CHAPTER 18
INTEGRATION OF FINANCIAL STATEMENT
ANALYSIS TECHNIQUES
Presenter’s name
Presenter’s title
dd Month yyyy
FRAMEWORK
The primary reason for performing financial statement analysis is to
facilitate an economic decision.
The framework for the analysis contains six phases:
1. Define the purpose for the analysis
2. Collect input data
3. Process data
4. Analyze/interpret the processed data
5. Develop and communicate conclusions
6. Follow-up
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FRAMEWORK: CASE STUDY 1
Evaluating Nestlé as a long-term equity investment.
1. Define the purpose for the analysis:
- Isolate the factors that have driven Nestlé’s financial success and assess their
sustainability.
- Understand the risks that may upset the sustainability of returns.
2. Collect input data: Gather several years of annual reports.
3. Process data:
- Conduct a DuPont analysis.
- Analyze the composition of Nestlé’s asset base and capital structure.
- Study the company’s segments and the allocation of capital among them.
- Examine the company’s earnings quality.
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies.
- Decompose the company’s valuation.
4. Analyze/interpret the processed data.
5. Develop and communicate conclusions: Write report.
6. Follow-up.
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DUPONT ANALYSIS
Net income Sales Assets
ROE =
×
×
Sales
Assets Equity
= Net profit margin × Assets turnover × Leverage
Nestlé’s ROE:
2007
2006
2005
Net profit margin
10.58%
10.00%
9.44%
Assets turnover
0.994
0.963
0.955
Leverage
2.02
2.01
2.16
21.25%
19.36%
19.48%
ROE
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FINANCIAL REPORTING CHOICES AND BIASES
Including the net investments and returns of associates with full reported value of
a company’s own assets and income would introduce noise into the analysis. For
example,
- Part of Nestlé’s income relates to Nestlé’s 30% stock ownership of L’Oreal.
- Subtracting the investment from total assets results in a figure that more
closely represents Nestlé’s own asset base.
- Subtracting the share of results of associates from the net income allows for
the analysis of exclusively Nestlé profitability resulting from the exclusively
Nestlé asset base.
Return on equity
Nestlé-only ROE
Associates’ contribution to ROE
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2007
21.25%
20.48%
0.77%
2006
19.36%
18.75%
0.61%
2005
19.48%
18.66%
0.82%
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FINANCIAL REPORTING CHOICES AND BIASES
• Comparing financial statements prepared under different accounting
treatments over the years could bias analysis.
• Adjustments are necessary to keep analysis logically consistent
throughout all the periods of study.
• For example, for comparability, Nestlé restated the 2004 balance
sheet, including changes for employee benefits plan accounting, lease
classification, a reclassification of a warrants premium, and the
cumulative effect on their investment of L’Oreal’s first-time adoption of
IFRS.
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CAPITAL STRUCTURE ANALYSIS
• Use common-size analysis.
- For example, below is Nestlé’s long-term capital structure on a
common-size analysis:
2007 2006 2005 2004
Long-term financial liabilities
8.6 10.0 12.4 18.4
Other long-term liabilities
15.4 13.7 14.2 15.3
Total equity
76.0 76.2 73.4 66.2
Total long-term capital
100.0 99.9* 100.0 99.9*
Deleveraging
*Does not add to 100% because of rounding
• When deleveraging occurs in the long-term capital structure, there is
offsetting change in the company’s working capital (i.e., leverage
improves, but liquidity deteriorates).
• Improvement in the management of receivables, inventory, and
payables can mitigate the concern associated with the decline in the
actual working capital.
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SEGMENT ANALYSIS
• Business Segment: A portion of a larger company that accounts for
more than 10% of the company’s revenues or assets and is
distinguishable from the company’s other lines of business in terms of
risk and return characteristics.
• Conducting segment analysis helps analysts understand any
geopolitical investment risks.
• Ratio of capital expenditures proportion to total asset proportion ranked
by EBIT margin:
- A ratio < 1 indicates that the segment is being allocated a lesser
proportion of capital expenditures than its proportion of total assets.
- A ratio > 1 indicates that the company is growing the segment.
- Comparing the ratio with the EBIT margin gives an analyst an idea of
whether the company is investing its capital in the most profitable
segments.
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SEGMENT ANALYSIS: EXAMPLE
Pharma
Nestlé Nutrition
Asia, Oceania, and Africa
Americas
Other Food and Beverage
Europe
Nestlé Waters
2007
EBIT
33.27%
17.16%
16.29%
16.28%
15.85%
11.99%
8.18%
2007
0.61
0.31
1.18
1.11
2.43
0.94
1.79
2006
0.74
0.81
1.06
0.92
1.52
0.82
1.62
2005
0.75
0.93
1.19
0.85
1.53
0.99
1.27
If the company were to continue to allocate capital
toward the lowest-margined business segment, the
overall corporate returns might be negatively affected.
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EARNINGS QUALITY
• Earnings quality: The persistence and sustainability of a firm’s earnings.
• Ways to evaluate earnings quality:
Analyze the accruals: Accrual ratio fluctuations indicate the use of accruals
to “time” earnings.
YTY change in NOA
Balance sheet based accruals ratio =
Average NOA
𝑁𝐼 − (𝐶𝐹𝑂 − 𝐶𝐹𝐼)
Cash flow based accruals ratio =
Average NOA
where NOA = Net operating Assets, CFO = Cash flow from operating, and CFI
= Cash flow from investing.
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EARNINGS QUALITY
Nestlé example:
(in millions of CHF)
B/S aggregate accruals (YTY ∆ in NOA)
Divided by: Average net operating assets
Balance sheet based accruals ratio
2007
11,589
69,614
16.6%
2006
5,026
61,306
8.20%
2005
9,345
54,121
17.3%
2004
(2,730)
50,813
−5.4%
2003
1,587
51,385
3.1%
Cash flow based aggregate accruals
Divided by: Average net operating assets
CF accruals ratio
13,696
69,614
19.7%
8,619
61,306
14.1%
3,071
54,632
5.6%
593
51,324
1.2%
1,196
51,385
2.3%
Fluctuated significantly.
Much higher in the most recent
year than in the earlier years.
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Increases steadily over time,
indicating a higher degree of
accruals present in the
company’s earnings.
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EARNINGS QUALITY
Study the company’s cash flow and its relationship to net income. Are
operating earnings backed by cash flow, or are the operating earnings
more of an accounting result?
- Appropriate adjustments to keep the comparisons between cash
flow and earnings symmetrical:
a) Add the cash paid for interest and taxes to the operating cash
flow. The resulting operating cash flow before interest and taxes
is the relevant operating cash flow for comparison with the
operating income.
b) Add goodwill amortization to the period prior to 31 March 2004.
IFRS 3, “Business Combinations,” suspended the amortization
of goodwill after 31 March 2004. To amortize goodwill in some
but not other years of operating earnings would produce a
misleading trend in the ratios.
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EARNINGS QUALITY
Examine the relationship between operating cash flow and total assets.
Total assets reflect the sum of management’s resource allocations.
• Compare cash flow with reinvestment, debt, and debt-servicing
capacity.
• Results indicate
-
whether the company has enough resources for its reinvestment
program, and
-
whether additional borrowing could be arranged should an
investment opportunity arise.
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VALUATION: EXAMPLE
To determine the value that the market is placing solely on the
company’s operations, analysts need to remove the value of the
company’s holdings of other companies from the market value.
(CHF in millions)
Alcon
L’Oreal
Implied Nestlé-only
Actual
Recap in %:
L’Oreal
Alcon
Nestlé
Market values
36,499
28,961
130,201
195,661
Earnings (Group
shareholder level)
1,361.5
1,302.0
7,985.5
10,649.0
Market value
14.8%
18.7%
66.5%
100.0%
Earnings
12.8%
12.2%
75.0%
100.0%
Respective
P/Es:
26.8
22.2
16.3
18.4
Nestlé has ample cash flow and low financial
leverage; thus, the discount may be
inappropriate and shares may be undervalued.
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FRAMEWORK: CASE STUDY 2
Evaluating investee’s off-balance-sheet leverage.
1. Define the purpose for the analysis:
- Look for companies in the fund’s holdings where off-balance-sheet financing may
be an issue (i.e., companies with unrecorded capital leases).
- Analyze the impact of the leverage if such leverage exists.
2. Collect input data:
- Multiply the current operating lease expenses reported by companies in the
fund’s holdings by 7.4 to get an estimate of the unrecorded assets and debt.
- If the ratio of “hidden” assets to total assets exceeds 5% for any of the
companies in the fund’s holdings, that company’s information will be subjected to
further analysis.
3. Process data.
4. Analyze/interpret the processed data:
- Examine the leverage ratio and interest coverage ratio for companies flagged in
the previous phase.
5. Develop and communicate conclusions: Write report.
6. Follow-up.
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OFF-BALANCE-SHEET LEVERAGE
• Off-balance-sheet leverage refers to operating leases.
• Capital lease
- Is reported as an asset and liability on lessee’s balance sheet.
- Results in interest expense and depreciation expense (instead of rental
expense) on lessee’s income statement.
• When capitalizing an operating lease, the lessee’s
- Financial leverage increases.
- Interest coverage ratio decreases.
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OFF-BALANCE SHEET LEVERAGE: EXAMPLE
Assume the present value of future operating lease payments is $1,075
million. The table below shows leverage ratios after capitalizing operating
leases (amounts in millions):
Total assets
Total equity
Financial leverage
Total long-term debt
Total equity
Debt to equity
Total long-term debt
Total long-term capital (=LT debt + equity)
Debt to long-term capital
As reported
12,244
2,225
5.5
1,293
2,225
58.10%
1,293
3,518
36.80%
Pro Forma
13,319
2,225
5.99
2,368
2,225
106.40%
2,368
4,593
51.60%
$1,075 is added to total assets and total longterm debt when calculating ratios in the pro
forma column if operating leases are capitalized.
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FRAMEWORK: CASE STUDY 3
Evaluating effects of changes in accounting standards.
1. Define the purpose for the analysis:
- Determine if Discover Financial Services could be at risk (i.e., increase in
reported leverage) from possible changes in accounting for securitizations.
2. Collect input data: 10-Q and 10-K filings.
3. Process data.
4. Analyze/interpret the processed data:
- Analyze the company’s leverage measures, assuming the liabilities issued
in connection with the securitization of assets have to be shown on the
company’s balance sheet.
5. Develop and communicate conclusions: Write report.
6. Follow-up.
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IMPACT FROM ACCOUNTING CHANGES
• Currently under Statement 140, a company can remove financial
assets from its balance sheet by placing them into a qualified special
purpose entity (QSPE).
- The combination of asset removal and nonrecognition of liabilities
may have a powerfully beneficial effect on financial leverage on the
balance sheet.
- If the concept of a QSPE is eliminated from the securitization
accounting, the securitized assets as well as the liabilities issued in
connection with the securitizations would likely be shown on the
balance sheet.
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IMPACT FROM ACCOUNTING CHANGES:
EXAMPLE
Software Services sold $267.5 million of finance receivables to a special
purpose entity. The company’s abbreviated balance sheet is below.
Year Ending:
Total Current Assets
Total Assets
Total Current Liabilities
Total Liabilities
Total Equity
31 December 2009
$1,412,900
$3,610,600
$1,276,300
$2,634,100
$976,500
What is the financial leverage if the company (1) treats them as sold and
(2) holds securitized financial receivables on the balance sheet?
1) 3,610,600/976,500 = 3.70
2) (3,610,000 + 267,500)/976,500 = 3.97
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SUMMARY
• The framework of financial statement analysis contains six steps:
define a purpose for the analysis, collect input data, process data,
analyze the processed data, communicate conclusions, and follow-up.
• Earnings are more easily manipulated than cash flows. An effective
way to examine earnings quality is to examine the pattern between
operating income and operating cash flows.
• To make a logical comparison, adjustments need to be made prior to
conducting financial statement analysis. For example, adjustments
may include removing assets owned and return earned by affiliates that
are not under control of the company.
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