What is Financial Analysis?

Defining Financial Analysis

• Financial analysis is the process of
evaluating financial and other information
for decision-making.
• A six-step approach is suggested for
systematic financial analysis.
 Six-step Process
• Identify purpose of financial analysis
• Corporate overview
• Financial analysis techniques
• Detailed accounting analysis
• Comprehensive analysis
• Decision or recommendation
 Corporate Overview
• Industry analysis--key economic
characteristics, historical context, profit
drivers, business risks
• Firm’s business strategy--competitive
strategy given the industry characteristics
 Industry Analysis
• Competition--growth rates, concentration
ratios, degree of product differentiation,
economies of scale (& relative fixed &
variable costs), substitute products
• Legal barriers--patent & copyrights,
licensing, regulation
• bargaining power of buyers (& suppliers) &
price sensitivity
 Industry Analysis Criteria
• What is the industry?
• Relative size & significance
• Largest companies
• Geographic presence
• Business cycle effects, current situation
• Future potential
 Business Strategy
• Cost leadership: low cost producer,
economies of scale, efficient production,
low input prices
• Product differentiation: specific attributes
that customers value (e.g., quality, variety,
service, delivery time), brand name
• Importance of core competencies
 Business Strategy Criteria
• Historical perspective
• Primary focus of operations
• Most important strategy
• Major operating segments
• Corporate outlook/ forecast
 Qualitative Analysis--Dell
Computer
• Industry—primarily PCs: high tech, competitive (e.g.,
Gateway, IBM, Apple, others), changing products,
high growth rates, low barriers of entry
• Business strategy--(1) cost leadership strategy: direct
selling, made-to-order manufacturing, early on the
internet, low receivables; (2) product differentiation??
[IBM clones, Intel & Microsoft components]
• Current situation—market share; what is the impact of
the business cycle (e.g., PCs are durable goods)?
 Quantitative Financial Analysis
• Systematic analysis of key elements based
on analysis context
• Ratios, cash flows, common-size, time
series, comparative (e.g., specific firms,
industry, all firms), models (e.g., DuPont,
Altman’s)
• In-depth analysis for “red flag” items
 Quantitative Financial Analysis
• Financial Statements
• Common-size Analysis
• Financial Ratios
• Growth/trend Analysis
• Quarterly analysis
• DuPont Model
• Market Analysis
 Detailed Accounting Analysis
• Does accounting information capture the
underlying business reality?
• Identify areas of “accounting flexibility” &
evaluate accounting policies (choices) &
disclosures; especially notes & MD&A
• Evaluate earnings management potential
• Recast accounting numbers when necessary
NB: MD&A =Management Discussions and Analysis
 Comprehensive Analysis
• Summarize key points: what is particularly
important for decision making?
• “Red flags” are particularly important
• Consider a written executive summary
• Consider a rating scale, such as 1-10
 Decision
• What is the recommendation or decision?
• What is the key rationale for this decision?
[This is based on the specific decision: for
a credit decision the key factors relate to
credit risk, with particular focus on leverage
and liquidity.]
• Be prepared to defend this decision.
The Financial Environment
 Capital Markets
Equity Debt

Primary Initial public Bank loan,

offering initial debt
security offering
Secondary Buying & Buying &
selling of stocks selling on
on securities secondary debt
markets market
 Credit Decisions
• Commercial banks provide short-term
commercial loans
• The major concern: will the company pay
interest & principal when due?
• Loan terms: interest rate, collateral, debt
covenants
 Equity Investment Decisions
• Public securities trade on formal market
exchanges (these are secondary markets)
• Buying & selling are now relatively cheap
transactions
• Mutual funds are a useful alternatives to
individual securities
• Stock investing has high short-term risks
Goals of Financial Accounting in
a Market Economy?
• Capture business economics of the firm
(e.g., relationship to industry, competitive
strategy, business model). How does firm
create value?
• Reduce management discretion on financial
reporting (what is reality? Vs. misleading
information--analysts sort this out). Note
management incentives for earnings
management
 Annual Report Information
• Corporate Overview
• MD&A
• Financial Statements: Balance Sheet,
Income Statement, Statement of Cash
Flows, Statement of Equity
• Notes to financial statements
• Auditor’s Opinion
 Management Incentives
• Managers have incentives to present information
in the most favorable light (e.g., bonuses, stock
options, promotions)
• Accounting choice: accounting policies, estimates,
additional disclosures
• Standardize vs. estimates: what is reality?
• Management have best information, but
communications to investors may not be
completely credible
 Financial Statement
Considerations
• Managers’ information on economic reality
• Estimation errors
• Distortion from managers’ accounting
choices & disclosure
• Question: Can investor perceptions be
manipulated?
 Finance Theory Perspectives
• Efficient Markets
• Random Walk
• Portfolio Theory
• Beta Analysis
• Economic Behavior & Agency Theory
• Earnings Management & Accounting
Choice
 Efficient Markets
• Markets are efficient if information is
impounded immediately in capital prices in
an unbiased fashion
• Research supports market efficiency in the
semi-strong form, for short windows
• Note long-term anomalies & other
challenges (e.g., behavioral economics)
 Random Walk
• The concept that a professional portfolio
cannot outperform a randomly selected
stock portfolio
• Research generally confirms this result
• Consistent with efficient markets; that is, all
information has been impounded in stock
price
 Portfolio Theory
• Harry Markowitz introduced the concept of
portfolio diversification with his 1952
dissertation
• Portfolio theory insists that investment
portfolios should be diversified to reduce
the risk relative to return
• Capital asset pricing model: E(Ri) = Rf +
[E(Rm) – Rf)
 Beta Analysis
• Beta () comes directly from the slope of
the market model: Rit = i + iRmt + eit
• Beta measures the relationship between
price movements of the individual stock to
market averages
• Beta is a measure of systematic risk, where
a =1 stock should move with the market; a
>1 stock has greater market risk
 Economic Behavior
• Rationality: assume bounded rationality—
people are intendedly rationale but limited
• Self-interest behavior:
Obedience
Simple self interest
Opportunism (self interest with guile--
that is, willing to violate normal ethical
boundaries for personal benefit)
 Agency Theory
• Contracts have a principal (e.g., owners)
and agent (e.g., managers). The principal
will attempt to maximize wealth, contract to
avoid conflict, and minimize transaction
and agency costs.
• Agency costs: information asymmetries
(limited information by one side), adverse
selection, moral hazard (e.g., shirking).
 How to Reduce Agency Costs
• Better acquisition decisions
• Monitoring--including audits and financial
reporting
• Align preferences of agents with principals
(e.g., debt covenants, management
compensation)--a reason for stock options
• Control devises such as budgets
 Earnings Management
• Operations and discretionary accounting
methods to adjust earnings to a desired
outcome, often income smoothing
• Underlying theory: agency theory,
transaction cost economics
• Importance of efficient contracting:
corporations are a network of contracts and
exist because they write contracts efficiently
 Accounting Choice
• Discretionary choices to optimize behavior,
using techniques such as:
1. Select alternative accounting
methods (e.g., inventory) & level
of disclosure (e.g., contingencies)
2. Lobbying (e.g., on proposed
standards)
3. Financial, production & investment
activities
 Earnings Manipulation
• Because alternatives are allowed, financial
accounting has many discretionary aspects.
• Managers can manipulate income by timing (e.g.,
recognition this year v next year) and
classification (e.g., ordinary v extraordinary)
• Accruals can be mandatory (e.g., other post
employment benefits) or voluntary (e.g.,
depreciation)
 Earnings Quality
• Importance of full disclosure
• Look for “conservative” reporting
• Review indicators of high quality
• Relationship of risk to earnings quality
• Be aware of earnings management
incentives and evidence of earnings
manipulation
 Normalizing Income
• Attempt to determine earning power--related to
normal operating earnings
• Remove the “noise”--usually associated with
nonrecurring items
• Separate analysis of nonrecurring items
• Evidence of earnings manipulation may require
substantial adjustments to arrive at “normal
earnings”
 Financial Analysis Decision
• Based on Elliott’s “value chain of
information”: this is the $1,000 per hour
stage
• The purpose of financial analysis is to arrive
at an informed recommendation or decision
The Financial Statements
 Financial Statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Stockholders’ Equity
 Balance Sheet
• Assets: probable future economic benefits
• Liabilities: probable future economic
sacrifices
• Stockholders’ Equity: residual interest,
representing ownership interest (also called
net assets)
 Assets
• Current Assets (cash & cash equivalents,
short-term marketable securities), accounts
receivable, inventory, other)
• Property, plant & equipment
• Long-term investments
• Other assets
 Liabilities
• Current Liabilities (accounts payable,
accrued & other current liabilities)
• Long-term debt
• Commitments & contingencies
• Other liabilities
• Potential off-balance sheet debt
 Stockholders’ Equity
• Preferred stock
• Common stock
• Other paid-in capital
• Retained earnings
• Treasury stock
• Other comprehensive income
• Other equity items
 Income Statement
• Revenues: inflows from major operations
• Expenses: outflows from major operations
• Gains & Losses: changes in equity from
peripheral activities
• Net income: bottom line all operating
activities recorded on the income statement
• Comprehensive income: Changes in equity
from all non-owner sources
 Revenue
• Sales
• Services
• Other revenue items
• Importance of revenue recognition criteria
 Operating Expenses
• Cost of goods sold (manufacturing)
• Cost of sales (services or services included)
• Operating expenses (selling, general &
administrative, research & development,
other)
• Interest income & expenses & related
• Provision for tax
 Non-recurring Items
• Extraordinary items
• Discontinued operations
• Accounting changes
• Other non-recurring items
• Other gains & losses
 Earnings Measures
• Gross profit
• Operating income
• Income before tax
• Income from continuing operations
• Net income
• Comprehensive income
 Cash Flow Statement
• Cash Flows from Operations
• Cash Flows from Investing Activities
• Cash Flows from Financial Activities
• Statement of Stockholders’ Equity
 Cash From Operations
• Net income
• Depreciation & amortization
• Other operating adjustments
• Changes in non-cash working capital items
 Cash From Investing &
Financing
• Cash from investing
Investment purchases
Investment maturities & sales
Capital expenditures
• Cash from financing
Issuance of equity
Purchase/acquisition of equity
New debt
Debt maturities or retirement
Dividends
Treasury Stock
 Statement of Stockholders’
Equity
• Reconciliation of stockholders’ equity,
alternative formats used
• Key categories (changes)
Common stock, other paid-in capital
Retained earnings
Treasury stock
Other comprehensive income
Quantitative Financial Analysis
Using Financial Statement
Information
 Quantitative Financial Analysis
• Systematic analysis of key elements based
on analysis context
• Quantitative techniques to standardize
financial information for relevant
comparisons
• In-depth analysis for key factors, including
“red flags”
 Quantitative Financial Analysis
• Financial Statements
• Common-size Analysis
• Financial Ratios
• Growth Analysis
• Du Pont Model
• Earnings Quality/Normalizing Earnings
 Useful Financial Comparisons
• Benchmarks: rules of thumb or averages
• Common Sense
• Trend Analysis (analysis over time)
• Near Competitors
• Industry Averages
• Market Averages
 Common-size Analysis
• Overview vs. detail
• Balance sheet: total assets = 100%
• Income Statement: sales (or total revenues)
= 100%
• Comparisons over time & across firms (or
industry averages)
• Useful starting point for financial overview
 Ratio Analysis
• A ratio converts financial information to a
percentage, one approach to standardization
• Each ratios provides a somewhat different analysis
• Ratios overlap—a problem in one area should
show up as problems in other areas
• The importance of specific ratios differs, based on
the purpose of the financial analysis
• Ratios for the most recent period are usually the
most important
 Ratio Categories
• Liquidity—cash, working capital & cash
flow related
• Activity—turnover ratios as possible
efficiency measures
• Leverage—debt & solvency analysis
• Performance (or profitability)—bottom line
or earnings related
 Liquidity Ratios
• Current ratio: current assets/current
liabilities
• Quick (acid test) ratio: (cash+marketable
securities+net receivables)/current liabilities
• Cash ratio: (cash+marketable
securities)/current liabilities
• Operating ratio: cash flows from
operations/current liabilities
 Leverage Ratios
• Debt to equity ratio: total liabilities/total stockholders’
equity
• Debt ratio: total liabilities/total assets
• Interest coverage: (income before tax +interest
expense)/interest expense [note that the numerator is
earnings before interest and taxes or EBIT]*
• Long-term debt to equity: long-term liabilities/total
stockholders’ equity
• Debt to market equity: total liabilities at book value/total
equity at market value

*alternatively: (income from continuing operations

+ interest expense + tax expense)/interest expense
 Activity Ratios
• Inventory turnover: cost of sales [or
COGS]/average inventory
• Receivables turnover: sales/average accounts
receivable
• Payables turnover: sales/average accounts payable
• Working capital turnover: sales/average working
capital
• Fixed asset turnover: sales/average property, plant
& equipment
• Total asset turnover: sales/average total assets
 Activity Ratios in Days
• Average days inventory in stock:
365/inventory turnover
• Average days receivables outstanding:
365/receivables turnover
• Average days payable outstanding:
365/payables turnover
• Length of operating cycle: average days
inventory + average days receivables
 Profitability
• Gross margin: (Sales-cost of sales)/sales
• Return on sales: net income/sales
• Return on assets: net income/average total assets
• Pretax return on assets: earnings before interest &
taxes/average total assets
• Return on total equity: net income/average
stockholders’ equity
• Dividend payout: common dividends/net income
[per share basis: dividends per share / EPS]
 Du Pont Model
• ROE = Profitability x Activity x Solvency
• Net Income / Average Common Equity =
(Net Income / Sales) x (Sales / Average
Total Assets) x (Average Total Assets /
Average Common Equity)

• ROA = Profitability x Activity

 Decomposition using Du Pont
• Start with Return on Sales
• Activity is avg. total asset ratio—this is a measure of asset
turnover or efficiency
• ROS x ATAR is Return on Assets (calculate as net income
/ average total assets)
• Solvency is ATA / Avgas. Common Equity—this is a
standard leverage ratio
• ROA x Solvency is Return on Equity (calculate as net
income / average common equity)
• In summary, the differences between ROS, ROA & ROE
depend on activity & solvency
 Du Pont Model
Ratio Calculation
Profit (Return on Sales) Net Income/Sales
Activity (Asset Sales/Avg. Total Assets
Turnover) (ATA)
Return on Assets Net Income/ATA
Solvency (Common ATA/Average Common
Equity Leverage) Equity (ACE)
Return on Equity Net Income/ ACE
 Ratio Analysis Limitations
• Ratios are presented on a percentage basis
• Relative size is ignored (e.g., both large &
small firms can be compared)
• It is assumed that all numbers used are
correct (consider both possible errors and
earnings management)
• If the numbers are not reliable, ratios are not
particularly useful
Multiperiod Quantitative Financial
Analysis
 Growth Analysis
(period-by-period change)
• Long-term trends over time can be significant. Are
current year performance measures consistent with
earlier years (e.g., maintaining consistent ratios
while sales are rising smoothly)?
• As a first step, present growth rates (including %
increases) for the last 5-10 years
• Declining or negative growth rates might be
obvious red flags; Red flags and other indicators
of poor growth performance require further
analysis
 Base-Year Analysis
(also called Trend Analysis)
• Set the earliest year, evaluated as the base
year, at 100. [Note: this assumes that
earliest year is “normal.”] Calculate growth
by dividing the more current year numbers
by the base year number.
• This is an alternative presentation to growth
rate percentages over 5-10 years (or more)
 Quarterly Analysis
• The most recent financial data is presented
quarterly [The one exception is at year end, with
annual information is presented]
• Financial analysts focus on quarterly data and the
quarterly earnings announcement is the most
important (& earliest) information
• Common-size and ratios analysis is conducted,
and compared over earlier quarters: particularly
important are current quarter data to (1) the
previous quarter and (2) the same quarter one year
ago
 Quantitative Financial Analysis
Techniques: Incorporating Market
Information
 Quantitative Market Analysis
• Stock prices & stock charts
• Earnings per share—actual & forecast
• Price earnings ratios (PE)
• Dividend yield
• Market value & market-to-book
• Price earnings to growth ratios (PEG)
• Valuation models
 Stock Prices
• Prices change continuously
• Using daily closing price
• Stock charts, various periods
• Industry & market comparisons
• Internet sites
 Earnings Per Share (EPS)
• Performance measure on per share basis
• Basic vs. diluted
• Forecasted EPS (Analysts’ Estimates on
Yahoo)
• Annual vs. quarterly EPS
• Annual—last 4 quarters
• 5 year forecasts (relevance vs. reliability)
 PE Ratios
• Stock price as a market premium for
earnings
• Which price? (most current, historic…)
• Which EPS? (current year actual--usually
last 4 quarters, future forecast, basic vs.
diluted)
• Closing prices
• Alternatives & how to evaluate them
 Market-based Ratios
• Price earnings ratio (PE): Stock price / EPS
• Dividend Yield: Dividend per share / Stock
price
• Market value: stock price x shares
outstanding
• Market-to-book: market value /
stockholders’ equity
 Dividends
• Dividends given on a per share basis; focus on
dividends per share, last 4 quarters. [Note—
equivalent to dividends/shares outstanding.]
• Dividend yield: dividends per share/stock price—
income focus; average yield is about 2% for the
S&P 500.
• Dividend payout: dividends per share/earnings per
share.
 Market-related Ratios
• Market-to-book: market value / stockholders’
equity [or measure on a per share basis—stock
price / book value per share]—why is a “market
premium to book” common?
• Sales to market value: annual sales to
outstanding shares x (1) year-end closing market
price or (2) most recent closing market price.
 Price Earnings to Growth (PEG)
• High PE is usually associated with the expectation
of high earnings growth, which can be evaluated
with PEG
• “Historic PEG” = PE based on actual EPS / 5-year
historic earnings growth
• “Forecast PEG” = PE based on forecast EPS / 5-
year earnings forecast
• PEG is useful to evaluate growth stocks, less
useful for income stocks
 Earnings-based Growth Model
• P = kE / (r – g) where P is “expected” stock price,
k is dividend payout rate (actual or predicted), E is
EPS, r is the discount rate, and g the projected
earnings growth rate
• This model requires dividends, the discount rate is
arbitrary (it could be the actual cost of capital—or
based something else), and the growth rate is a
forecast; results can change substantially using
different assumptions
 Stock Screening
• The purpose of stock screening is the
determine which firms meet specific criteria
(such as minimum ROE or dividend yield)
• Several internet sites have stock screeners,
such as Yahoo
• The technique is useful to limit the number
of companies on which to conduct a
complete financial analysis
 Corporate Liabilities
• Accounts Payable
• Commercial Paper & other short-term
market liabilities
• Other current liabilities
• Corporate Bonds
• Other long-term market debt
• Other liabilities (including off-balance-
sheet)