Financial Statement Analysis

CHAPTER 
12
Learning Objectives
After studying this chapter, you should be able to
•	Locate and use sources of information about company performance
•	Analyze the performance of a company using trend analysis, common-size financial statements and segment reporting
•	Use the basic financial ratios to guide your thinking
•	Evaluate corporate performance using various metrics, including ROA, ROE, and EVA
•	Calculate EPS when a company has preferred stock or dilutive securities
Learning Objectives
After studying this chapter, you should be able to
•	Understand the nature of nonrecurring items and how to adjust for them
•	Use financial information to help assess a company’s value
Sources of Information 
About Companies
•	Company annual reports include:
–	The financial statements
–	Footnotes to the financial statements
–	A summary of the accounting principles used
–	Management’s discussion and analysis (MD&A)
–	The auditor’s report
–	Management’s report on its responsibility for the financial statements
–	Comparative financial data for a series of years
–	Narrative information about the company
Sources of Information 
About Companies
•	Companies also prepare reports for the Securities and Exchange Commission (SEC)
–	Form 10-K (annual report)
–	Form 10-Q (quarterly report)
•	Other sources of information:
–	Company press releases
–	Company Websites
–	The general financial press
–	Trade and industry publications
–	Financial services
Objectives of 
Financial Statement Analysis
•	Investors use financial statement analysis to
–	Predict expected returns
–	Assess the risks associated with those returns
•	Creditors are primarily concerned with
–	Short-term liquidity – how much cash a company has on hand to meet current payments when due
–	Long-term solvency – a company’s ability to generate cash to repay long-term debts when due
•	Equity investors are more concerned with profitability and future security prices
Trend Analysis
•	Trend analysis compares financial statement changes over time and identifies predictable patterns that have occurred
•	To compute percentage changes, the dollar change for an item (like net sales) is divided by the base year amount:

Trend Analysis
•	Using the income statement for Eli Lily in Exhibit 12-1 in the text, the change in net sales is:
Trend Analysis
•	The company’s explanation for some trends can be found in the Management Discussion and Analysis (MD&A) in the annual report
•	The MD&A includes disclosures about
–	Capital resources and liquidity
–	Results of operations (including sales and expenses)
–	Contractual obligations and commitments
–	Critical accounting estimates
–	Adoption of new accounting policies
Trend Analysis
•	The compound annual growth rate (CAGR) is the year-over year growth rate over a specific period of time
•	A future value table must be used to compute the CAGR (Chapter 9)
Common-Size Statements
•	Common-size statements simplify the comparison of different companies because their amounts are stated in percentages
•	On a common-size income statement, each item is expressed as a percentage of sales
•	In the balance sheet, the common size is total assets
–	Balance sheet items are referred to as component percentages because they measure each component of the statement as a percentage of the total
Segment Reporting
•	Companies must report information about segments of the business in a footnote to the financial statements 
•	Segment information includes information on sales, profits, and assets
•	Reportable segments can be broken down by product line, geographical location, and major customer
Financial Ratios
•	The following exhibit summarizes the most popular financial ratios (from previous chapters) grouped into four categories:
–	Short-term liquidity
–	Long-term solvency
–	Profitability ratios
–	Market price and dividend ratios
•	Examples are provided from the Eli Lilly data in the text
Financial Ratios
Financial Ratios
Evaluating Financial Ratios
•	Financial ratios can be used for three types of comparisons:
•	Time-series comparisons – comparisons with a company’s own historical ratios
•	Benchmarks – comparisons with general rules of thumb
•	Cross-sectional comparisons – comparisons with other companies or with industry averages
•	Industry averages can be found in services such as Dun & Bradstreet and Standard & Poor’s
Evaluating Financial Ratios
•	Specific competitor companies can be found for ratio comparisons by using the 
–	North American Industry Classification System (NAICS), or the
–	Standard Industry Classification Code (SIC)
•	Changes in ratios over time alert investors and creditors to possible problems
Operating Performance and 
Financing Decisions
•	Operating management is concerned with the daily activities that generate revenues and expenses
•	Financial management is concerned with where the company gets cash and how it uses that cash to its benefit
Operating Performance
Operating Performance
•	These ratios for Ely Lilly are:
Operating Performance
•	Industries likely to display high EBIT to sales ratios and low total asset turnover ratios have high barriers to entry:
–	Utilities
–	Communications
•	Industries likely to display low EBIT to sales ratios and high total asset turnover ratios have low barriers to entry:
–	Retail grocery
Financing Decisions
•	Companies finance long-term investments with either
–	Long-term debt or
–	Stock
•	Debt is attractive because
–	Interest payments are tax deductible, but dividend payments are not
–	Present shareholders profits and voting rights are not diluted
Financing Decisions
•	Capitalization (capital structure) refers to the mix of debt and equity financing
•	Trading on the equity (financial leverage) means using debt at a fixed interest rate to try to increase the rate of return on stockholders’ equity (ROE)
Financing Decisions

•	When a company is debt free, ROE = ROA
•	When ROA > interest rate, ROE > ROA (favorable financial leverage)
•	When ROA < interest rate, ROE < ROA
Economic Value Added
•	Economic value added (EVA) measures the residual wealth of a company after deducting its cost of capital from operating profit
–	A firm must earn more than it pays if it is to increase in value
–	The cost of capital here refers to a weighted average cost of interest on debt and returns to equity investors
•	EVA is used as an internal management tool to help allocate and manage scarce capital resources such as equipment and real estate
Economic Value Added
•	If a company has a capitalization of $1 million, 10% cost of capital, and operating profit of $120,000:
Measuring Safety
•	Interest coverage (times interest earned) measures a company’s ability to make interest payments and repay debt on schedule

•	Rule of thumb: interest coverage should be at least 5 times
Earnings Per Share
•	In its simplest form, EPS is the net income divided by the number of common shares outstanding

•	The following slides address several complicating issues in the computation
Weighted Average Shares
•	The denominator should actually use the weighted-average number of common shares outstanding

Weighted Average Shares
•	Example: 750,000 shares were outstanding at the beginning of the year and 200,000 additional shares were issued 3 months before the year-end.  The weighted average number of shares would be:

•	The denominator must also be adjusted retroactively for any stock splits and stock dividends
Preferred Stock
•	If the company has nonconvertible preferred stock outstanding, net income must be reduced since the numerator should reflect just the net income that is available to common stockholders
Basic and Diluted EPS
•	Companies with convertible securities and stock options must report two EPS calculations:
–	Basic EPS
–	Diluted EPS
•	Assume the following data:
–	Convertible preferred stock at 5%, $100 par, each share convertible into two common shares: 100,000 shares
–	Common stock: 1,000,000 shares
–	Net income $10,500,000

Basic and Diluted EPS
•	The basic EPS calculation would be:

Basic and Diluted EPS
•	Diluted EPS assumes conversion of the preferred stock to common stock
•	Accordingly, no preferred dividends are deducted in the numerator and additional shares of common are added in the denominator

Disclosure of Nonrecurring Items
•	Nonrecurring items fall into four major categories:
•	Special items
•	Extraordinary items
•	Discontinued operations
•	Accounting changes
Special Items
•	Special items are revenues or expenses that are large enough and unusual enough to warrant separate disclosure on the income statement
•	Examples:
–	Impairment of PP&E
–	Impairment of goodwill
–	Restructuring charges
•	They appear with the operating expenses
Extraordinary Items
•	Extraordinary items are gains and losses resulting from events that are both
–	Unusual in nature
–	Infrequent in occurrence
•	They are reported net-of-tax on a separate line on the income statement
Discontinued Operations
•	Discontinued operations occur when a company disposes of an entire segment of the business
•	Segments must have assets and activities that are physically and operationally distinguishable from the remaining entity
•	Gains or losses from discontinued operations must be shown separately on the income statement net-of-tax
Changes in Accounting Method
•	A change in accounting method can occur when
–	The FASB issues a new pronouncement
–	The company changes to a preferred method of GAAP
•	The cumulative effect of the change in method on all previous years’ income is reported net-of-tax on a separate line on the income statement
Valuation Issues
•	Accounting data are important in determining the value of a company
•	The price-earnings (P-E) ratio is a useful valuation tool
•	“Value investors” believe that
–	Low P-E stocks may be undervalued
–	High P-E stocks may be overvalued
•	“Growth investors” believe that high P-E stocks are likely to be growth stocks
Valuation Issues
•	The price-earnings growth (PEG) ratio relates  P-E ratios directly to earnings growth rates

•	The earnings growth rate can be based on historical earnings, current earnings, or forecasted earnings
•	Many analysts prefer a current P-E ratio and a forecasted 5-year earnings growth rate
Valuation Issues
•	Some rules of thumb on using the PEG:
Relating Cash Flow and Net Income
•	Many valuation models use estimated cash flows rather than forecasted earnings
•	There are four possible combinations of positive and negative net income and cash flow from operations:
Relating Cash Flow and Net Income
•	When these relationships persist over multiple periods, it implies (in each case):
•	A company has positive profitability
•	A growth company is incurring large depreciation charges
•	A company is either
–	Rapidly growing and collections are lagging, or
–	Experiencing serious cash flow problems
•	Negative profitability is confirmed
Relating Cash Flow and Net Income
•	Analysts use the relationship between cash flow and net income as one indicator of earnings quality
•	Earnings quality means that revenues are not recognized prematurely and expenses are not deferred improperly
•	One ratio used to assess earnings quality is cash flow from operations divided by net income (it should be consistently greater than 1)