Financial Analysis

Credit Analysis Equity Analysis

Creditors What is the borrowing cause? What is the firm’s capital

structure? What will be the source of debt

repayment?

Credit Rating Business Risk

Industry characteristics Company position Management

Financial Risk Financial characteristics Financial Policy Profitability Capital Structure Cash Flow Protection Financial flexibility

Standard & Poor’s rating method

1. EBIT interest coverage2. EBITDA interest coverage3. Funds from operations/Total debt %4. Free operating cash flow/Total debt %5. Return on capital %6. Operating income/Sales7. Long-term debt/Capital8. Total debt/Capital

Standard and Poors Corporate Ratings

Financial distress

The deterioration in a company’s financial condition such that its ability to repay debt is impaired

Prediction of financial distressUnivariate models

Beaver (1966) relied on Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio No-credit (defensive) interval

Prediction of financial distressMultivariate models

Altman Z-score (Current assets – current liabilities)/total

assets (weight-1,2) Retained earnings/Total assets (weight-

1,4) EBIT/Total assets (weight-3,3) Preferred and common stock market

value/Book value of liabilities (weight-0,6) Sales/Total assets (weight-1,0)

Altman Z-score Z> 2,99 Not in financial distress Z< 1,81 In financial stress 2,99>Z>1,81 Uncertain

Altman Z score Anadolu Cam

Altman Z-score 2006 2005 2004Ratio 1 0,04 0,08 0,14 Ratio 2 0,11 0,12 0,10 Ratio 3 0,04 0,07 0,12 Ratio 4 1,60 2,27 2,97 Ratio 5 0,55 0,51 0,61 Altman Z-score 1,85 2,36 3,08

A. Cam

Additional considerations Mezzanine items

Could be debt or equity Off-balance-sheet liabilities

Operating leases Contingent liabilities Environmental liabilities

Equity Analysis Buy-side

Work for an institutional investors (mutual fund)

Make internal recommendations regarding the purchase of equity securities

Might review reports of sell-side analysts Sell-side

Work for brokerage firms Issue reports for retail and institutional

customers

Valuation Current value V0 is a function of

Present value of next year’s cash flow, CF1

Required rate of return, r Expected constant growth rate, g

10

CFV

r g

Equity Analysis

Provides information regarding1. The future cash flow generating

ability of the firm2. The growth (or lack thereof) of

those cash flows3. The risk of those cash flows, and4. The risk-free rate commanded by

the market

Top-Down Analysis Begin at highest (economy) level

Allocation between domestic and international equities

Market sectors Industries (within a sector) End with evaluation of specific

companies

Bottom-Up Analysis Begin with individual companies

Look for key strengths Screen large data bases for

attractive characteristics Compustat, Bloomberg, Baseline

Search for a combination of characteristics

Macroeconomic Analysis

Gross Domestic Product (GDP): total value of all final goods and services produced within a country. Nominal, measured in current dollars Real, adjusted for changing prices

Gross National Product (GNP): total value of all final goods and services produced by factors of production owned by citizens of a country regardless of production location

Growth rates of both can be used as an initial estimate of a firm’s growth rate

Business Cycle

Expansion Period of economic growth Increased need for PP&E, labor, inventory

Peak – high point following expansion Recession

Contraction following a peak Rising unemployment, decreased need for

factors of production Two quarters of falling real GDP

Business Cycle

Trough – low point following recession Depression

Prolonged and severe recession Some sectors and industries will perform

better in some stages of the cycle than in others.

Cyclical firms are sensitive to stages of the economic cycle.

Inflation Consumer Price Index (CPI) measures

inflation of a market basket of consumer goods

Producer Price Index (PPI) measures inflation at the wholesale level

Higher inflation, higher required risk-free rate of interest

Impacts all companies and all industries (to varying degrees)

Economic Indicators Leading indicators

Move in advance of the business cycle Unemployment claims, new orders

Lagging indicators Follow behind the business cycle Average duration of unemployment,

average prime rate Coincident indicators

Move with the business cycle Industrial production

Sector/Industry Analysis

Assess the ability of companies within the industry to generate cash flow

Assess the potential growth of that cash flow

Assess the risks related to receipt of those cash flows

Assess the industry’s ability to grow relative to the overall economy

Porter’s 5 Competitive Forces that determine industry profitability

1. Threat of New Entrants- Capital requirements, government policy, access to distribution

2. Bargaining Power of Suppliers - Supplier concentration, switching costs, differentiation of inputs

3. Bargaining Power of Buyers- Buyer concentration, price sensitivity, brand identity

4. Threat of Substitute Products or Services5. Rivalry Among Existing Firms

- Industry growth, barriers to exit, current industry concentration

Company Analysis

1. Understand the business2. Evaluate past performance3. Forecast performance4. Value the company5. Make an investment

recommendation

Understanding the Business

Gain an understanding of the products and services provided by the company and the market for those products and services

Talk to employees, suppliers, competitors Interview customers Utilize the company’s products or

services

Evaluating Past Performance

Understand reported financial information Common size and ratio analysis Consider efficiency, liquidity, solvency,

cash flow and relative valuation Understand US GAAP and IAS Financial reporting quality and

conservatism

Forecasting Performance Based on evaluation of past

performance, economic/industry conditions and expected changes

Pro-forma (projected) financial statements

Projection of future earnings Use earnings model or statistical

projection

Valuing the Company Determine the appropriate price

for making an equity investment Is the intrinsic value higher or

lower than the current market price?

Specific methods Discounted cash flow Market-multiple Residual income

Making an Investment Recommendation Current price of subject company’s

securities Results of valuation Risks of investment Investor’s risk tolerance, objectives and

time horizon Buy/Attractive Hold/Market Perform Sell/Market Under perform

Five Steps of a Financial Statement Analysis

Who are you and why are you interested in this company?

What questions would you like to have answered?

What info is vital to the decision at hand?

Establish objectives of the analysis

Step 1

Five Steps of a Financial Statement Analysis (cont.)

Study the industry in which the firm operates and relate industry climate to current and projected economic developments

Step 2Step 2

Five Steps of a Financial Statement Analysis (cont.)

How well does this firm appear to be run? Are they taking advantage of

opportunities? Are they innovative, forward-looking, etc?

Step 3

Develop knowledge of the firm and the quality of management

Five Steps of a Financial Statement Analysis (cont.)

Common-size financial statements Key financial ratios Trend analysis Structural analysis Comparison with industry competitors

Step 4

Evaluate financial statements–tools include:

Five Steps of a Financial Statement Analysis (cont.)

Short-term liquidity Operating efficiency Capital structure and long-term

solvency Profitability Market ratios Segmental analysis (when relevant) Quality of financial reporting

Step 4 Evaluate financial statements–areas include:

Five Steps of a Financial Statement Analysis (cont.)

Reach conclusions about the firm relevant to your established objectives

Step 5

Summarize findings based on analysis

What we have accomplished

Auditor’s Report

Statement of Cash Flows

MD&A

Statement of Shareholders’ EquityBalance Sheet

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Financial StatementsAn OverviewMap