1

Financial Statement Analysis

2

Evaluation of currentand past

financial 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

Roots = Financing Activities

Trunk & Branches = Investing Activities

Fruit = Operating Activities

Businesses are like Fruit Trees

21

Net Income vs. Cash Flow

Indirect 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

51

Other Issues in Bankruptcy Models

• Population does not include equal # of bankrupt and non-bank. Firms

• Excludes size and industry factors

• Accrual vs. cash flow variables• Models remain unchanged over

time

52

General Summary of Factors• Investment Factors

Liquidity lowers risk AT lowers risk

• Financing Factors Lower debt levels lowers risk S/T debt increases risk over L/T debt

• Operating Factors Profitability lowers risk Operational consistency lowers risk Small size, rapid growth and audit exceptions

increase risk

53

Market Risk• Drivers

Political Personnel Product

• Market risk drives market return• CAPM measures market risk

Market risk beta is driven by… Operating leverage Financial leverage Sales variability

54

Pro-forma Financials-Chapter 10

• Sales revenue (revenue growth)• Operating expenses• Asset requirements (asset

turnover)• Debt and equity requirements• Cost of financing-(interest etc.)• Statement of cash flows• Balance sheet

55

Pro Forma ApproachesExhibit 10.1

• Follow the 6 step plan page 742• FSAP has a Forecast pro forma

template• % analysis can be used to

project income statement and balance sheet

• Individual items Turnover ratios as a benchmark

56

Key Assumptions and Caveats

• Annual revenue growth rate• Expense relationships• Levels of investment

Working capital Fixed Assets

• Financing mix• 4-5 year range• Consistency• GIGO (garbage in garbage out)

57

Pro-forma Methodology

• Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template

58

Rev. Recognition OptionsChapter 7

• Period of production• Completion of production• Time of sale• During collection period• Upon cash receipt

59

Earnings Management

• Increases as cash flow period grows

• Increases as options for estimation grows

60

Criteria for Recognition

• Work is completed• Measurable amount• Costs are identifiable• Collection is reasonably

assured

61

Earnings Sustainability Risk

• Uncollectible A/R• High volume of returned goods• Unrecorded warranties

62

L/T Contractors

• Multiple accounting periods• Price established in advance of

work• Periodic payments• Percentage of completion

IRS approach

• Completed contract

63

Criteria for Exp. Recognition

• Matched with revenue• Consumption of service or

benefit

64

Rev. Recog. When Cash is Uncertain

• Installment method• Cost-recovery-first method

65

Disclosure

• Accounting policies footnote

66

Inventory Cost Flow Assumptions

• Weighted average• FIFO-first in; first out• LIFO-last in; first out

67

LIFO Liquidation

• Sales greater than production• Cash flow increases due to

reduced purchases• Cash flow decreases due to

higher income taxes

68

LIFO Characteristics

• Rapid price increases• Provides better income

smoothing in light of inventory change variability

• Tax savings• Industry specific• Larger firm size

69

Other LIFO Factors

• GAAP disclosure: LIFO reserve• Stock reaction is inconclusive

70

Analytical Considerations

• Cost flow assumption• Price variation & inventory

turnover• LIFO liquidation impact• Inventory obsolescence• Inventory financing

71

LIFO - FIFO Adj.

• Inventory value• Working capital changes• Income statement changes• SCF changes

72

Fixed Assets--Key Issues

• B/S Amount• Useful lives• Depreciation method• Recoverability• Maintenance & repair expense• Overall issue: undervaluation

potential

73

F/A--Earnings Sustainability

• B/S amount vs. replacement cost

• Choice of depr. Lives (instant profit)

• Choice of depr. method

74

Intangibles--General

• Expense cost of development• Recognize as asset purchased

intangibles• Amortize up to 40 years• Caution surrounding “in

process R&D”

75

S/W Development Costs

• Expense through “tech. feasibility”

• Capitalize, thereafter• Amortize over useful life

76

Goodwill

• Results from acquisitions Treat according to GAAP Eliminate from B/S

77

Intangibles--Earnings Sustainability

• Generally expense• The above is a questionable

approach• Needed-ways to value intangibles

78

Liability RecognitionChapter 8

• Probable future sacrifice• Little or no discretion to avoid• Event has occurred

79

No Liability, If...

• Mutually unexecuted contracts• Certain contingencies

Not probable Not measurable

80

Controversial Liability Issues

• Hybrid securities• Sale of A/R w/recourse• Product financing

arrangements• R&D financing arrangements• Take or pay contracts• Derivative instruments

81

Liability Valuation

• PV of future cash flows > 1 year

• Cost of future deliverables• Cash advance value

82

Leases• Operating lease

Expense

• Capital lease Capitalize w/liability SFAS 13

Title transfer Bargain purchase option 75% of life rule 90% of cost rule

Slightly different tax rules

• May want to restate all as capital

83

Retirement Benefits

• Pensions (FASB 87 & 132)• Post-retirement Health

Benefits (FASB 106 & 132)

84

pensions

Pension Fund Assets Assets-BOP

+/- Actual Earnings+ Contributions- Payments

= Assets-EOP

Pension Fund Liab.Liab-BOP

+ Incr.- Time+ Incr.- Service+/- Actuarial G & L- Payments= Liab-EOP

85

Key Terms

• ABO - amount expected to be paid--current salaries

• PBO - amount expected to be paid--future salaries

86

Pension Expense

• Service cost• Interest cost• Actual return on plan assets• Amort. of adoption cost• Amort. of PBO increase/decrease• Amort. of actuarial gains &

losses

87

Minimum Liability

• If ABO > FV of Assets, then adjust to Comprehensive Income

88

Health Care Benefits

• No minimum liability• Minor measurement

differences• Considers income tax impact• Sensitivity analysis• Note politicization on p. 410

89

Analyst’s Role

• Awareness of underfunding• Reasonableness of

assumptions• Actual performance vs.

expected performance

90

Income Taxes-FASB 109

• Book income• Permanent differences• Temporary differences

Taxables Deductibles

• Taxable income

91

FASB 109-History

• APB 11 - income statement focus

• FASB 109 - B/S focus• FASB 109 - Allows deferred

debits

92

Implementation

• Determine differences• Eliminate permanent differences• Classify temporary differences• Assess need for valuation allowance

Taxables > deductibles Negative factors Positive factors “more likely than not…”

93

Disclosure

• Income tax expense• Income before taxes• Statutory rate reconciliation• Composition of deferred taxes

and assets

94

Deferred Tax Liability

• Is it real?• Consider in terms of a “going

concern”

95

Analyst’s Role

• Effective tax rate changes• Changes in valuation

allowance• Tax rate by venue• Normalize rate excluding one

time changes

96

Reserves

• Matching principle• Exclude expenses• Defer negative asset

revaluation (ie FASB 115)• Difficult to assess & adjust

97

Combination IssuesChapter 9

• Corporate acquisitions• Investments in securities• Foreign currency translation• Segment reporting

98

Business Combinations

• Purchase accounting Record at FMV Excess to goodwill

• Pooling Assume assets and liabilities Must meet the 12 criteria for

pooling

99

Pooling Criteria• 2 year autonomy• independence• single transaction w/in one year• stock for at least 90% of stock• 2 year moratorium on equity interest changes• no reacquisition of shares for bus. Combos• ratio interests remain unchanged• no change in voting rights• no security issues remain outstanding• no reacquisition of securities• no special funding agreements• no disposal plans

100

Investment in Securities

• Under 20%• 20% to 50%• Over 50%

101

Under 20%

• Held to maturity• Available for sale…

comprehensive inc.• Trading…income statement• Analyst issues

include or exclude adj. from income

102

20% to 50%

• Equity method if influence exists

• Analyst issues relationship between income and

cash submerged assets

103

Over 50%

• Consolidation• Might want to consider ROA

after inclusion of unconsolidated subs.

104

Tax Consequences

• Under 80%…interest or dividends

• Over 80%…consolidated return

105

Foreign Currency Translations

• Functional currency Foreign currency

all-current method income stmt. at the avg. rate B/S at end-of-period rate unrealized translation adj. in comp. income

U.S. currency monetary method avg., end of period and historical rates

106

FX-Analyst Issues

• Translation adjustments in income?

• Difficult to interpret due to limited disclosure

• Significant international variance in practice

107

Disaggregation of Info.• Disclosure of segments (mgt. Approach)

operating segments geographic locations major customers

• 10% rule• Elements

operating income sales assets

108

Why Value Via Cash Flow?Chapter 11

• Cash = ultimate value• Cash = common denominator

109

Economists & Cash Flow

• Investors spend cash• Accrual method subject to “acctg.

Tricks• Mgt. can manipulate earnings

110

Valuation: Cash Flow Based

• Periodic cash flows• Residual value• Approximate discount rate

Cost of capital

111

Periodic Cash Flows

• Unleveraged Excludes interest, debt & pfd. stock Weighted avg. cost of capital Valuation of assets

• Leveraged Includes interest, debt & pfd. Stock Cost of equity capital Valuation of common shareholder equity

112

Periodic Cash Flows, cont.

• Appropriately reflect inflation Nominal vs. real cash

• Use after tax amounts

113

Residual Value

• Horizon = no growth• (last cash flow) x (1 + growth rate)

(discount rate - growth rate)

• Consider conversion tables (Stickney-p. 766)

114

Cost of Capital• Debt

Market rate (1-tax rate) Leases: use borrowing rate

• Preferred Equity Dividend rate

• Common Equity Risk free rate + ß(Mkt. Rate - RFR) Betas published in S&P’s stock reports

115

Releveraging @ New Capital Structure

• BL0=BU[1+(1-tax rate)(Current Debt)] Current Equity

• Substitute BU with new capital structure

• BL1=BU[1+(1-tax rate)(New Debt)] New Equity

116

CAPM Critique

• Unstable ß’s• Unstable MROR• Size vs. ß’s

117

Valuation Techniques

• Equity CFU-[(interest)(1-tax rate)]

Cost of equity capital

• Debt plus equity CFU ÷ Wtd. average cost of capital

• Adjusted present value CFU ÷ Unleveraged cost of equity cap. [interest(tax rate)] ÷ cost of debt cap.

118

Unleveraging

• CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]current equity

119

Cash Flow Evaluation

• Advantages Economic base Rigorous methodology

• Disadvantages Residual value dominant Time consuming Subjective

120

Price-Earnings RatioChapter 12

• Higher risk -> lower PE• Theoretical model

P/Actual earnings = (1+g)/(r-g)

121

Theoretical Variances: PE

• Earnings persistance Transitory…no change in PE Permanent…change in PE

• Accounting principles Lower earnings…higher PE

122

Trending

• Penman found transitory earnings consistency…that is high PE caused by lower than normal earnings is counterbalanced in the following year.

• 5-7 years reversion to mid-teens growth

123

PE Ratio Factors

• Risk (cost of capital)• Growth• Earnings persistence• GAAP

124

PE Analysis Keys

• Use a sustainable growth rate• Doesn’t work when g>r• Doesn’t work when g

approximates r• Test reasonableness with actual

PE• Existence of transitory earnings• Impact of GAAP

125

Price to Book Value

• Market rewards growth in excess of cost of capital

• Ultimately reverts to 1.0• Function of

Profitability BV growth

126

P/BV-Theoretical Model

• 1+ [(Expected ROCE-r)(BVt)/(1+r)t] … BV0

127

Theoretical Variances: P/BV

• ROCE errors• Cost of capital errors• Growth rate errors• Transitory earnings• GAAP impact

lower earnings…higher P:BV

128

Trending: P/BV

• ROCE remains consistent and reverts to 1.0 slowly.

129

Cash Flow vs. Earnings

• Long term impact is indifferent• Short term impact: earnings

more indicative• Use multiple approaches