Financial Statement Analysis: A Holistic Approach

Dan Goldzband, CMA

• University of California, San Diego (Extension Division)

• Cohu, Inc./Delta Design, Inc., Poway CA

Gross margin DuPont analysis Working capitalFixed asset T/O EPS Return on assetsDebt/equity Sales / SF Trend analysisFree cash flow Acid-test INV T/OHigh-low method DSO Op C/F per shareA/R T/O Revenue / ASMF Cash cycleOperating margin Vertical analysis Debt coverage ratioBook-to-bill R&D plough back Dividend payoutCurrent ratio Return on equity Same size

statementsSame-store sales Exhaustive method Times interest earnedPrice-earnings Dividend yield EBITDANet interest marginPayables T/O Cash burn rateLoans / deposits Average check Book value / share

Ratio overload!

Gross margin DuPont analysis Working capitalFixed asset T/O EPS Return on assetsDebt/equity Sales / SF Trend analysisFree cash flow Acid-test INV T/OHigh-low method DSO Op C/F per shareA/R T/O Revenue / ASMF Cash cycleOperating margin Vertical analysis Debt coverage ratioBook-to-bill R&D plough back Dividend payoutCurrent ratio Return on equity Same size

statementsSame-store sales Exhaustive method Times interest earnedPrice-earnings Dividend yield EBITDANet interest marginPayables T/O Cash burn rateLoans / deposits Average check Book value / share

Holistic Financial Statement Analysis

Approach: Focus on the most basic financial questions about any company.

Goals: To think about companies in terms of basic financial issues.

Use a “thematic” approach to F/S’s, providing a context for all those ratios.

Provide some hints for analyzing complex and detailed F/S’s

Who could use this method?

• Auditors: as a first step in analytical procedures;

• Commercial lenders: to evaluate new prospects or monitor existing customers;

• Financial analysts: as a first step in formal F/S analysis; and

• Corporate executives: to monitor their company’s (and competitors’) progress.

Critical underlying concepts and techniques

(not part of analysis/presentation)

• The importance of expectations (which are personal biases, not part of your analysis)

• Begin with results (bottom line), then work backwards to causes/drivers

• Remember that symptoms and results (financial statement figures) are not root causes or explanations

Steps to obtain financial statements for public companies

Usual sequence (may vary slightly):

• Go to company website, Investor Relations section

• Click on Financial Information

• Click on SEC filings

• Specify Annual filings from drop-down

• Download most recent 10-K (as pdf)

10-K items to read and print

• Item 1: Business

• Financial statements (found in exhibits, not main body of 10-K)– Income statement– Cash flow statement– Balance sheet

• Management’s Discussion and Analysis

Fundamental financial issues

• Recent financial performance

• Future financial performance

• Financial condition

• Relations with capital sources

Holistic Four-Questions Approach

• What is the trend and quality of recent earnings performance?

• What is the trend of recent operating cash flow performance?

• How has the company been providing for its future, and how is it financing this investment?

• Assess the company’s financial condition and its financial strategy.

Question 1: Trend and quality of earnings

Key components:

• Sales and net income trends

• Vertical analysis (each expense and profit measure as % of sales)

Expectations (not part of formal analysis or comments, but an essential part of analyst’s attitude)

• Net income trend: Positive and growing

• Vertical analysis: Improving margins

Evaluating earnings quality / profitability

• Vertical analysis

• Gross margin trend

• Operating income trend

• Net income trend

Cohu, Inc. P&L: Sales & Net Income trends

(in 000's of $) 2010 % change 2009 % change 2008

Net sales 322,667 88%

171,261 (14)%

199,659

Cost of sales (212,672) (118,873) (134,691)

Gross margin (not in P&L) 109,995 52,388 64,968

R&D (36,201) (31,964) (38,084)

SG&A (44,117) (35,519) (36,612)

Acquired, in process R&D - - (2,577)

Op income (loss) 29,677

(15,095) (12,305)

Interest/other income 561 1,300 5,483

EBT 30,238 (13,795) (6,822)

Income tax provision/benefit (5,594) (14,373) 1,379

Net income (loss) 24,644 187%

(28,168) -418% (5,443)

Cohu, Inc. Vertical analysis

(in 000's of $) 2010 2009 2008

Net sales

322,667 100% 171,261 100% 199,659 100%Cost of sales (212,672) -66% (118,873) -69% (134,691) -67%

Gross margin (not in P&L)

109,995 34% 52,388 31% 64,968 33%R&D (36,201) -11% (31,964) -19% (38,084) -19%SG&A (44,117) -14% (35,519) -21% (36,612) -18%

Acquired, in process R&D -

0% - 0% (2,577) -1%

Op income (loss)

29,677 9% (15,095) -9% (12,305) -6%Interest/other income 561 0% 1,300 1% 5,483 3%

EBT 30,238 9% (13,795) -8% (6,822) -3%

Income tax provision/benefit (5,594) -2% (14,373) -8% 1,379 1%

Net income (loss) 24,644 8% (28,168) -16% (5,443) -3%

Caterpillar, Inc.Comparative Income Statements

(millions of $) 2010 2009 2008

Sales and revenues:

Sales of Machinery and Engines 39,867 29,540 48,044

Revenues of Financial Products 2,721 2,856 3,280

Total sales and revenues 42,588 32,396 51,324

Operating costs:Cost of goods sold 30,367 23,886 38,415 SG&A 4,248 3,645 4,399 R&D 1,905 1,421 1,728 Interest expense of Financial Products 914 1,045 1,153 Other operating (income) expenses 1,191 1,822 1,181 Total operating costs 38,625 31,819 46,876

Operating profit 3,963 577 4,448

Gross profit (not in P&L) 11,307 7,465 11,756

Caterpillar, Inc. Vertical analysis (quality of earnings)

(millions of $) 2010 2009 2008

Total sales and revenues42,588

100.0% 32,396 100.0% 51,324 100.0%

Operating expenses:

Cost of products & services 31,281 73.5% 24,931 81.3% 39,568. 80.5%

R&D 1,905 4.5% 1,421 4.4% 1,728 3.4%

SG&A 4,248 0.0% 3,645 11.3% 4,399 8.6%

Other op (income) exp 1,191 2.8% 1,822 5.6% 1,181 2.3%

Operating profit

3,963 9.3% 577 1.8% 4,448 8.7%

Caterpillar, Inc. Vertical analysis 2010 (disaggregated by product line)

($ figures in millions)

2010Sales and revenues:

Sales of Machinery & Engines 39,867 Revenues of Financial Products 2,721 Total sales and revenues 42,588

Operating expenses:Cost of goods sold 30,367 SG&A 4,248 R&D 1,905

Interest exp of Financial Products 914 Other op (income) expenses 1,191 Total operating costs 31,819

Operating profit 3,963

Gross profit (not in P&L) 11,307

Vertical analysis:

Combined

100.0%

71.3%10.0%

4.4%

2.1%2.8%

74.7%

9.3%

26.5%

Mach & engines

100.0%

76.2%

4.8%

23.8%

Financial products

100.0%

33.6%

66.4%

Caterpillar, Inc. Profitability by period (disaggregated by product line)

(millions of $) 2010 2009 2008

Machinery and Engines

Sales 39,867 100.0% 29,540 100.0% 48,044 100.0%

Cost of goods sold 30,367 76.2% 23,886 80.9% 38,415 80.0%

Gross profit 9,500 23.8% 5,654 19.1% 9,629 20.0%

R&D 1,905 4.8% 1,421 4.8% 1,728 3.6%

M & E profit 7,595 19.1% 4,233 14.3% 7,901 16.4%

Financial Products

Revenues 2,721 100.0% 2,856 100.0% 3,280 100.0%

Interest expense 914 33.6% 1,045 36.6% 1,153 35.2%

Financial products profit 1,807 66.4% 1,811 63.4% 2,127 64.8%

Question 2:Evaluate operating C/F

• Net operating cash flow trend

• Significant Op C/F drivers: Identify significant Op C/F drivers and any year-over-year changes in them.

Expectation

• Operating C/F trend: Positive and growing

Caterpillar, Inc.Operating C/F (as presented)

(in millions of $) 2010 2009 2008

Net income 2,758 827 3,585 Adjustments for non-cash items:

Depr & amort 2,296 2,336 1,980

Other 469 137 355 Changes in assets & liabilities:

A/R (2,320) 4,014 (545)

INV (2,667) 2,501 (833)

A/P 2,570 (1,878) (129)

Accruals 964 (1,039) 814

Customer advances 604 (646) 286

Other assets - net 358 235 (470)

Other liab - net (23) 12 (371)

Op C/F 5,009 6,499 4,672

Caterpillar, Inc.Significant Operating C/F drivers by year

(in millions of $) 2010 2009 2008

Net income 2,758 827 3,585 Adjustments for non-cash items:

Depr & amort 2,296 2,336 1,980

Other 469 137 355 Changes in assets & liabilities:

A/R (2,320) 4,014 (545)

INV (2,667) 2,501 (833)

A/P 2,570 (1,878) (129)

Accruals 964 (1,039) 814

Customer advances 604 (646) 286

Other assets - net 358 235 (470)

Other liab - net (23) 12 (371)

Op C/F 5,009 6,499 4,672

Question 3: Providing for the future

• Two primary indicators:R&D (from Income Statement, not always presented)

Cap X (gross disbursements, not net, from C/F Statement, Investing section)

• Combined plough back ratio:

R&D expenses + Cap X disbursements Revenue

• Must also evaluate nominal R&D and Cap X spending. Revenue volatility can distort plough back ratios.

Providing for the future(continued)

Other possible indicators: • JV’s • Employee training and development

(both less visible from outside)

Expectations

• Cap X/Acquisitions: Consistent and appropriate investment in PP&E and acquisitions to meet strategic goals or as opportunities arise.

• R&D trend: Consistency, in either nominal terms or % of sales, or both.

• Reasonable plough back ratios

Caterpillar, Inc.Machinery and Engines

R&D plough back ratio & trend analysis

(millions of $) 2010% of sales % change 2009

% of sales % change 2008

% of sales

Sales

39,867 34.3%

29,540 -38.5%

48,044 Cost of goods sold 30,367 23,886 38,415

Gross profit 9,500 5,654

9,629 R&D 1,905 4.8% 34.1% 1,421 4.8% -17.8% 1,728 3.6%

M & E profit 7,5954,233

7,901

Caterpillar, Inc.Investing C/F (as presented)

(millions of $) 2010 2009 2008Cap X - excluding equipment leased to others (1,575) (1,504) (2,320)

Expenditures for equipment leased to others (1,011) (968) (1,566)

Proceeds from disposals of PP&E 1,469 1,242 982

Additions to finance receivables (8,498) (7,107) (14,031)

Collections of finance receivables 8,987 9,288 9,717

Proceeds from sale of finance receivables 16 100 949

Investments & acquisitions (net of cash acquired) (1,126) (19) (117)

Sale of available-for-sale securities 228 291 357

Investments in available-for-sale securities (217) (349) (339)

Other - net 132 128 197

Net cash provided by (used for) investing (1,595) 846 (6,171)

Caterpillar, Inc.Investing C/F (grouped by

purpose)(millions of $) 2010 2009 2008Cap X - excluding equipment leased to others (1,575) (1,504) (2,320)

Expenditures for equipment leased to others (1,011) (968) (1,566)

Proceeds from disposals of PP&E 1,469 1,242 982

Investments & acquisitions (net of cash acquired) (1,126) (19) (117)

Subtotal: non-financial (M&E) assets (2,243) (1,249) (3,021)

Additions to finance receivables (8,498) (7,107) (14,031)

Collections of finance receivables 8,987 9,288 9,717

Proceeds from sale of finance receivables 16 100 949

Subtotal: financial product assets 505 2,281 (3,365)

Sale of securities 228 291 357

Investments in securities (217) (349) (339)Other - net 132 (128) 197

Net cash provided by (used for) investing (1,595) 846 (6,171)

Caterpillar, Inc.Combined plough back ratio

($ figures in millions) 2010 2009 2008

Cap X - excluding equipment leased to others 1,575 1,504 2.,320

Investments & acquisitions (net of cash) 1,126 19 117

Gross "future-oriented" investing 2,701 1,523 2,437

R&D expenses 1,905 1,421 1,728

= Total "future-oriented" plough back * 4,606 2,944 4,165

-:- Sales of Machinery & Engines 39,867 29,540 48,044

= Combined Cap X / R&D plough back ratio 11.6% 10.0% 8.7%

*Note: Future-oriented plough back does not include expenditures for equipment leased to others (see prior slide). Reason: These represent costs of sales structured as leases rather than investment in PP&E for long-term growth.

Question 3 (continued):Financing investment in the future

Three possible sources to finance growth and investment:

•New external capital

•Asset sales

•Operating C/F

Financing growth and investment(continued)

If new capital, debt or equity?

Example of asset sales: Merck’s “big pharma” investment portfolio

Op C/F: Compare Op C/F to Net Investing C/F to calculate Free C/F:•If positive, future-oriented investment is financed from operating C/F•If negative, future-oriented investment requires outside financing

Caterpillar, Inc.Free C/F *

(millions of $) 2010 2009 2008Cap X - excluding equipment leased to others (1,575) (1,504) (2,320)

Proceeds from disposals of PP&E 1,469 1,242 982

Investments & acquisitions (net of cash) (1,126) (19) (117)

Total net “future-oriented” investing (excl R&D) (1,232) (281) (1,455)

Operating C/F 5,009 6,499 4,672

Free C/F * 3,777 6,218 3,217

* Note: Free C/F is measured in a variety of ways. This method is very specific and is not the same as most finance texts’ definition and formula. The standard definition addresses a company’s overall Free C/F, while this calculation only ascertains if new capital is needed to finance future-oriented investing activity.

Question 4: Financial condition

Most basic financial condition indicators:•Liquidity: Overall C/F and balance trends

Cash cycle

•Working capital: Current ratio

Quick ratio

A/R T/O

•Solvency Debt/equity ratio (degree of financial leverage in capital structure)

These ratios deferred to later, more

detailed analyses

Caterpillar, Inc.Overall liquidity: summary of net C/F

and balances

(in millions of $) 2010 2009 2008

Operating C/F 5,009 6,499 4,672

Investing C/F (1,595) 846 (6,171)

Financing C/F (4,613) (5,215) 2,955

Net C/F (1,199) 2,130 1,456

Effect of exchange rate changes on cash (76) 1 158

Beginning cash 4,867 2,736 1,122

Ending cash 3,592 4,867 2,736

Caterpillar, Inc.Debt / equity ratio

(millions of $) 2009 2008 2008

Short-term borrowings 4,056 4,083 7,209

Long-term debt 24,362 27,548 28,326

Total debt 28,418 31,631 35,535

Total stockholders' equity 10,864 8,823 6,190

Total financial capital 39,282 40,454 41,725

Debt / equity 2.6 3.6 5.7

Question 4 (continued): Financial strategy

Indicated by the company’s relationship with capital sources (the 3 R’s). With respect to capital sources, the company is either

•Raising capital from investors; or

•Returning capital to investors; or

•Restructuring capital (neutral to investors overall, but changing capital structure and/or terms).

Clues to financial strategy & condition

Financial condition: see C/F statement and B/S:• Change in financial capitalization (nominal $)• Change in capital structure (debt/equity ratio)

Financial strategy: see Financing section of C/F statement:

• Net financing C/F (positive, negative, neutral)• Dividends• Stock activity (new issues, buy-backs or both)• Debt activity (proceeds, repayments, or both)

Caterpillar, Inc.Financing C/F

(millions of $) 2010 2009 2008

Dividends paid (1,084) (1,029) (953)

Common stock issued, incl T-shares reissued 296 89 135

Treasury shares purchased 0 0 (1,800)

Debt issue proceeds:

Machinery & Engines 216 458 1,673

Financial Products 8,108 11,833 16,257

Payments on debt:

Machinery & Engines (1,298) (918) (296)

Financial Products (11,163) (11,769) (14,143)

Short-term borrowings (net) 291 (3,884 2,074

Other (not worth discussing) 21 5 8

Net cash provided (used for) financing (4,613) (5,215) 2,955

Caterpillar, Inc.Strategic vs tactical financing activities

(millions of $) 2010 2009 2008Dividends paid (1,084) (1,029) (953)Common stock issued, incl T-shares reissued 296 89 135Treasury shares purchased 0 0 (1,800)

Debt issue proceeds: Machinery & Engines 216 458 1,673 Financial Products 8,108 11,833 16,257

Payments on debt: Machinery & Engines (1,298) (918) (296) Financial Products (11,163) (11,769) (14,143)

Subtotal “strategic financing activities” (4,925) (1,336) 873Short-term net borrowings (“tactical financing activities”) 291 (3,884 2,074

Other (not worth discussing) 21 5 8

Net cash provided (used for) financing (4,613) (5,215) 2,955

Question 4: Conclusion

• Financial condition indicators:

Liquidity: cash balance increased by 28%;

Solvency: D/E ratio decreased by 54%.

• Caterpillar’s debt/equity trend indicates an consistent trend of increasing equity relative to debt in its capital structure.

• Over the past three years Caterpillar’s financing activity has indicated a net return of capital to investors.

Question 5: Any other major, significant or

exceptional events?

• Extraordinary losses (or even gains!)

• Restructuring costs

• BK

• Oil well problems

Holistic Financial Statement Analysis--Recap

Goals: To think about companies in terms of basic financial issues.

Approach: Focus on the most basic financial questions about any company:

• Recent financial performance• Future financial performance• Financial condition• Relations with capital sources

Important reminder

Regroup or disaggregate F/S data as necessary to gain insights and provide basis for more detailed levels of analysis.

Caveats, lessons and reminders• No substitute for rigorous, comprehensive

analysis—rather, a roadmap for starting, organizing and controlling it.

• If your boss wants you to do it differently, he (or she) is right—at least in the short run.

• Financial statement analysis is not the source of fundamental explanations. It only provides the questions.

• The most important question: Why? The answers are not in the financial statements—they lie outside the numbers.

One final piece of advice: familiarity and practice

• Practice: Essential for developing skill in financial statement analysis.

• Become familiar with F/S’s by choosing 2-3 companies and following them on an ongoing basis:– 10K– 10Q– In the financial news

Questions?

• Sample company report outline posted on Blackboard, in Resources section.

• Follow up: monypots@cox.net