Why Financial Statements Analysis? “You” may be an investor a creditor a supplier a customer an employee the manager a competitor an auditor a government agency Will you rely on pure hunches and guesses? Or,
Transcript
1. Why Financial Statements Analysis?
You may be
an investor
a creditor
a supplier
a customer
an employee
the manager
a competitor
an auditor
a government agency
Will you rely on pure hunches and guesses? Or,
Educated analysis model!
2. The Investment Environment
The Money Market
treasury bills, certificate of deposit, commercial paper,
etc.
The Fixed-Income Capital Market
treasury notes and bonds, municipal bonds, corporate bonds,
etc.
The Capital Market
common stock, preferred stock
The Derivative Market
options, futures
3. The Major Stock Market in the U.S.
The New York Stock Exchange (NYSE)
Largest stock exchange: About 3,025 companies or $16 trillion
in market value (July 1999)
382 non-U.S. companies (July 1999)
The American Stock Exchange (AMEX)
Listing of smaller and younger firms
The Over-the-Counter National Association of Securities Dealers
Automated Quotation ( NASDAQ )
Trade through computer-linked network
Include: Nasdaq National Market (4,400 securities) and Nasdaq
SmallCap Market (1,800 securities)
4. ACC 6213 Financial Statements and Analysis
Objectives
Discuss a framework for conducting business analysis with a
focus on the role of financial information
Learn how to apply the framework for security valuation and
risk analysis
Learn to retrieve market and financial data
5. Textbook and Related Materials
Palepu, Healy and Bernard, Business Analysis & Valuation:
Using Financial Statements, Text and Cases, 2 nd ed., 2000
Dells 10-K for fiscal year 1999
Computer skills:
Research, retrieve and download data from internet
Excel or any other spreadsheet program
6. Course Requirements
Course Outline
Individual Assignments
30%
Team Project
50%
Participation
20%
Grade: Expected distribution: 40-50% As,
20-30% Bs, rest Cs
7. Individual Assignments
Discussion allowed, but no copy of ideas or writing
No points will be given for similar assignments
Related to class discussion and cases in the book
Questions to be posted on Web
8. Participation
Come to class prepared with
Intelligent comments
Constructive questions
Thoughtful insights and observations
Quality counts more than Quantity
Team project to be discussed later
9. Palepu, Healy & Bernard (Figures 1-2 & 1-3)
A firm is involves in various business activities to create
value for investors
Financial statements summarize the economic consequences of a
firms business activities
Accounting system affects the quality of the financial data
provided
- affected by accounting rules, managements incentives
Analysts use a systematic framework to create inside
information from public financial data
10. Framework: Four Steps of Analysis Business Strategy
Analysis Accounting Analysis Financial Analysis Prospective
Analysis Business Analysis and Valuation Applications
11. I. Business Strategy Analysis
Purposes:
To identify key profit drivers and business risks
To assess profit potential at a qualitative level
Involves:
Industry analysis
Analysis of the firms strategy to create a sustainable
competitive level
How did the firm stay alive and possibility of prospering in
the future
Important first step for the following three analyses
12. II. Accounting Analysis
Purposes:
To evaluate the degree to which a firms accounting captures
underlying business reality
Involves:
identifying where there is accounting flexibility
evaluating the appropriateness of accounting policies and
estimates
assessing the degree of distortion in disclosures
undoing (if necessary) distortions
Improves the reliability of financial analysis
13. III. Financial Analysis
Purposes:
To evaluate current and past performance
To assess the sustainability of its performance
Requirements:
should be systematic and consistent
should allow the use of financial data to explore issues found
in business strategy analysis
Tools
Ratio analysis: profitability, efficiency, liquidity
Cash flow analysis: liquidity and financial flexibility
14. IV. Prospective Analysis
Purpose
To forecast a firms future
Final step in business analysis
Techniques
Financial statement forecasting
Valuation
15. Team Project
Teams of four
Select an industry and two companies in the same industry
No more than two teams on one industry
No group can work on the same company
Need my approval; first-come, first serve
Compare the two companies in terms of All of the FOUR
analyses:
Business Strategy Analysis
Accounting Analysis & Financial Analysis
Forecasting, Including Discussion of Assumptions
Valuation
16. Industry Choices
Agricultural
Construction
Manufacturing
Mining
Retail
Service
Transportation
Wholesale - Trade
No Finance, Insurance, and Real Estate Industry and Public
Administration Industry
17. Team Project Report
Must be typed
Limit to 10 pages: double-spaced, 12-point font size
Data source and calculation should be included as
appendices
Attach an evaluation on each of your group members: efforts and
contribution
18. Finding Information for Business Analysis
CSUH Library and Internet
Main data sources
Industry Research
Company Research
UC Berkeley
International Business
Other:
Annual Reports
Annual Report Gallery
10-K Reports
Accounting Rules
Financial Accounting Standard Board
Historical Stock Market Data
Historical Market Index Data
Historical Stock Price Data
On DJ interactive, Historical market data
19. Framework for Business Analysis & Valuation Business
Strategy Analysis Accounting Analysis Financial Analysis
Prospective Analysis
20. Business Strategy Analysis
Industry Analysis
Industry profitability and risk
Competitive Strategy Analysis
Which companies will sustain?
Corporate Strategy Analysis
Multibusiness management
21. Industry Analysis Standard Industrial Classification (SIC),
North American Industry Classification System (NAICS)
Factors affecting industry profitability: Porters five
forces
Degree of Actual & Potential Competition (3 forces)
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitute Products
Bargaining Power in Input & Output Markets (2 forces)
Buyers Power
Suppliers Power
Affect competitive strategy chosen to operate in the
industry
22. 1. Rivalry Among Existing Firms
Profitability is low if competition for market share is
strong:
Low industry concentration
Compute Industry Concentration Ratio, e.g. sales of largest
four or eight companies total industry sales
Low product differentiation
Large economy of scale, steep learning curve, high proportion
of fixed costs
Low industry growth
Excess capacity, high exit cost
23. 2. Threat of New Entrants
Profitability is low if threat of new entrants is high:
Small economy of scale
Less first mover advantages
Easy access to channels of distribution and distribution
relationships
Low legal barriers: e.g. government approval
24. 3. Threat of Substitute Products
Profitability is low, if threat of substitute products is
high:
price and performance are similar
customers are willing to switch
Products are similar or seen as being substitutes
Low brand allegiance
products are replaceable
25. 4. Buyers Power
Strong, if
More Sensitive to Price
Products are similar
Low switching costs
Unimportant products (relative cost and quality)
Higher Bargaining Power
Fewer buyer
Higher volume per buyer
Low switching cost
More substitute products
High threat of backward integration by the buyers
26. 5. Suppliers Power
Profit is low if suppliers power is strong:
Fewer number of suppliers
High volume per supplier
High Switching Costs
High product differentiation
Importance of product in terms of cost and quality
27. Power in Input Market (Suppliers) & Output Market
(Buyers) High Low Actual Profitability Low High Actual
Profitability Suppliers power Buyers power
28. Given a level of industry profitability
What determines which companies will win and which companies
will lose?
How can a company sustain profits in a competitive
environment?
Porter maintains that there are two generic competitive
strategies that firms can choose in order to maintain competitive
advantage
29. Competitive Strategy Analysis 1. Cost Leadership 2.
Differentiation And, Straddling of 1 and 2 ? Choices of competitive
strategies:
30. 1. Cost Leadership
Is a cost leader if it can supply same product or service at a
lower price because of
Economies of scale, scopes, and learning
Efficient production
Simpler product designs
Efficient organizational processes
Lower costs of inputs and distribution
Little R&D or brand advertising required
Tight cost control
31. 2. Differentiation
Supply a unique product or service at a cost lower than the
price customers are willing to pay:
Superior product quality
Superior product variety
Superior customer services
More flexible delivery
Investment in brand image
Investment in R&D and marketing
Note: Organizational and control system must foster creativity
and innovation
32. Achieving and Sustaining Competitive Advantage
Depend on:
Match between firms core competencies (the economic assets
possessed by the firm) and competitive strategies
Match between firms value chain (the activities to convert
inputs to outputs) and activities required to execute competitive
strategies
Flexibility to adopt to changes in the firms industry
structure
Difficulty for competitors to imitate
33. Applying Strategy Analysis to Dell
Industry Analysis
Describe the features of the personal computer industry that
determine its profit potential. How difficult is it to earn
abnormally high profit in this industry?
Competitive Strategies Analysis
Describe Dells business strategy and how it might allow Dell to
earn higher returns on investments than others in the
industry?
34. Personal Computer Industry
Degree of Actual and Potential Competition
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitute Products
Bargaining Power in Input and Output Markets
Buyers Power
Suppliers Power
35. Personal Computer Industry: Rivalry
Growth continues to be strong
pricing remains cut-throat
Lots of competitors
fragmented, no price co-ordination
Switching costs are low
commodity product; price is the key
Dell tries to compete on service
as knowledge rises, will service matter?
Dell needs to keep market share
recoup R&D and costs associated with made to order
strategy
allows them to lower component costs
36. PC: Entrants
Low barriers to entry
First mover advantage?
not technologically
Distribution is easy
Relationships with suppliers, customers?
37. PC: Substitute Products
Apples Macintosh, Suns work stations?
not in the near future
Competitive price and performance
PCs are commodities (price counts more)
price competition seems unavoidable
Buyers are willing to switch
brand name?
quality reputations?
38. PC: Power of Customers
Buyers are price sensitive
define price as hardware, software, and operations, not just
purchase price total cost of ownership
Dell maintains an extensive database of customer
information
unavailable to retail operators
Importance of product for cost & quality
39. PC: Suppliers Power
Two major one supplier relationships
Intel, Microsoft
Leverage will increase with volume
Can Intel reap some of the PC vendors profits?
Power of other suppliers is low
lots of keyboard, case, power supply, etc. manufacturers
40. PC Industry Analysis: Conclusion
Intense competition
Low barriers to entry
Not much power over customers and suppliers
Short product cycle; need to stay on edge technologically
Profit potential might be poor BUT, growth is an important
offsetting factor
41. What Should Dell Need to be Concerned?
General economy condition
Industry growth; technological changes
Competition:
Product quality; customer service/support; distribution
channels; price
International
Product mix, customer mix, geographic mix
New ventures: Internet
Inventory levels
Supply sources
Support of infrastructure
Government regulation
42. Dells performance
43. Customer profile: Foreign vs. Domestic Sales
44. Mergents Industry Review - 1999 Ranking 1st Return on
Capital 2nd Net income 2nd Revenue Dell
45. Stock Market Performance 121.2% 7790.4% 5 Year 56.0%
1176.2% 3 Year 19.5% 32.0% 1 Year Market Index (Value Line)
Dell
46. Dell: Competitive Strategy
Differentiation
Direct sales: no middle man; customer database
Customer made product
Lower economy of scales
Low inventory
Customer service and support
Enterprise systems
Cost Leadership
Through made to order
Not low cost seller
47. Dell: Sustainable Advantage?
What aspects of Dells strategy can be replicated by
others?
Can Dell avoid being replicated?
48. Dell: Conclusion
Competitive and thus low profitability industry
The success of Dells competitive strategy depends on
Product differentiation
Maintain higher profit margin
Reduce/control operating expenses
Goal: higher net margin
49. According to Dell (10-K)
Three key factors
Growth
Demand, competition, international market
Product, customer, geographic mix
servers business
Profitability
gross and net margins, sales mix, Internet sales
Technological changes and product transition
Liquidity
asset management, especially inventory
50. Experts Opinion?
Value Line on industry (4/21/2000)
The computer and peripheral industry probably will get off to
something of a slow start this year (2000). However, it should pick
up a better head of stream in the second half and stay on a fast
growth tract out to 2003-2005.
Investors should be able to find stocks in this group that will
be good fits for their portfolios, whether they are looking for
near-term out-performance or long-term capital appreciation.
Conservative accounts should tread cautiously, though, since
volatility can be high for some of these equities.
51. Experts Opinion?
Value line on Dell (4/21/2000)
Although the stock has pulled back a bit from its recent high,
Dell shares dont stand out for the year ahead or the pull to
2003-2005. But Dells direct sales approach (which has enabled it to
take share from competitors) appears to be working well, and we
think the push to penetrate the emerging Internet market is a
positive development.
52. Framework: Four Steps of Analysis Business Strategy
Analysis Accounting Analysis Financial Analysis Prospective
Analysis Business Analysis and Valuation Applications
53. Review of Business Strategy Analysis
What factors decide an industry profitability?
Porters five forces
Degree of Actual and Potential Competition
Rivalry among existing firms
Threat of new entrants
Threat of substitute products
Bargaining Power in the Input and Output Markets
Bargaining power of customers
Bargaining power of suppliers
54. What is Accounting Analysis? (Chapter 3)
Evaluate the degree to which a companys accounting captures its
underlying business reality
Evaluate the appropriateness of accounting policies and
estimates
Assess the distortion, if any, in the numbers
see where distortions are and whether they can undone
Goal: To improve the reliability of conclusions from financial
analyses
Note: Does accounting affect business strategy? (positive
accounting)
55. The Need of Financial Accounting
Separation between ownership and management (agency
problem)
Owners want to know:
Profitability: Income Statement
Economic resources and obligation: Balance Sheet
Cash flow position: Statement of Cash Flows
Owners equity: Statement of Stockholders Equity
56. Accounting - Review
Annual Reports
Management Discussion and Analysis (MD&A)
Financial Statements
Balance sheet (2 years)
Income Statement (3 years)
Statement of Stockholders Equity (3 years)
Statement of Cash Flows (3 years)
Notes
57. Importance of Notes
Integral part of the F/S
Augment the information provided in the F/S
Provide very important data for F/S analysis
E.G. Contingencies
58. MD&A
Results of operations, including discussion of trends in sales
and expenses
Capital resources and liquidity, including discussion of cash
flows trend
Outlook based on known trends
59. Financial Statements
Accountants are confronted with the potential dangers of bias,
misinterpretation, inaccuracy, and ambiguity
Must follow the Generally Accepted Accounting Principles
(GAAP)
E.g. FASB Publications , Statement 115
FASB , SEC , AICPA
60. Mechanics of the Accounting Process
Balance Sheet
Assets = Liabilities + Stockholders equity
Ending balance =
Opening balance carried from previous B/S
+/- Increases/Decreases
SE = Capital stock + Retained Earnings
Capital stock = Opening balance + Issuance Repurchase
R/E = Opening balance + NI - Dividends
61. Net Income
Income Statement
Revenue Expenses
Accrual Basis (v.s. Cash Basis)
Revenue is recognized when earned, not necessarily when cash is
received
Expense is recorded when incurred, not necessarily when cash is
paid
62. From I/S to B/S I/S Net Income R/E Statement of SE B/S R/E
Daily Transactions Capital Stock; R/E Assets = Liabilities +
SE
63. What Affect the Quality of Accounting Data? Not Reflect the
Economic Reality
Reports are prepared by management
Involves with managements incentives
Accrual basis versus cash basis
Involves estimations, not totally actual cash transactions
Accounting rules (GAAP)
Standardization versus flexibility
Auditing
Auditable?
Legal Liability
Threat of lawsuits improves credibility, but limits
disclosures
64. Accounting Analysis for Dell
Main concern: higher return on equity
What are the major areas we need to look into at Dell if we
want to understand how well they are doing?
Based on the industry and competitive strategy analyses
growth, profitability
65. Think About Dell
Accounting Rulesbiased?
Accounting Estimationbiased?
Factors that Affect Managers Accounting Choices
debt covenantsdoes Dell have any?
management compensationdoes Dell have earnings-based
bonuses?
corporate control contestis Dell concerned about a
takeover?
tax considerationsLIFO versus FIFO
regulatory considerationsconsider Microsoft
capital market considerations
stakeholder considerations consider auto industry
competitive considerationshow detailed should the reporting
be
66. How to Do Accounting Analysis
1. Identify Key Accounting Policies
2. Assess Accounting Flexibility
3. Evaluate Accounting Strategy
4. Evaluate the Quality of Disclosure
5. Identify Potential Red Flags
6. Undo Accounting Distortions
67. 1. Identify Key Accounting Policies
Ultimate goal
How well are the key success factors and risks identified by
the Business Strategy analysis managed by the firm?
Task
Identify and evaluate the policies and estimates the firm uses
to measure its critical factors and risks
68. 2. Assess Accounting Flexibility
All firms can choose:
depreciation & amortization methods and estimates
inventory methods
estimates of bad debts
Some items do not allow flexibility:
R&D and marketing expenditures must be expensed
software development can be capitalized
69. Flexibility, Informative, and Distortion Low High
Flexibility Less Informative More Informative Less Distortion More
Distortion
70. Flexibility AnalysisDell
Fiscal year-end: Friday nearest 1/31
Consolidate all wholly owned subsidiaries
Short-term investments: available-for-sale
Inventory: first-in, first-out
Depreciation: 2 to 5 years for non-buildings
Amortization of intangibles: 3 to 8 years
R&D and advertising: expensed
Warranty and post-sale support: estimated and expensed
Software development costs: capitalized
Segment information
71. 3. Evaluate Accounting Strategy
How do the firms policies compare to the industry norm?
Does management face strong incentives to manage earnings?
covenants, bonuses, political pressures
Has the firm changed policies or estimates?
Were policies and estimates realistic in the past?
write-off
discontinued operation
Does the firm structure transactions to achieve certain
accounting objectives?
capital lease versus operating lease
pooling-of-interest versus purchase accounting
72. 4. Evaluate Quality of Disclosure
Do the firms disclosures make it easy to assess the economic
reality?
Provide adequate disclosure of business strategies?
Explain in footnotes accounting policies, assumptions, and
their logic?
Explain current performance?
Provide additional disclosures to assess business reality?
Provide informative segment disclosure?
Reveal forthcoming bad news?
Provide detailed news to investors?
73. 5. Identify Potential Red Flags
Unexplained changes in accounting especially when performance
is poor
Unexplained transactions that boost profits
sale of assets or investments
Unusual increases in A/R in relation to sales increases
Unusual increases in inventories in relation to sales
increases
Increasing gap between earnings and cash flow from
operations
Increasing gap between financial income and taxable income
Off-F/S transactions
B/S (e.g., leases) and I/S (e.g., contingencies)
Large asset write-offs
Large 4 th -quarter adjustments
Qualified audit opinion or change in auditors
Related party transactions
74. 6. Undo Accounting Distortions
Try to make adjustments
use data in the notes
use cash flow data
use non-accounting sources:
Newspapers
Call investor relations
Example: Off-B/S financing
75. In-Class Case: Harnischfeger
Purpose: Demonstrate managerial motives for making accounting
changes
Background: GAAP allow flexibility for accounting choices. Even
after a firm chooses a set of accounting policies, it can still
change to another at the managements discretion.
Managerial incentive:
1982 Harnischfeger faced a financial crisis
New management was appointed to turn the company around
New management made a few financial reporting policy changes in
1984