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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