Financial Statement Analysis

Financial Reporting Definition

Provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.

Order of Business Analysis

Business Environment/Strategy Analysis (5 forces) —> Accounting Analysis (Improving consistency) —> Financial Analysis (Profitability Analysis, Analysis of Cash Flows, Risk Analysis) —> Prospective Analysis (Predicting future cash flows) —> Valuation

Credit Analysis (Creditors)

Fixed benefits —> interest pmts + maturity pmt

Risk of default is the focus, not profitability

Creditworthiness (honor obligations)

Liquidity = ability to meet short-term obligations

Solvency = long-term viability

Market Cap

# of shares outstanding x current stock price (today’s valuation)

Market Cap vs. Valuation

Market cap > valuation = don’t buy the stock!

Valuation > market cap = buy the stock!

Equity Analysis

Worried about being paid dividends and what equity can be sold for

Get extra after the firm meets the obligation to creditors

Symmetric risk —> care about upside and downside

Technical Analysis —> Searching for patterns in stock prices. Using past info to predict future.

Fundamental Analysis —> Determining value of company using FS information

Intrinsic value = true value of company (compared to market value)

Other Types of Business Analysis (Ways to use FS)

Benchmarking - comparing FS between companies

M&A + Divestitures - investment bankers targeting investment options

Capital Structure - How much debt to we need to have relative to equity? Dividends?

Director oversight - reward/fire managers

Regulation - SEC, IRS

Labor Negotiations - Unions use to determine negotiations

Industry Analysis

Porter’s 5 Forces.

Potential entrants, suppliers, buyers, substitutes —> industry rivalry

Strategy Analysis

Competition, market demands, distribution, performance, opportunities, obstacles, pricing, etc.

Financing Activities (BS) - Debt, Equity, RE (how much is going back into co. compared to what’s paid out in dividends

Investing Activities (BS) - intangibles

Operating Activities (IS) - How are they making money? Carrying out business plan

Accounting Analysis

Process to evaluate and adjust FS to better reflect economic reality

Arise due to comparability problems - companies adopting different accounting for similar events

Accounting Distortions - create risk

Accounting Standards - FASB not followed? Transparency?

Manager Estimation Error - estimates too high/low?

Earnings Management - not always nefarious, changing representation, managers can be biased but they do know more

Financial Analysis

Application of analytical tools and techniques to general-purpose FS and related data to derive estimates and inferences

Profitability Analysis

Evaluation of ROI

Revenues - expenses

Will we be able to pay dividends?

Risk Analysis

Can company meet commitments?

Pay debts? Cover liabilities with assets? Find CoC.

Analysis of Cash Flows

Analysis of how a company obtains and deploys funds

Merchandising company’s ratios

High advertising compared to sales, high gross profit margin ratio, long A/R turnover (b/c of card payments)

Pharma company’s ratios

High R&D. Highest gross profit margin ratio (pricing able to cover more than cost). High return on assets.

Utilities company’s ratios

NO gross profit margin ratio. High D/E (to pay for physical property). Turnover about 12 months because customers billed every month.

Prospective Analysis

Forecasting of future payoffs

Valuation

Converting forecasts into an estimate of company value

Dividend Discount

A type of valuation

From POV of stockholder who has invested and the dividends that they expect

Projects out dividends expected @ different periods and discounts back to today (stock price)

Residual Income Model

A type of valuation

POV of accounting

What we would receive if we sold all our assets and paid out liabilities (NBV) + abnormal returns from net assets

Efficient Market Hypothesis

Goods exchanged at rational value. All publicly available information is reflected in share prices. No one knows better than market. Investors harmed if full disclosure not made.

If true in its strongest form, financial analysis not necessary.

Plenty of evidence against it (ex. seasonal/day of the week, stock market crash, internet bubble)

Not always priced correctly, because some funds/stocks beat the average. In short term, popular firms sold even if not great. In long term, firms with valuable products/systems better.

Two types of financial analysts - fundamental analysis vs. statistical analysis (trading based on momentum)

Management is responsible for…

Preparation and integrity of financial statements

Required filings

10K, 10Q, 8K, Proxy, and Summary Annual Report (this one’s not for SEC)

10-K

Annual filing, audited.

Includes all FS plus market info, management discussion and analysis (letter from mgt to creditors and investors about future years), executive compensation, and related party transactions

10-Q

Quarterly, unaudited.

More timely than 10-K, but not as reliable.

8-K

Current report.

Reports the occurrence of any material events of corporate changes that might impact decisions (ex. M&A, bankruptcy, change in control, etc.)

Proxy

Notice and authorization of shareholder voting rights on corporate actions

Given prior to annual meeting and outlines exec compensation, board elections, and voting proposals

Content and form governed by SEC

Summary Annual Report

Not as useful as 10-Ks, mostly for promotion

Highly condensed financial info

Must be accompanied by statement containing full financial info

Not adequate for financial analysis

Earnings Announcements

Before 10-K and 10-Q, management talks with analysts/journalists to preview #’s for the year

Pro forma earnings - mgt may tweak earnings or revenue by omitting things they believe is unnecessary. They can change revenues of expenses

Earnings Walkdowns

Management will disclose what they believe its earnings will be for the year with the help of analysts

Sometimes too high, so mgt will have voluntary disclosure where they will walk down earnings expectations, and analysts revise

Safe Harbor Rules

Laws that protect management if a prediction is not true

But firms can still be sued even with this

Voluntary Disclosures

Reporting strategy

Safe Harbor Rules

Legal liability for misleading disclosures

Expectation management - info goes into expectations (ex. changes in revenue due to new advertising)

Signaling - market trying to pick up what mgt tells them

Information intermediaries - Analysts

In charge of valuing companies and comparing to MV

Information gathering + interpretation (for those who don’t understand fancy terms)

Prospective analysis

Recommendation to buy, hold, or sell

Information Intermediaries

Analysts, media, stock platforms (Yahoo, Bloomberg)

Anywhere to get info that is not directly from management

Desirable Qualities of Info for Analysis

Relevance - Useful in decision making?

Reliability - Can we trust it? Does it reflect economic position? Hard because of intangibles affecting estimates.

Comparability - Comparing different firms + present vs. past

Consistency - across time/firms

Materiality - # should be large enough to affect someone’s decision to invest or lend

Conservatism - GAAP requires, but we want the value to be accurate, not conservative.

Conservatism - who wants it?

Credit analysis WANTS conservatism (only worried about getting interest payments)

Equity analysis wants ACTUAL numbers

Limitations of FS Info

Timeliness

Frequency

Forward-looking

We want to be able to see the value updated minute by minute and project the future, but currently it’s slow and mainly about past info

Correlation between Accounting Numbers and Stock Prices

Earnings and book value had about a 50% correlation, but it would be lower today due to technology (difficulty valuing)

Accrual Accounting

Recording revenue in the period when the obligation is satisfied (Revenue recognition)

Match revenue and expenses in the same period (matching principle)

Why do we use Accrual Accounting?

Timing

Matching

Better evaluates financial performance (IS), better reflects financial condition (BS), better at predicting fufure cash flows, reflect business activities in timely matter

Free Cash Flows

Cash flows a company generates after covering operating expenses and capital expenses

Represents the money a firm has left to pay dividends, reduce debt, and fund expansion without external financing

Investing CF, Operating CF, income, and FCFs on a graph

Investing CF - negative until maturity when it starts selling PPE

Operating CF - start out negative then become positive (at maturity, cash cow)

Income - lower than OCF line because you subtract depreciation or amortization, but flows similarly to it

FCFs - negative in growth period and becomes positive after maturity because you have more $ to cover expenses, leaving more after

Accounting Income

Accrual based earnings

What’s on the IS (NI based on accrual accounting)

Shows what is permanent (ex. rent) vs. transitory (ex. condo impaired)

Value is irrelevant

Economic Income

Like accounting income, but includes economic effect when market value for items change (ex. appreciation of assets or impairment)

This is because, if sold, it would technically be a gain/loss

Chanhe in shareholder wealth - if sold today, what would we get?

Includes recurring and nonrecurring components

Similar to comprehensive income (which has things like investments that changes value)

Effects of Sales on Credit on Accounting Income, FCF, and Economic Income

Increase, Nil, Increase

Revenue increased, but no cash was received yet

Effects of Cash Collections on Credit Sales on Accounting Income, FCF, and Economic Income

Nil, Increase, Nil

Sale was already recorded for revenue, only cash increases here

Effects of Inventory Markdowns on Accounting Income, FCF, and Economic Income

Decrease, Nil, Decrease

COGS increase, inventory not sold so no cash moved, and inv. can’t be sold for as much as we paid

Effects of Changing Depreciation from SL to DB on Accounting Income, FCF, and Economic Income

Decrease, Nil, Nil

Going to DB means depreciation increases in early years, but asset is still on books for amount we paid so value doesn’t change

Effects of Cash Purchase of PPE on Accounting Income, FCF, and Economic Income

Nil, Decrease, Nil

Simply exchanging value from one asset to another so no revenue change, but cash is paid out

Differences in Accounting vs. Economic Income

Different earnings numbers

Accounting focuses on historical cost and recognizes transactions, while economic is based on changes in value

Conservatism and earnings management built into accounting income ONLY (b/c value doesn’t change)

Advantages of FV

Reflects current info (what we could sell an asset for)

Consistent measurement criteria (no confusion with mixed methods)

Comparability increase

No conservatism bias

Better for equity analysis - economic income (actual value)

Disadvantages of FV

Lower objectivity because of estimates

Susceptible to manipulation - estimates

Lack of conservatism - bad for credit analysis

More volatility (b/c market is volatile, companies don’t like this)

Accounting Distortions in Accounting Analysis

Want to remove these before valuation so it can be effective

Accounting Standards - political process (everybody wanting different things), methods used (historical cost), conservatism

Estimation errors - differences in estimation between firms, reporting assets if the market does not exist

Reliability vs. Relevance - can have one, or the other, or both

Earnings Management - shifting things to change revenue or expenses

Types of Earnings Management

Accrual based

Real - making decisions like selling assets that appreciated

Examples of Earnings Management

Increasing Income - recognizing sales on different dates at end of year, selling appreciated asset

Big Bath - if there’s one year where something bad happened, dumping everything into that year so future years seem good

Income Smoothing - wanting slow increase in revenue without much volatility

Evaluating Earnings Quality

Harder to predict quality with earnings management involved

Identify key accounting policies - room for EM?

Evaluate extent of accounting flexibility - the more flexible, the more it’s likely managed

Determine reporting strategy

Identify and assess red flags

When and how is a hidden reserve created for bad debts?

Company takes extra bad debt expense and puts more in allowance for bad debts that year

Decreases income in the good year, but sets reserve so that in bad years, they can say they overestimated what would be collected and back off on bad debt expense

When and how is a hidden reserve created for inventory?

Recognizing a lower NRV for inventory, marking it down, and selling it in a bad year so the difference in the NRV becomes a gain

When and how is a hidden reserve created for accruals associated with restructuring charges?

Layoffs, selling divisions, etc. is estimated

This can be high in a good year then reduced later because the charge wasn’t as much as expected

Short-term vs. Long-term debt

Short-term = paid within 1 year or 1 operating cycle (whichever is longer) —> more risky

Long-term = extend beyond that time, focuses on interest rates

Effective Interest Method

Required by GAAP for long-term debt

Interest expense (periodic interest) = carrying amount of debt x market rate on day debt was issued

Accounting for LTD

Requires future payment of cash in specified amount at specified dates

As time passes, interest accrues

Debt is reported at the PV of its related cash flows (interest + principal), discounted at the market rate at issuance

Loan agreement restrictions - bond/debt covenants might give additional rights to creditors, read info in 10K to make sure you meet qualifications so you don’t default

Stated Amount

Amount of $ company needs to borrow

Printed on the bond

Stated rate

Coupon rate, nominal rate

Interest rate printed on bond

ONLY used to determine interest payments

Market Rate

Effective rate

The going interest rate of similarly risky debt (varies frequently)

Bond indenture

The document that describes the promise made to bondholders

Set by investment bankers, includes stated rate

Cash paid/Interest payment formula

Stated rate x principal

Interest expense formula

Market rate x carrying value

Why does interest expense =/= interest payment?

Because market rate changes in the time between the bond being stated and actually paid out

Amortized cost vs. face value

Under GAAP, debt is recorded at amortized cost

Underestimates future cash commitments - usually less than the amount paid out

Face value reflects cash commitments

Difference bigger when stated and market rate diverge

Amortized cost formula

PV of all future cash payments (interest + principal), discounted at MR on issuance date

Same as effective interest method

FV Option

Company has option to value some or all its A/L at FV

Can mix and match methods

Reports changes in FV in IS

Not allowed to switch once chosen

Reflect current interest rates and represent liquidating value of debt

Creates contradicting results on IS

Lease

A contract that conveys the right to control PPE for a period of time in exchange for payments

Advantages of leasing

PPE might be too expensive otherwise, protection against obsolescence, flexibility (don’t have to sell), cheaper financing, achieves tax objectives

Changes to leasing

US GAAP adopted new standards in 2019

Prior there was operating (neither asset or liability shown, off B/S financing) and capital leases

Only leases that don’t show up now are < 1 year

Finance lease

Non-cancelable and control is transferred

Treated as if sale has taken place

Amount capitalized (ROU) is the PV of the lease payments

Lease payable = accrued interest + residual portion that reduces ROU balance

Amortized straight-line over term of lease

Operating lease

Control is not transferred

Still measures interest expense but amortizes the asset so that the lease expense is the same over periods

Only a SINGLE lease expense (interest on liability + amortization of ROU) is recognized

5 Questions to Determine Finance Lease

1. Does lease transfer ownership?

2. Is there a BPO?

3. Is the lease term for a major part of the remaining life of the asset?

4. Is PV of all lease payments a significant portion of the asset’s FV?

5. Is it super specialied (lessor can’t use it for anything else)?

Bargain Purchase Option

Opportunity to purchase an asset at the end of the lease for less than its worth

Lease Term

Non-cancelable term of the lease plus any BPO periods

Finance and Operating Leases - Lessee

Capitalize all leased assets as Right of Use (ROU - intangible asset)

Balance sheet the same for both types

Income statement differs

• Finance: Effective-interest method for liability + amortization for asset

• Operating: Single lease expense for every period

Short-term leases

Any lease with a term of 12 months or less

No ROU asset or lease payable

Any renewal options included