Financial Statement Analysis

Lecture 1 Based on lecture note 0 and HW1

Performance measure
ROA = Earnings beforeInterest (EBI) ,......., (1) Average Assets

1. How did company perform last year? 2. How did companys operation perform last year?

Weakness in ROA denition

The denominator of ROA above should exclude the operating liabilities In some occasions, it works nicely, showing overall performance of company, in particular, when there is no operating liabilities (but who doesnt?)

EBI is overall measure, total income that is earned by assets minus operating liabilities. (or net operating assets and nancial assets)

When company invests in nancial assets that have nothing to do with operation, one has to undo the income statement and balance sheet to compare the operating performance across the companies. This means that ROA is not appropriate measure for comparison of operating performance (namely, not for question #2 above).

Case 1
Two companies with same resources and
investment

Company A pays salary every Friday Company B pays salary 15th and last
working day of month.

Should the performance measure be

different for company A and B, given they have same revenue and expense?

Case 1

Net income = Revenue - Expense Net income for both company A and B is $6,300 ($21,000 - $10,500 40% x $10,500). Retained earnings, BB + NI - Dividend = Retained earnings, EB
Assets (all cash) Liability (salary payable) Equities Common stock Retained earnings Total Equities Total Liabilities & Equities Company A Company B $106,800 $106,300 500 0 $100,000 6,300 $106,300 $106,800 $100,000 6,300 $106,300 $106,300

Tax issue
Tax accounting is largely cash basis Revenue is all cash, but salary expense for company A is less. This is because company As salary payout policy.

Financial Accounting Revenue = $21,500 Salary Expense = 10,500 Pretax income = $10,500 Tax expense = 40% of $11,500 = $4,200

Tax accounting Cash in for company A = 21,000 Cash out for company A = 10,000 Cash paid for tax = 40% x $11,000 = $4,400

The difference is due to the fact that for tax purpose, it took less deduction now ($500 x 40% less) This means, in turn, in the future, there will be more deduction, leads to less future tax to be paid This is known as deferred tax assets

Evaluation of case 1

There is no difference between company A & B other than salary payout policy. But ROA calculation is different, because denominator is different It seems like if we use Assets - liabilities as denominator, and the problem disappears. Does this mean we have to deduct any liabilities? Certain liabilities are created for operating reasons (salary payable, accounts payable and accrued liabilities) Others are issued to fund the operations. Lets take a look at case 2.

Case 2
Two companies with same initial resources
and investment

Need an equipment ($60,000) A purchases the equipment by more

investment from shareholders debt

B purchases the equipment by issuing Should ROA be different?

Case 2
Balance sheet as of 5/2/2010 after the purchase of the equipment Assets (all cash) Cash $ 40,000 $40,000 Equipment 60,000 60,000 Total Assets $100,000 $100,000 Liability (Note payable) 0 60,000 Equities (common stock) $100,000 $40,000 Total Liabilities & Equities $100,000 $100,000 Income statement for May 2010 Sales Revenue Less: Salary Expense Depreciation Expense Interest Expense Pretax Income Less: Tax expense Net income Company A $21,000 (10,500) (1,000) 9,500 (3,800) $5,700 Company B $21,000 (10,500) (1,000) (600) 8900 (3,560) $5,340

Case 2
Balance Sheet (as of 5/31/2010) Cash Equipment Less: Acc. Depr Total Assets Liability Note payable Equities Common Stock Retained Earnings Total Equities Total Liabilities & Equities ROA EBI (NI + Int exp, AT) NI Interest Expense, AT EBI Average Assets ROA Company A $46,700 60,000 (1,000) $105,700 $0 $100,000 5,700 105,700 105,700 Company B $46,340 60,000 (1,000) $105,340 $60,000 $40,000 5,340 45,340 105,340

Company Company A B 5700 0 $5,700 $72,850 7.824% 5340 360 $5,700 $72,670 7.844%

Operating Performance measure should not be affected by nancial structure. Both companies have same operations, started with same investment, except company B borrowed $60,000 to pay for the equipment, whereas company A issued equity (in exchange for cash) $60,000 for the equipment. The ROA numerator of EBI does a nice job to undo the net income by adding the interest expense, so that it is operating outcome. How you nanced the equipment has no bearing on the companys operation. What is the difference between liability account in case 1 and 2? Case 1s liability is for companys operation, and case 2s is for funding (nancial). Note that the denominators are still different ($72,850 vs $72,670)

Evaluation of Case 2

Cash was used to pay the interest expense Cash account is too complicated and not disclosed enough for the analysts to adjust Some doesnt view cash as operating (see case 3)

Liabilities

Think about the purpose of EBI (NI + Interest expense, After tax). It is for companys total income that can be distributed to all the investors (both debtholders and shareholders) Case 1 says : Operating liabilities such as salary payable, accounts payable, accrued liabilities should not be in the denominator of ROA. Case 2 : Financial liabilities are used to nance operating assets, and how you nance your operation should not have impact on ROA. Therefore the correct denominator for EBI is Assets - Operating liabilities.

Side issue

ROA dened as EBI/Avg Assets has an inherent problem Suppose interest rate is 100% monthly Calculate ROA (EBI/Avg Assets) ROA when debt is issued is always higher, regardless of interest rate (assuming the interest is paid in May) This is mainly because of EBI measure. Whether shareholders are better off cant be answered using ROA Income relevant to shareholder is still net income.

Case 3

Three companies with same investment and operation (5 employees, 1 equipment) All has excess cash of $40,000 in the beginning

A decides not to do anything, deposit in checking account C decides to invest in risky assets (Apple, buy-and-hold) B decides to invest in less risky assets (US treasury)

Operating result is same across the companies A-C. EBI is going to be different How can we see the operating result is same when EBI is different?

Case 3 I/S
Income statement for May 2010 Sales Revenue Interest revenue Unrealized gain on STI* Less: Salary Expense Depreciation Expense Pretax Income Less: Tax expense Net income Company A Company B Company C $21,000 0 0 (10,500) (1,000) $ 9,500 (3,800) $ 5,700 $21,000 150 0 (10,500) (1,000) $ 9,650 (3,860) $ 5,790 $21,000 0 1,000 (10,500) (1,000) $10,500 (4,200) $ 6,300

*STI : Short term investment

Case 3 B/S
As of 5/31/2010 Assets (all cash) Cash Short-term investment Equipment Less: Acc Depr Total Assets Liability Equity (common stock) Retained Earnings Common Stock Total Equity Total Equity & Liab Company A Company B Company C $46,700 0 60,000 (1,000) $105,700 0 $ 5,700 $100,000 105,700 105,700 $16,790 30,000 60,000 (1,000) $105,790 0 $ 5,790 $100,000 105,790 105,790 $16,300 31,000 60,000 (1,000) 106,300 0 $ 6,300 $100,000 106,300 106,300

Case 3
Company A Company B Company C EBI (NI + Int exp, AT) NI Interest Expense, AT EBI Average Assets ROA $ 5,700 - $ 5,700 102,850 5.54% $ 5,790 - $ 5,790 102,895 5.63% $ 6,300 - $ 6,300 103,150 6.11%

Case 3 : Evaluation

ROA of company C is highest because of investment Took risk, and earned $1,000 This has nothing to do with companys operation In fact, all three companies operating result is same By looking at EBI, there is no way you can nd out it EBI did nice job by adding interest expense, because how you nance it has no bearing on operating result. But if company has nancial assets and invest, then EBI is not a measure for operating result EBI is total income earned from both net operating and nancial assets

Case 3 : Evaluation

How can we isolate operating performance for companies? Dene Net operating income, after tax or NOPAT, NOPAT = EBI - any gains (+ any losses) from nancial assets, after tax Because NOPAT is earned on net operating assets, correct denominator for NOPAT is net operating assets Dene return on investment, ROI = any gains (- any losses) on nancial assets / Average nancial assets

Case 3 : Evaluation for Company A

Company As operating result is good, but
excess cash is not earning anything

Two suggestions Expand operation (e.g. hire one more

employees)

Invest in nancial assets

Case 3 : Evaluation for Company B & C

Company C Investment strategy is too risky Diversify the investment or invest in less
risky assets as company B

Summary

EBI represents all the performance from both nancial assets and net operating assets, thus EBIs denominator should be average of (assets operating liabilities)

Net operating assets = Operating assets - Operating liabilities Financial assets + Net operating assets = Assets - Operating liabilities

Then EBI/Avg (Assets-OL) will answer question 1 in slide 2. NOPAT represents operating performance, earned from net operating assets NOPATs denominator is net operating assets (Operating assets operating liabilities)

Income earned on nancial assets = any gains/losses on income statement and other comprehensive income

Remaining Issues

It is difcult to understand the purpose of ROA (EBI/Average Assets), but assuming it was created for total performance measure and correct the error in denominator, it may be still very irrelevant EBI is income available to the following

Debtholders (Bank) Preferred shareholders Common shareholders

All three have different investment objectives, so to them, ROA may not mean anything to them, even if we correct the ROAs denominator. What are the metric of interest for the three parties? How are they connected to companys operating result?

Companys disclosure, role of Analysts, and stock reaction

A game between company, analysts and investors Before publishing annual reports, company holds an event - earnings announcement, conference call Often it will say it beats, meets, misses analysts forecasts Also it would issue forecast guidance for future quarters. Company announces earnings, and, more importantly, future outlook of the company. Then analysts will have time to ask questions to the managements. Often times, earnings announcement is not only about the current earnings, and used to mitigate potentially negative stock reaction. For example, if companys current earnings is not good, it can also release positive future outlook, to mitigate the stock reaction.

Apple 2011 1st quarter

On January 17, 2011, Apple announces that its CEO, Steve Jobs, is on medical leave and its chief operating ofcer, Tim Cook, will temporary ll for CEO position.

First announcement came at 9:09am, 1/17/2011. This day is Martin Luther Kings day, so no trading. Its possible to trade NASDAQ stock before market opens or after market closes. NASDAQ has pre-market session (between 7 am to 9:30am) and post-market session (between 4pm-8pm). Regular trading hours are 9:30am - 4pm. In a pre-market trading on 1/18/2011, Apple share price declined by 5.4%. When market closes on 4pm, Apple stock was down by 2.3%. On same day (after market closes, 4pm), Apple announced 2011 1st quarter earnings. Given the expected volatility of trading, NASDAQ halted the trading on 4:30pm and resumed on 4:50pm.

Apple 2011 1st quarter

Apples 1Q result is over Analysts expectation. (see http:// www.marketwatch.com/story/apple-beats-targets-on-iphone-ipadsales-2011-01-18, also on the role of analysts, see http:// www.marketwatch.com/story/wall-street-blows-chance-to-questionapple-2011-01-18) and mentioned some positiveness on future outlook Analysts forecast : $5.42 per share, Actual : $6.43 Analysts forecasted earnings (net income) and EPS. (net income / weighted number of shares outstanding) Median of analysts forecasts is known as consensus. Its not always the case that analysts predict earnings (net income). In Apple case, since its extremely straight forward accounting, net income is predicted. After the extended trading is over on 1/18, Apple recovered all the losses (-2.3%; see above)

E*Trade 2007 3Q

Unlike other electronic trading companies, E*Trade wanted higher growth, thus chose to invest in Mortgage backed securities (MBS) and aggressive lending practice. Exposure to MBS as of 2007 2Q end was about $3 billions. E*Trade hid the information on investment portfolio until 8/16/2007. Market guessed losses on MBS and E*Trade stock price went from $25.2 on 6/8/07 to $12.8 on 10/16/07

E*Trade 2007 3Q
10/17 is 2007 3rd quarter
earnings announcement date. (after trading hour, 4pm)
Date 20071016 20071017 20071018 Return -2.76% -1.81% -8.02%

Losses on MBS is estimated

to be $300 millions (on 3 Billions MBS holding) so important

News on Earnings was not

E*Trade 2007 3Q
On 11/9/07 (Friday), after market closed, E*Trade issued press release that essentially said E*trade sees higher write-downs than previously expected, so investors shouldn't rely on its previous announced earnings forecast. Monday 11/12 (around 7:42am), one analyst in Citi says that bankruptcy is likely. This sparks massive selling. Some efforts from management
Date 20071112 20071113 Return -58.7% 40.8%

E*Trade 2007 3Q
There is no way E*Trade management could avoid the meltdown.

Poor investment decision Until 8/16, stock market didnt even know how much exposure E*Trade had. From 8/16, E*Trade delayed the bad news as much as possible.

Stock market doesnt like uncertainty.

It is estimated that $3B MBS is worthless, which means that E*Trade has to write down the whole amount. After 11/12, E*Trade management was replaced and a hedge fund (Citadel) invested $1 billions. The hedge fund lost much of the investment, and the fund manager was red. E*Trade is traded now $0.95 per share (based on pre-reverse stock split basis, E*Trade has 1-for-10 reverse stock split on June 2010)