Ladies and Gents, these are the notes I have taken whilst I’ve been completing the Coursera course: Essentials of Corporate Financial Analysis and Decision-Making
I highly recommend it to anyone who is interested in investing but doesn’t yet know the basics of analysis, ie, how to read a financial statement etc. I apologize in advance for my shorthand notes, if you need clarification please feel free to ask questions.
The balance sheet tells the owners of a corporation the financial situation of the corporation at a particular point in time.
The profit and loss statement tells shareholders what the most recent performance of the company has been, a profit or loss in the most recent financial year.
Balance sheet gives a snapshot of the value of assets and liabilities at a particular point of time, usually at the end of the financial year.
Assets – Value of all property
Equity – Your contribution to the investment.
Liability – Other parties investments
Assets: Some are fixed, some are liquid.
Fixed assets are called Non Current Assets. Non Current Assets are assets that cannot be quickly and easily transformed into cash. They include: Property, plant and equipment and goodwill, other intangible assets (eg investment in research and development).
Goodwill refers to the value of an intangible asset found on the balance sheet. A company’s brand recognition, intellectual property and reputation among its customers and employees can all count towards the goodwill value. When a company is acquired for a higher price than its book value, the excess value of the target company under a balance sheets goodwill. Companies have to subject goodwill to amortization or impairment tests to accurately reflect the goodwill asset on the balance sheet.
How are assets turned into numbers on the balance sheet?
Book Value (Accumulated): The acquisition cost of the asset minus the accumulated depreciation expense.
Depreciation is the loss of value in an asset over time and accountants build a depreciation schedule so the book value of the assets is progressively diminishing over time.
Goodwill (Intangibles): Recorded at the purchase price – subtract the book value at the time of investment. There is a disparity here between the market price or purchase price of the companies assets and the value of them. Goodwill is also amortized over time.
The other major component on the balance sheet is current assets.
Current Assets: Assets that can be quickly converted into cash. Includes things like inventories, accounts receivable, cash
Liabilities: Located on the right hand side of the balance sheet. They include what the company owes to it’s lenders. They are distinguished between short term (current liabilities) and long term liabilities (non-current liabilities).
Current Liabilities – Liabilities that have to be repaid within a year. They include accounts payable/invoices (usually payable within 90 days), short term debt (bank loans) and current obligations on long term debt (interest and principle payments within a year).
Non-Current Liabilities – Long term debts (bonds), pension liabilities
Equity – The owners entitlement to the assets in the firm.
Corporations separate ownership and management of the company. Owners (shareholders) of the company don’t run the day to day business of the company. Obviously there is a lot of risk when you become a shareholder of a company that you don’t run, but this is offset by the fact that you have limited liability. Your only liability as a shareholder or owner of the company is limited to the amount you invested in the shares. If the company defaults on a payment or gets in trouble in some other way, the shareholders are not accountable past the value of their holdings.
Assets = Liabilities + Equity. Equity sits on the right hand side of the balance sheet under liabilities. The assets are paid for by liabilities (money owed) and equity (investments).
An easier way of looking at it is Assets – Liabilities = Equity. Over time in a profitable company, the liabilities (loans) are repaid so they decrease. Equity is what remains after the assets have repaid the liabilities.
Book value is not a good guide as it often depends on the historical cost of assets and does not capture future opportunities. An example would be a holding company who’s assets included gold bullion. The book value of the company may be very small if the gold price is depressed. The book value also fails in capturing the potential value of the company’s bullion holdings if the gold price was to increase substantially.
Market value: The market value of the company is determined by multiplying the share price by the number of shares outstanding. E.G. shares trading at $0.30 with 4 million shares outstanding:
0.30 X 4,000,000 = $1,200,000 market cap.
Market cap is not a good way of valuing a company, it merely serves to show the total value of all the shares outstanding at the current share price. The market is not perfect and doesn’t take into account all the information available on a company, hence the disparity between intrinsic value and market cap.
Profit and Loss Statement
Profit and loss statement – measures the company’s performance over the financial year.
Net Sales = Gross sales – deductions. Deductions = customer discounts (coupons) + returns (faulty products) + allowances (ie perishables diminishing).
Sales revenue is not always easy to define as there are other factors to consider such as the supply chain (internal sales) and international sales.
After we calculate the net sales, we then subtract from that number, what it cost to produce the product. I.E. Cost of goods sold (COGS).
COGS (direct costs): Also known as purchase, or conversion cost.
This incorporates: Product or raw materials including freight, direct labor costs (people making the product), direct overhead that is allocated to the sales (storage of goods) and adjustment or depreciation of the goods. Costs that are directly attributable to the sales.
After subtracting COGS from the Net sales, we are left with the gross profit. We then look at what the company spends.
Expenditure is accounted for with direct costs (ie COGS) and Indirect (overhead) expenses.
Indirect expenses include selling (marketing department), general and administrative (office) expenses, impairment losses, depreciation, interest expense, theft – aka taxes.
After accounting for direct costs and subtracting indirect costs, we arrive at operating profit.
Only after accounting for all the expenses, do we arrive at the net income for the company.
Here is the summary moving from the top-line (sales) to the bottom line (net income).
Net sales – cogs = gross profit
gross profit – indirect cost = operating profit
operating profit + other income = earnings before interest and taxes, depreciation and amortization (EBITDA)
EBIT = EBITDA – depreciation/amortization
EBT = EBIT – interest
Net income (profit/earnings) = EBT – tax
It is a successive stripping out of expenditure to arrive at the profit.
This is not the end of it, you need to make sure you read the fine print (notes that follow the profit and loss statement). Material items must be disclosed separately:
Notes to the profit and loss statement: The notes capture material items that have effected the firm in the recent past. They include:
Write-downs of inventories or property/plant/equipment, restructurings, disposals of property, plant and equipment or investments, discontinued operations and litigation settlements.
Because they have an impact on future operations and market value, they need to be disclosed.