Corporate Finance Interpreting Financial Statements

Corporate FinanceInterpreting Financial Statements Dr. Markus R. Neuhaus Dr. Marc Schmidli, CFA Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Corporate Finance: Course overview 2013 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Markus R. Neuhaus PricewaterhouseCoopers AG, Zürich Phone: +41 58 792 40 00 Email: markus.neuhaus@ch.pwc.com • Grade Chairman • QualificationDoctor of Law (University of Zurich), Certified Tax Expert • Career Development Joined PwC in 1985, became Partner in 1992and CEO from 2003 – 2012, became Chairman in 2012 • Subject-relatedExp. Corporate Tax Mergers & Acquisitions • Lecturing SFIT: Executive in Residence, lecture: Corporate Finance Multiple speeches on leadership, business, governance, commercialand tax law • PublishedLiteratureAuthor of commentary on the Swiss accounting rules Publisher of book on transfer pricing Author of multiple articles on tax and commercial law, M&A, IPO, etc. • Other professional roles: Member of the board of économiesuisse, member of the board and chairman of the tax chapter of the Swiss Institute of Certified Accountants and Tax Consultants Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Marc Schmidli PricewaterhouseCoopers AG, Zürich Phone: +41 58 792 15 64 Email: marc.schmidli@ch.pwc.com • Grade Partner • Qualification Dr. oec. HSG, CFA charterholder • Career Development Corporate Finance PricewaterhouseCoopers sinceJuly 2000 • Lecturing Euroforum – Valuation in M&A situations Guest speakeratZfU Seminars, Uni Zurich, ETH, etc. • PublishedLiterature Finanzielle Qualität in der schweizerischen Elektrizitätswirtschaft Variousarticles in „Treuhänder“, HZ, etc. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Contents Learning targets Pre-course reading Lecture „Interpreting Financial Statements“ Pre-course reading case studies / questions Solutions to case studies Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Learning targets Framework for financial statement analysis Understanding the need for financial statement analysis Understanding the financial reporting system Refreshing principal elements of financial statements (Balance sheet, income and cash flow statements) Analysis of financial statements Understand the purpose and use of ratio analysis Being able to apply the various ratio analyses Being able to evaluate corporate performance by the integrated analysis of ratios Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Pre-course reading Books Mandatory reading: Brigham, Houston (2012): Chapter 4 (pp. 96-130) White, Sondhi, Fried (2003): Chapter 3 (pp. 74-99) Optional reading: Brigham, Houston (2012): Chapter 3 (pp. 56-95) Slides Slides 1 to 11 – mandatory reading Other Slides – optional reading, will be dealt within the lecture Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Agenda I 1. Introduction Financial analysis Classes of users Need for financial statement analysis 2. Ratio analysis Significance of ratio analysis Sources Financial reporting systems and standards Important groups of ratio analysis Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Agenda II 3. Case study Beans Incorporation vs. Garlic Incorporation 4. Q&A and discussion Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Agenda: Introduction Financial analysis Classes of users Need for financial statement analysis Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Environment Macroeconomic situation, industry, market Financial Analysis Business Management, products, margins, technology, knowledge base, competition Financial Statements Balance sheet, income statement, cash flow, stockholders’ equity, budget Financial analysis • Evaluation of a firm‘s performance and development mainly by • identifying the key drivers of a firm‘s performance and financial position • calculating and interpreting important ratios of the firm • Balanced Scorecard (soft – hard) • A well rounded financial analysis takes into account not only the financials alone but also surrounding factors which can have significant influence on the firm’s development. Financial management does not operate in a vacuum. Source: White, Sondhi, Fried (2003), 2ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Classes of users • Internal users (such as managers or board members) • External users of financial information encompass a wide range of interests but can be classified into three general groups: • Credit and equity investors • Government, regulatory bodies, tax authorities • General public and special interest groups, labor unions and consumer groups Source: White, Sondhi, Fried (2003), 4. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Need for financial statement analysis • Internal: Financial statements provide the company with information on its performance and development over time and are a crucial basis for most financial decisions (i.e. investment, financing) • Costs • Efficiency • Profitability • Investments • Financing (needs) • External: Financial statements facilitate the interaction between the company and its business environment by providing third parties with essential information on the company’s development • Creditors • Investors • Shareholders • Government Financial analysis has great significance and impact on a company‘s development as it influences expectations on the capital markets Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Agenda: Ratio analysis Significance of ratio analysis Sources Financial reporting systems and standards Important groups of ratio analysis Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Ratio analysis • Financial statements help predict the future development of a company Firm A has total debt of $ 1’060m and $ 88m interest charges whereas firm B has total debt of $ 52m and $ 4m interest charges. Which firm is stronger, better financed? Or which firm is more liquid or more likely to generate higher cash flows?  Figures standing alone, such as total debt or interest charges, are not really helpful  By putting debt into perspective with other appropriate figures, we are able to predict which firm is more likely to succeed  such comparisons are ratio analysis The debt burden can be evaluated (a) by comparing each firm‘s debt with its assets and (b) by comparing the interest the company has to pay with the income it has available Source: Brigham, Houston (2012), 98f. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

„help predict the future development of a company” Significance of ratio analysis • As a company’s value is determined by its ability to generate cash today and in the future, ratio analysis has great importance • Share price development • Credit rating • However, there is no generally used list of ratios that could be applied to any company • Groups of ratios1): • Liquidity ratios • Asset management ratios • Debt or financing ratios • Profitability ratios • Market value ratios 1) Details later: see page 25ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Principal elements offinancial statements as primary source for financial analysis • Balance sheet • Income statement • Statement of cash flows • Statement of stockholders‘ equity • Further sources: Broker/analyst reports, Bloomberg, Reuters, Factset etc. Collectively, these interrelated financial statements provide relevant and timely information about the past and are essential for making crucial business decisions about investment or financing activities today and in the future. Financial statements are a key component to build trust in the financial community. Source: White, Sondhi, Fried (2003), 5. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Financial reporting systems and standards • Reporting systems and standards compel the company to meet a great number of requirements in order to ensure that the financial statements are, above all, transparent and comparable • The two most commonly used standards are: • IFRS (International Financial Reporting Standards) • US GAAP (United States Generally Accepted Accounting Principles) • Differences are found mainly in the classification of certain events (e.g. whether an interest payment is reported under operating costs or financing costs etc.) or with regard to financial instruments. Both aim to provide a “true and fair view”of the company’s performance. • In addition, there are local GAAPs (Generally Accepted Accounting Principles). In Switzerland we have rules in the Code of Obligation which permit hidden reserves and the FER (FachempfehlungfürRechnungslegung) which is a light form of IFRS. Source: White, Sondhi, Fried (2003), 5ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Balance sheet • Snapshot of the company‘s assets and liabilities at a certain reporting date • Assets = Liabilities + Equity USD m 2011 2010 Source: Brigham, Houston (2012), 62. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Income statement • Reports on the performance of a firm, the results of its operating activities • Matching principle = revenues and related costs must be accounted for during the same period of time. This requires the recognition of expenses incurred to generate revenues in the same period as the related revenues (revenue recognition, accrual method). USD m 2011 2010 Source: Brigham, Houston (2012), 67. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Statement of cash flow • The cash flow statement represents the cash generated by a company during the given accounting period • Separated into three categories: (I) operating activities, (II) investing activities, (III) financing activities • The investment section illustrates how cash was spent whereas section III, financing shows how those investments were financed • In the long run, cash flows from operating activities should considerably increase; investments should be equal to depreciation (plus a bit more to support stable growth)  In this example, the company has an operating problem as the cash flow from operating activities is negative • CAPEX = capital expenditures 2011 USD m Source: Brigham, Houston (2012), 69. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Statement of retained earnings • Changes in retained earnings occur because stockholders allow the management to retain and invest funds that otherwise would be paid out as dividend • Thus, the retained earnings position is not cash and is not available for spending 2011 USD m 2010 2011 2011 Source: Brigham, Houston (2012), 72. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Important groups of financial ratios • Liquidity ratios Is the company able to pay its debts as they become due this year? • Asset management ratios Does the amount of assets seem to be reasonable in relation to current and projected sales? And how efficiently does the company use its assets?” • Debt or financing ratios To what extent is the company using financial leverage? Risk from capital structure? • Profitability ratios How profitable is the company? How much output does the company generate in relation to a certain input? • Market value ratios How do the earnings and results appear in relation to the stock price? Be aware – the definition of ratios may vary between different authors or users! Source: Brigham, Houston (2012), 99ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Liquidity ratios • If a company is getting into financial difficulties, it will pay its bills more slowly, borrowing money from banks and from suppliers. This leads to increased current liabilities which causes the current ratio to decrease. If current liabilities grow faster than current assets, this is a an indication of financial difficulties. • The current ratio is also known as liquidity ratio 3. • Inventories are a firm’s least liquid current asset and therefore most likely to suffer losses if they have to be sold in liquidation. A company should be able to pay current liabilities with current assets less inventories. • The quick ratio is also known as liquidity ratio 2. Source: Brigham, Houston (2012), 99f; Volkart (2011), 161f. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Balance sheet and income statement USD m 2011 2010 2011 2010 USD m Source: Brigham, Houston (2012), 67. Source: Brigham, Houston (2012), 62. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 27

Liquidity ratios • If a company is getting into financial difficulties, it will pay its bills more slowly, borrowing money from banks and from suppliers. This leads to increased current liabilities which causes the current ratio to decrease. If current liabilities grow faster than current assets, this is a an indication of financial difficulties. • The current ratio is also known as liquidity ratio 3. • Inventories are a firm’s least liquid current asset and therefore most likely to suffer losses if they have to be sold in liquidation. A company should be able to pay current liabilities with current assets less inventories. • The quick ratio is also known as liquidity ratio 2. Source: Brigham, Houston (2012), 99ff; Volkart (2011), 161f. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 28

Balance sheet and income statement USD m 2011 2010 USD m 2011 2010 Source: Brigham, Houston (2012), 67. Source: Brigham, Houston (2012), 62. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 29

Asset management ratios • Inventory turnover indicates whether a company (compared with peer companies) holds too much inventory, which is very unproductive and represents an investment with a low return • The inventory turnover ratio can also be calculated by using “Cost of Goods Sold” instead of “Sales” • DSO shows the “average collection period” or how long customers usually take to pay their bills. The higher the DSO, the more money is lost, because the company has to finance the gap with expensive loans etc. • The fixed assets turnover ratio indicates how effectively the company is using its fixed assets compared with peer companies. Source: Brigham, Houston (2012), 102ff; Volkart (2011), 163f. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 30

Balance sheet and income statement USD m USD m 2011 2010 2011 2010 Source: Brigham, Houston (2012), 67. Source: Brigham, Houston (2012), 62. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 31

Debt management ratios • Creditors prefer a low debt to equity ratio whereas stockholders may want more leverage as it can magnify expected earnings ( pecking order theory). The optimal ratio between debt and assets is highly dependent on the firm’s business and industry. • The TIE ratio measures the extent to which operating profit can decline before the firm is unable to meet its interest costs. Not being able to pay interest costs will bring legal troubles and can result in bankruptcy. Source: Brigham, Houston (2012), 105ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Debt management ratios • Creditors prefer a low debt to equity ratio whereas stockholders may want more leverage as it can magnify expected earnings ( pecking order theory). The optimal ratio between debt and assets is highly dependent on the firm’s business and industry. • The TIE ratio measures the extent to which operating profit can decline before the firm is unable to meet its interest costs. Not being able to pay interest costs will bring legal troubles and can result in bankruptcy. Source: Brigham, Houston (2012), 105ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 38

Profitability ratios • The profit margin on sales shows the profit per unit of sales • Stockholders want to earn a return on their money invested. This ratio indicates the profitability of a stockholders’ invested money from an accounting perspective • This ratio shows the raw earning power of the firm’s assets excluding potential influence from interest payments or leverage effects. • Stockholders want to earn a return on their money invested. This ratio indicates the profitability of a stockholders’ invested money from an accounting perspective Source: Brigham, Houston (2012), 108ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Balance sheet and income statement USD m 2011 2010 2011 2010 USD m Source: Brigham, Houston (2012), 67. Source: Brigham, Houston (2012), 62. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 43

Market value ratios Numbers of shares: 50m Share price: 23 • This ratio shows how much an investor is willing to pay per unit of reported earnings. Thus, the P/E ratio indicates, by comparison with its peers, whether a company is regarded as being risky or expected to have poor growth. • The market to book ratio typically exceeds 1.0 as the balance sheet does not reflect inflation or goodwill. In addition, this ratio provides an indication whether a company is able to earn high returns. Source: Brigham, Houston (2012), 111ff. Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Corporate Finance Interpreting Financial Statements