Much of the information that is used in valuation and corporate finance comes from financial statements. An understanding of the basic financial statements and some of the financial ratios that are used in analysis is therefore a necessary first step for either pursuit. There is however a difference between what accountants try to measure in financial statements, and what financial analysts would like them to measure. Some of this difference can be traced to the differences in objective functions - accountants try to measure the current standing and immediate past performance of a firm, whereas financial analysis is much more forward looking.
In this primer, we begin with an inventory of the information we would like to obtain on a firm, and then examine how accounting statements attempt to provide this information, and where they might fall short.
Before looking at accounting principles and the details of accounting statements, let us start with a much more fundamental issue. When analyzing a firm, what are the questions to which we would like to know the answers? To do so, let us revert back to the description of a firm, from a financial standpoint:
When doing a financial analysis of a firm, we would like to be able to answer the following questions —
As we will see in this chapter, accounting statements allow us to get some information on all of these questions, but they fall short in terms of both the timeliness with which they provide this information and the way in which they measure asset value, earnings and risk. In the chapters that follow, we will examine some of the ways in which we can get beyond these limitations.
How Accountants measure earnings
The two basic principles that govern how accountants measure earnings seem to be the following:
The income statement is where accountants attempt to measure how profitable a firm was during the financial period. In the following table, we summarize the key parts of the income statement, and some key measurement issues:
|Only revenues from sales during the period should be included in revenues (i.e., not cash revenues). Thus, cash received from sales made in previous periods is not included in sales, and sales from the current period, even if not collected, is included.
|(minus) Operating Expenses (not including depreciation)
|Only those expenses incurred to create revenues in the current period should be included as part of operating expenses. Labor, material, marketing and general and administrative costs are all operating expenses. If material purchased in the current period is not used in production, it is carried over as inventory into the next period.
Inventory has to be valued to estimate operating expenses, and firms can choose to value inventory based upon what they paid for the material bought at the end of the period (FIFO), at the beginning of the period (LIFO) or an average price.
|(minus) Depreciation and Amortization
|Any expense that is expected to generate income over multiple periods is called a capital expense. A capital expense is written off over its lifetime, and the write-off each year is called depreciation (if it is a tangible asset like machinery) or amortization (if it is an intangible asset such as a copyright).
Since the value that an asset loses each period is subjective, depreciation schedules are mechanized. They can broadly be classified into two groups — straight line depreciation, where an equal amount gets written off each period, and accelerated, where more of the asset gets written off in the earlier years and less in later years.
|= Operating Income (EBIT)
|When operating expenses and depreciation are subtracted from revenues, we estimate operating income. This is designed to measure the income generated by a firms assets in place.
|(minus) Interest Expenses
|The most direct source of interest expenses is debt taken on by the firm either from a direct lender (such as a bank) or from bonds issued to the public. Interest expenses also include imputed interest computed on leases that qualify as capital leases.
If firms have substantial interest income from cash and marketable securities that they hold, it is usually shown at this point.
|= Taxable Income
|If the depreciation reported is the tax depreciation, netting the interest expenses from the operating income should yield the taxable income.
|These are the taxes due and payable on income in the current period. Generally speaking, it can be computed as
Tax = Taxable Income * Tax Rate
|= Net Income
|The income after taxes and interest is the net income.
|(minus) Losses (+ Profits) not associated with operations
|These are expenses (or income) not associated with operations.
|(minus) Profits or Losses associated with Accounting Changes
|Changes in accounting methods (such as how inventory is valued) can result in earnings effects.
|/ Number of Shares outstanding
|The actual number of shares outstanding is referred to as primary shares. When there are options and convertibles outstanding, the shares embedded in these options is sometimes added on to arrive at fully diluted shares.
|= Earnings per Share
|The earnings per share can be computed on a primary or fully diluted basis.
How Accountants Value Assets
The assets of a firm are measured and reported on in a firms balance sheet. In general, the assets of a firm can be categorized into fixed assets, current assets, intangible assets and financial assets. There seem to be three basic principles that underlie how accountants measure asset value:
The principles governing the accounting measurement of each of these asset categories is provided below, together with key measurement issues.
|Fixed assets refer to tangible assets with long lives. Generally accepted accounting principles in the United States require the valuation of fixed assets at historical costs, adjusted for any estimated loss in value from the aging of these assets. The loss in value is called depreciation.
|Current assets refer to assets with short lives (generally less than a year). Included here are items like inventory of both raw materials and finished goods, accounts receivable and cash.
The accounting convention is for accounts receivable to be recorded as the amount owed to the firm, based upon the billing at the time of the credit sale. Firms can set aside a portion of their income to cover expected bad debts, from credit sales, and accounts receivable will be reduced by this reserve.
Cash is valued at face value, and inventory can be valued using one of three approaches — the cost of the materials bought at the end of the period (FIFO), at the beginning of the period (LIFO) or a weighted average.
|Financial investments are categorized into three types:
Minority, passive investments: where the financial investment in another firm is less than 20% of the ownership of the firm. If this investment is long term, it is recorded at book value and the interest or dividend from it is shown in the income statement. If it is short term, it is marked to market, and the gains or losses recorded each period.
Minority, active investments: where the financial investment in another firm is between 20 and 50% of the ownership of the firm. Here, the investment is recorded at the original acquisition cost, but is adjusted for the proportional share of profits or losses made by the firm each period. (Equity approach)
Majority, active investments: where the financial investment in another firm is a controlling interest. Here, the financial statements of the two firms (income statement and balance sheet) have to be consolidated. The entire assets and liabilities of the two firms are consolidated, and the share of the firm held by others is called a minority interest.
|When one firm acquires another and the acquisition is accounted for with purchase accounting, the difference between the acquisition price and the book value of the acquired firm is called goodwill. It is amortized over 40 years, though the amortization is not tax deductible.
When firms acquire patents or copyrights from others, they are allowed to show these assets as intangible assets on the balance sheet. The amortization of these assets is usually tax deductible.
How Accountants Value Liabilities
The principles that underlie how accountants measure liabilities and equity are the following:
In keeping with the earlier principle of conservatism in estimating asset value, accountants recognize as liabilities only cash flow obligations that cannot be avoided. If an obligation is a residual obligation, accountants see the obligation as equity.
In the following table, we summarize how accountants measure liabilities and equity:
|Current liabilities refer to liabilities that will come due in the next year. It includes short term debt, accounts and salaries payable, as well as long term debt coming due in the next year. These amounts reflect the actual amounts due, and should be fairly close to market value.
|Long Term Debt
|This can include both long term bank debt and corporate bonds outstanding. Accountants measure the value of long term debt by looking at the present value of payments due on the loan or bond at the time of the borrowing, using the interest rate at the time of the borrowing. The present value is not recomputed, however, as interest rates change after the borrowing.
|Other Long Term Liabilities
|There are three primary items that go into this. First, if leases qualify for treatment as capital leases, the present value of lease payments is shown as long term debt. Second, if a firms defined benefit pension plan or health care plan is underfunded, the underfunding is shown as a long term liabilitiy. Third, if a firm has managed to defer taxes on income (for instance, by the use of accelerated depreciation and favorable inventory valuation methods), the deferred taxes is shown as a liabilitiy.
|Preferred stock generally comes with a fixed dividend. In some cases, the dividend is cumulated and paid, if the firm fails on its obligations. Preferred stock is valued on the balance sheet at its original issue price, with any cumulated unpaid dividends added on. Convertible preferred stock is treated similarly, but it is treated as equity on conversion.
|The accounting measure of equity is a historical cost measure. The value of equity shown on the balance sheet reflects the original proceeds received by the firm when it issued the equity, augmented by any earnings made since (or reduced by losses, if any) and reduced by any dividends paid out during the period.
How Accountants Measure Profitability
While the income statement allows us to estimate how profitable a firm in absolute terms, it is just as important that we gauge the profitability of the firm is in terms of percentage returns. There are two basic gauges used to measure profitability. One is to examine the profitability relative to the capital employed to get a rate of return on investment. This can be done either from the viewpoint of just the equity investors, or looking at the entire firm. Another is to examine profitability relative to sales, by estimating a profit margin.
The following table summarizes widely used accounting profitability measures, with measurement issues that come up with each.
|Return on Capital
|EBIT (1- tax rate) / (Book Value of Debt + Book Value of Equity)
|Return on Assets
|EBIT (1- tax rate) / (Book Value of Assets)
|Return on Equity
|Net Income / Book Value of Equity
|Net Income / Sales
|EBIT ( 1- tax rate) / Sales
How Accountants Measure Leverage
Accountants measure leverage, not surprisingly, using their book value measures of debt and equity. In the following table, we summarize the most widely used ratios for measuring leverage in accounting.
|Book Value of Debt / (Book Value of Debt + Book Value of Equity)
|Book Value of Debt / Book Value of Equity
|Cash Fixed Charges Coverage Ratio
|EBITDA / Cash Fixed Charges
|Interest Coverage Ratio
|EBIT / Interest Expenses
Financial statements remain the primary source of information for most investors and analysts. While an understanding of every detail and FASB rule may not be necessary, it is important that the basics be understood. This primer attempts to explain the basics of financial statements and the generally accepted accounting principles that underlie their construction, and the various financial ratios that often accompany financial analyses. As long as there is a recognition that financial statements and financial ratios are a means to an end, which is understanding and valuing the firm, they are useful.