Financial Statement Analysis P.V. Viswanath Based on Damodaran’s Corporate Finance

Questions we would like answered… As financial analysts… These are the fundamental questions to which we would like the answer from financial statements. Unfortunately, financial statements do not always do a good job at answering these questions. However, the information we have comes from the firm’s financial statements… P.V. Viswanath

Basic Financial Statements The balance sheet, which summarizes what a firm owns and owes at a point in time. The income statement, which reports on how much a firm earned in the period of analysis The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis We get most of the information we use in financial analysis from accounting statements. Knowing how to navigate through them and recognizing their limitations is a crucial part of financial analysis. P.V. Viswanath

The Balance Sheet The balance sheet reports on what a firm owns (as assets) and where it received the funds to finance them (as liabilities). The values assigned to these assets may not reflect what they are worth today because the principles underlying valuation are accounting principles. In general, Fixed assets: are shown at what was originally paid for them, net of any loss in value from use (shown as depreciation). The older the asset, the less likely it is that book value will be close to the current market value. Current assets: are shown at what was paid for them, but this is likely to be closer to current market value. Current assets include Inventory: which can be valued at prices paid at the the end of the year for the material (called FIFO accounting ) or the beginning of the year (called LIFO) Accounts receivable: which is valued at what customers owe to the firm, net of any expected bad debts Cash: which is valued at its stated value Marketable securities can be valued differently depending how they are categorized - as majority active or minority passive investments. Investments held for trading purposes are valued at market value. The most common intangible asset is goodwill, which arises from acquisitions. If the market value of the acquired company is greater than the book value, the difference is shown as goodwill (if purchase accounting is used) This is what we can see from the firm’s balance sheet… P.V. Viswanath

An example : Maxwell Shoe Company, Inc Maxwell Shoe Company Inc. designs, develops and markets casual and dress footwear for women and children under multiple brand names, each of which is targeted to a distinct segment of the footwear market. The Company offers casual and dress footwear for women in the moderately priced market segment under the Mootsies Tootsies brand name, in the upper moderately priced market segment under the Sam & Libby and Dockers Khakis Footwear For Women brand names and in the better market segment under the Anne Klein 2 and A Line Anne Klein brand names. It also sells moderately priced and upper moderately priced children's footwear under both the Mootsies Tootsies and Sam & Libby brand names. In addition, it designs and develops private label footwear for selected retailers under the retailers' own brand names. Maxwell has licensed the J.G. Hook trademark to source and develop private label products for retailers who require brand identification. In a financial balance sheet, we are much less concerned with recording what a firm paid for what it owns and much more concerned about how much it it is worth. There is therefore a greater emphasis on growth assets and the market values of equity and debt. P.V. Viswanath

An example of an Accountant’s Balance Sheet Maxwell Shoe Company, Inc. As of October 31, 2000 (In ‘000s) In a financial balance sheet, we are much less concerned with recording what a firm paid for what it owns and much more concerned about how much it it is worth. There is therefore a greater emphasis on growth assets and the market values of equity and debt. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are created when future taxable income is expected to exceed pretax income, while deferred tax liabilities occur in the reverse case. (Companies that pay more in taxes than the taxes they report in the financial statements create an asset called a deferred tax asset. This reflects the fact that the firm’s earnings in future periods will be greater as the firm is given credit for the deferred taxes.) Deferred tax assets ($798) reflect allowance for doubtful accounts, stock option compensation, inventory capitalization, and inventory reserve. Deferred tax liabilities ($479) reflect amortization of trademarks (long-term) and depreciation of property and equipment (short-term). P.V. Viswanath

Notes on the Maxwell Balance Sheet Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are created when future taxable income is expected to exceed pretax income, while deferred tax liabilities occur in the reverse case. If more deductions have been taken in the current period for reporting purposes, then tax payable (according to the GAAP income statement) will be lower than the actual tax paid. Hence it will seem like taxes have been prepaid. This is reflected in the balance sheet as an asset. Deferred tax assets ($798) reflect allowance for doubtful accounts, stock option compensation, inventory capitalization, and inventory reserve. Deferred tax liabilities ($479) reflect amortization of trademarks (long-term) and depreciation of property and equipment (short-term). P.V. Viswanath

A Financial Analyst’s Balance Sheet In a financial balance sheet, we are much less concerned with recording what a firm paid for what it owns and much more concerned about how much it it is worth. There is therefore a greater emphasis on growth assets and the market values of equity and debt. This is what we would like to see… P.V. Viswanath

The Income Statement P.V. Viswanath Accrual accounting principles require that Revenues be recorded as the transaction is completed, not when payment is made Expenses associated with these revenues be shown, even though payment might not have been made in the current period. Expenses are categorized as operating or capital expenses. Operating expenses are expenses designed to generate benefits only in the current period and are shown in the income statement. Capital expenses are expenses generating benefits over multiple periods, and are shown on the balance sheet and depreciated or amortized. Financial expenses are expenses associated with debt financing and generally represent interest expenses. If a firm maintains two sets of books - tax and reporting - the taxes due may not match up to the taxable income in the books Extraordinary gains or losses are supposed to be separated out from operating gains and losses (though there is some discretion that firms seem to have in this process) P.V. Viswanath

The Income Statement Maxwell Shoe Company, Inc. For the year ended October 31, 2000 (In ‘000s) Accrual accounting principles require that Revenues be recorded as the transaction is completed, not when payment is made Expenses associated with these revenues be shown, even though payment might not have been made in the current period. Expenses are categorized as operating or capital expenses. Operating expenses are expenses designed to generate benefits only in the current period and are shown in the income statement. Capital expenses are expenses generating benefits over multiple periods, and are shown on the balance sheet and depreciated or amortized. Financial expenses are expenses associated with debt financing and generally represent interest expenses. If a firm maintains two sets of books - tax and reporting - the taxes due may not match up to the taxable income in the books Extraordinary gains or losses are supposed to be separated out from operating gains and losses (though there is some discretion that firms seem to have in this process) P.V. Viswanath

The Income Statement The Income Statement provides us with information about changes in the balance sheet from one year to another. Hence it is crucial to creating the financial balance sheet that we want. However, the income statement is prepared according to GAAP. Underlying GAAP are certain principles, such as revenue recognition when the service for which the firm is being paid has been performed substantially, the matching principle governing recognition of expenses, a historical cost-based approach, and a basic conservatism in the recognition of assets. This leads to certain accounting practices that need to be corrected, from a financial analyst’s point of view… Accrual accounting principles require that Revenues be recorded as the transaction is completed, not when payment is made Expenses associated with these revenues be shown, even though payment might not have been made in the current period. Expenses are categorized as operating or capital expenses. Operating expenses are expenses designed to generate benefits only in the current period and are shown in the income statement. Capital expenses are expenses generating benefits over multiple periods, and are shown on the balance sheet and depreciated or amortized. Financial expenses are expenses associated with debt financing and generally represent interest expenses. If a firm maintains two sets of books - tax and reporting - the taxes due may not match up to the taxable income in the books Extraordinary gains or losses are supposed to be separated out from operating gains and losses (though there is some discretion that firms seem to have in this process) P.V. Viswanath

Desirable Modifications to Income Statement There are a few expenses that are consistently mis-categorized in financial statements. In particular, Operating leases are considered as operating expenses by accountants but they are really, partly, financial expenses R&D expenses are considered as operating expenses by accountants but they are really capital expenses. The degree of discretion granted to firms on revenue recognition and extraordinary items is used to manage earnings and provide misleading pictures of profitability. P.V. Viswanath

Dealing with Operating Leases A Lease is a long-term rental agreement Leases can either be capital leases or operating leases A capital lease is often for as long as the life of the equipment, or there may be an option for the lessee to buy the equipment at the end of the contract period. Capital leases have to be capitalized and shown on the balance sheet. In an operating lease, typically, the contract period is shorter than the life of the equipment, and the lessor pays all maintenance and servicing costs. Operating leases do not have to be shown on the balance sheet. However, operating leases also represent expected fixed periodic payments, and thus function similar to debt. As such, a financial analyst would want to see operating leases capitalized as well P.V. Viswanath

Dealing with Operating Lease Expenses How do we do this? First, we compute the “debt” value of the operating lease as the PV of the operating lease expenses, using the pre-tax cost of debt as the discount rate. This now creates an asset - the value of which is equal to the debt value of operating leases. This asset now has to be depreciated over time. Second, the operating income has to be adjusted to reflect these changes. P.V. Viswanath

Dealing with Operating Leases: Adjusting Operating Income Note that the operating lease expense has two components an operating expense component, i.e. the reduction in the value of the asset being used, represented by the depreciation, and a financing component, i.e. the cost of financing the asset. Using this model, we assume that Interest expense on the debt created by converting operating leases = Operating lease expense - Depreciation on asset created by operating lease. Then, Adjusted Operating Income = Operating Income - Depreciation on operating lease asset + operating lease expenses = Operating Income + Imputed Interest expense on operating leases. = Operating Income + Debt value of Operating leases x Cost of debt An operating lease creates a commitment to make lease payments much as a debt commitment with a bank creates a commitment to make interest payments. There is a ripple effect created when operating leases are converted into debt. P.V. Viswanath

Example: Capitalizing Operating Leases at Maxwell Shoe From the 10-K filing made by the company with the SEC on 1/29/2001: The Company leases equipment and office and warehouse space under long-term non-cancelable operating leases which expire at various dates through January 31, 2007. At October 31, 2000, future minimum payments under such leases were as given below (in ‘000s). Maxwell Shoe reports lease commitments in their financial statements. The present value of operating lease expenses is computed using the pre-tax cost of debt. (An argument can be made that the unsecured cost of debt should be used.) The interest expense for the current year, on capitalized lease obligations would be computed using the capitalized value of last year. Minimum payments are capitalized using an assumed pre-tax cost of debt of 7% p.a. This will be the value of the Lease Asset/Liability on the Oct. 31, 2000 balance sheet. Later years refer to 2006 and 2007. P.V. Viswanath

Example: Capitalizing Operating Leases at Maxwell Shoe I assume that payments are made at the end of the fiscal year, ending in October. Since the figure for "Later Years," $750, is larger than the declining sequence of amounts for previous years, I assume that this reflects the amounts for both 2006 and 2007. Since the leases expire in January 2007, which is 3 months past the fiscal year end, I have prorated the amounts for 2006 and 2007, viz. $600 for 2006 (payable at the end of October 2006) and $150 for 2007 (payable at the end of January 2007). Hence the $498.08 computed as the present value for the row “Later Years” equals 600/(1.07)6 + 150/(1.07)6.25. The present value of the minimum payments (as of Oct. 31, 2000) works out to $4441.38. Maxwell Shoe reports lease commitments in their financial statements. The present value of operating lease expenses is computed using the pre-tax cost of debt. (An argument can be made that the unsecured cost of debt should be used.) The interest expense for the current year, on capitalized lease obligations would be computed using the capitalized value of last year. P.V. Viswanath

Imputed Interest Expenses on Operating Leases Lease payments in 2000 were $1024. Hence the PV of operating leases as of end 1999 would be (PV of Op. Leases as of end 2000 + Lease expenses for 2000)/1.07 = (4441.38+1024)/1.07 = $5107.83. The imputed interest expense is the Debt Value of Operating Leases x Interest rate. Adjusted Operating Income = Operating Income + Imputed Interest Payment = $13,489 + $357.55 = $13,846.55 Net Income is not affected because the imputed interest expense will be subtracted from Operating Income, just as any other interest expense would be.   These will be added back to the operating income at Boeing and the Home Depot to get the corrected operating income. P.V. Viswanath

The Effects of Capitalizing Operating Leases Debt: will increase, leading to an increase in debt ratios used in the cost of capital and levered beta calculation Operating income: will increase, since operating income will now be before the imputed interest on the operating lease expense Net income: will be unaffected since it is after both operating and financial expenses anyway Return on Capital will generally decrease since the increase in operating income will be proportionately lower than the increase in book capital invested It is not just debt that is changed when operating leases are converted into debt. P.V. Viswanath

R&D Expenses: Operating or Capital Expenses Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. It is more logical to treat it as capital expenditures. An approach to capitalizing R&D (cost-based), Specify an amortizable life for R&D (2 - 10 years) Collect past R&D expenses for as long as the amortizable life Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5th of the R&D expense from four years ago, 2/5th of the R&D expense from four years ago...: R&D is the ultimate capital expenditure. The benefits are in the long term. The fact that the benefits are uncertain does not take away from this fact. A cash-flow based approach would be better, but it is much more difficult to obtain. P.V. Viswanath

Capitalizing R&D Expenses: Boeing Assuming a ten year life; thus, R&D expenses for 1998 will be amortized over the 1999-2008 period. Year R&D Outlay Unamortized Portion at end 1998 Value Amortization for 1998 1988 751 75.1 1989 754 0.1 75.4 1990 827 0.2 165.4 82.7 1991 1417 0.3 425.1 141.7 1992 1846 0.4 738.4 184.6 1993 1661 0.5 830.5 166.1 1994 1704 0.6 1022.4 170.4 1995 1300 0.7 910 130 1996 1633 0.8 1306.4 163.3 1997 1924 0.9 1731.6 192.4 1998 1895 1 Capitalized value of R&D for 1998 = 9100.2 Total R&D Amortization Expense for 1998 = 1381.7 I used a 10-year amortizable life. There seems to be a long gestation period between research and commercial products in this business. I am using straight line amortization (10% a year) for simplicity. P.V. Viswanath

Boeing’s Corrected Operating Income For 1998 Operating Income* $1,720.00 + Research and Development Expenses** $1,895.00 - Amortization of Research Asset** $1,381.70 = Adjusted Operating Income $2,233.30 * Data obtained from Income Statement ** Data obtained from Income Statement; see also previous slide In principle, it could be argued that R&D capitalized values should be restated in 1998 dollars, instead of using the raw unamortized portions of R&D outlays in past years; however, the current procedure may be defended on the grounds of conservatism. The amortization of the research asset is obtained by adding up the amortization on each of the expenses on the previous page. The $31 million in imputed interest expense on operating leases is carried over from a couple of pages prior. P.V. Viswanath

Boeing’s Corrected Balance Sheet There will be the following modifications on the balance sheet: There will be a new asset, R&D, that will show on the assets side. If one wants to show the gross value of R&D and accumulated amortization, however, that will require computation of the amortization in each year for as many years as the amortizable life of the R&D. Corresponding to that, the value of stockholder’s equity will be higher by the same amount. In our example, this amount will be $9,100. P.V. Viswanath

The Effect of Capitalizing R&D Operating Income will generally increase, though it depends upon whether R&D is growing or not. If it is flat, there will be no effect since the amortization will offset the R&D added back. The faster R&D is growing the more operating income will increase. Net income will increase proportionately, depending again upon how fast R&D is growing. Adjusted Net Income will also have to take the tax deductibility of R&D into account. Book value of equity (and capital) will increase by the capitalized Research asset Capital expenditures will increase by the amount of R&D; Depreciation will increase by the amortization of the research asset; for all firms, the net cap ex will increase by the same amount as the after-tax operating income. Here again, the effects are in many items in the financial statements. P.V. Viswanath