Financial Statement Analysis: A Holistic Approach

Dan Goldzband, CMA

• University of California, San Diego (Extension Division)

• General Dynamics Global Imaging Systems, San Diego CA

Gross margin DuPont analysis Working capitalFixed asset T/O EPS Return on assetsDebt/equity Sales / SF Trend analysisFree cash flow Acid-test INV T/OHigh-low method DSO Op C/F per shareA/R T/O Revenue / ASMF Cash cycleOperating margin Vertical analysis Debt coverage ratioBook-to-bill R&D plough back Dividend payoutCurrent ratio Return on equity Same size

statementsSame-store sales Exhaustive method Times interest earnedPrice-earnings Dividend yield EBITDANet interest marginPayables T/O Cash burn rateLoans / deposits Average check Book value / share

Ratio overload!

Gross margin DuPont analysis Working capitalFixed asset T/O EPS Return on assetsDebt/equity Sales / SF Trend analysisFree cash flow Acid-test INV T/OHigh-low method DSO Op C/F per shareA/R T/O Revenue / ASMF Cash cycleOperating margin Vertical analysis Debt coverage ratioBook-to-bill R&D plough back Dividend payoutCurrent ratio Return on equity Same size

statementsSame-store sales Exhaustive method Times interest earnedPrice-earnings Dividend yield EBITDANet interest marginPayables T/O Cash burn rateLoans / deposits Average check Book value / share

Holistic Financial Statement Analysis

Approach: Focus on the most basic financial questions about any company.

Goals: To think about companies in terms of basic financial issues.

Use a “thematic” approach to F/S’s, providing a context for all those ratios.

Who could use this method?

• Auditors: as a first step in analytical procedures;

• Commercial lenders: to evaluate new prospects or monitor existing customers;

• Financial analysts: as a first step in formal F/S analysis; and

• Corporate executives: to monitor their company’s (and competitors’) progress.

Critical underlying concepts and techniques

(not part of analysis/presentation)

• The importance of expectations (which are personal biases, not part of your analysis)

• Begin with results (bottom line), then work backwards to causes/drivers

• Remember that symptoms and results (financial statement figures) are not themselves root causes or explanations

Fundamental financial issues

• Recent financial performance

• Future financial performance

• Financial condition

• Relations with capital sources

Holistic Four-Questions Approach

• What is the trend and quality of recent earnings performance?

• What is the trend of recent operating cash flow performance?

• How has the company been providing for its future, and how is it financing this expenditure/investment?

• Assess the company’s financial condition and its financial strategy.

Question 1: Trend and quality of earnings

Key components:

• Sales and net income trends

• Vertical analysis (each expense and profit measure as % of sales)

Expectations (not part of formal analysis or comments, but an essential part of analyst’s attitude)

• Sales and Net income trends: Positive and growing

• Vertical analysis: Improving margins

Cohu, Inc. Comparative P&L’s

(in 000's of $) 2011 2010 2009

Net sales 308,968 322,667 171,261

Cost of sales (208,230) (212,672) (118,873)

Gross margin (not in P&L) 100,738 109,995 52,388

R&D (36,230) (36,201) (31,964)

SG&A (46,563) (44,117) (35,519)

Op income (loss) 17,336 29,677 (15,095)

Interest/other income 442 561 1,300

EBT 17,778 30,238 (13,795)Income tax provision/benefit 2,059 (5,594) (14,373)

Net income (loss) 15,719 24,644 (28,168)

Cohu, Inc. Sales & earnings trends

(in 000's of $) 2010 % change 2009 % change 2008

Net sales 308,968 (4.3)%

322,667 88.4%

171,261

Net income (loss) 15,719 (36.2)% 24,644 187.5%

(28,168)

Cohu, Inc. Quality of earnings: Profitability

(in 000's of $) 2011 2010 2009

Net sales 308,968 100% 322,667 100% 171,261 100%

Cost of sales (208,230) (67.4)% (212,672) (65.9% (118,873) (69.4)%

Gross margin 100,738 32.6% 109,995 34.1% 52,388 30.6%

R&D (36,230) (11.7)% (36,201) (11.2)% (31,964) (18.7)%

SG&A (46,563) (15.1)% (44,117) (13.7)% (35,519) (20.7)%

Op income (loss) 17,336 5.6% 29,677 9.2% (15,095) 8.8%

Interest/other income 442 0.1% 561 0.2% 1,300 0.8%

EBT 17,778 5.8% 30,238 9.4% (13,795) (8.1)%Income tax provision/benefit (2,059) (0.7)% (5,594) (1.7)% (14,373) (8.4%)

Net income (loss) 15,719 5.1% 24,644 7.6% (28,168) (16.4)%

Question 2:Evaluate operating C/F

• Net operating cash flow trend

• Significant Op C/F drivers: Identify significant Op C/F drivers and any year-over-year changes in them.

Expectation

• Operating C/F trend: Positive and growing

Cohu, Inc.Operating C/F

(in millions of $) 2011 2010 2009

Net income 15,719 24,644 (28,168)Adjustments for non-cash items:

Depreciation & amortization 10,067 10,988 11,029

Other (17,360 deferred tax in 2009) 2,990 1,116 21,165

Changes in current assets & liabilities—effect cash:

A/R 24,877 (23,434) (11,226)

INV (20,865) (13,866) 708

A/P 427 (4,402) 10,757

Income tax payable (6,462) 7,334 (514)

Deferred profit (12,013) 9,512 888

Accruals (832) 4,944 235

Other (1,670) 2,679 (2,112)

Op C/F 12,238 19,515 2,762

Cohu, Inc.Significant Op C/F drivers

(in millions of $) 2011 2010 2009

Net income 15,719 24,644 (28,168)Adjustments for non-cash items:

Depreciation & amortization 10,067 10,988 11,029

Other (17,360 deferred tax in 2009) 2,990 1,116 21,165

Changes in current assets & liabilities—effect cash:

A/R 24,877 (23,434) (11,226)

INV (20,865) (13,866) 708

A/P 427 (4,402) 10,757

Income tax payable (6,462) 7,334 (514)

Deferred profit (12,013) 9,512 888

Accruals (832) 4,944 235

Other (1,670) 2,679 (2,112)

Op C/F 12,238 19,515 2,762

Question 3: Providing for the future

Two primary indicators:• R&D (from Income Statement, if presented)

• Cap X (gross disbursements, not net, from C/F Statement, Investing section)

Key ratios (both plough back):• R&D ratio: R&D expense

Revenue

• Combined ploughCap X + R&D expenseback ratio: Revenue

Providing for the future(continued)

• Must also evaluate nominal R&D and Cap X spending. Revenue volatility can distort plough back ratios.

Other possible indicators: • JV’s • Employee training and development

(both less visible from outside)

Expectations

• Cap X/Acquisitions: Consistent and appropriate investment in PP&E and acquisitions to meet strategic goals or as opportunities arise.

• R&D trend: Consistency, in either nominal terms or % of sales, or both.

• Reasonable plough back ratios

Cohu, Inc.Investing C/F (as presented)

(millions of $) 2011 2010 2009

Purchase of short-term investments (75,128) (52491) (44,562)

Sale and maturities of short-term investments 75,657 46,979 56,458

Purchase of property, plant & equipment (1,413) (4,579) (2,507)

Other assets 78 314 42

Net cash provided by (used for) investing (806) (9,777) (9,431)

Cohu, Inc. R&D Expense (from P&L)

(in 000's of $) 2011 2010 2009

Net sales 308,968 322,667 171,261

Cost of sales (208,230) (212,672) (118,873)

Gross margin (not in P&L) 100,738 109,995 52,388

R&D (36,230) (36,201) (31,964)SG&A (46,563) (44,117) (35,519)

Op income (loss) 17,336 29,677 (15,095)

Interest/other income 442 561 1,300

EBT 17,778 30,238 (13,795)Income tax provision/benefit 2,059 (5,594) (14,373)

Net income (loss) 15,719 24,644 (28,168)

Cohu, Inc.Combined plough back ratio

($ figures in millions) 2011 2010 2009

Purchase of property, plant & equipment (CAPEX) 1,413 4,579 2,507

R&D expenses 36,230 36,201 31,964

= Total "future-oriented" plough back 37,643 40,780 34,471

-:- Net Sales 308,968 322,667 171,261

= Combined Cap X / R&D plough back ratio 12.2% 12.6% 20.1%

Note that all figures are positive, although disbursement and expense figures were presented previously (and are presented subsequently) as negatives. Since the plough back ratio evaluates the amount of revenue that is reinvested into the company, the R&D and CAPEX figures used in this calculation carry the same sign as the revenue figures. Plough back is a measure of intensity, not direction, of resource use, hence no change in sign.

Question 3 (continued):Financing investment in the future

Three possible sources to finance growth and investment:

•New external capital

•Asset sales

•Operating C/F

Financing growth and investment(continued)

If new capital, debt or equity?

Op C/F: Compare Op C/F to Net Investing C/F to calculate Free C/F:•If positive, future-oriented investment is financed from operating C/F•If negative, future-oriented investment requires outside financing

Cohu, Inc.Free C/F *

(millions of $) 2011 2010 2009Purchases of Property, Plant and Equipment (1,413) (4,579) (2,507)

Proceeds from disposals of PP&E 0 0 0

Investments & acquisitions (net of cash) 0 0 0

Total net “future-oriented” investing (excl R&D) (1,413) (4,579) (2,507)

Operating C/F 12,238 19,515 2,762

Free C/F * 10,825 14,936 255

* Note: Free C/F is measured in a variety of ways. This method is very specific and is not the same as the definition and formula in most finance texts. The standard definition addresses a company’s overall Free C/F, while this calculation only ascertains if new capital is needed to finance future-oriented investing activity.

Question 4: Financial condition

Most basic financial condition indicators:

•Liquidity: Overall C/F and balance trends

•Working capital: Cash conversion cycle

•Solvency Debt/equity ratio (degree of financial leverage in capital structure)

Cohu, Inc.Overall liquidity: summary of net C/F

and balances

(in millions of $) 2011 2010 2009

Operating C/F 12,238 19,515 2,762

Investing C/F (806) (9,777) 9,431

Financing C/F (3,864) (1,828) (4,901)

Net C/F 7,568 7,910 7,292

Effect of exchange rate changes on cash (227) (236) 761

Beginning cash 45,921 38,247 30,194

Ending cash 53,262 45,921 38,247

Calculating theCash Conversion Cycle

Days INV O/S: INV / CGS per day

+ Days Sales O/S: + AR / Sales per day- Days AP O/S: - AP / CGS per day

= CCC = CCC (in days)

Meaning: How long the company waits to collect from customers the cash it spent to acquire or manufacture INV.

Question 4 (continued): Financial strategy

Indicated by the company’s relationship with capital sources (the 3 R’s). With respect to capital sources, the company is either

•Raising capital from investors; or

•Returning capital to investors; or

•Restructuring capital (neutral to investors overall, but changing capital structure and/or terms).

Clues to financial strategy & condition

Financial condition: see C/F statement and B/S:• Change in financial capitalization (nominal $)• Change in capital structure (debt/equity ratio)

Financial strategy: see Financing section of C/F statement:

• Net financing C/F (positive, negative, neutral)• Dividends• Stock activity (new issues, buy-backs or both)• Debt activity (proceeds, repayments, or both)

Cohu, Inc.Financing C/F

(millions of $) 2011 2010 2009

Issuance of stock, net 1,911 3,617 709

Excess tax benefit from stock options exercised 2 234 0

Cash dividends paid (5,777) 5,679) (5,610)

Net cash used for financing activities (3,684) (1,828) (4,901)

Question 4: Conclusion

• Financial condition indicators:

Liquidity: cash balance increased by 39%;

Solvency: no debt, D/E ratio does not apply.

• Cohu’s financing activities have provided a net return of capital to investors in each of the past three years.

Question 5: Any other major, significant or

exceptional events?

• Extraordinary losses (or even gains!)

• Restructuring costs

• BK

• Oil well problems

Holistic Financial Statement Analysis--Recap

Goals: To think about companies in terms of basic financial issues and what they mean

Approach: Focus on the most basic financial questions about any company:

• Recent financial performance• Future financial performance• Current financial condition, recent trends• Relations with capital sources

Important reminder

Regroup or disaggregate F/S data as necessary to gain insights and provide basis for more detailed levels of analysis.

Caveats, lessons and reminders• No substitute for rigorous, comprehensive

analysis—rather, a roadmap for starting, organizing and controlling it.

• If your boss wants you to do it differently, he (or she) is right—at least in the short run.

• Financial statement analysis is not the source of fundamental explanations. It only provides the questions.

• The most important question: Why? The answers are not in the financial statements—they lie outside the numbers.

One final piece of advice: familiarity and practice

• Practice: Essential for developing skill in financial statement analysis.

• Become familiar with F/S’s by choosing 2-3 companies and following them on an ongoing basis:– 10K– 10Q– In the financial news

Questions?

• Sample company report outline posted on Blackboard, in Resources section.

• Follow up: monypots@cox.net