Download Chapter 12 Financial Statement Analysis

Financial Statement Analysis
CHAPTER
12
Learning Objectives
After studying this chapter, you should be able to
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Locate and use sources of information about company
performance
Analyze the performance of a company using trend analysis,
common-size financial statements and segment reporting
Use the basic financial ratios to guide your thinking
Evaluate corporate performance using various metrics, including
ROA, ROE, and EVA
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Calculate EPS when a company has preferred stock or dilutive
securities
Learning Objectives
After studying this chapter, you should be able to
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Understand the nature of nonrecurring items and how to adjust for
them
Use financial information to help assess a company’s value
Sources of Information
About Companies
Company annual reports include:
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The financial statements
Footnotes to the financial statements
A summary of the accounting principles used
Management’s discussion and analysis (MD&A)
The auditor’s report
Management’s report on its responsibility for the financial statements
Comparative financial data for a series of years
Narrative information about the company
Sources of Information
About Companies
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Companies also prepare reports for the Securities and Exchange
Commission (SEC)
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Form 10-K (annual report)
Form 10-Q (quarterly report)
Other sources of information:
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Company press releases
Company Websites
The general financial press
Trade and industry publications
Financial services
Objectives of
Financial Statement Analysis
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Investors use financial statement analysis to
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Assess the risks associated with those returns
Creditors are primarily concerned with
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Predict expected returns
Short-term liquidity – how much cash a company has on hand to
meet current payments when due
Long-term solvency – a company’s ability to generate cash to repay
long-term debts when due
Equity investors are more concerned with profitability and future security
prices
Trend Analysis
Trend analysis compares financial statement changes over time and
identifies predictable patterns that have occurred
To compute percentage changes, the dollar change for an item (like net
sales) is divided by the base year amount:
Trend Analysis
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Using the income statement for Eli Lily in Exhibit 12-1 in the text, the change
in net sales is:
Trend Analysis
The company’s explanation for some trends can be found in the
Management Discussion and Analysis (MD&A) in the annual report
The MD&A includes disclosures about
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Capital resources and liquidity
Results of operations (including sales and expenses)
Contractual obligations and commitments
Critical accounting estimates
Adoption of new accounting policies
Trend Analysis
The compound annual growth rate (CAGR) is the year-over year growth
rate over a specific period of time
A future value table must be used to compute the CAGR (Chapter 9)
Common-Size Statements
Common-size statements simplify the comparison of different companies
because their amounts are stated in percentages
On a common-size income statement, each item is expressed as a
percentage of sales
In the balance sheet, the common size is total assets
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Balance sheet items are referred to as component percentages
because they measure each component of the statement as a
percentage of the total
Segment Reporting
Companies must report information about segments of the business in a
footnote to the financial statements
Segment information includes information on sales, profits, and assets
Reportable segments can be broken down by product line, geographical
location, and major customer
Financial Ratios
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The following exhibit summarizes the most popular financial ratios (from
previous chapters) grouped into four categories:
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Long-term solvency
Profitability ratios
Market price and dividend ratios
Examples are provided from the Eli Lilly data in the text
Financial Ratios
Financial Ratios
Evaluating Financial Ratios
Financial ratios can be used for three types of comparisons:
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Short-term liquidity
Time-series comparisons – comparisons with a company’s own
historical ratios
Benchmarks – comparisons with general rules of thumb
Cross-sectional comparisons – comparisons with other
companies or with industry averages
Industry averages can be found in services such as Dun & Bradstreet and
Standard & Poor’s
Evaluating Financial Ratios
Specific competitor companies can be found for ratio comparisons by using
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North American Industry Classification System (NAICS), or the
Standard Industry Classification Code (SIC)
Changes in ratios over time alert investors and creditors to possible
problems
Operating Performance and
Financing Decisions
Operating management is concerned with the daily activities that generate
revenues and expenses
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Financial management is concerned with where the company gets cash
and how it uses that cash to its benefit
Operating Performance
Operating Performance
These ratios for Ely Lilly are:
Operating Performance
Industries likely to display high EBIT to sales ratios and low total asset
turnover ratios have high barriers to entry:
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Utilities
Communications
Industries likely to display low EBIT to sales ratios and high total asset
turnover ratios have low barriers to entry:
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Retail grocery
Financing Decisions
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Companies finance long-term investments with either
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Long-term debt or
Stock
Debt is attractive because
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Interest payments are tax deductible, but dividend payments are not
Present shareholders profits and voting rights are not diluted
Financing Decisions
Capitalization (capital structure) refers to the mix of debt and equity
financing
Trading on the equity (financial leverage) means using debt at a fixed
interest rate to try to increase the rate of return on stockholders’ equity
(ROE)
Financing Decisions
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When a company is debt free, ROE = ROA
When ROA > interest rate, ROE > ROA (favorable financial leverage)
When ROA < interest rate, ROE < ROA
Economic Value Added
Economic value added (EVA) measures the residual wealth of a company
after deducting its cost of capital from operating profit
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A firm must earn more than it pays if it is to increase in value
The cost of capital here refers to a weighted average cost of interest
on debt and returns to equity investors
EVA is used as an internal management tool to help allocate and manage
scarce capital resources such as equipment and real estate
Economic Value Added
If a company has a capitalization of $1 million, 10% cost of capital, and
operating profit of $120,000:
Measuring Safety
Interest coverage (times interest earned) measures a company’s ability to
make interest payments and repay debt on schedule
Rule of thumb: interest coverage should be at least 5 times
Earnings Per Share
In its simplest form, EPS is the net income divided by the number of common
shares outstanding
The following slides address several complicating issues in the computation
Weighted Average Shares
The denominator should actually use the weighted-average number of
common shares outstanding
Weighted Average Shares
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Example: 750,000 shares were outstanding at the beginning of the year and
200,000 additional shares were issued 3 months before the year-end. The
weighted average number of shares would be:
The denominator must also be adjusted retroactively for any stock splits and
stock dividends
Preferred Stock
If the company has nonconvertible preferred stock outstanding, net income
must be reduced since the numerator should reflect just the net income that
is available to common stockholders
Basic and Diluted EPS
Companies with convertible securities and stock options must report two
EPS calculations:
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Basic EPS
Diluted EPS
Assume the following data:
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Convertible preferred stock at 5%, $100 par, each share convertible
into two common shares: 100,000 shares
Common stock: 1,000,000 shares
Net income $10,500,000
Basic and Diluted EPS
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The basic EPS calculation would be:
Basic and Diluted EPS
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Diluted EPS assumes conversion of the preferred stock to common stock
Accordingly, no preferred dividends are deducted in the numerator and
additional shares of common are added in the denominator
Disclosure of Nonrecurring Items
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Nonrecurring items fall into four major categories:
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Special items
Extraordinary items
Discontinued operations
Accounting changes
Special Items
Special items are revenues or expenses that are large enough and unusual
enough to warrant separate disclosure on the income statement
Examples:
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Impairment of PP&E
Impairment of goodwill
Restructuring charges
They appear with the operating expenses
Extraordinary Items
Extraordinary items are gains and losses resulting from events that are
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Unusual in nature
Infrequent in occurrence
They are reported net-of-tax on a separate line on the income statement
Discontinued Operations
Discontinued operations occur when a company disposes of an entire
segment of the business
Segments must have assets and activities that are physically and
operationally distinguishable from the remaining entity
Gains or losses from discontinued operations must be shown separately on
the income statement net-of-tax
Changes in Accounting Method
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A change in accounting method can occur when
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The FASB issues a new pronouncement
The company changes to a preferred method of GAAP
The cumulative effect of the change in method on all previous years’ income
is reported net-of-tax on a separate line on the income statement
Valuation Issues
Accounting data are important in determining the value of a company
The price-earnings (P-E) ratio is a useful valuation tool
“Value investors” believe that
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Low P-E stocks may be undervalued
High P-E stocks may be overvalued
“Growth investors” believe that high P-E stocks are likely to be growth
stocks
Valuation Issues
The price-earnings growth (PEG) ratio relates P-E ratios directly to
earnings growth rates
The earnings growth rate can be based on historical earnings, current
earnings, or forecasted earnings
Many analysts prefer a current P-E ratio and a forecasted 5-year earnings
growth rate
Valuation Issues
Some rules of thumb on using the PEG:
Relating Cash Flow and Net Income
Many valuation models use estimated cash flows rather than forecasted
earnings
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There are four possible combinations of positive and negative net income
and cash flow from operations:
Relating Cash Flow and Net Income
When these relationships persist over multiple periods, it implies (in each
case):
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A company has positive profitability
A growth company is incurring large depreciation charges
A company is either
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Rapidly growing and collections are lagging, or
Experiencing serious cash flow problems
Negative profitability is confirmed
Relating Cash Flow and Net Income
Analysts use the relationship between cash flow and net income as one
indicator of earnings quality
Earnings quality means that revenues are not recognized prematurely
and expenses are not deferred improperly
One ratio used to assess earnings quality is cash flow from operations
divided by net income (it should be consistently greater than 1)