FBE 529 Lecture 2 PDF

Financial Analysis & Valuation Overview of the valuation process
 Understanding the business model

 Evaluating the historical financial performance of the firm
Financial Analysis & Performance  Selecting the valuation method
Evaluation  Applying the valuation model
(Part I)  Consider other valuation methods
 Overview of the Valuation Process

 Understanding Financial Statements
 Ratio Analysis
FBE 529 – Scott Abrams – Spring 2020 FBE 529 – Scott Abrams – Spring 2020
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What is the macroeconomic

Understanding the business model environment?
 Macroeconomic analysis Where are we in terms of the business cycle?
 Industry analysis  GDP growth rate ~ expanding or contracting economy?
 Competitive strategy analysis  Jobs
 Consumer and producer confidence
 Budget deficit
 Interest rates
 Inflation
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Supply and Demand Shocks Industry Analysis
 Political risk, Exchange risk, Legal/Regulatory risk, Capital
markets sentiment  How does the industry fit into the overall macroeconomy?
 Demand shocks (stimulating):  How attractive is the industry?
 Lower tax rates  Barriers to entry
 Increase in government spending  Rivalry among existing competitors
 Increase in money supply  Bargaining power of buyers
 Change in government regulation  Bargaining power of suppliers
 Supply shocks (rising production and capacity costs):  Threat of substitute products
 Increase in input prices/costs (oil) due to natural disasters (drought,  How does the firm fit into the industry?
freeze), war
 Does it have a sustainable competitive advantage?
 Decrease in quality of workforce
 Rise in wages
 Higher required return for invested capital
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What is the firm’s strategy to create Financial Analysis & Performance

value? To achieving a high ROIC? Evaluation (Part I)
 Product differentiation  Overview of financial statements
Innovative product

 Accounting rules regarding consolidations
 Quality
 Financial statement analysis
 Brand
 Understanding Financial Statements
 Customer lock-in
 Ratio Analysis
 Rational price discipline
 Low cost
 Innovative business model
 Unique resources
 Economies of scale / scope
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What is Financial Statement
Overview of the valuation process Analysis?
 Understanding the business model What is Financial Statement Analysis?
 Evaluating the historical financial performance of the firm  The process of analyzing a firm’s financial statements to
 Selecting the valuation method learn about how well the firm is being managed and the
firm’s future performance potential.
 Applying the valuation model
 Making the investment decision or recommendation What is it used for?
 Performance Evaluation
 Valuation
How does it lead to better decisions?

 Reduces uncertainty
 Serves as a monitoring function
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Why do we perform financial What Financial Ratios (Attempt to)

analysis? Measure
 Financial ratios attempt to measure certain economic
 To help us forecast of the investment’s free cash flow and concepts
estimate of the appropriate risk-adjusted discount rate  Operating performance
 Firms typically have a history of past performance that is
 Operating risk
recorded in their financial statements, whereas proposed
projects do not  Financial risk
 By using information from the financial statements about how  Efficiency

the firm has made money in the past, we can forecast future  Asset utilization
free cash flows and future financial performance.
 Growth
 We need to understand the relation between accounting
earnings and cash flows.
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Getting Started in Financial Analysis SEC Filings
Analyze Goals  For IPOs:
 Registration Statement (S-1)
Strategy  For communication with shareholders:
 Solicitation of proxies (proxy statement) (14A)
Market, Competitive & Regulatory Environment  Annual report to shareholders (10K)
 Quarterly report to shareholders (10Q)
Analyze Revenue Outlook (growth rate, volatility)  Report of securities offered to employees (11K)
 Notification of significant events (8K)
Analyze Investment in Assets Assess Economic Performance  Notification of tender offers by others (Schedule 14D-1)
 Notification of tender offers by issuer (repurchases) (Schedule 13E-4)
Analyze EFN Ensure Access to Target Sources of Finance  Notification of 5% equity holding or change in beneficial ownership
(Schedule 13D)
Assess Viability (3‐5 years)  For Foreign Firms:
 Registration and annual filing for foreign registrant and reconciliation to US
Formulate Current Year Operating / Financing Plan GAAP (F20-F)
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Analyst Report
Other sources of information
 Company website
 Analyst research reports
 Consensus estimates
 Wall Street Journal, Economist, Financial Times, Bloomberg
Businessweek, Barron’s
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Analyst Report Techniques for Financial Analysis
 Financial health
 Using ThomsonONE, download an analyst report  Common size financial statements
 What is the Analyst’s rating (BUY, HOLD, SELL)  Ratio Analysis
 What is the target price?  Analysis of the statement of cash flows
 Off balance-sheet exposure
 How did the Analyst value the company? DCF? Multiples?
 Performance Evaluation
 Does the report include a peer comparison?  ROE and the DuPont analysis
 What is the Analyst’s projections for EPS growth? How does  ROIC
this compare with the with Yahoo or Google Finance ‘Analyst  FCF vs. Earnings
Estimates’ or ‘Analyst Opinion’?  Analysis of revenue growth
 Risk analysis
 Quality of management
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Important Points to Remember about

Financial Statements Financial Statement Analysis
 Income Statement
 Financial statements are prepared in accordance with a set of  Sources of revenue and growth
reporting guidelines called generally accepted accounting principles  Profitability margins & overall performance
or GAAP
 Growth strategy, financial position
 Financial statements are constructed using estimates and
assumptions; GAAP allows for considerable room for legitimate  Balance Sheet & Statement of Cash Flows
reporting differences between firms in similar industries.  Evaluate liquidity, leverage, etc.
 Management prepares its own financial statements  Generating CFO? Major sources and uses of cash
 These guidelines come from the accounting profession as well as  Discuss use of capital structure and financing sources
various government regulatory bodies such as the Securities and
 “Operating” Net Working Capital & Capex
Exchange Commission (SEC) and the Public Company Accounting
Oversight Board (PCAOB)  Financial Ratios and Trends
 How does the target company compare to its industry and
historical performance?
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Income Statement: Operating
The Flow of Financial Statements Income vs. Non-Operating Income
Net sales $ 3,365
Cost of goods sold 2,252
Gross Margin 1,113
Selling, general, and administrative expenses 654
Operating income $ 459
Other income 200
Earnings before interest and taxes (EBIT) $ 659
Interest expense 28
Earnings before taxes $ 631
Income taxes 252
Income after tax and before extraordinary items 379
Extraordinary items 56
Net income $ 323
Preferred dividends 22
Net income available to common shareholders $ 301
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Income Statement: Operating

Income vs. Non-Operating Income Balance Sheet
 Operating income: the income generated by the firm’s  The balance sheet provides a
core business operations snapshot of the firm’s financial
 Non-operating income: income generated by investments position at a moment in time and a
the firm has made in assets that are unrelated to the firm’s detailed account of the company’s
primary business. assets, liabilities (debts), and
shareholders’ equity.
 Examples:
 The balance sheet equation
 Gains from the sale of investments requires that the sum of the book
 The sale of a subsidiary or division values of the firm’s assets equal the
 Costs incurred from restructuring sum of the debts the firm owes to
 Currency exchange its creditors plus the investment of
the stockholders’ equity.
 The write-off of obsolescent inventory
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Better Buys Inc. Historical Balance Sheet: Non-operating
Balance Sheet Assets and Investments
 The presence of a long-term investment category on a firm’s
balance sheet signifies the presence of a potentially significant
non-operating asset that will need to be valued
 This means that the analyst will need to dig deeper into the footnotes
of the financial statement to determine the exact nature of the
investments in order to determine an appropriate approach to valuing
them
 This line item (sometimes referred to as long-term investments
because they are assets the company intends to hold for longer than
one year) can consist of stocks and bonds of other companies, real
estate, as well as cash set aside for a specific purpose
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Balance Sheet: Non-operating

Assets and Investments Consolidation Rules
Ownership: <20% 20-50% >50%
 An equity investment involving more than 20% but less than
50% of the equity of another firm is recorded as an investment Accounting Cost Equity Consolidation
Method
 This will typically show up on the Balance Sheet as “Investments in
unconsolidated subsidiaries.” Balance Sheet Investment shown at Investment originally 100% of subsidiary
cost shown at cost, balance sheet
 If the firm owns more than 50% of a subsidiary, then the rules of adjusted for income consolidated; results
accounting call for consolidation of the subsidiary into the firm’s (+) and dividends (-); a noncontrolling
interest (NCI)
balance sheet and income statement.
Income Dividends recorded as % of profits recorded 100% of profits
 A minority interest account appears between liabilities and owners’ income as income recorded as net
Statement
equity, representing the value of the minority-owned shares, income; income
because 100% of the value of the subsidiary’s assets were attributable to
incorporated into the consolidated balance sheet. noncontrolling
interest then
subtracted out
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Consolidation Rules Consolidation Rules
 Example 1: ABC Inc. buys a 10% interest of XYZ Inc. for  Example 3: ABC Inc. buys an 80% interest of XYZ Inc. for
$10,000. XYZ records profits of $200,000 and pays out $80,000. XYZ records profits of $200,000 and pays out
dividends of $20,000. dividends of $20,000.
 Example 2: ABC Inc. buys a 30% interest of XYZ Inc. for

$30,000. XYZ records profits of $200,000 and pays out
dividends of $20,000.
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Statement of Cash Flow Other Information

Cash flow from operating activities
Net income $ 86
Depreciation 90
Deferred taxes
Changes in assets and liabilities
13  Management’s Discussion and Analysis (MD&A) of Financial
Accounts receivable (24) Position and Results of Operations
Inventories 11
Accounts payable 16  Notes to the financial statements
Accrued expenses 18
Other (8)
Total cash flow from operations $ 202
Cash flow from investing activities
Acquisition of fixed assets $ (198)
Sale of fixed assets 25
Total cash flow from investing activities $ (173)
Cash flow from financing activities
Retirement of long‐term debt $ (73)
Proceeds from issualnce of long‐term debt 86
Change in notes payable (3)
Dividends (43)
Repurchase of stock (6)
Proceeds from new stock issue 43
Total cash flow from financing activities $ 4
Change in cash (on the balance sheet) $ 33
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Steps in the Financial Statement
Analysis Process Ratio Analysis
 Identify competitors and/or comparable companies Categories of Ratios:
 Analyze the financial statements and adjust potential distortions  Profitability Ratios
 Calculate financial ratios for the company of interest and the  Short-Term Solvency (Liquidity Ratios)
comps over a set of years  Long-Term Solvency (Leverage)
 Assess the company of interest over time and relative to the  Coverage Ratios
comps  Asset Utilization Ratios
 Use the financial ratios in the valuation process – forecasting,
finalizing comps for measuring cost of capital and market
multiples, etc.
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Scooter Inc. Consolidated

Benchmarking using Ratios Balance Sheet (2014 – 2017)
 Time-trend analysis 2014 2015 2016 2017
Cash $ 9,000 $ 10,000 $ 15,000 $ 18,000
 Peer group analysis Accounts receivable 42,000 53,000 61,000 66,000
Inventories 21,000 28,000 30,000 29,000
 What is a good benchmark? Other current assets 10,000 13,000 21,000 20,000
Total current assets 82,000 104,000 127,000 133,000
 It is often not clear what is a “good” or “bad” level for a financial Net PP&E 9,000 12,000 13,000 18,000
ratio and no one benchmark exists for all companies in all Other assets
Total Assets
2,000
$ 93,000
2,000
$ 118,000
6,000
$ 146,000
8,000
$ 159,000
valuation contexts
Accounts payable $ 5,000 $ 6,000 $ 7,000 $ 6,000
 We know ratios vary over time and we know they vary by
Acccrued expenses 10,000 13,000 21,000 28,000
industry – we also know that companies tend to regress towards Notes payable 3,000 3,000 4,000 4,000
Other current liabilities 3,000 18,000 8,000 10,000
the mean – so a common benchmark is the company’s industry Total current liabilities 21,000 40,000 40,000 48,000
or comparable group Long‐term senior debt 10,000 9,000 8,000 7,000
Subordinated convertible debt ‐ ‐ 20,000 20,000
 That said, deviations from the “norm” might be good and Other liabilities 1,000 3,000 7,000 9,000
indicate an industry leader and a potential competitive C/S & R/E's
Treasury stock
61,000
‐
66,000
‐
71,000
‐
85,000
(10,000)
advantage Owners' equity 61,000 66,000 71,000 75,000
Total liabilities and equity $ 93,000 $ 118,000 $ 146,000 $ 159,000
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Scooter Inc. Consolidated
Income Statement (2014 – 2017) Sales Growth Rate
2013 2014 2015 2016 2017  During 2013 to 2017, sales grew at a ___ CAGR.
Sales $ 115,000 $ 147,000 $ 171,000 $ 205,000 $ 244,000  Sales growth is an important driver of the need to invest in
COGS (including depreciation)* 43,000 50,000 63,000 74,000 various types of assets and of the company’s value
Gross margin 104,000 121,000 142,000 170,000
R&D expenses 15,000 20,000 26,000 28,000  It also provides some indication of the effectiveness of firm’s
SG&A expenses 79,000 92,000 106,000 116,000 strategy and product development activities
EBIT / Operating income 10,000 9,000 10,000 26,000
Interest expense 1,000 2,000 2,000 2,000
Taxable income 9,000 7,000 8,000 24,000
Income tax 4,000 2,000 3,000 10,000
Net income $ 5,000 $ 5,000 $ 5,000 $ 14,000
*Depreciation expense 3,000 4,000 4,333 6,000
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Sales Growth of Medical Device

Companies: Analyzing Growth
Growth can be disaggregated into three main components:
 Portfolio momentum: organic revenue growth a company enjoys because of
CAGR Low High overall expansion in the market segments of its portfolio.
9 large companies 9.5% 5.0% 15.3%  Market share performance: organic revenue growth from a company gaining or
losing share in a particular market.
10 mid-size companies 12.0% 4.5% 31.8%  Mergers and acquisitions (M&A): inorganic growth a company achieves when it
Scooter Inc. 20.7% buys or sells revenues through acquisitions or divestments.
Growth and Value - Growth translates to value when return on invested capital
(ROIC) exceeds the cost of capital. We discuss the major types of growth and the
 Scooter’s organic sales growth is excellent, however the relative levels of value creation.
profitability of the first three years is noteworthy
Difficulty of sustaining growth - Sustaining high growth is much more difficult
than sustaining ROIC. Despite some variation on the patterns of growth, high
growth is not sustainable, due to the natural life cycles of products.
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Types of Growth and Value Creation Profitability Measures: 2017
Above average value creation  Profit Margin = Net Income/Sales
• Create new markets through new products
Value Creation “Spectrum”
1 
• Convince existing customers to buy more of a product
• Attract new customers to the market  This is an improvement/deterioration from 2014 (3.4%)
Average value creation  Return on Assets (ROA) = Net Income/Total Assets

2 • Gain market share in fast-growing market

• Make bolt-on acquisitions to accelerate product growth
 This is an improvement/deterioration from 2014 (5.4%)
Below average value creation
3 • Gain share from rivals through incremental innovation  Return on Equity (ROE) = Net Income/Total Equity
• Gain share from rivals through product promotion and pricing
• Make large acquisitions 
 This is an improvement/deterioration from 2014 (8.2%)
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Leverage/Long-term Solvency
Ratios: 2017 What is a ‘Liability’ vs. ‘Debt’?
 Total Liabilities to Total Assets = TL/TA
 Accountants describes a liability as:

 A present contractual commitment to another entity that entails
 This represents an increase/decrease from 2014 (34.4%)
settlement by probable future transfer or use of assets on an
 Total Liabilities to Total Equity = TL/TE agreed upon date (or timing) when the obligating event has
 already occurred
 This represents an increase/decrease from 2014 (52.5%)  No exact definition of debt in accounting
 Total Assets to Owners’ Equity (Equity Multiplier) = TA/TE  Not all liabilities are debt and it is possible that some types of
 debt are not considered a liability by accountants (off-balance
 This represents an increase/decrease from 2014 (1.53x) sheet financing)
 Total Debt to Equity = TD/TE

 This represents an increase/decrease from 2014 (21.3%)
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What is ‘Debt’? Coverage Ratios: 2017
 For our purposes, debt is an amount contractually owed to  Times Interest Earned/EBIT Interest Coverage = EBIT/Interest
another party that has an explicit or implicit interest payment

that we can measure
 This represents an improvement/deterioration from 2014 (10x)
 Includes notes, mortgages, bonds (debentures), and other
financing instruments that typically have an explicit or implicit
 Cash Coverage/EBITDA Interest Coverage =
interest rate
(EBIT + Depreciation)/Interest
 Excludes liabilities such as deferred income taxes, unearned

revenue, and most other operating liabilities (for example,
accounts payable, wages payable, accruals, etc.)  This represents an improvement/deterioration from 2014 (13x)
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Debt/EBITDA: 2017 Liquidity Ratios: 2017

 Debt/EBITDA =  Current Ratio = CA/CL
 
 This represents an increase/decrease from 2014 (1.0)  This represents an increase/decrease from 2014 (3.9x)
 FCF/Total Debt  Quick Ratio = (CA – Inventory)/CL



 This represents an increase/decrease from 2014 (2.9x)
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Activity Ratios: 2017 Inventory Turnover…
 Total Asset Turnover = Sales/Total Assets

 This is an improvement/deterioration from 2014 (1.6x)  Higher the Better?

 Does higher inventory turnover mean the retailer is getting
Inventory Turnover = Cost of Goods Sold/Inventory

more mileage out of the assets it has tied up on its shelves?

 Days in Inventory = 365/Inventory Turnover

 The longer inventory sits on a company’s shelves, the lower

the rate of return on those assets and the greater their
 This is an improvement/deterioration from 2014 (2.0x; 178 days) vulnerability to falling prices and obsolescence
 You want to keep your inventory turning, however not at the
 Receivables Turnover = Sales/Average Accounts Receivable expense of your overall profit margins or business strategy

 Average Collection Period = 365/Receivables Turnover


 This is an improvement/deterioration from 2014 (3.5x; 104 days)
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ROE and the Du Pont Identity ROIC (Return on Invested Capital)

NI
ROE
𝐸𝑞𝑢𝑖𝑡𝑦
 Issues with ROE and ROA
ROE
Profit
Margin
Total
Asset Turnover
Equity
Multiplier  𝑅𝑂𝐼𝐶
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸
𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
 NOPLAT = EBIT * (1-t)
𝑃𝑀 𝑇𝐴𝑇 𝐸𝑀  Total Invested Capital = Equity plus interest bearing debt
 The improvement in ROE from 2014 to 2017 is due to largely to:
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Example: Which company is better
performing? ROIC: 2017
AAL UAL  ROIC = NOPLAT/Total Capital

Revenues 10.0 10.0  This represents an improvement/deterioration from 2014

COGS (6.0) (6.0)
Gross Profit 4.0 4.0
Depreciation (1.0) (1.0)
EBIT 3.0 3.0
Interest Expense (1.0) ‐
EBT (Taxable Income) 2.0 3.0
Taxes @ 25% (0.5) (0.8)
Net Income 1.5 2.3
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Reorganizing the Balance Sheet: Invested Capital: Operating

Invested Capital Perspective
• By separating line items and rearranging the accounting identity, Operating assets include current operating assets (working cash, accounts
Operating receivable, inventory, prepaid expenses), along with PP&E and net other long-
Assets
Operating Nonoperating = Operating term operating assets. Include capitalized leases and R&D as operating assets.
+ Debt + Equity
Assets + Assets Liabilities −
Operating liabilities include non-interest-bearing current liabilities; the most
• We can create two new terms, invested capital and total funds invested: Operating Liabilities common are related to suppliers (accounts payable), employees (accrued
salaries), customers (deferred revenue and customer advances), and the
government (income taxes payable).
Operating Operating Nonoperating =
Assets
- Liabilities + Assets = Debt + Equity
Invested Capital
Invested capital equals + Nonoperating assets include excess cash, marketable securities, notes
operating assets less
operating liabilities. Nonoperating Assets receivable, prepaid pension assets, nonconsolidated subsidiaries, and other
equity investments).
=
Total funds invested equals Total funds invested can
invested capital plus also be measured by Total Funds Invested Total funds invested from an operating perspective.
nonoperating assets. summing debt plus equity
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Invested Capital:
Financing Perspective ROIC (Return on Invested Capital)
Debt includes all interest-bearing debt from banks and public capital markets.
Debt
$ million
Debt equivalents include off-balance-sheet debt and one-time debts owed to
+ others that are not part of ongoing operations (e.g., severance payments as part Accountant's balance sheet Invested capital
Debt of a restructuring, an unfunded pension liability, or expected environmental

Prior Current Prior Current
Equivalents remediation following a plant closure). Assets year year year year
Cash 5 15 Cash 5 15
+ Equity includes original investor funds (common stock and additional paid-in Inventory 200 225 Inventory 200 225 Operating liabilities
capital, net of treasury stock repurchased), investor funds reinvested into the Net PP&E 300 350 Accounts payable (125) (150) are netted against
Equity company (retained earnings and accumulated other comprehensive income),

Equity investments 15 25 Operating working capital 80 90 operating assets
Total assets 520 615
and investor funds to be paid out shortly (dividends payable).
+
Net PP&E 300 350
Liabilities and equity Invested capital 380 440
Equity equivalents include accounts that arise because of noncash Accounts payable 125 150 Nonoperating assets
Equity Equivalents adjustments to retained earnings; they are similar to debt equivalents but are Interest‐bearing debt 225 200 Equity investments 15 25 are not included in
Retained earnings 170 265 Total funds invested 395 465 invested capital
not deducted from enterprise value to determine equity value (e.g., most Total liabilities and equity 520 615
= deferred-tax accounts and income-smoothing provisions). Reconciliation of total funds invested
Interest‐bearing debt 225 200
Total Funds Total funds invested from a financing perspective. Retained earnings 170 265
Invested Total funds invested 395 465
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Reorganizing the Income Statement:

NOPLAT ROIC (Return on Invested Capital)
$ million
• Net operating profit less adjusted taxes (NOPLAT) is the after-tax operating
Accountant's income statement NOPLAT
profit available to all investors.
Current Current
• NOPLAT equals revenues minus operating costs, less any taxes that would year year
Revenues 1,000 Revenues 1,000
have been paid if the firm held only core assets and was financed only with Operating costs (700) Operating costs (700)
equity. Depreciation
Operating profit
(20)
280
Depreciation
EBITA
(20)
280
• Unlike net income, NOPLAT includes profits available to both debt holders Interest expense (20) Operating taxes
1
(70)
Taxes are calculated on
operating profits
and equity holders. Equity income
Earnings before taxes (EBT) 264
4 NOPLAT 210
Do not include income
Equity income 4 from any asset excluded
2
• In order to calculate ROIC and free cash flow properly, NOPLAT should be Taxes (66)
Nonoperating taxes
Income available to investors
4
218
from invested capital as
part of NOPLAT
defined consistently with invested capital. Net income 198
Reconciliation with net income Treat interest expense as a
• For instance, if a nonoperating asset is excluded from invested capital, any Net income
Interest expense
198
20
financial payout to
investors, not an operating
income from that asset should be excluded from NOPLAT. Income available to investors 218 expense
1
Assumes a marginal tax of 25% on all income.
2
Interest tax shield less taxes on equity income.
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Reorganizing the Financial Statements ~
Debt & Equity Equivalents Why Separate Nonoperating Items?
• Evaluation by parts: A good analysis will separate accounts with
different performance characteristics. For instance, excess cash will
 Deferred tax liability
typically have much lower returns than operating businesses.
 Deferred tax asset
 Unfunded pension liability
 Overfunded pension asset Total Asset Base
14% 3% 0%
Core Operations Excess Cash Equity Investments
9% 17%
Nonoperating Assets
Unit A Unit B
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J. J. Jones Company J. J. Jones Company

Adjusted for Excess Assets Adjusted for Excess Assets
J. J. Jones Company
J. J. Jones Company Balance Sheet
Income Statement Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Cash Balance $ 1,000.0 $ 1,200.0 $ -750.0 $ -900.0 $ 250.0 $ 300.0
Accounts Receivable 680.0 820.0 680.0 820.0
Revenue $ 5,000.0 $ 6,000.0 $ 5,000.0 $ 6,000.0 Inventory 660.0 790.0 660.0 790.0
Cost of Goods Sold -3,000.0 -3,600.0 -3,000.0 -3,600.0 Other Current Assets 250.0 300.0 250.0 300.0
Gross Margin $ 2,000.0 $ 2,400.0 $ 0 $ 0 $ 2,000.0 $ 2,400.0 Total Current Assets $ 2,590.0 $ 3,110.0 $ -750.0 $ -900.0 $ 1,840.0 $ 2,210.0
Property, Plant & Equipment $ 8,250.0 $ 10,180.0 $ 8,250.0 $ 10,180.0
Depreciation and Amortization -750.0 -830.0 -750.0 -830.0
Accumulated Depreciation -2,750.0 -3,580.0 -2,750.0 -3,580.0
Operating Expenses -500.0 -600.0 -500.0 -600.0 Property, Plant & Equipment (Net) $ 5,500.0 $ 6,600.0 $ 0 $ 0 $ 5,500.0 $ 6,600.0
Operating Income $ 750.0 $ 970.0 $ 0 $ 0 $ 750.0 $ 970.0 Other Assets $ 1,500.0 $ 1,500.0 $ -1,500.0 $ -1,500.0 $ 0 $ 0
Interest Expense -113.0 -160.0 0.0 0.0 -113.0 -160.0 Total Assets $ 9,590.0 $ 11,210.0 $ -2,250.0 $ -2,400.0 $ 7,340.0 $ 8,810.0
Other Income (Earnings on Excess Cash) 40.0 50.0 -40.0 -50.0 0.0 0.0
Accounts Payable $ 330.0 $ 390.0 $ 330.0 $ 390.0
Income Before Taxes $ 677.0 $ 860.0 $ -40.0 $ -50.0 $ 637.0 $ 810.0 Accrued Expenses 1,000.0 1,200.0 1,000.0 1,200.0
Income Tax Expense -270.8 -344.0 16.0 20.0 -254.8 -324.0 Current Portion of Long-Term Debt 800.0 1,300.0 800.0 1,300.0
Net Income $ 406.2 $ 516.0 $ -24.0 $ -30.0 $ 382.2 $ 486.0 Total Current Liabilities $ 2,130.0 $ 2,890.0 $ 0 $ 0 $ 2,130.0 $ 2,890.0
Long-Term Debt 1,200.0 1,700.0 1,200.0 1,700.0
Preferred Stock Dividends -100.0 -100.0 -100.0 -100.0 Non-Current Liabilities 500.0 600.0 500.0 600.0
Income to Common Shareholders $ 306.2 $ 416.0 $ -24.0 $ -30.0 $ 282.2 $ 386.0 Total Liabilities $ 3,830.0 $ 5,190.0 $ 0 $ 0 $ 3,830.0 $ 5,190.0
Preferred Stock $ 1,000.0 $ 1,000.0 $ 1,000.0 $ 1,000.0
Common Stock (and Other) 2,692.6 2,692.6 2,692.6 2,692.6
Retained Earnings 2,067.4 2,327.4 -2,250.0 -2,400.0 -182.6 -72.6
Total Shareholders Equity $ 5,760.0 $ 6,020.0 $ -2,250.0 $ -2,400.0 $ 3,510.0 $ 3,620.0
Total Liabilities and Equities $ 9,590.0 $ 11,210.0 $ -2,250.0 $ -2,400.0 $ 7,340.0 $ 8,810.0
Required Cash $ 250.0 $ 300.0 $ 250.0 $ 300.0 $ 250.0 $ 300.0
166 167
J. J. Jones Company
Adjusted for Excess Assets Apple’s War Chest
Adjusted
($ in millions) FY 2018 RoR Adjustments FY 2018 RoR
Return on Assets
Net income 59,531 (4,643) 54,888
= 16.1% = 29.2%
Average total assets 370,522 (182,757) 187,766
Return on Equity
Net income 59,531 (1,997) 57,534
= 49.4% 108.7%
Average total equity 120,597 (67,675) 52,922 =
Return on Invested Capital
NOPLAT 57,894 57,894
= 23.0% = 84.0%
Average invested capital 251,644 (182,757) 68,887
 At the end of FY18, AAPL reported that is has over $237B in cash, short-term investments,
and long-term investments. If we adjust for these non-operating assets, we see a very
different picture in terms of rate of returns.
 In this example, we deduct the after-tax income from these non-operating assets from
numerator. The denominator is adjusted for the average balance of non-operating assets (we
assume the cash and short-term investments are required for operations). For ROE, we first
assume that all debt is first paid down (and the numerator also excludes the interest expense
on this debt).
 There is no numerator adjustment to ROIC as the NOPLAT utilizes operating income.
168 169
Problems that can be detected

Scooter’s Financial Position with financial analysis
 Sales growth is excellent, although mediocre profitability in  Uncollectable A/R
the first three years  Unsalable inventory
 Profitability increased in 2017  Overstated values of PP&E
 ROIC increased from 7.5% in 2014 to 14.3% in 2017  Excessive probability of financial distress
 The improvement did not reflect a decrease in R&D
 It resulted from a reduction in SG&A as a % of sales
 ROE doubled
 PM increase
 leverage
170 171
Potential Effects of Questions to ask when doing Ratio
Accounting Treatments and Events Analysis
 Differences in accounting can cause differences in financial  Do the numbers in the financial statements capture the true
economics of the firm?
ratios and reduce comparability
 Need to assess the quality of earnings
 Accounting policies
 Does required GAAP do a good job reflecting the underlying
 Non-operating items
economics for this type of company?
 Non-recurring items
 The numbers in the financial statements might do a better job for
 Discontinued operations some industries than others (manufacturing versus
 Extraordinary items pharmaceutical versus high tech) and for some firms than others
 Cumulative effects of accounting changes (young growing versus established and stable)
 Events can affect comparability over time  How does management’s choices (choice of GAAP and assumptions
 Acquisitions used in GAAP) affect the ability of the numbers to capture the
underlying economics?
 Divestitures
 Change in accounting assumptions or methods  Does the company have off-balance sheet or other activities that
make it more difficult to capture the underlying economics?
 Bankruptcy
172 173
Limitations to Ratio Analysis Applications of Ratio Analysis

 Summary and some limitations of ratio analysis:
 Only quantitative data ~ requires human interpretation  Assessing financial health
 Need to assess quality of earnings  Driving and assessing forecasts
 Historical information may not project the future  Companies with similar operating risks
 Need a benchmark  Measuring the cost of capital
 Calculated in different ways by different analysts  Market multiples
 EBITDA is not cash flow but has some uses  Various characteristics can be relevant ~ risk, growth,
 Look for small and negative denominators profitability, investment requirements
 Look for outliers ~ if using averages, use medians not means
174 175

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Financial Analysis & Valuation Overview of the valuation process

 Understanding the business model

 Overview of the Valuation Process

What is the macroeconomic

 Competitive strategy analysis  Jobs

 Consumer and producer confidence

What is the firm’s strategy to create Financial Analysis & Performance

How does it lead to better decisions?

Why do we perform financial What Financial Ratios (Attempt to)

 By using information from the financial statements about how  Efficiency

Important Points to Remember about

Income Statement: Operating

Balance Sheet: Non-operating

 Example 2: ABC Inc. buys a 30% interest of XYZ Inc. for

Statement of Cash Flow Other Information

comps over a set of years  Long-Term Solvency (Leverage)

Scooter Inc. Consolidated

Sales Growth of Medical Device

Average value creation  Return on Assets (ROA) = Net Income/Total Assets

 This is an improvement/deterioration from 2014 (8.2%)

 This represents an increase/decrease from 2014 (21.3%)

Debt/EBITDA: 2017 Liquidity Ratios: 2017

 FCF/Total Debt  Quick Ratio = (CA – Inventory)/CL

 This is an improvement/deterioration from 2014 (1.6x)  Higher the Better?

 Days in Inventory = 365/Inventory Turnover

 Average Collection Period = 365/Receivables Turnover

 This is an improvement/deterioration from 2014 (3.5x; 104 days)

ROE and the Du Pont Identity ROIC (Return on Invested Capital)

 The improvement in ROE from 2014 to 2017 is due to largely to:

Revenues 10.0 10.0  This represents an improvement/deterioration from 2014

Reorganizing the Balance Sheet: Invested Capital: Operating

Debt of a restructuring, an unfunded pension liability, or expected environmental

Equity company (retained earnings and accumulated other comprehensive income),

Invested Total funds invested 395 465

Reorganizing the Income Statement:

Core Operations Excess Cash Equity Investments

J. J. Jones Company J. J. Jones Company

Required Cash $ 250.0 $ 300.0 $ 250.0 $ 300.0 $ 250.0 $ 300.0

Problems that can be detected

Limitations to Ratio Analysis Applications of Ratio Analysis

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