Financial Statement Analysis

1
 Evaluation of current
and past
financial conditions
• Estimated predictions about
• future financial conditions
• and performance

2
 Reasons for Analysis
• Investment decisions*
• Credit decisions*
• Performance*
• Valuation (investment)
• Legal liability amount (credit & perf.)
• Going concern decisions (credit & perf.)
• Unreasonable returns (performance)
3
 FSA Steps
• Identify the economic characteristics
• Identify the corporate strategies
• Understand the financial statements
• Assess the profitability and risk
• Value the particular firm

4
Tools for Economic Analysis

• Porter’s Five Forces

• Economic Attributes Framework

5
 Porter’s Five Forces
• Buyer Power- (price sensitivity)
• Supplier Power
• Rivalry among Firms
• Threat of New Entrants
• Threat of Substitutes

6
Economic Attributes Framework
• Demand
 price sensitivity
 demand growth
 cyclical demand
 seasonal demand
• Supply
 number of suppliers
 barriers to entry
• Manufacturing
 capital intensity
 process complexity
• Marketing
 marketing channel--corporate or consumer
 demand pull or demand creation
• Financing
 Nature of assets
 Asset risk
 Source of cash flow--internal or external

7
Strategic Analysis Framework
• Nature of product or service
• Degree of Integration
• Degree of Geographical
Diversification
• Degree of Industry Diversification

8
 Financial Statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Footnotes
• Auditors Report
• Management Discussion and Analysis

9
Income Statement Classification
• Operating income
• Other income and expense
• Income from continuing operations
• Income, gains & losses from
discontinued operations
• Extraordinary gains and losses
• Changes in accounting principles
10
 Comprehensive Income
• Net income plus or minus the
changes in shareholders’ equity
from other than net income or
transactions with owners.
• (we will look at this later)

11
 Other F/S Considerations
• Quality of Earnings
• Statement of Cash Flows
• Auditors Report

12
Tools of Profit and Risk Analysis
• Common Size Financial Statements
• Percentage Change Statements
• Comparative Analysis
• Critical Financial Ratios

13
Risks of Comparative Analysis
• Timing
• GAAP Application
• Degree of Conservatism-
management’s attitude
• Size
• Geographic Diversification

14
 Critical Financial Ratios
• Profitability Ratios
 EPS
 ROCE
• Risk Ratios
 Current ratio
 CFO/Avg. Current Liabilities
 Debt/Equity

15
 Valuation
• Price-Earnings Ratio
• Market value to Book value Ratio

16
Role of FSA in Capital Markets
• One View: FSA has no impact
• The Other View
 FSA is a catalyst
 FSA identifies individual opportunities
 Equity markets are not perfectly eff.
 FSA cleanses F/S biases
 FSA has unique purpose itself- (go back
to the reasons for analysis)
17
 Sources of Information
• Annual Report
• Form 10-K
• Form 10-Q
• Form 8-K
• Prospectus
• Form 20-F (foreign entity 10-K)

18
 Statement of Cash Flows-
chapter 3
• FASB 95--1987
• Components
 Operating cash: Operations and
working capital
 Investing cash: Non-current assets
and investments
 Financing cash: L/T debt, equity and
dividends
19
Businesses are like Fruit
Trees

Fruit = Operating Activities

Trunk & Branches = Investing Activities

Roots = Financing Activities

20
 Net Income vs. Cash Flow
Indirect Method
• Net Income
• +/- Non-cash Items
• +/- Changes in Operating Working
Capital
• = Cash Flow from Operations

21
Indirect vs. Direct Method
• FASB prefers the direct method
• FASB requires net income to cash from
operations reconciliation
• Components:
 Cash from customers
 Cash from dividends
 Cash from interest income
 Other operating cash receipts
 Cash paid to suppliers
 Cash paid to employees
 Cash paid for taxes
 Cash paid for interest
 Other operating cash payments

22
 Profitability Analysis
chapter 4 & 5
• Rate of Return on Assets--ROA
 Measures success in using assets to
generate earnings (excluding financing)
• Disaggregated ROA
 ROA = Profit Margin X Asset Turnover
 Line by line P & L Analysis
 A/R, Inventory & F/A turnover

23
 ROA Summary
• Level 1: ROA as a whole
• Level 2: Disaggregate ROA
• Level 3a: Margin analysis in detail
• Level 3b: Disaggregate turnover
• Level 4: ROA, margin & turnover by
geographic segment

24
 ROCE--Return on Common
Shareholders’ Equity
• Return after O-I-F activities
• ROA and ROCE
 ROCE > ROA when ROA exceeds the
cost of creditor and pref. Shareholder
capital

25
 Disaggregated ROCE
• ROCE = ROA X CEL X CSL
• Common Earnings Leverage = op.
Income available to common s/h
• Cap. Structure Leverage =
multiplier effect of other capital
sources

26
 Risk Analysis
• Types of risk
 International
 Domestic
 Industry
 Firm-specific
• Our focus will be on the financial
aspects of risk

27
 Relationship to O-I-F
• S/T liquidity…O…working capital
• L/T liquidity…I…plant capacity
• L/T liquidity…F…debt svc. rqmts

28
 S/T Liquidity
• Current ratio
• Quick ratio
• Ops. Cash flow to C/L
• W/C Activity ratios:
 A/R turnover
 Inventory turnover
 A/P turnover

29
 L/T Liquidity
• L/T Debt Ratio
• Debt/Equity Ratio
• Liabilities/Assets Ratio
• Interest coverage…fixed charges
coverage
• OCF to Total Liabilities
• OCF to Capital Expenditures
30
 Comparative Analyses
• Time series analysis (same company)
 Changes in customers, product or
geography
 Major M&A activity
 Accounting changes
• Cross-sectional analysis (industry)
 Industry definitions
 Metric calculations
31
 Industry Ratio Sources
• Robt. Morris Associates, Annual
Statement Studies
• Dun & Bradstreet, Industry Norms
and Key Financial Ratios

32
 Stickney’s Comparability
Risks…in additon to WFO’s
• Earnings not reflective of actual
economic value added
• F/S restatement
• F/S classification
• Time variations in excess of 3 mos.
• Global accounting factors

33
 Quality of Earnings Issues-
Chapter 6
• Non-recurring items…sustainability
• Earnings measurement
• Earnings management

• Essentially we are trying to

determine if what is reported is
going to recur in the future.
34
 Sustainability Issues
• Discontinued operations
• Extraordinary gains and losses
• Changes in accounting principles
• Impairment of long-lived assets
• Restructuring charges
• Changes in estimates
• Peripheral gains and losses
• Mgt. analysis including the MD&A
35
 Restructuring Difficulties
• Conservative vs. aggressive
accounting practices
• Periodic charges vs. one time event
• “Taking a bath”

36
 Analyst’s Role
• Is restructuring adequate
• Wall street point of view
• Significant judgement required

37
 Earnings Management
• Reasons it occurs:
 Incentive compensation factor
 Job security
 Smoothing reduces erratic performance which
lowers perceived risk
 Gov’t anti-trust avoidance
• Reasons against:
 Can’t do it forever
 Capital market penalties for excess

38
 Methods of Management
• GAAP choices
• Management judgement and
estimates
• Timing of transactions

39
 Restated F/S
• Discontinued operations
• Pooling of interests-(new guidelines)
• Accounting principle changes

• Big issue here is the difficulty of

calculating prior years’ impact if
information is not presented.
40
 Global Considerations
• Use SEC Form 20-F
 Discloses equity and net income
reconciliation between local GAAP and
US GAAP
• Evaluate environmental, customs and
strategic implications as well as
GAAP

41
 Chp. 6 Examples
• Ex. #1: Halliburton-discontinued segment
• Ex. #2: Fountain Pwerboats – extraordinary item
• Ex. #3: Tenneco Automotive – changes in acctg. Princ.
• Ex. #4: Brunswick- effect of actg. Changes
• Ex. #5: Ford-cumulative effect acctg changes
• Ex. #6: PepsiCo-other comprehensive loss
• Ex. #7: Cisco-other items
• Ex. #8: PepsiCo-asset impairment
• Ex. #9: JDS Uniphase- asset impairment
• Ex. #10: JDS Uniphase -restructuring
• Ex. #11: Brunswick-unusual charges
• Ex. #12: PepsiCo-merger related costs

42
 Chp. 6 Examples, cont.
• Ex. #13: DriveTime-change in actg estimate
• Ex. #14: Hersey-change in actg estimate
• Ex. #15: Delta Air Lines- other gains and losses
• Ex. #16: PepsiCo-other gains and losses
• Ex. #17: PepsiCo-other gains and losses
• Ex. #18: General Mills –restated statements
• Ex. #19: Account classification differences
• Ex. #20: Ericsson-worldwide reporting

43
 Extended Profitability-
(use for chapter 4 & 5)
• ROA=PM x AT
• ROA increases as Risk increases
• ROA increases as OL increases
• Sales cyclicality increases risk
• Offset with higher AT
• ROA varies with life cycle

44
 Economic Aspects
• Monopoly…high PM; low AT
• Pure Competition…low PM; high AT
• Oligopoly…mixture of the two

45
 ROCE Considerations
• ROCE tends to follow ROA
• Two theories
 Random walk…high stays high; low stays low
 Equilibrium…revision to average ROCE
• Penman’s findings
 Random walk valid 1-6years
 Equilibrium thereafter takes hold
• Capital structure not changed for ROCE
improvement

46
 Extended Risk
• Financial Distress
 Credit risk
 Bankruptcy risk
• Financial Distress Spectrum
 Payment omission
 Default
 Bankruptcy
 Liquidation
47
 Credit Risk C’s
• Circumstances
• Cash flows (Capability to repay)
• Collateral
• Capacity for debt
• Contingencies
• Character of management
• Conditions
48
 Bankruptcy
• Process
 Chapter XI…liquidation
 Chapter VII…reorganization
• Predictive Models
 Beaver…univariate
 Net income before amort. etc./total liab.
 Altman’s Z…see pages 631-633
 Multivariate

49
 Multivariate Criticisms
• Relevant ratios might be missing
• Subjective evaluation
• Model based on available info; lack of info
might bias model
• MDA assumes normal distribution of ratios
• MDA requires similar relationship of variables
for bankrupt and non-bankrupt firms

50
Other Issues in Bankruptcy
Models
• Population does not include equal #
of bankrupt and non-bank. Firms
• Excludes size and industry factors
• Accrual vs. cash flow variables
• Models remain unchanged over time

51
 General Summary of Factors
• Investment Factors
 Liquidity lowers risk
 AT lowers risk
• Financing Factors
 Lower debt levels lowers risk
 S/T debt increases risk over L/T debt
• Operating Factors
 Profitability lowers risk
 Operational consistency lowers risk
 Small size, rapid growth and audit exceptions increase risk

52
 Market Risk
• Drivers
 Political
 Personnel
 Product
• Market risk drives market return
• CAPM measures market risk
 Market risk beta is driven by…
 Operating leverage
 Financial leverage
 Sales variability

53
 Pro-forma Financials-
Chapter 10
• Sales revenue (revenue growth)
• Operating expenses
• Asset requirements (asset turnover)
• Debt and equity requirements
• Cost of financing-(interest etc.)
• Statement of cash flows
• Balance sheet
54
 Pro Forma Approaches
Exhibit 10.1
• Follow the 6 step plan page 742
• FSAP has a Forecast pro forma
template
• % analysis can be used to project
income statement and balance sheet
• Individual items
 Turnover ratios as a benchmark

55
 Key Assumptions and
Caveats
• Annual revenue growth rate
• Expense relationships
• Levels of investment
 Working capital
 Fixed Assets
• Financing mix
• 4-5 year range
• Consistency
• GIGO (garbage in garbage out)

56
 Pro-forma Methodology

• Chapter 10 provides you with a

format for building the excel
worksheet and integrating it with the
FSAP template

57
 Rev. Recognition Options
Chapter 7
• Period of production
• Completion of production
• Time of sale
• During collection period
• Upon cash receipt

58
 Earnings Management
• Increases as cash flow period grows
• Increases as options for estimation
grows

59
 Criteria for Recognition
• Work is completed
• Measurable amount
• Costs are identifiable
• Collection is reasonably assured

60
Earnings Sustainability Risk
• Uncollectible A/R
• High volume of returned goods
• Unrecorded warranties

61
 L/T Contractors
• Multiple accounting periods
• Price established in advance of work
• Periodic payments
• Percentage of completion
 IRS approach
• Completed contract

62
Criteria for Exp. Recognition
• Matched with revenue
• Consumption of service or benefit

63
 Rev. Recog. When Cash is
Uncertain
• Installment method
• Cost-recovery-first method

64
 Disclosure
• Accounting policies footnote

65
 Inventory Cost Flow
Assumptions
• Weighted average
• FIFO-first in; first out
• LIFO-last in; first out

66
 LIFO Liquidation
• Sales greater than production
• Cash flow increases due to reduced
purchases
• Cash flow decreases due to higher
income taxes

67
 LIFO Characteristics
• Rapid price increases
• Provides better income smoothing in
light of inventory change variability
• Tax savings
• Industry specific
• Larger firm size

68
 Other LIFO Factors
• GAAP disclosure: LIFO reserve
• Stock reaction is inconclusive

69
 Analytical Considerations
• Cost flow assumption
• Price variation & inventory turnover
• LIFO liquidation impact
• Inventory obsolescence
• Inventory financing

70
 LIFO - FIFO Adj.
• Inventory value
• Working capital changes
• Income statement changes
• SCF changes

71
 Fixed Assets--Key Issues
• B/S Amount
• Useful lives
• Depreciation method
• Recoverability
• Maintenance & repair expense
• Overall issue: undervaluation potential

72
F/A--Earnings Sustainability
• B/S amount vs. replacement cost
• Choice of depr. Lives (instant profit)
• Choice of depr. method

73
 Intangibles--General
• Expense cost of development
• Recognize as asset purchased
intangibles
• Amortize up to 40 years
• Caution surrounding “in process
R&D”

74
 S/W Development Costs
• Expense through “tech. feasibility”
• Capitalize, thereafter
• Amortize over useful life

75
 Goodwill
• Results from acquisitions
 Treat according to GAAP
 Eliminate from B/S

76
 Intangibles--Earnings
Sustainability
• Generally expense
• The above is a questionable approach
• Needed-ways to value intangibles

77
 Liability Recognition
Chapter 8
• Probable future sacrifice
• Little or no discretion to avoid
• Event has occurred

78
 No Liability, If...
• Mutually unexecuted contracts
• Certain contingencies
 Not probable
 Not measurable

79
 Controversial Liability Issues
• Hybrid securities
• Sale of A/R w/recourse
• Product financing arrangements
• R&D financing arrangements
• Take or pay contracts
• Derivative instruments

80
 Liability Valuation
• PV of future cash flows > 1 year
• Cost of future deliverables
• Cash advance value

81
 Leases
• Operating lease
 Expense
• Capital lease
 Capitalize w/liability
 SFAS 13
 Title transfer
 Bargain purchase option
 75% of life rule
 90% of cost rule
 Slightly different tax rules
• May want to restate all as capital
82
 Retirement Benefits
• Pensions (FASB 87 & 132)
• Post-retirement Health Benefits
(FASB 106 & 132)

83
 pensions
Pension Fund Assets Pension Fund Liab.
Assets-BOP Liab-BOP
+/- Actual Earnings
+ Contributions + Incr.- Time
- Payments + Incr.- Service
= Assets-EOP +/- Actuarial G & L
- Payments
= Liab-EOP

84
 Key Terms
• ABO - amount expected to be
paid--current salaries
• PBO - amount expected to be
paid--future salaries

85
 Pension Expense
• Service cost
• Interest cost
• Actual return on plan assets
• Amort. of adoption cost
• Amort. of PBO increase/decrease
• Amort. of actuarial gains & losses

86
 Minimum Liability
• If ABO > FV of Assets, then
adjust to Comprehensive Income

87
 Health Care Benefits
• No minimum liability
• Minor measurement differences
• Considers income tax impact
• Sensitivity analysis
• Note politicization on p. 410

88
 Analyst’s Role
• Awareness of underfunding
• Reasonableness of assumptions
• Actual performance vs. expected
performance

89
 Income Taxes-FASB 109
• Book income
• Permanent differences
• Temporary differences
 Taxables
 Deductibles
• Taxable income

90
 FASB 109-History
• APB 11 - income statement focus
• FASB 109 - B/S focus
• FASB 109 - Allows deferred debits

91
 Implementation
• Determine differences
• Eliminate permanent differences
• Classify temporary differences
• Assess need for valuation allowance
 Taxables > deductibles
 Negative factors
 Positive factors
 “more likely than not…”
92
 Disclosure
• Income tax expense
• Income before taxes
• Statutory rate reconciliation
• Composition of deferred taxes and
assets

93
 Deferred Tax Liability
• Is it real?
• Consider in terms of a “going
concern”

94
 Analyst’s Role
• Effective tax rate changes
• Changes in valuation allowance
• Tax rate by venue
• Normalize rate excluding one time
changes

95
 Reserves
• Matching principle
• Exclude expenses
• Defer negative asset revaluation (ie
FASB 115)
• Difficult to assess & adjust

96
 Combination Issues
Chapter 9
• Corporate acquisitions
• Investments in securities
• Foreign currency translation
• Segment reporting

97
 Business Combinations
• Purchase accounting
 Record at FMV
 Excess to goodwill
• Pooling
 Assume assets and liabilities
 Must meet the 12 criteria for pooling

98
 Pooling Criteria
• 2 year autonomy
• independence
• single transaction w/in one year
• stock for at least 90% of stock
• 2 year moratorium on equity interest changes
• no reacquisition of shares for bus. Combos
• ratio interests remain unchanged
• no change in voting rights
• no security issues remain outstanding
• no reacquisition of securities
• no special funding agreements
• no disposal plans

99
 Investment in Securities
• Under 20%
• 20% to 50%
• Over 50%

100
 Under 20%
• Held to maturity
• Available for sale…comprehensive inc.
• Trading…income statement
• Analyst issues
 include or exclude adj. from income

101
 20% to 50%
• Equity method if influence exists
• Analyst issues
 relationship between income and cash
 submerged assets

102
 Over 50%
• Consolidation
• Might want to consider ROA after
inclusion of unconsolidated subs.

103
 Tax Consequences
• Under 80%…interest or dividends
• Over 80%…consolidated return

104
Foreign Currency Translations
• Functional currency
 Foreign currency
 all-current method
 income stmt. at the avg. rate
 B/S at end-of-period rate
 unrealized translation adj. in comp. income
 U.S. currency
 monetary method
 avg., end of period and historical rates

105
 FX-Analyst Issues
• Translation adjustments in income?
• Difficult to interpret due to limited
disclosure
• Significant international variance in
practice

106
 Disaggregation of Info.
• Disclosure of segments (mgt. Approach)
 operating segments
 geographic locations
 major customers
• 10% rule
• Elements
 operating income
 sales
 assets

107
 Why Value Via Cash Flow?
Chapter 11
• Cash = ultimate value
• Cash = common denominator

108
 Economists & Cash Flow
• Investors spend cash
• Accrual method subject to “acctg. Tricks
• Mgt. can manipulate earnings

109
Valuation: Cash Flow Based
• Periodic cash flows
• Residual value
• Approximate discount rate
 Cost of capital

110
 Periodic Cash Flows
• Unleveraged
 Excludes interest, debt & pfd. stock
 Weighted avg. cost of capital
 Valuation of assets
• Leveraged
 Includes interest, debt & pfd. Stock
 Cost of equity capital
 Valuation of common shareholder equity
111
 Periodic Cash Flows, cont.
• Appropriately reflect inflation
 Nominal vs. real cash
• Use after tax amounts

112
 Residual Value
• Horizon = no growth
• (last cash flow) x (1 + growth rate)
(discount rate - growth rate)

• Consider conversion tables (Stickney-

p. 766)

113
 Cost of Capital
• Debt
 Market rate (1-tax rate)
 Leases: use borrowing rate
• Preferred Equity
 Dividend rate
• Common Equity
 Risk free rate + ß(Mkt. Rate - RFR)
 Betas published in S&P’s stock reports

114
 Releveraging @ New Capital
Structure
• BL0=BU[1+(1-tax rate)(Current Debt)]
Current Equity

• Substitute BU with new capital structure

• BL1=BU[1+(1-tax rate)(New Debt)]
New Equity

115
 CAPM Critique
• Unstable ß’s
• Unstable MROR
• Size vs. ß’s

116
 Valuation Techniques
• Equity
 CFU-[(interest)(1-tax rate)]
Cost of equity capital
• Debt plus equity
 CFU ÷ Wtd. average cost of capital
• Adjusted present value
 CFU ÷ Unleveraged cost of equity cap.
 [interest(tax rate)] ÷ cost of debt cap.

117
 Unleveraging
• CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]
current equity

118
 Cash Flow Evaluation
• Advantages
 Economic base
 Rigorous methodology
• Disadvantages
 Residual value dominant
 Time consuming
 Subjective

119
 Price-Earnings Ratio
Chapter 12
• Higher risk -> lower PE
• Theoretical model
 P/Actual earnings = (1+g)/(r-g)

120
 Theoretical Variances: PE
• Earnings persistance
 Transitory…no change in PE
 Permanent…change in PE
• Accounting principles
 Lower earnings…higher PE

121
 Trending
• Penman found transitory earnings
consistency…that is high PE caused
by lower than normal earnings is
counterbalanced in the following
year.
• 5-7 years reversion to mid-teens
growth

122
 PE Ratio Factors
• Risk (cost of capital)
• Growth
• Earnings persistence
• GAAP

123
 PE Analysis Keys
• Use a sustainable growth rate
• Doesn’t work when g>r
• Doesn’t work when g approximates r
• Test reasonableness with actual PE
• Existence of transitory earnings
• Impact of GAAP

124
 Price to Book Value
• Market rewards growth in excess of
cost of capital
• Ultimately reverts to 1.0
• Function of
 Profitability
 BV growth

125
 P/BV-Theoretical Model
• 1+ [(Expected ROCE-r)(BVt)/(1+r)t] …
BV0

126
 Theoretical Variances: P/BV
• ROCE errors
• Cost of capital errors
• Growth rate errors
• Transitory earnings
• GAAP impact
 lower earnings…higher P:BV

127
 Trending: P/BV
• ROCE remains consistent and
reverts to 1.0 slowly.

128
 Cash Flow vs. Earnings
• Long term impact is indifferent
• Short term impact: earnings more
indicative
• Use multiple approaches

129