Financial Statement Analysis

1. Financial Statement Analysis

2. Evaluation of currentand pastfinancial conditions • Estimated predictions about • future financial conditions • and performance

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

4. FSA Steps • Identify the economic characteristics • Identify the corporate strategies • Understand the financial statements • Assess the profitability and risk • Value the particular firm

5. Tools for Economic Analysis • Porter’s Five Forces • Economic Attributes Framework

6. Porter’s Five Forces • Buyer Power- (price sensitivity) • Supplier Power • Rivalry among Firms • Threat of New Entrants • Threat of Substitutes

7. 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

8. Strategic Analysis Framework • Nature of product or service • Degree of Integration • Degree of Geographical Diversification • Degree of Industry Diversification

9. Financial Statements • Balance Sheet • Income Statement • Statement of Cash Flows • Footnotes • Auditors Report • Management Discussion and Analysis

10. 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

11. 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)

12. Other F/S Considerations • Quality of Earnings • Statement of Cash Flows • Auditors Report

13. Tools of Profit and Risk Analysis • Common Size Financial Statements • Percentage Change Statements • Comparative Analysis • Critical Financial Ratios

14. Risks of Comparative Analysis • Timing • GAAP Application • Degree of Conservatism-management’s attitude • Size • Geographic Diversification

15. Critical Financial Ratios • Profitability Ratios • EPS • ROCE • Risk Ratios • Current ratio • CFO/Avg. Current Liabilities • Debt/Equity

16. Valuation • Price-Earnings Ratio • Market value to Book value Ratio

17. 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)

18. Sources of Information • Annual Report • Form 10-K • Form 10-Q • Form 8-K • Prospectus • Form 20-F (foreign entity 10-K)

19. 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

20. Businesses are like Fruit Trees Fruit = Operating Activities Trunk & Branches = Investing Activities Roots = Financing Activities

21. Net Income vs. Cash FlowIndirect Method • Net Income • +/- Non-cash Items • +/- Changes in Operating Working Capital • = Cash Flow from Operations

22. 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

23. 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

24. 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

25. 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

26. 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

27. Risk Analysis • Types of risk • International • Domestic • Industry • Firm-specific • Our focus will be on the financial aspects of risk

28. Relationship to O-I-F • S/T liquidity…O…working capital • L/T liquidity…I…plant capacity • L/T liquidity…F…debt svc. rqmts

29. 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

30. 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

31. 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

32. Industry Ratio Sources • Robt. Morris Associates, Annual Statement Studies • Dun & Bradstreet, Industry Norms and Key Financial Ratios

33. 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

34. 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.

35. 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

36. Restructuring Difficulties • Conservative vs. aggressive accounting practices • Periodic charges vs. one time event • “Taking a bath”

37. Analyst’s Role • Is restructuring adequate • Wall street point of view • Significant judgement required

38. 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

39. Methods of Management • GAAP choices • Management judgement and estimates • Timing of transactions

40. 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.

41. 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

42. 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

43. 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

44. 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

45. Economic Aspects • Monopoly…high PM; low AT • Pure Competition…low PM; high AT • Oligopoly…mixture of the two

46. 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

47. Extended Risk • Financial Distress • Credit risk • Bankruptcy risk • Financial Distress Spectrum • Payment omission • Default • Bankruptcy • Liquidation

48. Credit Risk C’s • Circumstances • Cash flows (Capability to repay) • Collateral • Capacity for debt • Contingencies • Character of management • Conditions

49. 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

50. 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