Chapter 5: Essentials of Financial Statement
Analysis
Learning objectives
1.
Essentials of financial statement analysis,
financial statement analysis tools and
approaches.
2.
How ROA is used to analyze profitability and
the insight to separate ROA to profit margin
and asset turnover rate.
3.
How ROA and financial leverage combine to
determine a firm’s return on equity (ROCE).
5-1
Learning objectives (contd.)
3.
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.
4.
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
3
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
4
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.
5
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.
6
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.
7
Learning Objective:
Essentials of Financial Statement
Analysis
8
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.
9
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.

10
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).

11
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.
12
How the financial accounting “filter”
sometimes works
GAAP puts capital leases
on the balance sheet, but
operating leases are “offbalance-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
Financial statement analysis:
Tools and approaches
Tools:
Approaches used with each tool:
1.
Common size statements
Time-series analysis: the same firm
over time (e.g., Wal-Mart in 2008 and
2006)
Trend statements
2. Cross-sectional analysis: different
firms at a single point in time (e.g.,
Wal-Mart and Target in 2008).
Financial ratios
(e.g., ROA and ROCE)
3. Benchmark comparison: using
industry norms or predetermined
standards.
5-14
Financial analysis tools
1.
2.
3.
4.
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.
15
Basic Approaches
1.
2.
3.
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.
16
Getting behind the numbers:
Case Study: Krispy Kreme Doughnuts, Inc.

Established in 1937.

Today has more than 290
doughnut stores (companyowned plus franchised)
throughout the U.S.

Serves more than 7.5 million
doughnuts every day.
70%
65%
60%
50%
40%
31%
30%
20%
10%
4%
0%
Compnay
stores

Strong earnings and consistent
sales growth.
Sales to
franchisees
Royalties
Revenue sources in 2002
17
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.
18
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.
19
Trend Income Statements:
Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Income
Statement
Base Year
$393.7 operating expenses in 2002
* Not adjusted for distortions caused by “special items”.
$194.5 operating expenses in 1999
Each statement item is calculated in percentage terms using a base year number.
20
Comparative Balance Sheets Assets
Krispy Kreme’s Financials: Balance Sheet Assets
21
Common Size Assets
Krispy 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.
22
Trend Assets
Krispy 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.
23
Comparative Balance Sheets Liability
and Equity: Krispy Kreme’s Financials
24
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.
25
Trend Liabilities and Equity
Krispy 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.
26
Krispy Kreme’s Financials:
Abbreviated cash flow statements
27
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.
28
Trend Cash Flow Statements
Krispy 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.
29
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.
30
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.
31
Learning Objective:
Profitability Analysis
32
Financial ratios and profitability analysis
Operating profit margin
EBI
Sales
Return on assets
ROA=
EBI
Average assets
NOPAT is net operating profit after taxes
X
Asset turnover
Sales
Average assets
Analysts do not always use the reported earnings, sales and asset figures.
Instead, they often consider three of adjustments to the reported numbers:
1. Remove non-operating and nonrecurring items to isolate
sustainable operating profits.
2. Eliminate after-tax interest expense to avoid financial structure
distortions.
3. Eliminate any accounting quality distortions (e.g., off-balance
operating leases).
33
Calculating Return on Assets
Eliminate
nonrecurring items
Eliminate interest
expense
Effective tax rate
34
How can ROA be increased?
There are just two ways:
1.
2.
Increase the operating
profit margin, or
Increase the intensity of
asset utilization
(turnover rate).
ROA=
EBI
Average assets
EBI
Sales
Asset turnover
Sales
Average assets
Operating profit margin
5-35
ROA, margin and turnover examples:

A company earns $9 million of EBI on sales of $100
million with an asset base of $50 million.

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.
36
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?
1. 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.
2. 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.
37
Further decomposition of ROA
Correspond to the common-size
Income statement items
Operating profit
margin
NOPAT
Sales
ROA = X
Sales
Average assets
Asset turnover
38
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.
39
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
40
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)


Competitive
ROA floor
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).
41
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
Net income available to
common shareholders
Average common
shareholders’ equity
Net income available to
common shareholders =
Net income – preferred
dividends
NOPAT
X
Financial structure leverage
Average assets
Average common
shareholders’ equity
ROCE= ROA * Common earnings leverage* Financial Structure leverage
42
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%.
43
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.

44
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.

45
Profitability and financial leverage:
Case Study
Leverage
Leveragehelps
helps
Leverage
Leverage neutral
neutral
Leverage hurts
46
Learning Objective:
Capital structure and
Assess Credit Risk
47
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.
48
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.
49
Traditional lending products

Short-term loans:
 Seasonal lines of credit
 Special purpose loans
(temporary needs)
 Secured or unsecured

Long-term loans:
 Mature in more than 1 year
 Purchase fixed assets,
another company,
Refinance debt ,etc.
 Often secured

Revolving loans
 Like a seasonal credit line
 Interest rate usually “floats”

Public Debt
 Bonds, debentures, notes

Special features: Sinking
fund and call provisions
50
Evaluating the borrower’s ability to repay
Step 1:
Understand
the business
Step 2:
Evaluate
accounting quality
Step 3:
Evaluate current
profitability and health
Step 4:
Prepare “pro forma”
cash flow forecasts
Step 5:
Due diligence
Step 6:
Comprehensive risk
assessment
• Business model and strategy
• Key risks and successful factors
• Industry competition
• Spot potential distortions
• Adjust reported numbers as needed
• Examine ratios and trends
• Look for changes in profitability, financial
conditions, or industry position.
• Develop financial statement forecasts
• Assess financial flexibility
• Kick the tires
• Likely impact on ability to pay
• Assess loss if borrower defaults
• Set loan terms
51
Credit risk: Short-term liquidity ratios
Including Inventory
Current ratio =
Liquidity
ratios
Quick ratio =
Current assets
Cash + Marketable securities + Receivables
Current liabilities
Short-term
liquidity
Accounts receivable turnover =
Activity
ratios
Very immediate
liquidity
Current liabilities
Inventory turnover =
Average accounts receivable
Cost of goods sold
Average inventory
Accounts payable turnover =
Activity ratios tell us
How efficiently the company is using its assets.
Net credit sales
Inventory purchases
Average accounts payable
Liquidity refers to the company’s short-term ability to generate cash for working
52
Capital needs and immediate debt repayment needs.
Receivables Turnover Ratio and collection
period
Receivables
Turnover =
Ratio
Net Sales
Average Accounts Receivable
This ratio measures how many
times a company converts its
receivables into cash each year.
Average Collection Period
Average
Collection
Period
=
365
Receivables Turnover Ratio
This ratio is an approximation of the
number of days the average accounts
receivable balance is outstanding. 53
Inventory Turnover Ratio and Average
Days in Inventory
Inventory
Turnover
Ratio
=
Cost of Goods Sold
Average Inventory
This ratio measures the number
of times merchandise inventory
is sold and replaced during the year.
Average Days in Inventory
Average =
365
Days in
Inventory Turnover Ratio
Inventory
This ratio indicates the number
of days it normally takes to sell inventory.
54
Credit risk:
Operating and cash conversion cycles
Working capital ratios:
Days accounts receivable outstanding =
365 days
Accounts receivable turnover
(Days before cash is collected from the customer)
Days inventory held =
45 days
Operating
cycle 75
days
30 days
365 days
Cash
conversion
cycle 55
(75-20) days
Inventory turnover
Days accounts payable outstanding =
365 days
( 20 days)
Accounts payable turnover
( Days that suppliers are paid after inventory is purchased)
Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).
55
Credit risk:
Long-term solvency
Long-term debt to assets =
Long-term debt
Including
Intangible assets
Total assets
Debt ratios
Long-term debt to tangible assets =
Long-term debt
Total tangible assets
Long-term
solvency
Interest coverage =
Operating incomes before taxes and interest
Interest expense
Coverage
ratios
Operating cash flow
to total liabilities =
Cash flow from continuing operations
Average current liabilities + long-term debt
Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain
56
its productive capacity and still meet the interest and principal payment on its long-term debt.
Credit risk of Krispy Kreme :
Short-term liquidity and Long-term solvency
57
Credit risk: Default Risk

A firm defaults when it fails
to make principal or
interest payments.

Lenders can then:
 Adjust the loan payment
schedule.
 Increase the interest
rate and require loan
collateral.
 Seek to have the firm
declared insolvent.
Source: Moody’s Investors Service (May 2000)
Default rates by Moody’s credit rating, 1983-1999
58
Financial Ratios and Default Risk
Return on assets (ROA)
ROA and probability of default is negatively associated.
Profitability: Return on Assets Percentiles (excludes extraordinary items)
Source: Moody’s Investors Service (May 2000)
59
Financial Ratios and Default Risk
Quick Ratio
Quick Ratio and probability of default is negatively associated.
Liquidity: Quick Ratio Percentiles
Source: Moody’s Investors Service (May 2000)
60
Credit analysis:
Case Study: G.T. Wilson’s credit risk



A bank client for over 40 years.
Owns 850 retail furniture stores throughout the
U.S.
Increased competition and changing consumer
tastes caused the following changes in
Wilson’s business strategy:
 Expand product line to include high quality
furniture, consumer electronics, and home
entertainment systems.
 Develop a credit card system to help
customers pay for purchases.
 Open new stores in suburban shopping
centers and close unprofitable downtown
stores.
61
Credit analysis:
Case Study: G.T. Wilson’s credit risk



Bank now has a $50 million secured
construction loan and a $200 million
revolving credit line which is up for
renewal with Wilson.
What do the Wilson’s financial
statements tell us about its credit risk?
Should the bank renew Wilson’s $200
million credit line?
62
Credit Analysis: Interpretation of cash flow components
.
.
.
Negative free
cash flow
Increased
borrowing
Continued
dividend
payment
63
Credit Analysis : Selected financial statistics
Declining
margin
Customers take
longer to pay,
but reserve is
smaller
Larger debt
burden
64
Credit analysis: Recommendation



Wilson is a serious credit risk:
 Inability to generate positive cash flows from
operations.
 Extensive reliance on short-term debt
financing.
The company may be forced into bankruptcy
unless:
 Other external financing sources can be
found.
 Operating cash flows can be turned positive.
Update: Bankruptcy was declared shortly after
these financials were released.
65
Learning Objective:
Pro Forma Earnings
66
Pro Forma Earnings
Companies often voluntarily provide a
pro forma earnings number when
they announce annual or quarterly
earnings.
 Pro forma earnings are
management’s assessment of
permanent earnings.

67
Pro Forma Earnings


Many companies today are highlighting
a non-GAAP earnings in press releases,
in analyst conference calls, and in
annual reports.
The Sarbanes-Oxley Act Section 401
requires a reconciliation between pro
forma earnings and earnings
determined according to GAAP.
68
Financial statement analysis:
Non-GAAP earnings:
Pro forma earnings and EBITDA

Many companies today are
highlighting a non-GAAP
earnings in press releases, in
analyst conference call, and
in annual reports.
 Sometimes these earnings
figures are called EBITDA
( earnings before interest,
income taxes, depreciation,
and amortization)

Sometimes it is called
“ adjusted earnings’.

Sometimes it is called
“ pro forma earnings”.
69
Financial statement analysis:
Pro forma earnings at Amazon.com
Company
defined numbers
Computed
according to GAAP
70
When use the EBITDA or “pro forma”
earnings, analysts should remember:

There are no standard definitions for nonGAAP earnings numbers.

Non-GAAP earnings ignore some real
business costs and thus provide an
incomplete picture of company profitability.

EBITDA and pro forma earnings do not
accurately measure firm cash flows.
71
Why do firms report EBITDA and “pro
forma” earnings?


Help investors and analysts spot nonrecurring or non-cash revenue and
expense items that might otherwise be
overlooked.
Pro forma earnings could mislead
investors and analysts by changing the
way in which profits are measured.



Transform a GAAP loss into a profit.
Show a profit improvement.
Meet or beat analysts’ earnings forecasts.
72
Summary


Financial ratios, common-size statements
and trend statements are powerful tools.
However:
 There is no single “correct” way to
compute financial ratios.
 Financial ratios don’t provide the
answers, but they can help you ask the
right questions.
 Watch out for accounting distortions that
can complicate your interpretation of
financial ratios and other comparisons.
73
Summary of financial statement analysis
How to use financial ratios


Profitability:
 ROA ( Return on assets)
 Operating Profit Margin
 ROCE ( Return on common stockholder’s
equity)
Market Measures:
 Earnings per share (EPS)
 Price/ earnings ( Market price of common
stock/ EPS)
 Dividend payout ( Dividends per share/ EPS)
 Dividend yield ( Dividends per share/ Market
price of common stock)
74
Summary of financial statement analysis
How to use financial ratios

Liquidity ( Evaluate short-term credit risk)
- Liquidity ratios: Current ratio and quick ratio
- Liquidity of working capital : Average collection
period, Days inventory held, days payable
outstanding, operating cycle days, cash
conversion cycle, etc.
- Operating Efficiency ( Activity ratios)
 Accounts receivable turnover
 Inventory turnover
 Accounts payable turnover
75
Summary of financial statement analysis
How to use financial ratios

Solvency ( Evaluate long-term credit
risk)
 Coverage ratios: interest coverage,
operating cash flows to total liabilities
 Debts ratios:
 Debt/ Assets
 Debt/ equity (Total liabilities/
Stockholders’ equity)
76
Whole Foods Market,
Comparative Income Statement
5-77
Common
Size
statements
5-78
Business Segment information
5-79
Comparative Balance Sheet
5-80
Comparative Balance Sheet
5-81
Common size and trend analysis
5-82
Common size and trend analysis
(Exhibit 5.5 continued)
5-83
Common size and trend analysis
5-84
Common size and trend analysis
(Exhibit 5.6 continued)
5-85
Comparative Cash Flows
5-86
Common size trend analysis
5-87