financial statement analysis - bfa v2.docx

Financial Statement Analysis Hi, my name is Joe Perfetti. I'm a professor of finance, and in this module I'd like to talk to you about financial statement analysis. Financial statements can be daunting. It really means understanding and learning a different language. And today, I'd like to help you...

Financial Statement Analysis Hi, my name is Joe Perfetti. I'm a professor of finance, and in this module I'd like to talk to you about financial statement analysis. Financial statements can be daunting. It really means understanding and learning a different language. And today, I'd like to help you understand that language and more importantly, help you understand the story that financial statements can tell you about an organization. When we think about financial statements, there's generally three types of financial statements. They're all based in the same cash flows, but they have different purposes, and ultimately they have different points of view. The first is what I would call the external statements. These are the statements that are provided to investors and others to give a general perspective of how the organization is doing. In the US, they're put into a format, a common format across companies, using what's known as generally accepted accounting principles or GAAP. And for an international companies, they're put into a format using a set of standard rules called International Financial Reporting Standards or IFRS. And so basically what the accounting organizations through the government regulatory bodies have done is that they have created these standardized formats that companies must report on so that no matter what industry you're looking at or what type of your company you're trying to analyze, you can see the information in a commonly accepted format. That's the idea. The reality is a little bit different because, unfortunately, even though it's in a common format, there are lots of exceptions and lots of nuances, and that's one of the things that we're going to discuss here today. But the key point and the key purpose of these statements is to provide information to investors and creditors to help them understand how the company is doing so that companies can attract capital. In the US, a good source for information on financial statements is actually the US government, www.sec.gov, which is the Securities and Exchange Commission website. They have a database called EDGAR, and the financial statements of publicly traded companies in the US are available there electronically, free of charge, and in pretty much real-time from the point that the company discloses them. On an annualized basis, a company's annual report is called a Form 10-K. In the US, a quarterly report is called a Form 10-Q, and any significant information that has to be reported between the quarterly reports is filed on what's called a form 8-K. All of those are freely available at this website, and many investors services will call this website to gather information based on what is reported by companies. The second type of reporting is what I would like to think of as internal or management reporting. This is how a company looks at itself and how it evaluates itself. Internal statements are a second type of statement. The main challenge with internal statements is there really are no rules that companies have to follow. Companies can choose to evaluate themselves any way they want, and they often do. They are loosely based on external rules, but they don't have to follow the external rules. And so, it's very important to understand your internal statements by asking questions about how they're actually prepared. What are some of the nuances for the categories? What metrics are most important to the organization? The third type of reporting is what I would call tax reporting. The governments actually make you file a different set of books under a different set of rules so they can decide how much you should pay in taxes. For purposes of today, I'm going to talk about the external rules. Financial statements measure the cash cycle of a firm. As discussed in a previous module the cash cycle consists of four phases: financing, investing, operating, and returning. The first two stages of the cash cycle, financing and making investments, are measured by a statement called the balance sheet. And the operating side of the cash cycle, to try and figure out whether we're generating more cash than we spend, is measured by a second statement called the income statement, also known as the profit and loss statement. Those are the two statements we're going to cover today. The insight that these statements provide us is how we're doing on this continuous cash cycle to understand if we're making progress and generating more cash than we spend. This course includes a module on the income statement and a module on the balance sheet to better understand the structure and terminology of those statements. Here we will focus on the analysis of the statements. We will use Nike as a working example. As we explain the Key Performance indicators with the Nike data you may want to pause the video to think about the answers to each question. What I'm going to do is talk to you about are the key things that we're going to look for on the statement and what it is telling us about Nike's business. We will look at annual statements, but we can also examine quarterly statements or even monthly statements with a similar process. Note that financial statements are the results of decisions. Our analysis is usually a series of questions which will often lead to more questions that we can further investigate. For example if I notice the company's margin is declining I might want to further investigate the reasons why that margin has been declining in the marketplace. Or maybe the company is having issues with costs. these may be follow up questions that i would need to evaluate. We will start our analysis with the income statement or profit and loss statement. Remember that the income statement is a period statement which looks at all activity during a period of time. It also follows the matching principle. The income statement represents is an ability to generate the cash. But it may not be the cash the company is generating during the period of time. So one of the challenges with income statements is income statements show you what your eventual cash flow is, but it doesn't show your actual cash flow today. Finally when we do financial statement analysis we not only look at the ratios of the company overtime, we also will compare the company's ratios to their peers in their industry. This is a process known as benchmarking. To make these comparisons we will put a company's statements into a common size which means eight percentage of the total. When looking at an income statement typically everything is looked at as a percentage of revenue or sales. The one exception is the revenue growth rate which is a percentage change. Let's get started with the ratios. We start with revenue, which is a representation of all the cash that is coming in based on the activities of the period. Typically when we look at revenue we look at the percentage change between periods. This is called the growth rate. If the growth rate is increasing more cash is coming in. If the growth rate is decreasing then less cash is coming in. Looking at Nike: What is their revenue growth rate over time? The second category that we'll look at on the income statement is what's often known as the bottom line or the net income or net profit of a business. It is what is left after all expenses have been taken out of revenue. This is the net cash generated by the firm based on the period's activities. Ideally we'd like to see a positive profit. If we have a positive profit that means we're generating more cash than we're spending. If we have a negative profit that means we're spending more cash that we're taking in. That net income is also with the cash that we have available to repay our shareholders or to reinvest in the firm. Net income as a percentage of sales it's a ratio called return on sales or R OS. It answers the question when we sell a product how much profit do we make on that final sale after all expenses have been taken out? In the case of Nike - how much profit does it make? How has this changed overtime? Next we will begin to look deeper at expenses. Expenses represent the cash that will eventually go out based on the costs incurred during the period. The first category of expense is something known as cost of goods sold, or some people will call this cost of sales or cost of revenue. What these represent, and here's the keyword, direct, the direct expenses associated with a product or service. So if I'm making a product at Nike, it's all the costs that go into making the shoes or the apparel. The direct labor. The people actually manufacturing the product. The parts. The inventory costs associated with that product. The manufacturing line. The facility that's making it, all the costs directly associated with manufacturing the product go into what's called cost of goods sold or COGS, C-O-G-S. We then take this direct product cost of goods sold and subtract it from revenue or sales and that will lead us with something called gross profit. This is what's left to pay the rest of expenses and make money after we take out those direct product costs. When we take gross profit as a percentage of sales or revenue we typically call that a gross margin. Is primarily the difference between the price and the product or the service direct cost. A higher gross margin is indicative of a higher markup: difference between price and cost. What is Nikes gross margin as a percentage of sales and how has it changed over time? The next cost category that we will look at represents the indirect cost of running the operations. These are the costs not directly related to a product or service but rather the cost to run the business and the operations. This category of cost is often called overhead or selling general and administrative cost, SG&A for short. The cost of leadership, the cost of shared services, marketing expense, distribution to a customer and research and development expenses are typical indirect SG&A expenses. How much is a percentage of sales is Nike spending on indirect SG&A costs? How are these costs changing overtime? Gross margin and SG&A as a percentage of sales are then typically looked at in tandem. In order to have a higher gross margin companies will often spend more on those indirect expenses. For example if I'm spending more on research and development and more on marketing and branding then I might be able to charge a premium price and would expect a higher gross margin. If I have a lower gross margin then I can't spend as much on those indirect operating expenses and I would often have to keep my SG&A expenditures lower because I can't afford to spend the extra money. What is the relationship between gross margin and SG&A as a percentage of sales at Nike and how has this changed over time? How does nikes gross margin and SG and a percentages compare against a peer group? Is Nike showing higher gross margins which would suggest higher markups? Is Nike spending more or less on indirect cost or overhead than it's peers? When we subtract the cash cost of goods sold and the cash indirect SG&A expenses from revenue we are left with something called EBITDA which stands for earnings before interest tax depreciation and amortization. EBITDA represents the cash profit from operations at running our business. What is Nike’s EBITDA margin and how has it changed overtime? After examining EBITDA the next category of expense is known as depreciation and amortization: the DA in EBITDA. These are non cash costs that have been spread out over time because of the matching principle. Examples of depreciation might be a piece of equipment whose cost is being spread out over 10 years or a building whose cost is being spread out over 20 or 40 years. When we subtract these non cash operating expenses from EBITDA we are left with something called EBIT or earnings before interest and tax. This is often called operating income or operating profit. EBIT represents typically what is left when we run and pay for the operations of the business after our sales. It is a core metric for determining company performance. On a side note EBIT and operating profit could be different if a company has some non operating items. These are not typical but they could happen. An operating item is a cost of running the business that is recurring. A non operating item typically would be a one time cost that has nothing to do with the ongoing operations of the business. An example might be if a company does a large downsizing or a layoff. These are often one time items that are non recurring expenses which might reduce the profit but are not recurring. The real goal of understanding EBIT or operating profit is to understand what is happening to a business based on recurring revenue and recurring expenses from running the business in normal operations. What is Nikes EBIT margin as a percentage of sales and how has it changed overtime? How does Nike's EBIT margin compare to its peer group? Is it higher which means it's generating more profit from operations when it sells its shoes and apparel? The next category of expense is what's called financing cost. This would be the interest expense that we're paying on our debt, which is a cost of doing business. After the financing costs are taken out we are then left with something called pretax profit. This is the final prophet before a company would pay taxes to a government. How much is a percentage of sales is Nike spending on interest expense? What is Nike’s pretax margin as a percentage of sales? How does Nike's pretax margin compared to its peers? And finally, another category is called taxes. Taxes are typically subtracted from pretax income and what is left it's typically called net income or the bottom line. What is Nike's tax rate as a percentage of sales and how has this changed overtime? Lower is considered better. These are the five categories of expenses and the indicators of performance on an income statement. The other statement that we're going to look at is known as the balance sheet. And again, the balance sheet is helping us measure the investment and the financing stages of the cash cycle. Now, what's interesting about the balance sheet ratios is that investors actually look at the balance sheet in combination with the income statement. So the idea is how much do I have to invest in order to generate sales? How much do invest in order to run my business day to day? How long does it take us to get paid from the time we invoice to the time we collect the cash from a customer? One of the metrics on the balance sheet is called accounts receivable. Receivables represents the total amount of unpaid invoices from the time a product is shipped or delivered or service is sold to the time that we collect the cash. When we convert receivables to days the metric is called day sales outstanding or DSO. How long does it take Nike to get paid and how is that changing over time? How much cash is tied up for Nike in each day of receivable? The next question I would like to look at is what I would call the inventory days. How long does it take Nike to sell the inventory it makes? How much cash is tied up in each inventory day? Next, we want to look at what's called facility efficiency, or what I would call Property Plant and Equipment, which is your facilities. How much am I spending on my facilities to generate a dollar of sales? Lower is more efficient as companies spend less to make its products and services. To get that number, take Net Property Plant and Equipment off the balance sheet and divide by sales or revenue. How much does Nike spend on PP&E and how is it changing over time? How does Nike’s spending on PPE compare to its peers? Is Nike more efficient than its peers? a lower ratio is considered more efficient. Now we go to the other side of the balance sheet - which is the financing side. Another question we might ask as an investor is how much financing is required to run its day-to-day operations? That is known as capital, or what's called invested capital. Now some people will call this capital employed, others will call it net assets. But the idea is it's the total amount of financing that requires a return that's used to run the business. It's all of the debt, short-term and long-term debt, that requires interest plus all of the equity. Note this will equal all of the investment in the assets of the firm less any non interest bearing liabilities. externally it's easier to track the financing. To measure productivity we then take the invested capital and divide by sales. This will tell us how much financing is required to generate a dollar of sales. Lower is better. What is the productivity of invested capital at Nike and how has this changed overtime? How does nikes productivity compare with its peers How much invested capital does Nike have and how has it changed over time? What does this also tell me about their productivity in terms of cycle time in days? So can I translate this into a day's number, or basically, how long does it take to turn that investment when they spend that money, that debt or equity to collect the cash to turn the investment into sales and actually collect the cash? What is the length of Nike’s cash cycle and how has it changed over time? How does Nikes financial cycle time compare to its peers? The next metric we are going to look at answers the question: What's my return on investment? This is a metric call ROIC: Return on Invested Capital. It measures how much profit from operations we make for every dollar of investment in the company. ROIC is a proxy for cash flow. If we make a 10% ROIC we are generating 10 cents of cash profit for every dollar of investment. If we make 15% ROIC we are generating 15 cents of profit for every dollar of cash profit. Generally, most large publicly traded companies in the US and Europe have earned somewhere around 9% to 10% annually over time. So that's a reasonable benchmark. But again, I'm going to eventually compare it to my cost of financing or what is known as the cost of capital. The cost of capital represents the expected ROIC that must be earned to compensate of the risk a company takes. An acronym for Cost of Capital is called WACC – or the Weighted Average Cost of Capital. The WACC averages the expectations of all debt and equity holders to come up with a blended return expectation. Value is created when we exceed expectations – said another way value is created when the ROIC is greater than the cost of capital. What is Nike’s ROIC and how has it changed over time? Is Nike’s ROIC exceeding its WACC and how is it performing on this benchmark over time? How does Nike spread compared to its peers? The next metric that we're going to look at involves whether the company can repay its debt. The metric is called interest coverage. This will tell us how many times we can repay the interest with the profits of the business. Higher is better. What is Nike’s interest coverage and how has it changed overtime? Finally, does a company have enough cash to pay its short-term obligations? Another way of thinking about this is current assets represents the assets that can be turned into cash in less than a year. And current liabilities are what's due in a year. So if current assets is the cash coming in and current liabilities is the cash going out within a year - what's the ratio of cash coming in divided by cash going out? This is called the current ratio. A ratio above 1 suggest the company will have enough cash to pay those liabilities in the next year. A ratio below 1 would mean that the company likely would need to borrow to pay those liabilities over the next year. This is called liquidity. A low ratio can be offset as long as the company has access to financing or a line of credit. A version of the current ratio is called the quick ratio. With the quick ratio we exclude inventory from current assets and recalculate. This assumes that we might have trouble selling the inventory and if we did could we still generate enough cash in the short term to repay those liabilities. What is Nike’s current and quick ratios and how have they changed overtime? how do Nikes current and quick ratio compare to its peers? This module has covered financial statement analysis and some of the key performance indicators known as KPIs that we will look at when we evaluate a company's performance.