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Financial Analysis and Valuation

Financial Statements, Growth & Ratio Analysis

The flow of the financial statements..

Statement of Cash Flows (in millions) Balance Sheet, 12/31/20X4 12/31/20X4-12/31/20X5 Cash All other assets Liabilities Capital Stock Retained earnings 30.0 1 ,233.2 1 ,263.2 652.0 172.0 439.2 1 ,263.2 Operating activities Investing activities Financing activities Net increase in cash Beginning cash Ending cash Income Statement, Net sales Expenses Net income 11.5 (92.8) (14.7) 10.0 30.0 40.0 1 ,530.o 1,434.5 95.5 Balance Sheet, Cash All other assets Liabilities Capital Stock Retained Earnings 40.0 1 ,284.o 1 ,324.0 632.0 194.0 1,324.0 498.0 Statement of Retained Earnings 12/31/20X4 - 12/31/20X5 Retained eamings, Net income Dividends Retained earnings, 12/31/20X4 12/31/20X5 439.2 95.5 36.7 498.0
 

Income Statement: Operating income vs non-operating income –  If we’re looking to value OPERATIONS ONLY, we’re stopping at the EBIT! After the EBIT come the financial performance.  
Operating Income: the income generated by the firm’s core business operations.
Non-operating Income: income generated by investments the firm has made in assets that are unrelated to the firm’s primary business. For example: 

  • Gains from the sale of investments 
  • The sale of a subsidiary or division 
  • Costs incurred from restructuring 
  • Currency exchange 
  • The write-off of obsolescent inventory 
Net sales Cost of goods sold Gross Margin Selling, general, and administrative expenses Operating income Other income Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes Income taxes Income after tax and before extraordinary items Extraordinary items Net income Preferred dividends Net income available to common shareholders 3,365 2,252 1,113 654 459 200 659 28 631 252 379 56 323 22 301

The Balance Sheet: provides a snapshot of the firm’s financial position at a moment in time and a detailed account of the company’s assets’ liabilities (debts), and shareholders’ equity. The balance sheet equation requires that the sum of the book values of the firm’s assets equal the sum of the debts the firm owes to its creditors plus the investment of the stockholders’ equity.  

Consolidation Rules: 

  • An equity investment involving more than 20% but less than 50% of the equity of another firm is recorded as an investment. This will typically show up on the balance sheet as ‘investments in unconsolidated subsidiaries’. 
  • If the firm owns more than 50% of a subsidiary, then the rules of accounting call for consolidation of the subsidiary into the firm’s balance sheet and income statement. A minority interest account appears between liabilities and shareholders’ equity, representing the value of the minority-owned shares, because 100% of the value of the subsidiary’s assets were incorporated into the consolidated balance sheet. 
  • 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 (sometime 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. 
Ownership: Accounting Method Balance Sheet Income Statement 20-50% Cost Investment shown at cost Dividends recorded as income Equity Investment originally shown at cost, adjusted for income (+) and dividends (-); % of profits recorded as income >50% Consolidation 100% of subsidiary balance sheet consolidated; results a noncontrolling interest (NCI) 100% of profits recorded as net income; income attributable to noncontrolling interest then subtracted out

Ratio Analysis

Categories of ratios: 

  • Profitability Ratios 
    • Profit margin (net income/sales) 
    • Return on assets (ROA) = net income/total assets 
    • Return on equity (ROE) = net income/total equity 
  • Short-term solvency (liquidity ratios) 
    • Current ratio (CA/CL) 
    • Quick ratio (CA-inventory)/CL 
  • Long-term solvency 
    • Leverage ratios 
      • Total liabilities to total assets (TL/TA) 
      • Total liabilities to total equity (TL/TE) 
      • Total assets to Owners’ equity (equity multiplier): TA/TE 
      • Total debt to equity (TD/TE) 
    • Coverage ratios 
      • Times interest earned/EBIT interest coverage (EBIT/interest) 
      • Cash coverage/EBITDA Interest coverage (EBIT + Depreciation)/Interest 
  • Asset utilization ratios (AKA Activity) 
    • Total assets turnover (sales/total assets) 
    • Inventory turnover (COGS/inventory) 
      • The longer inventory sits on a company’s shelves, the lower the rate of return on those assets, and the greater their vulnerability to falling prices and obsolescence. You want to keep your inventory turning, however not at the expense of your overall profit margins or business strategy 
    • Days in inventory (365/inventory turnover) 
    • Receivables turnover (sales/avg. Accounts receivable) 
    • Avg. Collection period (365/receivables turnover) 
  • Valuation multiples 

Benchmarking using ratios: so, what is a good benchmark? 

It is often not clear what is a ‘good’ or ‘bad’ level for a financial ratio and no one benchmark exists for all companies in all valuation contexts. We know ratios vary over time and we know they vary by industry – we also know that companies tend to regress towards the mean – so a common benchmark is the company’s industry or comparable group. That said – deviations from the ‘norm’ might be good and indicate an industry leader and a potential competitive advantage. 

Sales Growth Rate (CAGR = Compounded Annual Growth Rate)

Formula and Calculation of CAGR CAGR where: 1 EV = Ending value BV = Beginning value n = Number of years

ales growth is an important driver of the need to invest in various types of assets and of the company’s value. It also provides some indication of the effectiveness of firm’s strategy and product development activities. 

Analyzing Growth: 

Growth can be disaggregated into three main components: 

  • Portfolio Momentum: organic revenue growth a company enjoys because of overall expansion in the market segements of its portfolio 
  • Market share performance: organice revenue growth from a company gaining or losing share in a particular market 
  • Mergers and acquisitions: inorganic growth a company achieves when it 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(!!!). 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 cycles of products. 

Types of Growth and Value Creation Q.) o Q.) 1 2 3 Above average value creation Create new markets through new products Convince existing customers to buy more of a product Attract new customers to the market Average value creation Gain market share in fast-growing market Make bolt-on acquisitions to accelerate product growth Below average value creation Gain share from rivals through incremental innovation Gain share from rivals through product promotion and pricing Make large acquisitions

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