Lecture 3:

Financial Reporting and Analysis

Mark Hendricks
University of Chicago

September 2012

Outline

Financial Reporting

Financial Analysis

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Financial reporting

Financial reporting is important for well-functioning markets.

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Investors need information to properly allocate capital and

hedge risk.

Regulators need good information to monitor fraudulent

activity and systemic risk.

Financial reports are prepared according to accounting practices,

which often differ from the methods of finance and economics.

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Financial statements

There are three key financial statements.

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The balance sheet

The income statement

The statement of cash flows

We discuss each in turn.

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The balance sheet

The balance sheet details the financial condition of the firm at

one moment in time.

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The balance sheet is a list of the firms assets and liabilities.

The values are book values, not market values.

The book values are based more on historical transaction

prices than current valuations.

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Balance equation
The central idea behind the balance sheet is an accounting identity:
assets = liabilities + shareholders equity
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Note that this equation is an identity.

The shareholders equity component is not a real market

value of equity.

Rather, it is just a plug for the equation.

In finance, the market value of equitynot the (accounting) book

valueis typically used.

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Current assets/liabilities

The first section of the balance sheet lists the assets of the firm.
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The short-term, or current assets are listed first.

This is where cash and other liquid securities are listed.

After this, longer-term assets are listed.

Liabilities are listed similarly, with current liabilities being listed

first.

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Balance sheet for commercial banking

Figure: Balance statement for the banking sector, 2008.

Source: Mishkin (2010)
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Data: Book value of assets at FDIC commercial banks

Book Value of Assets at FDIC Commercial Banks
14000

Billions $

12000
10000
8000
6000
4000

2000 2002 2004 2006 2008 2010 2012

Source: FDIC (CB14)

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Data: Excess reserves of depository institutions

Source: St. Louis Fed: (EXCRESNS)

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Data: Nonperforming loans for U.S. banks

Source: St. Louis Fed: (USNPTL)

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Accounting rules
Book values in the balance sheet differ from market values:

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Depreciation. Accountants use fixed rules to calculate

depreciation on assets. This depreciation calculation can differ
substantially from the market value.

Capitalizing expenses. Capital is listed as an asset. However,

some potential assets such as R&D are left off the balance
sheet but rather treated as simple expenses.

Intangibles like goodwill also show up on the balance sheet,

though these intangible assets have no precise measure.

Taxes. The accounting rules for calculating taxes are often

different than the rules for financial reporting.

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Fair value accounting

Fair-value accounting is an attempt to make book values
reflective of current conditions rather than just historical
transactions.

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Many assets and liabilities held by a firm are not actively

traded nor have easily observed values. ie. Inventory,
buildings, employee benefits.

Historically, accountants list these on the books at historical

costs. But the true values fluctuate, of course.

Fair-value, or mark-to-market, accounting attempts to keep

the book values at current market values.

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Mark-to model
With mark-to-market accounting, assets are valued according to
three categories:
1. Assets with observable market prices, and these are used on
the books.
2. Assets are not actively traded, but similarly traded assets can
be used for market valuations, perhaps with the aid of a
pricing model.
3. Assets without market quotes. Thus, the values depend on
pricing models.
These model-based values are known as mark-to-model, and the
choice of model may leave room for manipulation.

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Criticisms
The role of fair value accounting in the financial crisis is
controversial.

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Theoretically, fair value accounting should lead to better

information in markets.

But in distressed and illiquid markets, current prices may not

reflect long-term value.

In this case of undervalued assets, the balance sheet may hit a

point where firms are forced to recapitalize.

But if it is hard to raise equity, a firm may need to liquidate

distressed assets, depressing the price even further!

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Income statement

The income statement is the second major financial report.

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It gives a summary of the profitability of the firm over a

period of time.

(Compare this to the balance sheet which gives the firms

financial conditions at a point in time.)

The income statement lists revenues and expenses for the

time period, (year, quarter, etc.)

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Earnings
Earnings, (or net income,) are simply revenues minus costs. They
are an accounting measure of profits.

Hendricks,

Earnings would not be a good measure of economic profits

given that the financial statements are subject to accounting
rules.

Earnings measure the return to equity holders. The

calculation subtracts debt interest payments and taxes owed.

Earnings Before Interest and Taxes (EBIT) is also an

important measure of profit. It includes payments that go to
debt holders and the tax authority.

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Retained earnings

Retained earnings are the earnings re-invested into the firm:

retained earnings = earnings dividends
The balance sheet can grow in one of three ways:
1. Internally, through retained earnings.
2. Externally by issuing new equity.
3. Externally by issuing new debt.

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Income statement for commercial banking

Income Statement for All Federally Insured Commercial Banks, 2008

Share of
Operating
Income or
Expenses (%)

Amount
($ billions)
Operating Income
Interest income
Noninterest income
Service charges on deposit accounts
Other noninterest income
Total operating income
Operating Expenses
Interest expenses
Noninterest expenses
Salaries and employee benefits
Premises and equipment
Other
Provisions for loan losses
Total operating expense
Net Operating Income
Gains (losses) on securities
Extraordinary items, net
Income taxes
Net Income

603.3
207.4
39.5
167.9

_____
810.7

74.4
25.6
4.9
20.7

245.6
367.9
151.9
43.4
172.6

_____
100.0
31.1
46.6

19.2
5.5
21.9
175.9
789.4

22.3
100.0

21.3
-15.3
5.3
-6.2
5.1

Figure: Income statement for the aggregated banking sector, 2008.

Source: Mishkin (2010)
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Data: Net income of FDIC commercial banks

Net Income for FDIC Commercial Banks
150

Billions $

100
50
0
50

2000 2002 2004 2006 2008 2010 2012

Source: FDIC (CB04)

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Data: Loss provision of FDIC commercial banks

Loss Provision for FDIC Commercial Banks
250

Billions $

200
150
100
50
0

2000 2002 2004 2006 2008 2010 2012

Source: FDIC (CB04)

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Cash-flow statement
The statement of cash flows is the third major financial
statement.
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Due to accounting rules, earnings are not a proper measure of

profits, nor of cash-flow.

This statement tracks the actual cash movements associated

with transactions.

Due to its simple nature, this statement is often favored by

analysts trying to cut through all the accounting rules and
issues.

The statement typically groups transactions into operating,

investment, and financing cash flows.

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Notes to statements

Aside from the three major financial statements, firms often attach
notes.

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These notes may often be skimmed or ignored, but at times

they reveal important clues.

For instance, if a firm is manipulating accounting data, the

notes may have clues.

The notes for AIG explained that their CDS position was not
hedged.

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Earnings management
Earnings management refers to the practice of taking actions in
order to manipulate reported earnings.

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Not all reported earnings are of the same quality.

Fair value accounting leaves some discretion in the reported

figures.

Nonrecurring items, such as the sale of an asset may not be

useful in assessing the firms future profitability.

Revenue recognition. Under accounting standards, managers

can take actions which recognize income in the present, and
push losses to the future.

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Off-balance-sheet holdings
The financial crisis has brought much attention to a certain kind of
accounting manipulation: off-balance-sheet assets and
liabilities.

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Firms may try to leave profitable parts of their business on

their books, while spinning losses off into entities that do not
show up on the books.

Enron put losses into subsidiary entities whose holdings did

not show up on Enrons books. Due to keeping their profits
and hiding their losses in these shells, 96% of their reported
earnings were phony. Source: Berk (2011).

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Capital leases

Another widespread use of off-balance-sheet accounting is capital

leases.

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Capital leases are long-term leases which more closely

resemble debt financing than a true lease.

By calling the transaction an ongoing lease rather than a

debt-financed purchase, the company keeps it off the books.

Rather, they report only the monthly lease amount, as if they

did not have the (often sizeable) debt for the whole purchase.

Recent regulations have made it harder for firms to reduce

their reported debt in this way.

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World Com

In fact, the firm World Com was manipulating their financial

statements using capital leases, but in a different way.

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World Com capitalized expenses which were truly operating

expenses. They called these expenses capital leases, and thus
the money spent was not deducted from earnings, but rather
counted as assets which were slowly depreciated.

World Com, which had a market capitalization of $120 billion

in 2002, was exposed and set a record for the largest
bankruptcy. Source: Berk (2011).

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Banks use of off-balance-sheet items

The financial sector has also increased its use of off-balance-sheet

holdings.

Hendricks,

Many believe this played a large role in causing the financial

crisis.

For banks, moving things off the balance sheet avoids

regulatory scrutiny.

The income, (as a percentage of total assets,) generated by

banks from these off-balance-sheet activities has doubled since
1970. Source: Mishkin (2010).

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Moving mortgages off the balance sheet

Consider the increased off-balance-sheet activities with regard to
mortgages.

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Historically, a savings association would give a mortgage to a

homeowner, and then hold it as an asset on the books for 30
years.

MBS allowed banks to originate a mortgage and then sell a

bundle of these mortgages in a special purpose vehicle.

This removed the asset and liability from the banks balance
sheet.

The banks would continue to manage the pool of mortgages

for a fee.

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Beyond earnings

The lesson is that earnings are not a sufficient statistic for the
financial health of a firm.

Hendricks,

World Com had suspicious levels of investment due to their

use of capital leases.

Enrons actual cash flows were not anything close to their

stellar earnings.

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The Sarbanes-Oxley act

In response to the scandals of the early 2000s, the U.S. passed the
Sarbanes-Oxley act in 2002.

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The purpose of Sarbanes-Oxley was to improve the integrity

of financial statements.

Auditors were given new rules to reduce conflicts of interest.

The law puts restrictions on the non-audit services which a
public accounting firm can provide.

Management was made personally liable for the accuracy of

financial reports.

It established a Public Company Accounting Oversight Board

which is overseen by the SEC.

The budget for the SEC was increased so that it could better
supervise securities markets.

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Disclosure requirements
Disclosure requirements are a key element of financial regulation.

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Basel 2 puts a particular emphasis on disclosure requirements.

It mandates increased disclosure by banks of their credit
exposure, reserves, and capital.

The Securities Act of 1933 and the SEC, which was

established in 1934 require disclosure on any corporation that
issues publicly traded securities.

More recently, there have been added rules about reporting

off-balance-sheet positions and more information about the
pricing models being used in coming up with the financial
reports.

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Getting regulation right

Increased disclosure requirements have made it more costly for a
firm go public, or to issue U.S. securities.
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The share of new corporate bonds initially sold in the U.S. has
fallen below the share sold in European debt markets.

In 2008, the London and Hong Kong stock exchanges each

handled a larger share of IPOs than did the NYSE, which had
been the dominant market until recently.

Combined with the increasing ease of obtaining non-public

financing, many firms are delaying IPOs.

Some have blamed regulation, and Sarbanes-Oxley in

particular, for these facts. Of course, there are other possible
causes.

The debate about reporting requirements is ongoing.

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Outline

Financial Reporting

Financial Analysis

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Measuring profit

Return on equity (ROE) uses accounting values: earnings divided

by book value of equity.

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ROE will not be the same as the firms stock return over the
period.

Given that ROE uses accounting earnings as the profit

measure, it is sensitive to the manipulations discussed above.

Earnings are measured over a period of time, (ie. year,)

whereas the book value of equity on the balance sheet is at a
specific point of time.

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Return on assets

Return on assets (ROA) is another important measure of

profitability.

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Again, ROA uses earnings to measure profit, but divides by

the firms book value.

ROA is insensitive to the firms financing decision.

Thus, it is a measure of operating profitability.

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Understanding ROE

It is useful to analyze ROE by breaking it into factors, something

known as the DuPont identity.
Earnings
| Sales
{z }

ROE =

Net Profit Margin

Sales
|Assets
{z }

Asset Turnover

{z

ROA

Assets
Book Value of Equity
|
{z
}
Leverage

This shows us three ways to influence ROE.

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Data: Return on equity for commercial banks

Return on Equity for FDIC Commercial Banks
20
15
ROE %

10
5
0
5
10

1985

1990

1995

2000

2005

2010

2015

Source: FRED (USROE)

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Three factors of ROE

The three factors of ROE correspond closely to the financial

statements.

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Profit margin gives a summary of the income statement

performance by showing profit per dollar of sales.

Asset turnover summarizes the asset side of the balance sheet.

It indicates the resources required to support sales.

Leverage ratio summarizes the liability and equity side of the

balance sheet by showing how the assets are financed.

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Profit margin
The profit margin measures the fraction of each dollar of sales
that ends up as earnings, adding to the balance sheet.
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In the decomposition above, we have used the net profit

margin.

Recall that earnings, or net income, has already deducted

interest payments on debt and taxes.

Another popular measure is gross profit margin which instead

of using earnings in the numerator, uses EBIT.

net profit margin =

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earnings
,
sales

gross profit margin =

Financial Reporting

EBIT
sales

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ROE and gross margins

Of course, the above decomposition wont work with gross profit

margin. Rather it must be expanded to
ROE =

Earnings

EBIT

EBIT
|Sales
{z }

Gross Profit Margin

Sales
|Assets
{z }

Asset Turnover

{z

ROA

Assets

Book Value of Equity

|
{z
}
Leverage

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Data: Net interest margin for U.S. banks

Source: St. Louis Fed: (USNIM)

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Asset turnover
Asset turnover measures the sales generated per dollar of assets
the firm owns.

Asset Turnover =

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Sales
Assets

Notice that assets reduce asset turnover and thus reduce ROA
and ROE.

One might expect lots of assets are a good thing.

But conditional on a certain profit stream, assets just measure

the amount of capital needed to generate this income stream.

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ROA
ROA captures the combined effects of margins and asset turnover:
ROA =(Net) profit margin Asset turnover =

Earnings
Assets

ROA is a basic measure of a firms efficiency in how it

transforms assets to profits.

Some industries achieve high returns by having high margins,

while other achieve it with high asset turnover.

A high profit margin and a high asset turnover is ideal, but can be
expected to attract considerable competition. Conversely, a low
profit margin combined with a low asset turn will attract only
bankruptcy lawyers. Higgins (2009).

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Data: Return on assets for commercial banks

Return on Assets for FDIC Commercial Banks
1.5

ROA %

1
0.5
0
0.5

1985

1990

1995

2000

2005

2010

2015

Source: FRED (USROA)

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Leverage
Leverage refers to how much of the firms capital comes from
equity holders versus debt holders.
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Unlike the other two ratios in ROE, more is not necessarily

better.

Rather, leverage decisions must take account of the pros and

cons of debt financing.

A firm does not pay taxes on income used for interest

payments. This debt tax shield incentives firms to lever up.

However, more debt increases the chances of financial distress

or bankruptcy.

Optimal leverage balances these forces, and varies widely across

industries. Not surprisingly, low leverage is used in industries where
financial distress is particularly costly.

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Leverage - balance-sheet measures

The leverage ratio in the ROE calculation is the asset-to-equity
value. This is often rescaled into other popular measures.

Debt-to-assets =

Liabilities
Assets

Debt-to-equity =

Liabilities
Equity

Notice that the asset-to-equity ratio used above is just the

debt-to-equity-ratio plus 1.

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Data: Leverage of commercial banking sector.

Accounting Leverage FDIC Commercial Banks

book (assets/equity)

20

15

10

1940 1950 1960 1970 1980 1990 2000 2010

Source: FDIC (CB14)

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Leverage - coverage measures

There are many other ways to measure the extent to which a firm
is financing with debt.
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Measures based on income are often preferred, given that

bankruptcy is caused by defaulting on payments, not on the
share of equity versus debt.

Interest coverage, or times interest earned, also measures

the financial risk of a firm. It shows how much burden interest
payments are on the cash flows.
interest coverage =

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EBIT
interest expense

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Rollover risk
There are many other ways to measure the extent to which a firm
is financing with debt.

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Times burden covered is similar to times interest earned,

but takes account of principal repayment.

Relying on the interest covered measure assumes that one can

roll over the debt principal.

In the summer of 2007, many investors in MBS found this is

not always the case.

Times burden covered is conservative in that it calculates as if

all principal will be repaid.

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Leverage - market measures

Given the problems with accounting values already discussed, many

prefer a market measure of leverage.

Hendricks,

Market measures of leverage are like the balance-sheet

measures seen above, but they use the market value of equity
rather than the book value.

This can make a big difference, especially for growing firms.

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Leverage in the crisis

Leverage played a big role in the recent financial crisis.

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Firms such as Lehman and Merril Lynch had 30-to-1 leverage.

This left them very little flexibility to deal with asset declines.

The total decline in mortgages was a relatively small amount

of money, but was more than enough to bankrupt highly
leveraged institutions.

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Capital requirements

Capital requirements are meant to keep financial institutions from

taking too much risk.

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Note that with high leverage, a firm has more incentive to

take very large gambles.

Losses mean little, while the upside from the gains gets larger.

Regulators want to prevent excess risk which could cause

failure in financial markets.

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Leverage ratio requirements

The capital requirements take two forms: the first is based on the
leverage ratio.

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A bank is well capitalized with a leverage ratio below 20.

But extra regulation kicks in if it goes above 33.

The FDIC must take steps to close down a bank with a

leverage ratio above 50.

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Basel

The second type of requirements are risk-based.

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Under regulation known as the Basel Accord, banks were

required to hold 8% of their risk-weighted capital.

The weighting system for capital leads to regulatory arbitrage.

Basel 2 was very recently rolled out after many years of

planning. However, due to the crisis, Basel 3 is already being
studied.

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ROE and ROA

We have seen then, that ROE is just an an adjustment of ROA to
account for leverage.
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ROA shows the return that comes from the operation of the
business

ROE shows both returns from operations and financing

For which type of returns should management be rewarded?

High ROE relative to ROA (relative to the industry,) may

show savy financing, but it could also show excessive risk.

Management seeking returns always has the temptation of

leveraging to get there.

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Table of ROE

Figure: ROE for various firms, 2007. Source: Higgins (2009)

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Problems with ROE

ROE is not necessarily a good measure of financial performance.

For as much attention as it gets, one must be careful.

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Market valuations are forward-looking and consider the

long-term prospects of the firm.

By contrast, ROE is largely backward-looking and considers

only one years data.

We have already noted that accounting values can easily be

manipulated to push earnings to different time periods.

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ROE and risk

We mentioned already, that ROE can be increased by taking on
more leverage.

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Clearly then, a higher ROE is not always better.

Improving ROE while keeping risk exposure level is an

acheivement. Increasing ROE by increasing risk, (leverage or
other types,) is not.

Thus, investors must consider whether high ROE is a good

deal.

If your money market fund returned 10%, would you be

happy?

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Banks and ROE

Currently, regulators are considering tougher capital requirements

for banks, (lower leverage.)

Hendricks,

Banks argue that this will lower their returns; they are
definitely right!

They say that this will cause investors to withdraw, which will
cause big problems in financial markets.

Is this true? Will investors need such a high ROE if capital

requirements are higher?

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Liquidity measures

Current ratio. Current assets and liabilities are those with a

maturity of one year or less. Thus, this measures the ability of
the firm to pay off short-term debt using its most liquid assets.
current ratio =

Hendricks,

current assets
current liabilities

Quick ratio. Also known as the acid test ratio. It is like the
current ratio, but does not include inventory in the numerator.

Cash ratio. Similar to the current ratio, but it does not

include current assets which are not marketable securities,
(things like accounts receivables.)

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Book and market values

We have noted that the book value of firm equity may be much
different than its market value.

Hendricks,

The market-to-book ratio is the market value of equity

divided by the book value of equity.

Book value of equity is considered a very conservative

estimate of share value, perhaps a floor.

Recall that the ratio can be much different than one given
that book-values tend to be based on historical transactions
while market values look forward to future growth.

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Growth and value

The price-earnings ratio (P/E) is a popular measure of firm value.

Hendricks,

The P/E ratio takes the market price at a given time, and it
divides by the earnings generated over some period.

Of course, the market price is affected by the future prospects

of the firm, while the periods earnings are a historical fact.

Thus, the P/E is a measure of how much future cash flows

the firm will deliver relative to its current earnings.

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Growth and value

Market-book and price-earnings values are both useful measures for

a firms future growth prospects.

Hendricks,

Stocks with a high market-book or P/E ratio are called

growth stocks.

A stock with a low market-book or P/E ratio is called a value

stock.

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Use of growth and value

The labels growth and value are widely used.

Hendricks,

Historically, value stocks have delivered higher average returns.

So-called value investors try to take advantage of this by

looking for stocks with low market-book ratios.

Much research has been done to try to explain this difference

of returns and whether it is reflective of risk.

Mutual funds are offered for both growth and value stocks
and have become very popular.

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References

Hendricks,

Berk, Jonathan and Peter DeMarzo. Corporate Finance. 2011.

Bodie, Kane, and Marcus. Investments. 2011.

Cochrane, John. Understanding Policy in the Great Recession

European Economic Review. 2011.

Higgins, Robert. Analysis for Financial Management. 2009.

Hull, John. Options, Futures, and Other Derivatives. 2012.

Mishkin, Frederic. Money, Banking, and Financial Markets.

2010.

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