Historical Financial Analysis Certificate course on valuation G. Chella Krishna,FCA CNGSN and Associates Please see acknowledgements on the last slide
Valuation-Historical AnalysisWhat’s the connection? • Valuation of a business is sum of netdiscountedfutureoperatingcash flows to be generated by the business • Historical Analysis helps us project these cash flows using proven techniques in order to get dependable predictions. • Historical analysis consists of working with financials in their absolute form as well the quality of the numbers
What is Historical Financial Analysis and what is its purpose? Historical Financial Analysis is the analysis of • General Economic Environment • Industry structure • The business and its value drivers • Accounting and accounting policy • Financial statements for the purpose of understanding the future maintainable operating profits of the business that is being valued
Analysis of General economic environment • What is the anticipated GDP Growth rate? • What is the rate of inflation? • What is the level of real interest rate in the economy? • How are currency markets affecting the growth of exports? • How are commodity markets like cement, steel, crude affecting overall cost of production for industry • What is the reward in the stock market for risks undertaken? • Investment climate and liquidity
Sources of General economic environment data • Government publications (RBI - www.rbi.org.in) • Annual reports of publicly traded companies • Filings for public offerings • Industry or trade associations • Industry or trade association reports • Internet searches, newspaper reports, trade journals • Research reports prepared by broking firms, economists, business data bases, other external parties • Conference call transcripts of analysts with companies
Industry Structure Analysis- Michael Porter’s five forces Industry protection and regulation-taxation/tariffs etc
Understanding the regulatory framework for the industry • What are the key regulations affecting this industry? Eg. Banking and Insurance, Mutual funds • What kind of FDI regulations are present for this business? Eg. Print media • What kind of Income tax exemptions and special depreciation rates are available for this business? Eg. Wind power, STPI for IT,80IA for infrastructure • Restrictions and licensing procedures applicable to the industry Eg. Ports, Banking, Power projects • Industries like Fertilizers, Sugar, Alcohol are subject to periodic change in government policy.
Understanding the business • What are the principal products sold by the business? Who are the main customers? What are the primary inputs and suppliers for the same? • What is the component of labor in the cost of making the finished product? How does overhead move with production? • Who are the key officers of the business? Does it have a succession plan? • What is the market share of the business in the overall industry? • What is the product mix of the company and which products are the ‘cash cows’ and which are the ‘loss leaders’? • What is the tax structure for the business? What is the gearing of the business? • What is the planned capex/future capacity planned, working capital requirements and dividend?
Value drivers of the business • Different types of value drivers: • Sales growth rate, operating profit margin, income tax rate, incremental investments in working capital and fixed capital, replacement of fixed capital, cost of finance, planning period. • The critical value drivers are the ones which affect free cash flow – therefore, do a sensitivity analysis. • The above value drivers can be decomposed for further analysis • Other important value drivers (industry related) – inventory turnover (retail), loan / deposit ratios (banks), cane recovery rate (Sugar), rooms (hotels), billable-non billable effort analysis (IT)
Accounting analysis • What are the key accounting policies that are employed by the entity to measure its various factors and risks? Are they in variance with Generally Accepted Accounting Practices (GAAP) or accepted industry norms? Eg.. Franchise accounting, ESOP accounting, FCCB accounting • Evaluate accounting strategy: Is the approach to communicate to share holders on all details or to hide, conceal particulars or give details only to the extent required by legislation? • Evaluate the quality of disclosure Eg. Attention to compliance to accounting standards and the level of compliance • Identify potential issues – Eg. Frequent revision of useful lives of assets, frequent sales returns • Undoing accounting distortions; Cookie-jar accounting (E.g.. Smoothing of revenues)
Steps in Accounting Analysis • Identify Key Accounting Policies • Evaluate Accounting Strategy • Evaluate the Quality of Disclosure • Identify Potential Red Flags/accounting land mines • Performing accounting adjustments for giving effect to market realities
Identify Key Accounting Policies • Which are the key accounting policies affecting the key numbers in the business and whether they accurately describe the operational achievements of the business? • In accounting analysis, identify and evaluate the policies and the estimates the firm uses to measure its various assets and liabilities Eg. Obsolescence of Hardware, R&D in pharma • Examples of key policies in certain industries • Banking – interest and credit risk management (loan loss reserves) • Retail – Inventory management • Leasing – accurate forecast of residual value at the end of lease term (residual values influence reported profits and asset base) • Manufacturer – R&D and product defects after sale (warranty expenses)
Evaluate Accounting Strategy • How do firm’s accounting policies compare to the norms in the industry? Are they aggressive or conservative? • Does the management face strong incentive to use accounting discretion for earnings management? Bonuses and PLVC • Has the firm changed its accounting policies? What is the justification? • Have company’s policies and estimates been realistic in the past? Intangibles especially • Does the firm structure any significant business transactions so that it can achieve certain accounting objectives? Eg. Group company sales • Does the tax year tie in with the financial year? Or are they kept different to plan taxes in March and show profits during the financial year?
Evaluate the Quality of Disclosure • Does the firm provide adequate disclosures to assess the firm’s business strategy and economic consequences? • Letter to shareholders, Berkshire Hathaway: Once a year but saying everything. Are predictions too perfect and accurate? • Do the footnotes adequately explain the key accounting policies and assumptions and their logic? Are omnibus accounts and extraordinary items broken down and explained? • Does the firm adequately explain executive compensation? • Is there an audit committee that is independent and vouchsafes the numbers?
Evaluate the Quality of Disclosure • If the accounting rules and regulations restrict the firm from measuring its key success factors appropriately, does the firm provide additional disclosures to help outsiders understand how these factors are being managed? Eg. Improved financial statement after a takeover • If the firm is in multiple businesses, what is the quality of segment disclosure? • How forthcoming is the management with respect to bad news? Is there an air of underperformance? • How good is the firms investor relations programme?
Identify Potential Red Flags • Unexplained changes in Accounting, policies, estimates especially when the performance is poor. • Unexplained transactions to boost profits • Unusual increase in AR in relation to sales • Unusual increase in inventories in relation to sales increases • Unusual increase in intangible assets • Reduction in managed costs like advertisement to boost profits. Eg. FMCG companies • Onetime source of income like sale of non-productive assets • Reliance on income sources other than company’s core business
Identify Potential Red Flags (Contd.) • Business combination accounting is being used to give illusion of growth • An increasing gap between a firm’s reported income and its tax income • An increasing gap between the reported income and the reported cash flows • Unexplained large asset write-off/Court scheme • Mergers and De-mergers with a hidden intention to write off assets • Tendency to use financial mechanisms like R&D partnerships, sale of receivables with recourse, special purpose entities • Large fourth quarter adjustments • Qualified audit report or changes in auditors • Unusually long audit report with unusual wording • Related party transactions
Accounting Minefields • Revenue Measurement and Recognition • Determining when a sale is complete or service fully rendered or simply when is revenue treated as earned • Revenue recognition when delivery is taken but payments are over several years. Customer may not survive • Does this present a reasonable measure of revenue earned by business during reporting period? Is it consistent with revenue measures of competitors? • If revenue is measured in an unusual or new way, is that disclosed? Is the approach justified in terms of risks and advantages? Real estate, registering UDS, Cancellation
Accounting Minefields • Provision for Uncertain Future Costs • Estimates inflated to create hidden reserves or diminished to enhance reported profits. Eg. Suspicion of cartel formation • Are estimates for uncertain events included in financial statements? • Do the financial statements present a reasonable measure of current period operating expenses and revenues, with sufficient disclosure in footnotes of these estimates and accounting treatment? • What is the policy of the company on capitalisation of interest on Fixed assets values?
Accounting Minefields • Asset Valuation • Whether the company is the owner of the asset or a mere licensee of the asset? FMCG companies • Accelerated write off R&D in process of acquired company • Conduct R&D through investments in partners to avoid treating costs as current expenses • Do tangible and intangible asset values and write downs of assets reflect real values and changes in value during current period? • Are these value adjustments fully disclosed? • In case assets are accredited with say the FDA, then whether such accreditation is still in existence. Ranbaxy-Daiichi • Is the accounting treatment consistent with industry and global competitors? If not, are the differences justifiable and adequately discussed in the financial statements?
Accounting Minefields • Derivatives • What hedging programs are in place? • To what extent are derivatives used? • What are the worst case scenarios of company’s use of derivatives? • Is the accounting treatment complete and in the spirit of GAAP? Is GAAP treatment sufficient to describe the business value and risks of the derivative program? Mark to market accounting? • Statue Based • Most often companies don’t comply the 365 days period allowed for remittances. Section 10A benefits are revoked
Accounting Minefields • Related-Party Transactions • Are all significant related party transactions and commitments disclosed? • What policy determines which transaction will be disclosed and what level of detail will be included in financial statements? • Whether transfer prices charged to related parties are adequate and at arms length? Are there any sole selling agents appointed by the company? • What proportion of business is done with related parties?
Companies Manipulating Accounts • High growth companies entering low growth phase • Companies that receive extensive coverage in business or popular press • New businesses where there are ambiguities about how key transactions should be measured • Weak control environments in which managers can manipulate reported financial results with impunity • Companies that are followed by small number of analysts • Companies with complex ownership and financial structures • Companies with significant market share with faster growth than industry • Companies doing too well to believe • History of using accounting decisions to achieve earning expectations • Firing of auditors
Length of financial history • Generally, three to five years considered adequate to determine maintainable earnings (five on a conservative basis – if a good reason, such as a change in business model or scale of operations causes you to consider only three years, it should be sufficient). • Consider length of company’s business cycle.
Adjustments to financial statements • Objectives – To normalise historical earnings, restate earnings under normal operating conditions and to adjust for departures for normal accounting practice. The resultant adjustments mean that the adjusted statements provide a better guide to predicting future earnings • Separation of non operating items – the test is, do the assets stand to the side of the business, so that the business could be continued without any curtailment of operations without them. Such surplus assets must be valued separately and added back to the business value to arrive at total value. • Recent amendment to quarterly reporting format
Adjustments to financial statements • Adjusting excess assets and deficiencies – the test and treatment is similar to that for non operating assets. Additionally, ratios / levels of assets can be compared with that of guideline / similar companies. • Contingent assets or liabilities – Adjust as a percentage, or ignore? • Cash basis accounting – adjust to accruals based • Normalising adjustments – Essentially, adjust for deviations from GAAP and industry accounting norms, as also one-off items. The intention is to present financial data on a consistent basis over time. Adjust for unusual, nonrecurring and extraordinary items, changes in accounting policy, deviations from GAAP.
Adjustments to financial statements • Controlling Adjustments (when a controlling interest is being valued) • Excess or deficient compensation and perquisites for family members or business owners • Other transactions with family and related businesses – examine for, ‘arm’s length’ values • Discretionary expenses and inefficiencies, e.g. too many cars and high petrol expenses, because the family cars may be used to obtain tax shields • Capital structure adjustments, which would not have been possible had the business been run on purely commercial lines, e.g. high interest (or no interest) debt, thin capitalisation, (un)favourable financing terms
Analysis of the 4 items • Analysis of the 4 items • Assets • Liabilities • Income • Expenses
Financial statements- Asset analysis • The point is that care has to be taken to see that no major expense is capitalized and no major asset is expensed. Criteria for recognizing assets: • Resources are owned by the firm • Resources are expected to provide future economic benefits, sufficient to recover their cost • The future economic benefits are measurable with a reasonable degree of certainty
Asset analysis (contd.) • Economic benefits are uncertain or difficult to measure? Consider goodwill, brands, etc. • There are changes in future economic benefits? • Do operating assets appear impaired (systematic poor performance, write downs by other firms in the industry)?
Liability analysis • Liabilities need to be properly recorded and reflected and must not be recorded as an income. Criteria for recognising liabilities: • An obligation has been incurred to provide future benefit(s) • The amount and timing of the obligation is measurable with reasonable certainty. • Restructuring charges, contingent liabilities • The amount and timing of future obligations is difficult to measure? Rewards programs, retirement benefits • Are liability values dynamic • Prudence vs. Smoothing
Income analysis • Criteria for recognition of income: • The product or service should have been provided • Cash is collected or is reasonably likely to be collected • Some specific points for further consideration: • When customers pay in advance, the advance element needs to be deferred. See that the advance element is properly estimated on a consistent and realistic basis along the lines prevalent for the industry • Multiple period product/service – similar to above, plus ensure that applicable guidance/standards e.g. for construction contracts are adhered to • SIGNED CONTRACTS VS SHORT ORDERS- BPO companies • Where residual rights remain with the seller, see that proper HP accounting is done. Refer to the notes to the accounts
Income analysis (contd.) • Creditworthiness of customers – Are bad debts being provided for on a consistent and realistic basis along the lines prevalent for the industry? If there is a change in estimation, is it justified by an underlying change in strategy? Is there a customer satisfaction program / survey in place? Credit appraisals? The idea is to see that this is being properly managed. • Sales returns – Look into whether these are being appropriately recorded and are generally at a similar rate for sales.
Expense Analysis • It is important to ensure that expenses are recorded in accordance with the matching principle. Principles for recognizing expenses: • Expenses associated with revenues should be recorded in the period when income is recognized (Cause-and-effect relationship) • Expenses associated with a specific period should be recorded in that period • Other expenses recorded as incurred (no cause-and-effect relationship) • Special cases (see that these are recorded in accordance with applicable standards, SEBI guidelines, etc.): Deferred revenue expenditure, pension costs, COGS (inventory valuation), ESOP expenses, impairment costs (where required to be routed through P&L) • Tescom case- Security, insurance, training costs
Financial Analysis Techniques Three Standards of Comparison • Compare the business against itself • Compare the business’ ratios to a set of benchmarks • Compare the business to an industry average • Similar size • Similar type
Five Financial Criteria Liquidity • Ability to meet financial obligations when they come due without disrupting the normal ongoing operations Solvency • Indication of the ability to repay all indebtedness if all the assets were sold Profitability • Extent to which a business generates a profit from the use of labor, management and capital • Relationship between revenues and expenses • Focus on level of profits in relation to the amount of investment
Five Financial Criteria Repayment Capacity • Ability to repay debt from both farm and non-farm income • Capacity to service additional debt Financial Efficiency • Degree of efficiency in using labor, management, and capital • Relationship between inputs and outputs
Objectives of Ratio Analysis Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations
Ratios and Forecasting • Common stock valuation based on • Expected cash-flows to stockholders • ROE and rate of growth of earnings are major determinants of cash-flows to stockholders • Ratios influence expectations by: • Showing where firm is now • Providing context for current performance • Current information influences expectations by: • Showing developments that will alter future performance