Financial Statement and
Industry analysis
Financial Statement Analysis
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To develop techniques for evaluating firms
using financial statement analysis for equity
and credit analysis.
Integrates financial statement analysis with
corporate finance, accounting and fundamental
analysis.
Adopts activist point of view to investing: the
market may be inefficient and the statements
may not tell all the truth.
Users of Firms’ Financial Information
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Equity Investors
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Investment analysis
Long term earnings power
Management performance evaluation
Ability to pay dividend
Risk – especially market
Debt Investors
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Short term liquidity
Probability of default
Long term asset protection
Covenant violations
Users of Firms’ Financial Information
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Management: Strategic planning; Investment in
operations; Performance Evaluation
Litigants - Disputes over value in the firm
Customers - Security of supply
Governments: Policy making and Regulation
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Taxation
Government contracting
Employees: Security and remuneration
Investors and management are the primary users of
financial statements
Fundamental Analysis -- Equity Investors
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Step 1 - Knowing the Business
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Step 2 - Analyzing Information
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In Financial Statements
Outside of Financial Statements
Step 3 - Forecasting Payoffs
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The Products; The Knowledge Base
The Competition; The Regulatory Constraints
Measuring Value Added
Forecasting Value Added
Step 4 - Convert Forecasts to a Valuation
Step 5 - Trading on the Valuation
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Outside Investor: Compare Value with Price to; BUY, SELL, or
HOLD
Inside Investor: Compare Value with Cost to; ACCEPT or REJECT
Strategy
Three Major Financial Statements
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Balance sheet: to report an enterprise’s
financial conditions, investing and financing
strategies on certain date, which usually is the
end of calendar year.
Income statement: also known as statement of
earnings. It is designed to report the make up
of the firm’s revenue, expanses, and profit.
Cash flow statement: it is designed to explain
the change in cash between periods. The
change in cash would be reported due to three
major activities, namely, operating, investing,
and financing.
Balance Sheet
Ended Dec.31, 1995
Assets
Liab. And Equity
Current Assets
Current Liab.
Cash
Marketable Securities
$20,000 Wages Payable
60,000 Accounts Payable
Accounts Receivable
122,000 Notes Payable
Inventories
350,000 Total Current Liab.
Total Current Assets
$42,000
200,000
50,000
$292,000
$552,000
Long term (fixed) Assets
Long term Debt
$440,000
Total Liab.
$732,000
Buildings and Equipment (net)
500,000 Owners’ Equity
Land
200,000 Stock and Surplus
350,000
Patents
100,000 Retained Earnings
270,000
Total Long term (fixed) Assets
Total Assets
$800,000
Total Equity
$1,352,000 Liab. and Equity
$620,000
$1,352,000
Measurement of Assets & Liabilities
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Historical Cost, for most components of Balance Sheet
May be at market under “lower of cost or market rule”
Reversals of prior write downs allowed for marketable
equity securities but not for inventories
Intangible assets have uncertain and hard to measure
benefits and are reported only when acquired via a
“purchase method” acquisition
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-- brand names
-- when reported, called Goodwill, Patents, etc.
Two Fundamental shortcomings of the
Balance Sheet
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Elusiveness of value
Value cannot be assigned to all assets
Book Value vs. Market Value
Inflation & Obsolescence
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Inflation causes book value to understate
market value
Obsolescence causes book value to
overstate market value
The effect of inflation & obsolescence may
not be apparent in an examination of book
values because they offset one another
Adjustments to Book Value
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Estimate Replacement Cost
Estimate Liquidation Value
Drawbacks
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Do adjusted book values reflect market values?
Adjusted book values do not consider
organizational capital
It is often difficult to determine if we have made the
correct adjustments
Adjustments often fail to consider the value of offbalance sheet items
Income Statement
Fiscal Year, 1995
Revenue
$2,400,000
Cost of Goods Sold
-1,600,000
Gross Profits
$800,000
Sales and Administrative Expanses
-120,000
Depreciations
-200,000
Operating Profits
Interest Expanses
Earnings before Taxes
Income Taxes
Earnings after taxes
Earnings per Share (EPS)
$480,000
-100,000
$380,000
-122,000
$258,000
$2.15
Income Statement
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Based on Accrual accounting:
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records financial events based on events that change
net worth. To record and recognize revenues in the
period in which they incur and to match them with
related expenses.
Based on Matching Principle:
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recognize all related cost attributed to the revenue on
the period that revenue incurs.
Income Statement: high quality income
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Revenues
+
Other income and revenues
Expenses
=
Income from CONTINUING OPERATIONS
 Unusual or infrequent events
=
Pre tax earnings from continuing operations
Income tax expense
=
After tax earnings from continuing operations*
 Discontinued operations (net of tax)*
 Extraordinary operations (net of tax)*
 Cumulative effect of accounting changes (net of tax) *
=
Net Income *
* Per share amounts are reported for each of these items
High quality income
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High quality income statement reflect
repeatable income statement
Gain from non-recurring items should be
ignored when examining earnings
High quality earnings result from the use of
conservative accounting principles that do
not overstate revenues or understate costs
High Quality of Earnings Indicators
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Net Income Backed up by Cash
Net Income not involving the Inclusion of
amortization costs related to questionable
assets, such as deferred charges
Net Income that reflects Economic Reality
Income Statements Components that are
Recognized Close to the Point of Cash
Inflow and Cash Outflow
Low Quality of Earnings Indicators
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Unreliable and inaccurate accounting
estimates
Earnings that have been artificially
smoothed or managed
Deferral of costs that do not have future
economic benefit
Unjustified Changes in Accounting
Principles and Estimate
Premature or Belated Revenue Recognition
Low Quality of Earnings Indicators
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Unstable Income Statement Elements
unrelated to normal business operations
Book Income Substantially Exceeds
Taxable Income
Residual Income that is substantially less
than Net Income
A High Degree of Uncertainty Associated
with Income Statement Components
Summary for Income Statement Analysis
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No single “real” net income figure exists
The analyst must adjust reported net income to an
earnings figure that is relative to him/her.
Earnings quality evaluation is important in investment,
credit, audit & management decision making.
Appraising the quality of earnings requires an
examination of accounting, financial, economic and
political factors.
Earnings quality elements are both quantitative and
qualitative
Cash flow statement
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SCF (Statement of Cash Flows) adds in
situations where Balance Sheet and Income
Statement provide limited insight
SCF helps identify the categories into which
companies fit
Financial flexibility is a useful weapon to gain
a competitive advantage and is best measured
by studying the SCF
Cash flow Statement
Fiscal Year, 1995
Cash inflow from selling activities
$2,600,000
Cash outflow from purchasing activities
-1,800,000
Cash outflows resulted from wages payment
-200,000
Cash outflows resulted from other expanses
-150,000
Cash outflows resulted from paying interest
-100,000
Cash outflows resulted from paying income taxes
-130,000
Cash flows from operating activities
Cash outflow from purchasing fixed assets
Cash inflows from selling long term investment
Cash flow from investing activities
$220,000
-$300,000
120,000
-$180,000
Cash inflow from issuing common stock
$400,000
Cash outflow from reducing long term financing
-440,000
Cash outflow from issuing common dividend
-200,000
Cash flow from financing activities
The increase (decrease) in cash and cash equivalents
-$160,000
-$120,000
The key analytical lessons for
Cash flow statement
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The cash flow statement – not the income
statement – provides the best information
about a highly leveraged firm’s financial
health
There is no advantage in showing an
accounting profit, the main consequence of
which is incurring taxes, resulting, in turn,
in reduced cash flows
Cash flows and competitive
advantages
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Cash rich firms are flexible to deploy various
competition strategies. Such as price
competitions, and acquisition etc..
Cash rich firms are tougher to beat when met
by adversaries.
Cash Flow and Company Life Cycle
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Cash Flow and Start-up Companies
Little or no operating cash flows
Large cash outflows for investing activities
Large need for external financing (mostly from
issuing common stock, issue long term debt)
Cash Flow and Company Life Cycle
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Cash Flows and Emerging Growth Companies
Some operating cash flow (not enough to sustain
growth)
Large cash outflows to expand activities
Requires cash flows from financing
Pay back some short-term debt, issue some
common stock
Cash Flow and Company Life Cycle
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Cash Flows and Established Growth
Companies
Fund growth from operating cash flow
Depreciation is substantial
Repayment of long term debt, begin to pay
dividend
Cash Flow and Company Life Cycle
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Cash Flows and Mature Industry Companies
Modest capital requirements
Depreciation and amortization is significant
Net negative reinvestment
Large dividend payout, reduction in long term
debt
Cash Flow and Company Life Cycle
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Cash Flows and Declining Industry
Companies
Net cash user (similar to emerging growth)
Lower dividends, Slim operating cash flows
Sell assets
Cash Flows and Financial Flexibility
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Safety of dividend
Finance growth with internal funds
Meet other financial obligations
Financial Ratios
Analysis
Ratios and Financial Analysis
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Comparability among firms of different sizes
Provides a profile of the firm
Financial Ratios and Analysis
Caution:
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Economic assumption of Linearity –
Proportionality
Is high Current ratio good? For whom?
Industry-wide norms.
Difference in Accounting Methods;
Liquidity Ratios:
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NWC = current assets - current liabilities
NWC/total asset ratio = net working capital / total
assets
Current ratio = current assets / current liabilities
Quick ratio =(cash + marketable securities +
accounts receivable) / current liabilities
Cash ratio = (cash + marketable securities) /
current liabilities
Cash flow from operation ratio = OCF / current
liabilities
Leverage Ratios
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Leverage ratios have two types:
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balance sheet ratios comparing leverage capital
to total capital or total assets, and
coverage ratios which measure the earnings or
cash-flow times coverage of fixed cost
obligations.
Leverage Ratios- Balance sheet ratios
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Long-term debt ratio = long-term debt /
( long-term debt + equity)
Debt-equity ratio = long-term debt/equity
Total debt ratio = total liabilities / total
assets
Leverage Ratios- Coverage ratios
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Times interest earned = EBIT / interest
expense
= (EAT+Tax+Interest Exp)/ interest
expense
Times Cash flow coverage
=(OCF+Tax+Interest Exp)/ interest
expense
Activity Ratios:
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Measures how efficient the firm using its
assets to generate cash.
Measures how fast a firm converts its current
assets into cash.
Activity Ratios:
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Total assets turnover = Sales / Total assets
Accounts Receivable turnover = Sales / AR
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Inventory turnover = Sales / Average Inventory,
or COGS / Average Inventory
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[Days A/R outstanding = 365 / Accounts Receivable
turnover]
[Inventory Conversion = 365 / Inventory turnover]
Payable turnover = Purchase (or COGS) / AP
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[Days A/P outstanding = 365 / Payable turnover]
The Operating Cycle and the Cash Cycle
Raw material
purchased
Finished goods sold
Cash
received
Order
Stock
Placed Arrives
Inventory period
Accounts receivable period
Time
Accounts payable period
Firm receives invoice
Cash paid for materials
Operating cycle
Cash cycle
Cash Cycle
Cash Cycle
= Operating cycle - Accounts payable period
= Inventory Conversion + Days A/R outstanding
– Days A/P outstanding
Cash Cycle measures a firm’s relying on the short
term borrowing.(bank credits) In practice, the
inventory period, the accounts receivable
period, and the accounts payable period are
measured by days in inventory, days in
receivables and days in payables.
Dell’s Working Capital Policy
DSI
DSO
DPO
CCC
31
42
33
40
Improvement
-18
-5
+21
-44
1997
13
37
54
-4
1996
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Q4
Q4
Dell’s daily sales was about $20M per day. Dell was
able to reduce the need of short term financing
$800M. Assuming a 6% short term cost of capital,
Dell was able to created $48M more pre tax earnings.
Profitability Ratios:
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Gross profit margin = gross profit / sales
Operating profit margin = EBIT / sales
Net profit margin = net income / sales
Return on assets = (net income + interest )/
average total assets
Return on equity = net income/ average equity
The Du Pont System
NI
NI
TA
ROE 
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Equity TA Equity
NI
Sales
TA
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Sales
TA
Equity
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Debt 
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 ROA  1 
Equity 
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 Pr ofitabilit y  Asset Turnover  Leverage Ratio
The Du Pont System
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Usually Profitability and Asset Turnover have
a negative relation. This negative relation
exists in the same industry, or even in different
industries.
Profitability shows a firm’s ability in product
differentiation. (product differentiation
advantage)
Asset turnover reflect a firm’s ability to lower
its cost and increase demand. (low cost
leadership)
Industry analysis:
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Definition of an industry: the group of
firms producing products that are close
substitutes for each other.
Structural Analysis of Industry Competition
Potential Entrants
Industry Competitors
Supplier
Bargaining
Power
Rivalry Among Existing
Competitors
Potential Substitutes
Customer
Buying Power
Profit margin = NI / Sales
(product differentiation)
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×
Asset turnover = Sales / TA
(Low cost leadership)
Profit margin decreases over time due to increase
in competition.
A firm thus would try to increase asset turnover
to compensate the loss in margin.
The strategy to increase asset turnover need to be
deployed when a firm still has advantage in profit
margin.
Threats of entry:
Barriers to entry:
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Economics of scales
Product differentiation:
Capital requirement:
Switching costs:
Access to distribution channels:
Cost disadvantages independent of scale:
proprietary, access to raw materials,
favorable locations, government subsidy.
Government policy:
Threats of entry:
Expected retaliation:
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A history of vigorous retaliation to entrants.
Established firms with substantial resources
to fight back.
Established firms with great commitments to
the industry and highly illiquid assets
employed in it.
Slow industry growth, which limits the ability
of the industry to absorb a new firm without
depressing the sales and financial
performance of established firms.
Intensity of rivalry among existing
competitors:
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Numerous or equally balanced competitors..
Slow industry growth:
High fixed and storage cost:
Lack of differentiation or switching costs:
Capacity augmented in large increments:
Diverse competitors:
High strategic stakes:
High exit barrier:
Pressure from substitute products:
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(1) substitute products are subject to
trends improving their price-performance
trade-off with the industry’s product.
(2) substitute products are produced by
industries earning high profit.
Bargaining power of buyers:
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It is concentrated or purchases large volume relative
to seller sales.
The products it purchases from the industry represent
a significant fraction of the buyer’s cost of purchase.
The product it purchases from the industry is standard
or undifferentiated.
It faces few switching costs.
It earns low profit.
Buyers pose a credible threat of backward integration.
The industry’s product is unimportant to the quality of
the buyer’s products or services.
The buyers have full information.
Bargaining power of suppliers:
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It is dominated by a few companies and is more
concentrated than the industry it sells to.
It is not obligated to contend with other substitute
product for sale to the industry.
The industry is not an important customer if the
suppliers’ group.
The suppliers’ product is an important input to the
buyer’s business.
The supplier group’s products are differentiated or it
has built up switching costs.
The supplier group poses a creditable threat of
forward integration.