(33) Financial Statement Analysis: Application Flashcards
LOS 33. a: Evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance.
Trends in a company’s financial ratios and differences between its financial ratios and those of its competitors or industry average ratios can reveal important aspects of its business strategy.
Ensure you know how to identify which ratios to use to determine which part of the business you are evaluation. (Ex. To analyze a company’s operating strategy, calculate the activity ratios.)
LOS 33. b: Forecast a company’s future net income and cash flow.
A company’s future income and cash flows can be projected by forecasting sales growth and using estimates of profit margins and the increase in working capital and fixed assets necessary to support the forecast sales growth.
LOS 33. b: Forecast a company’s future net income and cash flow. An analyst who is projecting a company’s net income and cash flow is likely to assume a constant relationship between the company’s sales and its…? How does this relate to borrowing/interest expenses?
Projections of net income and cash flows are typically based on assumptions that cost of goods sold, operating expenses, and noncash working capital remain a constant percentage of sales. The projections then show whether additional borrowing is needed during the forecasted period. If so, the analyst should adjust the interest expense to reflect the additional debt.
LOS 33. c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage.
Scale and diversification: Larger companies and those with a wider variety of produc tlines and greater geographic diversification are better credit risks.
LOS 33. c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage.
Operational efficiency: such items as operating ROA, operating margins, and EBITDA margins fall into this category. Along with greater vertical diversification, high operating efficiency is associated with better debt ratings.
LOS 33. c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage.
Margin stability: Stability of the relavant profitability margins indicates a higher probability of repayment (leads to a better debt rating and a lower interest rate). Highly variable operating resutls make lenders nervous.
LOS 33. c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage.
Leverage: Ratios of operating earings, EBITDA, or some measure of free cash flow to interest expense or total debt make up the most important part of the credit rating formula. Firms with greater earnings in relation to their debt and in relation to their interest expense are better credit risks.
LOS 33. d: Describe the use of financial statement analysis in screening for potential equity investments.
Potentially attractive equity investments can be identified by screening a universe of stocks, using minimum or maximum values of one or more ratios. Which (and how many) ratios to use, what minimum or maximum values to use, and how much importance to give each ratio all present challenges to the analyst.
LOS 33. e: Explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company. Analysts must adjust the financial statements of multiple companies for comparability, what are examples of areas where different accounting methods or estimates may differ between companies?
When companies use different accounting methods or estimates relating to areas such as inventory accounting, depreciation, capitalization, and off-balance-sheet financing, analysts must adjust the financial statements for comparability.
LOS 33. e: Explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company. How would an analyst adjust a company using LIFO to compare it to a company using FIFO?
LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO cost of goods sold can be adjusted to a FIFO basis by subtracting the change in LIFO reserve.
LOS 33. e: Explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company. What adjustments may be made to increase comparability of solvency ratios?
When calculating solvency ratios, analysts should estimate the present value of operating lease obligations and add it to the firm’s liabilities.
The appropriate adjustment for operating leases is to treat them as if they were capital leases by estimating the present value of the future lease obligations and adding that value to the firm’s liabilities and long-lived assets.
