Financial Statement Analysis and Security Valuation

Stephen H. Penman

Prepared by

Peter D. Easton and Gregory A. Sommers

Fisher College of Business The Ohio State University

With contributions by

Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-1

The Analysis of the Cash Flow Statement

Chapter 10

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-2

1.

2.

3.

Three Approaches to Calculate Free Cash Flow

A first approach to calculate FCF,

C - I = OI -



NOA

that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows,

C - I = NFE -



NFO + d

that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders.

Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-3

Business Activities: All the Stocks & Flows

Product and Input Markets The Firm Customers Suppliers

OR OE Net Operating Assets

C I

Net Financial Assets F d (NOA) (NFA) OR - OE = OI OI  NOA = C - I C - I =  NFA - NFI + d Operating Activities • OR is operating revenue • OE is operating expense • NFI is net financial income

McGraw-Hill/Irwin

Financing Activities •  indicates change • NFA can be negative (NFO )

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

Chapter 7 Page 218 Figure 7.3

Capital Markets Debt Holders or Issuers Share Holders

10-4

Business Activities and the Financial Statements

INCOME STATEMENT

NI t = OI t - NFE t

BALANCE SHEET Net Operating Assets

NOA t = NOA t-1 + OI t - (C t - I t )

Chapter 7 Summary Net Financial Obligations

NFO t = NFO t-1 - (C t - I t ) + NFE t + d t CSE t = CSE t-1 + OI t - NFE t - d t

McGraw-Hill/Irwin

CASH FLOW STATEMENT

C t - I t = d t + F t

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-5

1.

2.

3.

Three Approaches to Calculate Free Cash Flow

A first approach to calculate FCF,

C - I = OI -



NOA

that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows,

C - I = NFE -



NFO + d

that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders.

Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-6

Genentech, Inc. 1995 Reformulated Income Statement

Operating income: Operating revenues Operating expenses Special merger charge Operating income before tax 712,632 25,000 $857,283 737,632 119,651 Tax reported Tax on financial income 25,841 (20,523) 5,318 Operating income after tax Financial income: Interest revenue Interest expense Net interest income before tax Tax on net interest income (.39) Net interest income after tax Unrealized gain on securities Net financial income 52,622 20,523 32,099 44,681 114,333 60,562 7,940 76,780 Comprehensive income available to common Weighted average shares outstanding 121,220 Comprehensive income per share

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

$191,113 ======== $1.58

Chapter 9 Page 282 Exhibit 9.8

10-7

Genentech, Inc. 1995 OPERATING ASSETS Cash Accounts receivable, less allowances Inventories Prepaid expenses and other current assets Property, plant and equipment Other assets Operating assets Reformulated Balance Sheet OPERATING LIABILITIES Accounts payable Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Other long-term liabilities Operating liabilities NET OPERATING ASSETS (NOA) NET FINANCIAL ASSETS (NFA) Cash equivalents Short-term investments Long-term investments Current portion of long-term debt Long-term debt Chapter 9 Page 276 Exhibit 9.4

COMMON SHAREHOLDERS’ EQUITY 1995 $ 10,000 172,160 93,648 39,267 503,654 105,452 924,181 37,101 36,945 23,159 18,863 33,621 14,329 69,068 25,504 258,590 665,591 127,043 603,296 356,475 (358) (150,000) 936,456 $1,602,047 ========== 1994 $ 10,000 146,267 103,200 28,475 485,293 60,989 834,224 30,963 36,939 25,864 27,463 36,277 17,839 44,283 25,483 245,111 589,113 56,713 652,461 201,726 (871) (150,358) 759,671 $1,348,784 ==========

Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 1

• Method 1:

C - I = OI -



NOA

Operating income, 1995 Net operating assets, 1995 Net operating assets, 1994 Free cash flow, 1995 $665,591 589,113

Chapter 10 Page 311 Box 10.2

$114,333 76,478 $ 37,855

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-9

1.

2.

3.

Three Approaches to Calculate Free Cash Flow

A first approach to calculate FCF,

C - I = OI -



NOA

that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows,

C - I =



NFA - NFI + d

that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders.

Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-10

Genentech, Inc. 1995 Reformulated OPERATING ASSETS Cash Accounts receivable, less allowances Inventories Prepaid expenses and other current assets Property, plant and equipment Other assets Operating assets Balance Sheet OPERATING LIABILITIES Accounts payable Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Other long-term liabilities Operating liabilities NET OPERATING ASSETS (NOA) 1995 $ 10,000 172,160 93,648 39,267 503,654 105,452 924,181 37,101 36,945 23,159 18,863 33,621 14,329 69,068 25,504 258,590 665,591 NET FINANCIAL ASSETS (NFA) Cash equivalents Short-term investments Long-term investments Current portion of long-term debt Long-term debt NFA 127,043 603,296 356,475 (358) (150,000) 936,456 Chapter 9 Page 276 Exhibit 9.4

COMMON SHAREHOLDERS’ EQUITY

McGraw-Hill/Irwin

$1,602,047 ==========

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

1994 $ 10,000 146,267 103,200 28,475 485,293 60,989 834,224 30,963 36,939 25,864 27,463 36,277 17,839 44,283 25,483 245,111 589,113 56,713 652,461 201,726 (871) (150,358) 759,671 $1,348,784 ==========

10-11

Genentech, Inc. 1995 Reformulated Income Statement

Operating income: Operating revenues Operating expenses Special merger charge Operating income before tax 712,632 25,000 $857,283 737,632 119,651 Tax reported Tax on financial income 25,841 (20,523) 5,318 Operating income after tax Financial income: Interest revenue Interest expense Net interest income before tax Tax on net interest income (.39) Net interest income after tax Unrealized gain on securities Net financial income 52,622 20,523 32,099 44,681 114,333 60,562 7,940 76,780 Comprehensive income available to common Weighted average shares outstanding 121,220 Comprehensive income per share

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

$191,113 ======== $1.58

Chapter 9 Page 282 Exhibit 9.8

10-12

Reformulated Statement of Common Equity:

After Restatement: Genentech, Inc.

Balance - December 31, 1994: Transactions with shareholders Stock issues Stock repurchases Common dividends Comprehensive Income Net income Other comprehensive income Preferred dividends Balance - December 31, 1995: $62,150 $1,348,784 62,150 146,432 44,681 191,113 $1,602,047 Chapter 8 Page 235 Exhibit 8.1

• ROCE 1995 = 191,113 / [(1,348,784 + 1,602,047) / 2] = 12.95% • or on a per share basis

McGraw-Hill/Irwin

ROCE 1995 = [191,113 / 121,220] / 11.50

= 13.71%

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-13

Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 2

• Method 1:

C - I = OI -



NOA

Operating income, 1995 Net operating assets, 1995 Net operating assets, 1994 $665,591 589,113 Free cash flow, 1995 • Method 2:

C - I =



NFA - NFI + d

Net financial assets, 1995 $936,456 759,671 Net financial assets, 1994 Net financial income, 1995 Net dividend, 1995 Free cash flow, 1995

Chapter 10 Page 311 Box 10.2

$114,333 76,478 $ 37,855 $176,785 (76,780) (62,150) $ 37,855

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-14

1.

2.

3.

Three Approaches to Calculate Free Cash Flow

A first approach to calculate FCF,

C - I = OI -



NOA

that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows,

C - I =



NFA - NFI + d

that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders.

Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-15

The Standard Statement of Cash Flows

• Standard Statement of Cash Flows “Cash Flow from Operations” - “Cash Used in Investing Activities” + “Cash From Financing Activities” =  in Cash and Cash Equivalents

Chapter 10 Page 314

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10-16

Direct Method Cash Flow Statements: Northrop Grumman Corp. 1998

Logo courtesy of Northrop Grumman Corporation

Chapter 10 Page 313 Box 10.3

McGraw-Hill/Irwin

Year ended December 31, $ in millions Operating Activities Sources of Cash Cash received from customers Progress payments Other collections Interest received Income tax refunds received Other cash receipts Cash provided by operating activities Uses of Cash Cash paid to suppliers and employees Interest paid Income taxes paid Other cash payments Cash used in operating activities Net cash provided by operating activities Investing Activities Payment for businesses purchased, net Additions to property, plant and equipment Proceeds from sale of property & equipment Proceeds from sale of affiliates/operations Advances to affiliate Funding of retiree activities Other investing activities Net cash used in investing activities

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

1998 1997 $ 1,844 6,929 11 26 6 8,816 8,273 219 46 34 8,572 244 (50) (211) 63 (30) (2) (5) (235) $ 2,264 7,050 17 13 7 9,351 8,280 251 64 26 8,621 730 (238) 106 19 (113) 10-17

Genentech, Inc. 1995 Reported Statement of Cash Flows

Chapter 10 Page 316

McGraw-Hill/Irwin

YEAR ENDED DECEMBER 31 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Writedown of securities available-for-sale Gain on sales of securities available-for-sale Deferred income taxes Loss on fixed asset dispositions (including merger related in 1995) Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security Changes in assets and liabilities: Net cash flow from trading securities Receivables and other current assets Inventories Increase in Cash Equivalents 1995 $ 146,432 58,421 6,609 (7,432) (22,655) 1,032 469 (703) (50,014) (28,446) 9,552 Accounts payable, other current liabilities and other long-term liabilities Net cash provided by operating activities Cash flows from investing activities: 20,682 133,947 Purchases of securities held-to-maturity (682,396) Proceeds from maturities of securities held-to-maturity Purchases of securities available-for-sale 924,345 (353,118) 1994 $ 124,394 53,452 12,590 (34,193) 5,510 748 (4,634) (11,937) (18,475) 72,901 200,356 (1,088,737) 877,139 Proceeds from sales of securities available- for-sale Purchases of non-marketable equity securities Proceeds from sale of a non-marketable equity security Capital expenditures Change in other assets Net cash used in investing activities Cash flows from financing activities: Stock issuances 101,591 703 (70,166) (38,651) (117,692) (22,644)

37,855

(4,000) (82,837) (1,198) (322,277) Reduction in long-term debt, including current portion Net cash provided by financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year 54,946 (871) 54,075 70,330 66,713 $ 137,043 71,955 (794) 71,161 (50,760) 117,473 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized Income taxes $ 7,917 44,699 $ 7,058 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-18

Problems with the Standard Statement of Cash Flows

Chapter 10 Page 314-318

1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-19

Genentech, Inc. 1995 Reported Statement of Cash Flows

Chapter 10 Page 316

McGraw-Hill/Irwin

YEAR ENDED DECEMBER 31 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Writedown of securities available-for-sale Gain on sales of securities available-for-sale Deferred income taxes Loss on fixed asset dispositions (including merger related in 1995) Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security Changes in assets and liabilities: Net cash flow from trading securities Receivables and other current assets Inventories Accounts payable, other current liabilities and other long-term liabilities Net cash provided by operating activities Cash flows from investing activities: Purchases of securities held-to-maturity Proceeds from maturities of securities held-to-maturity Purchases of securities available-for-sale Proceeds from sales of securities available- for-sale Purchases of non-marketable equity securities Proceeds from sale of a non-marketable equity security Capital expenditures Change in other assets Net cash used in investing activities Cash flows from financing activities: Stock issuances Reduction in long-term debt, including current portion Net cash provided by financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Increase in Cash Equivalents 1995 1994 $ 146,432 58,421 6,609 (7,432) (22,655) 1,032 469 (703) (50,014) (28,446) 9,552 20,682 133,947 (682,396) 924,345 (353,118) 101,591 703 (70,166) (38,651) (117,692) 54,946 (871) 54,075 70,330 66,713 $ 137,043 $ 124,394 53,452 12,590 (34,193) 5,510 748 (4,634) (11,937) (18,475) 72,901 200,356 (1,088,737) 877,139 (22,644) (4,000) (82,837) (1,198) (322,277) 71,955 (794) 71,161 (50,760) 117,473 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized Income taxes $ 7,917 44,699 $ 7,058 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-20

Problems with the Standard Statement of Cash Flows

Chapter 10 Page 314-318

1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-21

Genentech, Inc. 1995 Reported Statement of Cash Flows

Chapter 10 Page 316

McGraw-Hill/Irwin

YEAR ENDED DECEMBER 31 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Writedown of securities available-for-sale Gain on sales of securities available-for-sale Deferred income taxes Loss on fixed asset dispositions (including merger related in 1995) Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security Changes in assets and liabilities: Net cash flow from trading securities Receivables and other current assets Inventories Accounts payable, other current liabilities and other long-term liabilities Net cash provided by operating activities Cash flows from investing activities: Purchases of securities held-to-maturity Proceeds from maturities of securities held-to-maturity Purchases of securities available-for-sale Proceeds from sales of securities available- for-sale Purchases of non-marketable equity securities Proceeds from sale of a non-marketable equity security Capital expenditures Change in other assets Net cash used in investing activities Cash flows from financing activities: Stock issuances Reduction in long-term debt, including current portion Net cash provided by financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Increase in Cash Equivalents 1995 1994 $ 146,432 58,421 6,609 (7,432) (22,655) 1,032 469 (703) (50,014) (28,446) 9,552 20,682 133,947 (682,396) 924,345 (353,118) 101,591 703 (70,166) (38,651) (117,692) 54,946 (871) 54,075 70,330 66,713 $ 137,043 $ 124,394 53,452 12,590 (34,193) 5,510 748 (4,634) (11,937) (18,475) 72,901 200,356 (1,088,737) 877,139 (22,644) (4,000) (82,837) (1,198) (322,277) 71,955 (794) 71,161 (50,760) 117,473 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized Income taxes $ 7,917 44,699 $ 7,058 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-22

Problems with the Standard Statement of Cash Flows

Chapter 10 Page 314-318

1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-23

Genentech, Inc. 1995 Reported Statement of Cash Flows

Chapter 10 Page 316

McGraw-Hill/Irwin

YEAR ENDED DECEMBER 31 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Writedown of securities available-for-sale Gain on sales of securities available-for-sale Deferred income taxes Loss on fixed asset dispositions (including merger related in 1995) Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security Changes in assets and liabilities: Net cash flow from trading securities Receivables and other current assets Inventories Accounts payable, other current liabilities and other long-term liabilities Net cash provided by operating activities Cash flows from investing activities: Purchases of securities held-to-maturity Proceeds from maturities of securities held-to-maturity Purchases of securities available-for-sale Proceeds from sales of securities available- for-sale Purchases of non-marketable equity securities Proceeds from sale of a non-marketable equity security Capital expenditures Change in other assets Net cash used in investing activities Cash flows from financing activities: Stock issuances Reduction in long-term debt, including current portion Net cash provided by financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Increase in Cash Equivalents 1995 1994 $ 146,432 58,421 6,609 (7,432) (22,655) 1,032 469 (703) (50,014) (28,446) 9,552 20,682 133,947 (682,396) 924,345 (353,118) 101,591 703 (70,166) (38,651) (117,692) 54,946 (871) 54,075 70,330 66,713 $ 137,043 $ 124,394 53,452 12,590 (34,193) 5,510 748 (4,634) (11,937) (18,475) 72,901 200,356 (1,088,737) 877,139 (22,644) (4,000) (82,837) (1,198) (322,277) 71,955 (794) 71,161 (50,760) 117,473 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized Income taxes $ 7,917 44,699 $ 7,058 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-24

Problems with the Standard Statement of Cash Flows

Chapter 10 Page 314-318

1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing 5. The statement does not reflect non-cash transactions 6. In the case of installment purchases, only the first installment is classified as investment

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-25

The Reformulated Statement of Cash Flows

GAAP Free Cash Flow + Net cash interest outflow (after tax) + Investments in financial assets Sale of financial assets Noncash investments Increase in operating cash Investment in operating assets on installment basis = Free Cash Flow GAAP Financing Flow + Net cash interest outflow (after tax) Noncash financing + Purchase of financial assets + Increase in cash equivalents = Financing Cash Flow

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

Chapter 10 Page 319 Box 10.4

10-26

The Calculation of Cash Flow from Operations

Chapter 10 Page 321

• The practical matter of distinguishing cash flow from operations from cash flow from investment activities is not an easy one: the cash flow from operations in the GAAP statement is not a clean measure.

• Some cash flows from investment activities are classified as cash flows from operations • Taxes on gains from assets sales are classified as cash flow from operations • Note, however, that if what is needed is just the FCF (C-I), then a misclassification between investment and operating activities has no effect

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved.

10-27

Cash Flows and Accrual Flows

• Net income has a cash flow component and an accrual component

Chapter 10 Page 313 Box 10.3

• The statement of cash flows gives the cash component, allowing one to calculate the accrual component by difference with net income NI GAAP CF from Operations  Accruals • The

indirect method

provides an explicit reconciliation of these two numbers. If the

direct method

is used instead, a reconciliation is required in the notes • Measurement of accruals includes a more subjective component than measurement of cash flows: the quality of earnings

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10-28

A Financial Statement Analysis Template

Chapter 9 Page 292

1. Reformulate the statement of stockholders’ equity on a clean-surplus basis.

2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the reformulated statement of common stockholders’ equity.

3. Reformulate the balance sheet to distinguish operating and financial assets and obligations.

4. Reformulate the income statement on a clean-surplus basis and distinguish operating and financing income.

5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis.

6. Reformulate the cash flow statement.

7. Carry out the analysis of ROCE.

8. Carry out the analysis of growth.

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10-29