1. Chapter 14 Financial Statement Analysis 14-1

2. Income Statement Four broad types of accounts: –Cost of goods sold –General and administrative expenses –Interest expense –Taxes on earnings Common Size income statements –Divide each account by net sales –Eliminates size distortions 14-2

3. Balance Sheet Assets –Current –Long-term Liability (current and long term) and stockholders’ equity Common size balance sheet –Divide each account by total assets –Each account presented as a percent of the total 14-3

4. Statement of Cash Flows A financial statement showing a firm’s cash receipts and cash payments during a specified period. –Recognizes transactions only if cash changes hands. –“Undoes” much of accrual accounting to get at cash changes –Does not allocate capital expenditures through time via depreciation as income statement does 14-4

5. Statement of Cash Flows Three main sections Cash flow related to operations CFO Cash flow related to investing CFI Cash flow related to financing CFF Allows the analyst to understand which of the firm’s activities are using and which generating cash. 14-5

6. Statement of Cash Flows Not all sources of cash are equally sustainable. –Would you rather invest in a firm that is primarily generating cash through operations or through financing? It is difficult to evaluate whether the amount of cash flow related to investing is ‘good’ or ‘bad.’ What else would we need to know? –Rate of return on the investment –Comparable data over time or from competitors 14-6

7. Accounting Versus Economic Earnings Accounting earnings –Earnings of a firm as reported on its income statement Economic earnings –The real flow of cash that firm could pay out to its stockholders without impairing its productive capacity.  14-7

8. Past Versus Future ROE ROE = Net Profits / Equity Data from recent past may provide information regarding future ROE Analysts should always keep an eye on the future Expectations of future dividends and earnings determine intrinsic value of stock 14-8

9. Financial Leverage and ROE The relationship among ROE, ROA, and leverage: ROE = Net Profits / Equity ROA = EBIT / Total Assets 14-9

10. Ratio Analysis Purpose of Ratio Analysis –Understand the factors that affect performance Methods –Trend analysis –Comparative analysis –Combination of the two Use by External Analysts –Important information for investment community –Important for credit markets  14-10

11. DuPont Decomposition of ROE ROE can be decomposed into various ratios that reflect different aspects of a firm’s performance:  14-11

12. Type of Financial Ratios Ratio (1) Tax Burden (TB): –Measures the percentage of pretax profit that the firm keeps after paying taxes Ratio (2) Interest Burden (IB): –Measures the percent of EBIT kept after paying interest expense – – This ratio is 1 if the firm has no debt 14-12

13. Type of Financial Ratios Ratio (3) Operating Profit Margin –Measures the percentage of sales revenue that remains after subtracting cost of goods sold, selling and administrative expenses and depreciation Ratio (4) Asset Turnover Ratio (ATO) –Measures the efficiency of the firm at generating sales per dollar invested in the assets – Note: Margin x ATO = ROA 14-13

14. Type of Financial Ratios Ratio (5) Leverage ratio –Leverage ratio = 1 + Debt / Equity –The leverage ratio is a measure of the percentage of debt in total capitalization. –Note that it appears that using more debt as a percent of capital will increase ROE, but using more debt also reduces the interest burden ratio 14-14

15. Type of Financial Ratios Ratio (5) Leverage ratio –Compound leverage factor (CLF) = Interest burden x Leverage –If the CLF > 1, the use of debt will increase ROE –If the CLF < 1, the use of debt will decrease ROE –CLF will be greater than 1 if ROA > Interest rate on debt –What does this imply about when firms should use more debt? 14-15

16. Ratio Analysis using GI Asset Utilization Ratios (2010 data for GI) 1.Total Asset Turnover 2.Fixed Asset Turnover 3.Inventory Turnover 4.Average collection period or days sales in receivables How will these ratios affect ROA and ROE? Industry Average 0.40 0.70 0.50 60 days 14-16

17. Ratio Analysis using GI Market Price Ratios (2010 data for GI) 1.Market-to-Book 2.P/E ratio 3.ROE Also Industry Average.69 8.0 8.64% 14-17

18. Figure 14.1 DuPont Decomposition for Hewlett-Packard  14-18

19. Table 14.10 Ratios for Major Industries 14-19

20. Economic Value Added Concept: A firm adds value only if the return on its projects exceeds its required rate of return For example: The effect of ROE and b on the Price/Book ratio for a stock with E 1 = $1, Book value/share = $8.33 and k =12%: Bold numbers are the Price/Book ratios that result from the given Plowback ratio and ROE. Plowback Ratio (b) ROE0%25%50%75% 10%1.000.950.860.67 12%1.00 14%1.001.061.202.00 14-20

21. Economic Value Added Concept: A firm adds value only if the return on its projects exceeds its required rate of return Approach to compare accounting profitability with the cost of capital Definition –ROA-k (Capital Invested in the firm) –k = opportunity cost for capital or required return 14-21

22. Table 14.11 Economic Value Added 14-22

23. Comparability Problems Ratios must have a benchmark, but it can be difficult to compare data of different firms Different inventory valuation –LIFO and FIFO Depreciation problems –Accounting depreciation  Economic depreciation –Different depreciation methods at different firms –In periods of inflation depreciation is understated in economic terms and real economic income is overstated 14-23

24. Comparability Problems Inflation and interest expense –Nominal interest rates include an inflation premium to compensate for erosion in the real value of the principal. –Conceptually then, from an economic viewpoint part of interest expense is actually principal repayment.  14-24

25. Fair Value Accounting Fair value accounting uses market values rather than book values in the firm’s financial statements. –Market value is a truer picture of the current value of the firm, –Market value is forward looking, book value is backward looking –Trend is toward market value accounting  14-25

26. Fair Value Accounting Financial Accounting Standards Board (FASB) Rule 157 classifies assets in one of three buckets: –Level 1: Assets that are traded in active markets and should be valued at market prices –Level 2: Asset that are not actively traded, but their values may be estimated from market data on similar assets –Level 3: Assets that can only be valued with inputs that are difficult to observe. Level 2 and Level 3 assets may be valued using pricing models and the values may be ‘marked to model’ 14-26

27. Quality of Earnings: Accounting Choices Quality of earnings refers to the realism and sustainability of reported earnings, Allowance for bad debts must be realistic Extraordinary and Non-recurring items are sometimes pretty ordinary and common Earnings smoothing is pervasive –Revenue & expense recognition options –Engaging in contingent off-balance sheet assets (certain leases) or liabilities (selling credit default swaps) that have unknowable effects on earnings 14-27

28. International Accounting Conventions Reserving practices –Overseas firms have far more discretion in their ability to set aside reserves for future contingencies (or not) than U.S. firms have. –This means foreign firms’ earnings are more subject to managerial manipulation Depreciation –Foreign firms typically use accelerated depreciation on their financial statements and U.S. firms don’t, so foreign firms have lower reported earnings, ceteris paribus. Intangibles –Treatment of intangibles varies widely between countries. 14-28

29. IFRS The International Financial Reporting Standards (IFRS) have been adopted by the European Union and by over 100 countries. In 2007 the SEC began allowing foreign firms to list their securities in U.S. markets if they prepared their statements using IFRS In 2008 the SEC ruled that large U.S. multinational firms may start using IFRS rather than GAAP in 2010 and that all firms should use IFRS by 2014. IFRS standards are principle based rather than rules based 14-29

30. Value Investing: The Graham Technique Benjamin Graham Founder of modern fundamental analysis Graham believed careful analysis of a firm’s financial statements could turn up bargain stocks and his work was used by generations of analysts He developed many different rules for determining the most important financial ratios, as his ideas became popular they stopped working. 14-30