Financial Statement Analysis

FINC 361 Fall 2016

Professor Mahdi Mohseni

Disclosure of Financial Information

Desired characteristic of financial statements
1. Reliability
2. Consistency
3. Comparability
4. Timeliness
5. Relevance
All of these features help for effective due diligence

Firm disclosure is regulated

Accounting standards
1. U.S. Generally Accepted Accounting Principles (GAAP)
2. International Financial Reporting Standards (IFRS)

Non-GAAP items
Firms can and do report non-GAAP items
Tradeoff:
(+) More relevant numbers for the business community
EBITDA, revenue per subscriber, # of Amazon Prime customers,
etc.

(-) More leeway to report opportunistically

What would you do when you are not doing well on a given
dimension?
What would be a valid reason for Amazon not to report the number of
Kindle sold?

Beware of Non-GAAP accounting:

The Case of Alibaba
Large difference between
GAAP and non-GAAP
results for Q2 2014
Non-GAAP: Excludes $490
million of share-based
compensation expenses
relating to stock awarded
to employees and
executives before IPO

Pros and cons?

Where and When?

Publicly-traded U.S. firm
Annually (10-K)
Quarterly (10-Q)
Significant events (8-K) at any time
Beware of bad news disclosed after the close on Friday
Niessner (2013)
What is the rational?

Where to find them?

Firms website; SECs Edgar website; Yahoo! finance

Auditing
Verified by auditors
Independent third party (e.g. Big four)
30% of all leading 1000 US firms have used same
auditors for at least a quarter of a century!
Conflicts of interests?
Potential solution?

Multiple users of financial statements

SHAREHOLDERS
(owners of the firm)

Current investors:
Monitor their
investment

BONDHOLDERS
BANKERS

Board of Directors

Bankers:
Monitor for
solvency risk

MANAGEMENT
(running the firm)

Multiple users = Multiple purposes!

What some users think is important
might not be for others

Regulators
(SEC, FDIC)
Tax (IRS)
Evaluate
managers
performance

SOCIETY

Analysts and potential investors:

Evaluate firms for investments

FINANCIAL MARKETS

1. Balance sheet
Liabilities

Assets
List of everything the
company owns (snapshot)

List of IOUs (snapshot)

Formally:
Obligation to creditors to deliver
something of value in the future

Stockholders Equity

Difference between assets and

liabilities
Accounting net worth

ASSETS = LIABILITIES + STOCKHOLDERS EQUITY

1. Current Assets

Assets

Definition: Converted into cash in less than one year

I.
II.
III.

Cash
Accounts receivable (what customers owe you)
Inventory

2. Long-Term Assets
I.

Net Property, plant and Equipment (Net PP&E)

Net PP&E = Gross PP&E Accumulated Depreciation

II. Capital lease assets
Leasing: Alternative to an outright purchase with debt financing
Quasi-ownership of asset for a given lease agreement
III. Intangible assets
IV. Goodwill
Created when acquiring a firm
Difference between price paid and book value of assets acquired
V. Deferred tax assets
Due to differences between what a firm can deduct for tax
purposes relative to accounting purposes

Liabilities
1. Current Liabilities

Definition: Obligation due within a year

I.
II.
III.

Accounts payable (what you owe your suppliers)

Notes payable (short term debt)
Current maturities of long term debt

2. Long-term Liabilities
I.
II.

Long-term debt
Capital lease obligations

Future payments in a lease are a liability

III. Pension liabilities
IV. Deferred tax liabilities
Due to differences between what a firm can deduct for tax
purposes relative to accounting purposes

Stockholders equity
Difference between what you own and what you owe:
Measure of net worth

Analogy to owning a house:

Equity in house = Value of house (assets) Mortgage (liabilities)

Accounting value market value

A. Accounting value
Value of house asset = Purchasing cost Accumulated depreciation

B. Market value
Value of house asset = How much you can sell it for today

Balance sheet example

Sources and uses of cash

Cash is king

Where is it being used? Where does it come from?

Two-Finger approach

Go through balance sheet items of two consecutive years

I.

Rules

A company generates cash in two ways:

1.
2.

II.

By reducing an asset account

Remark: Does not apply to the cash account

By increasing a liability account

A company uses cash in two ways:

1.
2.

By increasing an asset account

Remark: Does not apply to the cash account

By reducing a liability account

Statement of cash flows will be more useful to

capture sources and uses of cash

2. Income statement
Accountants attempt to measure profitability:

1. Revenues Expenses = Net Income

2. Earnings Per Share (EPS) = Net income /# shares outstanding
# shares outstanding: Basic vs. Fully diluted
Fully diluted: Includes shares reserved for stock options, etc.

Accrual accounting

1. Identify revenues for the period

2. Match the corresponding costs to revenues

Summary of activities over past year/quarter

Markets obsessed with EPS

Strong incentives to manipulate numbers in order to meet

earnings forecasts
EPS treadmill

Decomposition of expenses
1.

Operating expenses

2.

Capitalized expenses

3.

Providing benefits only for current period

Costs are immediately expensed
Example: Cost of labor for goods sold during the period
Expenditures providing benefits over multiple periods

Accrual accounting: Costs need to be reflected (capitalized) over those multiple periods

Straight line scheme

Accelerated scheme (MACRS)

Dollar outflows incurred at time of purchase but written off over time
Depreciation: Expense that corresponds to the use of a long-term assets
during the quarter/year under review
Example: Cost of buying buildings and machinery

Financing expenses

Non-equity financing related expenses

Example: Interest expenses on debt
One big omission in the accounting numbers: Cost of equity

Just as bondholders expect interest on loan, stockholders require a return on investment

Not directly observable so not recorded but equity is not free!!

What about R&D expenditures, is it capitalized or expensed immediately according to FASB?

What is the rational behind this accounting rule?

Income statement example

Revenues
(Top line)
Operating
expenses
Capitalized expenses
(sometimes included
in COGS instead)

Operating income

Bottom line
EPS

3. Statement of cash flows

Very useful: Gives the sources and uses of cash through the
following 3 activities:
1.

Operating Activity

Cash flows related to operations

2.

Negative operating cash flow not always a bad sign

(e.g. growing firm)

Investment Activity

Cash flows related to

A.
B.

Any gains (or losses) from investments in the financial markets

Amounts spent on investments in capital assets such as plant and
equipment

I.
II.

3.

Capital expenditures
Acquisitions
CRUCIAL ITEMS: They correspond to necessary investments to generate
future cash flows

Financing Activity

Cash flows related to financing

Uses:

Dividends and stock repurchases

Decreases in borrowing

Increase in borrowing
Stock issuances

Sources:

Statement of cash flows

INDIRECT METHOD:
Adjustments to
eliminate effects of
accrual accounting

The indirect method of computing cash

flows from operations
1.
2.
3.

4.

5.

Start with Net Income

Depreciation

Reasoning: Non-cash operating expense, hence it lowered income but had no corresponding outflows
Add back

Increase in accounts receivable

Reasoning: All sales were recognized in net income yet no cash was received for the portion
corresponding to the increase in accounts receivable
Deduct

Increase in accounts payable

Reasoning: Purchases from suppliers were recognized in net income as a cost, yet increases in accounts
payable correspond to increases in borrowings from suppliers hence correspond to purchases with no
corresponding cash outflows
Add back

Increase in inventory

Reasoning: Net income includes the cost of goods sold (COGS). Inventories are associated with goods
not sold hence are not reflected in net income computations. However, given that inventory is recorded
at cost, increases in inventory corresponds to a cash expense
Deduct

CASH FLOW FROM OPERATIONS = NET INCOME + ADJUSTMENTS

Adjustments are made to eliminate the effects of accrual accounting

4. Statement of Stockholders Equity

Bookkeeping purpose:
Breaks down book equity into:
1. Issuances of new shares
Common shares at par value
Paid-in capital

2. Retained earnings

Book equity:
Historical by nature: Equity investment in the firm
plus accumulated earnings/losses over time
Not useful for assessment of firm value!

Incentives to manipulate
Incentives are strong
Combination of two effects:
1.
2.

Large stock/options
compensation for management
Market rewarding firms that
meets or beats EPS forecast

Most common manipulation:

Earnings
Example: EPS to a 10th of a cent

Other manipulations:
Cash flows
Non-GAAP metrics
E.g. Revenue per user
Check the case of Groupon!
Profit-before-bad-stuff!

Earnings manipulations
A. EPS increasing manipulations:

1. Recording revenue too soon

2. Recording bogus revenue
3. Boosting income using one-time or unsustainable
activities
4. Shifting current expenses to a later period
5. Employing techniques to hide expenses or losses

B. EPS decreasing manipulations:

1. Shift current income to a later period

2. Shift future expenses to an earlier period
3. Depressing income using one-time items

Why would a manager want to decrease earnings?

Examples

1. Recognizing revenues too soon

a)

b)

2.

The case of Computer Associates:

Recognized present value of all licensing revenues related to multiyear contracts

According to SEC: From 1998 to 2000, it overstated revenues by over
$3.3Bn
Management had huge incentives to boost stock price ($1.1Bn in
bonus for top three executives if stock price above a certain price for
more than a month)

The case of IBM:

One-off gain from selling its Global Network business to AT&T

Booked one-off gain of $4.057Bn in SG&A in 1999!

Shifting current expenses to a later period

a)

The case of Time Warner Telecom:

Extended depreciable life for some of its fixed assets (fiber) from 15 to
20 years
It inflated profits by about $4.9M in that quarter, relative to an
operating income of $5.4M

Accounting scandals and SOX

2000-2001: Many accounting scandals (Enron, Worldcom)
Accountants were taking an active part
Bad incentives

Public outcry
New regulation for publicly traded companies

Sarbanes-Oxley Act (SOX)

Tightening of accounting regulations

Section 404:

Management required to produce internal control report

Report must affirm the responsibility of management for establishing
and maintaining an adequate internal control structure and procedures
for financial reporting
Expensive to comply
Rules have been relaxed by Dodd-Frank reforms for small firms

Section 302:

CEO and CFO now required to unequivocally take ownership for their
financial statements
Less incentives to manipulate earnings going forward

The Value Problem

Book value of equity True value of equity
If stock traded:
True value of equity = Market capitalization
Market cap = #shares outstanding x Stock price

Why the difference?

INVESTORS

FORWARD LOOKING

ACCOUNTANTS

BACKWARD LOOKING

The Value Problem

1. Investors:

Buy shares for future income generated by the business, not

the value of assets in place
Not reflected in financial statements:
Value of good management team
Value of loyal customers
New invention in the pipeline, etc.

2. Accountants:

Conservatism principle:

Preference for conservative value estimates

Example: What is the true value of a factory owned by a firm?

Answer: What you could get by selling it today

The issue for accountants: No liquid market for it
Conservative value = Historical cost Accumulated depreciation
Assets recorded at historical cost (transaction based)
Compounding the issue: Depreciation

Growth opportunities typically not in accounting numbers

Exceptions: Goodwill (acquisitions), Intangible assets (patents)

Conclusion of review of financial

statements
Despite weaknesses just mentioned, financial statements
remain the best source of financial information on the firm
Starting point to analyze the performance of the firm and
understand what is happening inside the firm
Necessary for due diligence process