Learning Objective:

Essentials of Financial Statement Analysis

Analysis, Forecast and Vulation Procedures

Reviewing the Financial Statements: Review comparative financial statements and audit opinion. Adjusting and forecasting accounting numbers:

Adjusting accounting numbers to remove nonrecurring items, the different choice in capital structures, distortions from earnings management, and significant subsequent events from reported net income.
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Analysis
Assessing Profitability and Creditworthiness:

Common size statements. Trend statements Financial ratio analysis: Use ratios to assess liquidity, profitability and solvency. Credit analysis: Use ratios and cash flow statement to determine the short term and long term risk of default.

Forecast and Valuation

Comprehensive Financial statement forecasts (see Appendix B of Chapter 6 ) Valuing Equity Securities (see Appendix A
of Chapter 6):

a. Free cash-flow model b. Abnormal earnings model (residual income model).

Essentials of Financial Statement Analysis

Step 1: To be informed that financial statement analysis is a careful evaluation of the quality of a companys reported accounting numbers. Step 2: Then adjust the numbers to overcome distortions caused by GAAP or by managers accounting and disclosure choices.

Only then you can truly get behind the numbers and see whats really going on the Company.

How the financial accounting filter sometimes works

GAAP puts capital leases on the balance sheet, but operating leases are offbalance-sheet.

Managers have some discretion over estimates such as bad debt expense.

Managers have some discretion over the timing of business transactions such as when to buy advertising.

Managers can choose any of several different inventory accounting methods.

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Financial statement analysis:

Tools and approaches
Tools:

Approaches used with each tool:

Common size statements 1. Time-series analysis: the same firm over time (e.g., Wal-Mart in 2008 and 2006) 2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2008). 3. Benchmark comparison: using industry norms or predetermined standards.

Trend statements

Financial ratios (e.g., ROA and ROCE)

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Financial analysis tools

1. Comparative Financial statements: Statements are compared across years. 2. Common-size statements: Recast each statement item as a percentage of a certain item. 3. Trend statements: Recast each statement item in percentage of a base year number. 4. Financial ratios.
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Basic Approaches
1. Time-series analysis : Identify financial trends over time for a single company. 2. Cross-sectional analysis: Identify similarities and differences across companies at a single moment in time. 3. Benchmark comparison: measures a companys performance against some predetermined standard.
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Getting behind the numbers: Case Study: Krispy Kreme Doughnuts, Inc.
Established in 1937. Today has more than 290 doughnut stores (companyowned plus franchised) throughout the U.S. Serves more than 7.5 million doughnuts every day.
70% 60% 50% 40% 30% 20% 10% 0% Compnay stores Sales to franchisees Royalties 31% 65%

4%

Strong earnings and consistent sales growth.

Revenue sources in 2002

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Comparative Income Statements:

Krispy Kremes Financials

Systemwide sales Include sales from company owned and franchised stores.

Includes a $5.733 million after-tax special charge for business dispute

Includes a $9.1 million charge to settle a business dispute

Sales increased from $220.2 million in 1999 to $491.5 million in 2002. Net income increased from $6 million in 1999 to $33.5 million in 2002.

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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to Income
Statements

Common Size Income Statements:

$393.7 operation expenses $491.5 sales * Not adjusted for distortions caused by special items.

Each statement item is computed as a percentage of sales.

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Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Income
Statement

Trend Income Statements:

Base Year
$393.7 operating expenses in 2002 * Not adjusted for distortions caused by special items. $194.5 operating expenses in 1999

Each statement item is calculated in percentage terms using a base year number.

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Comparative Balance Sheets Assets

Krispy Kremes Financials: Balance Sheet Assets

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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to assets

Common Size Assets

$3.2 cash $105.0 assets

Each statement item is computed as a percentage of Total assets.

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Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Balance sheet assets

Trend Assets

$7 cash in 2000 $3.2 cash in 1999

Each statement item is calculated in percentage terms using a base year number.

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Comparative Balance Sheets Liability and Equity: Krispy Kremes Financials

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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to Balance
sheet liabilities and equity

Common Size Liabilities and Equity:

$13.1 accounts payable $105.0 total liabilities and equity

Each statement item is computed as a percentage of Total liabilities and equity.

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Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Balance sheet
liabilities and equity

Trend Liabilities and Equity

$8.2 accounts payable in 2000 $13.1 accounts payable in 1999

Each statement item is calculated in percentage terms using a base year number.

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Krispy Kremes Financials:

Abbreviated cash flow statements

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Krispy Kremes Financials: Apply the analysis tool (Common Size statement) to Cash
Flow Statements

Common Size Cash Flow Statements:

$93.9 capital expenditures $491.5 sales

Each statement item is computed as a percentage of Sales.

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Krispy Kremes Financials: Apply the analysis tool (Trend statement) to Cash Flow
Statements

Trend Cash Flow Statements

$93.9 capital expenditures in 2002 $10.5 capital expenditures in 1999

Each statement item is calculated in percentage terms using a base year number.

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Krispy Kreme analysis: Lessons learned

Informed financial statement analysis begins with knowledge of the company and its industry.

Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes are easily recognized.
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Krispy Kreme analysis: Lessons learned

Common-size and trend statement techniques can be applied to all financial statements and every section of statements. Financial statements help analysts gain a sharper understanding of the companys economic condition and its prospects for the future.

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