Part A: Reformatting financial statements

The steps involved in Business Analysis
Step 1 – Understanding the
Business
e.g.:
• The Product market
• The Competition
• The Regulatory Constraints
• Business strategies
Step 2 – Analyzing Information
– Accounting Analysis and
Financial Analysis
• Quality of Accounting
information?
• Re-formatting to uncover
business activities
• Ratio and cash flow analysis
Step 3 – Prospective
analysis: Forecasting
• Profit and Loss
• Balance Sheet
• Cash Flow
Step 4 – Prospective
analysis: Valuation
• RIM
• Alternatives
• Sensitivity
Step 5 – Application
for example:
• Outside Investor
Compare Value with Price to BUY,
SELL, or HOLD
• Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy
Strategy
22319 Financial Statement Analysis 2
Learning Objectives
At the conclusion of this lecture you should
understand:

1. Why reformatting the financial
   statements is important
2. How to reformat financial statements
   22319 Financial Statement Analysis 3
   Return on Equity
   ROE is one of the most important financial indicators
   of firm performance
   Return on Equity = Net Income / Average Owners
   Equity
   ROE = NI / AvgOE
   22319 Financial Statement Analysis 4
   Return on Equity
   Example A:
   I save $1,000,000 and buy an apartment in Sydney.
   After 4 years, I sell the apartment for $1,200,000.
   Owners Equity = 1,000,000
   Profit = $200,000
   ROE = 20%
   22319 Financial Statement Analysis 5
   Return on Equity
   Example B:
   I save $500,000, and borrow $500,000 at 3% interest
   p.a. from the bank and buy an apartment in Sydney.
   After 4 years, I sell the apartment for $1,200,000.
   Owners Equity = 500,000
   Profit = 140,000 ($200,000 – 60,000 interest expense)
   ROE = 28%
   22319 Financial Statement Analysis 6
   Return on Equity
   The same ‘business operations’ of buying a house for
   $1,000,000 and selling it for $1,200,000 resulted in a
   different ROE.
   Borrowing money leveraged up the return.
   Lesson: ROE is influenced by both business
   operations, and how the business is financed
   22319 Financial Statement Analysis 7
   Return on Equity – Traditional DuPont
   Original ROE formula
   ROE = NI / AvgOE
   Traditional DuPont model for ROE
   ROE = (NI / Sales) * (Sales / Avg Total Assets) * (Total Assets / AvgOE)
   Profit Margin (PM) = NI / Sales
   Asset Turnover (ATO) = Sales / Total Assets
   Leverage (FLEV) = Total Assets / AvgOE
   22319 Financial Statement Analysis 8
   Return on Equity – Traditional DuPont
   Traditional DuPont model for ROE
   ROE = (NI / Sales) * (Sales / Avg Total Assets) * (Total Assets / AvgOE)
   Profit Margin (PM) = NI / Sales
   Asset Turnover (ATO) = Sales / Total Assets
   Leverage (FLEV) = Total Assets / AvgOE
   To understand business performance you need to
   understand the operations and financing of the firm.
   22319 Financial Statement Analysis 9
   Return on Equity – Traditional DuPont
   Example A:
   I save $1,000,000 and buy an apartment in Sydney.
   After 4 years, I sell the apartment for $1,200,000.
   Traditional Dupont Analysis
   PM = 200,000 / 1,200,000 = 16.67%
   ATO = 1,200,000 / 1,000,000 = 1.2
   Leverage = 1,000,000/1,000,000 = 1
   ROE = 16.67% * 1.2 * 1 = 20%
   22319 Financial Statement Analysis 10
   Return on Equity – Traditional DuPont
   Example B:
   I save $500,000, and borrow $500,000 at 3% interest
   p.a. from the bank and buy an apartment in Sydney.
   After 4 years, I sell the apartment for $1,200,000.
   Traditional Dupont Analysis
   PM = 140,000 / 1,200,000 = 11.67%
   ATO = 1,200,000 / 1,000,000 = 1.2
   Leverage = 1,000,000/ 500,000 = 2
   ROE = 11.67% * 1.2 * 2 = 28%
   22319 Financial Statement Analysis 11
   Interest expense
   lowered the
   Profit Margin
   Return on Equity – Traditional DuPont
   The financing decision influenced the calculation of
   operational performance.
   The Profit Margin (PM) was decreased due to interest
   expense lowering the net profit (NI).
   We want to compare the operational performance of
   different firms without the effects of financing
   Traditional DuPont analysis does not cleanly separate
   the effect of financing and operating decisions
   22319 Financial Statement Analysis 12
   Value Creation
   Firms create value when they earn a return higher than their cost
   of capital.
   i.e. ROE is larger than their Cost of Capital
   Firms create value with their operating and investing activities.
   i.e. Assets and liabilities are used in selling goods and services.
   22319 Financial Statement Analysis 13
   Value Creation
   Value is distributed by financing activities
   i.e. Raising cash for operations, and disbursing excess cash from
   operations.
   Financing activities occur at the cost of capital. They do not
   create value
   22319 Financial Statement Analysis 14
   Value Creation – Example
   Company A
    100,000 shares outstanding, and a share price of $45
    Market capitalization is $4,500,000 (100,000*$45)
    Company A engage in a financing transaction. They sell an
   additional 10,000 shares at the current market price of $45
   Did that transaction create value?
    Market capitalization increases to $4,950,000 (110,000 * $45)
    The share price stays at $45.
    No value is created
   22319 Financial Statement Analysis 15
   Value Creation – Example
   Company B
    100,000 shares outstanding, and a share price of $45
    Market capitalization is $4,500,000 (100,000$45)  Company A engage in a financing transaction. They try to sell an additional 10,000 shares for $50 per share. Did that transaction create value?  No one will buy the shares at $50 each, if they are currently trading at $45.  No value is created 22319 Financial Statement Analysis 16 Value Creation – Example Company C  100,000 shares outstanding, and a share price of $45  Market capitalization is $4,500,000 (100,000$45)
    Company A engage in a financing transaction. They sell an
   additional 10,000 shares below the current market price – for $40
   Did that transaction create value?
    Market capitalization increases to $4,900,000 (10,000 * $40 +
   4,500,000)
    The share price drops to $44.55 ($4,900,000 / 110,000 shares =
   $44.55)
    Value is destroyed
   22319 Financial Statement Analysis 17
   Value Creation – Example
   Financing activities occur at the cost of capital.
   They do not create value
   The share price never goes up from just selling more
   shares
   They can destroy value for existing shareholders
   The share price can decrease from selling more shares
   below market price
   22319 Financial Statement Analysis 18
   Value Creation
    Modigliani & Miller (1961) –
   Dividend Irrelevance Theory
    Dividend payments are irrelevant to
   the value of the firm
    Paying a dividend won’t create or
   destroy value.
    It simply distributes value
   22319 Financial Statement Analysis 19
   Return on Equity – Advanced DuPont
   We need to conduct an Advanced DuPont analysis to
   separate the effects of financing and operating decisions to
   better analyse business performance and understand value
   creation.
   To conduct Advanced DuPont analysis we need to first
   reformat the financial statements
   Reformatting the financial statements involves classifying
   every Income Statement and Balance Sheet account as
   either an Operating or Financing activity

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