CHAPTER 17 Financial statement analysis II. Contents Introduction – Framing of financial...

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 17Financial statement analysis II


Contents

Introduction – Framing of financial statement analysis

Quality of earnings Analytical techniques Strategic ratio analysis Z scores Shareholder value


Framing of financial statement analysis

Accounting numbers are not the only input into the assessment of a company’s prospects

Figure 17.1 provides an overview of relevant framing factors

Increasing use of investor briefings by companies


Fig. 17.1 Rating pyramidSovereign macro-economic analysis

Industry sector analysis

Regulatory environment (national and global)

Competitive trends in sector

Market position

Quantitative analysis financial statements past performance future projections

Qualitative analysis management strategic direction financial flexibility

Rating


Quality of earnings

Is profit (and profit growth) sustainable? What is the impact of short term conditions

? What is the impact of ‘creative’ accounting

changes ? Changes in accounting policies Changes in accounting estimates Changes in consolidation scope Changes in interest % Exceptional sale of assets or business segments Other extraordinary operations


Quality of earnings (cont.)

Quality of operating earnings =

Net operating cash flow

Net operating profit

Some analysts will compare, in a longitudinal fashion, operating profit to net operating cash flow to identify and analyse the effect of ‘accruals’- games on operating earnings.


Discontinuing operations

A discontinuing operation is a clearly distinguishable component of a group’s business, that(a) Is disposed of or terminated pursuant to a single plan(b) Represents a separate major line of business or

geographical area of operations, and(c) Can be distinguished operationally and for financial

reporting purposes.

Requires major additional disclosures Income statement / Cash Flow Statement / Notes


XYZ GROUP - INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20-2 (illustrating the classification of expenses by function)(in thousands of currency units)Continuing operations 20-2 20-1Revenue X XCost of sales (X) (X)Gross profit X XOther income X XDistribution costs (X) (X)Administrative expenses (X) (X)Other expenses (X) (X)Finance costs (X) (X)Share of profit of associates X XProfit before tax X XIncome tax expense (X) (X)Profit for the period from continuing

operations X X

IFRS 5 - Presentation of Discontinued Operations in the Income Statement (Extract)

continues


Discontinued operations

Profit for the period from discontinued operations1 X X

Profit for the period X X

Attributable to: Equity holders of the parent X X Minority interest X X

X X

1 The required analysis would be given in the notes

IFRS 5 - Presentation of Discontinued Operations in the Income Statement (Extract) – cont.

Source: IFRS 5 – Non-current assets held for sale and discontinued operations, Guidance on implementing


Analytical techniques

Common accounting base Common size Ebitda Objectives of analysis


Common accounting base

Adapt financial statement data for differences in accounting rules among companies, e.g. Accounting for R&D costs Depreciation rules Goodwill treatment Revaluation of fixed assets

Set up comparable pro-forma statements for cross-sectional analysis


Common size Common size financial statements

Resize components of balance sheet as a % of total assets

Express components of income statement as a % of sales

They allow a straightforward internal or structural analysis of a company’s financial position and performance

Useful for comparisons in time and in space


Ebitda

‘Earnings before interest, taxation, depreciation and amortization’

Proxy for net operating cash flow Cleans operating result for non-

cash costs and non-cash revenues Robust measure for comparison of

performance in time and space


Objectives of analysis

Investors and creditors as predominant users of financial statements

Broadly, both investor and creditor will use the same indicators, but the relative importance of specific indicators will be different and will be contingent on the type of investor (and creditor) decisions to be made


Strategic ratio analysis

Sustainable growth ROI decomposition Financial leverage Operational gearing


Recap ratio analysis Understand accounting principles Develop a consistent analysis

framework Constraints of an historical perspective Garbage in, garbage out Take into account trends and industry

comparisons Take into account worldwide variations

in accounting rules


Strategic analysis Elements of strategic analysis:

Phase in life cycle of company and products Nature of market

• Difficult entry <> large margins• Easy entry <> margins usually very low

Nature of products• Niche products (low volume, high price)• Bulk (high volume, low margins)

…. Develop (combinations of) ratios which

will give insights to a company’s strategic positioning


Sustainable growth Look at growth of key items of financial

statements Trend analysis Differentiate organic and acquired growth

Sustainable growth = ROE x (1 – Dividend payout ratio)

Dividend payout = Dividend / Earnings attributable to shareholders

= indicator of internally generated growth potential if the company’s profitability, dividend payout and level of debt financing are kept constant


Growth analysis Periodic growth of sales as point of

departure Link with profit growth ? Differentiate between organic and acquired

growth Identify regional or geographic location of

growth Differentiate growth potential by business

segment Impact on cash flow ?


ROI decompositionThere is a conventional relationship between management performance ratios which links return on investment, profit margin and asset turnover as follows:

Profit margin * Asset turnover = ROI

If we apply this reasoning to the ROA (return on assets) ratio, we arrive at the following algebraic equality:

Profit before

interest * Sales =

Profit before interest

SalesTotal

assets Total assets


ROI decomposition (2)Assume: ROA decreases over a number of periods

Cause? Asset turnover, Profit margin or both ?

Assume: Asset turnover drops => Cause? Sales, assets or both?

Potential causes:(1) Due to competition, sales decrease and one is not able

to adjust inventory levels accordingly(2) Recent investments in IT were necessary to support

current competitive position

Assume: Profit margin decreases => Cause ?Increasing operating expenses, decreasing market share, decreasing sales prices, …


Financial leverageTaking the analysis one step further, the return on equity can be analytically linked to the return on assets ratio with the introduction the concept of financial leverage.

ROA * Financial leverage = ROE

Profit before interest *

Total assets =

Profit before interest

Total assets Equity Equity

Alternatively, we can start from the original ROE definition and get the following:

Net profit for the period *

Total assets =

Net profit for the period

Total assets Equity Equity

Starting with the ROA (return on assets) ratio, we arrive at the following algebraic equality:


Final leverage coefficient

A related, but somewhat different, concept is the financial leverage coefficient ratio, defined as ROE divided by ROA:

Financial leverage coefficient = ROE% / ROA%


Table 17.1 Financial leverage effect at different debt/equity ratios

Total assets = 1,000 ROA = 10%After-tax cost of debt = 7%

Debt /Equity 100% 150% 300%

Profit before interest 100 100 100

Cost of debt 35 42 52.5

Net profit 65 58 47.5

ROE 13% 14.5% 19%

Financial leverage coefficient

13%/10% = 1.30

1.45 1.90


The DuPont modelCombining ROI decomposition and financial leverage brings us to the following overall model (also called the DuPont model):


=


*

Sales

*

Total assets

Equity SalesTotal

assets Equity

ROE = Net profit margin * Asset turnover * Financial leverage

or:


Operational gearing Volatility of profit as a function of changes

in sales (taking into account the cost structure)

Operational gearing is the % change in profit as sales changes 1%

Based on the traditional difference between fixed and variable costs

Operational gearing = (Sales – variable costs) / EBT or (Earnings before tax + fixed costs) / EBT


Fig. 17.2 Operational gearing

Value

Volume

Sales

Costs = Fixed + Variable Costs

Break-even


Fig. 17.2 Operational gearing (cont.)

Value

Volume

Sales


Break-even


Fig. 17.2 Operational gearing (cont.)

Value

Volume

Sales

Break-even



Different cost structures

Sales Fixed costs

Variable costs

PbT Operational gearing

Co. A 100 20 70 10 3:1

Co.B 100 70 20 10 8:1

If sales increase by 10%, profit before tax of company A increases by 30% and profit of company B by 80%

A decrease in sales will have a more dramatic effect in company B


Operational gearing indicators

Operational gearing = (Sales – variable costs) / EBT (Earnings before tax + fixed costs) /

EBT Proxy in external analysis:

LT assets / Total assets LT assets / Current assets


Investigate link between ratios and cash flows

Cash from operations ROCE, profit margins and growth

Changes in working capital Days credit given and net working capital

Investment outflows Capital intensity, age assets and depreciation

regime Free cash flow

Should be positive if company in stable position


Z-scores Failure prediction models: ratios are

used as input for more sophisticated models, taking into account the simultaneous impact of several factors

How measured ? 2 samples with mutual matching of which one with failed companies - data consist of financial ratios relative to years before failure => ratios which discriminate best between two groups are used as input for failure prediction models


Shareholder value

Focus on present (discounted) value of forecast earnings

Time value of money and present value calculations

Forecast cash flows Discount rate


Present valueThe essence of present value is that a rational person will prefer to have a receipt sooner rather than later because the money can be used to generate more money.

For example, if a company has a choice of receiving $1,000 now or $1,000 in a year’s time, it would prefer to have the cash now because it could be invested and earn a return. If the money was put into risk free securities where it could earn 15 per cent, then $1,000 now would be worth $1,150 in a year’s time.


Present value (cont.)

Extending that, the $1,000 to be received after a year is worth $1,000/1.15 (or $870) today, because $870 invested today at 15 per cent would yield $1,000 in a year’s time. Similarly, $1,000 to be received in two years’ time is worth $1,000/(1.15*1.15) = $756 at present (i.e. compound interest at 15 per cent for two years would be $244).

CHAPTER 17 Financial statement analysis II. Contents Introduction – Framing of financial...

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