After completing this chapter, you will be able to do the following:
The three case studies demonstrate the use of financial analysis in decision making. Each case is set in a different type of industry: manufacturing, service, and financial service. The different focus, purpose, and context for each analysis result in different techniques and tools being applied to the analysis. However, each case demonstrates the use of a common financial statement analysis framework. In each case, an economic decision is arrived at; this is consistent with the primary reason for performing financial analysis: to facilitate an economic decision.
The following information relates to Questions 1–8
Sergei Leenid, CFA, is a long-only fixed income portfolio manager for the Parliament Funds. He has developed a quantitative model, based on financial statement data, to predict changes in the credit ratings assigned to corporate bond issues. Before applying the model, Leenid first performs a screening process to exclude bonds that fail to meet certain criteria relative to their credit rating. Existing holdings that fail to pass the initial screen are individually reviewed for potential disposition. Bonds that pass the screening process are evaluated using the quantitative model to identify potential rating changes.
Leenid is concerned that a pending change in accounting rules could affect the results of the initial screening process. One current screen excludes bonds when the financial leverage ratio (equity multiplier) exceeds a given level and/or the interest coverage ratio falls below a given level for a given bond rating. For example, any “A” rated bond of a company with a financial leverage ratio exceeding 2.0 or an interest coverage ratio below 6.0 would fail the initial screening. The failing bonds are eliminated from further analysis using the quantitative model.
The new accounting rule would require substantially all leases to be capitalized on a company's balance sheets. To test whether the change in accounting rules will affect the output of the screening process, Leenid collects a random sample of “A” rated bonds issued by companies in the retail industry, which he believes will be among the industries most affected by the change.
Two of the companies, Silk Road Stores and Colorful Concepts, recently issued bonds with similar terms and interest rates. Leenid decides to thoroughly analyze the potential effects of the change on these two companies and begins by gathering information from their most recent annual financial statements (Exhibit 1).
After examining lease disclosures, Leenid estimates the average lease term for each company at 8 years with a fairly consistent lease expense over that time. He believes the leases should be capitalized using 6.5 percent, the rate at which both companies recently issued bonds.
EXHIBIT 1 Selected Financial Data for Silk Road Stores and Colorful Concepts
Silk Road | Colorful Concepts | |
Revenue | 3,945 | 7,049 |
EBIT | 318 | 865 |
Interest expense | 21 | 35 |
Income taxes | 121 | 302 |
Net income | 176 | 528 |
Average total assets | 2,075 | 3,844 |
Average total equity | 1,156 | 2,562 |
Lease expense | 213 | 406 |
While examining the balance sheet for Colorful Concepts, Leenid also discovers that the company has a 204 ending asset balance (188 beginning) for investments in associates, primarily due to its 20 percent interest in the equity of Exotic Imports. Exotic Imports is a specialty retail chain and in the most recent year reported 1,230 in sales, 105 in net income, and had average total assets of 620.
The following information relates to Questions 9–15
Quentin Abay, CFA, is an analyst for a private equity firm interested in purchasing Bickchip Enterprises, a conglomerate. His first task is to determine the trends in ROE and the main drivers of the trends using DuPont analysis. To do so he gathers the data in Exhibit 1.
EXHIBIT 1 Selected Financial Data for Bickchip Enterprises ( Thousands)
2009 | 2008 | 2007 | |
Revenue | 72,448 | 66,487 | 55,781 |
Earnings before interest and tax | 6,270 | 4,710 | 3,609 |
Earnings before tax | 5,101 | 4,114 | 3,168 |
Net income | 4,038 | 3,345 | 2,576 |
Asset turnover | 0.79 | 0.76 | 0.68 |
Assets/Equity | 3.09 | 3.38 | 3.43 |
After conducting the DuPont analysis, Abay believes that his firm could increase the ROE without operational changes. Further, Abay thinks that ROE could improve if the company divested segments that were generating the lowest returns on capital employed (total assets less non-interest-bearing liabilities). Segment EBIT margins in 2009 were 11 percent for Automation Equipment, 5 percent for Power and Industrial, and 8 percent for Medical Equipment. Other relevant segment information is presented in Exhibit 2.
EXHIBIT 2 Segment Data for Bickchip Enterprises ( Thousands)
Capital Employed | Capital Expenditures (Excluding Acquisitions) | |||||
Operating Segments | 2009 | 2008 | 2007 | 2009 | 2008 | 2007 |
Automation Equipment | 10,705 | 6,384 | 5,647 | 700 | 743 | 616 |
Power and Industrial | 15,805 | 13,195 | 12,100 | 900 | 849 | 634 |
Medical Equipment | 22,870 | 22,985 | 22,587 | 908 | 824 | 749 |
49,380 | 42,564 | 40,334 | 2,508 | 2,416 | 1,999 |
Abay is also concerned with earnings quality, so he intends to calculate Bickchip's cash-flow-based accruals ratio and the ratio of operating cash flow before interest and taxes to operating income. To do so, he prepares the information in Exhibit 3.
EXHIBIT 3 Earnings Quality Data for Bickchip Enterprises ( Thousands)
2009 | 2008 | 2007 | |
Net income | 4,038 | 3,345 | 2,576 |
Net cash flow provided by (used in) operating activitya | 9,822 | 5,003 | 3,198 |
Net cash flow provided by (used in) investing activity | (10,068) | (4,315) | (5,052) |
Net cash flow provided by (used in) financing activityb | (5,792) | 1,540 | (2,241) |
Average net operating assets | 43,192 | 45,373 | 40,421 |
a includes cash paid for taxes of: | (1,930) | (1,191) | (1,093) |
b includes cash paid for interest of: | (1,169) | (596) | (441) |
The following information relates to Questions 16–21
Michael Wetstone is an equity analyst covering the software industry for a public pension fund. Prior to comparing the financial results of Software Services Inc. and PDQ GmbH, Wetstone discovers the need to make adjustments to their respective financial statements. The issues preventing comparability, using the financial statements as reported, are the sale of receivables and the impact of minority interests.
Software Services sold $267.5 million of finance receivables to a special purpose entity. PDQ does not securitize finance receivables. An abbreviated balance sheet for Software Services is presented in Exhibit 1.
EXHIBIT 1 Abbreviated Balance Sheet for Software Services ($ 000)
Year Ending: | 31 December 2009 |
Total current assets | 1,412,900 |
Total assets | 3,610,600 |
Total current liabilities | 1,276,300 |
Total liabilities | 2,634,100 |
Total equity | 976,500 |
A significant portion of PDQ's net income is explained by its 20 percent minority interest in Astana Systems. Wetstone collects certain data (Exhibit 2) related to both PDQ and Astana in order to estimate the financials of PDQ on a stand-alone basis.
EXHIBIT 2 Selected Financial Data Related to PDQ and Astana Systems
PDQ ( in 000) | Astana ($ in 000) | |
Earnings before tax (2009) | 41,730 | 15,300 |
Income taxes (2009) | 13,562 | 5,355 |
Net income (2009) | 28,168 | 9,945 |
Market capitalization (recent) | 563,355 | 298,350 |
Average $/ exchange rate in 2009 | 1.55 | |
Current $/ exchange rate | 1.62 |
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