Com 4FK3

Financial Statement AnalysisWeek 1, 2012

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Why Analyse F. S. Data?

• Efficient market hypothesis; market reacts intelligently and quickly to new information so analysis should not lead to excess return

• Paradox, if analysis is not profitable, nobody will do the analysis… so how can the market price securities efficiently?

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Individual vs. Average

• Research studies on capital market efficiency study groups rather than single companies

• If the market is efficient on average, that doesn’t mean that there are not some mispriced securities

• Role of analyst: to bring about a correction to the mispricing of securities

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Perfect Efficiency?

• Studies show that equity markets are not perfectly efficient– January effect– Price lags– Over or under reaction

• Analysis can help detect under and over priced firms

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Purpose of Financial Statements

• Ideal world: disclose the true economic value of the company

• Real world:– required by law (Securities Regulators)– follows GAAP, wide latitude allowed

• Analysis required to “cleanse” statements of bias to set prices efficiently

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The Adversarial Nature of Financial Reporting

The purpose of financial reporting is to obtain cheap capital

Martin Fridson & Fernando Alvaez

• Other incentives for misstatements include managerial compensation, which is often tied to the financial statement numbers

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Other Uses

• Financial statements used for other purposes– credit analysis by a bank (not alone)– competitor analysis– merger and acquisition analysis

• Not Taxation– Corporations typically have separate sets of

books for tax purposes– These books are not compliant with GAAP

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Five Steps

• Identify the economic characteristics of the particular industry

• Identify the firm’s strategy• Understand the firm’s financial statements

and “cleanse” them• Assess profitability and risk• Value the firm

ImportantThis is an overview of the term paper

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Economic Characteristics

• How does the industry operate:– number of competitors– principal types of assets and liabilities– typical capital structure– risk levels and types– differentiability of products

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E. C. Pharmaceuticals

• High barriers to entry, research and approval costs before any revenue

• Patent protection gives high margins• High risks; product liability, other drug

makes your product obsolete• Business risk leads to low level of debt• Generic drug manufacturers, effectively a

separate industry

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Value Chain Analysis

• The various steps in the creation, manufacture, and distribution of a product or service

• Firm can be involved in all steps or concentrate on a few

Pharmaceuticals• Research• Approval process• Manufacture• Create demand• Distribution to retail outlets

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Porter’s Five Forces

• Competitors, rivalry among firms• Potential Entrants• Equivalent Products & substitutes• Bargaining Power of Customers• Bargaining Power of Input Suppliers

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Competitors

• Opportunities for growth• Number and size of competitors• Cost structure of product – fixed and

variable costs• Capacity issues• Pressure on selling price and delivery• Product quality

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Potential Entrants

• Size of initial investment• Degree of profit margin• Learning curve impact on costs• Relationship with customers• Non financial barriers

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Equivalent Products

• Availability of substitute products• Type of technology• Integration with customers end products• Continuous improvement of product• Downward pressure on costs

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Bargaining Power of Customers

• Purchase quantities• Generic nature of product• Availability of product

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Bargaining Power of Suppliers

• Quality requirements• Generic nature of products• Availability of materials and labour force• Skill level of labour force

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Economic Attribute Framework

• Demand: price sensitivity, growth, cyclic nature of demand

• Supply: number of firms, barriers to entry• Manufacturing: capital intensive, complex• Marketing: selling to business or consumer• Financing: short or long-term financing

needs

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Soft Drink Industry

Demand• Relatively insensitive to price• Low growth domestically, international

opportunities• Not cyclical• Higher demand in warmer weather

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Soft Drink Industry

Supply• 2 major branded suppliers• domination of distribution channels creates

barriers to entry

Manufacturing• Capital intensive but simple

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Soft Drink Industry

Marketing• high brand recognition and demand pull

Financing• Bottling and transport operations require

long term financing• High profitability and low growth (domestic)

lead to excess cash flow generation

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Strategy

• Nature of product or service: is it unique (product differentiation) or low price

• Degree of integration with value chain• Degree of geographical diversification• Degree of industry diversification

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Strategy for Coke

• Brand recognition allows for differentiation• Value chain: Coke develops and advertises

products and produces the syrup, but uses other companies to bottle and distribute

• Geographical: 67% of sales outside N. A.• Industry diversification: virtually zero…

operates in beverage industry but mainly in the soft drink subsection

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Principal Financial Statements

• Balance Sheet, Income Statement, Statement of Cash Flows, Notes

• SEC (US) or OSC (Canada) requirements• GAAP largely delegated to FASB (US) or

CICA (Canada)

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Balance Sheet

• Snapshot of the resources of the firm• Assets = Liabilities + Shareholder equity• Formats differ between countries

– France and Germany; reverse order of current and noncurrent

– UK; Assets + WC - Liabilities = Equity

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Assets

• 2 categories; monetary & non-monetary• Classification

– Current Assets– Investments– Property, Plant, and Equipment– Intangibles

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Liabilities

• Money to be paid in the future for goods or services already received

• Labour contracts, purchase orders, lease payments, etc. for benefits not yet received are not considered liabilities

• Noncurrent liabilities discounted at interest rate applicable when incurred

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Shareholders’ Equity

• Value of assets and liabilities determines shareholders’ equity

• Often broken down to:– amounts initially contributed– retained earnings– valuation allowances– treasury stock

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Quality of Balance Sheet

• Ignores valuable resources of the firm; patents, brand names, etc.

• Non-monetary assets at cost• Some legal claims against the cash flows of

the firm don’t appear as liabilities• Noncurrent liabilities discounted at rate

applicable when incurred, not current costs

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Income Statement

• Measures operating performance• Net Income = Revenues and gains –

Expenses and losses• GAAP requires accrual accounting

– Revenue recognized when service rendered and cash or measurable receivable gained

– Expenses matched with revenue

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Classification

• Income from continuing operations– Main form of earnings

• Income, gains and losses from discontinued operations

• Extraordinary gains and losses• Adjustments for changes in accounting

principals

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Quality of Earnings

• Managerial compensation is often tied to earnings, there is a potential that current earnings are not a good indicator of future earnings potential

• Analysts may want to adjust earnings for some items before assessing operating performance

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Statement of Cash Flows

• A high growth firm can report positive net income and be running out of cash to pay creditors

• Statement of cash flows can provide early warning of problems

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Classification

• Operating– The core business of the firm– In the long run, this must be positive for the

firm to survive

• Investing• Financing

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Common Size Statements

• To aid in analyzing a firm common size financial statements are often prepared

• Balance sheet: divide all numbers by the total assets of that year

• Income statement: divide by sales

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Financial Statement Ratios

• Profitability– EPS– ROCE

• Risk– Current ratio– CFO/average current liabilities– Interest coverage ratio– Debt/Equity ratio

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Valuation of Firms

• P/E ratio– Theoretical model

(1 + growth rate in earnings)Required return - growth rate in earnings

• Market to book ratio– Theoretical model

1 + Expected ROCE – required returnCost of equity - growth rate in earnings