Financial Statement Analysis
P.V. Viswanath
Based on Damodaran’s Corporate Finance
Questions we would like answered…
As financial analysts…
Assets
Liabilities
What are the assets in place?
How valuable are these assets? Assets in Place
How risky are these assets?
Debt
What is the value of the debt?
How risky is the debt?
What are the growth assets?
Growth Assets
How valuable are these assets?
Equity
What is the value of the equity?
How risky is the equity?
However, the information we have comes from
the firm’s financial statements…
P.V. Viswanath
2
Basic Financial Statements
 The balance sheet, which summarizes what a firm
owns and owes at a point in time.
 The income statement, which reports on how much
a firm earned in the period of analysis
 The statement of cash flows, which reports on cash
inflows and outflows to the firm during the period
of analysis
P.V. Viswanath
3
The Balance Sheet
Figure 4.1: The Balance Sheet
Assets
Long Lived Real Assets
Short-lived Assets
Investments in securities &
assets of other firms
Liabilities
Fixed Assets
Current
Liabilties
Current Assets
Debt
Debt obligations of firm
Financial Investments
Other
Liabilities
Other long-term obligations
Equity
Equity investment in firm
Assets which are not physical, Intangible Assets
like patents & trademarks
Short-term liabilities of the firm
This is what we can see from the firm’s balance sheet…
P.V. Viswanath
4
An example : Maxwell Shoe Company, Inc
Maxwell Shoe Company Inc. designs, develops and markets casual and dress
footwear for women and children under multiple brand names, each of which is
targeted to a distinct segment of the footwear market. The Company offers
casual and dress footwear for women in the moderately priced market segment
under the Mootsies Tootsies brand name, in the upper moderately priced market
segment under the Sam & Libby and Dockers Khakis Footwear For Women
brand names and in the better market segment under the Anne Klein 2 and A
Line Anne Klein brand names.
It also sells moderately priced and upper moderately priced children's footwear
under both the Mootsies Tootsies and Sam & Libby brand names. In addition, it
designs and develops private label footwear for selected retailers under the
retailers' own brand names. Maxwell has licensed the J.G. Hook trademark to
source and develop private label products for retailers who require brand
identification.
P.V. Viswanath
5
An example of an Accountant’s
Balance Sheet
Maxwell Shoe Company, Inc.
As of October 31, 2000 (In ‘000s)
ASSETS
Current assets:
Cash and cash equivalents
Accounts receivable, trade
Inventory, net
Prepaid expenses
Prepaid income taxes
Deferred income taxes....
Total current assets........
Property and equipment, net.
Trademarks, net..
Other assets.....
$48,074
34,244
12,036
LIABILITIES AND STOCKHOLDERS'
EQUITY
Current liabilities:
Accounts payable.........
Accrued expenses.........
Deferred income taxes.....
Current portion of Capital
lease obligations
536
1,478
798
97,166 Total current liabilities...
Long-term deferred income
$6,605 taxes........
15,479 Stockholders' equity
Additional paid-in
185 capital..........
Deferred compensation....
Retained earnings........
Total stockholders' equity..
$119,435
P.V. Viswanath
$1,863
7,254
479
102
9,698
1,540
88
43,112
-251
65,248
108,197
$119,435
6
Notes on the Maxwell Balance Sheet
 Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax
purposes. Deferred tax assets are created when future taxable income
is expected to exceed pretax income, while deferred tax liabilities
occur in the reverse case.
 If more deductions have been taken in the current period for reporting
purposes, then tax payable (according to the GAAP income
statement) will be lower than the actual tax paid. Hence it will seem
like taxes have been prepaid. This is reflected in the balance sheet as
an asset.
 Deferred tax assets ($798) reflect allowance for doubtful accounts,
stock option compensation, inventory capitalization, and inventory
reserve. Deferred tax liabilities ($479) reflect amortization of
trademarks (long-term) and depreciation of property and equipment
(short-term).
P.V. Viswanath
7
A Financial Analyst’s Balance Sheet
Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
Liabilities
Assets in Place
Debt
Growth Assets
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
This is what we would like to see…
P.V. Viswanath
8
The Income Statement
Figure 4.2: Income Statement
Gross revenues from sale
of products or services
Revenues
Expenses associates with
generating revenues
- Operating Expenses
Operating income for the
period
= Operating Income
Expenses associated with
borrowing and other financing
- Financial Expenses
Taxes due on taxable income
- Taxes
Earnings to Common &
Preferred Equity for
Current Period
= Net Income before extraordinary items
Profits and Losses not
associated with operations
- (+) Extraordinary Losses (Profits)
Profits or losses associated
with changes in accounting
rules
- Income Changes Associated with Accounting Changes
Dividends paid to preferred
stockholders
- Preferred Dividends
= Net Income to Common Stockholders
P.V. Viswanath
9
The Income Statement
Maxwell Shoe Company, Inc.
For the year ended October 31, 2000 (In ‘000s)
Net sales....
Cost of sales
Gross profit.
Operating expenses:
Selling.
General and administrative..
Operating income..
Other expenses (income)
Interest income, net...
Amortization of trademarks..
Other, net...
Income before income taxes..
Income taxes.
Net income...
P.V. Viswanath
$158,205
116,991
41,214
11,584
16,141
27,725
13,489
-3,039
367
-310
-2,982
16,471
6,589
$9,882
10
The Income Statement
The Income Statement provides us with information about changes in the
balance sheet from one year to another. Hence it is crucial to creating the
financial balance sheet that we want.
However, the income statement is prepared according to GAAP.
Underlying GAAP are certain principles, such as revenue recognition
when the service for which the firm is being paid has been performed
substantially, the matching principle governing recognition of expenses, a
historical cost-based approach, and a basic conservatism in the recognition
of assets.
This leads to certain accounting practices that need to be corrected, from a
financial analyst’s point of view…
P.V. Viswanath
11
Desirable Modifications to Income
Statement
 There are a few expenses that are consistently miscategorized in financial statements. In particular,


Operating leases are considered as operating expenses by
accountants but they are really, partly, financial expenses
R&D expenses are considered as operating expenses by accountants
but they are really capital expenses.
 The degree of discretion granted to firms on revenue
recognition and extraordinary items is used to manage
earnings and provide misleading pictures of profitability.
P.V. Viswanath
12
Dealing with Operating Leases
 A Lease is a long-term rental agreement
 Leases can either be capital leases or operating leases


A capital lease is often for as long as the life of the equipment, or there
may be an option for the lessee to buy the equipment at the end of the
contract period. Capital leases have to be capitalized and shown on the
balance sheet.
In an operating lease, typically, the contract period is shorter than the life
of the equipment, and the lessor pays all maintenance and servicing
costs. Operating leases do not have to be shown on the balance sheet.
However, operating leases also represent expected fixed periodic
payments, and thus function similar to debt.
As such, a financial analyst would want to see operating leases
capitalized as well
P.V. Viswanath
13
Dealing with Operating Lease
Expenses
 How do we do this?

First, we compute the “debt” value of the operating lease
as the PV of the operating lease expenses, using the pretax cost of debt as the discount rate.
This now creates an asset - the value of which is equal to
the debt value of operating leases. This asset now has to
be depreciated over time.

Second, the operating income has to be adjusted to
reflect these changes.
P.V. Viswanath
14
Dealing with Operating Leases:
Adjusting Operating Income
 Note that the operating lease expense has two components


an operating expense component, i.e. the reduction in the value of
the asset being used, represented by the depreciation, and
a financing component, i.e. the cost of financing the asset.
 Using this model, we assume that
Interest expense on the debt created by converting operating
leases = Operating lease expense - Depreciation on asset created
by operating lease. Then,
Adjusted Operating Income
= Operating Income - Depreciation on operating lease asset +
operating lease expenses
= Operating Income + Imputed Interest expense on operating leases.
= Operating Income + Debt value of Operating leases x Cost of debt
P.V. Viswanath
15
Example: Capitalizing Operating
Leases at Maxwell Shoe
From the 10-K filing made by the company with the SEC on 1/29/2001:
The Company leases equipment and office and warehouse space under long-term
non-cancelable operating leases which expire at various dates through January
31, 2007. At October 31, 2000, future minimum payments under such leases were
as given below (in ‘000s).
Minimum Payments Present Value at 7%
2001
1488
1390.65
2002
1008
880.43
2003
917
748.55
2004
650
495.88
2005
600
427.79
Later Years
750
498.08
Minimum payments are capitalized using an assumed pre-tax cost of debt of
7% p.a. This will be the value of the Lease Asset/Liability on the Oct. 31,
2000 balance sheet. Later years refer to 2006 and 2007.
P.V. Viswanath
16
Example: Capitalizing Operating
Leases at Maxwell Shoe
I assume that payments are made at the end of the fiscal year, ending in
October.
Since the figure for "Later Years," $750, is larger than the declining sequence
of amounts for previous years, I assume that this reflects the amounts for
both 2006 and 2007.
Since the leases expire in January 2007, which is 3 months past the fiscal
year end, I have prorated the amounts for 2006 and 2007, viz. $600 for 2006
(payable at the end of October 2006) and $150 for 2007 (payable at the end
of January 2007).
Hence the $498.08 computed as the present value for the row “Later Years”
equals 600/(1.07)6 + 150/(1.07)6.25.
The present value of the minimum payments (as of Oct. 31, 2000) works out
to $4441.38.
P.V. Viswanath
17
Imputed Interest Expenses on
Operating Leases
Lease payments in 2000 were $1024. Hence the PV of operating leases
as of end 1999 would be (PV of Op. Leases as of end 2000 + Lease
expenses for 2000)/1.07 = (4441.38+1024)/1.07 = $5107.83.
The imputed interest expense is the Debt Value of Operating Leases x
Interest rate.
PV(Operating Leases) as of Oct. 31, 1999
Interest rate on debt
Imputed Interest expense on PV of operating leases
5107.83
7%
357.55
Adjusted Operating Income = Operating Income + Imputed Interest
Payment
= $13,489 + $357.55 = $13,846.55
Net Income is not affected because the imputed interest expense will be
subtracted from Operating Income, just as any other interest expense
would be.
P.V. Viswanath
18
The Effects of
Capitalizing Operating Leases
 Debt: will increase, leading to an increase in debt ratios used
in the cost of capital and levered beta calculation
 Operating income: will increase, since operating income will
now be before the imputed interest on the operating lease
expense
 Net income: will be unaffected since it is after both
operating and financial expenses anyway
 Return on Capital will generally decrease since the increase
in operating income will be proportionately lower than the
increase in book capital invested
P.V. Viswanath
19
R&D Expenses: Operating or Capital
Expenses
 Accounting standards require us to consider R&D as an
operating expense even though it is designed to generate
future growth. It is more logical to treat it as capital
expenditures.
 An approach to capitalizing R&D (cost-based),



Specify an amortizable life for R&D (2 - 10 years)
Collect past R&D expenses for as long as the amortizable life
Sum up the unamortized R&D over the period. (Thus, if the
amortizable life is 5 years, the research asset can be obtained by
adding up 1/5th of the R&D expense from four years ago, 2/5th of
the R&D expense from four years ago...:
P.V. Viswanath
20
Capitalizing R&D Expenses: Boeing
Assuming a ten year life; thus, R&D expenses for 1998 will be
amortized over the 1999-2008 period.
Year
Unamortized Portion at
end 1998
R&D Outlay
Value
Amortization for 1998
1988
751
0
0
75.1
1989
754
0.1
75.4
75.4
1990
827
0.2
165.4
82.7
1991
1417
0.3
425.1
141.7
1992
1846
0.4
738.4
184.6
1993
1661
0.5
830.5
166.1
1994
1704
0.6
1022.4
170.4
1995
1300
0.7
910
130
1996
1633
0.8
1306.4
163.3
1997
1924
0.9
1731.6
192.4
1998
1895
1
1895
0
Capitalized value of R&D for 1998 =
9100.2
Total R&D Amortization Expense for 1998 =
P.V. Viswanath
1381.7
21
Boeing’s Corrected Operating Income
For 1998
Operating Income*
$1,720.00
+ Research and Development Expenses**
$1,895.00
- Amortization of Research Asset**
$1,381.70
= Adjusted Operating Income
$2,233.30
* Data obtained from Income Statement
** Data obtained from Income Statement; see also previous slide
In principle, it could be argued that R&D capitalized values should be
restated in 1998 dollars, instead of using the raw unamortized portions of
R&D outlays in past years; however, the current procedure may be
defended on the grounds of conservatism.
P.V. Viswanath
22
Boeing’s Corrected Balance Sheet
 There will be the following modifications on the
balance sheet:



There will be a new asset, R&D, that will show on the
assets side. If one wants to show the gross value of R&D
and accumulated amortization, however, that will require
computation of the amortization in each year for as many
years as the amortizable life of the R&D.
Corresponding to that, the value of stockholder’s equity
will be higher by the same amount.
In our example, this amount will be $9,100.
P.V. Viswanath
23
The Effect of Capitalizing R&D
 Operating Income will generally increase, though it depends
upon whether R&D is growing or not. If it is flat, there will be
no effect since the amortization will offset the R&D added
back. The faster R&D is growing the more operating income
will increase.
 Net income will increase proportionately, depending again
upon how fast R&D is growing. Adjusted Net Income will
also have to take the tax deductibility of R&D into account.
 Book value of equity (and capital) will increase by the
capitalized Research asset
 Capital expenditures will increase by the amount of R&D;
Depreciation will increase by the amortization of the research
asset; for all firms, the net cap ex will increase by the same
amount as the after-tax operating income.
P.V. Viswanath
24