Why Financial Statements

Analysis?
“You” may be
 an investor
 a creditor
 a supplier
 a customer
 an employee
 the manager
 a competitor
 an auditor
 a government agency
Will you rely on pure hunches and guesses? Or,
The Investment Environment
The Money Market
 treasury bills, certificate of deposit, commercial
paper, etc.
The Fixed-Income Capital Market
 treasury notes and bonds, municipal bonds,
corporate bonds, etc.
The Capital Market
 common stock, preferred stock
The Derivative Market
 options, futures
The Major Stock Market in the U.S.
The New York Stock Exchange (NYSE)
 Largest stock exchange: About 3,025 companies or $16
trillion in market value (July 1999)
 382 non-U.S. companies (July 1999)
The American Stock Exchange (AMEX)
 Listing of smaller and younger firms
The Over-the-Counter National Association of
Securities Dealers Automated Quotation (NASDAQ)
 Trade through computer-linked network
 Include: Nasdaq National Market (4,400 securities) and
Nasdaq SmallCap Market (1,800 securities)
ACC 6213
Financial Statements and Analysis
Objectives
 Discuss a framework for conducting
business analysis with a focus on the role
of financial information
 Learn how to apply the framework for
security valuation and risk analysis
 Learn to retrieve market and financial data
Textbook and Related Materials

Palepu, Healy and Bernard, “Business Analysis

& Valuation: Using Financial Statements”,
Text and Cases, 2nd ed., 2000
Dell’s 10-K for fiscal year 1999
Computer skills:
 Research, retrieve and download data from
internet
 Excel or any other spreadsheet program
Course Requirements
Course Outline
Individual Assignments
 30%
Team Project
 50%
Participation
 20%
Grade: Expected distribution: 40-50% A’s,
20-30% B’s, rest C’s
Individual Assignments
Discussion allowed, but no copy of ideas
or writing
 No points will be given for similar assignments
Related to class discussion and cases in
the book
Questions to be posted on Web
Participation

Come to class prepared with

 Intelligent comments
 Constructive questions
 Thoughtful insights and observations
Quality counts more than Quantity
Team project to be discussed later
Palepu, Healy & Bernard
(Figures 1-2 & 1-3)

A firm is involves in various business activities to

create value for investors
Financial statements summarize the economic
consequences of a firm’s business activities
Accounting system affects the quality of the
financial data provided
- affected by accounting rules, managements’ incentives
Analysts use a systematic framework to create
inside information from public financial data
Framework: Four Steps of Analysis
Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Analysis and

Valuation Applications
I. Business Strategy Analysis
Purposes:
 To identify key profit drivers and business risks
 To assess profit potential at a qualitative level
Involves:
 Industry analysis
 Analysis of the firm’s strategy to create a sustainable
competitive level
 How did the firm stay alive and possibility of prospering in
the future
Important first step for the following three
analyses
II. Accounting Analysis
Purposes:
 To evaluate the degree to which a firm’s
accounting captures underlying business reality
Involves:
 identifying where there is accounting flexibility
 evaluating the appropriateness of accounting
policies and estimates
 assessing the degree of distortion in disclosures
 undoing (if necessary) distortions
Improves the reliability of financial analysis
III. Financial Analysis
Purposes:
 To evaluate current and past performance
 To assess the sustainability of its performance
Requirements:
 should be systematic and consistent
 should allow the use of financial data to explore
issues found in business strategy analysis
Tools
 Ratio analysis: profitability, efficiency, liquidity
 Cash flow analysis: liquidity and financial flexibility
IV. Prospective Analysis
Purpose
 To forecast a firm’s future
Final step in business analysis
Techniques
 Financial statement forecasting
 Valuation
Team Project
Teams of four
Select an industry and two companies in the same
industry
 No more than two teams on one industry
 No group can work on the same company
 Need my approval; first-come, first serve
Compare the two companies in terms of All of the FOUR
analyses:
 Business Strategy Analysis
 Accounting Analysis & Financial Analysis
 Forecasting, Including Discussion of Assumptions
 Valuation
Industry Choices
 Agricultural  Retail
 Construction  Service
 Manufacturing  Transportation
 Mining  Wholesale - Trade

No Finance, Insurance, and Real Estate

Industry and Public Administration Industry
Team Project Report
Must be typed
Limit to 10 pages: double-spaced, 12-
point font size
Data source and calculation should be
included as appendices
Attach an evaluation on each of your
group members: efforts and
contribution
Finding Information for Business
Analysis
CSUH Library and Internet Historical Stock Market
 Main data sources
Data
 Industry Research
 Company Research
 Historical Market Index D
ata
 UC Berkeley
 International Business
 Historical Stock Price
Other: Data
 Annual Reports  On DJ interactive,
 Annual Report Gallery Historical market data
 10-K Reports
 Accounting Rules
 Financial Accounting Stand
ard Board
Framework for Business Analysis
& Valuation
Business Strategy Analysis

Accounting Financial Prospective

Analysis Analysis Analysis
Business Strategy Analysis

Industry Analysis
Industry profitability and risk
Competitive Strategy Analysis
Which companies will sustain?
Corporate Strategy Analysis
Multibusiness management
Industry Analysis
Standard Industrial Classification (SIC), North American Industry
Classification System (NAICS)

Factors affecting industry profitability: Porter’s

“five forces”
 Degree of Actual & Potential Competition (3 forces)
 Rivalry Among Existing Firms
 Threat of New Entrants
 Threat of Substitute Products
 Bargaining Power in Input & Output Markets (2 forces)
 Buyers’ Power
 Suppliers’ Power
 Affect competitive strategy chosen to
operate in the industry
1. Rivalry Among Existing Firms
Profitability is low if competition for market
share is strong:
 Low industry concentration
 Compute “Industry Concentration Ratio”, e.g. sales of
largest four or eight companies  total industry sales
 Low product differentiation
 Large economy of scale, steep learning curve,
high proportion of fixed costs
 Low industry growth
 Excess capacity, high exit cost
2. Threat of New Entrants
Profitability is low if threat of new
entrants is high:
 Small economy of scale
 Less “first mover advantages”
 Easy access to channels of distribution and
distribution relationships
 Low legal barriers: e.g. government
approval
3. Threat of Substitute Products

Profitability is low, if threat of substitute

products is high:
price and performance are similar
customers are willing to switch
 Products are similar or seen as being
substitutes
 Low brand allegiance
products are replaceable
4. Buyers’ Power
Strong, if
More Sensitive to Price
 Products are similar

 Low switching costs

 Unimportant products (relative cost and quality)

Higher Bargaining Power

 Fewer buyer

 Higher volume per buyer

 Low switching cost

 More substitute products

 High threat of backward integration by the buyers

5. Suppliers’ Power
Profit is low if suppliers’ power is strong:
Fewer number of suppliers
High volume per supplier
High Switching Costs
High product differentiation
Importance of product in terms of cost
and quality
Power in Input Market (Suppliers) &
Output Market (Buyers)

High Low Actual Profitability

Low  High Actual Profitability

Suppliers’ power
Buyers’ power
Given a level of industry profitability
…

What determines which companies will

win and which companies will lose?
How can a company sustain profits in a
competitive environment?
Porter maintains that there are two
generic competitive strategies that firms
can choose in order to maintain
competitive advantage
Competitive Strategy Analysis

?
Choices of competitive
strategies:
1. Cost Leadership

2. Differentiation

And, Straddling of “1” and “2”

1. Cost Leadership
Is a cost leader if it can supply same product
or service at a lower price because of
 Economies of scale, scopes, and learning
 Efficient production
 Simpler product designs
 Efficient organizational processes
 Lower costs of inputs and distribution
 Little R&D or brand advertising required
 Tight cost control
2. Differentiation
Supply a unique product or service at a cost lower
than the price customers are willing to pay:
 Superior product quality
 Superior product variety

 Superior customer services

 More flexible delivery

 Investment in brand image

 Investment in R&D and marketing

Note: Organizational and control system must foster

creativity and innovation
Achieving and Sustaining
Competitive Advantage
Depend on:
Match between firm’s core competencies (the
economic assets possessed by the firm) and
competitive strategies
Match between firm’s value chain (the activities
to convert inputs to outputs) and activities
required to execute competitive strategies
Flexibility to adopt to changes in the firm’s
industry structure
Difficulty for competitors to imitate
Applying Strategy Analysis to
Dell
Industry Analysis
 Describe the features of the personal
computer industry that determine its profit
potential. How difficult is it to earn
abnormally high profit in this industry?
Competitive Strategies Analysis
 Describe Dell’s business strategy and how
it might allow Dell to earn higher returns
on investments than others in the industry?
Personal Computer Industry

Degree of Actual and Potential Competition

 Rivalry Among Existing Firms
 Threat of New Entrants
 Threat of Substitute Products
Bargaining Power in Input and Output
Markets
 Buyers’ Power
 Suppliers’ Power
Personal Computer Industry:
Rivalry
Growth continues to be strong
 pricing remains cut-throat
Lots of competitors
 fragmented, no price co-ordination
Switching costs are low
 commodity product; price is the key
 Dell tries to compete on service
 as knowledge rises, will service matter?
Dell needs to keep market share
 recoup R&D and costs associated with made to order strategy
 allows them to lower component costs
PC: Entrants
Low barriers to entry
First mover advantage?
 not technologically
Distribution is easy
Relationships with suppliers, customers?
PC: Substitute Products
Apple’s Macintosh, Sun’s work stations?
 not in the near future
Competitive price and performance
 PCs are commodities (price counts more)
 price competition seems unavoidable
Buyers’ are willing to switch
 brand name?
 quality reputations?
PC: Power of Customers
Buyers are price sensitive
 define price as hardware, software, and
operations, not just purchase price— “total
cost of ownership”
Dell maintains an extensive database of
customer information
 unavailable to retail operators
Importance of product for cost & quality
PC: Suppliers’ Power
Two major “one supplier” relationships
 Intel, Microsoft
Leverage will increase with volume
Can Intel reap some of the PC vendors’
profits?
Power of other suppliers is low
 lots of keyboard, case, power supply, etc.
manufacturers
PC Industry Analysis: Conclusion
Intense competition
Low barriers to entry
Not much power over customers
and suppliers
Short product cycle; need to stay on
edge technologically
Profit potential might be poor
BUT, growth is an important offsetting factor
What Should Dell Need to be
Concerned?
General economy condition
Industry growth; technological changes
Competition:
 Product quality; customer service/support; distribution
channels; price
 International
 Product mix, customer mix, geographic mix
 New ventures: Internet
Inventory levels
Supply sources
Support of infrastructure
Government regulation
Dell’s performance
$30

$25
$ in billions

$20
Saes
$15
Profit
$10

$5

$0
1996 1997 1998 1999 2000
Customer profile: Foreign vs.
Domestic Sales
100%

80%

60%
Foreign
40% Domesic

20%

0%
1998 1999 2000
Mergent’s Industry Review
- 1999 Ranking
Dell

Revenue 2nd
Net income 2nd

Return on Capital 1st

Stock Market Performance
Dell Market Index
(Value Line)
1 Year 32.0% 19.5%
3 Year 1176.2% 56.0%

5 Year 7790.4% 121.2%

Dell: Competitive Strategy

Differentiation
 Direct sales: no middle man; customer database
 “Customer made” product
 Lower economy of scales
 Low inventory
 Customer service and support
 “Enterprise systems”
Cost Leadership
 Through “made to order”
 Not “low cost” seller
Dell: Sustainable Advantage?

What aspects of Dell’s strategy can be

replicated by others?
Can Dell avoid being replicated?
Dell: Conclusion

Competitive and thus low profitability

industry
The success of Dell’s competitive
strategy depends on
 Product differentiation
 Maintain higher profit margin
 Reduce/control operating expenses
 Goal: higher net margin
According to Dell (10-K)…
Three key factors
 Growth
 Demand, competition, international market
 Product, customer, geographic mix
 “servers” business
 Profitability
 gross and net margins, sales mix, Internet sales
 Technological changes and product transition
 Liquidity
 asset management, especially inventory
Experts’ Opinion?
Value Line on industry (4/21/2000)
The computer and peripheral industry probably will
get off to something of a slow start this year (2000).
However, it should pick up a better head of stream
in the second half and stay on a fast growth tract
out to 2003-2005.
Investors should be able to find stocks in this group
that will be good fits for their portfolios, whether
they are looking for near-term out-performance or
long-term capital appreciation. Conservative
accounts should tread cautiously, though, since
volatility can be high for some of these equities.
Experts’ Opinion?
Value line on Dell (4/21/2000)
Although the stock has pulled back a bit
from its recent high, Dell shares don’t stand
out for the year ahead or the pull to 2003-
2005. But Dell’s direct sales approach
(which has enabled it to take share from
competitors) appears to be working well,
and we think the push to penetrate the
emerging Internet market is a positive
development.
Framework: Four Steps of Analysis
Business Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Business Analysis and

Valuation Applications
Review of Business Strategy
Analysis
What factors decide an industry profitability?
Porter’s “five forces”
 Degree of Actual and Potential Competition
 Rivalry among existing firms
 Threat of new entrants
 Threat of substitute products
 Bargaining Power in the Input and Output Markets
 Bargaining power of customers
 Bargaining power of suppliers
What is Accounting Analysis?
(Chapter 3)
Evaluate the degree to which a company’s accounting
captures its underlying business reality
Evaluate the appropriateness of accounting policies and
estimates
Assess the distortion, if any, in the numbers
 see where distortions are and whether they can undone

Goal: To improve the reliability of conclusions from

financial analyses
Note: Does accounting affect business strategy? (“positive
accounting”)
The Need of Financial Accounting
Separation between ownership and
management (“agency problem”)
Owners want to know:
 Profitability: Income Statement
 Economic resources and obligation: Balance Sheet
 Cash flow position: Statement of Cash Flows
 Owners’ equity: Statement of Stockholders’ Equity
Accounting - Review
Annual Reports
 Management Discussion and Analysis
(MD&A)
 Financial Statements
 Balance sheet (2 years)
 Income Statement (3 years)
 Statement of Stockholders’ Equity (3 years)
 Statement of Cash Flows (3 years)
 Notes
Importance of Notes
Integral part of the F/S
Augment the information provided in
the F/S
Provide very important data for F/S
analysis
E.G. “Contingencies”
MD&A
Results of operations, including
discussion of trends in sales and
expenses
Capital resources and liquidity, including
discussion of cash flows trend
Outlook based on known trends
Financial Statements
Accountants are confronted with the
potential dangers of bias,
misinterpretation, inaccuracy, and
ambiguity
Must follow the Generally Accepted
Accounting Principles (GAAP)
 E.g. FASB Publications, Statement 115
 FASB, SEC, AICPA
Mechanics of the Accounting
Process
Balance Sheet
 Assets = Liabilities + Stockholders’ equity
 Ending balance =
Opening balance carried from previous B/S
+/- Increases/Decreases
SE = Capital stock + Retained Earnings
Capital stock = Opening balance + Issuance –
Repurchase
R/E = Opening balance + NI - Dividends
Net Income
Income Statement
Revenue – Expenses
 Accrual Basis (v.s. Cash Basis)
 Revenue is recognized when “earned”, not
necessarily when cash is received
 Expense is recorded when “incurred”, not
necessarily when cash is paid
From I/S to B/S
I/S Daily Transactions

Net Income

R/E
R/E Statement of SE

Capital Stock; R/E

B/S
Assets =
Liabilities + SE
What Affect the Quality of Accounting
Data? – Not Reflect the Economic Reality
Reports are prepared by management
 Involves with management’s incentives
Accrual basis versus cash basis
 Involves estimations, not totally actual cash transactions
Accounting rules (GAAP)
 Standardization versus flexibility
Auditing
 Auditable?
Legal Liability
 Threat of lawsuits improves credibility, but limits disclosures
Accounting Analysis for Dell

Main concern: higher return on equity

What are the major areas we need to
look into at Dell if we want to
understand how well they are doing?
 Based on the industry and competitive
strategy analyses
 growth, profitability
Think About Dell
 Accounting Rules—biased?
 Accounting Estimation—biased?
 Factors that Affect Managers’ Accounting Choices
 debt covenants—does Dell have any?
 management compensation—does Dell have earnings-based
bonuses?
 corporate control contest—is Dell concerned about a takeover?
 tax considerations—LIFO versus FIFO
 regulatory considerations—consider Microsoft
 capital market considerations
 stakeholder considerations —consider auto industry
 competitive considerations—how detailed should the reporting
be
How to Do Accounting Analysis

1. Identify Key Accounting Policies

2. Assess Accounting Flexibility
3. Evaluate Accounting Strategy
4. Evaluate the Quality of Disclosure
5. Identify Potential Red Flags
6. Undo Accounting Distortions
1. Identify Key Accounting
Policies
Ultimate goal
 How well are the key success factors and

risks identified by the Business Strategy

analysis managed by the firm?
Task
 Identify and evaluate the policies and
estimates the firm uses to measure its
critical factors and risks
2. Assess Accounting Flexibility

All firms can choose:

 depreciation & amortization methods and
estimates
 inventory methods
 estimates of bad debts
Some items do not allow flexibility:
 R&D and marketing expenditures must be
expensed
 software development can be capitalized
Flexibility, Informative, and Distortion

Low High
Flexibility

Less Informative More Informative

Less Distortion More Distortion
Flexibility Analysis—Dell
Fiscal year-end: Friday nearest 1/31
Consolidate all wholly owned subsidiaries
Short-term investments: available-for-sale
Inventory: first-in, first-out
Depreciation: 2 to 5 years for non-buildings
Amortization of intangibles: 3 to 8 years
R&D and advertising: expensed
Warranty and post-sale support: estimated and expensed
Software development costs: capitalized
Segment information
3. Evaluate Accounting Strategy
How do the firm’s policies compare to the industry norm?
Does management face strong incentives to manage
earnings?
 covenants, bonuses, political pressures
Has the firm changed policies or estimates?
Were policies and estimates realistic in the past?
 write-off
 discontinued operation
Does the firm structure transactions to achieve certain
accounting objectives?
 capital lease versus operating lease
 pooling-of-interest versus purchase accounting
4. Evaluate Quality of Disclosure
Do the firm’s disclosures make it easy to
assess the economic reality?
 Provide adequate disclosure of business strategies?
 Explain in footnotes accounting policies, assumptions,
and their logic?
 Explain current performance?
 Provide additional disclosures to assess business
reality?
 Provide informative segment disclosure?
 Reveal forthcoming bad news?
 Provide detailed news to investors?
5. Identify Potential Red Flags
Unexplained changes in accounting especially when performance is poor
Unexplained transactions that boost profits
 sale of assets or investments
Unusual increases in A/R in relation to sales increases
Unusual increases in inventories in relation to sales increases
Increasing gap between earnings and cash flow from operations
Increasing gap between financial income and taxable income
Off-F/S transactions
 B/S (e.g., leases) and I/S (e.g., contingencies)
Large asset write-offs
Large 4th-quarter adjustments
Qualified audit opinion or change in auditors
Related party transactions
6. Undo Accounting Distortions

Try to make adjustments

 use data in the notes
 use cash flow data
 use non-accounting sources:
 Newspapers
 Call investor relations

Example: Off-B/S financing

In-Class Case: Harnischfeger
Purpose: Demonstrate managerial motives for making
accounting changes
Background: GAAP allow flexibility for accounting
choices. Even after a firm chooses a set of accounting
policies, it can still change to another at the
management’s discretion.
Managerial incentive:
 1982 Harnischfeger faced a financial crisis
 New management was appointed to turn the company around
 New management made a few financial reporting policy
changes in 1984
 Harnischfeger turned into profit in 1984