Chapter 5: Essentials of Financial Statement Analysis Evaluating accounting “quality” How do we define financial reporting quality? Qualitative characteristics of accounting

Information: Understandability Decision usefulness Reliability Relevance Consistency Comparability

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Attributes of High Quality Financial Reporting Financial reporting (earnings) quality has

been considered positively associated with the following: High persistence of earnings and cash

flows High predictive ability of earnings and cash

flows High earnings response coefficient Low level of earnings management More voluntarily disclosure Strong corporate governance

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Manipulating Income and Earnings Management Earnings management: a practice that

earnings reported reflect more the desires of management than the underlying financial performance of the company. 1

Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.

“Most managers prefer to report earnings that follow a smooth, regular, upward path.”2

1. Arthur Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168. 3

What should the users be aware of ? Statement users must:

Understand current financial reporting settings and standards.

Recognize that management may manipulate the financial information.

Distinguish between reliable financial statement information and poor quality information.

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Financial statement analysis and accounting quality Financial analysis tools: Common-size

statements, trend statements and financial ratios.

But they can be no better than the data from which they are constructed (i.e., the comparative financial statements).

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Financial statement analysis and accounting quality The accounting distortions need to be

watched when using these tools. Examples include:

1. Nonrecurring gains and losses

2. Differences in accounting methods.

3. Differences in accounting estimates.

4. GAAP implementation differences.

5. Historical cost convention.

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Learning Objective:

Essentials of Financial Statement Analysis

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Analysis, Forecast and Vulation Procedures Reviewing the Financial Statements:

Review comparative financial statements and audit opinion.

Adjusting and forecasting accounting numbers: Adjusting Accounting Numbers to

remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income.

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Analysis Assessing Profitability and

Creditworthiness: Common size statements. Trend statements Financial ratio analysis: Use ratios to

assess liquidity, profitability and solvency.

Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default.

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Forecast and Valuation

Comprehensive Financial statement forecasts (see Appendix B of Chapter 6 )

Valuing Equity Securities (see Appendix A of Chapter 6): a. Free cash-flow model b. Abnormal earnings model

(residual income model).

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Essentials of Financial Statement Analysis Step 1: To be informed that financial statement

analysis is a careful evaluation of the quality of a company’s reported accounting numbers.

Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices.

Only then you can truly “ get behind the numbers” and see what’s really going on theCompany.

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Financial analysis tools

1. Comparative Financial statements: Statements are compared across years.

2. Common-size statements: Recast each statement item as a percentage of a certain item.

3. Trend statements: Recast each statement item in percentage of a base year number.

4. Financial ratios.

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Basic Approaches1. Time-series analysis : Identify

financial trends over time for a single company.

2. Cross-sectional analysis: Identify similarities and differences across companies at a single moment in time.

3. Benchmark comparison: measures a company’s performance against some predetermined standard.

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Getting behind the numbers:Case Study: 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.

Revenue sources in 2002

65%

31%

4%

0%

10%

20%

30%

40%

50%

60%

70%

Compnaystores

Sales tofranchisees

Royalties

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Comparative Income Statements: Krispy Kreme’s Financials

Includes a $9.1 million charge to settle a business dispute

Includes a $5.733 million after-tax special charge for business dispute

Sales increased from $220.2 million in 1999 to $491.5 million in 2002.Net income increased from $6 million in 1999 to $33.5 million in 2002.

Systemwide salesInclude sales from company owned and franchised stores.

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Common Size Income Statements:Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Income Statements

$393.7 operation expenses

$491.5 sales* Not adjusted for distortions caused by “special items”.

Each statement item is computed as a percentage of sales. 16

Trend Income Statements:Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Income Statement

* Not adjusted for distortions caused by “special items”.

$393.7 operating expenses in 2002

$194.5 operating expenses in 1999

Each statement item is calculated in percentage terms using a base year number.

Base Year

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Comparative Balance Sheets AssetsKrispy Kreme’s Financials: Balance Sheet

Assets

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Common Size AssetsKrispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to assets

$3.2 cash $105.0 assets

Each statement item is computed as a percentage of Total assets.19

Trend AssetsKrispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet assets

$7 cash in 2000

$3.2 cash in 1999

Each statement item is calculated in percentage terms using a base year number.20

Comparative Balance Sheets Liability and Equity: Krispy Kreme’s Financials

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Common Size Liabilities and Equity:Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Balance sheet liabilities and equity

$13.1 accounts payable

$105.0 total liabilities and

equity

Each statement item is computed as a percentage of Total liabilities and equity.22

Trend Liabilities and EquityKrispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet liabilities and equity

$8.2 accounts payable in 2000

$13.1 accounts payable in 1999

Each statement item is calculated in percentage terms using a base year number. 23

Krispy Kreme’s Financials:Abbreviated cash flow statements

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Common Size Cash Flow Statements:Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Cash Flow Statements

$93.9 capital expenditures

$491.5 sales

Each statement item is computed as a percentage of Sales.25

Trend Cash Flow StatementsKrispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Cash Flow Statements

$93.9 capital expenditures in 2002

$10.5 capital expenditures in 1999

Each statement item is calculated in percentage terms using a base year number. 26

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.

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Krispy Kreme analysis: Lessons learned Common-size and trend statement

techniques can be applied to all financial statements and every section of statements.

Financial statements help analysts gain a sharper understanding of the company’s economic condition and its prospects for the future.

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Learning Objective:

Profitability Analysis

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Financial ratios and profitability analysis

Return on assets

Asset turnover

Operating profit margin

NOPAT is net operating profit after taxes

Analysts do not always use the reported earnings, sales and asset figures. Instead, they often consider three of adjustments to the reported numbers:

1. Remove non-operating and nonrecurring items to isolate sustainable operating profits.

2. Eliminate after-tax interest expense to avoid financial structure distortions.

3. Eliminate any accounting quality distortions (e.g., off-balance operating leases).

ROA= NOPAT Average assets

NOPAT Sales

Sales Average assets

X

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Calculating Return on Assets

Eliminate nonrecurring items

Eliminate interest expense

Effective tax rate

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How can ROA be increased?

There are just two ways:

1. Increase the operating profit margin, or

2. Increase the intensity of asset utilization (turnover rate).

Assets turnover

Operating profit margin

NOPAT is net operating profit after taxes

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ROA, margin and turnover examples: A company earns $9 million of NOPAT on sales of

$100 million with an asset base of $50 million.

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.

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ROA Decomposition and Analysis

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

1. The expanded store base, along with increased sales, allowed the fixed costs be spread over a number of stores- The result was in an improved operating profit margin.

2. However, the asset based was considerably less productive in 2002 ( Asset turnover is 1.48) than it was in 1999 ( Asset turnover is 2.22) – More stores meant more resources ( assets) tied up operating cash, receivables, etc.

1. 2

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Further decomposition of ROA

Operating profit margin

Asset turnover

ROA

Sales Average assets

X

NOPAT Sales

=

Correspond to the common-size Income statement items

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Usages of Decomposition of ROA The profit margin components can help the

analyst identity areas where cost reductions have been achieved or where cost improvements are needed.

The current asset turnover ratio helps the analyst spot efficiency gains from improved accounts receivable and inventory management.

The long-term asset turnover ratio captures information about property, plant, and equipment utilization.

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ROA and competitive advantage:Krispy Kreme

Wendy’s, Baja Fresh, Café Express

S&P industry survey or other sources

Q: What was the key to Krispy Kreme’s success in 2002 ?

Answer: Krispy Kreme outperformed the competition by generating more sales perasset dollar.

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ROA and competitive advantage:Four hypothetical restaurant firms Competitive Advantage:

Companies that consistently earn an ROA above the floor. (e.g., Firm C) However, a high ROA attracts more

competition which can lead to an erosion of profitability and advantage. Competition works to drive down ROA toward the competitive floor.

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

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Learning Objective:

Capital structure and

Assess Credit Risk

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Credit risk and capital structure:Overview Credit risk refers to the risk of default by the

borrower. 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.

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.

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Credit risk and capital structure:Balancing cash sources and needs

The cash flow statements contain information enabling a user to assess aCompany’s credit risk, financial ratios are also useful for this purpose.

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Traditional lending products

Short-term loans: Seasonal lines of credit Special purpose loans

(temporary needs) Secured or unsecured

Revolving loans Like a seasonal credit line Interest rate usually “floats”

Long-term loans: Mature in more than 1 year Purchase fixed assets,

another company, Refinance debt ,etc.

Often secured

Public Debt Bonds, debentures, notes

Special features: Sinking fund and call provisions

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Evaluating the borrower’s ability to repay

Understandthe business

Step 1: • Business model and strategy• Key risks and successful factors• Industry competition

Evaluateaccounting quality

Step 2: • Spot potential distortions• Adjust reported numbers as needed

Evaluate current profitability and health

Step 3: • Examine ratios and trends• Look for changes in profitability, financial conditions, or industry position.

Prepare “pro forma”cash flow forecasts

Step 4: • Develop financial statement forecasts• Assess financial flexibility

Due diligenceStep 5:

• Kick the tires

Comprehensive risk assessment

Step 6: • Likely impact on ability to pay• Assess loss if borrower defaults• Set loan terms

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Credit risk: Short-term liquidity

ratios

Short-termliquidity

Activityratios

Liquidityratios

Current ratio =Current assets

Current liabilities

Quick ratio =Cash + Marketable securities + Receivables

Current liabilities

Accounts receivable turnover =Net credit sales

Average accounts receivable

Inventory turnover =Cost of goods sold

Average inventory

Accounts payable turnover =Inventory purchases

Average accounts payable

Liquidity refers to the company’s short-term ability to generate cash for working Capital needs and immediate debt repayment needs.

Including Inventory

Very immediateliquidity

Activity ratios tell us How efficiently the company is using its assets.

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Receivables Turnover Ratio and collection period

Net Sales Average Accounts Receivable

ReceivablesTurnover

Ratio=

This ratio measures how many times a company converts its

receivables into cash each year.

365 Receivables Turnover Ratio

Average Collection

Period

=

This ratio is an approximation of the number of days the average accounts

receivable balance is outstanding.

Average Collection Period

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Inventory Turnover Ratio and Average Days in Inventory

This ratio measures the numberof times merchandise inventory

is sold and replaced during the year.

Cost of Goods Sold Average Inventory

InventoryTurnover

Ratio=

Average Days in Inventory

365 Inventory Turnover Ratio

Average Days in

Inventory

=

This ratio indicates the numberof days it normally takes to sell inventory.

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Credit risk:Operating and cash conversion cycles

Working capital ratios:

Days accounts receivable outstanding =365 days

Accounts receivable turnover

Operating cycle 75 days

45 days

30 days

Days accounts payable outstanding =365 days

Accounts payable turnover

( 20 days)

Cash conversion cycle 55 (75-20) days

Days inventory held =365 days

Inventory turnover

(Days before cash is collected from the customer)

( Days that suppliers are paid after inventory is purchased)

Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).47

Credit risk:Long-term solvency

Long-termsolvency

Coverageratios

Debt ratios

Long-term debt to assets =Long-term debt

Total assets

Long-term debt to tangible assets =Long-term debt

Total tangible assets

Interest coverage =Operating incomes before taxes and interest

Interest expense

Operating cash flow to total liabilities

Cash flow from continuing operations

Average current liabilities + long-term debt=

Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain its productive capacity and still meet the interest and principal payment on its long-term debt.

Including Intangible assets

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Credit risk of Krispy Kreme : Short-term liquidity and Long-term solvency

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Credit risk: 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.

Default rates by Moody’s credit rating, 1983-1999

Source: Moody’s Investors Service (May 2000)

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Financial Ratios and Default RiskReturn on assets (ROA)

Source: Moody’s Investors Service (May 2000)

Profitability: Return on Assets Percentiles (excludes extraordinary items)

ROA and probability of default is negatively associated.

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Financial Ratios and Default RiskQuick Ratio

Source: Moody’s Investors Service (May 2000)

Liquidity: Quick Ratio Percentiles

Quick Ratio and probability of default is negatively associated.

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Credit analysis:Case Study: G.T. Wilson’s credit risk A bank client for over 40 years. Owns 850 retail furniture stores throughout the

U.S. Increased competition and changing consumer

tastes caused the following changes in Wilson’s business strategy: Expand product line to include high quality

furniture, consumer electronics, and home entertainment systems.

Develop a credit card system to help customers pay for purchases.

Open new stores in suburban shopping centers and close unprofitable downtown stores.

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Credit analysis:Case Study: G.T. Wilson’s credit risk Bank now has a $50 million secured

construction loan and a $200 million revolving credit line which is up for renewal with Wilson.

What do the Wilson’s financial statements tell us about its credit risk?

Should the bank renew Wilson’s $200 million credit line?

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Credit Analysis: Interpretation of cash flow components

.

.

Negative free cash flow

Increased borrowing

Continued dividend payment

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Credit Analysis : Selected financial statistics

Declining margin

Customers take longer to pay, but reserve is smaller

Larger debt burden

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Credit analysis: Recommendation Wilson is a serious credit risk:

Inability to generate positive cash flows from operations.

Extensive reliance on short-term debt financing.

The company may be forced into bankruptcy unless: Other external financing sources can be

found. Operating cash flows can be turned positive.

Update: Bankruptcy was declared shortly after these financials were released.

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Components of ROCE

Return on commonequity (ROCE)

Return on assets (ROA)

Common earnings leverage

Financial structure leverage

Net income available to common shareholders

Average common shareholders’ equity

NOPAT

Average assets

Net income available to common shareholders

NOPAT

Average assets

Average common shareholders’ equity

X

XNet income available to common shareholders = Net income – preferred dividends

•

ROCE= ROA * Common earnings leverage* Financial Structure leverage 58

Return on equity and financial leverage

2005: No debt; all the earnings belong to shareholders. 2006: $1 million borrowed at 10% interest; ROCE climbs

to 20%. 2007: Another $1 million borrowed at 20% interest;

ROCE falls to only 15%.

Unchanged – because of Financial leverage

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Return on Equity and financial leverage

Financial leverage is beneficial only when the company earns (i.e., ROA) more than the incremental after-tax cost of debt.

If the cost of debt is greater than the earnings, increased leverage will harm shareholders.

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Return on Equity and financial leverage (contd.)

The advantage of debt financing is the tax deduction on interests.

The disadvantage is the increase of the bankruptcy risk.

Both the cost of debt and the bankruptcy probability need to be considered in determining the capital structure.

It is hard to determine the optimal mix of capital and debt.

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Profitability and financial leverage:Case Study

Leverage helpsLeverage helps

Leverage neutral

Leverage hurts

Leverage neutral

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Learning Objective:

Pro Forma Earnings

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Pro Forma Earnings

Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings.

Pro forma earnings are management’s assessment of permanent earnings.

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Pro Forma Earnings

Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference calls, and in annual reports.

The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP.

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Financial statement analysis:

Non-GAAP earnings: Pro forma earnings and EBITDA

Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference call, and in annual reports. Sometimes these earnings

figures are called EBITDA ( earnings before interest, income taxes, depreciation, and amortization)

Sometimes it is called “ adjusted earnings’.

Sometimes it is called “ pro forma earnings”.

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Financial statement analysis:Pro forma earnings at Amazon.com

Company defined numbers

Computed according to GAAP

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When use the EBITDA or “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.

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Why do firms report EBITDA and “pro forma” earnings? Help investors and analysts spot non-

recurring or non-cash revenue and expense items that might otherwise be overlooked.

Pro forma earnings could 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.

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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.

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Summary of financial statement analysisHow to use financial ratios Profitability:

ROA ( Return on assets) Operating Profit Margin ROCE ( Return on common stockholder’s

equity) Market Measures:

Earnings per share (EPS) Price/ earnings ( Market price of common stock/

EPS) Dividend payout ( Dividends per share/ EPS) Dividend yield ( Dividends per share/ Market

price of common stock) 71

Summary of financial statement analysisHow to use financial ratios Liquidity ( Evaluate short-term credit risk)

- Liquidity ratios: Current ratio and quick ratio - Liquidity of working capital : Average collection

period, Days inventory held, days payable outstanding, operating cycle days, cash conversion cycle, etc.

- Operating Efficiency ( Activity ratios) Accounts receivable turnover Inventory turnover Accounts payable turnover

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Summary of financial statement analysisHow to use financial ratios Solvency ( Evaluate long-term credit

risk) Coverage ratios: interest coverage,

operating cash flows to total liabilities Debts ratios:

Debt/ Assets Debt/ equity (Total liabilities/

Stockholders’ equity)

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