Steps in Financial Analysis ACCY 291 Financial Statement Analysis Steps in Financial Analysis

Steps in comprehensive financial analysis 1. BUSINESS STRATEGY Analysis 2. ACCOUNTING Analysis 3. FINANCIAL Analysis 4. PROSPECTIVE Analysis

Business Strategy Industry analysis and Competitive strategy analysis Understand the business and the firm. Accounting Evaluate accounting & financial reporting quality. Financial Evaluate past performance. Prospective Make forecasts and Value business.

BUSINESS STRATEGY Analysis An 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?

FINANCIAL Analysis PROSPECTIVE 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.

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

ACCY 291 Financial Statement Analysis Financial Analysis Preliminaries

Overview of a Firm from Financial Analysis standpoint i-freedebt Assets i-bearing debt OE Investment Financing Payoffs to the “capital providers” (Measure of “Profit” for the “enterprise”) Managers’ task? Investment Operating Financing Accounting

Payoffs to the capital providers i-free debt Assets i-bearing debt OE Payoffs to the “capital providers” Measured in accounting numbers is typically called ____________________ Measured in cash is typically called

NOPAT and Free Cash Flow 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.

Day-to-Day Performance Goals i-free debt Assets i-bearing debt OE 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___________

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?

Properties of NOPAT (Net Operating Profit After Tax) What is NOPAT? How different from net income?

NOPAT is after tax income that would have been obtained regardless of its capital structure Revenue 1000 CGS (500) other S&A expense (150) depreciation (50) Interest expense (100) Pretax income 200 tax expense (40%) (80) Net income 120 NOPAT can be computed either as EBIT(1- ) net income + interest expense (1- ) NOPAT if interest expense is 200, not 100? if interest expense is 0, not 100?

Properties of NOPAT 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-t) EBIT *(1- t) = Net Income + Interest expense*(1- t)

EBIT and NOPAT Definition for our discussions Financial assets ______ Income i-free debt ?_____ i-bearing debt Operating assets OE ______ Income Assets Some authors define NOPAT as one excluding interest income.

Income statements of CVS & Walgreens 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 Pretax Income 4,358.7 3,189.1 Income Taxes - Total 1,721.7 1,147.8 Minority Interest Income Before Extraordinary Items & Discontinued Op. 2,637.0 2,041.3 Extraordinary Items Discontinued Operations Net Income (Loss) NOPAT? ______________ using reported tax rate NOPAT? ______________ using “normal” tax rate