markets: financial accounting...

Markets:

Financial Accounting Analysis

Mark Hendricks

Autumn 2016

FINM Intro: Markets

Outline

Statements

Beyond Accounting

Returns

Leverage

Hendricks, Autumn 2016 FINM Intro: Markets 2/68

Financial reporting

Financial reporting is important for well-functioning markets.

I Investors need information to properly allocate capital andhedge risk.

I Regulators need good information to monitor fraudulentactivity and systemic risk.

Financial reports are prepared according to accounting practices,which often differ from the methods of finance and economics.


Financial statements

There are three key financial statements.

I The balance sheet

I The income statement

I The statement of cash flows

We discuss each in turn.


The balance sheet

The balance sheet details the financial condition of the firm atone moment in time.

I The balance sheet is a list of the firms assets and liabilities.

I The values are “book” values, not market values.

I The “book” values are based more on historical transactionprices than current valuations.


Balance equation

The central idea behind the balance sheet is an accounting identity:

assets = liabilities + shareholders’ equity

I Note that this equation is an identity.

I The “shareholders’ equity” component is not a real marketvalue of equity.

I Rather, it is just a plug for the equation.

In finance, the market value of equity—not the (accounting) bookvalue—is typically used.


Current assets/liabilities

The first section of the balance sheet lists the assets of the firm.

I The short-term, or current assets are listed first.

I This is where cash and other liquid securities are listed.

I After this, longer-term assets are listed.

Liabilities are listed similarly, with current liabilities being listedfirst.


Balance sheet for commercial banking

Figure: Balance statement for the banking sector, 2008.

Source: Mishkin (2010)


Data: Book value of assets at FDIC commercial banks

2000 2002 2004 2006 2008 2010 20124000

6000

8000

10000

12000

14000B

illio

ns $

Book Value of Assets at FDIC Commercial Banks

Source: FDIC (CB14)


Data: Excess reserves of depository institutions

-400,000

0

400,000

800,000

1,200,000

1,600,000

2,000,000

2,400,000

2,800,000

Jan2008 Jan2009 Jan2010 Jan2011 Jan2012 Jan2013 Jan2014

ShadedareasindicateUSrecessions-2014research.stlouisfed.orgSource:FederalReserveBankofSt.Louis

(MillionsofDolla

rs)

Source: St. Louis Fed: (EXCRESNS)


http://www2.fdic.gov/hsob/index.asp

http://research.stlouisfed.org/fred2/series/EXCRESNS

Data: Nonperforming loans for U.S. banks

0

1

2

3

4

5

6

1985 1990 1995 2000 2005 2010

ShadedareasindicateUSrecessions-2014research.stlouisfed.orgSource:FederalFinancialInstitutionsExaminationCouncil

(Per

cent)

Source: St. Louis Fed: (USNPTL)


Accounting rules

“Book values” in the balance sheet differ from market values:

I Depreciation. Accountants use fixed rules to calculatedepreciation on assets. This depreciation calculation can differsubstantially from the market value.

I Capitalizing expenses. Capital is listed as an asset. However,some potential assets such as R&D are left off the balancesheet but rather treated as simple expenses.

I Intangibles like “goodwill” also show up on the balance sheet,though these intangible assets have no precise measure.

I Taxes. The accounting rules for calculating taxes are oftendifferent than the rules for financial reporting.


http://research.stlouisfed.org/fred2/series/USNPTL

Fair value accounting

Fair-value accounting is an attempt to make “book values”reflective of current conditions rather than just historicaltransactions.

I Many assets and liabilities held by a firm are not activelytraded nor have easily observed values. ie. Inventory,buildings, employee benefits.

I Historically, accountants list these on the books at historicalcosts. But the true values fluctuate, of course.

I Fair-value, or mark-to-market, accounting attempts to keepthe book values at current market values.


Mark-to model

With mark-to-market accounting, assets are valued according tothree categories:

1. Assets with observable market prices, and these are used onthe books.

2. Assets are not actively traded, but similarly traded assets canbe used for market valuations, perhaps with the aid of apricing model.

3. Assets without market quotes. Thus, the values depend onpricing models.

These model-based values are known as mark-to-model, and thechoice of model may leave room for manipulation.


Criticisms

The role of fair value accounting in the financial crisis iscontroversial.

I Theoretically, fair value accounting should lead to betterinformation in markets.

I But in distressed and illiquid markets, current prices may notreflect long-term value.

I In this case of undervalued assets, the balance sheet may hit apoint where firms are forced to recapitalize.

I But if it is hard to raise equity, a firm may need to liquidatedistressed assets, depressing the price even further!


Income statement

The income statement is the second major financial report.

I It gives a summary of the profitability of the firm over aperiod of time.

I (Compare this to the balance sheet which gives the firm’sfinancial conditions at a point in time.)

I The income statement lists revenues and expenses for thetime period, (year, quarter, etc.)


Earnings

Earnings, (or net income,) are simply revenues minus costs. Theyare an accounting measure of profits.

I Earnings would not be a good measure of economic profitsgiven that the financial statements are subject to accountingrules.

I Earnings measure the return to equity holders. Thecalculation subtracts debt interest payments and taxes owed.

I Earnings Before Interest and Taxes (EBIT) is also animportant measure of profit. It includes payments that go todebt holders and the tax authority.


Retained earnings

Retained earnings are the earnings re-invested into the firm:

retained earnings = earnings − dividends

The balance sheet can grow in one of three ways:

1. Internally, through retained earnings.

2. Externally by issuing new equity.

3. Externally by issuing new debt.


Income statement for commercial bankingIncome Statement for All Federally Insured Commercial Banks, 2008

Share ofOperating

Amount Income or($ billions) Expenses (%)

Operating IncomeInterest income 603.3 74.4Noninterest income 207.4 25.6

Service charges on deposit accounts 39.5 4.9Other noninterest income 167.9 _____ 20.7 _____

Total operating income 810.7 100.0

Operating ExpensesInterest expenses 245.6 31.1Noninterest expenses 367.9 46.6

Salaries and employee benefits 151.9 19.2Premises and equipment 43.4 5.5Other 172.6 21.9

Provisions for loan losses 175.9 22.3Total operating expense 789.4 100.0

Net Operating Income 21.3Gains (losses) on securities -15.3Extraordinary items, net 5.3Income taxes -6.2

Net Income 5.1

Figure: Income statement for the aggregated banking sector, 2008.

Source: Mishkin (2010)


Data: Net income of FDIC commercial banks

2000 2002 2004 2006 2008 2010 2012−50

0

50

100

150

Bill

ions

$

Net Income for FDIC Commercial Banks

Source: FDIC (CB04)



Data: Loss provision of FDIC commercial banks

2000 2002 2004 2006 2008 2010 20120

50

100

150

200

250B

illio

ns $

Loss Provision for FDIC Commercial Banks

Source: FDIC (CB04)


Cash-flow statement

The statement of cash flows is the third major financialstatement.

I Due to accounting rules, earnings are not a proper measure ofprofits, nor of cash-flow.

I This statement tracks the actual cash movements associatedwith transactions.

I Due to its simple nature, this statement is often favored byanalysts trying to cut through all the accounting rules andissues.

The statement typically groups transactions into operating,investment, and financing cash flows.



Notes to statements

Aside from the three major financial statements, firms often attachnotes.

I These notes may often be skimmed or ignored, but at timesthey reveal important clues.

I For instance, if a firm is manipulating accounting data, thenotes may have clues.

I The notes for AIG explained that their CDS position was nothedged.


Outline

Statements

Beyond Accounting

Returns

Leverage


Book and market values

We have noted that the book value of firm equity may be muchdifferent than its market value.

I The market-to-book ratio is the market value of equitydivided by the book value of equity.

I Book value of equity is considered a very conservativeestimate of share value, perhaps a floor.

I Recall that the ratio can be much different than one giventhat book-values tend to be based on historical transactionswhile market values look forward to future growth.


Growth and value

The price-earnings ratio (P/E) is a popular measure of firmvalue.

I The P/E ratio takes the market price at a given time, and itdivides by the earnings generated over some period.

I Of course, the market price is affected by the future prospectsof the firm, while the periods earnings are a historical fact.

I Thus, the P/E is a measure of how much future cash flowsthe firm will deliver relative to its current earnings.


Growth and value

Market-book and price-earnings values are both useful measures fora firms future growth prospects.

I Stocks with a high market-book or P/E ratio are calledgrowth stocks.

I A stock with a low market-book or P/E ratio is called a valuestock.


Use of growth and value

The labels “growth” and “value” are widely used.

I Historically, value stocks have delivered higher average returns.

I So-called “value” investors try to take advantage of this bylooking for stocks with low market-book ratios.

I Much research has been done to try to explain this differenceof returns and whether it is reflective of risk.

I Mutual funds are offered for both growth and value stocksand have become very popular.


Earnings management

Earnings management refers to the practice of taking actions inorder to manipulate reported earnings.

I Not all reported earnings are of the same quality.

I Fair value accounting leaves some discretion in the reportedfigures.

I Nonrecurring items, such as the sale of an asset may not beuseful in assessing the firm’s future profitability.

I Revenue recognition. Under accounting standards, managerscan take actions which recognize income in the present, andpush losses to the future.


Off-balance-sheet holdings

The financial crisis has brought much attention to a certain kind ofaccounting manipulation: off-balance-sheet assets andliabilities.

I Firms may try to leave profitable parts of their business ontheir books, while spinning losses off into entities that do notshow up on the books.

I Enron put losses into subsidiary entities whose holdings didnot show up on Enron’s books.

I Due to keeping their profits and hiding their losses in theseshells, 96% of their reported earnings were phony. Source:Berk (2011).


Capital leases

Another widespread use of off-balance-sheet accounting is capitalleases.

I Capital leases are long-term leases which more closelyresemble debt financing than a true lease.

I By calling the transaction an ongoing lease rather than adebt-financed purchase, the company keeps it off the books.

I Rather, they report only the monthly lease amount, as if theydid not have the (often sizeable) debt for the whole purchase.

I Recent regulations have made it harder for firms to reducetheir reported debt in this way.


World Com

In fact, the firm World Com was manipulating their financialstatements using capital leases, but in a different way.

I World Com capitalized expenses which were truly operatingexpenses.

I They called these expenses capital leases, and thus the moneyspent was not deducted from earnings, but rather counted asassets which were slowly depreciated.

I World Com, which had a market capitalization of $120 billionin 2002, was exposed and set a record for the largestbankruptcy. Source: Berk (2011).


Banks use of off-balance-sheet items

The financial sector has also increased its use of off-balance-sheetholdings.

I Many believe this played a large role in causing the financialcrisis.

I For banks, moving things off the balance sheet avoidsregulatory scrutiny.

I The income, (as a percentage of total assets,) generated bybanks from these off-balance-sheet activities has doubled since1970. Source: Mishkin (2010).


Moving mortgages off the balance sheet

Consider the increased off-balance-sheet activities with regard tomortgages.

I Historically, a savings association would give a mortgage to ahomeowner, and then hold it as an asset on the books for 30years.

I MBS allowed banks to originate a mortgage and then sell abundle of these mortgages in a special purpose vehicle.

I This removed the asset and liability from the banks’ balancesheet.

I The banks would continue to manage the pool of mortgagesfor a fee.


Beyond earnings

The lesson is that earnings are not a sufficient statistic for thefinancial health of a firm.

I World Com had suspicious levels of investment due to theiruse of capital leases.

I Enron’s actual cash flows were not anything close to theirstellar earnings.


The Sarbanes-Oxley act

In response to the scandals of the early 2000’s, the U.S. passed theSarbanes-Oxley act in 2002.

I Auditors were given new rules to reduce conflicts of interest.The law puts restrictions on the non-audit services which apublic accounting firm can provide.

I Management was made personally liable for the accuracy offinancial reports.

I It established a Public Company Accounting Oversight Boardwhich is overseen by the SEC.

I The budget for the SEC was increased so that it could bettersupervise securities markets.


Disclosure requirements

Disclosure requirements are a key element of financial regulation.

I Basel 2 puts a particular emphasis on disclosure requirements.It mandates increased disclosure by banks of their creditexposure, reserves, and capital.

I The Securities Act of 1933 and the SEC, which wasestablished in 1934 require disclosure on any corporation thatissues publicly traded securities.

I More recently, there have been added rules about reportingoff-balance-sheet positions and more information about thepricing models being used in coming up with the financialreports.


Decrease in issues

Increased disclosure requirements have made it more costly for afirm go public, or to issue U.S. securities.

I The share of new corporate bonds initially sold in the U.S. hasfallen below the share sold in European debt markets.

I In 2008, the London and Hong Kong stock exchanges eachhandled a larger share of IPO’s than did the NYSE, which hadbeen the dominant market until recently.

I Combined with the increasing ease of obtaining non-publicfinancing, many firms are delaying IPO’s.

The debate about reporting requirements is ongoing.


Outline

Statements

Beyond Accounting

Returns

Leverage


Measuring profit

Return on equity (ROE) uses accounting values: earnings dividedby book value of equity.

I ROE will not be the same as the firms stock return over theperiod.

I Given that ROE uses accounting earnings as the profitmeasure, it is sensitive to the manipulations discussed above.

I Earnings are measured over a period of time, (ie. year,)whereas the book value of equity on the balance sheet is at aspecific point of time.


Return on assets

Return on assets (ROA) is another important measure ofprofitability.

I Again, ROA uses earnings to measure profit, but divides bythe firm’s book value.

I ROA is insensitive to the firm’s financing decision.

I Thus, it is a measure of operating profitability.


Understanding ROE

It is useful to analyze ROE by breaking it into factors, somethingknown as the DuPont identity.

ROE =Earnings

Sales︸︷︷︸Net Profit Margin

× Sales

Assets︸︷︷︸Asset Turnover︸︷︷︸

ROA

× Assets

Book Value of Equity︸︷︷︸Leverage

This shows us three ways to influence ROE.


Data: Return on equity for commercial banks

1985 1990 1995 2000 2005 2010 2015−10

−5

0

5

10

15

20R

OE

%

Return on Equity for FDIC Commercial Banks

Source: FRED (USROE)


Three factors of ROE

The three factors of ROE correspond closely to the financialstatements.

I Profit margin gives a summary of the income statementperformance by showing profit per dollar of sales.

I Asset turnover summarizes the asset side of the balance sheet.It indicates the resources required to support sales.

I Leverage ratio summarizes the liability and equity side of thebalance sheet by showing how the assets are financed.


http://research.stlouisfed.org/fred2/series/USROE

Profit margin

The profit margin measures the fraction of each dollar of salesthat ends up as earnings, adding to the balance sheet.

I Equation above used the net profit margin.

I Recall that earnings, (net income,) already deducted interestpayments on debt and taxes.

I Gross profit margin uses EBIT in the numerator instead ofearnings.

net profit margin =earnings

sales, gross profit margin =

EBIT

sales


ROE and gross margins

Of course, the above decomposition won’t work with gross profitmargin. Rather it must be expanded to

ROE =Earnings

EBIT× EBIT

Sales︸︷︷︸Gross Profit Margin

× Sales

Assets︸︷︷︸Asset Turnover︸︷︷︸

ROA

×

× Assets

Book Value of Equity︸︷︷︸Leverage


Asset turnover

Asset turnover measures the sales generated per dollar of assetsthe firm owns.

Asset Turnover =Sales

Assets

I Notice that assets reduce asset turnover and thus reduce ROAand ROE.

I One might expect lots of assets are a good thing.

I But conditional on a certain profit stream, assets just measurethe amount of capital needed to generate this income stream.


ROA

ROA captures the combined effects of margins and asset turnover:

ROA =(Net) profit margin × Asset turnover =Earnings

Assets

I ROA is a basic measure of a firm’s efficiency in how ittransforms assets to profits.

I Some industries achieve high returns by having high margins,while other achieve it with high asset turnover.

A high profit margin and a high asset turnover is ideal, but can beexpected to attract considerable competition. Conversely, a lowprofit margin combined with a low asset turn will attract onlybankruptcy lawyers. — Higgins (2009).


Data: Return on assets for commercial banks

1985 1990 1995 2000 2005 2010 2015−0.5

0

0.5

1

1.5R

OA

%

Return on Assets for FDIC Commercial Banks

Source: FRED (USROA)


ROE and ROA

We have seen then, that ROE is just an an adjustment of ROA toaccount for leverage.

I ROA shows the return that comes from the operation of thebusiness

I ROE shows both returns from operations and financing

I For which type of returns should management be rewarded?

I High ROE relative to ROA (relative to the industry,) mayshow savy financing, but it could also show excessive risk.

Management seeking returns always has the temptation ofleveraging to get there.


http://research.stlouisfed.org/fred2/series/USROA

Table of ROE

Figure: ROE for various firms, 2007. Source: Higgins (2009)


Problems with ROE

ROE is not necessarily a good measure of financial performance.For as much attention as it gets, one must be careful.

I Market valuations are forward-looking and consider thelong-term prospects of the firm.

I By contrast, ROE is largely backward-looking and considersonly one year’s data.

I We have already noted that accounting values can easily bemanipulated to push earnings to different time periods.


ROE and risk

We mentioned already, that ROE can be increased by taking onmore leverage.

I Clearly then, a higher ROE is not always better.

I Improving ROE while keeping risk exposure level is anacheivement. Increasing ROE by increasing risk, (leverage orother types,) is not.

I Thus, investors must consider whether high ROE is a gooddeal.

I If your money market fund returned 10%, would you behappy?


Banks and ROE

Currently, regulators are considering tougher capital requirementsfor banks, (lower leverage.)

I Banks argue that this will lower their returns; they aredefinitely right!

I They say that this will cause investors to withdraw, which willcause big problems in financial markets.

I Is this true? Will investors need such a high ROE if capitalrequirements are higher?


Outline

Statements

Beyond Accounting

Returns

Leverage


Leverage

Leverage refers to how much of the firm’s capital comes fromequity holders versus debt holders.

I Unlike the other two ratios in ROE, more is not necessarilybetter.

I Rather, leverage decisions must take account of the pros andcons of debt financing.


Leverage tradeoff

A firm does not pay taxes on income used for interest payments.

I This debt tax shield incentives firms to lever up.

I However, more debt increases the chances of financial distressor bankruptcy.

I Optimal leverage balances these forces, and varies widelyacross industries.

Not surprisingly, low leverage is used in industries where financialdistress is particularly costly.


Leverage - balance-sheet measures

The leverage ratio in the ROE calculation is the asset-to-equityvalue. This is often rescaled into other popular measures.

Debt-to-assets =Liabilities

Assets

Debt-to-equity =Liabilities

Equity

Notice that the asset-to-equity ratio used above is just thedebt-to-equity-ratio plus 1.


Data: Leverage of commercial banking sector.

1940 1950 1960 1970 1980 1990 2000 20105

10

15

20bo

ok (

asse

ts/e

quity

)

Accounting Leverage FDIC Commercial Banks

Source: FDIC (CB14)


Leverage - coverage measures

There are many other ways to measure the extent to which a firmis financing with debt.

I Measures based on income are often preferred, given thatbankruptcy is caused by defaulting on payments, not on theshare of equity versus debt.

I Interest coverage, or times interest earned, also measuresthe financial risk of a firm. It shows how much burden interestpayments are on the cash flows.

interest coverage =EBIT

interest expense



Rollover risk

There are many other ways to measure the extent to which a firmis financing with debt.

I Times burden covered is similar to times interest earned,but takes account of principal repayment.

I Relying on the interest covered measure assumes that one canroll over the debt principal.

I In the summer of 2007, many investors in MBS found this isnot always the case.

I Times burden covered is conservative in that it calculates as ifall principal will be repaid.


Leverage - market measures

Given the problems with accounting values already discussed, manyprefer a market measure of leverage.

I Market measures of leverage are like the balance-sheetmeasures seen above, but they use the market value of equityrather than the book value.

I This can make a big difference, especially for growing firms.


Leverage in the crisis

Leverage played a big role in the recent financial crisis.

I Firms such as Lehman and Merril Lynch had 30-to-1 leverage.

I This left them very little flexibility to deal with asset declines.

I The total decline in mortgages was a relatively small amountof money, but was more than enough to bankrupt highlyleveraged institutions.


Capital requirements

Capital requirements are meant to keep financial institutions fromtaking too much risk.

I Note that with high leverage, a firm has more incentive totake very large gambles.

I Losses mean little, while the upside from the gains gets larger.

I Regulators want to prevent excess risk which could causefailure in financial markets.


Leverage ratio requirements

The capital requirements take two forms: the first is based on theleverage ratio.

I A bank is well capitalized with a leverage ratio below 20.

I But extra regulation kicks in if it goes above 33.

I The FDIC must take steps to close down a bank with aleverage ratio above 50.


Basel

The second type of requirements are risk-based.

I Under regulation known as the Basel Accord, banks wererequired to hold 8% of their risk-weighted capital.

I The weighting system for capital leads to regulatory arbitrage.

I Basel 2 was very recently rolled out after many years ofplanning. However, due to the crisis, Basel 3 is already beingstudied.


Liquidity measures

I Current ratio. Current assets and liabilities are those with amaturity of one year or less. Thus, this measures the ability ofthe firm to pay off short-term debt using its most liquid assets.

current ratio =current assets

current liabilities

I Quick ratio. Also known as the acid test ratio. It is like thecurrent ratio, but does not include inventory in the numerator.

I Cash ratio. Similar to the current ratio, but it does notinclude current assets which are not marketable securities,(things like accounts receivables.)


References

I Berk, Jonathan and Peter DeMarzo. Corporate Finance. 2011.

I Bodie, Kane, and Marcus. Investments. 2011.

I Cochrane, John. Understanding Policy in the Great RecessionEuropean Economic Review. 2011.

I Higgins, Robert. Analysis for Financial Management. 2009.

I Hull, John. Options, Futures, and Other Derivatives. 2012.

I Mishkin, Frederic. Money, Banking, and Financial Markets.2010.


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