Lecture 3: Financial Reporting and Analysis

Mark Hendricks
University of Chicago

September 2012

Outline

Financial Reporting

Financial Analysis

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Financial reporting

Financial reporting is important for well-functioning markets. Investors need information to properly allocate capital and hedge risk. Regulators need good information to monitor fraudulent activity and systemic risk. Financial reports are prepared according to accounting practices, which often dier from the methods of nance and economics.

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Financial statements

There are three key nancial statements. The balance sheet The income statement The statement of cash ows We discuss each in turn.

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The balance sheet

The balance sheet details the nancial condition of the rm at one moment in time. The balance sheet is a list of the rms assets and liabilities. The values are book values, not market values. The book values are based more on historical transaction prices than current valuations.

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Balance equation
The central idea behind the balance sheet is an accounting identity: assets = liabilities + shareholders equity Note that this equation is an identity. The shareholders equity component is not a real market value of equity. Rather, it is just a plug for the equation. In nance, the market value of equitynot the (accounting) book valueis typically used.

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Current assets/liabilities

The rst section of the balance sheet lists the assets of the rm. The short-term, or current assets are listed rst. This is where cash and other liquid securities are listed. After this, longer-term assets are listed. Liabilities are listed similarly, with current liabilities being listed rst.

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Balance sheet for commercial banking

Figure: Balance statement for the banking sector, 2008. Source: Mishkin (2010)
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Data: Book value of assets at FDIC commercial banks

Book Value of Assets at FDIC Commercial Banks 14000 12000 Billions $ 10000 8000 6000 4000 2000 2002 2004 2006 2008 2010 2012
Source: FDIC (CB14)
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Data: Excess reserves of depository institutions

Source: St. Louis Fed: (EXCRESNS)

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Data: Nonperforming loans for U.S. banks

Source: St. Louis Fed: (USNPTL)

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Accounting rules
Book values in the balance sheet dier from market values: Depreciation. Accountants use xed rules to calculate depreciation on assets. This depreciation calculation can dier substantially from the market value. Capitalizing expenses. Capital is listed as an asset. However, some potential assets such as R&D are left o the balance sheet but rather treated as simple expenses. Intangibles like goodwill also show up on the balance sheet, though these intangible assets have no precise measure. Taxes. The accounting rules for calculating taxes are often dierent than the rules for nancial reporting.

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Fair value accounting

Fair-value accounting is an attempt to make book values reective of current conditions rather than just historical transactions. Many assets and liabilities held by a rm are not actively traded nor have easily observed values. ie. Inventory, buildings, employee benets. Historically, accountants list these on the books at historical costs. But the true values uctuate, of course. Fair-value, or mark-to-market, accounting attempts to keep the book values at current market values.

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Mark-to model
With mark-to-market accounting, assets are valued according to three categories: 1. Assets with observable market prices, and these are used on the books. 2. Assets are not actively traded, but similarly traded assets can be used for market valuations, perhaps with the aid of a pricing model. 3. Assets without market quotes. Thus, the values depend on pricing models. These model-based values are known as mark-to-model, and the choice of model may leave room for manipulation.

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Criticisms
The role of fair value accounting in the nancial crisis is controversial. Theoretically, fair value accounting should lead to better information in markets. But in distressed and illiquid markets, current prices may not reect long-term value. In this case of undervalued assets, the balance sheet may hit a point where rms are forced to recapitalize. But if it is hard to raise equity, a rm may need to liquidate distressed assets, depressing the price even further!

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Income statement

The income statement is the second major nancial report. It gives a summary of the protability of the rm over a period of time. (Compare this to the balance sheet which gives the rms nancial conditions at a point in time.) The income statement lists revenues and expenses for the time period, (year, quarter, etc.)

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Earnings
Earnings, (or net income,) are simply revenues minus costs. They are an accounting measure of prots. Earnings would not be a good measure of economic prots given that the nancial statements are subject to accounting rules. Earnings measure the return to equity holders. The calculation subtracts debt interest payments and taxes owed. Earnings Before Interest and Taxes (EBIT) is also an important measure of prot. It includes payments that go to debt holders and the tax authority.

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Retained earnings

Retained earnings are the earnings re-invested into the rm: retained earnings = earnings dividends The balance sheet can grow in one of three ways: 1. Internally, through retained earnings. 2. Externally by issuing new equity. 3. Externally by issuing new debt.

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Income statement for commercial banking

Income Statement for All Federally Insured Commercial Banks, 2008

Amount ($ billions) Operating Income Interest income Noninterest income Service charges on deposit accounts Other noninterest income Total operating income Operating Expenses Interest expenses Noninterest expenses Salaries and employee benefits Premises and equipment Other Provisions for loan losses Total operating expense Net Operating Income Gains (losses) on securities Extraordinary items, net Income taxes Net Income 603.3 207.4 39.5 167.9 _____ 810.7 245.6 367.9 151.9 43.4 172.6 175.9 789.4 21.3 -15.3 5.3 -6.2 5.1

Share of Operating Income or Expenses (%) 74.4 25.6 4.9 20.7 _____ 100.0 31.1 46.6 19.2 5.5 21.9 22.3 100.0

Figure: Income statement for the aggregated banking sector, 2008. Source: Mishkin (2010)
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Data: Net income of FDIC commercial banks

Net Income for FDIC Commercial Banks 150 100 Billions $ 50 0 50

2000 2002 2004 2006 2008 2010 2012

Source: FDIC (CB04)

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Data: Loss provision of FDIC commercial banks

Loss Provision for FDIC Commercial Banks 250 200 Billions $ 150 100 50 0 2000 2002 2004 2006 2008 2010 2012
Source: FDIC (CB04)
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Cash-ow statement
The statement of cash ows is the third major nancial statement. Due to accounting rules, earnings are not a proper measure of prots, nor of cash-ow. This statement tracks the actual cash movements associated with transactions. Due to its simple nature, this statement is often favored by analysts trying to cut through all the accounting rules and issues. The statement typically groups transactions into operating, investment, and nancing cash ows.

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Notes to statements

Aside from the three major nancial statements, rms often attach notes. These notes may often be skimmed or ignored, but at times they reveal important clues. For instance, if a rm is manipulating accounting data, the notes may have clues. The notes for AIG explained that their CDS position was not hedged.

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Earnings management
Earnings management refers to the practice of taking actions in order to manipulate reported earnings. Not all reported earnings are of the same quality. Fair value accounting leaves some discretion in the reported gures. Nonrecurring items, such as the sale of an asset may not be useful in assessing the rms future protability. Revenue recognition. Under accounting standards, managers can take actions which recognize income in the present, and push losses to the future.

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O-balance-sheet holdings
The nancial crisis has brought much attention to a certain kind of accounting manipulation: o-balance-sheet assets and liabilities. Firms may try to leave protable parts of their business on their books, while spinning losses o into entities that do not show up on the books. Enron put losses into subsidiary entities whose holdings did not show up on Enrons books. Due to keeping their prots and hiding their losses in these shells, 96% of their reported earnings were phony. Source: Berk (2011).

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Capital leases

Another widespread use of o-balance-sheet accounting is capital leases. Capital leases are long-term leases which more closely resemble debt nancing than a true lease. By calling the transaction an ongoing lease rather than a debt-nanced purchase, the company keeps it o the books. Rather, they report only the monthly lease amount, as if they did not have the (often sizeable) debt for the whole purchase. Recent regulations have made it harder for rms to reduce their reported debt in this way.

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World Com

In fact, the rm World Com was manipulating their nancial statements using capital leases, but in a dierent way. World Com capitalized expenses which were truly operating expenses. They called these expenses capital leases, and thus the money spent was not deducted from earnings, but rather counted as assets which were slowly depreciated. World Com, which had a market capitalization of $120 billion in 2002, was exposed and set a record for the largest bankruptcy. Source: Berk (2011).

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Banks use of o-balance-sheet items

The nancial sector has also increased its use of o-balance-sheet holdings. Many believe this played a large role in causing the nancial crisis. For banks, moving things o the balance sheet avoids regulatory scrutiny. The income, (as a percentage of total assets,) generated by banks from these o-balance-sheet activities has doubled since 1970. Source: Mishkin (2010).

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Moving mortgages o the balance sheet

Consider the increased o-balance-sheet activities with regard to mortgages. Historically, a savings association would give a mortgage to a homeowner, and then hold it as an asset on the books for 30 years. MBS allowed banks to originate a mortgage and then sell a bundle of these mortgages in a special purpose vehicle. This removed the asset and liability from the banks balance sheet. The banks would continue to manage the pool of mortgages for a fee.

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Beyond earnings

The lesson is that earnings are not a sucient statistic for the nancial health of a rm. World Com had suspicious levels of investment due to their use of capital leases. Enrons actual cash ows were not anything close to their stellar earnings.

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The Sarbanes-Oxley act

In response to the scandals of the early 2000s, the U.S. passed the Sarbanes-Oxley act in 2002. The purpose of Sarbanes-Oxley was to improve the integrity of nancial statements. Auditors were given new rules to reduce conicts of interest. The law puts restrictions on the non-audit services which a public accounting rm can provide. Management was made personally liable for the accuracy of nancial reports. It established a Public Company Accounting Oversight Board which is overseen by the SEC. The budget for the SEC was increased so that it could better supervise securities markets.

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Disclosure requirements
Disclosure requirements are a key element of nancial regulation. Basel 2 puts a particular emphasis on disclosure requirements. It mandates increased disclosure by banks of their credit exposure, reserves, and capital. The Securities Act of 1933 and the SEC, which was established in 1934 require disclosure on any corporation that issues publicly traded securities. More recently, there have been added rules about reporting o-balance-sheet positions and more information about the pricing models being used in coming up with the nancial reports.

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Getting regulation right

Increased disclosure requirements have made it more costly for a rm go public, or to issue U.S. securities. The share of new corporate bonds initially sold in the U.S. has fallen below the share sold in European debt markets. In 2008, the London and Hong Kong stock exchanges each handled a larger share of IPOs than did the NYSE, which had been the dominant market until recently. Combined with the increasing ease of obtaining non-public nancing, many rms are delaying IPOs. Some have blamed regulation, and Sarbanes-Oxley in particular, for these facts. Of course, there are other possible causes. The debate about reporting requirements is ongoing.

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Outline

Financial Reporting

Financial Analysis

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Measuring prot

Return on equity (ROE) uses accounting values: earnings divided by book value of equity. ROE will not be the same as the rms stock return over the period. Given that ROE uses accounting earnings as the prot measure, it is sensitive to the manipulations discussed above. Earnings are measured over a period of time, (ie. year,) whereas the book value of equity on the balance sheet is at a specic point of time.

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Return on assets

Return on assets (ROA) is another important measure of protability. Again, ROA uses earnings to measure prot, but divides by the rms book value. ROA is insensitive to the rms nancing decision. Thus, it is a measure of operating protability.

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Understanding ROE

It is useful to analyze ROE by breaking it into factors, something known as the DuPont identity. Earnings Sales
Net Prot Margin ROA

ROE =

Sales Assets
Asset Turnover

Assets Book Value of Equity

Leverage

This shows us three ways to inuence ROE.

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Data: Return on equity for commercial banks

Return on Equity for FDIC Commercial Banks 20 15 10 ROE % 5 0 5 10 1985 1990 1995 2000 2005 2010 2015

Source: FRED (USROE)

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Three factors of ROE

The three factors of ROE correspond closely to the nancial statements. Prot margin gives a summary of the income statement performance by showing prot per dollar of sales. Asset turnover summarizes the asset side of the balance sheet. It indicates the resources required to support sales. Leverage ratio summarizes the liability and equity side of the balance sheet by showing how the assets are nanced.

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Prot margin
The prot margin measures the fraction of each dollar of sales that ends up as earnings, adding to the balance sheet. In the decomposition above, we have used the net prot margin. Recall that earnings, or net income, has already deducted interest payments on debt and taxes. Another popular measure is gross prot margin which instead of using earnings in the numerator, uses EBIT. net prot margin = earnings , sales gross prot margin = EBIT sales

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ROE and gross margins

Of course, the above decomposition wont work with gross prot margin. Rather it must be expanded to ROE = Earnings EBIT EBIT Sales
Gross Prot Margin ROA

Sales Assets
Asset Turnover

Assets Book Value of Equity

Leverage

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Data: Net interest margin for U.S. banks

Source: St. Louis Fed: (USNIM)

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Asset turnover
Asset turnover measures the sales generated per dollar of assets the rm owns. Sales Assets

Asset Turnover =

Notice that assets reduce asset turnover and thus reduce ROA and ROE. One might expect lots of assets are a good thing. But conditional on a certain prot stream, assets just measure the amount of capital needed to generate this income stream.

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ROA
ROA captures the combined eects of margins and asset turnover: ROA =(Net) prot margin Asset turnover = Earnings Assets

ROA is a basic measure of a rms eciency in how it transforms assets to prots. Some industries achieve high returns by having high margins, while other achieve it with high asset turnover. A high prot margin and a high asset turnover is ideal, but can be expected to attract considerable competition. Conversely, a low prot margin combined with a low asset turn will attract only bankruptcy lawyers. Higgins (2009).

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Data: Return on assets for commercial banks

Return on Assets for FDIC Commercial Banks 1.5 1 ROA % 0.5 0 0.5

1985

1990

1995

2000

2005

2010

2015

Source: FRED (USROA)

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Leverage
Leverage refers to how much of the rms capital comes from equity holders versus debt holders. Unlike the other two ratios in ROE, more is not necessarily better. Rather, leverage decisions must take account of the pros and cons of debt nancing. A rm does not pay taxes on income used for interest payments. This debt tax shield incentives rms to lever up. However, more debt increases the chances of nancial distress or bankruptcy. Optimal leverage balances these forces, and varies widely across industries. Not surprisingly, low leverage is used in industries where nancial distress is particularly costly.

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Leverage - balance-sheet measures

The leverage ratio in the ROE calculation is the asset-to-equity value. This is often rescaled into other popular measures. Liabilities Assets Liabilities Equity

Debt-to-assets = Debt-to-equity =

Notice that the asset-to-equity ratio used above is just the debt-to-equity-ratio plus 1.

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Data: Leverage of commercial banking sector.

Accounting Leverage FDIC Commercial Banks 20 book (assets/equity)

15

10

1940 1950 1960 1970 1980 1990 2000 2010

Source: FDIC (CB14)

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Leverage - coverage measures

There are many other ways to measure the extent to which a rm is nancing with debt. Measures based on income are often preferred, given that bankruptcy is caused by defaulting on payments, not on the share of equity versus debt. Interest coverage, or times interest earned, also measures the nancial risk of a rm. It shows how much burden interest payments are on the cash ows. interest coverage = EBIT interest expense

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Rollover risk
There are many other ways to measure the extent to which a rm is nancing with debt. Times burden covered is similar to times interest earned, but takes account of principal repayment. Relying on the interest covered measure assumes that one can roll over the debt principal. In the summer of 2007, many investors in MBS found this is not always the case. Times burden covered is conservative in that it calculates as if all principal will be repaid.

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Leverage - market measures

Given the problems with accounting values already discussed, many prefer a market measure of leverage. Market measures of leverage are like the balance-sheet measures seen above, but they use the market value of equity rather than the book value. This can make a big dierence, especially for growing rms.

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Leverage in the crisis

Leverage played a big role in the recent nancial crisis. Firms such as Lehman and Merril Lynch had 30-to-1 leverage. This left them very little exibility to deal with asset declines. The total decline in mortgages was a relatively small amount of money, but was more than enough to bankrupt highly leveraged institutions.

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Capital requirements

Capital requirements are meant to keep nancial institutions from taking too much risk. Note that with high leverage, a rm has more incentive to take very large gambles. Losses mean little, while the upside from the gains gets larger. Regulators want to prevent excess risk which could cause failure in nancial markets.

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Leverage ratio requirements

The capital requirements take two forms: the rst is based on the leverage ratio. A bank is well capitalized with a leverage ratio below 20. But extra regulation kicks in if it goes above 33. The FDIC must take steps to close down a bank with a leverage ratio above 50.

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Basel

The second type of requirements are risk-based. Under regulation known as the Basel Accord, banks were required to hold 8% of their risk-weighted capital. The weighting system for capital leads to regulatory arbitrage. Basel 2 was very recently rolled out after many years of planning. However, due to the crisis, Basel 3 is already being studied.

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ROE and ROA

We have seen then, that ROE is just an an adjustment of ROA to account for leverage. ROA shows the return that comes from the operation of the business ROE shows both returns from operations and nancing For which type of returns should management be rewarded? High ROE relative to ROA (relative to the industry,) may show savy nancing, but it could also show excessive risk. Management seeking returns always has the temptation of leveraging to get there.

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Table of ROE

Figure: ROE for various rms, 2007. Source: Higgins (2009)

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Problems with ROE

ROE is not necessarily a good measure of nancial performance. For as much attention as it gets, one must be careful. Market valuations are forward-looking and consider the long-term prospects of the rm. By contrast, ROE is largely backward-looking and considers only one years data. We have already noted that accounting values can easily be manipulated to push earnings to dierent time periods.

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ROE and risk

We mentioned already, that ROE can be increased by taking on more leverage. Clearly then, a higher ROE is not always better. Improving ROE while keeping risk exposure level is an acheivement. Increasing ROE by increasing risk, (leverage or other types,) is not. Thus, investors must consider whether high ROE is a good deal. If your money market fund returned 10%, would you be happy?

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Banks and ROE

Currently, regulators are considering tougher capital requirements for banks, (lower leverage.) Banks argue that this will lower their returns; they are denitely right! They say that this will cause investors to withdraw, which will cause big problems in nancial markets. Is this true? Will investors need such a high ROE if capital requirements are higher?

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Liquidity measures
Current ratio. Current assets and liabilities are those with a maturity of one year or less. Thus, this measures the ability of the rm to pay o short-term debt using its most liquid assets. current ratio = current assets current liabilities

Quick ratio. Also known as the acid test ratio. It is like the current ratio, but does not include inventory in the numerator. Cash ratio. Similar to the current ratio, but it does not include current assets which are not marketable securities, (things like accounts receivables.)

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Book and market values

We have noted that the book value of rm equity may be much dierent than its market value. The market-to-book ratio is the market value of equity divided by the book value of equity. Book value of equity is considered a very conservative estimate of share value, perhaps a oor. Recall that the ratio can be much dierent than one given that book-values tend to be based on historical transactions while market values look forward to future growth.

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Growth and value

The price-earnings ratio (P/E) is a popular measure of rm value. The P/E ratio takes the market price at a given time, and it divides by the earnings generated over some period. Of course, the market price is aected by the future prospects of the rm, while the periods earnings are a historical fact. Thus, the P/E is a measure of how much future cash ows the rm will deliver relative to its current earnings.

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Growth and value

Market-book and price-earnings values are both useful measures for a rms future growth prospects. Stocks with a high market-book or P/E ratio are called growth stocks. A stock with a low market-book or P/E ratio is called a value stock.

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Use of growth and value

The labels growth and value are widely used. Historically, value stocks have delivered higher average returns. So-called value investors try to take advantage of this by looking for stocks with low market-book ratios. Much research has been done to try to explain this dierence of returns and whether it is reective of risk. Mutual funds are oered for both growth and value stocks and have become very popular.

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References

Berk, Jonathan and Peter DeMarzo. Corporate Finance. 2011. Bodie, Kane, and Marcus. Investments. 2011. Cochrane, John. Understanding Policy in the Great Recession European Economic Review. 2011. Higgins, Robert. Analysis for Financial Management. 2009. Hull, John. Options, Futures, and Other Derivatives. 2012. Mishkin, Frederic. Money, Banking, and Financial Markets. 2010.

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