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Steps in Financial Steps in Financial AnalysisAnalysis

ACCY 291ACCY 291Financial Statement AnalysisFinancial Statement Analysis

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Steps in comprehensive financial analysis

1. BUSINESS STRATEGY Analysis

2. ACCOUNTING Analysis

3. FINANCIAL Analysis

4. PROSPECTIVE Analysis

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Accounting Evaluate accounting &financial reporting quality.

Financial

Evaluate past performance.

Prospective

Make forecasts and Value business.

Business StrategyIndustry analysis andCompetitive strategy analysis

Understand the business and the firm.

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BUSINESS STRATEGY AnalysisBUSINESS STRATEGY AnalysisAn effort to learn about the company’s product, strategy,

and operating environment. A qualitative analysis of profit drivers, profit potentials, and

the associated risk.

SWOT analysis can be useful

Know the Industry

Know the key players (leaders, followers, newcomers)

What is the source of competitive advantage/weakness?

What are Goals, Strategies, and Implementation history?

Where does the firm want to go? Is the goal achievable? Does the firm have a good track record?

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FINANCIAL Analysis

Quantitative evaluation of past performance,

Assessment of the status quo that is informative of the future.

PROSPECTIVE Analysis

Forecast of future financial statements.

Equity valuation.

What is involved is an empirical analysis where, we

Make informed guesses based on past data. Simplify complex numbers into simpler key

parameters.

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ACCOUNTING Analysis

Background

We use “Accrual Accounting” vs. ______ accounting.

What is an “accrual”? Key features? Outcome?

Accrual accounting system leads to…

Manager’s accounting and financial reporting discretion.

Manager’s financial reporting strategy.

Release of voluntary information Timing of the release of information

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Financial AnalysisFinancial AnalysisPreliminariesPreliminaries

ACCY 291ACCY 291Financial Statement AnalysisFinancial Statement Analysis

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Overview of a Firmfrom Financial Analysis standpoint

Assets

OE

i-bearing debt

Payoffs to the “capital providers”(Measure of “Profit” for the “enterprise”)

Managers’ task?

InvestmentOperatingFinancing

Accounting

Investment Financing

i-freedebt

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Payoffs to the capital providers

Assets

OE

i-bearing debt

Payoffs to the “capital providers”

Measured in accounting numbers is typically called

____________________

Measured in cash is typically called

____________________

i-free debt

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NOPAT (Net Operating Profit After Tax)

= Accounting profits for both debtholders and shareholders

= All sales, minus expenses payable to all parties except debtholders and shareholders.

Since debtholders and shareholders are combined into one class, this measure cannot be influenced by capital structure.

Free Cash Flow (FCF)

= Cash flows for both debtholders and shareholders

= All cash inflows, minus cash outflows to all parties except debtholders and shareholders.

NOPAT and Free Cash Flow

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Managers’ objective (in finance theory)?

Maximize ________________The market value of the enterprise is considered to be ____________________.

Practical period-by-period Performance Goals

(Typically relevant in conventional Ratio analysis)Maximize _____________While Minimizing____________ “Other things equal”

Together, they imply Maximizing___________

Day-to-Day Performance Goals

Assets

OE

i-bearing debt

i-free debt

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A Thought

If the firm’s value is present value of future free cash flows, then why do we bother with NOPAT in measuring the firm’s performance in any period?

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Properties of NOPAT(Net Operating Profit After Tax)

What is NOPAT?

How different from net income?

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NOPAT

is after tax income that would have been obtained regardless of its capital structure

Revenue 1000CGS (500)other S&A expense (150)depreciation (50)Interest expense (100) Pretax income 200tax expense (40%) (80)Net income 120

NOPAT can be computed either as

1. EBIT(1- )2. net income + interest expense (1- )

NOPAT if interest expense is 200, not 100?

NOPAT if interest expense is 0, not 100?

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Combined income payable to both the debt holders and the shareholders (the two are often called “capital providers”)

Cannot be affected by the amount of borrowing or borrowing rate.

Further caveats:

Definition of NOPAT can be different for different people. NOPAT cannot be pulled out from income statement. It

needs to be computed. NI= (EBIT- Interest expense)*(1-) EBIT *(1- ) = Net Income + Interest expense*(1- )

Properties of NOPAT

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EBIT and NOPATDefinition for our discussions

Assets

OE

i-bearing debt

i-free debt

Operating assets

Financial assets______ Income

______ Income

?_____

Some authors define NOPAT as one excluding interest income.

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Income statements of CVS & Walgreens

NOPAT? ______________ using reported tax rateNOPAT? ______________ using “normal” tax rate

Fiscal Year Ending Dec-07 Aug-07

Sales (Net) 76,329.5 53,762.0

Cost of Goods Sold 60,221.8 38,518.1

Gross Profit 16,107.7 15,243.9

Selling, General, & Admin Expenses 10,219.8 11,417.3

Operating Income Before Depreciation 5,887.9 3,826.6

Depreciation, Depletion, & Amortization 1,094.6 675.9

Operating Income After Depreciation 4,793.3 3,150.7

Interest Expense 468.3 0.0

Non-Operating Income/Expense 33.7 38.4

Special Items 0.0 0.0

Pretax Income 4,358.7 3,189.1

Income Taxes - Total 1,721.7 1,147.8

Minority Interest 0.0 0.0

Income Before Extraordinary Items & Discontinued Op. 2,637.0 2,041.3

Extraordinary Items 0.0 0.0

Discontinued Operations 0.0 0.0

Net Income (Loss) 2,637.0 2,041.3