Business Analysis Using Financial Statements

Lecture one
Suborna Barua
United International University

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 companys prospects & risks for the purpose of making business decision

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

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

j Managers are hired by a companys owners

to manage its business activities j Managers make operating and financing decision based on business analysis j Managers monitor and control company activities through the process of business analysis

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 companys profit potential at a qualitative level Strategy Analysis involves Industry analysis Competitive strategy Corporate strategy analysis
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Industry Analysis
Analyzing a firms 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 companys 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 Sources and uses Evaluate source & of funds analysis deployment of funds

Common tools

Ratio analysis

Cash flow analysis

Prospective Analysis
Process to forecast future payoffs
Business Environment & Strategy Analysis Accounting Analysis

Financial Analysis

Intrinsic Value

Sources of financial information

j Principle financial statements

The balance sheet The income statement The statement of cash flow The statement of stockholders equity Notes to the financial statements Auditors report Management discussion and analysis Other data sources Chairpersons 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

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 -

Kodak

(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)

(258) 186 ($3,944)

80 (44) 59 (4) 91 1,481 (570) (258) 128 46 $3,988

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 (Period of time) $ 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)

Sources of financial information

Auditing
y SEC requires Audit Report Accounting y Set by International y Audit opinion can be: Standards Board - clean (fairly presented) y Not -currently accepted in U.S. qualified (except for) Auditors - disclaimer (no opinion) y SEC adverse pressure to accept under (not fairly presented) IASAuditor quality & independence y Check

Sources of financial information

Notes to financial statements
j The first notes provide a summary of the firms accounting policies j Other notes present details about particular accounts such as inventory;

property, plant and equipment; investment; long term debt. j 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 informationMD&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)

y Independent, quasi-judicial government agency y Administer securities regulations & disclosures y Can modify & set GAAP, if necessary y Rarely directly challenges FASB y Major player in global accounting

The U.S. financial reporting system

Financial Accounting standards board
j FASB is a nongovernmental body with

seven full-time members j Sets accounting standards for all company issuing audited financial statements j 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)
y Set by International Accounting Standards Board y Not currently accepted in U.S. y SEC under pressure to accept IAS

Demands for financial reporting

Equity Investors
y Active & Speculative Investors rely on financial reports

Creditors
y 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

j Accrual accounting j Accounting standards and auditing

GAAP reduce managers ability to distort accounting information Auditing improves the quality of accounting information j Managers 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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Recent Issue

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Study questions and problems

j

j (a) (b)

C.Stern, chief financial officer of R-M Corp, has just reviewed the current years 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 firms 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 firms financial position.

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Study questions and problems

j 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 Companys 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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