Chapter 5: Essentials of Financial Statement Analysis Learning objectives • Essentials of financial statement analysis, financial statement analysis tools and approaches. • How ROA is used to analyze profitability and the insight to separate ROA to profit margin and asset turnover rate. • How ROA and financial leverage combine to determine a firm’s return on equity (ROCE). 5-1
Learning objectives (contd.) • Capital structure and credit risk: How short-term liquidity risk and long-term solvency risk are assessed and how to use the statement of cash flows to assess credit risk. • Why do companies issue pro forma earnings? 5-2
Qualitative Characteristics of Accounting Information: • How do we define financial reporting quality? • Qualitative characteristics of accounting Information: • Understandability • Decision usefulness • Reliability • Relevance • Consistency • Comparability
Attributes of High Quality Financial Reporting • Financial reporting (earnings) quality has been considered positively associated with the following: • High persistence of earnings and cash flows • High predictive ability of earnings and cash flows • High earnings response coefficient • Low level of earnings management • More voluntarily disclosure • Strong corporate governance
Manipulating Income and Earnings Management • Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 • Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance. • “Most managers prefer to report earnings that follow a smooth, regular, upward path.”2 1. Arthur Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.
What should the users be aware of ? • Statement users must: • Understand current financial reporting settings and standards. • Recognize that management may manipulate the financial information. • Distinguish between reliable financial statement information and poor quality information.
Financial statement analysis and accounting quality • The accounting distortions need to be watched when analyzing statements. Examples include: 1. Nonrecurring gains and losses 2. Differences in accounting methods. 3. Differences in accounting estimates. 4. GAAP implementation differences. 5. Historical cost convention.
Learning Objective: Essentials of Financial Statement Analysis
Analysis, Forecast and Vulation Procedures • Reviewing the Financial Statements: • Review comparative financial statements and audit opinion. • Adjusting and forecasting accounting numbers: • Adjusting accounting numbers to remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income.
Analysis • Assessing Profitability and Creditworthiness: • Common size statements. • Trend statements • Financial ratio analysis: Use ratios to assess liquidity, profitability and solvency. • Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default.
Forecast and Valuation • Comprehensive Financial statement forecasts (see Appendix B of Chapter 6 ) • Valuing Equity Securities (see Appendix A of Chapter 6): • a. Free cash-flow model • b. Abnormal earnings model (residual income model).
Essentials of Financial Statement Analysis • Step 1: To be informed that financial statement analysis is a careful evaluation of the quality of a company’s reported accounting numbers. • Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices. Only then you can truly “ get behind the numbers” and see what’s really going on the Company.
How the financial accounting “filter” sometimes works GAAP puts capital leases on the balance sheet, but operating leases are “off-balance-sheet”. Managers have some discretion over estimates such as “bad debt expense”. Managers have some discretion over the timing of business transactions such as when to buy advertising. Managers can choose any of several different inventory accounting methods. 5-13
Tools: Approaches used with each tool: Time-series analysis: the same firm over time (e.g., Wal-Mart in 2008 and 2006) Financial statement analysis:Tools and approaches Common size statements 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2008). Trend statements 3. Benchmark comparison: using industry norms or predetermined standards. Financial ratios (e.g., ROA and ROCE) 5-14
Financial analysis tools • Comparative Financial statements: Statements are compared across years. • Common-size statements: Recast each statement item as a percentage of a certain item. • Trend statements: Recast each statement item in percentage of a base year number. • Financial ratios.
Basic Approaches • Time-series analysis : Identify financial trends over time for a single company. • Cross-sectional analysis: Identify similarities and differences across companies at a single moment in time. • Benchmark comparison: measures a company’s performance against some predetermined standard.
Getting behind the numbers:Case Study: Krispy Kreme Doughnuts, Inc. • Established in 1937. • Today has more than 290 doughnut stores (company-owned plus franchised) throughout the U.S. • Serves more than 7.5 million doughnuts every day. • Strong earnings and consistent sales growth.
Comparative Income Statements: Krispy Kreme’s Financials Systemwide sales Include sales from company owned and franchised stores. Includes a $5.733 million after-tax special charge for business dispute Includes a $9.1 million charge to settle a business dispute Sales increased from $220.2 million in 1999 to $491.5 million in 2002. Net income increased from $6 million in 1999 to $33.5 million in 2002.
Common Size Income Statements:Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Income Statements $393.7 operation expenses $491.5 sales * Not adjusted for distortions caused by “special items”. Each statement item is computed as a percentage of sales.
Trend Income Statements:Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Income Statement Base Year $393.7 operating expenses in 2002 $194.5 operating expenses in 1999 * Not adjusted for distortions caused by “special items”. Each statement item is calculated in percentage terms using a base year number.
Comparative Balance Sheets AssetsKrispy Kreme’s Financials:Balance Sheet Assets
Common Size AssetsKrispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to assets $3.2 cash $105.0 assets Each statement item is computed as a percentage of Total assets.
Trend AssetsKrispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet assets $7 cash in 2000 $3.2 cash in 1999 Each statement item is calculated in percentage terms using a base year number.
Comparative Balance Sheets Liability and Equity: Krispy Kreme’s Financials
Common Size Liabilities and Equity:Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Balance sheet liabilities and equity $13.1 accounts payable $105.0 total liabilities and equity Each statement item is computed as a percentage of Total liabilities and equity.
Trend Liabilities and EquityKrispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet liabilities and equity $8.2 accounts payable in 2000 $13.1 accounts payable in 1999 Each statement item is calculated in percentage terms using a base year number.
Common Size Cash Flow Statements:Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Cash Flow Statements $93.9 capital expenditures $491.5 sales Each statement item is computed as a percentage of Sales.
Trend Cash Flow StatementsKrispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Cash Flow Statements $93.9 capital expenditures in 2002 $10.5 capital expenditures in 1999 Each statement item is calculated in percentage terms using a base year number.
Krispy Kreme analysis: Lessons learned • Informed financial statement analysis begins with knowledge of the company and its industry. • Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes are easily recognized.
Krispy Kreme analysis: Lessons learned • Common-size and trend statement techniques can be applied to all financial statements and every section of statements. • Financial statements help analysts gain a sharper understanding of the company’s economic condition and its prospects for the future.
Learning Objective: Profitability Analysis
Financial ratios and profitability analysis Operating profit margin EBI Sales Return on assets ROA= EBI Average assets X Asset turnover Sales Average assets NOPAT is net operating profit after taxes • Analysts do not always use the reported earnings, sales and asset figures. • Instead, they often consider three of adjustments to the reported numbers: • Remove non-operating and nonrecurring items to isolate sustainable operating profits. • Eliminate after-tax interest expense to avoid financial structure distortions. • Eliminate any accounting quality distortions (e.g., off-balance operating leases).
Calculating Return on Assets Eliminate nonrecurring items Eliminate interest expense Effective tax rate
How can ROA be increased? There are just two ways: • Increase the operating profit margin, or • Increase the intensity of asset utilization (turnover rate). Asset turnover ROA= EBI Average assets EBI Sales Sales Average assets Operating profit margin 5-35
Turnover improvement: Suppose assets can be reduced to $45 million without sacrificing sales or profits. • Margin improvement: Suppose expenses can be reduced so that EBI becomes $10. ROA, margin and turnover examples: • A company earns $9 million of EBI on sales of $100 million with an asset base of $50 million.
ROA Decomposition and Analysis 1. 2 • How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over this period? • The expanded store base, along with increased sales, allowed the fixed costs be spread over a number of stores- The result was in an improved operating profit margin. • However, the asset based was considerably less productive in 2002 ( Asset turnover is 1.48) than it was in 1999 ( Asset turnover is 2.22) – More stores meant more resources ( assets) tied up operating cash, receivables, etc.
NOPAT Sales Sales Average assets Further decomposition of ROA Correspond to the common-size Income statement items Operating profit margin ROA = X Asset turnover
Usages of Decomposition of ROA • The profit margin components can help the analyst identity areas where cost reductions have been achieved or where cost improvements are needed. • The current asset turnover ratio helps the analyst spot efficiency gains from improved accounts receivable and inventory management. • The long-term asset turnover ratio captures information about property, plant, and equipment utilization.
ROA and competitive advantage:Krispy Kreme Wendy’s, Baja Fresh, Café Express S&P industry survey or other sources Q: What was the key to Krispy Kreme’s success in 2002 ? Answer: Krispy Kreme outperformed the competition by generating more sales per asset dollar.
ROA and competitive advantage:Four hypothetical restaurant firms • Competitive Advantage: Companies that consistently earn an ROA above the floor. (e.g., Firm C) • However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. Competition works to drive down ROA toward the competitive floor. • Firm A and B earn the same ROA, but Firm A follows a differentiation strategy while Firm B is a low cost leader. • Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA). Competitive ROA floor
Components of ROCE Return on assets (ROA) NOPAT Average assets Return on common equity (ROCE) X Common earnings leverage Net income available to common shareholders Average common shareholders’ equity Net income available to common shareholders NOPAT Net income available to common shareholders = Net income – preferred dividends X Financial structure leverage Average assets Average common shareholders’ equity ROCE= ROA * Common earnings leverage* Financial Structure leverage
Return on equity and financial leverage Unchanged – because of Financial leverage • 2005: No debt; all the earnings belong to shareholders. • 2006: $1 million borrowed at 10% interest; ROCE climbs to 20%. • 2007: Another $1 million borrowed at 20% interest; ROCE falls to only 15%.
Return on Equity and financial leverage • Financial leverage is beneficial only when the company earns (i.e., ROA) more than the incremental after-tax cost of debt. • If the cost of debt is greater than the earnings, increased leverage will harm shareholders.
Return on Equity and financial leverage (contd.) • The advantage of debt financing is the tax deduction on interests. • The disadvantage is the increase of the bankruptcy risk. • Both the cost of debt and the bankruptcy probability need to be considered in determining the capital structure. • It is hard to determine the optimal mix of capital and debt.
Leverage helps Leverage neutral Leverage neutral Leverage hurts Profitability and financial leverage:Case Study Leverage helps
Learning Objective: Capital structure and Assess Credit Risk
Credit risk and capital structure:Overview • Credit risk refers to the risk of default by the borrower. • A company’s ability to repay debt is determined by it’s capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs. • Financial ratios play two roles in credit analysis: • They help quantify the borrower’s credit risk before the loan is granted. • Once granted, they serve as an early warning device for increased credit risk.
Credit risk and capital structure:Balancing cash sources and needs The cash flow statements contain information enabling a user to assess a Company’s credit risk, financial ratios are also useful for this purpose.
Short-term loans: Seasonal lines of credit Special purpose loans (temporary needs) Secured or unsecured Revolving loans Like a seasonal credit line Interest rate usually “floats” Long-term loans: Mature in more than 1 year Purchase fixed assets, another company, Refinance debt ,etc. Often secured Public Debt Bonds, debentures, notes Special features: Sinking fund and call provisions Traditional lending products