Essentials of Financial Statement Analysis

1. Essentials of Financial Statement Analysis Revsine/Collins/Johnson: Chapter 5

2. Learning objectives • How competitive forces and business strategies affect firms’ financial statements. • Why analysts worry about accounting quality. • How return on assets (ROA) is used to evaluate profitability. • How ROA and financial leverage combine to determine a firm’s return on equity (ROE). • How short-term liquidity risk and long-term solvency risk are assessed. • Why EBITDA can be a misleading indicator of profitability and cash flow.

3. Tools: Approaches used with each tool: Time-series analysis: the same firm over time (e.g., Wal-Mart in 2005 and 2006) Financial statement analysis:Tools and approaches Common size statements 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2005). Trend statements 3. Benchmark comparison: using industry norms or predetermined standards. Financial ratios (e.g., ROA and ROE)

4. Evaluating accounting “quality” • Analysts use financial statement information to “get behind the numbers”. • However, financial statements do not always provide a complete and faithful picture of a company’s activities and condition.

5. How the financial accounting “filter” sometimes works GAAP puts capital leases on the balance sheet, but operating leases are “off-balance-sheet”. Managers have some discretion over estimates such as “bad debt expense”. Managers have some discretion over the timing of business transactions such as when to buy advertising. Managers can choose any of several different inventory accounting methods.

6. Evaluating accounting “quality”:The message for analysts • The first step to informed financial statement analysis is a careful evaluation of the quality of a company’s reported accounting numbers. • Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices. • Only then can you truly “get behind the numbers” and see what’s really going on in the company.

7. Getting behind the numbers:Krispy Kreme Doughnuts, Inc. • Established in 1937. • Today has more than 290 doughnut stores (company-owned plus franchised) throughout the U.S. • Serves more than 7.5 million doughnuts every day. • Strong earnings and consistent sales growth.

8. Krispy Kreme’s Financials:Comparative Income Statements Includes a $5.733 million after-tax special charge for business dispute Includes a $9.1 million charge to settle a business dispute

9. Krispy Kreme’s Financials:Common size income statements $393.7 operation expenses $491.5 sales * Not adjusted for distortions caused by “special items”.

10. Krispy Kreme’s Financials:Tend income statements $393.7 operating expenses in 2002 $194.5 operating expenses in 1999 * Not adjusted for distortions caused by “special items”.

11. Krispy Kreme’s Financials:Business segment information Sell flour mix, doughnut making equipment, and supplies to franchised stores * Not adjusted for distortions caused by “special items”.

12. Krispy Kreme’s Financials:Business segments (common size) * Not adjusted for distortions caused by “special items”.

13. Krispy Kreme’s Financials:Balance sheet assets

14. Krispy Kreme’s Financials:Common size assets $3.2 cash $105.0 assets

15. Krispy Kreme’s Financials:Trend assets $7 cash in 2000 $3.2 cash in 1999

16. Krispy Kreme’s Financials:Balance sheet liabilities and equity

17. Krispy Kreme’s Financials:Common size liabilities and equity $13.0 accounts payable $105.0 total liabilities and equity

18. Krispy Kreme’s Financials:Trend liabilities and equity $8.2 accounts payable in 2000 $13.1 accounts payable in 1999

19. Krispy Kreme’s Financials:Abbreviated cash flow statements

20. Krispy Kreme’s Financials:Common size cash flow statements $93.9 capital expenditures $491.5 sales

21. Krispy Kreme’s Financials:Trend cash flow statements $93.9 capital expenditures in 2002 $10.5 capital expenditures in 1999

22. Krispy Kreme analysis:Lessons learned • Informed financial statement analysis begins with knowledge of the company and its industry. • Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes are easily recognized. • Financial statements help analysts gain a sharper understanding of the company’s economic condition and its prospects for the future.

23. Financial ratios and profitability analysis Operating profit margin NOPAT Sales Return on assets ROA= NOPAT Average assets X Asset turnover Sales Average assets NOPAT is net operating profit after taxes • Analysts do not always use the reported earnings, sales and asset figures. Instead, they • often consider three types of adjustments to the reported numbers: • Remove non-operating and nonrecurring items to isolate sustainable operating profits. • Eliminate after-tax interest expense to avoid financial structure distortions. • Eliminate any accounting quality distortions (e.g., off-balance operating leases).

24. Calculating ROA for Krispy Kreme Eliminate nonrecurring items Eliminate interest expense Effective tax rate

25. There are just two ways: Increase the operating profit margin, or Increase the intensity of asset utilization (turnover rate). How can ROA be increased? Assets turnover Operating profit margin

26. Turnover improvement: Suppose assets can be reduced to $45 million without sacrificing sales or profits. • Margin improvement: Suppose expenses can be reduced so that NOPAT becomes $10. ROA, margin and turnover:An example • A company earns $9 million of NOPAT on sales of $100 million with an asset base of $50 million.

27. Krispy Kreme:ROA decomposition How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over this period?

28. NOPAT Sales Sales Average assets Further decomposition of ROA Operating profit margin ROA = X Asset turnover

29. ROA and competitive advantage:Krispy Kreme Wendy’s, Baja Fresh, Café Express S&P industry survey or other sources

30. ROA and competitive advantage:Four hypothetical restaurant firms • Competition works to drive down ROA toward the competitive floor. • Companies that consistently earn an ROA above the floor are said to have a competitive advantage. • However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. • Firm A and B earn the same ROA, but Firm A follows a differentiation strategy while Firm B is a low cost leader. • Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA). Competitive ROA floor

31. Credit risk and capital structure:Overview • Credit risk refers to the risk of default by the borrower. • The lender risks losing interest payments and loan principal. • A company’s ability to repay debt is determined by it’s capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs. • A company’s willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment.

32. Credit risk and capital structure:Balancing cash sources and needs

33. Current assets Current ratio = Current liabilities Cash + Marketable securities + Receivables Quick ratio = Current liabilities Net credit sales Accounts receivable turnover = Average accounts receivable Cost of goods sold Inventory turnover = Average inventory Inventory purchases Accounts payable turnover = Average accounts payable Credit risk:Short-term liquidity ratios Liquidity ratios Short-term liquidity Activity ratios

34. 365 days Days accounts receivable outstanding = Accounts receivable turnover 365 days Days inventory held = Cash conversion cycle 55 days Inventory turnover 365 days ( 20 days) Days accounts payable outstanding = Accounts payable turnover Credit risk:Operating and cash conversion cycles Working capital ratios: 45 days Operating cycle 75 days 30 days

35. Credit risk:Operating and cash conversion cycle example

36. Credit risk:Short-term liquidity at Krispy Kreme

37. Credit risk:Long-term solvency Long-term debt Long-term debt to assets = Total assets Debt ratios Long-term debt Long-term debt to tangible assets = Total tangible assets Long-term solvency Operating incomes before taxes and interest Interest coverage = Interest expense Coverage ratios Cash flow from continuing operations Operating cash flow to total liabilities = Average current liabilities + long-term debt

38. Credit risk:Long-term solvency at Krispy Kreme

39. Credit risk:Financial ratios and default risk • A firm defaults when it fails to make principal or interest payments. • Lenders can then: • Adjust the loan payment schedule. • Increase the interest rate and require loan collateral. • Seek to have the firm declared insolvent. • Financial ratios play two roles in credit analysis: • They help quantify the borrower’s credit risk before the loan is granted. • Once granted, they serve as an early warning device for increased credit risk. Default rates by Moody’s credit rating, 1983-1999 Source: Moody’s Investors Service (May 2000)

40. Default frequency:Return on assets (ROA) Profitability: Return on Assets Percentiles (excludes extraordinary items) Source: Moody’s Investors Service (May 2000)

41. Default frequency:Debt-to-tangible assets and interest coverage Solvency: Debt-to-Tangible Assets and Interest Coverage Percentiles Source: Moody’s Investors Service (May 2000)

42. Default frequency:Quick ratio Liquidity: Quick Ratio Percentiles Source: Moody’s Investors Service (May 2000)

43. Return on equity and financial leverage • 2005: No debt, so all the earnings belong to shareholders. • 2006: $1 million borrowed at 10% interest, but ROCE climbs to 20%. • 2007: Another $1 million borrowed at 20% interest, and ROCE falls to only 15%.

44. Components of ROCE Return on assets (ROA) NOPAT Average assets Return on common equity (ROCE) X Common earnings leverage Net income available to common shareholders Average common shareholders’ equity Net income available to common shareholders NOPAT X Financial structure leverage Average assets Average common shareholders’ equity

45. Leverage helps Leverage neutral Leverage neutral Leverage hurts Profitability and financial leverage:Nodebt and Hidebt example Leverage helps

46. Financial statement analysis and accounting quality • Financial ratios, common-size statements, and trend statements are extremely powerful tools. • But they can be no better than the data from which they are constructed. • Be on the lookout for accounting distortions when using these tools. Examples include: Nonrecurring gains and losses Differences in accounting methods Differences in accounting estimates GAAP implementation differences Historical cost convention

47. Financial statement analysis:Pro forma earnings at Amazon.com Company defined numbers Computed according to GAAP

48. Impression management is the answer. Help investors and analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked. Mislead investors and analysts by changing the way in which profits are measured. Transform a GAAP loss into a profit. Show a profit improvement. Meet or beat analysts’ earnings forecasts. Why do firms report EBITDA and “pro forma” earnings? Analysts should remember: • There are no standard definitions for non-GAAP earnings numbers. • Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability. • EBITDA and pro forma earnings do not accurately measure firm cash flows.

49. GAAP earnings, pro forma earnings, and EBITDA

50. Summary • Financial ratios, common-size statements and trend statements are powerful tools. • However: • There is no single “correct” way to compute financial ratios. • Financial ratios don’t provide the answers, but they can help you ask the right questions. • Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons.