Analysis
Evaluating accounting “quality”
How do we define financial reporting quality?
Qualitative characteristics of accounting
Information:
Understandability
Decision usefulness
Reliability
Relevance
Consistency
Comparability
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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
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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. 3
What should the users be aware of ?
Statement users must:
Understand current financial reporting
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Financial statement analysis and
accounting quality
Financial analysis tools: Common-size
statements, trend statements and
financial ratios.
But they can be no better than the data
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Financial statement analysis and
accounting quality
The accounting distortions need to be watched
when using these tools. 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.
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Learning Objective:
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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.
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Analysis
Assessing Profitability and
Creditworthiness:
Common size statements.
Trend statements
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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).
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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
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Company.
Financial analysis tools
1. Comparative Financial statements:
Statements are compared across years.
2. Common-size statements: Recast each
statement item as a percentage of a
certain item.
3. Trend statements: Recast each statement
item in percentage of a base year
number.
4. Financial ratios.
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Basic Approaches
1. Time-series analysis : Identify
financial trends over time for a single
company.
2. Cross-sectional analysis: Identify
similarities and differences across
companies at a single moment in time.
3. Benchmark comparison: measures a
company’s performance against some
predetermined standard.
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Getting behind the numbers:
Case Study: Krispy Kreme Doughnuts, Inc.
Established in 1937.
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Comparative Income Statements:
Krispy Kreme’s Financials
Systemwide sales
Include sales from Includes a $5.733 million Includes a $9.1 million
company owned and after-tax special charge charge to settle a
franchised stores. for business dispute business dispute
Base Year
Each statement item is calculated in percentage terms using a base year number.
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Comparative Balance Sheets Assets
Krispy Kreme’s Financials: Balance Sheet Assets
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Common Size Assets
Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement)
to assets
$3.2 cash
$105.0 assets
$7 cash in 2000
$3.2 cash in 1999
Each statement item is calculated in percentage terms using a base year number.
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Comparative Balance Sheets
Liability and Equity: Krispy Kreme’s Financials
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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
$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.
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Krispy Kreme’s Financials:
Abbreviated cash flow statements
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Common Size Cash Flow
Statements:
Krispy Kreme’s Financials: Apply the analysis tool (Common Size statement)
to Cash Flow Statements
Each statement item is calculated in percentage terms using a base year number.
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Krispy Kreme analysis: Lessons learned
Informed financial statement analysis
begins with knowledge of the
company and its industry.
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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.
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Learning Objective:
Profitability Analysis
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Financial ratios and profitability analysis
Operating profit margin
NOPAT
Sales
Return on assets
NOPAT
ROA= X Asset turnover
Average assets
NOPAT is net operating profit after taxes Sales
Average assets
Analysts do not always use the reported earnings, sales and asset figures.
Instead, they often consider three of adjustments to the reported numbers:
1. Remove non-operating and nonrecurring items to isolate
sustainable operating profits.
2. Eliminate after-tax interest expense to avoid financial structure
distortions.
3. Eliminate any accounting quality distortions (e.g., off-balance
operating leases). 30
Calculating Return on Assets
Eliminate
nonrecurring items
Eliminate interest
expense
Operating profit
margin
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ROA, margin and turnover examples:
A company earns $9 million of NOPAT on sales of
$100 million with an asset base of $50 million.
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ROA Decomposition and Analysis
1.
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How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over
this period?
1. 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.
2. 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.
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Further decomposition of ROA
Correspond to the common-size
Income statement items
Operating profit
margin
NOPAT
Sales
ROA = X
Sales
Average assets
Asset turnover
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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.
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ROA and competitive advantage:
Krispy Kreme
Answer: Krispy Kreme outperformed the competition by generating more sales per
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asset dollar.
ROA and competitive advantage:
Four hypothetical restaurant firms
Competitive
Competitive Advantage: ROA floor
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.
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Learning Objective:
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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.
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Credit risk and capital structure:
Balancing cash sources and needs
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Evaluating the borrower’s ability to repay
Step 5:
Due diligence • Kick the tires
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Credit risk: Short-term liquidity ratios
Including Inventory
Current assets
Current ratio =
Current liabilities Very immediate
Liquidity liquidity
ratios Cash + Marketable securities + Receivables
Quick ratio =
Current liabilities
Short-term
liquidity Net credit sales
Accounts receivable turnover =
Average accounts receivable
Inventory purchases
Accounts payable turnover =
Activity ratios tell us Average accounts payable
How efficiently the company is using its assets.
Liquidity refers to the company’s short-term ability to generate cash for working
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Capital needs and immediate debt repayment needs.
Receivables Turnover Ratio and
collection period
Receivables
Turnover = Net Sales
Ratio Average Accounts Receivable
Operating cycle: That is how long it takes to sell inventory (30 days) and collect cash from the customers (45 days).
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Credit risk:
Long-term solvency
Including
Long-term debt Intangible assets
Long-term debt to assets =
Total
Debt ratios assets
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 Cash flow from continuing operations
to total liabilities = 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. 48
Credit risk of Krispy Kreme :
Short-term liquidity and Long-term solvency
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Credit risk: Default Risk
A firm defaults when it fails
to make principal or
interest payments.
schedule.
Increase the interest
declared insolvent.
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Financial Ratios and Default Risk
Quick Ratio
Quick Ratio and probability of default is negatively associated.
Liquidity: Quick Ratio Percentiles
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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.
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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?
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Credit Analysis: Interpretation of cash flow component
Negative free
cash flow
Increased
borrowing
Continued
dividend
payment
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Credit Analysis : Selected financial statistics
Declining
margin
Customers take
longer to pay,
but reserve is
smaller
Larger debt
burden
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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.
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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.
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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.
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Profitability and financial leverage:
Case Study
Leverage
Leveragehelps
helps
Leverage
Leverage neutral
neutral
Leverage hurts
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Learning Objective:
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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.
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Pro Forma Earnings
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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
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Financial statement analysis:
Pro forma earnings at Amazon.com
Company
defined numbers
Computed
according to GAAP
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When use the EBITDA or “pro forma”
earnings, analysts should remember:
There are no standard definitions for non-
GAAP earnings numbers.
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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.
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Summary
Financial ratios, common-size statements
and trend statements are powerful tools.
However:
There is no single “correct” way to
Market Measures:
Earnings per share (EPS)
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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.
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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)
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