4. 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. 5
Tools for Economic Analysis
• Porter’s Five Forces
• Economic Attributes Framework
6. 6
Porter’s Five Forces
• Buyer Power- (price sensitivity)
• Supplier Power
• Rivalry among Firms
• Threat of New Entrants
• Threat of Substitutes
7. 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. 8
Strategic Analysis Framework
• Nature of product or service
• Degree of Integration
• Degree of Geographical
Diversification
• Degree of Industry Diversification
9. 9
Financial Statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Footnotes
• Auditors Report
• Management Discussion and Analysis
10. 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. 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)
17. 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. 18
Sources of Information
• Annual Report
• Form 10-K
• Form 10-Q
• Form 8-K
• Prospectus
• Form 20-F (foreign entity 10-K)
19. 19
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. 20
Roots = Financing Activities
Trunk & Branches = Investing Activities
Fruit = Operating Activities
Businesses are like Fruit
Trees
21. 21
Net Income vs. Cash Flow
Indirect Method
• Net Income
• +/- Non-cash Items
• +/- Changes in Operating Working
Capital
• = Cash Flow from Operations
22. 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. 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. 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
25. 25
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. 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. 27
Risk Analysis
• Types of risk
International
Domestic
Industry
Firm-specific
• Our focus will be on the financial
aspects of risk
28. 28
Relationship to O-I-F
• S/T liquidity…O…working capital
• L/T liquidity…I…plant capacity
• L/T liquidity…F…debt svc. rqmts
29. 29
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
30. 30
L/T Liquidity
• L/T Debt Ratio
• Debt/Equity Ratio
• Liabilities/Assets Ratio
• Interest coverage…fixed charges
coverage
• OCF to Total Liabilities
• OCF to Capital Expenditures
31. 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. 32
Industry Ratio Sources
• Robt. Morris Associates, Annual
Statement Studies
• Dun & Bradstreet, Industry Norms
and Key Financial Ratios
33. 33
Stickney’s Comparability
Risks…in additon to WFO’s
• 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. 34
Quality of Earnings Issues-
Chapter 6
• Non-recurring items…sustainability
• Earnings measurement
• Earnings management
• Essentially we are trying to
determine if what is reported is
going to recur in the future.
35. 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
40. 40
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.
41. 41
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
43. 43
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
44. 44
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
46. 46
ROCE Considerations
• ROCE tends to follow ROA
• Two theories
Random walk…high stays high; low
stays low
Equilibrium…revision to average ROCE
• Penman’s findings
Random walk valid 1-6years
Equilibrium thereafter takes hold
• Capital structure not changed for
ROCE improvement
48. 48
Credit Risk C’s
• Circumstances
• Cash flows (Capability to repay)
• Collateral
• Capacity for debt
• Contingencies
• Character of management
• Conditions
49. 49
Bankruptcy
• Process
Chapter XI…liquidation
Chapter VII…reorganization
• Predictive Models
Beaver…univariate
Net income before amort. etc./total liab.
Altman’s Z…see pages 631-633
Multivariate
50. 50
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
51. 51
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. 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
55. 55
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
56. 56
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. 57
Pro-forma Methodology
• Chapter 10 provides you with a
format for building the excel
worksheet and integrating it with the
FSAP template
58. 58
Rev. Recognition Options
Chapter 7
• Period of production
• Completion of production
• Time of sale
• During collection period
• Upon cash receipt
62. 62
L/T Contractors
• Multiple accounting periods
• Price established in advance of work
• Periodic payments
• Percentage of completion
IRS approach
• Completed contract
63. 63
Criteria for Exp. Recognition
• Matched with revenue
• Consumption of service or benefit
64. 64
Rev. Recog. When Cash is
Uncertain
• Installment method
• Cost-recovery-first method
67. 67
LIFO Liquidation
• Sales greater than production
• Cash flow increases due to reduced
purchases
• Cash flow decreases due to higher
income taxes
68. 68
LIFO Characteristics
• Rapid price increases
• Provides better income smoothing in
light of inventory change variability
• Tax savings
• Industry specific
• Larger firm size
74. 74
Intangibles--General
• Expense cost of development
• Recognize as asset purchased
intangibles
• Amortize up to 40 years
• Caution surrounding “in process
R&D”
75. 75
S/W Development Costs
• Expense through “tech. feasibility”
• Capitalize, thereafter
• Amortize over useful life
79. 79
No Liability, If...
• Mutually unexecuted contracts
• Certain contingencies
Not probable
Not measurable
80. 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. 81
Liability Valuation
• PV of future cash flows > 1 year
• Cost of future deliverables
• Cash advance value
82. 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
84. 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. 85
Key Terms
• ABO - amount expected to be
paid--current salaries
• PBO - amount expected to be
paid--future salaries
86. 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
88. 88
Health Care Benefits
• No minimum liability
• Minor measurement differences
• Considers income tax impact
• Sensitivity analysis
• Note politicization on p. 410
89. 89
Analyst’s Role
• Awareness of underfunding
• Reasonableness of assumptions
• Actual performance vs. expected
performance
90. 90
Income Taxes-FASB 109
• Book income
• Permanent differences
• Temporary differences
Taxables
Deductibles
• Taxable income
98. 98
Business Combinations
• Purchase accounting
Record at FMV
Excess to goodwill
• Pooling
Assume assets and liabilities
Must meet the 12 criteria for pooling
99. 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
101. 101
Under 20%
• Held to maturity
• Available for sale…comprehensive inc.
• Trading…income statement
• Analyst issues
include or exclude adj. from income
102. 102
20% to 50%
• Equity method if influence exists
• Analyst issues
relationship between income and cash
submerged assets
105. 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. 106
FX-Analyst Issues
• Translation adjustments in income?
• Difficult to interpret due to limited
disclosure
• Significant international variance in
practice
107. 107
Disaggregation of Info.
• Disclosure of segments (mgt. Approach)
operating segments
geographic locations
major customers
• 10% rule
• Elements
operating income
sales
assets
108. 108
Why Value Via Cash Flow?
Chapter 11
• Cash = ultimate value
• Cash = common denominator
110. 110
Valuation: Cash Flow Based
• Periodic cash flows
• Residual value
• Approximate discount rate
Cost of capital
111. 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. 112
Periodic Cash Flows, cont.
• Appropriately reflect inflation
Nominal vs. real cash
• Use after tax amounts
113. 113
Residual Value
• Horizon = no growth
• (last cash flow) x (1 + growth rate)
(discount rate - growth rate)
• Consider conversion tables (Stickney-p.
766)
114. 114
Cost of Capital
• Debt
Market rate (1-tax rate)
Leases: use borrowing rate
• Preferred Equity
Dividend rate
• Common Equity
Risk free rate + ß(Mkt. Rate - RFR)
Betas published in S&P’s stock reports
115. 115
Releveraging @ New Capital
Structure
• BL0=BU[1+(1-tax rate)(Current Debt
)]
Current Equity
• Substitute BU with new capital structure
• BL1=BU[1+(1-tax rate)(New Debt
)]
New Equity
117. 117
Valuation Techniques
• Equity
CFU-[(interest)(1-tax rate)]
Cost of equity capital
• Debt plus equity
CFU ÷ Wtd. average cost of capital
• Adjusted present value
CFU ÷ Unleveraged cost of equity cap.
[interest(tax rate)] ÷ cost of debt cap.
121. 121
Theoretical Variances: PE
• Earnings persistance
Transitory…no change in PE
Permanent…change in PE
• Accounting principles
Lower earnings…higher PE
122. 122
Trending
• Penman found transitory earnings
consistency…that is high PE caused
by lower than normal earnings is
counterbalanced in the following
year.
• 5-7 years reversion to mid-teens
growth
124. 124
PE Analysis Keys
• Use a sustainable growth rate
• Doesn’t work when g>r
• Doesn’t work when g approximates r
• Test reasonableness with actual PE
• Existence of transitory earnings
• Impact of GAAP
125. 125
Price to Book Value
• Market rewards growth in excess of
cost of capital
• Ultimately reverts to 1.0
• Function of
Profitability
BV growth
