Overview of Financial Statement Analysis

1
CHAPTER

Business Analysis
Evaluate Prospects

Evaluate Risks

Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers

Information Sources for Business Analysis

Quantitative Financial Statements Industry Statistics Economic Indicators Regulatory filings Trade reports Qualitative
Management Discussion & Analysis Chairpersons Letter Vision/Mission Statement Financial Press Press Releases Web sites

Credit Analysis

Equity Analysis

Management & Control Types of Business Analysis

Labor Negotiations

Regulation

Director Oversight

Financial Management

External Auditing Mergers, Acquisitions & Divestitures

Credit Analysis
Creditors
Trade Creditors Provide goods or services Most short-term Usually implicit interest Bear risk of default Non-trade Creditors Provide major financing Most long-term Usually explicit interest Bear risk of default

Credit Analysis
Credit worthiness: Ability to honor credit obligations (downside risk)

Liquidity Ability to meet shortterm obligations Focus: Current Financial conditions Current cash flows Liquidity of assets

Solvency Ability to meet longterm obligations Focus: Long-term financial conditions Long-term cash flows Extended profitability

(or Fundamental Value)

Intrinsic Value

Value of Company (or stock) without reference to market value (or stock price)

Strategy

Intrinsic value > Market value Intrinsic value < Market value Intrinsic value = Market value

Buy Sell Hold

Business Environment & Strategy Analysis Industry Analysis Strategy Analysis

Financial Analysis Analysis of Sources Risk &Uses of Profitability Funds Analysis Analysis

Accounting Analysis

Prospective Analysis

Cost of Capital Estimate

Intrinsic Value

Accounting Analysis
Process to evaluate and adjust financial statements to better reflect economic reality

Comparability problems across firms and across time Manager estimation error Distortion problems Earnings management Distortion of business

Accounting Risk

Financial Analysis
Process to evaluate financial position and performance using financial statements
Profitability analysis Evaluate return on investments Risk analysis Evaluate riskiness & creditworthiness Sources and uses Evaluate source & of funds analysis deployment of funds

Common tools

Ratio analysis

Cash flow analysis

Prospective Analysis
Process to forecast future payoffs
Business Environment & Strategy Analysis

Accounting Analysis

Financial Analysis

Intrinsic Value

Dynamics of Business Activities

Business Activities
Investing Financing Planning

Time
Beginning of period

Operating

Planning
Investing Financing End of period

Business Activities
Competition Market demands Planning Activities: Goals & Objectives Pricing

Tactics

Distribution

Promotion
Projections

Managerial performance

Opportunities

Obstacles

Business Activities
Financing activities Owner (equity) Nonowner (liabilities)

Financing

Business Activities
Investing activities Buying resources Selling resources

Investing

Financing

Investing = Financing

Business Activities
Investing Activities Planning Activities Financial Activities

Operating Activities
Revenues and expenses from providing goods and services

Financial Statements Reflect Business Activities Planning Investing

Current:

Financing
Current:

Operating
Sales Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax Expense

Cash Accounts Receivable Inventories Marketable Securities Land, Buildings, & Equipment Patents Investments

Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings

Noncurrent:

Noncurrent:

Net Income Income statement

Liabilities & Equity

Assets
Balance Sheet

Cash Flow
Statement of Cash Flows

Balance Sheet
Statement of Shareholders Equity

Financial Statements

Balance Sheet Income Statement

Statement of Shareholders Equity

Statement of Cash Flows

Kodak
Dec 31, 2001 (In millions, except per share data)

Assets Current Assets Cash and cash equivalents Receivables Inventories Deferred income tax charges Other Total current assets Properties Land, buildings and equipment at cost Less: Accumulated depreciation Net properties Other Assets Goodwill (net of accumulated amortization of $920) Other non-current assets Total Assets

Liabilities and Shareholders Equity Current Liabilities Payables Short-term borrowings Accrued income taxes Current maturities of LTD Total current liabilities Other Liabilities Long-term borrowings Post-employment liabilities Other long-term liabilities Total liabilities Shareholders' Equity Common stock, par value $2.50 per share, 950,000,000 shares authorized; issued 391,292,760 shares Additional paid in capital Retained earnings Accumulated other comprehensive loss Treasury stock, as cost, 100,363,059 shares Total shareholders' equity Total liabilities and equity $ 3,276 1,378 544 156 5,354

448 2,337 1,137 521 240 4,683 12,982 7,323 5,659

1,666 2,728 720 10,468

948 2,072 $ 13,362

978 849 7,431 (597) 8,661 5,767 2,894 $ 13,362

Balance Sheet
Total Investing = Total Financing = Creditor Financing + Owner Financing

Kodak Financing $13,362 = $10,468 + $2,894

Income Statement
Kodak
For Year Ended Dec. 31, 2001 (In millions)

Sales Cost of goods sold Gross profit Selling, general and administrative expenses Research and development costs Goodwill amortization Restructuring costs and asset impairments EARNINGS FROM OPERATIONS Interest expense Other income (charges) Earnings before income taxes Provision for income taxes NET EARNINGS

$13,234 8,670 4,564 2,627 779 154 659 345 219 (18) 108 32 76

Statement of Shareholders Equity

Kodak
For year ended Dec. 31, 2001 Accumulated Additional Other Common Pail In Retained Comprehensive Treasury Stock Total Stock Capital Earnings Income (Loss) 978 871 7,869 (482) (5,808) 3,428 76 76

(In millions, except number of shares)

Shareholders Equity Dec 31, 2000 Net earnings Other comprehensive income (loss): Unrealized holding gains arising during period ($34 million pre-tax) Reclassification adjustment for gains included in net earnings ($13 million pre-tax) Currency translation adjustment Minimum pension liability adjustment ($7 million pre-tax) Hedging gains (losses) Comprehensive loss Cash dividends declared Treasury stock repurchased (3,541,295 shares) Treasury stock issued under employee plans (1,393,105 shares) Tax reductions employee plans Shareholders Equity Dec 31, 2001

$978

(25) 3 $849

(514) $7,431

(21) 8 (98) (37) 33 (115) $ (597)

(41) 82 ($5,767)

(21)

8 (98)
(37) 33 (115) (514) (41) 57 3 $2,894

Statement of Cash Flows

Kodak
For year Ended Dec. 31, 2001 (In millions)
Cash flows from operating activities: Net Earnings Adjustments to reconcile to net cash provided by operating activities: Depreciation and amortization Restructuring costs Provisions (benefit) for deferred income taxes (Increase) decrease in receivables (Increase) decrease in inventories (Decrease) increase in liabilities excluding borrowings Other items, net Net cash provided by operating activities $ 76 919 830 (44) 252 461 (529) 100 2,065

Cash flow from Investing activities: Additions to properties Acquisitions, net of cash acquired Marketable securities - sales Marketable securities - purchases Net cash used in investing activities

(743) (306) 54 (52) (1,047)

Cash flows from financing activities: Net increase (decrease) in borrowings with original maturities of 90 days or less Proceeds from other borrowings Repayment of other borrowings Dividends to shareholders Exercise of employee stock options Stock repurchase programs Net cash provided by (used in) financing activities Effect of exchange rate changes on cash Net (decrease) increase in cash and cash equivalents

(695) 1,907 (1,355) (643) 22 (44) (808) (8) 202

Financial Statement Links Kodak

Balance Sheet Dec. 31, 2000
Assets Cash Non-Cash Assets Total Assets Liabilities & Equity Total liabilities Equity: Share Capital Retained Earnings Treasury Stock Total equity Liabilities & Equity (Point in time) $ 246 13,966 $14,212

Statement of Cash Flows for Year Ended Dec. 31, 2001 Operating Cash flows $ 2,065 Investing Cash flows (1,047) Financing Cash flows (808) Exchange rate changes on cash (8) Net Change in Cash $ 202 Cash Balance, Dec. 31, 1997 246 Cash Balance, Dec. 31, 1998 $ 448 Income Statement for Year Ended Dec. 31, 2001 Sales $13,234 Expenses (13,158) Net Earnings $ 76 Other Comprehensive Income (115) Comprehensive Income $ (39) Statement of Shareholders Equity for Year Ended Dec. 31, 2001 Share Capital, Dec. 31, 1997 Adjustments/Stock Issue Share Capital, Dec. 31, 1998 Retained Earnings, Dec. 31, 1997 Add: Comprehensive Income Less: Dividends Retained Earnings, Dec. 31, 1998 Treasury Stock, Dec. 31, 1997 Treasury Stock Issued Treasury Stock Repurchased Treasury Stock, Dec. 31, 1998 $ 1,849 (22) $ 1,827 $ 7,387 (39) (514) $ 6,834 $ 5,808 82 (41) $ 5,767 Balance Sheet Dec. 31, 2001 Assets Cash Non-Cash Assets Total Assets Liabilities & Equity Total liabilities Equity: Share Capital Retained Earnings Treasury Stock Total equity Liabilities & Equity

448 12,914 $13,362

$ 10,784

$10,468

1,849 7,387 (5,808) $ 3,428 $14,212

1,827 6,834 (5,767) $ 2,894 $13,362

(Point in time)

Dec. 31, 2000

(Period of time)

Dec. 31, 2001

Additional Information
(Beyond Financial Statements)

Management Discussion & Analysis (MD&A) Management Report Auditor Report Notes to Financial Statements Supplementary Information (10-K, 10-Q, 8-K, 20-F) Proxy Statement Social Responsibility Report

Analysis Preview
Yr1 Yr2 Yr3

Comparative Analysis Purpose: Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types: Year-to-year Change Analysis Index-Number Trend Analysis

Analysis Preview
Kodak's Comparative Income Statements

Sales Cost of goods sold Gross profit Operating Expenses: 2,665 Selling, general and admin. 2,781 116 784 Research and development 779 (5) (44) Restructuring costs 659 703 Earnings from operations $ 345 $2,214 $(1,869) Interest Expense and other 237 82 155 Other income (charges) Earnings before income taxes $ 108 $ 2,132 $ (2,024) 725 Provision for income taxes 32 (693) Net earnings $ 76 $ 1,407 $ (1,331)

Change Change (in mil.) % $ 13,234 $13,994 $ (760) (5.4)% 8,670 8,375 295 3.5 $ 4,564 $ 5,619 $ (1,055) (18.8) 2001 2000 4.4 (0.6) (84.4) 189.0 (94.9) (95.6) (94.6)

Analysis Preview
Kodak's Index-Number Trends - Sales and Operating expenses (1997 = base year)
1.050 1.000 0.950 0.900 0.850 0.800 0.750 0.700 1997 1998 1999 2000 2001

Index - Base 1997

Sales Operating expenses

Kodak's Index-Number Trends - Sales and Operating Expenses (1998 = base year)
1.150

Index - Base 1998

1.100 1.050 1.000 0.950 0.900 0.850 1998 1999 2000 2001 Sales Operating expenses

Analysis Preview
Common-Size Analysis

Purpose : Evaluation of internal makeup of financial statements Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses

Analysis Preview
Common-Size Analysis
Kodak's Common-Size Income Statements 2001
Sales Cost of goods sold Gross profit Selling, general and administrative expenses Research and development costs Restructuring Costs Earnings from operations Interest expense and other costs (credits) Earnings before income taxes Provision for income taxes Net earnings 100.0% 65.5 34.5% 21.0 5.9 5.0 2.6% 1.8
0.8% 0.2 0.6%

2000
100.0% 59.9 40.1% 19.0 5.6 (0.3) 15.8% 0.6
15.2% 5.2 10.0%

Analysis Preview
Ratio Analysis
Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis) Output: Mathematical expression of relation between two or more items Cautions: Prior Accounting analysis is important Interpretation is key -- long vs short term & benchmarking

Analysis Preview
Valuation
Valuation - an important goal of many types of business analysis

Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money)

Analysis Preview
Debt (Bond) Valuation
Bt = It +1 + It +2 + It +3 + ... + It +n + F (1+r)1 (1+r)2 (1+r)3 (1+r)n (1+r)n

Bt is the value of the bond at time t It +n is the interest payment in period t+n F is the principal payment (usually the debts face value) r is the interest rate (yield to maturity)

Analysis Preview
Equity Valuation
Vt = E(Dt +1) + E(Dt +2) + E(Dt +3) + ... + E(Dt +n) + ... (1+k)1 (1+k)2 (1+k)3 (1+k)n

Vt is the value of an equity security at time t Dt +n is the dividend in period t+n k is the cost of capital E() refers to expected dividends

Analysis Preview
Equity Valuation - Free Cash Flow Model
Vt = E(FCFt +1) (1+k)1
+

E(FCFt +2) + E(FCFt +3) + ... (1+k)2 (1+k)3

E(FCFt +n) (1+k)n

...

FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures] k is the cost of capital E() refers to an expectation

Analysis Preview
Equity Valuation - Residual Income Model
Vt = BVt + E(RIt +1) (1+k)1
+

E(RIt +2) + E(RIt +3) + ... (1+k)2 (1+k)3

E(RIt +n) (1+k)n

...

Rit+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)] k is the cost of capital E() refers to an expectation

Analysis in an Efficient Market

Three assumed forms of market efficiency
Weak Form - prices reflect information in past prices Semi-strong Form - prices reflect all public information Strong Form - prices reflect all public and private information

Analysis in an Efficient Market

Market Efficiency
assumes competent and informed analysis distinguish aggregate from individual behavior reflects information (both reliable and unreliable) cross-country differences in rewards to analysis

Financial statement analysis relevant to more than just market analysis, e.g.,
credit and lending auditing valuation of nonpublicly traded firms mergers and acquisitions etc...

Book Organization
Financial Statement Analysis
Part I Introduction and Overview Part II Accounting Analysis Chapter 3: Analyzing Financial Activities Chapter 4: Analyzing Investing Activities Chapter 5: Analyzing Investing Activities: Special topic Chapter 6: Analyzing Operating Activities Part III Financial Analysis
Chapter 7: Cash Flow Analysis Chapter 8: Return on Invested Capital Chapter 9: Profitability Analysis Chapter 10: Prospective Analysis Chapter 11: Credit Analysis Chapter 12: Equity Analysis and Valuation

Chapter 1: Overview of Financial Statement Analysis

Chapter 2: Financial Reporting and Analysis

Credit Analysis
Passive Investing (beta strategies) Aim: Diversification based on risk propensity & investment horizon Example: Indexing Active Investing (alpha strategies) Aim: Beat the market -earn above normal stock returns Examples: Technical analysis & Fundamental analysis