About the Author
Bigel has delivered executive education programs for Morgan Stanley Capital Markets, Merrill Lynch Capital Markets, UBS, Lehman Brothers, CIBC, G.X. now part of Goldman Sachs), and China CITIC Bank. Bigel has been interviewed on US radio, has been a visiting researcher at Sichuan University and Xi'an Jiaotong University in China, and appeared on Chinese television.
Educational Background
At Touro University, he is a member of the Faculty Senate, the Touro Leadership and Management Academy, the Evaluation Committee and the Promotions Committee.
Author's Acknowledgements
This work began as class notes and gradually evolved into the product before you. I am humbled and grateful to everyone mentioned in these pages, and it is to you that these pages are dedicated.
Open Touro Acknowledgements
Preface
The text, in its early chapters, will gently guide the reader through the mysterious world of Accounting and point out the many pitfalls in reading statements and performing elementary Financial Analysis. As the reader moves through the text, he/she should increasingly gain a sense of power, confidence, and mastery of the subject.
Financial Statements and Ratio Analysis, and
Introduction
- Chapter One: Learning Outcomes
- The Corporation
- Business / Corporate Structure: The Management Organization
- The Finance Function Within the Corporation
- Capital Structure
- Thinking Like an Economist: Abstraction
- Abstraction: Absurd AND Necessary
- Modes of Reasoning: Dialectical versus Analytic
- Finance Style
There are two ways to be happy: We must either reduce our needs or supplement our means - or can do - the result is the same and it is for each man to decide for himself and to do what happens. The corporation, in order to attract investment, must therefore cover its Opportunity Cost, i.e. the alternative return that an investor gives up when making an investment in this corporation.
Financial
Statements Analysis: The Balance Sheet
Chapter Two: Learning Outcomes
The Finance in the Financial Statements
An experienced financial analyst will then read the statements because he is an "interested party" and wants to know whether an investment in the company is good and sound or whether a potential investment can be advised. May represent lenders or shareholders; any party may be considered an "investor". Reading the statements requires an advanced education in how the accountant prepared the statements.
The Balance Sheet
A = L + E (Assets = Liabilities plus Equity) A – L = E (Assets minus Liabilities = Equity) There are also opposite asset accounts (such as Accumulated Depreciation and Bad Debt Allowance) which are “credit balance” accounts (Credit = Cr). The phrase "current," as in "current assets," has to do with the life of the asset -- or liability.
Sample Bookkeeping Entries
The purchased capital becomes what is called "Treasury Stock", which is a contra account and thus a debit balance account. Another example of a contra account would be Doubtful Accounts Receivable, which would be a credit balance account against accounts receivable.
Current Assets: Inventory and Accounts Receivable
In the case of the seller, the account receivable is decreased (i.e. credited) and the cash account will be increased (i.e. debited). In the case of the buyer, the account payable will be reduced (i.e. debited) and cash will also be reduced (i.e. credited).
Financial Claims Hierarchy
Common shareholders bear the greatest risk as they are last "on the totem pole". This is the case whether the firm is a going concern or is being liquidated in bankruptcy. Common shareholders have a "residual" claim or interest in the company - after all other interests are taken into account.
Interest Paid on Bonds and Dividends Paid on Stock
Common stocks are the riskiest, firstly because dividends are paid last and secondly. However, since common stockholders are entitled to "residual" profits (i.e., after interest is paid on debt and, secondly, after preferred stock dividend payments) that the company can generate, common stockholders can.
Bankruptcy
If there is no agreement, the court intercedes; Debtors who file a second time are referred to as Chapter 22 filers. In this form, debtors retain ownership and possession of the assets (unlike Chapter 7), and will make payments to a trustee out of future earnings, which will then be paid out to creditors. Question: In the 2008 banking crisis, the US government bailed out or bailed out General Motors; it bought shares in the company using taxpayer funds.
The Balance Sheet, Net Income, and the Common Shareholder
Corporate Goals
As the company increases its capital, it is equipped to acquire more assets that will allow it to increase its sales and profits ad infinitum. So, as the balance sheet itself increases, so does the potential for business growth as we define it.
Words and Numbers (An Aside)
Chapter 2 Review Questions
When it is said that "dividends have accrued in arrears," what class of stock are we referring to - preferred or common. Using the template below, search online for a real, lifelike company's Balance Sheet and transfer the numbers to the template below.
Financial
Statements Analysis: The Income Statement
- Chapter Three: Learning Outcomes
- The Income Statement
- On Learning and Studying
- Financial Statements
The key connection between the income statement and balance sheet has largely to do with "addition to retained earnings". When the books are "closed" at year-end, this addition (or deduction) is transferred to "retained earnings" in the balance sheet; the income statement is. Think of the income statement as part of the balance sheet's equity section, which is also a credit balance account.
There are a few other basic things that the financial analyst needs to keep in mind in relation to the income statement.
Interpretation
- The Audit
- Perpetual Inventory Accounting
- Periodic Inventory Analysis: Ending Inventory and Cost of Goods Sold
- Units to Numbers: FIFO and LIFO
- Inventory Costing Calculations: A Closer Look at the COGS and Ending
- Inventory Accounting Issues: LIFO
- LIFO Base Illustration
- Accounting for Long-term Assets
Arbitrary use of costing or other methods – The accountant (along with company management) has options as to how he/she may choose to “cost”. Certified Public Accountants (C.P.A.s) examine, i.e., "audit," the books, ledgers, and records of corporations in order to ascertain the truth and accuracy of data entries and prepare summary financial statements such as those we have often seen on our balance sheet and income statement, which are complex summaries of transactions and my statements. period during the stated period - for the Income Statement, or "from" a specified date - in the case of the Balance Sheet. Unqualified opinion: This is the ideal opinion and is considered a "complete audit". The results are satisfactory, and the statements are satisfactory.
Under this system, the firm knows - at all times - the dollar value of its inventory.
Straight-Line Depreciation (For Reporting Purposes Only)
Accounting Entries for Depreciation
The following represents the accounting entries for straight-line depreciation in the second year (from the previous page), as an example. Notice above that the debits are indented to the left and the credits are further to the right. This is not a stretch, as retained earnings originate from the income statement, i.e. when the "retained earnings allowance" is transferred to the balance sheet - at the end of the year, at the time the books are closed.
Accelerated
Depreciation Methods
Sum-of-the-Years' Digits (For reporting purposes only)
- Accelerated Depreciation
- Comparative Summary of Depreciation Methods
- The Balance Sheet versus the Income Statement: A Summary
- Chapter Three: Review Questions
- Financial
Then all the income statement numbers go back to zero - the odometer goes back to zero. The income statement can be thought of as a subsection of the equity section of the balance sheet. When, if, and how, if so, do the income statement numbers return to zero.
Using the template below, create both dollar and “regular size” income statements, using the same company as you used in the previous set of problems.
Statements and Finance
Chapter Four: Learning Outcomes
Accounting versus Finance
Earnings Management: Accrual, Real, and Expectations Management
Earnings Management
Accrual, Real, and Expectations Management 1
Business Ethics: Examples of Fraudulent Revenue Recognition
Business Ethics
Business Ethics: Examples of Fraudulent Expense Recognition
Pat McConnell of Bear Stearns, the S&P's net income in 1999 would have been 6% lower if employee stock options had been included as an expense. McConnell found only Boeing and Winn-Dixie, i.e. just two of the 500 S&P companies, chose to report options as an expense. At 21 companies, the result fell by more than half when options were charged; this list includes McDermott International, Yahoo, Autodesk, and Polaroid.
Overall, the S&P 500 earnings growth rate would decline from 11% to 9% over the past three years – if options were priced.
Chapter 4: Review Questions
List, give some examples of, and discuss each of the four interpretive problems that readers of financial statements may encounter. What are the second year's depreciation expense and asset balances under each of the three reporting methods.
Ratio Analysis and Forecasting Modeling
Financial Ratios and Forecasting; Liquidity and
- Chapter Five: Learning Outcomes
- Financial Ratios and Forecasting
Now that we are done, for now, with reading and interpreting financial statements, let's discuss why this financial data is so important and what can be done to make the interpretation process more efficient. Potential and current lenders want to assess the company's creditworthiness, and shareholders want to assess the return their investments will provide. Do you really need to sift through two hundred pages of arcane financial statement information to make an investment decision.
Isn't the purpose of a statement to simplify and explain the financial condition and productivity of the corporation and its management.
On Achievement
Financial Ratios
Sometimes the construction of a financial relationship may involve comparing a Balance Sheet date with an Income Statement number. Comparing apples to apples, ie. when comparing an Income Statement to a Balance Sheet number, the analyst may choose to use an average number for the Balance Sheet date to make the Balance Sheet number look more like a "flow". The average can be calculated in several ways, e.g. using an average of two consecutive year-end data, using quarterly sheets, or, if available, monthly. Averaging may be particularly justified in cases where balance sheet data fluctuates widely due to seasonality or other factors.
That said, you will find a comprehensive exercise, including a balance sheet and income statement, that requires the calculation of all our financial ratios below - in the section.
Longitudinal vs. Cross-sectional Analysis (Example)
Financial Ratios Do Not Provide Answers
- Liquidity and Liquidity Ratios
- The Income Statement versus the Balance Sheet
- Accounts Receivable Aging Schedule
- Solvency Ratios
The first category is liquidity ratio. The idea of liquidity has to do with the ease and speed with which an asset can be converted into cash - without compromising its "true". In such cases as this, what the analyst may choose to do is to "average" the balance sheet figure. The "weaker" the EBIT line is, the more volatile its operating earnings are/will be over some periods or years.
The "TIE" ratio provides a measure of a company's ability to pay (i.e., "cover") the interest due (or payable) on its debt.
If at First….”
ProNtability and Return Ratios, and Turnover
- Chapter Six: Learning Outcomes
- ProNtability, Return and Asset Turnover Ratios
Profitability
The DuPont Model
The DuPont Model was developed by managers at DuPont Chemical Corporation for the purpose of internally identifying strengths and weaknesses within the company's management hierarchy. Imagine that you are at the head of the corporation, that you are the chairman of the board or the CEO, who answers to the shareholders of the company. Whether the ROE looks good or bad, you'll want to look further into the company's performance, make improvements, and support areas of strength.
The DuPont formula provides top management with a top-down view of the company's performance, starting with ROE, which is of greatest interest to the company's shareholders.
What Does the Dupont Model Show Us?
Too much debt will raise interest expenses to a possibly unsustainable level and thus may have a weakening of the TIE ratio, which may ultimately lead to insolvency and bankruptcy - in the worst case scenario.
Financial Ratios in Action
Liquidity and Profitability: Costco
Market Ratios
- Chapter Seven: Learning Outcomes
- Market Ratios
- Earnings Retention and Growth
- The P/BV and P/E Ratios
- Ratio Analysis Exercise
- Solution Template for Ratio Analysis Problem
- Solution for Ratio Analysis Problem
AValue Stock can be thought of as such because its price – relative to its earnings – represents a “good buy” for the money, i.e. cheaper. The analyst must be aware of the possibility that a low A private company will sell at a much lower PE ratio due to lack of liquidity. If the company is later sold in an IPO ("initial public offering" - the moment in which a stock is sold to the public for the first time), there will be plenty of profits to go around. The PE ratios shown in this example are much higher than will typically be found in the markets - even in good times.).
When an investor buys a stock, he/she is making an investment in the company's ability to generate profits.
