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Chapter 1

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Chapter 1

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  1. Chapter 1 What is Financial Analysis?

  2. 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.

  3. Six-step Process • Identify purpose of financial analysis • Corporate overview • Financial analysis techniques • Detailed accounting analysis • Comprehensive analysis • Decision or recommendation

  4. Corporate Overview • Industry analysis--key economic characteristics, historical context, profit drivers, business risks • Firm’s business strategy--competitive strategy given the industry characteristics

  5. 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

  6. Industry Analysis Criteria • What is the industry? • Relative size & significance • Largest companies • Geographic presence • Business cycle effects • Future potential

  7. 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

  8. Business Strategy Criteria • Historical perspective • Primary focus of operations • Most important strategy • Major operating segments • Corporate outlook

  9. 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?

  10. 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

  11. Financial Analysis • Financial Statements • Common-size Analysis • Financial Ratios • Growth/trend Analysis • Quarterly analysis • DuPont Model

  12. 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

  13. 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

  14. 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

  15. Chapter 2 The Financial Environment

  16. Capital Markets

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. The FASB Structure The FASB Structure

  24. 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]

  25. Annual Report Information • CEOs Letter • MD&A • Financial Statements: Balance Sheet, Income Statement, Statement of Cash Flows, Statement of Equity • Notes to financial statements

  26. 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

  27. Financial Statement Considerations • Managers’ information on economic reality • Estimation errors • Distortion from managers’ accounting choices & disclosure • Question: Can investor perceptions be manipulated?

  28. Finance Theory Perspectives • Efficient Markets • Random Walk • Portfolio Theory • Beta Analysis • Economic Behavior & Agency Theory • Earnings Management & Accounting Choice

  29. 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

  30. 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

  31. 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)

  32. 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

  33. 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)

  34. 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).

  35. 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

  36. 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

  37. 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

  38. 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)

  39. 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)

  40. 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

  41. 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”

  42. Chapter 3 The Financial Statements

  43. Balance Sheet • Assets: probable future economic benefits • Liabilities: probable future economic sacrifices • Stockholders’ Equity: residual interest, representing ownership interest (also called net assets)

  44. 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

  45. Cash Flow Statement • Cash Flows from Operations • Cash Flows from Investing Activities • Cash Flows from Financial Activities • Statement of Stockholders’ Equity

  46. Chapter 4 Financial Analysis Techniques Using Financial Statement Information

  47. 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”

  48. Financial Analysis • Financial Statements • Common-size Analysis • Financial Ratios • Growth Analysis • Du Pont Model • Earnings Quality/Normalizing Earnings

  49. Useful Financial Comparisons • Benchmarks: rules of thumb or averages • Common Sense • Trend Analysis (analysis over time) • Near Competitors • Industry Averages • Market Averages

  50. 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