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Financial Analysis

Financial Analysis. Credit Analysis Equity Analysis. Creditors. What is the borrowing cause? What is the firm’s capital structure? What will be the source of debt repayment?. Credit Rating. Business Risk Industry characteristics Company position Management Financial Risk

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Financial Analysis

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  1. Financial Analysis Credit Analysis Equity Analysis

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

  3. Credit Rating • Business Risk • Industry characteristics • Company position • Management • Financial Risk • Financial characteristics • Financial Policy • Profitability • Capital Structure • Cash Flow Protection • Financial flexibility

  4. Standard & Poor’s rating method • EBIT interest coverage • EBITDA interest coverage • Funds from operations/Total debt % • Free operating cash flow/Total debt % • Return on capital % • Operating income/Sales • Long-term debt/Capital • Total debt/Capital

  5. Standard and Poors Corporate Ratings

  6. Financial distress The deterioration in a company’s financial condition such that its ability to repay debt is impaired

  7. Prediction of financial distressUnivariate models • Beaver (1966) relied on • Cash flow to total debt • Net income to total assets • Total debt to total assets • Working capital to total assets • Current ratio • No-credit (defensive) interval

  8. Prediction of financial distressMultivariate models • Altman Z-score • (Current assets – current liabilities)/total assets (weight-1,2) • Retained earnings/Total assets (weight-1,4) • EBIT/Total assets (weight-3,3) • Preferred and common stock market value/Book value of liabilities (weight-0,6) • Sales/Total assets (weight-1,0)

  9. Altman Z-score • Z> 2,99  Not in financial distress • Z< 1,81  In financial stress • 2,99>Z>1,81 Uncertain

  10. Altman Z score Anadolu Cam

  11. Additional considerations • Mezzanine items • Could be debt or equity • Off-balance-sheet liabilities • Operating leases • Contingent liabilities • Environmental liabilities

  12. Equity Analysis • Buy-side • Work for an institutional investors (mutual fund) • Make internal recommendations regarding the purchase of equity securities • Might review reports of sell-side analysts • Sell-side • Work for brokerage firms • Issue reports for retail and institutional customers

  13. Valuation • Current value V0is a function of • Present value of next year’s cash flow, CF1 • Required rate of return, r • Expected constant growth rate, g

  14. Equity Analysis Provides information regarding • The future cash flow generating ability of the firm • The growth (or lack thereof) of those cash flows • The risk of those cash flows, and • The risk-free rate commanded by the market

  15. Top-Down Analysis • Begin at highest (economy) level • Allocation between domestic and international equities • Market sectors • Industries (within a sector) • End with evaluation of specific companies

  16. Bottom-Up Analysis • Begin with individual companies • Look for key strengths • Screen large data bases for attractive characteristics • Compustat, Bloomberg, Baseline • Search for a combination of characteristics

  17. Macroeconomic Analysis • Gross Domestic Product (GDP): total value of all final goods and services produced within a country. • Nominal, measured in current dollars • Real, adjusted for changing prices • Gross National Product (GNP): total value of all final goods and services produced by factors of production owned by citizens of a country regardless of production location • Growth rates of both can be used as an initial estimate of a firm’s growth rate

  18. Business Cycle • Expansion • Period of economic growth • Increased need for PP&E, labor, inventory • Peak – high point following expansion • Recession • Contraction following a peak • Rising unemployment, decreased need for factors of production • Two quarters of falling real GDP

  19. Business Cycle • Trough – low point following recession • Depression • Prolonged and severe recession • Some sectors and industries will perform better in some stages of the cycle than in others. • Cyclical firms are sensitive to stages of the economic cycle.

  20. Inflation • Consumer Price Index (CPI) measures inflation of a market basket of consumer goods • Producer Price Index (PPI) measures inflation at the wholesale level • Higher inflation, higher required risk-free rate of interest • Impacts all companies and all industries (to varying degrees)

  21. Economic Indicators • Leading indicators • Move in advance of the business cycle • Unemployment claims, new orders • Lagging indicators • Follow behind the business cycle • Average duration of unemployment, average prime rate • Coincident indicators • Move with the business cycle • Industrial production

  22. Sector/Industry Analysis • Assess the ability of companies within the industry to generate cash flow • Assess the potential growth of that cash flow • Assess the risks related to receipt of those cash flows • Assess the industry’s ability to grow relative to the overall economy

  23. Porter’s 5 Competitive Forces that determine industry profitability • Threat of New Entrants - Capital requirements, government policy, access to distribution • Bargaining Power of Suppliers - Supplier concentration, switching costs, differentiation of inputs 3. Bargaining Power of Buyers - Buyer concentration, price sensitivity, brand identity 4. Threat of Substitute Products or Services 5. Rivalry Among Existing Firms - Industry growth, barriers to exit, current industry concentration

  24. Company Analysis • Understand the business • Evaluate past performance • Forecast performance • Value the company • Make an investment recommendation

  25. Understanding the Business • Gain an understanding of the products and services provided by the company and the market for those products and services • Talk to employees, suppliers, competitors • Interview customers • Utilize the company’s products or services

  26. Evaluating Past Performance • Understand reported financial information • Common size and ratio analysis • Consider efficiency, liquidity, solvency, cash flow and relative valuation • Understand US GAAP and IAS • Financial reporting quality and conservatism

  27. Forecasting Performance • Based on evaluation of past performance, economic/industry conditions and expected changes • Pro-forma (projected) financial statements • Projection of future earnings • Use earnings model or statistical projection

  28. Valuing the Company • Determine the appropriate price for making an equity investment • Is the intrinsic value higher or lower than the current market price? • Specific methods • Discounted cash flow • Market-multiple • Residual income

  29. Making an Investment Recommendation • Current price of subject company’s securities • Results of valuation • Risks of investment • Investor’s risk tolerance, objectives and time horizon • Buy/Attractive • Hold/Market Perform • Sell/Market Under perform

  30. Five Steps of a Financial Statement Analysis Step 1 • 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? Establish objectives of the analysis

  31. Five Steps of a Financial Statement Analysis(cont.) Step 2 Study the industry in which the firm operates and relate industry climate to current and projected economic developments

  32. Five Steps of a Financial Statement Analysis(cont.) Step 3 • How well does this firm appear to be run? • Are they taking advantage of opportunities? • Are they innovative, forward-looking, etc? Develop knowledge of the firm and the quality of management

  33. Five Steps of a Financial Statement Analysis(cont.) Step 4 • Common-size financial statements • Key financial ratios • Trend analysis • Structural analysis • Comparison with industry competitors Evaluate financial statements–toolsinclude:

  34. Five Steps of a Financial Statement Analysis(cont.) Step 4 • Short-term liquidity • Operating efficiency • Capital structure and long-term solvency • Profitability • Market ratios • Segmental analysis (when relevant) • Quality of financial reporting Evaluate financial statements–areas include:

  35. Five Steps of a Financial Statement Analysis(cont.) • Reach conclusions about the firm relevant to your established objectives Step 5 Summarize findings based on analysis

  36. What we have accomplished Turned Maze Auditor’s Report MD&A Notes Statement of Cash Flows Income Statement Statement of Shareholders’ Equity Balance Sheet

  37. Financial StatementsAn Overview Map

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