Financial Statement Analysis

1
Financial Statement Analysis

• Answers some questions
• Raises others
• Confirms beliefs
• The art of FSA comes out as we do prospective
  analysis

2
Whats Next?

• Industry analysis Competitive strategy
• Accounting analysis
• Financial analysis
• Prospective analysis

3
Why Forecast Financials

• Internal
• single supplier analysis
• major customer analysis
• analysis of competitor
• cash flow projection
• merger, acquisition

• External
• investment banking
• merger, acquisition
• security analysis
• going concern
• cash flow projection

4
Relation to Other Analyses

• Business strategy
• what does industry analysis indicate about future
  trends?
• what is the companys response to those trends?
• Accounting
• is the accounting masking the real trends?
• are trends stronger or weaker than they appear?
• Financial
• what can be improved?
• what will be under pressure from competitors?
  from regulators?
• what are managements target areas for change?

5
General Approach

• Comprehensive vs. Piecemeal
• Comprehensive avoids internal inconsistencies
• Examples
• expanded sales without expanded plant and working
  capital
• need for new financing without additional
  interest
• additional marketable securities without
  investment earnings
• Focus on key drivers
• What are the key drivers of F/S relationships?

6
What are the Key Drivers of a Forecast?

• Sales
• Gross Margins
• Net Margins
• Asset Turnover

7
Starting Points

• Gather historical data about firm, industry
• What relationships appear stable? within a range?
• past is surprisingly good predictor of the future
• Business Strategy Analysis provides insights into
  what changes are likely
• why should things be different from last year?
• one-time events? change in strategy? change in
  environment?

8
Financial Analysis Framework
Taxes Operations
Leverage Interest
Efficiency
9
Whats happened so far this year?

• Review the 10-Qs
• Imagine you had an interview with Dell. The
  interviewer tosses you a copy of the 10-Q and
  says, Whadya think?
• How could you analyze the F/S in 5 minutes?

10
Analyzing a 10-Q in 5 minutes

• Need to know industry and competitive strategy to
  be able to know what to look at and how to
  evaluate changes (or lack thereof) in ratios and
  statistics

• Look at Income Statement
• Net income
• , trend, EPS
• one-time items?
• Sales
• , trend
• Gross Margin Percent
• level, trend
• SGA, RD
• of sales, trend
• Tax rate
• of pretax income, trend

11
Analyzing a 10-Q in 5 minutes

• Look at the Balance Sheet
• Current ratio
• portion in inventory
• A/R turnover
• Inventory turnover
• LTDebt to Equity

• Look at Cash Flow Statement
• Cash flow from operations
• greater than zero?
• greater than NI?
• why?
• What is the company doing with the cash?
• CF Investing
• CF Financing

12
Back to forecasting

• Armed with background knowledge about the company
  and recent trends, we can turn to the forecast
• Note to complete the analysis of the 10-Q we
  would read Managements Discussion and Analysis
  and the notes to the F/S
• Can we skip the boilerplate stuff?

13
Key Driver Sales

• Statistically, sales follow a random walk with
  drift process
• 2000 sales 1999 sales plus drift term
• drift can be based on past trend in sales and
  output of prior analyses
• What do quarterly trends tell us?
• is the trend changing?

14
Forecasting Step 1Sales

• How would you forecast sales at McDonalds?
• number of stores
• owned vs. franchised
• new vs. old
• domestic vs. foreign
• Same store sales in the past, adjusted for
• new menus, promotions
• competitors activities
• relation between sales and general economic
  factors
• demographic trends

15
Forecasting Sales

• How would you forecast sales at
• Merck?
• American Barrick?
• PepsiCo?
• Nordstrom?
• Amazon.com?
• Best Buy?
• Dell?

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Sales Forecast for Dell

• Trend?
• company, industry
• annual, quarterly
• Products?
• Customer mix?
• Geographic mix?

• Sources
• WSJ Interactive
• press releases
• news articles
• EDGAR
• SEC filings
• Dataquest, IDC
• on Web
• Lexis/Nexis
• search for news, trade publications
• Value Line et al.
• Company statements

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Sales ForecastRefinements

• Geographic Trends
• (in 1998) Michael Dell says 30 growth in Europe
  
• Germany is in a slump, but accounts for only 13
  of Dell sales in Europe
• UK accounts for 43, whats up there?
• Increased competition in Japan the Asian
  crisis
• But, growth of 2nd buyer market bodes well for
  Dell
• Product Line Trends

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Key Driver Earnings

• This is what we are trying to forecast
• But, it also tends to follow a random walk with
  drift process
• 2000 NI 1999 NI plus drift term
• this is especially true when forecasting for the
  longer range (early in the year, out several
  years)

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Key Constraining Factor ROE

• Keep in mind that ROE is not likely to persist at
  levels away from the average
• High ROE firms will attract competition
• unless there are sustainable barriers to entry
• unless growing capital base can be reinvested at
  above average returns
• Low ROE firms will improve or go out of business
• Regression to mean of 10-14 ROE
• Consider whether GAAP distorts ROE
• missing assets at high tech firms,
  pharmaceuticals understates equity

20
Forecasting Step 2Expenses

• Expenses should be forecast separately
• Many expenses are linked to sales
• COGSGross Margin analysis, tie-in to Business
  Strategy
• SGAEfficiencies
• RD (in the long run)Business Strategy
• Interest is a function of debt and capital
  structure
• Depreciation is a function of PPE, lease
  decisions
• Taxes are a function of pretax income and
  operating decisions (e.g., location)
• Equity earnings are a function of the affiliates
  performance
• Interest income is a function of investment
  decisions
• Need to consider changes over time

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Forecasting Dells Expenses

• Margins
• recent history and trends of sales
• SGA
• recent history and trends of sales
• RD
• MDA, recent history
• Interest
• recent rates, forecast debt levels
• Taxes
• of pretax income

22
ExpensesForecast Refinements

• Gross Margin Percent
• by product
• by region
• Fixed and Variable SGA
• Taxes
• analysis of tax footnote
• news about tax breaks in Malaysia, Brazil

23
Whats Missing?

• Investment Income
• Need data on Marketable Securities
• Preferred Dividends
• Need data on Preferred Stock
• Weve got depreciation buried in SGA
• Well need it for SCF

24
Key Factor Profit Margins

• Recall ROE Profit Margin Asset Turnover
  Adjusted Leverage
• If ROE is in competitive equilibrium, the company
  is efficiently managing assets, and leverage is
  at the target level
• THEN Profit Margin will fall out
• Normal profit margins depend on the industry
  (technology) and corporate strategy
• the higher the asset turnover, the lower the
  profit margin

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Forecasting Step 3Balance Sheet

• As with expenses, forecast individually
• Current Assets
• Cash comes out of cash flow forecast?
• MS cash flow forecast, investment plans
• target current ratio?
• A/R turnover ties to Sales forecast
• Inventory turnover ties to Sales forecast
• Other likely related to Sales

26
Forecasting the Balance Sheet

• PPE turnover ties to Sales forecast, investing
  activities (CAPEX), depreciation policy
• Other Non-Current acquisition plans?
• Liabilities
• Current function of Sales, target current ratio
• Noncurrent function of CAPEX, capital structure
  decisions

27
Forecasting the Balance Sheet

• Equity
• Retained Earnings Opening RE NI - Dividends
  other capital transactions
• Stock opening stock issuances, options,
  repurchases, retirements
• Other equity items (FOREX,unrealized gains and
  losses on available for sale MS) are difficult to
  forecast. Assume no change?

28
Forecasting Dells Balance Sheet

• Current Assets
• Cash of sales
• A/R turnover
• Inventory turnover
• What about marketable securities? Lets do SCF
  first
• CAPEXsee detailed slides
• Liabilities
• Current ratio excluding marketable securities?
• A/P turnover, accruals as of sales?
• Debt policies and refinancing on the horizon
  (MDA)
• Equity
• Buybacks? Conversions? Options?

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Forecasting Dells PPE

• First, look to MDA
• 1997 10-K says 180 million for F98
• 3rd Quarter 98 10-Q 120 million spent entered
  into a 250 lease facility
• Alternatively, develop a model
• need to make a number of assumptions

30
Model of Dells PPE

• Gross PPE f(Gross Ending PPE Turnover)
• Net PPE f(Net Ending PPE Turnover)
• Gross Ending Acc. Dep. falls out
• Depreciation f(Gross Ending PPE)
• Plug for Acc. Dep. on disposals
• Assume PPE sold for NBV 0
• therefore, we know cost of PPE sold
• Plug for CAPEX

31
Forecasting Cash Flows

• Armed with I/S and B/Ss, we should be able to
  develop SCF
• Key factors (all related to other F/S)
• CAPEXturnover, MDA, press releases
• Deferred taxhistorical plus analysis
• Depreciationhistorical rate
• Interest expenselevel of debt
• Capital structureMDA

32
Determining Marketable Securities

• Based on Statement of Cash Flows
• We know change in cash
• ending cash is independent of SCF in our model
• We know CF operations
• we didnt use ending MS to determine investment
  income
• We know CF Financing
• We know CAPEX
• Therefore MS falls out
• We could use the estimate of ending MS to refine
  the estimate of investment income

33
Forecasting Summary

• Forecasting involves all prior steps in the
  framework
• Comprehensive, iterative approach
• start with sales, determine operating costs
• are balance sheet changes required?
• CAPEX?
• how will they be financed?
• use I/S relationship with B/S to forecast B/S
• forecast of SCF may lead to changes in asset
  levels (depreciation should be reexamined), and
  debt levels (interest expense and income should
  be reexamined)
• Always a good idea to conduct ratio and
  sensitivity analyses on the forecasted numbers

34
Sensitivity Analysis

• Best guess vs. optimistic vs. pessimistic
• What if
• competition heats up? margins fall quickly?
• a product doesnt make it to market?
• a merger doesnt go through?
• theres a strike?

35
Next time

• Maxwell Shoes
• A basic forecasting case
• Use assumptions in the case
• Ill post a model for Dell
• Assumptions are not refined