Com 4FK3
Financial Statement Analysis
Week 7, 2012
Assessing Profitability and Risk
Adjusting Income
• Often done by Analysts to get a better
picture of the financial health of a company
 Reverse
the effect of accounting decisions
made by management
 Remove some artefacts caused by GAAP
• Attempt to show permanent earnings of the
company regardless of what is presented by
management or GAAP
2
Why Adjust I/S?
• GAAP Income reported is not sustainable
 Primary
use of analysis is to forecast the future
• Income on the statement does not reflect the
current year’s operations
 Gain
on sale occurred over the holding period
 Special provision for bad debts reflects the
cumulative effect of many years misstatements
3
Earnings Quality
• Net income often contains unusual and not
recurring items
• Analysis of ongoing profitability should
remove the effect of such items (after-tax)
 e.g.
Pepsi, in year 11, reports an impairment
and restructuring charge or $31, $19 after tax
 Add $19 to net income before finding ROA
4
Non-Recurring Charges
• Is the item really non-recurring?
 Some
items labelled as non-recurring happen
for several years in a row, if an item is likely to
be seen in subsequent years then it should be
left in the income statement for analysis
 An item that has recurred, but is related to a
program that has completed can usually be
removed form the statements for analysis
• Is this income level sustainable?
5
Other Unusual Items
• Items to consider
 Discontinued
operations
 Extraordinary items
 Changes in accounting principals
 Other comprehensive income items
 Asset impairment
 Restructuring charges
 Changes in estimates
6
Discontinued Operations
• Not relevant for predicting future results
 e.g.
the company no longer operates grocery
stores
• GAAP requires 3 years of income statement
effect to allow time series comparison
 For
finance, we would like more
 Further disclosure is not required
7
Extraordinary Items
• Must meet 3 criteria
1.
2.
3.
Unusual in nature
Infrequent in occurrence
Material in amount
• Examples include; lawsuit settlements, gain
or loss on sale of asset, etc.
8
Changes in Accounting Principals
• Why is it done?
 Imposed
from without
 Voluntarily
• Cumulative impact shown in year adopted
 Is
this relevant to this year?
 Does it make a significant impact on the time
series behaviour of income
9
Other Comprehensive Income
• Not included on the income statement, but
on the balance sheet in owners’ equity
section under GAAP
• Include; unrealized holding period gains,
foreign currency translation, derivatives
held as cash flow hedge, minimum pension
obligations
• Analyst’s discretion on how to handle
10
Asset Impairment
• Management has considerable discretion on
when or how much is recognized
 Is
the charge relevant to the year in which it is
recognized?
• Effect: lowered income this year, higher
income (less depreciation) is future years
 Is
the charge taken in a bad year?
11
Restructuring Charges
• Wide discretion allowed, no FASB rules on
how or when to report
• Does the firm spread out the costs or do
they take a “big bath”?
• Is the firm regularly taking restructuring
charges?
12
Changes in Estimates
• Every so often a firm realizes that an
estimate made in the past is wrong
• GAAP requires effect to be spread over
current and future periods
 Prior
years results, where incorrect estimates
were included, cannot be restated
 e.g. WT Grant and special provision
13
Profitability
• Two main measures of profitability
 Return
on Assets: the ability of the firm to
generate money independent of the capital
structure of the firm
 Return on Common Equity; the ability of the
firm to earn money for the shareholders
14
ROA
• The return on assets shows how well the
firm is using its assets to generate income
ROA 
Net Income  1 - tax rate interest expense   Minority interest in earnings
average total assets
Why average total assets?
Income statement is for the year
Balance sheet is “as of” a point in time
15
Disaggregating ROA
• Also known as the Dupont identity
ROA
= Profit Margin for ROA X Asset Turnover
Net Income + interest
Net Income + interest
expense (net of tax) +
expense (net of tax) +
Minority interest in
Minority interest in
earnings
=
earnings
X
Average Total Assets
Sales
Sales
Average Total
Assets
16
Insight
• Profit margin for ROA measures the firm’s
ability to generate income for a specific
level of sales
• Asset turnover measures the ability of the
firm to manage the level of investment or to
generate sales from a particular level of
investment
17
ROA for Pepsi
• Over the 3 year period Pepsi has been able
to increase ROA by increasing its profit
margin, and also by improving the asset
turnover rate between years 9 and 10
ROA
Profit Margin
Asset Turnover
Year 9
11.3%
10.2%
1.1
Year 10
13.9%
11.1%
1.3
Year 11
14.8%
11.7%
1.3
18
Industry Factors
• Firms in different industries have different
levels of appropriate asset turnover
• Utilities have a high profit margin but low
asset turnovers
• Grocery stores have low profit margins and
high asset turnovers
19
Changing ROA
• Three factors helping to explain differences
between firms and patterns of change over
time are;
 Operating
leverage
 Cyclicality of sales
 Product life cycle
20
Analysing Profit Margin
• The use of common size income statements
can highlight the source of profit margin for
ROA
• Statements for Pepsi shown below
Sales
Other Revenue
Cost of Goods Sold
Selling and Administrative
Goodwill Amortization
Income Taxes
Profit Margin
Year 9
100.0%
0.8%
-41.1%
-43.9%
-0.8%
-4.8%
10.2%
Year 10
100.0%
0.8%
-40.1%
-43.6%
-0.6%
-5.4%
11.1%
Year 11
100.0%
0.8%
-39.9%
-43.1%
-0.6%
-5.5%
11.7%
21
Cost of Goods Sold
• Changes in this account can be due to
several factors
 Increased
demand allowing for higher prices
 Reduced prices to help capture market share
 Productivity of production
 Shift in product mix
22
Selling and Administrative
• From the analysts point of view this is an
unfortunate lumping of
 Fixed
(administrative) costs
 Variable (selling) costs
• For Pepsi, the change is almost totally
explained in one note… advertising expense
increased every year, but decreased as a
percent of sales
23
Analysing Asset Turnover
• It is often beneficial to break down asset
turnover into; accounts receivable turnover,
inventory turnover, Fixed assets turnover
Net sales on account
average accounts receivable
Cost of goods sold
Inventory Turnover 
average inventory
Sales
Fixed Asset Turnover 
average fixed assets
Accounts Receivable Turnover 
24
ROCE
• The rate of return on common shareholders’
equity measures what income is available to
the common shareholders
• Shareholders’ equity excludes minority
interest in net assets and preferred shares
Net income - Preferred stock dividend
ROCE 
Average common shareholde rs' equity
25
ROA to ROCE
• Return on assets can be broken down into;
 Return
to creditors
 Return to preferred shareholders
 ROCE
26
Disaggregating ROCE
ROCE
=
Net Income to Common
Average common
shareholders equity
Profit Margin for ROCE
X
Asset Turnover
Net Income to Common
=
Sales
X Capital Structure Leverage
Sales
X
X
Average Total Assets
Average Total Assets
Average common
shareholders equity
Breakdown of ROCE for Pepsi
Year
9
10
11
ROCE
33.4%
36.1%
11.1%
Profit Margin
=
for ROCE X
9.1%
10.4%
11.1%
Asset
Turnover
1.1
1.3
1.3
X
Capital
Structure
Leverage
3.3
2.8
2.6
27
Earnings Per Common Share
• Another common measure of profitability
• Basic
Net earnings - Preferred share dividends
EPS 
Weighted average shares outstandin g
• Assigns a share of the reported income to
each of the common shares outstanding
28
Diluted EPS
• Companies with outstanding convertible
bonds, convertible preferred shares,
warrants or stock options have to report the
effect of this on EPS
 Numerator;
add back interest and dividends
paid to convertibles, also add back stock option
expenses reported as compensation
 Denominator; add net shares issued
29
Criticism of EPS
• Combines profit with capital structure
decisions
a
company could have declining earnings but
increasing EPS if buying back shares
 EPS falls significantly if there is a stock split
• EPS is not comparable across firms since
each company has different numbers of
common shares outstanding
30
Interpreting Ratios
• Compare to earlier periods
 How
has the firm’s profitability changed?
 Earlier periods give a benchmark
• Compare to other firms
 What
ratios are common in the industry?
 How widely are these ratios distributed?
 Where does the firm fall in this industry?
31
Types of Risk
• Six main types of risk
 Short
term liquidity risk
 Long term solvency risk
 Credit risk
 Bankruptcy risk
 Market equity beta risk
 Financial statement reporting manipulation risk
32
Short Term Liquidity Risk
• Is the firm likely to get into a cash flow
problem and have to raise money quickly?
• Main ratios for this are
 Current
ratio
 Quick ratio
 Operating cash flow to current liabilities
 Accounts receivable, accounts payable and
inventory turnover ratios
33
Current and Quick
• Current ratio is a simple ratio, divide
current assets by current liabilities
 Should
be substantially above 1
• Quick or Acid test ratio; only uses cash and
assets that can be quickly converted to cash;
 marketable
securities
 accounts receivable (usually but not always)
 inventories (less frequently used)
34
OCF to Current Liabilities
• Divide cash flow from operations by
average current liabilities
• For a healthy manufacturing or retail firm,
this number should be greater than 40%
35
Working Capital Ratios
Sales
Accounts Receivable Turnover 
average accounts receivable
Cost of goods sold
Inventory Turnover 
average inventory
Purchases
Accounts Payable Turnover 
average accounts payable
Purchases  CGS  ending inventory - beginning inventory
36
Long Term Solvency Risk
• How much leverage is in the company’s
capital structure
• Note; lease liabilities are long term debt
Long - term debt
Long - term debt  Shareholde rs' equity
Long - term debt
Debt/Equit y ratio 
Shareholde rs' equity
Total liabilitie s
Liabilitie s to assets ratio 
Total assets
Long - term Debt ratio 
37
Interest Coverage
• In addition to the total amount of debt, the
analyst should consider how easy it is for
the firm to pay the interest on that debt
Interest Coverage Ratio
Interest Coverage Ratio
Based on Cash Flows
=
Net Income + Interest Expense + Income
Tax Expense + Minority Interest in Earnings
Interest Expense
=
Cash Flow from Operations + Payments for
Interest and Income Taxes
Cash Payments for Interest
38
Credit Risk
• Factors to consider by lenders
 Circumstances
leading to need for loan
 Cash
Flows
 Collateral
 Capacity
 Contingencies
 Character of managers
 Conditions
39
Predicting Bankruptcy
• Investors can lose a lot of money if a firm
goes bankrupt
• For this reason there has been a lot of
research into predicting bankruptcy
 Type
I error; not predicting a bankruptcy
 Type II error; false prediction of bankruptcy
• Altman and Ohlson models
40
Altman’s Z-score
• Calculated Z-score, less than 1.81, high
bankruptcy chance, up to 3.00 is a gray area
and over 3 is safe
• Type II errors are quite low
• Type I errors (more expensive) get quite
high more than 3 years in advance
• WT Grant went gray in 1973. why so late?
41
Ohlson’s Probability
• Used logit analysis to generate a number
for the probability of bankruptcy
A
probability of greater than 3.8% would
identify a firm as likely to bankrupt, that rate
minimized the Type I & II errors
 WT Grant did not exceed that level even in
1974
Only mentioned in passing in
the current edition.
Skip the Ohlson requirement in Kroger
42
Market Risk
• From CAPM, only non-diversifiable risk is
rewarded in the market
• E(R) = Rf + (Rm – Rf)b
• Determinants of beta include
 Variability
of sales
 Operating leverage
 Financial leverage
43
Leverage Measures
• Degree of operating leverage

% change in EBIT
X P  VC 

% change in sales
X P  VC   FC
• Degree of financial leverage

% change in EPS
EBIT

% change in EBIT EBIT  I
• Combined leverage

% change in EPS
X P  VC 

% change in sales X P  VC   FC  I
44
Leverage Example
• PCG Inc. has;
 Fixed
costs of $275,000
 Variable costs of $1.75 per unit
 Selling price of $25 per unit
 Expected sales of 20,000 units
 What
is the degree of operating leverage?
X P  VC 
20,00025  1.75


 2.45
X P  VC   FC 20,00025  1.75  275,000
45
Leverage Example Continued
• PCG Inc. also has;
 Interest
 What

is the degree of financial leverage?
EBIT
190,000

 2.92
EBIT  I 190,000  125,000
 What

expense of $125,000
is the degree of combined leverage?
X P  VC 
20,00025  1.75

 7.15
X P  VC   FC  I 20,00025  1.75  275,000  125,000
46