Com 4FK3
Financial Statement Analysis
Week 1, 2012
Why Analyse F. S. Data?
• Efficient market hypothesis; market reacts
intelligently and quickly to new information
so analysis should not lead to excess return
• Paradox, if analysis is not profitable,
nobody will do the analysis… so how can
the market price securities efficiently?
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Individual vs. Average
• Research studies on capital market
efficiency study groups rather than single
companies
• If the market is efficient on average, that
doesn’t mean that there are not some
mispriced securities
• Role of analyst: to bring about a correction
to the mispricing of securities
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Perfect Efficiency?
• Studies show that equity markets are not
perfectly efficient
– January effect
– Price lags
– Over or under reaction
• Analysis can help detect under and over
priced firms
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Purpose of Financial Statements
• Ideal world: disclose the true economic
value of the company
• Real world:
– required by law (Securities Regulators)
– follows GAAP, wide latitude allowed
• Analysis required to “cleanse” statements of
bias to set prices efficiently
5
The Adversarial Nature of
Financial Reporting
The purpose of financial reporting
is to obtain cheap capital
Martin Fridson & Fernando Alvaez
• Other incentives for misstatements include
managerial compensation, which is often tied to
the financial statement numbers
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Other Uses
• Financial statements used for other purposes
– credit analysis by a bank (not alone)
– competitor analysis
– merger and acquisition analysis
• Not Taxation
– Corporations typically have separate sets of
books for tax purposes
– These books are not compliant with GAAP
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Five Steps
• Identify the economic characteristics of the
particular industry
• Identify the firm’s strategy
• Understand the firm’s financial statements
and “cleanse” them
Important
• Assess profitability and risk This is an overview
of the term paper
• Value the firm
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Economic Characteristics
• How does the industry operate:
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number of competitors
principal types of assets and liabilities
typical capital structure
risk levels and types
differentiability of products
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E. C. Pharmaceuticals
• High barriers to entry, research and
approval costs before any revenue
• Patent protection gives high margins
• High risks; product liability, other drug
makes your product obsolete
• Business risk leads to low level of debt
• Generic drug manufacturers, effectively a
separate industry
10
Value Chain Analysis
• The various steps in
the creation,
manufacture, and
distribution of a
product or service
• Firm can be involved
in all steps or
concentrate on a few
Pharmaceuticals
• Research
• Approval process
• Manufacture
• Create demand
• Distribution to retail
outlets
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Porter’s Five Forces
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Competitors, rivalry among firms
Potential Entrants
Equivalent Products & substitutes
Bargaining Power of Customers
Bargaining Power of Input Suppliers
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Competitors
• Opportunities for growth
• Number and size of competitors
• Cost structure of product – fixed and
variable costs
• Capacity issues
• Pressure on selling price and delivery
• Product quality
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Potential Entrants
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Size of initial investment
Degree of profit margin
Learning curve impact on costs
Relationship with customers
Non financial barriers
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Equivalent Products
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Availability of substitute products
Type of technology
Integration with customers end products
Continuous improvement of product
Downward pressure on costs
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Bargaining Power of Customers
• Purchase quantities
• Generic nature of product
• Availability of product
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Bargaining Power of Suppliers
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Quality requirements
Generic nature of products
Availability of materials and labour force
Skill level of labour force
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Economic Attribute Framework
• Demand: price sensitivity, growth, cyclic
nature of demand
• Supply: number of firms, barriers to entry
• Manufacturing: capital intensive, complex
• Marketing: selling to business or consumer
• Financing: short or long-term financing
needs
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Soft Drink Industry
Demand
• Relatively insensitive to price
• Low growth domestically, international
opportunities
• Not cyclical
• Higher demand in warmer weather
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Soft Drink Industry
Supply
• 2 major branded suppliers
• domination of distribution channels creates
barriers to entry
Manufacturing
• Capital intensive but simple
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Soft Drink Industry
Marketing
• high brand recognition and demand pull
Financing
• Bottling and transport operations require
long term financing
• High profitability and low growth (domestic)
lead to excess cash flow generation
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Strategy
• Nature of product or service: is it unique
(product differentiation) or low price
• Degree of integration with value chain
• Degree of geographical diversification
• Degree of industry diversification
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Strategy for Coke
• Brand recognition allows for differentiation
• Value chain: Coke develops and advertises
products and produces the syrup, but uses
other companies to bottle and distribute
• Geographical: 67% of sales outside N. A.
• Industry diversification: virtually zero…
operates in beverage industry but mainly in
the soft drink subsection
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Principal Financial Statements
• Balance Sheet, Income Statement,
Statement of Cash Flows, Notes
• SEC (US) or OSC (Canada) requirements
• GAAP largely delegated to FASB (US) or
CICA (Canada)
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Balance Sheet
• Snapshot of the resources of the firm
• Assets = Liabilities + Shareholder equity
• Formats differ between countries
– France and Germany; reverse order of current
and noncurrent
– UK; Assets + WC - Liabilities = Equity
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Assets
• 2 categories; monetary & non-monetary
• Classification
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Current Assets
Investments
Property, Plant, and Equipment
Intangibles
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Liabilities
• Money to be paid in the future for goods or
services already received
• Labour contracts, purchase orders, lease
payments, etc. for benefits not yet received
are not considered liabilities
• Noncurrent liabilities discounted at interest
rate applicable when incurred
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Shareholders’ Equity
• Value of assets and liabilities determines
shareholders’ equity
• Often broken down to:
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amounts initially contributed
retained earnings
valuation allowances
treasury stock
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Quality of Balance Sheet
• Ignores valuable resources of the firm;
patents, brand names, etc.
• Non-monetary assets at cost
• Some legal claims against the cash flows of
the firm don’t appear as liabilities
• Noncurrent liabilities discounted at rate
applicable when incurred, not current costs
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Income Statement
• Measures operating performance
• Net Income = Revenues and gains –
Expenses and losses
• GAAP requires accrual accounting
– Revenue recognized when service rendered and
cash or measurable receivable gained
– Expenses matched with revenue
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Classification
• Income from continuing operations
– Main form of earnings
• Income, gains and losses from discontinued
operations
• Extraordinary gains and losses
• Adjustments for changes in accounting
principals
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Quality of Earnings
• Managerial compensation is often tied to
earnings, there is a potential that current
earnings are not a good indicator of future
earnings potential
• Analysts may want to adjust earnings for
some items before assessing operating
performance
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Statement of Cash Flows
• A high growth firm can report positive net
income and be running out of cash to pay
creditors
• Statement of cash flows can provide early
warning of problems
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Classification
• Operating
– The core business of the firm
– In the long run, this must be positive for the
firm to survive
• Investing
• Financing
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Common Size Statements
• To aid in analyzing a firm common size
financial statements are often prepared
• Balance sheet: divide all numbers by the
total assets of that year
• Income statement: divide by sales
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Financial Statement Ratios
• Profitability
– EPS
– ROCE
• Risk
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Current ratio
CFO/average current liabilities
Interest coverage ratio
Debt/Equity ratio
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Valuation of Firms
• P/E ratio
– Theoretical model
(1 + growth rate in earnings)
Required return - growth rate in earnings
• Market to book ratio
– Theoretical model
1 + Expected ROCE – required return
Cost of equity - growth rate in earnings
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