FINC 664 Business Analysis Using Financial...

FINC 664, week 1 1

FINC 664 Business AnalysisUsing Financial Statements

Week 1–Introduction to the class,strategic elements, ratios, andmanagement communication

© Michael D. Kinsman, Ph.D.

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Welcome to FINC 664, BusinessAnalysis of Financial Statements!

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What will we cover this week?

• This week, we will– Introduce the class– Introduce each of us– Discuss where this course fits in– Discuss strategic elements of the firm– Talk about and use ratio analysis– Discuss management communication of results

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Who is the professor?• Dr. Michael Kinsman goes by the name

Mike. If you’ve gotta, Dr. Kinsman is fine.– Ph.D. in finance, Stanford University.– FINC in finance, Stanford University.– BA, math and econ, Claremont Men’s College

(now Claremont McKenna College)

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Who is the professor?– Practicing CPA in Laguna Beach.– At Pepperdine since 1975.– Formerly at UCI for 12 years.– Former systems programmer for General

Electric.– Former manager at Pacific Telephone.– Has taught this class many times before.– I am willing to make changes to make this class

better. If you see something that will make itbetter, let’s talk.

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How can I reach him?

• In person: Before class here or at my officeat the OCC, which is on the fourth floor inthe far corner. I tend to get there about 45minutes before class.

• By e-mail: [email protected]• By phone: (949) 223-2533.

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Why do you teach?

• I teach because I love it. I enjoy workingwith students and helping them learn. Ireally get excited as you can do new things.More than that, when you have become asuccess, and that happens a lot, I get prettyhappy seeing your name in the paper.

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Do people who took you forfinance have an advantage?

• I sure hope so. I did everything I could toget them to learn as much as they could. Sodid the prof you took.

• So…no, they have no advantage with mebecause they have taken me before, but Ihope they know a lot that will be of use tothem in this class.

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What are the books for the class?• Krishna Palepu, et al., Business Analysis

and Valuation Using Financial Statements:Text and Cases. (4th edition, SouthwesternPublishing Company, 2007). The firstedition of this book won all kinds of awardsfor best book. It is, in fact, an excellent textthat will help you learn a lot. I have foundit most stimulating as I have read it.

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Materials for the class• Within the Palepu book are cases. Those

cases are difficult, but they are at the rightlevel for you. Do them.

• You will probably not get the cases entirelyright. Do not be discouraged. You willlearn from them, and that is why you arehere.

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Materials for the class• In each week’s class notes (like this one) are

questions that may help you structure yourpreparation for the case.

• Work in groups on them (except for the oneyou are turning in for grading).

• The case you are turning in for grading mustbe done alone.

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Do I really have to do the cases?

• Yes, you do. Cases are hard. I’ll be the firstto admit that. And they are the closest toreal life situations I can give you without itcosting you a lot of money.

• You may believe you are the only personwho “doesn’t get a case.” You believewrong.

• Work in a group of 3 to 5 people. It helps.

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Materials for the class• A financial calculator. As you saw in my

letter to you, that’s a requirement of theclass.

• An e-mail account. You need it, with theability to download material from the web.

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Who are you?

• Name?• Where do you work?• What do you do there?• Why are you taking this class?

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Please fill out a 3x5 card

• Use the long direction, please!• At the top, FINC664• Name• Address• Office phone• Home phone• E-mail address

(If any of this is secret, writesecret and I won’t divulge it.Else, I’ll show it to anyone inthis class who asks for you.)

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Syllabus• Each week is listed separately.• The syllabus is also on the Web. Because

you are reading these notes, you have foundthat material.

• If there are updates, I will put them on theweb. You should also download class noteseach week.

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A helpful hint on note taking

• Also on the web pages (go back to my homepage) is Taking Notes in Graduate School.It might be useful.

• Some profs won’t allow you to tape recordclasses. I strongly encourage it. It lets youhear what’s going on again. And a lot isgoing on in this class.

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How will I be graded?• There’s a handout at the back of your syllabus that

shows:– Written case analysis: 25 percent of the total points.

– Class participation: 25 percent of the total points.– Class project presentation: 35 percent of the total

points.– Class project critique: 15 percent of the total points.

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Written class project

• We have a case due each week. You choosewhich one of the cases you will write up asyour written class project. You may writeno more than 5 pages (exhibits may be extraat the end, but I don’t promise I will go overthem in detail). This written analysis is tobe done alone, with help from no one.

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Participation

• Participation will count. Participating meansthat you add to our class with consideredpoints. Your ideas may be wrong, and youshould consider what you are saying beforeyou say it, but “good” wrong points areworth making.

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Group project

• The class will be divided into (probably)four teams. Each team will prepare a case (Iwill decide which team will prepare whichcase). Your team will present (in 35minutes or less) your analysis of the caseand your recommendations.

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Group project• Presentations will occur in the following format:

– You will present the case I assign you to ourclass. You will have 35 minutes for yourpresentation.

– I will assign you to critique one other team’spresentation. You will have 15 minutes forthat presentation.

– I will assign one other group to critique yourpresentation.

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Group project

• Your presentation is 35 percent of your classgrade. A guest panel and I will evaluate youbased on your preparation, presentation, andquality of analysis of your case.

• Your group will have 35 minutes (maximum)for your presentation.

• We will grade individuals as well as thegroup in this presentation.

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Group project• Your critique is 15 percent of your class grade.

You will critique a team that did not critiqueyour team. You will have read their case, and beprepared with questions for them. We willevaluate you based on your preparation,presentation, and quality of analysis of the case.

• Each critic will have 3 minutes of critique time.

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This class runs on yourquestions!

• I make the assumption that you understandthe material unless you indicate otherwise.It is really important that you ask questionsas you have them.

• I admit it. I can’t teach. I can only help youlearn. Let me help you!

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Weird stuff• I do weird stuff. For example:

– I really care if you get the content of the class.– I start the class on time right at 6:00. I really

appreciate your efforts to be here on time.– I call breaks for weird times like 9 minutes.

Why? We all know that 10 minutes is 15. But9 minutes is 9. When I call a 9 minute break, Istart nine minutes later.

– I call on people who don’t have their handsraised.

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My expectations

• My expectation is that you are here to learnas much finance as you can, so that you canuse that material in the world.

• I push people to learn. That’s off-puttingfor people who want me to be nice and letthem sit in the back of the room and justtake notes. But this is a participation class.

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What will you do in class?• I am going to ask you questions you don’t

know the answers to. And I’m going toexpect you to try to answer.

• “Why? If I don’t know it, I don’t know it.”• You know from experience that there are

lots of things both of us don’t know. Tryingto figure them out is what separates you as amanager from the people who won’tadvance.

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I heard four people died last timeyou taught this class

• Up front I’m telling you: This is a hard class.The amount of work you will do in it may wellbe worth more than 2 units. However, that’s allthe time I get to teach it to you.

• I believe you have signed up for this classbecause you really want the material.

• Stay on top of the class and you won’t be afatality. I want this to be the best class you’vetaken.

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How does this class fit in?• This is a specialty class in finance, which is a

subfield of economics.• The purpose of the class is to assure that you can

effectively utilize financial statements.• Utilization includes understanding statements and

how they are built.• You should have learned some of this in your first

finance class and some in accounting.

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The biggest question in finance

• How do you value assets—what is an assetworth?

• That asset can be a stock, a bond, abusiness, a piece of real estate, or a projectin your business.

• It can also be education or a spouse if youchoose to include financial aspects in eitherof those decisions.

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Cash or accrual basis?

• In this class, we will be dealing exclusivelywith accrual basis financial statements.

• What does that mean in terms of– Revenue recognition?– Expense recognition?– Realization of revenues and expenses?

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Who makes all these crazy rules?

• In a kinder, gentler time, businesses simplykept books to use as managementinformation systems. The tax collector mayhave come by occasionally (we even readthat in the Bible), but the pace of recordkeeping was slow compared with today.

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• And then someone decided he was going tosell off part of his business. And that leadto…D I S C L O S U R E

• Investors wanted to know about thecompany, in detail. And as time has goneby, they (we) have wanted more detail andmore comparability among statements.

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• Which has lead to financial statements thathave to follow rules (GAAP) so thatmanagers can’t cheat (so much) on theirstatements.

• The major rule setting bodies today areFASB and the SEC. Both are important toyou and me as we supply and useaccounting data.

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Strategic analysis

• The chart on page I-9 lays out a four stepprocess for strategic analysis. It reallybegins with two steps shown on the top ofthe “analysis tools:”

• Step 0-1: Gather data on both the companyand the outside world.

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Strategic analysis

• Step 0-2: Decide why you are doing theanalysis:– Credit analysis– Security analysis– Merger and acquisition purposes– Debt and dividend decisions– Communications with shareholders– General business analysis

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Strategic analysis• Step 1: Business strategy analysis

– IN WRITING (so you can circle back toconsider whether your other analysis coveredthis adequately) prepare an analysis of thecompany you are considering.

• What drives its profits?• What are its risks?• What drives its overall being?

– This is like the SWOT analysis you did inBusiness Strategy.

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Strategic analysis• Step 2: Accounting analysis

– Consider the financial statements of the firm(especially the notes) in regard to step 1.

• Are the statements adequate for your analysis?• Does the firm account like others in the industry,

or will you need to make adjustments?• Is the accounting in the industry adequate?

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Strategic analysis• Step 3: Financial analysis

– Examine the financial statements in asystematic way.

– Try to uncover the appropriateness of thecompany’s strategy and its strengths comparedto its industry.

• This is often done using a ratio analysis, a cashflow analysis, or common size financialstatements.

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Strategic analysis• Step 4: Prospective analysis

– Where is the firm going to be in the future?– This is obviously the most important issue in

any analysis, and the toughest to ascertain.• If you fail to do this analysis well, you will be left

with a simple analysis of where we have alreadybeen. That’s a pretty sterile and (usually)uninteresting analysis.

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Strategic analysis• We will study these steps in the process of a

strategic analysis of a firm sequentially.

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Business Strategy Analysis–the Industry

• Not all firms are created equal, and not allindustries are created equal. The bookidentifies five factors that are responsible forprofits in an industry. They are broadlybroken into two classes– Competitive factors– Supply and demand

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Business Strategy Analysis–the Industry (competitive factors)• Rivalry among existing firms: With barriers

to entry (in the economic sense) there areopportunities for higher profits. Barriersexist because of– Costs of entry– Customer switching costs– Excess capacity in the industry– Large fixed costs (requires high volume to

make a profit)

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Business Strategy Analysis–the Industry (competitive factors)• An allied issue is the threat of new entrants

into the industry.– Trade names or legal barriers may keep new

entrants out of otherwise profitableopportunities.

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Business Strategy Analysis–the Industry (competitive factors)• Substitute products

– The threat of substitute products may workto keep profits lower than they might havebeen. Cable TV rates, for example, might behigher but for the existence of a substitute,satellite TV.

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Business Strategy Analysis–the Industry (supply and demand)• Customers

– May have the ability to switch producteasily, or may be captive to you.

• Cigarettes may be a situation where a customeris captive (at least to the industry)

• Hamburgers have many close substitutes,costlessly switched to.

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Business Strategy Analysis–the Firm

• Firms can differentiate themselves in twoways:– Cost leadership

• Efficient production• Economies of scale• Lower profit margins• Lower other costs

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Business Strategy Analysis–the Firm

• Firms can differentiate themselves in twoways:– Product or brand differentiation

• You can create a (perceived) difference (forexample, Dell computers are better). Better canmean that quality; delivery; service; orsomething else is perceived as “better.”

• It doesn’t matter whether it really isbetter–perception is reality and is an exploitableadvantage.

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Business Strategy Analysis–Summary

• It is important to look at the industry andthe firm to see where they fit in.

• Failure to do so leads to an incompleteanalysis that may lead you in inappropriatedirections.

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Ratio analysis

• We’ve all done ratio analyses in the past.Essentially, we got a whole lot of ratios,compared them to the industry standard, andsighed deeply when they turned out to beOK.

• Palepu supplies us a way to look at ratiosand relating them to the goals of the firm ina structured way.

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Ratio analysis

• When you go to the doctor, the doctor takesyour blood pressure and checks certainother vital signs to check your physicalhealth.

• We are going to check the “moneypressure” and certain other vital signs ofcompanies to check their fiscal health.

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What are we looking for?

• Like the doctor, we are looking forunexplained difference.

• Explainable differences may be justfine–our management may simply bemanaging differently or there is anotherdifference.

• Unexplained difference gives us a list ofpotential problems.

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In the real world

• When you do ratios in the real world, youwill want to do those ratios for which youhave comparisons. Those are generallylisted in the front of your “comparisons”book.

• We will talk later about sources forcomparison ratios.

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The most important ratios

• What really matters? In the long run, whatmatters is whether the firm is makingmoney. Absent that, it cannot continue inbusiness long.

• The most important ratios, then, deal withprofit–explicitly, return on equity.

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Profitability Ratios

• Return on Equity

• You can think of ROE as comparable to arisk adjusted cost of capital for a firm(recognizing the flaws in accounting that gointo it).

Return on Equity

Net IncomeEquity=

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Profitability Ratios• Return on Equity can further be decomposed into

its two parts, return on assets and percent equity:

• The return on assets asks whether you are makingmoney at what your are doing, and the percentdebt gives you the magnifying glass that debtprovides the shareholders.

Return on Equity

Return on Assets Percent Equity

=

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Profitability Ratios• Return on Assets can further be decomposed into its

two parts, profit margin on sales and total assetturnover:

• To decompose sales, we do a percent of salesincome statement, which shows step by step wherethe income went. Palepu calls this decomposing thenet profit.

Return on Assets = Net Income Sales

Sales Assets*

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Alternative approach

• Palepu includes in the text an alternateapproach to decomposing net profit. Itavoids some problems (particularly thatROA includes all providers of funds) thatthe approach we just looked at has.

• We could use either. For simplicity, now,we will stick with “the simple one.”

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Decomposing Asset Turnover

• Palepu decomposes asset turnover usingfour sets of ratios for short term assets:

1a. Operating working capital to sales = Operating working capital/Sales 1b. Operating working capital turnover= Sales/Operating working capital

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• Inventory ratios 2a. Inventory turnover = CGS/Inventories or its cousin

2b. Days inventory = Inventory/CGS/Day

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• Receivables ratios 3a. A/R turnover = Sales/Accounts Receivable or its cousin

3b. Average collection period:

Days’ Accounts Receivable Receivables = Net Sales /365

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• Payables ratios 4a. A/P turnover = Purchases/Accounts Payable or its cousin

4b. Average payables period:

A/P turnover could also have CGS as its numerator.

Days’ Accounts Payable Payables = Purchases/365

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• Having decomposed short term assets,Palepu decomposes long term assetturnover. First, he defines net long termassets as

Long term assets minus

Non-interest bearing long term liabilities

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• Essentially, non-interest bearing LTliabilities, such as deferred taxes, aresupporting LT assets and don’t need to bepaid for, according to Palepu.

• I am not sure he is on strong ground on thisissue—the source of funds should not affectthe use you make of assets.

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• Net long term asset turnover ratio

• Property, plant and equipment turnover ratio

Net longterm assetturnover

= Sales

Net long term assets

PP & Eturnover =

Sales Net PP & E

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Short term financial leverageratios: Liquidity Ratios

• The liquidity ratios tell us about a firm’ssolvency in the near term– Acid-Test ratio (or Quick ratio)

– Current ratio

Current Assets - Inventories Current Liabilities

=Acid-TestRatio

Current Assets Current Liabilities=Current

Ratio

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Short term financial leverageratios: Liquidity Ratios

• Two other ratios are of interest as LiquidityRatios, Cash ratio and the cash flow fromoperations ratio.

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Long-Term Risk and CapitalStructure

• Palepu has a seemingly infinite number(actually seven) long term capital structureratios. Most measure the same thing indifferent ways. I will focus here on three.

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• Liabilities to equity ratio

• Debt equity ratio

Total Liabilities = Shareholders’ Equity

Liabilities toEquity Ratio

Debt to ST Debt + LT debt Equity = Ratio Shareholders’ Equity

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• Interest coverage (earnings basis)

Times Income Before Interest and TaxesInterest = Earned Interest Expense

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Sustainable growth

• As the name implies, this is a measure of howwell a firm can continue if it maintains itscurrent return and dividends. First, define thedividend payout ratio:

DivPayRatio = Cash dividends/Net income

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Sustainable growth

• Next, calculate sustainable growth: SGR = ROE * (1 – DivPayRatio)If we have a positive sustainable growth ratio,

based on current conditions the firm willcontinue at its growth rate indefinitely.

A negative SGR indicates a firm on adownhill trend.

Obviously, higher SGR is better.

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Additional analysis

• In addition to the traditional ratio analysis,we may want to do common sized incomestatements or balance sheets or trend orother analysis of a company’s financialstatements.

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Common-Size ComparativeStatements

• Common-size comparative statements usepercentages to express the relationship ofindividual components to a total.– Net sales is usually expressed as 100% on the

income statement.– Total assets is usually expressed as 100% on

the balance sheet.

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Trend Analysis

The purpose of trendanalysis is to identify apattern or trend over a

long time span - usuallyfive or more years.

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Trend Analysis

TrendPercentage

Current Year Amount Base Year Amount

100%= *

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Trend AnalysisOften, trend percentages are

used to construct a graphso we can see the trend

over time.

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So what?

• Once we have done our analyses, we arestill left with the “so what” question.

• A company must be compared to somethingbefore we can make judgments about it.

• Comparisons may be subjective orobjective.

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Subjective Standardsof Comparison

• Acquired from past experiences:– In this company, sales per square foot are never

below $300!

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Subjective Standardsof Comparison

• Acquired from past experiences.• Rule-of-thumb standards:

– 3 is a good current ratio.

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Objective Standardsof Comparison

• Published standards– Ratios and turnovers of competing companies in

the same industry:• Our competitor has six times turns on his financial

statement. Why can’t we!

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the same industry.

– Published ratios:• Our trade association shows that firms like us spend 13

percent on R&D.

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the same industry.

– Published ratios.– Standards or average ratios and turnovers for the

industry:• I went to the library (or the WWW) and checked out the

industry standards. They were...

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The Statement of Cash Flows

• The single most powerful of the financialstatements, in my view, is the statement ofcash flows. You should know how to prepareone, and you should know what it means.

• Palepu does an excellent analysis job on 5-25through 5-31. Let’s focus on table 5-11.

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Management communications

• One critical job of management is tocommunicate with “the markets” andinvestors in ways that will help raise theperceived value of the firm.

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Management communication

• Managers often believe their firms areundervalued in the marketplace. Why?– They may, in fact, have inside information and

the firm really is undervalued.– They may be seeing the firm through rose

colored glasses.– They may mis-perceive the whole economy.

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Management communications

• How can management communicate?– Through financial statements– Through management letters– Through discussion with shareholders and

analysts– Through what management does for the

company– Through what management does for itself

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Communicating throughfinancial statements

• Although financial accounting standards, asput forth by FASB and the SEC, somewhatlimit management accounting options,management still has the ability to makedecisions that will affect the firm’s financialstatements. Examples would include baddebt write-offs; inventory policies; and thetimings of some investments.

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Communicating company plans

• Most shareholders read the managementletter in the financial statement, which is agood chance for management to voice itsoptimism and its concerns. However, mostletters are similar in content.

• Management can also have discussions withanalysis (in “road shows”) that provideinformation to the public and affect price.

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A word of caution

• When management supplies information toits publics, it is also providing informationto its competition. It needs to be carefulthat it has not supplied “secrets” or data thatcan be used against it.

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Communicating by whatmanagement does for the firm

• Raising a dividend is a heck of a way formanagement (and the board of directors) tocommunicate with shareholders.

• So is changing capital structures ordeclaring bankruptcy.

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Communicating by whatmanagement does for itself

• When management buys or sells stock, it isrequired to file information on thoseactivities with the SEC. That informationcan be a good hint as to the future of thefirm.

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