Financial Statement Analysis 1

1.Discuss the need for comparative analysis and identify the tools of financial statement analysis. 2.Explain and apply horizontal and vertical analysis. 3.Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. 4.Understand the concept of earning power, and how irregular items are presented. 5.Understand the concept of quality of earnings. 2

3  Forensic... Assessment of Past Performance and Current position  Future... Assessment of Future potential and related Risk

4  Inside the company  Outside the company  Really outside the company

5  Inside the company – 10K, website, press releases  Outside the company – external analysts, Standard and Poors, Valueline, Hoovers, Dun & Bradstreet, Moody’s, etc.

6 Three basic tools are used in financial statement analysis : 1.Horizontal (also called trend)analysis 2.Vertical analysis 3.Ratio analysis

7  Looking at the Trends over time….  In $$$$$$$$$$ or %%%%%  From the base year  Shows growth or decline  Used with Balance Sheet and Income Statement

8 Kellogg ($ in millions) Selected Income Statement Items - Horizontal Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 Total Revenue (Sales $ 12,575 $ 12,822 $ 11, %108.88%100.00% Gross Profit 5,3915,3675, %103.63%100.00% Total Operating Expenses 3,3903,4143, %103.11%100.00% Net Income 1,212 1,148 1, %104.08%100.00% Analysis: Look at the Trends, all of them What can you say about them?

9 Kellogg ($ in millions) Selected Income Statement Items - Horizontal Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 Total Revenue (Sales $ 12,575 $ 12,822 $ 11, %108.88%100.00% Gross Profit 5,3915,3675, %103.63%100.00% Total Operating Expenses 3,3903,4143, %103.11%100.00% Net Income 1,212 1,148 1, %104.08%100.00% Analysis: Sales grew in 2009 compared to 2008, however dipped in Net income grew each year; reviewing costs, Kellogg’s Operating Expenses grew at a much slower pace, which contributed to the Net Income growth. Also Kellogg’s gross profit improved in 2010, even though its sales did not. This suggests that Kellogg’s is controlling costs. Note: with more space, you would quote actual numbers and % for evidence.

10 CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT 12,822.0 – 11,776= % 11,776.0 Net sales for Kellogg company increased 8.88% in 2011 compared to Horizontal Analysis – Income Statement

11 Analysis: Look at the Trends, all of them What can you say about them? Kellogg ($ in millions) Selected Balance Sheet Items - Horizontal Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 Current assets $ 2,558 $ 2,521 $ 2, %92.79%100.00% Total Assets 11,20010,94611, %96.04%100.00% Current Liabliities 2,2883,5524, %87.83%100.00% Long Term Liabilities 8,928 9,498 8, %107.07%100.00% Retained Earnings 5,461 4,836 4, %114.68%100.00%

12 Analysis: Total Assets are decreasing; Current Assets are decreasing at a faster rate, suggesting more funds are being dedicated to Long Term Assets. However, Long Term Liabilities are stable, suggesting that the company is maintaining the same debt levels. Retained Earnings has grown by almost 30% over the base year, indicating that the company has been profitable. Kellogg ($ in millions) Selected Balance Sheet Items - Horizontal Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 Current assets $ 2,558 $ 2,521 $ 2, %92.79%100.00% Total Assets 11,20010,94611, %96.04%100.00% Current Liabliities 2,2883,5524, %87.83%100.00% Long Term Liabilities 8,928 9,498 8, %107.07%100.00% Retained Earnings 5,461 4,836 4, %114.68%100.00%

13  BALANCE SHEET:  What changed and in what direction?  How was it financed?  INCOME STATEMENT:  Are sales increasing?  Are costs following sales? (growth, decline)

14  Tracks changes over time  Tracks changes in one area (sales) compared to other areas (net income)

15  Common size analysis  What is your basis?  Balance Sheet: Total Assets  Income Statement: Net Sales (net revenues)

Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this 16 Kellogg ($ in millions) Selected Income Statement Items - Vertical Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 AmountPercentAmountPercentAmountPercent Total Revenue (Sales 12, % 12, % 11, % Gross Profit5, % 5, % 5, % Total Operating Expenses3, % 3, % 3, % Net Income 1, % 1, % 1, % Analysis: Look at the Trends, all of them What can you say about them?

Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this 17 Analysis: You can’t analyze Sales much, as it is the 100% number; so talk about the other numbers: Net Income as a percent of sales increased in 2009 compared to It dipped slightly in 2010 compared to 2009, but is still above 2008’s percentage level. Analysis: The improvements in Net Income were caused by reduction in Operating Expenses which reduced almost 1.5%, as a percentage of net sales) and Gross Profit (declined in 2008, but improved) in 2010 Kellogg ($ in millions) Selected Income Statement Items - Vertical Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 AmountPercentAmountPercentAmountPercent Total Revenue (Sales 12, % 12, % 11, % Cost of Goods Sold7, % 7, % 6, % Gross Profit5, % 5, % 5, % Total Operating Expenses3, % 3, % 3, % Net Income 1, % 1, % 1, %

Note that Total Assets are the 100% base figure and all other items are a percentage of this 18 Kellogg ($ in millions) Selected Balance Sheet Items - Vertical Analysis Period Ending 2-Jan-103-Jan-0929-Dec-07 AmountPercentAmountPercentAmountPercent Current assets 2, % 2, % 2, % Total Assets11, % 10, % 11, % Current Liabliities2, % 3, % 4, % Long Term Liabilities 8, % 9, % 8, % Retained Earnings 5, % 4, % 4, %

 The years were 1998 and

KELLOGG COMPANY, INC. Condensed Income Statement – Vertical Analysis For the Years Ended December 31 (In millions) Amount Percent Amount Percent Net sales $6, $6, Cost of goods sold 3, , Gross profit 3, , Selling & Admin. 2, , Nonrecurring Chgs Income operations , Interest expense Other income (expense),net Income before income taxes Income tax expense Net income $ $

 Look at the changes in each year?  What is the trend in Sales?  Does Cost of Goods Sold follow the same trend?  What about other costs? You may not know the reason, but what are your questions as to WHY things do not look right? See end of slides for solution 21

22  Relative size of things on the statement....Over time  Allows comparisons between companies

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24  Estimates  Cost  Alternative Accounting Methods  Atypical Data  Diversification

25  Financial statements are based on estimates.  allowance for uncollectible accounts  depreciation  costs of warranties  contingent losses To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate.

26  Traditional financial statements are based on historical cost and are not adjusted for price level changes.  Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.

27  One company may use the FIFO method, while another company in the same industry may use LIFO.  If the inventory is significant for both companies, it is unlikely that their current ratios are comparable.  In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.

28 Fiscal year-end data may not be typical of a company's financial condition during the year.

29  Diversification in American industry also limits the usefulness of financial analysis.  Many firms are so diverse they cannot be classified by industry.

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31 è Types: è Liquidity ratios è Profitability ratios è Solvency ratios è Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. è Single ratio by itself is not very meaningful

32 RATIO Analysis – Galore!

33 Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as banks, suppliers, employees

34  Current ratio  Acid-test ratio  Receivables turnover ratio  Inventory turnover Liquidity Ratios

35 Indicates short-term debt-paying ability Current Assets Current Liabilities

36 Indicates immediate short-term debt- paying ability Cash + Short-term Investments + Net Receivables Current Liabilities

37 Indicates liquidity of receivables Net Credit Sales Average Net Receivables

38 Indicates liquidity of receivables and collection success 365 days Receivables Ratio Turnover

39 Indicates liquidity of inventory Cost of Goods Sold Average Inventory

40 Indicates liquidity of inventory and inventory management 365 days Inventory Turnover Ratio

41 Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects: é its ability to obtain debt and equity financing é its liquidity position é its ability to grow é

42  Return on common stockholders’ equity ratio  Return on assets ratio  Profit margin ratio  Assets turnover ratio  Gross profit rate  Operating expenses to sales ratio  Cash return on sales ratio  Earnings per share (EPS)  Price-earnings ratio  Payout ratio Profitability Ratios

43 Indicates profitability of common stockholders’ investment Net income -preferred stock dividends Average common stockholders’ equity

44 Reveals the amount of net income generated by each dollar invested Net income Average total assets Higher value suggests favorable efficiency.

45 Indicates net income generated by each dollar of sales Higher value suggests favorable return on each dollar of sales. Net income Net sales

46 Indicates how efficiently assets are used to generate sales Net sales Average total assets

47 Indicates margin between selling price and cost of good sold Gross profit Net sales

48 Indicates the cost incurred to support each dollar of sales Operating expenses Net sales

49 Indicates net cash flow generated by each dollar of sales Cash provided by operations Net sales

50 Indicates net income earned on each share of common stock sales Income available to common stockholders Average number of outstanding common shares

51 Indicates relationship between market price per share and earnings per share Stock Price Earnings Per Share

52 Indicates % of earnings distributed in the form of cash dividends Cash Dividends Net Income

53 Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders

54  Debt to total assets ratio  Times interest earned ratio Solvency Ratios

55 Indicates % of total assets provided by creditors Total Liabilities Total Assets

56 Indicates company’s ability to meet interest payments as they come due Income before* Interest Expense & Income Tax Interest Expense * Also called Operating Income

57  Review and STOP HERE!

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59 The value of a company is a function of its future cash flows at normal income levels.

60  Accounting methods & estimates  Industry dependent  Requires FULL DISCLOSURE & CONSISTENCY  Non operating items on the Income Statement  Look at the D-E-A

61 Three types of irregular items are reported -- (all net of taxes)

62 Refers to the disposal of a significant segment of a business...  the elimination of a major class of customers or an entire activity.

63  Pepsi spun off: Taco Bell, Pizza Hut, and KFC  Quaker Oats spun off: Gatorade  Western Wireless spun off: Voicestream  PACCAR spun off: Paccar Automotive and Trico (oil well digging manufacturer)

64  Assume a company, Agroworld Inc. During 2001 the company discontinued and sold its chemical division.  The income in 2001 from chemical operations was $200,000, and  The loss on disposal of the chemical division $130,000.  Apply a 30% tax rate Discontinued Operations

65 Or, I could word this:  During 2001 the company discontinued and sold its chemical division.  The income in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and  The loss on disposal of the chemical division (net of $39,000 taxes) was $91,000. Discontinued Operations

Agroworld Inc. Income Statement (Partial) For the Year Ended December 31, 2001 Income before income taxes$800,000 Income tax expense (30% Tax Rate) 240,000 Income from continuing operations 560,000 Discontinued operations: 1) Income from operations of chemical division, net of taxes, $60,000 $140,000 2) Loss from disposal of chemical division, net of $39,000 income tax saving (91,000) 49,000 Net income before extraordinary item 609,000 66

67 Are events and transactions that meet two conditions:  Unusual in nature  Infrequent in occurrence

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70  In 2001 a revolutionary foreign government expropriated property held as an investment by Agroworld Inc.  The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000. Extraordinary Items

Agroworld Inc. Income Statement(Partial) For the Year Ended December 31, 2001 Income before income taxes$800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations: Income from operations of chemical division, net of taxes, $60,000 $140,000 Loss from disposal of chemical division, net of $39,000 income tax saving (91,000) 49,000 Net income before extraordinary item 609,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving 49,000 Net income $560,000 71

72  Is permitted, when  New principle is PREFERABLE to the old and  Effects are clearly DISCLOSED in the income statement.

73  Examples:  a change in depreciation methods (such as declining-balance to straight-line)  a change in inventory costing methods (such as FIFO to average cost).

74  Use new principle in results of operations of the current year.  The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section below Net Income. Change in Accounting Principle

75  Most revenues, expenses, gains, and losses recognized during the period are included in net income.  Plus:  Discontinued Operations  Extraordinary Items  Accounting Changes.  Plus changes in unrealized investment gains and losses Comprehensive Income

76  The substance of earnings  And their sustainability into the future.

Companies have incentives to manage income to meet or beat Wall Street expectations, so that the market price of stock increases and the value of stock options increase. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. Quality of Earnings 77

Alternative Accounting Methods Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings. Pro Forma Income Pro forma income usually excludes items that the company thinks are unusual or nonrecurring. Some companies have abused the flexibility that pro forma numbers allow. Quality of Earnings 78

Improper Recognition Some managers have felt pressure to continually increase earnings and have manipulated the earnings numbers to meet these expectations. Abuses include: Improper recognition of revenue (channel stuffing). Improper capitalization of operating expenses (WorldCom). Failure to report all liabilities (Enron). Quality of Earnings 79

Good Bye and Good Luck. – solutions follow End of Chapter 14

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 COGS increased, but Sales went down – this is reverse trend as Costs should directly proportional to Sales (when sales go up, COGS should go up, when sales go down, COGS should go down)…what happened?  Selling & Admin dramatically went up 2.6%, why?  Most alarming, Net Income went down a full point (0.9%)  Why???????? 82

 Big, generic bags of cereal hit the supermarkets in 1997 and  Kellogg’s made the management decision not to participate in the big bags of cereal line  Argument: Our corn flake cereal is premium, fresh, in a box. Customer will pay more for a better product.  It didn’t work. Customers switched to the cheaper cereal.  Kellogg’s spent more on advertising (reflected in growth in Selling & Admin costs).  Kellogg’s finally reduced its prices (reflected in lower sales but no corresponding reduction in Cost of Goods Sold  The end result  Lower Net Income 83