McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-1 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-2 The Analysis of the Balance Sheet and Income Statement Chapter 9

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-3 Analysis of the Balance Sheet and Income Statement Reformulate to distinguish between Operating and Financial activities Carry out common size analysis Calculate balance sheet and income statement ratios Compute stocks and flows to get measures of profitability

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable Accrued expenses Deferred (unearned) revenues Advances from customers Short-term notes payable Short-term borrowings Deferred taxes (current portion) Current maturities of long-term debt Long-term liabilities: Bank loans Bonds payable Long-term notes payable Lease obligations Commitments and contingencies Deferred taxes Pension liabilities Post employment liabilities Minority interest Preferred equity Common equity The Typical GAAP Balance Sheet Chapter 9 Page 268 Exhibit 9.1 Assets Current assets: Cash Cash equivalents Short-term investments (marketable securities) Deposits and advances Accounts receivable (less allowances) Short-term notes receivable Other receivables Inventories Prepaid expenses Deferred income taxes (current portion) Long-term assets: Noncurrent receivables Long-term debt investments Long-term equity investments - less than 20% ownership Long-term equity investments - equity method Property plant & equipment (less accumulated depreciation) Land Buildings Equipment Leased assets Leasehold improvements Construction in progress Intangible assets Patents Licenses, franchises, & business rights Copyrights & trademarks Goodwill Software development costs Deferred taxes (non-current portion) Deferred charges

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-5 Chapter 9 Page 270 Exhibit 9.2 Assets Financial assets: Cash equivalents Short-term investments Short-term notes receivable (?) Long-term debt investments Operating assets: all else Liabilities and Stockholders’ Equity Financial liabilities: Short-term borrowings Current maturities of long-term debt Short-term notes payable (?) Long-term borrowing (bank loans, bonds payable, notes payable) Lease obligations Preferred stock Operating liabilities: all else Minority interest Common equity The Reformulated Balance Sheet

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-6 The Typical GAAP Income Statement Chapter 9 Page 277 Exhibit 9.5 Net sales (sales minus allowances) + Other revenue (royalties, rentals, license fees) - Cost of sales = Gross margin - Marketing and advertising expenses - General expenses - Administrative expenses - Pension expense  Special items and non-recurring items restructuring charges merger expenses gains and losses on asset sales asset impairments litigation settlements environmental remediation - Research and development expense = Operating income + Interest revenue - Interest (expense)  Realized gains and losses on financial assets + Equity share in subsidiary income = Income before tax - Income taxes = Income before extraordinary items and discontinued operations  Discontinued operations  Extraordinary items Gains and losses on debt retirement Abnormal gains and losses in operations  Cumulative effect of an accounting change - Minority interest = Comprehensive income ===================

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-7 The Reformulated Income Statement Chapter 9 Page 278 Exhibit 9.6 Operating income as reported + Share of subsidiary income  Discontinued operations  Cumulative effects of an accounting change  Abnormal gains and losses on operations  Dirty surplus operating items in Table 8.1 = Operating income before tax - Tax on operating income: + Tax as reported + Tax benefit from net interest expenses = Operating income after tax - Net financial expenses after tax + Interest expense - Interest revenue = Net interest expense before tax - Tax benefit from net interest expenses = Net interest expenses after tax  Gains and losses on debt retirement  Realized gains and losses on financial assets  Dirty surplus financial items in Table 8.1 (including preferred dividends) - Minority interest = Comprehensive Net Income ====================

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-8 The Allocation of Taxes In the income statement only one tax number is reported: It must be allocated to the operating and financial components to put both on an after-tax basis First, calculate the tax benefit (tax shield) provided by deducting interest expense Chapter 9 Page From the operating income deduct both the total tax and the tax shield, to capture what the operating income would have been if there had been no financing activities To the financial income add the tax shield, because its net effect is fully attributable to the financing activities where t is the marginal (not effective) tax rate

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 9-9 The Reformulated Income Statement Chapter 9 Page 278 Exhibit 9.6 Operating income as reported + Share of subsidiary income  Discontinued operations  Cumulative effects of an accounting change  Abnormal gains and losses on operations  Dirty surplus operating items in Table 8.1 = Operating income before tax - Tax on operating income: + Tax as reported + Tax benefit from net interest expenses = Operating income after tax - Net financial expenses after tax + Interest expense - Interest revenue = Net interest expense before tax - Tax benefit from net interest expenses = Net interest expenses after tax  Gains and losses on debt retirement  Realized gains and losses on financial assets  Dirty surplus financial items in Table 8.1 (including preferred dividends) - Minority interest = Comprehensive Net Income ====================

January ASSETS Current Assets Cash and equivalents$ 63,208$ 124,094 Accounts receivable, less allowances 705, ,934 Inventories 954, ,755 Deferred income taxes 99,608 94,750 Other current assets 25,595 19,933 Total current assets 1,848,152 1,601,466 Property, plant and equipment 776, ,990 Intangible assets 951, ,332 Other assets 260, ,994 $3,836,666$3,322,782========== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Short-term borrowings$ 244,910$ 24,191 Current portion of long-term debt Accounts payable 341, ,103 Accrued liabilities 446, ,164 Total current liabilities 1,033, ,908 Long-term debt 521, ,226 Other liabilities 181, ,813 Redeemable preferred stock 54,344 56,341 Deferred contribution to ESOP (20,399) (26,275) Total liabilities 1,770,358 1,456,013 Common Shareholders' Equity Common stock 119, ,225 Additional paid-in capital 801, ,108 Accumulated other comprehensive income (25,639) (36,110) Retained earnings 1,170,970 1,037,546 Total shareholders’ equity 2,066,308 1,866,769 $3,836,666$3,322,782========== VF Corporation 1998 Reported Balance Sheet Chapter 9 Page 274 Exhibit 9.3 S O O O O O O O F F O O F O F O

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 9 Page 275 Exhibit 9.3 January OPERATING ASSETS Cash$ 15,000$ 12,000 Accounts receivable, less allowances 705, ,934 Inventories 954, ,755 Other current assets 25,595 19,933 Property, plant and equipment 776, ,990 Goodwill (intangible assets) 951, ,332 Deferred income tax asset 200, ,469 Pension asset 35,164 27,713 Other assets 124,510 87,562 Deferred ESOP contributions 20,399 26,275 Operating assets 3,808,857 3,236,963 OPERATING LIABILITIES Accounts payable 341, ,103 Accrued liabilities 446, ,164 Other liabilities 181, ,813 Operating liabilities 968, ,080 NET OPERATING ASSETS (NOA) 2,839,980 2,351,883 NET FINANCIAL OBLIGATIONS (NFO) Short-term borrowings$ 244,910$ 24,191 Current portion of long-term debt Long-term debt 521, ,226 Preferred stock 54,344 56,341 Cash and equivalents (48,208) (112,094) 773, ,114 COMMON SHAREHOLDERS’ EQUITY$2,066,308$1,866,769========== VF Corporation 1998 Reformulated Balance Sheet

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 9 Page 280 Exhibit 9.7 VF Corporation 1998 Reported Income Statement FISCAL YEAR ENDEDJANUARY 2JANUARY NET SALES$5,478,807$5,222,246 COSTS AND OPERATING EXPENSES Cost of products sold 3,586,686 3,440,611 Marketing, administrative & general expenses 1,198,854 1,175,598 Other operating expense 9, ,794,638 4,617,173 OPERATING INCOME 684, ,073 OTHER INCOME (EXPENSE) Interest income 6,411 23,818 Interest expense (62,282) (49,695) Miscellaneous, net 3,300 6,684 (52,571) (19,193) INCOME BEFORE INCOME TAXES 631, ,880 INCOME TAXES 243, ,938 NET INCOME 388, ,942 OTHER COMPREHENSIVE INCOME Foreign currency translation 10,471 (42,538) COMPREHENSIVE INCOME$ 398,777$ 308,404========== O O O O F F O S O

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved FISCAL YEAR ENDEDJANUARY 2JANUARY Net sales$5,478,807$5,222,246 Cost of products sold(3,586,686)(3,440,611) Gross margin 1,892,121 1,781,635 Miscellaneous income 3,300 6,684 1,895,421 1,788,319 Advertising expense287,500309,300 Administrative and general expense911,354866,298 Other expense 9,098(1,207,952) 964(1,176,562) 687, ,757 Tax benefit on preferred dividends to ESOP Foreign currency translation adjustment 10,471 (42,538) Operating income before tax 698, ,919 Tax reported243,292234,938 Tax benefit of debt 21, ,523 9, ,771 Operating income after tax 433, ,148 Net financial expense Interest expense 62,282 49,695 Interest income (6,411)(23,818) Net interest before tax 55,871 25,877 Tax benefit of debt (38%)(21,231) (9,833) Net interest after tax 34,640 16,044 Preferred dividends 3,717 3,804 Preferred stock redemption loss 2,763 41,120 1,855 21,703 Comprehensive income (available to common)$ 392,862$ 303,445========== Chapter 9 Page 281 Exhibit 9.7 VF Corporation 1998 Reformulated Income Statement

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 5 Page 137 Exhibit 5.2 Genentech, Inc Reported Balance Sheet ASSETS: Current assets Cash and cash equivalents$ 137,043$ 66,713 Short-term investments 603, ,461 Accounts receivable (less allowances) 172, ,267 Inventories 93, ,200 Prepaid expenses & other current assets 39,267 28,475 Total current assets 1,045, ,116 Long-term marketable securities 356, ,726 Property, plant and equipment, at cost: Land 57,313 55,998 Buildings 258, ,871 Equipment 383, ,392 Leasehold improvements 12,508 11,988 Construction in progress 60,480 55,299 Less accumulated depreciation (268,751) (215,255) Net property, plant and equipment 503, ,293 Other assets 105,452 60,989 Total assets$2,010,995$1,745,124========== S F O O O F O O O O O O O Logo used with permission of Genetech, Inc.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable$ 37,101$ 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Current portion of long-term debt Total current liabilities 233, ,499 Long-term debt 150, ,358 Other long-term liabilities 25,504 25,483 Total liabilities 408, ,340 Stockholders' equity: Preferred stock - - Special common stock Redeemable common stock - 1,002 Common stock 1,532 1,343 Additional paid-in capital 1,281,640 1,207,720 Retained earnings 263, ,127 Net unrealized gain on securities available for sale 54,273 9,592 Total stockholders' equity 1,602,047 1,348,784 Total liabilities and stockholders' equity$2,010,995$1,745,124========== Genentech, Inc Reported Balance Sheet O O O O O O O F F O F Chapter 5 Page 137 Exhibit 5.2 Logo used with permission of Genetech, Inc.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Genentech, Inc Reformulated Balance Sheet Chapter 9 Page 276 Exhibit OPERATING ASSETS Cash$ 10,000$ 10,000 Accounts receivable, less allowances 172, ,267 Inventories 93, ,200 Prepaid expenses and other current assets 39,267 28,475 Property, plant and equipment 503, ,293 Other assets 105,452 60,989 Operating assets 924, ,224 OPERATING LIABILITIES Accounts payable 37,101 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Other long-term liabilities 25,504 25,483 Operating liabilities 258, ,111 NET OPERATING ASSETS (NOA) 665, ,113 NET FINANCIAL ASSETS (NFA) Cash equivalents 127,043 56,713 Short-term investments 603, ,461 Long-term investments 356, ,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) 936, ,671 COMMON SHAREHOLDERS’ EQUITY$1,602,047$1,348,784========== Logo used with permission of Genetech, Inc.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 5 Page 132 Exhibit 5.1 YEAR ENDED DECEMBER Revenues Product sales$635,263$601,064 Royalties 190, ,022 Contract and other 31,209 25,556 Interest 60,562 42,748 Total revenues 917, ,390 Costs and expenses Cost of sales 97,930 95,829 Research and development 363, ,322 Marketing, general and administrative 251, ,604 Special charge (primarily merger related) 25,000 - Interest 7,940 7,058 Total costs and expenses 745, ,813 Income before taxes 172, ,577 Income tax provision 25,841 5,183 Net income$146,432$124,394======== Net income per share$ 1.21$ 1.04 Weighted average number of shares used in computing per share amounts 121, ,465 Genentech, Inc Reported Income Statement O O O F O O O O F S Logo used with permission of Genetech, Inc.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 9 Page 282 Exhibit 9.8 Operating income: Operating revenues$857,283 Operating expenses 712,632 Special merger charge 25, ,632 Operating income before tax 119,651 Tax reported 25,841 Tax on financial income (20,523) 5,318 Operating income after tax 114,333 Financial income: Interest revenue 60,562 Interest expense 7,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income 76,780 Comprehensive income available to common$191,113 ======== Weighted average shares outstanding 121,220 Comprehensive income per share $1.58 Genentech, Inc Reformulated Income Statement Logo used with permission of Genetech, Inc.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Comparative Analysis Comparison to other firms is called cross-sectional analysis Comparison to a firm’s own history is called time-series analysis Common size analysis gives a ready comparison: The Balance Sheet –Operating items / Totals –Financing items / Totals The Income Statement –Operating items / Total revenues –Financing items / Total financing income Chapter 9 Page 282

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Common Size Income Statement for Genentech, Amgen & Chiron Ch. 9 Pg. 284 Ex. 9.9 Genentech Amgen Chiron $ % $ % $ % Operating revenues before other items: Product sales (unrelated parties) , Royalties Re venues partners and agreements Operating revenue , , Operating expenses before other items: Cost of sales Research and development Selling, general and administrative Write-off of purchased in-process technologies Special change (corporate transactions) Restructuring charge Other Operating expense , , Operating income before tax and other items (562.7)(55.1) Income tax reported Income tax on financial items(20.5) (2.4) (19.8) (1.0) Tax on operating income Operating income (loss) before other items (587.7)(57.6) Share of income (loss) of subsidiary - - (53.3) (2.7) Foreign currency translation adjustment Operating income after tax (504.9)(49.5) Financial income after tax: Net interest income (8.3)(21.3) Tax on interest income(20.5)(26.7) (19.8)(63.9) Unrealized gain on securities Comprehensive income, net (466.0)(45.7)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Genentech Amgen Chiron Balance Sheet Components: % $ % $ % Operating assets: Cash Accounts receivable Inventories Deferred taxes Other current assets Property, plant & equipment Purchased technologies Other intangibles assets Investments in subsidiaries Other long-term assets , , Operating liabilities: Accounts payable Accrued liabilities Taxes payable Unearned revenue Other current liabilities Other long-term liabilities Financial assets: Cash equivalents Short-term investments Long-term investments , Financial obligations: Short-term borrowings Current maturities Long-term debt Common stockholders’ equity -1, Common Size Balance Sheet for Genentech, Amgen & Chiron Chapter 9 Page 286 Exhibit 9.10

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Genentech Amgen Chiron Totals Relative to Equity (%): Operating assets Operating liabilities(16.1) 30.8(52.7) Net operating assets Financial assets Financial obligations (9.4)(14.8)(68.9) Net financial assets (37.2) ============ Common Size Balance Sheet for Genentech, Amgen & Chiron Chapter 9 Page 286 Exhibit 9.10

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Trend Analysis: VF Corporation’s Income Statement Base in Sales ,320 Cost of sales ,974 Gross margins ,346 Advertising expense Admin and general expense Operating income before tax Taxes on operating income Operating income after tax Net financial expense Comprehensive income Trend analysis of selected financial statement items for VF Corporation, Base = 100 for 1993 Chapter 9 Page 287 Exhibit 9.11

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Trend Analysis: VF Corporation’s Balance Sheet Base in Accounts receivable Inventory Property, plant and equipment (gross) ,250 Property, plant and equipment (net) Goodwill (gross) Goodwill (net) Deferred tax asset, before allowance Deferred tax asset, after allowance Operating assets ,794 Accounts payable Accrued liabilities Other liabilities Operating liabilities Net operating assets ,153 Financial assets Financial obligations Net financial obligations Common shareholders’ equity ,547 Trend analysis of selected financial statement items for VF Corporation, Base = 100 for 1993 Chapter 9 Page 287 Exhibit 9.11

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Income Statement Ratios Revenue composition ratios –Operating Revenue Composition Ratio: –Financial Income Composition Ratio: Profit Margin Ratios –Operating Profit Margin: –Sales Profit Margin: –Other Items Profit Margin: Chapter 9 Page 288 Box 9.3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Income Statement Ratios (cont.) Profit Margin Ratios (cont.) –Financial Income Contribution Ratio: Net Income Profit Margin Expense Ratios –Expense Ratio –1 - Sales PM = Sum of Expense Ratios Chapter 9 Page 288 Box 9.3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Balance Sheet Ratios Composition Ratios –Operating Asset Composition Ratio –Operating Liability Composition Ratio –Financial Asset Composition Ratio –Financial Liability Composition Ratio Chapter 9 Page 290 Box 9.4

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Balance Sheet Ratios (cont.) Operating Liability Leverage Ratio (OLLEV): Financial leverage ratios: –Capitalization Ratio: –Financial Leverage Ratio (FLEV) It is always the case that Capitalization Ratio - Leverage Ratio = 100.0%

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Growth Ratios –Growth rate in sales –Growth rate in operating income –Growth in RNOA –Growth in CSE Chapter 9 Page 291 Box 9.5

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 9 Page 292 A Financial Statement Analysis Template 1. Reformulate the statement of stockholders’ equity on a clean-surplus basis. 2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the reformulated statement of common stockholders’ equity. 3. Reformulate the balance sheet to distinguish operating and financial assets and obligations. 4. Reformulate the income statement on a clean-surplus basis and distinguish operating and financing income. 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis. 6. Reformulate the cash flow statement. 7. Carry out the analysis of ROCE. 8. Carry out the analysis of growth.