Financial Statement Analysis: A Holistic Approach

1. Financial Statement Analysis: A Holistic Approach Dan Goldzband, CMA • University of California, San Diego (Extension Division) • General Dynamics Global Imaging Systems, San Diego CA

2. Ratio overload! Gross margin DuPont analysis Working capital Fixed asset T/O EPS Return on assets Debt/equity Sales / SF Trend analysis Free cash flow Acid-test INV T/O High-low method DSO Op C/F per share A/R T/O Revenue / ASMF Cash cycle Operating margin Vertical analysis Debt coverage ratio Book-to-bill R&D plough back Dividend payout Current ratio Return on equity Same size statements Same-store sales Exhaustive method Times interest earned Price-earnings Dividend yield EBITDA Net interest margin Payables T/O Cash burn rate Loans / deposits Average check Book value / share

4. Gross margin DuPont analysis Working capital Fixed asset T/O EPS Return on assets Debt/equity Sales / SF Trend analysis Free cash flow Acid-test INV T/O High-low method DSO Op C/F per share A/R T/O Revenue / ASMF Cash cycle Operating margin Vertical analysis Debt coverage ratio Book-to-bill R&D plough back Dividend payout Current ratio Return on equity Same size statements Same-store sales Exhaustive method Times interest earned Price-earnings Dividend yield EBITDA Net interest margin Payables T/O Cash burn rate Loans / deposits Average check Book value / share

5. Holistic Financial Statement Analysis Approach: Focus on the most basic financial questions about any company. Goals: To think about companies in terms of basic financial issues. Use a “thematic” approach to F/S’s, providing a context for all those ratios.

6. Who could use this method? • Auditors: as a first step in analytical procedures; • Commercial lenders: to evaluate new prospects or monitor existing customers; • Financial analysts: as a first step in formal F/S analysis; and • Corporate executives: to monitor their company’s (and competitors’) progress.

7. Critical underlying concepts and techniques(not part of analysis/presentation) • The importance of expectations(which are personal biases, not part of your analysis) • Begin with results (bottom line), then work backwards to causes/drivers • Remember that symptoms and results (financial statement figures) are not themselves root causes or explanations

8. Fundamental financial issues • Recent financial performance • Future financial performance • Financial condition • Relations with capital sources

9. Holistic Four-Questions Approach • What is the trend and quality of recent earnings performance? • What is the trend of recent operating cash flow performance? • How has the company been providing for its future, and how is it financing this expenditure/investment? • Assess the company’s financial condition and its financial strategy.

10. Question 1: Trend and quality of earnings Key components: • Sales and net income trends • Vertical analysis (each expense and profit measure as % of sales)

11. Expectations (not part of formal analysis or comments, but an essential part of analyst’s attitude) • Sales and Net income trends: Positive and growing • Vertical analysis: Improving margins

12. Cohu, Inc. Comparative P&L’s

13. Cohu, Inc. Sales & earnings trends

14. Cohu, Inc. Quality of earnings: Profitability

15. Question 2:Evaluate operating C/F • Net operating cash flow trend • Significant Op C/F drivers: Identify significant Op C/F drivers and any year-over-year changes in them.

16. Expectation • Operating C/F trend: Positive and growing

17. Cohu, Inc.Operating C/F

18. Cohu, Inc.Significant Op C/F drivers

19. Question 3: Providing for the future Two primary indicators: • R&D(from Income Statement, if presented) • Cap X (gross disbursements, not net, from C/F Statement, Investing section) Key ratios (both plough back): • R&D ratio: R&D expense Revenue • Combined ploughCap X + R&D expense back ratio: Revenue

20. Providing for the future(continued) • Must also evaluate nominal R&D and Cap X spending. Revenue volatility can distort plough back ratios. Other possible indicators: • JV’s • Employee training and development (both less visible from outside)

21. Expectations • Cap X/Acquisitions: Consistent and appropriate investment in PP&E and acquisitions to meet strategic goals or as opportunities arise. • R&D trend: Consistency, in either nominal terms or % of sales, or both. • Reasonable plough back ratios

22. Cohu, Inc.Investing C/F (as presented)

23. Cohu, Inc. R&D Expense (from P&L)

24. Cohu, Inc.Combined plough back ratio Note that all figures are positive, although disbursement and expense figures were presented previously (and are presented subsequently) as negatives. Since the plough back ratio evaluates the amount of revenue that is reinvested into the company, the R&D and CAPEX figures used in this calculation carry the same sign as the revenue figures. Plough back is a measure of intensity, not direction, of resource use, hence no change in sign.

25. Question 3 (continued):Financing investment in the future Three possible sources to finance growth and investment: • New external capital • Asset sales • Operating C/F

26. Financing growth and investment(continued) If new capital, debt or equity? Op C/F: Compare Op C/F to Net Investing C/F to calculate Free C/F: • If positive, future-oriented investment is financed from operating C/F • If negative, future-oriented investment requires outside financing

27. Cohu, Inc.Free C/F * * Note: Free C/F is measured in a variety of ways. This method is very specific and is not the same as the definition and formula in most finance texts. The standard definition addresses a company’s overall Free C/F, while this calculation only ascertains if new capital is needed to finance future-oriented investing activity.

28. Question 4: Financial condition Most basic financial condition indicators: • Liquidity: Overall C/F and balance trends • Working capital: Cash conversion cycle • Solvency Debt/equity ratio (degree of financial leverage in capital structure)

29. Cohu, Inc.Overall liquidity: summary of net C/F and balances

30. Calculating theCash Conversion Cycle Days INV O/S: INV / CGS per day + Days Sales O/S: + AR / Sales per day • Days AP O/S: - AP / CGS per day = CCC = CCC (in days) Meaning: How long the company waits to collect from customers the cash it spent to acquire or manufacture INV.

31. Question 4 (continued): Financial strategy Indicated by the company’s relationship with capital sources (the 3 R’s). With respect to capital sources, the company is either • Raising capital from investors; or • Returning capital to investors; or • Restructuring capital (neutral to investors overall, but changing capital structure and/or terms).

32. Clues to financial strategy & condition Financial condition: see C/F statement and B/S: • Change in financial capitalization (nominal $) • Change in capital structure (debt/equity ratio) Financial strategy: see Financing section of C/F statement: • Net financing C/F (positive, negative, neutral) • Dividends • Stock activity (new issues, buy-backs or both) • Debt activity (proceeds, repayments, or both)

33. Cohu, Inc.Financing C/F

34. Question 4: Conclusion • Financial condition indicators: Liquidity: cash balance increased by 39%; Solvency: no debt, D/E ratio does not apply. • Cohu’s financing activities have provided a net return of capital to investors in each of the past three years.

35. Question 5: Any other major, significant or exceptional events? • Extraordinary losses (or even gains!) • Restructuring costs • BK • Oil well problems

36. Holistic Financial Statement Analysis--Recap Goals: To think about companies in terms of basic financial issues and what they mean Approach: Focus on the most basic financial questions about any company: • Recent financial performance • Future financial performance • Current financial condition, recent trends • Relations with capital sources

37. Important reminder Regroup or disaggregate F/S data as necessary to gain insights and provide basis for more detailed levels of analysis.

38. Caveats, lessons and reminders • No substitute for rigorous, comprehensive analysis—rather, a roadmap for starting, organizing and controlling it. • If your boss wants you to do it differently, he (or she) is right—at least in the short run. • Financial statement analysis is not the source of fundamental explanations. It only provides the questions. • The most important question: Why? The answers are not in the financial statements—they lie outside the numbers.

39. One final piece of advice: familiarity and practice • Practice: Essential for developing skill in financial statement analysis. • Become familiar with F/S’s by choosing 2-3 companies and following them on an ongoing basis: • 10K • 10Q • In the financial news

40. Questions? • Sample company report outline posted on Blackboard, in Resources section. • Follow up: monypots@cox.net