Chapter 12: Financial Statement Analysis Flashcards
Financial statement analysis
the process of evaluating a company’s performance based on an analysis of their financial statements: the statement of financial position, statement of income, statement of changes in equity, statement of cash flows, and the notes to the financial statements.
What Is the Process for Analyzing Financial Statements?
From the Chartered Financial Analyst Institute’s financial statement analysis framework
The steps in the process are as follows:
- Determine the purpose and context of the analysis.
- Collect the information needed for the analysis.
- Prepare common-size analysis and calculate ratios or other metrics.
- Analyze and interpret the metrics from Step 3.
- Develop conclusions and recommendations.
- Determine the purpose and context of the analysis.
Determine the questions that the analysis will help answer.
For example, should we invest in this company?
Knowing the context for the analysis or the type of questions you are trying to answer will help you make decisions regarding the type(s) of information that you will need to gather and determine the tools or techniques that would best support this analysis.
- Collect the information needed for the analysis.
May include the company’s annual report, which includes the annual financial statements and the management discussion and analysis (MD&A). Industry data (including industry ratios and trends) and other economic data (such as inflation rates and exchange rates)
-It is important to understand that the analyst must move beyond the four financial statements and use information from the notes to the financial statements.
- Prepare common-size analysis and calculate ratios or other metrics.
The challenge is to ensure the right data are being used and the metrics being calculated make sense given the purpose of the analysis.
- Analyze and interpret the metrics from Step 3.
Using the ratios or metrics calculated in Step 3, combined with the knowledge of the company and other information gathered, the analyst analyzes the information and interprets the results
-Comparing ratios over the years
-analyst adds the most value to the analysis
- Develop conclusions and recommendations.
These are answers to the questions established in Step 1. When developing conclusions, it is important that the analyst differentiate between factual results and their opinion(s).
What Are the Common Contexts for Financial Statement Analysis?
There is a wide variety of contexts that commonly require the analysis of financial statements, couple examples:
- A company’s credit department may analyze the financial statements of customers seeking credit terms.
- A pension fund may analyze the financial statements of companies it is considering as potential investments or of the companies it is currently invested in.
Why Is an Understanding of Context Essential to the Analysis?
It will determine the type of information and data that will be required.
It will also drive decisions regarding the techniques that will be used to complete the analysis.
An investment analyst
will analyze the company’s results relative to other companies
Why Is It Essential to Understand the Business Being Analyzed?
Understanding the business means more than understanding a company’s financial statements.
- It means having a grasp of:
- the operating activities of the business,
- the underlying economics,
- the risks involved,
- and the external economic factors that are crucial to the company’s long-term and short-term health.
It means having an understanding of the various types of businesses that the company is in.
When analyzing companies that have diverse business activities like Canadian Tire Corporation, analysts rely on
segmented information
operating segments
The various business activities within a company, or various geographic regions in which a company operates.
If a company has more than one operating segment and meets certain quantitative thresholds, it must disclose information related to the segments in a note to the financial statements
Segments can differ significantly with regard to risk and are affected in different ways by such economic factors:
as commodity prices, inflation, exchange rates, and interest rates
The two most common strategies are:
(corporation’s strategies)
(Business strategies)
1) being a low-cost producer
2) following a product differentiation strategy
A low-cost producer
Focuses on providing goods or services at the lowest possible cost and selling at low prices
- these companies need to sell a high volume of goods at the lower prices
Discount grocery chains or discount retailers usually follow this strategy.
The product differentiation strategy
to sell products that are specialized or to provide superior service that customers are willing to pay a premium for
-Sell for high to make the same amount of profit, but sell fewer volume
Gourmet grocery or specialty stores and high-end retailers usually follow this strategy
What Information Is the Financial Statement Analysis Based on and Where Is It Found?
Primary source is the company’s annual report
company’s annual report
contains several sections, including the:
1) management discussion and analysis (MD&A),
2) the auditor’s report,
3) the financial statements,
4) and the notes to the financial statements
Management Discussion and Analysis (MD&A)
Gain a basic understanding including its recent achievements and management’s future expectations
management discusses many aspects of the company’s financial performance in greater detail
a discussion of past results, but also of management’s expectations for the future and the risks the company is facing.
The objective of the MD&A is to
allow the user to see the company through the eyes of management.
The Auditor’s Report
A report in which auditors express their opinion on whether the financial statements present the information fairly according to accounting standards
- the auditor’s opinion does not guarantee the accuracy of the information contained in the financial statements
- External auditor appointed by the company’s board of director
- Doesn’t say whether the information is positive or negative (meaning either bad or good for results)
unmodified opinion
In the auditor’s opinion, the expression that the financial statements upon which the opinion is being based are fairly presented
modified opinion (aka qualified opinion)
In an auditor’s opinion, an expression that signals it has been concluded that the financial statements are not fairly presented.
Also known as a qualified opinion as it includes a qualification explaining the nature of the financial misstatement
-or was unable to obtain sufficient audit evidence
Auditor’s third choice ( adverse opinion)
adverse opinion (in which they state that the financial statements are materially misstated and should not be relied upon
Auditor’s fourth choice (disclaimer of opinion)
in which they don’t express an opinion due to an inability to obtain sufficient audit evidence.
The new auditor’s report (important)
places the auditor’s opinion at the beginning of the report; highlights the independence of the auditor; and provides an expanded discussion of the responsibilities of the management, the board, and the auditor with respect to the financial statements
- new standard related to key audit matters, which enables auditors to include in their auditor’s report any matters that they consider to be of most significance in the audit
- include items that are significant due to their materiality, complexity, or subjectivity
- include information on corrected or uncorrected misstatements, areas where obtaining audit evidence was difficult, or areas where weaknesses in the company’s internal controls were observed
The vast majority of auditor’s reports express
an unmodified opinion.
financial statement analysis is done to
help decision makers with investment or lending decisions
prospective analysis
A financial statement analysis of a company that attempts to look forward in time to predict future results
- foreshadowing or guessing the future
- predicting the future
generally the most reliable source of data available is the company’s historical results
Example: Forecasting future cash flows to ensure the company can pay their loans
Issues and challenges with prospective analysis
the world is an uncertain place; no one can predict the future with complete accuracy
retrospective analysis
A financial statement analysis of a company that looks only at historical data
-they must be confident that past results are a suitable predictor of future outcomes
Using the results of the last years to predict the next
There are two major types of retrospective analyses:
1) trend analysis
2) cross-sectional analysis.
trend analysis
the analyst examines a company’s information from multiple periods (normally years) to look for any patterns in the data over time (such as 3–10 years)
- Looking at sales over 5 years allows to see any increases or decreases
- is useful for identifying patterns and changes
EBITDAR (type of adjusted EBITDA)
earnings before interest, taxes, depreciation, amortization, acquisition, and restructuring
-It is the metric the company uses to evaluate recurring operating performance
Adjusted EBITDA
(earnings before interest, taxes, depreciation, and amortization)
Cross-sectional analysis
cross sectional analysis
cross-sectional definition
compares the data from one company with those of another company over the same time period.
- Normally, the companies should operate in the same industry, perhaps as competitors
- may also compare one company with an average of the other companies in the same industry
IMPORTANT: different companies use different accounting methods
–different countries may use different accounting principles
common-size analysis
common size analysis
It involves converting the dollar values in the financial statements into percentages of a specific base amount
when preparing common-size analysis of a statement of financial position
-the base used is normally total assets
When preparing common-size analysis of a statement of income,
the base is normally total revenues
common-size statement of financial position
each item is determined as a percentage of total assets
common-size statement of income
each item is expressed as a percentage of total revenues
The ratios compare the relationships between various elements in the financial statements, such as:
1) an amount from one statement, such as the statement of income, and an amount from another, such as the statement of financial position (for example, cost of goods sold relative to inventory)
2) amounts from the statement of financial position (such as current assets relative to current liabilities)
3) amounts from the statement of income (such as cost of goods sold relative to total sales revenue)
Ratios tell you about the relationship between two figures but not why these changes occurred
red flags
redflags
they identify areas that the user needs to investigate further.
five common categories of ratios:
(exhibit 12.5)
Exhibit 12.4 too
1) liquidity ratios
2) activity ratios
3) solvency ratios
4) profitability ratios
4) equity analysis ratios
- Liquidity Ratios
—used to assess a company’s ability to meet its obligations in the near future
Current ratio and Quick Ratio
- Activity Ratios
—used to assess how efficiently a company manages its operations
Accounts Receivable Turnover Average Collection Period Inventory Turnover Days to Sell Inventory Accounts Payable Turnover Accounts Payable Payment Period
- Solvency Ratios
—used to assess a company’s ability to meet its long-term obligations, including its obligation to pay interest
Debt to Equity
Net Debt as a Percentage Capitalization
Interest Coverage
Cash Flows to Total Liabilities
- Profitability Ratios
—used to assess a company’s ability to generate profits
Gross Margin Profit Margin Return on Equity Return on Assets
- Equity Analysis Ratios
—used to assess shareholder returns
Basic Earnings per Share
Price/Earnings (P/E) Ratio
Dividend Payout
Dividend Yield
Net Free Cash Flow
operating efficiency ratios
Ratios used to assess how efficiently a company manages its operations
accounts receivable turnover
The number of times that accounts receivable are turned over, or how often they are collected in full and replaced by new accounts.
Solvency
the company’s ability to pay its obligations in the long term (more than one year into the future)
-Analysts use it as a key indicator of a company’s level of risk
Two dimensions are used to assess solvency:
(1) risk, based on the level of leverage in the company, (2) coverage, based on the company’s ability to meet its interest and debt payments
Profitability measures
help analysts assess the potential return
What Are the Limitations of Ratio Analysis?
- Accounting policies
- Definitions of ratios
- Diversity of operations
- Seasonality
- Potential for manipulation
- Accounting policies
Public companies in Canada use IFRS, but some use U.S. accounting standards instead
some assets and liabilities are carried at historical cost values while others are at market values
Some companies may depreciate their capital assets using the straight-line method, while others may use an accelerated or production-based method
- Definitions of ratios
if you are trying to interpret a ratio that has been calculated by the company and presented in its annual report or is from some other source, it is important that you understand how it was determined before you attempt to interpret it.
- Diversity of operations
The degree of diversity in a company’s operations will affect your ability to interpret ratios related to it
While diversity of operations can make it difficult to compare companies, it does not normally affect trend analysis for the same company unless the company’s mix of operations has also changed over time, such as if it has acquired or divested of major segments.
- Seasonality
Companies normally choose to have their financial year end at the end of their business cycle
The effects of seasonality can be somewhat mitigated by using the quarterly financial information that public companies are required to report.
- Potential for manipulation (Window dressing)
Certain ratios, like the current and quick ratios, are based on figures at one point in time. This makes it possible for a company to manipulate them
window dressing
The manipulation of certain ratios, such as current and quick ratios, by undertaking or postponing transactions to produce a more desirable number.
IFRS financial measures ( aka GAAP Financial Measures)
Measures or ratios that are prepared using information taken directly from the financial statements that were prepared using generally accepted accounting principles (GAAP)
non-IFRS financial measures (or non-GAAP financial measures).
Measures that have not been defined by accounting standard setters as part of the International Financial Reporting Standards (IFRS)
Three commonly used non-IFRS financial measures are:
1) free cash flow
2) EBITDA (earnings before interest, taxes, depreciation, and amortization)
3) net debt
industry metrics (aka key performance indicators)
Quantifiable measures used to assess performance for a given industry
Include: same-store sales, comparable sales growth, average revenue per customer, and sales per square foot.
Why Should We Be Cautious When Using Non-IFRS Financial Measures and Industry Metrics?
We should exercise caution when using non-IFRS financial measures and industry metrics for a number of reasons, including.
There are no standard definitions for these measures, so management is free to define them as they see fit.
These measures are often not comparable across companies or across periods.
The information used in determining these measures is unaudited.
why complete financial analysis?
It will provide signals about financial health, cash flows, and operating efficiency
It will generate additional questions and point to areas that require even further analysis.
If sales are rising at a greater rate than the cost of those sales,
The new sales are producing more gross profit.
When other costs remain the same
An increase in sales results in an increase in net income
In fact, common-size statements are particularly useful in cross-sectional analysis because they allow you to compare companies of ______________
different sizes
When commenting on ratios and trends, be sure to use evaluative or interpretive terms. Do not simply make superficial, mathematical observations; show that you understand what the figures mean
Good hint for ratio analysis
Describing numerical results
do not simply say that a ratio or percentage is higher/lower or increasing/decreasing. Instead, try to use terms such as stronger/weaker, better/worse, and improving/deteriorating, when you describe the numeric results
diluted earnings per share
The reason the diluted EPS measure is presented is that companies may issue securities that are convertible into common shares. Examples of these types of securities are convertible debt, convertible preferred shares, and stock options. The key feature of these securities is that they are all convertible into common shares under certain conditions
If additional common shares are issued upon their conversion, the earnings per share number could decrease because of the larger number of shares that are outstanding. This is called the potential dilution of earnings per share. A diluted EPS figure is determined to reflect what EPS would have been if all of these securities had been converted into common shares. As you would expect, diluted EPS will be less than basic EPS whenever dilutive securities exist.
Canadian audit firms use ________ auditor’s report that includes entity-specific content.
Expanded
For 2020, a company reports profit of $813,000, average shareholders’ equity of $1,900,000, and preferred dividends of $13,000. Find the 2020 return on common shareholders’ equity
42.1
813,000 - 13,000 / 1,900,000
Sales revenue for the current year were $70,000, and gross profit margin was 25%. What was the amount of cost of goods sold for the current year?
$52,500
