Where We’ve Been, Where We’re Going

1. Where We’ve Been, Where We’re Going • Industry Analysis • What’s the outlook for this industry? What makes it succeed or fail? • Competitive Strategy • How is a given firm reacting to its environment? • Accounting analysis • Are our data reliable? Do they need adjustments? Does it reflect economic reality? • Next: Financial Analysis

2. Financial Analysis • Goal • To assess the performance of a firm in the context of its stated goals and strategy • To provide the foundation for making forecasts of future performance • To provide valuable feedback to the analyst and help generate important follow-up queries • Two Tools • Ratio Analysis • To assess the relations among F/S items • Cash Flow Analysis • To examine the firm’s liquidity and how does a firm manage its various cash flows

3. Various Aspects Analysts Want to Know About a Firm • Operating • How well is the firm managing revenue and expenses? • Investment • What investments have been made? Are they used effectively? • Financing • How are the investments paid for? How does that affect profitability? • Dividend Policy • What’s been repaid to the shareholders? Need a framework to analyze growth and profitability

4. Ratio Analysis Framework  Decomposition NI Ave SE Leverage Taxes Profitability Efficiency Interest

5. Use of Averages • In conducting ratio analysis, we often relate flows (e.g., net income) with stocks (e.g., shareholders’ equity, total assets) • It’s best to average the “stocks,” but the use of ending balances is acceptable • As analyses become more detailed, advantages of averaging (precision) increase • For simplicity we’ll use ending balances

6. General Tools • Time-Series Analyses • Compare a particular firm across time • Common size F/S • Trend F/S • Ratios • Cross-Sectional Analyses • Compare different firms at the same time point • Time-Series  Cross-Sectional Analyses • Compare different firms across time

7. Initial Data Preparation • Through Accounting Analysis, consider • Adjustments to accounting policies • Capitalize  Expense • LIFO  FIFO • Add in “off B/S” items • Adjustments to accounting classifications • Is a deferred tax liability really a liability? • Adjustments for non-recurring items • Are the non-recurring really non-recurring?

8. Financial Analysis: ROE • How profitable is the firm? • Publicly traded firms in the U.S.: 11-13% over the long-run • The firm’s equity value depends on the relationship between ROE and cost of equity capital • Can “excess returns” be earned indefinitely? • Attract competition  Equilibrium in the long term

9. ROE: Dell 1999: Net income = $1,666 Ending SE = $5,308 ROE = $1,666/$5,308 = 31.4% Trend: 1995 to 1999 (Some data are from “Selected Financial Data” on page 19 Analysis: Compared with? A competitor or industry average?

11. leverage profitability Decomposing ROE Total Assets • How much profit is generated from each dollar of investment in assets • The Profitability Measure • Who pay for the assets, the shareholders or the creditors? • The Financial Leverage Measure Total Assets

12. Financial Leverage: TA/SE • Assets could be financed through borrowing • The higher the leverage, the higher the Assets-to-SE ratio • Leverage may create potential return to shareholders, • if cost of borrowing is less than returns on the assets it finances • Leverage adds risk  Question: Is the risk worth the reward? • Sources of borrowing: • Short term: current liabilities  short term liquidity analysis • Long term: long term debt  long-term solvency analysis

13. Financial Leverage: Dell 1999: TA = $11,471 SE = $5,308 TA/SE = $11,471/$5,308 = 2.16 Interpretation: TA is 2.16 times of SE or for every one dollar invested by shareholder, Dell borrowed $1.16 from creditors

14. Financial Leverage: Dell Trend: Observation: Leverage is highest in 1996 and 1997 and dropped to “normal” in 1999 Question: Can the firm pay its debt obligation? (1) interest and principal (2) short-term and long-term

15. Leverage: Short-Term Liquidity- Ability to repay current liabilities

16. Short-Term Liquidity - Dell • Current Ratio for 1999 • CA = $7,681; CL = $5,192 • Current Ratio = $7,681/$5,192 = 1.48 • For every $1 of current liability, Dell has $1.48 CA available for payment

17. Short-Term Liquidity—Dell Observation: Although Current Ratio dropped in 1999, but Dell’s S-T liquidity actually improved because it has more “cash-like” current assets available Question: The higher the better?

18. Leverage: Long-Term Solvency- Debt financing versus equity financing (Note: =TA/SE –1)

19. Debt-to-Capital: Dell 1999: Short-term debt = $0 Long-term debt = $508 SE = $5,308 Total capital = $508 + 5,308 = $5,816 Debt-to-Capital = $508/$5,816 = 0.09 Interpretation: For every one dollar of capital Dell raised, $0.09 is from creditor. That is, most capital are from shareholders.

20. Long-Term Solvency—Dell Dell carries less debt in 1999 than in 1998

21. Leverage: Coverage Ratios- The ability to meet interest payment Earnings Basis Note: EBIT = Income before tax + Interest expense Cash Basis

22. Earnings-Based Coverage Ratio - Dell 1999 EBIT = $2,263 + Investment and other income $222 (page 48) = $2,485 Interest expense = $34 (page 48) Interest coverage ratio = $2,485/$34 = 73.1 Interpretation: For every one dollar of interest expense due, Dell has $73.1 profit generated from sale to pay for it.

23. Coverage Ratios—Dell Observation: Dell’s coverage ratios have been dropping probably due to its carrying higher debt in recent years. Should analysts be concerned? Probably not.

24. Profitability Analysis • How good is the company generating profit for its shareholders from assets investment? • Overall profitability: • ROA = Net income/Average TA • How much profit is generate for each dollar of assets invested • Doesn’t consider nature of the assets • Current versus non-current • Operating versus non-operating  Decomposing ROA • Doesn’t consider how assets are financed  Add the leverage analysis

25. Measuring Return on Assets • This formulation is not quite correct • Investments in assets are financed through debt and equity; Assets = Liabilities + SE • Profit generated from assets investment should be “NOPAT” (net operating profit after tax) = NI + After-tax interest  Pre-Interest ROA = NOPAT/TA

26. Return on Capital • This figure can be compared with WACC (Weighted Average Cost of Capital) • To be profitable, return on capital should be above WACC • Over the long run, US firms earn 9–11% ROC

27. ROA: Dell 1999: NI = $1,666 Interest expense = $34 Tax rate = 31% NOPAT = NI $1,666 + Int. 34 x (1-31%) = $1,687 TA = $11,471 ROA = $1,666/$11,471 = 14.5% Pretax ROA = NOPAT $1,689/ TA $11,471 = 14.7% Interpretation: For every one dollar Dell invested in assets, it generated $0.147 profit

28. ROA: Dell Observation: Dell’s profitability has been dropping Why? Industry trend? Strategy not working?

29. Decomposing ROA Sales • What factors could change ROA? • Profit margin: NI/Sales, Return on Sales (ROS) • Asset utilization: Sales/Assets Sales

30. Decomposing Profit Margins • NI = (Sales – COGS) – SGA +/- Other income/Expenses • Important profit drivers: Gross Margin, R&D, SGA, Interest, Tax • Questions • What is the company’s gross margin? Gross margin ratio? • Are margins consistent with competitive strategy? • Are the gross and net margins changing? Why? Price pressure? Cost pressure? • Competition • Cost management • Management of SGA • Tools • common-size income statements: Divide every I/S item by net sales in the same year

31. Common-Size I/S - Dell

32. Common-Size I/S - Dell • Dell’s net income % is dropping • Mostly due to dropping in GM% • Higher COGS • More R&D expenditure • Better control of SGS • Higher other income in 1999

33. Decomposing Asset Utilization Ratio • Overall asset utilization ratio: • We can examine how well particular assets are being managed • Current Assets & Working Capital • Inventory • Accounts Receivable • Accounts Payable • Operating Assets

34. CA and Working Capital Turnover Ratios • Current Asset Turnover • Sales  Current Assets • Working Capital Turnover • Sales  Working Capital • Questions: • Are current assets being effectively managed? • Is there an opportunity to free up cash? Need to invest in current assets? CA Turnover Ratio: Working Capital Turnover Ratio: Observation: Dell is more efficient in managing its short-term assets

35. Accounts Receivable Turnover Ratio: A/R Turnover Ratio: • A/R Turnover • Sales  A/R • Days in A/R • 365 A/R Turnover Ratio • Questions • Are customers paying on time? • Is there a new mix of customers? Days in A/R: Observation: Dell is more efficient in managing it’s A/R; customers are paying quicker

36. Inventory Turnover COGS  Inventory Questions: Is inventory well-managed? What risks are faced by holding this inventory? Is inventory increasing in expectation of increased sales? Inventory Turnover Ratios Inventory Turnover Ratio: Days in Inventory: Observation: Dell’s inventory management is as “good” as before

37. PPE Turnover Sales  net PPE Questions Is the investment in PPE generating sufficient sales volume? Is the company efficient in its use of PPE? PPE Turnover Ratios Observation: Dell is not generating as much sales from its investment in PPE

38. A/P Turnover Purchases  A/P, or COGS  A/P Days in A/P 365 A/P Turnover Ratio Questions Is the company using trade credit (cheaper)? Are relations with suppliers good? Accounts Payable Turnover Ratios A/P Turnover Ratio: Days in A/P: Observation: It takes Dell more time to pay its suppliers; more than it collect cash from its customers

39. Review Assets turnover ROS Leverage

40. ROE Breakdown—Dell Observation: Dell’s ROE dropped in 1999 Return on sales dropped: higher cost? Efficiency in utilizing assets investment dropped Leverage decreased

41. Taxes & Interest • We can refine the model by further breaking down Return on Sales • Our Model: Profitability Taxes Leverage Interest Efficiency

42. Profitability before interest and taxes Gross margin analysis SGA analysis R&D analysis Decomposing ROS

43. Measures the ratio of operating income kept by the company after paying fixed expense (interest, lease payments…) Are fixed costs well-managed? Analyst may need to find the fixed payments For example, interest, leases and preferred dividends How Does Interest Cut Into Profit?

44. Measures the proportion of pretax income kept by the company Note: 1 - NI / EBT = Average Tax Rate How does it compare to statutory tax rate? Foreign tax rates? Effective tax planning? Is all income taxable? How Does Tax Cut Into Profit?

45. ROE—Complete Decomposition

46. Sustainable Growth Rate • Definition • Sustainable Growth Rate is the rate at which a firm can grow, keeping its profitability and financial policies unchanged • SGR = ROE x (1 - dividend payout ratio) • Dividend payout ratio = cash dividends paid  NI • Why do we care? • Important input into valuation models • Benchmark against which to judge what will need to change if profitability is to change

47. Sustainable Growth Rate—Example SGR = ROE x (1 - dividend payout ratio) The higher the dividend payout ratio, the lower the SGR even with same ROE and NE

48. Next: Cash Flow Analysis • Why do it? • Indicator of past and present cash generating ability; not affected by accounting estimations and assumptions • Are past and present decisions leading to positive cash flow? • Indicator of future profitability • Is present cash flow available to generate future cash flows? • What kind of investments are being made?

49. Statement of Cash Flows (SCF) • Format • Operating Cash Flows (OCF) • Direct Method • Indirect Method: more popular • Investing Cash Flows (ICF) • Financing Cash Flows (FCF) • Net changes in cash • Supplemental disclosures: • Non-cash transactions • Cash payments for interest and tax

50. Operating Cash Flows (OCF) • Accrual NI versus OCF • current accruals • sales vs. actual cash collections  A/R • COGS versus actual cash purchase  Inventory, A/P  Investment in working capital • non-current accruals • Depreciation, amortization, equity method, deferred taxes  Investment in non-current assets • Domestic versus Foreign SCF • Cash vs. “Funds” • Funds = Working capital