Essentials of Financial Statement Analysis

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Essentials of Financial Statement Analysis

• Revsine/Collins/Johnson Chapter 5

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Learning objectives

• How competitive forces and business strategies
  affect firms financial statements.
• Why analysts worry about accounting quality.
• How return on assets (ROA) is used to evaluate
  profitability.
• How ROA and financial leverage combine to
  determine a firms return on equity (ROE).
• How short-term liquidity risk and long-term
  solvency risk are assessed.
• Why EBITDA can be a misleading indicator of
  profitability and cash flow.

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Financial statement analysisTools and approaches

• Tools

• Approaches used with each tool
• Time-series analysis the same firm over time
  (e.g., Wal-Mart in 2005 and 2006)

Common size statements

• 2. Cross-sectional analysis different firms at
  a single point in time (e.g., Wal-Mart and Target
  in 2005).

Trend statements

• 3. Benchmark comparison using industry norms
  or predetermined standards.

Financial ratios (e.g., ROA and ROE)
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Evaluating accounting quality

• Analysts use financial statement information to
  get behind the numbers.
• However, financial statements do not always
  provide a complete and faithful picture of a
  companys activities and condition.

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How the financial accounting filter sometimes
works
GAAP puts capital leases on the balance sheet,
but operating leases are off-balance-sheet.
Managers have some discretion over estimates such
as bad debt expense.
Managers have some discretion over the timing of
business transactions such as when to buy
advertising.
Managers can choose any of several different
inventory accounting methods.
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Evaluating accounting qualityThe message for
analysts

• The first step to informed financial statement
  analysis is a careful evaluation of the quality
  of a companys reported accounting numbers.
• Then adjust the numbers to overcome distortions
  caused by GAAP or by managers accounting and
  disclosure choices.
• Only then can you truly get behind the numbers
  and see whats really going on in the company.

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Getting behind the numbersKrispy Kreme
Doughnuts, Inc.

• Established in 1937.
• Today has more than 290 doughnut stores
  (company-owned plus franchised) throughout the
  U.S.
• Serves more than 7.5 million doughnuts every day.
• Strong earnings and consistent sales growth.

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Krispy Kremes FinancialsComparative Income
Statements
Includes a 9.1 million charge to settle a
business dispute
Includes a 5.733 million after-tax special
charge for business dispute
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Krispy Kremes FinancialsCommon size income
statements
393.7 operation expenses
491.5 sales
Not adjusted for distortions caused by special
items.
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Krispy Kremes FinancialsTend income statements
393.7 operating expenses in 2002
194.5 operating expenses in 1999
Not adjusted for distortions caused by special
items.
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Krispy Kremes FinancialsBusiness segment
information
Sell flour mix, doughnut making equipment, and
supplies to franchised stores
Not adjusted for distortions caused by special
items.
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Krispy Kremes FinancialsBusiness segments
(common size)
Not adjusted for distortions caused by special
items.
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Krispy Kremes FinancialsBalance sheet assets
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Krispy Kremes FinancialsCommon size assets
3.2 cash
105.0 assets
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Krispy Kremes FinancialsTrend assets
7 cash in 2000
3.2 cash in 1999
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Krispy Kremes FinancialsBalance sheet
liabilities and equity
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Krispy Kremes FinancialsCommon size
liabilities and equity
13.0 accounts payable
105.0 total liabilities and equity
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Krispy Kremes FinancialsTrend liabilities and
equity
8.2 accounts payable in 2000
13.1 accounts payable in 1999
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Krispy Kremes FinancialsAbbreviated cash flow
statements
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Krispy Kremes FinancialsCommon size cash flow
statements
93.9 capital expenditures
491.5 sales
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Krispy Kremes FinancialsTrend cash flow
statements
93.9 capital expenditures in 2002
10.5 capital expenditures in 1999
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Krispy Kreme analysisLessons learned

• Informed financial statement analysis begins with
  knowledge of the company and its industry.
• Common-size and trend statements provide a
  convenient way to organize financial statement
  information so that major financial components
  and changes are easily recognized.
• Financial statements help analysts gain a sharper
  understanding of the companys economic condition
  and its prospects for the future.

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Financial ratios and profitability analysis
Operating profit margin
NOPAT Sales
Return on assets
ROA
NOPAT Average assets
X
Asset turnover
Sales Average assets
NOPAT is net operating profit after taxes

• Analysts do not always use the reported earnings,
  sales and asset figures. Instead, they
• often consider three types of adjustments to the
  reported numbers
• Remove non-operating and nonrecurring items to
  isolate sustainable operating profits.
• Eliminate after-tax interest expense to avoid
  financial structure distortions.
• Eliminate any accounting quality distortions
  (e.g., off-balance operating leases).

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Calculating ROA for Krispy Kreme
Eliminate nonrecurring items
Eliminate interest expense
Effective tax rate
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How can ROA be increased?

• There are just two ways
• Increase the operating profit margin, or
• Increase the intensity of asset utilization
  (turnover rate).

Assets turnover
Operating profit margin
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ROA, margin and turnoverAn example

• A company earns 9 million of NOPAT on sales of
  100 million with an asset base of 50 million.

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Krispy KremeROA decomposition
How was Krispy Kreme able to increase its ROA
from 7.1 to 12.1 over this period?
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Further decomposition of ROA
Operating profit margin
ROA
X

Asset turnover
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ROA and competitive advantageKrispy Kreme
Wendys, Baja Fresh, Café Express
SP industry survey or other sources
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ROA and competitive advantageFour hypothetical
restaurant firms

• Competition works to drive down ROA toward the
  competitive floor.
• Companies that consistently earn an ROA above the
  floor are said to have a competitive advantage.
• However, a high ROA attracts more competition
  which can lead to an erosion of profitability and
  advantage.
• Firm A and B earn the same ROA, but Firm A
  follows a differentiation strategy while Firm B
  is a low cost leader.
• Differences in business strategies give rise to
  economic differences that are reflected in
  differences in operating margin, asset
  utilization, and profitability (ROA).

Competitive ROA floor
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Credit risk and capital structureOverview

• Credit risk refers to the risk of default by the
  borrower.
• The lender risks losing interest payments and
  loan principal.
• A companys ability to repay debt is determined
  by its capacity to generate cash from
  operations, asset sales, or external financial
  markets in excess of its cash needs.
• A companys willingness to repay debt depends on
  which of the competing cash needs management
  believes is most pressing at the moment.

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Credit risk and capital structureBalancing cash
sources and needs
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Credit riskShort-term liquidity ratios
Liquidity ratios
Short-term liquidity
Activity ratios
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Credit riskOperating and cash conversion cycles
Working capital ratios
45 days
Operating cycle 75 days
30 days
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Credit riskOperating and cash conversion cycle
example
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Credit riskShort-term liquidity at Krispy Kreme
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Credit riskLong-term solvency
Long-term debt
Long-term debt to assets
Total assets
Debt ratios
Long-term debt
Long-term debt to tangible assets
Total tangible assets
Long-term solvency
Operating incomes before taxes and interest
Interest coverage
Interest expense
Coverage ratios
Cash flow from continuing operations
Operating cash flow to total liabilities

Average current liabilities long-term debt
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Credit riskLong-term solvency at Krispy Kreme
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Credit riskFinancial ratios and default risk

• A firm defaults when it fails to make principal
  or interest payments.
• Lenders can then
• Adjust the loan payment schedule.
• Increase the interest rate and require loan
  collateral.
• Seek to have the firm declared insolvent.
• Financial ratios play two roles in credit
  analysis
• They help quantify the borrowers credit risk
  before the loan is granted.
• Once granted, they serve as an early warning
  device for increased credit risk.

Default rates by Moodys credit rating, 1983-1999
Source Moodys Investors Service (May 2000)
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Default frequencyReturn on assets (ROA)
Profitability Return on Assets Percentiles
(excludes extraordinary items)
Source Moodys Investors Service (May 2000)
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Default frequencyDebt-to-tangible assets and
interest coverage
Solvency Debt-to-Tangible Assets and Interest
Coverage Percentiles
Source Moodys Investors Service (May 2000)
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Default frequencyQuick ratio
Liquidity Quick Ratio Percentiles
Source Moodys Investors Service (May 2000)
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Return on equity and financial leverage

• 2005 No debt, so all the earnings belong to
  shareholders.
• 2006 1 million borrowed at 10 interest, but
  ROCE climbs to 20.
• 2007 Another 1 million borrowed at 20
  interest, and ROCE falls to only 15.

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Components of ROCE
Return on assets (ROA)
NOPAT Average assets
Return on common equity (ROCE)
X
Common earnings leverage
Net income available to common shareholders
Average common shareholders equity
Net income available to common shareholders NOPAT
X
Financial structure leverage
Average assets Average common shareholders
equity
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Profitability and financial leverageNodebt and
Hidebt example
Leverage helps
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Financial statement analysis and accounting
quality

• Financial ratios, common-size statements, and
  trend statements are extremely powerful tools.
• But they can be no better than the data from
  which they are constructed.
• Be on the lookout for accounting distortions when
  using these tools. Examples include

Nonrecurring gains and losses
Differences in accounting methods
Differences in accounting estimates
GAAP implementation differences
Historical cost convention
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Financial statement analysisPro forma earnings
at Amazon.com
Company defined numbers
Computed according to GAAP
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Why do firms report EBITDA and pro forma
earnings?

• Impression management is the answer.
• Help investors and analysts spot non-recurring or
  non-cash revenue and expense items that might
  otherwise be overlooked.
• Mislead investors and analysts by changing the
  way in which profits are measured.
• Transform a GAAP loss into a profit.
• Show a profit improvement.
• Meet or beat analysts earnings forecasts.

• Analysts should remember
• There are no standard definitions for non-GAAP
  earnings numbers.
• Non-GAAP earnings ignore some real business costs
  and thus provide an incomplete picture of company
  profitability.
• EBITDA and pro forma earnings do not accurately
  measure firm cash flows.

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GAAP earnings, pro forma earnings, and EBITDA
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Summary

• Financial ratios, common-size statements and
  trend statements are powerful tools.
• However
• There is no single correct way to compute
  financial ratios.
• Financial ratios dont provide the answers, but
  they can help you ask the right questions.
• Watch out for accounting distortions that can
  complicate your interpretation of financial
  ratios and other comparisons.