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Introduction to Financial Statement Analysis

Introduction to Financial Statement Analysis. P.V . Viswanath. They provide information to the owners and creditors of the firm about the company’s current status and past financial performance

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Introduction to Financial Statement Analysis

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  1. Introduction to Financial Statement Analysis P.V. Viswanath

  2. They provide information to the owners and creditors of the firm about the company’s current status and past financial performance Financial statements provide a convenient way for owners and creditors to set performance targets and to impose restrictions on the managers of the firm. Financial statements provide convenient templates for financial planning. Functions of Financial Statements P.V. Viswanath

  3. The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time Assets are listed in order of liquidity, i.e. ease of conversion to cash without significant loss of value Liabilities are listed in order of time to maturity The Balance Sheet P.V. Viswanath

  4. Assets • Assets are divided into current assets and long-term assets. Current assets are: • Cash and marketable securities • Accounts receivable • Inventories • Other current assets, such as prepaid expenses • Long-term assets include net property, plant and equipment (net PP&E). • This consists of the original cost of PP&E reduced each year by an amount called depreciation that is intended to account for wear-and-tear and obsolescence. P.V. Viswanath

  5. Assets • When a firm acquires another firm, it will acquire a set of assets that must be listed on its balance sheet. Often it will pay more for these assets than their book value on the acquired firm’s balance sheet. • The difference is listed as goodwill. • Trade-marks, patents and other such assets, along with goodwill are called intangible assets. • If their value decreases over time, they will be reduced by an amortization charge. • Amortization, like depreciation is not a cash expense. P.V. Viswanath

  6. Liabilities • Liabilities are divided into current and long-term liabilities. • Liabilities that will be satisfied in one year are known as current, and include: • Accounts payable, • Notes payable, short-term debt and all repayments of debt that will occur within the year. • Items such as salary or taxes that are owed but have not yet been paid. • The difference between current assets and current liabilities is known as (net) working capital. P.V. Viswanath

  7. Long-term liabilities • Long-term debt is any loan or debt obligation with a maturity of more than one year. • Capital leases are long-term lease contracts that obligate the firm to make regular payments in exchange for the use of an asset. • Deferred taxes are taxes that are owed but not yet paid. Firms keep two sets of books – one for financial reporting and one for tax purposes. Deferred tax liabilities arise when the firm’s financial income exceeds its income for tax purposes. If a firm depreciates assets faster for tax purposes than for reporting purposes, its tax paid will be less than tax due according to reported income. Hence it will look as if the firm has not paid taxes that it owes. • Over time, the discrepancy will disappear and the tax due will be “paid.” Hence deferred tax is recorded as a liability. P.V. Viswanath

  8. Stockholder’s Equity • The sum of current liabilities and long-term liabilities is total liabilities. The difference between the firm’s asset and its liabilities is Stockholders’ Equity or the book value of equity. • This number often does not provide us with an accurate assessment of the firm’s equity because book values are based on historical quantities and not on market values. • The market price of a share times shares outstanding is called market capitalization; this reflects what investors expect the firms assets to produce in the future that can be distributed to shareholders. P.V. Viswanath

  9. Example According to Generally Accepted Accounting Principles (GAAP), your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion. Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion. Market Value vs. Book Value P.V. Viswanath

  10. Example Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil Market Value vs. Book Value P.V. Viswanath

  11. Current Liabilities Payables Short-term Debt + Long-term Liabilities + Shareholders’ Equity Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets = The Balance Sheet Identity P.V. Viswanath

  12. Pepsico Inc. Balance Sheet (in mil. $) P.V. Viswanath

  13. The income statement is like a video of the firm’s operations for a specified period of time. You report revenues first and then deduct any expenses for the period. Matching principle – GAAP requires the income statement to show revenue when it accrues and match the expenses required to generate the revenue. Income Statement P.V. Viswanath

  14. Earnings Calculations • Gross Profit • The difference between sales revenues and the costs incurred to make and sell the products. • Operating Expenses • Expenses in the ordinary course of running the business, but not directly related to producing the goods; includes administrative expenses, marketing expenses, R&D • Earnings before Interest and Taxes (EBIT) • Includes other sources of income or expenses that arise from activities that are not the central part of the business, e.g. investment income. • Pretax Income and Net Income (NI) • From EBIT, we deduct interest paid and corporate taxes to determine Net Income. • EPS = NI/Shares Outstanding P.V. Viswanath

  15. Income Statement Pepsico Inc. (in mil. $) P.V. Viswanath

  16. The return to a stockholder of investing in a stock is simply the rate of return on his investment: Accountants often measure corporate performance using the return on equity (ROE): A big difference between the two is that the ROE does not incorporate the impact on the share price of future expected superior (or inferior) returns Accounting vs Economic Measures of Income P.V. Viswanath

  17. Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important Ratios are used both internally and externally Ratio Analysis P.V. Viswanath

  18. Liquidity ratios Short-term solvency or how easily the firm can lay its hands on cash. Financial leverage ratios Show long-term solvency; how heavily the firm is in debt. Efficiency or turnover ratios Indicate how productively the firm is using its assets Profitability ratios Used to measure the firm’s return on its investments Market value ratios Categories of Financial Ratios P.V. Viswanath

  19. Profit Margin = Net Income / Sales 3313/ 25112 = 0.1319 times or 13.19% Operating Profit Margin = (Operating Income) / Sales (4954) / 25112 = 0.1973 times or 19.73% Return on Assets (ROA) = (Net Income) / Av TA (3313) / [(23474+21695)/2] = 0.1467 times or 14.67% Return on Equity (ROE) = Net Income / Average Equity 3313 / [(9298+8674)/2] = 0.3687 times or 36.87% Computing Profitability Measures P.V. Viswanath

  20. Total Debt Ratio = (Total Debt) / TA Total debt, here, is usually interpreted to mean all debt-like obligations, which is effectively total liabilities (14176) / 23,474 = .6039 times or 60.39% The firm finances almost 60% of their assets with debt. Debt/Equity = Tot Debt / Tot Eq 14,176 / 9,298 = 1.5246 times These numbers can also be computed for long-term debt (i.e. long-term liabilities): Long Term Debt Ratio = LT Debt/ Total Assets = (2,187 + 5,937)/ 23,474 = 0.3461 Long Term Debt/Equity = (2,187 + 5,937)/9,298= 0.87375 Computing Leverage Ratios for 2002 P.V. Viswanath

  21. Determinants of the riskiness of a firm’s debt Times Interest Earned = EBIT / Interest (4868 + 178) / 178 = 28.35 times Cash Flow Coverage = (EBIT + Depreciation) / Interest (4868 + 178 + 1112) / 178 = 34.60 times Computing Coverage Ratios P.V. Viswanath

  22. Current Ratio = CA / CL 6413 /6052 = 1.06 times Quick Ratio = (CA – Inventory) / CL (6413 – 1342) / 6052 = 0.838 times Cash Ratio = Cash / CL 1,638 / 6,052 = .276 times Net Working Capital to TA Ratio = NWC/TA (6413-6052)/ 23474 = 0.154 Computing Liquidity Ratios P.V. Viswanath

  23. Inventory Turnover = Cost of Goods Sold / Average Inventory 10523 / [(1342+1310)/2] = 7.94 times Days’ Sales in Inventory = 365 / Inventory Turnover = Av Inv/(COGS/365) 365 / 7.94 = 45.99 days When you have ratios with Income Statement numbers in the numerator and Balance Sheet numbers in the denominator, use average of year beginning and year end quantities. Computing Inventory Ratios P.V. Viswanath

  24. Receivables Turnover = Sales / Av Accounts Receivable 25112 / [(2531+2142)/2] = 10.75 times Average Collection Period = Days’ Sales in Receivables = 365 / Receivables Turnover = Av Receiv/ (Av Sales) 365 / 10.75 = 33.96 days Computing Receivables Ratios P.V. Viswanath

  25. Total Asset Turnover = Sales / Av Total Assets 25112 / [(23474+21695)/2] = 1.11 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets. What is a reasonable value for TAT will depend on the industry in question Computing Total Asset Turnover P.V. Viswanath

  26. Market Price (end of 2002) = $42.22 per share Shares outstanding = 1753 million P/E Ratio = Price per share / Earnings per share 42.22 / 1.89 = 22.34 times Market-to-book ratio = mktvalue per share / book value per share 42.22 / (9298 / 1753) = 7.96 times Enterprise Value The value of the underlying business assets – computed as Mkt Value of Equity + Debt – Cash = 42.22(1,753) + 14,176 - 1,638 = 86,549.66m. This can be interpreted as the cost to take over the entire business. Computing Market Value Measures P.V. Viswanath

  27. Dividend payout ratio = Cash dividends / Net income Cash dividend equals common dividend + preferred divs 1041 / 3313 = .3142 or 31.42% Plowback ratio = Retention ratio = 1 – payout ratio 1 – 0.3142 = 0.6858 = 68.58% Payout and Retention Ratios P.V. Viswanath

  28. Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firm’s performance is changing through time Internal and external uses Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes Benchmarking P.V. Viswanath

  29. Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry Standardized Financial Statements P.V. Viswanath

  30. A firm’s cashflows can be quite different from its net income. For example: The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Those expenses are spread over time as a deduction for depreciation. The income statement recognizes revenues and expenses when sales are made, even though the money may not have been collected (revenues) or paid out (expenses). Statement of Cashflows P.V. Viswanath

  31. The statement of cashflows shows the firm’s cash inflows and outflows from Operations Investments and Financing The form of this statement is determined by accounting standards. The Statement of Cashflows P.V. Viswanath

  32. Operating activities are earnings-related activities. Generally these relate to Income Statement activities, and items included in working capital. Included are: Sales and expenses necessary to obtain sales Related operating activities, such as extending credit to customers investing in inventories obtaining credit from suppliers payment of taxes insurance payments Other activities that don't easily fit into the other two categories, such as settlements in lawsuits. Statement of Cash Flows:Operating Activities P.V. Viswanath

  33. Investing activities relate to the acquisition and disposal of noncash assets: assets which are expected to generate income for the company over a period of time. These include lending funds and collecting on these loans. Financing activities relate to the contribution, withdrawing and servicing of funds to support business activities. Statement of Cash Flows:Investing and Financing Activities P.V. Viswanath

  34. Pepsico Inc. (in mil. $)Statement of Cash Flows 2002 P.V. Viswanath

  35. The Notes to the Financial Statements are frequently very useful in assessing the financial health of the firm. They often contain: An explanation of accounting methods used Straight-line versus accelerated depreciation LIFO vs FIFO Restatement of results from prior years using the new standards Greater details regarding certain assets and liabilities Conditions and expiration dates of long- and short-term debt, leases, etc. Notes to Financial Statements P.V. Viswanath

  36. Information regarding the equity structure of the firm Conditions attached to the ownership of shares; these can be particularly useful to assess the firm’s vulnerability to takeovers. Documentation of changes in operations Acquisitions and Divestitures and their impact Off-balance sheet items Forward contracts, swaps, options and other derivative contracts, which do not appear in the balance sheet, but which can affect a firm greatly. A lot of Enron’s problems had to do with such off-balance sheet items. Notes to Financial Statements P.V. Viswanath

  37. Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm Determinants of Growth P.V. Viswanath

  38. ROA = NI/ TA ROA = (NI/ Sales)*(Sales / TA) ROA = (Net Profit Margin)*(Asset Turnover) ROE = NI / TE ROE = (NI/Sales)*(Sales/TA)*(TA/TE) = Net Profit Margin*Asset Turnover*Equity Multiplier Net Profit margin is a measure of the firm’s operating efficiency – how well it controls costs Total asset turnover is a measure of the firm’s asset use efficiency – how well it manages its assets Equity multiplier is a measure of the firm’s financial leverage The Du Pont Identity P.V. Viswanath

  39. Earnings in any period depends on the investment base, as well as the rate of return that the firm earns on that investment base: Et+1 = (TEt)ROE = (TEt-1+ DTEt)(ROE), where DTEtis the increment in total equity in period t over and above that in period t-1. = (TEt-1)ROE + (DTEt)(ROE) = Et + (DTEt)(ROE); Hence Et+1 - Et = (DTEt)(ROE) Dividing both sides by Et , we get gt= (DTEt/Et)(ROE) We have assumed that ROE does not change, i.e. that the debt-equity ratio will be kept constant, as we can see from the DuPont identity. Hence debt must be increased and equity decreased in such a way as to keep the debt ratio constant, assuming that the assets side of the business maintains a constant profitability. Determinants of Earnings Growth Rate P.V. Viswanath

  40. The sustainable growth rate tells us how fast the firm can grow, without increasing financial leverage and without any additional outside equity. We have already seen that gt = (DTEt/Et)(ROE) If only internal funds are used, then DTEtis simply retained earnings. Hence, sustainable growth rate (of earnings) = retention ratio x ROE 0.6858 x 0.3687 = 0.2528 or 25.28% If the firm can continue to earn 36.87% on its equity and can plow back 68.58% of earnings into operations, its earnings and equity should both grow at 25.28% p.a. As discussed above, ROE is assumed to be constant, i.e. that the debt-equity ratio will be kept constant. However, if the firm will not have access to new debt financing, the business can only grow at a lower rate. Sustainable Growth P.V. Viswanath

  41. 0.2169 x (9298+8674) /(23474+21695) = 0.2528 x 0.3979 = 0.1006 or 10.06% Internal Growth Rate • The rate at which the business as a whole, i.e. the total assets of the firm can grow without additional external financing is called the internal growth rate. P.V. Viswanath

  42. There are a few expenses that are consistently mis-categorized in financial statements. In particular, Operating leases are considered as operating expenses by accountants but they are really, partly, financial expenses. For example, CAKE classifies leases of its restaurant locations as operating leases and does not report them in its balance sheet. R&D expenses are considered as operating expenses by accountants but they are really capital expenses. The degree of discretion granted to firms on revenue recognition and extraordinary items is used to manage earnings and provide misleading pictures of profitability. Desirable Modifications to Income Statement P.V. Viswanath

  43. A Lease is a long-term rental agreement Leases can either be capital leases or operating leases A capital lease is often for as long as the life of the equipment, or there may be an option for the lessee to buy the equipment at the end of the contract period. Capital leases have to be capitalized and shown on the balance sheet. In an operating lease, typically, the contract period is shorter than the life of the equipment, and the lessor pays all maintenance and servicing costs. Operating leases do not have to be shown on the balance sheet.However, operating leases also represent expected fixed periodic payments, and thus function similar to debt. As such, a financial analyst would want to see operating leases capitalized as well Dealing with Operating Leases P.V. Viswanath

  44. How do we do this? First, we compute the “debt” value of the operating lease as the PV of the operating lease expenses, using the pre-tax cost of debt as the discount rate. This now creates an asset - the value of which is equal to the debt value of operating leases. This asset now has to be depreciated over time. Second, the operating income has to be adjusted to reflect these changes. Dealing with Operating Lease Expenses P.V. Viswanath

  45. Note that the operating lease expense has two components an operating expense component, i.e. the reduction in the value of the asset being used, represented by the depreciation, and a financing component, i.e. the cost of financing the asset. Using this model, we assume that Interest expense on the debt created by converting operating leases = Operating lease expense - Depreciation on asset created by operating lease. Then, Adjusted Operating Income = Operating Income - Depreciation on operating lease asset + operating lease expenses = Operating Income + Imputed Interest expense on operating leases. = Operating Income + Debt value of Operating leases x Cost of debt Operating Leases: Adjusting Operating Income P.V. Viswanath

  46. Capitalizing Operating Leases at Maxwell Shoe From the 10-K filing made by the company with the SEC on 1/29/2001: The Company leases equipment and office and warehouse space under long-term non-cancelable operating leases which expire at various dates through January 31, 2007. At October 31, 2000, future minimum payments under such leases were as given below (in ‘000s). Minimum payments are capitalized using an assumed pre-tax cost of debt of 7% p.a. This will be the value of the Lease Asset/Liability on the Oct. 31, 2000 balance sheet. Later years refer to 2006 and 2007. P.V. Viswanath

  47. Capitalizing Operating Leases at Maxwell Shoe I assume that payments are made at the end of the fiscal year, ending in October. Since the figure for "Later Years," $750, is larger than the declining sequence of amounts for previous years, I assume that this reflects the amounts for both 2006 and 2007. Since the leases expire in January 2007, which is 3 months past the fiscal year end, I have prorated the amounts for 2006 and 2007, viz. $600 for 2006 (payable at the end of October 2006) and $150 for 2007 (payable at the end of January 2007). Hence the $498.08 computed as the present value for the row “Later Years” equals 600/(1.07)6 + 150/(1.07)6.25. The present value of the minimum payments (as of Oct. 31, 2000) works out to $4441.38. P.V. Viswanath

  48. Imputed Interest Expenses on Operating Leases Lease payments in 2000 were $1024. Hence the PV of operating leases as of end 1999 would be (PV of Op. Leases as of end 2000 + Lease expenses for 2000)/1.07 = (4441.38+1024)/1.07 = $5107.83. The imputed interest expense is the Debt Value of Operating Leases x Interest rate. Adjusted Operating Income = Operating Income + Imputed Interest Payment = $13,489 + $357.55 = $13,846.55 Net Income is not affected because the imputed interest expense will be subtracted from Operating Income, just as any other interest expense would be.   P.V. Viswanath

  49. Debt: will increase, leading to an increase in debt ratios used in the cost of capital and levered beta calculation Operating income: will increase, since operating income will now be before the imputed interest on the operating lease expense Net income: will be unaffected since it is after both operating and financial expenses anyway Return on Capital will generally decrease since the increase in operating income will be proportionately lower than the increase in book capital invested Effects of Capitalizing Operating Leases P.V. Viswanath

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