Financial Statement Analysis Answers Some Questions 438

8/6/2019 Financial Statement Analysis Answers Some Questions 438

1/35

Financial Statement AnalysisAnswers some questions

Raises others Confirms beliefs

The art of FSA comes out as we do

prospective analysis


2/35

Whats Next?Industry analysis &

Competitive strategy

Accounting analysis

Financial analysis

Prospective analysis


3/35

Why Forecast Financials Internal

single supplier

analysis major customer

analysis

analysis of

competitor cash flow projection

merger, acquisition

External

investment banking

merger, acquisition

security analysis

going concern

cash flow projection


4/35

Relation to Other Analyses Business strategy

what does industry analysis indicate about futuretrends?

what is the companys response to those trends?

Accounting is the accounting masking the real trends?

are trends stronger or weaker than they appear?

Financial what can be improved?

what will be under pressure from competitors? fromregulators?

what are managements target areas for change?


5/35

General Approach Comprehensive vs. Piecemeal

Comprehensive avoids internal inconsistencies

Examples expanded sales without expanded plant and working

capital

need for new financing without additional interest

additional marketable securities without investmentearnings

Focus on key drivers What are the key drivers of F/S relationships?


6/35

What are the Key Drivers of a

Forecast? Sales

Gross Margins

Net Margins

Asset Turnover


7/35

Starting Points Gather historical data about firm, industry

What relationships appear stable? within arange?

past is surprisingly good predictor of the future

Business Strategy Analysis provides insights into

what changes are likely why should things be different from last year?

one-time events? change in strategy? change inenvironment?


8/35

Financial Analysis FrameworkROE !

Net Income

Common Shareholders' Equity

Taxes Operations Leverage

Interest Efficiency

ROE !NI

EBTv

EBT

EBITv

EBIT

Salesv

Sales

TAv

TA

CSE


9/35

Whats happened so far this

year? Review the 10-Qs

Imagine you had an interview with Dell.The interviewer tosses you a copy of the10-Q and says, Whadya think?

How could you analyze the F/S in 5

minutes?


10/35

Analyzing a 10-Q in 5 minutes Need to know

industry and

competitive strategyto be able to knowwhat to look at andhow to evaluate

changes (or lackthereof) in ratiosand statistics

Look at IncomeStatement Net income

$, trend, EPS

one-time items?

Sales $, trend

Gross Margin Percent level, trend

SG&A, R&D % of sales, trend

Tax rate % ofpretax income,

trend


11/35

Analyzing a 10-Q in 5 minutes Look at the Balance

Sheet

Current ratio portion in inventory

A/R turnover

Inventory turnover

LTDebt to Equity

Look at Cash FlowStatement

Cash flowfromoperations greater than zero?

greater than NI? why?

What is the companydoing with the cash? CF Investing

CF Financing


12/35

Back tofo

recastingArmed with background knowledge

about the company and recent trends,we can turn to the forecast

Note: to complete the analysis of the 10-Qwe would read Managements Discussion

and Analysis and the notes to the F/S Can we skip the boilerplate stuff?


13/35

Key Driver: Sales Statistically, sales follow a random

walk with drift process

2000 sales = 1999 sales plus drift term

drift can be based on past trend in sales andoutputofprior analyses

What do quarterly trends tell us? is the trend changing?


14/35

Forecasting: Step 1Sales

How would you forecast sales at McDonalds?

number of stores owned vs. franchised new vs. old

domestic vs. foreign

Same store sales in the past, adjusted for

new menus, promotions

competitors activities

relation between sales and general economic factors

demographic trends


15/35

Forecasting Sales

How would you forecast sales at Merck?

American Barrick?

PepsiCo?

Nordstrom?

Amazon.c

om?

Best Buy?

Dell?


16/35

Sales Forecast

for Dell

Trend?

company, industry

annual, quarterly Products?

Customer mix?

Geographic mix?

Sources WSJ Interactive

press releases

news articles

EDGAR SECfilings

Dataquest, IDC o

nW

eb Lexis/Nexis

search for news, tradepublications

Value Line et al.

Company statements


17/35

Sales Forecast

Refinements

Geographic Trends

(in 1998) Michael Dell says 30% growth in Europe

Germany is in a slump, but accounts for only 13% ofDellsales in Europe

UK accounts for 43%, whats up there?

Increased competition in Japan & the Asian crisis But, growth of 2nd buyer market bodes well for Dell

Product Line Trends


18/35

Key Driver: Earnings This is what we are trying toforecast

But, it also

tends tofo

llow a rand

omwalk with drift process

2000 NI = 1999 NI plus drift term

this is especially true when forecasting for the

longer range (early in the year, out severalyears)


19/35

Key Constraining Fact

or:ROE

Keep in mind thatROE is not likely to persistat levels away from the average High ROE firms will attract competition

unless there are sustainable barriers to entry

unless growing capital base can be reinvested at aboveaverage returns

Low ROE firms will improve or gooutofbusiness

Regression to mean of10-14% ROE

Consider whether GAAP distorts ROE missing assets at high tech firms,

pharmaceuticals: understates equity


20/35

Forecasting: Step 2Expenses

Expenses should be forecast separately Many expenses are linked to sales

COGSGross Margin analysis, tie-in to Business Strategy

SG&AEfficiencies R&D (in the long run)Business Strategy

Interest is a function ofdebt and capital structure

Depreciation is a function ofPPE, lease decisions

Taxes are a function ofpretax income and operating

decisions (e.g., location) Equity earnings are a function of the affiliates performance

Interest income is a function of investment decisions

Need to consider changes over time


21/35

Forecasting Dells Expenses

Margins recent history and trends: % of sales

SG&A recent history and trends: % of sales

R&D MD&A, recent history

Interest recent rates, forecast debt levels

Taxes % ofpretax income


22/35

ExpensesForecast

Refinements Gross Margin Percent

by product

by region

Fixed and Variable SG&A

Taxes

analysis of tax footnote

news about tax breaks in Malaysia, Brazil


23/35

Whats Missing?

Investment Income

Need data on Marketable Securities

Preferred Dividends

Need data on Preferred Stock

Weve got depreciation buried in SG&A

Well need itfor SCF


24/35

Key Factor: Pr

ofit Margins

Recall ROE = Profit Margin * Asset Turnover* Adjusted Leverage

IfROE is in competitive equilibrium, the companyis efficiently managing assets, and leverage is atthe target level THEN: Profit Margin will fall out

Normal profit margins depend on the industry(technology) and corporate strategy the higher the asset turnover, the lower the profit margin


25/35

Forecasting: Step 3Balance

SheetAs with expenses, forecast individually

Current Assets Cash: comes outofcash flow forecast?

MS: cash flow forecast, investment plans target current ratio?

A/R: turn

over ties t

oSales

forecast

Inventory: turnover ties to Sales forecast

Other: likely related to Sales


26/35

Forecasting the Balance Sheet

PPE: turnover ties to Sales forecast, investingactivities (CAPEX), depreciation policy

Other Non-Current: acquisition plans?

Liabilities

Current: function ofSales, target current ratio

Noncurrent: function ofCAPEX, capital structuredecisions


27/35

Forecasting the Balance Sheet

Equity Retained Earnings = Opening RE + NI -

Dividends other capital transactions Stock = opening stock + issuances,options, repurchases, retirements

Other equity items (FOREX,unrealized

gains and losses on available for sale MS)are difficult toforecast. Assume nochange?


28/35

Forecasting Dells Balance

Sheet Current Assets

Cash: % of sales

A/R: turnover

Inventory: turnover What about marketable securities? Lets do SCF first

CAPEXsee detailed slides

Liabilities Current ratio excluding marketable securities?

A/P turnover, accruals as % of sales? Debt policies and refinancing on the horizon (MD&A)

Equity Buybacks? Conversions? Options?


29/35

Forecasting Dells PPE

First, look to MD&A

1997 10-K says $180 million for F98

3rd Quarter 98 10-Q: $120 million spent &entered into a $250 lease facility

Alternatively, develop a model

need to make a number ofassumptions


30/35

Model

ofDells PPE

Gross PPE = f(Gross Ending PPE Turnover)

Net PPE = f(Net Ending PPE Turnover)

Gross Ending Acc. Dep. falls out

Depreciation = f(Gross Ending PPE)

Plug for Acc. Dep. on disposals

Assume PPE sold for NBV = 0 therefore, we know costofPPE sold

Plug for CAPEX


31/35

Forecasting Cash Fl

ows

Armed with I/S and B/Ss, we should beable to develop SCF

Key factors (all related toother F/S): CAPEXturnover, MD&A, press releases

Deferred taxhistorical plus analysis

Depreciationhist

orical rate

Interest expenselevel ofdebt

Capital structureMD&A


32/35


33/35

Forecasting: Summary

Forecasting involves all prior steps in the framework

Comprehensive, iterative approach start with sales, determine operating costs

are balance sheet changes required? CAPEX?

how will they be financed?

use I/S relationship with B/S toforecast B/S

forecastofSCF may lead to changes in asset levels

(depreciation should be reexamined), and debt levels(interest expense and income should be reexamined)

Always a good idea to conduct ratio and sensitivityanalyses on the forecasted numbers


34/35

Sensitivity Analysis Best guess vs. optimistic vs. pessimistic

What if

competition heats up? margins fall quickly?

a product doesnt make it to market?

a merger doesnt go through?

theres a strike?


35/35

Next time Maxwell Shoes

A basic forecasting case

Use assumptions in the case

Ill post a model for Dell

Assumptions are not refined

Financial Statement Analysis Answers Some Questions 438

Documents

Transcript of Financial Statement Analysis Answers Some Questions 438