INVESTMENT BANKING
LESSON 8 MAKING SENSE OF FINANCIAL
STATEMENTS
Investment Banking (2nd edition) Beijing Language and Culture University
Press, 2013
Investment Banking for Dummies, Matthew Krantz, Robert R.
Johnson,Wiley & Sons, 2014
WHAT’S IN THE NEWS OR
WHAT’S THERE TO LEARN?
How
China is Upsetting the Old
Economic World Order
FORBES CHINA 30 ENTREPRENEURS
UNDER THE AGE OF 30
LESSON 6 REVIEW
1. WHAT IS EDGAR AND HOW IS IT HELPFUL TO IB?
2. HOW CAN SOCIAL MEDIA, LIKE FACEBOOK,
TWITTER, WE CHAT, etc HELP OR HURT IB
ACTIVITIES?
1.
INTRODUCTION
2. SPOTTING TRENDS IN THE
FINANCIAL STATEMENTS – INCOME
STATEMENTS
3. FINDING IB OPPORTUNITIES
4. ANALYZING THE BALANCE SHEETS
5. UNDERSTANDING A COMPANY’S
FINANCIAL STRENGTH
6. LOCATING PITFALLS AND
OPPORTUNITIES
7. STATEMENT OF CASH FLOWS
8. CALCULATING FREE CASH FLOW
9. PROXY STATEMENTS
Just like we go to the doctor for a checkup,
the same situation happens between
investment banks and their clients.
Companies share details about their business
with close financial advisors.
It’s part of the relationship between IB and
companies, which is one reason why it is
heavily regulated.
But IB must still do their research.
A company’s financial statements
show how the company is performing,
what kind of economic condition it is in
and how it is positioned for the future.
In this lesson, we find out how IB use
the Income Statement, Balance Sheet
and Statement of Cash Flows.
And we will also look at the proxy
statement, which also has lots of info.
Every quarter (3 months) investors are fixed on
the income statement and the earnings reports
of major companies.
The Income Statement tells all the parties: stock
investors, bondholders, employees and of course,
investment bankers, how much a company earned
during the quarter.
How much did a company bring in by selling goods
and services? How much was left after paying
expenses?
In the US, the income statement
must meet strict guidelines called,
generally accepted accounting
principles (GAAP). All companies
that trade on the US exchanges file
statements with the SEC.
The income statement is used by IB to:
A. TRACK THE WAY A BUSINESS IS GOING –
Where is the company in it’s lifecycle? It
will show if a young company is growing
rapidly, or if a large company is struggling.
B. HOW IS MANAGEMENT DOING?
Management, including the CEO’s jobs may
be on the line if a co. can’t find a way to
drive profit higher.
C. WHAT IS “DRIVING” THE BUSINESS?
Which businesses are most important to a company? The
IS will show what is driving the success of a company.
Which divisions are doing well and which are not.
REAL WORLD EXAMPLE: Disney 2012
Disneyland Parks: Revenue (total payment of goods and
services) was $42.3 billion.
After paying all expenses it turned $10 billion in profit.
Disney theme parks accounted for 31% of the company’s
revenue, but only 19% profit.
The majority of revenue 46% and profit 66% came from
the Disney media networks, like the ESPN sports
network.
WHAT ARE THE AREAS OF INTEREST IN THE IS
FOR THE IB? Accountants look for “mistakes”.
Investors look for clues to determine an
investment opportunity. IB look for ways to
help companies improve results. IB focus on
the following line items:
Revenue – measures amount of dollar volume
and how quickly a company is growing.
Cost of goods sold (COGS) – looking at
direct costs like raw materials (expansion?)
Gross Profit – a good indicator of how
profitable a company’s line of business is
before analyzing overhead costs, some of
which are more controllable than direct
costs.
Selling, general & administrative costs
(SG&A) – Not just raw materials but sales
people to pay, advertising costs. These
overhead costs are indirect costs to the IB.
Operating Income – How much a company keeps
from revenue after paying both direct and
indirect costs. Gives IB a good idea of a
company’s profitability excluding taxes.
Interest expense – Borrowed money from
bondholders & other lenders. The portion of
expenses paid in the current period.
Income taxes – Companies pay taxes and tax
bills come into play when making decisions on
business moves & where to locate a business
(states have different taxes).
Net profit – How much the company earned
subtracting all the costs.
These line items apply to most
manufacturing firms and even many service
firms like restaurants chains. Financial
companies are different and the line items
on the IS are read differently.
Financial Statements look
backwards and IB like to look
forward. In chapter 7 we looked at
pro forma analysis, which means
“for the sake of” or “as a matter of
form”. IB take the financial
statements and create financial
models.
One of the adjustments IB make to the
income statement is NOPAT (net operating
profit after tax):
NOPAT = Operating Income x (1-Corporate
tax rate).
This allows IB to see how profitable a
company is leaving out the costs of debt
financing. This gives IB an idea of how much
debt a business can support before the
interest payments become too much of a
problem.
The income statement is used by IB to look
for holes that may be filled with a financial
product. The next lesson (9) we will look at
financial ratios which is part of the “magic”
IB pull out of the income statement. In
lesson 10 we will look at comparing a
company’s financial statements to the
industry or sector it is in. But there are
opportunities to spot, looking at the IS.
What are they? There are 3 main ones!
A. CAPACITY TO HANDLE MORE
DEBT – IB love finding ways to get
companies to take on more debt, or
leveraging it. When used properly
can boost profitability. The interest
expense line relative to the net
income can help the IB suggest
adding more debt.
B. RIPE (READY) FOR A BOOST IN
GROWTH
When IB see the revenue line growing
at a “snails pace” (so slowly), they see
opportunity. So, when CEO’s look for a
fast way to grow they will look to IB for
buyout candidates that will help the
company grow again.
C. CANDIDATES FOR DIVESTITURE
(SPINOFFS) – Slow growth in net income,
yet as revenue is expanding could mean the
co. is in a low-margin business. This can be
a drag on a company as it uses valuable
resources and employees with little
payback. IB see this as an opportunity for
the co. to be sold to another one that
focuses on the same business, then they
could become quite profitable. This is called
a “spinoff” or divestiture.
The balance sheet (BS) is a snapshot (quick
view) in time of the financial health of a co.
It shows the assets the co. owns and all the
liabilities based on past cost or book value.
The BS gives IB a look at the resources and
liabilities has, critical information when it
comes to selling financial products to a co.
What are the key parts? Let’s get to know the
assets!
1. CASH – Cold, hard cash! There’s nothing like it,
right! Cash is critical for any corporate deals.
Short term investments work well also.
2. ACCOUNTS RECEIVABLES – IOUs
3. INVENTORY – Co. must have raw materials to
make products. This line item counts the value of
products waiting to be sold or the various stages
of manufacturing.
4. PROPERTY, PLANT AND EQUIPMENT- How
much have these investments cost the co., minus
depreciation.
5. ACCUMULATED DEPRECIATION – This becomes
important to IB when considering the cash flow
statement.
6. LONG-TERM INVESTMENTS – Generally stocks,
bonds and real estate.
7. GOODWILL – Hard to describe but generally
copyrights, brand names (like Coca-Cola). Firms
accumulate goodwill when they buy another
company for than the book value. The difference
is shown on the balance sheet.
8. TOTAL ASSETS – All that the company controls.
B. LIABILITIES
1. ACCOUNTS PAYABLE – What the co. owes
2. SHORT-TERM BORROWINGS – What the co.
owes is due in less than a year.
3. LONG-TERM DEBT – Debt due in more than a
year.
4. CURRENT PORTION OF LONG-TERM DEBT –
The part of long term debt due in less than a year
5. CAPITAL LEASES – Renting can be convenient
but may have obligations, contracts that are
binding.
B. LIABILITIES
6. PENSION AND RETIREMENT BENEFITS – Some
companies may have obligations from pension
plans than many companies no longer offer.
C. EQUITIES – Means more than just stock. Equity
means shareholder’s ownership of the company.
The difference between assets and liabilities on
the balance sheet is equity.
The main way IB make the most of financial
statements is using ratios, but there is still much
they get from the balance sheet.
A. COMMON SIZING ANALYSIS – This is measuring
all of the items of a financial statement against
the total. All of the co. individual assets and
individual liabilities are divided by the total
assets.
Let’s look at a balance sheet for the Hershey
corporation that has been common-sized.
To an IB several things will “jump out”.
First, notice that 15% of Hershey’s total assets are
cash. There may be better uses for that cash.
Second, 35% of the co. assets are tied up plant, etc.
This means the co. is capital intensive with large
investments in plant & equipment.
B. COMPARING DEBT TO EQUITY – Important to IB is
this relationship. By dividing total liabilities by total
equity IB can see how leveraged a company is, or
how much of the cost of a company is financed by
debt or equity. The 78% debt is more than 3 times
the equity. Knowing this helps IB advise Hershey’s.
HERSHEY’S BALANCE SHEET COMMON-SIZED
Balance Sheet Line item
2012 Value
Common-size value
Cash
$728.3
15.3%
Accounts Receivable
Inventories
$461.4
$633.3
9.7%
13.3%
Property, Plant, Equipment
$1,674.1
35.2%
Goodwill
Other Assets
Total Assets
Accounts Payable
Short-term Debt
Current portion long-term debt
Long-term debt
Other Liabilities
$588.0
$669.70
$4,754.8
$442.0
$118.2
$257.7
$1,531.0
$1,357.6
12.4%
14.1%
100%
9.3%
2.5%
5.4%
32.2%
28.6%
Total liabilities
$3,706.5
78%
Total Equity
$1,048.4
22%
C. STUDYING BOOK VALUE – Book value of
equity is like a person’s net worth.
Are you familiar with the term net worth?
Simply, the book value of equity is what the
company’s assets are worth after paying all it’s
liabilities.
Book value of equity is calculated by subtracting
total liabilities and goodwill from a company’s
total assets.
4,755 – 3707 + 588 (4295) = 460 million book value
When clients of the bank met with me for
financial planning, one of the first things I would
have them do is create a net worth statement.
By looking at all the assets they own and then all
the liabilities they owe, I could set up priorities
for the person to achieve. Looking at the balance
sheet for IB will show the opportunities as well as
potential problems for a company.
There are 2 main ones to look at:
A. OPPORTUNITY TO INCREASE LEVERAGE
B. FINDING USES FOR CASH
A. OPPORTUNITY TO INCREASE LEVERAGE –
One of the “top tricks” of IB is to help
companies sell debt securities to increase
their level of leverage. Companies can push
up their profitability while pleasing
shareholders. When debt is used to boost
profit, that increases the return on equity
invested in the business.
But debt is always a “double edged sword” –
can be good or bad!
B. FINDING USES FOR CASH – Like a dog
can’t wait to get to it’s food, IB love to
see cash in a company, especially when
interest rates are low. Cash that is
sitting has a high opportunity cost
meaning co. are missing out on
opportunities elsewhere. IB will talk
with cash-rich companies about uses for
the cash such as M & A activity.
Most individual investors look at the income
statement and to a lesser degree the balance sheet.
They look for how much a company is earning (stock
price growth) and how much cash a co. has
(dividends).
IB know the power of the statement of cash flows.
This shows where the money is coming in and going
out of the business. Cash flow is different from net
income. A co. may make a sale but the cash hasn’t
been received yet. The statement of cash flows is
concerned with how dollars find it’s way into the
company.
Why is the cash flow statement so important?
Remember – CASH IS KING to an IB!
Income statements show profits. You can’t spend
profits! The cash flow statement shows when a
co. brings in cash or spends it!
IB focus on the statement of cash flow because it
is seen as more pure and less influenced by
accounting “gimmicks” (manipulations) than
other financial statements like the income
statement
UNDERSTANDING THE CASH FLOW STATEMENT –
THERE ARE 3 MAIN PARTS:
A. CASH FLOWS USED BY OPERATING ACTIVITIES
B. CASH FLOWS USED BY INVESTING ACTIVITIES
C. CASH FLOWS USED BY FINANCING ACTIVITIES
Let’s look at each of these!
Cash Flows from Operating Activities:
Operating Income (EBIT)
Depreciation expense
$2,000,000
100,000
Increase in Accts Receivable -200,000
Cash Flow from Financing Activities:
Payment of Dividends
-100,000
Increase in long-term debt
300,00
Repayment of debt
-100,000
Salaries Payable
Increase In accts payable
100,000
100,000
Net cash flow from financing Activ 100,000
Net change in cash
1,500,000
Increase in inventory
-300,000
Beginning Cash balance
Ending Cash balance
Net cash flow from operating activities $1,800,000
Sale of Equipment
$200,000
Acquisition of company
-500,000
Building Improvements
-100,000
Net cash flow from Investing Activities $-400,00
600,000
$2,100,000
CASH FLOWS PROVIDED FROM (USED BY) OPERATING
ACTIVITIES: Here, you find out how much of the co.
profit came from doing business in cash. Calculating cash
flows from operating activities starts with net income
from the income statement. Uses of cash are deducted
from net income and sources of cash are added back.
+Add back depreciation and amortization: Net income
takes a hit from an expense that doesn’t cost the co. a
bit of cash: depreciation. Accountants require co. to
deduct from profit wear and tear on equipment that
doesn’t cost cash. Depreciation is added back to net
income to come up with net cash flow from operations.
CASH FLOWS PROVIDED FROM (USED BY)
OPERATING ACTIVITIES:
+Stock-based compensation: Since a big
part of CEO pay is in stock and not cash, it’s
added back to net income.
- Accounts Receivables: Because some
goods and services aren’t collected right
away the sale does not count as net income,
thus it is subtracted.
CASH FLOWS PROVIDED FROM (USED BY)
INVESTING ACTIVITIES:
-
Capital Additions: Co. will need to improve
facilities (an investment) and when using cash,
the amount is subtracted from cash flow.
+ Proceeds from sales of properties, plant,
equipment: When these assets are sold, it is a
boost in cash. Added to cash flow.
- Business Acquisitions: When a co. buys another
co. (M & A) cash is often used and subtracted
CASH FLOWS PROVIDED FROM (USED BY)
FINANCING ACTIVITIES:
Where is a co. getting and using cash to pay for
its operation.
+ Increases in debt: Adding to debt by
borrowing increases cash and IB will keep an
eye on this. Is it short or long term. Which
type will indicate how much cash goes out.
- Repayment of long-term debt: Subtracted from
cash but can reduce debt and interest payments.
CASH FLOWS PROVIDED FROM (USED
BY) FINANCING ACTIVITIES:
- Cash dividends paid: A significant
subtraction from cash. Something
investors want a co. to pay when the
co. is “sitting on cash”. In hard times,
though, co. may suspend dividends.
Cash Flows from Operating Activities:
Operating Income (EBIT)
Depreciation expense
$2,000,000
100,000
Increase in Accts Receivable -200,000
Cash Flow from Financing Activities:
Payment of Dividends
-100,000
Increase in long-term debt
300,00
Repayment of debt
-100,000
Salaries Payable
Increase In accts payable
100,000
100,000
Net cash flow from financing Activ 100,000
Net change in cash
1,500,000
Increase in inventory
-300,000
Beginning Cash balance
Ending Cash balance
Net cash flow from operating activities $1,800,000
Sale of Equipment
$200,000
Acquisition of company
-500,000
Building Improvements
-100,000
Net cash flow from Investing Activities $-400,00
600,000
$2,100,000
As you can see, the statement of cash flow is
an important financial statement to IB. Every
dollar is counted and listed in a category.
IB often mix and match items from the 3
sections of the statement. Free cash flow
(FCF) measures the co. cash flow power from
its core operations, after making necessary
adjustments such as investing in plant and
equipment, if it wants to stay in business long
term.
Let’s look at how to calculate cash flow!
A. Start with net cash flows from operating
activities: This number is net income adjusted
for all uses and sources of cash from the co.
operations.
B. Subtract capital additions from net cash
flow from operating activities
C. Analyze the findings: This number gives IB
a look at how much cash the co. needs to keep
running on an ongoing basis.
If the co. free cash flow is negative, that is a
bad sign. Example of internet co. in the 1990’s
Besides the 3 main financial statements:
Income Statement, Balance Sheet and
Statement of Cash Flows, there is another
statement IB use – the proxy statement.
Because people are so important to the
running of a co. the proxy statement gives
information about:
A.Top Management:
1. CEO (Chief Executive Officer)
2. CFO (Chief Financial Officer)
3. COO (Chief Operating Officer)
B. Relationships top managers have with
other companies: Shows all the other
companies the managers work with, say on the
Board of Directors.
C. Details about the Board of Directors: The
CEO’s and management team answer to the
Board of Directors, which are professional
people hired by the shareholders to supervise
the co. management team.
D. Analyzing pay structure of the CEO:
D. Analyzing pay structure of the CEO:
1. Salary – small portion lower than 1 million
2. Bonuses – based on meeting goals
3. Stock awards – granted based on
performance
4. Stock options – the right but not the
obligation to buy stock at a pre-set value
5. Other Compensation – things like use of a
company jet, private security, etc
6. Total: The proxy statement shows it all.