Financial Statement Analysis

Evaluation of currentand past

financial conditions

Estimated predictions about future financial conditions and performance

Reasons for Analysis

Investment decisions* Credit decisions* Performance* Valuation (investment) Legal liability amount (credit & perf.) Going concern decisions (credit & perf.) Unreasonable returns (performance)

FSA Steps

Identify the economic characteristics Identify the corporate strategies Understand the financial statements Assess the profitability and risk Value the particular firm

Tools for Economic Analysis

Porter’s Five Forces Economic Attributes Framework

Porter’s Five Forces

Buyer Power- (price sensitivity) Supplier Power Rivalry among Firms Threat of New Entrants Threat of Substitutes

Economic Attributes Framework Demand

price sensitivity demand growth cyclical demand seasonal demand

Supply number of suppliers barriers to entry

Manufacturing capital intensity process complexity

Marketing marketing channel--corporate or consumer demand pull or demand creation

Financing Nature of assets Asset risk Source of cash flow--internal or external

Strategic Analysis Framework

Nature of product or service Degree of Integration Degree of Geographical Diversification Degree of Industry Diversification

Financial Statements

Balance Sheet Income Statement Statement of Cash Flows Footnotes Auditors Report Management Discussion and Analysis

Income Statement Classification

Operating income Other income and expense Income from continuing operations Income, gains & losses from discontinued

operations Extraordinary gains and losses Changes in accounting principles

Comprehensive Income

Net income plus or minus the changes in shareholders’ equity from other than net income or transactions with owners.

(we will look at this later)

Other F/S Considerations

Quality of Earnings Statement of Cash Flows Auditors Report

Tools of Profit and Risk Analysis

Common Size Financial Statements Percentage Change Statements Comparative Analysis Critical Financial Ratios

Risks of Comparative Analysis

Timing GAAP Application Degree of Conservatism-management’s

attitude Size Geographic Diversification

Critical Financial Ratios

Profitability Ratios EPS ROCE

Risk Ratios Current ratio CFO/Avg. Current Liabilities Debt/Equity

Valuation

Price-Earnings Ratio Market value to Book value Ratio

Role of FSA in Capital Markets

One View: FSA has no impact The Other View

FSA is a catalyst FSA identifies individual opportunities Equity markets are not perfectly eff. FSA cleanses F/S biases FSA has unique purpose itself- (go back to the

reasons for analysis)

Sources of Information

Annual Report Form 10-K Form 10-Q Form 8-K Prospectus Form 20-F (foreign entity 10-K)

Statement of Cash Flows-chapter 3

FASB 95--1987 Components

Operating cash: Operations and working capital Investing cash: Non-current assets and

investments Financing cash: L/T debt, equity and dividends

Roots = Financing Activities

Trunk & Branches = Investing Activities

Fruit = Operating Activities

Businesses are like Fruit Trees

Net Income vs. Cash FlowIndirect Method

Net Income +/- Non-cash Items +/- Changes in Operating Working Capital = Cash Flow from Operations

Indirect vs. Direct Method

FASB prefers the direct method FASB requires net income to cash from

operations reconciliation Components:

Cash from customers Cash from dividends Cash from interest income Other operating cash receipts Cash paid to suppliers Cash paid to employees Cash paid for taxes Cash paid for interest Other operating cash payments

Profitability Analysischapter 4 & 5

Rate of Return on Assets--ROA Measures success in using assets to generate

earnings (excluding financing)

Disaggregated ROA ROA = Profit Margin X Asset Turnover Line by line P & L Analysis A/R, Inventory & F/A turnover

ROA Summary

Level 1: ROA as a whole Level 2: Disaggregate ROA Level 3a: Margin analysis in detail Level 3b: Disaggregate turnover Level 4: ROA, margin & turnover by

geographic segment

ROCE--Return on Common Shareholders’ Equity

Return after O-I-F activities ROA and ROCE

ROCE > ROA when ROA exceeds the cost of creditor and pref. Shareholder capital

Disaggregated ROCE

ROCE = ROA X CEL X CSL Common Earnings Leverage = op. Income

available to common s/h Cap. Structure Leverage = multiplier effect of

other capital sources

Risk Analysis

Types of risk International Domestic Industry Firm-specific

Our focus will be on the financial aspects of risk

Relationship to O-I-F

S/T liquidity…O…working capital L/T liquidity…I…plant capacity L/T liquidity…F…debt svc. rqmts

S/T Liquidity

Current ratio Quick ratio Ops. Cash flow to C/L W/C Activity ratios:

A/R turnover Inventory turnover A/P turnover

L/T Liquidity

L/T Debt Ratio Debt/Equity Ratio Liabilities/Assets Ratio Interest coverage…fixed charges coverage OCF to Total Liabilities OCF to Capital Expenditures

Comparative Analyses

Time series analysis (same company) Changes in customers, product or geography Major M&A activity Accounting changes

Cross-sectional analysis (industry) Industry definitions Metric calculations

Industry Ratio Sources

Robt. Morris Associates, Annual Statement Studies

Dun & Bradstreet, Industry Norms and Key Financial Ratios

Stickney’s Comparability Risks…in additon to WFO’s

Earnings not reflective of actual economic value added

F/S restatement F/S classification Time variations in excess of 3 mos. Global accounting factors

Quality of Earnings Issues-Chapter 6

Non-recurring items…sustainability Earnings measurement Earnings management

Essentially we are trying to determine if what is reported is going to recur in the future.

Sustainability Issues

Discontinued operations Extraordinary gains and losses Changes in accounting principles Impairment of long-lived assets Restructuring charges Changes in estimates Peripheral gains and losses Mgt. analysis including the MD&A

Restructuring Difficulties

Conservative vs. aggressive accounting practices

Periodic charges vs. one time event “Taking a bath”

Analyst’s Role

Is restructuring adequate Wall street point of view Significant judgement required

Earnings Management

Reasons it occurs: Incentive compensation factor Job security Smoothing reduces erratic performance which

lowers perceived risk Gov’t anti-trust avoidance

Reasons against: Can’t do it forever Capital market penalties for excess

Methods of Management

GAAP choices Management judgement and estimates Timing of transactions

Restated F/S

Discontinued operations Pooling of interests-(new guidelines) Accounting principle changes

Big issue here is the difficulty of calculating prior years’ impact if information is not presented.

Global Considerations

Use SEC Form 20-F Discloses equity and net income reconciliation

between local GAAP and US GAAP

Evaluate environmental, customs and strategic implications as well as GAAP

Chp. 6 Examples

Ex. #1: Halliburton-discontinued segment Ex. #2: Fountain Pwerboats – extraordinary item Ex. #3: Tenneco Automotive – changes in acctg. Princ. Ex. #4: Brunswick- effect of actg. Changes Ex. #5: Ford-cumulative effect acctg changes Ex. #6: PepsiCo-other comprehensive loss Ex. #7: Cisco-other items Ex. #8: PepsiCo-asset impairment Ex. #9: JDS Uniphase- asset impairment Ex. #10: JDS Uniphase -restructuring Ex. #11: Brunswick-unusual charges Ex. #12: PepsiCo-merger related costs

Chp. 6 Examples, cont.

Ex. #13: DriveTime-change in actg estimate Ex. #14: Hersey-change in actg estimate Ex. #15: Delta Air Lines- other gains and losses Ex. #16: PepsiCo-other gains and losses Ex. #17: PepsiCo-other gains and losses Ex. #18: General Mills –restated statements Ex. #19: Account classification differences Ex. #20: Ericsson-worldwide reporting

Extended Profitability-(use for chapter 4 & 5)

ROA=PM x AT ROA increases as Risk increases ROA increases as OL increases Sales cyclicality increases risk Offset with higher AT ROA varies with life cycle

Economic Aspects

Monopoly…high PM; low AT Pure Competition…low PM; high AT Oligopoly…mixture of the two

ROCE Considerations

ROCE tends to follow ROA Two theories

Random walk…high stays high; low stays low Equilibrium…revision to average ROCE

Penman’s findings Random walk valid 1-6years Equilibrium thereafter takes hold

Capital structure not changed for ROCE improvement

Extended Risk

Financial Distress Credit risk Bankruptcy risk

Financial Distress Spectrum Payment omission Default Bankruptcy Liquidation

Credit Risk C’s

Circumstances Cash flows (Capability to repay) Collateral Capacity for debt Contingencies Character of management Conditions

Bankruptcy

Process Chapter XI…liquidation Chapter VII…reorganization

Predictive Models Beaver…univariate

Net income before amort. etc./total liab.

Altman’s Z…see pages 631-633 Multivariate

Multivariate Criticisms

Relevant ratios might be missing Subjective evaluation Model based on available info; lack of info

might bias model MDA assumes normal distribution of ratios MDA requires similar relationship of

variables for bankrupt and non-bankrupt firms

Other Issues in Bankruptcy Models

Population does not include equal # of bankrupt and non-bank. Firms

Excludes size and industry factors Accrual vs. cash flow variables Models remain unchanged over time

General Summary of Factors

Investment Factors Liquidity lowers risk AT lowers risk

Financing Factors Lower debt levels lowers risk S/T debt increases risk over L/T debt

Operating Factors Profitability lowers risk Operational consistency lowers risk Small size, rapid growth and audit exceptions increase risk

Market Risk

Drivers Political Personnel Product

Market risk drives market return CAPM measures market risk

Market risk beta is driven by… Operating leverage Financial leverage Sales variability

Pro-forma Financials-Chapter 10

Sales revenue (revenue growth) Operating expenses Asset requirements (asset turnover) Debt and equity requirements Cost of financing-(interest etc.) Statement of cash flows Balance sheet

Pro Forma ApproachesExhibit 10.1

Follow the 6 step plan page 742 FSAP has a Forecast pro forma template % analysis can be used to project income

statement and balance sheet Individual items

Turnover ratios as a benchmark

Key Assumptions and Caveats

Annual revenue growth rate Expense relationships Levels of investment

Working capital Fixed Assets

Financing mix 4-5 year range Consistency GIGO (garbage in garbage out)

Pro-forma Methodology

Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template

Rev. Recognition OptionsChapter 7

Period of production Completion of production Time of sale During collection period Upon cash receipt

Earnings Management

Increases as cash flow period grows Increases as options for estimation grows

Criteria for Recognition

Work is completed Measurable amount Costs are identifiable Collection is reasonably assured

Earnings Sustainability Risk

Uncollectible A/R High volume of returned goods Unrecorded warranties

L/T Contractors

Multiple accounting periods Price established in advance of work Periodic payments Percentage of completion

IRS approach

Completed contract

Criteria for Exp. Recognition

Matched with revenue Consumption of service or benefit

Rev. Recog. When Cash is Uncertain

Installment method Cost-recovery-first method

Disclosure

Accounting policies footnote

Inventory Cost Flow Assumptions

Weighted average FIFO-first in; first out LIFO-last in; first out

LIFO Liquidation

Sales greater than production Cash flow increases due to reduced purchases Cash flow decreases due to higher income

taxes

LIFO Characteristics

Rapid price increases Provides better income smoothing in light of

inventory change variability Tax savings Industry specific Larger firm size

Other LIFO Factors

GAAP disclosure: LIFO reserve Stock reaction is inconclusive

Analytical Considerations

Cost flow assumption Price variation & inventory turnover LIFO liquidation impact Inventory obsolescence Inventory financing

LIFO - FIFO Adj.

Inventory value Working capital changes Income statement changes SCF changes

Fixed Assets--Key Issues

B/S Amount Useful lives Depreciation method Recoverability Maintenance & repair expense Overall issue: undervaluation potential

F/A--Earnings Sustainability

B/S amount vs. replacement cost Choice of depr. Lives (instant profit) Choice of depr. method

Intangibles--General

Expense cost of development Recognize as asset purchased intangibles Amortize up to 40 years Caution surrounding “in process R&D”

S/W Development Costs

Expense through “tech. feasibility” Capitalize, thereafter Amortize over useful life

Goodwill

Results from acquisitions Treat according to GAAP Eliminate from B/S

Intangibles--Earnings Sustainability

Generally expense The above is a questionable approach Needed-ways to value intangibles

Liability RecognitionChapter 8

Probable future sacrifice Little or no discretion to avoid Event has occurred

No Liability, If...

Mutually unexecuted contracts Certain contingencies

Not probable Not measurable

Controversial Liability Issues

Hybrid securities Sale of A/R w/recourse Product financing arrangements R&D financing arrangements Take or pay contracts Derivative instruments

Liability Valuation

PV of future cash flows > 1 year Cost of future deliverables Cash advance value

Leases

Operating lease Expense

Capital lease Capitalize w/liability SFAS 13

Title transfer Bargain purchase option 75% of life rule 90% of cost rule

Slightly different tax rules

May want to restate all as capital

Retirement Benefits

Pensions (FASB 87 & 132) Post-retirement Health Benefits (FASB 106 &

132)

pensions

Pension Fund Assets

Assets-BOP+/- Actual Earnings+ Contributions- Payments

= Assets-EOP

Pension Fund Liab.

Liab-BOP

+ Incr.- Time+ Incr.- Service+/- Actuarial G & L- Payments

= Liab-EOP

Key Terms

ABO - amount expected to be paid--current salaries

PBO - amount expected to be paid--future salaries

Pension Expense

Service cost Interest cost Actual return on plan assets Amort. of adoption cost Amort. of PBO increase/decrease Amort. of actuarial gains & losses

Minimum Liability

If ABO > FV of Assets, then adjust to Comprehensive Income

Health Care Benefits

No minimum liability Minor measurement differences Considers income tax impact Sensitivity analysis Note politicization on p. 410

Analyst’s Role

Awareness of underfunding Reasonableness of assumptions Actual performance vs. expected performance

Income Taxes-FASB 109

Book income Permanent differences Temporary differences

Taxables Deductibles

Taxable income

FASB 109-History

APB 11 - income statement focus FASB 109 - B/S focus FASB 109 - Allows deferred debits

Implementation

Determine differences Eliminate permanent differences Classify temporary differences Assess need for valuation allowance

Taxables > deductibles Negative factors Positive factors “more likely than not…”

Disclosure

Income tax expense Income before taxes Statutory rate reconciliation Composition of deferred taxes and assets

Deferred Tax Liability

Is it real? Consider in terms of a “going concern”

Analyst’s Role

Effective tax rate changes Changes in valuation allowance Tax rate by venue Normalize rate excluding one time changes

Reserves

Matching principle Exclude expenses Defer negative asset revaluation (ie FASB

115) Difficult to assess & adjust

Combination IssuesChapter 9

Corporate acquisitions Investments in securities Foreign currency translation Segment reporting

Business Combinations

Purchase accounting Record at FMV Excess to goodwill

Pooling Assume assets and liabilities Must meet the 12 criteria for pooling

Pooling Criteria

2 year autonomy independence single transaction w/in one year stock for at least 90% of stock 2 year moratorium on equity interest changes no reacquisition of shares for bus. Combos ratio interests remain unchanged no change in voting rights no security issues remain outstanding no reacquisition of securities no special funding agreements no disposal plans

Investment in Securities

Under 20% 20% to 50% Over 50%

Under 20%

Held to maturity Available for sale…comprehensive inc. Trading…income statement Analyst issues

include or exclude adj. from income

20% to 50%

Equity method if influence exists Analyst issues

relationship between income and cash submerged assets

Over 50%

Consolidation Might want to consider ROA after inclusion

of unconsolidated subs.

Tax Consequences

Under 80%…interest or dividends Over 80%…consolidated return

Foreign Currency Translations

Functional currency Foreign currency

all-current method income stmt. at the avg. rate B/S at end-of-period rate unrealized translation adj. in comp. income

U.S. currency monetary method avg., end of period and historical rates

FX-Analyst Issues

Translation adjustments in income? Difficult to interpret due to limited disclosure Significant international variance in practice

Disaggregation of Info.

Disclosure of segments (mgt. Approach) operating segments geographic locations major customers

10% rule Elements

operating income sales assets

Why Value Via Cash Flow?Chapter 11

Cash = ultimate value Cash = common denominator

Economists & Cash Flow

Investors spend cash Accrual method subject to “acctg. Tricks Mgt. can manipulate earnings

Valuation: Cash Flow Based

Periodic cash flows Residual value Approximate discount rate

Cost of capital

Periodic Cash Flows

Unleveraged Excludes interest, debt & pfd. stock Weighted avg. cost of capital Valuation of assets

Leveraged Includes interest, debt & pfd. Stock Cost of equity capital Valuation of common shareholder equity

Periodic Cash Flows, cont.

Appropriately reflect inflation Nominal vs. real cash

Use after tax amounts

Residual Value

Horizon = no growth (last cash flow) x (1 + growth rate)

(discount rate - growth rate)

Consider conversion tables (Stickney-p. 766)

Cost of Capital

Debt Market rate (1-tax rate) Leases: use borrowing rate

Preferred Equity Dividend rate

Common Equity Risk free rate + ß(Mkt. Rate - RFR) Betas published in S&P’s stock reports

Releveraging @ New Capital Structure

BL0=BU[1+(1-tax rate)(Current Debt)] Current Equity

Substitute BU with new capital structure

BL1=BU[1+(1-tax rate)(New Debt)] New Equity

CAPM Critique

Unstable ß’s Unstable MROR Size vs. ß’s

Valuation Techniques

Equity CFU-[(interest)(1-tax rate)]

Cost of equity capital

Debt plus equity CFU ÷ Wtd. average cost of capital

Adjusted present value CFU ÷ Unleveraged cost of equity cap.

[interest(tax rate)] ÷ cost of debt cap.

Unleveraging

CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]current equity

Cash Flow Evaluation

Advantages Economic base Rigorous methodology

Disadvantages Residual value dominant Time consuming Subjective

Price-Earnings RatioChapter 12

Higher risk -> lower PE Theoretical model

P/Actual earnings = (1+g)/(r-g)

Theoretical Variances: PE

Earnings persistance Transitory…no change in PE Permanent…change in PE

Accounting principles Lower earnings…higher PE

Trending

Penman found transitory earnings consistency…that is high PE caused by lower than normal earnings is counterbalanced in the following year.

5-7 years reversion to mid-teens growth

PE Ratio Factors

Risk (cost of capital) Growth Earnings persistence GAAP

PE Analysis Keys

Use a sustainable growth rate Doesn’t work when g>r Doesn’t work when g approximates r Test reasonableness with actual PE Existence of transitory earnings Impact of GAAP

Price to Book Value

Market rewards growth in excess of cost of capital

Ultimately reverts to 1.0 Function of

Profitability BV growth

P/BV-Theoretical Model

1+ [(Expected ROCE-r)(BVt)/(1+r)t] … BV0

Theoretical Variances: P/BV

ROCE errors Cost of capital errors Growth rate errors Transitory earnings GAAP impact

lower earnings…higher P:BV

Trending: P/BV

ROCE remains consistent and reverts to 1.0 slowly.

Cash Flow vs. Earnings

Long term impact is indifferent Short term impact: earnings more indicative Use multiple approaches