Rudiments of Financial Analysis
Edward F. McKelvey
Oberlin College
Investment Club Meeting
September 19, 2016
Outline
1.
2.
3.
4.
5.
6.
Stocks vs. Flows
Balance Sheets
Income Statements
Cash Flow Statements
Key Ratios
Disciplined Investing
2
1. Stocks vs. Flows
• A stock is a quantity outstanding as of a given moment in
time.
– Either specify the exact time (e.g., end of period) or the period over
which you average.
• Economic examples:
– Money in your pocket right now.
– Balance in your checking account last night.
• average balance over the last month.
– Amount you owe on a student loan.
– Inventories on the shelf.
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1. Stocks vs. Flows
• A flow is a quantity (produced, spent or earned) during a
specific period.
– Can’t answer the question without knowing what period.
• Economic examples:
– Interest earned on your savings account (per month).
– The money you spend on food (in a day).
– A firm’s production (over the past week).
– Corporate profits (last quarter).
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Outline
1. Stocks vs. Flows
2. Balance Sheets
– Definitions of terms
– Schematic
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2. Balance Sheets
• An asset is anything of value that you own (or a firm owns):
– Two concepts of value
• Book value: what you paid for it.
• Market value: determined by the cash flow/value of services it generates
over time.
– Examples:
•
•
•
•
•
Cash on hand.
Deposits in the bank.
Inventories on the shelf.
Plant and equipment.
House.
– Assets are stocks.
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2. Balance Sheets
• A liability is something you owe (or a firm owes):
– Your liability is someone else’s asset.
– Changes in market value matter only to who holds the asset.
– Examples:
•
•
•
•
Student loan (for the student).
Borrowing from a friend (from your perspective as the borrower).
Accounts payable (what a company owes its suppliers).
A bond issued by a company (from the company’s perspective).
– Liabilities are also stocks.
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2. Balance Sheets
• Net worth is the difference between assets and liabilities:
– The balance sheet identity:
𝑨𝒔𝒔𝒆𝒕𝒔 ≡ 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 + 𝑵𝒆𝒕 𝑾𝒐𝒓𝒕𝒉
– Net worth is also called:
• Owners’ equity
• Shareholders’ equity
• Capital account
– Like assets and liabilities, net worth is a stock concept.
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2. Balance Sheets
Assets
Current assets
• Lives of less than one year
• Includes inventories as well
as short-term financial
assets such as cash and
accounts receivable.
Fixed assets
• Plant & equipment
• Intangible assets (patents,
etc.)
Liabilities & Owners’ Equity
Current liabilities
• Lives of one year or less
• Examples: accounts
payable, commercial paper.
Long-term liabilities
• Lives of more than one
year
• Example: bonds.
Net
working
capital.
Owners’ equity.
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2. Balance Sheets
• Balance Sheet: Example—Lockheed Martin
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Outline
1. Stocks vs. Flows
2. Balance Sheets
3. Income Statements
– Definitions of terms
– Schematic
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3. Income Statements
• Revenue is an inflow of money to the firm.
– Total operating income (from the basic business of the firm).
• Expenses are outflows
– Various types of expenses (not all cash outlays):
• Cost of producing the goods (“cost of goods sold”)
• Depreciation (a non cash allocation to replace worn out equipment)
• Taxes
• Income is the difference
– The income statement identity:
𝑰𝒏𝒄𝒐𝒎𝒆 ≡ 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 − 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔
– Distinguish between pretax and after-tax income.
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3. Income Statements
Total operating revenue
Less:Cost of goods sold
Less:Selling, general, and administrative (SGA) expenses
Less:Depreciation & amortization
Equals:Operating income
Plus:Other income
Equals:Earnings before interest and taxes (EBIT)
Less:Interest expense
Equals:Pretax income
Less:Taxes
Equals:Net income
Dividends
Addition to retained earnings
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3. Income Statements
• Income (Earnings) Statement: Example—Lockheed Martin
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Outline
1.
2.
3.
4.
Stocks vs. Flows
Balance Sheets
Income Statements
Key Ratios
–
–
–
–
Liquidity
Solvency
Profitability
Market value
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4. Cash Flow Statements
• Objective: Analyze the change in the company’s cash
balance
• Major activities:
– Operating activities (daily operations and changes in net
working capital)
– Financing activities (changes in long-term funding—i.e., in
the right side of the balance sheet)
• Exception: interest payments are usually included in the first
group.
– Investment activities (changes in the left-hand side of the
balance sheet)
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4. Cash Flow Statements—Bathtub Analogy
Sources of Cash (into the tub)
Operations activity
Net income + deprec.,
S-term borrowing
Sell s-term assets
Investment activity
Sell fixed assets
Financing activity
Issue debt
Issue stock
N.B.: Interest payments are here
(a charge against net income)
Cash on hand
Operations activity
Put $ in s-t assets,
including inventory
Pay down s-t debt
Investment activity
Buy fixed assets
Financing activity
Pay dividends
Retire debt
Buy back stock
Uses of Cash (out of the tub)
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4. Cash Flow Statements—Example
2015 Statement of Cash Flows
Cash, beginning of year
$5,000
Operating activity
Net income
Investment activity
$1,885
Plus:
Fixed asset acquisitions
Net cash from investment activity
Depreciation
$3,000
Increase in accounts payable
$3,000
Increase in short-term borrowing
$5,000
Less:
$0
$0
Financing activity
Net increase in long-term debt
$0
Increase in accounts receivable
-$2,000
Issuance of stock
$0
Increase in inventory
-$3,000
Dividends paid
$0
Decrease in short-term borrowing
-$5,000
Net cash from operating activity
$2,885
Net cash from financing activity
$0
Net increase in cash
$2,885
Cash, end of year
$7,885
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4. Cash Flow Statements
• Cash Flow Statement: Example—Lockheed Martin
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Outline
1.
2.
3.
4.
5.
Stocks vs. Flows
Balance Sheets
Income Statements
Cash Flow Statements
Key Ratios
–
–
–
–
Liquidity
Solvency
Profitability
Market value
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5. Key Ratios—Liquidity
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒓𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
• An alternative way to look at net working capital (NWC):
• A value greater than one means that current assets are large
enough to meet current liabilities.
• Short-term creditors value a high current ratio.
• But it can signal inefficient deployment of assets or be
affected by transitory events (e.g., proceeds from long-term
borrowing not yet invested).
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5. Key Ratios—Liquidity
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔 − 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
𝑸𝒖𝒊𝒄𝒌 𝒓𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
• Recognizes that inventories may not be very liquid or easy to
dispose of in an ongoing business.
• Transforms the current ratio into a comparison of financial
assets and liabilities.
• Large gaps between current and quick ratios occur when most
current assets are in inventory.
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5. Key Ratios—Solvency
𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕 𝒓𝒂𝒕𝒊𝒐 =
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 − 𝑬𝒒𝒖𝒊𝒕𝒚
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
𝑬𝒒𝒖𝒊𝒕𝒚
(also known as the leverage ratio)
𝑬𝒒𝒖𝒊𝒕𝒚 𝒎𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕
𝑫𝒆𝒃𝒕 − 𝒆𝒒𝒖𝒊𝒕𝒚 𝒓𝒂𝒕𝒊𝒐 =
𝑬𝒒𝒖𝒊𝒕𝒚
• Notice that:
𝟏
𝑬𝒒𝒖𝒊𝒕𝒚 𝒎𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝟏 − 𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕 𝒓𝒂𝒕𝒊𝒐
𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕 𝒓𝒂𝒕𝒊𝒐
𝑫𝒆𝒃𝒕 − 𝒆𝒒𝒖𝒊𝒕𝒚 𝒓𝒂𝒕𝒊𝒐 =
𝟏 − 𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕 𝒓𝒂𝒕𝒊𝒐
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5. Key Ratios—Profitability
𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆
𝑷𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑺𝒂𝒍𝒆𝒔
• What percentage of each dollar of sales flows to the bottom line?
• Helpful in focusing on cost-cutting.
• High margin obviously better all else equal.
– However, margin does not measure total profit.
– Higher profits can be associated with lower margins.
𝑬𝑩𝑰𝑻𝑫𝑨
𝑬𝑩𝑰𝑻𝑫𝑨 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑺𝒂𝒍𝒆𝒔
• EBITDA = EBIT + depreciation and amortization (noncash expenses).
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5. Key Ratios—Market Value
𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 (𝑬𝑷𝑺) =
𝑺𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈
• A stockholder’s proportionate share of the company’s
earnings.
• Not what you actually receive.
– Dividends are paid out to shareholders.
– The rest (if positive) is plowed back into the company’s
operations, presumably to help it grow.
• Influenced by number of shares outstanding, so hard to
compare one company to another.
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5. Key Ratios—Market Value
𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑷𝑬 𝒓𝒂𝒕𝒊𝒐 (𝒎𝒖𝒍𝒕𝒊𝒑𝒍𝒆) =
𝑬𝑷𝑺 (𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆)
• Common valuation metric for stock.
• Looks like an interest rate if you flip it upside down (except earnings
aren’t all paid out).
• Examples:
– Context: long-term Treasury yields are between 2% and 3%, however…
– Stock investments reflect risk of the business.
• Measurement issues:
– Earnings: Lagged (what you know) vs future (what investors care
about).
– If earnings are negative—ratio of price to sales may be substituted.
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5. Key Ratios—Market Value
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒚𝒊𝒆𝒍𝒅 =
𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
• The portion of earnings you actually receive.
• Stock returns come in two forms:
– Dividends
– Price appreciation (capital gains).
• Stocks that pay dividends usually don’t appreciate as much
over time.
– Utilities are the classic example.
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Outline
1.
2.
3.
4.
5.
6.
Stocks vs. Flows
Balance Sheets
Income Statements
Cash Flow Statements
Key Ratios
Disciplined Investing
–
–
–
–
Security Recommendation Template
Diversification/Portfolio Balance
Focus on When to Sell as Well as Whether to Buy
Key Danger Signs—Missing the Numbers
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