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Chapter 1 What is Financial Analysis? 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. Six-step Process Identify purpose of financial analysis

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chapter 1

Chapter 1

What is Financial Analysis?

defining financial analysis
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.
six step process
Six-step Process
  • Identify purpose of financial analysis
  • Corporate overview
  • Financial analysis techniques
  • Detailed accounting analysis
  • Comprehensive analysis
  • Decision or recommendation
corporate overview
Corporate Overview
  • Industry analysis--key economic characteristics, historical context, profit drivers, business risks
  • Firm’s business strategy--competitive strategy given the industry characteristics
industry analysis
Industry Analysis
  • Competition--growth rates, concentration ratios, 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
industry analysis criteria
Industry Analysis Criteria
  • What is the industry?
  • Relative size & significance
  • Largest companies
  • Geographic presence
  • Business cycle effects
  • Future potential
business strategy
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
business strategy criteria
Business Strategy Criteria
  • Historical perspective
  • Primary focus of operations
  • Most important strategy
  • Major operating segments
  • Corporate outlook
qualitative analysis dell computer
Qualitative Analysis--Dell Computer
  • Industry--high tech, competitive (e.g., Gateway, IBM, Compaq, others), changing products, high growth rates, low barriers of entry
  • Business strategy--(1) low cost strategy: direct selling, made-to-order manufacturing, early on the internet, low receivables; (2) product differentiation?? [IBM clones, Intel & Microsoft components]
  • Economic slowdown—what is the impact?
financial analysis
Financial Analysis
  • Systematic analysis of key elements based on analysis context
  • Ratios, cash flows, common-size, time series, comparative (e.g., specific firms, industry, all firms), models (e.g., DuPont, Altman’s)
  • In-depth analysis for “red flag” items
financial analysis11
Financial Analysis
  • Financial Statements
  • Common-size Analysis
  • Financial Ratios
  • Growth/trend Analysis
  • Quarterly analysis
  • DuPont Model
detailed accounting analysis
Detailed Accounting Analysis
  • Does accounting information capture the underlying business reality?
  • Identify areas of “accounting flexibility” & evaluate accounting policies (choices) & disclosures; e.g., MD&A
  • Evaluate earnings management potential
  • Recast accounting numbers when necessary
comprehensive analysis
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 or A-F
financial analysis decision
Financial Analysis Decision
  • Based on Elliott’s “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
chapter 2

Chapter 2

The Financial Environment

credit decisions
Credit Decisions
  • Commercial banks provide short-term commercial loans
  • The major concern: will the company pay interest & principal when due?
  • Loan terms: interest rate, collateral, debt covenants
equity investment decisions
Equity Investment Decisions
  • Public securities trade on formal market exchanges (these are secondary markets)
  • Buying & selling are now relatively cheap transactions
  • Mutual funds are a useful alternatives to individual securities
  • Stock investing has high short-term risks
sec regulation
SEC Regulation
  • Mission: Protect investors & maintain integrity of the 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
goals of financial accounting in a market economy
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 firm create value?
  • Reduce management discretion (what is reality? Vs. misleading information--analysts sort this out). Note management incentives for earnings management
accounting regulators
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 Commission (IASC)
  • Note: European Harmonization
standard setters 1938 present
Standard Setters: 1938-Present
  • Committee on Accounting Procedures (CAP) issued 51 Accounting Research Bulletins (ARBs)--1938-59
  • Accounting Principles Board (APB) issued 31 Opinions--1959-73
  • Financial Accounting Standards Board (FASB) has issued over 140 Statements (SFASs)--1973-present
the fasb
  • Seven member board, full time, appointed by FAF, presumed independent
  • Extensive due process: agenda items, discussion memoranda (DM), exposure drafts (ED), pronouncements, public exposure with written & oral comments
  • Super-majority (5-2 vote) [simple majority used 1977-90]
annual report information
Annual Report Information
  • CEOs Letter
  • MD&A
  • Financial Statements: Balance Sheet, Income Statement, Statement of Cash Flows, Statement of Equity
  • Notes to financial statements
management incentives
Management Incentives
  • Managers have incentives to present information in the most favorable light (e.g., bonuses, stock options, promotions)
  • Accounting choice: accounting polities, estimates, additional disclosures
  • Standardize vs. estimates: what is reality?
  • Management have best information, but communications to investors may not be completely credible
financial statement considerations
Financial Statement Considerations
  • Managers’ information on economic reality
  • Estimation errors
  • Distortion from managers’ accounting choices & disclosure
  • Question: Can investor perceptions be manipulated?
finance theory perspectives
Finance Theory Perspectives
  • Efficient Markets
  • Random Walk
  • Portfolio Theory
  • Beta Analysis
  • Economic Behavior & Agency Theory
  • Earnings Management & Accounting Choice
efficient markets
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
  • Why?—Analyst following
random walk
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 stock price
portfolio theory
Portfolio Theory
  • Harry Markowitz introduced the concept of portfolio diversification with his 1952 dissertation
  • Portfolio theory insists that investment portfolios should be diversified to reduce the risk relative to return
  • Capital asset pricing model: E(Ri) = Rf + [E(Rm) – Rf)
beta analysis
Beta Analysis
  • Beta () comes directly from the slope of the market model: Rit = i + iRmt + eit
  • Beta measures the relationship between price movements of the individual stock to market averages
  • Beta is a measure of systematic risk, where a =1 stock should move with the market; a >1 stock has greater market risk
economic behavior
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)
agency theory
Agency Theory
  • Contracts have a principal (e.g., owners) and agent (e.g., managers). The principal will attempt to maximize wealth, contract to avoid conflict, and minimize transaction and agency costs.
  • Agency costs: information asymmetries (limited information by one side), adverse selection, moral hazard (e.g., shirking).
how to reduce agency costs
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
earnings management
Earnings Management
  • Operations and discretionary accounting methods 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 and exist because they write contracts efficiently
accounting choice
Accounting Choice
  • Discretionary choices to optimize behavior, using techniques such as: 1. Select alternative accounting methods (e.g., inventory) & level of disclosure (e.g., contingencies) 2. Lobbying (e.g., on proposed standards) 3. Financial, production & investment activities
discretion under gaap
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)
earnings manipulation
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)
earnings quality
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
normalizing income
Normalizing Income
  • Attempt to determine earning power--related to normal operating earnings
  • Remove the “noise”--usually associated with nonrecurring items
  • Separate analysis of nonrecurring items--reorganization, “big bath” write-offs, changing GAAP
  • Evidence of earnings manipulation may require substantial adjustments to arrive at “normal earnings”
chapter 3

Chapter 3

The Financial Statements

balance sheet
Balance Sheet
  • Assets: probable future economic benefits
  • Liabilities: probable future economic sacrifices
  • Stockholders’ Equity: residual interest, representing ownership interest (also called net assets)
income statement
Income Statement
  • Revenues: inflows from major operations
  • Expenses: outflows from major operations
  • Gains & Losses: changes in equity from peripheral activities
  • Net income: bottom line all operating activities recorded on the income statement
  • Comprehensive income: Changes in equity from all non-owner sources
cash flow statement
Cash Flow Statement
  • Cash Flows from Operations
  • Cash Flows from Investing Activities
  • Cash Flows from Financial Activities
  • Statement of Stockholders’ Equity
chapter 4

Chapter 4

Financial Analysis Techniques Using Financial Statement Information

financial analysis47
Financial Analysis
  • Systematic analysis of key elements based on analysis context
  • Quantitative techniques to standardize financial information for relevant comparisons
  • In-depth analysis for key factors, including “red flags”
financial analysis48
Financial Analysis
  • Financial Statements
  • Common-size Analysis
  • Financial Ratios
  • Growth Analysis
  • Du Pont Model
  • Earnings Quality/Normalizing Earnings
useful financial comparisons
Useful Financial Comparisons
  • Benchmarks: rules of thumb or averages
  • Common Sense
  • Trend Analysis (analysis over time)
  • Near Competitors
  • Industry Averages
  • Market Averages
common size analysis
Common-size Analysis
  • 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
ratio analysis
Ratio Analysis
  • A ratio converts financial information to a percentage, one approach to standardization
  • Each ratios provides a somewhat different analysis
  • Ratios overlap—a problem in one area should show 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
ratio categories
Ratio Categories
  • Liquidity—cash, working capital & cash flow related
  • Activity—turnover ratios as possible efficiency measures
  • Leverage—debt & solvency analysis
  • Performance (or profitability)—bottom line or earnings related
du pont model
Du Pont Model
  • ROE = Profitability x Activity x Solvency
  • Net Income / Average Common Equity = (Net Income / Sales) x (Sales / Average Total Assets) x (Average Total Assets / Average Common Equity)
  • ROA = Profitability x Activity
ratio analysis limitations
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 and earnings management)
  • If not reliable, ratios are not particularly useful
chapter 5

Chapter 5

Multi-period Quantitative Financial Analysis

growth analysis
Growth Analysis
  • Long-term trends over time can be significant. Are current year performance measures consistent with earlier 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 be obvious red flags
  • Red flags and other indicators of poor growth performance require further analysis
trend analysis
Trend Analysis
  • Using trend analysis, set the earliest year, evaluated as the base year, at 100. Calculate growth by dividing the more current year numbers by the base year number.
  • This is an alternative presentation to growth rate percentages over 5-10 years
quarterly analysis
Quarterly Analysis
  • The most recent financial data is presented quarterly (e.g., 10-Q). [The one exception is at year end, with annual information is presented]
  • Financial analysts focus on quarterly data and the quarterly earnings announcement is the most important (& earliest) information
  • Common-size and ratios analysis is conducted, and compared over earlier quarters: particularly important are current quarter data to (1) the previous quarter and (2) the same quarter one year ago
chapter 11

Chapter 11

Capital Structure & Credit Risk

corporate debt
Corporate Debt
  • Accounts Payable
  • Commercial Paper & other short-term market liabilities
  • Other current liabilities
  • Corporate Bonds
  • Other long-term market debt
  • Other liabilities
default risk
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
altman s z score 1983 model
Altman’s 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)
  • = Altman’s Z-score
altman s z score
Altman’s Z-score
  • Indicator of overall financial health
  • Cutoffs: les than 1.1 bankrupt 1.1 – 2.6 gray area greater than 2.6 healthy
  • A Z-score of 1.1 or less does not mean the company is bankrupt, but does suggest that financial problems may exist
chapter 12

Chapter 12

Credit Analysis

credit analysis process
Credit Analysis Process
  • Loan Purpose
  • Corporate Overview
  • Financial Analysis
  • Accounting Analysis
  • Comprehensive Analysis
  • Loan Decision
loan purpose
Loan Purpose
  • Commercial Bank Loan: term loan revolving line of credit other
  • Commercial Paper
  • Corporate Bonds
corporate overview68
Corporate Overview
  • Wide variety of firms need bank loans
  • Size characteristics—local or regional to national & global
  • Industry specializations, including impact on bank credit risk
  • Large companies have more credit options
financial analysis69
Financial Analysis
  • 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 earnings performance & forecasts
accounting analysis
Accounting Analysis
  • Emphasis on liquidity & cash flow information
  • Analysis of unrecorded obligations & potential overstated assets
  • Forecasts of sales & operations plus future cash flows
comprehensive analysis71
Comprehensive Analysis
  • Summary of key information (executive summary recommended)
  • Importance of credit risk
  • Adequate information to make informed recommendations/decisions
loan decisions
Loan Decisions
  • Yes/ No on loan
  • What interest rate (prime rate +)?
  • What collateral?
  • What Debt covenants?
  • Other considerations (e.g., compensating balances)