Ch 3- Financial Statements, Cash Flow, Taxes Flashcards

Question

TIME-TREND ANALYSIS

Answer 1

One standard we could use is history. In our Prufrock example, we looked at two years of data. More generally, suppose we find that the current ratio for a particular firm is 2.4 based on the most recent financial statement information. Looking back over the last ten years, we might find that this ratio has declined fairly steadily. Based on this, we might wonder if the liquidity position of the firm has deteriorated. It could be, of course, that the firm has made changes to use its current assets more efficiently, that the nature of the firm’s business has changed, or that business practices have changed. If we investigate, these are all possible explanations. This is an example of what we mean by management by exception—a deteriorating time trend may not be bad, but it does merit investigation

Answer 2

The second means of establishing a benchmark is to identify firms that are similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. In other words, we need to identify a peer group. This approach is often used together with time-trend analysis and the two approaches are complementary. In our analysis of Prufrock, we used an industry average without worrying about where it came from. In practice, matters are not so simple because no two companies are identical. Ultimately, the choice of which companies to use as a basis for comparison involves judgment on the part of the analyst. One common way of identifying peers is based on the North American Industry Classification System (NAICS) codes. These are five-digit codes established by the statistical agencies of Canada, Mexico, and the United States for statistical reporting purposes. Firms with the same NAICS code are frequently assumed to be similar. Various other benchmarks are available. You can turn to Statistics Canada publications and websites that include typical statements of financial position, statements of comprehensive income, and selected ratios for firms in about 180 industries. Other sources of benchmarks for Canadian companies include financial 14 15 16 databases available from The Financial Post Datagroup and Dun & Bradstreet Canada. Several financial institutions gather their own financial ratio databases by compiling information on their loan customers. In this way, they seek to obtain more up-to-date information than is available from services like Statistics Canada and Dun & Bradstreet. Obtaining current information is not the only challenge facing the financial analyst. Most large Canadian corporations do business in several industries so the analyst must often compare the company against several industry averages. Keep in mind that the industry average is not necessarily where firms would like to be. For example, agricultural analysts might know that farmers are suffering with painfully low average profitability coupled with excessive debt. Despite these shortcomings, the industry average is a useful benchmark for the management by exception approach we advocate for ratio analysis.

Answer 3

As we discuss in other chapters, there are many cases where financial theory and economic logic provide guidance to making judgments about value and risk. Very little such help exists with financial statements. This is why we can’t say which ratios matter the most and what a high or low value might be. One particularly severe problem is that many firms are conglomerates, owning more or less unrelated lines of business. The consolidated financial statements for firms such as BCE Inc. don’t really fit any neat industry category. More generally, the kind of peer group analysis we have been describing works best when the firms are strictly in the same line of business, the industry is competitive, and there is only one way of operating. Another problem that is becoming increasingly common is having major competitors and natural peer group members in an industry scattered around the globe. As we discussed in Chapter 2, the trend toward adopting IFRS improves comparability across many countries but the U.S. remains on GAAP. This complicates interpretation of financial statements for companies with operations in both the U.S. and Canada as well as internationally. Even companies that are clearly in the same line of business may not be comparable. For example, electric utilities engaged primarily in power generation are all classified in the same group. This group is often thought to be relatively homogeneous. However, utilities generally operate as regulated monopolies, so they don’t compete with each other. Many have shareholders, and many are organized as cooperatives with no shareholders. There are several different ways of generating power, ranging from hydroelectric to nuclear, so their operating activities can differ quite a bit. Finally, profitability is strongly affected by regulatory environment, so utilities in different locations can be very similar but show very different profits. Several other general problems frequently crop up. First, different firms use different accounting procedures for inventory, for example. This makes it difficult to compare statements. Second, different firms end their fiscal years at different times. For firms in seasonal businesses (such as a retailer with a large Christmas season), this can lead to difficulties in comparing statements of financial position because of fluctuations in 16 accounts during the year. Finally, for any particular firm, unusual or transient events, such as a onetime profit from an asset sale, may affect financial performance. In comparing firms, such events can give misleading signals.