Chapter 5: Essentials of Financial Statement

Analysis
Evaluating accounting “quality”
 How do we define financial reporting quality?
 Qualitative characteristics of accounting
Information:
 Understandability
 Decision usefulness
 Reliability
 Relevance
 Consistency
 Comparability

1
Attributes of High Quality Financial
Reporting
 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

2
 Manipulating Income and Earnings
Management
 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 company’s underlying
performance.
 “Most managers prefer to report earnings that follow a
smooth, regular, upward path.”2
1.
Arthur Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168. 3
What should the users be aware of ?
 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.

4
Financial statement analysis and
accounting quality
 Financial analysis tools: Common-size
statements, trend statements and
financial ratios.
 But they can be no better than the data

from which they are constructed (i.e.,

the comparative financial statements).

5
Financial statement analysis and
accounting quality
 The accounting distortions need to be watched
when using these tools. 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.

6
Learning Objective:

Essentials of Financial Statement

Analysis

7
Analysis, Forecast and Vulation Procedures
 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.
8
Analysis
 Assessing Profitability and
Creditworthiness:
 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.

9
Forecast and Valuation
 Comprehensive Financial
statement forecasts (see Appendix B
of Chapter 6 )
 Valuing Equity Securities (see
Appendix A of Chapter 6):
 a. Free cash-flow model
 b. Abnormal earnings model
(residual income model).

10
Essentials of Financial Statement Analysis
 Step 1: To be informed that financial statement
analysis is a careful evaluation of the quality of a
company’s 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 what’s really going on the
11
Company.
Financial analysis tools
1. Comparative Financial statements:
Statements are compared across years.
2. Common-size statements: Recast each
statement item as a percentage of a
certain item.
3. Trend statements: Recast each statement
item in percentage of a base year
number.
4. Financial ratios.
12
Basic Approaches
1. Time-series analysis : Identify
financial trends over time for a single
company.
2. Cross-sectional analysis: Identify
similarities and differences across
companies at a single moment in time.
3. Benchmark comparison: measures a
company’s performance against some
predetermined standard.

13
Getting behind the numbers:
Case Study: Krispy Kreme Doughnuts, Inc.
 Established in 1937.

 Today has more than 290 70% 65%

doughnut stores (company- 60%
owned plus franchised) 50%
40%
throughout the U.S. 31%
30%
20%
 Serves more than 7.5 million 10% 4%
0%
doughnuts every day.
Compnay Sales to Royalties
stores franchisees
 Strong earnings and Revenue sources in 2002
consistent sales growth.

14
 Comparative Income Statements:
Krispy Kreme’s Financials

Systemwide sales
Include sales from Includes a $5.733 million Includes a $9.1 million
company owned and after-tax special charge charge to settle a
franchised stores. for business dispute business dispute

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. 15
Common Size Income Statements:
Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to
Income Statements

$393.7 operation expenses

$491.5 sales
* Not adjusted for distortions caused by “special items”.

Each statement item is computed as a percentage of sales.

16
Trend Income Statements:
Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to
Income Statement

Base Year

$393.7 operating expenses in 2002

$194.5 operating expenses in 1999
* Not adjusted for distortions caused by “special items”.

Each statement item is calculated in percentage terms using a base year number.
17
Comparative Balance Sheets Assets
Krispy Kreme’s Financials: Balance Sheet Assets

18
Common Size Assets
Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement)
to assets

$3.2 cash
$105.0 assets

Each statement item is computed as a percentage of Total assets.

19
 Trend Assets
Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance
sheet assets

$7 cash in 2000
$3.2 cash in 1999

Each statement item is calculated in percentage terms using a base year number.
20
Comparative Balance Sheets
Liability and Equity: Krispy Kreme’s Financials

21
Common Size Liabilities and Equity:
Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement)
to Balance sheet liabilities and equity

$13.1 accounts
payable
$105.0 total
liabilities and
equity

Each statement item is computed as a percentage of Total liabilities and equity.

22
Trend Liabilities and Equity
Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to
Balance sheet liabilities and equity

$8.2 accounts
payable in 2000
$13.1 accounts
payable in 1999

Each statement item is calculated in percentage terms using a base year number.
23
Krispy Kreme’s Financials:
Abbreviated cash flow statements

24
Common Size Cash Flow
Statements:
Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement)
to Cash Flow Statements

$93.9 capital expenditures

$491.5 sales

Each statement item is computed as a percentage of Sales.

25
Trend Cash Flow Statements
Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Cash
Flow Statements

$93.9 capital expenditures in 2002

$10.5 capital expenditures in 1999

Each statement item is calculated in percentage terms using a base year number.
26
Krispy Kreme analysis: Lessons 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.

27
Krispy Kreme analysis: Lessons learned
 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
company’s economic condition and
its prospects for the future.

28
Learning Objective:

Profitability Analysis

29
 Financial ratios and profitability analysis
Operating profit margin

NOPAT
Sales
Return on assets
NOPAT
ROA= X Asset turnover
Average assets
NOPAT is net operating profit after taxes Sales
Average assets

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). 30
Calculating Return on Assets

Eliminate
nonrecurring items

Eliminate interest
expense

Effective tax rate

31
How can ROA be increased?
There are just two ways:
1. Increase the operating profit margin, or

2. Increase the intensity of asset utilization

(turnover rate). Assets turnover

Operating profit
margin

NOPAT is net operating profit after taxes

32
ROA, margin and turnover examples:
 A company earns $9 million of NOPAT on sales of
$100 million with an asset base of $50 million.

 Turnover improvement: Suppose assets can be reduced to $45

million without sacrificing sales or profits.

 Margin improvement: Suppose expenses can be reduced so that

NOPAT becomes $10.

33
 ROA Decomposition and Analysis

1.
2

How was Krispy Kreme able to increase it’s 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.

34
Further decomposition of ROA
Correspond to the common-size
Income statement items
Operating profit
margin

NOPAT
Sales

ROA = X

Sales
Average assets

Asset turnover

35
Usages of Decomposition of ROA
 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.
36
ROA and competitive advantage:
Krispy Kreme

Wendy’s, Baja S&P industry

Fresh, Café survey or
Express other sources
Q: What was the key to Krispy Kreme’s success in 2002 ?

Answer: Krispy Kreme outperformed the competition by generating more sales per
37
asset dollar.
 ROA and competitive advantage:
Four hypothetical restaurant firms
Competitive
 Competitive Advantage: ROA floor
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).

38
Learning Objective:

Capital structure and

Assess Credit Risk

39
Credit risk and capital structure:
Overview
 Credit risk refers to the risk of default by the
borrower.
 A company’s ability to repay debt is
determined by it’s 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 borrower’s credit risk
before the loan is granted.
 Once granted, they serve as an early
warning device for increased credit risk.
40
Credit risk and capital structure:
Balancing cash sources and needs

The cash flow statements contain information enabling a user to assess a

Company’s credit risk, financial ratios are also useful for this purpose.
41
Traditional lending products

 Short-term loans:  Long-term loans:

 Seasonal lines of credit  Mature in more than 1 year

 Special purpose loans  Purchase fixed assets,

(temporary needs) another company,

 Secured or unsecured Refinance debt ,etc.
 Often secured

 Revolving loans  Public Debt

 Like a seasonal credit line  Bonds, debentures, notes

 Interest rate usually “floats”

 Special features: Sinking
fund and call provisions

42
Evaluating the borrower’s ability to repay

Step 1: • Business model and strategy

Understand • Key risks and successful factors
the business • Industry competition

Step 2: Evaluate • Spot potential distortions

accounting quality • Adjust reported numbers as needed

Step 3: • Examine ratios and trends

Evaluate current • Look for changes in profitability, financial
profitability and health conditions, or industry position.

Step 4: Prepare “pro forma” • Develop financial statement forecasts

cash flow forecasts • Assess financial flexibility

Step 5:
Due diligence • Kick the tires

Step 6: • Likely impact on ability to pay

Comprehensive risk • Assess loss if borrower defaults
assessment • Set loan terms

43
 Credit risk: Short-term liquidity ratios
Including Inventory

Current assets
Current ratio =
Current liabilities Very immediate
Liquidity liquidity
ratios Cash + Marketable securities + Receivables
Quick ratio =
Current liabilities
Short-term
liquidity Net credit sales
Accounts receivable turnover =
Average accounts receivable

Activity Cost of goods sold

Inventory turnover =
ratios Average inventory

Inventory purchases
Accounts payable turnover =
Activity ratios tell us Average accounts payable
How efficiently the company is using its assets.

Liquidity refers to the company’s short-term ability to generate cash for working
44
Capital needs and immediate debt repayment needs.
Receivables Turnover Ratio and
collection period
Receivables
Turnover = Net Sales
Ratio Average Accounts Receivable

This ratio measures how many

times a company converts its
receivables into cash each year.
Average Collection Period
Average =
Collection 365
Period Receivables Turnover Ratio

This ratio is an approximation of the

number of days the average accounts
receivable balance is outstanding. 45
Inventory Turnover Ratio and Average
Days in Inventory
Inventory
Cost of Goods Sold
Turnover = Average Inventory
Ratio
This ratio measures the number
of times merchandise inventory
is sold and replaced during the year.

Average Days in Inventory

Average =
Days in 365
Inventory Inventory Turnover Ratio

This ratio indicates the number

of days it normally takes to sell inventory.
46
 Credit risk:
Operating and cash conversion cycles
Working capital ratios:
365 days 45 days
Days accounts receivable outstanding =
Accounts receivable turnover
(Days before cash is collected from the customer) Operating
cycle 75
days

365 days 30 days

Days inventory held = Cash
Inventory turnover conversion
cycle 55
(75-20) days

365 days ( 20 days)

Days accounts payable outstanding =
Accounts payable turnover
( Days that suppliers are paid after inventory is purchased)

Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).
47
Credit risk:
Long-term solvency
Including
Long-term debt Intangible assets
Long-term debt to assets =
Total
Debt ratios assets
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
Operating cash flow Cash flow from continuing operations
to total liabilities = Average current liabilities + long-term debt

Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain
its productive capacity and still meet the interest and principal payment on its long-term debt. 48
Credit risk of Krispy Kreme :
Short-term liquidity and Long-term solvency

49
 Credit risk: 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.

Source: Moody’s Investors Service (May 2000)

Default rates by Moody’s credit rating, 1983-1999

50
Financial Ratios and Default Risk
Return on assets (ROA)
ROA and probability of default is negatively associated.
Profitability: Return on Assets Percentiles (excludes extraordinary items)

Source: Moody’s Investors Service (May 2000)

51
Financial Ratios and Default Risk
Quick Ratio
Quick Ratio and probability of default is negatively associated.
Liquidity: Quick Ratio Percentiles

Source: Moody’s Investors Service (May 2000)

52
Credit analysis:
Case Study: G.T. Wilson’s credit risk
 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 Wilson’s
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.

53
Credit analysis:
Case Study: G.T. Wilson’s credit risk
 Bank now has a $50 million secured
construction loan and a $200 million
revolving credit line which is up for
renewal with Wilson.
 What do the Wilson’s financial
statements tell us about its credit risk?
 Should the bank renew Wilson’s $200
million credit line?

54
Credit Analysis: Interpretation of cash flow component

Negative free
cash flow

Increased
borrowing

Continued
dividend
payment

55
Credit Analysis : Selected financial statistics

Declining
margin

Customers take
longer to pay,
but reserve is
smaller

Larger debt
burden

56
Credit analysis: Recommendation
 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.
57
 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 Net income available to
common shareholders
Average common
shareholders’ equity NOPAT

Net income available to X

Financial structure leverage
common shareholders = Average assets
Net income – preferred Average common
dividends shareholders’ equity

ROCE= ROA * Common earnings leverage* Financial Structure leverage 58

Return on equity and financial
leverage Unchanged – because of
Financial leverage

 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%.

59
Return on Equity and financial
leverage
 Financial leverage is beneficial only
when the company earns (i.e.,
ROA) more than the incremental
after-tax cost of debt.
 If the cost of debt is greater than the
earnings, increased leverage will
harm shareholders.

60
Return on Equity and financial
leverage (contd.)
 The advantage of debt financing is
the tax deduction on interests.
 The disadvantage is the increase of
the bankruptcy risk.
 Both the cost of debt and the
bankruptcy probability need to be
considered in determining the
capital structure.
 It is hard to determine the optimal
mix of capital and debt.
61
Profitability and financial leverage:
Case Study

Leverage
Leveragehelps
helps

Leverage
Leverage neutral
neutral

Leverage hurts

62
Learning Objective:

Pro Forma Earnings

63
Pro Forma Earnings
Companies often voluntarily provide a
pro forma earnings number when
they announce annual or quarterly
earnings.
 Pro forma earnings are

management’s assessment of
permanent earnings.

64
Pro Forma Earnings

 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.

65
 Financial statement analysis:
Non-GAAP earnings:
Pro forma earnings and EBITDA
 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”.

66
Financial statement analysis:
Pro forma earnings at Amazon.com

Company
defined numbers
Computed
according to GAAP

67
When use the EBITDA or “pro forma”
earnings, 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.

68
Why do firms report EBITDA and “pro
forma” earnings?
 Help investors and analysts spot non-
recurring 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.
69
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 don’t 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.
70
Summary of financial statement analysis
How to use financial ratios
 Profitability:
 ROA ( Return on assets)

 Operating Profit Margin

 ROCE ( Return on common stockholder’s 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)

71
Summary of financial statement analysis
How to use financial ratios
 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

72
Summary of financial statement analysis
How to use financial ratios
 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)

73