3.12 Application of financial statement analysis Flashcards
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:
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?
Past performance is more useful for mature companies than start-ups.
Mature companies
Credit analysis
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.
Factors that are considered as part of a quantitative credit analysis include:
Scale
Business profile
Leverage tolerance
Financial policy
Factors that are considered as part of a quantitative credit analysis include:
Scale
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.
Factors that are considered as part of a quantitative credit analysis include:
Business profile
Companies are more creditworthy if they have relatively stable and predictable profit margins and cash flows.
A geographically diverse customer base is also beneficial.
Factors that are considered as part of a quantitative credit analysis include:
Leverage tolerance
Companies with lower costs, especially lower fixed costs, are better positioned to meet their borrowing obligations.
Factors that are considered as part of a quantitative credit analysis include:
Financial policy
Companies with more debt in the capital structure have a lower ability to tolerate financial risk.
Back-testing
can be done to see how a particular screen would have performed in the past
biases against back-testing
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.
The task of comparing companies’ financial statements can be complicated by several factors:
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)
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:
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
Share of useful life that has passed formula
Accumulated Depreciation / Gross PPE
Average age of asset base formula
Accumulated Depreciation / Depreciation Expense
Years of useful life remaining formula
Net PPE / Depreciation expense
Average life of assets at acquisition formula
Gross PPE / Depreciation Expense
Share of asset base being renewed formula
CapEx / (Gross PPE + CapEx)
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.
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.
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.
A
is never acceptable.
LIFO is not permitted under IFRS.
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
B
Debt-to-total assets ratio below a certain cutoff point
