Where Weve Been, Where Were Going

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Where Weve Been, Where Were Going

• Industry Analysis
• Whats the outlook for this industry? What makes
  it succeed or fail?
• Competitive Strategy
• How is a given firm reacting to its environment?
• Accounting analysis
• Are our data reliable? Do they need adjustments?
  Does it reflect economic reality?
• Next Financial Analysis

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Financial Analysis

• Goal
• To assess the performance of a firm in the
  context of its stated goals and strategy
• To provide the foundation for making forecasts of
  future performance
• To provide valuable feedback to the analyst and
  help generate important follow-up queries
• Two Tools
• Ratio Analysis
• To assess the relations among F/S items
• Cash Flow Analysis
• To examine the firms liquidity and how does a
  firm manage its various cash flows

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Various Aspects Analysts Want to Know About a Firm

• Operating
• How well is the firm managing revenue and
  expenses?
• Investment
• What investments have been made? Are they used
  effectively?
• Financing
• How are the investments paid for? How does that
  affect profitability?
• Dividend Policy
• Whats been repaid to the shareholders?
• ?Need a framework to analyze growth and
  profitability

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Ratio Analysis Framework
? Decomposition
NI
Ave SE
Leverage
Taxes
Profitability
Efficiency
Interest
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Use of Averages

• In conducting ratio analysis, we often relate
  flows (e.g., net income) with stocks (e.g.,
  shareholders equity, total assets)
• Its best to average the stocks, but the use of
  ending balances is acceptable
• As analyses become more detailed, advantages of
  averaging (precision) increase
• For simplicity well use ending balances

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General Tools

• Time-Series Analyses
• Compare a particular firm across time
• Common size F/S
• Trend F/S
• Ratios
• Cross-Sectional Analyses
• Compare different firms at the same time point
• Time-Series ? Cross-Sectional Analyses
• Compare different firms across time

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Initial Data Preparation

• Through Accounting Analysis, consider
• Adjustments to accounting policies
• Capitalize ? Expense
• LIFO ? FIFO
• Add in off B/S items
• Adjustments to accounting classifications
• Is a deferred tax liability really a liability?
• Adjustments for non-recurring items
• Are the non-recurring really non-recurring?

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Financial Analysis ROE

• How profitable is the firm?

• Publicly traded firms in the U.S. 11-13 over
  the long-run
• The firms equity value depends on the
  relationship between ROE and cost of equity
  capital
• Can excess returns be earned indefinitely?
• Attract competition
• ? Equilibrium in the long term

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ROE Dell
1999 Net income 1,666 Ending SE
5,308 ROE 1,666/5,308 31.4
Trend 1995 to 1999 (Some data are from
Selected Financial Data on page 19
Analysis Compared with? A competitor or industry
average?
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Decomposing ROE
Total Assets
Total Assets

• How much profit is generated from each dollar of
  investment in assets
• The Profitability Measure
• Who pay for the assets, the shareholders or the
  creditors?
• The Financial Leverage Measure

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Financial Leverage TA/SE

• Assets could be financed through borrowing
• The higher the leverage, the higher the
  Assets-to-SE ratio
• Leverage may create potential return to
  shareholders,
• if cost of borrowing is less than returns on the
  assets it finances
• Leverage adds risk
• ? Question Is the risk worth the reward?
• Sources of borrowing
• Short term current liabilities ? short term
  liquidity analysis
• Long term long term debt ? long-term solvency
  analysis

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Financial Leverage Dell

• 1999
• TA 11,471
• SE 5,308
• TA/SE 11,471/5,308 2.16

Interpretation
TA is 2.16 times of SE or for every one dollar
invested by shareholder, Dell borrowed 1.16 from
creditors
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Financial Leverage Dell
Trend
Observation Leverage is highest in 1996 and 1997
and dropped to normal in 1999
Question Can the firm pay its debt
obligation? (1) interest and principal (2)
short-term and long-term
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Leverage Short-Term Liquidity- Ability to repay
current liabilities
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Short-Term Liquidity - Dell

• Current Ratio for 1999
• CA 7,681 CL 5,192
• Current Ratio 7,681/5,192 1.48
• For every 1 of current liability, Dell has 1.48
  CA available for payment

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Short-Term LiquidityDell
Observation Although Current Ratio dropped in
1999, but Dells S-T liquidity actually improved
because it has more cash-like current assets
available
Question The higher the better?
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Leverage Long-Term Solvency- Debt financing
versus equity financing
(Note TA/SE 1)
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Debt-to-Capital Dell

• 1999
• Short-term debt 0
• Long-term debt 508
• SE 5,308
• Total capital 508 5,308 5,816
• Debt-to-Capital 508/5,816 0.09

Interpretation
For every one dollar of capital Dell raised,
0.09 is from creditor. That is, most capital
are from shareholders.
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Long-Term SolvencyDell
Dell carries less debt in 1999 than in 1998
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Leverage Coverage Ratios- The ability to meet
interest payment
Earnings Basis
Note EBIT Income before tax Interest expense
Cash Basis
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Earnings-Based Coverage Ratio - Dell

• 1999
• EBIT 2,263 Investment and other income
  222 (page 48) 2,485
• Interest expense 34 (page 48)
• Interest coverage ratio 2,485/34 73.1

Interpretation For every one dollar of interest
expense due, Dell has 73.1 profit generated from
sale to pay for it.
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Coverage RatiosDell
Observation Dells coverage ratios have been
dropping probably due to its carrying higher debt
in recent years. Should analysts be
concerned? Probably not.
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Profitability Analysis

• How good is the company generating profit for its
  shareholders from assets investment?
• Overall profitability
• ROA Net income/Average TA
• How much profit is generate for each dollar of
  assets invested
• Doesnt consider nature of the assets
• Current versus non-current
• Operating versus non-operating
• ? Decomposing ROA
• Doesnt consider how assets are financed
• ? Add the leverage analysis

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Measuring Return on Assets

• This formulation is not quite correct
• Investments in assets are financed through debt
  and equity Assets Liabilities SE
• Profit generated from assets investment should be
  NOPAT (net operating profit after tax) NI
  After-tax interest
• ? Pre-Interest ROA NOPAT/TA

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Return on Capital

• This figure can be compared with WACC (Weighted
  Average Cost of Capital)
• To be profitable, return on capital should be
  above WACC
• Over the long run, US firms earn 911 ROC

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ROA Dell

• 1999
• NI 1,666
• Interest expense 34
• Tax rate 31
• NOPAT NI 1,666 Int. 34 x (1-31) 1,687
• TA 11,471
• ROA 1,666/11,471 14.5
• Pretax ROA NOPAT 1,689/ TA 11,471 14.7

Interpretation
For every one dollar Dell invested in assets, it
generated 0.147 profit
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ROA Dell
Observation Dells profitability has been
dropping Why? Industry trend? Strategy not
working?
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Decomposing ROA
Sales
Sales

• What factors could change ROA?
• Profit margin NI/Sales, Return on Sales (ROS)
• Asset utilization Sales/Assets

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Decomposing Profit Margins

• NI (Sales COGS) SGA /- Other
  income/Expenses
• Important profit drivers Gross Margin, RD, SGA,
  Interest, Tax
• Questions
• What is the companys gross margin? Gross margin
  ratio?
• Are margins consistent with competitive strategy?
• Are the gross and net margins changing? Why?
  Price pressure? Cost pressure?
• Competition
• Cost management
• Management of SGA
• Tools
• common-size income statements Divide every I/S
  item by net sales in the same year

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Common-Size I/S - Dell
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Common-Size I/S - Dell

• Dells net income is dropping
• Mostly due to dropping in GM
• Higher COGS
• More RD expenditure
• Better control of SGS
• Higher other income in 1999

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Decomposing Asset Utilization Ratio

• Overall asset utilization ratio

• We can examine how well particular assets are
  being managed
• Current Assets Working Capital
• Inventory
• Accounts Receivable
• Accounts Payable
• Operating Assets

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CA and Working Capital Turnover Ratios

• Current Asset Turnover
• Sales ? Current Assets
• Working Capital Turnover
• Sales ? Working Capital
• Questions
• Are current assets being effectively managed?
• Is there an opportunity to free up cash? Need to
  invest in current assets?

CA Turnover Ratio
Working Capital Turnover Ratio
Observation Dell is more efficient in managing
its short-term assets
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Accounts Receivable Turnover Ratio
A/R Turnover Ratio

• A/R Turnover
• Sales ? A/R
• Days in A/R
• 365? A/R Turnover Ratio
• Questions
• Are customers paying on time?
• Is there a new mix of customers?

Days in A/R
Observation Dell is more efficient in managing
its A/R customers are paying quicker
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Inventory Turnover Ratios
Inventory Turnover Ratio

• Inventory Turnover
• COGS ? Inventory
• Questions
• Is inventory well-managed?
• What risks are faced by holding this inventory?
• Is inventory increasing in expectation of
  increased sales?

Days in Inventory
Observation Dells inventory management is as
good as before
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PPE Turnover Ratios

• PPE Turnover
• Sales ? net PPE
• Questions
• Is the investment in PPE generating sufficient
  sales volume?
• Is the company efficient in its use of PPE?

Observation Dell is not generating as much sales
from its investment in PPE
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Accounts Payable Turnover Ratios

• A/P Turnover
• Purchases ? A/P, or
• COGS ? A/P
• Days in A/P
• 365 ?A/P Turnover Ratio
• Questions
• Is the company using trade credit (cheaper)?
• Are relations with suppliers good?

A/P Turnover Ratio
Days in A/P
Observation It takes Dell more time to pay its
suppliers more than it collect cash from its
customers
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Review
Assets turnover
ROS
Leverage
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ROE BreakdownDell
Observation Dells ROE dropped in 1999
Return on sales dropped higher cost?
Efficiency in utilizing assets investment
dropped Leverage decreased
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Taxes Interest

• We can refine the model by further breaking down
  Return on Sales
• Our Model

Profitability
Taxes
Leverage
Interest
Efficiency
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Decomposing ROS

• Profitability before interest and taxes

• Gross margin analysis
• SGA analysis
• RD analysis

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How Does Interest Cut Into Profit?

• Measures the ratio of operating income kept by
  the company after paying fixed expense (interest,
  lease payments)
• Are fixed costs well-managed?

• Analyst may need to find the fixed payments
• For example, interest, leases and preferred
  dividends

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How Does Tax Cut Into Profit?

• Measures the proportion of pretax income kept by
  the company
• Note 1 - NI / EBT Average Tax Rate

• How does it compare to statutory tax rate?
• Foreign tax rates?
• Effective tax planning?
• Is all income taxable?

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ROEComplete Decomposition
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Sustainable Growth Rate

• Definition
• Sustainable Growth Rate is the rate at which a
  firm can grow, keeping its profitability and
  financial policies unchanged
• SGR ROE x (1 - dividend payout ratio)
• Dividend payout ratio cash dividends paid ? NI
• Why do we care?
• Important input into valuation models
• Benchmark against which to judge what will need
  to change if profitability is to change

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Sustainable Growth RateExample

• SGR ROE x (1 - dividend payout ratio)

The higher the dividend payout ratio, the lower
the SGR even with same ROE and NE
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Next Cash Flow Analysis

• Why do it?
• Indicator of past and present cash generating
  ability not affected by accounting estimations
  and assumptions
• Are past and present decisions leading to
  positive cash flow?
• Indicator of future profitability
• Is present cash flow available to generate future
  cash flows?
• What kind of investments are being made?

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Statement of Cash Flows (SCF)

• Format
• Operating Cash Flows (OCF)
• Direct Method
• Indirect Method more popular
• Investing Cash Flows (ICF)
• Financing Cash Flows (FCF)
• Net changes in cash
• Supplemental disclosures
• Non-cash transactions
• Cash payments for interest and tax

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Operating Cash Flows (OCF)

• Accrual NI versus OCF
• current accruals
• sales vs. actual cash collections ? A/R
• COGS versus actual cash purchase ? Inventory, A/P
• ? Investment in working capital
• non-current accruals
• Depreciation, amortization, equity method,
  deferred taxes
• ? Investment in non-current assets
• Domestic versus Foreign SCF
• Cash vs. Funds
• Funds Working capital

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Investing Cash Flows (ICF)

• Investment in equity and debt securities
• Cash management
• Investment in PPE
• Expanding
• Divesting
• List by item

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Financing Cash Flows (FCF)

• Debt financing
• From creditors
• Borrowing and principal payments
• Equity financing
• From shareholders
• Issuance/buyback shares and dividend payment
• List by item

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Cash Flow Analysis

• Where did the cash come from? How was the cash
  used?
• OCF
• Has the firm been generating positive OCF? If
  not, why? Start-up? Difficulty in managing
  working capital?
• ICF
• Did the firm invest in growth? Consistent with
  business strategy? How was the investment
  financed?
• FCF
• Could the firm use OCF to pay its debt? What
  types of financing the company rely on?
  Consistent with business strategy?
• Business Cycle Analysis
• E.g. start-up OCF (-), ICF (-), FCF ()

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Free Cash Flows

• The amount of cash that the owners of a business
  (shareholders) can consume without reducing the
  value of the business
• No unique definition
• Standard and Poor Pre-tax income Investment in
  PPE
• Another OCF before interest capital spending
• Free cash flows can be used to pay
• Creditors interest or principal (reducing debt)
• Shareholders dividends, shares buyback
• Free cash flows increase the value of the firm

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Decomposing Operating Cash Flow

• Net income
• interest expense (income)
• accruals on non-current assets (e.g.
  depreciation)
• OCF before working capital investments and
  interest
• adjustments for accruals on working capital
  (e.g. changes in A/R, A/P)
• OCF before interest
• Interest received (paid)
• CF from operations after interest

• In a steady state, should be positive
• Net investment in working capital is a function
  of credit policies (A/R), payment policies (A/P),
  and growth (inventory)
• Does this make sense in light of the firms
  growth strategy, industry, credit policies?
• Do OCF ()cover net interest? (is positive?)
• Do assets need to be sold to pay for debt?

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Further Analysis of Cash Flows

• CF from operations (before interest)
• Capital expenditure
• Other investing activities
• Free Cash Flow available to debt and equity
• Interest
• Debt issuance or repayment
• Free Cash Flows available to equity
• Dividend
• Stock issuance or repurchase
• Net Cash Flow

• Is the company using OCF to pursue long-term
  growth opportunities?
• Flexibility is greater when such growth is
  financed internally
• Dont have to justify risky investments
• Dont have to disclose details externally
• But, does external capital lead to better
  decision making?
• Is the companys free cash flow due to divesting
  assets?
• not a sustainable approach

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Capital Expenditures

• Maintenance
• Adequate to keep up the current level of
  production
• E.g. growth rate of COGS
• Discretionary
• Actual adequate capital spending

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Capital Expenditures Analysis Dell
Necessary capital expenditure to maintain
growth Actual capital expenditure
Discretionary capital expenditure 397 5
392
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Cash Flow Analysis Dell
Tax expense Interest Tax rate 785 34
32
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Cash Flow Analysis Dell
Interest x (1-Tax rate) 34 x (1-32)
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Total Cash Flow Earnings Quality

• Ties in with Accounting Analysis
• What make NI differ from OCF?
• Accounting policies
• One-time items
• Relation between NI and OCF over time
• Are discrepancies due to the firms operations or
  the firms accounting policies and estimates?
• Any window dressing?
• Assess revenue and expense recognition
• Cash versus accrual
• What uncertainties need to be resolved?

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What is Next?
Business Strategy Analysis
Accounting Analysis
Financial Analysis
Prospective Analysis