APPENDIX B
Exercises to Build Your Financial Intelligence
Income Statement Exercise
The following exercises will give you the opportunity to practice what you learned about the income statement.
Our goals with this practice are for you to:
- Get comfortable reading an income statement. Half the battle is simply learning to find the right data, so we’ll ask you to find the numbers that you’ll need to do some analysis.
- Begin to analyze the results. By looking at the trends and doing a few simple percentage calculations, you’ll start to see a layer of meaning behind the numbers.
- Understand the meaning of the numbers. You will answer a few questions about the numbers that will help you understand their significance.
EXERCISE DESCRIPTION
There are two income statements, one for Under Armour and one for eBay, in appendix C. You can practice with one or both. We’ve included these two companies because one is a manufacturer and one is a service company. Of course, there are many other types of organizations (retail, banking, nonprofit, and so on), but two will give you a good start.
A few cautions: because one company is in manufacturing and one is a service business, the income statements contain some different line items. Even common line items may be labeled differently. Remember, too, that these two companies are just samples—other manufacturers’ and service companies’ statements will have slightly different line items and labels. But once you familiarize yourself with the key lines, you’ll be able to work your way through most financial statements.
Follow the instructions here, and you’ll be building your financial intelligence.
INSTRUCTIONS
- Choose which company’s financial information you want to work with, and then find the correct table to fill in. The tables are different because the two companies’ income statements have different line items. Use the tables to enter your numbers or as a guide to write your answers on a separate piece of paper or in a spreadsheet.
- Try your hand at the calculations and questions. You’ll see the calculation to do (either a “percent of” or a “percent change” calculation), a column for the data, and a column for the results. Pay close attention to the year you are working on, and be sure your data and results match the correct year. That will help you later when you are looking at trends. The tables and questions are labeled for Under Armour and for eBay. Doing the calculations and answering the questions will give you an opportunity to think about what the numbers you just wrote down mean.
- Step back and be proud of your work!
- Take a look at the answers and see how you did. (Yes, the answers are right here. We don’t want you to have to flip back and forth, and it is OK if you peek. The whole point is to learn. This is not a test!)
CALCULATIONS
Really do try these—you’ll be surprised at how easy they are and how much more information you’ll have about the company once you do them.
Under Armour, Inc. and Subsidiaries
Percent of:
Percent Change:
eBay Inc.
Percent of:
Percent Change:
QUESTIONS
Now let’s try answering a few questions. You can answer them for one or both companies:
1. What trends do you see by looking at the income statement itself, the raw numbers? What are they telling you?
Under Armour:
eBay:
2. Look at your percent of and percent change results. What are they telling you?
Under Armour:
eBay:
CALCULATION RESULTS
Under Armour, Inc. and Subsidiaries
Percent of:
Percent Change:
eBay Inc.
Percent of:
Percent Change:
ANSWERS TO THE QUESTIONS
Here are just a few thoughts in response to each of the questions we asked you to consider. There is certainly plenty of data to look at, with various possible conclusions, so there is no one right answer. These answers are just to give you a flavor of what you might look at as you study the results.
1. What trends do you see in the raw numbers? What are they telling you?
Under Armour: The trend is great—just what an investor would hope to see. Gross margin improved from 46.5 percent in 2004 to 50.1 percent in 2006. Operating margins improved as well. The only area of concern is the increasing SG&A as a percent of revenue: it rose from 34.1 percent in 2004 to 38.6 percent in 2006. We would like to see this ratio improving as the company grows, not getting worse. eBay: EBay appears to be facing a challenge. All its margins are decreasing while its costs relative to revenue are increasing. EBay needs to reverse this trend. This is particularly true for G&A: from 2005 to 2006, G&A as a percent of revenue rose from 14.3 percent to 16.4 percent.
2. Look at your percent of and percent change results. What are they telling you?
Under Armour: Under Armour is growing fast. Investors like to see more growth in operating profit than in revenue—exactly what is happening here. eBay: EBay is interesting. Revenue is growing rapidly, but margin actually decreased from 2005 to 2006. This is a concern for eBay. The declining margin could be due to competition in the marketplace or to significant increases in costs.
INTERESTING THINGS TO NOTE
- Remember that many terms mean the same thing and that sometimes the same company will use different terms to indicate the same thing. Here, both Under Armour and eBay use the terms gross profit and net income for the various forms of profit. Keep an eye out for those differences, and remember it is all one form or another of profit.
- Note that eBay shows more detail in the operating expenses section, with line items for sales and marketing, product development, and general and administrative categories. Under Armour just includes the line item selling, general, and administrative expenses. Companies have discretion about the level of detail they provide.
- Although this might seem insignificant, take a look at how the statements are laid out. Under Armour indents the total lines, and eBay does not. Each time you read a financial statement, one of the first things you should do is figure out the layout. Doing so makes it much easier to find what you are looking for.
- Both statements are for the year ended December 31. Remember, companies can use any year-end they want to, although they must be consistent and must disclose any change in year-end. Both statements are also “in thousands,” except for per-share amounts. That means that the “true” numbers have three additional zeros, except for the last sections of each statement.
- Although it is typical to call net profit the “bottom line,” you can see that the real bottom line in both these statements is per-share data—that is, data based on the number of common shares outstanding. Be careful: sometimes those line item names will be very close to what you might expect for net profit. Check to be sure they are not per-share data.
Balance Sheet Exercise
The balance sheet is a little tougher than the income statement, but remember that this is the statement that outsiders look at first. If you really understand it, you might start doing that, too.
Once again, our goals for you are:
- To get comfortable reading the balance sheet. You’ll get more practice finding certain numbers.
- To begin to analyze the results. You’ll do just a little analysis here.
There will be more later, in the ratios exercise.
- To understand the numbers you are finding. The questions will help you do just that.
EXERCISE DESCRIPTION
The balance sheets for Under Armour and eBay are found in appendix C. Do one or both. The general exercise is the same as in the income statement exercise: use the appropriate table and then analyze the results.
INSTRUCTIONS
- Based on the financial statement of your choice, find the appropriate table.
- Try your hand at the calculations and questions. You’ll see the formula, a column for the data, and a column for the result, just as with the income statement calculations. There are only a few calculations to do with the balance sheet for now. You’ll do more when we get to ratios. Doing the calculations and answering the questions will give you an opportunity to think about what the numbers mean.
- Step back and be proud of your work!
- Take a look at the answers and see how you did.
CALCULATIONS
Let’s do the calculations. For the balance sheet calculations, the names of the categories are the same, so do these calculations for both companies (of course, only if you want to practice).
Under Armour, Inc. and Subsidiaries
| 2005 to 2006 Data | 2005 to 2006 Result | |
|---|---|---|
| Percent change in total assets | ||
| Percent change in total liabilities |
eBay Inc.
| 2005 to 2006 Data | 2005 to 2006 Result | |
|---|---|---|
| Percent change in total assets (shown but not labeled) | ||
| Percent change in total liabilities |
QUESTIONS
Now let’s try answering a few questions:
1. What trends do you see in the raw numbers? What are they telling you?
Under Armour:
eBay:
2. Look at your percent change results. What are they telling you?
Under Armour:
eBay:
CALCULATION RESULTS
Under Armour, Inc. and Subsidiaries
| 2005 to 2006 Data | 2005 to 2006 Result | |
|---|---|---|
| Percent change in total assets |  |
42.1% |
| Percent change in total liabilities |  |
41.9% |
eBay Inc.
| 2005 to 2006 Data | 2005 to 2006 Result | |
|---|---|---|
| Percent change in total assets (shown but not labeled) |  |
14.5% |
| Percent change in total liabilities |  |
48.7% |
ANSWERS TO THE QUESTIONS
As in the income statement exercise, here are just a few thoughts in response to each of the questions we asked you to consider about the balance sheet results.
1. What trends do you see in the raw numbers? What are they telling you?
Under Armour: Under Armour looks great. Its cash is strong, and it is growing a lot of equity on its balance sheet. It is also paying down its long-term debt. This company has very little debt relative to its equity. eBay: EBay looks strong on the balance sheet. There is a sharp increase in current liabilities, but the company has lots of cash. EBay does not have any long-term debt. This is very conservative but may be warranted because of the company’s declining margins.
2. Look at your percent change results. What are they telling you?
Under Armour: Under Armour is consistent. Its asset and liability growth are close together. It appears to be a stable company in the years presented here.
eBay: EBay’s liabilities are growing faster than its assets. It has plenty of cash, so that should not be a major concern in the short term. If the trend continues, it should be watched closely.
INTERESTING THINGS TO NOTE
- The asset line items are slightly different in the two statements, based at least in part on their different businesses. For example, Under Armour has inventory and eBay doesn’t, as you would expect. Only eBay has goodwill, which tells us that it has acquired at least one company. In accounts receivable, Under Armour gives us the details for its allowance for doubtful accounts; eBay simply lists its accounts receivable number as net, without providing the detail (although we bet you’d be able to find it in the footnotes). As we’ve discussed, companies have latitude in how they present their numbers, as long as they are consistent and disclose any changes.
- The liability line items are different, again based on the difference in the businesses. For example, eBay has lines that relate to its business, such as funds payable, amounts due to customers, deferred revenue, and customer advances. These are liabilities related to eBay’s business model. Under Armour has more typical liability line items.
- Under Armour and eBay use different names for the stockholders’ equity section. Under Armour’s title is “Stockholders’ equity and comprehensive loss,” while eBay is simply “Stockholders’ equity.” Under Armour’s title is descriptive of what is included in that section.
- Neither company provides all the totals that would be helpful in reading the statements. For example, eBay includes but does not label total assets or the total of liabilities and stockholders’ equity. Often it is difficult to see the dividing line between liabilities and stockholders’ equity, just because the sections run together. One way of ensuring you have all your numbers correct: add up what you think are all the liabilities, and then add that to the stockholders’ equity. If that total is the same as total assets, you have the right answer.
Cash Flow Statement Exercise
OK, let’s practice the cash flow statement. Here we’ll just look at the numbers and trends but not do any calculations (whew—enough already with the calculator!).
To review, our goals for you are:
- To get comfortable reading the cash flow statement.
- To understand the numbers you find.
- To be able to identify where the cash is coming from and where it is going.
EXERCISE DESCRIPTION
Once again, pick Under Armour, eBay, or both, and use the tables. Then answer the questions that follow.
INSTRUCTIONS
- Using the financial statement of your choice, find the line items indicated in the table in the appropriate cash flow statement for 2006, 2005, and 2004.
- After you’ve finished, answer the questions. They will help you think about the numbers you just found.
- Step back and be proud of your work!
- Take a look at the answers and see how you did.
Under Armour, Inc. and Subsidiaries: Consolidated Statements of Cash Flows, in thousands
Years ended December 31
eBay Inc.: Consolidated Statement of Cash Flows, in thousands
Years ended December 31
QUESTIONS
Now for a few thought-provoking questions:
1. Where is the cash coming from? Is it from operations (the business of the company), from investing, or from financing? What might that mean?
Under Armour:
eBay:
2. What are the trends in the three categories of cash?
Under Armour:
eBay:
CASH FLOW DATA RESULTS
Under Armour, Inc. and Subsidiaries: Consolidated Statements of Cash Flows, in thousands
Year ended December 31
eBay Inc.: Consolidated Statement of Cash Flows, in thousands
Year ended December 31
ANSWERS TO THE QUESTIONS
Here are our thoughts in response to each of the questions we asked you to consider.
1. Where is the cash coming from? Is it from operations (the business of the company), from investing, or from financing? What might that mean?
Under Armour: For Under Armour, cash is coming from investors through stock sales in 2004 and from operations in 2005 and 2006. The company seems to have turned the corner in terms of operating cash flow.
eBay: EBay has very strong operating cash flow. This somewhat mitigates the concern about its margins. It will be interesting to see how eBay’s cash flow is in future years. This strong operating cash flow is a good sign for the business.
2. What are the trends in the three categories of cash?
Under Armour: Under Armour is growing but was still getting positive operating cash flow in 2005 and 2006. It is investing heavily, and it was financing some of this investment through sizable equity investments in 2005. Overall, primary financing for the business is coming from operations and equity financing.
eBay: EBay is generating great cash from operations and was using the cash for investments in 2004 and 2005. In 2006 the company stopped investing and bought back a large portion of stock. This is a sign that the company believes the stock price is relatively low and that the cash generation from operations is going to continue. EBay is a strong company in terms of cash flow.
INTERESTING THINGS TO NOTE
- Remember that every company uses its own terminology. It just happens that these two companies use the same terms for the main categories of cash flow (cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities). However, take a look at the totals for each category. You will get a flavor of both the differences and the difficulties in reading the cash flow statement. For the first category, cash flows from operating activities, Under Armour’s total says, “Net cash provided by (used in) operating activities.” This means that in one or more years cash was positive from operations (no parentheses), and in the other years cash was negative from operations (parentheses). Look at the numbers, and you’ll see that in 2006 and 2005 cash was positive, but in 2004 it was negative. So 2004 is the year that net cash was “(used in)” operations. The line item label should always indicate what the parentheses mean.
- Remember that the cash flow statement is the most difficult to read. But now that we have real numbers, you can see how it works in action. Look at accounts receivable for Under Armour. On the balance sheet, you can see that accounts receivable went up from 2005 to 2006 by $20,828. When accounts receivable increases, other things being equal, cash goes down. Now look at the cash flow statement. The accounts receivable line in the “cash flows from operating activities” section shows a negative total of $20,828 (we know it is negative because it is in parentheses). That is the same amount that accounts receivable changed from one year to the next on the balance sheet.
Ratios Exercise
Now we get to put it all together and calculate some ratios for our two sample companies, Under Armour and eBay. Remember what we said when we introduced ratios: that ratios give us more information than the raw numbers alone. So let’s see what our ratios can tell us.
Once again, our goals for you are as follows:
- To find the numbers required to calculate the ratios.
- To get comfortable using the ratio formulas.
- To get you thinking about what the ratios mean.
EXERCISE DESCRIPTION
Depending on which ratio you’ll be calculating, you’ll be using one or more of Under Armour’s or eBay’s financial statements. Again, you can calculate the ratios for one or both companies. Here it might be really interesting to do both. Some of the differences between a manufacturing company and a service company will reveal themselves in ratio results.
You won’t be calculating all the ratios you learned in part 5, just enough to get a good feel for how ratios work and what they might tell you. Also, you won’t calculate exactly the same ratios for Under Armour as you will for eBay. For example, eBay doesn’t have inventory, so you can’t calculate days in inventory or inventory turnover.
You may have noticed in the previous practices that the language in the tables matched the financial statements exactly. That was to minimize confusion. In real life, however, everyone will be using different terminology. So this time our formulas are generic: we use just one word for profit, sales, and so on, and you will need to find the appropriate line item, even if it doesn’t match exactly. With as much reading as you’ve been doing, we are confident you’ll master this challenge.
Your next step, after you finish this book, is to get the financials for your own company and calculate all the ratios that make sense for your type of organization. That should tell you a lot about your company—information you’ll be able to use in running the business.
INSTRUCTIONS
- Calculate the ratios indicated. We’ve listed the name of the ratio and the formula to use. Then there are columns for the longhand calculation and the result. Use these tables, a separate piece of paper, or a spreadsheet.
- After you’ve finished, answer the questions that follow the table. They will help you look at your results with a critical eye.
- Step back and be proud of your work!
- Take a look at the answers in the next set of tables and see how you did.
Under Armour, Inc. and Subsidiaries: Ratio Table
(continued)
eBay Inc.: Ratio Table
QUESTIONS
Now let’s consider the results.
1. What do the ratio results tell you that the raw numbers didn’t? For example, what do the profitability ratios tell you that the raw numbers didn’t?
Under Armour:
eBay:
2. What do you see in the leverage and liquidity ratio results?
Under Armour:
eBay:
3. What are the trends in the efficiency ratios?
Under Armour:
eBay:
CALCULATION RESULTS
Now let’s see how you did.
Under Armour, Inc. and Subsidiaries: Ratio Results
(continued)
eBay Inc.: Ratio Results
ANSWERS TO THE QUESTIONS
Interpreting these ratios accurately would require us to know a lot about the companies in question. We don’t work for Under Armour or eBay, and we aren’t analysts studying the companies over time. The following responses, therefore, are just a few thoughts on the little information that we do have.
1. What do the ratio results tell you that the raw numbers didn’t? For example, what do the profitability ratios tell you that the raw numbers didn’t?
Under Armour: Under Armour is improving its margins and getting an improving return on its assets and equity. The company is holding its debt constant as it grows. It is apparently improving its asset management.
eBay: While eBay is growing rapidly, it is losing ground in terms of profitability. It has slightly lower returns on assets and equity from 2005 to 2006. This is a trend that investors would want to keep an eye on for 2007.
2. What do you see in the leverage and liquidity ratio results?
Under Armour: Under Armour has plenty of working capital and a very high current ratio. It is a low-debt business—only $0.35 of debt for every dollar of equity. This company may be able to improve its return for its shareholders by increasing its use of debt to finance the business.
eBay: EBay is a business that is financed mostly by equity. This is typical for an Internet-based technology company. Its debt-to-equity ratio increased in 2006 mostly because of a significant stock buyback. The company had plenty of cash and a high current ratio that actually increased from 2.14 in 2005 to 2.30 in 2006.
3. What are the trends in the efficiency ratios?
Under Armour: Under Armour is getting more efficient. Its days sales outstanding (DSO) improved, and its total asset turnover improved significantly, from 1.38 to 1.49. This is a sign of a maturing and more efficient business. eBay: EBay is getting more efficient at asset management. Its DSO improved, and its total asset turnover improved from .39 in 2005 to .44 in 2006. One way to offset the effect of lower margins is to improve asset efficiency. Unfortunately, the improvement in asset management was not enough to overcome the lower margin in 2006; that’s why return on assets decreased from 9.2 percent in 2005 to 8.3 percent in 2006.