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17. Learning Objectives. Help yourself grow as a stock analyst by knowing: How to obtain financial information about companies. How to read basic financial statements. How to use performance and price ratios. How to use the percentage of sales method in financial forecasting.
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Learning Objectives Help yourself grow as a stock analyst by knowing: How to obtain financial information about companies. How to read basic financial statements. How to use performance and price ratios. How to use the percentage of sales method in financial forecasting.
Earnings and Cash Flow Analysis Our goal in this chapter is to show you the financial accounting concepts necessary to: Understand basic financial statements and Perform earnings and cash flow analysis using basic financial statements. Keep in mind: Cash flow is a company’s lifeblood.
Sources of Financial Information, I. An excellent primary source: annual reports Visit www.wsj.com and enter a stock symbol in the appropriate box. A company research page appears. Click on “Annual Reports.” Free service for subscribers of The Wall Street Journal. Internet The New York Stock Exchange web site provides a directory of web sites for companies listed on the NYSE. Web sites, like finance.yahoo.com, provide some financial information. Information at the Investor Relations area of a company’s web site.
Sources of Financial Information, II. The Securities and Exchange Commission (SEC) requires companies to prepare and submit regular reports When received by the SEC, these reports are freely made available through the Electronic Data Gathering and Retrieval (EDGAR) archives. 10K: Annual company report filed with the SEC. 10Q: Quarterly updates of 10K reports. Companies file many reports with the SEC.
Sources of Financial Information, III. Also, the SEC Regulation FD (Fair Disclosure) requires companies making a public disclosure of materialnonpublicinformation to do so fairly without preferential recipients. Materialnonpublicinformationis previously unknown information that could reasonably be expected to affect the price of a security. Most companies satisfy Regulation FD by distributing important announcements via e-mail alerts to those who register for the service at the company’s website (look in the investor relations section).
Three Important Financial Statements The Balance Sheet: Provides a snapshot view of a company’s assets and liabilities. The Balance Sheet is as of a particular date. The Income Statement: Provides a summary of a firm’s revenues and expenses. The Income Statement is over a specific accounting period, usually a quarter or a year. The Cash Flow Statement: Is an analysis of the sources and uses of cash by the firm over an accounting period. Summarizes operating, investing, and financing cash flows.
The Balance Sheet Asset- Anything a company owns that has value. Liability - A firm’s financial obligation. Equity- An ownership interest in the company. The fundamental accounting identity: Assets = Liabilities + Equity
The Income Statement Income- The difference between a company’s revenues and expenses. Income is used to: pay dividends to stockholders or kept as retained earnings to finance future growth. • Net income = Revenues – Expenses • = Dividends + Retained earnings
The Cash Flow Statement Net Incomedoes not equal cash flow. Net income contains non-cash items. Non-cash items are income and expenses not realized in cash form. Depreciation can be a significant non-cashitem. Cash flow represents all income realized in cash form. Adjusting net income for non-cash items yields Operating CashFlow. Investment Cash Flow includes any purchases or sales of fixed assets and investments. Financing Cash Flowincludes funds raised by issuing securities or expended by repurchasing outstanding securities.
Performance, or Profitability, Ratios Four common performance ratios often reported in 10Ks and 10Qs to help investors interpret financial information are: Note thatROA and ROEare calculated using thecurrent year-endvalues fortotal assets and stockholder equity. Although one could use prior-year values, it is more common to use current year-end values.
Example: Calculating Profitability Ratios Using the data provided by the Borg Company in the year 2536, we can calculate the profitability ratios:
Price Ratio Inputs Annual reports will often report per-share calculations of book value, earnings, and operating cash flow. Per share calculations require the number of shares outstanding. Cash flow per share uses operating cash flow!
Example: Calculating Price Ratio Inputs For the Borg Company in the year 2536:
Price Ratios Using the inputs we just calculated, we can calculate three important Price Ratios:
Example: Calculating Price Ratios For the Borg Company, these three ratios are:
Financial Statement Forecasting, I. You are an analyst employed by Vulcan Ventures, and you are assigned as an analyst for the Borg Corp. In December 2536, Borg announces the completed acquisition of some distribution outlets from Klingon Enterprises, LLC. The stated purpose of the acquisition is to increase sales. Borg also announces plans for a marketing campaign—goal: increase sales to $137,500. Your job is to examine the potential financial impact from these announcements on the Borg Corp. How do you proceed?
Financial Statement Forecasting, II. You decide to build pro forma financial statements using the percentage of sales approach. Under this approach: Every accounting item increases at the same rate as sales. This may be reasonable for some items and unreasonable for others—as an analyst you must judge this “reasonableness.” Reasonable: accounts receivable Not Reasonable: long-term debt Management decides the level of long-term debt.
Building the Pro Forma Income Statement, I. A sales level of $137,500 for year 2537 represents a 25% increase over sales in the year 2536. Assumptions: Ratio of total costs to net sales is about 94.55% in 2536. You assume this ratio to be 94.55% in 2537 too. Depreciation can be handled many ways. As a practical matter, you use the percentage of sales approach. Depreciation to sales in 2536 was $3,000 / $110,000. For 2537, you estimate depreciation as: ($3,000 / $110,000) × $137,500 = $3,750.
Building the Pro Forma Income Statement, II. Assumptions, cont. Interest Expense: 4% interest on short-term debt, 8% interest on long-term debt, and 5% interest on debt issued to finance the new outlets. To maintain the ratio of total costs to net sales (94.55%), you use other operating expenses as the “plug”, so you set it to $12,500. Tax rate is 40%. Dividends are a constant percentage of net income.
Building the Pro Forma Balance Sheet You assume some balance sheet items vary with sales, but others do not (“n/a” is next to the items that do not). Asset accounts that do: Cash Accounts receivable Prepaid expenses Materials and supplies Inventory However, the only liability account that you assume does is accounts payable.
The Partial Pro Forma Balance Sheet, II. Inspecting the partial pro forma balance sheet: Assets are projected to increase by $22,000. However, without additional financing (i.e., short-term or long-term debt), liabilities and equity will increase by only $4,400. What do you do about this $17,600 difference (labeled external financing needed (EFN) )? After all, the balance sheet must balance.
The Partial Pro Forma Balance Sheet, III. First, note that EFN points out a potentially serious problem for Borg: The company cannot increase sales to $137,500 unless it can raise $17,600 in additional financing. If Borg management does not want to take on more debt or raise more equity, then they cannot increase sales to $137,500. You assume that the ratio of current assets to current liabilities should remain constant. This means that Borg should borrow $2,500 more short-term. This leaves $15,100 to be financed via long-term debt. • These are the amounts shown at the bottom of Table 17.6
Another Scenario to Consider Hidden assumption: You assumed that Borg was using its fixed assets at 100% of capacity (i.e., increasing sales increased fixed assets). But, suppose there is some capacity slack. Suppose you find out from Borg management that Borg is currently running at 75% of capacity. That is, current sales level is 75% of full capacity sales level. Therefore, sales could increase by about 1/3 before any new fixed assets are required.
Notes on this New Pro Forma Balance Sheet A sales level of $137,500 increases assets (other than fixed assets) by $7,000. Accounts payable increase by $1,250. A sales level of $137,500 increases retained earnings by $3,150 (after dividends are paid). The difference between the increase in assets and the increases in liabilities and shareholder equity would be $2,600 (without additional financing). The balance sheet balances if Borg borrows $2,600 more in short-term debt.
Projected Profitability and Price Ratios,The Borg Corporation (I) Borg running at full capacity; (II) Borg running at 75% capacity
Projected Stock Prices for Year 2537,The Borg Corporation Assume that the current stock price is $40. Which projected stock price is “right”? Clearly depends on which price ratio financial markets will use to price Borg shares. Your job as an analyst will be to assess the situation and make an investment recommendation (supported by facts, investigation, and analysis).
Starbucks Corporation,Case Study The purpose of studying the Borg Corporation was to help you gain an understanding of basic financial statements and how to make financial projections. To further illustrate these concepts, let’s perform an analysis using a real company—which provides a challenge! We will use the 2009 financial statements for Starbucks Corporation. Suppose revenue increases by either 11.5% or 1.3%. The numbers that follow are in $thousands (except EPS).
Starbucks Corporation, 2009 and2008 Condensed Income Statements
Pro Forma Statements, Notes I. The pro forma income statements correspond to a 11.5% increase and a 1.3% increase in revenue. We employ the percentage of sales approach. Assume that gross margin, operating margin, and interest income are the same percentage of sales for 2010 as they were in 2009. Assume the tax rate remains constant. Net effect: Profit margin remains constant at about 4.0%. Assume no dividends are paid. Assume Starbucks will not issue or repurchase shares. All net income will flow to retained earnings. Number of shares remains at 745.9 million. These assumptions lead to EPS’s of $0.58 and $0.53, respectively.
Pro Forma Statements, Notes II. Using the high sales estimate, EFN is about $26.3 million. Using the low sales estimate, EFN is a negative $342.7 million. Current assets grow about $372 million less than net income Current liabilities increase by about $13 million Quite the “cash cow” This is $342.7 million of “excess” cash. What can management do with it? Buy other companies Look for new ways to expand the company Buy back shares Declare a cash dividend Existing profit margin enjoyed by Starbucks is such that considerable growth can be financed out of sales.
Projected Profitability and Price Ratios,Starbucks Corporation BTW, the mean and median 2010 price estimates for SBUX by (highly paid) Wall Street analysts were $22.60 and $24.00, respectively.
Useful Internet Sites www.nyse.com (the website of NYSE Euronext) www.thestreet.com (look at the portfolio/tools section) www.moneyunder30.com (check out the investing section) www.starbucks.com Sources for financial statement information: www.sec.gov (reference for electronic data archives, EDGAR) www.freeedgar.com (free EDGAR) www.annualreportservice.com (annual report service) www.prars.com (free annual reports)
Chapter Review, I. Sources of Financial Information Financial Statements The Balance Sheet The Income Statement The Cash Flow Statement Performance Ratios and Price Ratios
Chapter Review, II. Financial Statement Forecasting The Percentage of Sales Approach The Pro Forma Income Statement The Partial Pro Forma Balance Sheet External Financing Needed (EFN) The Pro Forma Balance Sheet Projected Profitability and Price Ratios Starbucks Corporation Case Study
