Easton 6E Module 2 (7 Files Merged)

Financial
Statement
Analysis &
Valuation Sixth Edition
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 2
Review of Business Activities
and Financial Statements
© Cambridge Business Publishers, 2021

Learning Objective 1
Examine and interpret
a balance sheet.

Balance Sheet Basics
 The balance sheet has three sections:

 Assets
 Liabilities AKA: Owners’ equity
 Stockholders’ equity Shareholders’ equity
ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY
 The balance sheet reports the assets, liabilities, and

equity at a point in time.
 Balance sheet accounts are permanent accounts
because their balance carries over from period to
period.
© Cambridge Business Publishers, 2021 4
Assets
An ASSET confers expected future economic benefits.
An asset must meet the following two conditions to be

reported on the balance sheet:
1. It must be owned or controlled by the company.
2. It must arise from a past transaction or event.

Apple Inc.
Balance Sheet―Assets

Current Assets
 Cash—currency and bank deposits
 Cash equivalents—investments with an original
maturity of 90 days or fewer
 Short-term investments—marketable securities the
company expects to sell within the year
 Accounts receivable, net—amounts due from
customers arising from the sales on credit
NET: After uncollectible accounts have
been subtracted
 Inventories—goods purchased or produced for sale to

customers
 Prepaid expenses—costs paid in advance for rent,
insurance, advertising, and other services
Long-Term Assets
 Property, plant, and equipment (PPE), net—land,

buildings, and equipment
NET: After accumulated depreciation
has been subtracted
 Long-term investments—investments the company

does not intend to sell within the year
 Intangible and other assets—assets without physical
substance such patents, trademarks, franchise rights,
and goodwill

Measuring Assets
Most assets are reported at historical cost―the original

acquisition cost and NOT at current market value.
 If a company cannot value an asset with relative
certainty, it does not recognize an asset on the
balance sheet.
 This means that significant “assets” are not reflected
on a balance sheet.
 Excluded assets often relate to knowledge-based or
intellectual property (IP) assets, such as a strong
management team, a solid supply chain, or superior
technology.

Effects of “Missing” Assets

Liabilities
Liabilities are future economic sacrifices.
A liability has the following two characteristics:

1. It is an unavoidable obligation for the company
2. It must arise from a past transaction or event
A liability represents an amount that must be repaid

and can be:
1. Interest bearing―as in a bank loan
2. Non-interest bearing―as to a vendor or partner

Stockholders’ Equity
Stockholders’ equity represents capital that has been

invested by the stockholders.
 Directly via the purchase of stock
 Indirectly in the form of retained earnings that reflect
earnings that are reinvested in the business and not
paid out as dividends

Apple’s Liabilities and Equity

Current Liabilities
 Accounts payable—amounts owed to suppliers for goods
and services purchased on credit
AKA: Accrued expenses
 Accrued liabilities—obligations for expenses that have

been incurred but not yet paid (such as wages earned by
employees but not yet paid)
AKA: Deferred revenues
 Unearned revenues—cash received from a customer in

advance for goods or services to be delivered later
 Short-term debt—short-term loans owing to banks or other
lenders AKA: Current portion
 Current maturities of long-term debt—principal portion of

long-term debt that is due to be paid within one year
Net Working Capital
AKA: Working capital
 Net working capital
 The net working capital required to conduct business

depends on the company’s operating cycle, which is
the time between paying cash for goods and
receiving cash from customers.
AKA: Cash Cycle

Cash Conversion Cycle (CCC)

Operating Cycle

Operating Cycle
Companies buy
inventory with cash
and supplier credit
(accounts payable)

Operating Cycle
Companies sell
inventory either on
credit (accounts
receivable) or for cash

Operating Cycle
When receivables are

collected, a portion of the
cash received is used to
repay accounts payable. The
remainder goes to the cash
account for the next
operating cycle.

Operating Cycle

Cash Conversion Cycle
Apple & 3M
 Apple’s cash conversion cycle is negative.

 Apple can invest the cash it receives from customers
for 73.6 days before paying suppliers.
 3M’s cash conversion cycle is positive which is more
typical.

Noncurrent Liabilities
 Noncurrent liabilities—obligations due after one year

 Long-term debt—principal loan amounts that are
scheduled to be repaid more than one year hence
 Long-term debt includes bonds, notes, debentures,
mortgages, and other long-term loans
 Other long-term liabilities—such as pension liabilities
and long-term tax liabilities, that will be settled a year
or more into the future

Contributed Capital
 Common stock—par value received from the original sale

of common stock to investors AKA: Capital in excess of par
 Additional paid-in capital—amounts received from the

original sale of stock to investors in excess of the par value
of stock
 Preferred stock—value received from the original sale of
preferred stock to investors
 Treasury stock—amount the company paid to reacquire its
common stock from shareholders. Treasury shares are
“held” by the company for potential resale on the open
market.

Earned Capital
 Retained earnings—cumulative net income that has not

been distributed to stockholders via dividends or share
repurchases
 Accumulated other comprehensive income or loss—

cumulative changes in asset and liability fair values
that are not reported in the income statement

Analyst Adjustments 2.1

Common Size Balance Sheet
Common Size, aka, Vertical analysis or Right-sizing
 What?
 Expresses the balance sheet in % terms
 Every line item on the balance sheet (A, L & Eq) divided by
total assets
 WHY?
 Compare a company across two or more years
 Compare two or more companies―adjusts for size and currency
differences
 Compare a company to industry or other benchmark

Boston Scientific
Common-Size Balance Sheet

Book Value vs. Market Value
AKA: Book Value
Book value of equity
 Stockholders’ Equity―the “value” of the company per

GAAP AKA: Market capitalization
Market cap
 Market value = Number of common shares outstanding

× Company’s stock price
 Book value ≠ Market value
 GAAP reports assets and liabilities at historical costs, whereas
the market attempts to estimate fair values.
 GAAP excludes assets that cannot be reliably measured.
 Market value adjusts for companies’ market characteristics.
 GAAP does not consider expected future performance.

Market Value vs. Book Value

Examine and interpret
an income statement.

Income Statement
 The income statement reports
 Revenues earned during a period
 Expenses incurred to produce those revenues
 Net income or loss (Revenue – Expenses)
 The general structure of the income statement:

AKA: Net revenue, Sales
AKA: Cost of sales, Cost of revenues
AKA: Earnings before interest and

taxes (EBIT)

Apple’s Income Statement
Operating Expenses
usual and customary
costs a company incurs
to support its
operating activities
Nonoperating
Income / Expenses
relate to the company’s
financing and
investing activities

Accrual Accounting
 Revenues and expenses recognized on the income

statement are NOT determined by the cash received
or paid.
 Two principles are the foundation of accrual
accounting
1. Revenue recognition principle
2. Expense recognition principle

Revenue Recognition Principle
 Recognize revenue when a performance obligation

is satisfied by transferring to a customer a promised
good or service.
 Good or service is transferred when the customer
obtains control of that good or service.
 Revenue is the amount the company expects to
receive.
 Revenue recognition may or may not coincide with
cash received.
1. Revenue recognized & cash received simultaneously
2. Revenue recognized in current period & cash received later
3. Cash received in advance & revenue recognized later
Expense Recognition Principle
 Recognize expenses when incurred

 Expense recognition may or may not coincide with
cash payment
1. Expense recognized & cash paid simultaneously
2. Cash paid in advance & expense recognized later
3. Expense recognized in current period & cash paid later

Income Statement
 The income statement reports
 Revenues earned during a period
 Expenses incurred to produce those revenues
 Net income or loss (Revenue – Expenses)
 The general structure of the income statement:

Discontinued Operations
 Discontinued operations―A disposal of a business unit

that represents a strategic shift that has, or will have,
a major effect on the company’s financial results
 Two components on the income statement (often
combined)
1. Net income / loss from the business prior to sale
2. Any gain or loss on the actual sale of the business
 Segregating Discontinued operations from Continuing
operations helps analysts to better isolate the core
reoccurring profit and cash flow of the business.


Adjusting for
Should we treat these items as Operating or Nonoperating?
 “Operating”
 The subsidiary has historically been treated as an operating
asset
 Any income, gain, or loss should also be treated as operating
 “Nonoperating”
 The subsidiary ceases to be part of the company’s operations
once the decision is made to dispose of it
 Any income, gain, or loss is not core operating income
 Cash flow from the discontinued operations will not persist into
the future
Analyst Adjustments
 Discontinued operations at Eli Lilly in 2018 and 2019
 Analysts would NOT expect the huge 2019 gain to

recur
 Would treat the entire amount as nonoperating

Two Important Margins
 Gross profit margin (Gross profit / Sales)

 The gross profit margin is influenced by both the selling price of
the company’s products and the cost to make or buy those
products.
 Operating expense margins (Operating expense/Sales)

 Analysis of operating expenses over time and compared with
peer companies.


Common Size Income Statement
AKA, Vertical Analysis or Right-Sizing.
 What?
 Every line item on the income statement divided by total
revenue
 Express the income statement in % terms
 WHY?
 Compare a company across two or more years
 Compare two or more companies―adjusts for size and currency
differences
 Compare a company to industry or other benchmark

Boston Scientific
Common-Size Income Statements

Examine and interpret a
statement of stockholders’ equity.

Statement of Stockholders’ Equity
Statement of stockholders’ equity reconciles the beginning

and ending balances of stockholders’ equity accounts.
 Common stock and additional paid-in capital increase by

the proceeds from the sale of stock.
 Retained earnings increase by net income and decrease
by dividends to shareholders and by stock repurchased
and retired.
 Accumulated other comprehensive income increases and
decreases by changes in asset and liability fair values that
are not reported in the income statement.

Apple’s Liabilities and Equity

Apple’s

Describe a statement of cash flows.

Statement of Cash Flows
 The income statement measures income using GAAP

principles and provides information about the
economic viability of the company’s products and
services.
 The statement of cash flows provides information
about the company’s ability to generate cash from
those same transactions.

Statement of Cash Flows Format
 Cash flows from operating activities―cash flows from

the company’s transactions and events that relate to
its operations
 Cash flows from investing activities―cash flows from
acquisitions and divestitures of investments and long-
term assets
 Cash flows from financing activities―cash flows from
issuances of and payments toward borrowings and
equity

Apple’s Statement of Cash Flows
AKA: Total cash flow

Apply linkages among the four
financial statements.

Financial Statement Linkages
AKA, Financial Statement Articulation.
 What?
 Connections among the four financial statements that link
activity during the period to the balances at the beginning and
end of the period
 WHY?
 Point out the interconnection among profit, cash flow and the
balance sheet
 Help managers and external financial statement users assess
the impact of potential transactions

Financial Statement Linkages

Explain the accounting cycle,
and apply the financial statement
effects template to analyze
accounting transactions.

Four-Step Accounting Cycle
 Step 1 Record transactions in the accounting

records
 Step 2 Prepare accounting adjustments to

recognize a number of events that have
occurred but that have not yet been
recorded
 Step 3 Construct the financial statements
 Step 4 Close the books in anticipation of the start

of a new accounting cycle

Financial Statement Effects Template
(FSET)
 Simple way to capture transactions

 Template captures all four financial statements
 Powerful way to consider potential (“what-if”)
transactions and the effect on financial reports

Apple FSET 2017-2018
For each transaction, we ask these three questions:
 What accounts are affected?

 What is the direction of the effect?
 What is the amount of the effect?

Prepare and explain
accounting adjustments and
their financial statement effects.

Accounting Adjustments
Companies make accounting adjustments so that

financial statements are accurate and complete.
 For example, employees might have earned wages during
an accounting period but not been paid before the end of
the period.
 Failure to recognize the wages owed would understate
liabilities (because wages payable would be too low) and
would overstate net income for the period.
(because wages expense would be too low)
 Both the balance sheet and the income statement
would be inaccurate.
 SO, the company makes an accounting adjustment.

Four Types
of Accounting Adjustments
 Prepaid (deferred) expenses―advance cash payments that will

ultimately become expenses
 Unearned (deferred) revenues―cash received from customers
before any services or goods are provided
 Accrued expenses―expenses incurred and recognized on the
income statement even though cash has not been paid yet
 Accrued revenues―revenues earned and recognized on the
income statement even though cash is not received yet
Prepaid (Deferred) Expenses

Unearned (Deferred) Revenues

Accrued Expenses

Accrued Revenues

Four Types
of Accounting Adjustments
 Prepaid (deferred) expenses―advance cash payments that will

ultimately become expenses
 Unearned (deferred) revenues―cash received from customers
before any services or goods are provided
 Accrued expenses―expenses incurred and recognized on the
income statement even though cash has not been paid yet
 Accrued revenues―revenues earned and recognized on the
income statement even though cash is not received yet
Construct financial statements
from the accounting records.

Constructing
the Financial Statements
 When all transactions and adjustments have been

recorded in the FSET, sum each column to obtain
ending balances.
 Prepare financial statements in this order:
1. Income statement
2. Statement of stockholders’ equity―including the retained
earnings reconciliation
3. Balance sheet
4. Statement of cash flows

Apple’s Income Statement
 Apple’s income statement accounts are in the last
three columns of the FSET.
 We use the data from those columns to prepare the
income statement.

Apple’s
Retained Earnings Reconciliation
Update the retained earnings balance:
 Add net income
 Subtract dividends
 Subtract any stock repurchased and retired

Apple’s
We use the information from the contributed capital
and earned capital columns in the FSET to prepare the
statement of stockholders’ equity.

Apple’s Balance Sheet
 Use the ending balances from the last row in the FSET.
 Balance sheet accounts are called permanent
accounts because their respective balances carry
over from one period to the next.

Explain and apply
the closing process.

The Closing Process
 AKA, Closing the books.
 The closing process―“zeroing out” of the temporary

accounts by transferring their ending balances to
retained earnings
 Revenues, expenses, and dividends are temporary
accounts because the balance at the start of each
accounting period is $0 so that only the current
period’s activities are included in the total amount.
 Balance sheet accounts are permanent accounts
and do NOT CLOSE each period.

The Closing Process
FSET vs. Practice
Closing Process: FSET
 The FSET and T-accounts are pedagogical tools that represent
transactions’ effects on financial statements.
 The FSET is highly stylized, but its simplicity is instructive.
 Each transaction and adjustment is automatically transferred to retained
earnings―no additional closing process.
Closing Process: Practice

 Journal entries capture transactions and adjustments.
 Retained earnings are not continuously updated.
 Companies use a formal “closing process” at the end of each reporting
period.
Journal Entries
Debit Credit Debit Credit Debit Credit

1. Close Revenue and Gain Accounts

2. Close Expense and Loss Accounts

3. Close Dividend Accounts

Locate and use additional
financial information
from public sources.

Additional SEC Information
 Form 10-K / 10Q
 Annual / quarterly report
 Form 20-F
 Non-GAAP or IFRS companies’ annual report, provides a table that
reconciles net income as reported to U.S. GAAP net income.
 Form 40-F
 Same as 20-F but for Canadian companies
 Form 8-K
 Wide range of corporate events, reported within 4 days
 Entry into or termination of a material definitive agreement (including petition
for bankruptcy)
 Exit from a line of business or impairment of assets
 Change in the company’s certified public accounting firm
 Change in control of the company
 Departure of the company’s executive officers
 Changes in the company’s articles of incorporation or bylaws
Other Information Sources
 Equity Analyst Reports―sell-side analysts provide clients with:

 Objective analysis of company activities
 Forecasts for revenues and EPS
 Stock price target
 Credit Reports―credit rating agencies provide:

 Objective credit analysis that evaluates a company’s creditworthiness
 Credit rating (alphanumeric score)
 Data Services―a number of companies supply financial

statement data in easy-to-download spreadsheet formats

Global Accounting
GAAP vs. IFRS
 Balance Sheet―the most visible difference is that

many IFRS-based balance sheets are presented in
reverse order of liquidity.
 Income Statement―the most visible differences are:
 GAAP requires three years’ of data on the income statement
whereas IFRS requires only two.
 IFRS firms can classify expenses by function (cost of sales,
SG&A, R&D, etc.) or by type (raw materials, labor,
depreciation, etc.)

Financial
Statement
Analysis &
Cambridge Business Publishers

www.cambridgepub.com
Financial
Statement
Analysis &
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 11
Financial Statement
Forecasting

Explain the process of
forecasting financial statements.

Forecasting Process
 Forecasting financial performance is integral to a

variety of business decisions.
 Managers, investors and others forecast future
financial statements to:
 Value stocks and inform investment decisions
 Evaluate the creditworthiness of a prospective borrower
 Determining bond ratings
 Evaluate alternative strategic investment decisions
 Assess the shareholder value created by strategic investments
 All of these decisions require accurate financial

forecasts.

Adjusted Financial Statements
 The forecasting process begins with a retrospective analysis.

 We adjust financial statements to ensure they accurately
reflect the company’s financial condition and
performance.
 Because we seek to forecast future income and cash flow,
we first identify and eliminate transitory items including:
 Restructuring expenses
 Litigation expenses
 Discontinued operations
 Gains and losses on asset dispositions and impairments
 Unusual income tax expense or benefit
 Acquisitions and divestitures

Forecasting Order and Mechanics
 We forecast future income statements, balance sheets,
and statements of cash flows, in that order.
 The revenues forecast is the most crucial in the forecasting
process because other income-statement and balance
sheet accounts derive from the revenues forecast.

Forecasting
Consistency and Precision
It is important to keep two points in mind:
 Internal consistency
 The forecasted financial statements are linked in the same way
historical financial statements are—they must articulate within and
across time.
 We also must ensure that our forecast assumptions are internally
consistent.
 Level of precision
 Computing forecasts to the “nth decimal place” is easy and might
appear to make the resulting forecasts appear more precise, but
they are not necessarily more accurate.
 Decisions that depend on a high level of forecasting precision are
ill-advised.

Company Guidance
 Companies frequently provide guidance for forecasting
purposes.
 For example―P&G provided the following sales growth
guidance that we can use to inform our revenue forecast
assumptions:
 We use 3.5% growth, the midpoint of the range, in our

forecasting process.
Company Guidance
 P&G also provides guidance regarding anticipated capital
spending (CAPEX), dividends, and share repurchases:
 We use this guidance to produce the following forecasts:

 CAPEX as 4.75% of sales
 Dividends of $7.5 billion
 Share repurchases (treasury stock purchases) of $7 billion

Forecast revenues
and the income statement.

Forecasting the Income Statement
Overview
 We forecast the Income Statement first.
 Sales estimate―for P&G we use 3.5% (from company
guidance)
 Expense estimate
 COGS―as a % of sales
 SG&A―as a % of sales
 Nonoperating expenses―assume no change and adjust later
 One-time items―assume the items will not recur

 Income tax―as a % of pre-tax income (from company
guidance)
 Noncontrolling interest―no change in historic ratio

P&G’s Forecasted
2020 Income Statement

Forecasting Cost of Goods Sold
 Start with historic ratio of COGS / Sales.
 Companies often discuss COGS in the MD&A to provide
insight into recent trends, anticipated effects of planned
restructuring, or product mix changes.
 For example P&G reports:
 For P&G, we use the FY2019 rate of 51.4% to forecast

FY2020.
Forecasting SG&A
 To forecast SG&A expense, we start with historic ratio of
SG&A / Sales and then check the MD&A:
 We use the FY2019 percent of 28.2% because the MD&A

includes no significant operational changes to SG&A.
Forecasting Interest Expense
Interest expense
= Average debt balance × Estimated interest rate
 For 2019 P&G reported $509M interest expense and average

debt of $30,689M.
 We calculate an estimated rate = $509M / $30,689M = 1.7%
 We apply the average FY2019 rate to the expected FY2020
debt.
 FY2019 debt – Expected FY2020 repayments = $20,704M

Forecasting Income Tax Expense
 We estimate tax expense using an estimated tax rate.
 For FY2020, we use an effective rate of 17.5% from PG’s
guidance.
 In the absence of company guidance, we use tax
footnotes:
 Given that the Goodwill impairment is a one-time

occurrence, and Stock option taxes and “Other” are so
volatile, we might forecast a tax rate of 20.2%
(21% - 0.5% - 0.3%).
Impact of Acquisitions
 When one company acquires another, the revenues and
expenses of the acquired company are consolidated, but
only from the date of acquisition onward.
 Acquisitions can greatly impact the acquirer’s income
statement and distort the growth rates that we compute.
 P&G acquired Gillette in October 2005.
Growth = 20.2%
 20.2% is incorrect because 2006 Net sales include Gillette
sales for 8 months and 2005 Net sales include NO Gillette
sales.
Impact of Acquisitions
 Until all three income statements include the acquired

company, the acquirer must disclose what revenue and net
income would have been.
 For example, P&G disclosed the following re: Gillette
Sales Growth = 4.5%

Impact of Divestitures
 When companies divest of discontinued operations,

they are required to:
 Exclude sales and expenses of discontinued operations from
continuing operations.
 Separately report net income from the discontinued operations
on one line.
 Report any gain/loss on the disposal.
 Report discontinued assets and liabilities on separate line items,
labeled “held for sale”.
 We assume these discontinued operations will be sold
in the coming year and we forecast zero balances for
them.
Forecast the balance sheet.

Forecasting the Balance Sheet
Overview
Here is an overview of balance sheet forecasting:
 Working capital accounts―as a % of sales
 PPE―increase estimated CAPEX and reduce by forecasted
depreciation expense
 Intangible assets―subtract forecasted amortization expense
 Current and long-term debt―assume company makes all
contractual payments of long-term debt, assume total debt
remains unchanged
 Stockholders’ equity―assume no change for paid-in capital
accounts except for stock-based compensation and planned
treasury stock transactions
 Retained earnings―increase by forecasted net income and
reduced by estimated dividends
Forecasting Working Capital
 We use each working capital item’s historical relation

to sales to forecast the item for next year.
 We use this approach for P&G for seven working

capital accounts.
 We assume that nonoperating will remain unchanged.
 Where provided, we use company guidance such as
with debt due within one year.

Forecasting PPE
 For P&G, we use the guidance about anticipated

purchases of PPE assets (called capital expenditures or
CAPEX).
 P&G expects fiscal 2020 CAPEX to be 4.5% to 5% of sales.

 We use the midpoint of 4.75% of sales and forecast CAPEX
of $3,328 million ($70,053 million of forecasted sales × 4.75%).
Forecasting PPE
 Absent CAPEX guidance, we can use the following
approach:
Also consider additional CAPEX We use PRIOR year PPE to measure

expansion plans in MD&A historical depreciation rate

Forecasting Intangible Assets
 Analysts typically forecast intangible assets to decrease

during the year by the amount of amortization.
 It is common to assume no change in amortization expense
from the prior year.
 If the company provides guidance about amortization
expense, like P&G does, we can consider using it.
 For P&G, we forecast 2020 intangible assets to be $359

lower than in 2019.

Forecasting Long-Term Debt
 Companies report maturities of long-term debt for the next
five years in debt footnote, which we use to forecast
long-term debt.
 P&G’s footnote provides the following details
 To forecast debt we make the following three adjustments:

1. Subtract $3,388M from debt due within one year
2. To reclassify long term debt, we add $2,009 M to debt due within 1
year
3. Subtract $2,009M from long-term debt to reflect the reclassification

Forecasting Dividends
and Retained Earnings
 We forecast retained earnings as follows:
 This approach uses historic dividend payout ratio.

 This might not be accurate if there were large one-time
items in the prior year—in that case:
 Adjust for one-time items and recalculate payout
 Use company guidance $7,500
 Use historic dividend per share data and current shares
outstanding.
Forecasting Equity and Treasury Stock
 Assume no change for common stock (par) and additional

paid-in capital unless MD&A suggests otherwise.
 If a company uses stock-based compensation we add
the fair-value of anticipated awards to additional paid-in
capital.
 For treasury stock, we proceed as follows:
 Many companies disclose multiyear stock repurchase programs in
footnotes or in the MD&A.
 If a company provides guidance, we can use that to forecast
repurchases.
 Absent explicit disclosures or guidance, we can forecast future
repurchases using historic data, either from the most recent year or by
looking for a trend over the past two or three years.

Forecasting Cash
 We forecast cash last as the amount that balances the
balance sheet after we have forecast all other items.
 We assess the forecasted cash balance and determine if
it deviates from the historical cash-to-sales percentage.
 If cash forecast is higher than normal:
 Increase marketable securities
We should attempt
 Reduce debt
to maintain the historic
 Forecast additional stock repurchases debt-to-equity ratio
 Increase dividend payments when we forecast
 If cash forecast is lower than normal: additional borrowing,
debt repayment,
 Sell marketable securities
stock sales, or
 Increase debt
stock repurchases.
 Decrease dividend payments

P&G’s Forecasted 2020 Balance Sheet

Prepare forecasts using
segment data.

Forecasts from the Bottom Up
 The sales forecast that we illustrate above relies on

company guidance to form assumptions and
estimates.
 An alternative approach that financial analysts
typically use relies on information from conference
calls with company management and other
proprietary data sources.
 Analysts often prepare separate sales forecasts for the
company’s business segments and then sum up the
segment sales to arrive at the overall sales estimate.

Segment Data and Sales Forecasts
 Companies report financial data
for each operating segment.
 P&G’s segment disclosure
includes current and historical
data for each of its five operating
segments.
 These disclosures provide a
wealth of information that we
can use to separately forecast
sales for each operating
segment.
 Sales of forecasts are more
accurate when they incorporate
all available data.
Morgan Stanley Sales Forecasts
 Morgan Stanley analysts forecast organic sales growth for
each of P&G’s segments by considering
 Effects of changes in unit volume
 Effects of expected price increases
 Effects of expected changes in product mix
 Morgan Stanley
forecasts a 4.7% growth
for Beauty segment:

Forecast
the statement of cash flows.

Forecasting the SCF
The Process
 The process begins with net income, adds back or

deducts any noncash expenses or revenues.
 Then we determine the cash flow effect of changes
in working capital accounts as well as in the remaining
asset, liability, and equity items.
 A common method is to compute changes in each
line item on the forecasted balance sheet and classify
changes as:
 Operating
 Investing
 Financing

P&G’s Forecasted
2020 Statement of Cash Flows
Significant
use of cash

Prepare multiyear forecasts
of financial statements.

Multiyear Forecasting
 Multiyear forecasting proceeds in the same way as for one-
year forecasting.
 Analysts typically need multiyear forecasts to:
 Value a firm’s equity or determine enterprise value
 Assess a company’s ability to repay its debt
 Assign credit ratings to firms
 Managers typically use multiyear forecasts for:

 Cash flow budgets
 Capital expenditure plans
 Divestiture decisions
 Mergers and acquisitions

Normal Cash Balance
 We balance the balance sheet with a “plug” to the cash

account and then adjust cash to a normal balance.
 For example, for P&G in FY2020:
 FY2019 cash of $4,239 million is 6.3% of reported sales of $67,684M.
 Maintaining the same proportion, the target level of cash will be
$4,413M (forecasted FY2020 sales of $70,053M × 6.3%).
 Forecasted cash balance is $(1,550)million.
 Consequently, we assume additional borrowing of $6,000 million
(rounded up) to achieve a 6.3% cash-to-sales percentage.

P&G’s Forecasted
2021 Income Statement

P&G’s Forecasted
2021 Balance Sheet

Forecasting Sensitivity
 Analysts commonly perform a sensitivity analysis of
their forecasts.
 Typically, analysts prepare additional forecasts
(characterized as Bull and Bear scenarios) and
present these together with their “most likely” scenario
forecasts.
 The forecasted cash flow (and resulting stock price
estimates) are recomputed under these additional
assumptions.
 This sensitivity analysis allows analysts to develop a
possible range of stock prices that are included in their
analyst’s report.
Apply a parsimonious method
for forecasting net operating profit
and net operating assets.

Parsimonious Method
 The parsimonious method requires three crucial inputs:

 Sales growth rate
 Net operating profit margin (NOPM) = NOPAT / Sales
 Net operating asset turnover (NOAT) = Sales / YEAR-END NOA
 We forecast Sales and then forecast NOPAT and NOA

as follows:
Forecasted NOPAT = Forecasted sales × NOPM
Forecasted NOA = Forecasted sales / NOAT

P&G Multiyear
Parsimonious Forecast
 Each year’s forecasted sales is the prior year sales multiplied

by (1 + growth rate) and then rounded to whole digits.
 We use rounded sales and historical NOPM and NOAT to
forecast NOPAT and NOA.

Financial
Statement
Analysis &

Financial
Statement
Analysis &
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 4
Credit Risk Analysis
and Interpretation

Describe the demand for
and supply of credit.

Market for Credit
 Companies demand credit for operating, investing,

and financing activities.
 Many parties offer credit including:
 Trade creditors
 Banks
 Public debt investors
 Private lenders
 Laws of demand and supply affect the credit market.

Demand for Credit―
Operating Activities
 Operating credit demand can be a routine low risk

need created by:
 Cyclical operating cash needs such as materials or labor
 Advance seasonal purchases
 Or operating credit demand could signal higher risk

 When used to cover operating losses
 A willing creditor could make the difference between

bankruptcy and continued operations for a company.

Investing Activities
 Companies require large amounts of cash for

investing activities such as the purchase of property,
plant and equipment or for corporate acquisitions.
 Needs can vary in timing and amount.
 Long-term debt routinely used for start-up and growth
 Mature firms settle into predictable capital

expenditure patterns and credit demands.

Financing Activities
 Occurs less frequently than operating and investing

activities.
 Common situations
 A bank loan or bond comes due and a company does not
have the necessary funds on hand.
 Funds to pay dividends or repurchase stock

Supply of Credit―
Trade Credit
 Trade credit from suppliers is routine and most often

non-interest bearing.
 Suppliers’ credit terms specify
 The amount and timing of any early payment discounts
 The maximum credit limit
 Payment terms
 Other restrictions or specifications.
 Suppliers often tailor contractual terms to particular

customer’s existing and ongoing creditworthiness.

Supply of Credit―
Bank Loans
 Structured to meet specific client needs
 Balanced with myriad of rules and regulations by regulators
 Revolving credit line
 Cash available on demand, balance fluctuates
 Floating interest rate
 Letters of credit
 Bank is interposed between the company and its supplier
 Bank provides a guaranty of payment
 Term loans
 A set loan amount (principal) with specified periodic payments
 Interest rates are either fixed or floating for duration of the loan
 Mortgages―term loan based on collateral, typically
real estate
Supply of Credit―
Other Forms of Financing
 Nonbank private financing

 Used when bank financing is limited or unavailable
 Provided by private lenders that have experience in industry
 Lender creatively structures loan repayment and may act as a
management consultant
 Lease financing
 Typically used for PPE acquisition
 Leasing firm considers credit risk of the lessee and collateral

Supply of Credit―
Publicly Traded Debt
 Efficient way to raise funds in public markets
 Regulated by the SEC even if the company’s stock
does not trade publicly.
 Commercial paper
 Short-term borrowing, 270 days or less
 Makes it exempt from SEC regulation
 Bonds or debentures
 Public borrowings for longer durations
 Regulated by the SEC
 Principal borrowed is paid back on a fixed term with semi-
annual or annual interest payments.
Explain the credit risk analysis
process.

Credit Risk Analysis Process
 Purpose of credit risk analysis is to quantify potential
credit losses so lending decisions are made with full
information.
 Expected credit loss is the product of two factors:
Debtor’s ability Size of loss if

to repay the debt debtor defaults
 Many parties perform credit risk analysis:

 Trade creditors
 Financial institutions
 Public debt market participants
 Credit rating agencies
Chance of Default
 Purpose is to quantify the risk of loss from non-

payment.
 Chance of default depends on the company’s ability
to repay its obligations and this depends on future
cash flow and profitability.
 Involves several steps:
 Step 1 Evaluate the nature and purpose of the loan
 Step 2 Assess macroeconomic environment and industry
conditions
 Step 3 Perform financial analysis
 Step 4 Perform prospective analysis

Step 1
Evaluate Nature and Purpose
of the Loan
 Must determine why the loan is necessary.

 Nature and purpose of the loan affect its riskiness.
 Possible loan uses:
 Cyclical cash flow needs
 Major capital expenditures or acquisitions
 Fund temporary or ongoing operating losses
 Reconfigure capital structure

Step 2
Assess Macroeconomics Environment
and Industry Conditions
 Industry competition―Competition and rivalry raise the cost
of doing business
 Bargaining power of buyers―Buyers with strong bargaining
power can extract price concessions
 Bargaining power of suppliers―Suppliers with strong
bargaining power can demand higher prices
 Threat of substitution―As the number of product substitutes
increases, sellers have less power to raise prices and/or pass
on costs to buyers
 Threat of entry―New market entrants increase competition
and companies must develop new technologies and
human capital to create barriers to entry and economies
of scale
Step 3
Analyze Financial Ratios
 Financial ratios play a key role in credit-risk analysis. There is

no general agreement about the best set of ratios to use
to assess credit risk.
 Also there is not one “correct” way to calculate specific
ratios.
 For our purposes, we compute three classes of credit-risk
ratios:
 Profitability and coverage
 Liquidity
 Solvency

Step 4
Perform Prospective Analysis
 To evaluate creditworthiness, creditors must forecast the

borrower’s cash flows to estimate its ability to repay its
obligations.
 Projected cash flows are especially critical because a
company must have sufficient cash in the future to:
1. Repay debts as they mature
2. Service those debts along the way
 Must first project (forecast) financial statements
 Then we can use forecasted numbers to compute future
ratios (profitability, liquidity, and solvency) and coverage
ratios and evaluate changes or trends.

Loss Given Default (LGD)
 LGD―the amount that could be lost if the company

defaulted on its obligations
 Defaults include failure to make payments and violation of
loan covenants.
 Potential loss depends on priority of the claim compared
with all other existing claims.
 Companies must repay senior claims first.
 U.S. Bankruptcy Code specifies the priority of other claims.
 To minimize potential loss, lenders structure credit terms
including:
 Credit limits
 Collateral
 Repayment terms
 Covenants

Loss Given Default Factors
Credit Limits
 Credit limits represent the maximum that a creditor will
allow a customer to owe at any point in time.
 Limits are based on the lender’s experience with similar
borrowers and by firm-specific analysis.
 Trade creditors
 Set low limits for new customers and higher limits for established
customers.
 Bankruptcy laws protect ordinary trade creditors: goods shipped to
a customer within 20 days before the bankruptcy have higher priority
for payment.
 Banks
 Set credit limits on revolving credit.
 Specify that if a borrower’s credit rating falls, credit limit may be
reduced.
Collateral
 Collateral is property pledged by the borrower to
guarantee repayment, most often real estate.
 A full credit analysis should include an assessment of the
number of existing liens on the collateral.
 Bankruptcy laws protect ordinary trade creditors―seller
can reclaim goods shipped within 45 days before
bankruptcy to settle an unpaid balance.
 Collateral will limit the amount of the loss but amounts
owing in excess of the fair-value of the collateral will be
lost.
 Given a default, the time and costs incurred to gain
control of and liquidate collateral can be substantial.
Repayment Terms
 Term of loan is the length of time the creditor has to repay
the debt.
 Early payment discounts often offered by trade creditors.
 To assess LGD must consider whether the economic life of
the asset matches or exceeds the loan term.
Greater Greater Higher cost

Longer
chance of credit of debt
terms
default risk financing

Covenants
 Covenants are loan terms and conditions designed to
limit the loss given default.
 Three common types of covenants:
 Those that require the borrower to take certain actions, such as
submitting financial statements to the lender.
 Those that restrict the borrower from taking certain actions, such as
preventing mergers or other major investments.
 Those requiring the borrower maintain specific financial conditions,
including certain ratios and minimum equity.

Compute and interpret credit risk
measures.

Adjusting Financial Information
 Analysts scrutinize current and prior years’ financial

statements to ensure they accurately reflect the company’s
financial condition and operating performance.
 General-purpose GAAP financial statements prepared in
conformity with do not always accurately reflect our
estimate of the “true” financial condition and operating
performance.
 Before we begin the analysis process, we make appropriate
adjustments.
 For example, we adjust Home Depot’s February 2019
income statement to “undo” the effects of a 53rd week in
their fiscal year.

Adjusting Financial Information
Home Depot

 Retailers’ typically have a 53rd week every 4-5 years.

 We must adjust all affected income statement numbers.
 Adjust sales and expenses that vary proportionately with sales (such as
cost of sales and SG&A) by multiplying by 52/53
 We do not adjust other expenses that are measured annually (such as
interest, depreciation, and gains or losses)
 We adjust tax expense proportionately based on effective tax rates
(Tax expense / Pretax income)
 For Target Corp, trends in total revenue and cost of sales

are more obvious when we use adjusted numbers.
 Unadjusted numbers:
 Adjusted numbers:

Profitability Analysis
 Profitability is related to credit risk because firms pay

interest and repay their debt with cash generated
from profits.
 The more profitable the firm, the less likely it is to
default.
 We can disaggregate ROE to assess profitability:

Profitability Analysis
Home Depot
 For Home Depot using numbers reported:
 Home Depot’s 2019 ROE is negative due to negative

stockholders’ equity owing to large levels of treasury stock.
 2017 and 2018 ROE is very high because treasury stock
reduced stockholders’ equity to a small number and
inflated ROE.
 Adjust equity by adding back the treasury stock book value.

Expanded Profitability Analysis
 RNOA is an aggregate measure of the return from
operating activities and is a comprehensive profitability
measure.
 RNOA is not affected by the company’s leverage or
treasury stock activity.
 Home Depot:

Coverage Analysis
 Considers a company’s ability to generate additional

cash to cover principal and interest payments when
due.
 Called “flow” ratios because they consist of cash flow
and income statement data.
 There are MANY coverage ratios including:
 Times interest earned
 EBITDA coverage ratio
 Cash from operations to total debt
 Free operating cash flow to total debt

Times Interest Earned Ratio
 Reflects the operating income available to pay interest

expense
 Assumes only interest must be paid because the principal
will be refinanced
 For Home Depot:
Home Depot
can cover its
interest expense
14.5 times over.

 Credit analysts adjust or reformulate companies’ financial

statements prior to ratio analysis.
 Moody’s adjusts a number of items and these are typical for
credit analysts.

EBITDA Coverage Ratio
 EBITDA is a non-GAAP performance metric.

 More widely used than the times interest earned ratio
because depreciation and amortization do not require a
cash outflow.
 Always higher than times interest earned ratio.
 Measures company’s ability to pay interest out of current
profits.
 For Home Depot: Depreciation and
amortization from the
statement of cash flows.

Income Coverage Ratios
Home Depot

Coverage Analysis
Based on Cash Flow
 Cash from operations to total debt measures the

ability to generate additional cash to cover debt
payments as they come due.
 Free operating cash flow to total debt considers

excess operating cash flow after cash is spent on
capital expenditures.

Cash Flow Coverage Ratios
Home Depot

Liquidity Ratios
Liquidity refers to cash availability―how much cash a

company has, and how much it can generate on short
notice.
Assets a company expects
to convert into cash
within a year.
Liabilities that come due

within a year.

Liquidity Ratios
Home Depot

Solvency Ratios
Solvency refers to a company’s ability to meet its debt

obligations.
 Solvency is crucial―an insolvent company is a failed
company
 Two common solvency ratios:
How reliant a company is
on creditor financing compared
with equity financing
Distinguishes between operating creditors

and debt obligations

Solvency Analysis
 Solvency varies by industry and depends on the
relative stability of cash flows.

Solvency Analysis
Home Depot
Recall that Home Depot has negative equity and in

such situations ratios should be calculated on RESTATED
numbers for better comparability.

Describe the credit rating process
and explain why companies are
interested in their credit ratings.

Credit Ratings
 A credit rating is an opinion of an entity’s creditworthiness,
captured in alpha-numeric scales.
Investment
Grade
Non-investment
Grade

Credit Rating Analysis
 Credit analysts at rating agencies:

 Consider macroeconomic, industry, and firm-specific information
 Assess chance of default and ultimate payment in the event of default
 Provide ratings on both debt issues and issuers
 Predict loan default with fair degree of accuracy

Credit Rating Process
 Every agency has a unique approach.
 Moody’s process involves the following 9 steps:

Bond Rating Distribution
 Evidence suggests companies try to maintain investment
grade bond ratings (above BB+).
Appears that BB+

and BB are lower
than expected
Ratings AAA through BBB- account

for 55% of all corporate issuers

Ratio Values for Different Risk Classes
of Corporate Debt
 Debt is increasingly more risky as we move from the

first row to the last.
 For the most part, ratios weaken from row to row.

Credit Rating Agency Reform Act
 Signed into law in 2006
 Establishes a registration system for credit rating
agencies
 Allows experienced agencies to register with the SEC
 Created list of Nationally Recognized Statistical Ratings
Organizations (NRSRO)
 SEC has designated only 9 of nearly 100 agencies as
NRSROs:

Apply bankruptcy prediction models
to evaluate bankruptcy risk.

Bankruptcy Prediction Indicators
 Assess a company’s bankruptcy risk
 Altman’s Z model used to predict bankruptcy risk
Working Capital Retained Earnings

Z-Score = 1.2 x + 1.4 x
Total Assets Total Assets
Market Value of
EBIT
+ 3.3 x + 0.6 x Equity
Total Assets Total Liabilities
Sales
+ 0.99 x
Total Assets

Z-Score Interpretation
 Shown to reasonably predict bankruptcy accurately

for up to two years
 95% accuracy in Year 1
 72% accuracy in Year 2

Application of Z-Score
Home Depot’s financial statement information for year

ending February 3, 2019.
Z-Score > 3.00

HD is healthy.
Low risk of
bankruptcy in
the short term.

Financial
Statement
Analysis &

Financial
Statement
Analysis &
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 5
Revenues, Recognition,
and Operating Income

Apply revenue recognition
principles and assess results.

Pfizer’s Income Statement

Revenue Recognition Rule
General
 Financial Accounting Standards Board (FASB) Revenue

Recognition rules effective for fiscal year ends
beginning after December 15, 2017 (or earlier if
companies choose)
 The general revenue recognition principle:
 Recognize revenue when the company transfers the good or
service to the customer
 When the customer obtains control of the good or service
 It is not necessary to receive cash to recognize revenue.

Sales on Credit
 Many sales are on credit, meaning the customer has

agreed to pay the company in the future.
 The company recognizes revenue when the good or
service is transferred to the customer, and records an
account receivable to be collected later.
 Revenue recognition is unaffected by the delayed
receipt of cash if the company has fulfilled its
performance obligation.

5 Steps
1. Identify the contract(s) with the customer
 Parties to the contract should be identifiable.
 Terms of the sale should be specified.
2. Identify the performance obligation(s) in the contract

 Performance obligation is a contractual promise to transfer a good
or service to the customer.
 For contracts with more than one good or service, company must
identify separate performance obligations for each contractual
promise.
3. Determine the transaction price
 If the purchase price is variable, estimate revenue using the
expected purchase price.

5 Steps
4. Allocate the transaction price to the performance
obligation(s)
 For contracts with more than one performance obligation,
allocate the transaction price to each performance obligation at
its fair value (standalone selling price).
 If standalone prices are not available, use a reasonable estimate of
the selling price.
5. Recognize revenue as/when each performance
obligation is satisfied
 Performance obligation is satisfied when the customer obtains
control of the goods or services.
 Performance obligations satisfied over a period of time should be
recognized as revenue over time.

Revenue Recognition
Pfizer
Chargebacks, rebates, sales allowances and sales

returns are deducted from GROSS REVENUE.

Complications
of Revenue Recognition
 Nonrefundable up-front fees―recognize as revenue when
the goods or services are provided
 Bill-and-hold arrangements―recognize when control of the
goods transfers to the customer
 Consignment sales―recognize commission when goods are
sold
 Licenses―revenue recognition depends on the contract
 Right to use―recognize revenue when the customer can first use the
licensed IP
 Promise of access―recognize over a period of time
 Franchises―recognize revenue as goods or services are

delivered
Complications
of Revenue Recognition
 Variable consideration―recognize the expected amount to
be received when goods or services are provided
 Multiple element contracts―multiple performance
obligations
 Distinct goods and services sold for one price
 Performance obligations fulfilled at various points in time
 Recognize revenue as / when each performance obligation is satisfied
 Right of return―estimate the expected return and recognize

NET revenue when control of the goods transfers to the
customer
 Gift cards―recognize when gift card is used or expires

Performance Obligations
Satisfied Over Time
Cost-to-Cost Method
 Recognize revenue as a proportion of total costs incurred to
fulfill the contract.
 For example, if 15% of the total expected cost to create the
product are incurred in the current period, 15% of contract is
recognized as revenue.
 Consider Raytheon’s 2018 disclosure:

Cost-to-Cost Method
Example
Assume the following facts:
 Raytheon signs a $10 million contract
 Construction will take 2 years and cost $7.5 million
 Costs incurred
 Year 1: $4.5 million
 Year 2: $3 million

Cost-to-Cost Method
Example
Revenue and expenses recognized as follows:

Cost-to-Cost Method
Example
Raytheon’s reported revenues and expenses for Years 1 and 2:
 Note that cash collected from the customer may or may not
coincide with the revenue recognized.
 Raytheon discloses these timing differences in footnotes:

Cost-to-Cost Method
Example
Raytheon’s balance sheet includes:
 Receivables (revenues earned and billed to the customer)
 Contract assets (costs incurred but not yet billed)

New Revenue Recognition Standard
 PwC 2018 survey of 700 finance executives

 “What impact did new Revenue Recognition Standard
have?”
 “How difficult will it be to implement the new standard

in the following areas?” Response: Somewhat―Very
difficult

Examine and evaluate
sales allowances.

Sales Allowances
 Many companies offer customers a variety of sales

allowances
 Rights of return
 Sales discounts for volume purchases
 Retailer promotions (point-of-sale price markdowns and other
promotions)
 These reduce the amount of cash the company
receives.
 Under GAAP companies must report amount of cash
expected to be received (NET sales).
 Companies must deduct from GROSS sales the
expected sales returns and other allowances.
Sales Allowances
Example
Assume the following for Levi Strauss:
 Sells jeans to a customer for $130 on account; jeans cost $80
 Expects returns of 3% of sales
 Levi’s income statement reports the following:

Reporting Sales Allowances
 Companies provide a reconciliation of their sales

allowances
 Sales returns
 Sales discounts & incentives
 Levi’s disclosure is typical

Analysis of Sales Allowances
Three metrics to analyze sales allowances:
1 Additions charged to Gross Sales
 Measures the income statement amount
 Reveals effects of the pricing pressure on net sales
 Expect the percentage of sales allowances to gross sales to
increase (thus reducing net sales) as pricing pressure
increases
2 Allowance as Percentage of Gross Sales
 Measures the balance sheet amount
3 Adequacy of the allowance amount
 Compares the dollar amount of the estimates for future sales
returns to the amount actually realized

Three Analysis Metrics
Levi Strauss

 Because sales allowances require estimates, managers can (and

do) pad or shave their estimates to help the company meet net
sales or earnings targets.
 Analyst seek to adjust numbers to “undo” any deliberate variation
across years.
 To adjust our numbers, we estimate an “average” rate of
additions charged (income statement number) to the Gross sales.
 Apply that average rate to determine adjusted amounts for the
related balance sheet and income statement accounts.
for Levi Strauss
 Estimate an “average” rate.
 Apply that average rate to determine adjusted amounts for

the related balance sheet and income statement accounts.

for Levi Strauss
 Use the adjusted numbers to restate income statement

numbers.
 Use the adjusted numbers to restate balance sheet

numbers.

Analyze deferred revenue.

Unearned (Deferred) Revenue
 In some industries, it is common to receive cash before

recording revenue.
 This creates a liability (Unearned Revenue) for the
company’s obligation to deliver a good or perform a
service at a future date.
 When the good is provided or the service rendered,
the unearned revenue liability is reduced and
revenue is recognized.

Unearned (Deferred) Revenue
 Lowe’s Companies reports unearned (deferred)

revenue details:

Analysis of Unearned Revenue
 If deferred revenue liabilities decrease, we infer the
company’s current reported revenue was collected from
customers in a prior accounting period and there have
been fewer new prepayments for which revenue will be
recognized in the future.
 Such a trend could predict future declines in revenue and
profit.
 This is not the case for Lowe’s. The company reports a
reconciliation of the unearned (deferred) revenue account.

Evaluate how foreign currency
exchange rates affect revenue.

Accounting for
Foreign Currency Effects
 Companies’ foreign subsidiaries maintain their
accounting records in foreign currencies (other than
the $US).
 Before the subsidiaries’ financial statements are
consolidated, they must be translated into $US.
 As the $US weakens vis-à-vis other world currencies each unit of
foreign currency buys more $US.
 When the income statement of a foreign subsidiary is translated
into $US, the income statement grows.
 Reported revenues and expenses are larger than before the
$US weakened.
 The balance sheet also grows, resulting in a higher $US value for
assets, liabilities, and equity.
Foreign Currency Effects
Pfizer
 Revenues “increased” in 2018 due to foreign currency

changes.
 We can infer that the $US dollar weakened during the year.
Foreign Currency and Cash Flows
Consider three examples of how foreign currency gains and

losses may affect cash flow:
1. $US company transacts business in foreign currencies

 For example, a U.S. company might write a sales contract in Euros.
 If the $US weakens between the date of the sale and the collection
of a Euro-denominated account receivable, the U.S. company
realizes a foreign currency transaction gain.
 Conversely, If a U.S. company purchases goods, and the $US
weakens, the foreign currency denominated account payable
would grow and more $US would be required to settle the obligation,
the U.S. company realizes a foreign currency transaction loss.

Foreign Currency and Cash Flows
Consider three examples of how foreign currency gains and

losses may affect cash flow:
2. $US company borrows in a foreign currency

 If a U.S. parent company borrows in foreign currencies and the $US
weakens, the parent company will realize a loss as it repays more $US
to settle the foreign currency-denominated loan.
3. Foreign subsidiary’s cash is repatriated

 If the U.S. parent repatriates cash from foreign subsidiaries by means
of a cash dividend, the parent company will realize a foreign
currency transaction gain if the $US weakens before the dividend is
converted into $US.
These transactions describe realized gains/losses,

whereas translation effects are unrealized gains/losses.
Analysis of Foreign Currency
 U.S. companies hold about $1 trillion of overseas

earnings, mostly invested in U.S. marketable securities.
 The Tax Cuts and Jobs Act (TCJA) removed a major
tax barrier to repatriating these overseas profits.
 From 2017 onward, companies must pay a one-time
tax of 15.5% (down from 35%) on repatriated earnings.
 Since the new tax law was passed, companies have
started to bring foreign profits back to the U.S.
 Companies repatriated more earnings in the first half
of 2018 than in 2015, 2016, and 2017 combined.

Foreign Profits and Repatriation
 Using the income statement as reported implicitly includes
the foreign currency effects.
 10-K disclosures report foreign currency effects, which
allows analysts to isolate the effects. For example, Pfizer
reports:
 Good analysis computes ratios WITH and WITHOUT the

effect of foreign currency.
 Because foreign currency effects are unpredictable and
out of the company’s direct control, good analysis exclude
foreign currency effects to better forecast operating cash
flow.
Analyze accounts receivable and
uncollectible amounts.

Accounts Receivable
 Accounts receivable are reported on the balance
sheet net of the allowance for doubtful (uncollectible)
accounts:
 Firms use aging analysis to estimate uncollectible

accounts.

Accounting for Accounts Receivable
 Assume a company
 Sells goods on account for $100,000
 Establishes an allowance for uncollectible accounts of $2,900
 The financial statement effects are as follows:
 The company reports the following on its balance sheet:

Write-Off of Uncollectible Account
 Assume a customer who owes $500 files for bankruptcy.
 If the company determines the receivable is now
uncollectible, the company records a “write off” and
adjusts the allowance.
 The company reports the following balances at period end:

Analysis of (A/R)—Magnitude
 The magnitude of accounts receivable is measured

with the following two ratios:
1. Accounts receivable turnover = Sales .
Average A/R
2. Days sales outstanding (DSO) = 365 .
A/R Turnover
 For Pfizer:

Interpretation of A/R Ratios
 When accounts receivable have grown more quickly

than sales, we observe:
 Lower accounts receivable turnover ratio
 Higher percentage of accounts receivable to sales
 Lengthening of the DSO
 Generally, such a trend is not favorable for two

possible reasons
 The company is becoming more lenient in granting credit to its
customers
 Credit quality is deteriorating

A/R Turnover and DSO
Pfizer
 Pfizer’s A/R turnover ratio increased over the past five

years—a good sign
 DSO declined by 10 days from 2014 to 2018
 Collecting A/R more quickly increases operating cash flow

Analysis of A/R—Quality
 10-K Schedule II reports a “roll forward” of the allowance
that shows movements in the account.
 Over the 3-year period, the company wrote off $7,112

($3,973 + $1,893 + $1,246) but only increased the allowance
by $6,124 ($2,284 + $1,645 + $2,195).
 Allowance / Gross Receivables has declined:

Analysis of A/R—Quality
There are two possible interpretations for the Levi Strauss

trend:
1. Credit quality has improved
 If Levi Strauss feels that the collectability of its remaining
receivables has improved, it can feel confident in allowing the
allowance for uncollectible accounts to decline.
2. Levi Strauss is underestimating the allowance

account
 This is the more troubling of the two possibilities.
 Levi Strauss might be attempting to increase its profitability by not
adding to the allowance account, and thus, avoiding more bad
debt expense.

 Allowance for doubtful accounts is an estimate, managers can

(and do) use the allowance account to help the company meet
net sales or earnings targets (via bad debt expense.)
 Analyst seek to adjust numbers to “undo” any deliberate variation
across years.
 To adjust our numbers, we estimate an “average” rate of the
allowance to Accounts receivable, gross.
 Apply that average rate to determine adjusted amounts for the
related balance sheet and income statement accounts.
for Pfizer
 Estimate an “average” rate.
 Apply that average rate to determine adjusted amounts for

the related balance sheet and income statement accounts.

for Pfizer
 Use the adjusted numbers to restate income statement

numbers.
 Use the adjusted numbers to restate balance sheet

numbers.

Evaluate operating expenses
and discontinued operations.

Deductions From Income
Pfizer
 Cost of sales―The cost Pfizer incurred to make or buy the

products it sold during the year
 Selling, informational and administrative expense―Usually,
this expense category is labelled Selling, general and
administrative (SG&A) expense, and includes a number of
general overhead expense categories, such as Salaries,
Marketing, IT, Legal, etc.
 Research and development expense―This is the amount
Pfizer incurs to conduct research for new products
 Amortization of intangible assets―Amortization expense is a
noncash expense, similar to depreciation expense

Deductions From Income
Pfizer
 Restructuring charges―The cost Pfizer incurred (and expects
to incur) to restructure its operations
 Provision for taxes on income―Taxes to federal and state
tax authorities as well as income taxes levied by foreign
governments
 Discontinued operations―The operating profit (or loss) on
businesses that Pfizer has decided to divest plus the gain (or
loss) on the sale of those businesses
 Income attributable to noncontrolling interest―The portion
of the subsidiaries’ income that is owned by the
noncontrolling shareholders, that is, the portion NOT
attributable to Pfizer’s shareholders (who own the
controlling interest)
Research and Development Expense
 R&D costs broadly consist of the following:

 Salaries and benefits for researchers and developers
 Supplies needed to conduct the research
 Licensing fees for intellectual property or software used in the
R&D process
 Third-party payments to collaborators at other firms and
universities
 Laboratory and other equipment
 Property and buildings to be used as research facilities
 R&D costs are expensed as incurred except for

general purpose PPE assets which are capitalized and
depreciated as usual.
Median S&P 500 Firm R&D/Revenue
2018

Analysis of R&D
 To analyze R&D:
 Compare R&D expense ($ and as a % of revenue) over time
 Compare the company’s R&D spending to peers
 Financial analysts aim to develop forward-looking

predictions of a company’s income and cash flow.
 Monitor new products in the pipeline
 Develop estimates of their ultimate commercial feasibility
Provision (Benefit)
for Taxes on Income
 Tax expense―the income taxes the company has paid and
expects to pay to federal, state, municipal, and foreign tax
authorities
 The Tax Cuts and Jobs Act (TCJA) made sweeping changes
that impacted taxes and income statements
 Reduced the corporate tax rate from 35% to 21%
 Imposed tax on all future foreign earnings even if the cash profits
remain abroad
 Reduced the repatriation tax on prior foreign earnings to 15.5% (from
35%)
 TCJA effective in 2017 but companies took action in 2016 in
anticipation of the new rules and continued to respond in 2018
 U.S. company income statements gyrated wildly 2016 – 2019
Provision (Benefit)
for Taxes on Income
5.9% -73.5% 13.4%
Average (effective) tax rate = Tax expense/Income before tax
 Average rates during the 2016 to 2019 period are not

predictive of future tax rates.
 Pfizer projects a 16% tax rate for 2019 and beyond.
 Critical to carefully read tax footnotes

 Companies often divest of business segments.
 When this occurs, the company reports the event at the
bottom of the income statement by segregating income
from continuing versus discontinued operations.
 The discontinued operations line item has two components:
 Net income (or loss) from the segment’s business activities prior to the
divestiture
 Any gain (or loss) on the sale of the business

Why Segregate
Discontinued Operations?
 Discontinued operations are segregated in the income

statement because they represent a transitory item.
 Transitory items won’t recur and thus, they are largely
irrelevant to predicting future performance.
 Investors tend to focus on income from continuing
operations because that is the level of profitability that is
likely to persist (continue) into the future.
 In order to be classified as a discontinued operation, the
disposal of the business unit must:
 Represent a strategic shift for the company
 Have a major effect on the company’s financial results

 To analyze return for 2018 (ROE and ROA) and to compare to the
two prior years, the appropriate earnings number is “Income from
continuing operations”.

Interpret pro forma
and non-GAAP disclosures.

Pro Forma Income Reporting
 Pro forma income statements are non-GAAP numbers that

company management believes provide a better measure
of their financial performance.
 The Securities and Exchange Commission (SEC) requires
that companies reconcile non-GAAP information to GAAP
numbers (Regulation G).
 Remember that a company’s purpose for making a non-
GAAP disclosure is to portray its financial performance the
way that management would like us to analyze it.
 Unscrupulous companies might attempt to present
financial results in the best possible light (opportunism).

Pro Forma Disclosure
Pfizer
 Adjusted diluted EPS is not a GAAP metric.

 Analysts may or may not agree with Pfizer’s adjustments
that excludes costs relating to acquisitions, discontinued
operations, and other one-time nonrecurring items.
 Must examine disclosure carefully and consider the
company’s incentives for reporting “adjusted” numbers.
SEC Warning

Disclosures and Market Assessments
For a thorough reading of the GAAP financials:
 Read the external audit report and note any deviation from
boilerplate language.
 Peruse accounting policy footnote and compare to peers.
 Examine changes in accounting policies.
 Compare key ratios over time.
 Review competitors’ ratios and consider how macroeconomic
conditions have shifted ratios over time.
 Identify nonrecurring items and separately assess their impact on
company performance and position.
 Recast financial statements as necessary to reflect accounting
policies more in line with competitors or that better reflect
economically relevant numbers.

Financial
Statement
Analysis &

Financial
Statement
Analysis &
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 3
Profitability Analysis and
Interpretation

Compute and interpret
return on equity (ROE).

Return on Equity (ROE)
 The most common analysis metric used by managers

and investors alike
 ROE relates net income to the average total
stockholders’ equity.
 ROE measures return from the perspective of the

company’s stockholders.

ROE Calculated
ROE for the S&P 500 firms has ranged from 13.5% to
15.6% from 2014 to 2018.

S&P 500
 500 of the largest U.S. publicly traded companies

 Accounts for about 75% of the U.S. stock market
capitalization
 U.S. based companies are selected for inclusion based
on market cap, industry, long-term profitability, and
trading volume.
 In 2019, Boston Scientific was #97 on the S&P 500 list.

Apply DuPont disaggregation
of ROE into return on assets (ROA)
and financial leverage.

Return on Equity
 Performance analysis seeks to uncover the drivers of

ROE and how those drivers have trended over time to
better predict future performance.
 Two methods to measure ROE drivers:
1. Traditional DuPont analysis that disaggregates ROE into
components of profitability, productivity, and leverage
2. ROE analysis with an operating focus that distinguishes
between operating and
nonoperating activities
Operating activities
drive shareholder
value

DuPont Disaggregation of ROE
 ROE reflects both

 Company performance (as measured by ROA)
 How assets are financed (as measured by Financial Leverage)
 ROE is higher when there is more debt and less equity

for a given level of assets.
 Tradeoff―greater debt means higher risk for the
company

Return on Assets
Income Statement
Balance Sheet
 Return on assets (ROA) measures return from the

perspective of the entire company (enterprise level).
 This return includes both profitability (numerator) and
total company assets (denominator).
 To earn a high ROA, the company must be profitable
and manage assets (hold the lowest level of assets
possible to achieve the desired profit).
 ROA analysis encourages managers to focus on both
the income statement and the balance sheet.
Return on Assets
Boston Scientific
Median ROA for S&P 500 firms:

 6.1% in 2018
 Ranged from 5.2% to 6.1% from 2014 – 2018

Financial Leverage
 Financial leverage measures the
relative use of debt versus equity to
finance the company’s assets.
 Financial leverage is important
because debt is a contractual
obligation and a company’s failure to
repay principal or interest can result in
legal repercussions or even
bankruptcy.
Many ways to measure  Higher financial leverage means
financial leverage: higher debt and interest payments.
Here: FL  All else equal, higher financial
Later: FLEV leverage increases the probability of
default and possible bankruptcy.

Financial Leverage
Boston Scientific
Median FL for S&P 500 firms:

 2.66 in 2018
 Ranged from 2.46 to 2.74 from 2014 – 2018

Accounts to Use to Compute ROE
ROE measures return to the common stockholders
Preferred Stock necessitates two adjustments:

1. Numerator: Subtract preferred dividends from
net income
2. Denominator: Subtract preferred stock from
stockholders’ equity

Accounts to Use to Compute ROE
ROE measures return to the controlling (parent

company) stockholders.
Noncontrolling interests: Must use the correct line items

1. Numerator: Use net income attributable to the
parent company’s stockholders
2. Denominator: Use equity attributable to the
parent company’s stockholders

Disaggregate ROA into
profitability and productivity
and analyze both.

Disaggregation of Return on Assets
What the company earns

on each sales dollar
Sales generated from each

dollar invested in assets
Managers can increase ROA by:

 Increase PM: increase profitability for a given level of assets
 Increase AT: reduce assets while still generating same profit level
Or Both

Putting It All Together

Analysis of
Profitability and Productivity

Analysis of Profitability
Gross Profit Margin
 = Gross profit / Sales
 Influenced by both the selling price of a company’s
products and the cost to make or buy those products
 Generally high and increasing gross profit margin is better
 Low or decreasing gross profit margin signals more
competition or less demand for the company’s products
 Competitive intensity has increased
 Product line has lost appeal
 Product costs have increased
 Product mix has changed
 Volume has declined and fixed costs have not

Analysis of Profitability
Operating Expense Margin
 Measures general operating costs for each sales dollar
 Consider each expense in whatever detail the company
provides in its income statement
 Compare margins over time and against peers (making
sure that peers have similar business models)

Analysis of

Analysis of Productivity
Sales
 Asset Turnover (AT) =
Average Total Assets
 Turnover =
Income statement item Natural
Average Balance sheet item linkage
 Working capital turnover ratios:
A/R turnover Inventory turnover A/P turnover
Sales COGS COGS

= = =
Average A/R Average Inventory Average A/P

 Cash conversion cycle is the average number of days to:
 Buy inventory on credit (accounts payable)
 Sell inventories of credit (accounts receivable)
 Collect the receivables
 Pay the accounts payable
365 365 365

DSO = DIO = DPO =
A/R turnover Inventory turnover A/P turnover
CCC = DSO + DIO – DPO

 Generally, companies prefer a lower cash conversion cycle
because then the operating cycle is generating profit and
cash flow quickly.
 Our analysis of this measure focuses on trends over time
and comparisons to peers (with similar business models).

Apple’s
 Apple carries little inventory as its products are pre-sold and

shipped when manufactured.
 Quick sales and relatively longer time to pay suppliers results
in a negative cash conversion cycle of (73.6) days.
 The negative number means that Apple can invest the
cash it receives from product sales for 73.6 days before that
cash is needed to pay suppliers.
 Apple generates profit from the sale and from investing its
cash.
 A negative cash conversion cycle is viewed positively.
Merck’s

Merck’s
Compare 2017 and 2018:

Merck’s
Compare 2017 and 2018:
 Trends for Merck are favorable

 TOO favorable?
 Beware of short-term improvement at the expense of longer-term
market position and supplier relations.

Analysis of PPE
Sales
PPE turnover =
Average PPE
Improving PPE turnover is not easy; it often entails:

 Divesting of unproductive assets or entire business lines
 Joint ventures to share assets such as distribution networks,
information technology, production facilities, transportation fleets,
and warehouses
 Selling production facilities with agreements to purchase finished
goods from the facilities’ new owners
 Sale and leaseback of administrative buildings

Analysis of

Analysis of Financial Leverage
 Judicial use of financial leverage benefits stockholders

 It is a relatively inexpensive source of capital
 But, adds risk because debt repayment is mandatory
 Analysis of financial leverage typically involves:

 The level of borrowed money relative to equity capital
 The level of profit or cash flow relative to required debt
payments
Total liabilities
Total liabilities to equity =
Total equity
Earnings before interest and tax

Times interest earned =
Interest expense, gross


Net Income
Return on Assets =
Average Assets
 Return on assets uses net income which includes the effects

of financing decisions.
 Managers who oversee assets rarely also control financing
decisions.
 Analysts adjust ROA to exclude effects of financing.
Net Income + (1 − tax rate) × Net interest expense
Adjusted ROA =
Average Assets
 Boston Scientific 2018:
 ROA = 8.35% Difference is minimal due to small net interest.


 Many balance sheets report small or negative equity
because of large stock buybacks.
 Small equity balances in the denominator inflates ROE.
 Negative equity balances arise when amounts spent for
stock repurchases exceeds the original contributed capital
from shareholders and make ROE negative and
uninterpretable.
 Analysts address this issue in two ways:
1. Use return metrics that are less sensitive to low or negative equity
(ROA or RNOA)
2. Compute ROE after adding back treasury stock. For example, for
Johnson & Johnson in 2018:

Identify balance sheet
operating items and compute
net operating assets.

Operating Focus to ROE Analysis
 ROE disaggregation with an operating focus recognizes

that companies create value mainly through core
operations
 The balance sheet and income statement include both
operating and nonoperating items.
 Return on assets in the traditional DuPont method, reflects
a blend of the return on a company’s operating assets and
its nonoperating return.
 Analysis can be improved if we separately identify the
operating and nonoperating components of the business
and their separate returns.

ROE
Operating Focus
ROE consists of two returns:
 Return from operating  Return from financing and

activities investing activities
 Earned from operating  Earned from nonoperating
assets & liabilities assets & liabilities

Financial Leverage
in Traditional DuPont
 Financial leverage in the traditional DuPont analysis is the
ratio of total assets to stockholders’ equity:
 Liabilities used in this computation include all liabilities.

 Liabilities = Borrowed money + Operating liabilities
 Loans/Bonds/Mortgages  Accounts payable/Accruals

 Interest bearing  Interest rate
 Severe legal repercussions  Self-liquidating
 The operating focus ROE treats these two types of liabilities

differently for ROE analysis.
Return on Net Operating Assets
(RNOA)
Operating returns are measured by return on net

operating assets (RNOA).
Average NOA = NOA start of year + NOA end of year

2

Net Operating Assets
(NOA)
Operating Assets
= $20,853

= $15,636
Operating Liabilities
= $5,217

Net Nonoperating Obligations
(NNA)
Nonoperating Assets
= $146
Net Nonoperating
Obligations
= $6,910
Nonoperating Liabilities
= $7,056

Appendix 3A

Identify income statement
operating items and compute
net operating profit after tax.

Net Operating Profit After Tax
(NOPAT)
NOPBT = Sales – Operating expenses

 Revenues
 Costs of goods sold (COGS)
 SG&A including wages, advertising, occupancy, insurance,
depreciation and amortization, litigation, and restructuring
expenses
 Research and development
 Impairments of operating assets such as goodwill
 Income from strategic investments (not marketable securities)—
including joint ventures, partnerships, and associated companies
 Gains and losses on asset disposals
 “Other” operating expenses or income
Boston Scientific’s Income Statement
NOPBT = $1,506

Net Operating Profit After Tax
(NOPAT)
 The amount in parentheses is called the tax shield, which are the
taxes that a company saves by having tax-deductible
nonoperating expenses.
 By definition, the taxes saved (by the tax shield) do not relate to
operating profits.
 Thus, we must add back the tax shield to total tax expense to
compute the tax on operating profit.
 Our starting point to determine tax on operating profit, is the
PRETAX net nonoperating expenses.
Pretax net operating expenses

= $241 – $156 = $85

Income tax expense

= (249)
A TAX BENEFIT !

Boston Scientific’s NOPAT
 Assume a 22% statutory tax rate

Appendix 3A


return on net operating assets
(RNOA).

Return on Net Operating Assets
(RNOA)
 RNOA measures operating returns
Average NOA = NOA start of year + NOA end of year

2

RNOA at Boston Scientific
Boston Scientific’s return on net operating assets (RNOA)

for 2018 is computed as follows:
RNOA for S&P 500 firms:

 11.3% in 2018
 Ranged from 9.3% to 12.5% from 2014 – 2018

RNOA vs. ROA
 RNOA > ROA for two reasons:

 Numerator effect: NOPAT > Net income because of the after-
tax effect of nonoperating expenses, $66 million
 Denominator effect: Average NOA < Average assets because
NOA is net of operating liabilities & Assets includes
nonoperating assets

ROE and Financial Leverage
ROE = Operating return (via RNOA) + Nonoperating return

21.24% = 12.37% + 8.87%
Effects of nonoperating activities

~~ Financial Leverage~~
Financial leverage quantifies risk associated with use of debt.

Disaggregate RNOA into
net operating profitability and
net operating asset turnover.

RNOA Disaggregation
into Margin and Turnover
We can disaggregate RNOA into two components:

Net Operating Profit Margin
(NOPM)
 Net operating profit margin (NOPM) reveals how

much operating profit the company earns from each
sales dollar.
 Boston Scientific’s net operating profit margin is
computed as follows ($ millions):
 For every dollar of sales, the company earns nearly

18 cents of operating profit after all expenses,
including tax.

Net Operating Asset Turnover
(NOAT)
 Net operating asset turnover (NOAT) measures the

productivity of the company’s net operating assets.
 Boston Scientific’s net operating asset turnover ratio
follows:
 For every dollar of net operating assets, the company

earns 70 cents of sales revenue.

Interpretation of NOPM and NOAT
 NOPM―affected by
 The level of gross profit
 The level of operating expenses
 The level of competition
 NOAT―can be increased by
 Either increasing sales for a given level of
operating assets or by reducing the amount
of operating assets while generating the
same sales, or both.
 Reducing operating working capital EASIER
 Using corporate alliances, outsourcing, and special

purpose entities to reduce operating assets

Margin vs. Turnover


Operating Nonoperating Operating Nonoperating Stockholders’

+ = + +
Assets Assets Liabilities Liabilities Equity
Operating Operating Nonoperating Nonoperating Stockholders’

– = – +
Assets Liabilities Liabilities Assets Equity
NET Operating Assets NET Nonoperating Obligations

NOA NNO
Invested Capital
RNOA = NOPAT / NOA ROIC = NOPAT / Invested Capital


Appendix 3B
Nonoperating Return
Component of ROE

nonoperating return.

Nonoperating Return

FLEV & Spread at Boston Scientific
 Step 1: Determine NOA, NNO and Equity from the

balance sheet
 Step 2: Calculate FLEV
 Step 3: Determine NOPAT and NNE from the income
statement
 Step 4: Calculate RNOA and NNEP
 Step 5: Calculate Spread
Step 1
NOA, NNO, and Equity
Operating Assets
= $20,853

= $15,636
Operating Liabilities
= $5,217

Boston Scientific’s Operating &
Nonoperating Balance Sheet
Nonoperating Assets
= $146
Net Nonoperating
Obligations
= $6,910
Nonoperating Liabilities
= $7,056

Step 2
Calculate FLEV
 Step 1: Determine NOA, NNO and Equity from the

balance sheet
Average equity = $8,726 + $7,012 = $7,869

2
 Step 2: Calculate FLEV

Step 3
NOPAT and NNE

Boston Scientific’s
NOPAT and NNE
 Step 3: Determine NOPAT and NNE from the income

statement
NOPAT = Net income + NNE

= $1,671 + $66
= $1,737

Steps 4 & 5
RNOA, NNEP, and Spread
 Step 4: Calculate RNOA and NNEP
RNOA = NOPAT / Average NOA
= $1,737 / [($15,636 + $12,440) / 2]
= 12.37%
NNEP = NNE / Average NNO
= $66 / $6,169
= 1.07%
 Step 5: Calculate Spread
Spread = RNOA – NNEP
= 12.37% - 1.07%
= 11.30%
Nonoperating Return
21.24%
12.37% 0.784 11.3%
8.86%

ROE for Amazon
28.26%
46.46% (0.337) 54.00%
(18.2)%

Nonoperating Return
NNO < 0

Noncontrolling Interest
 Noncontrolling interest―arises when a parent

company owns less than 100% of the subsidiaries’ stock
 Parent company must consolidate the subsidiary
 Add 100% of assets & liabilities on the balance sheet
 Add 100% of the revenue & expenses on the income statement
 Need to modify the ROE definition:

ROE disaggregation is adjusted for the NCI ratio
Income Statement % of Controlling to Total
Balance Sheet % of Controlling to Total



Appendix 3C
Liquidity and Solvency
Analysis

Perform vertical and horizontal
analysis.

Vertical and Horizontal Analysis
 Vertical analysis expresses financial statements in ratio form

 Income statement items: as a percent of net sales
 Balance sheet items: as a percent of total assets.
 Such common-size financial statements facilitate

comparisons across companies of different sizes and
comparisons of accounts within a set of financial
statements.
 Horizontal analysis is the scrutiny of financial data across
time.
(Current balance – Previous balance) / Previous balance
 We compare data across two or more consecutive periods
to analyze trends in company performance and to predict
future performance.
Limitations of Ratio Analysis
 Blindly analyzing numbers can lead to faulty
conclusions and suboptimal decisions.
 Must consider factors that limit usefulness of ratio
analysis
 GAAP limitations―current accounting rules omit many assets
 Company changes―mergers and divestitures as well as
changes in strategies can impair the comparability of
company ratios across time
 Conglomerate effects―Few companies are a pure-play;
consolidated statements are challenging to analyze
 Fuzzy view―Ratios reduce, to a single number, the myriad
complexities of a company’s operations. No scalar can
accurately capture all qualitative aspects of a company.
Financial
Statement
Analysis &

Financial
Statement
Analysis &
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 15
Market-Based Valuation

Explain company valuation
using balance sheet multiples.

Valuation Model
Using Market Multiples
 Valuation using market multiples does not have

rigorous theoretical underpinnings.
 Market multiple valuation models are popular due to
their simplicity relying on a straightforward process
Value = Summary performance measure × Market multiple
 These models are often used as a shortcut valuation

method or a precursor to more rigorous valuation.
 The market multiple models do not rely on subjective
forecasts of future payoffs.
 Also referred to as the method of comparables.
Company or Equity Value?
 The market multiple approach does not specify
whether the value obtained is the equity value or the
company value.
 It depends on the nature of the performance measure
used to determine the market multiple.
If an EQUITY Output will be an

performance measure equity value
is selected:
Examples: earnings, book value
If a COMPANY Output will be a

performance measure company value
is selected: Examples: NOPAT, NOA

Using the Valuation Model
 Step 1: Select the summary performance measure to use
as the valuation basis (earnings, book value,
NOPAT or NOA, etc.).
 Step 2: Select the comparable companies to determine
the market multiple.
 Step 3: Compute the market multiple from the
comparable companies’ market values and
performance measures.
 Step 4: Compute the target company’s value using its
performance measure and the market multiple
from Step 3.
 Step 5: Calculate equity value per share using
appropriate method.
Market Multiple Model
Challenges
 No one right measure to use as the multiple.
 Because company value depends on future performance.
 No one right set of companies to use as comparables.

 Comparable companies could be under- or overvalue.
 Thus, the computed market multiple could under- or over-value the
target company.
 No one right way to combine comparable company data
to produce a multiple.
 Median, equal-weighted average, value-weighted average, or other
averaging methods are common.
 Despite deficiencies in valuing companies using market
multiples, it is commonly applied in practice.

Data for Balance Sheet Multiples
 Dollar General is the target company in this Module.

 Dollar Tree and Big Lots are the comparable
companies—we will use their financial data and stock
prices to calculate the market multiples.
 We will use the following data to estimate the intrinsic
value of Dollar General’s equity:

Valuation Using a
Net Operating Asset (NOA) Multiple
Determine the market multiple for each company:
NOA Market Multiple = (2.80 + 1.33) / 2 = 2.065)

Applying the NOA Multiple
 Dollar General’s company intrinsic value (in millions)

= Net operating assets × NOA market multiple
= $10,575 × 2.065 = $21,837
 Dollar General’s equity intrinsic value (in millions)

= Company intrinsic value – Net nonoperating obligations
= $21,837 – $2,629 = $19,208
 Dollar General’s equity intrinsic value per share
Equity intrinsic value $ 19,208

= = = $71.49
Common shares outstanding 268.7 shares

Valuation Using a
Book Value (BV) Multiple
This method yields the intrinsic value for equity, not for
the entire company.
BV Market Multiple = (4.08 + 1.81) / 2 = 2.945)

Applying the Book Value (BV) Multiple
 Dollar General’s equity intrinsic value (in millions)

= Book value of equity x BV market multiple
= $6,417 × 2.945 = $18,898
 Dollar General’s equity intrinsic value per share
Equity intrinsic value $ 18,898

= = = $70.33
Common shares outstanding 268.7 shares
The $70.33 stock price estimate suggests that Dollar General stock
was markedly overvalued given its $115.04 closing price.

Assessing Quality of Value Estimates
 Factors considered when selecting comparable companies

include profitability, growth, and risk.
 Our NOA and BV multiple estimates controlled for operating
risk but not for profitability, growth, or financial risk.
 Consequently, our estimate based on NOA market multiple
is likely “better” because company financial risk does not
materially affect the value of net operating assets, but it
does affect the value of equity.
 Different capital structures of companies do not matter
when applying NOA multiples in valuation.
 But, when using book value multiples, it is important to
select comparables with similar capital structures.

Explain company valuation using
income statement multiples.

Valuation Using Earnings
 Earnings is the most commonly used performance measure

for estimating company value with market multiples.
 Price-to-earnings (PE) ratios are cited in news articles and
analysts’ reports, used in stocks screens, and trading
strategies.
 The intuition in using earnings as the basis for valuation is
straightforward:
 Dividends are paid out of earnings, and potential dividend payouts
are the basis for company value.
 Higher earnings should warrant higher stock price.
 We demonstrate two earnings-based multiples valuation

models to estimate intrinsic value for Dollar General:
NOPAT and net income.
Valuation Using NOPAT Multiple
Dollar General’s
= $1,668 × 16.3 = $27,188 million
intrinsic value
NNO
Dollar General’s equity $27,188 - $2,629

= = $91.40
intrinsic value per share 268.7 shares

Valuation Using
Net Income (NI) Multiple
Net income intrinsic value for Dollar General:
Dollar General’s equity $1,589 x 14.1

= = $83.56
intrinsic value per share 268.7 shares

Valuation Using
Industry-Based Multiples
 Some industries have specific measures related to industry
characteristics that are closely watched by investors and
analysts.
 In the retail industry sales per square foot of selling space is
a common measure that relates sales to store size.
The $54.48 stock price estimate suggests that Dollar General stock
was markedly overvalued given its $115.04 closing price.
Combining Estimates
from Differing Multiples
 Rather than trading off the merits of different estimates,
some investors combine them in the hope that estimation
error for a specific multiple is mitigated by other multiples.
 Including NOPAT or net income in the average yields about

the same stock price for Dollar General.
 For other companies, the numbers can differ greatly.

Identify comparable companies
to derive market multiple.

Selecting Comparables
for Market Multiples
 When valuing companies using market multiples, it is

important to select comparables with similar levels of
profitability, growth, and risk.
 Recall that choosing comparables for NOA and
NOPAT multiples does not assume that the
comparables have similar capital structures.
 Theoretically correct market multiples can be derived
from the residual operating income (ROPI) model.

Residual Operating Income Model
ROPI = NOPAT – (NOAbeg x rw)
This formula reveals the parameters for determining PB

ratios:
 Residual operating income
 Expected growth rate in residual operating income
 Weighted average cost of capital
 Leverage

PB Increases with
Company Expected Profitability
Model assumes that residual operating income grows at a

constant rate, g, in perpetuity.
Company A: Price-to-Book* = 1 + ($150 / $100) = 2.5

Company B: Price-to-Book* = 1 + ($50 / $100) = 1.5
*Price-to-Book = 1 + (PV of expected ROPI / Stockholders’ equity)

PB Increases with
Company Expected Growth
Company C: Price-to-Book* = 1 + ($200 / $100) = 3.0

Company D: Price-to-Book* = 1 + ($120 / $100) = 2.2

PB Decreases with
Increasing Company Operating Risk
Company E: Price-to-Book* = 1 + ($46.7 / $100) = 1.47

Company F: Price-to-Book* = 1 + ($120 / $100) = 2.2

PB Increases with Leverage
Price-to-Book ratios are higher than Price-to-NOA ratios for
companies with debt.
Company G: Price-to-Book* = 1 + ($120 / $100) = 2.2

Company H: Price-to-Book* = 1 + ($120 / $40) = 4.0
Company G: Price-to-NOA* = 1 + ($120 / $100) = 2.2

Company H: Price-to-NOA* = 1 + ($120 / $100) = 2.2
*Price-to-NOA = 1 + (PV of expected ROPI / Net operating assets)

PE and
Residual Operating Income Model
 The theoretical value of the price-to-earnings (PE) ratio

using residual operating income model is as follows:
 Price-to-Earnings ratio (PE) equals the capitalized

value of current income (normal income and residual
income) PLUS the capitalized PV of changes in future
residual income.

PE Ratios in Relation to
Profitability, Growth, and Risk
 Growth and risk affect PE.

 Profitability has no effect on PE.
 PE ratio is unaffected by RNOA.
 Expected growth in residual income leads to higher
PE ratios.
 Higher cost of equity capital leads to lower PE ratios.
Consider earnings growth and risk when selecting comparables

to use for valuing a firm based on earnings multiples.

Interpret and reverse engineer
market multiples to assess the
reliability of market expectations.

Reverse Engineering the PB Ratio
 Reverse engineering is the process of
 Observing market price metrics such as the PB and PE ratios
 Assessing the quality of the underlying expectations supporting the
observed stock price
 Recall the following relation:
 If we divide both sides by EQ we get:
 If we assume that residual income is a perpetuity, we

obtain:

 This PB formula has three unknowns: expected ROE,

discount rate re, and growth rate g.
 We can manipulate these unknowns to infer the market’s
expectations about these valuation parameters.
 For example for Walmart:
$314,583 million
Walmart’s PB = = 4.5
$70,327 million

 Case 1 Assumes we know the market’s expectation for

ROE and the discount rate
Implied growth rates from 0.1% to 3.8% seem a little high—the rate is
expected to continue in perpetuity.

Reverse Engineering
Walmart’s PB Ratio
 Case 2 Assumes we know the market’s expectation for
ROE and the growth rate and we solve for the
discount rate (re)
A discount rate between 5.6% and 7.2% is required

to support a 4.5 PB ratio.

Reverse Engineering
Walmart’s PB Ratio
 Case 3 Assumes we know the market’s expectation
about the discount rate and growth rate and we
solve for expected ROE
A high level of profitability in perpetuity is required (ROE 12.0 to 24.5%)

to justify a 4.5 PB ratio.

Interpreting the PE Ratio
 This formula shows that the PE ratio approximates the

capitalization factor plus an adjustment for expected
increases or decreases in future residual income.
 For example, if a company has a 10% equity cost of
capital, the implied capitalization factor is 11:
(1 + 10%)/10% = 11
 If investors believe residual income will NOT change,
PE ratio ≈ 11
 If investors believe residual income will increase more than 10%
times the change in book value, PE ratio > 11
Process of Fundamental Analysis
 Methods that require explicit modeling of a company’s
future performance and the use of those forecasts for
valuation include:
 Discounted dividends
 Discounted cash flows
 Residual operating income model
 The resulting valuation can contain error because forecasts

are wrong, or because the discount rate is wrong, but not
because of an inherent problem with the valuation model.
 Method that uses market multiples does not have rigorous
theoretical underpinnings.
 Errors can arise because comparables might not be true
“peers” and performance metric might be unstable over
time.
Implementing Valuation Multiples
If we use market multiples for company valuation, there

are at least three steps we should take in implementing
this approach:
Step 1: Use forward-looking performance measures to
compute the market multiples for comparable
companies.
Step 2: Select comparable companies with care so as

to match them on profitability, growth, and risk.
Step 3: Use both income statement and balance

sheet-based valuation multiples.

Financial
Statement
Analysis &

Financial
Statement
Analysis &
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 1
Framework for Analysis
and Valuation

Explain and assess the four main
business activities.

Framework for Analysis and Valuation
 Financial statement analysis―the process of extracting

information from financial statements to better
understand a company’s current and future
performance and financial condition.
 Financial statements serve many objectives
 Management
 Investors and analysts
 Creditors, lenders, and rating agencies
 Regulatory agencies

 Valuation―the process of drawing on the results of

financial statement analysis to estimate a company’s
worth (enterprise value).
 Two types of claims on the company’s “value”:


Step 1
Business Environment and Accounting
Three main groups of financial statement users:

1. Investors and equity analysts
2. Lenders and credit analysts
3. Company managers and employees
Companies undertake four types of activities:
1. Plan business activities
2. Finance those activities
3. Invest in those activities
4. Then engage in Operating activities

Business Activities and
Financial Statements
Generally Accepted Accounting Principles (GAAP)

Developed by Financial Accounting Standards Board (FASB)

Identify and discuss
the users and suppliers of
financial statement information.

Demand for
Financial Accounting Information
 Managers and employees―gauge current and future

financial health
 Investment analysts and information intermediaries―
predict future performance
 Creditors and suppliers―determine loan terms, loan
amounts, interest rates, and collateral
 Stockholders and directors―assess profitability and risks
and glean other information useful in their investment
decisions

Demand for
 Customers and strategic partners―assess a company’s

ability to provide products or services and assess the
company’s staying power and reliability
 Regulators and tax agencies―for antitrust assessments,
public protection, setting prices, import-export
analyses, and setting tax policies
 Voters and their representatives―economic, social,
taxation, and other initiatives, and to monitor
government spending

Supply of
Two primary reports that companies MUST supply:
 Form 10-K: the audited Annual Report
 Four financial statements
 Explanatory notes
 Management’s discussion and analysis (MD&A)
 Form 10-Q: the unaudited Quarterly Report
 Summary versions of the four financial statements
 Limited additional disclosures
Managers consider the benefits and costs of disclosure

when deciding on the quantity and quality of
accounting information to supply.

Benefits of Disclosure
The benefits of supplying high-quality accounting

information extend to a company’s capital, labor, input,
and output markets.
 Cost of capital (as reflected in lower interest rates or
higher stock prices)
 Recruiting efforts in labor markets
 The ability to establish superior supplier-customer
relations in the input and output markets

Costs of Disclosure
 Preparation and dissemination of the financial

information
 Competitive disadvantages―revealing proprietary
information
 Litigation potential
 Political costs

SEC’s Regulation Fair Disclosure (FD)
Goal is to curb the practice of selective disclosure by

public companies.
Reg FD reads as follows:

“Whenever an issuer discloses any material nonpublic information
regarding that issuer, the issuer shall make public disclosure of that
information . . . simultaneously, in the case of an intentional
disclosure; and . . . promptly, in the case of a non-intentional
disclosure.”

International Accounting Standards
(IFRS)
 Companies in more than 120 countries, including

the European Union, the United Kingdom,
Canada, and Japan use IFRS for their financial
reports.
 International Accounting Standards Board (IASB)
oversees the development of IFRS.
 The IASB and the Financial Accounting Standards
Board (FASB) work together cooperatively on joint
projects.
 IFRS and U.S. GAAP are generally more alike than
different for most transactions.
Review the four financial statements.

Financial Statement Links Across Time

Balance Sheet
Reports a company’s financial position at a point in

time:
 Resources (assets): what the company owns
 Sources: where the assets are financed
 NONOWNER financing from banks, creditors and suppliers
 OWNER financing from stockholders
Accounting Equation
The accounting equation works for ALL companies at ALL points in time.

Apple Inc. Balance Sheet
Consolidated
Assets = Liabilities + Equity

$365,725 = $258,578 + $107,147

Investing Activities
 Represented by the company’s assets
 Assets are listed on the balance sheet in order of their
nearness to cash.
 The relative proportion of short- and long-term assets
is largely determined by a company’s industry and
business model.

Financing Activities
Companies use a combination of owner (equity) and
nonowner financing (liabilities or debt).
Owner financing has two components:
 Resources contributed to the company by owners
 Profits retained by the company

Income Statement
Reports on a company’s performance over a period of
time, and lists:
 Revenues (also called sales)
 Expenses
Revenues – Expenses = Net Income
 Net income―also known as

 Earnings
 Net earnings
 Profit
 Bottom line

Income Statement
Revenue – Expenses = Net income

$265,595 – $206,064 = $59,531

Expenses
Cost of goods sold (COGS)―the amount Apple paid to
purchase or manufacture the goods (inventories) that
it sold
Gross profit = Revenues - Cost of goods sold
Selling, general, and administrative expenses (SG&A)―
the overhead of the company, including:
 Salaries
 Marketing costs
 Occupancy cost
 HR
 IT costs
 Other operating expenses the company incurs

Operating Income
A company’s ability to create barriers to competitive
pressure, either by patent protection, effective
marketing, etc. is key factor to determining its level of
operating profitability.

Reports on year-over-year changes in the equity

accounts that are reported on the balance sheet:
 Contributed capital―the stockholders’ net contributions to the
company
 Retained earnings―cumulative net income over the life of the
company minus all dividends ever paid
 Other equity (explained later in the book)


Statement of Cash Flows
Reports cash inflows and outflows from three types of

activities:
 Operating
 Investing
 Financing

Information
Beyond Financial Statements
 Financial statement footnotes

 Management Discussion and Analysis (MD&A)
 Independent auditor report
 Regulatory filings, including proxy statements and
other SEC filings


Assess business operations
within the context of a
competitive environment.

Analyzing the Business Environment
 Inadvisable to assess a company’s performance or

develop corporate strategy without first considering
the company’s competitive environment.
 To understand a company we must “know the
business”.
 Three frameworks to analyze business environment:
 Porter’s value chain model
 Porter’s 5 forces
 SWOT model

Porter’s Value Chain Framework

Porter’s Five Forces
Porter, M. 1998. “Competitive Strategy: Techniques for Analyzing Industries and Competitors.”

Porter’s Five Forces
 Industry competition―Competition and rivalry raise the cost
of doing business
 Bargaining power of buyers―Buyers with strong bargaining
power can extract price concessions
 Bargaining power of suppliers―Suppliers with strong
bargaining power can demand higher prices
 Threat of substitution―As the number of product substitutes
increases, sellers have less power to raise prices and/or pass
on costs to buyers.
 Threat of entry―New market entrants increase competition
and companies must develop new technologies and
human capital to create barriers to entry and economies
of scale.
Porter, M. 1998. “Competitive Strategy: Techniques for Analyzing Industries and Competitors.”

SWOT Analysis
 Positive―Strengths and Opportunities

 Negative―Weaknesses and Threats
 Internal―Strengths and Weaknesses

 External―Opportunities and Threats
Analyzing Competitive Advantage
 Does the company actually have a competitive

advantage, and, if so, what factors explain it?
 Is the competitive advantage sustainable?
 If the company has no competitive advantage, does

its management have a plan to develop a sustainable
competitive advantage that can be implemented in
an acceptable period of time and with a reasonable
amount of investment?

Achieving Competitive Advantage
Barriers to entry
 Patents, copyrights and other legal protections
 Regulatory and licensing barriers
 Scarce resources
Product / Service differentiation
 Technological innovation and Product design
 Marketing, distribution, and after-sale customer support
Cost leader
 Access to low-cost raw materials or labor
 Manufacturing or service efficiency
 Manufacturing scale efficiencies
 Greater bargaining power with suppliers
 Sophisticated IT systems
Apply basic profitability analysis.

Step 2
Adjusting and Analyzing Financial Data
 Analysis of financial performance is crucial in assessing

prior strategic decisions and evaluating strategic
alternative
 Managers have choice in financial reportin
 Historically, GAAP standards were complicated and replete
with guidelines
 Now, company management assess whether the statements
taken as a whole “fairly present” the company’s financial
condition
 CEO and CFO must attest that the financial statements are
accurate and complete

Return on Assets

Across Companies

Return on Equity (ROE)
 ROE = Net income / Average Stockholders’ Equity
Stockholders’ equity (start of year) + Stockholders’ equity (end of year)

2
 ROE reflects the return to stockholders, which is

different from the return for the entire company (ROA).

Explain the financial statement
forecasting process.

Step 3
Forecasting Financial Numbers
 Forecasting involves formalizing our predictions and stating

them as financial projections.
 Quality of our forecasts depends on two factors:
1. Quality of the analysis in Steps 1 and 2. Ask:
 How well do we understand the company’s business?
 How thoroughly did we examine and adjust the company’s
financial statements?
2. Realistic and achievable assumptions
 Objectively examine what evidence supports, or challenges, the
forecast assumptions

Forecasting Order and Mechanics
1. Income statement
 Forecast REVENUE first because it is the most crucial number
and the most difficult to estimate.
 Other income-statement and balance-sheet accounts derive,
either directly or indirectly, from the revenue forecast.
2. Balance sheet
3. Statement of cash flows

Explain the role of financial
information in business valuation.

Step 4
Business Valuation
STEP  All financial decisions involve valuation at

4 some level
STEP  In making these financial decisions, we

3 attempt to predict the future―the key to good
valuation estimates is accurate forecasts of
future cash flows
STEP  And, the key to forecasting is a thorough

2 assessment of the company’s current financial
performance and position, and
STEP  A solid knowledge of the business environment

1 in which the company competes
Valuation Models
 Valuation models fall roughly into two camps:
Fundamental Market Multiples

Firm-Specific Data
Dividends Earnings
Cash flows Book value
Earnings

Relation Between
Earnings and Stock Prices
Ball, R., and P. Brown. 1968. “An empirical evaluation of accounting income numbers.” Journal of Accounting Research (Autumn): 159–178.

Relation Between
Financial Ratios and Credit Ratings

Financial Statement Analysis
in an Efficient Capital Market
 Market-efficiency is the idea that security prices reflect

available information and respond rapidly to new
information when it is available
 If that’s true, then are gains still possible with
independent financial statement analysis and firm
valuation?
 If our expectations differ from those of other investors there
exists an opportunity to trade
 Investors and analysts gather information, interpret it, and then
trade based on their analysis
 These trades create supply or demand pressures such that
market prices adjust to reflect the new information
Management Incentives
 Management often has incentive to report favorable

financial information to maximize share price for
compensation contracts or other reasons.
 Financial data potentially can be biased, misleading,
or obfuscated.
 Good analysis is required to recognize and adjust for
such possibilities.

Access and analyze
financial statement data.

SEC’s EDGAR www.sec.gov/edgar





Data Analytics
Diverse activities that use data to inform decisions

 Gather
 Organize
 Analyze
Four types of data analytics

1. Descriptive – what happened?
2. Diagnostic – why did it happen?
3. Predictive – what will happen?
4. Prescriptive – what should be done?

Data Analytics in the Textbook
 Visualization in each module opener for the focus

company or industry

company or industry
 Graphics throughout the book convey information in
a more easily accessible way

company or industry
 Graphics throughout the book to convey information
in a more easily accessible way
 End of chapter exercises that use visualization and
Power BI as a tool

Financial
Statement
Analysis &


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Financial

© Cambridge Business Publishers, 2021

© Cambridge Business Publishers, 2021

 The balance sheet has three sections:

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

 The balance sheet reports the assets, liabilities, and

An ASSET confers expected future economic benefits.

An asset must meet the following two conditions to be

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 Inventories—goods purchased or produced for sale to

 Property, plant, and equipment (PPE), net—land,

 Long-term investments—investments the company

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Most assets are reported at historical cost―the original

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Liabilities are future economic sacrifices.

A liability has the following two characteristics:

A liability represents an amount that must be repaid

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Stockholders’ equity represents capital that has been

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 Accrued liabilities—obligations for expenses that have

 Unearned revenues—cash received from a customer in

 Current maturities of long-term debt—principal portion of

 Net working capital

 The net working capital required to conduct business

AKA: Cash Cycle

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When receivables are

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 Apple’s cash conversion cycle is negative.

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 Noncurrent liabilities—obligations due after one year

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 Common stock—par value received from the original sale

 Additional paid-in capital—amounts received from the

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 Retained earnings—cumulative net income that has not

 Accumulated other comprehensive income or loss—

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Common Size, aka, Vertical analysis or Right-sizing

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 Stockholders’ Equity―the “value” of the company per

 Market value = Number of common shares outstanding

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 The general structure of the income statement:

AKA: Cost of sales, Cost of revenues

AKA: Earnings before interest and

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 Revenues and expenses recognized on the income

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 Recognize revenue when a performance obligation