Financial Accounting

Greg Gleeson, CPA, CFAChief Operating Officer- GROW Partners, LLC

ggleeson@growpartnersllc.com

How to think like an Accountant …(esp around Valentine’s Day)

Financial Health of Company Track Record of Management Independently Audited & Objective Ease of Comparison Across Companies Valuation of Company Starting point for all Financial Analysis

Why are Financial Statements Important?

Backward Looking Highly Summarized Accrual Basis Non Cash Items (“Stock Options”) Subjective “One-Time” Charges Accounting Elections can Make Comparisons

Difficult

Why are Financial Statements Limited?

Financial Data Providers have Distilled (Bloomberg, Factset, Reuters) many important facts

Financial Ratios provide important information and details, without having to read financials themselves

There are many analysts out there who review info for you

…however…

Strong fundamental research requires in-depth review/knowledge of accounting

Ability to review/examine/digest financial statements is a growing area of need in money management (e.g., forensic accounting research, fraud specialization)

Do you need CPA to Review and Understand Financial Statements?

Auditors Report Balance Sheet Income Statement Statement of Cash Flows Statement of Changes in Equity & Retained

Earnings Footnotes Management Discussion and Analysis Ratios

Financial Statement Components

Auditors Report

Was an Audit Even Done? Who are the Auditors? Was it Prepared in Accordance with GAAP? Is the Report Unqualified (i.e., Clean)Is the report QualifiedHas the Firm Changed Audit Firms in Recent

Years?

Financial Statement- Balance Sheet

Assets◦ Current:

Cash/Inventory/Receivables

◦ Non-Current Fixed Assets Long term receivables Intangibles – such as goodwill

Liabilities◦ Current

Accounts Payable

◦ Non Current Long-Term Debt

Equity◦ Capital Raised◦ Cumulative P&L ◦ Dividends Paid

Accounting Joke…

Financial Statement- Income Statement

Revenues◦ Accounted for an accrual basis◦ Cost of good sold (inventory), can greatly distort◦ Can be subject to management’s estimates of timing

Expenses◦ Accounted for on an accrual basis◦ Can be subject management’s estimates of timing

Other (One-time)◦ Why does the company have one-time charges?◦ Are “one-time” charges routine at this company?

Accounting Jokes…cont’d

Statement of Cash Flows

Cash Flow From Operations◦ Translates Accrual Basis to Cash Basis

Cash Flow from Investing Activities◦ Accounts for “big ticket” items that are typically capitalized

Cash From Financing Activities◦ Shows the sources of capital raising activities during the period

Statement of Changes in Equity & Retained Earning:

Drills Down the Equity Section of the Balance Sheet

Shows the Roll-Forward of Equity for Various Types of Shareholders (e.g., common, preferred)

Shows if There are Other Minority Owners of Company Out There That You Need to Worry About

Footnotes: Devil’s in the Details…

“Minimum” Color Required by GAAP Audited Provides Critical Information to Understand

Financial Statements

Ratios: Accounting Shorthand

Reader’s Digest of Financial Statements Allows for Quick Comparisons against Prior

Periods and Peers Widely Used Ratios can Measure Many

Dimensions of Financial Reporting:

Other Information: MD&A

Additional Color Provided by Management Can be Forward Looking Unaudited Can Highlight Items Not in the Financial

Statements

Case Study: Cisco (CSCO)

Key Statistics

52 Week Range 14.96-21.34

Avg Daily Vol (3 Mo) 38,579,652.0

Market Value (B) 111.3

Ent Value (B) 82.7

Shares Out (M) 5,309

Dividend Yield 2.7%

Float 99.7%

Institutional 73.8%

Top 10 Inst Hldrs 22.3%

Analyst Coverage 39

Target Price $22.89

LT Growth Rate 10.9%

Avg RatingOverweight

(1.39)

4/10 7/10 10/10 1/11 4/11 7/11 10/11 1/12 4/12 7/12 10/12 1/1312

14

16

18

20

22

24

26

28

30

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

Source: FactSet Prices

Cisco Systems Inc. vs. S&P 500 (Operating Basis)11-Feb-2010 to 11-Feb-2013 Price (Local Currency)

Cisco Systems Inc. (Right) S&P 500 (Operating Basis) (Left)

Case Study: Cisco - Balance Sheet

Almost $49B in Cash and Growing

Low A/R (falling)

Purchased Companies in Past

Took Cash, Haven’t Booked Revs

25% of Company Leveraged

Cumulatively, Have Been Profitable

Has Healthy Equity

Leases (increasing)

Grew 12% over past 3 years

Grew 24% over past 3 years

Grew 10% over past 3 years

Grew 10% over past 3 years

Grew 3.5% over past 3 years

Case Study: Cisco – Income Statement

Grew 10% over past 3 years

Starting Paying Dividend

Collecting Faster than in Past

More Profitable than P&L Shows

Stopped Buying Companies

Slowed down Purchasing Own Stock

Increasing Dividend

Case Study: Cisco – Stmt of Cash Flow

Extending more Credit (leases)

Leases grew by 9.5% in 1 year, Faster than revenues….

Past Due Increased by 43% in 1 year

Case Study: Cisco – Footnotes (40 pages worth)

Provides warning about When Revenues Booked

Case Study: Cisco – MD&A (Un-Audited)

Case Study: Cisco – Ratios (Unaudited)

CSCO S&P 500 Diff Notes

Valuation

Price/Earnings (x) 10.70 14.17 -32% Low Valuation

Price/Sales (x) 1.86 1.30 30% High Valuation

Price/Book Value (x) 1.65 2.27 -38% Low Valuation

Price/Cash Flow (x) 7.50 8.70 -16% High Valuation

Enterprise Value/EBIT (x) 5.02 11.66 -132% Low Valuation

Enterprise Value/EBITDA (x) 4.01 8.53 -113% Low Valuation

Enterprise Value/Sales (x) 1.13 1.83 -62% Low Valuation

Profitability

Gross Margin (%) 60.43 31.09 49% Good Margin

SG&A to Sales (%) 37.87 22.57 40% High expenses

Operating Margin (%) 13.53 22.06 -63%

Net Margin (%) 17.46 9.23 47% Good Margin

Return on Assets (%) 8.99 3.38 62% Good Margin

Return on Equity (%) 16.32 15.52 5% Good Margin

Efficiency

Revenue/Employee 0.69 690k/employee

Receivables Turnover (x) 6.63 How many times a year do you collect full A/R

Inventory Turnover (x) 11.58How many times a year do you deplete inv

Days of Inventory on Hand 31.53 Tight inventory

Payables Turnover (x) 21.21 Aren't sitting on bills

Days of Payables Outstanding 17.21 Aren't sitting on bills

Liquidity

Current Ratio 3.49Have the ability to pay off liabilities 3.4x

Quick Ratio 3.40Have the ability to pay off liabilities 3.4x (excluding inventory)

Credit Analysis

EBITDA/Interest Expense (x) 21.84 12.85 41%Interest not a concern

LT Debt/Total Capital (%) 24.10 36.02 -49% Not highly levered

Total Debt/Total Assets (%) 17.79 23.83 -34% Not highly levered

Total Debt/Total Equity (%) 31.84 109.24 -243% Not highly levered

CSCO--- Accounting Observations

Generally…Low Valuation in Relation to Other Large Companies

Cash Cow…However…

Earnings Not Growing Very Fast Net Margins are Not Terrific Their Cash Flow May decline it they Continue to

Lease Don’t seem to know what to do with their Cash

Epilogue…