Credit Analysis Equity Analysis Financial Analysis Credit Analysis Equity Analysis

Creditors What is the borrowing cause? What is the firm’s capital structure? What will be the source of debt repayment?

Credit Rating Business Risk Financial Risk Industry characteristics Company position Management Financial Risk Financial characteristics Financial Policy Profitability Capital Structure Cash Flow Protection Financial flexibility

Standard & Poor’s rating method EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt % Free operating cash flow/Total debt % Return on capital % Operating income/Sales Long-term debt/Capital Total debt/Capital

Standard and Poors Corporate Ratings

Financial distress The deterioration in a company’s financial condition such that its ability to repay debt is impaired

Prediction of financial distress Univariate models Beaver (1966) relied on Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio No-credit (defensive) interval

Prediction of financial distress Multivariate models Altman Z-score (Current assets – current liabilities)/total assets (weight-1,2) Retained earnings/Total assets (weight-1,4) EBIT/Total assets (weight-3,3) Preferred and common stock market value/Book value of liabilities (weight-0,6) Sales/Total assets (weight-1,0)

Altman Z-score Z> 2,99  Not in financial distress Z< 1,81  In financial stress 2,99>Z>1,81 Uncertain

Altman Z score Anadolu Cam

Additional considerations Mezzanine items Could be debt or equity Off-balance-sheet liabilities Operating leases Contingent liabilities Environmental liabilities

Equity Analysis Buy-side Sell-side Work for an institutional investors (mutual fund) Make internal recommendations regarding the purchase of equity securities Might review reports of sell-side analysts Sell-side Work for brokerage firms Issue reports for retail and institutional customers

Valuation Current value V0 is a function of Present value of next year’s cash flow, CF1 Required rate of return, r Expected constant growth rate, g

Provides information regarding Equity Analysis Provides information regarding The future cash flow generating ability of the firm The growth (or lack thereof) of those cash flows The risk of those cash flows, and The risk-free rate commanded by the market

Top-Down Analysis Begin at highest (economy) level Market sectors Allocation between domestic and international equities Market sectors Industries (within a sector) End with evaluation of specific companies

Bottom-Up Analysis Begin with individual companies Look for key strengths Screen large data bases for attractive characteristics Compustat, Bloomberg, Baseline Search for a combination of characteristics

Macroeconomic Analysis Gross Domestic Product (GDP): total value of all final goods and services produced within a country. Nominal, measured in current dollars Real, adjusted for changing prices Gross National Product (GNP): total value of all final goods and services produced by factors of production owned by citizens of a country regardless of production location Growth rates of both can be used as an initial estimate of a firm’s growth rate

Business Cycle Expansion Peak – high point following expansion Period of economic growth Increased need for PP&E, labor, inventory Peak – high point following expansion Recession Contraction following a peak Rising unemployment, decreased need for factors of production Two quarters of falling real GDP

Business Cycle Trough – low point following recession Depression Prolonged and severe recession Some sectors and industries will perform better in some stages of the cycle than in others. Cyclical firms are sensitive to stages of the economic cycle.

Inflation Consumer Price Index (CPI) measures inflation of a market basket of consumer goods Producer Price Index (PPI) measures inflation at the wholesale level Higher inflation, higher required risk-free rate of interest Impacts all companies and all industries (to varying degrees)

Economic Indicators Leading indicators Lagging indicators Move in advance of the business cycle Unemployment claims, new orders Lagging indicators Follow behind the business cycle Average duration of unemployment, average prime rate Coincident indicators Move with the business cycle Industrial production

Sector/Industry Analysis Assess the ability of companies within the industry to generate cash flow Assess the potential growth of that cash flow Assess the risks related to receipt of those cash flows Assess the industry’s ability to grow relative to the overall economy

Porter’s 5 Competitive Forces that determine industry profitability Threat of New Entrants - Capital requirements, government policy, access to distribution Bargaining Power of Suppliers - Supplier concentration, switching costs, differentiation of inputs 3. Bargaining Power of Buyers - Buyer concentration, price sensitivity, brand identity 4. Threat of Substitute Products or Services 5. Rivalry Among Existing Firms - Industry growth, barriers to exit, current industry concentration

Company Analysis Understand the business Evaluate past performance Forecast performance Value the company Make an investment recommendation

Understanding the Business Gain an understanding of the products and services provided by the company and the market for those products and services Talk to employees, suppliers, competitors Interview customers Utilize the company’s products or services

Evaluating Past Performance Understand reported financial information Common size and ratio analysis Consider efficiency, liquidity, solvency, cash flow and relative valuation Understand US GAAP and IAS Financial reporting quality and conservatism

Forecasting Performance Based on evaluation of past performance, economic/industry conditions and expected changes Pro-forma (projected) financial statements Projection of future earnings Use earnings model or statistical projection

Valuing the Company Determine the appropriate price for making an equity investment Is the intrinsic value higher or lower than the current market price? Specific methods Discounted cash flow Market-multiple Residual income

Making an Investment Recommendation Current price of subject company’s securities Results of valuation Risks of investment Investor’s risk tolerance, objectives and time horizon Buy/Attractive Hold/Market Perform Sell/Market Under perform

Five Steps of a Financial Statement Analysis Establish objectives of the analysis Who are you and why are you interested in this company? What questions would you like to have answered? What info is vital to the decision at hand?

Five Steps of a Financial Statement Analysis (cont.) Study the industry in which the firm operates and relate industry climate to current and projected economic developments

Five Steps of a Financial Statement Analysis (cont.) Develop knowledge of the firm and the quality of management How well does this firm appear to be run? Are they taking advantage of opportunities? Are they innovative, forward-looking, etc?

Five Steps of a Financial Statement Analysis (cont.) Evaluate financial statements–tools include: Common-size financial statements Key financial ratios Trend analysis Structural analysis Comparison with industry competitors

Five Steps of a Financial Statement Analysis (cont.) Evaluate financial statements–areas include: Short-term liquidity Operating efficiency Capital structure and long-term solvency Profitability Market ratios Segmental analysis (when relevant) Quality of financial reporting

Five Steps of a Financial Statement Analysis (cont.) Summarize findings based on analysis Reach conclusions about the firm relevant to your established objectives

What we have accomplished Turned Maze Auditor’s Report MD&A Notes Statement of Cash Flows Income Statement Statement of Shareholders’ Equity Balance Sheet

Financial Statements An Overview Map