Accounting Basics: Agenda

• • Introduction to Financial Statements – Balance Sheet – Income Statement – Statement of Cash Flows Metrics and Ratios

Balance Sheet

• • • • • “Snapshot” of a company’s financial standings Details a company’s Assets, Liabilities and Equity Assets: All of the resources of a company Liabilities: All of the obligations of the company Stockholders Equity: The equity stake owned by equity investors. Also referred to as Book Value because it is the value of the company after all obligations have been paid, at book

Balance Sheet

• • • Based on the equation Assets = Liabilities + Stockholder’s Equity – In words: The resources of a company must be equal to all of the capital that is attributed to the company (i.e. Debt and Equity) Important Note: Assets, Liabilities and Stockholder’s Equity are recorded at historical cost per GAAP rules, not market value Let’s take a look at the left hand of the equation

• • • • • Listed in order of liquidity – how quickly can they be converted to cash Current assets are those that mature in 1 year or less Receivables are essentially products or services bought on account – cash hasn’t changed hands Tangible vs. Intangible Goodwill is a common intangible assets. It represents the excess amount paid over the carrying value of a company acquired, it is impaired not amortized.

• • • • Liabilities are listed in order of time to be repaid Accounts payable represents services or products bought on account – have not yet been paid Current portion of long term debt is the portion of long term debt that must be paid within 1 year Minority represents the portion of the company that is not owned

• • • • Common stock represents the par value of the stock issued by the company – Sometimes there will be an account called additional paid-in capital to account for the surplus over par value Retained earnings is the accumulative account that captures all of the earnings of the company (net income flows into this account) Treasury stock represents the amount of stock repurchased Preferred stock is a common type of equity that has higher claim than common equity, but lower claim than debt. Generally have regular dividends.

Income Statement

• • • • Income Statement shows the performance of a business over a given amount of time (i.e. quarter or year) By definition income is simply Revenue – Expenses Revenue is recognized when it accrues, not when cash trades hands – This causes a discrepancy between income and cash flow There are also non-cash items on an income statement which are expenses that don’t actually effect cash flow, but do effect the amount of taxes paid – This will be an important concept moving forward

Income Statement

Income Statement Revenues - COGS

Gross Profit

- SG&A - Depreciation and Amortization

EBIT or Operating Income

- Interest Expense

EBT

- Income Taxes

Net Income or Earnings

• • • • • Cost of Goods sold includes all of the cost associated with producing the product SG&A is Selling General & Administrative Expenses Depreciation is how purchases of fixed assets are expensed – non cash expense Amortization is the depreciation of intangible assets – non cash expense EBIT stands for Earning Before Interest and Taxes

Income Statement

Statement of Cash Flows

• • Reconciles the amount of money earned (NI) with the actual cash that the firm generates – Very important because in Finance we focus on cash over earnings because earnings can be manipulated and cash cannot Breaks cash flows into three separate segments – Cash from Operating Activities • Cash provided/used in the normal operations of the business – Cash from Investing Activities • Investing activities refer to investments in capital assets (PP&E) – Cash from Financing Activities • Refers to any transactions between the firm and holders of capital (debt or equity)

Statement of Cash Flows

Interview Question

• How would a purchase of fixed assets worth $100 effect the three financial statements? Assume straight-line depreciation over 10 years.

Answer

• • • Balance Sheet: Cash decreases by 100, Net PP&E increases by 90, Retained Earnings decreases by 10 Income Statement: Depreciation increases by $10 and Net Income decreases by same amount Statement of Cash Flows: – Operating Activities: Net Income decreases by 10, depreciation increases by 10 – Net Change in cash = $0 – Investing Activities: Capital Expenditure of $100 – Net Change in cash = $100

Metrics and Ratios

• • • Solvency: – – Current Ratio: Current Assets/Current Liabilities Quick Ratio: Current Assets – Inventory / Current Liabilities Leverage: – – – Debt-to-Equity Ratio: Total Debt / Total Equity Debt Ratio: Total Debt / Total Assets Times Interest Earned Ratio (TIE) or EBIT Coverage: EBIT/Int Expense Profitability – – – – Return on Assets: Net Income / Average Assets Return on Equity: Net Income / Average Equity Gross Margin: Gross Profit / Total Revenue Net Profit Margin: Net Income / Total Revenue

Cash Flows Equations

• • • Equations that are used for the DCF Two Options – Free Cash Flow to Firm – Free Cash Flow to Equity For our DCF we use FCF to Equity

Components of FCF to Equity

• Net Income + Depreciation – Change in Net Working Capital – Capital Expenditure + Net New Debt – – – Net Income: We start with levered (i.e. after interest) earnings Depreciation: We add back Depreciation as it is a non-cash expense Net Working Capital: Current Assets – Current Liabilities. Companies like to maintain a positive net working capital position and a positive NWC represents an “investment” in NWC – Capital Expenditure: Change in Net Fixed Assets. We need to invest in the assets that make our business profitable every year – Net New Debt: Increasing our debt means we get more cash, which we add back