Financial Statement Analysis

Street Of Walls Investment Banking Technical Training

In the Financial Statement Analysis chapter, we will cover five primary topic areas:

Financial Statement Overview

Income Statement
Balance Sheet Statement
Cash Flow Statement
How Financial Statement Tie Together

Financial Statement Overview

What are financial statements, why are they important, and why do financial analysts use
them?
Financial statements are formal records of the financial activities of a business. For a corporation with
publicly traded securities, there are three primary financial statements that must be reported quarterly
(4 times per year):

Income Statement: Reports a snapshot of a companys business performance over a period

of time. This statement indicates how much revenue (sales) is generated by a business, and
also accounts for direct product costs, general expenses, Interest on Debt, Taxes, and other
expense items. The purpose of this statement is to show the companys level of profitability,
which is equal to a companys Revenue net of its expenses.
Statement of Cash Flows: Reports on all of the companys activities that affect its cash
position over a period of time. These activities are broken down into three primary categories:
Operating, Investing, and Financing. The purpose of this statement is to give a detailed
reconciliation of how the companys Cash is being used (and how much Cash is being
generated).

These financial statements all aim to provide an overview of a businesss performance and position,
either over time, or at a given point in time. They are highly interrelated and must tie together perfectly.
For example, in the Statement of Cash Flows, a detailed account of the change in a companys Cash
balances is given. This change must exactly match the change in Cash balances listed on the
beginning and ending Balance Sheets for the Company. Similarly, many items in the Income
Statement directly reflect changes in Balance Sheet accounts over time, and must match the changes
there. More discussion of this concept can be found at the end of the chapter.
Financial statements are issued by companies and reviewed by the Securities & Exchange
Commission (SEC). The SEC requires publicly traded companies to file quarterly and annual results of
operations. These are the summarized financial results of the company, and they are the backbone of
financial modeling, company profiles and pitch book presentations. Without financial statements, most
valuation work would be difficult or nearly impossible.
Locating Financial Statements
All publicly traded companies are required by the SEC to file quarterly and annual reports. Private
companies are not required to file financial reports, although some may have to if they have publicly
traded debt. Company filings are found on the SECs EDGAR website.
Primary Information Found in Financial Statements (Forms 10-K & 10-Q)

Management Discussion & Analysis

Income Statement
Balance Sheet Statement
Statement of Cash Flows

 Notes and Exhibits to Financial Statements

Annual reports are filed as 10-Ks with the SEC and must be filed within 60 days of the companys
fiscal year end. 10-Ks are much more detailed than quarterly reports (10-Qs, discussed below), and
contain information such as the companys Business Overview, Risk Factors, Financial Data (Income
Statement, Balance Sheet, and Statement of Cash Flows), Management Discussion & Analysis, and
other important disclosures.
Quarterly reports are filed as 10-Qs with the SEC and have to be filed within 40 days of the end of the
fiscal quarter. 10-Qs are less detailed than annual form 10-Ks but do provide helpful detail around the
quarterly Financial Data (Income Statement, Balance Sheet, and Cash Flow), Management Discussion
& Analysis, and other Company disclosures.
Income Statement
The Income Statement shows how much Revenue (sales) is being generated by a business, and also
accounts for Costs, Expenses, Interest, Taxes and other items. The main purpose of this statement is
to show the companys level of profitability. The Income Statement represents items over a period of
time, usually over a quarter (3 months) or a year. This statement is also referred to as the Profit and
Loss Statement (P&L).
Income Statement: Key Line Items

Revenue represents the sales brought in from selling a product or performing a service.
Cost of Goods Sold (COGS) represents direct costs of producing goods and services that
the business has sold, such as material costs and direct labor.
Selling, General, & Administrative Expense (SG&A) represents expenses associated with
selling products and managing the business. This will include salaries, shipping, insurance,
utilities, rent, compensation for executives, etc.
Depreciation & Amortization (D&A) represents the expenses associated with fixed assets
and intangible assets that have been capitalized on the Balance Sheet. D&A that is directly
related to production will generally be included in COGS and will be separated out on the
Statement of Cash Flows (more on this later).
Net Interest Expense represents the total Interest paid on Debt liabilities; net of the total
Interest received on Cash assets.
Tax Expense represents the amount of taxes paid.
Net Income represents the companys profit, which is Revenue minus all of the
aforementioned costs and expenses.

Calculating Earnings Per Share (EPS)

EPS equals Net Income (after dividends on preferred stock) divided by the companys Weighted
Average Shares Outstanding. Shares Outstanding will typically be found either on the Income
Statement, below Net Income, or on the first page of the most recent 10-Q or 10-K. It can also be
calculated as the average of the number of common shares outstanding at the beginning of the period
and end of the period (from the companys Balance Sheet).
EPS is an extremely important metric of a companys value: it represents the profit generated by the
company for each shareholder. It will be used extensively when working through valuation techniques
such as Comparable Company Analysis and Precedent Transaction Analysis.
Here is an example of an Income Statement, showing all of discussed line items, from Amazon at the
end of 2010 (ticker: AMZN):

Balance Sheet
The Balance Sheet provides a snapshot of a companys financial position at the end of a period (either
quarterly or annually). The balance sheet lists company Assets, Liabilities, and Shareholders Equity as
of a specific point in time. An important rule is that the Balance Sheet for a company must balance. In
other words:
BALANCE SHEET GOLDEN RULE: ASSETS = LIABILITIES + SHAREHOLDERS EQUITY
This may seem like an obvious statement, but in producing financial models it is easy to make an error
wherein the balance sheet does not properly balance, which will lead to serious problems with financial
projection. Always make sure your balance sheet balances!
As demonstrated above, the difference between Assets and Liabilities is Shareholders Equity. In other
words, the value of a companys equity is equal to the value of its assets net of the outstanding
obligations it has to other entities. This is, from an accounting (or book) perspective, what the value
of a companys shareholders positions should be. As we have seen, there are many reasons why a
companys equity will trade at a different valuation in the market than that derived from the Balance
Sheet (usually, and hopefully a higher valuation Book Value).
From the perspective of a financial analyst, the most important Balance Sheet line items fall into the
following categories:

Cash (Asset): Money owned by the company. For accounting purposes, Cash generally
includes currency and coin on hand, checking account balances, and un-deposited customer
checks.
Current Assets: Assets whose value is expected to translate into Cash in the near future
(generally within one year). Cash is a Current Asset. Most Current Assets besides Cash are
classified as Operating Assets, or Assets generated by the company as part of the
functioning of its business operations.
Other or Long-term Assets: Assets whose value will not translate into Cash in the near
future (outside of one year). Most Long-term Assets are classified as Operating Assets, or
Assets required by the company as part of the functioning of its business operations.
Debt (Liability): An obligation (almost always interest-bearing) that represents borrowed
money that the company must repay. Debt is usually part of Long-Term Liabilities (see below),
although any portion of Debt, which must be repaid within the next year, will be classified as a
Current Liability.
Current Liabilities: Liabilities that a company must meet (via payment) in the near future
(generally within one year). Most Current Liabilities (other than Debt) are classified as
Operating Liabilities, or Liabilities generated by the company as part of the functioning of its
business operations.
Other or Long-term Liabilities: Liabilities that do not need to be met (via payment) in the
near future (outside of one year). Most Long-term Liabilities are classified as Debt, although
some qualify as Operating Liabilities, or Liabilities generated by the company as part of the
functioning of its business operations.
Shareholders Equity: The difference between Assets and Liabilities. This represents the
value of the companys assets after all outstanding obligation have been paid off. This value
accrues directly to the companys owners, or Shareholders.

Note that the difference between Current Assets and Current Liabilities is referred to as Working
Capital or Net Working Capital, while the difference between Operating Assets and Operating
Liabilities is referred to as Operating Working Capital. Working Capital is an important consideration
in financial modeling this is a particularly true of Operating Working Capital. This concept will be
discussed in further detail later in this training course.

Here is an example of a Balance Sheet, showing all of the discussed line items, from Amazon at the
end of 2010 (ticker: AMZN):

Statement of Cash Flows

The Statement of Cash Flows, or Cash Flow Statement (CFS), provides an accounting of the Cash
being generated by a business, and the uses of the Cash, over a period of time. The CFS shows how
Net Income (from the Income Statement) and changes in Balance Sheet items affect a companys
Cash balance.
Generally speaking the CFS will provide a clear view of the short-term viability of a business and its
ability to pay its debts. If the business is not generating enough Cash from its operations to service its
obligations, it should be evident from its CFS. The bottom line, therefore, is that the CFS reflects a
companys liquidity, solvency, and ongoing viability.
Three Parts of a Cash Flow Statement

All Cash flows can be broken down into one of the important categories:

Operating Activities: The Cash generated/used by a companys business operations. This

includes earnings delivered by the company as well as payments collected from its
customers. In its simplest form, Cash Flow from Operating Activities (CFO) will equal Net
Income + Depreciation & Amortization changes in Operating Working Capital.
Investing Activities: The cash generated/used by a companys investment in assets. Cash
Flow from Investing Activities (CFI) includes the purchases of Fixed (long-term) Assets and
maintenance of those Assets (Capital Expenditures), payments made for M&A activities
(usually acquisitions of other companies), or Cash generated by Marketable Securities or
other non-operating uses of Cash.
Financing Activities: The Cash generated/used by a companys financing of its operations.
Cash Flow from Financing Activities (CFF) includes the Cash inflows from shareholders and
lenders as well as the outflows of dividends or sales of stock. Items found in the line time will
include: Dividends Paid, Cash raised via the sale of Common Stock, Cash proceeds from
Borrowings (Debt), and repayment of Debt obligations.

The SCF is greatly affected by the change in Balance Sheet line items. When Assets on the Balance
Sheet fall, Cash typically rises. For example: if Accounts Receivable (an Operating Current Asset on
the Balance Sheet) falls, this is because a customer had paid its bill and hence Cash increases.
Simultaneously, the Accounts Receivable line item decreases by the same amount. By contrast, when
Liabilities and Equity rise, typically so does Cash. For example, if a company issues Debt (a Liability
on the Balance Sheet), Cash will rise by the same amount as the value of a loan taken out. Similarly, if
a Company repurchases common shares outstanding, Cash will decrease by the same amount as the
value of the Equity being retired in the transaction.
In summary, Assets are uses of Cash while Liabilities and Equity are sources of Cash. This is
important concept will come into play directly in building financial models that help determine a
companys value.

Here is an example of a Statement of Cash Flows, showing all of the discussed line items, from
Amazon at the end of 2010 (ticker: AMZN)

How Financial Statements Tie Together

Now that you are familiar with the three main Financial Statements, we can ascertain how they all tie
together. In short, the Financial Statements are interconnected in many places. In particular, practically
every line item on the SCF is connected to one of the two other statements.
Connected Line Items on the Financial Statements
While this list is not exhaustive, it covers most of the basic interconnections across a companys
Financial Statements:
Income Statement:

Depreciation: Fixed Long-term Assets (Balance Sheet) are depreciated over a period of time;
this is expensed on the Income Statement.

Amortization: Some other Long-term Assets (Balance Sheet) are amortized (similar to being
depreciated) over a period of time; this is expensed on the Income Statement.

Balance Sheet:

Cash: Ending Cash on the Cash Flow Statement flows into Cash within Current Assets on the
Balance Sheet.

Shareholders Equity: Net Income (Earnings from the Income Statement) after Dividends Paid
flow into Retained Earnings in Shareholders Equity.
Cash Flow Statement:
Beginning Cash: This is equal to the previous periods ending Cash balance on the
Companys Balance Sheet.
Net Income (CFO): Equals Net Income found on the Income Statement.
Depreciation (CFO): Depreciation is a (generally unlisted) component of COGS and other
expense items found on the Income Statement; it is added back because it is a non-Cash
expense. In other words, the company did not actually spend the money being represented
the Depreciation during the period that Cash expense was recorded as a Capital
Expenditure in a prior period. That value is allocated over a long time horizon, and
Depreciation in any given year represents that years ascribed value of the Assets being used.
Amortization (CFO): Amortization is a (generally unlisted) component of COGS and other
expense items found on the Income Statement; like Depreciation, it is added back because it
is a non-Cash expense. The Cash was generally spent in a prior period, usually as part of an
acquisition.
Capital Expenditures (CFI): This is money spent on Long-term (Fixed) Assets on the
Balance Sheet. The change in these Assets should equal Capital Expenditures minus the
years Depreciation on these Assets.
Repayments of and Proceeds from Long-term Debt (CFF): This is money raised from, or
used to repay, Long-term Debt obligations (Liabilities) on the Balance Sheet. (Note that
mandatory Debt repayments coming due in the near future are moved from Long-Term
Liabilities to Current Liabilities on the Balance Sheet as their repayment dates draw near.)
Ending Cash: This is equal to the current periods ending Cash balance on the Companys
Balance Sheet.
How does depreciation affect the Financial Statements?
Depreciation is an especially tricky line item because it affects all three Financial Statements, but is
often not broken out directly in the Income Statement even through it is an annual expense. Here is a
summary of how Depreciation affects all three statements (a similar description also applies to
Amortization):

Income Statement: Depreciation is an expense on the Income Statement (often buried inside
displayed line items such as COGS). Increasing Depreciation will increase expenses, thereby
decreasing Net Income.
Cash Flow Statement: Because Depreciation is incorporated into Net Income, it must be
added back in the SCF, because it is a non-cash expense and therefore does not decrease
Cash when it is expensed.
Balance Sheet: Net Fixed Assets (generally Plant, Property, and Equipment) is reduced by
the amount of Depreciation. This reduces Fixed Assets. It also reduces Net Income and
therefore Retained Earnings (Shareholders Equity) as well. As discussed previously,
Depreciation is a non-Cash expense. Therefore, increases or decreases to Depreciation will
not impact Cash directly.