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Why Financial Statements Analysis?

“You” may be an investor a creditor a supplier a customer an employee the manager a competitor an auditor a government agency

Will you rely on pure hunches and guesses? Or,

The Investment Environment

The Money Market treasury bills, certificate of deposit,

commercial paper, etc.

The Fixed-Income Capital Market treasury notes and bonds, municipal bonds,

corporate bonds, etc.

The Capital Market common stock, preferred stock

The Derivative Market options, futures

The Major Stock Market in the U.S.

The New York Stock Exchange (NYSE) Largest stock exchange: About 3,025 companies or

$16 trillion in market value (July 1999) 382 non-U.S. companies (July 1999)

The American Stock Exchange (AMEX) Listing of smaller and younger firms

The Over-the-Counter National Association of Securities Dealers Automated Quotation (NASDAQ) Trade through computer-linked network Include: Nasdaq National Market (4,400 securities)

and Nasdaq SmallCap Market (1,800 securities)

ACC 6213Financial Statements and Analysis

Objectives Discuss a framework for conducting

business analysis with a focus on the role of financial information

Learn how to apply the framework for security valuation and risk analysis

Learn to retrieve market and financial data

Textbook and Related Materials

Palepu, Healy and Bernard, “Business Analysis & Valuation: Using Financial Statements”, Text and Cases, 2nd ed., 2000Dell’s 10-K for fiscal year 1999 Computer skills: Research, retrieve and download data from

internet Excel or any other spreadsheet program

Course Requirements

Course OutlineIndividual Assignments 30%

Team Project 50%

Participation 20%

Grade: Expected distribution: 40-50% A’s, 20-30% B’s, rest C’s

Individual Assignments

Discussion allowed, but no copy of ideas or writing No points will be given for similar

assignments

Related to class discussion and cases in the bookQuestions to be posted on Web

Participation

Come to class prepared with Intelligent comments Constructive questions Thoughtful insights and observations

Quality counts more than QuantityTeam project to be discussed later

Palepu, Healy & Bernard(Figures 1-2 & 1-3)

A firm is involves in various business activities to create value for investorsFinancial statements summarize the economic consequences of a firm’s business activitiesAccounting system affects the quality of the financial data provided- affected by accounting rules, managements’

incentives

Analysts use a systematic framework to create inside information from public financial data

Framework: Four Steps of Analysis

Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Analysis andValuation Applications

I. Business Strategy Analysis

Purposes: To identify key profit drivers and business risks To assess profit potential at a qualitative level

Involves: Industry analysis Analysis of the firm’s strategy to create a

sustainable competitive level How did the firm stay alive and possibility of

prospering in the future

Important first step for the following three analyses

II. Accounting AnalysisPurposes: To evaluate the degree to which a firm’s

accounting captures underlying business reality

Involves: identifying where there is accounting flexibility evaluating the appropriateness of accounting

policies and estimates assessing the degree of distortion in disclosures undoing (if necessary) distortions

Improves the reliability of financial analysis

III. Financial AnalysisPurposes: To evaluate current and past performance To assess the sustainability of its performance

Requirements: should be systematic and consistent should allow the use of financial data to explore

issues found in business strategy analysis

Tools Ratio analysis: profitability, efficiency, liquidity Cash flow analysis: liquidity and financial

flexibility

IV. Prospective Analysis

Purpose To forecast a firm’s future

Final step in business analysisTechniques Financial statement forecasting Valuation

Team ProjectTeams of fourSelect an industry and two companies in the same industry

No more than two teams on one industry No group can work on the same company Need my approval; first-come, first serve

Compare the two companies in terms of All of the FOUR analyses:

Business Strategy Analysis Accounting Analysis & Financial Analysis Forecasting, Including Discussion of Assumptions Valuation

Industry Choices

Agricultural Construction Manufacturing Mining

Retail Service Transportation Wholesale - Trade

No Finance, Insurance, and Real Estate Industry and Public Administration Industry

Team Project Report

Must be typedLimit to 10 pages: double-spaced, 12-point font sizeData source and calculation should be included as appendicesAttach an evaluation on each of your group members: efforts and contribution

Finding Information for Business Analysis

CSUH Library and Internet

Main data sources Industry Research Company Research UC Berkeley International Business

Other: Annual Reports

Annual Report Gallery 10-K Reports Accounting Rules

Financial Accounting Standard Board

Historical Stock Market Data

Historical Market Index Data

Historical Stock Price Data

On DJ interactive, Historical market data

Framework for Business Analysis & Valuation

Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Strategy Analysis

Industry AnalysisIndustry profitability and risk

Competitive Strategy AnalysisWhich companies will sustain?

Corporate Strategy AnalysisMultibusiness management

Industry AnalysisStandard Industrial Classification (SIC), North American Industry Classification System (NAICS)

Factors affecting industry profitability: Porter’s “five forces” Degree of Actual & Potential Competition (3 forces)

Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products

Bargaining Power in Input & Output Markets (2 forces) Buyers’ Power Suppliers’ Power

Affect competitive strategy chosen to operate in the industry

1. Rivalry Among Existing Firms

Profitability is low if competition for market share is strong: Low industry concentration

Compute “Industry Concentration Ratio”, e.g. sales of largest four or eight companies total industry sales

Low product differentiation Large economy of scale, steep learning

curve, high proportion of fixed costs Low industry growth Excess capacity, high exit cost

2. Threat of New Entrants

Profitability is low if threat of new entrants is high:

Small economy of scale Less “first mover advantages” Easy access to channels of distribution

and distribution relationships Low legal barriers: e.g. government

approval

3. Threat of Substitute Products

Profitability is low, if threat of substitute products is high:

price and performance are similar customers are willing to switch

Products are similar or seen as being substitutes

Low brand allegiance

products are replaceable

4. Buyers’ PowerStrong, if

More Sensitive to Price Products are similar Low switching costs Unimportant products (relative cost and quality)

Higher Bargaining Power Fewer buyer Higher volume per buyer Low switching cost More substitute products High threat of backward integration by the buyers

5. Suppliers’ Power

Profit is low if suppliers’ power is strong:Fewer number of suppliersHigh volume per supplierHigh Switching CostsHigh product differentiationImportance of product in terms of cost and quality

Power in Input Market (Suppliers) & Output Market (Buyers)

High Low Actual Profitability

Low High Actual ProfitabilitySuppliers’ power

Buyers’ power

Given a level of industry profitability …

What determines which companies will win and which companies will lose?How can a company sustain profits in a competitive environment?Porter maintains that there are two generic competitive strategies that firms can choose in order to maintain competitive advantage

Competitive Strategy Analysis

1. Cost Leadership

2. Differentiation

And, Straddling of “1” and “2”??Choices of competitive strategies:

1. Cost Leadership

Is a cost leader if it can supply same product or service at a lower price because of Economies of scale, scopes, and learning Efficient production Simpler product designs Efficient organizational processes Lower costs of inputs and distribution Little R&D or brand advertising required Tight cost control

2. Differentiation

Supply a unique product or service at a cost lower than the price customers are willing to pay: Superior product quality Superior product variety Superior customer services More flexible delivery Investment in brand image Investment in R&D and marketingNote: Organizational and control system must

foster creativity and innovation

Achieving and Sustaining Competitive Advantage

Depend on:Match between firm’s core competencies (the economic assets possessed by the firm) and competitive strategiesMatch between firm’s value chain (the activities to convert inputs to outputs) and activities required to execute competitive strategiesFlexibility to adopt to changes in the firm’s industry structureDifficulty for competitors to imitate

Applying Strategy Analysis to Dell

Industry Analysis Describe the features of the personal

computer industry that determine its profit potential. How difficult is it to earn abnormally high profit in this industry?

Competitive Strategies Analysis Describe Dell’s business strategy and

how it might allow Dell to earn higher returns on investments than others in the industry?

Personal Computer Industry

Degree of Actual and Potential Competition Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products

Bargaining Power in Input and Output Markets Buyers’ Power Suppliers’ Power

Personal Computer Industry: Rivalry

Growth continues to be strong pricing remains cut-throat

Lots of competitors fragmented, no price co-ordination

Switching costs are low commodity product; price is the key Dell tries to compete on service

as knowledge rises, will service matter?

Dell needs to keep market share recoup R&D and costs associated with made to order

strategy allows them to lower component costs

PC: EntrantsLow barriers to entryFirst mover advantage? not technologically

Distribution is easyRelationships with suppliers, customers?

PC: Substitute Products

Apple’s Macintosh, Sun’s work stations? not in the near future

Competitive price and performance PCs are commodities (price counts more) price competition seems unavoidable

Buyers’ are willing to switch brand name? quality reputations?

PC: Power of Customers

Buyers are price sensitive define price as hardware, software, and

operations, not just purchase price— “total cost of ownership”

Dell maintains an extensive database of customer information unavailable to retail operators

Importance of product for cost & quality

PC: Suppliers’ Power

Two major “one supplier” relationships Intel, Microsoft

Leverage will increase with volumeCan Intel reap some of the PC vendors’ profits?Power of other suppliers is low lots of keyboard, case, power supply,

etc. manufacturers

PC Industry Analysis: Conclusion

Intense competitionLow barriers to entryNot much power over customersand suppliersShort product cycle; need to stay on edge technologically

Profit potential might be poorBUT, growth is an important offsetting factor

What Should Dell Need to be Concerned?

General economy conditionIndustry growth; technological changesCompetition: Product quality; customer service/support;

distribution channels; price International Product mix, customer mix, geographic mix New ventures: Internet

Inventory levelsSupply sourcesSupport of infrastructureGovernment regulation

Dell’s performance

$0

$5

$10

$15

$20

$25

$30

1996 1997 1998 1999 2000

$ in b

illions

SaesProfit

Customer profile: Foreign vs. Domestic Sales

0%

20%

40%

60%

80%

100%

1998 1999 2000

Foreign

Domesic

Mergent’s Industry Review- 1999 Ranking

Dell

Revenue 2nd

Net income 2nd

Return on Capital

1st

Stock Market Performance

Dell Market Index(Value Line)

1 Year 32.0% 19.5%

3 Year 1176.2% 56.0%

5 Year 7790.4% 121.2%

Dell: Competitive Strategy

Differentiation Direct sales: no middle man; customer

database “Customer made” product

Lower economy of scales Low inventory

Customer service and support “Enterprise systems”

Cost Leadership Through “made to order” Not “low cost” seller

Dell: Sustainable Advantage?

What aspects of Dell’s strategy can be replicated by others?Can Dell avoid being replicated?

Dell: Conclusion

Competitive and thus low profitability industryThe success of Dell’s competitive strategy depends on Product differentiation Maintain higher profit margin Reduce/control operating expenses Goal: higher net margin

According to Dell (10-K)…

Three key factors Growth

Demand, competition, international market Product, customer, geographic mix “servers” business

Profitability gross and net margins, sales mix, Internet sales Technological changes and product transition

Liquidity asset management, especially inventory

Experts’ Opinion?

Value Line on industry (4/21/2000)The computer and peripheral industry probably will get off to something of a slow start this year (2000). However, it should pick up a better head of stream in the second half and stay on a fast growth tract out to 2003-2005.Investors should be able to find stocks in this group that will be good fits for their portfolios, whether they are looking for near-term out-performance or long-term capital appreciation. Conservative accounts should tread cautiously, though, since volatility can be high for some of these equities.

Experts’ Opinion?Value line on Dell (4/21/2000)Although the stock has pulled back a bit from its recent high, Dell shares don’t stand out for the year ahead or the pull to 2003-2005. But Dell’s direct sales approach (which has enabled it to take share from competitors) appears to be working well, and we think the push to penetrate the emerging Internet market is a positive development.

Framework: Four Steps of Analysis

Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Analysis andValuation Applications

Review of Business Strategy Analysis

What factors decide an industry profitability?Porter’s “five forces” Degree of Actual and Potential Competition

Rivalry among existing firms Threat of new entrants Threat of substitute products

Bargaining Power in the Input and Output Markets Bargaining power of customers Bargaining power of suppliers

What is Accounting Analysis?(Chapter 3)

Evaluate the degree to which a company’s accounting captures its underlying business realityEvaluate the appropriateness of accounting policies and estimatesAssess the distortion, if any, in the numbers see where distortions are and whether they can

undoneGoal: To improve the reliability of conclusions from financial analyses

Note: Does accounting affect business strategy? (“positive accounting”)

The Need of Financial Accounting

Separation between ownership and management (“agency problem”)Owners want to know: Profitability: Income Statement Economic resources and obligation: Balance

Sheet Cash flow position: Statement of Cash Flows Owners’ equity: Statement of Stockholders’

Equity

Accounting - Review

Annual Reports Management Discussion and Analysis

(MD&A) Financial Statements

Balance sheet (2 years) Income Statement (3 years) Statement of Stockholders’ Equity (3

years) Statement of Cash Flows (3 years)

Notes

Importance of Notes

Integral part of the F/SAugment the information provided in the F/SProvide very important data for F/S analysisE.G. “Contingencies”

MD&A

Results of operations, including discussion of trends in sales and expensesCapital resources and liquidity, including discussion of cash flows trendOutlook based on known trends

Financial Statements

Accountants are confronted with the potential dangers of bias, misinterpretation, inaccuracy, and ambiguityMust follow the Generally Accepted Accounting Principles (GAAP) E.g. FASB Publications, Statement 115 FASB, SEC, AICPA

Mechanics of the Accounting Process

Balance Sheet Assets = Liabilities + Stockholders’ equity Ending balance = Opening balance carried from previous B/S +/- Increases/Decreases

SE = Capital stock + Retained EarningsCapital stock = Opening balance + Issuance – Repurchase R/E = Opening balance + NI - Dividends

Net Income

Income StatementRevenue – Expenses Accrual Basis (v.s. Cash Basis) Revenue is recognized when

“earned”, not necessarily when cash is received

Expense is recorded when “incurred”, not necessarily when cash is paid

From I/S to B/SI/S

Net Income

R/E Statement of SE

B/S

R/E

Daily Transactions

Capital Stock; R/E

Assets = Liabilities + SE

What Affect the Quality of Accounting Data? – Not Reflect the Economic Reality

Reports are prepared by management Involves with management’s incentives

Accrual basis versus cash basis Involves estimations, not totally actual cash transactions

Accounting rules (GAAP) Standardization versus flexibility

Auditing Auditable?

Legal Liability Threat of lawsuits improves credibility, but limits

disclosures

Accounting Analysis for Dell

Main concern: higher return on equityWhat are the major areas we need to look into at Dell if we want to understand how well they are doing? Based on the industry and competitive

strategy analyses growth, profitability

Think About Dell Accounting Rules—biased? Accounting Estimation—biased? Factors that Affect Managers’ Accounting Choices

debt covenants—does Dell have any? management compensation—does Dell have earnings-

based bonuses? corporate control contest—is Dell concerned about a

takeover? tax considerations—LIFO versus FIFO regulatory considerations—consider Microsoft capital market considerations stakeholder considerations —consider auto industry competitive considerations—how detailed should the

reporting be

How to Do Accounting Analysis

1. Identify Key Accounting Policies2. Assess Accounting Flexibility3. Evaluate Accounting Strategy4. Evaluate the Quality of Disclosure5. Identify Potential Red Flags6. Undo Accounting Distortions

1. Identify Key Accounting Policies

Ultimate goal How well are the key success factors

and risks identified by the Business Strategy analysis managed by the firm?

Task Identify and evaluate the policies and

estimates the firm uses to measure its critical factors and risks

2. Assess Accounting Flexibility

All firms can choose: depreciation & amortization methods and

estimates inventory methods estimates of bad debts

Some items do not allow flexibility: R&D and marketing expenditures must be

expensed software development can be capitalized

Flexibility, Informative, and Distortion

Low High

Flexibility

Less Informative More Informative

Less Distortion More Distortion

Flexibility Analysis—DellFiscal year-end: Friday nearest 1/31Consolidate all wholly owned subsidiariesShort-term investments: available-for-saleInventory: first-in, first-outDepreciation: 2 to 5 years for non-buildingsAmortization of intangibles: 3 to 8 yearsR&D and advertising: expensedWarranty and post-sale support: estimated and expensedSoftware development costs: capitalizedSegment information

3. Evaluate Accounting Strategy

How do the firm’s policies compare to the industry norm?Does management face strong incentives to manage earnings?

covenants, bonuses, political pressures

Has the firm changed policies or estimates? Were policies and estimates realistic in the past?

write-off discontinued operation

Does the firm structure transactions to achieve certain accounting objectives?

capital lease versus operating lease pooling-of-interest versus purchase accounting

4. Evaluate Quality of Disclosure

Do the firm’s disclosures make it easy to assess the economic reality? Provide adequate disclosure of business

strategies? Explain in footnotes accounting policies,

assumptions, and their logic? Explain current performance? Provide additional disclosures to assess business

reality? Provide informative segment disclosure? Reveal forthcoming bad news? Provide detailed news to investors?

5. Identify Potential Red Flags

Unexplained changes in accounting especially when performance is poorUnexplained transactions that boost profits

sale of assets or investmentsUnusual increases in A/R in relation to sales increasesUnusual increases in inventories in relation to sales increasesIncreasing gap between earnings and cash flow from operationsIncreasing gap between financial income and taxable incomeOff-F/S transactions

B/S (e.g., leases) and I/S (e.g., contingencies)Large asset write-offsLarge 4th-quarter adjustmentsQualified audit opinion or change in auditorsRelated party transactions

6. Undo Accounting Distortions

Try to make adjustments use data in the notes use cash flow data use non-accounting sources:

Newspapers Call investor relations

Example: Off-B/S financing

In-Class Case: Harnischfeger

Purpose: Demonstrate managerial motives for making accounting changesBackground: GAAP allow flexibility for accounting choices. Even after a firm chooses a set of accounting policies, it can still change to another at the management’s discretion.Managerial incentive:

1982 Harnischfeger faced a financial crisis New management was appointed to turn the company

around New management made a few financial reporting policy

changes in 1984 Harnischfeger turned into profit in 1984