Analysis of Financial Statements

Analysis of Financial Statements Chapter 4 Chapter 4: Analysis of Financial Statements

Background • Financial statements aid in the process of fundamental analysis • Fundamental analysts evaluate financial ratios as an aid to determine if a security is over- or under-priced • The efficient market theory suggests that publicly available financial statements offer nothing of value • Professional security analysts have already discovered pertinent information and traded based on that information Chapter 4: Analysis of Financial Statements

Financial Statements • Large public firms issue quarterly financial statements • Small firms may only issue annual statements • Closely-held corporations may not issue public financial statements • Main financial statements • Balance sheet • Income and expense statement • Statement of cash flows Chapter 4: Analysis of Financial Statements

Balance Sheet • Represents historical value of firm’s assets, liabilities and stockholders’ equity on the day the accounting period ends • Assets = Liability + Stockholders’ Equity • Stockholders’ Equity represents firm’s net worth (Book value of owners’ equity) • Most firms end the fiscal year on December 31 Chapter 4: Analysis of Financial Statements

KO’s Balance Sheet Chapter 4: Analysis of Financial Statements

Income & Expense Statement • Report the flows that occurred during the accounting period • AKA profit and loss statement • Sales – Total Expenses = Income (Loss) Chapter 4: Analysis of Financial Statements

KO’s Income & Expense Statement Chapter 4: Analysis of Financial Statements

Statement of Cash Flows • Cash flows are the net cash remaining after all reinvestments have been deducted • Cash flow is not affected by • Accelerated depreciation rules • Arbitrary inventory valuation rules • Accrual methods of accounting • Accounting income is more ambiguous than a firm’s cash flows Chapter 4: Analysis of Financial Statements

KO’s Statement of Cash Flows Chapter 4: Analysis of Financial Statements

KO’s Cash Flows KO uses its large cash flows for reinvesting within the firm, joint ventures, stock repurchases and cash dividends. KO generates tremendous cash flows from operations Chapter 4: Analysis of Financial Statements

Sources of Financial Statements • Publicly traded companies in the U.S. are required to make full disclosure of their financial statements • Usually a phone call or letter is all that is needed & firm will mail statements to you • SEC’s Electronic Data Gathering Analysis and Retrieval (EDGAR) System has the information for free at www.sec.gov/edgarhp.htm • Not user friendly • EDGAR Online at www.edgar-online.com and FreeEDGAR at www.freeedgar.com are more user friendly but not all the data is free • Hoover’s On-Line at www.hoovers.com, PR Newswire at www.prnewswire.com and Yahoo!Finance at http://quotes.yahoo.com offer additional information Chapter 4: Analysis of Financial Statements

Common-Sized Financial Statements • Express each item as a percentage of a common base number • Such as Assets or Sales • Useful when comparing • A firm over time • Different sized firms • Firms from different countries Chapter 4: Analysis of Financial Statements

KO’s Common-Sized Balance Sheet Chapter 4: Analysis of Financial Statements

KO’s Common-Sized Income & Expense Statement Chapter 4: Analysis of Financial Statements

Analysis of Sales and Competition • KO manufactures syrups for the following products • Coke Products (70% of total sales) • Classic Coke • Diet Coke • Decaffeinated Diet Coke • Cherry Coke • Diet Cherry Coke • Non-Coke soft drinks (21% of total sales) • Sprite • Fanta • TAB • Nestea • Mello Yello • Lift • Barq’s • Specialty local drinks • Diet Sprite • Mr. PiBB • Fresca • POWERaDE Chapter 4: Analysis of Financial Statements

Analysis of Sales and Competition • Food Sales • Fruit juices generate 9% of total sales • Minute Maid juice • Hi-C • Fruitopia • In the 1970s and 80s KO also sold • Wines • Straws • Plastic cups • Water conditioning equipment Discontinued these product lines to focus on core business. Chapter 4: Analysis of Financial Statements

Analysis of Sales and Competition • KO products made up 18% of the non-alcoholic soft drinks purchased in the world in 1999 • Sales have grown at 6% annually for the last decade • EPS grew at 4.8% during the same period Chapter 4: Analysis of Financial Statements

Analysis of Sales and Competition • KO sells its products in 200 countries Only 21% are made in the U.S. where KO is headquartered. Chapter 4: Analysis of Financial Statements

Analysis of Sales and Competition • Company strengths • Multinational diversification • Differentiated product line • Executives forecast a continuation of past growth • Main competitor • PepsiCo • Only weak line is the ‘food products’ line Chapter 4: Analysis of Financial Statements

Financial Ratios • A financial ratio combines multiple values to produce a new, meaningful value • Used to quantify, summarize and interpret financial data • Types of ratios • Solvency or liquidity ratio • Measure firm’s ability to meet short-term obligations • Turnover ratios • Measure rate of activity • Coverage ratios • Measure extent to which the firm’s earnings can cover debt-related expenses Chapter 4: Analysis of Financial Statements

Financial Ratios • Leverage ratios • Measure extent to which firm has been financed by creditors • Profitability ratios • Measures productivity of money invested in firm • Per share data • Examines items that affect common stock’s market price per share • Growth ratios • Measures contribution of various items to firm’s development • Risk analysis ratios • Measures variability Chapter 4: Analysis of Financial Statements

Solvency (Liquidity) Ratios • Current Ratio • Formula • Current Assets  Current Liabilities • Values • 1997: 0.81 • 1998: 0.74 • 1999: 0.66 For every $1 in current liabilities the firm had $0.66 in current assets. KO did not quite have enough current assets to pay its bills. • Quick Ratio • Formula • (Current Assets – Inventory)  Current Liabilities • Values • 1997: 0.68 • 1998: 0.64 • 1999: 0.55 Quick ratio is more discriminating than Current Ratio—only includes the most liquid assets. If the firm’s inventory becomes worthless, KO does not have enough liquid current assets to pay its bills. Chapter 4: Analysis of Financial Statements

Solvency (Liquidity) Ratios • Even though KO has experienced huge cash flows, the firm’s current and quick ratios are quite low • Thus, the solvency ratios did not tell the whole story Chapter 4: Analysis of Financial Statements

Turnover Ratios • Inactive assets might not be generating earnings • Turnover ratios help pinpoint the non-earning assets • Receivables Turnover Ratio • Formula • Annual credit sales  Accounts receivable • Values • 1997: 11.51 • 1998: 11.29 • 1999: 11.02 Receivables turn over slightly less than once a month. Is this too low/high? Cannot be determined without knowing firm’s credit policy and industry customs. Chapter 4: Analysis of Financial Statements

Turnover Ratios • Collection Period • Formula • Accounts receivable  Average day’s sales • Values • 1997: 31.71 days • 1998: 32.32 days • 1999: 33.14 days Acceptable value depends on product being sold and credit terms. • Inventory Turnover • Formula • Annual sales (at cost)  Average Inventory (at cost) • Values • 1997: 6.27 • 1998: 6.25 • 1999: 5.58 Need more information before we can evaluate these values. Chapter 4: Analysis of Financial Statements

Turnover Ratios • Asset Turnover Ratio • Formula • Annual Sales  Total Assets • Values • 1997: 1.11 • 1998: 0.98 • 1999: 0.92 Needs to be compared to competitors’ values. • Equity Turnover Ratio • Formula • Annual Sales  Equity • Values • 1997: 2.58 • 1998: 2.24 • 1999: 2.08 Equity turns over faster than assets because firm uses financial leverage. Chapter 4: Analysis of Financial Statements

Coverage Ratios • Times Interest Earned • Formula • Annual operating income  Annual interest payment • Some financial analysts prefer to use the pre-tax gross income instead of operating income • Values • 1997: 106.40 • 1998: 85.64 • 1999: 51.71 • Some analysts use all debt-service charges, lease payment and cash dividends on preferred stock instead of interest payment alone. KO’s income can fall 98.07% (1 – (1/51.7 times) before it will be insufficient to cover the firm’s interest expense. Chapter 4: Analysis of Financial Statements

A Cash Flow Ratio • Two values from the Income & Expense Statement can be used to define a company’s cash flow • Earnings before interest and taxes (EBIT) • Depreciation/Amortization • Allocates an asset’s cost over its useful life • A non-cash expense deducted from revenue • Reduces taxes • KO’s 1999 cash flow is • EBIT of $3,982 + Depreciation of $792 = $4,774 • Can now calculate the Cash flow-to-long-term-debt ratio • 4,774  854 = 5.59 Chapter 4: Analysis of Financial Statements

Financial Leverage Ratios • Total Debt to Total Asset Ratio • Formula • Total debt  Total assets • Values • 1997: 0.57 • 1998: 0.56 • 1999: 0.56 • Total Debt to Total Equity • Formula • Total debt  Total equity • Values • 1997: 131.7 • 1998: 127.8 • 1999: 127.3 Chapter 4: Analysis of Financial Statements

Financial Leverage Ratios • Long-term Debt to Equity • Formula • Long-term debt  Equity • Values • 1997: 0.31 • 1998: 0.25 • 1999: 0.24 • Long-term Debt to Capitalization • Formula • Long-term debt  Capitalization • Values • 1997: 0.24 • 1998: 0.20 • 1999: 0.19 Sum of permanent current liabilities, long-term debt, preferred stock and stockholders’ equity. Chapter 4: Analysis of Financial Statements

Financial Leverage Ratios • Total Asset to Equity Ratio • Formula • Total assets  Equity • Values • 1997: 231.7% • 1998: 227.8% • 1999: 227.3% • Financial ratios are sometimes calculated with market values rather than book values • Often more realistic and relevant Chapter 4: Analysis of Financial Statements

Profitability Ratios • Net Profit Margin • Formula • Net income  Sales • Values • 1997: 0.22 or 22% • 1998: 0.19 or 19% • 1999: 0.12 or 12% An appropriate standard is needed to interpret a profit margin. • Return on Asset • Formula • Net income  Total assets • Values • 1997: 0.24 or 24% • 1998: 0.18 or 18% • 1999: 0.11 or 11% A dollar’s worth of assets yielded about 11¢ of after-tax earnings in 1999. Chapter 4: Analysis of Financial Statements

Profitability Ratios • Return on Equity (ROE) • Formula • Net income  Equity • Values • 1997: 0.57 or 57% • 1998: 0.42 or 42% • 1999: 0.26 or 26% If a firm has zero debt, its ROA and ROE are equal. • Long-Term Capital’s Pretax Rate of Return • Formula • (Interest + Pretax earnings)  Capitalization • Values • 1997: 0.75 or 75% • 1998: 0.58 or 58% • 1999: 0.37 or 37% If the rate does not exceed current interest rates, the firm is not earning enough to pay its debts. Chapter 4: Analysis of Financial Statements

Per Share Data for Common Stock • Earnings Per Share (EPS) • Formula • Net income  # of common shares outstanding • Values • 1997: $1.67 • 1998: $1.43 • 1999: $0.98 • Cash Dividend Per Share • Formula • Total corporate dividend  # of common shares outstanding • Values • 1997: $0.56 • 1998: $0.60 • 1999: $0.64 Chapter 4: Analysis of Financial Statements

Per Share Data for Common Stock • Payout Ratio • Formula • Cash dividends per share  EPS • Values • 1997: 0.336 or 33.6% • 1998: 0.419 or 41.9% • 1999: 0.653 or 65.3% Measures the percentage of earnings the firm pays out as a dividend. • Retention Rate • Formula • Retained Earnings  Net income • Values • 1997: 0.664 or 66.4% • 1998: 0.581 or 58.1% • 1999: 0.350 or 35.0% Measures the percentage of earnings the firm retains. Chapter 4: Analysis of Financial Statements

Per Share Data for Common Stock • Price-Earnings Ratio (P-E) • Formula • Market price per share  EPS • Values • 1997: Low of 32 to high of 47 • 1998: Low of 36 to high of 56 • 1999: Low of 48 to high of 72 Chapter 4: Analysis of Financial Statements

Analyzing and Interpreting Ratios • DuPont Analysis • Allows for a thorough analysis of ROE Chapter 4: Analysis of Financial Statements

KO’s DuPont Analysis Profit Margin rose and then fell over the decade. The increased use of financial leverage increased ROE through 1996. Asset Turnover rose and then fell over the decade. Chapter 4: Analysis of Financial Statements

Analysis of Growth • Common stock price appreciation depends on various factors • Growth financed internally depends on the amount of retained earnings • A corporation’s growth rate depends on the return on equity • Growth rate = RR x ROE • Substituting the three-part DuPont ROE equation, we obtain Shows that multiple factors influence growth—one factor can rise and another fall and growth can remain unchanged. Chapter 4: Analysis of Financial Statements

Risk Analysis • As a firm’s risk increases • Investors demand higher interest rates (returns) • Thus, the price of the firm’s bonds and stocks will drop (inverse relationship) • How do you measure risk? • Coefficient of variation • Standard deviation  average value • Rescales different-size standard deviations to make them easily comparable Chapter 4: Analysis of Financial Statements

Risk Analysis • Business risk • Determined by volatility of operating income • Arises from fluctuations in sales and production costs • Financial risk • Arises due to the use of financial leverage (debt) Chapter 4: Analysis of Financial Statements

Ratio Standards of Comparison • Cross-Sectional standards • Compare a firm’s financial ratios to other firms or industry average • Industry averages are published by companies such as • Moody’s • Standard & Poor’s • Fitchs • Value Line • Duff and Phelps • Dunn and Bradstreet • Can reveal a firm’s strengths/weaknesses compared to other firms Chapter 4: Analysis of Financial Statements

Ratio Standards of Comparison • Time-Series standards • Compare a firm to its own ratios from other years • Helps highlight trends/changes that have occurred Chapter 4: Analysis of Financial Statements

Potential Problems with Financial Analysis • Inflation distortions • Can be a serious problem with the balance sheet • Some fixed assets are reported at their historical costs • After several years of high inflation historical costs can be irrelevant • Vague definition of accounting income • A firm can modify its accounting income depending upon certain actions • Such as which depreciation method or inventory valuation technique is used Chapter 4: Analysis of Financial Statements

Potential Problems with Financial Analysis • Consolidated financial statements • When a firm owns a subsidiary corporation accounting issues arise when considering minority interests • Goodwill • When a company merges, oftentimes ‘goodwill’ is then reflected on the consolidated balance sheet • This intangible asset cannot be measured with precision Chapter 4: Analysis of Financial Statements

The Bottom Line • Financial ratios are computed using basic financial statements like the balance sheet, income and expense statement and the statement of cash flows • Financial ratios include • solvency ratios • coverage ratios • turnover ratios • profitability ratios • cash flow ratios • leverage ratios • growth ratios • per share data • statistical risk analysis Chapter 4: Analysis of Financial Statements

The Bottom Line • Comparison of a firm’s ratios can be done on a • Cross-sectional basis • Time-series basis • Many additional ratios exist that were not covered in this chapter • Some analysts like to restate ratios • Some industries have ratios peculiar to that industry • Financial ratios can be distorted by • Inflation • Different accounting methods • Mergers Chapter 4: Analysis of Financial Statements

Analysis of Financial Statements