Chapter 1 What is Financial Analysis?


Published on

Published in: Economy & Finance, Business
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Chapter 1 What is Financial Analysis?

  1. 1. Chapter 1 What is Financial Analysis?
  2. 2. Defining Financial Analysis <ul><li>Financial analysis is the process of evaluating financial and other information for decision-making. </li></ul><ul><li>A six-step approach is suggested for systematic financial analysis. </li></ul>
  3. 3. Six-step Process <ul><li>Identify purpose of financial analysis </li></ul><ul><li>Corporate overview </li></ul><ul><li>Financial analysis techniques </li></ul><ul><li>Detailed accounting analysis </li></ul><ul><li>Comprehensive analysis </li></ul><ul><li>Decision or recommendation </li></ul>
  4. 4. Corporate Overview <ul><li>Industry analysis--key economic characteristics, historical context, profit drivers, business risks </li></ul><ul><li>Firm’s business strategy--competitive strategy given the industry characteristics </li></ul>
  5. 5. Industry Analysis <ul><li>Competition--growth rates, concentration ratios, degree of product differentiation, economies of scale (& relative fixed & variable costs), substitute products </li></ul><ul><li>Legal barriers--patent & copyrights, licensing, regulation </li></ul><ul><li>bargaining power of buyers (& suppliers) & price sensitivity </li></ul>
  6. 6. Industry Analysis Criteria <ul><li>What is the industry? </li></ul><ul><li>Relative size & significance </li></ul><ul><li>Largest companies </li></ul><ul><li>Geographic presence </li></ul><ul><li>Business cycle effects </li></ul><ul><li>Future potential </li></ul>
  7. 7. Business Strategy <ul><li>Cost leadership: low cost producer, economies of scale, efficient production, low input prices </li></ul><ul><li>Product differentiation: specific attributes that customers value (e.g., quality, variety, service, delivery time), brand name </li></ul><ul><li>Importance of core competencies </li></ul>
  8. 8. Business Strategy Criteria <ul><li>Historical perspective </li></ul><ul><li>Primary focus of operations </li></ul><ul><li>Most important strategy </li></ul><ul><li>Major operating segments </li></ul><ul><li>Corporate outlook </li></ul>
  9. 9. Qualitative Analysis--Dell Computer <ul><li>Industry--high tech, competitive (e.g., Gateway, IBM, Compaq, others), changing products, high growth rates, low barriers of entry </li></ul><ul><li>Business strategy--(1) low cost strategy: direct selling, made-to-order manufacturing, early on the internet, low receivables; (2) product differentiation?? [IBM clones, Intel & Microsoft components] </li></ul><ul><li>Economic slowdown—what is the impact? </li></ul>
  10. 10. Financial Analysis <ul><li>Systematic analysis of key elements based on analysis context </li></ul><ul><li>Ratios, cash flows, common-size, time series, comparative (e.g., specific firms, industry, all firms), models (e.g., DuPont, Altman’s) </li></ul><ul><li>In-depth analysis for “red flag” items </li></ul>
  11. 11. Financial Analysis <ul><li>Financial Statements </li></ul><ul><li>Common-size Analysis </li></ul><ul><li>Financial Ratios </li></ul><ul><li>Growth/trend Analysis </li></ul><ul><li>Quarterly analysis </li></ul><ul><li>DuPont Model </li></ul>
  12. 12. Detailed Accounting Analysis <ul><li>Does accounting information capture the underlying business reality? </li></ul><ul><li>Identify areas of “accounting flexibility” & evaluate accounting policies (choices) & disclosures; e.g., MD&A </li></ul><ul><li>Evaluate earnings management potential </li></ul><ul><li>Recast accounting numbers when necessary </li></ul>
  13. 13. Comprehensive Analysis <ul><li>Summarize key points: what is particularly important for decision making? </li></ul><ul><li>“Red flags” are particularly important </li></ul><ul><li>Consider a written executive summary </li></ul><ul><li>Consider a rating scale, such as 1-10 or A-F </li></ul>
  14. 14. Financial Analysis Decision <ul><li>Based on Elliott’s “value chain of information”: this is the $1,000 per hour stage </li></ul><ul><li>The purpose of financial analysis is to arrive at an informed recommendation or decision </li></ul>
  15. 15. Chapter 2 The Financial Environment
  16. 16. Capital Markets Buying & selling on secondary debt market Buying & selling of stocks on securities markets Secondary Bank loan, initial debt security offering Initial public offering Primary Debt Equity
  17. 17. Credit Decisions <ul><li>Commercial banks provide short-term commercial loans </li></ul><ul><li>The major concern: will the company pay interest & principal when due? </li></ul><ul><li>Loan terms: interest rate, collateral, debt covenants </li></ul>
  18. 18. Equity Investment Decisions <ul><li>Public securities trade on formal market exchanges (these are secondary markets) </li></ul><ul><li>Buying & selling are now relatively cheap transactions </li></ul><ul><li>Mutual funds are a useful alternatives to individual securities </li></ul><ul><li>Stock investing has high short-term risks </li></ul>
  19. 19. SEC Regulation <ul><li>Mission: Protect investors & maintain integrity of the securities markets </li></ul><ul><li>Established following the Great Market Crash (SEC Act of 1934) </li></ul><ul><li>SEC requires public registration, proxy statements & annual (10-K) and quarterly (10-Q) reports </li></ul>
  20. 20. Goals of Financial Accounting in a Market Economy? <ul><li>Capture business economics of the firm (e.g., relationship to industry, competitive strategy, business model). How does firm create value? </li></ul><ul><li>Reduce management discretion (what is reality? Vs. misleading information--analysts sort this out). Note management incentives for earnings management </li></ul>
  21. 21. Accounting Regulators <ul><li>Securities & Exchange Commission (SEC)--regulates securities markets and financial reporting (10-K, 10-Q, 8-K) </li></ul><ul><li>Financial Accounting Standards Board (FASB)--promulgates GAAP </li></ul><ul><li>International Accounting Standards Commission (IASC) </li></ul><ul><li>Note: European Harmonization </li></ul>
  22. 22. Standard Setters: 1938-Present <ul><li>Committee on Accounting Procedures (CAP) issued 51 Accounting Research Bulletins (ARBs)--1938-59 </li></ul><ul><li>Accounting Principles Board (APB) issued 31 Opinions--1959-73 </li></ul><ul><li>Financial Accounting Standards Board (FASB) has issued over 140 Statements (SFASs)--1973-present </li></ul>
  23. 23. The FASB Structure The FASB Structure
  24. 24. The FASB <ul><li>Seven member board, full time, appointed by FAF, presumed independent </li></ul><ul><li>Extensive due process: agenda items, discussion memoranda (DM), exposure drafts (ED), pronouncements, public exposure with written & oral comments </li></ul><ul><li>Super-majority (5-2 vote) [simple majority used 1977-90] </li></ul>
  25. 25. Annual Report Information <ul><li>CEOs Letter </li></ul><ul><li>MD&A </li></ul><ul><li>Financial Statements: Balance Sheet, Income Statement, Statement of Cash Flows, Statement of Equity </li></ul><ul><li>Notes to financial statements </li></ul>
  26. 26. Management Incentives <ul><li>Managers have incentives to present information in the most favorable light (e.g., bonuses, stock options, promotions) </li></ul><ul><li>Accounting choice: accounting polities, estimates, additional disclosures </li></ul><ul><li>Standardize vs. estimates: what is reality? </li></ul><ul><li>Management have best information, but communications to investors may not be completely credible </li></ul>
  27. 27. Financial Statement Considerations <ul><li>Managers’ information on economic reality </li></ul><ul><li>Estimation errors </li></ul><ul><li>Distortion from managers’ accounting choices & disclosure </li></ul><ul><li>Question: Can investor perceptions be manipulated? </li></ul>
  28. 28. Finance Theory Perspectives <ul><li>Efficient Markets </li></ul><ul><li>Random Walk </li></ul><ul><li>Portfolio Theory </li></ul><ul><li>Beta Analysis </li></ul><ul><li>Economic Behavior & Agency Theory </li></ul><ul><li>Earnings Management & Accounting Choice </li></ul>
  29. 29. Efficient Markets <ul><li>Markets are efficient if information is impounded immediately in capital prices in an unbiased fashion </li></ul><ul><li>Research supports market efficiency in the semi-strong form </li></ul><ul><li>Why?—Analyst following </li></ul>
  30. 30. Random Walk <ul><li>The concept that a professional portfolio cannot outperform a randomly selected stock portfolio </li></ul><ul><li>Research generally confirms this result </li></ul><ul><li>Consistent with efficient markets; that is, all information has been impounded in stock price </li></ul>
  31. 31. Portfolio Theory <ul><li>Harry Markowitz introduced the concept of portfolio diversification with his 1952 dissertation </li></ul><ul><li>Portfolio theory insists that investment portfolios should be diversified to reduce the risk relative to return </li></ul><ul><li>Capital asset pricing model: E(R i ) = R f +  [E(R m ) – R f ) </li></ul>
  32. 32. Beta Analysis <ul><li>Beta (  ) comes directly from the slope of the market model: R it =  i +  i R mt + e it </li></ul><ul><li>Beta measures the relationship between price movements of the individual stock to market averages </li></ul><ul><li>Beta is a measure of systematic risk, where a  =1 stock should move with the market; a  >1 stock has greater market risk </li></ul>
  33. 33. Economic Behavior <ul><li>Rationality: assume bounded rationality—people are intendedly rationale but limited </li></ul><ul><li>Self-interest behavior: Obedience Simple self interest Opportunism (self interest with guile-- that is, willing to violate normal ethical boundaries for personal benefit) </li></ul>
  34. 34. Agency Theory <ul><li>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. </li></ul><ul><li>Agency costs: information asymmetries (limited information by one side), adverse selection, moral hazard (e.g., shirking). </li></ul>
  35. 35. How to Reduce Agency Costs <ul><li>Better acquisition decisions </li></ul><ul><li>Monitoring--including audits and financial reporting </li></ul><ul><li>Align preferences of agents with principals (e.g., debt covenants, management compensation)--a reason for stock options </li></ul><ul><li>Control devises such as budgets </li></ul>
  36. 36. Earnings Management <ul><li>Operations and discretionary accounting methods to adjust earnings to a desired outcome, often income smoothing </li></ul><ul><li>Underlying theory: agency theory, transaction cost economics </li></ul><ul><li>Importance of efficient contracting: corporations are a network of contracts and exist because they write contracts efficiently </li></ul>
  37. 37. Accounting Choice <ul><li>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 </li></ul>
  38. 38. Discretion Under GAAP <ul><li>Taking a bath </li></ul><ul><li>Creating hidden reserves </li></ul><ul><li>Off-balance-sheet financing </li></ul><ul><li>Overstating performance (e.g., aggressive revenue recognition) </li></ul><ul><li>Not reporting obligations (contingencies, commitments, other liabilities) </li></ul>
  39. 39. Earnings Manipulation <ul><li>Because alternatives are allowed, financial accounting has many discretionary aspects. </li></ul><ul><li>Managers can manipulate income by timing (e.g., recognition this year v next year) and classification (e.g., ordinary v extraordinary) </li></ul><ul><li>Accruals can be mandatory (e.g., other post employment benefits) or voluntary (e.g., depreciation) </li></ul>
  40. 40. Earnings Quality <ul><li>Importance of full disclosure </li></ul><ul><li>Look for “conservative” reporting </li></ul><ul><li>Review indicators of high quality </li></ul><ul><li>Relationship of risk to earnings quality </li></ul><ul><li>Be aware of earnings management incentives and evidence of earnings manipulation </li></ul>
  41. 41. Normalizing Income <ul><li>Attempt to determine earning power--related to normal operating earnings </li></ul><ul><li>Remove the “noise”--usually associated with nonrecurring items </li></ul><ul><li>Separate analysis of nonrecurring items--reorganization, “big bath” write-offs, changing GAAP </li></ul><ul><li>Evidence of earnings manipulation may require substantial adjustments to arrive at “normal earnings” </li></ul>
  42. 42. Chapter 3 The Financial Statements
  43. 43. Balance Sheet <ul><li>Assets: probable future economic benefits </li></ul><ul><li>Liabilities: probable future economic sacrifices </li></ul><ul><li>Stockholders’ Equity: residual interest, representing ownership interest (also called net assets) </li></ul>
  44. 44. Income Statement <ul><li>Revenues: inflows from major operations </li></ul><ul><li>Expenses: outflows from major operations </li></ul><ul><li>Gains & Losses: changes in equity from peripheral activities </li></ul><ul><li>Net income: bottom line all operating activities recorded on the income statement </li></ul><ul><li>Comprehensive income: Changes in equity from all non-owner sources </li></ul>
  45. 45. Cash Flow Statement <ul><li>Cash Flows from Operations </li></ul><ul><li>Cash Flows from Investing Activities </li></ul><ul><li>Cash Flows from Financial Activities </li></ul><ul><li>Statement of Stockholders’ Equity </li></ul>
  46. 46. Chapter 4 Financial Analysis Techniques Using Financial Statement Information
  47. 47. Financial Analysis <ul><li>Systematic analysis of key elements based on analysis context </li></ul><ul><li>Quantitative techniques to standardize financial information for relevant comparisons </li></ul><ul><li>In-depth analysis for key factors, including “red flags” </li></ul>
  48. 48. Financial Analysis <ul><li>Financial Statements </li></ul><ul><li>Common-size Analysis </li></ul><ul><li>Financial Ratios </li></ul><ul><li>Growth Analysis </li></ul><ul><li>Du Pont Model </li></ul><ul><li>Earnings Quality/Normalizing Earnings </li></ul>
  49. 49. Useful Financial Comparisons <ul><li>Benchmarks: rules of thumb or averages </li></ul><ul><li>Common Sense </li></ul><ul><li>Trend Analysis (analysis over time) </li></ul><ul><li>Near Competitors </li></ul><ul><li>Industry Averages </li></ul><ul><li>Market Averages </li></ul>
  50. 50. Common-size Analysis <ul><li>Overview vs. detail </li></ul><ul><li>Balance sheet: total assets = 100% </li></ul><ul><li>Income Statement: sales (or total revenues) = 100% </li></ul><ul><li>Comparisons over time & across firms (or industry averages) </li></ul><ul><li>Useful starting point for financial overview </li></ul>
  51. 51. Ratio Analysis <ul><li>A ratio converts financial information to a percentage, one approach to standardization </li></ul><ul><li>Each ratios provides a somewhat different analysis </li></ul><ul><li>Ratios overlap—a problem in one area should show up as problems in other areas </li></ul><ul><li>The importance of specific ratios differs, based on the purpose of the financial analysis </li></ul><ul><li>Ratios for the most recent period are usually the most important </li></ul>
  52. 52. Ratio Categories <ul><li>Liquidity—cash, working capital & cash flow related </li></ul><ul><li>Activity—turnover ratios as possible efficiency measures </li></ul><ul><li>Leverage—debt & solvency analysis </li></ul><ul><li>Performance (or profitability)—bottom line or earnings related </li></ul>
  53. 53. Du Pont Model <ul><li>ROE = Profitability x Activity x Solvency </li></ul><ul><li>Net Income / Average Common Equity = (Net Income / Sales) x (Sales / Average Total Assets) x (Average Total Assets / Average Common Equity) </li></ul><ul><li>ROA = Profitability x Activity </li></ul>
  54. 54. Ratio Analysis Limitations <ul><li>Ratios are presented on a percentage basis </li></ul><ul><li>Relative size is ignored (e.g., both large & small firms can be compared) </li></ul><ul><li>It is assumed that all numbers used are correct (consider both possible errors and earnings management) </li></ul><ul><li>If not reliable, ratios are not particularly useful </li></ul>
  55. 55. Chapter 5 Multi-period Quantitative Financial Analysis
  56. 56. Growth Analysis <ul><li>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)? </li></ul><ul><li>As a first step, present growth rates (including % increases) for the last 5-10 years </li></ul><ul><li>Declining or negative growth rates might be obvious red flags </li></ul><ul><li>Red flags and other indicators of poor growth performance require further analysis </li></ul>
  57. 57. Trend Analysis <ul><li>Using trend analysis, set the earliest year, evaluated as the base year, at 100. Calculate growth by dividing the more current year numbers by the base year number. </li></ul><ul><li>This is an alternative presentation to growth rate percentages over 5-10 years </li></ul>
  58. 58. Quarterly Analysis <ul><li>The most recent financial data is presented quarterly (e.g., 10-Q). [The one exception is at year end, with annual information is presented] </li></ul><ul><li>Financial analysts focus on quarterly data and the quarterly earnings announcement is the most important (& earliest) information </li></ul><ul><li>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 </li></ul>
  59. 59. Chapter 11 Capital Structure & Credit Risk
  60. 60. Corporate Debt <ul><li>Accounts Payable </li></ul><ul><li>Commercial Paper & other short-term market liabilities </li></ul><ul><li>Other current liabilities </li></ul><ul><li>Corporate Bonds </li></ul><ul><li>Other long-term market debt </li></ul><ul><li>Other liabilities </li></ul>
  61. 61. Default Risk <ul><li>What is the chance (probability) that the corporation will fail to make interest or principal payments when due? </li></ul><ul><li>Because of high collection costs, creditors evaluate credit risk carefully </li></ul><ul><li>Failure events: restructurings, especially troubled debt restructuring; default; bond rating down-grading; going-concern qualifications; bankruptcy </li></ul>
  62. 62. Altman’s Z-score, 1983 Model <ul><li>6.56 x (working capital / total assets) </li></ul><ul><li>+ 3.26 x (retained earnings / total assets) </li></ul><ul><li>+ 6.72 x (EBIT / total assets) </li></ul><ul><li>+ 1.05 x (book value of equity / book value of debt) </li></ul><ul><li>= Altman’s Z-score </li></ul>
  63. 63. Altman’s Z-score <ul><li>Indicator of overall financial health </li></ul><ul><li>Cutoffs: les than 1.1 bankrupt 1.1 – 2.6 gray area greater than 2.6 healthy </li></ul><ul><li>A Z-score of 1.1 or less does not mean the company is bankrupt, but does suggest that financial problems may exist </li></ul>
  64. 64. Bond Ratings Below C D Speculative Below Caa CCC Speculative Below B B Speculative Below Ba BB Speculative Investment Baa BBB High Qual. Investment A A High Qual. Investment Aa AA Very High Investment Aaa AAA Highest Category Moody’s S & P
  65. 65. Chapter 12 Credit Analysis
  66. 66. Credit Analysis Process <ul><li>Loan Purpose </li></ul><ul><li>Corporate Overview </li></ul><ul><li>Financial Analysis </li></ul><ul><li>Accounting Analysis </li></ul><ul><li>Comprehensive Analysis </li></ul><ul><li>Loan Decision </li></ul>
  67. 67. Loan Purpose <ul><li>Commercial Bank Loan: term loan revolving line of credit other </li></ul><ul><li>Commercial Paper </li></ul><ul><li>Corporate Bonds </li></ul>
  68. 68. Corporate Overview <ul><li>Wide variety of firms need bank loans </li></ul><ul><li>Size characteristics—local or regional to national & global </li></ul><ul><li>Industry specializations, including impact on bank credit risk </li></ul><ul><li>Large companies have more credit options </li></ul>
  69. 69. Financial Analysis <ul><li>Primary focus is on financial report analysis, with less emphasis on market information </li></ul><ul><li>Particular interest in liquidity & leverage </li></ul><ul><li>Evidence of financial health (as measured by credit risk) rather than earnings performance & forecasts </li></ul>
  70. 70. Accounting Analysis <ul><li>Emphasis on liquidity & cash flow information </li></ul><ul><li>Analysis of unrecorded obligations & potential overstated assets </li></ul><ul><li>Forecasts of sales & operations plus future cash flows </li></ul>
  71. 71. Comprehensive Analysis <ul><li>Summary of key information (executive summary recommended) </li></ul><ul><li>Importance of credit risk </li></ul><ul><li>Adequate information to make informed recommendations/decisions </li></ul>
  72. 72. Loan Decisions <ul><li>Yes/ No on loan </li></ul><ul><li>What interest rate (prime rate +)? </li></ul><ul><li>What collateral? </li></ul><ul><li>What Debt covenants? </li></ul><ul><li>Other considerations (e.g., compensating balances) </li></ul>