Essentials of Financial Statement Analysis

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 6

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Learning Objectives 1 After studying this chapter, you will understand:

How cause-of-change analysis and common-size and trend statements illuminate complex financial statement patterns and shed light on business activities.

How competitive forces and business strategies affect a company’s profitability and financial position.

How return on assets (R O A) can be used to analyze a company’s profitability, and what insights are gained from disaggregating R O A into its profit margin and asset turnover components.

How return on common equity (R O C E) can be used to assess the effect of financial leverage on profitability.

How short-term liquidity risk differs from long-term solvency risk, and what financial ratios are helpful in assessing these two dimensions of credit risk.

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Learning Objectives 2 After studying this chapter, you will understand:

How to use the cash flow statement information when assessing credit risk.

How to interpret the results of an analysis of profitability and risk.

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Financial Analysis Tools and Approaches

Financial Analysis Tools

Cause-of-change analysis

Common-size statements

Trend statements

Financial ratios

Basic Approaches

Time-series analysis Helps identify trends for a single company or business unit.

Cross-sectional analysis Helps identify similarities and differences across companies or business units at a single point in time.

Benchmark comparison Uses industry norms or predetermined standards.

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Financial Statement Analysis and Accounting Quality

Analysts use financial statement information to see more clearly the economic activities and condition of a company and its prospects.

However, financial statements do not always provide a complete and faithful picture of a company’s activities and condition.

Access the text alternative for slide images.

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Examples of How the Financial Accounting “Filter” Works

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Another Potential Threat to Quality: Conflicts of Interest

Conflicts of interest pose another potential threat to the quality of financial reports.

Conflicts of interest arise when what is good for one party (for example, management) isn’t necessarily good for another party (say, lenders or outside investors).

Companies have an obligation to disclose business transactions that involve potential conflicts of interest.

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A Case in Point: Getting Behind the Numbers at Kroger

EXHIBIT 6.1 The Kroger Co.

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Cause-of-Change Analysis 1

One way to quantify the components of change is with a “cause-of-change analysis,” which shows the effects of individual changes on the change in some performance metric of interest, in this case net earnings including noncontrolling interests.

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Cause-of-Change Analysis 2

EXHIBIT 6.2 The Kroger Co.

Simple Financial Model Representation of Net Earnings Including Noncontrolling Interests

Fiscal Year: 2017 2016 2015 2014
($ in millions) Year Ended: February 3, 2018 January 28, 2017 January 30, 2016 January 31, 2015
Weekly sales $ 2,358.88 $ 2,176.17 $ 2,112.12 $ 2,085.87
× Number of weeks in year 52 53 52 52
Sales 122,662 115,337 109,830 108,465
× Operating margin % 1.6998% 2.9791% 3.2559% 2.8922%
Operating profit 2,085 3,436 3,576 3,137
Interest expense (601) (522) (482) (488)
Income before income taxes 1,484 2,914 3,094 2,649
× One minus adjusted* effective income tax rate 0.66509 0.67159 0.66225 0.65949
Net earnings before effect of new tax law 987 1,957 2,049 1,747
Effect of new tax law 902 . . .
Net earnings including noncontrolling interests $ 1,889 $ 1,957 $ 2,049 $ 1,747

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The Kroger Co: Cause-of-Change Analysis 2014 versus 2015 1

EXHIBIT 6.3 The Kroger Co.

Panel (a): Cause-of-Change Analysis Fiscal 2014 versus 2015

($ in millions) Fiscal 2014 FYE 1/31/2015 Growth in Weekly Sales Change in Number of Weeks in Year Change in Operating Margin Change in Interest Expense Change in Tax Rate
Weekly sales $2,085.87 $2,112.12 $ 2,112.12 $ 2,112.12 $ 2,112.12 $ 2,112.12
× Number of weeks in year 52 52 52 52 52 52
Sales 108,465 109,830 109,830 109,830 109,830 109,830
× Operating margin % 2.8922% 2.8922% 2.8922% 3.2559% 3.2559% 3.2559%
Operating profit 3,137 3,176 3,176 3,576 3,576 3,576
Interest expense (488) (488) (488) (488) (488) (488)
Income before income taxes 2,649 2,688 2,688 3,088 3,094 3,094
× One minus effective income tax rate 0.65949 0.65949 0.65949 0.65949 0.65949 0.66225
Net earnings including noncontrolling interests $ 1,747 $ 1,773 $ 1,773 $ 2,037 $ 2,040 $ 2,049
Effect of change   $ 26 $ 0 $ 264 $ 3 $ 9

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The Kroger Co: Cause-of-Change Analysis 2014 versus 2015 2

EXHIBIT 6.3 The Kroger Co.

Panel (a): Cause-of-Change Analysis Fiscal 2014 versus 2015

Cause-of-Change Analysis Summary Fiscal 2014 versus 2015
Net earnings for fiscal 2014 $1,747
Earnings effect of increase in weekly sales 26
Earnings effect of change in number of weeks in year 0
Earnings effect of change in operating margin 264
Earnings effect of change in interest expense 3
Earnings effect of change in income tax rate 9
Change in net income 302
Net earnings for fiscal 2015 $2,049

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The Kroger Co: Cause-of-Change Analysis 2015 versus 2016 1

We can use cause-of-change analysis to compare any two years.

Panel (a): Cause-of-Change Analysis Fiscal 2015 versus 2016

($ in millions) Fiscal 2015 FYE 1/30/2016 Growth in Weekly Sales Change in Number of Weeks in Year Change in Operating Margin Change in Interest Expense Change in Tax Rate
Weekly sales $ 2,112.12 $ 2,176.17 $ 2,176.17 $ 2,176.17 $ 2,176.17 $ 2,176.17
× Number of weeks in year 52 52 53 53 53 53
Sales 109,830 113,161 115,337 115,337 115,337 115,337
× Operating margin % 3.2559% 3.2559% 3.2559% 2.9791% 2.9791% 2.9791%
Operating profit 3,576 3,684 3,755 3,436 3,436 3,436
Interest expense (482) (482) (482) (482) (522) (522)
Income before income taxes 3,094 3,202 3,273 2,954 2,914 2,914
× One minus effective income tax rate 0.66225 0.66225 0.66225 0.66225 0.66225 0.67159
Net earnings including noncontrolling interests $ 2,049 $ 2,121 $ 2,168 $ 1,956 $ 1,930 $ 1,957
Effect of change   $ 72 $ 47 $ (212) $ (26) $ 27

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The Kroger Co: Cause-of-Change Analysis 2015 versus 2016 2

We can use cause-of-change analysis to compare any two years.

Panel (a): Cause-of-Change Analysis Fiscal 2015 versus 2016

Cause-of-Change Analysis Summary Fiscal 2015 versus 2016
Net earnings for fiscal 2015 $2,049
Earnings effect of increase in weekly sales 72
Earnings effect of change in number of weeks in year 47
Earnings effect of change in operating margin (212)
Earnings effect of change in interest expense (26)
Earnings effect of change in income tax rate 27
Change in net income (92)
Net earnings for fiscal 2016 $1,957

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Common-Size Statements

Financial analysts use common-size and trend statements of net income to help spot changes in a company’s cost structure and profit performance.

Common-size income statements recast each statement item as a percentage of sales.

Common-size income statements show how much of each sales dollar the company spent on operating expenses and other business costs and how much of each sales dollar hit the bottom line as profit.

Common-size balance sheets recast each statement item as a percentage of total assets.

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The Kroger Co: Common-Size Income Statements

EXHIBIT 6.4 The Kroger Co.

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The Kroger Co: Trend Income Statements

Each item is recast in percentage terms using a base year number.

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The Kroger Co: Common-Size Balance Sheets – Assets

Each item is recast as percentage of total assets.

EXHIBIT 6.7 The Kroger Co.

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The Kroger Co: Trend Balance Sheets – Assets

Each item is recast in percentage terms using a base year number.

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The Kroger Co: Common-Size Balance Sheets – Liabilities and Stockholders’ Equity

EXHIBIT 6.8 The Kroger Co.

Highlights changes in financial structure

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The Kroger Co: Common-Size and Trend Analysis of Cash Flow Statements 1

Common-size cash flow statements are constructed by dividing each cash flow item by sales for the year.

EXHIBIT 6.13 The Kroger Co.

Common-Size and Trend Analysis of Selected Cash Flow Items

Common-Size Statements
Fiscal Year: 2017 2016 2015 2014
(% of sales) Year Ended: February 3, 2018 January 28, 2017 January 30, 2016 January 31, 2015
Selected Items
Net cash provided by operating activities 2.8% 3.7% 4.5% 3.9%
Payments for property and equipment, including payment for lease buyouts (2.3) (3.2) (3.0) (2.6)
Trend Statements (2014 = 100%)

A major use of operating cash flows was for development property and equipment.

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The Kroger Co: Common-Size and Trend Analysis of Cash Flow Statements 2

Common-size cash flow statements are constructed by dividing each cash flow item by sales for the year.

EXHIBIT 6.13 The Kroger Co.

Common-Size and Trend Analysis of Selected Cash Flow Items

Fiscal Year: 2017 2016 2015 2014
Year Ended: February 3, 2018 January 28, 2017 January 30, 2016 January 31, 2015
Selected Items
Net cash provided by operating activities 81.0% 101.4% 116.7% 100.0%
Payments for property and equipment, including payment for lease buyouts 99.2 130.7 118.3 100.0

A major use of operating cash flows was for development property and equipment.

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Financial Ratios and Profitability Analysis

Before computing R O A, analysts may adjust the company’s reported earnings and asset figures. The adjustments fall into three broad categories:

Adjustments aimed at isolating a company’s sustainable profits by removing nonrecurring items from reported income.

An adjustment that eliminates after-tax interest expense from the profit calculation so that profitability comparisons over time or across companies are not affected by differences in financial structure.

Adjustments for distortions related to accounting quality concerns.

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The Kroger Co: Return on Assets

Before R O A is computed, adjustments are made to reported earnings each year to eliminate interest expense, net of its related tax savings. In addition, there is an adjustment to exclude the $902 million arising due to the enactment of the new tax law because it is a one-time nonrecurring item.

EXHIBIT 6.14 The Kroger Co.

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