Financial Statement Analysis

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Financial Statement Analysis

• P.V. Viswanath
• Based on Damodarans Corporate Finance

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Questions we would like answered
As financial analysts
However, the information we have comes from the
firms financial statements
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Basic Financial Statements

• The balance sheet, which summarizes what a firm
  owns and owes at a point in time.
• The income statement, which reports on how much a
  firm earned in the period of analysis
• The statement of cash flows, which reports on
  cash inflows and outflows to the firm during the
  period of analysis

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The Balance Sheet
This is what we can see from the firms balance
sheetBut, not all assets and liabilities are
recorded here!Also, numbers are historical, not
market values!
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An example Maxwell Shoe Company, Inc
Maxwell Shoe Company Inc. designs, develops and
markets casual and dress footwear for women and
children under multiple brand names, each of
which is targeted to a distinct segment of the
footwear market. The Company offers casual and
dress footwear for women in the moderately priced
market segment under the Mootsies Tootsies brand
name, in the upper moderately priced market
segment under the Sam Libby and Dockers Khakis
Footwear For Women brand names and in the better
market segment under the Anne Klein 2 and A Line
Anne Klein brand names. It also sells
moderately priced and upper moderately priced
children's footwear under both the Mootsies
Tootsies and Sam Libby brand names. In
addition, it designs and develops private label
footwear for selected retailers under the
retailers' own brand names. Maxwell has licensed
the J.G. Hook trademark to source and develop
private label products for retailers who require
brand identification.
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An example of an Accountants Balance Sheet
Maxwell Shoe Company, Inc.
As of October 31, 2000 (In 000s)
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Notes on the Maxwell Balance Sheet

• Deferred income taxes reflect the net tax effects
  of temporary differences between the carrying
  amounts of assets and liabilities for financial
  reporting purposes and the amounts used for
  income tax purposes. Deferred tax assets are
  created when future taxable income is expected to
  exceed pretax income, while deferred tax
  liabilities occur in the reverse case.
• If more deductions have been taken in the current
  period for reporting purposes, then tax payable
  (according to the GAAP income statement) will be
  lower than the actual tax paid. Hence it will
  seem like taxes have been prepaid. This is
  reflected in the balance sheet as an asset.
• Deferred tax assets (798) reflect allowance for
  doubtful accounts, stock option compensation,
  inventory capitalization, and inventory reserve.
  Deferred tax liabilities (479) reflect
  amortization of trademarks (long-term) and
  depreciation of property and equipment
  (short-term).

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A Financial Analysts Balance Sheet
This is what we would like to see
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The Income Statement
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The Income Statement
Maxwell Shoe Company, Inc.
For the year ended October 31, 2000 (In 000s)
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The Income Statement
The Income Statement provides us with information
about changes in the balance sheet from one year
to another. Hence it is crucial to creating the
financial balance sheet that we want. However,
the income statement is prepared according to
GAAP. Underlying GAAP are certain principles,
such as revenue recognition when the service for
which the firm is being paid has been performed
substantially, the matching principle governing
recognition of expenses, a historical cost-based
approach, and a basic conservatism in the
recognition of assets. This leads to certain
accounting practices that need to be corrected,
from a financial analysts point of view
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Desirable Modifications to Income Statement

• 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
• RD 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.

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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

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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.

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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.
• The interest expense is computed by multiplying
  the debt value of the lease by the interest
  rate. What is left over from the operating lease
  expense is then assumed to be the depreciation.
• Depreciation on asset created by operating lease
  Operating lease expense - Interest expense on
  debt value of operating lease Adjusted
  Operating Income Operating Inc.
  operating lease expense - Dep. on op. lease asset
  Operating Income Imputed Interest
  expense on operating leases. Operating
  Income Debt value of Operating leases x Cost of
  debt

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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 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.
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Example Capitalizing Operating Leases at Maxwell
Shoe
I assume that payments are made at the end of the
fiscal year, ending in October. Since the figure
for "Later Years," 750, is larger than the
declining sequence of amounts for previous years,
I assume that this reflects the amounts for both
2006 and 2007. Since the leases expire in January
2007, which is 3 months past the fiscal year end,
I have prorated the amounts for 2006 and 2007,
viz. 600 for 2006 (payable at the end of October
2006) and 150 for 2007 (payable at the end of
January 2007). Hence the 498.08 computed as
the present value for the row Later Years
equals 600/(1.07)6 150/(1.07)6.25. The present
value of the minimum payments (as of Oct. 31,
2000) works out to 4441.38.
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Imputed Interest Expenses on Operating Leases
Lease payments in 2000 were 1024. Hence the PV
of operating leases as of end 1999 would be (PV
of Op. Leases as of end 2000 Lease expenses for
2000)/1.07 (4441.381024)/1.07 5107.83.
The imputed interest expense is the Debt Value
of Operating Leases x Interest rate.
Adjusted Operating Income Operating Income
Imputed Interest Payment 13,489
357.55 13,846.55 Net Income is not affected
because the imputed interest expense will be
subtracted from Operating Income, just as any
other interest expense would be.  
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The Effects of Capitalizing Operating Leases

• Debt will increase, leading to an increase in
  debt ratios used in the cost of capital and
  levered beta calculation
• Operating income will increase, since operating
  income will now be before the imputed interest on
  the operating lease expense
• Net income will be unaffected since it is after
  both operating and financial expenses anyway
• Return on Capital will generally decrease since
  the increase in operating income will be
  proportionately lower than the increase in book
  capital invested

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RD Expenses Operating or Capital Expenses

• Accounting standards require us to consider RD
  as an operating expense even though it is
  designed to generate future growth. It is more
  logical to treat it as capital expenditures.
• An approach to capitalizing RD (cost-based),
• Specify an amortizable life for RD (2 - 10
  years)
• Collect past RD expenses for as long as the
  amortizable life
• Sum up the unamortized RD over the period.
  (Thus, if the amortizable life is 5 years, the
  research asset can be obtained by adding up 1/5th
  of the RD expense from four years ago, 2/5th of
  the RD expense from four years ago...

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Capitalizing RD Expenses Boeing
Assuming a ten year life thus, RD expenses for
1998 will be amortized over the 1999-2008 period.
Year RD Outlay Unamortized Portion at end 1998 Value Amortization for 1998
1988 751 0 0 75.1
1989 754 0.1 75.4 75.4
1990 827 0.2 165.4 82.7
1991 1417 0.3 425.1 141.7
1992 1846 0.4 738.4 184.6
1993 1661 0.5 830.5 166.1
1994 1704 0.6 1022.4 170.4
1995 1300 0.7 910 130
1996 1633 0.8 1306.4 163.3
1997 1924 0.9 1731.6 192.4
1998 1895 1 1895 0
Capitalized value of RD for 1998 Capitalized value of RD for 1998 Capitalized value of RD for 1998 9100.2
Total RD Amortization Expense for 1998 Total RD Amortization Expense for 1998 Total RD Amortization Expense for 1998 Total RD Amortization Expense for 1998 1381.7
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Boeings Corrected Operating Income
For 1998
Operating Income 1,720.00
Research and Development Expenses 1,895.00
- Amortization of Research Asset 1,381.70
Adjusted Operating Income 2,233.30
Data obtained from Income Statement Data
obtained from Income Statement see also previous
slide In principle, it could be argued that RD
capitalized values should be restated in 1998
dollars, instead of using the raw unamortized
portions of RD outlays in past years however,
the current procedure may be defended on the
grounds of conservatism.
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Boeings Corrected Balance Sheet

• There will be the following modifications on the
  balance sheet
• There will be a new asset, RD, that will show on
  the assets side. If one wants to show the gross
  value of RD and accumulated amortization,
  however, that will require computation of the
  amortization in each year for as many years as
  the amortizable life of the RD.
• Corresponding to that, the value of stockholders
  equity will be higher by the same amount.
• In our example, this amount will be 9,100.

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The Effect of Capitalizing RD

• Operating Income will generally increase, though
  it depends upon whether RD is growing or not. If
  it is flat, there will be no effect since the
  amortization will offset the RD added back. The
  faster RD is growing the more operating income
  will increase.
• Net income will increase proportionately,
  depending again upon how fast RD is growing.
  Adjusted Net Income will also have to take the
  tax deductibility of RD into account.
• Book value of equity (and capital) will increase
  by the capitalized Research asset
• Capital expenditures will increase by the amount
  of RD Depreciation will increase by the
  amortization of the research asset for all
  firms, the net cap ex will increase by the same
  amount as the after-tax operating income.