Chapter 1 What is Financial Analysis?
Defining Financial Analysis • Financial analysis is the process of evaluating financial and other information for decision-making. • A six-step approach is suggested for systematic financial analysis.
Six-step Process • Identify purpose of financial analysis • Corporate overview • Financial analysis techniques • Detailed accounting analysis • Comprehensive analysis • Decision or recommendation
Corporate Overview • Industry analysis--key economic characteristics, historical context, profit drivers, business risks • Firm’s business strategy--competitive strategy given the industry characteristics
Industry Analysis • Competition--growth rates, concentration ratios, degree of product differentiation, economies of scale (& relative fixed & variable costs), substitute products • Legal barriers--patent & copyrights, licensing, regulation • bargaining power of buyers (& suppliers) & price sensitivity
Industry Analysis Criteria • What is the industry? • Relative size & significance • Largest companies • Geographic presence • Business cycle effects, current situation • Future potential
Business Strategy • Cost leadership: low cost producer, economies of scale, efficient production, low input prices • Product differentiation: specific attributes that customers value (e.g., quality, variety, service, delivery time), brand name • Importance of core competencies
Business Strategy Criteria • Historical perspective • Primary focus of operations • Most important strategy • Major operating segments • Corporate outlook/ forecast
Qualitative Analysis--Dell Computer • Industry—primarily PCs: high tech, competitive (e.g., Gateway, IBM, Apple, others), changing products, high growth rates, low barriers of entry • Business strategy--(1) cost leadership strategy: direct selling, made-to-order manufacturing, early on the internet, low receivables; (2) product differentiation?? [IBM clones, Intel & Microsoft components] • Current situation—market share; what is the impact of the business cycle (e.g., PCs are durable goods)?
Quantitative Financial Analysis • Systematic analysis of key elements based on analysis context • Ratios, cash flows, common-size, time series, comparative (e.g., specific firms, industry, all firms), models (e.g., DuPont, Altman’s) • In-depth analysis for “red flag” items
Quantitative Financial Analysis • Financial Statements • Common-size Analysis • Financial Ratios • Growth/trend Analysis • Quarterly analysis • DuPont Model • Market Analysis
Detailed Accounting Analysis • Does accounting information capture the underlying business reality? • Identify areas of “accounting flexibility” & evaluate accounting policies (choices) & disclosures; especially notes & MD&A • Evaluate earnings management potential • Recast accounting numbers when necessary
Comprehensive Analysis • Summarize key points: what is particularly important for decision making? • “Red flags” are particularly important • Consider a written executive summary • Consider a rating scale, such as 1-10
Decision • What is the recommendation or decision? • What is the key rationale for this decision? [This is based on the specific decision: for a credit decision the key factors relate to credit risk, with particular focus on leverage and liquidity.] • Be prepared to defend this decision.
Chapter 2 The Financial Environment
Credit Decisions • Commercial banks provide short-term commercial loans • The major concern: will the company pay interest & principal when due? • Loan terms: interest rate, collateral, debt covenants
Equity Investment Decisions • Public securities trade on formal market exchanges (these are secondary markets) • Buying & selling are now relatively cheap transactions • Mutual funds are a useful alternatives to individual securities • Stock investing has high short-term risks
SEC Regulation • Mission: Protect investors & maintain integrity of the securities markets • Established following the Great Market Crash (SEC Act of 1934) • SEC requires public registration, proxy statements & annual (10-K) and quarterly (10-Q) reports, 8-K for specific events • Update: Sarbanes-Oxley Act of 2002 & Public Company Accounting Oversight Board
Goals of Financial Accounting in a Market Economy? • Capture business economics of the firm (e.g., relationship to industry, competitive strategy, business model). How does firm create value? • Reduce management discretion on financial reporting (what is reality? Vs. misleading information--analysts sort this out). Note management incentives for earnings management
Accounting Regulators • Securities & Exchange Commission (SEC)--regulates securities markets and financial reporting (10-K, 10-Q, 8-K) • Financial Accounting Standards Board (FASB)--promulgates GAAP • International Accounting Standards Board (IASB)—issuing International Financial Reporting Standards (IFRS)
U.S. Standard Setters: 1938-Present • Committee on Accounting Procedures (CAP) issued 51 Accounting Research Bulletins (ARBs)--1938-59 • Accounting Principles Board (APB) issued 31 Opinions--1959-73 • Financial Accounting Standards Board (FASB) has issued 168 Statements through 2008 (SFASs) plus other standards—now Standards Codification
The FASB • Seven member board, full time, appointed by FAF, presumed independent • Extensive due process: agenda items, discussion memoranda (DM), exposure drafts (ED), pronouncements, public exposure with written & oral comments • Super-majority (5-2 vote) [simple majority used 1977-90] • Standard setting a political process
Annual Report Information • Corporate Overview • MD&A • Financial Statements: Balance Sheet, Income Statement, Statement of Cash Flows, Statement of Equity • Notes to financial statements • Auditor’s Opinion
Management Incentives • Managers have incentives to present information in the most favorable light (e.g., bonuses, stock options, promotions) • Accounting choice: accounting polities, estimates, additional disclosures • Standardize vs. estimates: what is reality? • Management have best information, but communications to investors may not be completely credible
Financial Statement Considerations • Managers’ information on economic reality • Estimation errors • Distortion from managers’ accounting choices & disclosure • Question: Can investor perceptions be manipulated?
Finance Theory Perspectives • Efficient Markets • Random Walk • Portfolio Theory • Beta Analysis • Economic Behavior & Agency Theory • Earnings Management & Accounting Choice
Efficient Markets • Markets are efficient if information is impounded immediately in capital prices in an unbiased fashion • Research supports market efficiency in the semi-strong form, for short windows • Why?—Analyst following • Note long-term anomalies & other challenges (e.g., behavioral economics)
Random Walk • The concept that a professional portfolio cannot outperform a randomly selected stock portfolio • Research generally confirms this result • Consistent with efficient markets; that is, all information has been impounded in stock price
Portfolio Theory • Harry Markowitz introduced the concept of portfolio diversification with his 1952 dissertation • Portfolio theory insists that investment portfolios should be diversified to reduce the risk relative to return • Capital asset pricing model: E(Ri) = Rf + [E(Rm) – Rf)
Beta Analysis • Beta () comes directly from the slope of the market model: Rit = i + iRmt + eit • Beta measures the relationship between price movements of the individual stock to market averages • Beta is a measure of systematic risk, where a =1 stock should move with the market; a >1 stock has greater market risk
Economic Behavior • Rationality: assume bounded rationality—people are intendedly rationale but limited • Self-interest behavior: Obedience Simple self interest Opportunism (self interest with guile-- that is, willing to violate normal ethical boundaries for personal benefit)
Agency Theory • Contracts have a principal (e.g., owners) and agent (e.g., managers). The principal will attempt to maximize wealth, contract to avoid conflict, and minimize transaction and agency costs. • Agency costs: information asymmetries (limited information by one side), adverse selection, moral hazard (e.g., shirking).
How to Reduce Agency Costs • Better acquisition decisions • Monitoring--including audits and financial reporting • Align preferences of agents with principals (e.g., debt covenants, management compensation)--a reason for stock options • Control devises such as budgets
Earnings Management • Operations and discretionary accounting methods to adjust earnings to a desired outcome, often income smoothing • Underlying theory: agency theory, transaction cost economics • Importance of efficient contracting: corporations are a network of contracts and exist because they write contracts efficiently
Accounting Choice • Discretionary choices to optimize behavior, using techniques such as: 1. Select alternative accounting methods (e.g., inventory) & level of disclosure (e.g., contingencies) 2. Lobbying (e.g., on proposed standards) 3. Financial, production & investment activities
Discretion Under GAAP • Taking a bath • Creating hidden reserves • Off-balance-sheet financing • Overstating performance (e.g., aggressive revenue recognition) • Not reporting obligations (contingencies, commitments, other liabilities)
Earnings Manipulation • Because alternatives are allowed, financial accounting has many discretionary aspects. • Managers can manipulate income by timing (e.g., recognition this year v next year) and classification (e.g., ordinary v extraordinary) • Accruals can be mandatory (e.g., other post employment benefits) or voluntary (e.g., depreciation)
Earnings Quality • Importance of full disclosure • Look for “conservative” reporting • Review indicators of high quality • Relationship of risk to earnings quality • Be aware of earnings management incentives and evidence of earnings manipulation
Normalizing Income • Attempt to determine earning power--related to normal operating earnings • Remove the “noise”--usually associated with nonrecurring items • Separate analysis of nonrecurring items--reorganization, “big bath” write-offs, changing GAAP • Evidence of earnings manipulation may require substantial adjustments to arrive at “normal earnings”
Financial Analysis Decision • Based on Elliott’s “value chain of information”: this is the $1,000 per hour stage • The purpose of financial analysis is to arrive at an informed recommendation or decision
Chapter 3 The Financial Statements
Financial Statements • Balance Sheet • Income Statement • Statement of Cash Flows • Statement of Stockholders’ Equity
Balance Sheet • Assets: probable future economic benefits • Liabilities: probable future economic sacrifices • Stockholders’ Equity: residual interest, representing ownership interest (also called net assets)
Assets • Current Assets (cash & cash equivalents, short-term marketable securities), accounts receivable, inventory, other) • Property, plant & equipment • Long-term investments • Other assets
Liabilities • Current Liabilities (accounts payable, accrued & other current liabilities) • Long-term debt • Commitments & contingencies • Other liabilities • Potential off-balance sheet debt
Stockholders’ Equity • Preferred stock • Common stock • Other paid-in capital • Retained earnings • Treasury stock • Other comprehensive income • Other equity items
Income Statement • Revenues: inflows from major operations • Expenses: outflows from major operations • Gains & Losses: changes in equity from peripheral activities • Net income: bottom line all operating activities recorded on the income statement • Comprehensive income: Changes in equity from all non-owner sources
Revenue • Sales • Services • Other revenue items • Importance of revenue recognition criteria