANALYZING THE INCOME STATEMENT--CONTINUED
• Earnings per share and diluted earnings per share • Use figures to calculate profit margins, which reveal how effectively the firm generates profit from its sales revenue.
• Link between income statement and balance sheet: net income is added to retained earnings at the end of the fiscal period.
• Limitations (weaknesses) of the income statement: Figures (revenues, expenses, gains and losses) are easy to manipulate—the quality of some firms’ earnings is low. For such firms, net income is not a meaningful measure of real economic profit. firm’s recurring operating profit.
Income statement does not provide a standardized measure of a Cannot determine portion of growth that is organic.
ANALYZING THE INCOME STATEMENT -- CONTINUED
Step One: Identify Sources of Income Identify income statement items...