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Investments: Financial Statement Analysis (review). Professor Scott Hoover Business Administration 365. What questions are important in assessing the health of a firm? Can the firm meet its debt obligations? How well are assets being managed? How profitable is the firm?

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Investments:Financial Statement Analysis (review)

Professor Scott Hoover

Business Administration 365

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  • What questions are important in assessing the health of a firm?

    • Can the firm meet its debt obligations?

    • How well are assets being managed?

    • How profitable is the firm?

    • How risky is the firm?

    • What does the market think of the firm?

    •  Ratio Analysis: interpretation of accounting and market information to assess the health of companies.

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  • Why do we use ratios? firm?

    • We must consider things on a relative basis, not an absolute one.

      • e.g.: If one company has earnings of $2,000,000 and another of $1,000,000, which is better?

        • We can’t say because one company may be considerably bigger than the other.

    • By using ratios, we are able to compare a company to its peers.

  • There are no hard-and-fast rules here. We can and should be creative by creating our own ratios to investigate specific areas.

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  • The DuPont Relationship firm?

    • We begin any analysis by examining the factors that contribute to the Return on Equity (ROE).

      • Why?

        • Measures the return to shareholders

    • DuPont: ROE  NI / E = (NI / S)  (S / TA)  (TA / E ) = profit margin  asset turnover  leverage multiplier

      • Note that ROE = ROA  (TA / E )

      • leverage multiplier = TA / E = TA / (TA - D) = 1 / (1 - debt ratio)

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  • The DuPont approach is nice because it divides the firm into three tasks

    • expense management (measured by the profit margin)

    • asset management (measured by asset turnover)

    • debt management (represented by the debt ratio or leverage multiplier)

  • The DuPont Method

    • layered approach

      • examine the three components

      • dig deeper to identify possible weaknesses and strengths

      • dig deeper to find specific causes and hopefully to identify possible corrective action

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  • factors of the leverage multiplier? three tasks

    • Since we are concerned with whether or not the firm can meet its debt obligations, the “factors” don’t really matter.

    • Instead…

      • current assets vs. current liabilities

        • current ratio

        • quick ratio

      • profits vs. debt payments

        • ROIC vs. after-tax interest

        • times-interest-earned

    • Ultimately, we must assess debt on a cash flow basis.

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  • Tools three tasks

    • Common Size statements

      • express the balance sheet as a percentage of total assets

      • express the income statement as a percentage of sales

    • Indexed statements

      • express the financial statements from one period as a percentage of some base year.

    • See spreadsheet example

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  • Profit Measures three tasks

    • Earnings (net income)

      • accounting profits

      • useful if not misleading (intentionally or otherwise),

      • problem: does not reflect cash flow

        • includes Depreciation as an expense

        • ignores Capital Expenditures

        • uses Sales instead of receipts

        • uses Cost of Goods Sold instead of disbursements

    • EBITDA

      • earnings without Depreciation, Interest, Taxes

      • looks at earnings without the effects of financing and accounting decisions

      • useful for understanding the ability to service debt

      • problem: still does not reflect cash flow

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  • Free Cash Flow three tasks

    • measures the true cash flow of the firm in a given period, ignoring all financing-related cash flows and effects

      • Why ignore financing?

    • can be misleading due to fixed asset effects

      • e.g., firm with old, fully depreciated equipment vs. one that has bought new equipment during the period.

    • very useful when viewed over multiple periods

    • provides the basis for the DCF model

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  • Building the Free Cash Flow Equation three tasks

    • How do earnings differ from cash flow?

      • Earnings include financing-related cash flows

        • adjust by using EBIT(1-T) (i.e., NOPAT) instead of earnings.

        • This is just net income assuming zero interest expense

      • Depreciation: subtracted, but is not a cash flow

        • adjust by adding depreciation

      • Capital Expenditures: ignored entirely

        • adjust by subtracting CapEx

      • Sales: recorded when made, not when cash is received.

        • adjust by subtracting the increase in receivables

      • Cost of Goods Sold: recorded when sold, not when the goods are paid for

        • adjust by subtracting the increase in inventory

        • and by subtracting the decrease in payables

      • Ignores cash needed for operations

        • adjust by subtracting the increase in operating cash

        • Note that most financial analysts ignore this effect entirely

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  • Note the following three tasks

    • subtracting the increases in cash, inventory, and receivables  subtracting the increase in current assets.

    • adding the increase in payables  subtracting the decrease in current liabilities.

  • It follows that we subtract CA- CL.

  • Since Net Working Capital (NWC) is CA-CL, we subtract NWC. This gives us our final equation

  • The Free Cash Flow Equation

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  • FCF yield = FCF / EV three tasks

    • EV  enterprise value = equity + preferred stock + debt – cash & equivalents

    • i.e., EV is the amount of capital the firm has currently invested

    • Why do we subtract cash & equivalents?

  • What happens if FCF yield < WACC?

    • company earns less than what it “owes” investors

    • higher sales  lower stock value!

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  • Another Look at ROE three tasks

    • ROE = NI/E

    • NI = (EBIT-Interest)(1-t) = (EBIT-iD)(1-t)

      • t  effective tax rate

      • i  interest rate on debt

      • D  amount of outstanding debt

    • We can rearrange these equations to get an expression that is more helpful.

    • First, recall that the Return on Invested Capital is

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  • What do we learn from this exercise? three tasks

    • i(1-t)<ROIC  taking on more debt will increase ROE.

    • i(1-t)>ROIC  taking on more debt will decrease ROE.

    • Implications

      • optimal strategy might be to use debt whenever the after-tax interest rate on marginal debt is below the ROIC and to use equity otherwise.

      • But….

        • How far into the future should we look? One data point is hardly sufficient to draw strong conclusions.

        • The equation does not incorporate risk.

        • The equation ignores other important factors.

  • Revisiting our example…

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    • Difficulties with Financial Statement Analysis three tasks

      • Information is always old.

      • Book values are reported instead of market values

      • We often must compare companies at different points in time.

      • Companies often use different terminology

      • Managers may have incentives to mislead

      • Financial statements often lack detail

      • Industry averages are often misleading

        • Should we include negative ratios in averages?

        • Should we include outliers in averages?

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    • Other Comments three tasks

      • We should always consider the notes to the financial statements.

        • They give explanations for unusual items as well as notes that suggest an accounting explanation for a peculiarity.

      • We should always consider news stories on the company.

        • They often contain statements concerning the financial condition of the firm and/or comments on things to expect.

        • They provide updates since the date of the last financials.