1. Chapter 5: Essentials of Financial Statement Analysis
Learning objectives
Essentials of financial statement analysis, financial statement analysis tools and approaches.
How ROA is used to analyze profitability and the insight to separate ROA to profit margin and asset turnover rate.
How ROA and financial leverage combine to determine a firm’s return on equity (ROCE).
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2. Learning objectives (contd.)
Capital structure and credit risk: How short-term liquidity risk and long-term solvency risk are assessed and how to use the statement of cash flows to assess credit risk.
Why do companies issue pro forma earnings?
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3. Qualitative Characteristics of Accounting Information:
How do we define financial reporting quality?
Qualitative characteristics of accounting Information:
Understandability
Decision usefulness
Reliability
Relevance
Consistency
Comparability

4. Attributes of High Quality Financial Reporting
Financial reporting (earnings) quality has been considered positively associated with the following:
High persistence of earnings and cash flows
High predictive ability of earnings and cash flows
High earnings response coefficient
Low level of earnings management
More voluntarily disclosure
Strong corporate governance

5. Manipulating Income and Earnings Management
Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1
Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.
“Most managers prefer to report earnings that follow a smooth, regular, upward path.”2
1. Arthur Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.

6. What should the users be aware of ?
Statement users must:
Understand current financial reporting settings and standards.
Recognize that management may manipulate the financial information.
Distinguish between reliable financial statement information and poor quality information.

7. Financial statement analysis and accounting quality
The accounting distortions need to be watched when analyzing statements. Examples include:
1. Nonrecurring gains and losses
2. Differences in accounting methods.
3. Differences in accounting estimates.
4. GAAP implementation differences.
5. Historical cost convention.

8. Essentials of Financial Statement Analysis
Learning Objective:
Essentials of Financial Statement Analysis

9. Analysis, Forecast and Vulation Procedures
Reviewing the Financial Statements:
Review comparative financial statements and audit opinion.
Adjusting and forecasting accounting numbers:
Adjusting accounting numbers to remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income.

10. Analysis Common size statements. Trend statements
Assessing Profitability and Creditworthiness:
Common size statements.
Trend statements
Financial ratio analysis: Use ratios to assess liquidity, profitability and solvency.
Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default.

11. Forecast and Valuation
Comprehensive Financial statement forecasts (see Appendix B of Chapter 6 )
Valuing Equity Securities (see Appendix A of Chapter 6):
a. Free cash-flow model
b. Abnormal earnings model (residual income model).

12. Essentials of Financial Statement Analysis
Step 1: To be informed that financial statement analysis is a careful evaluation of the quality of a company’s reported accounting numbers.
Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices.
Only then you can truly “ get behind the numbers” and see what’s really going on the
Company.

13. 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.
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14. Financial statement analysis: Tools and approaches
Approaches used with each tool:
Time-series analysis: the same firm over time (e.g., Wal-Mart in 2008 and 2006)
Common size statements
Trend statements
2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2008).
Financial ratios
(e.g., ROA and ROCE)
3. Benchmark comparison: using industry norms or predetermined standards.
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15. Financial analysis tools
Comparative Financial statements: Statements are compared across years.
Common-size statements: Recast each statement item as a percentage of a certain item.
Trend statements: Recast each statement item in percentage of a base year number.
Financial ratios.

16. Basic Approaches
Time-series analysis : Identify financial trends over time for a single company.
Cross-sectional analysis: Identify similarities and differences across companies at a single moment in time.
Benchmark comparison: measures a company’s performance against some predetermined standard.

17. Getting behind the numbers: Case Study: 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.

18. Comparative Income Statements: Krispy Kreme’s Financials
Systemwide sales
Include sales from company owned and franchised stores.
Includes a $5.733 million after-tax special charge for business dispute
Includes a $9.1 million charge to settle a business dispute
Sales increased from $220.2 million in 1999 to $491.5 million in 2002.
Net income increased from $6 million in 1999 to $33.5 million in 2002.

19. Common Size Income Statements: Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Income Statements
$393.7 operation expenses
$491.5 sales
* Not adjusted for distortions caused by “special items”.
Each statement item is computed as a percentage of sales.

20. Trend Income Statements: Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Income Statement
Base Year
$393.7 operating expenses in 2002
$194.5 operating expenses in 1999
* Not adjusted for distortions caused by “special items”.
Each statement item is calculated in percentage terms using a base year number.

21. Comparative Balance Sheets Assets Krispy Kreme’s Financials: Balance Sheet Assets

22. Common Size Assets Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to assets
$3.2 cash
$105.0 assets
Each statement item is computed as a percentage of Total assets.

23. Trend Assets Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet assets
$7 cash in 2000
$3.2 cash in 1999
Each statement item is calculated in percentage terms using a base year number.

24. Comparative Balance Sheets Liability and Equity: Krispy Kreme’s Financials

25. $105.0 total liabilities and equity
Common Size Liabilities and Equity: Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Balance sheet liabilities and equity
$13.1 accounts payable
$105.0 total liabilities and equity
Each statement item is computed as a percentage of Total liabilities and equity.

26. Trend Liabilities and Equity Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Balance sheet liabilities and equity
$8.2 accounts payable in 2000
$13.1 accounts payable in 1999
Each statement item is calculated in percentage terms using a base year number.

27. Krispy Kreme’s Financials: Abbreviated cash flow statements

28. $93.9 capital expenditures
Common Size Cash Flow Statements: Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement) to Cash Flow Statements
$93.9 capital expenditures
$491.5 sales
Each statement item is computed as a percentage of Sales.

29. Trend Cash Flow Statements Krispy Kreme’s Financials: Apply the analysis tool (Trend statement) to Cash Flow Statements
$93.9 capital expenditures in 2002
$10.5 capital expenditures in 1999
Each statement item is calculated in percentage terms using a base year number.

30. Krispy Kreme analysis: Lessons learned
Informed financial statement analysis begins with knowledge of the company and its industry.
Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes are easily recognized.

31. Krispy Kreme analysis: Lessons learned
Common-size and trend statement techniques can be applied to all financial statements and every section of statements.
Financial statements help analysts gain a sharper understanding of the company’s economic condition and its prospects for the future.

32. Profitability Analysis
Learning Objective:
Profitability Analysis

33. Financial ratios and profitability analysis
Operating profit margin
EBI
Sales
Return on assets
ROA=
EBI
Average assets X
Asset turnover
Sales
Average assets
NOPAT is net operating profit after taxes
Analysts do not always use the reported earnings, sales and asset figures.
Instead, they often consider three of adjustments to the reported numbers:
Remove non-operating and nonrecurring items to isolate sustainable operating profits.
Eliminate after-tax interest expense to avoid financial structure distortions.
Eliminate any accounting quality distortions (e.g., off-balance operating leases).

34. Calculating Return on Assets
Eliminate nonrecurring items
Eliminate interest expense
Effective tax rate

35. How can ROA be increased?
There are just two ways:
Increase the operating profit margin, or
Increase the intensity of asset utilization (turnover rate).
Asset turnover
ROA=
EBI
Average assets
EBI
Sales
Sales
Average assets
Operating profit margin
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36. ROA, margin and turnover examples:
A company earns $9 million of EBI 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 EBI becomes $10.

37. ROA Decomposition and Analysis1. 2
How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over this period?
The expanded store base, along with increased sales, allowed the fixed costs be spread over a number of stores- The result was in an improved operating profit margin.
However, the asset based was considerably less productive in 2002 ( Asset turnover is 1.48) than it was in 1999 ( Asset turnover is 2.22) – More stores meant more resources ( assets) tied up operating cash, receivables, etc.

38. Further decomposition of ROA
Correspond to the common-size
Income statement items
Operating profit
margin
NOPAT
Sales
ROA = X
Sales
Average assets
Asset turnover

39. Usages of Decomposition of ROA
The profit margin components can help the analyst identity areas where cost reductions have been achieved or where cost improvements are needed.
The current asset turnover ratio helps the analyst spot efficiency gains from improved accounts receivable and inventory management.
The long-term asset turnover ratio captures information about property, plant, and equipment utilization.

40. ROA and competitive advantage: Krispy Kreme
Wendy’s, Baja Fresh, Café Express
S&P industry survey or other sources
Q: What was the key to Krispy Kreme’s success in 2002 ?
Answer: Krispy Kreme outperformed the competition by generating more sales per
asset dollar.

41. ROA and competitive advantage: Four hypothetical restaurant firms
Companies that consistently earn an ROA above the floor. (e.g., Firm C)
However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage. Competition works to drive down ROA toward the competitive floor.
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

42. Components of ROCE
Return on assets (ROA)
NOPAT
Average assets
Return on common
equity (ROCE) X
Common earnings leverage
Net income available to common shareholders
Average common shareholders’ equity
Net income available to common shareholders
NOPAT
Net income available to common shareholders = Net income – preferred dividends X
Financial structure leverage
Average assets
Average common shareholders’ equity
ROCE= ROA * Common earnings leverage* Financial Structure leverage

43. Return on equity and financial leverage
Unchanged – because of Financial leverage
2005: No debt; all the earnings belong to shareholders.
2006: $1 million borrowed at 10% interest; ROCE climbs to 20%.
2007: Another $1 million borrowed at 20% interest; ROCE falls to only 15%.

44. Return on Equity and financial leverage
Financial leverage is beneficial only when the company earns (i.e., ROA) more than the incremental after-tax cost of debt.
If the cost of debt is greater than the earnings, increased leverage will harm shareholders.

45. Return on Equity and financial leverage (contd.)
The advantage of debt financing is the tax deduction on interests.
The disadvantage is the increase of the bankruptcy risk.
Both the cost of debt and the bankruptcy probability need to be considered in determining the capital structure.
It is hard to determine the optimal mix of capital and debt.

46. Profitability and financial leverage: Case Study
Leverage helps
Leverage neutral
Leverage helps
Leverage hurts
Leverage neutral

47. Learning Objective:
Capital structure and
Assess Credit Risk

48. Credit risk and capital structure: Overview
Credit risk refers to the risk of default by the borrower.
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.
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.

49. Credit risk and capital structure: Balancing cash sources and needs
The cash flow statements contain information enabling a user to assess a
Company’s credit risk, financial ratios are also useful for this purpose.

50. Traditional lending products
Short-term loans:
Seasonal lines of credit
Special purpose loans (temporary needs)
Secured or unsecured
Revolving loans
Like a seasonal credit line
Interest rate usually “floats”
Long-term loans:
Mature in more than 1 year
Purchase fixed assets, another company, Refinance debt ,etc.
Often secured
Public Debt
Bonds, debentures, notes
Special features: Sinking fund and call provisions

51. Evaluating the borrower’s ability to repay
Step 1:
Understand
the business
Business model and strategy
Key risks and successful factors
Industry competition
Evaluate
accounting quality
Step 2:
Spot potential distortions
Adjust reported numbers as needed
Evaluate current
profitability and health
Step 3:
Examine ratios and trends
Look for changes in profitability, financial
conditions, or industry position.
Prepare “pro forma”
cash flow forecasts
Step 4:
Develop financial statement forecasts
Assess financial flexibility
Due diligence
Step 5:
Kick the tires
Comprehensive risk
assessment
Step 6:
Likely impact on ability to pay
Assess loss if borrower defaults
Set loan terms

52. Credit risk: Short-term liquidity ratios
Including Inventory
Current ratio =
Current assets
Current liabilities
Very immediate
liquidity
Liquidity
ratios
Quick ratio =
Cash + Marketable securities + Receivables
Current liabilities
Short-term
liquidity
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
Activity
ratios
Activity ratios tell us
How efficiently the company is using its assets.
Liquidity refers to the company’s short-term ability to generate cash for working
Capital needs and immediate debt repayment needs.

53. Receivables Turnover Ratio and collection period
Net Sales
Average Accounts Receivable
Receivables
Turnover
Ratio =
This ratio measures how many times a company converts its receivables into cash each year.
Average Collection Period
365
Receivables Turnover Ratio
Average Collection Period =
This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 48 48

54. Inventory Turnover Ratio and Average Days in Inventory
Cost of Goods Sold
Average Inventory
Inventory
Turnover
Ratio =
This ratio measures the number
of times merchandise inventory
is sold and replaced during the year.
Average Days in Inventory
365
Inventory Turnover Ratio
Average Days in Inventory =
This ratio indicates the number
of days it normally takes to sell inventory. 50 50

55. Credit risk: Operating and cash conversion cycles
Working capital ratios:
Days accounts receivable outstanding =
365 days
Accounts receivable turnover
45 days
(Days before cash is collected from the customer)
Operating cycle 75 days
Days accounts payable outstanding =
365 days
Accounts payable turnover
( 20 days)
Cash conversion cycle 55 (75-20) days
Days inventory held =
365 days
Inventory turnover
30 days
( Days that suppliers are paid after inventory is purchased)
Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).

56. Credit risk: Long-term solvency
Including
Intangible assets
Long-term debt
Long-term debt to assets =
Total assets
Debt ratios
Long-term debt
Long-term debt to tangible assets =
Total tangible assets
Long-term
solvency
Operating incomes before taxes and interest
Interest coverage =
Interest expense
Coverage
ratios
Operating cash flow to total liabilities
Cash flow from continuing operations =
Average current liabilities + long-term debt
Solvency refers to the ability of a company to generate a stream of cash inflows sufficient to maintain its productive capacity and still meet the interest and principal payment on its long-term debt.

57. Credit risk of Krispy Kreme : Short-term liquidity and Long-term solvency

58. Credit risk: 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.
Source: Moody’s Investors Service (May 2000)
Default rates by Moody’s credit rating,

59. Financial Ratios and Default Risk Return on assets (ROA)
ROA and probability of default is negatively associated.
Profitability: Return on Assets Percentiles (excludes extraordinary items)
Source: Moody’s Investors Service (May 2000)

60. Financial Ratios and Default Risk Quick Ratio
Quick Ratio and probability of default is negatively associated.
Liquidity: Quick Ratio Percentiles
Source: Moody’s Investors Service (May 2000)

61. Credit analysis: Case Study: G.T. Wilson’s credit risk
A bank client for over 40 years.
Owns 850 retail furniture stores throughout the U.S.
Increased competition and changing consumer tastes caused the following changes in Wilson’s business strategy:
Expand product line to include high quality furniture, consumer electronics, and home entertainment systems.
Develop a credit card system to help customers pay for purchases.
Open new stores in suburban shopping centers and close unprofitable downtown stores.

62. Credit analysis: Case Study: G.T. Wilson’s credit risk
Bank now has a $50 million secured construction loan and a $200 million revolving credit line which is up for renewal with Wilson.
What do the Wilson’s financial statements tell us about its credit risk?
Should the bank renew Wilson’s $200 million credit line?

63. Credit Analysis: Interpretation of cash flow components.
Negative free cash flow
Increased borrowing
Continued dividend payment

64. Credit Analysis : Selected financial statistics
Declining margin
Customers take longer to pay, but reserve is smaller
Larger debt burden

65. Credit analysis: Recommendation
Wilson is a serious credit risk:
Inability to generate positive cash flows from operations.
Extensive reliance on short-term debt financing.
The company may be forced into bankruptcy unless:
Other external financing sources can be found.
Operating cash flows can be turned positive.
Update: Bankruptcy was declared shortly after these financials were released.

66. Learning Objective:
Pro Forma Earnings

67. Pro Forma Earnings
Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings.
Pro forma earnings are management’s assessment of permanent earnings.

68. Pro Forma Earnings
Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference calls, and in annual reports.
The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP.

69. Sometimes it is called “ adjusted earnings’.
Financial statement analysis: Non-GAAP earnings: Pro forma earnings and EBITDA
Many companies today are highlighting a non-GAAP earnings in press releases, in analyst conference call, and in annual reports.
Sometimes these earnings figures are called EBITDA ( earnings before interest, income taxes, depreciation, and amortization)
Sometimes it is called “ adjusted earnings’.
Sometimes it is called “ pro forma earnings”.

70. Financial statement analysis: Pro forma earnings at Amazon.com
Company defined numbers
Computed according to GAAP

71. When use the EBITDA or “pro forma” earnings, analysts should remember:
There are no standard definitions for non-GAAP earnings numbers.
Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability.
EBITDA and pro forma earnings do not accurately measure firm cash flows.

72. Why do firms report EBITDA and “pro forma” earnings?
Help investors and analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked.
Pro forma earnings could 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.

73. 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.

74. Summary of financial statement analysis How to use financial ratios
Profitability:
ROA ( Return on assets)
Operating Profit Margin
ROCE ( Return on common stockholder’s equity)
Market Measures:
Earnings per share (EPS)
Price/ earnings ( Market price of common stock/ EPS)
Dividend payout ( Dividends per share/ EPS)
Dividend yield ( Dividends per share/ Market price of common stock)

75. Summary of financial statement analysis How to use financial ratios
Liquidity ( Evaluate short-term credit risk)
- Liquidity ratios: Current ratio and quick ratio
- Liquidity of working capital : Average collection period, Days inventory held, days payable outstanding, operating cycle days, cash conversion cycle, etc.
- Operating Efficiency ( Activity ratios)
Accounts receivable turnover
Inventory turnover
Accounts payable turnover

76. Summary of financial statement analysis How to use financial ratios
Solvency ( Evaluate long-term credit risk)
Coverage ratios: interest coverage, operating cash flows to total liabilities
Debts ratios:
Debt/ Assets
Debt/ equity (Total liabilities/ Stockholders’ equity)

77. Whole Foods Market, Comparative Income Statement
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78. Common Size statements
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79. Business Segment information
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80. Comparative Balance Sheet
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81. Comparative Balance Sheet
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82. Common size and trend analysis
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83. Common size and trend analysis (Exhibit 5.5 continued)
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84. Common size and trend analysis
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85. Common size and trend analysis (Exhibit 5.6 continued)
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86. Comparative Cash Flows
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87. Common size trend analysis
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