fsa slides - lecture 1

8/2/2019 FSA Slides - Lecture 1

1/15

Financial Statement

AnalysisLecture 1

Based on lecture note 0 and HW1

Performance measure

1. How did company perform last year?

2. How did companys operation perform lastyear?

ROA =EarningsbeforeInterest (EBI)

Average Assets,.......,(1)


2/15

Weakness in ROAdefinition

The denominator of ROA above should exclude the operatingliabilities

In some occasions, it works nicely, showing overall performance ofcompany, in particular, when there is no operating liabilities (but whodoesnt?)

EBI is overall measure, total income that is earned by assets minusoperating liabilities. (or net operating assets and financial assets)

When company invests in financial assets that have nothing to dowith operation, one has to undo the income statement and balancesheet to compare the operating performance across the companies.

This means that ROA is not appropriate measure for comparison ofoperating performance (namely, not for question #2 above).

Case 1

Two companies with same resources andinvestment

Company A pays salary every Friday

Company B pays salary 15th and lastworking day of month.

Should the performance measure bedifferent for company A and B, given theyhave same revenue and expense?


3/15

Case 1

Net income = Revenue - Expense

Net income for both company A and B is $6,300 ($21,000- $10,500 40% x $10,500).

Retained earnings, BB + NI - Dividend = Retainedearnings, EB

CompanyA CompanyB

Assets(allcash) $106,800 $106,300

Liability(salarypayable) 500 0

Equities

Commonstock $100,000 $100,000

Retainedearnings 6,300 6,300TotalEquities $106,300 $106,300

TotalLiabilities&Equities $106,800 $106,300

Tax issue

Tax accountingCash in for company A = 21,000

Cash out for company A = 10,000Cash paid for tax = 40% x$11,000 = $4,400

Financial AccountingRevenue = $21,500

Salary Expense = 10,500Pretax income = $10,500Tax expense = 40% of $11,500= $4,200

Tax accounting is largely cash basis Revenue is all cash, but salary expense for company A is

less.

This is because company As salary payout policy.

The difference is due to the fact that for tax purpose, ittook less deduction now ($500 x 40% less)

This means, in turn, in the future, there will be morededuction, leads to less future tax to be paid

This is known as deferred tax assets


4/15

Evaluation of case 1

There is no difference between company A & B other thansalary payout policy.

But ROA calculation is different, because denominator isdifferent

It seems like if we use Assets - liabilities as denominator, andthe problem disappears.

Does this mean we have to deduct any liabilities? Certain liabilities are created for operating reasons (salary

payable, accounts payable and accrued liabilities)

Others are issued to fund the operations. Lets take a look at case 2.

Case 2

Two companies with same initial resourcesand investment

Need an equipment ($60,000)

A purchases the equipment by moreinvestment from shareholders

B purchases the equipment by issuingdebt

Should ROA be different?


5/15

Case 2

IncomestatementforMay2010 CompanyA CompanyB

SalesRevenue $21,000 $21,000

Less:SalaryExpense (10,500) (10,500)

DepreciationExpense (1,000) (1,000)

InterestExpense (600)

PretaxIncome 9,500 8900Less:Taxexpense (3,800) (3,560)

Netincome $5,700 $5,340

Balancesheetasof5/2/2010 afterthepurchaseo ftheequipment

Assets(allcash)

Cash $40,000 $40,000

Equipment 60,000 60,000TotalAssets $100,000 $100,000

Liability(Notepayable) 0 60,000

Equities(commonstock) $100,000 $40,000

TotalLiabilities&Equities $100,000 $100,000

Case 2BalanceSheet(asof5/31/2010) CompanyA CompanyB

Cash $46,700 $46,340Equipment 60,000 60,000Less:Acc.Depr (1,000) (1,000)TotalAssets $105,700 $105,340LiabilityNotepayable $0 $60,000Equities

CommonStock $100,000 $40,000RetainedEarnings 5,700 5,340TotalEquities 105,700 45,340TotalLiabilities&Equities 105,700 105,340

ROACompany

A

Company

B

EBI(NI+Intexp,AT)NI 5700 5340InterestExpense,AT 0 360EBI $5,700 $5,700AverageAssets $72,850 $72,670

ROA 7.824% 7.844%


6/15

Evaluation of Case 2 Operating Performance measure should not be affected by financial structure.

Both companies have same operations, started with same investment, exceptcompany B borrowed $60,000 to pay for the equipment, whereas company Aissued equity (in exchange for cash) $60,000 for the equipment.

The ROA numerator of EBI does a nice job to undo the net income by addingthe interest expense, so that it is operating outcome. How you financed the equipment has no bearing on the companys operation. What is the difference between liability account in case 1 and 2? Case 1s liability is for companys operation, and case 2s is for

funding (financial).

Note that the denominators are still different ($72,850 vs $72,670) Cash was used to pay the interest expense

Cash account is too complicated and not disclosed enough for the analysts toadjust

Some doesnt view cash as operating (see case 3)

Liabilities

Think about the purpose of EBI (NI + Interest expense, After tax). It is for companys total income that can be distributed to all the

investors (both debtholders and shareholders)

Case 1 says : Operating liabilities such as salary payable, accountspayable, accrued liabilities should not be in the denominator ofROA.

Case 2 : Financial liabilities are used to finance operating assets,and how you finance your operation should not have impact onROA.

Therefore the correct denominator for EBI is Assets - Operatingliabilities.


7/15

Side issue ROA defined as EBI/Avg Assets has an inherent

problem

Suppose interest rate is 100% monthly Calculate ROA (EBI/Avg Assets) ROA when debt is issued is always higher, regardless of

interest rate (assuming the interest is paid in May)

This is mainly because of EBI measure. Whether shareholders are better off cant be answered

using ROA

Income relevant to shareholder is still net income.

Case 3

Three companies with same investment and operation (5employees, 1 equipment)

All has excess cash of $40,000 in the beginning

A decides not to do anything, deposit in checking account C decides to invest in risky assets (Apple, buy-and-hold) B decides to invest in less risky assets (US treasury)

Operating result is same across the companies A-C. EBI is going to be different How can we see the operating result is same when EBI is different?


8/15

Case 3 I/S

IncomestatementforMay2010 CompanyA CompanyB CompanyC

SalesRevenue $21,000 $21,000 $21,000

Interestrevenue 0 150 0

UnrealizedgainonSTI* 0 0 1,000

Less:SalaryExpense (10,500) (10,500) (10,500)

DepreciationExpense (1,000) (1,000) (1,000)

PretaxIncome $9,500 $9,650 $10,500

Less:Taxexpense (3,800) (3,860) (4,200)

Netincome $5,700 $5,790 $6,300

*STI : Short term investment

Case 3 B/S

Asof5/31/2010 CompanyA CompanyB CompanyC

Assets(allcash)

Cash $46,700 $16,790 $16,300

Short-terminvestment 0 30,000 31,000

Equipment 60,000 60,000 60,000Less:AccDepr (1,000) (1,000) (1,000)

TotalAssets $105,700 $105,790 106,300

Liability 0 0 0

Equity(commonstock)

RetainedEarnings $5,700 $5,790 $6,300

CommonStock $100,000 $100,000 $100,000

TotalEquity 105,700 105,790 106,300

TotalEquity&Liab 105,700 105,790 106,300


9/15

Case 3

CompanyA CompanyB CompanyC

EBI(NI+Intexp,AT)

NI $5,700 $5,790 $6,300

InterestExpense,AT - - -

EBI $5,700 $5,790 $6,300

AverageAssets 102,850 102,895 103,150

ROA 5.54% 5.63% 6.11%

Case 3 : Evaluation

ROA of company C is highest because of investment Took risk, and earned $1,000 This has nothing to do with companys operation

In fact, all three companies operating result is same By looking at EBI, there is no way you can find out it EBI did nice job by adding interest expense, because how you finance

it has no bearing on operating result.

But if company has financial assets and invest, then EBI is not ameasure for operating result

EBI is total income earned from both net operating and financialassets


10/15

Case 3 : Evaluation

How can we isolate operating performance forcompanies?

Define Net operating income, after tax or NOPAT, NOPAT = EBI - any gains (+ any losses) from financial

assets, after tax

Because NOPAT is earned on net operating assets,correct denominator for NOPAT is net operating assets

Define return on investment, ROI = any gains (- anylosses) on financial assets / Average financial assets

Case 3 : Evaluation forCom an A

Company As operating result is good, butexcess cash is not earning anything

Two suggestions Expand operation (e.g. hire one more

employees)

Invest in financial assets


11/15

Case 3 : Evaluation forCom an B & C

Company C Investment strategy is too risky Diversify the investment or invest in less

risky assets as company B

Summary EBI represents all the performance from both financial assets and net

operating assets, thus EBIs denominator should be average of (assets -operating liabilities)

Net operating assets = Operating assets - Operating liabilities

Financial assets + Net operating assets = Assets - Operating liabilities Then EBI/Avg (Assets-OL) will answer question 1 in slide 2. NOPAT represents operating performance, earned from net operating

assets

NOPATs denominator is net operating assets (Operating assets -operating liabilities)

Income earned on financial assets = any gains/losses on incomestatement and other comprehensive income


12/15

Remaining Issues

It is difficult to understand the purpose of ROA (EBI/Average Assets),but assuming it was created for total performance measure and correct

the error in denominator, it may be still very irrelevant

EBI is income available to the following Debtholders (Bank) Preferred shareholders Common shareholders

All three have different investment objectives, so to them, ROA may notmean anything to them, even if we correct the ROAs denominator.

What are the metric of interest for the three parties? How are they connected to companys operating result?

Companys disclosure, role ofAnalysts, and stock reaction

A game between company, analysts and investors Before publishing annual reports, company holds an event - earnings

announcement, conference call

Often it will say it beats, meets, misses analysts forecasts Also it would issue forecast guidance for future quarters. Company announces earnings, and, more importantly, future outlook

of the company. Then analysts will have time to ask questions to themanagements.

Often times, earnings announcement is not only about the currentearnings, and used to mitigate potentially negative stock reaction.

For example, if companys current earnings is not good, it can alsorelease positive future outlook, to mitigate the stock reaction.


13/15

Apple 2011 1st quarter On January 17, 2011, Apple announces that its CEO, Steve Jobs, is on medical leave

and its chief operating officer, Tim Cook, will temporary fill for CEO position.

First announcement came at 9:09am, 1/17/2011.

This day is Martin Luther Kings day, so no trading. Its possible to trade NASDAQ stock before market opens or after market

closes.

NASDAQ has pre-market session (between 7 am to 9:30am) and post-marketsession (between 4pm-8pm). Regular trading hours are 9:30am - 4pm.

In a pre-market trading on 1/18/2011, Apple share price declined by 5.4%. When market closes on 4pm, Apple stock was down by 2.3%. On same day (after market closes, 4pm), Apple announced 2011 1st quarter

earnings.

Given the expected volatility of trading, NASDAQ halted the trading on4:30pm and resumed on 4:50pm.

Apple 2011 1st quarter Apples 1Q result is over Analysts expectation. (see http://

www.marketwatch.com/story/apple-beats-targets-on-iphone-ipad-sales-2011-01-18, also on the role of analysts, see http://www.marketwatch.com/story/wall-street-blows-chance-to-question-apple-2011-01-18) and mentioned some positiveness on future outlook

Analysts forecast : $5.42 per share, Actual : $6.43 Analysts forecasted earnings (net income) and EPS. (net income / weighted

number of shares outstanding)

Median of analysts forecasts is known as consensus. Its not always the case that analysts predict earnings (net income). In Apple

case, since its extremely straight forward accounting, net income ispredicted.

After the extended trading is over on 1/18, Apple recovered all the losses(-2.3%; see above)


14/15

E*Trade 2007 3Q

Unlike other electronic trading companies, E*Tradewanted higher growth, thus chose to invest inMortgage backed securities (MBS) and aggressivelending practice.

Exposure to MBS as of 2007 2Q end was about $3billions.

E*Trade hid the information on investment portfoliountil 8/16/2007.

Market guessed losses on MBS and E*Trade stockprice went from $25.2 on 6/8/07 to $12.8 on 10/16/07

E*Trade 2007 3Q

10/17 is 2007 3rd quarterearnings announcementdate. (after trading hour,

4pm)

Losses on MBS is estimatedto be $300 millions (on 3Billions MBS holding)

News on Earnings was notso important

Date Return

20071016 -2.76%

20071017 -1.81%

20071018 -8.02%


15/15

E*Trade 2007 3Q

On 11/9/07 (Friday), after market closed, E*Trade issued

press release that essentially said E*trade sees higherwrite-downs than previously expected, so investorsshouldn't rely on its previous announced earnings forecast.

Monday 11/12 (around 7:42am), one analyst in Citi saysthat bankruptcy is likely.

This sparks massive selling.

Some efforts from management

Date Return

20071112 -58.7%

20071113 40.8%

E*Trade 2007 3Q There is no way E*Trade management could avoid the meltdown.

Poor investment decision Stock market doesnt like uncertainty.

Until 8/16, stock market didnt even know how much exposure E*Tradehad.

From 8/16, E*Trade delayed the bad news as much as possible. It is estimated that $3B MBS is worthless, which means that E*Trade has to

write down the whole amount.

After 11/12, E*Trade management was replaced and a hedge fund (Citadel)invested $1 billions.

The hedge fund lost much of the investment, and the fund manager was fired. E*Trade is traded now $0.95 per share (based on pre-reverse stock split

fsa slides - lecture 1

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