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Why Financial Statements Analysis? “You” may be an investor a creditor a supplier a customer an employee the manager a competitor an auditor a government agency Will you rely on pure hunches and guesses? Or, Educated analysis model! The Investment Environment The Money Market

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Why Financial Statements Analysis?

  • “You” may be

    • an investor

    • a creditor

    • a supplier

    • a customer

    • an employee

    • the manager

    • a competitor

    • an auditor

    • a government agency

  • Will you rely on pure hunches and guesses? Or,

Educated analysis model!


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The Investment Environment

  • The Money Market

    • treasury bills, certificate of deposit, commercial paper, etc.

  • The Fixed-Income Capital Market

    • treasury notes and bonds, municipal bonds, corporate bonds, etc.

  • The Capital Market

    • common stock, preferred stock

  • The Derivative Market

    • options, futures


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The Major Stock Market in the U.S.

  • The New York Stock Exchange (NYSE)

    • Largest stock exchange: About 3,025 companies or $16 trillion in market value (July 1999)

    • 382 non-U.S. companies (July 1999)

  • The American Stock Exchange (AMEX)

    • Listing of smaller and younger firms

  • The Over-the-Counter National Association of Securities Dealers Automated Quotation (NASDAQ)

    • Trade through computer-linked network

    • Include: Nasdaq National Market (4,400 securities) and Nasdaq SmallCap Market (1,800 securities)


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ACC 6213Financial Statements and Analysis

  • Objectives

    • Discuss a framework for conducting business analysis with a focus on the role of financial information

    • Learn how to apply the framework for security valuation and risk analysis

    • Learn to retrieve market and financial data


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Textbook and Related Materials

  • Palepu, Healy and Bernard, “Business Analysis & Valuation: Using Financial Statements”, Text and Cases, 2nd ed., 2000

  • Dell’s 10-K for fiscal year 1999

  • Computer skills:

    • Research, retrieve and download data from internet

    • Excel or any other spreadsheet program


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Course Requirements

  • Course Outline

  • Individual Assignments

    • 30%

  • Team Project

    • 50%

  • Participation

    • 20%

  • Grade: Expected distribution: 40-50% A’s,

    20-30% B’s, rest C’s


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Individual Assignments

  • Discussion allowed, but no copy of ideas or writing

    • No points will be given for similar assignments

  • Related to class discussion and cases in the book

  • Questions to be posted on Web


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Participation

  • Come to class prepared with

    • Intelligent comments

    • Constructive questions

    • Thoughtful insights and observations

  • Quality counts more than Quantity

  • Team project to be discussed later


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Palepu, Healy & Bernard(Figures 1-2 & 1-3)

  • A firm is involves in various business activities to create value for investors

  • Financial statements summarize the economic consequences of a firm’s business activities

  • Accounting system affects the quality of the financial data provided

    - affected by accounting rules, managements’ incentives

  • Analysts use a systematic framework to create inside information from public financial data


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Framework: Four Steps of Analysis

Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Analysis and

Valuation Applications


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I. Business Strategy Analysis

  • Purposes:

    • To identify key profit drivers and business risks

    • To assess profit potential at a qualitative level

  • Involves:

    • Industry analysis

    • Analysis of the firm’s strategy to create a sustainable competitive level

      • How did the firm stay alive and possibility of prospering in the future

  • Important first step for the following three analyses


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II. Accounting Analysis

  • Purposes:

    • To evaluate the degree to which a firm’s accounting captures underlying business reality

  • Involves:

    • identifying where there is accounting flexibility

    • evaluating the appropriateness of accounting policies and estimates

    • assessing the degree of distortion in disclosures

    • undoing (if necessary) distortions

  • Improves the reliability of financial analysis


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III. Financial Analysis

  • Purposes:

    • To evaluate current and past performance

    • To assess the sustainability of its performance

  • Requirements:

    • should be systematic and consistent

    • should allow the use of financial data to explore issues found in business strategy analysis

  • Tools

    • Ratio analysis: profitability, efficiency, liquidity

    • Cash flow analysis: liquidity and financial flexibility


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Purpose

To forecast a firm’s future

Final step in business analysis

Techniques

Financial statement forecasting

Valuation

IV. Prospective Analysis


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Team Project

  • Teams of four

  • Select an industry and two companies in the same industry

    • No more than two teams on one industry

    • No group can work on the same company

    • Need my approval; first-come, first serve

  • Compare the two companies in terms of All of the FOUR analyses:

    • Business Strategy Analysis

    • Accounting Analysis & Financial Analysis

    • Forecasting, Including Discussion of Assumptions

    • Valuation


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Agricultural

Construction

Manufacturing

Mining

Retail

Service

Transportation

Wholesale - Trade

Industry Choices

No Finance, Insurance, and Real Estate Industry and Public Administration Industry


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Team Project Report

  • Must be typed

  • Limit to 10 pages: double-spaced, 12-point font size

  • Data source and calculation should be included as appendices

  • Attach an evaluation on each of your group members: efforts and contribution


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CSUH Library and Internet

Main data sources

Industry Research

Company Research

UC Berkeley

International Business

Other:

Annual Reports

Annual Report Gallery

10-K Reports

Accounting Rules

Financial Accounting Standard Board

Historical Stock Market Data

Historical Market Index Data

Historical Stock Price Data

On DJ interactive, Historical market data

Finding Information for Business Analysis


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Framework for Business Analysis & Valuation

Business Strategy Analysis

Financial Analysis

Prospective Analysis

Accounting Analysis


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Business Strategy Analysis

  • Industry Analysis

    • Industry profitability and risk

  • Competitive Strategy Analysis

    • Which companies will sustain?

  • Corporate Strategy Analysis

    • Multibusiness management


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Industry AnalysisStandard Industrial Classification (SIC), North American Industry Classification System (NAICS)

  • Factors affecting industry profitability: Porter’s “five forces”

    • Degree of Actual & Potential Competition (3 forces)

      • Rivalry Among Existing Firms

      • Threat of New Entrants

      • Threat of Substitute Products

    • Bargaining Power in Input & Output Markets (2 forces)

      • Buyers’ Power

      • Suppliers’ Power

         Affect competitive strategy chosen to operate in the industry


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1. Rivalry Among Existing Firms

  • Profitability is low if competition for market share is strong:

    • Low industry concentration

      • Compute “Industry Concentration Ratio”, e.g. sales of largest four or eight companies  total industry sales

    • Low product differentiation

    • Large economy of scale, steep learning curve, high proportion of fixed costs

    • Low industry growth

    • Excess capacity, high exit cost


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2. Threat of New Entrants

Profitability is low if threat of new entrants is high:

  • Small economy of scale

  • Less “first mover advantages”

  • Easy access to channels of distribution and distribution relationships

  • Low legal barriers: e.g. government approval


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3. Threat of Substitute Products

Profitability is low, if threat of substitute products is high:

  • price and performance are similar

  • customers are willing to switch

    • Products are similar or seen as being substitutes

    • Low brand allegiance

  • products are replaceable


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4. Buyers’ Power

Strong, if

  • More Sensitive to Price

    • Products are similar

    • Low switching costs

    • Unimportant products (relative cost and quality)

  • Higher Bargaining Power

    • Fewer buyer

    • Higher volume per buyer

    • Low switching cost

    • More substitute products

    • High threat of backward integration by the buyers


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5. Suppliers’ Power

Profit is low if suppliers’ power is strong:

  • Fewer number of suppliers

  • High volume per supplier

  • High Switching Costs

  • High product differentiation

  • Importance of product in terms of cost and quality


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Power in Input Market (Suppliers) & Output Market (Buyers)

High Low Actual Profitability

Low  High Actual Profitability

Suppliers’ power

Buyers’ power


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Given a level of industry profitability …

  • What determines which companies will win and which companies will lose?

  • How can a company sustain profits in a competitive environment?

  • Porter maintains that there are two generic competitive strategies that firms can choose in order to maintain competitive advantage


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Competitive Strategy Analysis

?

Choices of competitive strategies:

1. Cost Leadership

2. Differentiation

And, Straddling of “1” and “2”


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1. Cost Leadership

  • Is a cost leader if it can supply same product or service at a lower price because of

    • Economies of scale, scopes, and learning

    • Efficient production

    • Simpler product designs

    • Efficient organizational processes

    • Lower costs of inputs and distribution

    • Little R&D or brand advertising required

    • Tight cost control


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2. Differentiation

  • Supply a unique product or service at a cost lower than the price customers are willing to pay:

    • Superior product quality

    • Superior product variety

    • Superior customer services

    • More flexible delivery

    • Investment in brand image

    • Investment in R&D and marketing

      Note: Organizational and control system must foster creativity and innovation


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Achieving and Sustaining Competitive Advantage

Depend on:

  • Match between firm’s core competencies (the economic assets possessed by the firm) and competitive strategies

  • Match between firm’s value chain (the activities to convert inputs to outputs) and activities required to execute competitive strategies

  • Flexibility to adopt to changes in the firm’s industry structure

  • Difficulty for competitors to imitate


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Applying Strategy Analysis to Dell

  • Industry Analysis

    • Describe the features of the personal computer industry that determine its profit potential. How difficult is it to earn abnormally high profit in this industry?

  • Competitive Strategies Analysis

    • Describe Dell’s business strategy and how it might allow Dell to earn higher returns on investments than others in the industry?


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Personal Computer Industry

  • Degree of Actual and Potential Competition

    • Rivalry Among Existing Firms

    • Threat of New Entrants

    • Threat of Substitute Products

  • Bargaining Power in Input and Output Markets

    • Buyers’ Power

    • Suppliers’ Power


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Personal Computer Industry: Rivalry

  • Growth continues to be strong

    • pricing remains cut-throat

  • Lots of competitors

    • fragmented, no price co-ordination

  • Switching costs are low

    • commodity product; price is the key

    • Dell tries to compete on service

      • as knowledge rises, will service matter?

  • Dell needs to keep market share

    • recoup R&D and costs associated with made to order strategy

    • allows them to lower component costs


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PC: Entrants

  • Low barriers to entry

  • First mover advantage?

    • not technologically

  • Distribution is easy

  • Relationships with suppliers, customers?


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PC: Substitute Products

  • Apple’s Macintosh, Sun’s work stations?

    • not in the near future

  • Competitive price and performance

    • PCs are commodities (price counts more)

    • price competition seems unavoidable

  • Buyers’ are willing to switch

    • brand name?

    • quality reputations?


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PC: Power of Customers

  • Buyers are price sensitive

    • define price as hardware, software, and operations, not just purchase price— “total cost of ownership”

  • Dell maintains an extensive database of customer information

    • unavailable to retail operators

  • Importance of product for cost & quality


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PC: Suppliers’ Power

  • Two major “one supplier” relationships

    • Intel, Microsoft

  • Leverage will increase with volume

  • Can Intel reap some of the PC vendors’ profits?

  • Power of other suppliers is low

    • lots of keyboard, case, power supply, etc. manufacturers


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PC Industry Analysis: Conclusion

  • Intense competition

  • Low barriers to entry

  • Not much power over customersand suppliers

  • Short product cycle; need to stay on edge technologically

Profit potential might be poor

BUT, growth is an important offsetting factor


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What Should Dell Need to be Concerned?

  • General economy condition

  • Industry growth; technological changes

  • Competition:

    • Product quality; customer service/support; distribution channels; price

    • International

    • Product mix, customer mix, geographic mix

    • New ventures: Internet

  • Inventory levels

  • Supply sources

  • Support of infrastructure

  • Government regulation


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Dell’s performance


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Customer profile: Foreign vs. Domestic Sales


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Mergent’s Industry Review- 1999 Ranking


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Stock Market Performance


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Dell: Competitive Strategy

  • Differentiation

    • Direct sales: no middle man; customer database

    • “Customer made” product

      • Lower economy of scales

      • Low inventory

    • Customer service and support

    • “Enterprise systems”

  • Cost Leadership

    • Through “made to order”

    • Not “low cost” seller


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Dell: Sustainable Advantage?

  • What aspects of Dell’s strategy can be replicated by others?

  • Can Dell avoid being replicated?


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Dell: Conclusion

  • Competitive and thus low profitability industry

  • The success of Dell’s competitive strategy depends on

    • Product differentiation

    • Maintain higher profit margin

    • Reduce/control operating expenses

    • Goal: higher net margin


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According to Dell (10-K)…

  • Three key factors

    • Growth

      • Demand, competition, international market

      • Product, customer, geographic mix

      • “servers” business

    • Profitability

      • gross and net margins, sales mix, Internet sales

      • Technological changes and product transition

    • Liquidity

      • asset management, especially inventory


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Experts’ Opinion?

  • Value Line on industry (4/21/2000)

    The computer and peripheral industry probably will get off to something of a slow start this year (2000). However, it should pick up a better head of stream in the second half and stay on a fast growth tract out to 2003-2005.

    Investors should be able to find stocks in this group that will be good fits for their portfolios, whether they are looking for near-term out-performance or long-term capital appreciation. Conservative accounts should tread cautiously, though, since volatility can be high for some of these equities.


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Experts’ Opinion?

  • Value line on Dell (4/21/2000)

    Although the stock has pulled back a bit from its recent high, Dell shares don’t stand out for the year ahead or the pull to 2003-2005. But Dell’s direct sales approach (which has enabled it to take share from competitors) appears to be working well, and we think the push to penetrate the emerging Internet market is a positive development.


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Framework: Four Steps of Analysis

Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Analysis and

Valuation Applications


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Review of Business Strategy Analysis

  • What factors decide an industry profitability?

  • Porter’s “five forces”

    • Degree of Actual and Potential Competition

      • Rivalry among existing firms

      • Threat of new entrants

      • Threat of substitute products

    • Bargaining Power in the Input and Output Markets

      • Bargaining power of customers

      • Bargaining power of suppliers


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What is Accounting Analysis?(Chapter 3)

  • Evaluate the degree to which a company’s accounting captures its underlying business reality

  • Evaluate the appropriateness of accounting policies and estimates

  • Assess the distortion, if any, in the numbers

    • see where distortions are and whether they can undone

  • Goal: To improve the reliability of conclusions from financial analyses

    Note: Does accounting affect business strategy? (“positive accounting”)


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The Need of Financial Accounting

  • Separation between ownership and management (“agency problem”)

  • Owners want to know:

    • Profitability: Income Statement

    • Economic resources and obligation: Balance Sheet

    • Cash flow position: Statement of Cash Flows

    • Owners’ equity: Statement of Stockholders’ Equity


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Accounting - Review

  • Annual Reports

    • Management Discussion and Analysis (MD&A)

    • Financial Statements

      • Balance sheet (2 years)

      • Income Statement (3 years)

      • Statement of Stockholders’ Equity (3 years)

      • Statement of Cash Flows (3 years)

    • Notes


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Importance of Notes

  • Integral part of the F/S

  • Augment the information provided in the F/S

  • Provide very important data for F/S analysis

  • E.G. “Contingencies”


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MD&A

  • Results of operations, including discussion of trends in sales and expenses

  • Capital resources and liquidity, including discussion of cash flows trend

  • Outlook based on known trends


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Financial Statements

  • Accountants are confronted with the potential dangers of bias, misinterpretation, inaccuracy, and ambiguity

  • Must follow the Generally Accepted Accounting Principles (GAAP)

    • E.g. FASB Publications, Statement 115

    • FASB, SEC, AICPA


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Mechanics of the Accounting Process

  • Balance Sheet

    • Assets = Liabilities + Stockholders’ equity

    • Ending balance =

      Opening balance carried from previous B/S

      +/- Increases/Decreases

  • SE = Capital stock + Retained Earnings

  • Capital stock = Opening balance + Issuance – Repurchase

  • R/E = Opening balance + NI - Dividends


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Net Income

  • Income Statement

  • Revenue – Expenses

    • Accrual Basis (v.s. Cash Basis)

    • Revenue is recognized when “earned”, not necessarily when cash is received

    • Expense is recorded when “incurred”, not necessarily when cash is paid


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From I/S to B/S

Daily Transactions

I/S

Net Income

R/E

R/E

Statement of SE

Capital Stock; R/E

B/S

Assets = Liabilities + SE


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What Affect the Quality of Accounting Data? – Not Reflect the Economic Reality

  • Reports are prepared by management

    • Involves with management’s incentives

  • Accrual basis versus cash basis

    • Involves estimations, not totally actual cash transactions

  • Accounting rules (GAAP)

    • Standardization versus flexibility

  • Auditing

    • Auditable?

  • Legal Liability

    • Threat of lawsuits improves credibility, but limits disclosures


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Accounting Analysis for Dell

  • Main concern: higher return on equity

  • What are the major areas we need to look into at Dell if we want to understand how well they are doing?

    • Based on the industry and competitive strategy analyses

      • growth, profitability


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Think About Dell

  • Accounting Rules—biased?

  • Accounting Estimation—biased?

  • Factors that Affect Managers’ Accounting Choices

    • debt covenants—does Dell have any?

    • management compensation—does Dell have earnings-based bonuses?

    • corporate control contest—is Dell concerned about a takeover?

    • tax considerations—LIFO versus FIFO

    • regulatory considerations—consider Microsoft

    • capital market considerations

    • stakeholder considerations —consider auto industry

    • competitive considerations—how detailed should the reporting be


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How to Do Accounting Analysis

1. Identify Key Accounting Policies

2. Assess Accounting Flexibility

3. Evaluate Accounting Strategy

4. Evaluate the Quality of Disclosure

5. Identify Potential Red Flags

6. Undo Accounting Distortions


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1. Identify Key Accounting Policies

  • Ultimate goal

    • How well are the key success factors and risks identified by the Business Strategy analysis managed by the firm?

  • Task

    • Identify and evaluate the policies and estimates the firm uses to measure its critical factors and risks


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2. Assess Accounting Flexibility

  • All firms can choose:

    • depreciation & amortization methods and estimates

    • inventory methods

    • estimates of bad debts

  • Some items do not allow flexibility:

    • R&D and marketing expenditures must be expensed

    • software development can be capitalized


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Flexibility, Informative, and Distortion

Low

High

Flexibility

Less Informative

More Informative

Less Distortion

More Distortion


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Flexibility Analysis—Dell

  • Fiscal year-end: Friday nearest 1/31

  • Consolidate all wholly owned subsidiaries

  • Short-term investments: available-for-sale

  • Inventory: first-in, first-out

  • Depreciation: 2 to 5 years for non-buildings

  • Amortization of intangibles: 3 to 8 years

  • R&D and advertising: expensed

  • Warranty and post-sale support: estimated and expensed

  • Software development costs: capitalized

  • Segment information


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3. Evaluate Accounting Strategy

  • How do the firm’s policies compare to the industry norm?

  • Does management face strong incentives to manage earnings?

    • covenants, bonuses, political pressures

  • Has the firm changed policies or estimates?

  • Were policies and estimates realistic in the past?

    • write-off

    • discontinued operation

  • Does the firm structure transactions to achieve certain accounting objectives?

    • capital lease versus operating lease

    • pooling-of-interest versus purchase accounting


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4. Evaluate Quality of Disclosure

  • Do the firm’s disclosures make it easy to assess the economic reality?

    • Provide adequate disclosure of business strategies?

    • Explain in footnotes accounting policies, assumptions, and their logic?

    • Explain current performance?

    • Provide additional disclosures to assess business reality?

    • Provide informative segment disclosure?

    • Reveal forthcoming bad news?

    • Provide detailed news to investors?


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5. Identify Potential Red Flags

  • Unexplained changes in accounting especially when performance is poor

  • Unexplained transactions that boost profits

    • sale of assets or investments

  • Unusual increases in A/R in relation to sales increases

  • Unusual increases in inventories in relation to sales increases

  • Increasing gap between earnings and cash flow from operations

  • Increasing gap between financial income and taxable income

  • Off-F/S transactions

    • B/S (e.g., leases) and I/S (e.g., contingencies)

  • Large asset write-offs

  • Large 4th-quarter adjustments

  • Qualified audit opinion or change in auditors

  • Related party transactions


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6. Undo Accounting Distortions

  • Try to make adjustments

    • use data in the notes

    • use cash flow data

    • use non-accounting sources:

      • Newspapers

      • Call investor relations

  • Example: Off-B/S financing


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In-Class Case: Harnischfeger

  • Purpose: Demonstrate managerial motives for making accounting changes

  • Background: GAAP allow flexibility for accounting choices. Even after a firm chooses a set of accounting policies, it can still change to another at the management’s discretion.

  • Managerial incentive:

    • 1982 Harnischfeger faced a financial crisis

    • New management was appointed to turn the company around

    • New management made a few financial reporting policy changes in 1984

    • Harnischfeger turned into profit in 1984


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