Business Analysis Using Financial Statements
Chapter one Framework for business analysis using financial statements
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Learning Objectives
1. Explain business analysis and its relation 2.
3.
4. 5. 6.
to financial statement analysis Identify and discuss different types of business analysis Describe the component analysis Learn the sources of financial information Accounting system features Company reporting strategy
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Introduction to Business Analysis
Evaluation Prospects Evaluation Risk
Business Decision Makers •Equity Investors •Creditors •Managers •Merger and Acquisition Analysis •External Auditors •Directors •Regulators •Employees and Unions Business analysis is the evaluation of a company’s prospects & risks for the purpose of making business decision
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Introduction to financial statement analysis
Financial statement analysis is the process of analyzing financial information to predict the future financial performance and condition • An important part of business analysis • Provide a systematic and effective statement analysis • Reliable inferences are drawn about a company prospects and risks
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Credit Analysis
Equity Analysis
Management & Control Types of Business Analysis
Labor Negotiations
Regulation
Director Oversight
Financial Management
External Auditing Mergers, Acquisitions & Divestitures
Credit Analysis
Credit worthiness: Ability to honor credit obligations (downside risk)
Liquidity Ability to meet shortterm obligations
Focus: • Current Financial conditions • Current cash flows • Liquidity of assets
Solvency Ability to meet longterm obligations
Focus: • Long-term financial conditions • Long-term cash flows • Extended profitability
Equity Analysis
Passive Investing (beta strategies) Aim: • Diversification based on risk propensity & investment horizon
Example: Indexing
Active Investing (alpha strategies) Aim: • Beat the market -earn above normal stock returns Examples: Technical
analysis & Fundamental
analysis
Intrinsic Value
(or Fundamental Value)
Value of Company (or stock) without reference to market value (or stock price)
Strategy
Intrinsic value > Market value Intrinsic value < Market value Intrinsic value = Market value
Buy Sell Hold
Management and Control
Managers are hired by a company’s owners
to manage its business activities Managers make operating and financing decision based on business analysis Managers monitor and control company activities through the process of business analysis
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Accounting Analysis
Process to evaluate and adjust financial statements to better reflect economic reality
Comparability problems — across firms and across time
Manager estimation error Distortion problems Earnings management Distortion of business Accounting Risk
Strategy Analysis
• The purpose of Business Strategy Analysis
Identify key profit drives and business risks Assess company’s profit potential at a qualitative level • Strategy Analysis involves Industry analysis Competitive strategy Corporate strategy analysis
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Industry Analysis
Analyzing a firm’s profit potential must first assess industry profitability. It includes: • Degree of actual and potential competition (1) Rivalry among existing firms (2) Threat of new entrants (3) Threat of substitute products • Bargaining power in input and output markets (1) Bargaining power of buyers (2) Bargaining power of suppliers
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Competitive strategy analysis
Competitive strategy analysis is the evaluation of a company’s decisions and success at establishing a competitive advantages • Cost leadership: supply same product and service at the lower cost • Differentiation: supply a unique product or service at a cost lower than the price premium customers will pay
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Corporate strategy analysis
• Involves examining whether a company is
able to create value in multiple businesses • A well-crafted corporate strategy reduces costs or increase revenues from running several businesses in one firm. • Cost saving or revenue increases come from specialized resources that the firm has to exploit synergies across these businesses
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Business Environment & Strategy Analysis
Industry Analysis
Strategy Analysis
Financial Analysis
Analysis of Sources Risk &Uses of Profitability Funds Analysis Analysis
Accounting Analysis
Prospective Analysis
Cost of Capital Estimate
Intrinsic Value
Financial Analysis
Process to evaluate financial position and performance using financial statements
Profitability analysis —Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness
Common tools
Ratio analysis
Sources and uses —Evaluate source & of funds analysis deployment of funds
Cash flow analysis
Prospective Analysis
Process to forecast future payoffs
Business Environment & Strategy Analysis Accounting Analysis
Financial Analysis
Intrinsic Value
Sources of financial information
Principle financial statements
• • • •
The balance sheet The income statement The statement of cash flow The statement of stockholders’ equity Notes to the financial statements Auditor’s report Management discussion and analysis Other data sources Chairperson’s letter, Finance press, Web sites, Industry statistics, Economic indicators.
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Kodak
Dec 31, 1998 (In millions, except per share data)
Assets Current Assets Cash and cash equivalents Marketable securities Receivables Inventories Deferred income tax charges Other Total current assets Properties Land, buildings and equipment at cost Less: Accumulated depreciation Net properties Other Assets Goodwill (net of accumulated amortization of $534) Long-term receivables and other non-current assets Deferred income tax charges Total Assets
Liabilities and Shareholders’ Equity $ 457 43 2,527 1,424 855 293 5,599 13,482 7,568 5,914 Current Liabilities Payables Short-term borrowings Taxes - income and other Dividends payable Deferred income tax credits Total current liabilities Other Liabilities Long-term borrowings Post-employment liabilities Other long-term liabilities Deferred income tax credits Total liabilities Shareholders' Equity Common stock, par value $2.50 per share, 950,000,000 shares authorized; issued 391,292,760 shares Additional paid in capital Retained earnings Accumulated other comprehensive loss Treasury stock, as cost, 68,494,402 shares Total shareholders' equity Total liabilities and equity $ 3,906 1,518 593 142 19 6,178 504 2,962 1,032 69 10,745
1,232
1,705 283 $ 14,733
$
978 902 6,163 (111) 7,932 3,944 3,988 14,733
Balance Sheet
Total Investing = Total Financing = Creditor Financing + Owner Financing
Kodak Financing
$14,733 = $10,745 + $3,988
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Income Statement
Kodak
For Year Ended Dec. 31, 1998 (In millions, except per share data)
Sales Cost of goods sold Gross profit Selling, general and administrative expenses Research and development costs Purchased research and development Restructuring costs and asset impairments EARNINGS FROM OPERATIONS Interest expense Other income (charges) Earnings before income taxes Provision for income taxes Earnings from continuing operations Gain on sale of discontinued operations NET EARNINGS
$13,406 7,293 6,113 3,303 880 42 1,888 110 328 2,106 716 1,390 $ 1,390
Statement of Shareholders’ Equity
Kodak
For year ended Dec. 31, 1998 Accumulated Additional Other Common Pail In Retained Comprehensive Treasury Stock Capital Earnings Income (Loss) Stock 978 914 5,343 (202) (3,872) 1,390 -
(In millions, except number of shares)
Shareholders’ Equity Dec 31, 1997 Net earnings Other comprehensive income (loss): Unrealized holding gains arising during period ($122 million pre-tax) Reclassification adjustment for gains included in net earnings ($66 million pre-tax) Currency translation adjustment Minimum pension liability adjustment ($7 million pre-tax) Other comprehensive income Comprehensive income Cash dividends declared Treasury stock repurchased (3,541,295 shares) Treasury stock issued under employee plans (3,272,713 shares) Tax reductions - employee plans Shareholders’ Equity Dec 31, 1998
Total 3,161 1,390
$978
(58) 46 $902
(570) $6,163
91 ($111)
-
80 (44) 59
(4) 91 1,481 (258)(570) (258) 128 186 $3,988 ($3,944) 46
Statement Kodak of Cash Flows
For year Ended Dec. 31, 1998 (In millions)
Cash flows from operating activities: Earnings from continuing operations Adjustments to reconcile to net cash provided by operating activities: Depreciation and amortization Purchased research and development Provisions (benefit) for deferred income taxes (Gain) loss on sale/retirement of assets (Increase) decrease in receivables (Increase) decrease in inventories (Decrease) increase in liabilities excluding borrowings Other items, net Total adjustments Net cash provided by operating activities Cash flow from Investing activities: Additions to properties Proceeds from sale of assets Cash flows related to sales of businesses Acquisitions, net of cash acquired Marketable securities - sales Marketable securities - purchases Net cash used in investing activities Cash flows from financing activities: Net increase (decrease) in borrowings with original maturities of 90 days or less Proceeds from other borrowings Repayment of other borrowings Dividends to shareholders Exercise of employee stock options Stock repurchase programs Net cash provided by (used in) financing activities Effect of exchange rate changes on cash Net (decrease) increase in cash and cash equivalents $ 1,390 853 42 202 (166) (1) (43) (516) (278) 93 1,483
(1,108) 297 (59) (949) 162 (182) (1,839)
894 1,133 (1,251) (569) 128 (258) 77 8 (271)
Financial Statement Links Kodak
Balance Sheet Dec. 31, 1997
Assets Cash Non-Cash Assets Total Assets Liabilities & Equity Total liabilities Equity: Share Capital Retained Earnings Treasury Stock Total equity Liabilities & Equity $ 728 12,417 $13,145
Statement of Cash Flows for Year Ended Dec. 31, 1998 Operating Cash flows $ 1,483 Investing Cash flows (1,839) Financing Cash flows 77 Exchange rate changes on cash 8 Net Change in Cash $ (271) Cash Balance, Dec. 31, 1997 728 Cash Balance, Dec. 31, 1998 $ 457 Income Statement for Year Ended Dec. 31, 1998 Sales $13,406 Expenses 12,016 Net Earnings $ 1,390 Other Comprehensive Income 91 Comprehensive Income $ 1,481 Statement of Shareholders’ Equity for Year Ended Dec. 31, 1998 Share Capital, Dec. 31, 1997 Adjustments/Stock Issue Share Capital, Dec. 31, 1998 Retained Earnings, Dec. 31, 1997 Add: Comprehensive Income Less: Dividends Retained Earnings, Dec. 31, 1998 Treasury Stock, Dec. 31, 1997 Treasury Stock Issued Treasury Stock Repurchased Treasury Stock, Dec. 31, 1998 $ 1,892 (12) $ 1,880 $ 5,141 1,481 (570) $ 6,052 $ 3,872 186 (258) $ 3,944 Balance Sheet Dec. 31, 1998 Assets Cash Non-Cash Assets Total Assets Liabilities & Equity Total liabilities Equity: Share Capital Retained Earnings Treasury Stock Total equity Liabilities & Equity (Period of time)
$ 457 14,276 $14,733
$ 9,984
$10,745
1,892 5,141 (3,872) $ 3,161 $13,145
1,880 6,052 (3,944) $ 3,988 $14,733
(Period of time)
(Period of time)
Sources of financial information
Auditing
SEC requires Audit Report Accounting Set by International Audit opinion can be: Standards Board - clean (fairly presented) Not -currently accepted in U.S. qualified (except for) Auditors - disclaimer (no opinion) SEC adverse pressure to accept under (not fairly presented) IASAuditor quality & independence Check
Sources of financial information
Notes to financial statements
The first notes provide a summary of the firm’s accounting policies Other notes present details about particular accounts such as inventory;
property, plant and equipment; investment; long term debt. The notes also include Major acquisitions or divestitures Officer and employee retirement, pension and stock option plans Leasing arrangement The term, cost and maturity of debt Pending legal proceeding Income taxes Contingencies and commitments Operating segments
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Sources of financial information—MD&A
• One of ways management communicates
the reasons for changes in financial and operating data • The content of the section includes coverage of any favorable or unfavorable trends and significant events or Uncertainties in the areas of liquidity, capital resources, and results of operations.
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The U.S. financial reporting system
Securities and Exchange Commission (SEC)
Independent, quasi-judicial government agency Administer securities regulations & disclosures Can modify & set GAAP, if necessary Rarely directly challenges FASB Major player in global accounting
The U.S. financial reporting system
Financial Accounting standards board
FASB is a nongovernmental body with
seven full-time members Sets accounting standards for all company issuing audited financial statements Issues “statements of financial accounting standards (SFAS) and interpretation (part of GAAP)
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The U.S. financial reporting system
Unions Securities and Exchange Commission Investors AICPA Lenders Politicians Others
Accountants
Provide input to
Financial Accounting Standards Board
Help set
Generally Accepted Accounting Principles
International reporting system
International Accounting Standards (IAS)
Set by International Accounting Standards Board
Not currently accepted in U.S.
SEC under pressure to accept IAS
Form 10-K
(Annual Report)
10-Q
(Quarterly Report)
20-F
(Registration Statement/ Annual Report [Foreign])
8-K
(Current Report)
Statutory Financial Reports
14-A
(Proxy Statement/ Prospectus)
Other SEC Filings
Demands for financial reporting
Equity Investors
Active & Speculative Investors rely on financial reports
Creditors
Solvency & Liquidity analysis relies on financial reports
Demands for financial reporting
Internal Users External Users
Managers Officers Internal Auditors Sales Managers Budget Officers Controller
Lenders Shareholders Governments Labor Unions External Auditors Customers
Accounting system feature
Accrual accounting
Accounting standards and auditing
GAAP reduce manager’s ability to distort accounting information Auditing improves the quality of accounting information Manager’s reporting strategy
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Reporting strategy
Reporting strategy is policies used by management
when choosing accounting method, normally designed to achieve specific reporting objectives There are four common strategies Overstating financial performance and condition Building hidden reserves Taking a bath Off-balance-sheet financing
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Study questions and problems
(a) (b)
C.Stern, chief financial officer of R-M Corp, has just reviewed the current year’s third-quarter financial results. R-M Corp sets an annual target for earnings growth of 12%. It now appears likely that the company will fall short of that goal and achieve only a 9% increase in earnings. This would have a potentially detrimental impact of the firm’s stock price. Stern wants to develop alternative plans to stimulate earnings during the last quarter in order to reach the 12% target. Discuss techniques that could be used increase earnings. Differentiate between those that would Increase earnings but lower quality of reported earnings. Increase earnings and also have a positive “real” impact on the firm’s financial position.
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Study questions and problems
Read the auditors’ report for Royal Appliance Co. What type of
opinion was issued by the auditors? Explain why this type of opinion was given. To the shareholders and Board of Directors of Royal Appliance Co. We have audited the Consolidated Financial Statements of Royal Appliance Co. of this form 10-K. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion and these financial statements based on our audits. We conducted our audits in accordance with generally accepted standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining…… We believe that our audits provide a reasonable basis for our opinion. Continue to next slide
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Study questions and problems
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Royal Appliance Co. as of Dec. 31,1994 and 1995, and the consolidated results of their operations and their cash flow for each of the three years in the period ended Dec. 31,1995, in conformity with GAAP. As discussed in footnote 1 to the Consolidated Financial Statements, effective September 1995, the Company changed its method of accounting for domestic inventories from the last-in , firstout(LIFO) method to the first-in, first-out(FIFO) method. Coopers & Lybrand LLP Cleveland, Ohio March 27,1996
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