Financial Statement Analysis

Lecture 1

Lecture 1 1
Purpose
Analysis
 To analyze the information in financial
reports in order to assess how well a business
is doing
Forecasting
 To project future performance based on past
and current performance and other available
information
Valuation
 To evaluate a company’s investment potential

Lecture 1 2
Role of Security Analysts
 Analysis, forecasting, valuation are the three
roles security analysts perform in capital
markets
 They analyze financial reports, and other
information like industry trends, product
markets, general economic information
 They forecast earnings, revenues, cashflows,
long-term growth
 They value investment potential and issue
stock recommendations (buy, hold, sell)

Lecture 1 3
Importance of FSA
 Financial reports are a primary source of
information
 Improper analysis could mislead investors
into making wrong investment decisions
 Analysts often differ in their interpretations
and recommendations. Why?
 Because they differ in ability
 Because they differ in how they analyze
information
 Because some aspects of analysis require
qualitative and subjective assessments. Examples?

Lecture 1 4
Two examples
 Hewlett Packard
HP delivers vital technology for business Current Jaywalk Latest
and life. The company's solutions span IT Consensus Report    
 
infrastructure, personal computing and
access devices, global services and
imaging and printing for consumers,
enterprises and small and medium
business. Our $3.5 billion annual R&D
investment fuels the invention of 2.45                                                                           

products, solutions and new technologies,

so that we can better serve customers and IRP Rating Distribution for HPQ

enter new markets. We invent, engineer

and deliver technology solutions that
drive business value, create social value

 
and improve the lives of our customers.
HP has a dynamic, powerful team of
150,000 employees with capabilities in 170
countries doing business in more than 40
currencies and more than 10 languages.                                                                     
Revenues were $79.9 billion for the fiscal
year that ended October 31, 2004.

Lecture 1 5
 Two examples
 Elan Corporation
Elan Corporation, plc is a Current Jaywalk Latest
Consensus Report     
neuroscience-based
biotechnology company
that is focused on
discovering, developing,
manufacturing and 3.08                                                                           

marketing advanced
IRP Rating Distribution for ELN
therapies in neurology,
autoimmune diseases,
and severe pain.

                                                                      

Lecture 1 6
Where do we start?
 Develop a systematic approach to understanding and
analyzing financial reports
 Just knowing how to prepare is not enough
 Need to understand accounting policies and procedures
 Need to understand managerial incentives
 Develop the necessary tools to evaluate financial
performance in conjunction with other information
such as industry trends, the nature of products and
product markets, firm strategy relative to
competition
 Are interested in building a “tool” kit

Lecture 1 7
FSA using a Five step approach
Step 1 Identify industry characteristics
Step 2 Identify company strategy
Step 3 Analyze financial statements
Step 4 Forecast future performance and
risk attributes
Step 5 Estimate firm value

Lecture 1 8
Step 1 Identify industry characteristics
 Nature of the product
 Good or a service
 Differentiated versus commodity product
 Product life cycle
 Diversity of product offerings
 Nature of technology
 Mix of human resources versus technology
 Capital intensity
 Level of R&D and product development required
 Nature of the Value chain
 Position in the value chain
 Value added by the company to the value chain
 Relative bargaining power in the value chain
Lecture 1 9
Step 1 Identify industry characteristics
 Nature of market
 Extent of competition
 Porter’s five forces
 Buyer power
 Supplier power
 Rivalry among existing firms
 Threat of new entrants
 Threat of substitute products
 Inherent demand attributes
 Primary versus derived demand
 Demand growth
 Seasonal/cyclical demand patterns
 Staple versus convenience/luxury item

Lecture 1 10
Problem 1.12
 Let us do problem 1.12 from the book.
 Can you match the firms to the
common-size financial statements?
 Some tips
 Use your knowledge about the industry
and the nature of the product. How would
you expect these to show up in
relationships between financial statement
elements?
Lecture 1 11
Problem 1.12 Some industry characteristics
For example:
 Financing Industry
 High proportion of receivables among its assets.
 Substantial borrowing in the capital structure.
 Service Industry
 Unlikely to have much inventory.
 The higher percentages for receivables and current liabilities
(indicate the agency nature of advertising firms).
 Restaurants:
 High inventory turn over.
 High receivables.
 High proportion of assets in property, plant and equipment

Lecture 1 12
Problem 1.12 Some industry
characteristics
 R&D Activities
 Report research and development (R&D) expenditures.
 These industries typically have significant R&D
expenditures for discovering new technologies or
developing new products
 Insurance Industry
 A high proportion of cash and marketable securities among
its assets.
 A high proportion of liabilities in its capital structure.
 There is high potential for low quality earnings.

Lecture 1 13
Problem 1.12 Some product characteristics
 Commodity products:
 High cost of goods sold to operating
revenues.
 Relatively low selling and administrative
expense percentage to consumer products.
 Consumer products:
 High profit margin.
 High selling and administrative expense.

Lecture 1 14
FSA using a Five step approach
Step 1 Identify industry characteristics
Step 2 Identify company strategy
Step 3 Analyze financial statements
Step 4 Forecast future performance and
risk attributes
Step 5 Estimate firm value

Lecture 1 15
Step 2 Identify company strategy
 Corporate strategy
 Criteria for corporate resource allocation
 Investment choice
 Across industry diversification
 Degree of vertical integration
 Degree of geographical diversification
 Business strategy
 Narrow product line or a diverse product line?
 Product differentiation strategy or a cost
leadership strategy

Lecture 1 16
Step 2 Identify company strategy
 Example: General Electric, Dell
 Products?
 Degree of industry diversification?
 Degree of geographical diversification?
 Degree of vertical integration?
 Business strategy?
 Degree of product diversity
 Product differentiation or cost leadership?

Lecture 1 17
 General Electric
 Product: A wide variety of products for the generation,
transmission, distribution, control and utilization of electricity.

 Degree of industry diversification:

 The Company operated in 11 segments which are in six
industry-focused businesses which are GE Infrastructure, GE
Industrial, GE Commercial Financial Services, GE NBC
Universal, GE Healthcare and GE Consumer Finance.

 Degree of vertical integration:

 Engaged in developing, manufacturing and marketing.

Lecture 1 18
 General Electronic
 Recent Activities:
1. GE acquired the commercial lending business of
Transamerica Finance Corporation.

2. GE acquired Australian Financial Investments Group.

3. GE completed the merger of NBC with Vivendi Universal

Entertainment LLLP.

4. GE Infrastructure completed the acquisition of InVision

Technologies, Inc. Also in December 2004, GE sold a
majority interest in Gecis.
Lecture 1 19
 Dell Inc.
 Product: Enterprise systems (servers, storage, workstations and
networking products), client systems (notebook and desktop computer
systems), printing and imaging systems, software and peripherals, and
global services.

 Degree of industry diversification: Not too much.

 Degree of geographical diversification:

 Regional headquarters include England, Europe, Middle East , Africa,
Singapore, Japan, India, China, Australia and New Zealand.
 The company manufactures its computer systems in seven locations:
Austin, Texas; Nashville, Tenn.; Winston-Salem, North Carolina;
Eldorado do Sul, Brazil (Americas); Limerick, Ireland (Europe, Middle
East and Africa); Penang, Malaysia (Asia Pacific and Japan) and Xiamen,
China (China). Dell sells its products and services worldwide.

Lecture 1 20
Dell Inc.
 Degree of vertical integration:
The company designs, develops, manufactures, markets, sells
and supports a range of products and services.
 Product Differentiation:
 The products and services enable customers to build their
information technology (IT) and Internet infrastructures.
 Dell offers a portfolio of services that help customers maximize
the value of their information technology investments, rapidly
deploy systems, and educate IT professionals and consumers.
 The Company also offers various financing alternatives, asset
management services and other customer financial services.

Lecture 1 21
FSA using a Five step approach
Step 1 Identify industry characteristics
Step 2 Identify company strategy
Step 3 Analyze financial statements
Step 4 Forecast future performance and
risk attributes
Step 5 Estimate firm value

Lecture 1 22
Step 3 Analyze financial statements
 Balance sheet
 Statement of financial position – a snapshot as of a particular date
 Asset portion reflects investment decisions
 Liability and shareholders’ equity portion reflects financing decisions

 Income statement
 Performance report
 The importance of the matching principle
 Earnings quality – How well does reported income convey a
company’s “true” performance?

 Statement of Cashflows
 Statement of sources and uses of cash
 Connects operating, investing and financing activities

Lecture 1 23
Balance sheet
 Assets
 Estimates of future economic benefits
 Could be monetary or non-monetary. Non-monetary assets stated at acquisition cost?
 Could be tangible or intangible
 Classified into current assets, investments, PP&E, Intangibles
 Some assets never make it to the balance sheet. Examples? How to deal with them in
valuation?

 Liabilities
 Future obligations
 Most liabilities monetary
 Some liabilities never make it on the balance sheet. Examples?

 Shareholders’ equity
 Residual claim of shareholders as of the balance sheet date.
 Is it a measure of the value of the company to shareholders? Why or why not?

Lecture 1 24
Income statement
 The capital market views income as an important measure of
performance for evaluation
 Accrual basis of accounting vs cash basis of accounting
 Revenue recognition and the matching principle
 Analysts look at different measures of income depending on the
nature of business, industry.
 Net income, EBITDA, EBIDA, NOPAT
 Income does not include some items that are relevant for
valuation – certain equity adjustments that do not relate directly
to operating performance
 Included directly in comprehensive income in shareholders’ equity
section
 Analysts have to assess the quality of earnings
 Managers (are said to) have incentives to manage earnings to
project their companies in the most favorable light!

Lecture 1 25
FSA using a Five step approach
Step 1 Identify industry characteristics
Step 2 Identify company strategy
Step 3 Analyze financial statements
Step 4 Forecast future performance and
risk attributes
Step 5 Estimate firm value

Lecture 1 26
Step 4 Forecast future performance and
risk attributes

 Forecast future performance

 Use of common size statements
 Project financial statement elements into
the future
 Assess risk

Lecture 1 27
Project financial statement elements
into the future
 Use past trends and industry comparisons
 Has the company exhibited steady earnings growth in the
past? Have other “peer” companies been able to do so?
 What trends do profitability ratios in the past reflect? Asset
turnover ratios? Inventory turnover
 What is the industry experience?
 Make assumptions about key financial ratios
 Liquidity ratios
 Profitability ratios
 Capital structure
 Project changes in financial statement elements

Lecture 1 28
Assess risk
 Earnings volatility
 Some companies exhibit more volatility in
performance than others
 Some industries are less stable than others
 Volatility imposes risk
 Inability to generate enough cashflows
to finance operations and growth
 High levels of debt in capital structure

Lecture 1 29
FSA using a Five step approach
Step 1 Identify industry characteristics
Step 2 Identify company strategy
Step 3 Analyze financial statements
Step 4 Forecast future performance and
risk attributes
Step 5 Estimate firm value

Lecture 1 30
Valuation models
 Based on forecasts, analysts decide what
recommendations to issue to the investment
community
 This involves deciding whether the current
market price is in line with the forecasts or
not.
 If the market is under-pricing a stock, then the
stock is a “bargain.”
 Ball and Brown study quoted in the book.
 The role of capital market efficiency.

Lecture 1 31
Lecture 1 32
Ball and Brown (1968) Study
 Their empirical study shows:
 On average, the firm announced an increase in
earnings experienced positive abnormal stock
returns.( roughly 7%).
 On average, the firm announced a decrease in
earnings experienced negative abnormal stock
returns. (roughly 9%).
 The results suggest that merely the sign of the
change in earnings is associated with a 16% stock
returns.

Lecture 1 33
Valuation models
 There are many valuation models and
techniques
 Dividend discount models
 Residual income models
 Free cash flow models
 Use of simple indicators such PE and PEG
ratios.
 We will cover these in chapters 11-14

Lecture 1 34