Financial Statement Analysis

Financial Statement Analysis P.V. Viswanath Based on Damodaran’s Corporate Finance

Questions we would like answered… As financial analysts… However, the information we have comes from the firm’s financial statements… P.V. Viswanath

Basic Financial Statements • The balance sheet, which summarizes what a firm owns and owes at a point in time. • The income statement, which reports on how much a firm earned in the period of analysis • The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis P.V. Viswanath

The Balance Sheet This is what we can see from the firm’s balance sheet… P.V. Viswanath

An example : Maxwell Shoe Company, Inc Maxwell Shoe Company Inc. designs, develops and markets casual and dress footwear for women and children under multiple brand names, each of which is targeted to a distinct segment of the footwear market. The Company offers casual and dress footwear for women in the moderately priced market segment under the Mootsies Tootsies brand name, in the upper moderately priced market segment under the Sam & Libby and Dockers Khakis Footwear For Women brand names and in the better market segment under the Anne Klein 2 and A Line Anne Klein brand names. It also sells moderately priced and upper moderately priced children's footwear under both the Mootsies Tootsies and Sam & Libby brand names. In addition, it designs and develops private label footwear for selected retailers under the retailers' own brand names. Maxwell has licensed the J.G. Hook trademark to source and develop private label products for retailers who require brand identification. P.V. Viswanath

An example of an Accountant’s Balance Sheet Maxwell Shoe Company, Inc. As of October 31, 2000 (In ‘000s) P.V. Viswanath

Notes on the Maxwell Balance Sheet • Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are created when future taxable income is expected to exceed pretax income, while deferred tax liabilities occur in the reverse case. • If more deductions have been taken in the current period for reporting purposes, then tax payable (according to the GAAP income statement) will be lower than the actual tax paid. Hence it will seem like taxes have been prepaid. This is reflected in the balance sheet as an asset. • Deferred tax assets ($798) reflect allowance for doubtful accounts, stock option compensation, inventory capitalization, and inventory reserve. Deferred tax liabilities ($479) reflect amortization of trademarks (long-term) and depreciation of property and equipment (short-term). P.V. Viswanath

A Financial Analyst’s Balance Sheet This is what we would like to see… P.V. Viswanath

The Income Statement P.V. Viswanath

The Income Statement Maxwell Shoe Company, Inc. For the year ended October 31, 2000 (In ‘000s) P.V. Viswanath

The Income Statement The Income Statement provides us with information about changes in the balance sheet from one year to another. Hence it is crucial to creating the financial balance sheet that we want. However, the income statement is prepared according to GAAP. Underlying GAAP are certain principles, such as revenue recognition when the service for which the firm is being paid has been performed substantially, the matching principle governing recognition of expenses, a historical cost-based approach, and a basic conservatism in the recognition of assets. This leads to certain accounting practices that need to be corrected, from a financial analyst’s point of view… P.V. Viswanath

Desirable Modifications to Income Statement • 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 • 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. P.V. Viswanath

Dealing with Operating Leases • 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 P.V. Viswanath

Dealing with Operating Lease Expenses • 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. P.V. Viswanath

Dealing with Operating Leases: Adjusting Operating Income • 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 P.V. Viswanath

Example: 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

Example: 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

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

The Effects of Capitalizing Operating Leases • 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 P.V. Viswanath

R&D Expenses: Operating or Capital Expenses • Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. It is more logical to treat it as capital expenditures. • An approach to capitalizing R&D (cost-based), • Specify an amortizable life for R&D (2 - 10 years) • Collect past R&D expenses for as long as the amortizable life • Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5th of the R&D expense from four years ago, 2/5th of the R&D expense from four years ago...: P.V. Viswanath

Capitalizing R&D Expenses: Boeing Assuming a ten year life; thus, R&D expenses for 1998 will be amortized over the 1999-2008 period. P.V. Viswanath

Boeing’s Corrected Operating Income For 1998 * Data obtained from Income Statement ** Data obtained from Income Statement; see also previous slide In principle, it could be argued that R&D capitalized values should be restated in 1998 dollars, instead of using the raw unamortized portions of R&D outlays in past years; however, the current procedure may be defended on the grounds of conservatism. P.V. Viswanath

Boeing’s Corrected Balance Sheet • There will be the following modifications on the balance sheet: • There will be a new asset, R&D, that will show on the assets side. If one wants to show the gross value of R&D and accumulated amortization, however, that will require computation of the amortization in each year for as many years as the amortizable life of the R&D. • Corresponding to that, the value of stockholder’s equity will be higher by the same amount. • In our example, this amount will be $9,100. P.V. Viswanath

The Effect of Capitalizing R&D • Operating Income will generally increase, though it depends upon whether R&D is growing or not. If it is flat, there will be no effect since the amortization will offset the R&D added back. The faster R&D is growing the more operating income will increase. • Net income will increase proportionately, depending again upon how fast R&D is growing. Adjusted Net Income will also have to take the tax deductibility of R&D into account. • Book value of equity (and capital) will increase by the capitalized Research asset • Capital expenditures will increase by the amount of R&D; Depreciation will increase by the amortization of the research asset; for all firms, the net cap ex will increase by the same amount as the after-tax operating income. P.V. Viswanath

Financial Statement Analysis