Why Financial Statements Analysis?

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Why Financial Statements Analysis?

• You may be
• an investor
• a creditor
• a supplier
• a customer
• an employee
• the manager
• a competitor
• an auditor
• a government agency
• Will you rely on pure hunches and guesses? Or,

Educated analysis model!
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The Investment Environment

• The Money Market
• treasury bills, certificate of deposit,
  commercial paper, etc.
• The Fixed-Income Capital Market
• treasury notes and bonds, municipal bonds,
  corporate bonds, etc.
• The Capital Market
• common stock, preferred stock
• The Derivative Market
• options, futures

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The Major Stock Market in the U.S.

• The New York Stock Exchange (NYSE)
• Largest stock exchange About 3,025 companies or
  16 trillion in market value (July 1999)
• 382 non-U.S. companies (July 1999)
• The American Stock Exchange (AMEX)
• Listing of smaller and younger firms
• The Over-the-Counter National Association of
  Securities Dealers Automated Quotation (NASDAQ)
• Trade through computer-linked network
• Include Nasdaq National Market (4,400
  securities) and Nasdaq SmallCap Market (1,800
  securities)

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ACC 6213Financial Statements and Analysis

• Objectives
• Discuss a framework for conducting business
  analysis with a focus on the role of financial
  information
• Learn how to apply the framework for security
  valuation and risk analysis
• Learn to retrieve market and financial data

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Textbook and Related Materials

• Palepu, Healy and Bernard, Business Analysis
  Valuation Using Financial Statements, Text and
  Cases, 2nd ed., 2000
• Dells 10-K for fiscal year 1999
• Computer skills
• Research, retrieve and download data from
  internet
• Excel or any other spreadsheet program

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Course Requirements

• Course Outline
• Individual Assignments
• 30
• Team Project
• 50
• Participation
• 20
• Grade Expected distribution 40-50 As,
• 20-30 Bs, rest Cs

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Individual Assignments

• Discussion allowed, but no copy of ideas or
  writing
• No points will be given for similar assignments
• Related to class discussion and cases in the book
• Questions to be posted on Web

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Participation

• Come to class prepared with
• Intelligent comments
• Constructive questions
• Thoughtful insights and observations
• Quality counts more than Quantity
• Team project to be discussed later

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Palepu, Healy Bernard(Figures 1-2 1-3)

• A firm is involves in various business activities
  to create value for investors
• Financial statements summarize the economic
  consequences of a firms business activities
• Accounting system affects the quality of the
  financial data provided
• - affected by accounting rules, managements
  incentives
• Analysts use a systematic framework to create
  inside information from public financial data

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Framework Four Steps of Analysis
Business Strategy Analysis
Accounting Analysis
Financial Analysis
Prospective Analysis
Business Analysis and Valuation Applications
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I. Business Strategy Analysis

• Purposes
• To identify key profit drivers and business risks
• To assess profit potential at a qualitative level
• Involves
• Industry analysis
• Analysis of the firms strategy to create a
  sustainable competitive level
• How did the firm stay alive and possibility of
  prospering in the future
• Important first step for the following three
  analyses

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II. Accounting Analysis

• Purposes
• To evaluate the degree to which a firms
  accounting captures underlying business reality
• Involves
• identifying where there is accounting flexibility
• evaluating the appropriateness of accounting
  policies and estimates
• assessing the degree of distortion in disclosures
• undoing (if necessary) distortions
• Improves the reliability of financial analysis

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III. Financial Analysis

• Purposes
• To evaluate current and past performance
• To assess the sustainability of its performance
• Requirements
• should be systematic and consistent
• should allow the use of financial data to explore
  issues found in business strategy analysis
• Tools
• Ratio analysis profitability, efficiency,
  liquidity
• Cash flow analysis liquidity and financial
  flexibility

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IV. Prospective Analysis

• Purpose
• To forecast a firms future
• Final step in business analysis
• Techniques
• Financial statement forecasting
• Valuation

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Team Project

• Teams of four
• Select an industry and two companies in the same
  industry
• No more than two teams on one industry
• No group can work on the same company
• Need my approval first-come, first serve
• Compare the two companies in terms of All of the
  FOUR analyses
• Business Strategy Analysis
• Accounting Analysis Financial Analysis
• Forecasting, Including Discussion of Assumptions
• Valuation

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Industry Choices

• Agricultural
• Construction
• Manufacturing
• Mining

• Retail
• Service
• Transportation
• Wholesale - Trade

No Finance, Insurance, and Real Estate Industry
and Public Administration Industry
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Team Project Report

• Must be typed
• Limit to 10 pages double-spaced, 12-point font
  size
• Data source and calculation should be included as
  appendices
• Attach an evaluation on each of your group
  members efforts and contribution

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Finding Information for Business Analysis

• CSUH Library and Internet
• Main data sources
• Industry Research
• Company Research
• UC Berkeley
• International Business
• Other
• Annual Reports
• Annual Report Gallery
• 10-K Reports
• Accounting Rules
• Financial Accounting Standard Board

• Historical Stock Market Data
• Historical Market Index Data
• Historical Stock Price Data
• On DJ interactive, Historical market data

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Framework for Business Analysis Valuation
Business Strategy Analysis
Financial Analysis
Prospective Analysis
Accounting Analysis
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Business Strategy Analysis

• Industry Analysis
• Industry profitability and risk
• Competitive Strategy Analysis
• Which companies will sustain?
• Corporate Strategy Analysis
• Multibusiness management

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Industry AnalysisStandard Industrial
Classification (SIC), North American Industry
Classification System (NAICS)

• Factors affecting industry profitability
  Porters five forces
• Degree of Actual Potential Competition (3
  forces)
• Rivalry Among Existing Firms
• Threat of New Entrants
• Threat of Substitute Products
• Bargaining Power in Input Output Markets (2
  forces)
• Buyers Power
• Suppliers Power
• ? Affect competitive strategy chosen to operate
  in the industry

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1. Rivalry Among Existing Firms

• Profitability is low if competition for market
  share is strong
• Low industry concentration
• Compute Industry Concentration Ratio, e.g.
  sales of largest four or eight companies ? total
  industry sales
• Low product differentiation
• Large economy of scale, steep learning curve,
  high proportion of fixed costs
• Low industry growth
• Excess capacity, high exit cost

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2. Threat of New Entrants

• Profitability is low if threat of new entrants is
  high
• Small economy of scale
• Less first mover advantages
• Easy access to channels of distribution and
  distribution relationships
• Low legal barriers e.g. government approval

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3. Threat of Substitute Products

• Profitability is low, if threat of substitute
  products is high
• price and performance are similar
• customers are willing to switch
• Products are similar or seen as being substitutes
• Low brand allegiance
• products are replaceable

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4. Buyers Power

• Strong, if
• More Sensitive to Price
• Products are similar
• Low switching costs
• Unimportant products (relative cost and quality)
• Higher Bargaining Power
• Fewer buyer
• Higher volume per buyer
• Low switching cost
• More substitute products
• High threat of backward integration by the buyers

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5. Suppliers Power

• Profit is low if suppliers power is strong
• Fewer number of suppliers
• High volume per supplier
• High Switching Costs
• High product differentiation
• Importance of product in terms of cost and quality

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Power in Input Market (Suppliers) Output Market
(Buyers)
High? Low Actual Profitability
Low ? High Actual Profitability
Suppliers power Buyers power
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Given a level of industry profitability

• What determines which companies will win and
  which companies will lose?
• How can a company sustain profits in a
  competitive environment?
• Porter maintains that there are two generic
  competitive strategies that firms can choose in
  order to maintain competitive advantage

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Competitive Strategy Analysis
?
Choices of competitive strategies
1. Cost Leadership 2. Differentiation And,
Straddling of 1 and 2
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1. Cost Leadership

• Is a cost leader if it can supply same product or
  service at a lower price because of
• Economies of scale, scopes, and learning
• Efficient production
• Simpler product designs
• Efficient organizational processes
• Lower costs of inputs and distribution
• Little RD or brand advertising required
• Tight cost control

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2. Differentiation

• Supply a unique product or service at a cost
  lower than the price customers are willing to
  pay
• Superior product quality
• Superior product variety
• Superior customer services
• More flexible delivery
• Investment in brand image
• Investment in RD and marketing
• Note Organizational and control system must
  foster creativity and innovation

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Achieving and Sustaining Competitive Advantage

• Depend on
• Match between firms core competencies (the
  economic assets possessed by the firm) and
  competitive strategies
• Match between firms value chain (the activities
  to convert inputs to outputs) and activities
  required to execute competitive strategies
• Flexibility to adopt to changes in the firms
  industry structure
• Difficulty for competitors to imitate

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Applying Strategy Analysis to Dell

• Industry Analysis
• Describe the features of the personal computer
  industry that determine its profit potential.
  How difficult is it to earn abnormally high
  profit in this industry?
• Competitive Strategies Analysis
• Describe Dells business strategy and how it
  might allow Dell to earn higher returns on
  investments than others in the industry?

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Personal Computer Industry

• Degree of Actual and Potential Competition
• Rivalry Among Existing Firms
• Threat of New Entrants
• Threat of Substitute Products
• Bargaining Power in Input and Output Markets
• Buyers Power
• Suppliers Power

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Personal Computer Industry Rivalry

• Growth continues to be strong
• pricing remains cut-throat
• Lots of competitors
• fragmented, no price co-ordination
• Switching costs are low
• commodity product price is the key
• Dell tries to compete on service
• as knowledge rises, will service matter?
• Dell needs to keep market share
• recoup RD and costs associated with made to
  order strategy
• allows them to lower component costs

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PC Entrants

• Low barriers to entry
• First mover advantage?
• not technologically
• Distribution is easy
• Relationships with suppliers, customers?

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PC Substitute Products

• Apples Macintosh, Suns work stations?
• not in the near future
• Competitive price and performance
• PCs are commodities (price counts more)
• price competition seems unavoidable
• Buyers are willing to switch
• brand name?
• quality reputations?

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PC Power of Customers

• Buyers are price sensitive
• define price as hardware, software, and
  operations, not just purchase price total cost
  of ownership
• Dell maintains an extensive database of customer
  information
• unavailable to retail operators
• Importance of product for cost quality

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PC Suppliers Power

• Two major one supplier relationships
• Intel, Microsoft
• Leverage will increase with volume
• Can Intel reap some of the PC vendors profits?
• Power of other suppliers is low
• lots of keyboard, case, power supply, etc.
  manufacturers

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PC Industry Analysis Conclusion

• Intense competition
• Low barriers to entry
• Not much power over customersand suppliers
• Short product cycle need to stay on edge
  technologically

Profit potential might be poor BUT, growth is an
important offsetting factor
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What Should Dell Need to be Concerned?

• General economy condition
• Industry growth technological changes
• Competition
• Product quality customer service/support
  distribution channels price
• International
• Product mix, customer mix, geographic mix
• New ventures Internet
• Inventory levels
• Supply sources
• Support of infrastructure
• Government regulation

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Dells performance
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Customer profile Foreign vs. Domestic Sales
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Mergents Industry Review- 1999 Ranking
Dell
Revenue 2nd
Net income 2nd
Return on Capital 1st
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Stock Market Performance
Dell Market Index (Value Line)
1 Year 32.0 19.5
3 Year 1176.2 56.0
5 Year 7790.4 121.2
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Dell Competitive Strategy

• Differentiation
• Direct sales no middle man customer database
• Customer made product
• Lower economy of scales
• Low inventory
• Customer service and support
• Enterprise systems
• Cost Leadership
• Through made to order
• Not low cost seller

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Dell Sustainable Advantage?

• What aspects of Dells strategy can be replicated
  by others?
• Can Dell avoid being replicated?

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Dell Conclusion

• Competitive and thus low profitability industry
• The success of Dells competitive strategy
  depends on
• Product differentiation
• Maintain higher profit margin
• Reduce/control operating expenses
• Goal higher net margin

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According to Dell (10-K)

• Three key factors
• Growth
• Demand, competition, international market
• Product, customer, geographic mix
• servers business
• Profitability
• gross and net margins, sales mix, Internet sales
• Technological changes and product transition
• Liquidity
• asset management, especially inventory

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Experts Opinion?

• Value Line on industry (4/21/2000)
• The computer and peripheral industry probably
  will get off to something of a slow start this
  year (2000). However, it should pick up a better
  head of stream in the second half and stay on a
  fast growth tract out to 2003-2005.
• Investors should be able to find stocks in this
  group that will be good fits for their
  portfolios, whether they are looking for
  near-term out-performance or long-term capital
  appreciation. Conservative accounts should tread
  cautiously, though, since volatility can be high
  for some of these equities.

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Experts Opinion?

• Value line on Dell (4/21/2000)
• Although the stock has pulled back a bit from its
  recent high, Dell shares dont stand out for the
  year ahead or the pull to 2003-2005. But Dells
  direct sales approach (which has enabled it to
  take share from competitors) appears to be
  working well, and we think the push to penetrate
  the emerging Internet market is a positive
  development.

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Framework Four Steps of Analysis
Business Strategy Analysis
Accounting Analysis
Financial Analysis
Prospective Analysis
Business Analysis and Valuation Applications
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Review of Business Strategy Analysis

• What factors decide an industry profitability?
• Porters five forces
• Degree of Actual and Potential Competition
• Rivalry among existing firms
• Threat of new entrants
• Threat of substitute products
• Bargaining Power in the Input and Output Markets
• Bargaining power of customers
• Bargaining power of suppliers

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What is Accounting Analysis?(Chapter 3)

• Evaluate the degree to which a companys
  accounting captures its underlying business
  reality
• Evaluate the appropriateness of accounting
  policies and estimates
• Assess the distortion, if any, in the numbers
• see where distortions are and whether they can
  undone
• Goal To improve the reliability of conclusions
  from financial analyses
• Note Does accounting affect business strategy?
  (positive accounting)

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The Need of Financial Accounting

• Separation between ownership and management
  (agency problem)
• Owners want to know
• Profitability Income Statement
• Economic resources and obligation Balance Sheet
• Cash flow position Statement of Cash Flows
• Owners equity Statement of Stockholders Equity

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Accounting - Review

• Annual Reports
• Management Discussion and Analysis (MDA)
• Financial Statements
• Balance sheet (2 years)
• Income Statement (3 years)
• Statement of Stockholders Equity (3 years)
• Statement of Cash Flows (3 years)
• Notes

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Importance of Notes

• Integral part of the F/S
• Augment the information provided in the F/S
• Provide very important data for F/S analysis
• E.G. Contingencies

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MDA

• Results of operations, including discussion of
  trends in sales and expenses
• Capital resources and liquidity, including
  discussion of cash flows trend
• Outlook based on known trends

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Financial Statements

• Accountants are confronted with the potential
  dangers of bias, misinterpretation, inaccuracy,
  and ambiguity
• Must follow the Generally Accepted Accounting
  Principles (GAAP)
• E.g. FASB Publications, Statement 115
• FASB, SEC, AICPA

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Mechanics of the Accounting Process

• Balance Sheet
• Assets Liabilities Stockholders equity
• Ending balance
• Opening balance carried from previous B/S
• /- Increases/Decreases
• SE Capital stock Retained Earnings
• Capital stock Opening balance Issuance
  Repurchase
• R/E Opening balance NI - Dividends

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Net Income

• Income Statement
• Revenue Expenses
• Accrual Basis (v.s. Cash Basis)
• Revenue is recognized when earned, not
  necessarily when cash is received
• Expense is recorded when incurred, not
  necessarily when cash is paid

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From I/S to B/S
Daily Transactions
I/S
Net Income
R/E
R/E
Statement of SE
Capital Stock R/E
B/S
Assets Liabilities SE
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What Affect the Quality of Accounting Data? Not
Reflect the Economic Reality

• Reports are prepared by management
• Involves with managements incentives
• Accrual basis versus cash basis
• Involves estimations, not totally actual cash
  transactions
• Accounting rules (GAAP)
• Standardization versus flexibility
• Auditing
• Auditable?
• Legal Liability
• Threat of lawsuits improves credibility, but
  limits disclosures

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Accounting Analysis for Dell

• Main concern higher return on equity
• What are the major areas we need to look into at
  Dell if we want to understand how well they are
  doing?
• Based on the industry and competitive strategy
  analyses
• growth, profitability

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Think About Dell

• Accounting Rulesbiased?
• Accounting Estimationbiased?
• Factors that Affect Managers Accounting Choices
• debt covenantsdoes Dell have any?
• management compensationdoes Dell have
  earnings-based bonuses?
• corporate control contestis Dell concerned about
  a takeover?
• tax considerationsLIFO versus FIFO
• regulatory considerationsconsider Microsoft
• capital market considerations
• stakeholder considerations consider auto
  industry
• competitive considerationshow detailed should
  the reporting be

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How to Do Accounting Analysis

• 1. Identify Key Accounting Policies
• 2. Assess Accounting Flexibility
• 3. Evaluate Accounting Strategy
• 4. Evaluate the Quality of Disclosure
• 5. Identify Potential Red Flags
• 6. Undo Accounting Distortions

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1. Identify Key Accounting Policies

• Ultimate goal
• How well are the key success factors and risks
  identified by the Business Strategy analysis
  managed by the firm?
• Task
• Identify and evaluate the policies and estimates
  the firm uses to measure its critical factors and
  risks

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2. Assess Accounting Flexibility

• All firms can choose
• depreciation amortization methods and estimates
• inventory methods
• estimates of bad debts
• Some items do not allow flexibility
• RD and marketing expenditures must be expensed
• software development can be capitalized

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Flexibility, Informative, and Distortion
Low
High
Flexibility
Less Informative
More Informative
Less Distortion
More Distortion
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Flexibility AnalysisDell

• Fiscal year-end Friday nearest 1/31
• Consolidate all wholly owned subsidiaries
• Short-term investments available-for-sale
• Inventory first-in, first-out
• Depreciation 2 to 5 years for non-buildings
• Amortization of intangibles 3 to 8 years
• RD and advertising expensed
• Warranty and post-sale support estimated and
  expensed
• Software development costs capitalized
• Segment information

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3. Evaluate Accounting Strategy

• How do the firms policies compare to the
  industry norm?
• Does management face strong incentives to manage
  earnings?
• covenants, bonuses, political pressures
• Has the firm changed policies or estimates?
• Were policies and estimates realistic in the
  past?
• write-off
• discontinued operation
• Does the firm structure transactions to achieve
  certain accounting objectives?
• capital lease versus operating lease
• pooling-of-interest versus purchase accounting

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4. Evaluate Quality of Disclosure

• Do the firms disclosures make it easy to assess
  the economic reality?
• Provide adequate disclosure of business
  strategies?
• Explain in footnotes accounting policies,
  assumptions, and their logic?
• Explain current performance?
• Provide additional disclosures to assess business
  reality?
• Provide informative segment disclosure?
• Reveal forthcoming bad news?
• Provide detailed news to investors?

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5. Identify Potential Red Flags

• Unexplained changes in accounting especially when
  performance is poor
• Unexplained transactions that boost profits
• sale of assets or investments
• Unusual increases in A/R in relation to sales
  increases
• Unusual increases in inventories in relation to
  sales increases
• Increasing gap between earnings and cash flow
  from operations
• Increasing gap between financial income and
  taxable income
• Off-F/S transactions
• B/S (e.g., leases) and I/S (e.g., contingencies)
• Large asset write-offs
• Large 4th-quarter adjustments
• Qualified audit opinion or change in auditors
• Related party transactions

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6. Undo Accounting Distortions

• Try to make adjustments
• use data in the notes
• use cash flow data
• use non-accounting sources
• Newspapers
• Call investor relations
• Example Off-B/S financing

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In-Class Case Harnischfeger

• Purpose Demonstrate managerial motives for
  making accounting changes
• Background GAAP allow flexibility for accounting
  choices. Even after a firm chooses a set of
  accounting policies, it can still change to
  another at the managements discretion.
• Managerial incentive
• 1982 Harnischfeger faced a financial crisis
• New management was appointed to turn the company
  around
• New management made a few financial reporting
  policy changes in 1984
• Harnischfeger turned into profit in 1984