Professional Documents
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Learning objectives
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Essentials of financial statement analysis, financial statement analysis tools and approaches. How ROA is used to analyze profitability and the insight to separate ROA to profit margin and asset turnover rate. How ROA and financial leverage combine to determine a firms return on equity (ROCE).
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Capital structure and credit risk: How short-term liquidity risk and long-term solvency risk are assessed and how to use the statement of cash flows to assess credit risk.
Why do companies issue pro forma earnings?
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Financial reporting (earnings) quality has been considered positively associated with the following: High persistence of earnings and cash flows High predictive ability of earnings and cash flows High earnings response coefficient Low level of earnings management More voluntarily disclosure Strong corporate governance
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Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the companys underlying performance.
Most managers prefer to report earnings that follow a
smooth, regular, upward path.2
Levitt, former SEC chairman. 2.Bethany McLean, Hocus-Pocus: How IBM Grew 27% a Year, Fortune, June 26, 2000, p. 168.
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Statement users must: Understand current financial reporting settings and standards. Recognize that management may manipulate the financial information. Distinguish between reliable financial statement information and poor quality information.
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The accounting distortions need to be watched when analyzing statements. Examples include: 1. Nonrecurring gains and losses 2. Differences in accounting methods. 3. Differences in accounting estimates. 4. GAAP implementation differences. 5. Historical cost convention.
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Learning Objective:
Reviewing the Financial Statements: Review comparative financial statements and audit opinion. Adjusting and forecasting accounting numbers:
Adjusting accounting numbers to remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income.
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Analysis
Common size statements. Trend statements Financial ratio analysis: Use ratios to assess liquidity, profitability and solvency. Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default.
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Valuing
Step 1: To be informed that financial statement analysis is a careful evaluation of the quality of a companys reported accounting numbers. Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers accounting and disclosure choices.
Only then you can truly get behind the numbers and see whats really going on the Company.
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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.
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Time-series analysis: the same firm over time (e.g., Wal-Mart in 2008 and 2006)
Trend statements
2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2008). 3. Benchmark comparison: using industry norms or predetermined standards.
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Comparative Financial statements: Statements are compared across years. Common-size statements: Recast each statement item as a percentage of a certain item. Trend statements: Recast each statement item in percentage of a base year number. Financial ratios.
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Basic Approaches
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Time-series analysis : Identify financial trends over time for a single company. Cross-sectional analysis: Identify similarities and differences across companies at a single moment in time. Benchmark comparison: measures a companys performance against some predetermined standard.
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Getting behind the numbers: Case Study: Krispy Kreme Doughnuts, Inc.
Established in 1937. Today has more than 290 doughnut stores (companyowned plus franchised) throughout the U.S. Serves more than 7.5 million doughnuts every day.
70% 60% 50% 40% 30% 20% 10% 0% Compnay stores Sales to franchisees Royalties 31% 65%
4%
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Systemwide sales Include sales from company owned and franchised stores.
Sales increased from $220.2 million in 1999 to $491.5 million in 2002. Net income increased from $6 million in 1999 to $33.5 million in 2002.
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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to Income
$393.7 operation expenses $491.5 sales * Not adjusted for distortions caused by special items.
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Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Income
Base Year
$393.7 operating expenses in 2002 * Not adjusted for distortions caused by special items. $194.5 operating expenses in 1999
Each statement item is calculated in percentage terms using a base year number.
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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to
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Trend Assets
sheet assets
Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Balance
Each statement item is calculated in percentage terms using a base year number . 23
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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to
Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Balance
Each statement item is calculated in percentage terms using a base year number . 26
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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to
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Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Cash
Each statement item is calculated in percentage terms using a base year number.
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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.
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Common-size and trend statement techniques can be applied to all financial statements and every section of statements. Financial statements help analysts gain a sharper understanding of the companys economic condition and its prospects for the future.
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Learning Objective:
Profitability Analysis
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Analysts do not always use the reported earnings, sales and asset figures. Instead, they often consider three of adjustments to the reported numbers:
1. Remove non-operating and nonrecurring items to isolate sustainable operating profits. 2. Eliminate after-tax interest expense to avoid financial structure distortions. 3. Eliminate any accounting quality distortions (e.g., off-balance operating leases). 33
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Increase the operating profit margin, or Increase the intensity of asset utilization (turnover rate).
ROA= EBI Average assets EBI Sales
Asset turnover
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A company earns $9 million of EBI on sales of $100 million with an asset base of $50 million.
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How was Krispy Kreme able to increase its ROA from 7.1% to 12.1% over this period?
1. The expanded store base, along with increased sales, allowed the fixed costs be spread over a number of stores- The result was in an improved operating profit margin. 2. However, the asset based was considerably less productive in 2002 ( Asset turnover is 1.48) than it was in 1999 ( Asset turnover is 2.22) More stores meant more resources ( assets) tied up operating cash, receivables, etc.
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The profit margin components can help the analyst identity areas where cost reductions have been achieved or where cost improvements are needed. The current asset turnover ratio helps the analyst spot efficiency gains from improved accounts receivable and inventory management. The long-term asset turnover ratio captures information about property, plant, and
equipment utilization.
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Wendys, Baja Fresh, Caf Express Q: What was the key to Krispy Kremes success in 2002 ?
Answer: Krispy Kreme outperformed the competition by generating more sales per 40 asset dollar.
Competitive Advantage:
Companies that consistently earn an ROA above the floor. (e.g., Firm C)
However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. Competition works to drive down ROA toward the competitive floor.
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).
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Components of ROCE
2005: No debt; all the earnings belong to shareholders. 2006: $1 million borrowed at 10% interest; ROCE climbs to 20%. 2007: Another $1 million borrowed at 20% interest; ROCE falls to only 15%.
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Leverage hurts
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Learning Objective:
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Credit risk refers to the risk of default by the borrower. 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. 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.
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The cash flow statements contain information enabling a user to assess a Companys credit risk, financial ratios are also useful for this purpose.
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Short-term loans: Seasonal lines of credit Special purpose loans (temporary needs) Secured or unsecured
Long-term loans: Mature in more than 1 year Purchase fixed assets, another company, Refinance debt ,etc. Often secured Public Debt Bonds, debentures, notes
Revolving loans Like a seasonal credit line Interest rate usually floats
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Step 2:
Step 3:
Step 4:
Step 5:
Due diligence Step 6: Comprehensive risk assessment
Kick the tires Likely impact on ability to pay Assess loss if borrower defaults Set loan terms
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Liquidity ratios
Quick ratio =
Current liabilities
Cash + Marketable securities + Receivables Current liabilities Net credit sales Average accounts receivable
Short-term liquidity
Accounts receivable turnover =
Activity ratios
Inventory turnover =
Activity ratios tell us How efficiently the company is using its assets.
Inventory purchases
Average accounts payable
Liquidity refers to the companys short-term ability to generate cash for working 52 Capital needs and immediate debt repayment needs.
= 365 Receivables Turnover Ratio This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 53
Average = 365 Days in Inventory Turnover Ratio Inventory This ratio indicates the number of days it normally takes to sell inventory.
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Credit risk:
Operating and cash conversion cycles
Working capital ratios:
Days accounts receivable outstanding = 365 days Accounts receivable turnover
Operating cycle 75 days 30 days Cash conversion cycle 55 (75-20) days ( 20 days) 45 days
Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).
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Credit risk:
Long-term solvency
Long-term debt to assets = Long-term debt Total assets Long-term debt Total tangible assets
Including Intangible assets
Debt ratios
Long-term debt to tangible assets =
Long-term solvency
Interest coverage = Operating incomes before taxes and interest Interest expense
Coverage ratios
Operating cash flow to total liabilities = Cash flow from continuing operations Average current liabilities + long-term debt
Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain 56 its productive capacity and still meet the interest and principal payment on its long-term debt.
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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.
Source: Moodys Investors Service (May 2000)
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Credit analysis:
A bank client for over 40 years. Owns 850 retail furniture stores throughout the U.S. Increased competition and changing consumer tastes caused the following changes in Wilsons business strategy: Expand product line to include high quality furniture, consumer electronics, and home entertainment systems. Develop a credit card system to help customers pay for purchases. Open new stores in suburban shopping centers and close unprofitable downtown stores.
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Credit analysis:
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Declining margin
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Wilson is a serious credit risk: Inability to generate positive cash flows from operations. Extensive reliance on short-term debt financing. The company may be forced into bankruptcy unless: Other external financing sources can be found. Operating cash flows can be turned positive. Update: Bankruptcy was declared shortly after these financials were released.
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Learning Objective:
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Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference calls, and in annual reports. The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP.
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Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference call, and in annual reports. Sometimes these earnings figures are called EBITDA ( earnings before interest, income taxes, depreciation, and amortization) Sometimes it is called adjusted earnings. Sometimes it is called pro forma earnings.
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When use the EBITDA or pro forma earnings, analysts should remember:
There are no standard definitions for nonGAAP 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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Help investors and analysts spot nonrecurring or non-cash revenue and expense items that might otherwise be overlooked. Pro forma earnings could 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.
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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.
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Profitability: ROA ( Return on assets) Operating Profit Margin ROCE ( Return on common stockholders equity) Market Measures: Earnings per share (EPS) Price/ earnings ( Market price of common stock/ EPS) Dividend payout ( Dividends per share/ EPS) Dividend yield ( Dividends per share/ Market price of common stock)
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Liquidity ( Evaluate short-term credit risk) - Liquidity ratios: Current ratio and quick ratio - Liquidity of working capital : Average collection period, Days inventory held, days payable outstanding, operating cycle days, cash conversion cycle, etc. - Operating Efficiency ( Activity ratios) Accounts receivable turnover Inventory turnover Accounts payable turnover
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Solvency ( Evaluate long-term credit risk) Coverage ratios: interest coverage, operating cash flows to total liabilities Debts ratios: Debt/ Assets Debt/ equity (Total liabilities/ Stockholders equity)
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