Lecture 5 - Understanding Financial Statements II

FINANCIAL ANALYSIS – 37299
A.A. 2023-2024
Lecture 5: Understanding
Financial Statement II
Prof. Lorenzo Dal Maso

Dipartimento Scienze Aziendali
Statement of Changes in Equity
FINANCIAL STATEMENTS 31/12/X2
Income Statement X2
LINKING ‘EM TOGETHER
(+) Beg. Equity (+) Contributions
Revenues (-) Distribution
(-) Expenses
(+/-) Gain/Loss
(+/-) Net income/Net Loss
(=) Net income/Net Loss
Equity
Assets Ending
Assets Equity
Cash Flow Statement X2

Cash & Cash Liabilities
Equivalent
(+) Beg. Cash & Cash Equivalent Cash & Cash
Equivalent Liabilities
(+/-) Operating Cash Flow
(+/-) Investing Cash Flow
(+/-) Financing Cash Flow
(=) End. Cash & Cash Equivalent
Balance sheet 31/12/X1 Time Balance sheet 31/12/X2

UNDERSTANDING BALANCE SHEET
• Statement of Financial Position, lists what a
company owns (assets), what it owes (liabilities,)
and the amount of its ownership (equity) in a
specific point in time (i.e., a snapshot).
Assets
• Asset
– Resource controlled by the entity.
– Result of past events.
– Future economic benefits are expected to flow to
the entity.
Liabilities
Equity
•
– Present obligation of the entity.
– Arising from past events.
Settlement is expected to result in an outflow of
Liabilities
–
resources embodying economic benefits.
• Equity
– Residual interest in the assets of the entity after
deducting all its liabilities.
Source: Ferrari Annual Report 2022.

• However, balance sheet amounts of

equity (assets, net of liabilities) should not
Assets
be viewed as a measure of either the
market or intrinsic value of a company’s
equity.
• Why?
Equity
– The balance sheet is a mixed model with respect to
measurement (some items at historical cost, some items at
current value).
– Even current value reflects a value that was current at the
Liabilities
end of the reporting period.
– Future cash flows, which affect value, are driven by items

excluded from the balance sheet (e.g., reputation,
management skills).

See what you

have in here…
Most of the valuable
Assets
assets are off-balance
sheet…
Equity
Liabilities
Source: https://brandfinance.com/press-releases/i-top-brand-italiani-e-il-brand-italia-si-rafforzano-e-
incrementano-il-
valore#:~:text=Ferrari%2C%20con%20un%20punteggio%20pari,7%2C2%20miliardi%20di%20euro.
Most of the valuable
See what you
assets are off-balance
have in here…
sheet…
Assets
Equity
Liabilities
Source: https://finance.yahoo.com/quote/RACE/

UNDERSTANDING BALANCE SHEET Working capital: The excess of current assets
over current liabilities (ability of an entity to meet
liabilities as they fall due).
Current assets: Assets expected to Current liabilities: Liabilities

be sold, used up, or otherwise expected to be settled within
realized in cash within one year or one year or within one
one operating cycle of the Current Liabilities
Current Assets operating cycle of the
business, whichever is greater, after business.
the reporting period.
Noncurrent liabilities: All

Non-current Liabilities liabilities not classified as
current.
Noncurrent assets: Assets not

classified as current. Also Non-current Assets
known as long-term or long-
lived assets. Equity: The amount of
Equity Contributed Capital + Earnings
retained during the years.
Total Assets Total Liabilities + Equity
Balance Sheet
• Current assets: focus on the

most relevant ones!
• Cash & Cash equivalents
• Accounts Receivables
• Inventory
• Prepaid Expenses
Current Assets
Non-current Assets
Total Assets

• Trade receivables: Amounts owed to a

company by its customers for products
and services already delivered.
• Notes receivable refer to formal written
promises of indebtedness due from
others
• Typically reported at net realizable
value, an approximation of fair value,
based on estimates of collectability.
Current Assets
Non-current Assets
Total Assets

• Trade receivables: Amounts owed to a

company by its customers for products
and services already delivered.
• Notes receivable refer to formal written
promises of indebtedness due from
others
• Typically reported at net realizable
value, an approximation of fair value,
based on estimates of collectability.
Current Assets
Non-current Assets
Total Assets

• What is inventory?
• Why is inventory relevant?
Current Assets
Non-current Assets
Total Assets

• Non-Current assets: resources that

are used to generate revenues (or
reduce costs) in the long run.
• Intangible assets such as
patents, trademarks, copyrights,
and goodwill
• Tangible assets such as property,
plant, and equipment
Current Assets
Non-current Assets
Total Assets

• Property, plant, and equipment (PP&E): Tangible assets that are used in company operations
over more than one fiscal period.
• Under the cost model, PP&E is reported at historical cost less any accumulated depreciation
and less any impairment losses.
– Depreciation: Systematic allocation of cost over an asset’s useful life.
– Land is not depreciated.
– Impairment losses reflect an unanticipated decline in value.
– Reversals of impairment losses are permitted under IFRS but not under U.S. GAAP.
• Under the revaluation model, PP&E is reported at fair value at the date of revaluation less any
subsequent accumulated depreciation.
– The revaluation model is NOT permitted under U.S. GAAP.
Ratio Description
Weight of tangible
Net tangible Assets (BS) ÷ Total Assets
assets
Accumulated depreciation at year end (BS) ÷

Average age
Depreciation Expenses for the year (IS)
Gross value of depreciable assets at year end

Average useful life
(Notes) ÷ Depreciation Expenses for the year (IS)
Accumulated
Gross Value of
Depreciation of
PP&E = 4,197 mln€
PP&E = 2,740 mln€
Net Value of PP&E = 1,457 mln€

Average Age = (2,740/259)= 11Y

• Intangible assets: Identifiable nonmonetary assets without physical substance (e.g., patents, licenses,
trademarks). Generally expensed when incurred, although capitalized in some situations.
• IFRS:
– Expenditures on research are expensed.
– Expenditures on development are capitalized (if certain criteria are met, including a demonstration of the technical
feasibility of completing the intangible asset and the intent to use or sell the asset).
• U.S. GAAP:
• Generally, both research and development costs are expensed.

– For costs related to software development:
• Products for sale: Both research and development expenditures are expensed until technology feasibility is established; they are
subsequently capitalized.
• Software for internal use: Both research and development expenditures are expensed until probable completion is demonstrated;
they are subsequently capitalized.
• What is goodwill?
• Before giving this answer, what is the
value of the brand Coca Cola?
• We can say – for sure – that it is valuable
brand, but it is hard to be measured.
• Conservatism principle of accounting
standards > ignore everything we
cannot measure precisely.
Current Assets
Non-current Assets
Total Assets

Source: https://interbrand.com/best-global-brands/coca-cola/; Coca Cola 10K: LINK

• Microsoft is famous for its
acquisitions.
• To complete an acquisition, we
must agree upon a transaction
price.
• When a company acquires

another company by paying a
price which is higher than the
value of its assets, that difference is
%Goodwill 2021= 49,711 ÷ 333,779 = 14,89%

typically recorded as goodwill.
%Goodwill 2021= 43,351 ÷ 301,311 = 14,38%
Source: https://www.microsoft.com/investor/reports/ar21/index.html
• In June 2016, we entered into a definitive agreement to acquire LinkedIn for $196 per share in an all-cash transaction valued at
$26.2 billion, inclusive of LinkedIn’s net cash (the “Merger Agreement”). We will finance the transaction primarily through the
issuance of new indebtedness. […] The acquisition is anticipated to accelerate the growth of LinkedIn, as well as Office 365 and
Dynamics.
Source: https://www.microsoft.com/investor/reports/ar16/index.html
Equity: represents the owners’ residual

interest in the company’s assets after
deducting its liabilities:
• Capital contributed by owners (or
common stock or share capital)
• Preferred shares; Treasury shares (or
treasury stock)
• Retained earnings
• Accumulated other comprehensive
income (or other reserves, items
recognized directly in equity)
• Non-controlling interest (or minority
interest)
Current Liabilities
Non-current Liabilities
Equity
Total Liabilities + Equity

Expanded Accounting Equation:

Basic Equation:
ASSETS = LIABILITIES + CONT. CAPITAL + BEG. RETAINED EARNINGS + REVENUE -
ASSETS = LIABILITIES + EQUITY
EXPENSES - DIVIDENDS
Contributed Capital
Capital contributed by owners during the incorporation
Equity
Retained Earnings
Earnings retained (i.e., earnings not distributed as dividends) in
Assets the business up to date
Liabilities
Revenues Expenses Dividends
UNDERSTANDING BALANCE SHEET What is a treasury
share?
What does it
mean share
repurchase?

• Share Repurchases
• Purpose:
– To service the possible exercise of options.
– To shift the mix of debt and equity financing.
– To signal to investors that corporate management believes the stock is
undervalued.
– To tackle a takeover attempt.
– Improve EPS.
• Treasury Stock: stock repurchased for reissue at a later date.
Source: https://www.microsoft.com/en-us/Investor/earnings/trended/cash-returned.aspx
• ROE is a common proxy for performance
UNDERSTANDING BALANCE SHEET (investor) evaluation.
• Net income ÷ Equity
– (as is) >> 2,352 ÷ 869 = 375.7%
– (adjusted) >> 2,352 ÷ 5,768 = 40.7%
Source: https://investor.kimberly-clark.com/static-files/029c0249-a08d-498a-808b-9452f12eb02f
• Current liabilities: Liabilities

expected to be settled within one
year or within one operating cycle
of the business.
• Noncurrent liabilities: All liabilities
not classified as current.
Current Liabilities
Non-current Liabilities
Equity
Total Liabilities + Equity

Short-term liabilities
• Trade payables, also known as accounts payable: Amounts that a company owes its
vendors for purchases of goods and services—in other words, the unpaid amounts of the
company’s purchases on credit as of the balance sheet date.
• Notes payable: Financial liabilities owed by a company to creditors, including trade

creditors and banks, through a formal loan agreement.
• Accrued expenses: expenses that have been recognized on a company’s income

statement but that have not yet been paid as of the balance sheet date.
• Unearned revenue: arises when a company receives payment in advance of delivery of

the goods and services associated with the payment.
Long-term liabilities
• Long-term financial liabilities: Include loans (i.e., borrowings from banks) and notes or
bonds payable (i.e., fixed-income securities issued to investors).
• Usually reported at amortized cost on the balance sheet.
• In certain cases, liabilities, such as bonds, issued by a company are reported at fair
value.
• Deferred tax liabilities: Amount of income taxes payable in future periods with respect
of taxable temporary differences.
• Result from temporary timing differences between a company’s income as
reported for tax purposes (taxable income) and income as reported for financial
statement purposes (reported income).
CREDIT ANALYSIS
ANALYSIS OF BALANCE SHEETS
Analytical Tools
Common-
Balance sheet ratios.
size analysis.
Less relevant
than Liquidity Solvency
before…
Assessment focus: The Assessment focus: The

A company’s ability to
A company’s ability to company’s ability to company’s financial
meet its financial
meet its short-term convert assets to cash and structure and its ability to
obligations over the longer
financial commitments. to pay for operating pay long-term financing
term.
needs. obligations.
Ferrari Porsche
Vertical Analysis
FY2018 FY2019 FY2020 FY2021 FY2022 FY2018 FY2019 FY2020 FY2021 FY2022
Current Assets - Total 51.1% 48.5% 49.1% 49.0% 50.9% 29.2% 29.9% 33.2% 36.1% 42.3%
NonCurrent Assets - Total 48.9% 51.5% 50.9% 51.0% 49.1% 70.8% 70.1% 66.8% 63.9% 57.7%
TOTAL ASSETS 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Current Liabilities - Total 33.3% 35.9% 36.9% 31.9% 37.5% 31.5% 26.7% 24.8% 25.5% 34.8%
NonCurrent Liabilities - Total 38.8% 36.8% 34.6% 35.9% 29.0% 25.3% 32.2% 30.7% 29.9% 29.4%
TOTAL LIABILITIES 72.1% 72.7% 71.4% 67.8% 66.5% 56.8% 58.9% 55.5% 55.4% 64.3%
TOTAL SHAREHOLDERS EQUITY 27.9% 27.3% 28.6% 32.2% 33.5% 43.2% 41.1% 44.5% 44.6% 35.7%
TOTAL LIABILITIES AND EQUITY 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Current Liabilities Current Liabilities

Current Assets
37,5% Current Assets 34,9%
42%
51%
Non-current Liabilities Non-current Liabilities

29% 29,4%
Non-current Assets Non-current Assets

49% 58%
Equity Equity
33,5% 35,7%
Total Assets Total Liabilities + Equity Total Assets Total Liabilities + Equity
Balance Sheet Ferrari FY2022 Balance Sheet Porsche FY2022

ANALYZING LIQUIDITY RISK
• Measures a firm’s ability to generate sufficient cash to supply

operating working capital needs and to service debts.
• Financial statement ratios:

– Current ratio
– Quick ratio
– Cash ratio
• Liquidity - Ability to convert assets into cash or to obtain cash to meet short-
term obligations.
• No direct relation between balances of working capital accounts and likely

patterns of future cash flows.
• Managerial policies regarding receivables and inventories are directed

primarily at efficient and profitable asset utilization and secondarily at liquidity.
• Quality of current assets and the composition of current liabilities are more
important in evaluating the current ratio.
• Liquidity ratios indicate a company’s ability to meet current

liabilities.
–The current ratio expresses current assets in relation to current liabilities.
–It quantifies how many dollars (or whatever reporting currency) of current
assets the company has to pay each dollar of current liabilities.
• A higher (lower) ratio indicates a higher (lower) level of liquidity (i.e., a
greater (lower) ability to meet short-term obligations).
• Current Ratio = Current assets ÷ Current liabilities

• The quick ratio expresses the quick assets (i.e., faster to convert
into cash!) in relation to current liabilities.
– This ratio is more conservative than the current ratio because it
includes only the more liquid current assets in the numerator.
– Indeed the inventory might not be easily and quickly converted into
cash >> financial crisis..!
• Quick Ratio (acid test) = (Cash & Cash eq. + Marketable Sec. +
Acc. Receivables ) ÷ Current liabilities
• The cash ratio expresses cash and marketable securities in

relation to current liabilities.
– The cash ratio normally represents a reliable measure of an entity’s
liquidity in a crisis situation.
– The cash ratio reflects that there can be a time lag involved even in
turning receivables into cash.
• Cash Ratio = (Cash & Cash Eq. + Marketable securities) ÷

Current liabilities
Selected Information from Balance Sheet Ferrari Porsche

Reformulated (€ mln) FY2018 FY2019 FY2020 FY2021 FY2022 FY2018 FY2019 FY2020 FY2021 FY2022
ASSETS
Cash & Equivalents 794 € 898 € 1,362 € 1,344 € 1,389 € 2,932 € 3,962 € 5,255 € 5,668 € 5,545 €
Receivables - Trade (Net) 211 € 231 € 184 € 185 € 232 € 759 € 842 € 1,081 € 1,199 € 1,290 €
Inventories - Total 391 € 420 € 461 € 541 € 675 € 3,889 € 4,013 € 4,108 € 4,517 € 5,504 €
Current Assets - Other 1,081 € 1,092 € 1,069 € 1,294 € 1,657 € 3,571 € 3,842 € 4,652 € 7,168 € 7,846 €
Current Assets - Total 2,477 € 2,641 € 3,076 € 3,364 € 3,953 € 11,151 € 12,659 € 15,096 € 18,552 € 20,185 €
Short-term debt obligations 352 € 421 € 889 € 516 € 979 € 2,215 € 2,239 € 2,657 € 3,128 € 3,464 €
Accounts payable 654 € 712 € 714 € 798 € 903 € 3,134 € 2,582 € 2,335 € 2,447 € 2,899 €
Other current liabilities 609 € 822 € 705 € 876 € 1,031 € 6,668 € 6,478 € 6,293 € 7,504 € 10,249 €
Total Current Liabilities 1,615 € 1,955 € 2,309 € 2,190 € 2,913 € 12,017 € 11,299 € 11,285 € 13,079 € 16,612 €
Current Ratio 1.53 1.35 1.33 1.54 1.36 0.93 1.12 1.34 1.42 1.22
Quick Ratio 0.62 0.58 0.67 0.70 0.56 0.31 0.43 0.56 0.53 0.41
Cash Ratio 0.49 0.46 0.59 0.61 0.48 0.24 0.35 0.47 0.43 0.33
THE WHOLE PICTURE….
1.80 0.80
0.70
1.60 0.60
0.50
0.40
1.40
0.30
0.20
1.20 0.10
-
FY2018 FY2019 FY2020 FY2021 FY2022
1.00
Quick Ratio - Ferrari Quick Ratio - Porsche
0.80
0.70
0.60
0.60
0.50
0.40 0.40
0.30
0.20 0.20
0.10
- -
Current Ratio - Ferrari Current Ratio - Porsche Cash Ratio - Ferrari Cash Ratio - Porsche
THE WHOLE PICTURE (EXTENDED)….
1.80 1.00
0.80
1.60
0.60
0.40
1.40
0.20
1.20 -
FY 2021 FY2022
1.00 Quick Ratio - Ferrari Quick Ratio - Porsche

Quick Ratio - Mercedes-Benz Group Quick Ratio - STELLANTIS
Quick Ratio - Volkswagen Group
0.80
1.00
0.60
0.80
0.40 0.60
0.40
0.20
0.20
- -
FY 2021 FY2022 FY 2021 FY2022
Current Ratio - Ferrari Current Ratio - Porsche Cash Ratio - Ferrari Cash Ratio - Porsche
Current Ratio - Mercedes-Benz Group Current Ratio - STELLANTIS Cash Ratio - Mercedes-Benz Group Cash Ratio - STELLANTIS
Current Ratio - Volkswagen Group Cash Ratio - Volkswagen Group
ANALYZING SOLVENCY RISK
 Examines a firm’s ability to make interest and principal

payments on long-term debt and similar obligations.
 These measures are used (mostly) to examine long-

term solvency risk:
 Debt ratios
 Interest coverage ratio

• Debt Ratios:
– It is used to measure the amount of liabilities, particularly
long-term debt in a firm’s capital structure.
– The higher this proportion, the greater the long-term

solvency risk.
– Most common: debt to equity ratio & financial leverage.

• Debt to equity ratio measures the amount of debt capital relative to

total equity capital.
• Debt to equity (Credit Analysts’ approach) =
Total Liabilities ÷ Total equity
– Debt includes both short-term + long-term liabilities.
– A higher ratio indicates higher financial risk and thus weaker
solvency.
• Financial leverage ratio: This ratio (often called simply the “leverage ratio”)
measures the amount of total assets supported for each one money unit of
equity.
• Financial leverage = Total assets ÷ Total equity
– For example, a value of 3 for this ratio means that each €1 of equity
supports €3 of total assets.
– The higher the financial leverage ratio, the more leveraged the company is
in the sense of using debt and other liabilities to finance assets.
THE WHOLE PICTURE….
3.00 4.00
3.50
2.50
3.00
2.00
2.50
1.50 2.00
1.50
1.00
1.00
0.50
0.50
- -
Debt Equity - Ferrari Debt Equity - Porsche Financial Leverage - Ferrari Financial Leverage - Porsche
THE WHOLE PICTURE (EXTENDED)….
3.00 4.00
3.50
2.50
3.00
2.00
2.50
1.50 2.00
1.50
1.00
1.00
0.50
0.50
-
-
FY2021 FY2022
FY2021 FY2022
Debt Equity - Ferrari Debt Equity - Porsche
Financial Leverage - Ferrari Financial Leverage - Porsche
Debt Equity - Mercedes-Benz Group Debt Equity - STELLANTIS Financial Leverage - Mercedes-Benz Group Financial Leverage - STELLANTIS
Debt Equity - Volkswagen Group Financial Leverage - Volkswagen Group
70.00
• Interest coverage 60.00
• Indicates the number of 50.00
times a firm’s income 40.00
could cover interest

30.00
20.00
charges
10.00
– EBIT ÷ Financial Expenses

-
FY2018 FY2019 FY2020 FY2021 FY2022
Interest Coverage - Ferrari Interest Coverage - Porsche

COMING NEXT: UNDERSTANDING CASH FLOW STATEMENT
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FINANCIAL ANALYSIS – 37299

Prof. Lorenzo Dal Maso

Cash Flow Statement X2

Balance sheet 31/12/X1 Time Balance sheet 31/12/X2

Source: Ferrari Annual Report 2022.

• However, balance sheet amounts of

– Even current value reflects a value that was current at the

– Future cash flows, which affect value, are driven by items

Source: Ferrari Annual Report 2022.

See what you

Most of the valuable

Source: Ferrari Annual Report 2022.

Current assets: Assets expected to Current liabilities: Liabilities

Noncurrent liabilities: All

Noncurrent assets: Assets not

Total Assets Total Liabilities + Equity

• Current assets: focus on the

Source: Ferrari Annual Report 2022.

• Trade receivables: Amounts owed to a

Source: Ferrari Annual Report 2022.

• Trade receivables: Amounts owed to a

Source: Ferrari Annual Report 2022.

Source: Ferrari Annual Report 2022.

• Non-Current assets: resources that

Source: Ferrari Annual Report 2022.

– Land is not depreciated.

– Impairment losses reflect an unanticipated decline in value.

Accumulated depreciation at year end (BS) ÷

Gross value of depreciable assets at year end

Net Value of PP&E = 1,457 mln€

Source: Ferrari Annual Report 2022.

• Generally, both research and development costs are expensed.

Source: Ferrari Annual Report 2022.

Source: https://interbrand.com/best-global-brands/coca-cola/; Coca Cola 10K: LINK

• When a company acquires

%Goodwill 2021= 49,711 ÷ 333,779 = 14,89%

Equity: represents the owners’ residual

Total Liabilities + Equity

Source: Ferrari Annual Report 2022.

Expanded Accounting Equation:

Source: Ferrari Annual Report 2022.

• Current liabilities: Liabilities

Total Liabilities + Equity

Source: Ferrari Annual Report 2022.

• Notes payable: Financial liabilities owed by a company to creditors, including trade

• Accrued expenses: expenses that have been recognized on a company’s income

• Unearned revenue: arises when a company receives payment in advance of delivery of

Assessment focus: The Assessment focus: The

Current Liabilities Current Liabilities

Non-current Liabilities Non-current Liabilities

Non-current Assets Non-current Assets

Balance Sheet Ferrari FY2022 Balance Sheet Porsche FY2022

• Measures a firm’s ability to generate sufficient cash to supply

• Financial statement ratios:

• No direct relation between balances of working capital accounts and likely

• Managerial policies regarding receivables and inventories are directed

• Liquidity ratios indicate a company’s ability to meet current

• Current Ratio = Current assets ÷ Current liabilities

• The cash ratio expresses cash and marketable securities in

• Cash Ratio = (Cash & Cash Eq. + Marketable securities) ÷

Selected Information from Balance Sheet Ferrari Porsche

1.00 Quick Ratio - Ferrari Quick Ratio - Porsche

 Examines a firm’s ability to make interest and principal

 These measures are used (mostly) to examine long-