DIAGNOSING FINANCIAL HEALTH USING FINANCIAL STATEMENTSAnalysis

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1 1 DIAGNOSING FINANCIAL HEALTH USING FINANCIAL STATEMENTSAnalysis Philip S. Russel, Ph.D. Associate Dean & Associate Professor of Finance Kanbar College of Design, Engineering and Commerce Philadelphia University ì

2 2 Agenda 1. What is the purpose and what are the key components of financial statements? 2. How to Analyze the financial health of any company? 3. What are some limitamons of using financial statements as the basis for analysis?

3 Why do we Need Financial Statements? 3

4 The Need for Financial Statements: It Records and Organizes Flow of $$ (4 Key Decisions) 4 Money is Raised (FINANCING DECISION) Money is Invested (INVESTMENT DECISION) Business incurs daily cash inflows and ou6lows (WORKING CAPITAL DECISION) Profits used to pay (a) interest on bonds, (b) distribute dividends to shareholders, (c) reinvest in business (DIVIDEND POLICY)

5 5 Comments ì Financing decision such as whether to raise money through bank loans, issuing stocks or bonds ì Investment decisions How to use the money to buy machines, building, etc.? ì Working capital How to monitor and control daily flow of cash through sales and expenses?

6 6 Comments ì All three decisions are crifcal to the success and survival of any organizafon. ì These decisions also generate a lot of transacfons it is the genius of accounfng profession that all of these transacfons are captured in four financial statements and in a few pages!!!! ì Without such organized financial statements, managers will be unable to make good decisions!

7 7 The Three Main Financial Statements ì

8 8 1. The Balance Sheet Provides a snapshot of firm s financial posifon at a specific point in Fme: Assets (A): What the firm owns LiabiliMes (L): What the firm owes to outsiders Equity (E): Net worth (A- L) A = L + E

9 9 Balance Sheet: Main Components CURRENT ASSETS CURRENT LIABILITIES LONG-TERM ASSETS LONG-TERM DEBT OWNER s EQUITY Total Assets (what the Company owns) Total Liabilities and Owners equity (How the Assets are financed)

10 10 Balance Sheet

11 11 Comments ì In order to build the equity, we want to maximize the value of assets and minimize the value of debt. ì For example, if we buy a house for $400K with 100% financing, A = $400K and L=$400K and E=$0. ì As we start paying down the debt and as the market value of asset increases, Equity also increases

12 12 2. Income Statement Indicates the profits or losses generated over a period of Fme. Sales Revenue All Expenses = Profits (the bo_om line)

13 13 Income Statement: Main Components REVENUES ì Less: COST OF SALES = GROSS PROFIT Less: OPERATING EXP. = OPERATING PROFIT Less: INTEREST EXPENSE Less: INCOME TAXES = EARNINGS BEFORE TAXES = NET INCOME

14 14 Income Statement in-brief (AAPL) Revenues = 156.5M ì Less: Cost of goods sold = 87.8M Less: Operating expenses =13.2M = Gross Profit = 68.6M = Net Operating Profit = 55.4M Less: Income taxes = Equals: NET INCOME =41.63 Million

15 15 Comments ì It is important to look at the trend of sales (going up or down and by what %) rather than the $- figure. It is possible for a firm to generate $100m in sales and sfll be headed to the cemetery! ì It is important to look at the various expense item and observe the trend in the expenses. SomeFmes lowering cost (through outsourcing) reduces the expense but may reduce sales (due to poorer quality of product and customer safsfacfon)

16 16 3. The Cash Flow Statement The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time.

17 CASH FLOW STATEMENT: Three Sources and Uses of Cash 17 Cash flow from OperaMons Cash flow from Investments Cash flow from Financing AcFviFes = Net Change in Cash

18 18 Comments ì Cash flow from operafons may include items like cash from sales, cash paid for various expenses (includes Income Statement Items) ì Cash flow from financing may include cash raised from loans or interest paid on loans (Includes Liability side items) ì Cash flow from invesfng may include cash paid for buying building or cash raised from selling exisfng machinery (Includes Asset side items)

19 Cash Flow Statement (in Millions of $) BLACKBERRY AAPL Beginning Cash 1,791 9,815 From OperaFons 2,912 50,856 From Investments - 2,240-48,227 From Financing ,698 Net Change in

20 20 Four Financial Statements

21 21 Assessing the Assessing the Financial Health Using Financial Statements ì

22 22 How is BB doing?

23 Falling 5- year Stock Prices (high:$80, low $7) 23

24 Would we reach the same conclusion from Analyzing Financial Statements for BlackBerry? 24

25 Financial Statement Analysis: Two Broad Approaches Benchmarking: How is Black Berry performing relafve to other companies in the industry? 25 Trend Analysis: Are the performance indicators gejng be_er or worse over Fme?

26 Uses of Financial Statement Analysis 26 Helps various stakeholders (managers, lenders, shareholders) to: ì evaluate performance (peers, previous years) ì set standards ì idenffy areas of growth/problem/new opportunifes ì Assess risk and profitability

27 Analyzing Financial Health: Five Important Questions How liquid is the firm? 2. Is management generafng adequate operafng profits on the firm s assets? 3. How is the firm financing its assets? 4. Is management providing a good return on the capital provided by the shareholders? 5. Is the management team creafng shareholder value?

28 28 1. Analyzing Liquidity ì

29 29 Liquidity Key QuesMon: Can the company meet its short- term (less than 1 year) debt obligafons? Analysis: Compare the rafo of short- term assets (current assets) to short- term debt (current liabilifes)

30 Current RaFo (CR) & Quick RaFo (QR) 30 CR = Current assets Current liabilifes QR = (Current assets Inventory) Current liabilifes 2012 BB AAPL Current RaFo Quick RaFo

31 31 Comments ì Both companies seem healthy, from lender s perspecfve. BB has $2.06 in current assets to cover every $1 in current liabilifes. ì In Quick ramo, we remove the inventories as they are the least liquid and in some cases may have no or li_le market value (for example, outdated technology items) ì If the rafos are too high, it is safe for the lenders but shows that company has too much invested in liquid assets that generate low return (and hence not good for shareholders).

32 2. ANALYZING DEBT ì 32

33 33 KEY QUESTIONS ì How is the company financing its assets? ì Does the company rely too much on debt? ì Can the company repay its debt obligamons?

34 34 Debt RaFo ì Debt ramo & Ability to Service Debt 2012 BB AAPL Debt RaMo NO Long- term Debt NO Long- term Debt

35 35 Comments Debt offers a_racfve tax benefits (as interest expense can be wri_en off). However, it comes with constraints (lenders may not allow excessive risk), and risk (inability to pay interest will force the firm into bankruptcy). Newer and high- risk firms prefer to raise money through equity rather than debt.

36 36 Comments ì Just like individuals, many companies have gone out of business because of exercising poor judgment in the area of debt financing. ì Debt, by itself, is not bad! However, ill conceived debt financing plan with no regard for future profits, will prove to be suicidal! US growth is driven by debt financing!

37 ì 3. How Profitable is the firm? 3. Analyzing Profitability 37

38 38 Gross Profit Margin Gross income margin ramo shows the percentage of sales revenue that is available for operamng and other expenses. Gross Income Margin = Gross Income Sales

39 39 Gross Profit Margin Gross Profit Margin = Gross Profit Sales 2012 BB AAPL Gross Profit Margin 32.55% 38.27%

40 40 Comments Both companies have healthy gross profit margin but that is only part of the story. We need to make it 0ll the end of the income statement (to net profits)!

41 41 Net Profit Margin Net income margin rafo shows the percentage of sales revenue that goes towards net income. Net Income Margin= Net Income Sales

42 Net Profit Margin

43 43 Comments ì One should invesfgate deeper to see why Blackberry is unable to have a posifve net profit despite a healthy gross profit margin. ì This will require a more careful analysis of expense items, beyond cost of sales.

44 44 Return on Assets (ROA) Measures management s ability to use firm s assets to generate profits.

45 45 Return on Assets (ROA) ROA = Net Income Total Assets 2012 BB AAPL ROA % 20.81% AAPL returns $20.81 for every $100 invested in business!

46 46 Return on Equity (ROE) ROE rafo measures the return earned on the shareholder s equity capital. Return on Equity (ROE) = Net Income Shareholders Equity

47 47 Return on Equity (ROE) 2012 BB AAPL ROE % 32.11% AAPL shareholders earn a healthy return on their original investment.

48 Deeper Analysis of ROE ì 48

49 49 Return On Equity (ROE) ROE = NET INCOME SHAREHOLDERS EQUITY % (BlackBerry) Versus 32.11% (AAPL)

50 50 ROE ANALYSIS ROE = Profitability (P) Asset Turnover (AT) Leverage (L) L & AT similar for both companies ì Difference in ROE driven by differences in profitability (- 1.87% versus %)

51 51 Comments If Blackberry wishes to improve their prospects, it needs to analyze why AAPL is able to make profits while they are losing money in the same market. It could be a combinafon of price, sales volume, cost factors.

52 4. ANALYZING EFFICIENCY ì ARE THE COMPANY S ASSETS BEING EFFICIENTLY MANAGED? 52

53 53 Inventory RaMos How many Fmes inventory is rolled over during the year? Inventory Turnover = Cost of Sales Inventory Days in Inventory = 365 Inventory Turnover rafo

54 54 Inventory RaFos 2012 BB AAPL Inventory Turnover # of Days in Inventory

55 55 Comments ì Low inventory turnover may indicate low sales or it could indicate company s policy to maintain high levels of inventory. Low inventory turnover rafo may also mean not using just- in- Fme or similar inventory management techniques. ì Levels of inventory have obvious tradeoffs a high inventory incurs higher storage costs but customers are happy due to no shortage; a low inventory lowers the storage cost but raises the risk of not being able to safsfy customers and thus losing sales.

56 56 Asset Turnover Indicates how efficiently a firm is using its assets in generafng sales. It indicates the sales dollars generated per dollar investment in fixed assets Assets turnover = Sales Total Assets

57 57 Asset Turnover Assets turnover = Sales Total Assets 2012 BB AAPL Asset Turnover

58 58 Comments ì The numbers are about the same for both companies, with a dollar invested generafng around 90 cents. Obviously, higher the number, the more efficient is the use of assets. ì A low number could mean inefficient machines or idle capacity. ì Note the numbers are biased as the value of assets are in historical costs while sales are in current dollar terms. So the numbers are generally upward biased.

59 59 Receivables RaFos The rafo computes how many Fmes trade receivable are rolled over during a year? Receivables Turnover = Sales Trade Receivables Average CollecMon period (lower the be_er) = 365 Receivable turnover

60 60 Payables RaFos This rafo computes how quickly payment is being made on purchases bought on credit (that is, trade payables). Payables Turnover = Purchases Trade Payables Number of days of Payables = 365 Payables turnover

61 61 5. ValuaMon RaMos 2012 BB AAPL Price/Earnings Price/Sales Price/Book Price/Cash flow

62 62 Comments ì PE rafo is commonly quoted in press. For APPL, investors are willing to pay nearly 12 Fmes its current earnings. This shows investors are opfmisfc about company s future growth prospects and ability to make good on their investments. ì Stocks with PE rafo above 25 or 30 are generally considered to be over opfmisfc or speculafve.

63 63 Growth Data 2012 BB AAPL 12- month revenue growth 12- month net income growth 36- month net income growth Analysts RecommendaFon (1=Strong buy; 5= Sell) Next 5- years growth (per annum) % % % % 14.53%

64 64 Declining Market Share!

65 Annual Sales

66 Shareholder s PerspecMve ì 66

67 67 Per share data 2012 BB AAPL Revenue per Share $21.63 $ Dividend per Share - $11.00 Cash flow per Share $4.24 $56.19

68 5- Year Stock Performance BB (- 50%) Versus AAPL (400%) Versus Nasdaq (100%) 68

69 We tried to answer the following: How liquid is the firm? 2. Is management generamng adequate operamng profits on the firm s assets? 3. How is the firm financing its assets? 4. Is management providing a good return on the capital provided by the shareholders?

70 We tried to answer the following: Is the management team creamng shareholder value? 6. What is market s percepmon? 7. How does the firm compare to its compemtor? 8. What are some projecmons on growth, etc?

71 71 Concluding Comments ì What we have done is perform some fundamental analysis based on financial statements. While it does not give all the answers it is a good starfng point based on credible data. ì Further analysis should consider broader macroeconomic data, industry specific trends, and company specific data (such as quality of management, etc.)

72 BlackBerry s FINANCIAL Diagnosis Report ì 72

73 73

74 74 Blackberry Diagnosis FINANCIALS WEAK MARKET & FORECASTS DOWN CONSUMERS NEGATIVE

75 LimitaMons of Financial Statement Analysis ì 75

76 76 LimitaFons ì There is considerable subjecfvity in preparing financial statements. ì RaFos may not be strictly comparable for different companies due to a variety of factors ì RaFos are based on financial statements that reflect the past and not the future. Unless the rafos are stable, one cannot make reasonable projecfons about the future trend.

77 77 LimitaFons ì Financial statements provide an assessment of the costs and not value. For example, the market value of items may be very different from the cost figure given in the balance sheet. ì Financial statements do not include all items. For example, it is hard to put a value on human capital (such as management experfse).

78 78 LimitaFons AccounFng standards and pracfces vary across countries and thus hamper meaningful global comparisons. Management decision making is a dynamic process in a constantly changing environment while rafo analysis is a stafc analysis based on historical data. The linkage among various rafos is not readily obvious.

79 79 Use and Abuse of Financial Statements ì ì ì Financial statements provide important informafon regarding the health and value of the firm. Nonetheless, you should keep in mind: ì It does not give the complete picture of a firm and in some cases, it gives a wrong picture of the firm ì It fails to fully capture Mme and uncertainty, the two crimcal variables in any decision ì It ignores many important qualitamve informamon (such as quality of management, economic prospects) In short, you cannot reach meaningful conclusion about a company based purely on financial statement analysis. There are too many gaps in GAAP

80 80 Financial Statement Analysis ì Financial statements are like a fine perfume to be sniffed but not swallowed Abraham Brilloff

81 81 References ì All Financial statement numbers are taken from Hoover Financial database.

82 82? Please Or call

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