Research: Financial Domain & Case Studies – Part 2 Welcome to Class 19 Research: Financial Domain & Case Studies – Part 2 Chapter 8

The Balance Sheet Assets = Debts = Equity = Current Noncurrent Liabilities Short-term Long-term Equity Earned Paid-in Assets = Tangible and intangible items or rights owned (Current + Noncurrent) Debts = Financial obligations (Short + Long-term) Equity = The difference between Assets and Debts (Earned + Paid-in)

The Income Statement Revenue (-) Costs Gross Profit Expenses (+/-) Other Items Net Income Reports revenues, expenses, net income, and related items for the current fiscal year (plus two or more prior years). Net Income less dividends – is added to Retained Earnings which is on the Balance Sheet.

The Statement of Cash Flows Operating Activities Investing Financing The Statement has three segments: (1) Operating Activities (2) Investing Activities (3) Financing Activities Each will indicate whether cash has been “used in” or “provided by” The Statement of Cash Flows bridges the informational gap between accrual accounting and the need to know how cash is flowing through the business.

“OPERATING” ACTIVITIES: “Operating Activities” include cash used in or provided by:  The routine process of day to day business activities. NOT included in “OPERATING” ACTIVITIES:  Buying or selling equipment, facilities, patents, etc. Transactions with stockholders and long-term creditors

Investing Activities “Investing Activities” include cash used in or provided by:  Acquiring subsidiary companies  Selling subsidiary companies  Investing in other companies  Selling investments in other companies  Buying or selling property, plant, and equipment  Buying or selling other fixed, productive and/or intangible assets, etc.

Financing Activities “Financing Activities” include cash used in or provided by:  Selling or repurchasing a company’s own stock  Issuing corporate notes or bonds  Borrowing money from institutions – Banks, Insurance companies, etc.  Debt repayment  Payment of dividends, etc.

1. Common-size financial data Two (2) Step Harmony in Financial Analysis 1. Common-size financial data (Convert currency data into percentages) Enables comparison of firms of different sizes Enables firms with different currencies to be compared 2. Separate performance into categories The Financial Four are: (1) Profit, Equity, & Share Value Management (2) Debt Management (3) Cash Management (4) Asset Management $

Financial Four Categories 1) Profit, Equity, & Share Value Management  Continuously expanding profitability  Increasing equity balances  Strengthening the value of traded shares … are interrelated and tied closely to a firm’s ability to: Achieve and sustain competitive advantages Yield above average returns for stockholders

2) Debt Management Financial leverage is important to most (not all) firms. The degree of leverage and the proper configuration (long-term and short-term) are crucial considerations. Debt levels should be sufficient to: Satisfy current financial requirements, Amplify shareholder returns, and Facilitate corporate growth. BUT, caution is important since excessive levels of debt can shift corporate decision-making from TMTs to creditors.

3) Cash Management Inadequate funds can lead to:  Lost purchasing discounts (2% 10, n 30 = 36% apr) Missed business opportunities Alienation of suppliers, etc. Excessive funds can lead to: Lack of financial productivity Increased risk of hostile takeover bids

It is possible for a firm to have: 4) Asset Management Optimal Asset Managements means the firm has the appropriate amount of investment in the right type of assets. It is possible for a firm to have: Too much invested in non-current assets = unproductive Too little invested in non-current assets = unproductive Outdated non-current assets (need to upgrade) = unproductive Slow payment by customers = unproductive Slow sales of Inventory = unproductive

Financial Statements Analysis: After data has been common-sized… 1. Prepare a list of performance questions 2. Perform multiple analyses: Vertical analysis Horizontal analysis Cross-sectional analysis Time-series analysis

Performance Questions  Have revenues increased?  Has gross margin improved?  Has net income increased?  Has EPS increased?  Has the share price increased?  Has total shareholder equity increased?  Has retained earnings increased?  Is return on equity adequate compared to a benchmark?  How does return on assets compare to the benchmark?  Is cash flow from operations positive (provided by) or negative (used in)?  Does "times interest earned" (cost of capital) look appropriate?  What does the independent auditor (Certified Public Accounting firm) say about the financial data?

These are potential signs of trouble Look for Red Flags These are potential signs of trouble The Red Flags

The Red Flags 1) Management bonuses or stock options increase when profits decrease or are level 2) Acquisition of a competitor for a significant premium (Paying too much?) 3) Diversifications appear nonsensical – (unrelated or new ventures that appear to lack the opportunity for synergy) 4) Reverse stock splits 5) Dividends are declared even though the firm is losing money 6) Off Balance Sheet Financing 7) Debt Refinancing 8) Restructuring, reengineering, downsizing, rightsizing, resizing, and related euphemisms 9) Significant increases in Treasury Stock 10) Public statements about stock value or performance such as: “We know of no better investment than our own company so we will be reacquiring stock.” 11) Erratic or inconsistent decisions, actions, or achievements

The Red Flags 12) Disgruntled Board of Directors 13) Financial Statements that look a little too good or perhaps slightly incongruent when compared to other data 14) Unusual financial arrangements or joint-ventures that appear strangely complex 15) Assets that seem relatively too high or too low when compared by percentage to the benchmark 16) Rapid changes in assets or debts – (Unusual increases or decreases in Inventory, Receivables, Short-term Debt, etc.) 17) Restatement of earnings 18) Investigation by the SEC

The Red Flags 19) Changes in reported Net Income that seem inconsistent with changes in Cash position – (e.g. Net Income up significantly while Cash is down significantly) 20) Large or unusual non-operating expenses or income 21) Footnotes (endnotes) that seem unclear or ambiguous 22) Golden parachutes for executives that appear a little too generous 23) Extraordinary compensation packages for top management 24) The firm's independent auditors (CPAs) express a "reservation" in their opinion section of the annual report

Analysis Methods 1. Vertical Analysis 2. Horizontal Analysis 3. Cross-Sectional Analysis 4. Time-Series Analysis

End Financial Domain Lecture Read Chapter Nine: Performance Perspective: A Stakeholder Perspective Study these slides, some will be on the test. Smile! 