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##### CHAPTER 17 Financial statement analysis II

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**Contents**• Introduction – Framing of financial statement analysis • Quality of earnings • Analytical techniques • Strategic ratio analysis • Z scores • Shareholder value**Framing of financial statement analysis**• Accounting numbers are not the only input into the assessment of a company’s prospects • Figure 17.1 provides an overview of relevant framing factors • Increasing use of investor briefings by companies**Fig. 17.1 Rating pyramid**Sovereign macro-economic analysis Industry sector analysis Regulatory environment (national and global) Competitive trends in sector Market position Quantitative analysis financial statements past performance future projections Qualitative analysis management strategic direction financial flexibility Rating**Quality of earnings**• Is profit (and profit growth) sustainable? • What is the impact of short term conditions ? • What is the impact of ‘creative’ accounting changes ? • Changes in accounting policies • Changes in accounting estimates • Changes in consolidation scope • Changes in interest % • Exceptional sale of assets or business segments • Other extraordinary operations**Quality of earnings (cont.)**Some analysts will compare, in a longitudinal fashion, operating profit to net operating cash flow to identify and analyse the effect of ‘accruals’- games on operating earnings.**Discontinuing operations**• A discontinuing operation is a clearly distinguishable component of a group’s business, that (a) Is disposed of or terminated pursuant to a single plan (b) Represents a separate major line of business or geographical area of operations, and (c) Can be distinguished operationally and for financial reporting purposes. • Requires major additional disclosures • Income statement / Cash Flow Statement / Notes**IFRS 5 - Presentation of Discontinued Operations in the**Income Statement (Extract) continues**IFRS 5 - Presentation of Discontinued Operations in the**Income Statement (Extract) – cont. Source: IFRS 5 – Non-current assets held for sale and discontinued operations, Guidance on implementing**Analytical techniques**• Common accounting base • Common size • Ebitda • Objectives of analysis**Common accounting base**• Adapt financial statement data for differences in accounting rules among companies, e.g. • Accounting for R&D costs • Depreciation rules • Goodwill treatment • Revaluation of fixed assets • Set up comparable pro-forma statements for cross-sectional analysis**Common size**• Common size financial statements • Resize components of balance sheet as a % of total assets • Express components of income statement as a % of sales • They allow a straightforward internal or structural analysis of a company’s financial position and performance • Useful for comparisons in time and in space**Ebitda**• ‘Earnings before interest, taxation, depreciation and amortization’ • Proxy for net operating cash flow • Cleans operating result for non-cash costs and non-cash revenues • Robust measure for comparison of performance in time and space**Objectives of analysis**• Investors and creditors as predominant users of financial statements • Broadly, both investor and creditor will use the same indicators, but the relative importance of specific indicators will be different and will be contingent on the type of investor (and creditor) decisions to be made**Strategic ratio analysis**• Sustainable growth • ROI decomposition • Financial leverage • Operational gearing**Recap ratio analysis**• Understand accounting principles • Develop a consistent analysis framework • Constraints of an historical perspective • Garbage in, garbage out • Take into account trends and industry comparisons • Take into account worldwide variations in accounting rules**Strategic analysis**• Elements of strategic analysis: • Phase in life cycle of company and products • Nature of market • Difficult entry <> large margins • Easy entry <> margins usually very low • Nature of products • Niche products (low volume, high price) • Bulk (high volume, low margins) • …. • Develop (combinations of) ratios which will give insights to a company’s strategic positioning**Sustainable growth**• Look at growth of key items of financial statements • Trend analysis • Differentiate organic and acquired growth • Sustainable growth = ROE x (1 – Dividend payout ratio) • Dividend payout = Dividend / Earnings attributable to shareholders = indicator of internally generated growth potential if the company’s profitability, dividend payout and level of debt financing are kept constant**Growth analysis**• Periodic growth of sales as point of departure • Link with profit growth ? • Differentiate between organic and acquired growth • Identify regional or geographic location of growth • Differentiate growth potential by business segment • Impact on cash flow ?**ROI decomposition**There is a conventional relationship between management performance ratios which links return on investment, profit margin and asset turnover as follows: Profit margin * Asset turnover = ROI If we apply this reasoning to the ROA (return on assets) ratio, we arrive at the following algebraic equality:**ROI decomposition (2)**Assume: ROA decreases over a number of periods • Cause? Asset turnover, Profit margin or both ? Assume: Asset turnover drops => Cause? Sales, assets or both? Potential causes: • Due to competition, sales decrease and one is not able to adjust inventory levels accordingly • Recent investments in IT were necessary to support current competitive position Assume: Profit margin decreases => Cause ? Increasing operating expenses, decreasing market share, decreasing sales prices, …**Financial leverage**Taking the analysis one step further, the return on equity can be analytically linked to the return on assets ratio with the introduction the concept of financial leverage. ROA * Financial leverage = ROE Starting with the ROA (return on assets) ratio, we arrive at the following algebraic equality: Alternatively, we can start from the original ROE definition and get the following:**Final leverage coefficient**A related, but somewhat different, concept is the financial leverage coefficient ratio, defined as ROE divided by ROA: Financial leverage coefficient = ROE% / ROA%**Table 17.1 Financial leverage effect at different**debt/equity ratios**The DuPont model**Combining ROI decomposition and financial leverage brings us to the following overall model (also called the DuPont model): ROE = Net profit margin * Asset turnover * Financial leverage or:**Operational gearing**• Volatility of profit as a function of changes in sales (taking into account the cost structure) • Operational gearing is the % change in profit as sales changes 1% • Based on the traditional difference between fixed and variable costs • Operational gearing = • (Sales – variable costs) / EBT or • (Earnings before tax + fixed costs) / EBT**Fig. 17.2 Operational gearing**Value Sales Costs = Fixed + Variable Costs Break-even Volume**Fig. 17.2 Operational gearing (cont.)**Value Sales Costs = Fixed + Variable Costs Volume Break-even**Fig. 17.2 Operational gearing (cont.)**Value Sales Costs = Fixed + Variable Costs Volume Break-even**Different cost structures**If sales increase by 10%, profit before tax of company A increases by 30% and profit of company B by 80% A decrease in sales will have a more dramatic effect in company B**Operational gearing indicators**• Operational gearing = • (Sales – variable costs) / EBT • (Earnings before tax + fixed costs) / EBT • Proxy in external analysis: • LT assets / Total assets • LT assets / Current assets**Investigate link between ratios and cash flows**• Cash from operations • ROCE, profit margins and growth • Changes in working capital • Days credit given and net working capital • Investment outflows • Capital intensity, age assets and depreciation regime • Free cash flow • Should be positive if company in stable position**Z-scores**• Failure prediction models: ratios are used as input for more sophisticated models, taking into account the simultaneous impact of several factors • How measured ? 2 samples with mutual matching of which one with failed companies - data consist of financial ratios relative to years before failure => ratios which discriminate best between two groups are used as input for failure prediction models**Shareholder value**• Focus on present (discounted) value of forecast earnings • Time value of money and present value calculations • Forecast cash flows • Discount rate**Present value**The essence of present value is that a rational person will prefer to have a receipt sooner rather than later because the money can be used to generate more money. For example, if a company has a choice of receiving $1,000 now or $1,000 in a year’s time, it would prefer to have the cash now because it could be invested and earn a return. If the money was put into risk free securities where it could earn 15 per cent, then $1,000 now would be worth $1,150 in a year’s time.**Present value (cont.)**Extending that, the $1,000 to be received after a year is worth $1,000/1.15 (or $870) today, because $870 invested today at 15 per cent would yield $1,000 in a year’s time. Similarly, $1,000 to be received in two years’ time is worth $1,000/(1.15*1.15) = $756 at present (i.e. compound interest at 15 per cent for two years would be $244).