3.12 Application of financial statement analysis

Question 1

A company’s historical performance can be analyzed and compared to that of its peers or across time. The analysis should include what happened and why it happened.

Key questions include:

Answer 1

How and why have measures of profitability, efficiency, liquidity, and solvency changed over time?

How do the above measures compare to peers?

What are the critical aspects of performance? How did the company do on those critical aspects?

What is the company’s business model? How was it reflected in the performance?

Question 2

Past performance is more useful for mature companies than start-ups.

Answer 2

Mature companies

Question 3

Credit analysis

Answer 3

the evaluation of credit risk, which is the possibility of losses due to a counterparty’s failure to meet its payment obligations.

Because debt obligations are almost always met with cash, credit analysts give particular attention to metrics based on operating cash flows.

Question 4

Factors that are considered as part of a quantitative credit analysis include:

Answer 4

Scale

Business profile

Leverage tolerance

Financial policy

Question 5

Factors that are considered as part of a quantitative credit analysis include:

Scale

Answer 5

Companies with a history of success and strong purchasing power relative to their suppliers are better positioned to respond to adverse events and market conditions.

Larger companies also typically have better access to capital markets.

Question 6

Factors that are considered as part of a quantitative credit analysis include:

Business profile

Answer 6

Companies are more creditworthy if they have relatively stable and predictable profit margins and cash flows.

A geographically diverse customer base is also beneficial.

Question 7

Factors that are considered as part of a quantitative credit analysis include:

Leverage tolerance

Answer 7

Companies with lower costs, especially lower fixed costs, are better positioned to meet their borrowing obligations.

Question 8

Factors that are considered as part of a quantitative credit analysis include:

Financial policy

Answer 8

Companies with more debt in the capital structure have a lower ability to tolerate financial risk.

Question 9

Back-testing

Answer 9

can be done to see how a particular screen would have performed in the past

Question 10

biases against back-testing

Answer 10

Survivorship bias exists if the data includes only companies or funds that have survived to the end of the data period.

Look-ahead bias occurs if screens are based on data that would not have been available when the investment decision was made.

Data-snooping refers to using the same dataset as other researchers to test the same or similar screens.

Question 11

The task of comparing companies’ financial statements can be complicated by several factors:

Answer 11

Companies adhere to different sets of accounting standards (e.g., IFRS, US GAAP).

Companies may choose between different methods and models (e.g., historical cost, fair value)

Companies have some discretion in making estimates (e.g., useful lives of PP&E)

Question 12

Financial statement disclosures are often insufficient to allow for specific comparison, but analysts may use the following ratios as indicators of a company’s use of its fixed assets:

Answer 12

Share of useful life that has passed

Average age of asset base

Years of useful life remaining

Average life of assets at acquisition

Share of asset base being renewed

Question 13

Share of useful life that has passed formula

Answer 13

Accumulated Depreciation / Gross PPE

Question 14

Average age of asset base formula

Answer 14

Accumulated Depreciation / Depreciation Expense

Question 15

Years of useful life remaining formula

Answer 15

Net PPE / Depreciation expense

Question 16

Average life of assets at acquisition formula

Answer 16

Gross PPE / Depreciation Expense

Question 17

Share of asset base being renewed formula

Answer 17

CapEx / (Gross PPE + CapEx)

Question 18

When forecasting a company’s expected profit margin based on the values reported in its most recent set of financial statements, the impact of any expenses that have been treated as non-recurring items should most likely be:

A
excluded completely.

B
included only to the extent that the company is likely to incur these expenses again.

C
included on the grounds that the companies often report non-recurring expenses.

Answer 18

B
included only to the extent that the company is likely to incur these expenses again.

Expenses not expected to continue in the future should not have any impact on a forecast of future performance. However, these items should be included to the extent that they can be expected to recur. Analysts should make appropriate adjustments based on an assessment of which components of past performance are deemed to be transitory.

Question 19

When comparing a US company that uses the last in, first out (LIFO) method of inventory with companies that prepare their financial statements under international financial reporting standards (IFRS), analysts should be aware that according to IFRS, the LIFO method of inventory:

A
is never acceptable.

B
is always acceptable.

C
is acceptable when applied to finished goods inventory only.

Answer 19

A
is never acceptable.

LIFO is not permitted under IFRS.

Question 20

One concern when screening for stocks with low price-to-earnings ratios is that companies with low P/Es may be financially weak. What criterion might an analyst include to avoid inadvertently selecting weak companies?

A
Net income less than zero

B
Debt-to-total assets ratio below a certain cutoff point

C
Current-year sales growth lower than prior-year sales growth

Answer 20

B
Debt-to-total assets ratio below a certain cutoff point