Financial Analysis

3rd Edition

Steven M. Bragg

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Table of Contents Chapter 1 – Overview of Financial Analysis ......................................................................................... 1

Learning Objectives ............................................................................................................................. 1 Introduction .......................................................................................................................................... 1 The Purpose of Financial Analysis ....................................................................................................... 1 Key Financial Analysis Concepts ......................................................................................................... 2 Judgment in Financial Analysis ............................................................................................................ 3 Precision of Financial Analysis ............................................................................................................. 3 Death by a Thousand Cuts .................................................................................................................. 4 Monitoring Analysis .............................................................................................................................. 4 Role of the Financial Analyst ................................................................................................................ 5 A Conservative Bias............................................................................................................................. 6 Summary ............................................................................................................................................. 6 Review Questions ................................................................................................................................ 7 Review Answers .................................................................................................................................. 8

Chapter 2 – The Financial Statements .................................................................................................. 9 Learning Objectives ............................................................................................................................. 9 Introduction .......................................................................................................................................... 9 The Income Statement ......................................................................................................................... 9

Income Statement Overview ............................................................................................................ 9 The Single-Step Income Statement ................................................................................................ 11 The Multi-Step Income Statement .................................................................................................. 12 The Contribution Margin Income Statement ................................................................................... 13 The Multi-Period Income Statement ............................................................................................... 13

The Balance Sheet ............................................................................................................................ 14 Overview of the Balance Sheet ...................................................................................................... 14 The Comparative Balance Sheet .................................................................................................... 18

The Statement of Cash Flows ............................................................................................................ 19 Overview of the Statement of Cash Flows ...................................................................................... 19 The Direct Method ......................................................................................................................... 19 The Indirect Method ....................................................................................................................... 21

The Statement of Retained Earnings .................................................................................................. 21 Overview of the Statement of Retained Earnings............................................................................ 21

Financial Statement Disclosures ........................................................................................................ 22 Summary ........................................................................................................................................... 28 Review Questions .............................................................................................................................. 29 Review Answers ................................................................................................................................ 30

Chapter 3 – Accounting Issues Impacting the Financials ................................................................. 31 Learning Objectives ........................................................................................................................... 31 Introduction ........................................................................................................................................ 31 The Basis of Accounting .................................................................................................................... 31

Accrual Basis of Accounting ........................................................................................................... 31 Cash Basis of Accounting .............................................................................................................. 32 Modified Cash Basis of Accounting ................................................................................................ 32

Effect of the Fiscal Year ..................................................................................................................... 33 Recordation of Revenue at Gross or Net ............................................................................................ 33 Bill and Hold Revenue ....................................................................................................................... 34 Negative Cash ................................................................................................................................... 34 Inventory Costing Methods ................................................................................................................ 35 Depreciation Methods ........................................................................................................................ 36 Current Value Accounting .................................................................................................................. 37 Illusory Profits .................................................................................................................................... 37 Financial Statement Reporting Issues ................................................................................................ 38

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Headline Earnings.......................................................................................................................... 38 Pro Forma Earnings ....................................................................................................................... 38 Window Dressing ........................................................................................................................... 39

Auditor Certification ........................................................................................................................... 39 Summary ........................................................................................................................................... 40 Review Questions .............................................................................................................................. 41 Review Answers ................................................................................................................................ 42

Chapter 4 – Interpretation of Financial Statements ........................................................................... 43 Learning Objectives ........................................................................................................................... 43 Introduction ........................................................................................................................................ 43 Interpretation of Financial Statements ................................................................................................ 43 Horizontal Analysis ............................................................................................................................ 44 Vertical Analysis ................................................................................................................................ 45 Cash Coverage Ratio ......................................................................................................................... 46 Current Ratio ..................................................................................................................................... 47 Quick Ratio ........................................................................................................................................ 48 Liquidity Index .................................................................................................................................... 48 Accounts Payable Turnover Ratio ...................................................................................................... 49 Accounts Receivable Turnover Ratio ................................................................................................. 50 Inventory Turnover Ratio .................................................................................................................... 50 Fixed Asset Turnover Ratio ................................................................................................................ 51 Sales to Working Capital Ratio ........................................................................................................... 51 Debt to Equity Ratio ........................................................................................................................... 52 Fixed Charge Coverage ..................................................................................................................... 53 Breakeven Point ................................................................................................................................ 53 Gross Profit Ratio .............................................................................................................................. 54 Net Profit Ratio .................................................................................................................................. 54 Return on Net Assets ......................................................................................................................... 55 EBITDA ............................................................................................................................................. 55 NOPAT .............................................................................................................................................. 56 Limitations of Ratio Analysis .............................................................................................................. 57 Summary ........................................................................................................................................... 58 Review Questions .............................................................................................................................. 59 Review Answers ................................................................................................................................ 60

Chapter 5 – Cost-Volume-Profit Analysis ........................................................................................... 61 Learning Objectives ........................................................................................................................... 61 Introduction ........................................................................................................................................ 61 Contribution Margin ........................................................................................................................... 61 Breakeven Point ................................................................................................................................ 62 Margin of Safety................................................................................................................................. 64 Cost-Volume-Profit Analysis............................................................................................................... 65 Sales Mix ........................................................................................................................................... 67 Summary ........................................................................................................................................... 68 Review Questions .............................................................................................................................. 69 Review Answers ................................................................................................................................ 70

Chapter 6 – Pricing Decisions............................................................................................................. 71 Learning Objectives ........................................................................................................................... 71 Introduction ........................................................................................................................................ 71 Psychological Pricing ......................................................................................................................... 71 Cost Plus Pricing ............................................................................................................................... 72 Dynamic Pricing ................................................................................................................................. 73 Freemium Pricing ............................................................................................................................... 74 High-Low Pricing................................................................................................................................ 75 Premium Pricing ................................................................................................................................ 75

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Time and Materials Pricing ................................................................................................................. 76 Value Based Pricing........................................................................................................................... 78 Other Pricing Strategies ..................................................................................................................... 79 When to Review Pricing ..................................................................................................................... 80 Price Elasticity of Demand ................................................................................................................. 80 Cross Price Elasticity of Demand ....................................................................................................... 82 Non-Price Determinants of Demand ................................................................................................... 82 Summary ........................................................................................................................................... 83 Review Questions .............................................................................................................................. 84 Review Answers ................................................................................................................................ 85

Chapter 7 – Cost Object Analysis ....................................................................................................... 87 Learning Objectives ........................................................................................................................... 87 Introduction ........................................................................................................................................ 87 Factors in Cost Object Analysis.......................................................................................................... 87 The Assignability of Costs .................................................................................................................. 88 The Customer Cost Object ................................................................................................................. 89

Customer Acquisition Costs ........................................................................................................... 90 Customer Lifetime Value ................................................................................................................ 90

The Employee Cost Object ................................................................................................................ 91 The Product Cost Object .................................................................................................................... 92 The Product Line Cost Object ............................................................................................................ 93 The Sales Channel Cost Object ......................................................................................................... 94 Cost Object Termination Issues ......................................................................................................... 95 Which Cost Objects to Track .............................................................................................................. 95 Summary ........................................................................................................................................... 96 Review Questions .............................................................................................................................. 97 Review Answers ................................................................................................................................ 98

Chapter 8 – Constraint Analysis ......................................................................................................... 99 Learning Objectives ........................................................................................................................... 99 Introduction ........................................................................................................................................ 99 Constraint Analysis Operational Terminology ..................................................................................... 99 Overview of Constraint Analysis ....................................................................................................... 100 The Cost of the Bottleneck ............................................................................................................... 101 Local Optimization ........................................................................................................................... 102 Constraint Analysis Financial Terminology ....................................................................................... 103 Constraint Analysis from a Financial Perspective ............................................................................. 103 The Constraint Analysis Model ......................................................................................................... 103 The Decision to Sell at a Lower Price ............................................................................................... 105 The Decision to Outsource Production ............................................................................................. 106 The Capital Investment Decision ...................................................................................................... 107 The Decision to Cancel a Product .................................................................................................... 108 Summary ......................................................................................................................................... 109 Review Questions ............................................................................................................................ 110 Review Answers .............................................................................................................................. 111

Chapter 9 – Credit Decisions ............................................................................................................ 113 Learning Objectives ......................................................................................................................... 113 Introduction ...................................................................................................................................... 113 The Credit Rating ............................................................................................................................. 113 Internal Credit Rating Systems ......................................................................................................... 113 Third Party Credit Ratings ................................................................................................................ 115 Evaluating Credit Scores .................................................................................................................. 116 Use of Credit Ratings ....................................................................................................................... 117 Credit Rating Errors ......................................................................................................................... 117 Indicators of Future Payment Delinquency ....................................................................................... 117

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Ongoing Credit Monitoring Actions ................................................................................................... 118 Requests for Credit Increases .......................................................................................................... 121 The Riskiest Customers ................................................................................................................... 121 The Demanding Customer ............................................................................................................... 122 Effects of Industry Credit Practices................................................................................................... 123 Summary ......................................................................................................................................... 123 Review Questions ............................................................................................................................ 124 Review Answers .............................................................................................................................. 125

Chapter 10 – Financing Choices ....................................................................................................... 127 Learning Objectives ......................................................................................................................... 127 Introduction ...................................................................................................................................... 127 Overview of Debt Funding ................................................................................................................ 127 The Line of Credit ............................................................................................................................ 127 The Borrowing Base ........................................................................................................................ 128 Early Payment Discounting .............................................................................................................. 129 Invoice Discounting .......................................................................................................................... 130 Factoring ......................................................................................................................................... 131 Inventory Financing ......................................................................................................................... 131 Purchase Order Financing ............................................................................................................... 132 Leases ............................................................................................................................................. 132 The Long-Term Loan ....................................................................................................................... 132 Bonds .............................................................................................................................................. 133 Agency Financing ............................................................................................................................ 134 Deleveraging ................................................................................................................................... 134 Overview of Equity Funding ............................................................................................................. 135 Restricted Stock............................................................................................................................... 135 Unrestricted Stock ........................................................................................................................... 136 Warrants .......................................................................................................................................... 136 Angel Investors and Venture Capital ................................................................................................ 137 Crowdfunding .................................................................................................................................. 137 Private Investment in Public Equity .................................................................................................. 138 Debt for Equity Swaps ..................................................................................................................... 138 Summary ......................................................................................................................................... 139 Review Questions ............................................................................................................................ 140 Review Answers .............................................................................................................................. 141

Chapter 11 – Financial Leverage ...................................................................................................... 143 Learning Objectives ......................................................................................................................... 143 Introduction ...................................................................................................................................... 143 The Financial Leverage Concept ...................................................................................................... 143 Issues Impacting Leverage .............................................................................................................. 145 Leverage Risk .................................................................................................................................. 146 Impact of Compensation on Leverage .............................................................................................. 147 Summary ......................................................................................................................................... 147 Review Questions ............................................................................................................................ 148 Review Answers .............................................................................................................................. 149

Chapter 12 – Capital Structure Analysis........................................................................................... 151 Learning Objectives ......................................................................................................................... 151 Introduction ...................................................................................................................................... 151 Optimal Capital Structure ................................................................................................................. 151 Capital Structure Analysis ................................................................................................................ 152 Line of Credit Issues ........................................................................................................................ 153 Tax Shield Effects ............................................................................................................................ 153 Future Financing Flexibility............................................................................................................... 153 Loan Covenant Issues ..................................................................................................................... 154

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Maturity Structure of Debt ................................................................................................................ 154 Creditor Position Considerations ...................................................................................................... 155 Debt Paydown ................................................................................................................................. 155 Cost of Capital Reduction ................................................................................................................ 155 Planning for a Bond Rating .............................................................................................................. 156 Capital Structure Measurements ...................................................................................................... 157

Interest Coverage Ratio ............................................................................................................... 157 Debt Service Coverage Ratio ....................................................................................................... 157

Recapitalization ............................................................................................................................... 158 Timing of Changes to the Capital Structure ...................................................................................... 158 Summary ......................................................................................................................................... 158 Review Questions ............................................................................................................................ 159 Review Answers .............................................................................................................................. 160

Chapter 13 – Dividend Analysis ........................................................................................................ 161 Learning Objectives ......................................................................................................................... 161 Introduction ...................................................................................................................................... 161 The Investor Viewpoint .................................................................................................................... 161 The Company Viewpoint .................................................................................................................. 162 The Stock Buyback Option ............................................................................................................... 163 The Stock Dividend .......................................................................................................................... 164 Summary ......................................................................................................................................... 164 Review Questions ............................................................................................................................ 165 Review Answers .............................................................................................................................. 166

Chapter 14 – Foreign Exchange Risk Analysis ................................................................................ 167 Learning Objectives ......................................................................................................................... 167 Introduction ...................................................................................................................................... 167 Foreign Exchange Risk Overview .................................................................................................... 167 Foreign Exchange Risk Management ............................................................................................... 168

Take No Action ............................................................................................................................ 168 Avoid Risk ................................................................................................................................... 169 Shift Risk ..................................................................................................................................... 169 Time Compression ....................................................................................................................... 170 Payment Leading and Lagging ..................................................................................................... 170 Build Reserves............................................................................................................................. 170 Maintain Local Reserves .............................................................................................................. 171 Hedging ....................................................................................................................................... 171

Types of Foreign Exchange Hedges ................................................................................................ 172 Loan Denominated in a Foreign Currency .................................................................................... 172 The Forward Contract .................................................................................................................. 172 The Futures Contract ................................................................................................................... 173 The Currency Option .................................................................................................................... 174 The Cylinder Option ..................................................................................................................... 175 Swaps ......................................................................................................................................... 175

Netting ............................................................................................................................................. 176 Summary ......................................................................................................................................... 176 Review Questions ............................................................................................................................ 177 Review Answers .............................................................................................................................. 178

Chapter 15 – Interest Rate Risk Analysis ......................................................................................... 179 Learning Objectives ......................................................................................................................... 179 Introduction ...................................................................................................................................... 179 Interest Risk Overview ..................................................................................................................... 179 Interest Rate Risk Management ....................................................................................................... 179

Take No Action ............................................................................................................................ 179 Avoid Risk ................................................................................................................................... 180

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Asset and Liability Matching ......................................................................................................... 180 Hedging ....................................................................................................................................... 180

Types of Interest Rate Hedges ......................................................................................................... 180 The Forward Rate Agreement ...................................................................................................... 180 The Futures Contract ................................................................................................................... 182 The Interest Rate Swap ............................................................................................................... 184 Interest Rate Options ................................................................................................................... 185 Interest Rate Swaptions ............................................................................................................... 187

Summary ......................................................................................................................................... 188 Review Questions ............................................................................................................................ 189 Review Answers .............................................................................................................................. 190

Chapter 16 – Financial Forecasting .................................................................................................. 191 Learning Objectives ......................................................................................................................... 191 Introduction ...................................................................................................................................... 191 The Differences between a Budget and a Forecast .......................................................................... 191 The Run Rate Concept .................................................................................................................... 192 Sensitivity Analysis .......................................................................................................................... 192 Revenue Forecasting ....................................................................................................................... 193 The System of Budgets .................................................................................................................... 196 The Number of Budget Scenarios .................................................................................................... 199 The Rolling Forecast ........................................................................................................................ 200 The Cash Forecast .......................................................................................................................... 203

The Short-Term Cash Forecast .................................................................................................... 204 The Medium-Term Cash Forecast ................................................................................................ 207 The Long-Term Cash Forecast .................................................................................................... 207 The Use of Averages ................................................................................................................... 208 The Use of Clearing Dates in a Forecast ...................................................................................... 208

Summary ......................................................................................................................................... 209 Review Questions ............................................................................................................................ 210 Review Answers .............................................................................................................................. 211

Chapter 17 – Managing the Rate of Growth...................................................................................... 213 Learning Objectives ......................................................................................................................... 213 Introduction ...................................................................................................................................... 213 The Funding of Growth .................................................................................................................... 213 Contribution Margins and Sustainable Growth .................................................................................. 215 Organic Growth ............................................................................................................................... 215 Step Costs and Sales Growth .......................................................................................................... 216 Other Constraints on Growth ............................................................................................................ 217 Negative Effects of Excessive Growth .............................................................................................. 217 The Ideal Rate of Growth ................................................................................................................. 218 Summary ......................................................................................................................................... 219 Review Questions ............................................................................................................................ 220 Review Answers .............................................................................................................................. 221

Chapter 18 – The Cost of Capital ...................................................................................................... 223 Learning Objectives ......................................................................................................................... 223 Introduction ...................................................................................................................................... 223 Cost of Capital Derivation ................................................................................................................ 223

Cost of Debt................................................................................................................................. 223 Cost of Preferred Stock ................................................................................................................ 223 Cost of Common Stock ................................................................................................................ 224 Weighted Average Cost of Capital................................................................................................ 224

Variations in the Cost of Capital ....................................................................................................... 225 Adjustments to the Cost of Capital ................................................................................................... 227 Cost of Capital as a Threshold Value ............................................................................................... 227

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Summary ......................................................................................................................................... 228 Review Questions ............................................................................................................................ 229 Review Answers .............................................................................................................................. 230

Chapter 19 – Discounted Cash Flow Techniques ............................................................................ 231 Learning Objectives ......................................................................................................................... 231 Introduction ...................................................................................................................................... 231 Time Value of Money ....................................................................................................................... 231 Present and Future Value Tables ..................................................................................................... 232 Net Present Value ............................................................................................................................ 234 Internal Rate of Return ..................................................................................................................... 235 Incremental Internal Rate of Return.................................................................................................. 236 Terminal Value ................................................................................................................................ 236 Inclusions in Cash Flow Analysis ..................................................................................................... 237 Summary ......................................................................................................................................... 237 Review Questions ............................................................................................................................ 238 Review Answers .............................................................................................................................. 239

Chapter 20 – Capital Budgeting ........................................................................................................ 241 Learning Objectives ......................................................................................................................... 241 Introduction ...................................................................................................................................... 241 Overview of Capital Budgeting ......................................................................................................... 241 The Capital Request Form ............................................................................................................... 242 The Payback Method ....................................................................................................................... 243 Real Options .................................................................................................................................... 245 Capital Budget Proposal Analysis .................................................................................................... 246 Complex Systems Analysis .............................................................................................................. 247 Research and Development Funding Analysis ................................................................................. 247 The Outsourcing Decision ................................................................................................................ 249 The Post Installation Review ............................................................................................................ 249 Summary ......................................................................................................................................... 250 Review Questions ............................................................................................................................ 251 Review Answers .............................................................................................................................. 252

Chapter 21 – The Lease or Buy Decision ......................................................................................... 253 Learning Objectives ......................................................................................................................... 253 Introduction ...................................................................................................................................... 253 The Lease Arrangement .................................................................................................................. 253 The Lease or Buy Decision .............................................................................................................. 253 Leasing Concerns ............................................................................................................................ 254 Leasing Advantages ........................................................................................................................ 255 Summary ......................................................................................................................................... 256 Review Questions ............................................................................................................................ 257 Review Answers .............................................................................................................................. 258

Chapter 22 – Acquisition Valuation .................................................................................................. 259 Learning Objectives ......................................................................................................................... 259 Introduction ...................................................................................................................................... 259 Liquidation Value ............................................................................................................................. 259 Real Estate Value ............................................................................................................................ 259 Relief-from-Royalty Method.............................................................................................................. 260 Book Value ...................................................................................................................................... 260 Enterprise Value .............................................................................................................................. 262 Multiples Analysis ............................................................................................................................ 262 Discounted Cash Flows ................................................................................................................... 265

Post Five-Year Cash Flows .......................................................................................................... 265 Negotiation of DCF Contents ....................................................................................................... 265

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Replication Value ............................................................................................................................. 267 Comparison Analysis ....................................................................................................................... 268

The Comparison of Sales Multiples .............................................................................................. 268 The Comparison of Cash Flows ................................................................................................... 269 The Comparison of Contract Revenues ........................................................................................ 269

52-Week High .................................................................................................................................. 270 Influencer Price Point ....................................................................................................................... 270 The Initial Public Offering Valuation.................................................................................................. 270 The Strategic Purchase.................................................................................................................... 271 Intellectual Property Valuation .......................................................................................................... 271 Extraneous Valuation Factors .......................................................................................................... 271 The Control Premium ....................................................................................................................... 272 The Earnout ..................................................................................................................................... 272 Synergy Analysis ............................................................................................................................. 273 The Valuation Floor and Ceiling ....................................................................................................... 275 Summary ......................................................................................................................................... 276 Review Questions ............................................................................................................................ 277 Review Answers .............................................................................................................................. 278

Chapter 23 – The Enhancement of Shareholder Value .................................................................... 279 Learning Objectives ......................................................................................................................... 279 Introduction ...................................................................................................................................... 279 Return on Equity .............................................................................................................................. 279 Economic Value Added .................................................................................................................... 281 Cash Flow Analysis.......................................................................................................................... 282 Opportunity Cost of Capital .............................................................................................................. 283 Key Success Factors ....................................................................................................................... 283 Stock Price Enhancement ................................................................................................................ 284 Long-Term and Short-Term Value Considerations............................................................................ 284 The Industry Setting ......................................................................................................................... 285 Summary ......................................................................................................................................... 285 Review Questions ............................................................................................................................ 286 Review Answers .............................................................................................................................. 287

Glossary ............................................................................................................................................. 289

Index .................................................................................................................................................. 295