Why Financial Statements Analysis?

1. Why Financial Statements Analysis? • “You” may be • an investor • a creditor • a supplier • a customer • an employee • the manager • a competitor • an auditor • a government agency • Will you rely on pure hunches and guesses? Or, Educated analysis model!

2. The Investment Environment • The Money Market • treasury bills, certificate of deposit, commercial paper, etc. • The Fixed-Income Capital Market • treasury notes and bonds, municipal bonds, corporate bonds, etc. • The Capital Market • common stock, preferred stock • The Derivative Market • options, futures

3. The Major Stock Market in the U.S. • The New York Stock Exchange (NYSE) • Largest stock exchange: About 3,025 companies or $16 trillion in market value (July 1999) • 382 non-U.S. companies (July 1999) • The American Stock Exchange (AMEX) • Listing of smaller and younger firms • The Over-the-Counter National Association of Securities Dealers Automated Quotation (NASDAQ) • Trade through computer-linked network • Include: Nasdaq National Market (4,400 securities) and Nasdaq SmallCap Market (1,800 securities)

4. ACC 6213Financial Statements and Analysis • Objectives • Discuss a framework for conducting business analysis with a focus on the role of financial information • Learn how to apply the framework for security valuation and risk analysis • Learn to retrieve market and financial data

5. Textbook and Related Materials • Palepu, Healy and Bernard, “Business Analysis & Valuation: Using Financial Statements”, Text and Cases, 2nd ed., 2000 • Dell’s 10-K for fiscal year 1999 • Computer skills: • Research, retrieve and download data from internet • Excel or any other spreadsheet program

6. Course Requirements • Course Outline • Individual Assignments • 30% • Team Project • 50% • Participation • 20% • Grade: Expected distribution: 40-50% A’s, 20-30% B’s, rest C’s

7. Individual Assignments • Discussion allowed, but no copy of ideas or writing • No points will be given for similar assignments • Related to class discussion and cases in the book • Questions to be posted on Web

8. Participation • Come to class prepared with • Intelligent comments • Constructive questions • Thoughtful insights and observations • Quality counts more than Quantity • Team project to be discussed later

9. Palepu, Healy & Bernard(Figures 1-2 & 1-3) • A firm is involves in various business activities to create value for investors • Financial statements summarize the economic consequences of a firm’s business activities • Accounting system affects the quality of the financial data provided - affected by accounting rules, managements’ incentives • Analysts use a systematic framework to create inside information from public financial data

10. Framework: Four Steps of Analysis Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis Business Analysis and Valuation Applications

11. I. Business Strategy Analysis • Purposes: • To identify key profit drivers and business risks • To assess profit potential at a qualitative level • Involves: • Industry analysis • Analysis of the firm’s strategy to create a sustainable competitive level • How did the firm stay alive and possibility of prospering in the future • Important first step for the following three analyses

12. II. Accounting Analysis • Purposes: • To evaluate the degree to which a firm’s accounting captures underlying business reality • Involves: • identifying where there is accounting flexibility • evaluating the appropriateness of accounting policies and estimates • assessing the degree of distortion in disclosures • undoing (if necessary) distortions • Improves the reliability of financial analysis

13. III. Financial Analysis • Purposes: • To evaluate current and past performance • To assess the sustainability of its performance • Requirements: • should be systematic and consistent • should allow the use of financial data to explore issues found in business strategy analysis • Tools • Ratio analysis: profitability, efficiency, liquidity • Cash flow analysis: liquidity and financial flexibility

14. Purpose To forecast a firm’s future Final step in business analysis Techniques Financial statement forecasting Valuation IV. Prospective Analysis

15. Team Project • Teams of four • Select an industry and two companies in the same industry • No more than two teams on one industry • No group can work on the same company • Need my approval; first-come, first serve • Compare the two companies in terms of All of the FOUR analyses: • Business Strategy Analysis • Accounting Analysis & Financial Analysis • Forecasting, Including Discussion of Assumptions • Valuation

16. Agricultural Construction Manufacturing Mining Retail Service Transportation Wholesale - Trade Industry Choices No Finance, Insurance, and Real Estate Industry and Public Administration Industry

17. Team Project Report • Must be typed • Limit to 10 pages: double-spaced, 12-point font size • Data source and calculation should be included as appendices • Attach an evaluation on each of your group members: efforts and contribution

18. CSUH Library and Internet Main data sources Industry Research Company Research UC Berkeley International Business Other: Annual Reports Annual Report Gallery 10-K Reports Accounting Rules Financial Accounting Standard Board Historical Stock Market Data Historical Market Index Data Historical Stock Price Data On DJ interactive, Historical market data Finding Information for Business Analysis

19. Framework for Business Analysis & Valuation Business Strategy Analysis Financial Analysis Prospective Analysis Accounting Analysis

20. Business Strategy Analysis • Industry Analysis • Industry profitability and risk • Competitive Strategy Analysis • Which companies will sustain? • Corporate Strategy Analysis • Multibusiness management

21. Industry AnalysisStandard Industrial Classification (SIC), North American Industry Classification System (NAICS) • Factors affecting industry profitability: Porter’s “five forces” • Degree of Actual & Potential Competition (3 forces) • Rivalry Among Existing Firms • Threat of New Entrants • Threat of Substitute Products • Bargaining Power in Input & Output Markets (2 forces) • Buyers’ Power • Suppliers’ Power  Affect competitive strategy chosen to operate in the industry

22. 1. Rivalry Among Existing Firms • Profitability is low if competition for market share is strong: • Low industry concentration • Compute “Industry Concentration Ratio”, e.g. sales of largest four or eight companies  total industry sales • Low product differentiation • Large economy of scale, steep learning curve, high proportion of fixed costs • Low industry growth • Excess capacity, high exit cost

23. 2. Threat of New Entrants Profitability is low if threat of new entrants is high: • Small economy of scale • Less “first mover advantages” • Easy access to channels of distribution and distribution relationships • Low legal barriers: e.g. government approval

24. 3. Threat of Substitute Products Profitability is low, if threat of substitute products is high: • price and performance are similar • customers are willing to switch • Products are similar or seen as being substitutes • Low brand allegiance • products are replaceable

25. 4. Buyers’ Power Strong, if • More Sensitive to Price • Products are similar • Low switching costs • Unimportant products (relative cost and quality) • Higher Bargaining Power • Fewer buyer • Higher volume per buyer • Low switching cost • More substitute products • High threat of backward integration by the buyers

26. 5. Suppliers’ Power Profit is low if suppliers’ power is strong: • Fewer number of suppliers • High volume per supplier • High Switching Costs • High product differentiation • Importance of product in terms of cost and quality

27. Power in Input Market (Suppliers) & Output Market (Buyers) High Low Actual Profitability Low  High Actual Profitability Suppliers’ power Buyers’ power

28. Given a level of industry profitability … • What determines which companies will win and which companies will lose? • How can a company sustain profits in a competitive environment? • Porter maintains that there are two generic competitive strategies that firms can choose in order to maintain competitive advantage

29. Competitive Strategy Analysis ? Choices of competitive strategies: 1. Cost Leadership 2. Differentiation And, Straddling of “1” and “2”

30. 1. Cost Leadership • Is a cost leader if it can supply same product or service at a lower price because of • Economies of scale, scopes, and learning • Efficient production • Simpler product designs • Efficient organizational processes • Lower costs of inputs and distribution • Little R&D or brand advertising required • Tight cost control

31. 2. Differentiation • Supply a unique product or service at a cost lower than the price customers are willing to pay: • Superior product quality • Superior product variety • Superior customer services • More flexible delivery • Investment in brand image • Investment in R&D and marketing Note: Organizational and control system must foster creativity and innovation

32. Achieving and Sustaining Competitive Advantage Depend on: • Match between firm’s core competencies (the economic assets possessed by the firm) and competitive strategies • Match between firm’s value chain (the activities to convert inputs to outputs) and activities required to execute competitive strategies • Flexibility to adopt to changes in the firm’s industry structure • Difficulty for competitors to imitate

33. Applying Strategy Analysis to Dell • Industry Analysis • Describe the features of the personal computer industry that determine its profit potential. How difficult is it to earn abnormally high profit in this industry? • Competitive Strategies Analysis • Describe Dell’s business strategy and how it might allow Dell to earn higher returns on investments than others in the industry?

34. Personal Computer Industry • Degree of Actual and Potential Competition • Rivalry Among Existing Firms • Threat of New Entrants • Threat of Substitute Products • Bargaining Power in Input and Output Markets • Buyers’ Power • Suppliers’ Power

35. Personal Computer Industry: Rivalry • Growth continues to be strong • pricing remains cut-throat • Lots of competitors • fragmented, no price co-ordination • Switching costs are low • commodity product; price is the key • Dell tries to compete on service • as knowledge rises, will service matter? • Dell needs to keep market share • recoup R&D and costs associated with made to order strategy • allows them to lower component costs

36. PC: Entrants • Low barriers to entry • First mover advantage? • not technologically • Distribution is easy • Relationships with suppliers, customers?

37. PC: Substitute Products • Apple’s Macintosh, Sun’s work stations? • not in the near future • Competitive price and performance • PCs are commodities (price counts more) • price competition seems unavoidable • Buyers’ are willing to switch • brand name? • quality reputations?

38. PC: Power of Customers • Buyers are price sensitive • define price as hardware, software, and operations, not just purchase price— “total cost of ownership” • Dell maintains an extensive database of customer information • unavailable to retail operators • Importance of product for cost & quality

39. PC: Suppliers’ Power • Two major “one supplier” relationships • Intel, Microsoft • Leverage will increase with volume • Can Intel reap some of the PC vendors’ profits? • Power of other suppliers is low • lots of keyboard, case, power supply, etc. manufacturers

40. PC Industry Analysis: Conclusion • Intense competition • Low barriers to entry • Not much power over customersand suppliers • Short product cycle; need to stay on edge technologically Profit potential might be poor BUT, growth is an important offsetting factor

41. What Should Dell Need to be Concerned? • General economy condition • Industry growth; technological changes • Competition: • Product quality; customer service/support; distribution channels; price • International • Product mix, customer mix, geographic mix • New ventures: Internet • Inventory levels • Supply sources • Support of infrastructure • Government regulation

42. Dell’s performance

43. Customer profile: Foreign vs. Domestic Sales

44. Mergent’s Industry Review- 1999 Ranking

45. Stock Market Performance

46. Dell: Competitive Strategy • Differentiation • Direct sales: no middle man; customer database • “Customer made” product • Lower economy of scales • Low inventory • Customer service and support • “Enterprise systems” • Cost Leadership • Through “made to order” • Not “low cost” seller

47. Dell: Sustainable Advantage? • What aspects of Dell’s strategy can be replicated by others? • Can Dell avoid being replicated?

48. Dell: Conclusion • Competitive and thus low profitability industry • The success of Dell’s competitive strategy depends on • Product differentiation • Maintain higher profit margin • Reduce/control operating expenses • Goal: higher net margin

49. According to Dell (10-K)… • Three key factors • Growth • Demand, competition, international market • Product, customer, geographic mix • “servers” business • Profitability • gross and net margins, sales mix, Internet sales • Technological changes and product transition • Liquidity • asset management, especially inventory

50. Experts’ Opinion? • Value Line on industry (4/21/2000) The computer and peripheral industry probably will get off to something of a slow start this year (2000). However, it should pick up a better head of stream in the second half and stay on a fast growth tract out to 2003-2005. Investors should be able to find stocks in this group that will be good fits for their portfolios, whether they are looking for near-term out-performance or long-term capital appreciation. Conservative accounts should tread cautiously, though, since volatility can be high for some of these equities.