Welcome to Class 17

1. Welcome to Class 17 Research: Financial Domain & Case Studies – Part 2 Chapter 8

2. Key Financial Statements A Review for non-Accountants

3. The Balance Sheet Reports the financial condition of a corporation on the last day of its fiscal year. (Assets, Debts, and Equity)

4. The Balance Sheet (Cont) Assets = tangible and intangible valuables that have an assignable numerical value) Debts = financial obligations to creditors and others Equity = the residual after deducting debts from assets Remember: Organizations have other important resources that do not have an assignable numerical value – e.g. people

6. Important Note about Stockholders Equity, Retained Earnings, & Deficits! STOCKHOLDERS EQUITY: is comprised of a variety of subcategories however; each of these originates from one of two basic sources: (1) Profits* (earnings/gains) (2) Paid-in (sales the corporation’s stock) * The term “Profits” is used as a proxy for any increase in stockholders equity that is not a result of additional investments by shareholders. RETAINED EARNINGS: The PSC reflects two categories for retained earnings: Retained Earnings REPORTED(directly off the firm’s balance sheet) and …..Retained Earnings NET. The two will rarely be the same since the NET category is meant to provide a larger perspective of individual categories. Not combining these categories is analogous to trying to understand what a building looks like by studying the individual doors and windows. This provides a precise picture of these individual items but how helpful is it to understanding how the building looks as a whole? You must stand back for a broader perspective.

7. CAUTION! DEFICIT: It is possible for a Deficit to appear in Retained Earnings – NET even though the Retained Earnings – REPORTED by the corporation does not reflect a Deficit. If this is the case, it is a RED FLAG. It does not mean the company is in immediate financial trouble but is COULD be a harbinger of potential problems in the future. It suggests researching further and PROCEEDING WITH CAUTION!

8. The Income Statement Reports a firm’s revenues, expenses, net income, and related items for the current fiscal year (plus two or more prior years). Corporate net income = total net revenue + other income - expenses and other deductions

9. The Income Statement (Cont) Revenue may appear by many other names such as: Sales, Fees, Commissions, Turnover, etc. The after tax net income less dividends is added to Stockholders Equity in the "earned capital" section, generally called retained earnings. If the company experienced a loss the amount of the loss plus any dividends declared will be subtracted from equity.

11. The Statement of Cash Flows Most businesses report their Income Statements and Balance Sheets using the accrual basisof accounting. Consequence : Lack of information related to how cash is generated and used by a firm. Solution: The statement of cash flows provides this information. The Statement of Cash Flows bridges the informational gaps between accounting reports and finance reports.

12. The Statement of Cash Flows (Cont) Divides business activities into three (3) segments and examines the cash flow through these Each will indicate whether cash has been “used in” or “provided by” The three segments are: (1) Operating Activities (2) Investing Activities (3) Financing Activities

14. Operating Activities • “Operating Activities” include cash used inor provided by: •  The routine processof buying and selling products or providing services. • NOT included AS OPERATING ACTIVITIES: •  Buying or selling productive assets or other noncurrent assets • Transactions with stockholders and long-term creditors

15. Investing Activities “Investing Activities” include cash used inor 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.

16. Financing Activities • “Financing Activities” include cash used inor provided by: •  Selling or repurchasing a company’s own stock •  Issuing corporate notes or bonds •  Borrowing money from other institutions (banks, insurance companies, etc.) •  Debt repayment •  Payment of dividends, etc.

17. Cost of Capital/Interest Rate Terms: • Euribor = Euro interbank offered rate • Libor = London interbank offered rate • Prime Rate = Interest rate charged by commercial banks to their most credit-worthy customers • Fed Funds Rate = Overnight rate that banks charge each other • 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

18. The Statement of Cash Flows, The Income Statement, & The Balance Sheet … Need to be “Common-sized” and organized into financial categories

19. The Financial Four Common-sizing financial data: 1. Translates financial data to allow comparison of different size firms 2. Converts currency data into percentages 3. Enables firms with different currencies to be compared 4. Facilitates grouping of various categories of performance into those that are closely related – the Financial Four. The Financial Four are: 1) Profit, Equity, & Share Value Management 2) Debt Management 3) Cash Management 4) Asset Management $

20. 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: • Achieve and sustain a competitive advantages • Yields above average returns for stockholders

21. 2) Debt Management Financial leverage is important to most (not all) firms. The degree of leverage andthe proper configuration (long-term and short-term) are crucial considerations. Debt levels should be sufficient to satisfy current financial requirements, amplify shareholder returns, and facilitate corporate growth and expansion. BUT, caution is important since excessive levels of debt can shift corporate decision-making from TMTs to creditors.

22. 3) Cash Management • Inadequate fundscan lead to: •  Lost purchasing discounts (2% 10, n 30 = 36% apr) • Missed business opportunities • Alienation of suppliers, etc. • Excessive fundscan lead to: • Lack of financial productivity • Render the firm highly prone to hostile takeover bids

23. 4) Asset Management • An appropriate level , type, and configuration of Assets is essential to the health of a corporation. • It is possible for a firm to have: • Too much invested in productive assets • Too little invested in productive assets • Outdated productive assets (need to upgrade) • Slowly turning Accounts Receivable (long collection period) • Slowly turning Inventory

24. Primary Techniques for Studying Financial Statements

25. The A-B-Cs of studying financial statements: A – Preparing a list of performance questions B – Commonsizing the financial data C – Utilizing analysis methods, including: 1. Vertical analysis 2. Horizontal analysis 3. Cross-sectional analysis 4. Time-series analysis

26. A – 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" look appropriate?  What does the independent auditor (Certified Public Accounting firm) say about the financial data?

27. B – Common-sizing • 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 Common-sizing is the process of converting all items on the financial statements to a percentage.

28. C – Analysis Methods 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.

29. 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.

30. 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.

31. 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.

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

33. The Red Flags 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

34. The Red Flags 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

35. The Red Flags 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

36. Every student READ THIS! Go to Page 247 in your online textbook “Management: Strategy & Performance” There are several large, global, publicly–traded companies in your text.. Team Presidents YOU should select one (1) of the companies and IMMEDIATELY notify your team of the company name. Every member of the team MUSTthen review it carefully and discuss it at the team meeting – Team Class 2 Team secretaries: In your report to the professor you should name each team participant and include the exact comment each member of your team had relative to the company in the team meeting. Members not commenting will LOSE 25 POINTS!

37. Important!!! Go to the Addendum below – Information on these slides may help you with your… TEST! End, Research: Financial Domain & Case Studies – Part 2 Prepare for Team Class 2 including the two assignments: The one detailed above, and The Team Culture Exercise Link to Team Class 2 Details

38. Addendum

39. Revenue Income Statement Costs Gross Profit Operating Expenses Other Expenses Other Income Net Income

40. 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.

41. 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. More information see – http://www.xbrl.org/Home/

42. 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

43. Another important document required by the SEC is the Proxy Statement 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

44. 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.

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