1

Financial Statement Analysis

2
Evaluation of current
and past
financial conditions
Estimated predictions about
future financial conditions
and performance
3
Reasons for Analysis
Investment decisions*
Credit decisions*
Performance*
Valuation (investment)
Legal liability amount (credit & perf.)
Going concern decisions (credit & perf.)
Unreasonable returns (performance)
4
FSA Steps
Identify the economic characteristics
Identify the corporate strategies
Understand the financial statements
Assess the profitability and risk
Value the particular firm
5
Tools for Economic Analysis

Porters Five Forces
Economic Attributes Framework
6
Porters Five Forces
Buyer Power- (price sensitivity)
Supplier Power
Rivalry among Firms
Threat of New Entrants
Threat of Substitutes
7
Economic Attributes Framework
Demand
price sensitivity
demand growth
cyclical demand
seasonal demand
Supply
number of suppliers
barriers to entry
Manufacturing
capital intensity
process complexity
Marketing
marketing channel--corporate or consumer
demand pull or demand creation
Financing
Nature of assets
Asset risk
Source of cash flow--internal or external
8
Strategic Analysis Framework
Nature of product or service
Degree of Integration
Degree of Geographical
Diversification
Degree of Industry Diversification
9
Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Footnotes
Auditors Report
Management Discussion and Analysis
10
Income Statement Classification
Operating income
Other income and expense
Income from continuing operations
Income, gains & losses from
discontinued operations
Extraordinary gains and losses
Changes in accounting principles
11
Comprehensive Income
Net income plus or minus the
changes in shareholders equity
from other than net income or
transactions with owners.
(we will look at this later)
12
Other F/S Considerations
Quality of Earnings
Statement of Cash Flows
Auditors Report
13
Tools of Profit and Risk Analysis
Common Size Financial Statements
Percentage Change Statements
Comparative Analysis
Critical Financial Ratios
14
Risks of Comparative Analysis
Timing
GAAP Application
Degree of Conservatism-
managements attitude
Size
Geographic Diversification
15
Critical Financial Ratios
Profitability Ratios
EPS
ROCE
Risk Ratios
Current ratio
CFO/Avg. Current Liabilities
Debt/Equity
16
Valuation
Price-Earnings Ratio
Market value to Book value Ratio
17
Role of FSA in Capital Markets
One View: FSA has no impact
The Other View
FSA is a catalyst
FSA identifies individual opportunities
Equity markets are not perfectly eff.
FSA cleanses F/S biases
FSA has unique purpose itself- (go
back to the reasons for analysis)
18
Sources of Information
Annual Report
Form 10-K
Form 10-Q
Form 8-K
Prospectus
Form 20-F (foreign entity 10-K)
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Statement of Cash Flows-
chapter 3
FASB 95--1987
Components
Operating cash: Operations and
working capital
Investing cash: Non-current assets
and investments
Financing cash: L/T debt, equity and
dividends
20
Roots = Financing Activities
Trunk & Branches = Investing Activities
Fruit = Operating Activities
Businesses are like Fruit
Trees
21
Net Income vs. Cash Flow
Indirect Method
Net Income
+/- Non-cash Items
+/- Changes in Operating Working
Capital
= Cash Flow from Operations
22
Indirect vs. Direct Method
FASB prefers the direct method
FASB requires net income to cash
from operations reconciliation
Components:
Cash from customers
Cash from dividends
Cash from interest income
Other operating cash receipts
Cash paid to suppliers
Cash paid to employees
Cash paid for taxes
Cash paid for interest
Other operating cash payments
23
Profitability Analysis
chapter 4 & 5
Rate of Return on Assets--ROA
Measures success in using assets to
generate earnings (excluding financing)
Disaggregated ROA
ROA = Profit Margin X Asset Turnover
Line by line P & L Analysis
A/R, Inventory & F/A turnover
24
ROA Summary
Level 1: ROA as a whole
Level 2: Disaggregate ROA
Level 3a: Margin analysis in detail
Level 3b: Disaggregate turnover
Level 4: ROA, margin & turnover by
geographic segment
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ROCE--Return on Common
Shareholders Equity
Return after O-I-F activities
ROA and ROCE
ROCE > ROA when ROA exceeds the
cost of creditor and pref. Shareholder
capital
26
Disaggregated ROCE
ROCE = ROA X CEL X CSL
Common Earnings Leverage = op.
Income available to common s/h
Cap. Structure Leverage =
multiplier effect of other capital
sources
27
Risk Analysis
Types of risk
International
Domestic
Industry
Firm-specific
Our focus will be on the financial
aspects of risk
28
Relationship to O-I-F
S/T liquidityOworking capital
L/T liquidityIplant capacity
L/T liquidityFdebt svc. rqmts
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S/T Liquidity
Current ratio
Quick ratio
Ops. Cash flow to C/L
W/C Activity ratios:
A/R turnover
Inventory turnover
A/P turnover
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L/T Liquidity
L/T Debt Ratio
Debt/Equity Ratio
Liabilities/Assets Ratio
Interest coveragefixed charges
coverage
OCF to Total Liabilities
OCF to Capital Expenditures
31
Comparative Analyses
Time series analysis (same company)
Changes in customers, product or
geography
Major M&A activity
Accounting changes
Cross-sectional analysis (industry)
Industry definitions
Metric calculations
32
Industry Ratio Sources
Robt. Morris Associates, Annual
Statement Studies
Dun & Bradstreet, Industry Norms
and Key Financial Ratios
33
Stickneys Comparability
Risksin additon to WFOs
Earnings not reflective of actual
economic value added
F/S restatement
F/S classification
Time variations in excess of 3 mos.
Global accounting factors
34
Quality of Earnings Issues-
Chapter 6
Non-recurring itemssustainability
Earnings measurement
Earnings management

Essentially we are trying to
determine if what is reported is
going to recur in the future.
35
Sustainability Issues
Discontinued operations
Extraordinary gains and losses
Changes in accounting principles
Impairment of long-lived assets
Restructuring charges
Changes in estimates
Peripheral gains and losses
Mgt. analysis including the MD&A
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Restructuring Difficulties
Conservative vs. aggressive
accounting practices
Periodic charges vs. one time event
Taking a bath
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Analysts Role
Is restructuring adequate
Wall street point of view
Significant judgement required
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Earnings Management
Reasons it occurs:
Incentive compensation factor
Job security
Smoothing reduces erratic
performance which lowers perceived
risk
Govt anti-trust avoidance
Reasons against:
Cant do it forever
Capital market penalties for excess
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Methods of Management
GAAP choices
Management judgement and
estimates
Timing of transactions
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Restated F/S
Discontinued operations
Pooling of interests-(new guidelines)
Accounting principle changes

Big issue here is the difficulty of
calculating prior years impact if
information is not presented.
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Global Considerations
Use SEC Form 20-F
Discloses equity and net income
reconciliation between local GAAP and
US GAAP
Evaluate environmental, customs and
strategic implications as well as
GAAP
42
Chp. 6 Examples
Ex. #1: Halliburton-discontinued segment
Ex. #2: Fountain Pwerboats extraordinary item
Ex. #3: Tenneco Automotive changes in acctg. Princ.
Ex. #4: Brunswick- effect of actg. Changes
Ex. #5: Ford-cumulative effect acctg changes
Ex. #6: PepsiCo-other comprehensive loss
Ex. #7: Cisco-other items
Ex. #8: PepsiCo-asset impairment
Ex. #9: JDS Uniphase- asset impairment
Ex. #10: JDS Uniphase -restructuring
Ex. #11: Brunswick-unusual charges
Ex. #12: PepsiCo-merger related costs
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Chp. 6 Examples, cont.
Ex. #13: DriveTime-change in actg estimate
Ex. #14: Hersey-change in actg estimate
Ex. #15: Delta Air Lines- other gains and losses
Ex. #16: PepsiCo-other gains and losses
Ex. #17: PepsiCo-other gains and losses
Ex. #18: General Mills restated statements
Ex. #19: Account classification differences
Ex. #20: Ericsson-worldwide reporting

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Extended Profitability-
(use for chapter 4 & 5)
ROA=PM x AT
ROA increases as Risk increases
ROA increases as OL increases
Sales cyclicality increases risk
Offset with higher AT
ROA varies with life cycle
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Economic Aspects
Monopolyhigh PM; low AT
Pure Competitionlow PM; high AT
Oligopolymixture of the two
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ROCE Considerations
ROCE tends to follow ROA
Two theories
Random walkhigh stays high; low
stays low
Equilibriumrevision to average ROCE
Penmans findings
Random walk valid 1-6years
Equilibrium thereafter takes hold
Capital structure not changed for
ROCE improvement
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Extended Risk
Financial Distress
Credit risk
Bankruptcy risk
Financial Distress Spectrum
Payment omission
Default
Bankruptcy
Liquidation
48
Credit Risk Cs
Circumstances
Cash flows (Capability to repay)
Collateral
Capacity for debt
Contingencies
Character of management
Conditions


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Bankruptcy
Process
Chapter XIliquidation
Chapter VIIreorganization
Predictive Models
Beaverunivariate
Net income before amort. etc./total liab.
Altmans Zsee pages 631-633
Multivariate
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Multivariate Criticisms

Relevant ratios might be missing
Subjective evaluation
Model based on available info; lack
of info might bias model
MDA assumes normal distribution of
ratios
MDA requires similar relationship of
variables for bankrupt and non-
bankrupt firms
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Other Issues in Bankruptcy
Models
Population does not include equal #
of bankrupt and non-bank. Firms
Excludes size and industry factors
Accrual vs. cash flow variables
Models remain unchanged over time
52
General Summary of Factors
Investment Factors
Liquidity lowers risk
AT lowers risk
Financing Factors
Lower debt levels lowers risk
S/T debt increases risk over L/T debt
Operating Factors
Profitability lowers risk
Operational consistency lowers risk
Small size, rapid growth and audit
exceptions increase risk
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Market Risk
Drivers
Political
Personnel
Product
Market risk drives market return
CAPM measures market risk
Market risk beta is driven by
Operating leverage
Financial leverage
Sales variability
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Pro-forma Financials-
Chapter 10
Sales revenue (revenue growth)
Operating expenses
Asset requirements (asset turnover)
Debt and equity requirements
Cost of financing-(interest etc.)
Statement of cash flows
Balance sheet
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Pro Forma Approaches
Exhibit 10.1
Follow the 6 step plan page 742
FSAP has a Forecast pro forma
template
% analysis can be used to project
income statement and balance sheet
Individual items
Turnover ratios as a benchmark

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Key Assumptions and
Caveats
Annual revenue growth rate
Expense relationships
Levels of investment
Working capital
Fixed Assets
Financing mix
4-5 year range
Consistency
GIGO (garbage in garbage out)
57
Pro-forma Methodology

Chapter 10 provides you with a
format for building the excel
worksheet and integrating it with the
FSAP template

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Rev. Recognition Options
Chapter 7
Period of production
Completion of production
Time of sale
During collection period
Upon cash receipt
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Earnings Management
Increases as cash flow period grows
Increases as options for estimation
grows
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Criteria for Recognition
Work is completed
Measurable amount
Costs are identifiable
Collection is reasonably assured
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Earnings Sustainability Risk
Uncollectible A/R
High volume of returned goods
Unrecorded warranties
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L/T Contractors
Multiple accounting periods
Price established in advance of work
Periodic payments
Percentage of completion
IRS approach
Completed contract
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Criteria for Exp. Recognition
Matched with revenue
Consumption of service or benefit
64
Rev. Recog. When Cash is
Uncertain
Installment method
Cost-recovery-first method
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Disclosure
Accounting policies footnote
66
Inventory Cost Flow
Assumptions
Weighted average
FIFO-first in; first out
LIFO-last in; first out
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LIFO Liquidation
Sales greater than production
Cash flow increases due to reduced
purchases
Cash flow decreases due to higher
income taxes
68
LIFO Characteristics
Rapid price increases
Provides better income smoothing in
light of inventory change variability
Tax savings
Industry specific
Larger firm size
69
Other LIFO Factors
GAAP disclosure: LIFO reserve
Stock reaction is inconclusive
70
Analytical Considerations
Cost flow assumption
Price variation & inventory turnover
LIFO liquidation impact
Inventory obsolescence
Inventory financing
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LIFO - FIFO Adj.
Inventory value
Working capital changes
Income statement changes
SCF changes
72
Fixed Assets--Key Issues
B/S Amount
Useful lives
Depreciation method
Recoverability
Maintenance & repair expense
Overall issue: undervaluation potential
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F/A--Earnings Sustainability
B/S amount vs. replacement cost
Choice of depr. Lives (instant profit)
Choice of depr. method
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Intangibles--General
Expense cost of development
Recognize as asset purchased
intangibles
Amortize up to 40 years
Caution surrounding in process
R&D
75
S/W Development Costs
Expense through tech. feasibility
Capitalize, thereafter
Amortize over useful life
76
Goodwill
Results from acquisitions
Treat according to GAAP
Eliminate from B/S
77
Intangibles--Earnings
Sustainability
Generally expense
The above is a questionable approach
Needed-ways to value intangibles
78
Liability Recognition
Chapter 8
Probable future sacrifice
Little or no discretion to avoid
Event has occurred
79
No Liability, If...
Mutually unexecuted contracts
Certain contingencies
Not probable
Not measurable
80
Controversial Liability Issues
Hybrid securities
Sale of A/R w/recourse
Product financing arrangements
R&D financing arrangements
Take or pay contracts
Derivative instruments
81
Liability Valuation
PV of future cash flows > 1 year
Cost of future deliverables
Cash advance value
82
Leases
Operating lease
Expense
Capital lease
Capitalize w/liability
SFAS 13
Title transfer
Bargain purchase option
75% of life rule
90% of cost rule
Slightly different tax rules
May want to restate all as capital
83
Retirement Benefits
Pensions (FASB 87 & 132)
Post-retirement Health Benefits
(FASB 106 & 132)
84
pensions
Pension Fund Assets
Assets-BOP
+/- Actual Earnings
+ Contributions
- Payments
= Assets-EOP
Pension Fund Liab.
Liab-BOP

+ Incr.- Time
+ Incr.- Service
+/- Actuarial G & L
- Payments
= Liab-EOP
85
Key Terms
ABO - amount expected to be
paid--current salaries
PBO - amount expected to be paid-
-future salaries
86
Pension Expense
Service cost
Interest cost
Actual return on plan assets
Amort. of adoption cost
Amort. of PBO increase/decrease
Amort. of actuarial gains & losses
87
Minimum Liability
If ABO > FV of Assets, then
adjust to Comprehensive Income
88
Health Care Benefits
No minimum liability
Minor measurement differences
Considers income tax impact
Sensitivity analysis
Note politicization on p. 410
89
Analysts Role
Awareness of underfunding
Reasonableness of assumptions
Actual performance vs. expected
performance
90
Income Taxes-FASB 109
Book income
Permanent differences
Temporary differences
Taxables
Deductibles
Taxable income
91
FASB 109-History
APB 11 - income statement focus
FASB 109 - B/S focus
FASB 109 - Allows deferred debits

92
Implementation
Determine differences
Eliminate permanent differences
Classify temporary differences
Assess need for valuation allowance
Taxables > deductibles
Negative factors
Positive factors
more likely than not
93
Disclosure
Income tax expense
Income before taxes
Statutory rate reconciliation
Composition of deferred taxes and
assets
94
Deferred Tax Liability
Is it real?
Consider in terms of a going
concern
95
Analysts Role
Effective tax rate changes
Changes in valuation allowance
Tax rate by venue
Normalize rate excluding one time
changes
96
Reserves
Matching principle
Exclude expenses
Defer negative asset revaluation (ie
FASB 115)
Difficult to assess & adjust
97
Combination Issues
Chapter 9
Corporate acquisitions
Investments in securities
Foreign currency translation
Segment reporting
98
Business Combinations
Purchase accounting
Record at FMV
Excess to goodwill
Pooling
Assume assets and liabilities
Must meet the 12 criteria for pooling
99
Pooling Criteria
2 year autonomy
independence
single transaction w/in one year
stock for at least 90% of stock
2 year moratorium on equity interest changes
no reacquisition of shares for bus. Combos
ratio interests remain unchanged
no change in voting rights
no security issues remain outstanding
no reacquisition of securities
no special funding agreements
no disposal plans
100
Investment in Securities
Under 20%
20% to 50%
Over 50%
101
Under 20%
Held to maturity
Available for salecomprehensive inc.
Tradingincome statement
Analyst issues
include or exclude adj. from income
102
20% to 50%
Equity method if influence exists
Analyst issues
relationship between income and cash
submerged assets
103
Over 50%
Consolidation
Might want to consider ROA after
inclusion of unconsolidated subs.
104
Tax Consequences
Under 80%interest or dividends
Over 80%consolidated return
105
Foreign Currency Translations
Functional currency
Foreign currency
all-current method
income stmt. at the avg. rate
B/S at end-of-period rate
unrealized translation adj. in comp. income
U.S. currency
monetary method
avg., end of period and historical rates
106
FX-Analyst Issues
Translation adjustments in income?
Difficult to interpret due to limited
disclosure
Significant international variance in
practice
107
Disaggregation of Info.
Disclosure of segments (mgt. Approach)
operating segments
geographic locations
major customers
10% rule
Elements
operating income
sales
assets
108
Why Value Via Cash Flow?
Chapter 11
Cash = ultimate value
Cash = common denominator
109
Economists & Cash Flow
Investors spend cash
Accrual method subject to acctg. Tricks
Mgt. can manipulate earnings
110
Valuation: Cash Flow Based
Periodic cash flows
Residual value
Approximate discount rate
Cost of capital
111
Periodic Cash Flows
Unleveraged
Excludes interest, debt & pfd. stock
Weighted avg. cost of capital
Valuation of assets
Leveraged
Includes interest, debt & pfd. Stock
Cost of equity capital
Valuation of common shareholder equity
112
Periodic Cash Flows, cont.
Appropriately reflect inflation
Nominal vs. real cash
Use after tax amounts
113
Residual Value
Horizon = no growth
(last cash flow) x
(1 + growth rate)
(discount rate - growth rate)

Consider conversion tables (Stickney-
p. 766)
114
Cost of Capital
Debt
Market rate (1-tax rate)
Leases: use borrowing rate
Preferred Equity
Dividend rate
Common Equity
Risk free rate + (Mkt. Rate - RFR)
Betas published in S&Ps stock reports
115
Releveraging @ New Capital
Structure
B
L0
=B
U
[1+(1-tax rate)(
Current Debt
)]

Current Equity
Substitute B
U
with new capital structure
B
L1
=B
U
[1+(1-tax rate)(
New Debt
)]

New Equity

116
CAPM Critique
Unstable s
Unstable MROR
Size vs. s
117
Valuation Techniques
Equity
CF
U
-[(interest)(1-tax rate)]
Cost of equity capital
Debt plus equity
CF
U
Wtd. average cost of capital
Adjusted present value
CF
U
Unleveraged cost of equity cap.
[interest(tax rate)] cost of debt cap.
118
Unleveraging
CEC
U
= CEC
L
- [(
current debt
)(1-tax rate)(CEC
U
-CDC)]

current equity

119
Cash Flow Evaluation
Advantages
Economic base
Rigorous methodology
Disadvantages
Residual value dominant
Time consuming
Subjective
120
Price-Earnings Ratio
Chapter 12
Higher risk -> lower PE
Theoretical model
P/Actual earnings = (1+g)/(r-g)
121
Theoretical Variances: PE
Earnings persistance
Transitoryno change in PE
Permanentchange in PE
Accounting principles
Lower earningshigher PE
122
Trending
Penman found transitory earnings
consistencythat is high PE caused
by lower than normal earnings is
counterbalanced in the following
year.
5-7 years reversion to mid-teens
growth
123
PE Ratio Factors
Risk (cost of capital)
Growth
Earnings persistence
GAAP

124
PE Analysis Keys
Use a sustainable growth rate
Doesnt work when g>r
Doesnt work when g approximates r
Test reasonableness with actual PE
Existence of transitory earnings
Impact of GAAP
125
Price to Book Value
Market rewards growth in excess of
cost of capital
Ultimately reverts to 1.0
Function of
Profitability
BV growth
126
P/BV-Theoretical Model
1+ [(Expected ROCE-r)(BV
t
)/(1+r)
t
]
BV
0

127
Theoretical Variances: P/BV
ROCE errors
Cost of capital errors
Growth rate errors
Transitory earnings
GAAP impact
lower earningshigher P:BV
128
Trending: P/BV
ROCE remains consistent and
reverts to 1.0 slowly.
129
Cash Flow vs. Earnings
Long term impact is indifferent
Short term impact: earnings more
indicative
Use multiple approaches