2. Welcome to Class 16 Research: Financial Domain & Case Studies – Part 2 Chapter 8

3. Financial Statements A Cursory Review

4. The Balance Sheet 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) BalanceSheet Assets Current Noncurrent Liabilities Short-term Long-term Equity Earned Paid-in

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

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

7. Operating Activities “Operating Activities” provided by “Operating Activities” include cash used in or provided by : routine process 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

8. 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.

9. 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.

10. The Financial Four are: (1) Profit, Equity, & Share Value Management (2) Debt Management (3) Cash Management (4) Asset Management 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 Two (2) Step Harmony in Financial Analysis 2. Group performance categories

11. 1. Common-size financial data Common-sizing is the process of converting all items on the financial statements to a percentage. Advantages of common-sizing:  Allows the comparison of a small corporation to a large corporation  Allows the comparison of two corporations reporting in different currencies e.g. Yen vs. Dollar

12. 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: AA chieve and sustain competitive advantages YY ield above average returns for stockholders 2. Group Performance Categories

13. 2) Debt Management Financial leverage is important to most (not all) firms. and The degree of leverage and the proper configuration (long-term and short-term) are crucial considerations. Debt levels should be sufficient to: 1.Satisfy current financial requirements, 2.Amplify shareholder returns, and 3.Facilitate corporate growth. BUT BUT, caution is important since excessive levels of debt can shift corporate decision-making from TMTs to creditors.

14. 3) Cash Management Inadequate funds can lead to: 36% apr  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

15. 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: unproductive Too much invested in non-current assets = unproductive unproductive Too little invested in non-current assets = unproductive unproductive Outdated non-current assets ( need to upgrade ) = unproductive unproductive Slow payment by customers = unproductive unproductive Slow sales of Inventory = unproductive

16. 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

17. 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?

18. 1. Vertical Analysis 2. Horizontal Analysis 3. Cross-Sectional Analysis 4. Time-Series Analysis Analysis Methods Students: Study slides after the Stop Sign – this is important to you!

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

20. 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

21. 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

22. 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 The Red Flags

23. STOP! End Lecture BUT… The following slides are for homework.

24. Table of Contents: Analysis Methods XBRL Segments of the Annual Report Proxy Statements Cost of Capital & Interest Rate terms Financial Abbreviations

25. 1. Vertical Analysis Each line item is divided by a base number Income Statement Revenue as the divisor for all other items on the Income Statement Balance Sheet Total Assets as the divisor for everything on the Balance Sheet This allows the measurement of deviation from acceptable norm. Analysis Methods

26. 2. Horizontal Analysis (partial Time-Series) Each line item is divided by its corresponding number from the budget or from a previous period. For example: On both the Income Statement & the Balance Sheet Each line item is divided by its counterpart from last year and then 100% is subtracted to compute the % of change. This allows the measurement of variance by category.

27. 3. Cross-Sectional Analysis { also called Target/Benchmark analysis } The Cross-Sectional Analysis is a comparison of the target company to the benchmark company. It involves the comparison of common-sized financial statement analyses (Balance Sheet and Income Statement) of both companies.

28. 4. Time-series Analysis Time-series analysis is a combination of other analyses. Time series analyses normally begin with a horizontal analysis, which is a “sideways” line-item summary of period-over-period changes in revenue, expenses, assets, debts, and equity. Example: If a firm spent 20% more (or less) on advertising than it did in the previous period, this would be revealed by this analysis. Time-series analyses also include two vertical analyses. Comparing the two vertical analyses reveals the extent to which individual categorical activities have changed as a percentage of a base number. Example: The firm may have spent 4% of Sales on advertising during the current period whereas in the previous period, 10% of Sales was spent on advertising. Even though the absolute amount spent on advertising may have increased the relative commitment has been reduced. The example above represents a 6% relative reduction in advertising.

29. Annual Reports can be difficult for the uninitiated to read because they lack standardization. Some degree of standardization my be on the horizon with the advent of the XBRL system. XBRL

30. XBRL is a semi-standardized language that may offer future help to readers of financial reports. This acronym stands for eXtensible Business Reporting Language. XBRL is a language for the electronic communication of business and financial data that is meant to simplify the preparation of financial data and to improve communication. It originally began as a project by the American Institute of Certified Public Accountants (AICPA) and now there are multiple companies selling products (mostly software and books) and services to assist with the implementation of XBRL. http://www.xbrl.org/Home/ More information see – http://www.xbrl.org/Home/

31. The annual report contains separate segments, each with unique and valuable data and these typically include: Chair's report CEO's report Auditor's report on corporate governance Mission Statement Compliance statement (Corporate Governance) Statement of Directors responsibilities Auditor's report on the financial statements Selected Financial Highlights Statement of Financial Position (Balance Sheet) Statement of Retained Earnings Statement of Revenues and Expenses (Income Statement) Statement of Cash Flows Notes to the Financial Statements Accounting Policies Segments of the Annual Report

32. Proxy Statement Another important document required by the SEC is the The SEC requires that shareholders of a company whose securities are registered under Section 12 of the Securities Exchange Act of 1934 receive a proxy statement prior to a shareholder meeting, whether an annual or special meeting. The information contained in the statement must be filed with the SEC before soliciting a shareholder vote on the election of directors and the approval of other corporate action. Solicitations, whether by management or shareholders, must disclose all important facts about the issues on which shareholders are asked to vote.* *Data directly from SEC website

33. Proxy Statements (cont) Information included:  Voting procedures  Background information about the company's nominated directors (history with the company or industry, positions on other corporate boards, and potential conflicts in interest)  Compensation received by Board Members  TMT compensation, (salary, bonus, non-equity compensation, stock awards, options, and deferred compensation).  Data related to perks (personal use of company vehicles, aircraft, travel)  Golden parachutes (payout packages to TMTs upon leaving the firm)  Who is on the audit committee and detail about fees for both audit and non- audit fees paid to CPA firm.

34. Cost of Capital/Interest Rate Terms: 1.Euribor = 1.Euribor = Euro interbank offered rate 2.Libor = 2.Libor = London interbank offered rate 3.Prime Rate = 3.Prime Rate = Interest rate charged by commercial banks to their most credit-worthy customers 4.Fed Funds Rate = 4.Fed Funds Rate = Overnight rate that banks charge each other 5.Discount Rate * = 5.Discount Rate * = Interest rate charged to commercial banks by the Federal Reserve Also is a term used in discounted cash flow (DCF) analyses to determine the present value of future cash flows * Also is a term used in discounted cash flow (DCF) analyses to determine the present value of future cash flows

35. Financial Abbreviations MRQ: Most Recent Quarter TTM: Trailing Twelve Months YOY: Year Over Year LFY: Last Fiscal Year FYE: Fiscal Year Ending Enough!!