Financial Statement Analysis

1
Financial Statement Analysis

• Chapter Six

2
Business and Financial Analysis

• Analysis of companies for possible investments
  and valuation involves many components.
• The entire business must be considered.

3
Components of analysis

• Business strategy analysis
• Accounting analysis
• Financial analysis (ratios etc.)
• Prospective analysis

4
Business strategy analysis

• Generate Performance expectations through
  industry analysis and competitive strategy
  analysis

5
Accounting analysis

• Evaluate accounting quality by assessing
  accounting policies and estimates

6
Financial analysis

• Evaluate performance ratios using ratios and cash
  flow analysis

7
Fundamental Analysis
8
Prospective analysis

• Forecast future events and value the business

9
Strategic analyses (Porter)

• Industry analysis
• Competitive strategy analysis
• Corporate strategy analysis

10
Structural Analysis of Industries

• Determines the ultimate profit potential of the
  industry
• Mix of economic factors and technology
• Level of competition and long-run ROI
• Firm will respond with unique competitive strategy

11
Forces Driving Industry Competition and profit

• Threat of entry
• Rivalry among current competitors
• Threat of substitution
• Bargaining power of buyers
• Bargaining power of suppliers

12
Competitive Strategies

• Overall Cost Leadership
• Differentiation
• Focus (unique products/ market niche)

13
Impact of strategy on financial statements

• A companys competitive strategy will affect the
  look of its financial statements.
• In a competitive industry, gross profits will
  tend to equalize.
• In a monopoly we will see very high profits

14
Quality of Accounting

• We are looking here at the way in which the firm
  applies the rules of accounting
• The quality of accounting relates to the extent
  to which the financial statements reflect the
  true economic picture of the company

15
Accounting quality?
16
Factors Influencing Accounting Quality

• Accounting Rules
• Uniformity of Accounting rules do not reflect the
  economic situation of all firm equally well
• Forecast Errors
• Management must make estimates in preparing
  financial statements
• Some of the estimates are less accurate than
  others
• Firms differ in the materiality of the effect of
  estimates on inferences made from information in
  the financial statements

17
Factors Influencing Accounting Quality and
Managers Choices

• Managerial Compensation
• Corporate Control Contests
• Tax Considerations
• Regulatory Considerations
• Capital Market Considerations (international vs.
  US)
• Stakeholder Considerations
• Competition Within the Industry

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Accounting Analysis

• Identify Key Accounting Policies
• Assess Accounting Flexibility
• Evaluate Accounting Strategy
• Evaluate Quality of Disclosure
• Identify Potential Red Flags
• Undo Accounting Distortions

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Identify Key Accounting Policies

• We will be learning about how to do this
  throughout the course
• First footnote to financial statements
• Differ somewhat by industry

20
Assess Accounting Flexibility

• Some of the policies that have a substantial
  effect on one industry are governed by rigid
  rules, while others allow managerial discretion
• Need to evaluate both situations carefully
• These differ by industry

21
Evaluate Accounting Strategy

• Does manager use flexibility to reveal true
  economic situation of the firm or to hide it?
  Questions to ask
• How do accounting policies compare to industry
  norms
• Does manager have strong incentive to use
  discretion to manage earnings
• Have accounting policies or estimates changed
  recently
• Have policies been realistic in the past

22
Evaluate Quality of Disclosure

• Does firm provide adequate disclosure to allow an
  assessment of its business strategy ?
• Do footnote adequately explain accounting
  policies ?
• Does management explain current performance
  adequately?
• If rigid accounting rules do not allow the firm
  the flexibility to reveal relevant information in
  the financial statements, do they do so in other
  sections of the financial statements?
• Is segment disclosure adequate?
• How is bad news revealed ?
• Investor relations program?

23
Identify Potential Red Flags (Shenanigans)

• Unexpected changes in accounting policies
• Unexpected sale of assets or other actions that
  boost profits
• Unusual increases in Accounts Receivable relative
  to sales
• Unusual increases in Inventory relative to sales
• Increasing gap between reported income and CFO

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Red flags (continued)

• Increasing gap between reported income and tax
  income
• Sale of receivables and other off balance sheet
  financing
• Large asset write-offs
• Qualified audit opinion or change in opinion

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Accounting Analysis

• Nature of Accounting policies
• Aggressive
• Income increasing
• Conservative
• Income decreasing

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Receivables

• Are they collectible?
• Is the allowance for uncollectible accounts
  reasonable?

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Inventory

• FIFO Or LIFO?
• Turnover?
• Read the Footnotes!

28
Accounting changes

• Discretionary or required
• income increasing or decreasing
• Do they seem justified?

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Unusual gains/losses

• What is their impact?
• How are they reported?

30
Disclosures

• VERY IMPORTANT
• Are they consistent with what you think?
• Are footnotes adequate?

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Disclosures (cont)

• Are there hidden liabilities?
• Operating leases
• Contingent liabilities
• Unfunded pension liabilities
• Purchase commitments

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Financial Analysis

• Separate from accounting analysis
• Use ratios and other information to make
  inferences about a companys prospects and
  performance.

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Chapter Six Objectives

• Recognize the need to adjust financial statements
  to give effect to differences in accounting
  methods and understand how to make basic
  adjustments.
• Calculate and interpret common financial ratios.
• Evaluate a firms short-term and long-term debt
  repayment abilities and its profitability.
• Have a basic understanding of methods of
  forecasting future revenues or earnings.
• Understand the concept of present value and is
  application to valuing free cash flows and
  residual earnings.

34
Overview
Financial statement analysis refers to a set of
procedures that transforms data from financial
statements into information that can be used for
future decision making.
35
Types of Comparisons

• Inter-temporal analysis identifies trends and
  highlights areas for concern.
• Cross-sectional analysis involves comparing the
  subject to its competitors.

36
Comparison Issues

• Problem Sizes of companies may vary.
• Example Comparing Taco Bell (sales in 2003 of
  1.3 billion) with Taco Bueno (sales in 2003 of
  108 million)
• Solution Analysts compares using financial
  ratios.
• Problem Accounting policies may vary from
  company to company.
• Example One company uses accelerated
  depreciation, while the other does not.
• Solution Analyst performs analysis as if the
  statements were prepared with the same
  procedures.

37
Operating Forecasts

• Forecasting Factors
• Industry outlook
• Economic outlook
• Companys
• business plan
• Competition

Using the comparison trend analysis analysts
must forecast future prospects.
38
Financial Statement Analysis Steps

• Review financial statements.
• Determine if they need to be adjusted.
• Decide on how accounts on comparative statements
  would look.
• Perform ratio analysis.
• Change statements so that it looks as if
  companies had used similar policies.

39
As If Adjustments

• When comparing different firms analysts need to
  compare similar data.
• Because of the various methods in accounting, it
  is possible that companies are using different
  methods.
• In order to compare, analysts restate statements
  as if the company had used a certain method all
  along.

40
Examples of As If (pro-forma )adjustments

• Revenue (as if recognized at time of collection)
  Revenue (as reported) Dec or Inc in A/R.
• Purpose To impose a conservative recording of
  revenue.
• Cost of goods sold (as if FIFO was used)
• COGS (as reported with LIFO) Dec or Inc in
  LIFO reserve.
• Purpose To calculate COGS under FIFO.

41
As If Adjustments

• Must note that the adjustments will have effects
  on income and may impact tax calculation.
• Income statement restatements are reflected only
  in the current year, BUT
• Balance sheet restatements require cumulative
  adjustments.

42
Accounting Policy Changes

• FASB SEC make accounting rule changes often.
• The changes are highlighted by auditors usually
  require restatement of statements.
• Analysts must assess the impact of the change on
  the companys statements.
• Analysts must also consider the motivation behind
  management initiated changes in policy.

43
Financial Ratios

• Used to evaluate past performance.
• Adjusts for size differences between companies.

44
Profitability Ratios

• ROE Net Income
• Average Stockholders Equity
• Rate of return on equity measures profitability
  of the firms past investments.
• Trading on equity refers to the use of leverage
  to increase ROE.

45
Profitability Ratios

• Rate of return Net Income Sales
• on Assets (ROA) Sales Average Assets
• Return NI Interest Expense x (1-tax rate)
• on Capital Average debt Average Equity
• (ROC)
• Shows the efficiency of assets employed in the
  firms operating activities.

x
46
Common Size Income Statement

• Shows each line item in income statement as a
  percentage of sales.
• Advantage shows analysts the factors that have
  impacted the profit margin.
• Common Size Income Statement                     
                                                    
                                                    
          Industry                                 
                                                    
         2003           2004           2004 Net
  Sales                                             
                             100.0       
  100.0        100.0 Costs excluding
  depreciation                                      
        87.6             87.2              87.6
  Depreciation                                     
                                   
  3.2               3.3               2.8   Total
  Operating Costs                                   
                    90.8             
  90.5             90.4 Earnings before interest
  taxes                                        
  9.2               9.5               9.6   Less
  interest                                          
                             2.1               2.9 
                1.3 Earnings before
  taxes                                             
              7.1               6.5              
  8.3   Taxes (40)                                
                                     
  2.8               2.6              3.3 Net
  income before preferred dividends                 
                4.3               3.9             
  5.0   Preferred dividends                        
                                   
  0.1               0.1               0.0 Net
  income available to common stockholders           
         4.1               3.8               5.0

47
Turnover Ratios

• Purpose Shows the companys ability to use
  assets to generate sales and collect cash from
  sales.
• Receivables Turnover Sales
• Average Receivables
• Inventory Turnover Cost of Goods Sold
• Average Inventories
• Answers How many times is the firm converting
  assets into sales?

48
Days Turnover Ratios

• Purpose To see the number of days a firm holds
  the asset.
• Days Receivables 365
• Receivables Turnover
• Days Inventory 365
• Inventory Turnover
• Decreases in these turnover ratios may mean there
  could be collections and sales issues.

49
Other Turnover Ratios

• Payables turnover COGS
• Average Payables
• Indicates the efficiency a firm manages its
  credit from suppliers.
• Days payables 365
• Payables Turnover
• Working Capital Turnover Sales
• Average Current Assets
• Capital Assets Turnover Sales
• Average PPE
• These ratios show operating efficiency.

50
Common Size Balance Sheet

• Shows each line item on the balance sheet as a
  percentage of total assets.
• Common Size Balance Sheets                       
                                                    
                 Industry                          
                                 2003        
  2004        2004 Assets Cash Marketable
  securities            4.8        0.5       
  3.2 Accounts receivable                         
  18.8           18.8         17.8
  Inventories                                      
     24.7          30.8         19.8   Total
  Current Assets                       
  48.2          50.0         40.8 Net plant
  equipment                       51.8         
  50.0         59.2 Total Assets                   
                    100.0        100.0       100.0
• Liabilities Equity Accounts payable            
                      1.8        3.0        1.8
  Notes payable                                    
    3.6            5.5           4.4
  Accruals                                         
        7.7            7.0           3.6   Total
  current liabilities                       3.1     
       15.5           9.8 Long term
  bonds                                
  34.5          37.7         30.2   Total
  Debt                                       
  47.6          53.2         40.0 Preferred
  equity                                  
  2.4            2.0           0.0 Common
  equity                                 
  50.0          44.8          60.0 Total Liab.
  Equity                          100.0       
  100.0       100.0

51
Debt Repayment Ratios

• Short term debt measures show a firms ability to
  meet current obligations from existing assets
• Current Ratio Current Assets
• Current Liabilities
• Quick Ratio Cash, Marketable Securities and
  Receivables
• Current Liabilities
• Cash Ratio Cash and Cash Equivalents
• Current Liabilities
• Low ratios mean there could be difficulty
  repaying short term debt.

52
Long Term Debt Measures

• Does the firm generate enough cash to make
  interest payments?
• Interest coverage Income before interest
  and tax expenses
• Interest Expense
• Debt Equity Ratio ST Debt LT Debt
• Stockholders Equity
• The more debt - more payments, giving
  stockholders less change at a return.

53
Question Time

• Which ratio would you use to evaluate if
  shareholders are better off this year than they
  were last year?
• ROE
• Interest Coverage
• Quick Ratio
• Days Receivable

54
Forecasting

• Start with predicting sales using
• Economic Models
• Functional relationships between sales and time
• Analysts intuition and judgment
• Statistical time series models

55
Time Series Analysis

• Study the past to find trends, then formulate
  future looking models.
• Test the model to see how well it captures the
  time series behavior.
• Use the model to create fully forecasted
  financial statements called pro forma statements.
• Note Time series models may ignore changes in
  strategy and firm structure.

56
Pro Forma Statements

• These statements show the effects of future
  financing
• Formulating different versions and passes can
  also show the analyst the effects of different
  accounting methods.
• This analysis can be carried from one firm to
  help analysts determine industry trends predict
  the business cycle.

57
Time Value of Money

• Present Value is the value of a today vs. the
  value of a in the future.
• Method used to compare the two is the time value
  of usually shown as an interest or discount
  rate.
• Future Value C x FVnr let n years and r
  discount rate.
• It shows the effect of compound interest for a
  certain amount of years with a certain interest
  rate.

58
Present Value

• What is the amount received in the future worth
  now?
• It will be less than the future value because the
  money could be invested and would have time to
  grow.
• PVnr 1
• (1r)n

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The Role of Uncertainty

• The higher the risk the higher the return.
• Interest rate increases as risk increases.

60
Models for Valuing Equity

• Discounted Cash Flow Model
• Operating Income is changed into cash from
  operations by adjusting non-cash items.
• Take cash out from investing and financing to
  find free cash flows (FCF).
• Forecast FCF through a given time horizon.
• Calculate a terminal value ( a firms value at
  the end of the time period.)
• Discount the terminal value and FCF with the
  discount rate.

61
Models for Valuing Equity

• RI approach
• Calculate abnormal earnings (earnings above or
  below earnings that investors are expecting.)
• Calculate by reducing net income with a charge
  taken for the use of capital from stockholders.
• This capital charge BV of equity x the
  beginning cost of equity.
• Estimate of Stockholders Equity Present value
  of the abnormal earnings (projected over the life
  of the firm) initial book value of stockholders
  equity.