Chapter 18: Integration of Financial Statement Analysis

Transcript Chapter 18: Integration of Financial Statement Analysis

CHAPTER 18 INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES

Presenter’s name Presenter’s title dd Month yyyy

FRAMEWORK

The primary reason for performing financial statement analysis is to facilitate an economic decision.

The framework for the analysis contains six phases: 1. Define the purpose for the analysis 2. Collect input data 3. Process data 4. Analyze/interpret the processed data 5. Develop and communicate conclusions 6. Follow-up Copyright © 2013 CFA Institute 2

FRAMEWORK: CASE STUDY 1

Evaluating Nestlé as a long-term equity investment.

1. Define the purpose for the analysis: Isolate the factors that have driven Nestlé’s financial success and assess their sustainability.

- Understand the risks that may upset the sustainability of returns.

2. Collect input data: Gather several years of annual reports.

3. Process data: - Conduct a DuPont analysis.

- Analyze the composition of Nestlé’s asset base and capital structure.

- Study the company’s segments and the allocation of capital among them.

Examine the company’s earnings quality.

- Study the company’s cash flows and their adequacy for the company’s continued operations and strategies.

- Decompose the company’s valuation.

4. Analyze/interpret the processed data.

5. Develop and communicate conclusions: Write report.

6. Follow-up.

DUPONT ANALYSIS

ROE = Net income × Sales Sales Assets × Assets Equity = Net profit margin × Assets turnover × Leverage Nestl é’s ROE: Net profit margin Assets turnover Leverage ROE 2007 10.58% 0.994

2.02

21.25% 2006 10.00% 0.963

2.01

19.36% 2005 9.44% 0.955

2.16

FINANCIAL REPORTING CHOICES AND BIASES

Including the net investments and returns of associates with full reported value of a company’s own assets and income would introduce noise into the analysis. For example, Part of Nestlé’s income relates to Nestlé’s 30% stock ownership of L’Oreal.

- Subtracting the investment from total assets results in a figure that more closely represents Nestlé’s own asset base.

- Subtracting the share of results of associates from the net income allows for the analysis of exclusively Nestlé profitability resulting from the exclusively Nestlé asset base.

Return on equity Nestlé-only ROE Associates’ contribution to ROE

2007

21.25% 20.48% 0.77%

2006

19.36% 18.75% 0.61%

2005

19.48% 18.66% 0.82%

FINANCIAL REPORTING CHOICES AND BIASES

• Comparing financial statements prepared under different accounting treatments over the years could bias analysis.

• Adjustments are necessary to keep analysis logically consistent throughout all the periods of study.

• For example, for comparability, Nestlé restated the 2004 balance sheet, including changes for employee benefits plan accounting, lease classification, a reclassification of a warrants premium, and the cumulative effect on their investment of L’Oreal’s first-time adoption of IFRS.

CAPITAL STRUCTURE ANALYSIS

• Use common-size analysis. For example, below is Nestlé’s long-term capital structure on a common-size analysis: Long-term financial liabilities Other long-term liabilities Total equity

2007 2006 2005 2004

8.6 10.0 12.4 18.4 15.4 13.7 76.0 76.2

100.0 99.9

14.2 73.4 15.3 66.2

100.0 99.9

* Total long-term capital

Deleveraging *Does not add to 100% because of rounding • When deleveraging occurs in the long-term capital structure, there is offsetting change in the company’s working capital (i.e., leverage improves, but liquidity deteriorates).

• Improvement in the management of receivables, inventory, and payables can mitigate the concern associated with the decline in the actual working capital.

SEGMENT ANALYSIS

•

Business Segment:

A portion of a larger company that accounts for more than 10% of the company’s revenues or assets and is distinguishable from the company’s other lines of business in terms of risk and return characteristics.

• Conducting segment analysis helps analysts understand any geopolitical investment risks.

• Ratio of capital expenditures proportion to total asset proportion ranked by EBIT margin: - A ratio < 1 indicates that the segment is being allocated a lesser proportion of capital expenditures than its proportion of total assets.

- A ratio > 1 indicates that the company is growing the segment.

- Comparing the ratio with the EBIT margin gives an analyst an idea of whether the company is investing its capital in the most profitable segments.

SEGMENT ANALYSIS: EXAMPLE

Pharma Nestlé Nutrition Asia, Oceania, and Africa Americas Other Food and Beverage Europe Nestlé Waters

2007 EBIT

33.27% 17.16% 16.29% 16.28% 15.85% 11.99% 8.18%

2007

0.61

0.31

1.18

1.11

2.43

0.94

1.79

2006

0.74

0.81

1.06

0.92

1.52

0.82

1.62

If the company were to continue to allocate capital toward the lowest-margined business segment, the overall corporate returns might be negatively affected.

2005

0.75

0.93

1.19

0.85

1.53

0.99

1.27

EARNINGS QUALITY

•

Earnings quality:

The persistence and sustainability of a firm’s earnings.

• Ways to evaluate earnings quality: Analyze the accruals: Accrual ratio fluctuations indicate the use of accruals to “time” earnings.

Balance sheet based accruals ratio = YTY change in NOA Average NOA Cash flow based accruals ratio = 𝑁𝐼 − (𝐶𝐹𝑂 − 𝐶𝐹𝐼) Average NOA where NOA = Net operating Assets, CFO = Cash flow from operating, and CFI = Cash flow from investing. Copyright © 2013 CFA Institute 10

EARNINGS QUALITY

Nestlé example: (in millions of CHF) B/S aggregate accruals (YTY ∆ in NOA) Divided by: Average net operating assets Balance sheet based accruals ratio Cash flow based aggregate accruals Divided by: Average net operating assets CF accruals ratio Fluctuated significantly.

Much higher in the most recent year than in the earlier years.

2007

11,589 69,614

16.6%

13,696 69,614

19.7% 2006

5,026 61,306

8.20%

8,619 61,306

14.1% 2005 2004

9,345 (2,730) 54,121

17.3%

50,813

−5.4%

3,071 593 54,632

5.6%

51,324

1.2% 2003

1,587 51,385

3.1%

1,196 51,385

2.3%

Increases steadily over time, indicating a higher degree of accruals present in the company’s earnings.

EARNINGS QUALITY

Study the company’s cash flow and its relationship to net income. Are operating earnings backed by cash flow, or are the operating earnings more of an accounting result?

- Appropriate adjustments to keep the comparisons between cash flow and earnings symmetrical: a) Add the cash paid for interest and taxes to the operating cash flow. The resulting operating cash flow before interest and taxes is the relevant operating cash flow for comparison with the operating income.

b) Add goodwill amortization to the period prior to 31 March 2004. IFRS 3, “Business Combinations,” suspended the amortization of goodwill after 31 March 2004. To amortize goodwill in some but not other years of operating earnings would produce a misleading trend in the ratios.

EARNINGS QUALITY

Examine the relationship between operating cash flow and total assets. Total assets reflect the sum of management’s resource allocations.

• Compare cash flow with reinvestment, debt, and debt-servicing capacity. • Results indicate whether the company has enough resources for its reinvestment program, and whether additional borrowing could be arranged should an investment opportunity arise.

VALUATION: EXAMPLE

To determine the value that the market is placing solely on the company’s operations, analysts need to remove the value of the company’s holdings of other companies from the market value.

(CHF in millions) Alcon L’Oreal Implied Nestlé-only Actual

Recap in %:

L’Oreal Alcon Nestlé

Market values

36,499 28,961 130,201 195,661

Market value

14.8% 18.7% 66.5% 100.0%

Earnings (Group shareholder level)

1,361.5 1,302.0 7,985.5 10,649.0

Earnings

12.8% 12.2% 75.0% 100.0%

Respective P/Es:

26.8 22.2 16.3 18.4 Nestlé has ample cash flow and low financial leverage; thus, the discount may be inappropriate and shares may be undervalued.

FRAMEWORK: CASE STUDY 2

Evaluating investee’s off-balance-sheet leverage.

1. Define the purpose for the analysis: Look for companies in the fund’s holdings where off-balance-sheet financing may be an issue (i.e., companies with unrecorded capital leases).

- Analyze the impact of the leverage if such leverage exists.

2. Collect input data: - Multiply the current operating lease expenses reported by companies in the fund’s holdings by 7.4 to get an estimate of the unrecorded assets and debt.

- If the ratio of “hidden” assets to total assets exceeds 5% for any of the companies in the fund’s holdings, that company’s information will be subjected to further analysis.

3. Process data.

4. Analyze/interpret the processed data: - Examine the leverage ratio and interest coverage ratio for companies flagged in the previous phase.

5. Develop and communicate conclusions: Write report.

6. Follow-up.

OFF-BALANCE-SHEET LEVERAGE

• Off-balance-sheet leverage refers to operating leases.

• Capital lease Is reported as an asset and liability on lessee’s balance sheet.

- Results in interest expense and depreciation expense (instead of rental expense) on lessee’s income statement.

• When capitalizing an operating lease, the lessee’s - Financial leverage increases.

- Interest coverage ratio decreases.

OFF-BALANCE SHEET LEVERAGE: EXAMPLE

Assume the present value of future operating lease payments is $1,075 million. The table below shows leverage ratios after capitalizing operating leases (amounts in millions): Total assets Total equity

Financial leverage

Total long-term debt Total equity

Debt to equity

Total long-term debt Total long-term capital (=LT debt + equity)

Debt to long-term capital

As reported 12,244 2,225

5.5

1,293 2,225

58.10%

1,293 3,518

36.80%

Pro Forma 13,319 2,225

5.99

2,368 2,225

106.40%

2,368 4,593

51.60%

FRAMEWORK: CASE STUDY 3

Evaluating effects of changes in accounting standards.

1. Define the purpose for the analysis: - Determine if Discover Financial Services could be at risk (i.e., increase in reported leverage) from possible changes in accounting for securitizations.

2. Collect input data: 10-Q and 10-K filings.

3. Process data.

4. Analyze/interpret the processed data: Analyze the company’s leverage measures, assuming the liabilities issued in connection with the securitization of assets have to be shown on the company’s balance sheet.

5. Develop and communicate conclusions: Write report.

6. Follow-up.

IMPACT FROM ACCOUNTING CHANGES

• Currently under Statement 140, a company can remove financial assets from its balance sheet by placing them into a qualified special purpose entity (QSPE).

- The combination of asset removal and nonrecognition of liabilities may have a powerfully beneficial effect on financial leverage on the balance sheet.

- If the concept of a QSPE is eliminated from the securitization accounting, the securitized assets as well as the liabilities issued in connection with the securitizations would likely be shown on the balance sheet.

IMPACT FROM ACCOUNTING CHANGES: EXAMPLE

Software Services sold $267.5 million of finance receivables to a special purpose entity. The company’s abbreviated balance sheet is below.

Year Ending: Total Current Assets Total Assets Total Current Liabilities Total Liabilities Total Equity 31 December 2009 $1,412,900 $3,610,600 $1,276,300 $2,634,100 $976,500 What is the financial leverage if the company (1) treats them as sold and (2) holds securitized financial receivables on the balance sheet? 1) 3,610,600/976,500 = 3.70

2) (3,610,000 + 267,500)/976,500 = 3.97

SUMMARY

• The framework of financial statement analysis contains six steps: define a purpose for the analysis, collect input data, process data, analyze the processed data, communicate conclusions, and follow-up. • Earnings are more easily manipulated than cash flows. An effective way to examine earnings quality is to examine the pattern between operating income and operating cash flows.

• To make a logical comparison, adjustments need to be made prior to conducting financial statement analysis. For example, adjustments may include removing assets owned and return earned by affiliates that are not under control of the company. Copyright © 2013 CFA Institute 21

Chapter 18: Integration of Financial Statement Analysis

Transcript Chapter 18: Integration of Financial Statement Analysis