Gibson Chapter 11 Expanded Analysis (Editted)

L14 - Chapter 11
Expanded
Analysis
COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson,

the Star logo, and South-Western are trademarks used herein under license.
Perceptions of Financial Ratios
• Commercial loan departments

• Corporate controllers
• CPAs
• Chartered financial analysts
Chapter 11, Slide #2

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Commercial Loan Departments
Significance Primary
Ratio Rating Measure
Debt/equity 8.71 Debt
Current ratio 8.25 Liquidity
Cash flow/current maturities
of long-term debt 8.08 Debt
Fixed charge coverage 7.58 Debt
Net profit margin after tax 7.56 Profitability
Times interest earned 7.50 Debt
Net profit margin before tax 7.43 Profitability
Degree of financial leverage 7.33 Debt
Inventory turnover in days 7.25 Liquidity
Accounts receivable turnover
in days 7.08 Liquidity

Corporate Controllers
Primary
Ratio Percentage* Measure
Earnings per share 80.6 Profitability
Debt/equity ratio 68.8 Debt
Return on equity after tax 68.5 Profitability
Dividend payout ratio 54.3 Other
Return on total invested capital after tax 53.3 Profitability
Accounts receivable turnover in days 47.3 Liquidity
Return on assets after tax 47.3 Profitability
*Percentage of firms indicating that the ratio was included in corporate objectives.

Certified Public Accountants
Accounts receivable turnover in days 6.94 Liquidity
After-tax return on equity 6.79 Profitability
Debt/equity ratio 6.78 Debt
Quick (acid test) ratio 6.77 Liquidity
Return on total invested capital after tax 6.30 Profitability
Inventory turnover in days 6.09 Liquidity

Chartered Financial Analysts
Return on equity after tax 8.21 Profitability
Price/earnings ratio 7.65 Other
Earnings per share 7.58 Profitability
Return on equity before tax 7.41 Profitability
Fixed charge coverage 7.22 Debt
Quick (acid test) ratio 7.10 Liquidity
Times interest earned 7.06 Debt

Comparison of Responses by
Loan Departments, Controllers, CPAs, and CFAs
Significance Loan Corporate
Ranking Departments Controllers CPAs CFAs
Earnings per Return on
1 Debt/Equity Current Ratio
Share Equity After Tax
Debt/Equity Accts Rec Price/Earnings
2 Current Ratio
Ratio Turnover Ratio
Cash
Return on Return on
Flow/Current Earnings per
3 Equity After Equity After
Maturities LT Share
Tax Tax
Debt
Fixed Charge Debt/Equity Net Profit
4 Current ratio
Coverage Ratio Margin
Net Profit Net Profit Return on
5 Margin After Margin After Quick Ratio Equity Before
Tax Tax Tax
Key: Debt Liquidity Profitability Other

Financial Ratios in Annual Reports
Number President's Management Management Financial Financial
Included Letter Discussion Highlights Review Summary
Earnings per share 100 66 5 98 45 93
Dividends per share 98 53 10 85 49 88
Book value per share 84 10 3 53 18 63
Working capital 81 1 1 50 23 67
Return on equity 62 28 3 21 23 37
Profit margin 58 10 3 21 23 35
Effective tax rate 50 2 1 2 46 6
• Ratios related to profitability and investing most frequently included

• Computation of ratios not consistent
• No regulatory agency currently accepts responsibility for determining content or format for presentation of ratios in annual reports

Conservatism and Quality of Earnings
• Conservatism
– Achieved through the slowest reporting of net income
– Yields higher quality of earnings
• Inventory (in periods of inflation)
– LIFO reports highest cost of goods sold and lowest
asset (inventory) value
• Fixed Assets
– Accelerated depreciation methods
– Shorter life estimates

Conservatism and Quality of Earnings
(cont’d)
• Intangible Assets
– Shorter life estimates
– Expensing of R&D as incurred
• Pensions
– Assumed discount rate
– Rate of compensation increase

Forecasting Financial Failure
• Financial failure defined as

– Liquidation
– Deferment of payments on debt
– Passing on preferred dividend
• Financial failure criteria
– No standard set of criteria

Forecasting Financial Failure (cont’d)
• Isolate ratios that may forecast failure;

construct model
– Used by management as a preventative measure
– Used by investors in portfolio management
– Used by creditors in lending decisions
– Used by auditor to assess ‘going concern’ status
• Recognized models
– Univariate [Beaver]
– Multivariate [Altman]

Univariate [Beaver] Model
• Single variable
• Identified ratios
– Cash flow/total debt
– Net income/total assets (return on assets)
– Total debt/total assets (debt ratio)
• Observed relationships
– Failed firms have less cash
– Failed firms have higher receivables
– Failed firms have less inventory

Multivariate [Altman] Model
• Multiple regression model with five ratios
Z = .012X1 + .014X2 + .033X3 + .006X4 + .010X5

X1 = Working Capital ÷ Total Assets
X2 = Retained Earnings ÷ Total Assets
X3 = Earnings Before Interest and Taxes ÷ Total Assets
X4 = Market Value of Equity ÷ Book Value of Total Debt
X5 = Sales ÷ Total Assets
• The lower the “Z” score, the more likely is failure

Forecasting Financial Failure
• Many academic studies exist

• Weaker ratios indicate higher risk of failure
• No conclusive model has been identified
• Use an integrated approach

Analytical Review Procedures
• Auditors isolate
– Significant fluctuations
– Unusual items
• Performed in various stages of the audit
– Planning
– Fieldwork as substantive tests
– Review

Management’s Use of Analysis
• Relative liquidity, debt, and profitability

– Financial ratios
– Common-size analysis
• Indicative of investor’s perception of the firm
• As part of corporation planning
– General and specific objectives
– Budgeting

Use of LIFO Reserves
• Firms that use LIFO for financial reporting

• Disclosure:
– LIFO cost basis of inventory
– Approximate current cost of that inventory
– Difference is the LIFO reserve

Use of LIFO Reserves (cont’d)
• Determine adjusted financial statement

information based on LIFO reserve
– Inventory
– Deferred income tax
– Cost of goods sold
– Net income
– Liquidity, debt, and profitability ratios

Graphing Financial Information
• Line graph
– A set of points connected by a line
– Shows change over time
25
20
Units (in millions)
15
10
0
2001 2002 2003 2004 2005 2006
Fiscal Year

Graphing Financial Information (cont’d)
• Column graph
– Most appropriate for accounting data
$35
$30
$25
Sales (000s)
$20
$15
$10
$5
$0
Apr May Jun Jul Aug Sep
Canoes Tents Bikes

Graphing Financial Information (cont’d)
• Pie graph
– Presented in segments
– Segments aggregate to 100%
Jan
Apr
18%
22%
Feb
26%
Mar
34%

Management of Earnings
• Cash basis of accounting
– Recognize revenue when cash is collected
– Recognize expenses when cash is paid
– Does not usually provide reasonable determination of income
over the short run
• Accrual basis of accounting
– Usually provides reasonable determination of income over the
short run
– Realization concept (revenue recognized when earned)
– Matching concept (expenses recognized when incurred)
– Requires use of estimates, assumptions, and judgment

Management of Earnings (cont’d)
• Manipulate earnings through

– Improper use of estimates
– Improper judgment
– Intentional errors
• Revenue recognition is often the focus of
financial manipulation
– Premature recognition of revenue
– Inventory cutoff
– Receivable timing and valuation

Enron
• 2001
– October: reduced after-tax income by $500 million
– November: restated 1997–2000 net income
– December: filed for bankruptcy
• Techniques
– Special-purpose entities
– Complex and opaque financial statements

WorldCom
• 2002
– June: $3.8 billion of overstated profits over 5
quarters
– November: special bankruptcy court examiner
reported that the improper accounting would
exceed $7.2 billion
• Techniques
– Moved funds from reserve accounts to bolster
profits
– Capitalized operating costs

Valuation
• A process of estimating the value of a firm or

some component of a firm
• Approaches to valuation
– Fundamental analysis
– Discounted valuation models

Fundamental Valuation Analysis
• Acceptance
– Not well accepted by traditional financial literature
– Preferred by security analysts and fund managers
• Utilize basic accounting measures
– Reported earnings
– Cash flow
– Book value
• Use one or more multiples
– Price-to-earnings
– Price-to-book
– Price-to-operating cash flow
– Price-to-sales

Multiperiod Discounted Valuation
Models
• Acceptance
– Strongly supported by financial literature
– Not widely used by analysts
• Discounted earnings models
– Discounted abnormal earnings
– Residual income
• Discounted cash flow models
– Free cash flow
– Dividend discount model
– Discounted cash flow

Discounted Earnings Models
• Discounted abnormal earnings (DAE)
– The value of the firm’s equity is the sum of its book value and
discounted forecasts of abnormal earnings.
– The valuation model looks at the expected profit that can be
generated by the management.
– If the earnings are higher than expected, an investor would be willing
to pay more than the book value, and if it’s not expected to achieve
the same, the investor would not be willing to pay anything more
than the book value. In fact, he would like to receive the same on
discount.
• The discounting factor used should be the return required on equity
rather than the weighted average cost of capital. If the second half of the
formula is positive, it means that the management is creating value by
delivering higher than expected returns for the shareholders.
• Value of the Stock = Book Value + Perpetual Value of Future Expected

Residual Incomes
Residual income Valuation (RI)
- Discounted future expected earnings

–Earnings are a periodic measure of shareholder wealth creation
Residual Income= Net Income – Equity Capital * Cost of Equity

Residual Income = Net Income – Equity Charge
• After the calculation of residual incomes, the intrinsic value of a stock can be
determined as the sum of the current book value of the company’s equity and
the present value of future residual incomes discounted at the relevant cost of
equity.
• The valuation formula for the residual income model can be expressed in the
following way:
•
• Where:
• BV0 – Current book value of the company’s equity
• RIt – Residual income of a company at time period t
• r – Cost of equity
Discounted Cash Flow Models
• Free cash flow (FCF)

– The projected future stream of free cash flows are
discounted to the present
Operating cash flows

– Interest
– Cash outlays for operating capacity
– Debt repayments
– Preferred dividends
= Free cash flow

Discounted Cash Flow Models (cont’d)
• Dividend discount model (DDM)
– The projected future stream of common stock dividends are discounted to the
present
• Discounted cash flow (DCF)
– Projected future cash flows are discounted to the present at the firm’s cost of capital
– Discounted cash flow (DCF) is a valuation method used to estimate the value of an
investment based on its expected future cash flows.
• The value of any asset is the present value of all future cash flows it is expected to
provide over the relevant time period.
• The value of any asset at time zero, V0, can be expressed as
Where
v0= Value of the asset at time zero
CFT= cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period

What Analysts Use
• Barker European Accounting Review (1999,8:2)

– Price-earnings ratio was the preferred method of valuation
– Valuation models are important in the context of one another
rather than in isolation
• Demirakos, et al Accounting Horizons (2004,18:4)
– Price-earnings ratio is predominant
– Analysis tailor valuation methodologies to the industry
• Asquith, et al Journal of Financial Economics
(2005,75)
– Market-to-book value used as the asset multiple

Valuation and Management Consultants
• Discounted cash flows provide a more reliable picture of

a company’s value than an earnings-multiple approach
• Discounted cash flows drive the value of a company
• Focus on long-term cash flows
– Short-term cash flows are subject to manipulation
• Mergers and acquisitions
– Shareholders of the acquired company experience greater
returns
– Acquiring companies may pay too much for the acquired
company


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L14 - Chapter 11

COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson,

• Commercial loan departments

Chapter 11, Slide #2

Chapter 11, Slide #3

Chapter 11, Slide #4

Chapter 11, Slide #5

Chapter 11, Slide #6

Key: Debt Liquidity Profitability Other

• Ratios related to profitability and investing most frequently included

Chapter 11, Slide #8

Chapter 11, Slide #9

Chapter 11, Slide #10

• Financial failure defined as

Chapter 11, Slide #11

• Isolate ratios that may forecast failure;

Chapter 11, Slide #12

Chapter 11, Slide #13

• Multiple regression model with five ratios

Z = .012X1 + .014X2 + .033X3 + .006X4 + .010X5

• The lower the “Z” score, the more likely is failure

Chapter 11, Slide #14

• Many academic studies exist

Chapter 11, Slide #15

Chapter 11, Slide #16

• Relative liquidity, debt, and profitability

Chapter 11, Slide #17

• Firms that use LIFO for financial reporting

Chapter 11, Slide #18

• Determine adjusted financial statement

Chapter 11, Slide #19

Chapter 11, Slide #20

Canoes Tents Bikes

Chapter 11, Slide #22

Chapter 11, Slide #23

• Manipulate earnings through

Chapter 11, Slide #24

Chapter 11, Slide #25

Chapter 11, Slide #26

• A process of estimating the value of a firm or

Chapter 11, Slide #27

Chapter 11, Slide #28

Chapter 11, Slide #29

• Value of the Stock = Book Value + Perpetual Value of Future Expected

- Discounted future expected earnings

Residual Income= Net Income – Equity Capital * Cost of Equity

• Free cash flow (FCF)

Operating cash flows

Chapter 11, Slide #32

Chapter 11, Slide #33

• Barker European Accounting Review (1999,8:2)

Chapter 11, Slide #34

• Discounted cash flows provide a more reliable picture of

Chapter 11, Slide #35

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