Uchicago Financial Ratios
Financial Reporting and Analysis
Mark Hendricks
Financial Mathematics
University of Chicago
September 2011
Outline
Financial Reporting
Financial Analysis
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Financial reporting
Financial reporting is important for well-functioning markets.
Investors need information to properly allocate capital and hedge risk.
Regulators need good information to monitor fraudulently activity and systemic risk.
Financial reports are prepared according to accounting practices.
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Financial statements
There are three key financial statements.
The balance …show more content…
sheet
The income statement
The statement of cash flows
We discuss each in turn.
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The balance sheet
The balance sheet details the financial condition of the firm at one moment in time.
The balance sheet is a list of the firms assets and liabilities.
The values are “book” values, not market values.
Namely, assets and liabilities are valued in the statements according to accounting principles.
The values are based more on historical transaction prices than current valuations.
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Balance equation
The central idea behind the balance sheet is an accounting identity: assets = liabilities + shareholders’ equity
Note that this equation is an identity. The “shareholders’ equity” component is not a real market value of equity.
Rather, it is just a plug for the equation. This “book” value is rarely used.
The first section of the balance sheet lists the assets of the firm. The short-term, or current assets are listed first. This is where cash and other liquid securities are listed. After this, longer-term assets are listed.
Liabilities are listed similarly, with current liabilities being listed first.
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Balance sheet for commercial banking
Figure: Income statement for the banking sector, 2008.
Source: Mishkin (2010)
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Mathematics
7/55
Accounting rules
The values in the balance sheet differ from market values in a few important ways.
Depreciation. Accountants use fixed rules to calculate depreciation on assets. This depreciation calculation can differ substantially from the market value.
Capitalizing expenses. Expenses for capital show up as assets, of course. However, some expenditures like R&D do not show up as assets on the balance sheet even though they potentially provide a flow of benefits like an asset.
Intangibles like “goodwill” also show up on the balance sheet at times, though they do not have a precise economic definition. To make matters worse, the accounting rules for calculating taxes are often different than the rules for reporting.
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UChicago Financial Mathematics
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Fair value accounting
Fair-value accounting is an attempt to make “book values” reflective of current conditions rather than just historical transactions. Many assets and liabilities held by a firm are not actively traded nor have easily observed values. ie. Inventory, buildings, employee benefits.
Historically, accountants list these on the books at historical costs. But the true values fluctuate, of course.
Fair-value, or mark-to-market, accounting attempts to keep the book values at current market values.
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Financial Reporting and Analysis
UChicago Financial Mathematics
9/55
Mark-to model
With mark-to-market accounting, the standards call for assets to be valued according to three categories:
The first category of assets have observable market prices, and these are used on the books.
The second category of assets are not actively traded, but similarly traded assets can be used for market valuations, perhaps with the aid of a pricing model.
The third category of assets are those which are difficult to get market quotes. Thus, the values depend on pricing models.
These model-based values are known as mark-to-model. Due to the reliance of some firms on pricing models, there is room for manipulation. Hendricks,
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UChicago Financial Mathematics
10/55
Criticisms
The role of fair value accounting in the financial crisis is controversial. Theoretically, fair value accounting should lead to better information in markets.
On the other hand, in distressed and illiquid markets, market prices may not be reflective of long-term value.
Under fair value accounting, the statements use these distressed prices. This could cause asset values to be written down too much which could then cause firms even more distress as they are forced to recapitalize.
Others argue that keeping the book values at historic value just ignores the market reality, particularly when it can be hard to tell what is behind the low prices.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
11/55
Income statement
The income statement is another important financial report.
It gives a summary of the profitability of the firm over a period of time.
(Compare this to the balance sheet which gives the firm’s financial conditions at a point in time.)
The income statement lists revenues and expenses for the period. Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
12/55
Earnings
Earnings, (or net income,) are simply revenues minus costs. They are an accounting measure of profits.
Of course, earnings would not be a good measure of economic profits given the accrual method of accounting along with the differences noted above.
The calculation for “earnings” subtracts debt interest payments and taxes owed. This is the total earnings of equity holders. Earnings Before Interest and Taxes (EBIT) is also an important measure of profit. This is closer to what economists would call the free cash flow of the firm.
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Financial Reporting and Analysis
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Retained earnings
Retained earnings are the earnings re-invested into the firm: retained earnings = earnings − dividends
Thus, absent any external financing for the firm, retained earnings describe the growth in the balance sheet.
The balance sheet could also grow from raising fresh equity.
Finally, the balance sheet will grow if new debt is issued.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Income statement for commercial banking
Income Statement for All Federally Insured Commercial Banks, 2008
Share of
Operating
Income or
Expenses (%)
Amount
($ billions)
Operating Income
Interest income
Noninterest income
Service charges on deposit accounts
Other noninterest income
Total operating income
Operating Expenses
Interest expenses
Noninterest expenses
Salaries and employee benefits
Premises and equipment
Other
Provisions for loan losses
Total operating expense
Net Operating Income
Gains (losses) on securities
Extraordinary items, net
Income taxes
Net Income
603.3
207.4
39.5
167.9
_____
810.7
74.4
25.6
4.9
20.7
245.6
367.9
151.9
43.4
172.6
_____
100.0
31.1
46.6
19.2
5.5
21.9
175.9
789.4
22.3
100.0
21.3
-15.3
5.3
-6.2
5.1
Figure: Income statement for the aggregated banking sector, 2008.
Source: Mishkin (2010)
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
15/55
Cash-flow statement
Earnings are certainly not economic profits, and due to the accrual system of accounting they are not the same as actual cash-flows.
The statement of cash flows fills an important role.
This statement tracks the actual cash movements associated with transactions.
Due to its simple nature, this statement is often favored by analysts trying to cut through all the accounting rules and issues. The statement typically groups transactions into operating, investment, and financing cash flows.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Notes to statements
Aside from the three major financial statements, firms often attach notes. These notes may often be skimmed or ignored, but at times they reveal important clues.
For instance, if a firm is manipulating accounting data, the notes may have clues.
The notes for AIG explained that their CDS position was not hedged. Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
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Earnings management
Earnings management refers to the practice of taking actions in order to manipulate reported earnings. For this reason, not all reported earnings are of the same quality.
As noted, fair value accounting leaves some discretion in the reported figures.
Nonrecurring items, such as the sale of an asset or an unusually high asset return are not expected to repeat. These earnings are of lower quality in assessing the firm’s future profitability. Revenue recognition. Under accounting standards, a firm is allowed to recognize revenues from a sale before it has been paid. This, along with other details of accrual accounting mean that managers can take actions which recognize income in the present, and push losses to the future.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Off-balance-sheet holdings
The financial crisis has brought much attention to a certain kind of accounting manipulation: off-balance-sheet assets and liabilities. Firms may try to leave profitable parts of their business on their books, while spinning losses off into entities that do not show up on the books.
For example, this is what Enron was doing. They put losses into subsidiary entities whose holdings did not show up on
Enron’s books. Due to keeping their profits and hiding their losses in these shells, 96% of their reported earnings were phony. Source: Berk (2011).
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Capital leases
Another widespread use of off-balance-sheet accounting is capital leases. Capital leases are long-term leases which more closely resemble debt financing than a true lease.
By calling the transaction an ongoing lease rather than a debt-financed purchase, the company keeps it off the books.
Rather, they report only the monthly lease amount, as if they did not have the (often sizeable) debt for the whole purchase.
Recent regulations have made it harder for firms to reduce their reported debt in this way.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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World Com
In fact, the firm World Com was manipulating their financial statements using capital leases, but in a different way.
World Com capitalized expenses which were truly operating expenses. They called these expenses capital leases, and thus the money spent was not deducted from earnings, but rather counted as assets which were slowly depreciated.
World Com, which had a market capitalization of $120 billion in 2002, was exposed and set a record for the largest bankruptcy. Source: Berk (2011).
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Banks use of off-balance-sheet items
The financial sector has also increased its use of off-balance-sheet holdings. Many believe this played a large role in causing the financial crisis. For banks, moving things off the balance sheet avoids regulatory scrutiny.
The income, (as a percentage of total assets,) generated by banks from these off-balance-sheet activities has doubled since
1970. Source: Mishkin (2010).
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Moving mortgages off the balance sheet
Consider the increased off-balance-sheet activities with regard to mortgages. Historically, a savings association would give a mortgage to a homeowner, and then hold it as an asset on the books for 30 years. MBS allowed banks to originate a mortgage and then sell a bundle of these mortgages in a special purpose vehicle.
This removed the asset and liability from the banks’ balance sheet. The banks would continue to manage the pool of mortgages for a fee.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
23/55
Beyond earnings
The lesson is that earnings are not a sufficient statistic for the financial health of a firm.
World Com had suspicious levels of investment due to their use of capital leases.
Enron’s actual cash flows were not anything close to their stellar earnings.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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The Sarbanes-Oxley act
In response to the scandals of the early 2000’s, the U.S. passed the
Sarbanes-Oxley act in 2002.
The purpose of Sarbanes-Oxley was to improve the integrity of financial statements.
Auditors were given new rules to reduce conflicts of interest.
The law puts restrictions on the non-audit services which a public accounting firm can provide.
Management was made personally liable for the accuracy of financial reports.
It established a Public Company Accounting Oversight Board which is overseen by the SEC.
The budget for the SEC was increased so that it could better supervise securities markets.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Disclosure requirements
Disclosure requirements are a key element of financial regulation.
Basel 2 puts a particular emphasis on disclosure requirements.
It mandates increased disclosure by banks of their credit exposure, reserves, and capital.
The Securities Act of 1933 and the SEC, which was established in 1934 require disclosure on any corporation that issues publicly traded securities.
More recently, there have been added rules about reporting off-balance-sheet positions and more information about the pricing models being used in coming up with the financial reports. Hendricks,
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Getting regulation right
Increased disclosure requirements have made it more costly for a firm go public, or to issue U.S. securities.
The share of new corporate bonds initially sold in the U.S. has fallen below the share sold in European debt markets.
In 2008, the London and Hong Kong stock exchanges each handled a larger share of IPO’s than did the NYSE, which had been the dominant market until recently.
Combined with the increasing ease of obtaining non-public financing, many firms are delaying IPO’s.
Some have blamed regulation, and Sarbanes-Oxley in particular, for these facts. Of course, there are other possible causes. The debate about reporting requirements is ongoing.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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UChicago Financial Mathematics
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Outline
Financial Reporting
Financial Analysis
Hendricks,
Financial Reporting and Analysis
Measuring profit
Earnings and EBIT are (accounting) measure of profits, but of course they do not adjust for size.
Return on equity (ROE) uses accounting values: earnings divided by book value of equity.
Earnings are measured over a period of time, (ie. year,) whereas the book value of equity on the balance sheet is at a specific point of time. Thus, sometimes the calculation uses the average value of book equity over the period.
Given that ROE uses accounting earnings as the profit measure, it is sensitive to the manipulations discussed above.
ROE will not be the same as the firms stock return over the period. It is important to read ROE as one measure of performance, not the summary.
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Financial Reporting and Analysis
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Return on assets
Return on assets (ROA) is another important measure of profitability. Again, ROA uses earnings to measure profit, but divides by the firm’s book value.
ROA is insensitive to the firm’s financing decision.
Thus, it is a measure of operating profitability.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Understanding ROE
It is useful to analyze ROE by breaking it into factors, something known as the DuPont identity.
ROE =
Earnings
Sales
×
Net Profit Margin
Sales
Assets
×
Assets
Book Value of Equity
Asset Turnover
Leverage
ROA
This shows us three ways to influence ROE.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Three factors of ROE
The three factors of ROE correspond closely to the financial statements. Profit margin gives a summary of the income statement performance by showing profit per dollar of sales.
Asset turnover summarizes the asset side of the balance sheet.
It indicates the resources required to support sales.
Leverage ratio summarizes the liability and equity side of the balance sheet by showing how the assets are financed.
Thus, this decomposition captures a lot of the important information in the financial reports.
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UChicago Financial Mathematics
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Profit margin
The profit margin measures the fraction of each dollar of sales that ends up as earnings, adding to the balance sheet.
In the decomposition above, we have used the net profit margin. Recall that earnings, or net income, has already deducted interest payments on debt and taxes.
Another popular measure is gross profit margin which instead of using earnings in the numerator, uses EBIT. net profit margin =
Hendricks,
earnings
,
sales
gross profit margin =
Financial Reporting and Analysis
EBIT sales UChicago Financial Mathematics
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ROE and gross margins
Of course, the above decomposition won’t work with gross profit margin. Rather it must be expanded to
ROE =
Earnings
×
EBIT
EBIT
Sales
Gross Profit Margin
×
Sales
Assets
×
Asset Turnover
ROA
×
Assets
Book Value of Equity
Leverage
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Asset turnover
Asset turnover measures the sales generated per dollar of assets the firm owns.
Asset Turnover =
Sales
Assets
Notice that assets reduce asset turnover and thus reduce ROA and ROE.
One might expect lots of assets are a good thing.
Of course, if a company is liquidating, then this is good.
But conditional on a certain profit stream, assets just measure the amount of capital needed to generate this income stream.
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ROA
ROA captures the combined effects of margins and asset turnover:
ROA =(Net) profit margin × Asset turnover =
Earnings
Assets
ROA is a basic measure of a firm’s efficiency in how it transforms assets to profits.
Some industries achieve high returns by having high margins, while other achieve it with high asset turnover.
A high profit margin and a high asset turnover is ideal, but can be expected to attract considerable competition.
Conversely, a low profit margin combined with a low asset turn will attract only bankruptcy lawyers. — Higgins (2009).
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Leverage
Leverage refers to how much of the firm’s capital comes from equity holders versus debt holders.
Unlike the other two ratios in ROE, more is not necessarily better. Rather, leverage decisions must take account of the pros and cons of debt financing.
A firm does not pay taxes on income used for interest payments. This debt tax shield incentives firms to lever up.
However, more debt increases the chances of financial distress or bankruptcy.
Optimal leverage balances these forces, and varies widely across industries. Not surprisingly, low leverage is used in industries where financial distress is particularly costly.
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Leverage - balance-sheet measures
The leverage ratio in the ROE calculation is the asset-to-equity value. This is often rescaled into other popular measures.
Liabilities
Assets
Liabilities
Debt-to-equity =
Equity
Debt-to-assets =
Notice that the asset-to-equity ratio used above is just the debt-to-equity-ratio plus 1.
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Leverage - coverage measures
There are many other ways to measure the extent to which a firm is financing with debt.
Measures based on income are often preferred, given that bankruptcy is caused by defaulting on payments, not on the share of equity versus debt.
Interest coverage, or times interest earned, also measures the financial risk of a firm. It shows how much burden interest payments are on the cash flows. interest coverage =
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EBIT interest expense
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Rollover risk
There are many other ways to measure the extent to which a firm is financing with debt.
Times burden covered is similar to times interest earned, but takes account of principal repayment.
Relying on the interest covered measure assumes that one can roll over the debt principal.
In the summer of 2007, many investors in MBS found this is not always the case.
Times burden covered is conservative in that it calculates as if all principal will be repaid.
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Leverage - market measures
Given the problems with accounting values already discussed, many prefer a market measure of leverage.
Market measures of leverage are like the balance-sheet measures seen above, but they use the market value of equity rather than the book value.
This can make a big difference, especially for growing firms.
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Leverage in the crisis
Leverage played a big role in the recent financial crisis.
Firms such as Lehman and Merril Lynch had 30-to-1 leverage.
This left them very little flexibility to deal with asset declines.
The total decline in mortgages was a relatively small amount of money, but was more than enough to bankrupt highly leveraged institutions.
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Capital requirements
Capital requirements are meant to keep financial institutions from taking too much risk.
Note that with high leverage, a firm has more incentive to take very large gambles. Losses mean little, while the upside from the gains gets larger.
Regulators want to prevent excess risk which could cause failure in financial markets.
The capital requirements take two forms. The first is based on the leverage ratio.
A bank is well capitalized with a leverage ratio below 20, but extra regulation kicks in if it goes above 33. The FDIC must take steps to close down a bank with a leverage ratio above
50.
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Basel
The second type of requirements are risk-based.
Under regulation known as the Basel Accord, banks were required to hold 8% of their risk-weighted capital.
The weighting system for capital leads to regulatory arbitrage.
Basel 2 was very recently rolled out after many years of planning. However, due to the crisis, Basel 3 is already being studied. Hendricks,
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ROE and ROA
We have seen then, that ROE is just an an adjustment of ROA to account for leverage.
ROA shows the return that comes from the operation of the business ROE shows both returns from operations and financing
For which type of returns should management be rewarded?
High ROE relative to ROA (relative to the industry,) may show savy financing, but it could also show excessive risk.
Management seeking returns always has the temptation of leveraging to get there.
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Table of ROE
Figure: ROE for various firms, 2007.
Source: Higgins (2009)
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Problems with ROE
ROE is not necessarily a good measure of financial performance.
For as much attention as it gets, one must be careful.
Market valuations are forward-looking and consider the long-term prospects of the firm.
By contrast, ROE is largely backward-looking and considers only one year’s data.
We have already noted that accounting values can easily be manipulated to push earnings to different time periods.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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ROE and risk
We mentioned already, that ROE can be increased by taking on more leverage.
Clearly then, a higher ROE is not always better.
Improving ROE while keeping risk exposure level is an acheivement. Increasing ROE by increasing risk, (leverage or other types,) is not.
Thus, investors must consider whether high ROE is a good deal. If your money market fund returned 10%, would you be happy? Hendricks,
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Analysis
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Banks and ROE
Currently, regulators are considering tougher capital requirements for banks, (lower leverage.)
Banks argue that this will lower their returns; they are definitely right!
They say that this will cause investors to withdraw, which will cause big problems in financial markets.
Is this true? Will investors need such a high ROE if capital requirements are higher?
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Liquidity measures
Current ratio. Current assets and liabilities are those with a maturity of one year or less. Thus, this measures the ability of the firm to pay off short-term debt using its most liquid assets. current ratio =
current assets current liabilities
Quick ratio. Also known as the acid test ratio. It is like the current ratio, but does not include inventory in the numerator.
Cash ratio. Similar to the current ratio, but it does not include current assets which are not marketable securities,
(things like accounts receivables.)
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UChicago Financial Mathematics
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Book and market values
We have noted that the book value of firm equity may be much different than its market value.
The market-to-book ratio is the market value of equity divided by the book value of equity.
Book value of equity is considered a very conservative estimate of share value, perhaps a floor.
Recall that the ratio can be much different than one given that book-values tend to be based on historical transactions while market values look forward to future growth.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Growth and value
The price-earnings ratio (P/E) is a popular measure of firm value. The P/E ratio takes the market price at a given time, and it divides by the earnings generated over some period.
Of course, the market price is affected by the future prospects of the firm, while the periods earnings are a historical fact.
Thus, the P/E is a measure of how much future cash flows the firm will deliver relative to its current earnings.
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UChicago Financial Mathematics
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Growth and value
Market-book and price-earnings values are both useful measures for a firms future growth prospects.
Stocks with a high market-book or P/E ratio are called growth stocks.
A stock with a low market-book or P/E ratio is called a value stock. Hendricks,
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Use of growth and value
The labels “growth” and “value” are widely used.
Historically, value stocks have delivered higher average returns.
So-called “value” investors try to take advantage of this by looking for stocks with low market-book ratios.
Much research has been done to try to explain this difference of returns and whether it is reflective of risk.
Mutual funds are offered for both growth and value stocks and have become very popular.
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References
Berk, Jonathan and Peter DeMarzo. Corporate Finance. 2011.
Bodie, Kane, and Marcus. Investments. 2011.
Cochrane, John. Understanding Policy in the Great Recession
European Economic Review. 2011.
Higgins, Robert. Analysis for Financial Management. 2009.
Hull, John. Options, Futures, and Other Derivatives. 2012.
Mishkin, Frederic. Money, Banking, and Financial Markets.
2010.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
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Mark Hendricks
Financial Mathematics
University of Chicago
September 2011
Outline
Financial Reporting
Financial Analysis
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
2/55
Financial reporting
Financial reporting is important for well-functioning markets.
Investors need information to properly allocate capital and hedge risk.
Regulators need good information to monitor fraudulently activity and systemic risk.
Financial reports are prepared according to accounting practices.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
3/55
Financial statements
There are three key financial statements.
The balance …show more content…
sheet
The income statement
The statement of cash flows
We discuss each in turn.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
4/55
The balance sheet
The balance sheet details the financial condition of the firm at one moment in time.
The balance sheet is a list of the firms assets and liabilities.
The values are “book” values, not market values.
Namely, assets and liabilities are valued in the statements according to accounting principles.
The values are based more on historical transaction prices than current valuations.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
5/55
Balance equation
The central idea behind the balance sheet is an accounting identity: assets = liabilities + shareholders’ equity
Note that this equation is an identity. The “shareholders’ equity” component is not a real market value of equity.
Rather, it is just a plug for the equation. This “book” value is rarely used.
The first section of the balance sheet lists the assets of the firm. The short-term, or current assets are listed first. This is where cash and other liquid securities are listed. After this, longer-term assets are listed.
Liabilities are listed similarly, with current liabilities being listed first.
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Financial Reporting and Analysis
UChicago Financial Mathematics
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Balance sheet for commercial banking
Figure: Income statement for the banking sector, 2008.
Source: Mishkin (2010)
Hendricks,
Financial Reporting and Analysis
UChicago Financial …show more content…
Mathematics
7/55
Accounting rules
The values in the balance sheet differ from market values in a few important ways.
Depreciation. Accountants use fixed rules to calculate depreciation on assets. This depreciation calculation can differ substantially from the market value.
Capitalizing expenses. Expenses for capital show up as assets, of course. However, some expenditures like R&D do not show up as assets on the balance sheet even though they potentially provide a flow of benefits like an asset.
Intangibles like “goodwill” also show up on the balance sheet at times, though they do not have a precise economic definition. To make matters worse, the accounting rules for calculating taxes are often different than the rules for reporting.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
8/55
Fair value accounting
Fair-value accounting is an attempt to make “book values” reflective of current conditions rather than just historical transactions. Many assets and liabilities held by a firm are not actively traded nor have easily observed values. ie. Inventory, buildings, employee benefits.
Historically, accountants list these on the books at historical costs. But the true values fluctuate, of course.
Fair-value, or mark-to-market, accounting attempts to keep the book values at current market values.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
9/55
Mark-to model
With mark-to-market accounting, the standards call for assets to be valued according to three categories:
The first category of assets have observable market prices, and these are used on the books.
The second category of assets are not actively traded, but similarly traded assets can be used for market valuations, perhaps with the aid of a pricing model.
The third category of assets are those which are difficult to get market quotes. Thus, the values depend on pricing models.
These model-based values are known as mark-to-model. Due to the reliance of some firms on pricing models, there is room for manipulation. Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
10/55
Criticisms
The role of fair value accounting in the financial crisis is controversial. Theoretically, fair value accounting should lead to better information in markets.
On the other hand, in distressed and illiquid markets, market prices may not be reflective of long-term value.
Under fair value accounting, the statements use these distressed prices. This could cause asset values to be written down too much which could then cause firms even more distress as they are forced to recapitalize.
Others argue that keeping the book values at historic value just ignores the market reality, particularly when it can be hard to tell what is behind the low prices.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
11/55
Income statement
The income statement is another important financial report.
It gives a summary of the profitability of the firm over a period of time.
(Compare this to the balance sheet which gives the firm’s financial conditions at a point in time.)
The income statement lists revenues and expenses for the period. Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
12/55
Earnings
Earnings, (or net income,) are simply revenues minus costs. They are an accounting measure of profits.
Of course, earnings would not be a good measure of economic profits given the accrual method of accounting along with the differences noted above.
The calculation for “earnings” subtracts debt interest payments and taxes owed. This is the total earnings of equity holders. Earnings Before Interest and Taxes (EBIT) is also an important measure of profit. This is closer to what economists would call the free cash flow of the firm.
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Retained earnings
Retained earnings are the earnings re-invested into the firm: retained earnings = earnings − dividends
Thus, absent any external financing for the firm, retained earnings describe the growth in the balance sheet.
The balance sheet could also grow from raising fresh equity.
Finally, the balance sheet will grow if new debt is issued.
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Income statement for commercial banking
Income Statement for All Federally Insured Commercial Banks, 2008
Share of
Operating
Income or
Expenses (%)
Amount
($ billions)
Operating Income
Interest income
Noninterest income
Service charges on deposit accounts
Other noninterest income
Total operating income
Operating Expenses
Interest expenses
Noninterest expenses
Salaries and employee benefits
Premises and equipment
Other
Provisions for loan losses
Total operating expense
Net Operating Income
Gains (losses) on securities
Extraordinary items, net
Income taxes
Net Income
603.3
207.4
39.5
167.9
_____
810.7
74.4
25.6
4.9
20.7
245.6
367.9
151.9
43.4
172.6
_____
100.0
31.1
46.6
19.2
5.5
21.9
175.9
789.4
22.3
100.0
21.3
-15.3
5.3
-6.2
5.1
Figure: Income statement for the aggregated banking sector, 2008.
Source: Mishkin (2010)
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Cash-flow statement
Earnings are certainly not economic profits, and due to the accrual system of accounting they are not the same as actual cash-flows.
The statement of cash flows fills an important role.
This statement tracks the actual cash movements associated with transactions.
Due to its simple nature, this statement is often favored by analysts trying to cut through all the accounting rules and issues. The statement typically groups transactions into operating, investment, and financing cash flows.
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Notes to statements
Aside from the three major financial statements, firms often attach notes. These notes may often be skimmed or ignored, but at times they reveal important clues.
For instance, if a firm is manipulating accounting data, the notes may have clues.
The notes for AIG explained that their CDS position was not hedged. Hendricks,
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Earnings management
Earnings management refers to the practice of taking actions in order to manipulate reported earnings. For this reason, not all reported earnings are of the same quality.
As noted, fair value accounting leaves some discretion in the reported figures.
Nonrecurring items, such as the sale of an asset or an unusually high asset return are not expected to repeat. These earnings are of lower quality in assessing the firm’s future profitability. Revenue recognition. Under accounting standards, a firm is allowed to recognize revenues from a sale before it has been paid. This, along with other details of accrual accounting mean that managers can take actions which recognize income in the present, and push losses to the future.
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Off-balance-sheet holdings
The financial crisis has brought much attention to a certain kind of accounting manipulation: off-balance-sheet assets and liabilities. Firms may try to leave profitable parts of their business on their books, while spinning losses off into entities that do not show up on the books.
For example, this is what Enron was doing. They put losses into subsidiary entities whose holdings did not show up on
Enron’s books. Due to keeping their profits and hiding their losses in these shells, 96% of their reported earnings were phony. Source: Berk (2011).
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Capital leases
Another widespread use of off-balance-sheet accounting is capital leases. Capital leases are long-term leases which more closely resemble debt financing than a true lease.
By calling the transaction an ongoing lease rather than a debt-financed purchase, the company keeps it off the books.
Rather, they report only the monthly lease amount, as if they did not have the (often sizeable) debt for the whole purchase.
Recent regulations have made it harder for firms to reduce their reported debt in this way.
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World Com
In fact, the firm World Com was manipulating their financial statements using capital leases, but in a different way.
World Com capitalized expenses which were truly operating expenses. They called these expenses capital leases, and thus the money spent was not deducted from earnings, but rather counted as assets which were slowly depreciated.
World Com, which had a market capitalization of $120 billion in 2002, was exposed and set a record for the largest bankruptcy. Source: Berk (2011).
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Banks use of off-balance-sheet items
The financial sector has also increased its use of off-balance-sheet holdings. Many believe this played a large role in causing the financial crisis. For banks, moving things off the balance sheet avoids regulatory scrutiny.
The income, (as a percentage of total assets,) generated by banks from these off-balance-sheet activities has doubled since
1970. Source: Mishkin (2010).
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Moving mortgages off the balance sheet
Consider the increased off-balance-sheet activities with regard to mortgages. Historically, a savings association would give a mortgage to a homeowner, and then hold it as an asset on the books for 30 years. MBS allowed banks to originate a mortgage and then sell a bundle of these mortgages in a special purpose vehicle.
This removed the asset and liability from the banks’ balance sheet. The banks would continue to manage the pool of mortgages for a fee.
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Beyond earnings
The lesson is that earnings are not a sufficient statistic for the financial health of a firm.
World Com had suspicious levels of investment due to their use of capital leases.
Enron’s actual cash flows were not anything close to their stellar earnings.
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The Sarbanes-Oxley act
In response to the scandals of the early 2000’s, the U.S. passed the
Sarbanes-Oxley act in 2002.
The purpose of Sarbanes-Oxley was to improve the integrity of financial statements.
Auditors were given new rules to reduce conflicts of interest.
The law puts restrictions on the non-audit services which a public accounting firm can provide.
Management was made personally liable for the accuracy of financial reports.
It established a Public Company Accounting Oversight Board which is overseen by the SEC.
The budget for the SEC was increased so that it could better supervise securities markets.
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Disclosure requirements
Disclosure requirements are a key element of financial regulation.
Basel 2 puts a particular emphasis on disclosure requirements.
It mandates increased disclosure by banks of their credit exposure, reserves, and capital.
The Securities Act of 1933 and the SEC, which was established in 1934 require disclosure on any corporation that issues publicly traded securities.
More recently, there have been added rules about reporting off-balance-sheet positions and more information about the pricing models being used in coming up with the financial reports. Hendricks,
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Getting regulation right
Increased disclosure requirements have made it more costly for a firm go public, or to issue U.S. securities.
The share of new corporate bonds initially sold in the U.S. has fallen below the share sold in European debt markets.
In 2008, the London and Hong Kong stock exchanges each handled a larger share of IPO’s than did the NYSE, which had been the dominant market until recently.
Combined with the increasing ease of obtaining non-public financing, many firms are delaying IPO’s.
Some have blamed regulation, and Sarbanes-Oxley in particular, for these facts. Of course, there are other possible causes. The debate about reporting requirements is ongoing.
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Outline
Financial Reporting
Financial Analysis
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Measuring profit
Earnings and EBIT are (accounting) measure of profits, but of course they do not adjust for size.
Return on equity (ROE) uses accounting values: earnings divided by book value of equity.
Earnings are measured over a period of time, (ie. year,) whereas the book value of equity on the balance sheet is at a specific point of time. Thus, sometimes the calculation uses the average value of book equity over the period.
Given that ROE uses accounting earnings as the profit measure, it is sensitive to the manipulations discussed above.
ROE will not be the same as the firms stock return over the period. It is important to read ROE as one measure of performance, not the summary.
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Return on assets
Return on assets (ROA) is another important measure of profitability. Again, ROA uses earnings to measure profit, but divides by the firm’s book value.
ROA is insensitive to the firm’s financing decision.
Thus, it is a measure of operating profitability.
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Understanding ROE
It is useful to analyze ROE by breaking it into factors, something known as the DuPont identity.
ROE =
Earnings
Sales
×
Net Profit Margin
Sales
Assets
×
Assets
Book Value of Equity
Asset Turnover
Leverage
ROA
This shows us three ways to influence ROE.
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Three factors of ROE
The three factors of ROE correspond closely to the financial statements. Profit margin gives a summary of the income statement performance by showing profit per dollar of sales.
Asset turnover summarizes the asset side of the balance sheet.
It indicates the resources required to support sales.
Leverage ratio summarizes the liability and equity side of the balance sheet by showing how the assets are financed.
Thus, this decomposition captures a lot of the important information in the financial reports.
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Profit margin
The profit margin measures the fraction of each dollar of sales that ends up as earnings, adding to the balance sheet.
In the decomposition above, we have used the net profit margin. Recall that earnings, or net income, has already deducted interest payments on debt and taxes.
Another popular measure is gross profit margin which instead of using earnings in the numerator, uses EBIT. net profit margin =
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ROE and gross margins
Of course, the above decomposition won’t work with gross profit margin. Rather it must be expanded to
ROE =
Earnings
×
EBIT
EBIT
Sales
Gross Profit Margin
×
Sales
Assets
×
Asset Turnover
ROA
×
Assets
Book Value of Equity
Leverage
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Asset turnover
Asset turnover measures the sales generated per dollar of assets the firm owns.
Asset Turnover =
Sales
Assets
Notice that assets reduce asset turnover and thus reduce ROA and ROE.
One might expect lots of assets are a good thing.
Of course, if a company is liquidating, then this is good.
But conditional on a certain profit stream, assets just measure the amount of capital needed to generate this income stream.
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ROA
ROA captures the combined effects of margins and asset turnover:
ROA =(Net) profit margin × Asset turnover =
Earnings
Assets
ROA is a basic measure of a firm’s efficiency in how it transforms assets to profits.
Some industries achieve high returns by having high margins, while other achieve it with high asset turnover.
A high profit margin and a high asset turnover is ideal, but can be expected to attract considerable competition.
Conversely, a low profit margin combined with a low asset turn will attract only bankruptcy lawyers. — Higgins (2009).
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Leverage
Leverage refers to how much of the firm’s capital comes from equity holders versus debt holders.
Unlike the other two ratios in ROE, more is not necessarily better. Rather, leverage decisions must take account of the pros and cons of debt financing.
A firm does not pay taxes on income used for interest payments. This debt tax shield incentives firms to lever up.
However, more debt increases the chances of financial distress or bankruptcy.
Optimal leverage balances these forces, and varies widely across industries. Not surprisingly, low leverage is used in industries where financial distress is particularly costly.
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Leverage - balance-sheet measures
The leverage ratio in the ROE calculation is the asset-to-equity value. This is often rescaled into other popular measures.
Liabilities
Assets
Liabilities
Debt-to-equity =
Equity
Debt-to-assets =
Notice that the asset-to-equity ratio used above is just the debt-to-equity-ratio plus 1.
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Leverage - coverage measures
There are many other ways to measure the extent to which a firm is financing with debt.
Measures based on income are often preferred, given that bankruptcy is caused by defaulting on payments, not on the share of equity versus debt.
Interest coverage, or times interest earned, also measures the financial risk of a firm. It shows how much burden interest payments are on the cash flows. interest coverage =
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Rollover risk
There are many other ways to measure the extent to which a firm is financing with debt.
Times burden covered is similar to times interest earned, but takes account of principal repayment.
Relying on the interest covered measure assumes that one can roll over the debt principal.
In the summer of 2007, many investors in MBS found this is not always the case.
Times burden covered is conservative in that it calculates as if all principal will be repaid.
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Leverage - market measures
Given the problems with accounting values already discussed, many prefer a market measure of leverage.
Market measures of leverage are like the balance-sheet measures seen above, but they use the market value of equity rather than the book value.
This can make a big difference, especially for growing firms.
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Leverage in the crisis
Leverage played a big role in the recent financial crisis.
Firms such as Lehman and Merril Lynch had 30-to-1 leverage.
This left them very little flexibility to deal with asset declines.
The total decline in mortgages was a relatively small amount of money, but was more than enough to bankrupt highly leveraged institutions.
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Capital requirements
Capital requirements are meant to keep financial institutions from taking too much risk.
Note that with high leverage, a firm has more incentive to take very large gambles. Losses mean little, while the upside from the gains gets larger.
Regulators want to prevent excess risk which could cause failure in financial markets.
The capital requirements take two forms. The first is based on the leverage ratio.
A bank is well capitalized with a leverage ratio below 20, but extra regulation kicks in if it goes above 33. The FDIC must take steps to close down a bank with a leverage ratio above
50.
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Basel
The second type of requirements are risk-based.
Under regulation known as the Basel Accord, banks were required to hold 8% of their risk-weighted capital.
The weighting system for capital leads to regulatory arbitrage.
Basel 2 was very recently rolled out after many years of planning. However, due to the crisis, Basel 3 is already being studied. Hendricks,
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ROE and ROA
We have seen then, that ROE is just an an adjustment of ROA to account for leverage.
ROA shows the return that comes from the operation of the business ROE shows both returns from operations and financing
For which type of returns should management be rewarded?
High ROE relative to ROA (relative to the industry,) may show savy financing, but it could also show excessive risk.
Management seeking returns always has the temptation of leveraging to get there.
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Table of ROE
Figure: ROE for various firms, 2007.
Source: Higgins (2009)
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Problems with ROE
ROE is not necessarily a good measure of financial performance.
For as much attention as it gets, one must be careful.
Market valuations are forward-looking and consider the long-term prospects of the firm.
By contrast, ROE is largely backward-looking and considers only one year’s data.
We have already noted that accounting values can easily be manipulated to push earnings to different time periods.
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ROE and risk
We mentioned already, that ROE can be increased by taking on more leverage.
Clearly then, a higher ROE is not always better.
Improving ROE while keeping risk exposure level is an acheivement. Increasing ROE by increasing risk, (leverage or other types,) is not.
Thus, investors must consider whether high ROE is a good deal. If your money market fund returned 10%, would you be happy? Hendricks,
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Banks and ROE
Currently, regulators are considering tougher capital requirements for banks, (lower leverage.)
Banks argue that this will lower their returns; they are definitely right!
They say that this will cause investors to withdraw, which will cause big problems in financial markets.
Is this true? Will investors need such a high ROE if capital requirements are higher?
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Liquidity measures
Current ratio. Current assets and liabilities are those with a maturity of one year or less. Thus, this measures the ability of the firm to pay off short-term debt using its most liquid assets. current ratio =
current assets current liabilities
Quick ratio. Also known as the acid test ratio. It is like the current ratio, but does not include inventory in the numerator.
Cash ratio. Similar to the current ratio, but it does not include current assets which are not marketable securities,
(things like accounts receivables.)
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Book and market values
We have noted that the book value of firm equity may be much different than its market value.
The market-to-book ratio is the market value of equity divided by the book value of equity.
Book value of equity is considered a very conservative estimate of share value, perhaps a floor.
Recall that the ratio can be much different than one given that book-values tend to be based on historical transactions while market values look forward to future growth.
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Growth and value
The price-earnings ratio (P/E) is a popular measure of firm value. The P/E ratio takes the market price at a given time, and it divides by the earnings generated over some period.
Of course, the market price is affected by the future prospects of the firm, while the periods earnings are a historical fact.
Thus, the P/E is a measure of how much future cash flows the firm will deliver relative to its current earnings.
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Growth and value
Market-book and price-earnings values are both useful measures for a firms future growth prospects.
Stocks with a high market-book or P/E ratio are called growth stocks.
A stock with a low market-book or P/E ratio is called a value stock. Hendricks,
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Use of growth and value
The labels “growth” and “value” are widely used.
Historically, value stocks have delivered higher average returns.
So-called “value” investors try to take advantage of this by looking for stocks with low market-book ratios.
Much research has been done to try to explain this difference of returns and whether it is reflective of risk.
Mutual funds are offered for both growth and value stocks and have become very popular.
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References
Berk, Jonathan and Peter DeMarzo. Corporate Finance. 2011.
Bodie, Kane, and Marcus. Investments. 2011.
Cochrane, John. Understanding Policy in the Great Recession
European Economic Review. 2011.
Higgins, Robert. Analysis for Financial Management. 2009.
Hull, John. Options, Futures, and Other Derivatives. 2012.
Mishkin, Frederic. Money, Banking, and Financial Markets.
2010.
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