Chapter 5 Essentials of Financial Statement Analysis Learning

Chapter 5: Essentials of Financial Statement Analysis Learning objectives 1. Essentials of financial statement analysis, financial statement analysis tools and approaches. 2. How ROA is used to analyze profitability and the insight to separate ROA to profit margin and asset turnover rate. 3. How ROA and financial leverage combine to determine a firm’s return on equity (ROCE). 5 -1

Learning objectives (contd. ) 3. Capital structure and credit risk: How short -term liquidity risk and long-term solvency risk are assessed and how to use the statement of cash flows to assess credit risk. 4. Why do companies issue pro forma earnings? 5 -2

Qualitative Characteristics of Accounting Information: n n How do we define financial reporting quality? Qualitative characteristics of accounting Information: q q q Understandability Decision usefulness Reliability Relevance Consistency Comparability 3

Attributes of High Quality Financial Reporting n Financial reporting (earnings) quality has been considered positively associated with the following: q High persistence of earnings and cash flows q High predictive ability of earnings and cash flows q High earnings response coefficient q Low level of earnings management q More voluntarily disclosure q Strong corporate governance 4

Manipulating Income and Earnings Management n n n Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance. “Most managers prefer to report earnings that follow a smooth, regular, upward path. ” 2 1. Arthur Levitt, former SEC chairman. 2. Bethany Mc. Lean, “Hocus-Pocus: How IBM Grew 27% a Year, ” Fortune, June 26, 2000, p. 168. 5

What should the users be aware of ? n Statement users must: q Understand current financial reporting settings and standards. q Recognize that management may manipulate the financial information. q Distinguish between reliable financial statement information and poor quality information. 6

Financial statement analysis and accounting quality n The accounting distortions need to be watched when analyzing statements. Examples include: 1. Nonrecurring gains and losses 2. Differences in accounting methods. 3. Differences in accounting estimates. 4. GAAP implementation differences. 5. Historical cost convention. 7

Learning Objective: Essentials of Financial Statement Analysis 8

Analysis, Forecast and Vulation n Reviewing the Financial Statements: Procedures Review comparative financial statements and audit opinion. Adjusting and forecasting accounting numbers: q n q Adjusting accounting numbers to remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income. 9

Analysis n Assessing Profitability and Creditworthiness: Common size statements. q Trend statements q Financial ratio analysis: Use ratios to assess liquidity, profitability and solvency. q Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default. q 10

Forecast and Valuation n Comprehensive Financial statement forecasts (see Appendix B of Chapter 6 ) n Valuing Equity Securities (see Appendix A of Chapter 6): a. Free cash-flow model q b. Abnormal earnings model (residual income model). q 11

Essentials of Financial Statement n Step 1: To be informed that financial statement Analysis n analysis is a careful evaluation of the quality of a company’s reported accounting numbers. Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices. Only then you can truly “ get behind the numbers” and see what’s really going on the Company. 12

How the financial accounting “filter” sometimes works GAAP puts capital leases on the balance sheet, but operating leases are “offbalance-sheet”. Managers have some discretion over estimates such as “bad debt expense”. Managers have some discretion over the timing of business transactions such as when to buy advertising. Managers can choose any of several different inventory accounting methods. 5 -13

Financial statement analysis: Tools and approaches Tools: Approaches used with each tool: 1. Common size statements Time-series analysis: the same firm over time (e. g. , Wal-Mart in 2008 and 2006) Trend statements 2. Cross-sectional analysis: different firms at a single point in time (e. g. , Wal-Mart and Target in 2008). Financial ratios (e. g. , ROA and ROCE) 3. Benchmark comparison: using industry norms or predetermined standards. 5 -14

Financial analysis tools 1. 2. 3. 4. Comparative Financial statements: Statements are compared across years. Common-size statements: Recast each statement item as a percentage of a certain item. Trend statements: Recast each statement item in percentage of a base year number. Financial ratios. 15

Basic Approaches 1. 2. 3. Time-series analysis : Identify financial trends over time for a single company. Cross-sectional analysis: Identify similarities and differences across companies at a single moment in time. Benchmark comparison: measures a company’s performance against some predetermined standard. 16

Getting behind the numbers: Case Study: Krispy Kreme Doughnuts, Established in 1937. Inc. n n Today has more than 290 doughnut stores (companyowned plus franchised) throughout the U. S. n Serves more than 7. 5 million doughnuts every day. n Strong earnings and consistent sales growth. 17

Comparative Income Statements: Krispy Kreme’s Financials Systemwide sales Include sales from company owned and franchised stores. Includes a $5. 733 million after-tax special charge for business dispute Includes a $9. 1 million charge to settle a business dispute Sales increased from $220. 2 million in 1999 to $491. 5 million in 2002. Net income increased from $6 million in 1999 to $33. 5 million in 2002. 18

Common Size Income Statements: Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Income Statements $393. 7 operation expenses $491. 5 sales * Not adjusted for distortions caused by “special items”. Each statement item is computed as a percentage of sales. 19

Trend Income Statements: Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Income Statement Base Year $393. 7 operating expenses in 2002 * Not adjusted for distortions caused by “special items”. $194. 5 operating expenses in 1999 Each statement item is calculated in percentage terms using a base year number. 20

Comparative Balance Sheets Assets Krispy Kreme’s Financials: Balance Sheet Assets 21

Common Size Assets Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to assets $3. 2 cash $105. 0 assets Each statement item is computed as a percentage of Total assets. 22

Trend Assets Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet assets $7 cash in 2000 $3. 2 cash in 1999 Each statement item is calculated in percentage terms using a base year number. 23

Comparative Balance Sheets Liability and Equity: Krispy Kreme’s Financials 24

Common Size Liabilities and Equity: Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Balance sheet liabilities and equity $13. 1 accounts payable $105. 0 total liabilities and equity Each statement item is computed as a percentage of Total liabilities and equity. 25

Trend Liabilities and Equity Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet liabilities and equity $8. 2 accounts payable in 2000 $13. 1 accounts payable in 1999 Each statement item is calculated in percentage terms using a base year number. 26

Krispy Kreme’s Financials: Abbreviated cash flow statements 27

Common Size Cash Flow Statements: Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Cash Flow Statements $93. 9 capital expenditures $491. 5 sales Each statement item is computed as a percentage of Sales. 28

Trend Cash Flow Statements Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Cash Flow Statements $93. 9 capital expenditures in 2002 $10. 5 capital expenditures in 1999 Each statement item is calculated in percentage terms using a base year number. 29

Krispy Kreme analysis: Lessons learned w Informed financial statement analysis begins with knowledge of the company and its industry. w Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes are easily recognized. 30

Krispy Kreme analysis: Lessons learned w w Common-size and trend statement techniques can be applied to all financial statements and every section of statements. Financial statements help analysts gain a sharper understanding of the company’s economic condition and its prospects for the future. 31

Learning Objective: Profitability Analysis 32

Financial ratios and profitability analysis Operating profit margin EBI Sales Return on assets ROA= EBI Average assets NOPAT is net operating profit after taxes X Asset turnover Sales Average assets Analysts do not always use the reported earnings, sales and asset figures. Instead, they often consider three of adjustments to the reported numbers: 1. Remove non-operating and nonrecurring items to isolate sustainable operating profits. 2. Eliminate after-tax interest expense to avoid financial structure distortions. 3. Eliminate any accounting quality distortions (e. g. , off-balance operating leases). 33

Calculating Return on Assets Eliminate nonrecurring items Eliminate interest expense Effective tax rate 34

How can ROA be increased? There are just two ways: 1. 2. Increase the operating profit margin, or Increase the intensity of asset utilization (turnover rate). EBI ROA= Average assets Asset turnover EBI Sales Average assets Operating profit margin 5 -35

ROA, margin and turnover A company earns $9 million of EBI on sales of $100 examples: million with an asset base of $50 million. n q Turnover improvement: Suppose assets can be reduced to $45 million without sacrificing sales or profits. q Margin improvement: Suppose expenses can be reduced so that EBI becomes $10. 36

ROA Decomposition and Analysis 1. 2 How was Krispy Kreme able to increase it’s ROA from 7. 1% to 12. 1% over this period? 1. The expanded store base, along with increased sales, allowed the fixed costs be spread over a number of stores- The result was in an improved operating profit margin. 2. However, the asset based was considerably less productive in 2002 ( Asset turnover is 1. 48) than it was in 1999 ( Asset turnover is 2. 22) – More stores meant more resources ( assets) tied up operating cash, receivables, etc. 37

Further decomposition of ROA Correspond to the common-size Income statement items Operating profit margin NOPAT Sales ROA = X Sales Average assets Asset turnover 38

Usages of Decomposition of ROA n n n The profit margin components can help the analyst identity areas where cost reductions have been achieved or where cost improvements are needed. The current asset turnover ratio helps the analyst spot efficiency gains from improved accounts receivable and inventory management. The long-term asset turnover ratio captures information about property, plant, and equipment utilization. 39

ROA and competitive advantage: Krispy Kreme Wendy’s, Baja Fresh, Café Express S&P industry survey or other sources Q: What was the key to Krispy Kreme’s success in 2002 ? Answer: Krispy Kreme outperformed the competition by generating more sales per 40 asset dollar.

ROA and competitive advantage: Four hypothetical restaurant firms n Competitive Advantage: Companies that consistently earn an ROA above the floor. (e. g. , Firm C) q n Competitive ROA floor However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. Competition works to drive down ROA toward the competitive floor. Firm A and B earn the same ROA, but Firm A follows a differentiation strategy while Firm B is a low cost leader. q Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA). 41

Components of ROCE • Return on assets (ROA) NOPAT Return on common equity (ROCE) Average assets X Net income available to common shareholders Average common shareholders’ equity Net income available to common shareholders = Net income – preferred dividends Common earnings leverage NOPAT X Financial structure leverage Average assets Average common shareholders’ equity ROCE= ROA * Common earnings leverage* Financial Structure leverage 42

Return on equity and financial leverage Unchanged – because of Financial leverage n n n 2005: No debt; all the earnings belong to shareholders. 2006: $1 million borrowed at 10% interest; ROCE climbs to 20%. 2007: Another $1 million borrowed at 20% interest; ROCE falls to only 15%. 43

Return on Equity and financial leverage Financial leverage is beneficial only when the company earns (i. e. , ROA) more than the incremental after-tax cost of debt. n If the cost of debt is greater than the earnings, increased leverage will harm shareholders. n 44

Return on Equity and financial leverage (contd. ) The advantage of debt financing is the tax deduction on interests. n The disadvantage is the increase of the bankruptcy risk. n Both the cost of debt and the bankruptcy probability need to be considered in determining the capital structure. n It is hard to determine the optimal mix of capital and debt. n 45

Profitability and financial leverage: Case Study Leveragehelps Leverage neutral Leverage hurts 46

Learning Objective: Capital structure and Assess Credit Risk 47

Credit risk and capital structure: Overview n n n Credit risk refers to the risk of default by the borrower. A company’s ability to repay debt is determined by it’s capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs. Financial ratios play two roles in credit analysis: q They help quantify the borrower’s credit risk before the loan is granted. q Once granted, they serve as an early warning device for increased credit risk. 48

Credit risk and capital structure: Balancing cash sources and needs The cash flow statements contain information enabling a user to assess a Company’s credit risk, financial ratios are also useful for this purpose. 49

Traditional lending products n Short-term loans: q Seasonal lines of credit q Special purpose loans (temporary needs) q Secured or unsecured n Long-term loans: q Mature in more than 1 year q Purchase fixed assets, another company, Refinance debt , etc. q Often secured n Revolving loans q Like a seasonal credit line q Interest rate usually “floats” n Public Debt q Bonds, debentures, notes n Special features: Sinking fund and call provisions 50

Evaluating the borrower’s ability to repay Step 1: Understand the business Step 2: Evaluate accounting quality Step 3: Evaluate current profitability and health Step 4: Prepare “pro forma” cash flow forecasts Step 5: Step 6: Due diligence Comprehensive risk assessment • Business model and strategy • Key risks and successful factors • Industry competition • Spot potential distortions • Adjust reported numbers as needed • Examine ratios and trends • Look for changes in profitability, financial conditions, or industry position. • Develop financial statement forecasts • Assess financial flexibility • Kick the tires • Likely impact on ability to pay • Assess loss if borrower defaults • Set loan terms 51

Credit risk: Short-term liquidity ratios Including Inventory Current ratio = Liquidity ratios Quick ratio = Short-term liquidity Current assets Cash + Marketable securities + Receivables Current liabilities Accounts receivable turnover = Activity ratios Very immediate liquidity Current liabilities Inventory turnover = Average accounts receivable Cost of goods sold Average inventory Accounts payable turnover = Activity ratios tell us How efficiently the company is using its assets. Net credit sales Inventory purchases Average accounts payable Liquidity refers to the company’s short-term ability to generate cash for working 52 Capital needs and immediate debt repayment needs.

Receivables Turnover Ratio and collection period Receivables Turnover = Ratio Net Sales Average Accounts Receivable This ratio measures how many times a company converts its receivables into cash each year. Average Collection Period = 365 Receivables Turnover Ratio This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 53

Inventory Turnover Ratio and Average Days in Inventory Turnover Ratio = Cost of Goods Sold Average Inventory This ratio measures the number of times merchandise inventory is sold and replaced during the year. Average Days in Inventory Average = 365 Days in Inventory Turnover Ratio Inventory This ratio indicates the number of days it normally takes to sell inventory. 54

Credit risk: Operating and cash conversion cycles Working capital ratios: Days accounts receivable outstanding = 365 days Accounts receivable turnover (Days before cash is collected from the customer) Days inventory held = 45 days Operating cycle 75 days 30 days 365 days Cash conversion cycle 55 (75 -20) days Inventory turnover Days accounts payable outstanding = 365 days ( 20 days) Accounts payable turnover ( Days that suppliers are paid after inventory is purchased) Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days). 55

Credit risk: Long-term solvency Long-term debt to assets = Debt ratios Long-term debt Including Intangible assets Total assets Long-term debt to tangible assets = Long-term debt Total tangible assets Long-term solvency Interest coverage = Operating incomes before taxes and interest Interest expense Coverage ratios Operating cash flow to total liabilities = Cash flow from continuing operations Average current liabilities + long-term debt Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain 56 its productive capacity and still meet the interest and principal payment on its long-term debt.

Credit risk of Krispy Kreme : Short-term liquidity and Long-term solvency 57

Credit risk: Default Risk n A firm defaults when it fails to make principal or interest payments. n Lenders can then: q Adjust the loan payment schedule. q Increase the interest rate and require loan collateral. q Seek to have the firm declared insolvent. Source: Moody’s Investors Service (May 2000) Default rates by Moody’s credit rating, 1983 -1999 58

Financial Ratios and Default Risk Return on assets (ROA) ROA and probability of default is negatively associated. Profitability: Return on Assets Percentiles (excludes extraordinary items) Source: Moody’s Investors Service (May 2000) 59

Financial Ratios and Default Risk Quick Ratio and probability of default is negatively associated. Liquidity: Quick Ratio Percentiles Source: Moody’s Investors Service (May 2000) 60

Credit analysis: Case Study: G. T. Wilson’s credit risk n n n A bank client for over 40 years. Owns 850 retail furniture stores throughout the U. S. Increased competition and changing consumer tastes caused the following changes in Wilson’s business strategy: q Expand product line to include high quality furniture, consumer electronics, and home entertainment systems. q Develop a credit card system to help customers pay for purchases. q Open new stores in suburban shopping centers and close unprofitable downtown stores. 61

Credit analysis: Case Study: G. T. Wilson’s credit risk n n n Bank now has a $50 million secured construction loan and a $200 million revolving credit line which is up for renewal with Wilson. What do the Wilson’s financial statements tell us about its credit risk? Should the bank renew Wilson’s $200 million credit line? 62

Credit Analysis: Interpretation of cash flow components. . . Negative free cash flow Increased borrowing Continued dividend payment 63

Credit Analysis : Selected financial statistics Declining margin Customers take longer to pay, but reserve is smaller Larger debt burden 64

Credit analysis: Recommendation n Wilson is a serious credit risk: q Inability to generate positive cash flows from operations. q Extensive reliance on short-term debt financing. The company may be forced into bankruptcy unless: q Other external financing sources can be found. q Operating cash flows can be turned positive. Update: Bankruptcy was declared shortly after these financials were released. 65

Learning Objective: Pro Forma Earnings 66

Pro Forma Earnings Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. n Pro forma earnings are management’s assessment of permanent earnings. n 67

Pro Forma Earnings Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference calls, and in annual reports. n The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP. n 68

Financial statement analysis: Non-GAAP earnings: Pro forma earnings and EBITDA n Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference call, and in annual reports. q Sometimes these earnings figures are called EBITDA ( earnings before interest, income taxes, depreciation, and amortization) q Sometimes it is called “ adjusted earnings’. q Sometimes it is called “ pro forma earnings”. 69

Financial statement analysis: Pro forma earnings at Amazon. com Company defined numbers Computed according to GAAP 70

When use the EBITDA or “pro forma” earnings, analysts should remember: n There are no standard definitions for non. GAAP earnings numbers. n Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability. n EBITDA and pro forma earnings do not accurately measure firm cash flows. 71

Why do firms report EBITDA and “pro forma” earnings? n n Help investors and analysts spot nonrecurring or non-cash revenue and expense items that might otherwise be overlooked. Pro forma earnings could mislead investors and analysts by changing the way in which profits are measured. q q q Transform a GAAP loss into a profit. Show a profit improvement. Meet or beat analysts’ earnings forecasts. 72

Summary n n Financial ratios, common-size statements and trend statements are powerful tools. However: q There is no single “correct” way to compute financial ratios. q Financial ratios don’t provide the answers, but they can help you ask the right questions. q Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons. 73

Summary of financial statement analysis n Profitability: How to use financial ratios ROA ( Return on assets) q Operating Profit Margin q ROCE ( Return on common stockholder’s equity) Market Measures: q Earnings per share (EPS) q Price/ earnings ( Market price of common stock/ EPS) q Dividend payout ( Dividends per share/ EPS) q Dividend yield ( Dividends per share/ Market price of common stock) q n 74

Summary of financial statement analysis n Liquidity ( Evaluate short-term How to use financial ratioscredit risk) - Liquidity ratios: Current ratio and quick ratio - Liquidity of working capital : Average collection period, Days inventory held, days payable outstanding, operating cycle days, cash conversion cycle, etc. - Operating Efficiency ( Activity ratios) n Accounts receivable turnover n Inventory turnover n Accounts payable turnover 75

Summary of financial statement analysis How to use financial ratios n Solvency ( Evaluate long-term credit risk) q Coverage ratios: interest coverage, operating cash flows to total liabilities q Debts ratios: n Debt/ Assets n Debt/ equity (Total liabilities/ Stockholders’ equity) 76

Whole Foods Market, Comparative Income Statement 5 -77

Common Size statements 5 -78

Business Segment information 5 -79

Comparative Balance Sheet 5 -80

Comparative Balance Sheet 5 -81

Common size and trend analysis 5 -82

Common size and trend analysis (Exhibit 5. 5 continued) 5 -83

Common size and trend analysis 5 -84

Common size and trend analysis (Exhibit 5. 6 continued) 5 -85

Comparative Cash Flows 5 -86

Common size trend analysis 5 -87