Financial Statement Analysis K R Subramanyam John J Wild McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Overview of Financial Statement Analysis 1 CHAPTER 1-2 1-3 Business Analysis Evaluate Prospects Evaluate Risks Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers 1-4 Information Sources for Business Analysis Quantitative Financial Statements Qualitative Management discussion & Analysis Chairperson’s Letter Industry Statistics Press Releases Economic Indicators Financial press Regulatory filings Vision/Mission Statement Trade reports Web sites 1-5 Credit Analysis Equity Analysis Management & Control Regulation Financial Management Labor Negotiations Types of Business Analysis Director Oversight External Auditing Mergers, Acquisitions & Divestitures 1-6 Credit Analysis Trade Creditors Non-trade Creditors Provide goods or services Bear risk of default Provide major financing Bear risk of default Most shortterm Usually implicit interest Most longterm Usually explicit interest 1-7 Credit Analysis Credit worthiness: Ability to honor credit obligations (downside risk) Liquidity Ability to meet shortterm obligations Focus: • Current cash flows • Make up of current assets and liabilities • Liquidity of assets Solvency Ability to meet longterm obligations Focus: • Long-term profitability • Capital structure 1-8 Equity Analysis Assessment of downside risk and upside potential Technical analysis / Charting • Patterns in price or volume history of a stock • Predict future price movements Fundamental Analysis Determine Intrinsic value without reference to price • Analyze and interpret key factors – Economy – Industry – Company 1-9 Component Processes of Business Analysis Business Environment & Strategy Analysis Industry Analysis Strategy Analysis Financial Analysis Accounting Analysis Analysis of cash flows Risk Profitability Analysis Analysis Cost of Capital Estimate Prospective Analysis Intrinsic Value 1-10 Accounting Analysis Process to evaluate and adjust financial statements to better reflect economic reality Comparability problems — across firms and across time Manager estimation error Distortion problems Earnings management Accounting Standards Accounting Risk 1-11 Financial Analysis Process to evaluate financial position and performance using financial statements Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Analysis of — cash flows Evaluate source & deployment of funds Common tools Ratio analysis Cash flow analysis 1-12 Prospective Analysis Process to forecast future payoffs Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Intrinsic Value 1-13 Dynamics of Business Activities Business Activities Time Beginning of period Investing Financing Planning Operating Planning Investing Financing End of period 1-14 Business Activities Pricing Competition Market demands Distribution Tactics Planning Activities: Goals & Objectives Promotion Projections Managerial performance Opportunities Obstacles 1-15 Business Activities Financing activities • Owner (equity) • Nonowner (liabilities) Financing 1-16 Business Activities Investing activities • Buying resources • Selling resources Investing Financing Investing = Financing 1-17 Business Activities Investing Activities Planning Activities Financial Activities Operating Activities Revenues and expenses from providing goods and services 1-18 Financial Statements Reflect Business Activities Planning Investing Operating Current: • • • • Cash Accounts Receivable Inventories Marketable Securities Noncurrent: • • • Land, Buildings, & Equipment Patents Investments Sales • Cost of Goods Sold • Selling Expense • Administrative Expense • Interest Expense • Income Tax Expense • Balance Sheet Current: • • • • • • Net Income Cash Flow Statement of Cash Flows Notes Payable Accounts Payable Salaries Payable Income Tax Payable Noncurrent: • Income statement Assets Financing Bonds Payable Common Stock Retained Earnings Liabilities & Equity Balance Sheet Statement of Shareholders’ Equity 1-19 Financial Statements Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows 1-20 1-21 Balance Sheet Total Investing = Total Financing = Creditor Financing + Owner Financing Colgate Financing (in $billions) $9.138 = $7.727 + $1.410 1-22 1-23 Income Statement Revenues – Cost of goods sold = Gross Profit Gross profit – Operating expenses = Operating Profit Colgate’s Profitability (in $billions) $12.238 - $5.536 = $6.701 Gross Profit $6.701 - $4.5411 = $2.160 Operating profit 1-24 1-25 Statement of Cash Flows Net Cash Flows from Operating Activities Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities 1-26 1-27 Additional Information (Beyond Financial Statements) Management’s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information Proxy Statement 1-28 Analysis Preview Yr1 Yr2 Yr3 Comparative Analysis Purpose: Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types: Year-to-year Change Analysis Index-Number Trend Analysis 1-29 Analysis Preview 1-30 Analysis Preview Common-Size Analysis Purpose : Evaluation of internal makeup of financial statements Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses 1-31 Analysis Preview 1-32 Analysis Preview 1-33 Analysis Preview Ratio Analysis Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis) Output: Mathematical expression of relation between two or more items Cautions: Prior Accounting analysis is important Interpretation is key - long vs short term & benchmarking 1-34 Analysis Preview Valuation Valuation - an important goal of many types of business analysis Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) 1-35 Analysis Preview Debt (Bond) Valuation Bt is the value of the bond at time t It +n is the interest payment in period t+n F is the principal payment (usually the debt’s face value) r is the investor’s required interest rate (yield to maturity) 1-36 Analysis Preview Equity Valuation Vt is the value of an equity security at time t Dt +n is the dividend in period t+n k is the cost of capital E refers to expected dividends 1-37 Analysis Preview Equity Valuation - Free Cash Flow to Equity Model FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures] k is the cost of capital E refers to an expectation 1-38 Analysis Preview Equity Valuation - Residual Income Model BV is the book value at the end of period t Rit+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)] k is the cost of capital E refers to an expectation t 1-39 Analysis in an Efficient Market Three assumed forms of market efficiency Weak Form - prices reflect information in past prices Semi-strong - prices reflect all public Form information Strong Form - prices reflect all public and private information 1-40 Book Organization Financial Statement Analysis Part I Introduction and Overview Chapter 1: Overview of Financial Statement Analysis Chapter 2: Financial Reporting and Analysis Part II Accounting Analysis Chapter 3: Analyzing Financial Activities Chapter 4: Analyzing Investing Activities Chapter 5: Analyzing Investing Activities: Special topic Chapter 6: Analyzing Operating Activities Part III Financial Analysis Chapter 7: Cash Flow Analysis Chapter 8: Return on Invested Capital Chapter 9: Profitability Analysis Chapter 10: Prospective Analysis Chapter 11: Credit Analysis Chapter 12: Equity Analysis and Valuation