Financial Statement Analysis

Financial Statement Analysis CHAPTER 12

Learning Objectives After studying this chapter, you should be able to • Locate and use sources of information about company performance • Analyze the performance of a company using trend analysis, common-size financial statements and segment reporting • Use the basic financial ratios to guide your thinking • Evaluate corporate performance using various metrics, including ROA, ROE, and EVA • Calculate EPS when a company has preferred stock or dilutive securities

Learning Objectives After studying this chapter, you should be able to • Understand the nature of nonrecurring items and how to adjust for them • Use financial information to help assess a company’s value

Sources of Information About Companies • Company annual reports include: • The financial statements • Footnotes to the financial statements • A summary of the accounting principles used • Management’s discussion and analysis (MD&A) • The auditor’s report • Management’s report on its responsibility for the financial statements • Comparative financial data for a series of years • Narrative information about the company

Sources of Information About Companies • Companies also prepare reports for the Securities and Exchange Commission (SEC) • Form 10-K (annual report) • Form 10-Q (quarterly report) • Other sources of information: • Company press releases • Company Websites • The general financial press • Trade and industry publications • Financial services

Objectives of Financial Statement Analysis • Investors use financial statement analysis to • Predict expected returns • Assess the risks associated with those returns • Creditors are primarily concerned with • Short-term liquidity – how much cash a company has on hand to meet current payments when due • Long-term solvency – a company’s ability to generate cash to repay long-term debts when due • Equity investors are more concerned with profitability and future security prices

Trend Analysis • Trend analysis compares financial statement changes over time and identifies predictable patterns that have occurred • To compute percentage changes, the dollar change for an item (like net sales) is divided by the base year amount: 2002 $ - 2001 $ Percentage change = x 100 2001 $

Trend Analysis • Using the income statement for Eli Lily in Exhibit 12-1 in the text, the change in net sales is: $11,077.5 - $11,542.5 x 100 Percentage change = $11,542.5 = - 4%

Trend Analysis • The company’s explanation for some trends can be found in the Management Discussion and Analysis (MD&A) in the annual report • The MD&A includes disclosures about • Capital resources and liquidity • Results of operations (including sales and expenses) • Contractual obligations and commitments • Critical accounting estimates • Adoption of new accounting policies

Trend Analysis • The compound annual growth rate (CAGR) is the year-over year growth rate over a specific period of time • A future value table must be used to compute the CAGR (Chapter 9)

Common-Size Statements • Common-size statements simplify the comparison of different companies because their amounts are stated in percentages • On a common-size income statement, each item is expressed as a percentage of sales • In the balance sheet, the common size is total assets • Balance sheet items are referred to as component percentages because they measure each component of the statement as a percentage of the total

Segment Reporting • Companies must report information about segments of the business in a footnote to the financial statements • Segment information includes information on sales, profits, and assets • Reportable segments can be broken down by product line, geographical location, and major customer

Financial Ratios • The following exhibit summarizes the most popular financial ratios (from previous chapters) grouped into four categories: • Short-term liquidity • Long-term solvency • Profitability ratios • Market price and dividend ratios • Examples are provided from the Eli Lilly data in the text

Financial Ratios

Evaluating Financial Ratios • Financial ratios can be used for three types of comparisons: • Time-series comparisons – comparisons with a company’s own historical ratios • Benchmarks – comparisons with general rules of thumb • Cross-sectional comparisons – comparisons with other companies or with industry averages • Industry averages can be found in services such as Dun & Bradstreet and Standard & Poor’s

Evaluating Financial Ratios • Specific competitor companies can be found for ratio comparisons by using the • North American Industry Classification System (NAICS), or the • Standard Industry Classification Code (SIC) • Changes in ratios over time alert investors and creditors to possible problems

Operating Performance and Financing Decisions • Operating management is concerned with the daily activities that generate revenues and expenses • Financial management is concerned with where the company gets cash and how it uses that cash to its benefit

Operating Performance EBIT Rate of return on total assets (ROA) = Average total assets Where EBIT = Earnings before interest and taxes ROA can be decomposed into the (1) EBIT to sales ratio and (2) total asset turnover ratio: EBIT = (EBIT / Sales) x (Sales / Average total assets) Average total assets

Operating Performance • These ratios for Ely Lilly are: EBIT $3,537.40 EBIT to Sales Ratio  31.9% Sales $11,077.50  ROA = Sales $11,077.50 Total Asset Turnover  0.624 Times Average Total Assets $17,738.05

Operating Performance • Industries likely to display high EBIT to sales ratios and low total asset turnover ratios have high barriers to entry: • Utilities • Communications • Industries likely to display low EBIT to sales ratios and high total asset turnover ratios have low barriers to entry: • Retail grocery

Financing Decisions • Companies finance long-term investments with either • Long-term debt or • Stock • Debt is attractive because • Interest payments are tax deductible, but dividend payments are not • Present shareholders profits and voting rights are not diluted

Financing Decisions • Capitalization (capital structure) refers to the mix of debt and equity financing • Trading on the equity (financial leverage) means using debt at a fixed interest rate to try to increase the rate of return on stockholders’ equity (ROE)

Financing Decisions • When a company is debt free, ROE = ROA • When ROA > interest rate, ROE > ROA (favorable financial leverage) • When ROA < interest rate, ROE < ROA EBIT Rate of return on total assets (ROA) = Average total assets EBIT Rate of return on total assets (ROE) = Average stockholders’ equity

Economic Value Added • Economic value added (EVA) measures the residual wealth of a company after deducting its cost of capital from operating profit • A firm must earn more than it pays if it is to increase in value • The cost of capital here refers to a weighted average cost of interest on debt and returns to equity investors • EVA is used as an internal management tool to help allocate and manage scarce capital resources such as equipment and real estate

Economic Value Added • If a company has a capitalization of $1 million, 10% cost of capital, and operating profit of $120,000: EVA = Operating profit – Cost of capital EVA = $120,000 – ($1,000,000 x 10%) EVA = $20,000

Measuring Safety • Interest coverage (times interest earned) measures a company’s ability to make interest payments and repay debt on schedule • Rule of thumb: interest coverage should be at least 5 times EBIT Interest expense Interest coverage =

Earnings Per Share • In its simplest form, EPS is the net income divided by the number of common shares outstanding • The following slides address several complicating issues in the computation Net income Number of common shares outstanding EPS =

Weighted Average Shares • The denominator should actually use the weighted-average number of common shares outstanding Net income Weighted-average common shares outstanding EPS =

Weighted Average Shares • Example: 750,000 shares were outstanding at the beginning of the year and 200,000 additional shares were issued 3 months before the year-end. The weighted average number of shares would be: • The denominator must also be adjusted retroactively for any stock splits and stock dividends 750,000 x 9/12 = 562,500 950,000 x 3/12 = 237,500 800,000

Preferred Stock • If the company has nonconvertible preferred stock outstanding, net income must be reduced since the numerator should reflect just the net income that is available to common stockholders Net income – Preferred dividends Weighted-average common shares outstanding EPS =

Basic and Diluted EPS • Companies with convertible securities and stock options must report two EPS calculations: • Basic EPS • Diluted EPS • Assume the following data: • Convertible preferred stock at 5%, $100 par, each share convertible into two common shares: 100,000 shares • Common stock: 1,000,000 shares • Net income $10,500,000

Basic and Diluted EPS • The basic EPS calculation would be: $10,500,000 – $500,000 1,000,000 EPS = = $10.00

Basic and Diluted EPS • Diluted EPS assumes conversion of the preferred stock to common stock • Accordingly, no preferred dividends are deducted in the numerator and additional shares of common are added in the denominator $10,500,000 1,000,000 + 200,000 EPS = = $8.75

Disclosure of Nonrecurring Items • Nonrecurring items fall into four major categories: • Special items • Extraordinary items • Discontinued operations • Accounting changes

Special Items • Special items are revenues or expenses that are large enough and unusual enough to warrant separate disclosure on the income statement • Examples: • Impairment of PP&E • Impairment of goodwill • Restructuring charges • They appear with the operating expenses

Extraordinary Items • Extraordinary items are gains and losses resulting from events that are both • Unusual in nature • Infrequent in occurrence • They are reported net-of-tax on a separate line on the income statement

Discontinued Operations • Discontinued operations occur when a company disposes of an entire segment of the business • Segments must have assets and activities that are physically and operationally distinguishable from the remaining entity • Gains or losses from discontinued operations must be shown separately on the income statement net-of-tax

Changes in Accounting Method • A change in accounting method can occur when • The FASB issues a new pronouncement • The company changes to a preferred method of GAAP • The cumulative effect of the change in method on all previous years’ income is reported net-of-tax on a separate line on the income statement

Valuation Issues • Accounting data are important in determining the value of a company • The price-earnings (P-E) ratio is a useful valuation tool • “Value investors” believe that • Low P-E stocks may be undervalued • High P-E stocks may be overvalued • “Growth investors” believe that high P-E stocks are likely to be growth stocks

Valuation Issues • The price-earnings growth (PEG) ratio relates P-E ratios directly to earnings growth rates • The earnings growth rate can be based on historical earnings, current earnings, or forecasted earnings • Many analysts prefer a current P-E ratio and a forecasted 5-year earnings growth rate P-E ratio Earnings growth rate PEG =

Valuation Issues • Some rules of thumb on using the PEG: .50 or less Buy .50 to .65 Look to buy .65 to 1.00 Hold 1.00 to 1.30 Look to sell 1.30 to 1.70 Consider shorting Over 1.70 Short Source: Motley Fool Website (www.fool.com)

Relating Cash Flow and Net Income • Many valuation models use estimated cash flows rather than forecasted earnings • There are four possible combinations of positive and negative net income and cash flow from operations: Relationship 1 2 3 4 Cash flow from operations + + - - Net income + - + -

Relating Cash Flow and Net Income • When these relationships persist over multiple periods, it implies (in each case): • A company has positive profitability • A growth company is incurring large depreciation charges • A company is either • Rapidly growing and collections are lagging, or • Experiencing serious cash flow problems • Negative profitability is confirmed

Relating Cash Flow and Net Income • Analysts use the relationship between cash flow and net income as one indicator of earnings quality • Earnings quality means that revenues are not recognized prematurely and expenses are not deferred improperly • One ratio used to assess earnings quality is cash flow from operations divided by net income (it should be consistently greater than 1)

Financial Statement Analysis