Financial Statement and Industry analysis

Financial Statement Analysis

To develop techniques for evaluating firms using financial statement analysis for equity and credit analysis.

Integrates financial statement analysis with corporate finance, accounting and fundamental analysis.

Adopts activist point of view to investing: the market may be inefficient and the statements may not tell all the truth.

Users of Firms’ Financial Information

Equity Investors Investment analysis Long term earnings power Management performance evaluation Ability to pay dividend Risk – especially market

Debt Investors Short term liquidity Probability of default Long term asset protection Covenant violations

Users of Firms’ Financial Information

Management: Strategic planning; Investment in operations; Performance Evaluation

Litigants - Disputes over value in the firm Customers - Security of supply Governments: Policy making and Regulation

Taxation Government contracting

Employees: Security and remuneration Investors and management are the primary users of

financial statements

Fundamental Analysis -- Equity Investors Step 1 - Knowing the Business

The Products; The Knowledge Base The Competition; The Regulatory Constraints

Step 2 - Analyzing Information In Financial Statements Outside of Financial Statements

Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added

Step 4 - Convert Forecasts to a Valuation Step 5 - Trading on the Valuation

Outside Investor: Compare Value with Price to; BUY, SELL, or HOLD

Inside Investor: Compare Value with Cost to; ACCEPT or REJECT Strategy

Three Major Financial Statements

Balance sheet: to report an enterprise’s financial conditions, investing and financing strategies on certain date, which usually is the end of calendar year.

Income statement: also known as statement of earnings. It is designed to report the make up of the firm’s revenue, expanses, and profit.

Cash flow statement: it is designed to explain the change in cash between periods. The change in cash would be reported due to three major activities, namely, operating, investing, and financing.

Balance SheetEnded Dec.31, 1995

Assets Liab. And Equity

Current Assets Current Liab.

Cash $20,000 Wages Payable $42,000

Marketable Securities 60,000 Accounts Payable 200,000

Accounts Receivable 122,000 Notes Payable 50,000

Inventories 350,000 Total Current Liab. $292,000

Total Current Assets $552,000

Long term Debt $440,000

Long term (fixed) Assets Total Liab. $732,000

Buildings and Equipment (net) 500,000 Owners’ Equity

Land 200,000 Stock and Surplus 350,000

Patents 100,000 Retained Earnings 270,000

Total Long term (fixed) Assets $800,000 Total Equity $620,000

Total Assets $1,352,000 Liab. and Equity $1,352,000

Measurement of Assets & Liabilities Historical Cost, for most components of Balance Sheet May be at market under “lower of cost or market rule” Reversals of prior write downs allowed for marketable

equity securities but not for inventories Intangible assets have uncertain and hard to measure

benefits and are reported only when acquired via a “purchase method” acquisition -- brand names -- when reported, called Goodwill, Patents, etc.

Two Fundamental shortcomings of the Balance Sheet

Elusiveness of value Value cannot be assigned to all assets

Book Value vs. Market Value Inflation & Obsolescence

Inflation causes book value to understate market value

Obsolescence causes book value to overstate market value

The effect of inflation & obsolescence may not be apparent in an examination of book values because they offset one another

Adjustments to Book Value Estimate Replacement Cost Estimate Liquidation Value Drawbacks

Do adjusted book values reflect market values? Adjusted book values do not consider

organizational capital It is often difficult to determine if we have made the

correct adjustments Adjustments often fail to consider the value of off-

balance sheet items

Income StatementFiscal Year, 1995

Revenue $2,400,000

Cost of Goods Sold -1,600,000

Gross Profits $800,000

Sales and Administrative Expanses -120,000

Depreciations -200,000

Operating Profits $480,000

Interest Expanses -100,000

Earnings before Taxes $380,000

Income Taxes -122,000

Earnings after taxes $258,000

Earnings per Share (EPS) $2.15

Income Statement

Based on Accrual accounting: records financial events based on events that change

net worth. To record and recognize revenues in the period in which they incur and to match them with related expenses.

Based on Matching Principle: recognize all related cost attributed to the revenue on

the period that revenue incurs.

Income Statement: high quality income Revenues + Other income and revenues - Expenses = Income from CONTINUING OPERATIONS Unusual or infrequent events = Pre tax earnings from continuing operations - Income tax expense = After tax earnings from continuing operations* Discontinued operations (net of tax)* Extraordinary operations (net of tax)* Cumulative effect of accounting changes (net of tax) * = Net Income * * Per share amounts are reported for each of these items

High quality income High quality income statement reflect

repeatable income statement Gain from non-recurring items should be

ignored when examining earnings High quality earnings result from the use of

conservative accounting principles that do not overstate revenues or understate costs

High Quality of Earnings Indicators

Net Income Backed up by Cash Net Income not involving the Inclusion of

amortization costs related to questionable assets, such as deferred charges

Net Income that reflects Economic Reality Income Statements Components that are

Recognized Close to the Point of Cash Inflow and Cash Outflow

Low Quality of Earnings Indicators

Unreliable and inaccurate accounting estimates

Earnings that have been artificially smoothed or managed

Deferral of costs that do not have future economic benefit

Unjustified Changes in Accounting Principles and Estimate

Premature or Belated Revenue Recognition

Low Quality of Earnings Indicators

Unstable Income Statement Elements unrelated to normal business operations

Book Income Substantially Exceeds Taxable Income

Residual Income that is substantially less than Net Income

A High Degree of Uncertainty Associated with Income Statement Components

Summary for Income Statement Analysis

No single “real” net income figure exists The analyst must adjust reported net income to an

earnings figure that is relative to him/her. Earnings quality evaluation is important in investment,

credit, audit & management decision making. Appraising the quality of earnings requires an

examination of accounting, financial, economic and political factors.

Earnings quality elements are both quantitative and qualitative

Cash flow statement

SCF (Statement of Cash Flows) adds in situations where Balance Sheet and Income Statement provide limited insight

SCF helps identify the categories into which companies fit

Financial flexibility is a useful weapon to gain a competitive advantage and is best measured by studying the SCF

Cash flow StatementFiscal Year, 1995

Cash inflow from selling activities $2,600,000

Cash outflow from purchasing activities -1,800,000

Cash outflows resulted from wages payment -200,000

Cash outflows resulted from other expanses -150,000

Cash outflows resulted from paying interest -100,000

Cash outflows resulted from paying income taxes -130,000

Cash flows from operating activities $220,000

Cash outflow from purchasing fixed assets -$300,000

Cash inflows from selling long term investment 120,000

Cash flow from investing activities -$180,000

Cash inflow from issuing common stock $400,000

Cash outflow from reducing long term financing -440,000

Cash outflow from issuing common dividend -200,000

Cash flow from financing activities -$160,000

The increase (decrease) in cash and cash equivalents

-$120,000

The key analytical lessons for Cash flow statement

The cash flow statement – not the income statement – provides the best information about a highly leveraged firm’s financial health

There is no advantage in showing an accounting profit, the main consequence of which is incurring taxes, resulting, in turn, in reduced cash flows

Cash flows and competitive advantages

Cash rich firms are flexible to deploy various competition strategies. Such as price competitions, and acquisition etc..

Cash rich firms are tougher to beat when met by adversaries.

Cash Flow and Company Life Cycle

Cash Flow and Start-up Companies

Little or no operating cash flows

Large cash outflows for investing activities

Large need for external financing (mostly from issuing common stock, issue long term debt)

Cash Flow and Company Life Cycle

Cash Flows and Emerging Growth Companies

Some operating cash flow (not enough to sustain growth)

Large cash outflows to expand activities

Requires cash flows from financing

Pay back some short-term debt, issue some common stock

Cash Flow and Company Life Cycle

Cash Flows and Established Growth Companies

Fund growth from operating cash flow

Depreciation is substantial

Repayment of long term debt, begin to pay dividend

Cash Flow and Company Life Cycle

Cash Flows and Mature Industry Companies

Modest capital requirements

Depreciation and amortization is significant

Net negative reinvestment

Large dividend payout, reduction in long term debt

Cash Flow and Company Life Cycle

Cash Flows and Declining Industry Companies

Net cash user (similar to emerging growth)

Lower dividends, Slim operating cash flows

Sell assets

Cash Flows and Financial Flexibility

Safety of dividend Finance growth with internal funds Meet other financial obligations

Financial Ratios Analysis

Ratios and Financial Analysis Comparability among firms of different sizes Provides a profile of the firm

Financial Ratios and Analysis Caution:

Economic assumption of Linearity – Proportionality

Is high Current ratio good? For whom? Industry-wide norms. Difference in Accounting Methods;

Liquidity Ratios: NWC = current assets - current liabilities NWC/total asset ratio = net working capital / total

assets Current ratio = current assets / current liabilities Quick ratio =(cash + marketable securities +

accounts receivable) / current liabilities Cash ratio = (cash + marketable securities) /

current liabilities Cash flow from operation ratio = OCF / current

liabilities

Leverage Ratios

Leverage ratios have two types: balance sheet ratios comparing leverage capital

to total capital or total assets, and coverage ratios which measure the earnings or

cash-flow times coverage of fixed cost obligations.

Leverage Ratios- Balance sheet ratios

Long-term debt ratio = long-term debt / ( long-term debt + equity)

Debt-equity ratio = long-term debt/equity Total debt ratio = total liabilities / total

assets

Leverage Ratios- Coverage ratios

Times interest earned = EBIT / interest expense

= (EAT+Tax+Interest Exp)/ interest expense

Times Cash flow coverage =(OCF+Tax+Interest Exp)/ interest expense

Activity Ratios:

Measures how efficient the firm using its assets to generate cash.

Measures how fast a firm converts its current assets into cash.

Activity Ratios:

Total assets turnover = Sales / Total assets Accounts Receivable turnover = Sales / AR

[Days A/R outstanding = 365 / Accounts Receivable turnover]

Inventory turnover = Sales / Average Inventory, or COGS / Average Inventory [Inventory Conversion = 365 / Inventory turnover]

Payable turnover = Purchase (or COGS) / AP [Days A/P outstanding = 365 / Payable turnover]

The Operating Cycle and the Cash Cycle

TimeAccounts payable period

Cash cycle

Operating cycle

Cash received

Accounts receivable periodInventory period

Finished goods sold

Firm receives invoice Cash paid for materials

Order Placed

Stock Arrives

Raw material purchased

Cash CycleCash Cycle

= Operating cycle - Accounts payable period

= Inventory Conversion + Days A/R outstanding

– Days A/P outstanding

Cash Cycle measures a firm’s relying on the short term borrowing.(bank credits) In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables.

Dell’s Working Capital Policy

Dell’s daily sales was about $20M per day. Dell was able to reduce the need of short term financing $800M. Assuming a 6% short term cost of capital, Dell was able to created $48M more pre tax earnings.

DSI DSO DPO CCC

1996 Q4 31 42 33 40

Improvement -18 -5 +21 -44

1997 Q4 13 37 54 -4

Profitability Ratios:

Gross profit margin = gross profit / sales Operating profit margin = EBIT / sales Net profit margin = net income / sales Return on assets = (net income + interest )/

average total assets Return on equity = net income/ average equity

The Du Pont System

Ratio Pr

1

LeverageTurnoverAssetyofitabilit

Equity

DebtROA

Equity

TA

TA

Sales

Sales

NI

Equity

TA

TA

NI

Equity

NIROE

The Du Pont System

Usually Profitability and Asset Turnover have a negative relation. This negative relation exists in the same industry, or even in different industries.

Profitability shows a firm’s ability in product differentiation. (product differentiation advantage)

Asset turnover reflect a firm’s ability to lower its cost and increase demand. (low cost leadership)

Industry analysis:

Definition of an industry: the group of firms producing products that are close substitutes for each other.

Structural Analysis of Industry Competition

Industry Competitors

Rivalry Among ExistingCompetitors

Potential Entrants

CustomerBuying Power

SupplierBargaining Power

Potential Substitutes

Asset turnover = Sales / TA(Low cost leadership)

Profit margin = NI / Sales(product differentiation) ×

Profit margin decreases over time due to increase in competition.

A firm thus would try to increase asset turnover to compensate the loss in margin.

The strategy to increase asset turnover need to be deployed when a firm still has advantage in profit margin.

Threats of entry:

Barriers to entry: Economics of scales Product differentiation: Capital requirement: Switching costs: Access to distribution channels: Cost disadvantages independent of scale:

proprietary, access to raw materials, favorable locations, government subsidy.

Government policy:

Threats of entry:

Expected retaliation: A history of vigorous retaliation to entrants. Established firms with substantial resources

to fight back. Established firms with great commitments to

the industry and highly illiquid assets employed in it.

Slow industry growth, which limits the ability of the industry to absorb a new firm without depressing the sales and financial performance of established firms.

Intensity of rivalry among existing competitors:

Numerous or equally balanced competitors.. Slow industry growth: High fixed and storage cost: Lack of differentiation or switching costs: Capacity augmented in large increments: Diverse competitors: High strategic stakes: High exit barrier:

Pressure from substitute products:

(1) substitute products are subject to trends improving their price-performance trade-off with the industry’s product.

(2) substitute products are produced by industries earning high profit.

Bargaining power of buyers: It is concentrated or purchases large volume relative

to seller sales. The products it purchases from the industry represent

a significant fraction of the buyer’s cost of purchase. The product it purchases from the industry is

standard or undifferentiated. It faces few switching costs. It earns low profit. Buyers pose a credible threat of backward integration. The industry’s product is unimportant to the quality of

the buyer’s products or services. The buyers have full information.

Bargaining power of suppliers:

It is dominated by a few companies and is more concentrated than the industry it sells to.

It is not obligated to contend with other substitute product for sale to the industry.

The industry is not an important customer if the suppliers’ group.

The suppliers’ product is an important input to the buyer’s business.

The supplier group’s products are differentiated or it has built up switching costs.

The supplier group poses a creditable threat of forward integration.