Chapter 1 : (Part 2)

Question 1

What are the two rules of Item 1- Business under the regulation S-K?

Answer 1

• The first rule requires a company to describe the overall development of its business over the last five years, or a shorter period if the company has been operating for less than five years.
• The second rule requires a company to describe the business it currently does and plans to do, focusing on its main segments or divisions that are reported in its financial statements.

Question 2

How can we explain and understand a company’s business model in simple terms?

Answer 2

• Articulate how the company makes money
• Identify the type of economic frictions the company addresses in the economic system.

Question 3

What are economic efficiencies?

Answer 3

Economic frictions refer to problems or inefficiencies in the market that the company aims to solve or improve.

Question 4

What is a SWOT analysis?

Answer 4

It’s a planning tool used to understand key factors:

Strength
Weakness
Opportunities
Threats

• Strengths, Weaknesses (are internal factors) → Positive factors
• Opportunities, Threats (External factors) → Negative factors

Question 5

How do we know a company has a competitive advantage?

Answer 5

What factors does this company have that explains its competitive advantage?

Examples: Strong brand recognition, cost efficiency

Is the competitive advantage sustainable?

This focuses on whether the advantage can last over time.

Question 6

What if a company has no competitive advantage?

Answer 6

• Does the company’s management team have a plan to develop a sustainable competitive advantage that can be implemented in:

An acceptable period of time
With a reasonable amount of investment

Question 7

What are some ways a company can achieve a competitive advantage in the market?

Answer 7

Barriers to entry:

Patents, copyright and other legal protections
Regulatory and licensing barriers
Scarce resources

Product/Service differentiation:

Technological innovation and product design
Marketing, distribution and after-sale customer support
Market segmentation

Cost leader:

Access to low-cost raw materials or labour
Manufacturing or service efficiency
Manufacturing scale efficiencies
Greater bargaining power with suppliers
Sophisticated IT systems

Question 8

What is a business model?

Answer 8

The term business model refers to a company’s plan for making a profit.

Question 9

What are the factors under the business model + factors under it?

Answer 9

Business description:

Industry
Life Cycle Stage

Competition:

Major competitors
Market share
Competitive advantage

Product and/or service:

Product profile
Sales driver
Life cycle

Customers:

Major customers
Customer concentration
Marketing strategy/distribution process

Supplier:

Key suppliers
Credit terms
Bargaining power
Alternative source of supplier

Ownership:

Owners
Owner structure
Owners involvement

Governance and Management:

Board of directors
Management and directors background and experience
Compensation
Successor plan

Question 10

What are the two types of ratio comparison?

Answer 10

Time-series comparison (Horizontal analysis)
Cross-sectional comparison

Question 11

What is the time-series comparison (horizontal analysis)?

Answer 11

• This method compares financial ratios over different time periods (e.g., quarterly or yearly) to track trends and changes.
• It helps us identify changes in performance and detect the underlying cause of this change in performance (normal vs abnormalities)
• Triangulating the ratios with structural changes means analysing financial ratios from multiple angles alongside key structural changes in the company or market to understand what’s driving changes in performance

Question 12

What is the cross-sectional comparison?

Answer 12

• Its when we compare the firm’s ratios with competitors
• We can also call a cross-sectional comparison a comparative analysis (or comps for short)
• Triangulate the ratios with corporate strategy

{This means triangulation means looking at the ratios alongside the company’s strategic goals to see if they align.}

Question 13

What is the purpose of ratio comparison?

Answer 13

Its to forecast future

Question 14

What does the ratio tend to do?

Answer 14

Mean-revert

Question 15

What does mean revert (mean reversion)?

Answer 15

Mean reversion is when ratios tend to return to a normal or average level over time:

If ratios are high they tend to fall
If ratios are usually low they tend to rise

The speed and completeness of a ratio reverting to its average or normal can depend on the ratio and the specific firm.

Question 16

What does the caveat have to say about man reversion?

Answer 16

This means that most ratios tend to go back to their average values over time when looking at a lot of companies. But not every individual company or ratio will follow this pattern exactly.

Question 17

What is a common size (vertical statement)?

Answer 17

• Its when all accounts in the financial statements are expressed as a % of one account
• It makes it easier to compare companies of different sizes or track trends over time.

Question 18

What should be the common denominator for a common size income statement?

Answer 18

revenue

Question 19

What are some advantages of the common size (vertical statements)

Answer 19

• It allows ut to make meaningful comparisons over time while controlling for changes in firm size (measured as either sales or total assets)
• Allows meaning comparisons for firms using different currencies
• Allows meaningful comparisons between firms

Question 20

What should be the common denominator for a common size balance sheet?

Answer 20

Assets

Question 21

What is a disadvantage of the common size (vertical statements)?

Answer 21

• While common size statements are useful for high-level comparisons, you still need to investigate underlying causes to fully understand the changes.

Example changes in expenses may not be directly related to changes in sales

Question 22

What are horizontal financial statements?

Answer 22

Its when each line item is expressed as a percentage of a base year (fixed or rolling)

Question 23

What does horizontal analysis help measure?

Answer 23

It help us measure the growth on each item over time.

Question 24

What is a disadvantage of a horizontal financial statement?

Answer 24

• When we compute the % changes to be cautious that a large percentage change of a small (immaterial) account can be misleading.
• Just because there’s a big % change is big does not mean it’s meaningful or relevant.

Question 25

What is forecasting?

Answer 25

It involves us formulating our predictions and stating them as financial projections

Question 26

What are the two factors that help the quality of our forecasts?

Answer 26

Quality of the priori analysis:

How well we understand the business
How thoroughly we examined and adjusted the companies financial statements

Realistic and achievable assumptions:

Objectively examine what evidence supports or challenges the forecast assumptions

Question 27

What is the order of forecasting financial statements?

Answer 27

Income statement
Balance sheet
Statement of cash flows