financial statement and industry analysis. financial statement analysis to develop techniques for...
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Financial Statement and Industry analysis
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.
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
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
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
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.
Balance SheetEnded Dec.31, 1995
Assets Liab. And Equity
Current Assets Current Liab.
Cash $20,000 Wages Payable $42,000
Marketable Securities 60,000 Accounts Payable 200,000
Accounts Receivable 122,000 Notes Payable 50,000
Inventories 350,000 Total Current Liab. $292,000
Total Current Assets $552,000
Long term Debt $440,000
Long term (fixed) Assets Total Liab. $732,000
Buildings and Equipment (net) 500,000 Owners’ Equity
Land 200,000 Stock and Surplus 350,000
Patents 100,000 Retained Earnings 270,000
Total Long term (fixed) Assets $800,000 Total Equity $620,000
Total Assets $1,352,000 Liab. and Equity $1,352,000
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.
Two Fundamental shortcomings of the Balance Sheet
Elusiveness of value Value cannot be assigned to all assets
Book Value vs. Market Value Inflation & Obsolescence
Inflation causes book value to understate market value
Obsolescence causes book value to overstate market value
The effect of inflation & obsolescence may not be apparent in an examination of book values because they offset one another
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
Income StatementFiscal Year, 1995
Revenue $2,400,000
Cost of Goods Sold -1,600,000
Gross Profits $800,000
Sales and Administrative Expanses -120,000
Depreciations -200,000
Operating Profits $480,000
Interest Expanses -100,000
Earnings before Taxes $380,000
Income Taxes -122,000
Earnings after taxes $258,000
Earnings per Share (EPS) $2.15
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.
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
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
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
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
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
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
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
Cash flow StatementFiscal Year, 1995
Cash inflow from selling activities $2,600,000
Cash outflow from purchasing activities -1,800,000
Cash outflows resulted from wages payment -200,000
Cash outflows resulted from other expanses -150,000
Cash outflows resulted from paying interest -100,000
Cash outflows resulted from paying income taxes -130,000
Cash flows from operating activities $220,000
Cash outflow from purchasing fixed assets -$300,000
Cash inflows from selling long term investment 120,000
Cash flow from investing activities -$180,000
Cash inflow from issuing common stock $400,000
Cash outflow from reducing long term financing -440,000
Cash outflow from issuing common dividend -200,000
Cash flow from financing activities -$160,000
The increase (decrease) in cash and cash equivalents
-$120,000
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
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.
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)
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
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
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
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
Cash Flows and Financial Flexibility
Safety of dividend Finance growth with internal funds Meet other financial obligations
Financial Ratios Analysis
Ratios and Financial Analysis Comparability among firms of different sizes Provides a profile of the firm
Financial Ratios and Analysis Caution:
Economic assumption of Linearity – Proportionality
Is high Current ratio good? For whom? Industry-wide norms. Difference in Accounting Methods;
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
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.
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
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
Activity Ratios:
Measures how efficient the firm using its assets to generate cash.
Measures how fast a firm converts its current assets into cash.
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]
The Operating Cycle and the Cash Cycle
TimeAccounts payable period
Cash cycle
Operating cycle
Cash received
Accounts receivable periodInventory period
Finished goods sold
Firm receives invoice Cash paid for materials
Order Placed
Stock Arrives
Raw material purchased
Cash CycleCash 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.
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.
DSI DSO DPO CCC
1996 Q4 31 42 33 40
Improvement -18 -5 +21 -44
1997 Q4 13 37 54 -4
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
The Du Pont System
Ratio Pr
1
LeverageTurnoverAssetyofitabilit
Equity
DebtROA
Equity
TA
TA
Sales
Sales
NI
Equity
TA
TA
NI
Equity
NIROE
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)
Industry analysis:
Definition of an industry: the group of firms producing products that are close substitutes for each other.
Structural Analysis of Industry Competition
Industry Competitors
Rivalry Among ExistingCompetitors
Potential Entrants
CustomerBuying Power
SupplierBargaining Power
Potential Substitutes
Asset turnover = Sales / TA(Low cost leadership)
Profit margin = NI / Sales(product differentiation) ×
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.
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:
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.
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:
Pressure from substitute products:
(1) substitute products are subject to trends improving their price-performance trade-off with the industry’s product.
(2) substitute products are produced by industries earning high profit.
Bargaining power of buyers: It is concentrated or purchases large volume relative
to seller sales. The products it purchases from the industry represent
a significant fraction of the buyer’s cost of purchase. The product it purchases from the industry is
standard or undifferentiated. It faces few switching costs. It earns low profit. Buyers pose a credible threat of backward integration. The industry’s product is unimportant to the quality of
the buyer’s products or services. The buyers have full information.
Bargaining power of suppliers:
It is dominated by a few companies and is more concentrated than the industry it sells to.
It is not obligated to contend with other substitute product for sale to the industry.
The industry is not an important customer if the suppliers’ group.
The suppliers’ product is an important input to the buyer’s business.
The supplier group’s products are differentiated or it has built up switching costs.
The supplier group poses a creditable threat of forward integration.