Balance Sheet

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Security Analysis
Financial Statements
Balance Sheet
1
Income Statement
Revenues
-Cost of Goods
Gross Income
-Operating Expenses
Operating Income
-Financing Expenses
-Taxes
Net Income Before Extraordinary Items
+/- Extraordinary Profits/(Losses)
Preferred Dividends
Net Common Income to Shareholders
2
Principles


Accrual Accounting
Categorization of Expenses into
1. Operating Expenses
2. Financing Expenses
3. Capital Expenditures
3
Warning Signs





EPS Growing Faster than Revenue Year
after Year
Frequent Acquisitions or One Time
Charges
Rapid Growth in Working Capital
Changes in Inventory/Depreciation
Methods
Change in Auditors
4
Balance Sheet
What is it and What can Investors Use it
For?
5
Statement of Financial Position
as of a Specific Date
Assets
Cash
Accts Receivable
Inventory
Prepaid Expenses
Current Assets
Liabilities and Equity
Accounts Payable
Accrued Expenses
Current Debt
Taxes Payable
Current Liabilities
Other Assets
Long Term Debt
Fixed Assets
Net Fixed Assets
Retained Earnings
Shareholders Equity
Total Assets
Total Liabilities & Equity
==================================
6
Uses of the Balance Sheet

Assess Risk

Identify Value

Understand Competitive Advantage
7
Info in the Balance Sheet



Division of Capital Between Senior
Obligations and Common Equity
Strength or Weakness of Working
Capital Position
Reconciliation of Earnings reported in
income statement
8
Info on the Balance Sheet


Data for Analyzing Relationship
between Earnings Power and Asset
Values. (Fixed/Variable Costs)
Data to Test True Business Success
(ROIC)
9
Impact of Debt

Magnifies Returns (Positive AND
Negative)

Adds Fixed Costs

Adds Uncertainty
10
How Much Debt is Enough?

Versus Business Model

Versus Peers

Working Capital
11
Historic Value of Book Value





Originally Represented Value of Private
Business (Tangible Assets)
Today Little Relation to Market Value for
Many Companies
Intangibles as Valuable as Plant
Useful to Corroborate Income Statement
Still Relevant in Energy, Financials, Distressed
12
Relationship of Going Concern Value
And Liquidation Value
Liquidation Value
Going Concern Value
13
Relationship of Going Concern Value
And Liquidation Value
Liquidation Value
Going Concern Value
14
Business Model and
Profitability Drive BV Multiples
EBAY
Price
9/7/04
Price to
Return on
Book Value Assets
$89.28
10.18x
8.88%
2.4x
0.87%
International $41.08
Paper
15
Balance Sheet Can Discern
Efficiency Trends



Cash Cycle: Time it Takes to Turn Raw
Materials into Cash
Day in Inventory+Days Receivable-Days
Payable
Fast is Good!
16
Hewlett Packard 7/03
Cash Cycle
10/1
1/02
4/02
7/02
10/02 1/03
4/03
7/03
DSO
62
55
57
62
59
58
56
56
Inventory
Days
44
36
34
41
39
42
39
43
Payable
Days
43
48
46
46
49
48
43
48
CCC
63
45
45
57
49
52
52
51
17
Dell 7/03
Cash Cycle
10/1
1/02
4/02
7/02
10/02 1/03
4/03
7/03
DSO
32
25
26
28
26
24
25
27
Inventory
Days
4
4
4
4
4
3
3
4
Payable
Days
70
66
68
73
71
68
70
72
CCC
(34) (37) (38) (41) (41) (41) (42) (41)
18
Relative Profitability Dell/HPQ
Profit
metrics
1/02 4/02 7/02 10/02
1/03
4/03 7/03
Dell
ROA%
13
13
13
14
15
15
15
HPQ
ROA%
4
3.3
2.4
4.2
4.9
4.9
3.9
DELL
ROE%
35
36
39
42
46
48
48
HPQ
ROE%
4.7
4.8
4.7
6.5
7.1
8.3
8.8
19
Update on Dell/HPQ
Earnings
Interest Exp
Assets
Dell 1/05
HPQ 10/04
3,043
3,497
0
225
23,215
76,138
Shareholders’ Equity
6,485
37,564
ROA
13.1%
4.9%
ROE
46.9%
9.3%
20
Accounting Ratios/Stock Price: Dell/HPQ
Dell
HPQ
ROE
59.1%
8.08%
P/B
15.53
2.15
“Return on Mkt Cap”
3.81%
3.77%
P/E
26.4
25.5
P/B = Price/Equity
ROE = NI/Equity
ROE x 1/(P/B) = return on market cap
= (NI/Equity x (1/(price/equity)
Figures are per Yahoo Finance 9-05-05
21
Balance Sheet Manipulation

Leases: Operating versus Capital

Pension Assets

Special Purpose entities
22
Ratio Analysis: Combining IS
and BS




Liquidity: Current Ratio, Working Capital
to Sales Ratio
Asset Management: Inventory Turns,
Asset Turns, Days Receivable
Profitability: Gross Margin, Operating
Margin, ROA, ROE
Leverage Ratios: Debt to Capitalization
23
For Company Selection



Calculate Liquidity, Asset, Profitability,
and Leverage Ratios for your selected
company and its comparable companies
over each of the 5 years
LOOK at them. THINK about them
Identify likely areas of required
accounting adjustments
24
Ratios

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Current Ratio= Current Assets/Current Liabilities
Working Capital Ratio= Working Capital/Sales
Inventory Turns=Cost of Goods Sold/Inventory
Asset Turns=Sales/Assets
Receivable Days=Receivables/Sales x 365
Return on Assets=Net Income*/Total Assets
Return on Equity=Net Inc/Shareholders Equity
Return on Sales=Net Inc/Net Sales
Gross Margin= (Sales-Cost of Gds Sold)/Sales
Operating Margin=Operating Income/Sales
Debt/Capital=Long Term Debt/Long Term Debt+Shrhldrs Equity
*Some add back interest on debt
25
What is in the 10k and What
can We Learn?
Item 1: Business Model and Strategy
Industry Trends/ Comparisons
2. Properties: Sources of Capacity and Revenues.
Exposure to currency and variation in cost levels
3. Legal Proceedings: Potential Liquidity issues
4. Matters Requiring Shareholder Vote. Potential
material change in business (M&A)
5. Stock Performance, Listings, Float, Dividend
6. Selected Financial Data: Snapshot of data
deemed important by management. One time
items
26
What is in the 10k and What
can We Learn?
7. Management Discussion. Analysis of past financial
performance and future outlook. Strength and
weakness in business operations and funding
issues. Supplement to data in notes.
7a. Market Risk: Laundry list of risks and competition
8. Financial Statements and Supplementary Data
(notes). Indications for future sustainability and
quality of earnings/Profitability
9. Changes and Disagreements w/Accountants.
Potential red flags regarding quality of disclosure and
financial performance.
27
What is in the 10k and What
can We Learn?
10. Directors/Officers and Conflicts
11. Executive Compensation
12. Ownership of Stock. Executives and
certain beneficial owners
13. Related Party Transactions/Conflicts
14. Exhibits, Statement Schedules. More
info providing insight (subjective
accruals). New contracts. Off balance
sheet entities. Changes in Bank
covenants.
28
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