Financial Statements & Analysis

1. Financial Statements & Analysis Resa Lundkvist Former Financial Analyst, Standard & Poor’s Retired Managing Director, JP Morgan Adjunct Professor, Finance, SNHU

2. Brady Inc. Balance Sheetas of 12/31/13 Assets=Liabilities + Stockholders Equity Cash $100 Accounts Payable $300 Accounts Receivable 200 Notes Payable 200 Inventory 400 Current portion LTD 100 Current Assets 900 Current Liabilities 600 Equipment, net of Dep’n 800 Long-Term Debt 700 Property 900 Total Liabilities 1,300 Noncurrent Assets 1,700 Common Stock 900 Retained Earnings 600 Stockholders Equity 1,500 Total Assets 2,800 Total Liab. & SE 2,800 ↓↓ Company’s Economic ResourcesCompany’s Sources of Financing

3. Balance Sheet • The B/S is a financial snapshot on a specific date • The B/S doesn’t reflect amounts for which assets could currently be sold (an asset’s market value). Instead, balance sheets report book values less any accumulated depreciation. • Assets are listed in order of liquidity (closeness to cash) • Current assets will be turned into cash in < 1 year • Noncurrent assets will be turned into cash > 1 year • Inventory is included as a Current Asset regardless of how long its cycle to cash • Liabilities are listed in order of maturity, so obligations due within the next year are classified as current liabilities

4. Key Liquidity Tests Why is liquidity so important? Because cash is king.You can’t repay debt with equipment or property – you need cash!A company can’t meet its ST obligations if all its assets are tied up long-term. Companies have failed more often for liquidity problems than for solvency problems. A profitable company that can’t meet its payroll obligations has liquidity problems. So, keep an eye on: • Net working capital = current assets – current liabilities • Current ratio = current assets/current liabilities

5. Debt vs. Equity and Capital Structure • Debt/equity - describes a company’s capital structure. Long-term asset purchases are financed either by debt capital, supplied by creditors, or by equity capital, supplied by owners. A company’s particular mix of debt and equity is called its capital structure. The capital structure is how a firm finances its operations and growth by using different sources of funds. • Debt is typically a cheaper source of funding than equity, but debt has a major drawback: • it has to be serviced and repaid in full and on time. Debt payments place a burden on the company that must be met, regardless of the company’s profitability. There is no flexibility. • Equity is a permanent and more flexible source of funding

6. Brady Inc. Income Statement (P&L)FYE 12/31/13 Sales $3,000 Cost of Goods Sold (COGS) 1,000 Gross Profit 2,000 Selling, General, & Admin Expenses (SG&A) 500 Depreciation Expense 200 Earnings before Interest & Taxes (EBIT) 1,300 Interest Expense 100 Pretax Income 1,200 Income taxes (25%) 300 Net Income 900 ↓ Dividends +/or Retained Earnings

7. Income Statement (P&L) • If the B/S is a snapshot, then the P&L is a video, recording all of the company’s transactions • Net Income is allocated to dividends (shows up in cash flow statement) +/or retained earnings (shows up in Stockholders’ Equity section of B/S) • Good example of how the 3 main financial statements are connected and explains why all 3 have to be calculated to have a complete financial picture of a company

8. P&L Analysis Ratios focus on operating or “core” profitability • How much of each $1 of sales is turned into gross profit or EBIT? • Gross Profit Margin = Gross Profit/Sales • EBIT Margin = EBIT/Sales • How much Net Income are the company’s assets or equity generating (return on invested capital)? • Return on Assets = Net Income/Total Assets • Return on Equity = Net Income/Equity Ratios are industry specific: identify correct peer group

9. P&L Analysis (#2) • Depreciation – a non-cash allocation of an asset’s cost over its estimated useful life. • Note that interest expense is deducted below core profitability measures, because it’s a consequence of capital structure, not operations. • Interest expense is tax-deductible, thus reducing tax expense. No flexibility, but lower-cost. • Dividends, however, are after-tax payments. More flexibility but also more expensive. • Payout Ratio = Dividends/Net Income • Plowback Ratio = Retained Earnings added/Net Income

10. Cash Flow Statement Cash Flow Statement is the summation of all the company’s transactions that had a direct impact on cash. It explains the change in the Cash account on the B/S from 1 year to the next. A giant Cash T-account. • Cash from Operations – start with Net Income … then adjust • +/- Cash from Investing Activities – transactions with an operational nature, like buying a new equipment, opening a new factory, closing a factory or selling land • +/- Cash from Financing Activities – transactions related to capital structure, such as selling new shares, paying dividends, borrowing new debt, or repaying loans -->Change in Cash on B/Sfrom last year

11. My income statement says I made money, so why doesn’t my bank account agree? OR: Why isn’t net income = cash from operations? 2 reasons: 1 easy, 1 not-so-easy • Depreciation is a non-cash expense that has been deducted on the P&L but doesn’t affect cash, and must be added back. • The P&L doesn’t capture changes in current assets and current liabilities that result from accrual accounting and cause changes in cash. Example: Reported revenues don’t always equal cash collected from customers because some sales may be on credit, causing Accounts Receivable, a current asset, to increase. To calculate cash from operations, this increase must be deducted from Net Income. If a CA ↑, deduct from NI. If a CL ↑, add to NI.

12. Example: Calculating Cash from Operations Brady Inc.’s Net Income = $900 & Depreciation = $200 2013 A/R = $200 & 2012 A/R = $150, using cash 2013 A/P = $300 & 2012 A/P = $100, releasing cash To calculate CFO: Start with Net Income $900 Add back Depreciation + 200 Subtract ↑ in Current Assets (A/R) - 50 Add ↑ in Current Liabilities (A/P) + 150 Cash from Operations $800