FINANCIAL STATEMENT ANALYSIS

1. 1 FINANCIAL STATEMENT ANALYSIS Lecture 5

2. 2 The Analysis of Financial Statements

3. 3 Objectives of Analysis Specify the objectives of the analysis Focus on WHO is the financial statement user Remember--the identity of the user helps define what information is needed

4. 4  Objectives of Analysis Creditors Investors Management

5. 5 Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds

6. 6  Creditors What is the borrowing cause? What is the firm’s capital structure? What will be the source of debt repayment?

7. 7  Creditors Circumstances Are ongoing operations solid? Operating problems, emerging businesses, investment in intangibles – all riskier . . . Cash Flows Can the firm generate the cash to repay? A/R or Inventories growing faster than sales? A/P increases > increase in inventories? Consistent negative CFOA?

8. 8  Creditors Contingencies – what else is going on that is not revealed in filed documents – labor disputes, etc. Character of Management – How commited are they to repaying the debt Conditions Debt covenants

9. 9 Investors The ultimate objective is to determine whether the investment is sound One key method is to derive an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation

10. 10  Investors How has the firm performed/what are future expectations? How much risk is inherent in the existing capital structure? What are expected returns? What is firm’s competitive position?

11. 11 Management Creditors Investors Employees General public Regulators Financial press

12. 12  Management How well the firm has performed and why? What operating areas have contributed to success and which have not?

13. 13  Management What are strengths/weaknesses of company’s financial position? What changes are indicated to improve future performance?

14. 14 Caution!!! Keep in mind: management PREPARES financial statements Analyst should be alert to potential for management to influence reporting to make data more “appealing” May want to supplement analysis with information apart from Annual Report prepared by management

15. 15 Sources of Information Proxy Statement MD&A Supplementary schedules Form 10-K and Form 10-Q

16. 16 Other Sources of Information Computerized data bases Info on industry norms/ratios Info on particular companies/industries/ mutual funds Articles in popular/business press Industry websites Weblogs Message Boards – Just be careful of “Hype” and manipulation by disgruntled parties

17. 17 Tools and Techniques Common-size financial statements Financial ratios Trend analysis Structural analysis

18. 18 Common-Size Financial Statements Express each account on the balance sheet as a percentage of total assets and each account on the income statement as a percentage of net sales

19. 19 Key Financial Ratios Standardize financial data in terms of mathematical relationships expressed in the form of percentages or times or even days

20. 20  Key Financial Ratios Continued Liquidity Ratio Measures a firm’s ability to meet cash needs as they arise

21. 21  Four Categories of Ratios Continued Activity Ratio Measures the liquidity of specific assets and the efficiency of managing assets

22. 22  Four Categories of Ratios Continued Leverage Ratio Measures the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges

23. 23  Four Categories of Ratios Continued Profitability Ratio Measures the overall performance of a firm and its efficiency in managing assets, liabilities and equity

24. 24 Caution! Ratios are valuable, BUT. . . They do not provide answers in and of themselves and are not predictive

25. 25 More Cautions! Ratios should be used with other elements of financial analysis There are no “rules of thumb” that apply to interpretation of ratios.

26. 26 General Rule of Thumb Look at Ratios of comparables and competitors to determine what the ratios should be. Competitors are those who provide similar products or services – regardless of size. (i.e., Microsoft and SCO Group) Comparable are those companies of a similar size who are in the same general industry – not necessarily direct competitors. (i.e.,Microsoft and Oracle)

27. 27  More Cautions! Continued Keeping this in mind, let’s take a look at some of the ratios. . . .

28. 28 Liquidity Ratios: Short-Term Solvency Measures ability to meet short-term cash needs

29. 29 Liquidity Ratios: Short-Term Solvency Remember: Current Assets – Current Liabilities = Working Capital. The relationship of Current Assets and Current Liabilities is very important. Rule of Thumb – a 2:1 ratio is generally pretty good. Caution - While a high ratio may be good it also may represent a waste of cash that could be put to other productive uses.

30. 30 Liquidity Ratios: Short-Term Solvency Continued Measures ability to meet short-term cash needs more rigorously

31. 31 Liquidity Ratios: Short-Term Solvency Continued Focuses on ability of the firm to generate operating cash flows as a source of liquidity

32. 32 Liquidity Ratios: Short-Term Solvency Continued Helps gauge liquidity of accounts receivable (ability to collect cash from customers).

33. 33 Liquidity Ratios: Short-Term Solvency Continued Is the average number of days it takes to sell inventory to customers

34. 34 Liquidity Ratios: Short-Term Solvency (cont.) Current Yr. Prior Year 2 Yrs. Prior 5 days 5 days 4 days

35. 35 Liquidity Ratios: Short-Term Solvency Continued Is the average number of days it takes to pay accounts payables in cash

36. 36 Net Trade Cycle (AKA Cash Conversion) Buying or manufacturing inventory, with some purchases on credit Selling inventory, with some sales on credit Collecting the cash

37. 37  Net Trade Cycle Continued Average collection period Plus Days inventory held Minus Days payable outstanding Equals Net trade cycle

38. 38 Activity Ratios: Assets Liquidity, Asset Management Efficiency Another measure of efficiency of firm’s collection and credit policies

39. 39 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Measures efficiency of inventory management

40. 40 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Another measure of efficiency of inventory management

41. 41 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Assesses effectiveness in generating sales from investment in fixed assets and helps support future CAPX

42. 42 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Assesses effectiveness in generating sales from investment in total assets

43. 43 Leverage Ratios: Debt Financing and Coverage Measures the extent of firm’s financing with debt

44. 44 Leverage Ratios: Debt Financing and Coverage Con’t. Measures the extent of firm’s financing with long-term debt

45. 45 Leverage Ratios: Debt Financing and Coverage Con’t Measures the extent of firm’s financing with debt

46. 46 Leverage Ratios: Debt Financing and Coverage Con’t Indicates how well operating earnings cover fixed interest charges

47. 47 Leverage Ratios: Debt Financing and Coverage Con’t Measures how many times interest payments can be covered by cash flow from operations before interest and taxes

48. 48 Leverage Ratios: Debt Financing and Coverage Con’t Broader measure of how well operating earnings cover fixed charges

49. 49 Leverage Ratios: Debt Financing and Coverage Con’t Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year

50. 50 Profitability Ratios: Overall Efficiency and Performance Measures profit generated after consideration of cost of products sold

51. 51 Profitability Ratios: Overall Efficiency and Performance Con’t. Measures profit generated after consideration of operating expenses.

52. 52 Profitability Ratios: Overall Efficiency and Performance Con’t. Measures profit generated after consideration of all expenses and revenues. Generally Operating profit less interest, taxes and special charges.

53. 53 Profitability Ratios: Overall Efficiency and Performance Con’t. Measures ability to translate sales into cash (with which to pay bills!)

54. 54 Profitability Ratios: Overall Efficiency and Performance Con’t. Important Note about Cash Flow – there are a variety of ways to calculate it i.e., Cash Flow from Ops – through the Cash Flow statement. Generic Cash Flow – Net Income + non-cash expenses on income statement (i.e., deprec/amort, charges recognized to shut down operation) Free Cash Flow – Generic (above) less funds used during the period for CAPX

55. 55 Profitability Ratios: Overall Efficiency and Performance Con’t. Measures overall efficiency of firm in managing investment in assets and generating profits

56. 56 Profitability Ratios: Overall Efficiency and Performance Con’t. Measures rate of return on stockholders’ investment

57. 57 Profitability Ratios: Overall Efficiency and Performance Con’t. Useful comparison to return on investment Indicates firm’s ability to generate cash from utilizing its assets

58. 58 Analyzing the Data Now that some of the “tools” of financial analysis have been illustrated, where does one go from here? Taking a general approach to financial statement analysis, one might proceed as follows. . .

59. 59 Five Steps of a Financial Statement Analysis Who are you and why are you interested in this company? What questions would you like to have answered? What info is vital to the decision at hand?

60. 60 Five Steps of a Financial Statement Analysis Con’t. Study the industry in which the firm operates and relate industry climate to current and projected economic developments

61. 61 Five Steps of a Financial Statement Analysis Con’t How well does this firm seem to be run? Are they taking advantage of opportunities? Are they innovative, forward-looking, etc? Are they aware of the risks?

62. 62 Five Steps of a Financial Statement Analysis Con’t Tools: Common-size financial statements, key financial ratios, trend analysis, structural analysis, and comparison with industry competitors

63. 63 Five Steps of a Financial Statement Analysis Con’t Major Areas: Short term liquidity, operating efficiency capital structure and long-term solvency, profitability, market ratios, and segmental analysis (when relevant)

64. 64 Five Steps of a Financial Statement Analysis Con’t Reach conclusions about the firm relevant to your established objectives

65. 65 Relating the Ratios—The Du Pont System It is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios

66. 66 Relating the Ratios—The Du Pont System Continued The Du Pont System helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity

67. 67 Relating the Ratios—The Du Pont System Continued

68. 68 Four Market Ratios Earnings per common share Price-to-earnings Dividend payout Dividend yield

69. 69  Market Ratios Continued Provides the investor with a common denominator to gauge investment returns

70. 70  Market Ratios Continued Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings

71. 71  Market Ratios Continued This ratio is determined by the formula cash dividends per share divided by earnings per share

72. 72  Market Ratios Continued Shows that relationship between cash dividends and market price

73. 73 A Few Words About Valuations Determining an appropriate valuation for a company should be based on several methodologies: Standard Methodologies: Comparable ratios (Compare Price/Earnings, Price/Revenue, Price/Book, etc to comparables and competitors)

74. 74 A Few Words About Valuations Discounted Cash Flow (DCF) – Future cash flows of a company discounted at a rate that reflects appropriate risk. DCF usually takes 3 – 5 years of cash flow and then assigns a terminal value to the remaining cash flows. Terminal Value – Current Value of a stream of perpetual cash flows.

75. 75 A Few Words About Valuations Basic Concept: Offer:  $1,000 today or  $1,000 1 year from now Rational Man: Take the $1,000 now and invest it at his expected rate of return (using CAPM).

76. 76 A Few Words About Valuations Basic Concept: Rational man expects return (Cash Flow) of 5% - $1,050 or 10% - $1,100 or 12% - $1,200 or Etc. These are future values (FV)

77. 77 A Few Words About Valuations Basic Concept: Alternatively, the Present Value of these is: 5% - $1,050/1.05 or $1,000 10% - $1,100/1.10 or $1,000 12% - $1,200/1.20 or $1,000 Etc. These are Present Values (PV) given the discount rate (5 – 12%)

78. 78 A Few Words About Valuations Discounted Cash Flow (Present Value) Model sample: