Financial Statement Analysis

Evaluation of current
and past
financial conditions
Estimated predictions about
future financial conditions
and performance

Reasons for Analysis

Investment decisions*
Credit decisions*
Performance*
Valuation (investment)
Legal liability amount (credit & perf.)
Going concern decisions (credit & perf.)
Unreasonable returns (performance)
3

FSA Steps

Identify the economic characteristics

Identify the corporate strategies
Understand the financial statements
Assess the profitability and risk
Value the particular firm

Tools for Economic Analysis

Porters Five Forces
Economic Attributes Framework

Porters Five Forces

Buyer Power- (price sensitivity)

Supplier Power
Rivalry among Firms
Threat of New Entrants
Threat of Substitutes

Economic Attributes Framework

Demand

Supply

capital intensity
process complexity

Marketing

number of suppliers
barriers to entry

Manufacturing

price sensitivity
demand growth
cyclical demand
seasonal demand

marketing channel--corporate or consumer

demand pull or demand creation

Financing

Nature of assets
Asset risk
Source of cash flow--internal or external

Strategic Analysis Framework

Nature of product or service
Degree of Integration
Degree of Geographical
Diversification
Degree of Industry Diversification

Financial Statements

Balance Sheet
Income Statement
Statement of Cash Flows
Footnotes
Auditors Report
Management Discussion and Analysis
9

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

10

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)

11

Other F/S Considerations

Quality of Earnings
Statement of Cash Flows
Auditors Report

12

Tools of Profit and Risk Analysis

Common Size Financial Statements

Percentage Change Statements
Comparative Analysis
Critical Financial Ratios

13

Risks of Comparative Analysis

Timing
GAAP Application
Degree of Conservatismmanagements attitude
Size
Geographic Diversification
14

Critical Financial Ratios

Profitability Ratios
EPS
ROCE

Risk Ratios
Current ratio
CFO/Avg. Current Liabilities
Debt/Equity
15

Valuation
Price-Earnings Ratio
Market value to Book value Ratio

16

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)
17

Sources of Information

Annual Report
Form 10-K
Form 10-Q
Form 8-K
Prospectus
Form 20-F (foreign entity 10-K)
18

Statement of Cash Flowschapter 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
19

Businesses are like Fruit

Trees
Fruit = Operating Activities

Trunk & Branches = Investing Activities

Roots = Financing Activities

20

Net Income vs. Cash Flow

Indirect Method
Net Income
+/- Non-cash Items
+/- Changes in Operating Working
Capital
= Cash Flow from Operations

21

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

22

Profitability Analysis
chapter 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
23

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
24

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

25

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

26

Risk Analysis
Types of risk

International
Domestic
Industry
Firm-specific

Our focus will be on the financial

aspects of risk
27

Relationship to O-I-F
S/T liquidityOworking capital
L/T liquidityIplant capacity
L/T liquidityFdebt svc. rqmts

28

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
29

L/T Liquidity
L/T Debt Ratio
Debt/Equity Ratio
Liabilities/Assets Ratio
Interest coveragefixed charges
coverage
OCF to Total Liabilities
OCF to Capital Expenditures

30

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
31

Industry Ratio Sources

Robt. Morris Associates, Annual
Statement Studies
Dun & Bradstreet, Industry Norms
and Key Financial Ratios

32

Stickneys Comparability
Risksin additon to WFOs
Earnings not reflective of actual
economic value added
F/S restatement
F/S classification
Time variations in excess of 3 mos.
Global accounting factors
33

Quality of Earnings IssuesChapter 6

Non-recurring itemssustainability
Earnings measurement
Earnings management
Essentially we are trying to
determine if what is reported is
going to recur in the future.
34

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
35

Restructuring Difficulties
Conservative vs. aggressive
accounting practices
Periodic charges vs. one time event
Taking a bath

36

Analysts Role
Is restructuring adequate
Wall street point of view
Significant judgement required

37

Earnings Management
Reasons it occurs:
Incentive compensation factor
Job security
Smoothing reduces erratic performance which
lowers perceived risk
Govt anti-trust avoidance

Reasons against:
Cant do it forever
Capital market penalties for excess

38

Methods of Management
GAAP choices
Management judgement and
estimates
Timing of transactions

39

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.
40

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
41

Chp. 6 Examples

Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.

#1: Halliburton-discontinued segment

#2: Fountain Pwerboats extraordinary item
#3: Tenneco Automotive changes in acctg. Princ.
#4: Brunswick- effect of actg. Changes
#5: Ford-cumulative effect acctg changes
#6: PepsiCo-other comprehensive loss
#7: Cisco-other items
#8: PepsiCo-asset impairment
#9: JDS Uniphase- asset impairment
#10: JDS Uniphase -restructuring
#11: Brunswick-unusual charges
#12: PepsiCo-merger related costs
42

Chp. 6 Examples, cont.

Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.
Ex.

#13:
#14:
#15:
#16:
#17:
#18:
#19:
#20:

DriveTime-change in actg estimate

Hersey-change in actg estimate
Delta Air Lines- other gains and losses
PepsiCo-other gains and losses
PepsiCo-other gains and losses
General Mills restated statements
Account classification differences
Ericsson-worldwide reporting

43

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
44

Economic Aspects
Monopolyhigh PM; low AT
Pure Competitionlow PM; high AT
Oligopolymixture of the two

45

ROCE Considerations

ROCE tends to follow ROA

Two theories

Random walkhigh stays high; low stays low

Equilibriumrevision to average ROCE

Penmans findings
Random walk valid 1-6years
Equilibrium thereafter takes hold

Capital structure not changed for ROCE

improvement

46

Extended Risk
Financial Distress
Credit risk
Bankruptcy risk

Financial Distress Spectrum

Payment omission
Default
Bankruptcy
Liquidation
47

Credit Risk Cs

Circumstances
Cash flows (Capability to repay)
Collateral
Capacity for debt
Contingencies
Character of management
Conditions
48

Bankruptcy
Process
Chapter XIliquidation
Chapter VIIreorganization

Predictive Models
Beaverunivariate
Net income before amort. etc./total liab.

Altmans Zsee pages 631-633

Multivariate
49

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

50

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

51

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

52

 Drivers

Market Risk

Political
Personnel
Product

Market risk drives market return

CAPM measures market risk
Market risk beta is driven by
Operating leverage
Financial leverage
Sales variability

53

Pro-forma FinancialsChapter 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
54

Pro Forma Approaches

Exhibit 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
55

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)

56

Pro-forma Methodology
Chapter 10 provides you with a
format for building the excel
worksheet and integrating it with the
FSAP template

57

Rev. Recognition Options

Chapter 7

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

58

Earnings Management
Increases as cash flow period grows
Increases as options for estimation
grows

59

Criteria for Recognition

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

60

Earnings Sustainability Risk

Uncollectible A/R
High volume of returned goods
Unrecorded warranties

61

L/T Contractors

Multiple accounting periods

Price established in advance of work
Periodic payments
Percentage of completion
IRS approach

Completed contract
62

Criteria for Exp. Recognition

Matched with revenue
Consumption of service or benefit

63

Rev. Recog. When Cash is

Uncertain
Installment method
Cost-recovery-first method

64

Disclosure
Accounting policies footnote

65

Inventory Cost Flow

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

66

LIFO Liquidation
Sales greater than production
Cash flow increases due to reduced
purchases
Cash flow decreases due to higher
income taxes

67

LIFO Characteristics
Rapid price increases
Provides better income smoothing in
light of inventory change variability
Tax savings
Industry specific
Larger firm size
68

Other LIFO Factors

GAAP disclosure: LIFO reserve
Stock reaction is inconclusive

69

Analytical Considerations

Cost flow assumption

Price variation & inventory turnover
LIFO liquidation impact
Inventory obsolescence
Inventory financing

70

LIFO - FIFO Adj.

Inventory value
Working capital changes
Income statement changes
SCF changes

71

Fixed Assets--Key Issues

B/S Amount
Useful lives
Depreciation method
Recoverability
Maintenance & repair expense
Overall issue: undervaluation potential
72

F/A--Earnings Sustainability
B/S amount vs. replacement cost
Choice of depr. Lives (instant profit)
Choice of depr. method

73

Intangibles--General
Expense cost of development
Recognize as asset purchased
intangibles
Amortize up to 40 years
Caution surrounding in process
R&D

74

S/W Development Costs

Expense through tech. feasibility
Capitalize, thereafter
Amortize over useful life

75

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

76

Intangibles--Earnings
Sustainability
Generally expense
The above is a questionable approach
Needed-ways to value intangibles

77

Liability Recognition
Chapter 8
Probable future sacrifice
Little or no discretion to avoid
Event has occurred

78

No Liability, If...
Mutually unexecuted contracts
Certain contingencies
Not probable
Not measurable

79

Controversial Liability Issues

Hybrid securities
Sale of A/R w/recourse
Product financing arrangements
R&D financing arrangements
Take or pay contracts
Derivative instruments
80

Liability Valuation
PV of future cash flows > 1 year
Cost of future deliverables
Cash advance value

81

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

82

Retirement Benefits
Pensions (FASB 87 & 132)
Post-retirement Health Benefits
(FASB 106 & 132)

83

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

84

Key Terms
ABO - amount expected to be
paid--current salaries
PBO - amount expected to be
paid--future salaries

85

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
86

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

87

Health Care Benefits

No minimum liability
Minor measurement differences
Considers income tax impact
Sensitivity analysis
Note politicization on p. 410

88

Analysts Role
Awareness of underfunding
Reasonableness of assumptions
Actual performance vs. expected
performance

89

Income Taxes-FASB 109

Book income
Permanent differences
Temporary differences
Taxables
Deductibles

Taxable income

90

FASB 109-History
APB 11 - income statement focus
FASB 109 - B/S focus
FASB 109 - Allows deferred debits

91

Implementation

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

Taxables > deductibles

Negative factors
Positive factors
more likely than not
92

Disclosure

Income tax expense

Income before taxes
Statutory rate reconciliation
Composition of deferred taxes and
assets

93

Deferred Tax Liability

Is it real?
Consider in terms of a going
concern

94

Analysts Role

Effective tax rate changes

Changes in valuation allowance
Tax rate by venue
Normalize rate excluding one time
changes

95

Reserves
Matching principle
Exclude expenses
Defer negative asset revaluation (ie
FASB 115)
Difficult to assess & adjust

96

Combination Issues
Chapter 9

Corporate acquisitions
Investments in securities
Foreign currency translation
Segment reporting

97

Business Combinations
Purchase accounting
Record at FMV
Excess to goodwill

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

98

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

99

Investment in Securities
Under 20%
20% to 50%
Over 50%

100

Under 20%

Held to maturity
Available for salecomprehensive inc.
Tradingincome statement
Analyst issues
include or exclude adj. from income

101

20% to 50%
Equity method if influence exists
Analyst issues
relationship between income and cash
submerged assets

102

Over 50%
Consolidation
Might want to consider ROA after
inclusion of unconsolidated subs.

103

Tax Consequences
Under 80%interest or dividends
Over 80%consolidated return

104

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
105

FX-Analyst Issues
Translation adjustments in income?
Difficult to interpret due to limited
disclosure
Significant international variance in
practice

106

Disaggregation of Info.
Disclosure of segments (mgt. Approach)
operating segments
geographic locations
major customers

10% rule
Elements
operating income
sales
assets

107

Why Value Via Cash Flow?

Chapter 11
Cash = ultimate value
Cash = common denominator

108

Economists & Cash Flow

Investors spend cash
Accrual method subject to acctg. Tricks
Mgt. can manipulate earnings

109

Valuation: Cash Flow Based

Periodic cash flows
Residual value
Approximate discount rate
Cost of capital

110

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
111

Periodic Cash Flows, cont.

Appropriately reflect inflation
Nominal vs. real cash

Use after tax amounts

112

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

(discount rate - growth rate)

Consider conversion tables (Stickneyp. 766)

113

Cost of Capital
Debt
Market rate (1-tax rate)
Leases: use borrowing rate

Preferred Equity
Dividend rate

Common Equity
Risk free rate + (Mkt. Rate - RFR)
Betas published in S&Ps stock reports

114

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

115

CAPM Critique
Unstable s
Unstable MROR
Size vs. s

116

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.
117

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

118

Cash Flow Evaluation

Advantages
Economic base
Rigorous methodology

Disadvantages
Residual value dominant
Time consuming
Subjective
119

Price-Earnings Ratio
Chapter 12
Higher risk -> lower PE
Theoretical model
P/Actual earnings = (1+g)/(r-g)

120

Theoretical Variances: PE
Earnings persistance
Transitoryno change in PE
Permanentchange in PE

Accounting principles
Lower earningshigher PE

121

Trending
Penman found transitory earnings
consistencythat is high PE caused
by lower than normal earnings is
counterbalanced in the following
year.
5-7 years reversion to mid-teens
growth
122

PE Ratio Factors

Risk (cost of capital)

Growth
Earnings persistence
GAAP

123

PE Analysis Keys

Use a sustainable growth rate

Doesnt work when g>r
Doesnt work when g approximates r
Test reasonableness with actual PE
Existence of transitory earnings
Impact of GAAP
124

Price to Book Value

Market rewards growth in excess of
cost of capital
Ultimately reverts to 1.0
Function of
Profitability
BV growth

125

P/BV-Theoretical Model
1+ [(Expected ROCE-r)(BVt)/(1+r)t]
BV0

126

Theoretical Variances: P/BV

ROCE errors
Cost of capital errors
Growth rate errors
Transitory earnings
GAAP impact
lower earningshigher P:BV

127

Trending: P/BV
ROCE remains consistent and
reverts to 1.0 slowly.

128

Cash Flow vs. Earnings

Long term impact is indifferent
Short term impact: earnings more
indicative
Use multiple approaches

129