Essentials of Financial Statement Analysis Revsine/Collins/Johnson: Chapter 5
How competitive forces and business strategies affect firms’ financial statements.
Why analysts worry about accounting quality.
How return on assets (ROA) is used to evaluate profitability.
How ROA and financial leverage combine to determine a firm’s return on equity (ROE).
How short-term liquidity risk and long-term solvency risk are assessed.
Why EBITDA can be a misleading indicator of profitability and cash flow.
Financial statement analysis: Tools and approaches
Approaches used with each tool:
Time-series analysis: the same firm over time (e.g., Wal-Mart in 2005 and 2006)
Common size statements Trend statements Financial ratios (e.g., ROA and ROE) 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2005). 3. Benchmark comparison: using industry norms or predetermined standards.
Evaluating accounting “quality”
Analysts use financial statement information to “get behind the numbers”.
However, financial statements do not always provide a complete and faithful picture of a company’s activities and condition.
How the financial accounting “filter” sometimes works GAAP puts capital leases on the balance sheet, but operating leases are “off-balance-sheet”. Managers have some discretion over estimates such as “bad debt expense”. Managers have some discretion over the timing of business transactions such as when to buy advertising. Managers can choose any of several different inventory accounting methods.
Evaluating accounting “quality”: The message for analysts
The first step to informed financial statement analysis is a careful evaluation of the quality of a company’s reported accounting numbers.
Then adjust the numbers to overcome distortions caused by GAAP or by managers’ accounting and disclosure choices.
Only then can you truly “get behind the numbers” and see what’s really going on in the company.
Getting behind the numbers: Krispy Kreme Doughnuts, Inc.
Established in 1937.
Today has more than 290 doughnut stores (company-owned plus franchised) throughout the U.S.
Serves more than 7.5 million doughnuts every day.
Strong earnings and consistent sales growth.
Krispy Kreme’s Financials: Comparative Income Statements Includes a $9.1 million charge to settle a business dispute Includes a $5.733 million after-tax special charge for business dispute
Krispy Kreme’s Financials: Common size income statements $393.7 operation expenses $491.5 sales * Not adjusted for distortions caused by “special items”.
Krispy Kreme’s Financials: Tend income statements * Not adjusted for distortions caused by “special items”. $393.7 operating expenses in 2002 $194.5 operating expenses in 1999
Krispy Kreme’s Financials: Business segment information * Not adjusted for distortions caused by “special items”. Sell flour mix, doughnut making equipment, and supplies to franchised stores
Krispy Kreme’s Financials: Business segments (common size) * Not adjusted for distortions caused by “special items”.
Increase the intensity of asset utilization ( turnover rate).
Assets turnover Operating profit margin
ROA, margin and turnover: An example
A company earns $9 million of NOPAT on sales of $100 million with an asset base of $50 million.
Turnover improvement: Suppose assets can be reduced to $45 million without sacrificing sales or profits.
Margin improvement: Suppose expenses can be reduced so that NOPAT becomes $10.
Krispy Kreme: ROA decomposition How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over this period?
Further decomposition of ROA Operating profit margin Asset turnover ROA X = Sales Average assets NOPAT Sales
ROA and competitive advantage: Krispy Kreme Wendy’s, Baja Fresh, Café Express S&P industry survey or other sources
ROA and competitive advantage: Four hypothetical restaurant firms
Competition works to drive down ROA toward the competitive floor.
Companies that consistently earn an ROA above the floor are said to have a competitive advantage .
However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage.
Firm A and B earn the same ROA, but Firm A follows a differentiation strategy while Firm B is a low cost leader .
Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA).
Competitive ROA floor
Credit risk and capital structure: Overview
Credit risk refers to the risk of default by the borrower.
The lender risks losing interest payments and loan principal.
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.
A company’s willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment.
Credit risk and capital structure: Balancing cash sources and needs
Credit risk: Short-term liquidity ratios Short-term liquidity Activity ratios Liquidity ratios Current ratio = Current assets Current liabilities Quick ratio = Cash + Marketable securities + Receivables Current liabilities Accounts receivable turnover = Net credit sales Average accounts receivable Inventory turnover = Cost of goods sold Average inventory Accounts payable turnover = Inventory purchases Average accounts payable
Credit risk: Operating and cash conversion cycles Working capital ratios: Operating cycle 75 days 45 days 30 days Days accounts receivable outstanding = 365 days Accounts receivable turnover Days accounts payable outstanding = 365 days Accounts payable turnover ( 20 days) Cash conversion cycle 55 days Days inventory held = 365 days Inventory turnover
Credit risk: Operating and cash conversion cycle example
Credit risk: Short-term liquidity at Krispy Kreme
Credit risk: Long-term solvency Long-term solvency Coverage ratios Debt ratios Long-term debt to assets = Long-term debt Total assets Long-term debt to tangible assets = Long-term debt Total tangible assets Interest coverage = Operating incomes before taxes and interest Interest expense Operating cash flow to total liabilities Cash flow from continuing operations Average current liabilities + long-term debt =
Credit risk: Long-term solvency at Krispy Kreme
Credit risk: Financial ratios and default risk
A firm defaults when it fails to make principal or interest payments.
Lenders can then:
Adjust the loan payment schedule.
Increase the interest rate and require loan collateral.
Seek to have the firm declared insolvent.
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.
Default rates by Moody’s credit rating, 1983-1999 Source: Moody’s Investors Service (May 2000)
Default frequency: Return on assets (ROA) Source: Moody’s Investors Service (May 2000) Profitability: Return on Assets Percentiles (excludes extraordinary items)
Default frequency: Debt-to-tangible assets and interest coverage Source: Moody’s Investors Service (May 2000) Solvency: Debt-to-Tangible Assets and Interest Coverage Percentiles
Default frequency: Quick ratio Source: Moody’s Investors Service (May 2000) Liquidity: Quick Ratio Percentiles
Return on equity and financial leverage
2005: No debt, so all the earnings belong to shareholders.
2006: $1 million borrowed at 10% interest, but ROCE climbs to 20%.
2007: Another $1 million borrowed at 20% interest, and ROCE falls to only 15%.
Components of ROCE Return on common equity (ROCE) Return on assets (ROA) Common earnings leverage Financial structure leverage Net income available to common shareholders Average common shareholders’ equity NOPAT Average assets Net income available to common shareholders NOPAT Average assets Average common shareholders’ equity X X
Profitability and financial leverage: Nodebt and Hidebt example Leverage helps Leverage helps Leverage neutral Leverage hurts Leverage neutral
Financial statement analysis and accounting quality
Financial ratios, common-size statements, and trend statements are extremely powerful tools.
But they can be no better than the data from which they are constructed.
Be on the lookout for accounting distortions when using these tools. Examples include:
Nonrecurring gains and losses Differences in accounting methods Differences in accounting estimates GAAP implementation differences Historical cost convention
Financial statement analysis: Pro forma earnings at Amazon.com Company defined numbers Computed according to GAAP
Why do firms report EBITDA and “pro forma” earnings?
Impression management is the answer.
Help investors and analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked.
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.
Analysts should remember:
There are no standard definitions for non-GAAP earnings numbers.
Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability.
EBITDA and pro forma earnings do not accurately measure firm cash flows.
GAAP earnings, pro forma earnings, and EBITDA
Financial ratios, common-size statements and trend statements are powerful tools.
There is no single “correct” way to compute financial ratios.
Financial ratios don’t provide the answers, but they can help you ask the right questions.
Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons.