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Midterm Review

Midterm Review. Business Strategy Analysis BC part A (chapter 1, 3) Accounting Analysis BC part B, Prepaid Legal, Overstock (chapter 4) Financial/Cash Flow Analysis BC part C, RCL part A (chapter 5, 6) Forecasting RCL part B, GAAP vs Street, Home Depot 2004 (chapters 2, 7, 8).

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Midterm Review

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  1. Midterm Review • Business Strategy Analysis • BC part A (chapter 1, 3) • Accounting Analysis • BC part B, Prepaid Legal, Overstock (chapter 4) • Financial/Cash Flow Analysis • BC part C, RCL part A (chapter 5, 6) • Forecasting • RCL part B, GAAP vs Street,Home Depot 2004 (chapters 2, 7, 8)

  2. Business Strategy Analysis • identify the key success factors and risks associated with a firm’s business strategy • evaluate the sustainability of profits generated by the strategy, given the threat of competition.

  3. Competitive Analysis • Competition from substitutes • Rivalry between established competitors • Threat of entry • Bargaining power of customers • Bargaining power of suppliers

  4. Accounting Analysis • assess the amount of accounting flexibility • assess management’s accounting choices • identify potential red flags • using different accounting methods or estimates than the industry • unexplained changes in methods/estimates • big gap between NI and CFO • unusual income-boosting transactions • related-party transactions • change in auditor • poor overall disclosure

  5. Restating the financial statements • Revenue recognition • Expense recognition AR xx revenue xx CGS yy inventory yy asset xx cash xx expense xx asset xx

  6. “Plug and Chug” Asset beg. bal. cash spent on asset amortized to expense end. bal. OR, beg. bal. + cash spent – expense = end. bal., so cash spent – expense = change in balance. use this to change between cash acctg and accrual acctg.

  7. And what about taxes? • if pretax accounting income changes but not taxable income, then the timing difference changes Δ tax expense = tax rate * Δ timing difference = tax rate * Δ pretax income Δ dt liability = tax rate * Δ cumulative timing difference = tax rate * Δ asset or liability Use the ETR! Not on test!

  8. Cash Flow Analysis • Evaluate the cash flow implications • are net operating and investing cash flows negative? - if so, how is the cash shortfall to be financed? • are net operating and investing cash flows positive? - if so, what does management propose to do with the free cash flow? • what are the cash flow commitments associated with the firm’s financing policy? - how does management propose to meet these commitments? • what are management’s capital expenditure plans and how will these be financed? • Information on cash flows is found in the ‘Liquidity and Capital Resources’ section of the MD&A

  9. Cash Flow Analysis BEWARE: changes in Operating section of SCF not equal to changes on BS due to a) business acquisitions b) foreign currency translation adjustments

  10. the return on net operating assets total assets – operating liabilities – debt = common equity net operating assets debt (1-t) X operating income – (1-t) X interest expense = net income net operating income after-tax interest expense minority interest capital lease obligations NOA = CE + debt NOI = NI + (1-t)int.exp.

  11. the advancedDupont model RNOA = net operating income/net operating assets after-tax cost of debt = after-tax interest expense/debt ROE = RNOA + (leverage X spread) = RNOA + debt/CE (RNOA – after-tax cost of debt) and RNOA = net operating margin X net operating asset turnover net operating income/revenue revenue/net operating assets

  12. Strategic Choices Influencing the Margin vs. Turnover Trade-Off • lower turnover / higher margins result from: • following a product differentiation versus a cost leadership strategy • following a vertical integration versus an outsourcing strategy • providing customer financing or holding inventory for customers

  13. Income Statement Forecasts • make a Sales forecast each period • the (1+g)(1+c)-1 model • seasonality • divine inspiration • use common size income statements to forecastprofit margin each period • economies of scale/scope in cost structure, • drivers of costs are not always Sales • results inEarnings forecast each period • but this may change when done with BS forecasts!

  14. BS Forecasts • combine sales forecasts with Asset Turnover forecasts to determine Assets each period • constant AT ratio. e.g. Sales/AR = 2.2 each period. Know sales so can solve for AR each period. • changing AT ratio. e.g. Sales1/AR1=2.2, Sales2/AR2=2.3 etc.. But can still solve for AR each period using Sales and turnover. • Think about • Scale Economies • available capacity

  15. BS forecasts continued • combine asset forecasts with leverage forecasts to determine financial liabilities each period. • constant leverage ratio. e.g. Debt/Asset = 1.6. Know Assets so can solve for Debt each period. • changing leverage ratio. e.g. Debt1/A1=1.6, Debt2/A2=1.7, etc.. But can still solve for Debt each period.

  16. Some internal checks • debt - interest relation • Does the implied interest rate articulate with your profit margin forecasts? • PPE – depreciation relation • Does your depreciation forecast change with the amount of forecasted PPE? • implied dividends (capital contributions) • with Assets and Liability forecasts for each period, can solve for common equity CE. • with CE forecasts and Earnings forecasts for each period, can solve for Div: CE1+E2-Div2=CE2. • Does the implied dividend/capital contribution seem reasonable? Jackson 5 - Dancing Machine

  17. Exploiting Information in Accruals • Accruals represent the difference between earnings and cash flows, so earnings consists of an ‘accrual component’ and a ‘cash flow component’. • In long run, earnings = cash flows and accruals=0. • Accruals are the less reliable component of earnings, and represent the component that is typically used to manage/manipulate earnings: • Artificially high accruals temporarily inflate earnings • Artificially low accruals temporarily depress earnings

  18. Operating Accruals • Definition: Operating Accruals = Earnings - Cash from Operations, deflated by average total assets SCF Operating section: Earnings 200 + depreciation +50 - Change in working capital -30 + non-cash special item charges +10 =Cash From Operations 230 operating accruals Dechow and Ge (2005)

  19. Differential Earnings Persistence Next year’s earnings = a + b*current earnings +…+ e Dechow and Ge (2005) The accrual component of earnings is less persistent than cash component, and the special item component of accruals is less persistent still.

  20. Operating Accruals and Future Stock Returns Dechow and Ge (2005)

  21. Would Operating Accruals have identified Boston Chicken’s distortion? Boston Chicken, 1996 Average Total Assets = $1,308,747k, so Operating Accruals = (66958 – 144910)/1,308,747 = -.06.

  22. Expanded Definition of Accruals • In the absence of accrual accounting, the only asset/liability account would be the cash account • Earnings would equal cash payments to/from owners plus the change in the cash account • Total accruals for any period therefore equal the change in all non-cash assets less the change in all liabilities • Accruals = (DAssets – DCash) – (DLiabilities)

  23. Total Accruals and Future Stock Returns Dechow and Ge (2005)

  24. Balance Sheet Decomposition • Assets • Cash • Short-Term Investments • Current Operating Assets • Long-Term Investments • Non-Current Operating Assets • Liabilities and Equity • Debt in Current Liabilities • Current Operating Liabilities • Long-Term Debt • Non-Current Operating Liabilities • Preferred Stock • Common Equity Cash Basis

  25. Balance Sheet Decomposition • Assets • Cash • Short-Term Investments • Current Operating Assets • Long-Term Investments • Non-Current Operating Assets • Liabilities and Equity • Debt in Current Liabilities • Current Operating Liabilities • Long-Term Debt • Non-Current Operating Liabilities • Preferred Stock • Common Equity Working Capital (WC)

  26. Balance Sheet Decomposition • Assets • Cash • Short-Term Investments • Current Operating Assets • Long-Term Investments • Non-Current Operating Assets • Liabilities and Equity • Debt in Current Liabilities • Current Operating Assets • Long-Term Debt • Non-Current Operating Liabilities • Preferred Stock • Common Equity Non-Current Operating (NCO)

  27. Balance Sheet Decomposition • Assets • Cash • Short-Term Investments • Current Operating Assets • Long-Term Investments • Non-Current Operating Assets • Liabilities and Equity • Debt in Current Liabilities • Current Operating Assets • Long-Term Debt • Non-Current Operating Liabilities • Preferred Stock • Common Equity Financing (FIN)

  28. Future Stock Returns and Initial Accrual Decomposition 4+5=12+3=4 1 2 3 4 5 Richardson, Sloan, Soliman and Tuna (2004) – different sample than Dechow and Ge (2005)

  29. How big is a big accrual? on page 121 in textbook

  30. Would Operating Accruals have identified Boston Chicken’s distortion? Boston Chicken, 1996 average noncash Net Operating Assets = $930,534k, so DnonCurrentOperatingAssets/noncashNetOperatingAssets = 525,025/930,534 = 56%.

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