Financial Statement Analysis: Applications. In this reading, we will
talk about the application of financial statement
analysis. We will understand how to evaluate past
financial performance. We will then look at how to project
future financial performance and then we will get into the two major reasons
why analysts evaluate financial statements.
One is to assess credit risk and the other
is related to Equity Investments. And finally we will talk about
Adjustments to Reported Financials. Evaluating past
Financial Performance. These points are taken straight
from the curriculum and they highlight what we need to consider
when we evaluate past financial performance.
I will simply read this for you. As an analyst, you need to consider how a
company's measures of profitability, efficiency,
liquidity, and solvency change over the period being analyzed
and why is this happening. As the industry matures
a company might try to improve its efficiency.
If you are a credit analyst you might be particularly concerned with the
liquidity and solvency of a company. These are items
that we will see in more detail later. How do the level and trend in a
company's profitability, efficiency, liquidity,
and solvency compare with the corresponding results
of other companies in the same industry or more specifically you can look at the
peer group and then how can the differences be
explained. What aspects of performance are critical
for a company to successfully compete in its industry? How did the company
perform relative to those critical performance aspects? And then
what is the company's business strategy, what is the company's business model
and do the financials reflect the strategy?
The curriculum gives several examples in this
reading. Most of the examples are fairly long-winded.
You can read the examples if you have time, I think they are
very interesting, but from a testability perspective, there are just a few core
points that you need to recognize, and what I'll
try to do in this lecture is highlight those
important points. The first example is a case study on
Apple, and it showcases how Apple's change in strategy is reflected in its
financial performance. In the early to
mid 2000's, Apple primarily was a personal
computer company. Its sales came mostly from the Apple Macintosh or
the Mac, but then apple changed its strategy,
and the focus moved away from being purely a PC company
to a company that provides several integrated
products. And if you look at Apple in 2010, it had
the iPhone, Apple sold iPads, iPods, music was downloadable
through iTunes, so the product mix
changed substantially, and if we look at Apple's
revenue and the mix of revenue coming from different sources,
we will see that that product mix and the corresponding revenue changed
substantially between 2007 and 2010, so what that tells us is that the
financial performance is reflecting Apple's stated
strategy. Apple strategy involved selling differentiated products so Apple
is a major innovator in its field, and when a company sells differentiated
products it can charge higher prices which is what Apple does,
and that should be reflected in higher gross
margins. If we look at Apple's gross margins between 2007
and 2010, as the strategy was being implemented,
the gross margins are actually becoming better, so that again reflects the fact
that the financial numbers do point out that the strategy was
working. The impact on operating profit margins
is weaker. The reason is that for a company that is providing differentiated
products, innovative products, there still needs to
be a substantial amount of investment in R&D,
in marketing and so on. These relatively high costs will have a
impact on profit margins so just because the company has differentiated products
and higher gross margins doesn't necessarily mean that the
operating profit margins will also be very high.
The example also showcases Apple's liquidity.
If we look at the liquidity ratios, they are quite high
in the 2 to 3 range. This says that Apple had a lot of extra
cash or at least a lot of current assets
relative to liabilities. There are several reasons
why this might happen and there are several ways in which a
company can use that extra cash. One interpretation might be that this
would be an inefficient usage of funds, but another
explanation would be that this is like Apple's 'War chest' where the
extra liquidity could be used to make acquisitions.
Example 2, highlights the effect of differences in accounting standards on
return on equity comparisons. Return on equity is
net income over equity. We are looking at three telecom companies;
one is Verizon in the US which uses US
GAAP, then we have a telecom company in Mexico using Mexican GAAP,
and a company in Brazil using Brazilian GAAP. It is a long example but
the main point is that differences in accounting standards can have a
substantial impact on financial ratios. In other words, it
does not make sense to take the un-adjusted numbers,
for say return on equity, and simply compare them.
If we do want to compare these three telecom companies which are using
different accounting standards, we need to first make sure that all the
numbers are presented in a particular standard,
US GAAP, for example, and then it makes more sense to compare ratios
This example shows that after we make adjustments
the change in ratios are quite significant.
Next, we talk about projecting future financial
performance. The first thing we need to do
is forecast sales for a company, and what is presented here is a
simplistic way of forecasting sales. We first forecast the expected GDP
growth, then we forecast the expected industry
sales based on historical relationship with
GDP, so if historical data tells us that a 3%
increase in GDP corresponds to a 3% increase
in sales, then we use that. In some industries
a 3% increase in GDP might have a much higher
increase in sales numbers. This relationship between increase in GDP
and the company sales or the industry sales
is available by looking at historical data and doing
regression analysis. We should then consider the market share of the company
that we are evaluating and whether that market share is going
to change or not. If the market share is not
going to change then we can simply say that the increase
in sales will correspond to the increase in the size of the industry.
Based on this information, we then forecast company
sales. Then to come up with the estimated net
income, we have to forecast expenses. We can use
historical margins such as gross profit margin
and operating margins for stable companies,
and this works for companies such as JNJ, which are large and diversified
and stable. For companies, which are not stable there might be new
companies, a company like Facebook, for example,
here we need to estimate each expense item. We should also remove any
non-recurring items because with our forecast we are
concerned about revenue items and expense items that will recur.
Those that will not recur should not be considered in our forecasts.
Generally, we estimate interest expense and tax expense
separately. The reason is with interest expense, the amount depends
on the level of debt and the rate, so we have to estimate the debt
that we expect in the future, and we need to estimate the interest rate,
and it is the combination of these two which will define
interest expense. With tax expense, we need to have an estimate for the tax
rate and obviously the earnings before tax
which will be calculated based on the forecasted sales
and the forecasted expenses. Once we have the EBT and the tax rate we
can come up with the tax expense.
To come up with cash flows, we also need to estimate changes
in working capital. If our working capital, such as
inventory, is going up that is not reflected
in the income statement, but obviously it has a
impact on cash flow, so an estimate of changes in working capital is important.
We should also estimate investment expenditures
because these will not be reflected in the
income statement. but they also impact cash flow. We need to estimate dividend
payments and so on. Again these are just high
level points. With this information we can then
project the cash flow for a given company.
The level of analysis presented here is simplistic,
but from a exam perspective this should be
reasonable. The curriculum presents several examples;
examples 2, 3, and 4 are fairly long. If you have time you can read them but
what I'll do here is give you the most important
point related to each example. Example 2
deals with using historical operating profit margin to forecast
operating profits. We are given the example of a stable diversified firm
like JNJ. For a company like JNJ, it makes sense to
use historical margins to project future operating profits.
Whereas we are given another company, which is
a Chinese search engine company, that is relatively new.
There it would not make sense to use historical operating profit margins
because of the uncertainties involved. There it
would make more sense to project each expense item
separately. Example 3 deals with issues in
forecasting. The most important point in this example is
that we need to recognize which expenses and which items are non-recurring,
so these items are not included in a forecasting model.
Example 4 is a basic financial model or a basic financial
forecast. This is a spreadsheet model and I don't think
this is overly testable. The example here is based on the
discussion from the previous slide, so if you know all the items from the
previous slide you are reasonably well prepared from an exam perspective.
Example 5 is a multiple choice question, it tests your knowledge of ratios, I
would strongly encourage you to do this example from the curriculum.
Assessing Credit Risk. Imagine you are considering the purchase of a
bond that has been issued by a company. One of your major concerns will be
whether the company will make its coupon payments and whether the company will
make its principal payment at the end.
The process whereby you assess whether or not the company will make
its payments is called assessing credit risk. You can also call this
credit analysis. The high level items that you
will be concerned with are the ability of the issuer to meet
interest and principal payments on schedule. To do this
one of the most important things you will look at is
cash flow forecasts. This will look at the amount of cash flows and also the
variability of cash flows. If the cash flow
is very volatile then obviously that will be a concern because if the cash
flow is low then there will be a question as to
whether coupon payments will be made. You also need to consider
the business risk and the financial risk of a company.
When we say business risk what we are talking about is the risk of the company
not having sufficient revenues or the risk of
expenses being too high. Financial risk arises
when the level of debt is high which means that
interest payments are high. If the operating profits are low
and debt is high then the company is in a very risky situation because
all the operating income might get used in paying
interest. The curriculum gives some specific examples on assessing
credit risk and I will again highlight the most
important points. You need to look at the size and scale
of the company that has issued the bond or issued debt. You need
to look at total revenue, you need to look at operating profit,
you need to look at the business profile, revenue, sustainability, and efficiency.
If a company has relatively high revenue which is
sustainable and the company is operating efficiently,
all these are indicators that the credit risk is good.
Good credit risk means that the company will make
its payments on time. You should also consider financial leverage and
flexibility. With leverage ratios we are talking
about ratios such as debt to equity. Low ratios are good
because for a given amount of equity, if a company has low debt that means
that it will easily be able to make its debt related payments. Coverage ratios
such as EBIT over interest--you want these
ratios to be high. High ratio means that the operating profit
is relatively high compared to the interest payments.
Debt over EBITDA. You want debt to be relatively low and EBITDA
which is a proxy for cash flows should ideally be high.
If this ratio is low that's a good thing. Free cash flow to debt. You want free
cash flow to be relatively high and debt to be relatively low, so if this
ratio is high that is good--by good we mean
low credit risk. We should also be concerned about the liquidity of a
company. The classic liquidity ratio is the
current ratio which is current assets over current liabilities.
If this ratio is high that means the company will easily
meet its short-term obligations.