Book 3 - FRA - FSA: Application Flashcards
Evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance.
Trends in financial ratios and differences between a firm’s financial ratios and those of its competitors or industry averages can indicate important aspects of a firm’s business strategy. Consider two firms in the personal computer business. One builds relatively high-end computers with cutting-edge features, and one competes primarily on price and produces computers with various configurations using readily available technology. What differences in their financial statements would we expect to find?
Premium products are usually sold at higher gross margins than less differentiated commodity-like products, so we should expect cost of goods sold to be a higher proportion of sales for the latter. We might also expect the company with cutting-
edge features and high quality to spend a higher proportion of sales on research and development, which may be quite minimal for a firm purchasing improved components from suppliers rather than developing new features and capabilities in-house. The ratio of gross profits to operating profits will be larger for a firm that spends highly on research and development or on advertising.
In general, it is important for an analyst to understand a subject firm’s business strategy. If the firm claims it is going to improve earnings per share by cutting costs, examination of operating ratios and gross margins over time will reveal whether the firm has actually been able to implement such a strategy and whether sales have suffered as a result.
Prepare a basic projection of a company’s future net income and cash flow.
A forecast of future net income and cash flow often begins with a forecast of future sales. Over shorter horizons, the “top down” approach to forecasting sales is used. The analyst begins with a forecast of GDP growth, often supplied by outside research or an in house economics group. Historical relationships can be used to estimate the relationship between GDP growth and the growth of industry sales. If the subject firm’s market share is expected to remain the same, the growth of firm sales will be the same as the growth in industry sales. If the analyst has reason to believe the firm’s market share will increase or decrease next period, the market share can be adjusted for this change and then multiplied by estimated industry sales for the next period to get the forecast of firm sales for the period.
In a simple forecasting model, some historical average or trend-adjusted measure of profitability (operating margin, EBT margin, or net margin) can be used to forecast earnings. In complex forecasting models, each item on an income statement and balance sheet can be estimated based on separate assumptions about its growth in relation to revenue growth. For multi-period forecasts, the analyst typically employs a single estimate of sales growth at some point that is expected to continue indefinitely.
Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.
Traditionally, credit analysts have spoken of the “three Cs,” “four Cs,” or even the “five Cs” of credit analysis. One version o f the three Cs includes: Character, Collateral, and Capacity to repay.
Character refers to the firm management’s professional reputation and the firm’s history of debt repayment. The ability to pledge specific collateral reduces lender risk. It is the third C, the capacity to repay, that requires close examination of a firm’s financial statements and ratios. Since some debt is for periods of 30 years or longer, the credit analyst must take a very long-term view of the firm’s prospects.
Describe the use of financial statement analysis in screening for potential equity investments.
In many cases, an analyst must select portfolio stocks from the large universe of potential equity investments. Whether the object is to select growth stocks, income stocks, or value stocks, accounting items and ratios can be used to identify a manageable subset of available stocks for further analysis.
Some investment strategies even have financial ratios in their names, such as low price/earnings and low price/sales investing. Multiple criteria are used because a screen based on a single factor can include firms with other undesirable characteristics. For example, a company with a low price/earnings ratio may also have operating losses, declining sales prospects, or very high leverage.
Backtesting refers to using a specific set of criteria to screen historical data to determine how portfolios based on those criteria would have performed.
Determine and justify appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.
**Investments in Securities. **Because the classification ofa firm’s investment securities affects how changes in their values are recorded, it can significantly affect reported earnings and assets.
Inventory Accounting Differences. A firm using LIFO (permitted only under U.S. GAAP) will report higher cost of goods sold, lower income, and lower inventory compared to FIFO inventory accounting when costs are rising. The LIFO reserve, which all LIFO firms must report, can be used to adjust LIFO cost of goods and inventory to their FIFO-equivalent values.
**Differences in Depreciation Methods and Estimates. **Disclosures related to depreciation are not specific enough to permit adjustments to ensure comparability. However, some qualitative information for comparing companies’ methods can be obtained.
Off-Balance-Sheet Financing. Debt ratios should include liabilities for both capital (finance) leases and operating leases. Firms include the estimated present value of future capital lease payments with their financials, so that part is straightforward. Although firms must report payments due under operating leases (each year for five years, and total beyond five years), the present value of these is not a required item. To estimate the present value of operating lease liabilities, an analyst can use the ratio of the present value of capital lease obligations to the sum of these future payments, or make some assumption about the timing of operating lease payments beyond five years and calculate a discount rate to use when calculating the present value of operating lease payments. We illustrate both methods in the following example.
Goodwill. Two companies with identical assets, but where one has grown through acquisition of some business units while the other has grown internally by creating such business units, will show different balance sheet values for the same assets.
**Other Intangible Assets. **Additional adjustment may be required for IFRS firms that revalue intangible assets upward, which is not permitted under U.S. GAAP. As revaluations that do not reverse previously reported impairment are taken directly to equity, an analyst can improve comparability of financial ratios by reducing intangible asset values (and thereby equity) by the cumulative amount of any such upward revaluations.
An alternative ratio, price to tangible book value, removes both goodwill and intangible assets from equity to get tangible book value. This adjustment will reduce assets and equity and produce a ratio that is not affected by differences in intangible asset values resulting from differences in how the assets were acquired.
