essentials of financial statement analysis

Essentials of Financial Statement

Analysis

Revsine/Collins/Johnson: Chapter 5

2RCJ: Chapter 5 © 2005

Learning objectives

1. How competitive forces and business strategies affect firms’ financial statements.

2. Why analysts worry about accounting quality.

3. How return on assets (ROA) is used to evaluate profitability.

4. How ROA and financial leverage combine to determine a firm’s return on equity (ROE).

5. How short-term liquidity risk and long-term solvency risk are assessed.

6. Why EBITDA can be a misleading indicator of profitability and cash flow.


Financial statement analysis:Tools and approaches

Tools: Approaches used with each tool:

1. Time-series analysis: the same firm over time (e.g., Wal-Mart in 2005 and 2006)

Common size statements

Trend statements

Financial ratios(e.g., ROA and ROE)

2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2005).

3. Benchmark comparison: using industry norms or predetermined standards.


Evaluating accounting “quality”

Analysts use financial statement information to “get behind the numbers”.

However, financial statements do not always provide a complete and faithful picture of a company’s activities and condition.


How the financial accounting “filter” sometimes works

GAAP puts capital leases on the balance sheet, but operating leases are “off-balance-sheet”.

Managers have some discretion over estimates such as “bad debt expense”.

Managers have some discretion over the timing of business transactions such as when to buy advertising.

Managers can choose any of several different inventory accounting methods.


Evaluating accounting “quality”:The message for analysts

The first step to informed financial statement analysis is a careful evaluation of the quality of a company’s reported accounting numbers.

Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices.

Only then can you truly “get behind the numbers” and see what’s really going on in the company.


Getting behind the numbers:Krispy Kreme Doughnuts, Inc.

Established in 1937.

Today has more than 290 doughnut stores (company-owned plus franchised) throughout the U.S.

Serves more than 7.5 million doughnuts every day.

Strong earnings and consistent sales growth.

Revenue sources in 2002

65%

31%

4%

0%

10%

20%

30%

40%

50%

60%

70%

Compnaystores

Sales tofranchisees

Royalties


Krispy Kreme’s Financials:Comparative Income Statements

Includes a $9.1 million charge to settle a business dispute

Includes a $5.733 million after-tax special charge for business dispute


Krispy Kreme’s Financials:Common size income statements

$393.7 operation expenses

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


Krispy Kreme’s Financials:Tend income statements

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

$393.7 operating expenses in 2002

$194.5 operating expenses in 1999


Krispy Kreme’s Financials:Business segment information


Sell flour mix, doughnut making equipment, and supplies to franchised stores


Krispy Kreme’s Financials:Business segments (common size)



Krispy Kreme’s Financials:Balance sheet assets


Krispy Kreme’s Financials:Common size assets

$3.2 cash $105.0 assets


Krispy Kreme’s Financials:Trend assets

$7 cash in 2000

$3.2 cash in 1999


Krispy Kreme’s Financials:Balance sheet liabilities and equity


Krispy Kreme’s Financials:Common size liabilities and equity

$13.0 accounts payable

$105.0 total liabilities and

equity


Krispy Kreme’s Financials:Trend liabilities and equity

$8.2 accounts payable in 2000

$13.1 accounts payable in 1999


Krispy Kreme’s Financials:Abbreviated cash flow statements


Krispy Kreme’s Financials:Common size cash flow statements

$93.9 capital expenditures

$491.5 sales


Krispy Kreme’s Financials:Trend cash flow statements

$93.9 capital expenditures in 2002

$10.5 capital expenditures in 1999


Krispy Kreme analysis:Lessons learned

1. Informed financial statement analysis begins with knowledge of the company and its industry.

2. Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes are easily recognized.

3. Financial statements help analysts gain a sharper understanding of the company’s economic condition and its prospects for the future.


Financial ratios and profitability analysis

Return on assets

Asset turnover

Operating profit margin

NOPAT is net operating profit after taxes

Analysts do not always use the reported earnings, sales and asset figures. Instead, theyoften consider three types 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).

ROA= NOPAT Average assets

NOPAT Sales

Sales Average assets

X


Calculating ROA for Krispy Kreme

Eliminate nonrecurring items

Eliminate interest expense

Effective tax rate


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



ROA, margin and turnover:An example

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.


Krispy Kreme:ROA decomposition

How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over this period?


Further decomposition of ROA


Asset turnover

ROA

Sales Average assets

X

NOPAT Sales

=


ROA and competitive advantage:Krispy Kreme

Wendy’s, Baja Fresh, Café Express

S&P industry survey or other sources


ROA and competitive advantage:Four hypothetical restaurant firms

Competition works to drive down ROA toward the competitive floor.

Companies that consistently earn an ROA above the floor are said to have a competitive advantage.

However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage.

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).

Competitive ROA floor


Credit risk and capital structure:Overview

Credit risk refers to the risk of default by the borrower.

The lender risks losing interest payments and loan principal.

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.

A company’s willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment.


Credit risk and capital structure:Balancing cash sources and needs


Credit risk:Short-term liquidity ratios

Short-termliquidity

Activityratios

Liquidityratios

Current ratio =Current assets

Current liabilities

Quick ratio =Cash + Marketable securities + Receivables

Current liabilities

Accounts receivable turnover =Net credit sales

Average accounts receivable

Inventory turnover =Cost of goods sold

Average inventory

Accounts payable turnover =Inventory purchases

Average accounts payable


Credit risk:Operating and cash conversion cycles

Working capital ratios:

Days accounts receivable outstanding =365 days

Accounts receivable turnover

Operating cycle 75 days

45 days

30 days

Days accounts payable outstanding =365 days

Accounts payable turnover

( 20 days)

Cash conversion cycle 55 days

Days inventory held =365 days

Inventory turnover


Credit risk:Operating and cash conversion cycle example


Credit risk:Short-term liquidity at Krispy Kreme


Credit risk:Long-term solvency

Long-termsolvency

Coverageratios

Debt ratios

Long-term debt to assets =Long-term debt

Total assets

Long-term debt to tangible assets =Long-term debt

Total tangible assets

Interest coverage =Operating incomes before taxes and interest

Interest expense

Operating cash flow to total liabilities

Cash flow from continuing operations

Average current liabilities + long-term debt=


Credit risk:Long-term solvency at Krispy Kreme


Credit risk:Financial ratios and 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.

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.

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

Source: Moody’s Investors Service (May 2000)


Default frequency:Return on assets (ROA)


Profitability: Return on Assets Percentiles (excludes extraordinary items)


Default frequency:Debt-to-tangible assets and interest coverage


Solvency: Debt-to-Tangible Assets and Interest Coverage Percentiles


Default frequency:Quick ratio


Liquidity: Quick Ratio Percentiles


Return on equity and financial leverage

2005: No debt, so all the earnings belong to shareholders.

2006: $1 million borrowed at 10% interest, but ROCE climbs to 20%.

2007: Another $1 million borrowed at 20% interest, and ROCE falls to only 15%.


Components of ROCE

Return on commonequity (ROCE)

Return on assets (ROA)

Common earnings leverage

Financial structure leverage

Net income available to common shareholders

Average common shareholders’ equity

NOPAT

Average assets

Net income available to common shareholders

NOPAT

Average assets

Average common shareholders’ equity

X

X


Profitability and financial leverage:Nodebt and Hidebt example

Leverage helpsLeverage helps

Leverage neutral

Leverage hurts

Leverage neutral


Financial statement analysis and accounting quality

Financial ratios, common-size statements, and trend statements are extremely powerful tools.

But they can be no better than the data from which they are constructed.

Be on the lookout for accounting distortions when using these tools. Examples include:

Nonrecurring gains and losses

Differences in accounting methods

Differences in accounting estimates

GAAP implementation differences

Historical cost convention


Financial statement analysis:Pro forma earnings at Amazon.com

Company defined numbers

Computed according to GAAP


Why do firms report EBITDA and “pro forma” earnings?

Impression management is the answer.

Help investors and analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked.

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.

Analysts should remember:

1. There are no standard definitions for non-GAAP earnings numbers.

2. Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability.

3. EBITDA and pro forma earnings do not accurately measure firm cash flows.


GAAP earnings, pro forma earnings, and EBITDA


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.

essentials of financial statement analysis

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