Financial Analysis.ppt

8/10/2019 Financial Analysis.ppt

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Chapter 1

What is Financial Analysis?


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Defining Financial Analysis

Financial analysis is the process of

evaluating financial and other information

for decision-making.

A six-step approach is suggested for

systematic financial analysis.


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Six-step Process

Identify purpose of financial analysis

Corporate overview

Financial analysis techniques

Detailed accounting analysis

Comprehensive analysis Decision or recommendation


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Corporate Overview

Industry analysis--key economic

characteristics, historical context, profit

drivers, business risks

Firms business strategy--competitive

strategy given the industry characteristics


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Industry Analysis

Competition--growth rates, concentrationratios, degree of product differentiation,

economies of scale (& relative fixed &variable costs), substitute products

Legal barriers--patent & copyrights,licensing, regulation

bargaining power of buyers (& suppliers) &price sensitivity


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Industry Analysis Criteria

What is the industry?

Relative size & significance

Largest companies

Geographic presence

Business cycle effects, current situation Future potential


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Business Strategy

Cost leadership: low cost producer,

economies of scale, efficient production,

low input prices

Product differentiation: specific attributes

that customers value (e.g., quality, variety,

service, delivery time), brand name Importance of core competencies


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Business Strategy Criteria

Historical perspective

Primary focus of operations

Most important strategy

Major operating segments

Corporate outlook/ forecast


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Qualitative Analysis--Dell

Computer Industryprimarily PCs: high tech, competitive (e.g.,

Gateway, IBM, Apple, others), changing products,high growth rates, low barriers of entry

Business strategy--(1) cost leadership strategy: directselling, made-to-order manufacturing, early on theinternet, low receivables; (2) product differentiation??[IBM clones, Intel & Microsoft components]

Current situationmarket share; what is the impact ofthe business cycle (e.g., PCs are durable goods)?


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Quantitative Financial Analysis

Systematic analysis of key elements based

on analysis context

Ratios, cash flows, common-size, timeseries, comparative (e.g., specific firms,

industry, all firms), models (e.g., DuPont,

Altmans) In-depth analysis for red flag items


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Financial Statements

Common-size Analysis

Financial Ratios

Growth/trend Analysis

Quarterly analysis DuPont Model

Market Analysis


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Detailed Accounting Analysis

Does accounting information capture the

underlying business reality?

Identify areas of accounting flexibility &evaluate accounting policies (choices) &

disclosures; especially notes & MD&A

Evaluate earnings management potential

Recast accounting numbers when necessary


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Comprehensive Analysis

Summarize key points: what is particularly

important for decision making?

Red flags are particularly important

Consider a written executive summary

Consider a rating scale, such as 1-10


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Decision

What is the recommendation or decision?

What is the key rationale for this decision?

[This is based on the specific decision: for

a credit decision the key factors relate to

credit risk, with particular focus on leverage

and liquidity.] Be prepared to defend this decision.


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Chapter 2

The Financial Environment


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Capital Markets

Equity Debt

Primary Initial public

offering

Bank loan,

initial debt

security offering

Secondary Buying &

selling of stocks

on securities

markets

Buying &

selling on

secondary debt

market


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Credit Decisions

Commercial banks provide short-term

commercial loans

The major concern: will the company payinterest & principal when due?

Loan terms: interest rate, collateral, debt

covenants


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Equity Investment Decisions

Public securities trade on formal market

exchanges (these are secondary markets)

Buying & selling are now relatively cheaptransactions

Mutual funds are a useful alternatives to

individual securities

Stock investing has high short-term risks


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SEC Regulation

Mission: Protect investors & maintain integrity ofthe securities markets

Established following the Great Market Crash(SEC Act of 1934)

SEC requires public registration, proxy statements& annual (10-K) and quarterly (10-Q) reports, 8-K

for specific events Update: Sarbanes-Oxley Act of 2002 & Public

Company Accounting Oversight Board; Dodd-Frank, 2010


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Goals of Financial Accounting in

a Market Economy? Capture business economics of the firm

(e.g., relationship to industry, competitive

strategy, business model). How does firmcreate value?

Reduce management discretion on financial

reporting (what is reality? Vs. misleadinginformation--analysts sort this out). Note

management incentives for earnings

management


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Accounting Regulators

Securities & Exchange Commission (SEC)--

regulates securities markets and financial

reporting (10-K, 10-Q, 8-K) Financial Accounting Standards Board (FASB)--

promulgates GAAP

International Accounting Standards Board

(IASB)issuing International Financial Reporting

Standards (IFRS)


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U.S. Standard Setters:

1938-Present Committee on Accounting Procedures (CAP)

issued 51 Accounting Research Bulletins

(ARBs)--1938-59 Accounting Principles Board (APB) issued 31Opinions--1959-73

Financial Accounting Standards Board (FASB)

has issued 168 Statements through 2009(SFASs) plus other standardsnow StandardsCodification in 4 volumes, by topic


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The FASB Structure

FASAC

Pronouncements

Due Process

FASB

Pronouncements

Due Process

GASB GASAC

FAF

Sponsoring Organizations


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The FASB

Seven member board, full time, appointed byFAF, presumed independent

Extensive due process: agenda items, discussionmemoranda (DM), exposure drafts (ED),pronouncements, public exposure with written &oral comments

Super-majority (5-2 vote) [simple majority used1977-90]

Standard setting a political process


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Annual Report Information

Corporate Overview

MD&A

Financial Statements: Balance Sheet,

Income Statement, Statement of Cash

Flows, Statement of Equity

Notes to financial statements

Auditors Opinion


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Management Incentives

Managers have incentives to present informationin the most favorable light (e.g., bonuses, stockoptions, promotions)

Accounting choice: accounting polities, estimates,additional disclosures

Standardize vs. estimates: what is reality?

Management have best information, butcommunications to investors may not becompletely credible


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Financial Statement

Considerations Managers information on economic reality

Estimation errors

Distortion from managers accounting

choices & disclosure

Question: Can investor perceptions be

manipulated?


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Finance Theory Perspectives

Efficient Markets

Random Walk

Portfolio Theory

Beta Analysis

Economic Behavior & Agency Theory

Earnings Management & Accounting

Choice


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Efficient Markets

Markets are efficient if information is

impounded immediately in capital prices in

an unbiased fashion Research supports market efficiency in the

semi-strong form, for short windows

Why?Analyst following

Note long-term anomalies & other

challenges (e.g., behavioral economics)


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Random Walk

The concept that a professional portfolio

cannot outperform a randomly selected

stock portfolio Research generally confirms this result

Consistent with efficient markets; that is, all

information has been impounded in stockprice


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Portfolio Theory

Harry Markowitz introduced the concept ofportfolio diversification with his 1952

dissertation Portfolio theory insists that investment

portfolios should be diversified to reducethe risk relative to return

Capital asset pricing model: E(Ri) = Rf+[E(Rm)Rf)


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Beta Analysis

Beta () comes directly from the slope ofthe market model: Rit= i+ iRmt+ eit

Beta measures the relationship betweenprice movements of the individual stock tomarket averages

Beta is a measure of systematic risk, wherea =1 stock should move with the market; a>1 stock has greater market risk


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Economic Behavior

Rationality: assume bounded rationality

people are intendedly rationale but limited

Self-interest behavior:Obedience

Simple self interest

Opportunism (self interest with guile--that is, willing to violate normal ethical

boundaries for personal benefit)


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Agency Theory

Contracts have a principal (e.g., owners)

and agent (e.g., managers). The principal

will attempt to maximize wealth, contract toavoid conflict, and minimize transaction

and agency costs.

Agency costs: information asymmetries(limited information by one side), adverse

selection, moral hazard (e.g., shirking).


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How to Reduce Agency Costs

Better acquisition decisions

Monitoring--including audits and financial

reporting

Align preferences of agents with principals

(e.g., debt covenants, management

compensation)--a reason for stock options

Control devises such as budgets


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Earnings Management

Operations and discretionary accountingmethods to adjust earnings to a desired

outcome, often income smoothing Underlying theory: agency theory,

transaction cost economics

Importance of efficient contracting:corporations are a network of contracts andexist because they write contracts efficiently


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Accounting Choice

Discretionary choices to optimize behavior,using techniques such as:

1. Select alternative accountingmethods (e.g., inventory) & levelof disclosure (e.g., contingencies)

2. Lobbying (e.g., on proposed

standards)3. Financial, production & investment

activities


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Discretion Under GAAP

Taking a bath

Creating hidden reserves

Off-balance-sheet financing

Overstating performance (e.g., aggressive

revenue recognition)

Not reporting obligations (contingencies,

commitments, other liabilities)


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Earnings Manipulation

Because alternatives are allowed, financial

accounting has many discretionary aspects.

Managers can manipulate income by timing (e.g.,recognition this year v next year) and

classification (e.g., ordinary v extraordinary)

Accruals can be mandatory (e.g., other post

employment benefits) or voluntary (e.g.,depreciation)


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Earnings Quality

Importance of full disclosure

Look for conservative reporting

Review indicators of high quality

Relationship of risk to earnings quality

Be aware of earnings management

incentives and evidence of earnings

manipulation


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Normalizing Income

Attempt to determine earning power--related tonormal operating earnings

Remove the noise--usually associated withnonrecurring items

Separate analysis of nonrecurring items--reorganization, big bath write-offs, changingGAAP

Evidence of earnings manipulation may requiresubstantial adjustments to arrive at normalearnings


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Financial Analysis Decision

Based on Elliotts value chain of

information: this is the $1,000 per hour

stage The purpose of financial analysis is to arrive

at an informed recommendation or decision


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Chapter 3

The Financial Statements


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Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Stockholders Equity


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Balance Sheet

Assets: probable future economic benefits

Liabilities: probable future economic

sacrifices

Stockholders Equity: residual interest,

representing ownership interest (also called

net assets)


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Assets

Current Assets (cash & cash equivalents,

short-term marketable securities), accounts

receivable, inventory, other) Property, plant & equipment

Long-term investments

Other assets


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Liabilities

Current Liabilities (accounts payable,

accrued & other current liabilities)

Long-term debt

Commitments & contingencies

Other liabilities

Potential off-balance sheet debt


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Stockholders Equity

Preferred stock

Common stock

Other paid-in capital

Retained earnings

Treasury stock

Other comprehensive income

Other equity items


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Income Statement

Revenues: inflows from major operations

Expenses: outflows from major operations

Gains & Losses: changes in equity fromperipheral activities

Net income: bottom line all operating

activities recorded on the income statement Comprehensive income: Changes in equity

from all non-owner sources


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Revenue

Sales

Services

Other revenue items

Importance of revenue recognition criteria


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Operating Expenses

Cost of goods sold (manufacturing)

Cost of sales (services or services included)

Operating expenses (selling, general &

administrative, research & development,

other)

Interest income & expenses & related

Provision for tax


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Non-recurring Items

Extraordinary items

Discontinued operations

Accounting changes

Other non-recurring items

Other gains & losses


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Earnings Measures

Gross profit

Operating income

Income before tax

Income from continuing operations

Net income

Comprehensive income


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Cash Flow Statement

Cash Flows from Operations

Cash Flows from Investing Activities

Cash Flows from Financial Activities

Statement of Stockholders Equity


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Cash From Operations

Net income

Depreciation & amortization

Other operating adjustments

Changes in non-cash working capital items


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Cash From Investing &

Financing Cash from investing

Investment purchases

Investment maturities & sales

Capital expenditures

Cash from financing

Issuance of equity

Purchase/acquisition of equity

New debtDebt maturities or retirement

Dividends

Treasury Stock


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Statement of Stockholders

Equity Reconciliation of stockholders equity,

alternative formats used

Key categories (changes)Common stock, other paid-in capital

Retained earnings

Treasury stockOther comprehensive income


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Chapter 4


Using Financial Statement

Information


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Systematic analysis of key elements based

on analysis context

Quantitative techniques to standardizefinancial information for relevant

comparisons

In-depth analysis for key factors, includingred flags


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Financial Ratios

Growth Analysis

Du Pont Model

Earnings Quality/Normalizing Earnings


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Useful Financial Comparisons

Benchmarks: rules of thumb or averages

Common Sense

Trend Analysis (analysis over time)

Near Competitors

Industry Averages

Market Averages


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Overview vs. detail

Balance sheet: total assets = 100%

Income Statement: sales (or total revenues)= 100%

Comparisons over time & across firms (or

industry averages)

Useful starting point for financial overview


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Ratio Analysis

A ratio converts financial information to apercentage, one approach to standardization

Each ratios provides a somewhat different analysis

Ratios overlapa problem in one area shouldshow up as problems in other areas

The importance of specific ratios differs, based on

the purpose of the financial analysis Ratios for the most recent period are usually the

most important


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Ratio Categories

Liquiditycash, working capital & cash

flow related

Activityturnover ratios as possibleefficiency measures

Leveragedebt & solvency analysis

Performance (or profitability)bottom lineor earnings related


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Liquidity Ratios

Current ratio: current assets/currentliabilities

Quick (acid test) ratio: (cash+marketablesecurities+net receivables)/current liabilities

Cash ratio: (cash+marketablesecurities)/current liabilities

Operating ratio: cash flows fromoperations/current liabilities


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Leverage Ratios

Debt to equity ratio: total liabilities/total stockholdersequity

Debt ratio: total liabilities/total assets

Interest coverage: (income before tax +interestexpense)/interest expense [note that the numerator isearnings before interest and taxes or EBIT]*

Long-term debt to equity: long-term liabilities/totalstockholders equity

Debt to market equity: total liabilities at book value/totalequity at market value

*alternatively: (income from continuing operations+ interest expense + tax expense)/interest expense


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Activity Ratios

Inventory turnover: cost of sales [orCOGS]/average inventory

Receivables turnover: sales/average accounts

receivable Payables turnover: sales/average accounts payable

Working capital turnover: sales/average workingcapital

Fixed asset turnover: sales/average property, plant& equipment

Total asset turnover: sales/average total assets


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Activity Ratios in Days

Average days inventory in stock:365/inventory turnover

Average days receivables outstanding:365/receivables turnover

Average days payable outstanding:365/payables turnover

Length of operating cycle: average daysinventory + average days receivables


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Profitability

Gross margin: (Sales-cost of sales)/sales

Return on sales: net income/sales

Return on assets: net income/average total assets

Pretax return on assets: earnings before interest &taxes/average total assets

Return on total equity: net income/average

stockholders equity Dividend payout: common dividends/net income

[per share basis: dividends per share / EPS]


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Du Pont Model

ROE = Profitability x Activity x Solvency

Net Income / Average Common Equity =

(Net Income / Sales) x (Sales / AverageTotal Assets) x (Average Total Assets /

Average Common Equity)

ROA = Profitability x Activity


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Decomposition using Du Pont

Start with Return on Sales

Activity is avg. total asset ratiothis is a measure of assetturnover or efficiency

ROS x ATAR is Return on Assets (calculate as net income/ average total assets)

Solvency is ATA / Avgas. Common Equitythis is astandard leverage ratio

ROA x Solvency is Return on Equity (calculate as netincome / average common equity)

In summary, the differences between ROS, ROA & ROEdepend on activity & solvency


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Du Pont Model

Ratio

Profit (Return on Sales)

Activity (AssetTurnover)

Return on Assets

Solvency (Common

Equity Leverage)

Return on Equity

Calculation

Net Income/Sales

Sales/Avg. Total Assets(ATA)

Net Income/ATA

ATA/Average Common

Equity (ACE)

Net Income/ ACE


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Ratio Analysis Limitations

Ratios are presented on a percentage basis

Relative size is ignored (e.g., both large &

small firms can be compared) It is assumed that all numbers used are

correct (consider both possible errors andearnings management)

If the numbers are not reliable, ratios are notparticularly useful


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Rating the PC Companies

Dell Gateway Apple

Liquidity 4 5 8

Activity 9 6 8

Leverage 6 6 8

Perform. 6 1 RF 2 RF

Du Pont 6 1 RF 2 RF

Overall 6 2 RF 4


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Chapter 5

Multiperiod Quantitative Financial

Analysis


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Growth Analysis

(period-by-period change) Long-term trends over time can be significant. Are

current year performance measures consistent withearlier years (e.g., maintaining consistent ratios

while sales are rising smoothly)? As a first step, present growth rates (including %

increases) for the last 5-10 years

Declining or negative growth rates might beobvious red flags; Red flags and other indicatorsof poor growth performance require furtheranalysis


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Base-Year Analysis

(also called Trend Analysis) Set the earliest year, evaluated as the base

year, at 100. [Note: this assumes that

earliest year is normal.] Calculate growthby dividing the more current year numbers

by the base year number.

This is an alternative presentation to growthrate percentages over 5-10 years (or more)


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Quarterly Analysis

The most recent financial data is presentedquarterly (e.g., 10-Q). [The one exception is atyear end, with annual information is presented]

Financial analysts focus on quarterly data and thequarterly earnings announcement is the mostimportant (& earliest) information

Common-size and ratios analysis is conducted,and compared over earlier quarters: particularlyimportant are current quarter data to (1) the

previous quarter and (2) the same quarter one yearago


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Chapter 6


Techniques: Incorporating Market

Information


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Quantitative Market Analysis

Stock prices & stock charts

Earnings per shareactual & forecast

Price earnings ratios (PE)

Dividend yield

Market value & market-to-book

Price earnings to growth ratios (PEG)

Valuation models


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Stock Prices

Prices change continuously

Using daily closing price

Stock charts, various periods

Industry & market comparisons

Internet sites


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Earnings Per Share (EPS)

Performance measure on per share basis

Basic vs. diluted

Forecasted EPS (Analysts Estimates onYahoo)

Annual vs. quarterly EPS

Annuallast 4 quarters

5 year forecasts (relevance vs. reliability)


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PE Ratios

Stock price as a market premium forearnings

Which price? (most current, historic) Which EPS? (current year actual--usually

last 4 quarters, future forecast, basic vs.diluted)

Closing prices

Alternatives & how to evaluate them


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Market-based Ratios

Price earnings ratio (PE): Stock price / EPS

Dividend Yield: Dividend per share / Stock

price Market value: stock price x shares

outstanding

Market-to-book: market value /stockholders equity


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Dividends

Dividends given on a per share basis; focus on

dividends per share, last 4 quarters. [Note

equivalent to dividends/shares outstanding.]

Dividend yield: dividends per share/stock price

income focus; average yield is about 2% for the

S&P 500.

Dividend payout: dividends per share/earnings pershare.


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Market-related Ratios

Market-to-book: market value / stockholders

equity [or measure on a per share basisstock

price / book value per share]why is a market

premium to book common?

Sales to market value: annual sales to

outstanding shares x (1) year-end closing market

price or (2) most recent closing market price.


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Price Earnings to Growth (PEG)

High PE is usually associated with the expectationof high earnings growth, which can be evaluatedwith PEG

Historic PEG = PE based on actual EPS / 5-yearhistoric earnings growth

Forecast PEG = PE based on forecast EPS / 5-year earnings forecast

PEG is useful to evaluate growth stocks, lessuseful for income stocks


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Earnings-based Growth Model

P = kE / (rg) where P is expected stock price,

k is dividend payout rate (actual or predicted), E is

EPS, r is the discount rate, and g the projected

earnings growth rate

This model requires dividends, the discount rate is

arbitrary (it could be the actual cost of capitalor

based something else), and the growth rate is aforecast; results can change substantially using

different assumptions


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Stock Screening

The purpose of stock screening is thedetermine which firms meet specific criteria(such as minimum ROE or dividend yield)

Several internet sites have stock screeners,such as Yahoo

The technique is useful to limit the number

of companies on which to conduct acomplete financial analysis


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Chapter 11

Capital Structure & Credit Risk


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Corporate Liabilities

Accounts Payable

Commercial Paper & other short-term

market liabilities Other current liabilities

Corporate Bonds

Other long-term market debt

Other liabilities (including off-balance-

sheet)


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Credit Risk

Credit risk: probability that a corporation

will either default on debt or declare

bankruptcy.Default risk: probability that a

corporation will not pay interest &

principal when they come due

Bankruptcy risk: probability that a

corporation will file for bankruptcy


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Default Risk

What is the chance (probability) that the

corporation will fail to make interest or principal

payments when due?

Because of high collection costs, creditors

evaluate credit risk carefully

Failure events: restructurings, especially troubled

debt restructuring; default; bond rating down-grading; going-concern qualifications; bankruptcy


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Bankruptcy Risk

Probability that a firm will file for Chapter

11 bankruptcy.

Importance of failure events: losses,defaults, troubled debt restructuring, going

concern qualified audit opinion

Altmans Z-score can be used as aprediction model for credit risk


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Financial Leverage

Financial leverage is the relative mix of debt (especiallylong-term debt) & equity

Long-term debt increases credit risk & has interest charges

The financial leverage index (FLI) is ROE/ROA A high FLI indicates the increasing use of leverage to raise

ROE relative to ROA

The financial structure leverage ratio (FSLR) is average totalassets/average common equity. This is the same ratio used in

the DuPont Model for solvency. A higher ratio means higherleverage, but also a higher ROE. The ratio is identical to FL1if there is no preferred stock. When preferred stock ispresent, the FSLR is higher than FLI.


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Altmans Z-score, 1983 Model

6.56 x (working capital / total assets)

+ 3.26 x (retained earnings / total assets)

+ 6.72 x (EBIT / total assets)

+ 1.05 x (book value of equity / book value

of debt)

= Altmans Z-score


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Altmans Z-score

Indicator of overall financial health

Cutoffs: les than 1.1 bankrupt

1.12.6 gray areagreater than 2.6 healthy

A Z-score of 1.1 or less does not mean the

company is bankrupt, but does suggest thatfinancial problems may exist


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Bond Ratings

Bond rating agencies include Standard &Poors & Moodys

Corporations are expected to haveinvestment grade ratings, Baa and above(for Moodys)

Bond ratings below investment grade are

junk bonds, which is usually recognized asa red flag


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Bond Ratings

S & P Moodys Category

Highest AAA Aaa Investment

Very High AA Aa InvestmentHigh Qual. A A Investment

High Qual. BBB Baa Investment

Speculative BB Ba BelowSpeculative B B Below

Speculative CCC Caa Below

Speculative D C Below


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Chapter 12

Credit Analysis


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Credit Analysis Process

Loan Purpose

Corporate Overview

Financial Analysis

Accounting Analysis


Loan Decision


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Loan Purpose

Commercial Bank Loan:

term loan

revolving line of creditother

Commercial Paper

Corporate Bonds


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Corporate Overview

Wide variety of firms need bank loans

Size characteristicslocal or regional to

national & global Industry specializations, including impact

on bank credit risk

Large companies have more credit options


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Primary focus is on financial report

analysis, with less emphasis on market

information Particular interest in liquidity & leverage

Evidence of financial health (as measured

by credit risk) rather than earningsperformance & forecasts


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Accounting Analysis

Emphasis on liquidity & cash flow

information

Analysis of unrecorded obligations &potential overstated assets

Forecasts of sales & operations plus future

cash flows


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Summary of key information (executive

summary recommended)

Importance of credit risk Adequate information to make informed

recommendations/decisions


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Loan Decisions

Yes/ No on loan

What interest rate (prime rate +)?

What collateral? What Debt covenants?

Other considerations (e.g., compensating

balances)


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Chapter 13Equity Investment Analysis


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Investment Portfolio

Importance of Portfolio Diversification

Based on Investor Goals

Short-term, liquidity focus Mid-term, return but limited risk focus

Long-term, return focus


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Mutual Funds

Investment portfolios managed by

professionals & regulated by the SEC

Advantages: diversification, professionalmanagement, liquidity, small investment

Disadvantages: Fees, average returns less

than expected, lack of control overinvestments, taxes


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Mutual Fund Categories

Money Market Funds

Bond

Stock: growth, income, value, assetallocation, international, sector, regional

Balanced

Real estate, usually REITs


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Gotrocks Funds

Growth Fund: maximize long-term market appreciationusing large-cap stocks (focus on earnings & earningsgrowth potential)

Income Fund: maximize intermediate- & long-term incomeusing bonds and large-cap stock that pay high dividends (+total return as a secondary goal)

Value Fund: invest in large-cap stocks that out of favorrequires evidence of substantial stock price drop &

ongoing restructuring (usually low market-to-book)


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Investment Strategies

Buy & hold

Index funds

Dollar-cost averaging Risk measures, such as Beta analysis

Asset allocation decisions; e.g., % of cash,

bonds & stocks


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Six-step Analysis

Investment purpose

Corporate overview

Quantitative financial & market analysis Detailed accounting analysis

Comprehensive analysis

Recommendation or decision


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Investment Purpose

Short-term (stressing liquidity & low risk)

Long-term (e.g., retirementstressing long-

term return, willing to accept more risk) Using market averages such as the Dow Jones

Industrial Average

Utilities may fit income funds because of high

dividend yields

High tech firms may fit growth funds


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Decisions

Decisions: buy, sell, hold (& how much?)

Different important characteristics based on

investment goals:Income Investment: importance of

dividend yield

Growth fund: importance of profit &

earnings growth forecastValues funds: importance of bargain

Documents

Financial Analysis.ppt