Financial Statement and Industry analysis

1. Financial Statement and Industry analysis

2. Financial Statement Analysis • To develop techniques for evaluating firms using financial statement analysis for equity and credit analysis. • Integrates financial statement analysis with corporate finance, accounting and fundamental analysis. • Adopts activist point of view to investing: the market may be inefficient and the statements may not tell all the truth.

3. Users of Firms’ Financial Information • Equity Investors • Investment analysis • Long term earnings power • Management performance evaluation • Ability to pay dividend • Risk – especially market • Debt Investors • Short term liquidity • Probability of default • Long term asset protection • Covenant violations

4. Users of Firms’ Financial Information • Management: Strategic planning; Investment in operations; Performance Evaluation • Litigants - Disputes over value in the firm • Customers - Security of supply • Governments: Policy making and Regulation • Taxation • Government contracting • Employees: Security and remuneration • Investors and management are the primary users of financial statements

5. Fundamental Analysis -- Equity Investors • Step 1 - Knowing the Business • The Products; The Knowledge Base • The Competition; The Regulatory Constraints • Step 2 - Analyzing Information • In Financial Statements • Outside of Financial Statements • Step 3 - Forecasting Payoffs • Measuring Value Added • Forecasting Value Added • Step 4 - Convert Forecasts to a Valuation • Step 5 - Trading on the Valuation • Outside Investor: Compare Value with Price to; BUY, SELL, or HOLD • Inside Investor: Compare Value with Cost to; ACCEPT or REJECT Strategy

6. Three Major Financial Statements • Balance sheet: to report an enterprise’s financial conditions, investing and financing strategies on certain date, which usually is the end of calendar year. • Income statement: also known as statement of earnings. It is designed to report the make up of the firm’s revenue, expanses, and profit. • Cash flow statement: it is designed to explain the change in cash between periods. The change in cash would be reported due to three major activities, namely, operating, investing, and financing.

8. Measurement of Assets & Liabilities • Historical Cost, for most components of Balance Sheet • May be at market under “lower of cost or market rule” • Reversals of prior write downs allowed for marketable equity securities but not for inventories • Intangible assets have uncertain and hard to measure benefits and are reported only when acquired via a “purchase method” acquisition • -- brand names • -- when reported, called Goodwill, Patents, etc.

9. Two Fundamental shortcomings of the Balance Sheet • Elusiveness of value • Value cannot be assigned to all assets

10. Book Value vs. Market Value Inflation & Obsolescence • Inflation causes book value to understatemarket value • Obsolescence causes book value to overstatemarket value • The effect of inflation & obsolescence may not be apparent in an examination of book values because they offset one another

11. Adjustments to Book Value • Estimate Replacement Cost • Estimate Liquidation Value • Drawbacks • Do adjusted book values reflect market values? • Adjusted book values do not consider organizational capital • It is often difficult to determine if we have made the correct adjustments • Adjustments often fail to consider the value of off-balance sheet items

13. Income Statement • Based on Accrual accounting: • records financial events based on events that change net worth. To record and recognize revenues in the period in which they incur and to match them with related expenses. • Based on Matching Principle: • recognize all related cost attributed to the revenue on the period that revenue incurs.

14. Income Statement: high quality income • Revenues • + Other income and revenues • - Expenses • = Income from CONTINUING OPERATIONS • Unusual or infrequent events • = Pre tax earnings from continuing operations • - Income tax expense • = After tax earnings from continuing operations* • Discontinued operations (net of tax)* • Extraordinary operations (net of tax)* • Cumulative effect of accounting changes (net of tax) * • = Net Income * • * Per share amounts are reported for each of these items

15. High quality income • High quality income statement reflect repeatable income statement • Gain from non-recurring items should be ignored when examining earnings • High quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

16. High Quality of Earnings Indicators • Net Income Backed up by Cash • Net Income not involving the Inclusion of amortization costs related to questionable assets, such as deferred charges • Net Income that reflects Economic Reality • Income Statements Components that are Recognized Close to the Point of Cash Inflow and Cash Outflow

17. Low Quality of Earnings Indicators • Unreliable and inaccurate accounting estimates • Earnings that have been artificially smoothed or managed • Deferral of costs that do not have future economic benefit • Unjustified Changes in Accounting Principles and Estimate • Premature or Belated Revenue Recognition

18. Low Quality of Earnings Indicators • Unstable Income Statement Elements unrelated to normal business operations • Book Income Substantially Exceeds Taxable Income • Residual Income that is substantially less than Net Income • A High Degree of Uncertainty Associated with Income Statement Components

19. Summary for Income Statement Analysis • No single “real” net income figure exists • The analyst must adjust reported net income to an earnings figure that is relative to him/her. • Earnings quality evaluation is important in investment, credit, audit & management decision making. • Appraising the quality of earnings requires an examination of accounting, financial, economic and political factors. • Earnings quality elements are both quantitative and qualitative

20. Cash flow statement • SCF (Statement of Cash Flows) adds in situations where Balance Sheet and Income Statement provide limited insight • SCF helps identify the categories into which companies fit • Financial flexibility is a useful weapon to gain a competitive advantage and is best measured by studying the SCF

22. The key analytical lessons for Cash flow statement • The cash flow statement – not the income statement – provides the best information about a highly leveraged firm’s financial health • There is no advantage in showing an accounting profit, the main consequence of which is incurring taxes, resulting, in turn, in reduced cash flows

23. Cash flows and competitive advantages • Cash rich firms are flexible to deploy various competition strategies. Such as price competitions, and acquisition etc.. • Cash rich firms are tougher to beat when met by adversaries.

24. Cash Flow and Company Life Cycle • Cash Flow and Start-up Companies Little or no operating cash flows Large cash outflows for investing activities Large need for external financing (mostly from issuing common stock, issue long term debt)

25. Cash Flow and Company Life Cycle • Cash Flows and Emerging Growth Companies Some operating cash flow (not enough to sustain growth) Large cash outflows to expand activities Requires cash flows from financing Pay back some short-term debt, issue some common stock

26. Cash Flow and Company Life Cycle • Cash Flows and Established Growth Companies Fund growth from operating cash flow Depreciation is substantial Repayment of long term debt, begin to pay dividend

27. Cash Flow and Company Life Cycle • Cash Flows and Mature Industry Companies Modest capital requirements Depreciation and amortization is significant Net negative reinvestment Large dividend payout, reduction in long term debt

28. Cash Flow and Company Life Cycle • Cash Flows and Declining Industry Companies Net cash user (similar to emerging growth) Lower dividends, Slim operating cash flows Sell assets

29. Cash Flows and Financial Flexibility • Safety of dividend • Finance growth with internal funds • Meet other financial obligations

30. Financial Ratios Analysis

31. Ratios and Financial Analysis • Comparability among firms of different sizes • Provides a profile of the firm

32. Financial Ratios and Analysis Caution: • Economic assumption of Linearity – Proportionality • Is high Current ratio good? For whom? • Industry-wide norms. • Difference in Accounting Methods;

33. Liquidity Ratios: • NWC = current assets - current liabilities • NWC/total asset ratio = net working capital / total assets • Current ratio = current assets / current liabilities • Quick ratio =(cash + marketable securities + accounts receivable) / current liabilities • Cash ratio = (cash + marketable securities) / current liabilities • Cash flow from operation ratio = OCF / current liabilities

34. Leverage Ratios • Leverage ratios have two types: • balance sheet ratios comparing leverage capital to total capital or total assets, and • coverage ratios which measure the earnings or cash-flow times coverage of fixed cost obligations.

35. Leverage Ratios- Balance sheet ratios • Long-term debt ratio = long-term debt / ( long-term debt + equity) • Debt-equity ratio = long-term debt/equity • Total debt ratio = total liabilities / total assets

36. Leverage Ratios- Coverage ratios • Times interest earned = EBIT / interest expense • = (EAT+Tax+Interest Exp)/ interest expense • Times Cash flow coverage =(OCF+Tax+Interest Exp)/ interest expense

37. Activity Ratios: • Measures how efficient the firm using its assets to generate cash. • Measures how fast a firm converts its current assets into cash.

38. Activity Ratios: • Total assets turnover = Sales / Total assets • Accounts Receivable turnover = Sales / AR • [Days A/R outstanding = 365 / Accounts Receivable turnover] • Inventory turnover = Sales / Average Inventory, or COGS / Average Inventory • [Inventory Conversion = 365 / Inventory turnover] • Payable turnover = Purchase (or COGS) / AP • [Days A/P outstanding = 365 / Payable turnover]

39. Raw material purchased Order Placed Stock Arrives Inventory period Accounts receivable period Cash cycle The Operating Cycle and the Cash Cycle Cash received Finished goods sold Time Accounts payable period Firm receives invoice Cash paid for materials Operating cycle

40. Cash Cycle Cash Cycle = Operating cycle - Accounts payable period = Inventory Conversion + Days A/R outstanding – Days A/P outstanding Cash Cycle measures a firm’s relying on the short term borrowing.(bank credits) In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables.

41. Dell’s Working Capital Policy • Dell’s daily sales was about $20M per day. Dell was able to reduce the need of short term financing $800M. Assuming a 6% short term cost of capital, Dell was able to created $48M more pre tax earnings.

42. Profitability Ratios: • Gross profit margin = gross profit / sales • Operating profit margin = EBIT / sales • Net profit margin = net income / sales • Return on assets = (net income + interest )/ average total assets • Return on equity = net income/ average equity

43. The Du Pont System

44. The Du Pont System • Usually Profitability and Asset Turnover have a negative relation. This negative relation exists in the same industry, or even in different industries. • Profitability shows a firm’s ability in product differentiation. (product differentiation advantage) • Asset turnover reflect a firm’s ability to lower its cost and increase demand. (low cost leadership)

45. Industry analysis: • Definition of an industry: the group of firms producing products that are close substitutes for each other.

46. Structural Analysis of Industry Competition Potential Entrants Industry Competitors Rivalry Among Existing Competitors Supplier Bargaining Power Customer Buying Power Potential Substitutes

47. Profit margin = NI / Sales (product differentiation) Asset turnover = Sales / TA (Low cost leadership) • Profit margin decreases over time due to increase in competition. • A firm thus would try to increase asset turnover to compensate the loss in margin. • The strategy to increase asset turnover need to be deployed when a firm still has advantage in profit margin. ×

48. Threats of entry: Barriers to entry: • Economics of scales • Product differentiation: • Capital requirement: • Switching costs: • Access to distribution channels: • Cost disadvantages independent of scale: proprietary, access to raw materials, favorable locations, government subsidy. • Government policy:

49. Threats of entry: Expected retaliation: • A history of vigorous retaliation to entrants. • Established firms with substantial resources to fight back. • Established firms with great commitments to the industry and highly illiquid assets employed in it. • Slow industry growth, which limits the ability of the industry to absorb a new firm without depressing the sales and financial performance of established firms.

50. Intensity of rivalry among existing competitors: • Numerous or equally balanced competitors.. • Slow industry growth: • High fixed and storage cost: • Lack of differentiation or switching costs: • Capacity augmented in large increments: • Diverse competitors: • High strategic stakes: • High exit barrier: