Financial Statement Analysis: A Holistic Approach
Dan Goldzband, CMA
• University of California, San Diego (Extension Division)
• Cohu, Inc./Delta Design, Inc., Poway 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.
Provide some hints for analyzing complex and detailed F/S’s
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 root causes or explanations
Steps to obtain financial statements for public companies
Usual sequence (may vary slightly):
• Go to company website, Investor Relations section
• Click on Financial Information
• Click on SEC filings
• Specify Annual filings from drop-down
• Download most recent 10-K (as pdf)
10-K items to read and print
• Item 1: Business
• Financial statements (found in exhibits, not main body of 10-K)– Income statement– Cash flow statement– Balance sheet
• Management’s Discussion and Analysis
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 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)
• Net income trend: Positive and growing
• Vertical analysis: Improving margins
Evaluating earnings quality / profitability
• Vertical analysis
• Gross margin trend
• Operating income trend
• Net income trend
Cohu, Inc. P&L: Sales & Net Income trends
(in 000's of $) 2010 % change 2009 % change 2008
Net sales 322,667 88%
171,261 (14)%
199,659
Cost of sales (212,672) (118,873) (134,691)
Gross margin (not in P&L) 109,995 52,388 64,968
R&D (36,201) (31,964) (38,084)
SG&A (44,117) (35,519) (36,612)
Acquired, in process R&D - - (2,577)
Op income (loss) 29,677
(15,095) (12,305)
Interest/other income 561 1,300 5,483
EBT 30,238 (13,795) (6,822)
Income tax provision/benefit (5,594) (14,373) 1,379
Net income (loss) 24,644 187%
(28,168) -418% (5,443)
Cohu, Inc. Vertical analysis
(in 000's of $) 2010 2009 2008
Net sales
322,667 100% 171,261 100% 199,659 100%Cost of sales (212,672) -66% (118,873) -69% (134,691) -67%
Gross margin (not in P&L)
109,995 34% 52,388 31% 64,968 33%R&D (36,201) -11% (31,964) -19% (38,084) -19%SG&A (44,117) -14% (35,519) -21% (36,612) -18%
Acquired, in process R&D -
0% - 0% (2,577) -1%
Op income (loss)
29,677 9% (15,095) -9% (12,305) -6%Interest/other income 561 0% 1,300 1% 5,483 3%
EBT 30,238 9% (13,795) -8% (6,822) -3%
Income tax provision/benefit (5,594) -2% (14,373) -8% 1,379 1%
Net income (loss) 24,644 8% (28,168) -16% (5,443) -3%
Caterpillar, Inc.Comparative Income Statements
(millions of $) 2010 2009 2008
Sales and revenues:
Sales of Machinery and Engines 39,867 29,540 48,044
Revenues of Financial Products 2,721 2,856 3,280
Total sales and revenues 42,588 32,396 51,324
Operating costs:Cost of goods sold 30,367 23,886 38,415 SG&A 4,248 3,645 4,399 R&D 1,905 1,421 1,728 Interest expense of Financial Products 914 1,045 1,153 Other operating (income) expenses 1,191 1,822 1,181 Total operating costs 38,625 31,819 46,876
Operating profit 3,963 577 4,448
Gross profit (not in P&L) 11,307 7,465 11,756
Caterpillar, Inc. Vertical analysis (quality of earnings)
(millions of $) 2010 2009 2008
Total sales and revenues42,588
100.0% 32,396 100.0% 51,324 100.0%
Operating expenses:
Cost of products & services 31,281 73.5% 24,931 81.3% 39,568. 80.5%
R&D 1,905 4.5% 1,421 4.4% 1,728 3.4%
SG&A 4,248 0.0% 3,645 11.3% 4,399 8.6%
Other op (income) exp 1,191 2.8% 1,822 5.6% 1,181 2.3%
Operating profit
3,963 9.3% 577 1.8% 4,448 8.7%
Caterpillar, Inc. Vertical analysis 2010 (disaggregated by product line)
($ figures in millions)
2010Sales and revenues:
Sales of Machinery & Engines 39,867 Revenues of Financial Products 2,721 Total sales and revenues 42,588
Operating expenses:Cost of goods sold 30,367 SG&A 4,248 R&D 1,905
Interest exp of Financial Products 914 Other op (income) expenses 1,191 Total operating costs 31,819
Operating profit 3,963
Gross profit (not in P&L) 11,307
Vertical analysis:
Combined
100.0%
71.3%10.0%
4.4%
2.1%2.8%
74.7%
9.3%
26.5%
Mach & engines
100.0%
76.2%
4.8%
23.8%
Financial products
100.0%
33.6%
66.4%
Caterpillar, Inc. Profitability by period (disaggregated by product line)
(millions of $) 2010 2009 2008
Machinery and Engines
Sales 39,867 100.0% 29,540 100.0% 48,044 100.0%
Cost of goods sold 30,367 76.2% 23,886 80.9% 38,415 80.0%
Gross profit 9,500 23.8% 5,654 19.1% 9,629 20.0%
R&D 1,905 4.8% 1,421 4.8% 1,728 3.6%
M & E profit 7,595 19.1% 4,233 14.3% 7,901 16.4%
Financial Products
Revenues 2,721 100.0% 2,856 100.0% 3,280 100.0%
Interest expense 914 33.6% 1,045 36.6% 1,153 35.2%
Financial products profit 1,807 66.4% 1,811 63.4% 2,127 64.8%
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
Caterpillar, Inc.Operating C/F (as presented)
(in millions of $) 2010 2009 2008
Net income 2,758 827 3,585 Adjustments for non-cash items:
Depr & amort 2,296 2,336 1,980
Other 469 137 355 Changes in assets & liabilities:
A/R (2,320) 4,014 (545)
INV (2,667) 2,501 (833)
A/P 2,570 (1,878) (129)
Accruals 964 (1,039) 814
Customer advances 604 (646) 286
Other assets - net 358 235 (470)
Other liab - net (23) 12 (371)
Op C/F 5,009 6,499 4,672
Caterpillar, Inc.Significant Operating C/F drivers by year
(in millions of $) 2010 2009 2008
Net income 2,758 827 3,585 Adjustments for non-cash items:
Depr & amort 2,296 2,336 1,980
Other 469 137 355 Changes in assets & liabilities:
A/R (2,320) 4,014 (545)
INV (2,667) 2,501 (833)
A/P 2,570 (1,878) (129)
Accruals 964 (1,039) 814
Customer advances 604 (646) 286
Other assets - net 358 235 (470)
Other liab - net (23) 12 (371)
Op C/F 5,009 6,499 4,672
Question 3: Providing for the future
• Two primary indicators:R&D (from Income Statement, not always presented)
Cap X (gross disbursements, not net, from C/F Statement, Investing section)
• Combined plough back ratio:
R&D expenses + Cap X disbursements Revenue
• Must also evaluate nominal R&D and Cap X spending. Revenue volatility can distort plough back ratios.
Providing for the future(continued)
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
Caterpillar, Inc.Machinery and Engines
R&D plough back ratio & trend analysis
(millions of $) 2010% of sales % change 2009
% of sales % change 2008
% of sales
Sales
39,867 34.3%
29,540 -38.5%
48,044 Cost of goods sold 30,367 23,886 38,415
Gross profit 9,500 5,654
9,629 R&D 1,905 4.8% 34.1% 1,421 4.8% -17.8% 1,728 3.6%
M & E profit 7,5954,233
7,901
Caterpillar, Inc.Investing C/F (as presented)
(millions of $) 2010 2009 2008Cap X - excluding equipment leased to others (1,575) (1,504) (2,320)
Expenditures for equipment leased to others (1,011) (968) (1,566)
Proceeds from disposals of PP&E 1,469 1,242 982
Additions to finance receivables (8,498) (7,107) (14,031)
Collections of finance receivables 8,987 9,288 9,717
Proceeds from sale of finance receivables 16 100 949
Investments & acquisitions (net of cash acquired) (1,126) (19) (117)
Sale of available-for-sale securities 228 291 357
Investments in available-for-sale securities (217) (349) (339)
Other - net 132 128 197
Net cash provided by (used for) investing (1,595) 846 (6,171)
Caterpillar, Inc.Investing C/F (grouped by
purpose)(millions of $) 2010 2009 2008Cap X - excluding equipment leased to others (1,575) (1,504) (2,320)
Expenditures for equipment leased to others (1,011) (968) (1,566)
Proceeds from disposals of PP&E 1,469 1,242 982
Investments & acquisitions (net of cash acquired) (1,126) (19) (117)
Subtotal: non-financial (M&E) assets (2,243) (1,249) (3,021)
Additions to finance receivables (8,498) (7,107) (14,031)
Collections of finance receivables 8,987 9,288 9,717
Proceeds from sale of finance receivables 16 100 949
Subtotal: financial product assets 505 2,281 (3,365)
Sale of securities 228 291 357
Investments in securities (217) (349) (339)Other - net 132 (128) 197
Net cash provided by (used for) investing (1,595) 846 (6,171)
Caterpillar, Inc.Combined plough back ratio
($ figures in millions) 2010 2009 2008
Cap X - excluding equipment leased to others 1,575 1,504 2.,320
Investments & acquisitions (net of cash) 1,126 19 117
Gross "future-oriented" investing 2,701 1,523 2,437
R&D expenses 1,905 1,421 1,728
= Total "future-oriented" plough back * 4,606 2,944 4,165
-:- Sales of Machinery & Engines 39,867 29,540 48,044
= Combined Cap X / R&D plough back ratio 11.6% 10.0% 8.7%
*Note: Future-oriented plough back does not include expenditures for equipment leased to others (see prior slide). Reason: These represent costs of sales structured as leases rather than investment in PP&E for long-term growth.
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?
Example of asset sales: Merck’s “big pharma” investment portfolio
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
Caterpillar, Inc.Free C/F *
(millions of $) 2010 2009 2008Cap X - excluding equipment leased to others (1,575) (1,504) (2,320)
Proceeds from disposals of PP&E 1,469 1,242 982
Investments & acquisitions (net of cash) (1,126) (19) (117)
Total net “future-oriented” investing (excl R&D) (1,232) (281) (1,455)
Operating C/F 5,009 6,499 4,672
Free C/F * 3,777 6,218 3,217
* Note: Free C/F is measured in a variety of ways. This method is very specific and is not the same as most finance texts’ definition and formula. 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
Cash cycle
•Working capital: Current ratio
Quick ratio
A/R T/O
•Solvency Debt/equity ratio (degree of financial leverage in capital structure)
These ratios deferred to later, more
detailed analyses
Caterpillar, Inc.Overall liquidity: summary of net C/F
and balances
(in millions of $) 2010 2009 2008
Operating C/F 5,009 6,499 4,672
Investing C/F (1,595) 846 (6,171)
Financing C/F (4,613) (5,215) 2,955
Net C/F (1,199) 2,130 1,456
Effect of exchange rate changes on cash (76) 1 158
Beginning cash 4,867 2,736 1,122
Ending cash 3,592 4,867 2,736
Caterpillar, Inc.Debt / equity ratio
(millions of $) 2009 2008 2008
Short-term borrowings 4,056 4,083 7,209
Long-term debt 24,362 27,548 28,326
Total debt 28,418 31,631 35,535
Total stockholders' equity 10,864 8,823 6,190
Total financial capital 39,282 40,454 41,725
Debt / equity 2.6 3.6 5.7
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)
Caterpillar, Inc.Financing C/F
(millions of $) 2010 2009 2008
Dividends paid (1,084) (1,029) (953)
Common stock issued, incl T-shares reissued 296 89 135
Treasury shares purchased 0 0 (1,800)
Debt issue proceeds:
Machinery & Engines 216 458 1,673
Financial Products 8,108 11,833 16,257
Payments on debt:
Machinery & Engines (1,298) (918) (296)
Financial Products (11,163) (11,769) (14,143)
Short-term borrowings (net) 291 (3,884 2,074
Other (not worth discussing) 21 5 8
Net cash provided (used for) financing (4,613) (5,215) 2,955
Caterpillar, Inc.Strategic vs tactical financing activities
(millions of $) 2010 2009 2008Dividends paid (1,084) (1,029) (953)Common stock issued, incl T-shares reissued 296 89 135Treasury shares purchased 0 0 (1,800)
Debt issue proceeds: Machinery & Engines 216 458 1,673 Financial Products 8,108 11,833 16,257
Payments on debt: Machinery & Engines (1,298) (918) (296) Financial Products (11,163) (11,769) (14,143)
Subtotal “strategic financing activities” (4,925) (1,336) 873Short-term net borrowings (“tactical financing activities”) 291 (3,884 2,074
Other (not worth discussing) 21 5 8
Net cash provided (used for) financing (4,613) (5,215) 2,955
Question 4: Conclusion
• Financial condition indicators:
Liquidity: cash balance increased by 28%;
Solvency: D/E ratio decreased by 54%.
• Caterpillar’s debt/equity trend indicates an consistent trend of increasing equity relative to debt in its capital structure.
• Over the past three years Caterpillar’s financing activity has indicated a net return of capital to investors.
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.
Approach: Focus on the most basic financial questions about any company:
• Recent financial performance• Future financial performance• Financial condition• 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: [email protected]