Financial Statement Analysis Contents • Overview and objective of financial statement analysis • Review and Re-formatting Statements for Financial Analysis • Income Statement – EBITDA and NOPLAT • Cash Flow Statement - Free Cash Flow and Equity Cash Flow • Financial ratio analysis • Management Performance • Valuation • Credit Analysis • Financial Model Drivers • Reference Slides • Financial Ratio Calculations • Discussion of Economic Profit
Financial Statement Analysis - Introduction • Financial Statement Analysis should tell a story about the company – How profitable is the company, what are the trends, how much risk is there etc. • You should be comfortable in reading various different financial statements to be effective at financial modeling and financial analysis. • Financial statement analysis is also important in: • Assessing management performance of a company and whether projections of improvement or sustainability are reasonable. • Assessing the value of a company from historic performance. • Assessing the reasonableness of financial projections provided by a company or the validity of earnings projections • Assessing whether the financial structure of a company is of investment grade quality
Objectives of Financial Statement Analysis • Financial statement analysis is like detective work – How can we use information in financial statements to make assessments of various issues. The financials should paint a picture of what has happened to the company: • How can we quickly review the income statement, balance sheet and cash flow statement to determine how the stock market value of a company compares to inherent value. • How can we look the financial statements and assess risks associated with a company and whether the company has sufficient cash flow to pay off debt. • Finance and valuation are about projecting the future -- how can financial statement analysis be used in making projections. • The problem in any financial analysis and valuation is that measuring risk is very difficult
Double Counting and Judgments in Financial Ratio Analysis • In analyzing financial statements judgments must be made in computing key data such as EBITDA and in developing financial ratios. • Examples • Whether or not to include Other Income in EBITDA • If other income not in EBITDA, then should not add non-consolidated subsidiary companies in invested capital • Exploration Expenses taken out of EBITDA • Make consistent between companies with different accounting policies • Goodwill (ROIC with or without goodwill depending on analysis issue) • Minority Interest (if include or exclude do for both income and balance) • Total of minority interest is in EBITDA, therefore must include financing of minority interest in invested capital • A key principle is that the financial data and the financial ratios are consistent and logical – work through simple examples
Income Statement • Review trends in EBITDA, EBIT, EBT and Net Income and explain what is happening to the company • EBITDA includes operating earnings and other income, but it does not include foreign exchange gains or losses, minority interest, extraordinary income or interest income. • EBITDA is a rough proxy for free cash flow • EBITDA is not generally shown on Income Statement • Potential Adjustments for items such as exploration expense • Compare EBIT to Net Assets and Net Capital • Ratio of EBITDA to Revenues should be shown for historic and projected periods • EBITDA is related to un-levered cash flow while Net Income and EPS are after leverage • NOPLAT is computed by EBIT less adjusted taxes, where taxes are computed through adjusting income taxes.
Problems with EBITDA • EBITDA is useful in its simplicity, and can be a good reference for comparison of debt and value, but it has weaknesses: • EBIT is more important than DA, because must use cash for replacing depreciation and amoritsation • In credit analysis, EBITDA works better for low rated credits than high rated credits. (Moody’s) • EBITDA is a better measure for companies with long-lived assets • EBITDA can be manipulated through accounting policies (operating expenses versus capital expenditures) • EBITDA ignores changes in working capital, does not consider required re-investment, says nothing about the quality of earnings, and it ignores unique attributes of industries.
Simplified Income Statement • Sales- COGS • = Gross Margin- SG&A- Other Expenses • + Other Income • = EBITDA • - Depreciation and Amortization • = EBIT • - Interest Expense (income) • = EBT- Income Taxes • - Minority Interest • = Net Income NOPLAT = EBIT x (1-tax rate) NOPLAT = Net Income + Interest Expense x (1-tax) There is a debate about how to handle other income from non-consolidated subsidiary companies. One school of thought (McKinsey) is that they should be valued separately since they will have different cost of capital etc. In this case, do not include in EBITDA and remove the asset balance from the invested capital. Must be consistent
Analysis of Income Statement – Computation of EBITDA, Minority Interest, Preferred Dividends, Exploration Expense
Income Statement Analysis • Example of Adjustments to EBITDA • Exploration Expenses (EBITDAX) • Rental and Lease Payments (EBITDR) • EBITDA Computation • Top Down – move other income • Bottom-up (Indirect) • EBITDA Notes • Interest Income out of EBITDA • Interest Expense not in EBITDA • Understand Non-cash Expenses • Deferred Mining Costs • Equity Income • Minority Interest
Discounted Cash Flow Analysis – Real World Example • Credit Suisse First Boston estimated the present value of the stand-alone, Unlevered, after-tax free cash flows that Texaco could produce over calendar years 2001 through 2004 and that Chevron could produce over the same period. The analysis was based on estimates of the managements of Texaco and Chevron adjusted, as reviewed by or discussed with Texaco management, to reflect, among other things, differing assumptions about future oil and gas prices. • Ranges of estimated terminal values were calculated by multiplying estimated calendar year 2004 earnings before interest, taxes, depreciation, amortization and exploration expense, commonly referred to as EBITDAX, by terminal EBITDAX multiples of 6.5x to 7.5x in the case of both Texaco and Chevron. • The estimated un-levered after-tax free cash flows and estimated terminal values were then discounted to present value using discount rates of 9.0 percent to 10.0 percent. • That analysis indicated an implied exchange ratio reference range of 0.56x to 0.80x.
Employee Stock Options • One can debate the treatment of employee stock options for EBITDA, free cash flow and valuation. • Think of options as giving stock to employees • If the treatment has changed over the years and it is a significant expense, make adjustments to current or prior statements for consistency. • Think of options as giving free shares to employees. The value of existing shareholders is diluted. • One can argue that this is two things • First, employees are compensated and the cash should be accounted for • Second, invested capital is increased and the new equity should be included in the capital base
Cash Flow Statement • Modern Cash Flow Statement has separation between • Operations • Capital expenditures (to maintain and grow operations) and • Financing • Operating Cash Flow • Add back items from the income statement that do not use cash (depreciation, dry hole costs etc) • Analyze how much cash flow the company generated and how it raised funds or disposed funds • Use Cash Flow statement as a basis to compute free cash flow although cash flow not presented on the statement • Problem: Interest Expense – related to financing and not operations – is in the Net Income and is included in Cash From Operations
Cash Flow Statement • A. Operating Cash Flows • 1) Net Income including interest expense, interest income and taxes • 2) Depreciation • 3) Deferred Taxes • 4) Working Capital Changes • 5) Minority Interest on Income Statement and Other Items • B. Investing Cash Flows • 1) Capital Expenditure and Asset Purchases • 3) Sale of Property, Plant, & Equipment • 4) Inter-Corporate Investment • C. Financing Cash Flows • 1) Dividend Payments • 3) Proceeds from Equity or Debt Issuance • 4) Equity Repurchased • 5) Debt Principal Payments
The Notion of Free Cash Flow • In practice the term cash flow has many uses. For example, operating cash flow is net income plus depreciation. • Free cash flow is the cash flow that is available to investors – FREE of obligations such as capital expenditures and taxes -- to both debt and equity investors – after re-investing in plant, and financing and paying taxes. • Accountants define cash flow from operations as net income plus depreciation and other non-cash items less changes in working capital. However, this cash flow is not available for distribution to equity holders and debt holders. The free cash flow must account for capital expenditures, repayments of debt, deferred items and other factors. • Free cash flow consists of • Cash flow to equity holders • Cash flow to debt holders
Theoretical Context – Miller and Modigliani • Theory that changed finance in 1958 • Value assets on fundamental operating characteristics such as the capacity utilisation, the cost and the efficiency of assets and not the manner in which assets are financed – debt versus equity or the manner in which assets are hedged. • This has led to the discounted cash flow model that underlies most valuations • The proof was based on a simple arbitrage idea that you could buy stock in a company that has no debt and then borrow against the stock. This will yield the same results as if the company borrowed money instead of you. • The implication of this is that project finance is irrelevant
Fundamental Distinction in Financial Analysis – Free Cash Flow and Equity Cash Flow • Free Cash flow that is independent from financing • Valuation • Performance in managing assets • Claims on free cash flow • Cash flow to pay debt obligations • Comparisons unbiased by capital structure policy • Equity cash flow • Valuation of equity securities • Performance for shareholders
Importance of Free Cash Flow • Alternative Definitions, but one correct concept • Free Cash Flow Is Also Known As Unleveraged Cash Flow • Unleveraged Cash Flow Is Not Distorted By The Capital Structure • Free Cash Flow should not change when the capital structure changes • Free Cash Flow should be the same as equity cash flow if no debt is outstanding and not cash balances are built up. • Free Cash Flow in Valuation • PV of Free Cash Flow Defines Enterprise Value • The Relevant Discount Rate Is The Unlevered Discount Rate or the Weighted Average Cost of Capital • IRR on Free Cash Flow is the Project IRR • Free Cash Flow in Economic Value • FCF – Carrying Charge = Economic Profit
Cash Flow Statement in Financial Model • Analysis in Cash Flow Statements • Compute Cash Flow before Financing • Operating Cash Flow minus Capital Expenditures • Use Cash Flow Before Financing in Deriving Free Cash Flow • Equity Cash Flow • Dividends less Cash Investments • Cash Flow Before Financing less Maturities plus New Debt Issues • Last Line on Cash Flow Statement Includes • Change in Cash Balance • Change in Short-term Debt or Overdrafts • Beginning Balance + Change = Ending Cash • Beginning Balance of STD + Change = Ending Short-term Debt
Free Cash Flow Formulas • Free cash flow can be computed from the income statement or from the cash flow statement. • From the cash flow statement, the formula is: • Cash Before Financing • Plus: Interest Expense • Less: Tax Shield on Interest • From the income statement, the formula is: • EBITDA • Less: Taxes on EBIT • Less: Working Capital Investment • Less: Capital Expenditures • From Net Income • Net Income • Add: Net of Tax Interest • Add Depreciation, Deferred Taxes and Other Non-Cash Changes • Less: Changes in Working Capital • Less: Capital Expenditures Some argue that free cash flow should not include non-operating items. Here the non-consolidated companies are treated in a similar manner as liquid investments
Free Cash Flow from NOPLAT • Free cash flow can be computed using the notion of net operating profit less adjusted tax as follows (assuming no extraordinary income) • Step 1: Compute NOPLAT • Net Income • Plus Net Interest after Tax • Plus Deferred tax • Equals NOPLAT • Step 2: Compute Free Cash Flow • NOPLAT • Plus: Depreciation • Less: Change in Working Capital • Less: Capital Expenditures • Equals Free Cash Flow
One could make adjustments for dividends payable, interest payable and other items in the working capital analysis. Free Cash Flow Example In actual situations, must adjust the free cash flow for deferred tax
Balance Sheet Adjustments • When analysing the balance sheet, various items should be adjusted and grouped together: • Net Debt • Total short and long term debt minus liquid investments held and surplus cash • Cash Bucket • For modelling, subtract short-term debt from surplus cash and liquid investments • Surplus Cash • Include temporary investments and also include long-term investments • Current Assets and Current Liabilities • Separate the surplus cash from current assets and the debt from current liabilities and relate remaining working capital items to revenue and expense items
Balance Sheet Issues • Treat surplus cash as negative debt and debt as negative cash • Rule of thumb – cash is 2% of revenues • Example – when developing a basic cash flow model, group the cash and the debt as one account and then separate this account on the balance sheet. • Unfunded pension expenses should be treated like debt – they involve a fixed obligation and they can be replaced with debt when they are funded. • Deferred taxes depend on the way deferred taxes are modelled for cash flow purposes. If you model future changes in deferred taxes and take account of these in projections, do not put deferred taxes as a component of equity.
Problems with Equity Balance • Would like the return on equity and the return on invested capital to measure equity invested by shareholders for return on investment and return on equity • Problems with using equity balance on the balance sheet to measure equity investment • Write-offs of plant • Accumulated Other Comprehensive Income • Goodwill • Re-structuring losses • Employee Stock options • Can make adjustments to equity balance
Free Cash Flow Project IRR ROIC (ROCE) WACC Enterprise Value EV/EBITDA Market to Replacement Cost Equity Cash Flow Equity IRR ROE Cost of Equity Market Capitalisation P/E Market to Book Ratio Tension between Equity Analysis and Asset Analysis EV = Σ Value of Business Units = Debt + Equity Value In ratio analysis, cash = negative debt
IRR Mathematics and IRR Exercise Why we raise to a power with two year case FV = PV (1+r) (1+r) FV = PV (1+r)2 FV/PV = (1+r)2 (FV/PV)^(1/2) = (1+r) (FV/PV)^(1/2) – 1 = r • IRR is simply rate of return • Example: Invest 100 and receive 120 in 1 year • IRR = 120/100 = 120% - 100% = 20% • If the cash flow is over two years • IRR = -100 , 60 , 60 13.07% • Modified IRR with 5% Re-investment • 60 receives 5% in year two 60 x (1.05) = 63 • Plus final 60 = 123 • MIRR = (123/100)^(1/2) - 1 = 10.9%
Financial Ratio Analysis • Purpose : • Evaluate relation between two or more economically important items (one is the starting point for further analysis) Cautions: • Accounting analysis is important (deferred taxes etc.) • Interpretation is key • What does the P/E mean • Is an interest coverage of 3.5 good • Why is the ROIC low • Should we use MB, PE or EV/EBITDA • Document financial ratios (numerator and denominator) with footnotes and comments • Show components of numerator and denominator in rows above the ratio calculation
General Discussion of Financial Ratios • Financial Ratios Often Compares Income Statement or Cash Flow with Balance Sheet • In developing ratios, understand why the formula is developed (e.g. other income and other investments in return on invested capital) • There is Not Necessarily One Single Correct Formula • For example, pre-tax or after-tax return on assets. • Keep the numerator consistent with the denominator • Financial Ratios should be evaluated in the context of benchmarks • Credit ratios and bond rating standards • Returns and cost of capital • Operating ratios and history
Classes of Financial Ratios • Management Performance • Ratios that measure the historic economic performance of management and evaluate whether the economic performance can be maintained (e.g. ROIC) • Valuation • Ratios that are used to give an indication of the value of the company (e.g. P/E) • Credit Analysis • Ratios that gauge the credit quality and liquidity of the company (e.g. Interest coverage and current ratio) • Model Evaluation • Ratios used to evaluate the assumptions and mechanics of financial forecasts
Class 1: Financial Indicators of Management Performance • Evaluate Whether Management is Doing a Good Job with Investor Funds (Not if the company is appropriately valued) • Return on Invested Capital • Return on Assets • Return on Equity • Market/Book Ratio • Market Value/Replacement Cost • Key Issue • Evaluate relative to risk • ROE versus Cost of Equity • ROIC versus WACC
ROIC, WACC and Growth • ROIC is before interest and the return covers both debt and equity financing – EBIT is before interest and investment includes both debt and equity investment • WACC is the blended average of debt and equity required returns • ROIC versus WACC measures the ability to make true economic profit • Once have economic profit, should grow the business as much as possible.
Basic Economic Principles, ROIC and Financial Analysis • When you measure value, you are gauging the ability of a firm to realize economic profit. For example, when you compare the equity IRR with the equity cost of capital. • When you assess assumptions in a financial forecast, you must assess whether economic profit implicit in the assumptions can in fact be realized. For example, if the financial forecast has a very high ROE, is that reasonable. • When you interpret financial statistics, you are gauging the strategy of the company in terms of whether economic profit is being realized. In reviewing the return on invested capital, does this demonstrate that the company has the potential to earn economic profit.
Return on Invested Capital Analysis • ROIC is not distorted by the leverage of the company • ROIC can be used to gauge economic profit and whether the company should grow operations • ROIC can be used to assess the reasonableness of projections • For example, if ROIC is very high and the company is in a competitive business with few barriers to entry, the forecast is probably not realistic. • ROIC can be computed on a division basis EBIT and allocation of capital to divisions from net assets to gauge the profit of parts of the company • ROIC comes from sustainable competitive advantage and high market share
Formula for Return on Invested Capital • The return in invested capital formula can be for a division or an entire corporation. It is after tax and after depreciation. Cash balances should be excluded from the denominator and interest income from the numerator. Goodwill and goodwill amortization should be excluded. • Formula: • ROIC = EBITAT/Invested Capital • Where: • EBITAT: Earnings before Interest Taxes and Goodwill Amortization less taxes on EBITAT • Taxes on EBITAT: Cash Income Taxes Less Tax on Interest Expense and Interest Income and Tax on Non-operating Income • Invested Capital less cash balance • Adjustments • Other Assets • Cash Balances • Goodwill • Other
Issues in Management Performance Evaluation • Basic Formula: ROIC versus WACC • How to compute ROIC • NOPLAT/Average Invested Capital • May or may not include goodwill – If goodwill is not included, compute NOPLAT without subtracting goodwill write-off and subtract net goodwill from invested capital • Reduce the invested capital by surplus cash balances • Some don’t include other income – then the invested capital should be reduced by other investments • Can compute with ratios • EBIT Margin x (1-t) * Asset Turn • Asset Turn = Sales/Assets; EBIT Margin = EBIT/Sales • ROCE vs ROIC • ROCE is generally computed in an indirect way by starting with net income, and adding net of tax interest and adding minorities
Exxon Mobil Return on Average Capital Employed • Return on average capital employed (ROCE) is a performance measure ratio. From the perspective of the business segments, ROCE is annual business segment earnings divided by average business segment capital employed (average of beginning and end-of-year amounts). • These segment earnings include ExxonMobil’s share of segment earnings of equity companies, consistent with our capital employed definition, and exclude the cost of financing. • The corporation’s total ROCE is net income excluding the after-tax cost of financing, divided by total corporate average capital employed. The corporation has consistently applied its ROCE definition for many years and views it as the best measure of historical capital productivity in our capital intensive long-term industry, both to evaluate management’s performance and to demonstrate to shareholders that capital has been used wisely over the long term. Additional measures, which tend to be more cash flow based, are used for future investment decisions.
Exxon Mobil Return on Capital Employed – Where are they making expenditures
ROE and ROIC – Note how to compute growth rates from ROE and Retention
Example of Return on Capital Employed (Return on Invested Capital) in Financial Analysis • The argument has been made that the best measure to evaluate management performance that is not distorted by leverage (as in the case of ROE) or has the problems of ROA is the return on invested capital. An example of use of this ratio is in the Exxon Mobile Merger: • J.P. Morgan reviewed and analyzed the return on capital employed ("ROCE") of both Exxon and Mobil since 1993. J.P. Morgan observed that Exxon's ROCE has consistently been 2-3% above that of Mobil. • J.P. Morgan's analysis indicated that if Mobil were to be merged with Exxon, the combined entity's capital productivity would eventually be higher than the pro forma capital productivity of Exxon and Mobil. • J.P. Morgan indicated that it would be reasonable to assume that the benefits of this capital productivity increase would occur within three years of the closing of the merger.