CHAPTER 17 INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES Presenter’s name Presenter’s title dd Month yyyy FRAMEWORK The primary reason for performing financial statement analysis is to facilitate an economic decision. The framework for the analysis contains six phases: 1. Define the purpose for the analysis 2. Collect input data 3. Process data 4. Analyze/interpret the processed data 5. Develop and communicate conclusions 6. Follow-up Copyright © 2013 CFA Institute 2 FRAMEWORK: CASE STUDY 1 Evaluating Nestlé as a long-term equity investment. 1. Define the purpose for the analysis: - Isolate the factors that have driven Nestlé’s financial success and assess their sustainability. - Understand the risks that may upset the sustainability of returns. 2. Collect input data: Gather several years of annual reports. 3. Process data: - Conduct a DuPont analysis. - Analyze the composition of Nestlé’s asset base and capital structure. - Study the company’s segments and the allocation of capital among them. - Examine the company’s earnings quality. - Study the company’s cash flows and their adequacy for the company’s continued operations and strategies. - Decompose the company’s valuation. 4. Analyze/interpret the processed data. 5. Develop and communicate conclusions: Write report. 6. Follow-up. Copyright © 2013 CFA Institute 3 DUPONT ANALYSIS Net income Sales Assets ROE = × × Sales Assets Equity = Net profit margin × Assets turnover × Leverage Nestlé’s ROE: 2007 2006 2005 Net profit margin 10.58% 10.00% 9.44% Assets turnover 0.994 0.963 0.955 Leverage 2.02 2.01 2.16 21.25% 19.36% 19.48% ROE Copyright © 2013 CFA Institute 4 FINANCIAL REPORTING CHOICES AND BIASES Including the net investments and returns of associates with full reported value of a company’s own assets and income would introduce noise into the analysis. For example, - Part of Nestlé’s income relates to Nestlé’s 30% stock ownership of L’Oreal. - Subtracting the investment from total assets results in a figure that more closely represents Nestlé’s own asset base. - Subtracting the share of results of associates from the net income allows for the analysis of exclusively Nestlé profitability resulting from the exclusively Nestlé asset base. Return on equity Nestlé-only ROE Associates’ contribution to ROE Copyright © 2013 CFA Institute 2007 21.25% 20.48% 0.77% 2006 19.36% 18.75% 0.61% 2005 19.48% 18.66% 0.82% 5 FINANCIAL REPORTING CHOICES AND BIASES • Comparing financial statements prepared under different accounting treatments over the years could bias analysis. • Adjustments are necessary to keep analysis logically consistent throughout all the periods of study. • For example, for comparability, Nestlé restated the 2004 balance sheet, including changes for employee benefits plan accounting, lease classification, a reclassification of a warrants premium, and the cumulative effect on their investment of L’Oreal’s first-time adoption of IFRS. Copyright © 2013 CFA Institute 6 CAPITAL STRUCTURE ANALYSIS • Use common-size analysis. - For example, below is Nestlé’s long-term capital structure on a common-size analysis: 2007 2006 2005 2004 Long-term financial liabilities 8.6 10.0 12.4 18.4 Other long-term liabilities 15.4 13.7 14.2 15.3 Total equity 76.0 76.2 73.4 66.2 Total long-term capital 100.0 99.9* 100.0 99.9* Deleveraging *Does not add to 100% because of rounding • When deleveraging occurs in the long-term capital structure, there is offsetting change in the company’s working capital (i.e., leverage improves, but liquidity deteriorates). • Improvement in the management of receivables, inventory, and payables can mitigate the concern associated with the decline in the actual working capital. Copyright © 2013 CFA Institute 7 SEGMENT ANALYSIS • Business Segment: A portion of a larger company that accounts for more than 10% of the company’s revenues or assets and is distinguishable from the company’s other lines of business in terms of risk and return characteristics. • Conducting segment analysis helps analysts understand any geopolitical investment risks. • Ratio of capital expenditures proportion to total asset proportion ranked by EBIT margin: - A ratio < 1 indicates that the segment is being allocated a lesser proportion of capital expenditures than its proportion of total assets. - A ratio > 1 indicates that the company is growing the segment. - Comparing the ratio with the EBIT margin gives an analyst an idea of whether the company is investing its capital in the most profitable segments. Copyright © 2013 CFA Institute 8 SEGMENT ANALYSIS: EXAMPLE Pharma Nestlé Nutrition Asia, Oceania, and Africa Americas Other Food and Beverage Europe Nestlé Waters 2007 EBIT 33.27% 17.16% 16.29% 16.28% 15.85% 11.99% 8.18% 2007 0.61 0.31 1.18 1.11 2.43 0.94 1.79 2006 0.74 0.81 1.06 0.92 1.52 0.82 1.62 2005 0.75 0.93 1.19 0.85 1.53 0.99 1.27 If the company were to continue to allocate capital toward the lowest-margined business segment, the overall corporate returns might be negatively affected. Copyright © 2013 CFA Institute 9 EARNINGS QUALITY • Earnings quality: The persistence and sustainability of a firm’s earnings. • Ways to evaluate earnings quality: Analyze the accruals: Accrual ratio fluctuations indicate the use of accruals to “time” earnings. YTY change in NOA Balance sheet based accruals ratio = Average NOA 𝑁𝐼 − (𝐶𝐹𝑂 − 𝐶𝐹𝐼) Cash flow based accruals ratio = Average NOA where NOA = Net operating Assets, CFO = Cash flow from operating, and CFI = Cash flow from investing. Copyright © 2013 CFA Institute 10 EARNINGS QUALITY Nestlé example: (in millions of CHF) B/S aggregate accruals (YTY ∆ in NOA) Divided by: Average net operating assets Balance sheet based accruals ratio 2007 11,589 69,614 16.6% 2006 5,026 61,306 8.20% 2005 9,345 54,121 17.3% 2004 (2,730) 50,813 −5.4% 2003 1,587 51,385 3.1% Cash flow based aggregate accruals Divided by: Average net operating assets CF accruals ratio 13,696 69,614 19.7% 8,619 61,306 14.1% 3,071 54,632 5.6% 593 51,324 1.2% 1,196 51,385 2.3% Fluctuated significantly. Much higher in the most recent year than in the earlier years. Copyright © 2013 CFA Institute Increases steadily over time, indicating a higher degree of accruals present in the company’s earnings. 11 EARNINGS QUALITY Study the company’s cash flow and its relationship to net income. Are operating earnings backed by cash flow, or are the operating earnings more of an accounting result? - Appropriate adjustments to keep the comparisons between cash flow and earnings symmetrical: a) Add the cash paid for interest and taxes to the operating cash flow. The resulting operating cash flow before interest and taxes is the relevant operating cash flow for comparison with the operating income. b) Add goodwill amortization to the period prior to 31 March 2004. IFRS 3, “Business Combinations,” suspended the amortization of goodwill after 31 March 2004. To amortize goodwill in some but not other years of operating earnings would produce a misleading trend in the ratios. Copyright © 2013 CFA Institute 12 EARNINGS QUALITY Examine the relationship between operating cash flow and total assets. Total assets reflect the sum of management’s resource allocations. • Compare cash flow with reinvestment, debt, and debt-servicing capacity. • Results indicate - whether the company has enough resources for its reinvestment program, and - whether additional borrowing could be arranged should an investment opportunity arise. Copyright © 2013 CFA Institute 13 VALUATION: EXAMPLE To determine the value that the market is placing solely on the company’s operations, analysts need to remove the value of the company’s holdings of other companies from the market value. (CHF in millions) Alcon L’Oreal Implied Nestlé-only Actual Recap in %: L’Oreal Alcon Nestlé Market values 36,499 28,961 130,201 195,661 Earnings (Group shareholder level) 1,361.5 1,302.0 7,985.5 10,649.0 Market value 14.8% 18.7% 66.5% 100.0% Earnings 12.8% 12.2% 75.0% 100.0% Respective P/Es: 26.8 22.2 16.3 18.4 Nestlé has ample cash flow and low financial leverage; thus, the discount may be inappropriate and shares may be undervalued. Copyright © 2013 CFA Institute 14 FRAMEWORK: CASE STUDY 2 Evaluating investee’s off-balance-sheet leverage. 1. Define the purpose for the analysis: - Look for companies in the fund’s holdings where off-balance-sheet financing may be an issue (i.e., companies with unrecorded capital leases). - Analyze the impact of the leverage if such leverage exists. 2. Collect input data: - Multiply the current operating lease expenses reported by companies in the fund’s holdings by 7.4 to get an estimate of the unrecorded assets and debt. - If the ratio of “hidden” assets to total assets exceeds 5% for any of the companies in the fund’s holdings, that company’s information will be subjected to further analysis. 3. Process data. 4. Analyze/interpret the processed data: - Examine the leverage ratio and interest coverage ratio for companies flagged in the previous phase. 5. Develop and communicate conclusions: Write report. 6. Follow-up. Copyright © 2013 CFA Institute 15 OFF-BALANCE-SHEET LEVERAGE • Off-balance-sheet leverage refers to operating leases. • Capital lease - Is reported as an asset and liability on lessee’s balance sheet. - Results in interest expense and depreciation expense (instead of rental expense) on lessee’s income statement. • When capitalizing an operating lease, the lessee’s - Financial leverage increases. - Interest coverage ratio decreases. Copyright © 2013 CFA Institute 16 OFF-BALANCE SHEET LEVERAGE: EXAMPLE Assume the present value of future operating lease payments is $1,075 million. The table below shows leverage ratios after capitalizing operating leases (amounts in millions): Total assets Total equity Financial leverage Total long-term debt Total equity Debt to equity Total long-term debt Total long-term capital (=LT debt + equity) Debt to long-term capital As reported 12,244 2,225 5.5 1,293 2,225 58.10% 1,293 3,518 36.80% Pro Forma 13,319 2,225 5.99 2,368 2,225 106.40% 2,368 4,593 51.60% $1,075 is added to total assets and total longterm debt when calculating ratios in the pro forma column if operating leases are capitalized. Copyright © 2013 CFA Institute 17 FRAMEWORK: CASE STUDY 3 Evaluating effects of changes in accounting standards. 1. Define the purpose for the analysis: - Determine if Discover Financial Services could be at risk (i.e., increase in reported leverage) from possible changes in accounting for securitizations. 2. Collect input data: 10-Q and 10-K filings. 3. Process data. 4. Analyze/interpret the processed data: - Analyze the company’s leverage measures, assuming the liabilities issued in connection with the securitization of assets have to be shown on the company’s balance sheet. 5. Develop and communicate conclusions: Write report. 6. Follow-up. Copyright © 2013 CFA Institute 18 IMPACT FROM ACCOUNTING CHANGES • Currently under Statement 140, a company can remove financial assets from its balance sheet by placing them into a qualified special purpose entity (QSPE). - The combination of asset removal and nonrecognition of liabilities may have a powerfully beneficial effect on financial leverage on the balance sheet. - If the concept of a QSPE is eliminated from the securitization accounting, the securitized assets as well as the liabilities issued in connection with the securitizations would likely be shown on the balance sheet. Copyright © 2013 CFA Institute 19 IMPACT FROM ACCOUNTING CHANGES: EXAMPLE Software Services sold $267.5 million of finance receivables to a special purpose entity. The company’s abbreviated balance sheet is below. Year Ending: Total Current Assets Total Assets Total Current Liabilities Total Liabilities Total Equity 31 December 2009 $1,412,900 $3,610,600 $1,276,300 $2,634,100 $976,500 What is the financial leverage if the company (1) treats them as sold and (2) holds securitized financial receivables on the balance sheet? 1) 3,610,600/976,500 = 3.70 2) (3,610,000 + 267,500)/976,500 = 3.97 Copyright © 2013 CFA Institute 20 SUMMARY • The framework of financial statement analysis contains six steps: define a purpose for the analysis, collect input data, process data, analyze the processed data, communicate conclusions, and follow-up. • Earnings are more easily manipulated than cash flows. An effective way to examine earnings quality is to examine the pattern between operating income and operating cash flows. • To make a logical comparison, adjustments need to be made prior to conducting financial statement analysis. For example, adjustments may include removing assets owned and return earned by affiliates that are not under control of the company. Copyright © 2013 CFA Institute 21