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OVERVIEW OF FINANCIAL STATEMENT ANALYSIS We view effective financial statement analysis as a three-legged stool, as Exhibit 1.1 depicts. The three legs of the stool in the figure represent effective analysis based on the following: 1. Identifying the economic characteristics of the industries in which a firm participates and the relation of those economic characteristics to various financial statement ratios 2. Describing the strategies that a firm pursues to differentiate itself from competitors as a basis for evaluating a firm’s competitive advantages, the sustainability of a firm’s earnings, and its risks  Evaluating the financial statements, including the accounting concepts and methods that underlie them and the quality of the information they provide
Our approach to effective analysis of financial statements for valuation and many other decisions involves six interrelated sequential steps, depicted in Exhibit 1.2. 1. Identify the economic characteristics and competitive dynamics of the industry in which a particular firm participates.What dynamic forces drive competition in the industry? For example, does the industry include a large number of firms selling similar products, such as grocery stores, or only a small number of competitors selling unique products, such as pharmaceutical companies? Does technological change play an important role in maintaining a competitive advantage, as in computer software? Are industry sales growing rapidly or slowly? 2. Identify the strategies the firm pursues to gain and sustain a competitive advantage. What business model is the firm executing to be different and successful in its industry? Does the firm have competitive advantages? If so, how sustainable are they? Are its products designed to meet the needs of specific market segments, such as ethnic or health foods, or are they intended for a broader consumer market, such as typical grocery stores and family restaurants? Has the firm integrated backward into the growing or manufacture of raw materials for its products, such as a steel company that owns iron ore mines? Has the firm integrated forward into retailing to final consumers, such as an athletic footwear manufacturer that operates retail stores to sell its products? Is the firm diversified across several geographic markets or industries? 3. Assess the quality of the firm’s  financial statements and, if necessary, adjust them for such desirable characteristics as sustainability or comparability. Do the firm’s financial statements provide an informative and complete representation of the firm’s economic performance, financial position, and risk? Has the firm prepared its financial statements in accordance with GAAP in the United States or some other country, or are they prepared in accordance with the IFRS established by the International Accounting Standards Board (IASB)? Does the balance sheet provide a faithful representation of the economic resources and obligations of the firm? Does the firm recognize revenues at the appropriate time, after considering the uncertainties regarding the collectibility of cash from customers? Does the firm recognize expenses at the appropriate time? Do earnings include nonrecurring gains or losses, such as a write-down of an equity investment or goodwill, which the analyst should evaluate differently from recurring components of earnings? Has the firm structured transactions or commercial arrangements or has it selected accounting principles to appear more profitable or less risky than economic conditions otherwise suggest? 4. Analyze the current profitability and risk of the firm using information in the financial statements. Most financial analysts assess the profitability of a firm relative to the risks involved. What rate of return is the firm generating from the use of its assets? How much return is the firm generating for the equity capital invested? Is the firm’s profit margin increasing or decreasing over time? Are returns and profit margins higher or lower than those of its key competitors? How much leverage does the firm have in its capital structure? How much of the leverage consists of debt financing that will come due in the short-term versus the long-term? Ratios that reflect relations among particular items in the financial statements are the tools used to analyze profitability and risk. 5. Prepare forecasted financial statements. What will be the firm’s future resources, obligations, investments, cash flows, revenues, and expenses? What will be the likely future profitability and risk and, in turn, the likely future returns from investing in the company? Forecasts of a firm’s ability to manage risks, particularly those elements of risk with measurable financial consequences, permit the analyst to estimate the likelihood that the firm will experience financial difficulties in the future. Forecasted financial statements that rely on the analyst’s projections of the firm’s future operating, investing, and financing activities provide the basis for projecting future profitability and risk. 6. Value the firm. What is the firm worth? What is the value of the firm’s common shares? Financial analysts use their estimates of share value to make recommendations to buy, sell, or hold the equity securities of various firms whose market price they think is too low, too high, or about right. Investment banking firms that underwrite the initial public offering of a firm’s common stock must set the initial offering price. Financial analysts in corporations considering whether to acquire a company (or to divest a subsidiary or division) must assess a reasonable range of values to bid in order to acquire a target (or to expect to receive from a divestiture). Translating information
CHE-WAHLEN-09-1211-001.qxd:.  6/30/10  2:58 PM  Page 4
Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Step 1: Identify the Industry Economic Characteristics 5
from the financial statements into reliable estimates of firm value (and therefore into intelligent investment  decisions) is the principal activity of financial analysts. These six interrelated steps represent the subject matter of this book. We use these six steps as the analytical framework for analysts to follow in their efforts to analyze and value a company. This chapter briefly explores each step. Subsequent chapters develop the important concepts and tools in considerably more depth. Throughout this book, we use financial statements, notes, and other information provided by PepsiCo, Inc. and Subsidiaries (PepsiCo) to illustrate the various topics discussed. Appendix A at the end of the book includes the fiscal year 2008 financial statements and notes for PepsiCo, as well as statements by management and the opinion of the independent accountant regarding these financial statements. Appendix B includes excerpts from a financial review provided by management that discusses the business strategy of PepsiCo; it also offers explanations for changes in PepsiCo’s profitability and risk over time. Appendix C presents the output of the FSAP (Financial Statements Analysis Package), which is the financial statement analysis software that accompanies this book. The FSAP model is an Excel add-in that enables analysts to enter financial statement data, after which the model computes a wide array of profitability and risk ratios and creates templates for forecasting future financial statements and estimating a variety of valuation models. Appendix C presents the use of FSAP for PepsiCo for recent years, including PepsiCo’s profitability and risk ratios, projected future financial statements, and valuation. FSAP is available at www.cengage.com/ accounting/wahlen. You can use FSAP for many of the problems and cases in this book to aid in your analysis (FSAP applications are highlighted with the FSAP icon in the margin of the text). FSAP contains a user manual with guides to assist you. Appendix D presents tables of descriptive statistics on a wide array of financial ratios across 48 industries.
STEP 1: IDENTIFY THE INDUSTRY ECONOMIC CHARACTERISTICS The economic characteristics and competitive dynamics of an industry play a key role in influencing the strategies firms in the industry will employ and therefore the types of financial statement relationships the analyst should expect to observe when analyzing a set of financial statements. Consider, for example, the financial statement data for firms in four different industries shown in Exhibit 1.3. This exhibit expresses all items on the balance sheets and income statements as percentages of revenue. Consider how the economic characteristics of these industries affect their financial statements. Grocery Store Chain
 
. Grocery stores, however, need relatively few assets to generate sales
Thus, extensive competition and nondifferentiated products result in a relatively low net income to sales, or profit margin
Pharmaceutical Company
These high entry barriers (research and development expenditures, government approval process, patent protection) permit pharmaceutical firms to realize much higher profit margins on approved patent-protected products compared to the profit margins of grocery stores.
Because of these business risks, pharmaceutical firms tend to take on relatively small amounts of debt financing as compared to firms in industries such as electric utilities and commercial banks.
Electric Utility
The monopoly position and regulatory protection reduced the risk of financial failure and permitted electric utilities to invest large amounts of capital in long-lived assets and take on relatively high proportions of debt in their capital structures.
Commercial Bank
The principal assets of commercial banks are investments in financial securities and loans to businesses and consumers. The principal financing for commercial banks comes from customers’ deposits and short-term borrowings. Because customers can generally withdraw deposits at any time, commercial banks invest in securities that they can quickly convert into cash if necessary.
. Thus, one would expect a commercial bank to realize a small profit margin on the revenue it earns from lending (interest revenue) over the price it pays for its borrowed funds (interest expense). The profit margins on lending are indeed relatively small
TOOLS FOR STUDYING INDUSTRY ECONOMICS Three tools for studying the economic characteristics of an industry are (1) value chain analysis, (2) Porter’s five forces classification framework, and (3) an economic attributes framework. The microeconomics literature suggests other analytical frameworks as well.
Value Chain Analysis
The value chain for an industry sets forth the sequence or chain of activities involved in the creation, manufacture, and distribution of its products and services
Porter’s Five Forces Classification Framework
Porter suggests that five forces influence the level of competition and the profitability of firms in an industry. Three of the forces—rivalry among existing firms, potential entry, and substitutes—represent horizontal competition among current or potential future firms in the industry and closely related products and services. The other two forces—buyer power and supplier power—depict vertical competition in the value chain, from the suppliers through the existing rivals to the buyers. We discuss each of these forces next and illustrate them within the soft drink/beverage industry. Exhibit 1.7 depicts Porter’s five forces in the soft drink/beverage industry.
 

1. Rivalry among Existing Firms. Direct rivalry among existing firms is often the first order of competition in an industry. Some industries can be characterized by concentrated rivalry (such as a monopoly, a duopoly, or an oligopoly), whereas others have diffuse rivalry across many firms.

Economists often assess the level of competition with industry concentration ratios, such as a four-firm concentration index that measures the proportion of industry sales controlled by the four largest competitors. Economics teaches that in general, the greater the industry concentration, the lower the competition between existing rivals and thus the more profitable the firms will be
 

2. Threat of New Entrants. How easily can new firms enter a market? Are there entry barriers such as large capital investment, technological expertise, patents, or regulations that inhibit new entrants? Do the existing rivals have distinct competitive advantages (such as brand names) that will make it difficult for other firms to enter and compete successfully? If so, firms in the industry will likely generate higher profits than if new entrants can enter the market easily and compete away the excess profits.

 
3 Threat of Substitutes. How easily can customers switch to substitute products or services? How likely are they to switch?
 

4. Buyer Power. Buyer power relates to the relative number of buyers and sellers in a particular industry and the leverage buyers have with respect to price.

the buyer can exert significant downward pressure on prices and therefore on the profitability of suppliers. If there are few sellers and many buyers
Buyer power also relates to buyers’ price sensitivity and the elasticity of demand

5. Supplier Power.A similar set of factors with respect to leverage in negotiating prices applies on the input side as well. If an industry is comprised of a large number of potential buyers of inputs that are produced by relatively few suppliers, the suppliers will have greater power in setting prices and generating profits.

 
Economic Attributes Framework We find the following framework useful in studying the economic attributes of a business, in part because it ties in with items reported in the financial statements.

1. Demand

Demand is relatively insensitive to price. • There is low growth in the United States, but more rapid growth opportunities are available in other countries. • Demand is not cyclical. • Demand is higher during warmer weather
 
Supply

• Two principal suppliers (PepsiCo and Coca-Cola) sell branded products. • Branded products and domination of distribution channels by two principal suppliers create significant competitive advantages.

Manufacturing

• Manufacturing process for concentrate and syrup is not capital-intensive. • Bottling and distribution of final product is capital-intensive. • Manufacturing process is simple (essentially a mixing operation) with some tolerance for quality variation.

Marketing

• Brand recognition and established demand pull products through distribution channels, but advertising can stimulate demand to some extent.

Investing and Financing

• Bottling operations and transportation of products to retailers require long-term financing. • Profitability is relatively high and growth is slow in the United States, leading to excess cash flow generation. Growth markets in other countries require financing from internal domestic cash flow or from external source

 
 
 
 
 
STEP 2: IDENTIFY THE COMPANY STRATEGIES Firms establish business strategies to differentiate themselves from competitors, but an industry’s economic characteristics affect the flexibility that firms have in designing these strategies. In some cases, firms can create sustainable competitive advantages.
 
Framework for Strategy Analysis The set of strategic choices confronting a particular firm varies across industries. The following framework dealing with product and firm characteristics helps the analyst identify and structure the set of trade-offs and choices a firm must face
 
Nature of Product or Service. Is a firm attempting to create unique products or services for particular market niches, thereby achieving relatively high profit margins (referred to as a product differentiation strategy)? Or is it offering nondifferentiated products at low prices, accepting a lower profit margin in return for a higher sales volume and market share (referred to as a low-cost leadership strategy)? Is a firm attempting to achieve both objectives by differentiating (perhaps by creating brand loyalty or technological innovation) and being price competitive by maintaining tight control over costs?
 

2. Degree of Integration in Value Chain. Is the firm pursuing a vertical integration strategy, participating in all phases of the value chain, or selecting just certain phases in the chain? With respect to manufacturing, is the firm conducting all manufacturing operations itself (as usually occurs in steel manufacturing), outsourcing all manu- facturing (common in athletic shoes), or outsourcing the manufacturing of components but conducting the assembly operation in-house (common in automobile and computer hardware manufacturing)? With respect to distribution, is the firm maintaining control over the distribution function or outsourcing it? Some restaurant chains, for example, own all of their restaurants, while other chains operate through independently owned franchises. Computer hardware firms have recently shifted from selling through their own sales staffs to using various indirect sellers, such as value-added resellers and systems integrators—in effect shifting from in-house sourcing to outsourcing of the distribution function.
3. Degree of Geographical Diversification. Is the firm targeting its products to its domestic market or integrating horizontally across many countries? Operating in other countries creates opportunities for growth but exposes firms to risks from changes in exchange rates, political uncertainties, and additional competitors.
4. Degree of Industry Diversification. Is the firm operating in a single industry or diversifying across multiple industries? Operating in multiple industries per firms to diversify product, cyclical, regulatory, and other risks encountered when operating in a single industry but raises questions about management’s ability to understand and manage multiple and different businesses effectively

 
STEP 3: ASSESS THE QUALITY OF THE FINANCIAL STATEMENTS Business firms prepare three principal financial statements to report the results of their activities: (1) balance sheet, (2) income statement, and (3) statement of cash flows. Many firms prepare a fourth statement, the statement of shareholders’ equity, which provides further detail of the shareholders’ equity section of the balance sheet. Firms also include a set of notes that elaborate on items included in these statements. Together, the financial statements and notes provide an extensive set of information about the firm’s financial position, performance, and cash flows. The statements provide insights to an analyst about the firm’s profitability, risk, and growth. Using the financial statements and notes for PepsiCo in Appendix A as examples, this section presents a brief overview of the purpose and content of each of these three financial statements. Understanding accounting concepts and methods and evaluating the quality of a firm’s financial statements is a central element of effective financial statement analysis .
 
Assessing the quality of financial accounting information,
è The format of the four statements, and the connections among the statements
è How do we define quality of financial information? Economic position
è How quality of financial information can be challenged
On the balance sheet,
è recognition, valuation of assets
è measurement basis, historical cost or fair value?
liabilities, same concerns.
On the income statement,
è accrual basis recognition, timing issues
è which income number matters? Above the line, below the line, where is the line? Look at an income statement.
Other comprehensive income
On the cash flow statement,
è Cash inflow and accounting income, which matters?
Notes to financial statements,
 
 

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