Financial Statement Analysis

Introduction to Financial Statement Analysis P.V. Viswanath

Functions of Financial Statements They provide information to the owners and creditors of the firm about the company s current status and past financial performance Financial statements provide a convenient way for owners and creditors to set performance targets and to impose restrictions on the managers of the firm. Financial statements provide convenient templates for financial planning. P.V. Viswanath 2

The Balance Sheet The balance sheet is a snapshot of the firm s assets and liabilities at a given point in time Assets are listed in order of liquidity, i.e. ease of conversion to cash without significant loss of value Liabilities are listed in order of time to maturity P.V. Viswanath 3

Assets Assets are divided into current assets and long-term assets. Current assets are: Cash and marketable securities Accounts receivable Inventories Other current assets, such as prepaid expenses Long-term assets include net property, plant and equipment (net PP&E). This consists of the original cost of PP&E reduced each year by an amount called depreciation that is intended to account for wear-and-tear and obsolescence. P.V. Viswanath 4

Assets When a firm acquires another firm, it will acquire a set of assets that must be listed on its balance sheet. Often it will pay more for these assets than their book value on the acquired firm s balance sheet. The difference is listed as goodwill. Trade-marks, patents and other such assets, along with goodwill are called intangible assets. If their value decreases over time, they will be reduced by an amortization charge. Amortization, like depreciation is not a cash expense. P.V. Viswanath 5

Liabilities Liabilities are divided into current and long-term liabilities. Liabilities that will be satisfied in one year are known as current, and include: Accounts payable, Notes payable, short-term debt and all repayments of debt that will occur within the year. Items such as salary or taxes that are owed but have not yet been paid. The difference between current assets and current liabilities is known as (net) working capital. P.V. Viswanath 6

Long-term liabilities Long-term debt is any loan or debt obligation with a maturity of more than one year. Capital leases are long-term lease contracts that obligate the firm to make regular payments in exchange for the use of an asset. Deferred taxes are taxes that are owed but not yet paid. Firms keep two sets of books one for financial reporting and one for tax purposes. Deferred tax liabilities arise when the firm s financial income exceeds its income for tax purposes. If a firm depreciates assets faster for tax purposes than for reporting purposes, its tax paid will be less than tax due according to reported income. Hence it will look as if the firm has not paid taxes that it owes. Over time, the discrepancy will disappear and the tax due will be paid. Hence deferred tax is recorded as a liability. P.V. Viswanath 7

Stockholders Equity The sum of current liabilities and long-term liabilities is total liabilities. The difference between the firm s asset and its liabilities is Stockholders Equity or the book value of equity. This number often does not provide us with an accurate assessment of the firm s equity because book values are based on historical quantities and not on market values. The market price of a share times shares outstanding is called market capitalization; this reflects what investors expect the firms assets to produce in the future that can be distributed to shareholders. P.V. Viswanath 8

Market Value vs. Book Value Example According to Generally Accepted Accounting Principles (GAAP), your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm s 100 million shares at $75 per share and the debt at $4 billion. Q: What is the market value of your assets? A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion. P.V. Viswanath 9

Market Value vs. Book Value Example Book Value Balance Sheet Assets = $10 bil Debt = $4 bil Equity = $6 bil Market Value Balance Sheet Assets = $11.5 bil Debt = $4 bil Equity = $7.5 bil P.V. Viswanath 10

Intangible Assets Shareholders Equity The Balance Sheet Identity Current Liabilities Payables Short-term Debt Current Assets Cash & Securities Receivables Inventories + = + Long-term Liabilities Fixed Assets + Tangible Assets P.V. Viswanath 11

Pepsico Inc. Balance Sheet (in mil. $) Assets Current Assets Liabilities Current Liabilities 28-Dec-02 29-Dec-01 28-Dec-02 29-Dec-01 6,052 5,490 562 4,998 3,484 354 1 ,1 60 4,998 2,651 5,398 13,021 Cash And Cash Short Term Investments Net Receivables Inventory 1 ,638 207 2,531 1 ,342 695 6,413 2,61 1 7,390 3,631 1 ,588 1 ,841 23,474 683 966 2,1 42 1 ,31 0 752 5,853 2,871 6,876 3,374 1 ,467 1 ,254 21,695 Tot Liabs & Shareholders' Equity Accounts Payable Short/Current Long Term Debt Other Current Liabilities Total Current Liabilities - 6,052 2,1 87 5,937 14,176 Other Current Assets Total Current Assets Long Term Investments Property Plant and Equipment Long Term Debt Other long-term liabilities Total Liabilities 30 43 Common Stock & Other Paid-up Capital Retained Earnings 9,268 9,298 8,605 8,674 Goodwill Intangible Assets Other Assets Total Stockholders' Equity 21,695 Total Assets 23,474 P.V. Viswanath 12

Income Statement The income statement is like a video of the firm s operations for a specified period of time. You report revenues first and then deduct any expenses for the period. Matching principle GAAP requires the income statement to show revenue when it accrues and match the expenses required to generate the revenue. P.V. Viswanath 13

Earnings Calculations Gross Profit The difference between sales revenues and the costs incurred to make and sell the products. Operating Expenses Expenses in the ordinary course of running the business, but not directly related to producing the goods; includes administrative expenses, marketing expenses, R&D Earnings before Interest and Taxes (EBIT) Includes other sources of income or expenses that arise from activities that are not the central part of the business, e.g. investment income. Pretax Income and Net Income (NI) From EBIT, we deduct interest paid and corporate taxes to determine Net Income. EPS = NI/Shares Outstanding P.V. Viswanath 14

Income Statement Pepsico Inc. (in mil. $) As of year ending Dec 02 Dec 01 Revenue 25,112 26,935 Cost of Goods Sold 10,523 9,837 Gross Profit 14,589 17,098 SG&A Expense 8,523 11,608 Depreciation & Amortization 1,112 1,082 Operating Income 4,954 4,408 Nonoperating Income 316 227 EBIT 5046 4248 Interest 178 219 Income Before Taxes 4,868 4,029 Income Taxes 1,555 1,367 Net Income After Taxes 3,313.00 2,662.00 P.V. Viswanath 15

Accounting vs Economic Measures of Income The return to a stockholder of investing in a stock is simply the rate of return on his investment: Cash + Ending Price of Beginning - Share Price Dividend = r Beginning Price of Share Accountants often measure corporate performance using the return on equity (ROE): Net = ROE Income Shareholde Equity rs' A big difference between the two is that the ROE does not incorporate the impact on the share price of future expected superior (or inferior) returns P.V. Viswanath 16

Ratio Analysis Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important Ratios are used both internally and externally P.V. Viswanath 17

Categories of Financial Ratios Liquidity ratios Short-term solvency or how easily the firm can lay its hands on cash. Financial leverage ratios Show long-term solvency; how heavily the firm is in debt. Efficiency or turnover ratios Indicate how productively the firm is using its assets Profitability ratios Used to measure the firm s return on its investments Market value ratios P.V. Viswanath 18

Computing Profitability Measures Profit Margin = Net Income / Sales 3313/ 25112 = 0.1319 times or 13.19% Operating Profit Margin = (Operating Income) / Sales (4954) / 25112 = 0.1973 times or 19.73% Return on Assets (ROA) = (Net Income) / Av TA (3313) / [(23474+21695)/2] = 0.1467 times or 14.67% Return on Equity (ROE) = Net Income / Average Equity 3313 / [(9298+8674)/2] = 0.3687 times or 36.87% P.V. Viswanath 19

Computing Leverage Ratios for 2002 Total Debt Ratio = (Total Debt) / TA Total debt, here, is usually interpreted to mean all debt-like obligations, which is effectively total liabilities (14176) / 23,474 = .6039 times or 60.39% The firm finances almost 60% of their assets with debt. Debt/Equity = Tot Debt / Tot Eq 14,176 / 9,298 = 1.5246 times These numbers can also be computed for long-term debt (i.e. long-term liabilities): Long Term Debt Ratio = LT Debt/ Total Assets = (2,187 + 5,937)/ 23,474 = 0.3461 Long Term Debt/Equity = (2,187 + 5,937)/9,298= 0.87375 P.V. Viswanath 20

Computing Coverage Ratios Determinants of the riskiness of a firm s debt Times Interest Earned = EBIT / Interest (4868 + 178) / 178 = 28.35 times Cash Flow Coverage = (EBIT + Depreciation) / Interest (4868 + 178 + 1112) / 178 = 34.60 times P.V. Viswanath 21

Computing Liquidity Ratios Current Ratio = CA / CL 6413 /6052 = 1.06 times Quick Ratio = (CA Inventory) / CL (6413 1342) / 6052 = 0.838 times Cash Ratio = Cash / CL 1,638 / 6,052 = .276 times Net Working Capital to TA Ratio = NWC/TA (6413-6052)/ 23474 = 0.154 P.V. Viswanath 22

Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Average Inventory 10523 / [(1342+1310)/2] = 7.94 times Days Sales in Inventory = 365 / Inventory Turnover = Av Inv/(COGS/365) 365 / 7.94 = 45.99 days When you have ratios with Income Statement numbers in the numerator and Balance Sheet numbers in the denominator, use average of year beginning and year end quantities. P.V. Viswanath 23

Computing Receivables Ratios Receivables Turnover = Sales / Av Accounts Receivable 25112 / [(2531+2142)/2] = 10.75 times Average Collection Period = Days Sales in Receivables = 365 / Receivables Turnover = Av Receiv/ (Av Sales) 365 / 10.75 = 33.96 days P.V. Viswanath 24

Computing Total Asset Turnover Total Asset Turnover = Sales / Av Total Assets 25112 / [(23474+21695)/2] = 1.11 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets. What is a reasonable value for TAT will depend on the industry in question P.V. Viswanath 25

Computing Market Value Measures Market Price (end of 2002) = $42.22 per share Shares outstanding = 1753 million P/E Ratio = Price per share / Earnings per share 42.22 / 1.89 = 22.34 times Market-to-book ratio = mkt value per share / book value per share 42.22 / (9298 / 1753) = 7.96 times Enterprise Value The value of the underlying business assets computed as Mkt Value of Equity + Debt Cash = 42.22(1,753) + 14,176 - 1,638 = 86,549.66m. This can be interpreted as the cost to take over the entire business. P.V. Viswanath 26

Payout and Retention Ratios Dividend payout ratio = Cash dividends / Net income Cash dividend equals common dividend + preferred divs 1041 / 3313 = .3142 or 31.42% Plowback ratio = Retention ratio = 1 payout ratio 1 0.3142 = 0.6858 = 68.58% P.V. Viswanath 27

Benchmarking Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firm s performance is changing through time Internal and external uses Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes P.V. Viswanath 28

Standardized Financial Statements Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry P.V. Viswanath 29

Statement of Cashflows A firm s cashflows can be quite different from its net income. For example: The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Those expenses are spread over time as a deduction for depreciation. The income statement recognizes revenues and expenses when sales are made, even though the money may not have been collected (revenues) or paid out (expenses). P.V. Viswanath 30

The Statement of Cashflows The statement of cashflows shows the firm s cash inflows and outflows from Operations Investments and Financing The form of this statement is determined by accounting standards. P.V. Viswanath 31

Statement of Cash Flows: Operating Activities Operating activities are earnings-related activities. Generally these relate to Income Statement activities, and items included in working capital. Included are: Sales and expenses necessary to obtain sales Related operating activities, such as extending credit to customers investing in inventories obtaining credit from suppliers payment of taxes insurance payments Other activities that don't easily fit into the other two categories, such as settlements in lawsuits. P.V. Viswanath 32

Statement of Cash Flows: Investing and Financing Activities Investing activities relate to the acquisition and disposal of noncash assets: assets which are expected to generate income for the company over a period of time. These include lending funds and collecting on these loans. Financing activities relate to the contribution, withdrawing and servicing of funds to support business activities. P.V. Viswanath 33

Pepsico Inc. (in mil. $) Statement of Cash Flows 2002 3,313 Net Income Operating Activities, Cash Flows P rovided By or Used In 1 ,1 1 2 -390 -260 704 -53 201 4,627 Depreciation Adjustments To Net Income Changes In Accounts Receivables Changes In Liabilities Changes In Inventories Changes In Other Operating Activities Total Cash Flow From Operating Activities Investing Activities, Cash Flows P rovided By or Used In Capital Expenditures Investments -1 ,437 757 1 53 -527 Other Cashflows from Investing Activities Total Cash Flows From Investing Activities Financing Activities, Cash Flows P rovided By or Used In Dividends Paid Sale Purchase of Stock Net Borrowings -1 ,041 -1 ,734 -404 -3,179 Total Cash Flows From Financing Activities Effect Of Exchange Rate Changes 34 $ 955 Change In Cash and Cash Equivalents P.V. Viswanath 34

Notes to Financial Statements The Notes to the Financial Statements are frequently very useful in assessing the financial health of the firm. They often contain: An explanation of accounting methods used Straight-line versus accelerated depreciation LIFO vs FIFO Restatement of results from prior years using the new standards Greater details regarding certain assets and liabilities Conditions and expiration dates of long- and short-term debt, leases, etc. P.V. Viswanath 35

Notes to Financial Statements Information regarding the equity structure of the firm Conditions attached to the ownership of shares; these can be particularly useful to assess the firm s vulnerability to takeovers. Documentation of changes in operations Acquisitions and Divestitures and their impact Off-balance sheet items Forward contracts, swaps, options and other derivative contracts, which do not appear in the balance sheet, but which can affect a firm greatly. A lot of Enron s problems had to do with such off- balance sheet items. P.V. Viswanath 36

Determinants of Growth Profit margin operating efficiency Total asset turnover asset use efficiency Financial leverage choice of optimal debt ratio Dividend policy choice of how much to pay to shareholders versus reinvesting in the firm P.V. Viswanath 37

The Du Pont Identity ROA = NI/ TA ROA = (NI/ Sales)*(Sales / TA) ROA = (Net Profit Margin)*(Asset Turnover) ROE = NI / TE ROE = (NI/Sales)*(Sales/TA)*(TA/TE) = Net Profit Margin*Asset Turnover*Equity Multiplier Net Profit margin is a measure of the firm s operating efficiency how well it controls costs Total asset turnover is a measure of the firm s asset use efficiency how well it manages its assets Equity multiplier is a measure of the firm s financial leverage P.V. Viswanath 38

Determinants of Earnings Growth Rate Earnings in any period depends on the investment base, as well as the rate of return that the firm earns on that investment base: Et+1 = (TEt)ROE = (TEt-1 + TEt)(ROE), where TEt is the increment in total equity in period t over and above that in period t-1. = (TEt-1)ROE + ( TEt)(ROE) = Et + ( TEt)(ROE); Hence Et+1 - Et = ( TEt)(ROE) Dividing both sides by Et , we get gt = ( TEt/Et)(ROE) We have assumed that ROE does not change, i.e. that the debt- equity ratio will be kept constant, as we can see from the DuPont identity. Hence debt must be increased and equity decreased in such a way as to keep the debt ratio constant, assuming that the assets side of the business maintains a constant profitability. P.V. Viswanath 39

Sustainable Growth The sustainable growth rate tells us how fast the firm can grow, without increasing financial leverage and without any additional outside equity. We have already seen that gt = ( TEt/Et)(ROE) If only internal funds are used, then TEt is simply retained earnings. Hence, sustainable growth rate (of earnings) = retention ratio x ROE 0.6858 x 0.3687 = 0.2528 or 25.28% If the firm can continue to earn 36.87% on its equity and can plow back 68.58% of earnings into operations, its earnings and equity should both grow at 25.28% p.a. As discussed above, ROE is assumed to be constant, i.e. that the debt-equity ratio will be kept constant. However, if the firm will not have access to new debt financing, the business can only grow at a lower rate. P.V. Viswanath 40

Internal Growth Rate The rate at which the business as a whole, i.e. the total assets of the firm can grow without additional external financing is called the internal growth rate. Internal retained earnings = growth rate total assets retained earnings net income equity = x x net income equity e total assets Internal Sustainabl equity = x growth rate Growth Rate total assets 0.2169 x (9298+8674) /(23474+21695) = 0.2528 x 0.3979 = 0.1006 or 10.06% P.V. Viswanath 41

Questions we would like answered As financial analysts Assets Liabilities What are the assets in place? How valuable are these assets? How risky are these assets? What is the value of the debt? How risky is the debt? Assets in Place Debt What are the growth assets? How valuable are these assets? Growth Assets Equity What is the value of the equity? How risky is the equity? However, the information we have comes from the firm s financial statements which are generally prepared by accountants P.V. Viswanath 42

The Accountants Balance Sheet Figure 4.1: The Balance Sheet Assets Liabilities Current Liabilties Short-term liabilities of the firm Long Lived Real Assets Fixed Assets Short-lived Assets Current Assets Debt Debt obligations of firm Investments in securities & assets of other firms Financial Investments Other Liabilities Other long-term obligations Assets which are not physical, like patents & trademarks Intangible Assets Equity Equity investment in firm This is what we can see from the firm s balance sheet P.V. Viswanath 43

Growth Assets In a financial balance sheet, we are much less concerned with recording what a firm paid for what it owns and much more concerned about how much it is worth and how the nature of the asset affects the firm s decision-making and risk. There is therefore a greater emphasis on growth assets and the market values of equity and debt. Growth assets represent the capitalized value of net cashflows to be generated from assets that the firm does not currently own, but has the ability to acquire and/or is expected to acquire. Thus a firm might have the capabilities to expand --whether such capabilities represent organic growth or inorganic growth (through mergers). The NPV from such future growth to the extent the market recognizes it is already included in the market value of a firm and should be recognized in the financial balance sheet as an asset. P.V. Viswanath 44

Growth Assets The characterization of an asset as a growth asset is important for several reasons: One, the valuation of the firm is incomplete without the inclusion of such assets. Valuation of such assets may also require option techniques as opposed to simply expected cashflow methods. Two, growth assets represent future discretionary expenditure and represent a higher level of risk for the investor furthermore, such risk can be asymmetric; growth assets may have a higher upside beta than the corresponding downside beta (since the firm does not own the asset, it can decide to forgo the option to acquire it in bad states of the economy). Two, growth assets are more susceptible to agency costs of debt and must be financed by equity P.V. Viswanath 45

Desirable Modifications to Income Statement In addition to the failure to inclued growth assets, there are a few expenses that are consistently mis-categorized in financial statements. In particular, Operating leases are considered as operating expenses by accountants but they are really, partly, financial expenses R&D expenses are considered as operating expenses by accountants but they are really capital expenses. The degree of discretion granted to firms on revenue recognition and extraordinary items is used to manage earnings and provide misleading pictures of profitability. P.V. Viswanath 46

Dealing with Operating Leases A Lease is a long-term rental agreement Leases can either be capital leases or operating leases A capital lease is often for as long as the life of the equipment, or there may be an option for the lessee to buy the equipment at the end of the contract period. Capital leases have to be capitalized and shown on the balance sheet. In an operating lease, typically, the contract period is shorter than the life of the equipment, and the lessor pays all maintenance and servicing costs. Operating leases do not have to be shown on the balance sheet. However, operating leases also represent expected fixed periodic payments, and thus function similar to debt. As such, a financial analyst would want to see operating leases capitalized as well P.V. Viswanath 47

Dealing with Operating Lease Expenses How do we do this? First, we compute the debt value of the operating lease as the PV of the operating lease expenses, using the pre- tax cost of debt as the discount rate. This now creates an asset - the value of which is equal to the debt value of operating leases. This asset now has to be depreciated over time. Second, the operating income has to be adjusted to reflect these changes. P.V. Viswanath 48

Dealing with Operating Leases: Adjusting Operating Income Note that the operating lease expense has two components an operating expense component, i.e. the reduction in the value of the asset being used, represented by the depreciation, and a financing component, i.e. the cost of financing the asset. Using this model, we assume that Interest expense on the debt created by converting operating leases = Operating lease expense - Depreciation on asset created by operating lease. Then, Adjusted Operating Income = Operating Income - Depreciation on operating lease asset + operating lease expenses = Operating Income + Imputed Interest expense on operating leases. = Operating Income + Debt value of Operating leases x Cost of debt P.V. Viswanath 49

Example: Capitalizing Operating Leases at Maxwell Shoe From the 10-K filing made by the company with the SEC on 1/29/2001: The Company leases equipment and office and warehouse space under long-term non-cancelable operating leases which expire at various dates through January 31, 2007. At October 31, 2000, future minimum payments under such leases were as given below (in 000s). Minimum Payments Present Value at 7% 2001 2002 2003 2004 2005 Later Years 1488 1008 917 650 600 750 1390.65 880.43 748.55 495.88 427.79 498.08 Minimum payments are capitalized using an assumed pre-tax cost of debt of 7% p.a. This will be the value of the Lease Asset/Liability on the Oct. 31, 2000 balance sheet. Later years refer to 2006 and 2007. P.V. Viswanath 50