CHAPTER 18

INTEGRATION OF FINANCIAL STATEMENT

ANALYSIS TECHNIQUES
Presenters name
Presenters title
dd Month yyyy

FRAMEWORK
The primary reason for performing financial statement analysis is to
facilitate an economic decision.
The framework for the analysis contains six phases:
1. Define the purpose for the analysis
2. Collect input data
3. Process data
4. Analyze/interpret the processed data
5. Develop and communicate conclusions
6. Follow-up

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FRAMEWORK: CASE STUDY 1

Evaluating Nestl as a long-term equity investment.
1. Define the purpose for the analysis:
- Isolate the factors that have driven Nestls financial success and assess their
sustainability.
- Understand the risks that may upset the sustainability of returns.
2. Collect input data: Gather several years of annual reports.
3. Process data:
- Conduct a DuPont analysis.
- Analyze the composition of Nestls asset base and capital structure.
- Study the companys segments and the allocation of capital among them.
- Examine the companys earnings quality.
- Study the companys cash flows and their adequacy for the companys continued
operations and strategies.
- Decompose the companys valuation.
4. Analyze/interpret the processed data.
5. Develop and communicate conclusions: Write report.
6. Follow-up.

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DUPONT ANALYSIS

Nestls ROE:
2007

2006

2005

Net profit margin

10.58%

10.00%

9.44%

Assets turnover

0.994

0.963

0.955

Leverage

2.02

2.01

2.16

21.25%

19.36%

19.48%

ROE

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FINANCIAL REPORTING CHOICES AND BIASES

Including the net investments and returns of associates with full reported value of
a companys own assets and income would introduce noise into the analysis. For
example,
- Part of Nestls income relates to Nestls 30% stock ownership of LOreal.
- Subtracting the investment from total assets results in a figure that more
closely represents Nestls own asset base.
- Subtracting the share of results of associates from the net income allows for
the analysis of exclusively Nestl profitability resulting from the exclusively
Nestl asset base.

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FINANCIAL REPORTING CHOICES AND BIASES

Comparing financial statements prepared under different accounting
treatments over the years could bias analysis.
Adjustments are necessary to keep analysis logically consistent
throughout all the periods of study.
For example, for comparability, Nestl restated the 2004 balance
sheet, including changes for employee benefits plan accounting, lease
classification, a reclassification of a warrants premium, and the
cumulative effect on their investment of LOreals first-time adoption of
IFRS.

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CAPITAL STRUCTURE ANALYSIS

Use common-size analysis.
- For example, below is Nestls long-term capital structure on a commonsize analysis:

Deleveraging
*Does not add to 100% because of rounding

When deleveraging occurs in the long-term capital structure, there is

offsetting change in the companys working capital (i.e., leverage improves,
but liquidity deteriorates).
Improvement in the management of receivables, inventory, and payables
can mitigate the concern associated with the decline in the actual working
capital.

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SEGMENT ANALYSIS
Business Segment: A portion of a larger company that accounts for
more than 10% of the companys revenues or assets and is
distinguishable from the companys other lines of business in terms of
risk and return characteristics.
Conducting segment analysis helps analysts understand any
geopolitical investment risks.
Ratio of capital expenditures proportion to total asset proportion ranked
by EBIT margin:
- A ratio < 1 indicates that the segment is being allocated a lesser
proportion of capital expenditures than its proportion of total assets.
- A ratio > 1 indicates that the company is growing the segment.
- Comparing the ratio with the EBIT margin gives an analyst an idea of
whether the company is investing its capital in the most profitable
segments.
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SEGMENT ANALYSIS: EXAMPLE

If the company were to continue to allocate capital

toward the lowest-margined business segment, the
overall corporate returns might be negatively affected.

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EARNINGS QUALITY
Earnings quality: The persistence and sustainability of a firms earnings.
Ways to evaluate earnings quality:
Analyze the accruals: Accrual ratio fluctuations indicate the use of accruals
to time earnings.

where NOA = Net operating Assets, CFO = Cash flow from operating, and CFI
= Cash flow from investing.

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EARNINGS QUALITY
Nestl example:

Fluctuated significantly.
Much higher in the most recent
year than in the earlier years.

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Increases steadily over time,

indicating a higher degree of
accruals present in the
companys earnings.

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EARNINGS QUALITY
Study the companys cash flow and its relationship to net income. Are
operating earnings backed by cash flow, or are the operating earnings
more of an accounting result?
- Appropriate adjustments to keep the comparisons between cash
flow and earnings symmetrical:
a) Add the cash paid for interest and taxes to the operating cash
flow. The resulting operating cash flow before interest and taxes
is the relevant operating cash flow for comparison with the
operating income.
b) Add goodwill amortization to the period prior to 31 March 2004.
IFRS 3, Business Combinations, suspended the amortization
of goodwill after 31 March 2004. To amortize goodwill in some
but not other years of operating earnings would produce a
misleading trend in the ratios.

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EARNINGS QUALITY
Examine the relationship between operating cash flow and total assets.
Total assets reflect the sum of managements resource allocations.
Compare cash flow with reinvestment, debt, and debt-servicing
capacity.
Results indicate
-

whether the company has enough resources for its reinvestment

program, and

whether additional borrowing could be arranged should an

investment opportunity arise.

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VALUATION: EXAMPLE
To determine the value that the market is placing solely on the
companys operations, analysts need to remove the value of the
companys holdings of other companies from the market value.

Nestl has ample cash flow and low financial

leverage; thus, the discount may be
inappropriate and shares may be undervalued.
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FRAMEWORK: CASE STUDY 2

Evaluating investees off-balance-sheet leverage.
1. Define the purpose for the analysis:
- Look for companies in the funds holdings where off-balance-sheet financing may be
an issue (i.e., companies with unrecorded capital leases).
- Analyze the impact of the leverage if such leverage exists.
2. Collect input data:
- Multiply the current operating lease expenses reported by companies in the funds
holdings by 7.4 to get an estimate of the unrecorded assets and debt.
- If the ratio of hidden assets to total assets exceeds 5% for any of the companies in
the funds holdings, that companys information will be subjected to further analysis.
3. Process data.
4. Analyze/interpret the processed data:
- Examine the leverage ratio and interest coverage ratio for companies flagged in the
previous phase.
5. Develop and communicate conclusions: Write report.
6. Follow-up.

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OFF-BALANCE-SHEET LEVERAGE
Off-balance-sheet leverage refers to operating leases.

Capital lease
- Is reported as an asset and liability on lessees balance sheet.
- Results in interest expense and depreciation expense (instead of rental
expense) on lessees income statement.
When capitalizing an operating lease, the lessees
- Financial leverage increases.
- Interest coverage ratio decreases.

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OFF-BALANCE SHEET LEVERAGE: EXAMPLE

Assume the present value of future operating lease payments is $1,075
million. The table below shows leverage ratios after capitalizing operating
leases (amounts in millions):

$1,075 is added to total assets and total longterm debt when calculating ratios in the pro forma
column if operating leases are capitalized.
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FRAMEWORK: CASE STUDY 3

Evaluating effects of changes in accounting standards.
1. Define the purpose for the analysis:
- Determine if Discover Financial Services could be at risk (i.e., increase in
reported leverage) from possible changes in accounting for securitizations.
2. Collect input data: 10-Q and 10-K filings.
3. Process data.
4. Analyze/interpret the processed data:
- Analyze the companys leverage measures, assuming the liabilities issued
in connection with the securitization of assets have to be shown on the
companys balance sheet.
5. Develop and communicate conclusions: Write report.
6. Follow-up.

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IMPACT FROM ACCOUNTING CHANGES

Currently under Statement 140, a company can remove financial
assets from its balance sheet by placing them into a qualified special
purpose entity (QSPE).
- The combination of asset removal and nonrecognition of liabilities
may have a powerfully beneficial effect on financial leverage on the
balance sheet.
- If the concept of a QSPE is eliminated from the securitization
accounting, the securitized assets as well as the liabilities issued in
connection with the securitizations would likely be shown on the
balance sheet.

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IMPACT FROM ACCOUNTING CHANGES:

EXAMPLE
Software Services sold $267.5 million of finance receivables to a special
purpose entity. The companys abbreviated balance sheet is below.

What is the financial leverage if the company (1) treats them as sold and
(2) holds securitized financial receivables on the balance sheet?
1) 3,610,600/976,500 = 3.70
2) (3,610,000 + 267,500)/976,500 = 3.97

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SUMMARY
The framework of financial statement analysis contains six steps:
define a purpose for the analysis, collect input data, process data,
analyze the processed data, communicate conclusions, and follow-up.
Earnings are more easily manipulated than cash flows. An effective
way to examine earnings quality is to examine the pattern between
operating income and operating cash flows.
To make a logical comparison, adjustments need to be made prior to
conducting financial statement analysis. For example, adjustments
may include removing assets owned and return earned by affiliates
that are not under control of the company.

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