A mixed notes of Coursera: Introduction to Financial Accounting and basic term definitions from investopedia.com
- Financial position (i.e., listing of resources and obligations) on a specific date
Assets = Liabilities + Stockholders'Equity
- This equation must always balance!
Definition of Assets, Liabilities, Stockholders'Equity
Assets - Resources owned by a business that are expected to provide future economic benefits (either provide cash coming in or save the company from having to spend cash in the future)
Liabilities - Claims on assets by "creditors" (non-owners) that represent an obligation to make future payment of cash, goods, or services
Stockholders'Equity - Claims on assets by owners of business - Contributed Capital (arises from sale of shares) - Retained Earnings (arises from operations) - Increased by Revenues - Decreased by Expenses and Dividends
- Results of operations over a period of time using accrual account (i.e., recognition tied to business activities, not to cash flows)
Net income = Revenues - Expenses
Revenue vs Income vs Profit vs Earning
Revenue: Revenue is simply the total amount of cash generated by the sale of products or services associated with the company's primary operations, less any returns or discounts. It can also be thought of as net sales.
E.g.For a grocery store, this includes the sale of anything found in the store, from vegetables to floral arrangements
Income: In a financial context, the term income almost always refers the net income, is a concrete concept. Also referred to as net profit.
Net income accounts for every dime that flows in and out of a company. It includes expenses for product manufacturing, operations, debt payments and other obligations, as well as additional income streams from subsidiary holdings, asset sales, and other considerations.
Income =(often refer to)=> Net Income <==> Net Profit
Profit: Profit is the revenue that remains after expenses are paid, and it can refer to a number of figures at a number of levels.
For example, gross profit is revenue less the cost of goods sold. Operating profit is revenue minus the cost of goods sold and operating expenses.
Earning: A company's earnings are equal to revenue less costs of production over a given period of time. Earnings typically refer to after-tax net income.
A company's earnings are equal to revenue less costs of production over a given period of time. Profit is equal to total revenue less all expenses. In the right context, these could be equal to each other, although that is rare. Big gaps between earnings and profits might be a sign the company spends too much time and money on unproductive activity.
Statement of Cash flows
- Sources and uses of cash over a period of time
- Operating activities
- The provision of goods or services and other normal business activities
- Investing activities
- The acquisition or disposal of long-lived productive assets
- Financing activities
- Transactions related to owners or creditors
Sources of Financial Statement
- Company's website
- I.e. bottom page -> Investor Relations -> Financial -> annual report
- SEC Edgar website
- Internet finance site
- Google finance
- Yahoo finance
- Wharton Research Data Science
- Very expensive
ROE = ROA * Leverage
De-levered Net Income
ROA would measure operating performance independent of the company’s financing decisions - But, the numerator of ROA, Net Income, includes: Interest Expense -
More leverage => higher Interest Expense => lower Net Income - To truly remove all financing effects from ROA, we must de-lever Net Income -
ROA = De-Levered Net Income / Avg. Assets -
De-levered Net Income = Net Income + (1 - tax rate) x Interest Expense
An example of De-levered Net Income
|Company A (No debt)||Company B (Some debt)|
|Pretax, pre-interest income||300||300|
|De-levered Net Income||195||195 (162.5 + 50 * (1 - 0.35))|
An example of competitor comparison
A couple things to look at for beginners
- How does the industry perform?
- What's the trend of ROE for each company?
- Who drives ROE in each company? (Who caused the increase/decrease of ROE)
- Does the company perform good/so so/bad?
Quick note on finding comparison firms
Another approach is to look at who analysts and data services use as comparisons for the company - Analyst reports will often mention competitors - Google Finance give a list of “RelatedCompanies” - Reuters gives Industry and Sector comparisons
Profitability and Turnover Ratios
What are the drivers of profitability? Decompose Return on Sales by income statement line item
Gross Margin = (Sales - Cost of Goods Sold) / Sales
- Sales <=> Operating Revenue
- Cost of goods sold (COGS) are the direct costs attributable to the production of the goods sold by a company.
- Read more: Cost Of Goods Sold - COGS Definition - Investopedia
SG&A-to-Sales = SG&A Expense / Sales
- SG&A: Selling, General and Administrative Expenses, which is a major non-production cost presented in an income statement
Operating Margin = Operating Income / Sales
- A measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc.
- An indicator of a company's pricing strategy and operating efficiency.
- Read more: Operating Margin Definition - Investopedia
Operating Income = Gross Income - Operating Expenses - Depreciation - Amortization
- Read more: Operating Income Definition - Investopedia
Interest Expense-to-Sales = Interest Expense / Sales
Effective Tax Rate = Income Taxes / Pre-tax Income
- Pre-tax income = the firm's earnings before taxes
- The tax is calculated by different tax brackets
- Read more: Effective Tax Rate Definition - Investopedia
Gross Margin vs Operating Margin
Gross margin (profit) = (revenue - cost of goods) / revenue
- Revenue <=> Operating Revenue <=> Sales
Operating margin (net profit) = (revenue - cost of goods - operating expenses - other expenses - interest - taxes) / revenue
- A more accurate measure of a company's profitability
- Examining its net profit margin can help a company gain a much clearer picture of its overall expenses compared to revenue
Asset Turnover (Efficiency) Ratios
Turnover Ratio in general tells us: How many times per year do we cycle through accounts? Example: Inventory Turnover of 8 means that we build and sell Inventory 8 times per year, on average.
Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory
Accounts Receivable Turnover = Sales / Average Accounts Receivable
Accounts Payable Turnover = Purchases / Average Accounts Payable
Purchases = Ending Inventory + COGS – Beginning Inventory)
Fixed Asset Turnover = Sales / Avg. Net PP&E
- PP&E: Property, plant and equipment
These turnover ratios are hard to interpret
Days Outstanding Ratios are transformable to turnover ratios and more intuitive than turnover ratios.
Days Outstanding Ratios
How many days, on average, are accounts outstanding? Example: Days Inventory of 45 means that it takes 45 days,on average, from the time we start building Inventory until we sell it
Days Inventory = 365 * (Average Inventory / Cost of Goods Sold)
Days Receivable (Sales) Outstanding = 365 * (Average Accounts Receivable / Sales)
Days Payable = 365 * (Average Accounts Payable / Purchases)
Net Trade Cycle = Days Receivable + Days Inventory - Days Payable
- Net Trade Cycle represents the gap between cash outflows and cash inflows that we have to bridge with short-term borrowing
It tells a company's cash position: e.g., have cash to pay out in short-term, borrowing capacity.
Short-Term Liquidity Ratios
Does the company have enough cash coming in to cover obligations to pay out cash? Ideally,ratios would be over 1.
Current Ratio = Current Assets / Current Liabilities
- Keep in mind some current assets are non-cash pre-paids
- Keep in mind some liabilities are non-cash unearned revenue
- Current Ratio is just an approximation, because of it, we have the Quick Ratio
Quick Ratio = (Cash + Receivables) / Current Liabilities
Cash from Operations(CFO) to Current Liabilities = CFO / Avg. Current Liabilities
- It tells us did the business generate enough cash during the period to cover its avg. level of current liabilities
Interest Coverage Ratios
Does the company have enough cash coming in from operations to cover interest obligations? Ideally,ratios would be over 1.
Interest Coverage = (Operating Income before Depreciation) / Interest Expense
Cash Interest Coverage = (Cash from Operations + Cash Interest Paid + Cash Taxes) / Cash Interest Paid
- more direct measure than Interest Coverage
Long Term Debt Ratios
How does the company finance its growth? Also provide measure of bankruptcy risk and borrowing capacity
Debt to Equity = Total Liabilities / Total Stockholders’ Equity
- Total Assets is sometimes used in the denominator
Long-Term-Debt to Equity = Total Long-Term Debt / Total Stockholders’ Equity
Long-Term Debt to Tangible Assets = Total Long-Term Debt / (Total Assets - Intangible Assets)
Common Size Financial Statements
Derived from historical financial statements to help forecasting the trends
- Common Size Balance Sheet
- Express all numbers as a percent of Total Assets
- Common Size Income Statement
- Express all numbers as a percent of Sales
- Cash Flow Statement
- Typically not common sized
- Remove effects of growth to help spot trends in the financial statements
- Growth in Assets and Sales drive trends in all of the line items
- Are certain line items growing more or less than would be expected given the growth in assets or sales?
- Facilitate preparation of forecasted future financial statements
- Combine historical common size statements with growth forecasts to get future statements
Forecasting Financial Statements
To be continued if needed ...
To be continued if needed ...