Com 4FK3

1. Com 4FK3 Financial Statement Analysis Week 7, 2012 Assessing Profitability and Risk

2. Adjusting Income • Often done by Analysts to get a better picture of the financial health of a company • Reverse the effect of accounting decisions made by management • Remove some artefacts caused by GAAP • Attempt to show permanent earnings of the company regardless of what is presented by management or GAAP

3. Why Adjust I/S? • GAAP Income reported is not sustainable • Primary use of analysis is to forecast the future • Income on the statement does not reflect the current year’s operations • Gain on sale occurred over the holding period • Special provision for bad debts reflects the cumulative effect of many years misstatements

4. Earnings Quality • Net income often contains unusual and not recurring items • Analysis of ongoing profitability should remove the effect of such items (after-tax) • e.g. Pepsi, in year 11, reports an impairment and restructuring charge or $31, $19 after tax • Add $19 to net income before finding ROA

5. Non-Recurring Charges • Is the item really non-recurring? • Some items labelled as non-recurring happen for several years in a row, if an item is likely to be seen in subsequent years then it should be left in the income statement for analysis • An item that has recurred, but is related to a program that has completed can usually be removed form the statements for analysis • Is this income level sustainable?

6. Other Unusual Items • Items to consider • Discontinued operations • Extraordinary items • Changes in accounting principals • Other comprehensive income items • Asset impairment • Restructuring charges • Changes in estimates

7. Discontinued Operations • Not relevant for predicting future results • e.g. the company no longer operates grocery stores • GAAP requires 3 years of income statement effect to allow time series comparison • For finance, we would like more • Further disclosure is not required

8. Extraordinary Items • Must meet 3 criteria • Unusual in nature • Infrequent in occurrence • Material in amount • Examples include; lawsuit settlements, gain or loss on sale of asset, etc.

9. Changes in Accounting Principals • Why is it done? • Imposed from without • Voluntarily • Cumulative impact shown in year adopted • Is this relevant to this year? • Does it make a significant impact on the time series behaviour of income

10. Other Comprehensive Income • Not included on the income statement, but on the balance sheet in owners’ equity section under GAAP • Include; unrealized holding period gains, foreign currency translation, derivatives held as cash flow hedge, minimum pension obligations • Analyst’s discretion on how to handle

11. Asset Impairment • Management has considerable discretion on when or how much is recognized • Is the charge relevant to the year in which it is recognized? • Effect: lowered income this year, higher income (less depreciation) is future years • Is the charge taken in a bad year?

12. Restructuring Charges • Wide discretion allowed, no FASB rules on how or when to report • Does the firm spread out the costs or do they take a “big bath”? • Is the firm regularly taking restructuring charges?

13. Changes in Estimates • Every so often a firm realizes that an estimate made in the past is wrong • GAAP requires effect to be spread over current and future periods • Prior years results, where incorrect estimates were included, cannot be restated • e.g. WT Grant and special provision

14. Profitability • Two main measures of profitability • Return on Assets: the ability of the firm to generate money independent of the capital structure of the firm • Return on Common Equity; the ability of the firm to earn money for the shareholders

15. ROA • The return on assets shows how well the firm is using its assets to generate income Why average total assets? Income statement is for the year Balance sheet is “as of” a point in time

16. Disaggregating ROA • Also known as the Dupont identity

17. Insight • Profit margin for ROA measures the firm’s ability to generate income for a specific level of sales • Asset turnover measures the ability of the firm to manage the level of investment or to generate sales from a particular level of investment

18. ROA for Pepsi • Over the 3 year period Pepsi has been able to increase ROA by increasing its profit margin, and also by improving the asset turnover rate between years 9 and 10

19. Industry Factors • Firms in different industries have different levels of appropriate asset turnover • Utilities have a high profit margin but low asset turnovers • Grocery stores have low profit margins and high asset turnovers

20. Changing ROA • Three factors helping to explain differences between firms and patterns of change over time are; • Operating leverage • Cyclicality of sales • Product life cycle

21. Analysing Profit Margin • The use of common size income statements can highlight the source of profit margin for ROA • Statements for Pepsi shown below

22. Cost of Goods Sold • Changes in this account can be due to several factors • Increased demand allowing for higher prices • Reduced prices to help capture market share • Productivity of production • Shift in product mix

23. Selling and Administrative • From the analysts point of view this is an unfortunate lumping of • Fixed (administrative) costs • Variable (selling) costs • For Pepsi, the change is almost totally explained in one note… advertising expense increased every year, but decreased as a percent of sales

24. Analysing Asset Turnover • It is often beneficial to break down asset turnover into; accounts receivable turnover, inventory turnover, Fixed assets turnover

25. ROCE • The rate of return on common shareholders’ equity measures what income is available to the common shareholders • Shareholders’ equity excludes minority interest in net assets and preferred shares

26. ROA to ROCE • Return on assets can be broken down into; • Return to creditors • Return to preferred shareholders • ROCE

27. Disaggregating ROCE

28. Earnings Per Common Share • Another common measure of profitability • Basic • Assigns a share of the reported income to each of the common shares outstanding

29. Diluted EPS • Companies with outstanding convertible bonds, convertible preferred shares, warrants or stock options have to report the effect of this on EPS • Numerator; add back interest and dividends paid to convertibles, also add back stock option expenses reported as compensation • Denominator; add net shares issued

30. Criticism of EPS • Combines profit with capital structure decisions • a company could have declining earnings but increasing EPS if buying back shares • EPS falls significantly if there is a stock split • EPS is not comparable across firms since each company has different numbers of common shares outstanding

31. Interpreting Ratios • Compare to earlier periods • How has the firm’s profitability changed? • Earlier periods give a benchmark • Compare to other firms • What ratios are common in the industry? • How widely are these ratios distributed? • Where does the firm fall in this industry?

32. Types of Risk • Six main types of risk • Short term liquidity risk • Long term solvency risk • Credit risk • Bankruptcy risk • Market equity beta risk • Financial statement reporting manipulation risk

33. Short Term Liquidity Risk • Is the firm likely to get into a cash flow problem and have to raise money quickly? • Main ratios for this are • Current ratio • Quick ratio • Operating cash flow to current liabilities • Accounts receivable, accounts payable and inventory turnover ratios

34. Current and Quick • Current ratio is a simple ratio, divide current assets by current liabilities • Should be substantially above 1 • Quick or Acid test ratio; only uses cash and assets that can be quickly converted to cash; • marketable securities • accounts receivable (usually but not always) • inventories (less frequently used)

35. OCF to Current Liabilities • Divide cash flow from operations by average current liabilities • For a healthy manufacturing or retail firm, this number should be greater than 40%

36. Working Capital Ratios

37. Long Term Solvency Risk • How much leverage is in the company’s capital structure • Note; lease liabilities are long term debt

38. Interest Coverage • In addition to the total amount of debt, the analyst should consider how easy it is for the firm to pay the interest on that debt

39. Credit Risk • Factors to consider by lenders • Circumstances leading to need for loan • Cash Flows • Collateral • Capacity • Contingencies • Character of managers • Conditions

40. Predicting Bankruptcy • Investors can lose a lot of money if a firm goes bankrupt • For this reason there has been a lot of research into predicting bankruptcy • Type I error; not predicting a bankruptcy • Type II error; false prediction of bankruptcy • Altman and Ohlson models

41. Altman’s Z-score • Calculated Z-score, less than 1.81, high bankruptcy chance, up to 3.00 is a gray area and over 3 is safe • Type II errors are quite low • Type I errors (more expensive) get quite high more than 3 years in advance • WT Grant went gray in 1973. why so late?

42. Ohlson’s Probability • Used logit analysis to generate a number for the probability of bankruptcy • A probability of greater than 3.8% would identify a firm as likely to bankrupt, that rate minimized the Type I & II errors • WT Grant did not exceed that level even in 1974 Only mentioned in passing in the current edition. Skip the Ohlson requirement in Kroger

43. Market Risk • From CAPM, only non-diversifiable risk is rewarded in the market • E(R) = Rf + (Rm – Rf)b • Determinants of beta include • Variability of sales • Operating leverage • Financial leverage

44. Leverage Measures • Degree of operating leverage • Degree of financial leverage • Combined leverage

45. Leverage Example • PCG Inc. has; • Fixed costs of $275,000 • Variable costs of $1.75 per unit • Selling price of $25 per unit • Expected sales of 20,000 units • What is the degree of operating leverage?

46. Leverage Example Continued • PCG Inc. also has; • Interest expense of $125,000 • What is the degree of financial leverage? • What is the degree of combined leverage?