Introduction to Financial Statement Analysis P.V.

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Introduction to Financial Statement Analysis P.V.

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Introduction to Financial Statement Analysis P.V. Viswanath P.V. Viswanath 2 Functions of Financial Statements They provide information to the owners and creditors of the firm about the companys current status and past financial

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Introduction to Financial Statement Analysis P.V. Viswanath

P.V. Viswanath 2 Functions of Financial Statements They provide information to the owners and creditors of the firm about the company’s current status and past financial performance
Financial statements provide a convenient way for owners and creditors to set performance targets and to impose restrictions on the managers of the firm.
Financial statements provide convenient templates for financial planning.

P.V. Viswanath 3 The Balance Sheet The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time
Assets are listed in order of liquidity, i.e. ease of conversion to cash without significant loss of value
Liabilities are listed in order of time to maturity

Assets Assets are divided into current assets and long-term assets. Current assets are:
Cash and marketable securities
Accounts receivable
Inventories
Other current assets, such as prepaid expenses
Long-term assets include net property, plant and equipment (net PP&E).
This consists of the original cost of PP&E reduced each year by an amount called depreciation that is intended to account for wear-and-tear and obsolescence. P.V. Viswanath 4

Assets When a firm acquires another firm, it will acquire a set of assets that must be listed on its balance sheet. Often it will pay more for these assets than their book value on the acquired firm’s balance sheet.
The difference is listed as goodwill.
Trade-marks, patents and other such assets, along with goodwill are called intangible assets.
If their value decreases over time, they will be reduced by an amortization charge.
Amortization, like depreciation is not a cash expense. P.V. Viswanath 5

Liabilities Liabilities are divided into current and long-term liabilities.
Liabilities that will be satisfied in one year are known as current, and include:
Accounts payable,
Notes payable, short-term debt and all repayments of debt that will occur within the year.
Items such as salary or taxes that are owed but have not yet been paid.
The difference between current assets and current liabilities is known as (net) working capital. P.V. Viswanath 6

Long-term liabilities Long-term debt is any loan or debt obligation with a maturity of more than one year.
Capital leases are long-term lease contracts that obligate the firm to make regular payments in exchange for the use of an asset.
Deferred taxes are taxes that are owed but not yet paid. Firms keep two sets of books – one for financial reporting and one for tax purposes. Deferred tax liabilities arise when the firm’s financial income exceeds its income for tax purposes. If a firm depreciates assets faster for tax purposes than for reporting purposes, its tax paid will be less than tax due according to reported income. Hence it will look as if the firm has not paid taxes that it owes.
Over time, the discrepancy will disappear and the tax due will be “paid.” Hence deferred tax is recorded as a liability. P.V. Viswanath 7

Stockholder’s Equity The sum of current liabilities and long-term liabilities is total liabilities. The difference between the firm’s asset and its liabilities is Stockholders’ Equity or the book value of equity.
This number often does not provide us with an accurate assessment of the firm’s equity because book values are based on historical quantities and not on market values.
The market price of a share times shares outstanding is called market capitalization; this reflects what investors expect the firms assets to produce in the future that can be distributed to shareholders. P.V. Viswanath 8

P.V. Viswanath 9 Market Value vs. Book Value Example
According to Generally Accepted Accounting Principles (GAAP), your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.
Q: What is the market value of your assets?

A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.

P.V. Viswanath 10 Market Value vs. Book Value Example
Book Value Balance Sheet
Assets = $10 bil Debt = $4 bil
Equity = $6 bil

P.V. Viswanath 11 The Balance Sheet Identity

P.V. Viswanath 12 Pepsico Inc. Balance Sheet (in mil. $)

P.V. Viswanath 13 Income Statement The income statement is like a video of the firm’s operations for a specified period of time.
You report revenues first and then deduct any expenses for the period.
Matching principle – GAAP requires the income statement to show revenue when it accrues and match the expenses required to generate the revenue.

Earnings Calculations Gross Profit
The difference between sales revenues and the costs incurred to make and sell the products.
Operating Expenses
Expenses in the ordinary course of running the business, but not directly related to producing the goods; includes administrative expenses, marketing expenses, R&D
Earnings before Interest and Taxes (EBIT)
Includes other sources of income or expenses that arise from activities that are not the central part of the business, e.g. investment income.
Pretax Income and Net Income (NI)
From EBIT, we deduct interest paid and corporate taxes to determine Net Income.
EPS = NI/Shares Outstanding P.V. Viswanath 14

P.V. Viswanath 15 Income Statement Pepsico Inc. (in mil. $)

P.V. Viswanath 16 Accounting vs Economic Measures of Income The return to a stockholder of investing in a stock is simply the rate of return on his investment:

Accountants often measure corporate performance using the return on equity (ROE):

A big difference between the two is that the ROE does not incorporate the impact on the share price of future expected superior (or inferior) returns

P.V. Viswanath 17 Ratio Analysis Ratios also allow for better comparison through time or between companies
As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important
Ratios are used both internally and externally

P.V. Viswanath 18 Categories of Financial Ratios Liquidity ratios
Short-term solvency or how easily the firm can lay its hands on cash.
Financial leverage ratios
Show long-term solvency; how heavily the firm is in debt.
Efficiency or turnover ratios
Indicate how productively the firm is using its assets
Profitability ratios
Used to measure the firm’s return on its investments
Market value ratios

P.V. Viswanath 19 Computing Profitability Measures Profit Margin = Net Income / Sales
3313/ 25112 = 0.1319 times or 13.19%
Operating Profit Margin = (Operating Income) / Sales
(4954) / 25112 = 0.1973 times or 19.73%
Return on Assets (ROA) = (Net Income) / Av TA
(3313) / [(23474+21695)/2] = 0.1467 times or 14.67%
Return on Equity (ROE) = Net Income / Average Equity
3313 / [(9298+8674)/2] = 0.3687 times or 36.87%

P.V. Viswanath 20 Computing Leverage Ratios for 2002 Total Debt Ratio = (Total Debt) / TA
Total debt, here, is usually interpreted to mean all debt-like obligations, which is effectively total liabilities
(14176) / 23,474 = .6039 times or 60.39%
The firm finances almost 60% of their assets with debt.
Debt/Equity = Tot Debt / Tot Eq
14,176 / 9,298 = 1.5246 times
These numbers can also be computed for long-term debt (i.e. long-term liabilities):
Long Term Debt Ratio = LT Debt/ Total Assets = (2,187 + 5,937)/ 23,474 = 0.3461
Long Term Debt/Equity = (2,187 + 5,937)/9,298 = 0.87375

P.V. Viswanath 21 Computing Coverage Ratios Determinants of the riskiness of a firm’s debt

Times Interest Earned = EBIT / Interest
(4868 + 178) / 178 = 28.35 times
Cash Flow Coverage = (EBIT + Depreciation) / Interest
(4868 + 178 + 1112) / 178 = 34.60 times

P.V. Viswanath 22 Computing Liquidity Ratios Current Ratio = CA / CL
6413 /6052 = 1.06 times
Quick Ratio = (CA – Inventory) / CL
(6413 – 1342) / 6052 = 0.838 times
Cash Ratio = Cash / CL
1,638 / 6,052 = .276 times
Net Working Capital to TA Ratio = NWC/TA
(6413-6052)/ 23474 = 0.154

P.V. Viswanath 23 Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Average Inventory
10523 / [(1342+1310)/2] = 7.94 times
Days’ Sales in Inventory = 365 / Inventory Turnover = Av Inv/(COGS/365)
365 / 7.94 = 45.99 days
When you have ratios with Income Statement numbers in the numerator and Balance Sheet numbers in the denominator, use average of year beginning and year end quantities.

P.V. Viswanath 24 Computing Receivables Ratios Receivables Turnover = Sales / Av Accounts Receivable
25112 / [(2531+2142)/2] = 10.75 times
Average Collection Period = Days’ Sales in Receivables = 365 / Receivables Turnover = Av Receiv/ (Av Sales)
365 / 10.75 = 33.96 days

P.V. Viswanath 25 Computing Total Asset Turnover Total Asset Turnover = Sales / Av Total Assets
25112 / [(23474+21695)/2] = 1.11 times
Measure of asset use efficiency
Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets.
What is a reasonable value for TAT will depend on the industry in question

P.V. Viswanath 26 Computing Market Value Measures Market Price (end of 2002) = $42.22 per share
Shares outstanding = 1753 million
P/E Ratio = Price per share / Earnings per share
42.22 / 1.89 = 22.34 times
Market-to-book ratio = mkt value per share / book value per share
42.22 / (9298 / 1753) = 7.96 times
Enterprise Value
The value of the underlying business assets – computed as Mkt Value of Equity + Debt – Cash = 42.22(1,753) + 14,176 - 1,638 = 86,549.66m.
This can be interpreted as the cost to take over the entire business.

P.V. Viswanath 27 Payout and Retention Ratios Dividend payout ratio = Cash dividends / Net income
Cash dividend equals common dividend + preferred divs
1041 / 3313 = .3142 or 31.42%
Plowback ratio = Retention ratio = 1 – payout ratio
1 – 0.3142 = 0.6858 = 68.58%

P.V. Viswanath 28 Benchmarking Ratios are not very helpful by themselves; they need to be compared to something
Time-Trend Analysis
Used to see how the firm’s performance is changing through time
Internal and external uses
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes

P.V. Viswanath 29 Standardized Financial Statements Common-Size Balance Sheets
Compute all accounts as a percent of total assets
Common-Size Income Statements
Compute all line items as a percent of sales
Standardized statements make it easier to compare financial information, particularly as the company grows
They are also useful for comparing companies of different sizes, particularly within the same industry

P.V. Viswanath 30 Statement of Cashflows A firm’s cashflows can be quite different from its net income. For example:
The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Those expenses are spread over time as a deduction for depreciation.
The income statement recognizes revenues and expenses when sales are made, even though the money may not have been collected (revenues) or paid out (expenses).

P.V. Viswanath 31 The Statement of Cashflows The statement of cashflows shows the firm’s cash inflows and outflows from
Operations
Investments and
Financing
The form of this statement is determined by accounting standards.

P.V. Viswanath 32 Statement of Cash Flows:Operating Activities Operating activities are earnings-related activities. Generally these relate to Income Statement activities, and items included in working capital. Included are:
Sales and expenses necessary to obtain sales
Related operating activities, such as extending credit to customers
investing in inventories
obtaining credit from suppliers
payment of taxes
insurance payments
Other activities that don't easily fit into the other two categories, such as settlements in lawsuits.

P.V. Viswanath 33 Statement of Cash Flows:Investing and Financing Activities Investing activities relate to the acquisition and disposal of noncash assets: assets which are expected to generate income for the company over a period of time. These include lending funds and collecting on these loans.
Financing activities relate to the contribution, withdrawing and servicing of funds to support business activities.

P.V. Viswanath 34 Pepsico Inc. (in mil. $)Statement of Cash Flows 2002

P.V. Viswanath 35 Notes to Financial Statements The Notes to the Financial Statements are frequently very useful in assessing the financial health of the firm. They often contain:
An explanation of accounting methods used
Straight-line versus accelerated depreciation
LIFO vs FIFO
Restatement of results from prior years using the new standards
Greater details regarding certain assets and liabilities
Conditions and expiration dates of long- and short-term debt, leases, etc.

P.V. Viswanath 36 Notes to Financial Statements Information regarding the equity structure of the firm
Conditions attached to the ownership of shares; these can be particularly useful to assess the firm’s vulnerability to takeovers.
Documentation of changes in operations
Acquisitions and Divestitures and their impact
Off-balance sheet items
Forward contracts, swaps, options and other derivative contracts, which do not appear in the balance sheet, but which can affect a firm greatly. A lot of Enron’s problems had to do with such off-balance sheet items.

P.V. Viswanath 37 Determinants of Growth Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

P.V. Viswanath 38 The Du Pont Identity ROA = NI/ TA
ROA = (NI/ Sales)*(Sales / TA)
ROA = (Net Profit Margin)*(Asset Turnover)
ROE = NI / TE
ROE = (NI/Sales)*(Sales/TA)*(TA/TE)
= Net Profit Margin*Asset Turnover*Equity Multiplier
Net Profit margin is a measure of the firm’s operating efficiency – how well it controls costs
Total asset turnover is a measure of the firm’s asset use efficiency – how well it manages its assets
Equity multiplier is a measure of the firm’s financial leverage

P.V. Viswanath 39 Determinants of Earnings Growth Rate Earnings in any period depends on the investment base, as well as the rate of return that the firm earns on that investment base:
Et+1 = (TEt)ROE
= (TEt-1 + DTEt)(ROE), where DTEt is the increment in total equity in period t over and above that in period t-1.
= (TEt-1)ROE + (DTEt)(ROE)
= Et + (DTEt)(ROE);
Hence Et+1 - Et = (DTEt)(ROE)
Dividing both sides by Et , we get gt = (DTEt/Et)(ROE)
We have assumed that ROE does not change, i.e. that the debt-equity ratio will be kept constant, as we can see from the DuPont identity.
Hence debt must be increased and equity decreased in such a way as to keep the debt ratio constant, assuming that the assets side of the business maintains a constant profitability.

P.V. Viswanath 40 Sustainable Growth The sustainable growth rate tells us how fast the firm can grow, without increasing financial leverage and without any additional outside equity.
We have already seen that gt = (DTEt/Et)(ROE)
If only internal funds are used, then DTEt is simply retained earnings.
Hence, sustainable growth rate (of earnings) = retention ratio x ROE
0.6858 x 0.3687 = 0.2528 or 25.28%
If the firm can continue to earn 36.87% on its equity and can plow back 68.58% of earnings into operations, its earnings and equity should both grow at 25.28% p.a.
As discussed above, ROE is assumed to be constant, i.e. that the debt-equity ratio will be kept constant.
However, if the firm will not have access to new debt financing, the business can only grow at a lower rate.

P.V. Viswanath 41 Internal Growth Rate 0.2169 x (9298+8674) /(23474+21695) = 0.2528 x 0.3979 = 0.1006 or 10.06% The rate at which the business as a whole, i.e. the total assets of the firm can grow without additional external financing is called the internal growth rate.

P.V. Viswanath 42 Questions we would like answered… As financial analysts… However, the information we have comes from the firm’s financial statements which are generally prepared by accountants…

P.V. Viswanath 43 The Accountant’s Balance Sheet This is what we can see from the firm’s balance sheet…

Growth Assets In a financial balance sheet, we are much less concerned with recording what a firm paid for what it owns and much more concerned about how much it is worth and how the nature of the asset affects the firm’s decision-making and risk.
There is therefore a greater emphasis on growth assets and the market values of equity and debt.
Growth assets represent the capitalized value of net cashflows to be generated from assets that the firm does not currently own, but has the ability to acquire and/or is expected to acquire.
Thus a firm might have the capabilities to expand --whether such capabilities represent organic growth or inorganic growth (through mergers). The NPV from such future growth – to the extent the market recognizes it – is already included in the market value of a firm and should be recognized in the financial balance sheet as an asset. P.V. Viswanath 44

Growth Assets The characterization of an asset as a growth asset is important for several reasons:
One, the valuation of the firm is incomplete without the inclusion of such assets. Valuation of such assets may also require option techniques as opposed to simply expected cashflow methods.
Two, growth assets represent future discretionary expenditure and represent a higher level of risk for the investor – furthermore, such risk can be asymmetric; growth assets may have a higher upside beta than the corresponding downside beta (since the firm does not own the asset, it can decide to forgo the option to acquire it in bad states of the economy).
Two, growth assets are more susceptible to agency costs of debt and must be financed by equity P.V. Viswanath 45

P.V. Viswanath 46 Desirable Modifications to Income Statement In addition to the failure to inclued growth assets, there are a few expenses that are consistently mis-categorized in financial statements. In particular,
Operating leases are considered as operating expenses by accountants but they are really, partly, financial expenses
R&D expenses are considered as operating expenses by accountants but they are really capital expenses.
The degree of discretion granted to firms on revenue recognition and extraordinary items is used to manage earnings and provide misleading pictures of profitability.

P.V. Viswanath 47 Dealing with Operating Leases A Lease is a long-term rental agreement
Leases can either be capital leases or operating leases
A capital lease is often for as long as the life of the equipment, or there may be an option for the lessee to buy the equipment at the end of the contract period. Capital leases have to be capitalized and shown on the balance sheet.
In an operating lease, typically, the contract period is shorter than the life of the equipment, and the lessor pays all maintenance and servicing costs. Operating leases do not have to be shown on the balance sheet.However, operating leases also represent expected fixed periodic payments, and thus function similar to debt. As such, a financial analyst would want to see operating leases capitalized as well

P.V. Viswanath 48 Dealing with Operating Lease Expenses How do we do this?
First, we compute the “debt” value of the operating lease as the PV of the operating lease expenses, using the pre-tax cost of debt as the discount rate. This now creates an asset - the value of which is equal to the debt value of operating leases. This asset now has to be depreciated over time.

Second, the operating income has to be adjusted to reflect these changes.

P.V. Viswanath 49 Dealing with Operating Leases: Adjusting Operating Income Note that the operating lease expense has two components
an operating expense component, i.e. the reduction in the value of the asset being used, represented by the depreciation, and
a financing component, i.e. the cost of financing the asset.
Using this model, we assume that Interest expense on the debt created by converting operating leases = Operating lease expense - Depreciation on asset created by operating lease. Then, Adjusted Operating Income = Operating Income - Depreciation on operating lease asset + operating lease expenses = Operating Income + Imputed Interest expense on operating leases. = Operating Income + Debt value of Operating leases x Cost of debt

P.V. Viswanath 50 Example: Capitalizing Operating Leases at Maxwell Shoe From the 10-K filing made by the company with the SEC on 1/29/2001:
The Company leases equipment and office and warehouse space under long-term non-cancelable operating leases which expire at various dates through January 31, 2007. At October 31, 2000, future minimum payments under such leases were as given below (in ‘000s). Minimum payments are capitalized using an assumed pre-tax cost of debt of 7% p.a. This will be the value of the Lease Asset/Liability on the Oct. 31, 2000 balance sheet. Later years refer to 2006 and 2007.

P.V. Viswanath 51 Example: Capitalizing Operating Leases at Maxwell Shoe I assume that payments are made at the end of the fiscal year, ending in October.
Since the figure for "Later Years," $750, is larger than the declining sequence of amounts for previous years, I assume that this reflects the amounts for both 2006 and 2007.
Since the leases expire in January 2007, which is 3 months past the fiscal year end, I have prorated the amounts for 2006 and 2007, viz. $600 for 2006 (payable at the end of October 2006) and $150 for 2007 (payable at the end of January 2007).
Hence the $498.08 computed as the present value for the row “Later Years” equals 600/(1.07)6 + 150/(1.07)6.25.
The present value of the minimum payments (as of Oct. 31, 2000) works out to $4441.38.

P.V. Viswanath 52 Imputed Interest Expenses on Operating Leases Adjusted Operating Income = Operating Income + Imputed Interest Payment
= $13,489 + $357.55 = $13,846.55
Net Income is not affected because the imputed interest expense will be subtracted from Operating Income, just as any other interest expense would be. Lease payments in 2000 were $1024. Hence the PV of operating leases as of end 1999 would be (PV of Op. Leases as of end 2000 + Lease expenses for 2000)/1.07 = (4441.38+1024)/1.07 = $5107.83.
The imputed interest expense is the Debt Value of Operating Leases x Interest rate.

P.V. Viswanath 53 The Effects of Capitalizing Operating Leases Debt: will increase, leading to an increase in debt ratios used in the cost of capital and levered beta calculation
Operating income: will increase, since operating income will now be before the imputed interest on the operating lease expense
Net income: will be unaffected since it is after both operating and financial expenses anyway
Return on Capital will generally decrease since the increase in operating income will be proportionately lower than the increase in book capital invested

P.V. Viswanath 54 R&D Expenses: Operating or Capital Expenses Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. It is more logical to treat it as capital expenditures.
An approach to capitalizing R&D (cost-based),
Specify an amortizable life for R&D (2 - 10 years)
Collect past R&D expenses for as long as the amortizable life
Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5th of the R&D expense from four years ago, 2/5th of the R&D expense from four years ago...:

P.V. Viswanath 55 Capitalizing R&D Expenses: Boeing Assuming a ten year life; thus, R&D expenses for 1998 will be amortized over the 1999-2008 period.

P.V. Viswanath 56 Boeing’s Corrected Operating Income For 1998 * Data obtained from Income Statement
** Data obtained from Income Statement; see also previous slide
In principle, it could be argued that R&D capitalized values should be restated in 1998 dollars, instead of using the raw unamortized portions of R&D outlays in past years; however, the current procedure may be defended on the grounds of conservatism.

P.V. Viswanath 57 Boeing’s Corrected Balance Sheet There will be the following modifications on the balance sheet:
There will be a new asset, R&D, that will show on the assets side. If one wants to show the gross value of R&D and accumulated amortization, however, that will require computation of the amortization in each year for as many years as the amortizable life of the R&D.
Corresponding to that, the value of stockholder’s equity will be higher by the same amount.
In our example, this amount will be $9,100.

P.V. Viswanath 58 The Effect of Capitalizing R&D Operating Income will generally increase, though it depends upon whether R&D is growing or not. If it is flat, there will be no effect since the amortization will offset the R&D added back. The faster R&D is growing the more operating income will increase.
Net income will increase proportionately, depending again upon how fast R&D is growing. Adjusted Net Income will also have to take the tax deductibility of R&D into account.
Book value of equity (and capital) will increase by the capitalized Research asset
Capital expenditures will increase by the amount of R&D; Depreciation will increase by the amortization of the research asset; for all firms, the net cap ex will increase by the same amount as the after-tax operating income.

Introduction to Financial Statement Analysis P.V.

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