Chapter 7 - Analysis of published Financial Statements

Question 1

What are the 5 key measures for determining the financial strength of a company?

Answer 1

• Profitability : the main objective of a company and its management (the agent) is to earn a satisfactory return on
  the funds invested by the investors or shareholders (the principal). Financial analysis ascertains whether adequate
  profits are being earned on the capital invested. It is also useful to understand the earning capacity of a company, its
  wellbeing and its prospects, including the capacity to pay the interest and dividends.
• Trend of achievements: analysis can be done through the comparison of financial statements with previous years
  – especially in relation to trends regarding various expenses, sales/revenue, gross profits and operating profit.
  Users can compare the value of assets and liabilities and forecast the future prospects of a company.
• Growth potential of a company: financial analysis indicates the growth potential of a company.
• Comparative position in relation to similar companies or businesses: financial analysis help the management
  to study the competitive position of their company in respect of sales/revenue, expenses, profitability and capital
  utilisation.
• Overall financial strength and solvency of a company: analysis helps users make decisions by determining
  whether funds required for the purchase of new equipment and other assets are provided from internal sources or
  received from external sources and whether the company has sufficient funds to meet its short-term and long-term
  liabilities.

Question 2

Factors considered by fundemental analysis

Answer 2

Economic environment company operates in / industry it belongs to and other factors such as:
* interest rates
* production
* earnings
* employment
* gross domestic product (GDP)
* housing
* manufacturing
* management

Question 3

What are the objectives of fundemental analysis of published financial statements?

Answer 3

The combination of qualitative and quantitative data depicts a holistic picture of the company. The end goal of this
analysis is to generate insights and forecasts about the company’s future performance.
There are several other
objectives, including:
* valuing the company
* evaluating the performance of company management and auditing business decisions
* determining the company’s intrinsic value and its growth prospects
* benchmarking the performance of the company against its industry and the wider ec

Question 4

4 stages of the economic cycle per NBER

Answer 4

• recovery (expansion),
• boom (peak),
• recession (contraction)
• depression (trough).

Question 5

Per Grodinsky what are the stages of industry life cycle (4)

Answer 5

• Pioneer stage: this is the first stage of a new industry where products and technology are newly introduced and
  have not reached a state of perfection – such as new mobile applications and the software industry. There is an
  opportunity for rapid growth and profit – and high risk.
• Expansion stage: this is the second stage of expansion of those that survived the pioneering stage. Companies
  grow larger and are quite attractive for investment purposes.
• Stagnation stage: growth stabilises and sales grow at a slower rate than that experienced by competitive industries
  or by the overall economy.
• Decay stage: the industry becomes obsolete and ceases to exist with the arrival of new products and new
  technologies (for example, the black-and-white television industry).

Question 6

Michael Porter - 5 main forces that collectively determine the long-term profit potential of a company

Answer 6

• Barriers to entry for new players to enter the market: this refers to how difficult or easy it is for a new player to
  enter the industry. In an industry with little-to-no barrier to entry, new players have a competitive advantage while
  existing suppliers constantly face a new set of competitors. Barriers to entry include heavy capital requirement,
  significant differentiation via technology, regulation challenges and poor distribution channels.
• Bargaining power of customers: a strong buyer can make an industry more competitive and can push existing
  businesses to lower their prices or offer additional services in comparison to its competitors. Customers now have
  more bargaining power as they can switch between suppliers.
• Bargaining power of suppliers: suppliers in a strong bargaining position can choose to reduce the quantity of the
  product available. If there are few close substitutes, buyers can switch as and when the switching cost to new suppliers
  is too high. The suppliers hold the power to influence the customers and establish competitive advantage. Suppliers
  are also in a strong position if the product or service they supply is an essential component of the end product.
• Availability of substitute goods: product substitution occurs when customers can switch easily between competitors.
  If all players are producing similar products with little to no differentiation, pricing is fixed. However, businesses can
  work against this by adding significant product differentiation with a clear focus on consumer requirements.
• Competitors and nature of competition: the rivalry among players places significant barriers to the industry. This
  rivalry can result in price wars, constant innovation in product offerings and new product launches, leading to lower
  profits. In the long term, it increases fixed costs for businesses, lowers growth rates for the industry and stagnates
  company performance.

Question 7

What is ‘company analysis’?

Answer 7

Company analysis evaluates information relating to the company’s profile, products and services as well as its profitability and financial position.<br></br>
During the process of company analysis, an investor also considers factors that have
contributed to shaping the company. Different companies from the selected industry are usually analysed and evaluated
so that the most attractive company can be identified.

Question 8

Elements of ‘company analysis’

Answer 8

• An overview of the company: the most important points about the company, like its mission statement, legal
  structure, goals and values, history, management team and location. Other useful information includes the
  company’s service performance, product lifecycle stages, competitive strategy, sales and marketing practice,
  management track record and its future prospects.
• Analysis of competitive strategies: broadly, the company will either have a low-cost approach or a product/
  service differentiation approach when combating competition. There may be a hybrid approach in certain situations.
  This will help when understanding product positioning.
• Analysis of financial statements: conducted using trend analysis, financial ratios and other financial statistics.

Question 9

What is ‘trend analysis’?

Answer 9

Trend analysis is the process of analysing financial data to identify any consistent results or trends<br></br>
Trends can be horizontal or vertical.<br></br>
* Horizontal analysis - compares line items in a company’s financial statements or financial ratios over multiple time periods

• Vertical analysis - proportional analysis of line items as a percentage of a base item

<br></br>Trend analysis is useful when evaluating the true picture of a company.

Question 10

What are the 4 main reasons trend analysis is helpful?

Answer 10

• analysing revenue patterns across products, geography, or customers
• checking the impact of any unusual one-off expenditure in a period
• preparing financial projections for the company
• comparing results from multiple companies in the same industry

Question 11

Horizonal analysis - between periods calculation

Answer 11

Change (in amount) = Current period amount - Base period amount period amount

Question 12

Main usefulness

Answer 12

• Trend analysis: analyse pattners across periods / check impact of one off expenditures/prepare financial projections/compare multiple companies in same industry
• Ratio analysis: predicting future performance

Question 13

5

5 Categories of financial ratios

Answer 13

• profitability ratios
• efficiency or turnover ratios
• liquidity or solvency ratios
• gearing or debt ratios
• investment or market value ratios

Question 14

What is the purpose of profitability ratios

Answer 14

Profitability ratios measure the capability of the company to generate profit compared to revenue, expenses, assets
and shareholders’ equity. They indicate the effectiveness of the capital and asset utilisation. There are various types of
profitability ratios which are used by companies and analysts.

Question 15

2 main types of profitability ratios

Answer 15

Margin Ratios - company ability to covert revenue into profit
Gross profit margin ratio
Operating profit margin ratio
Net profit margin ratio
<br></br>
Return Ratios - company ability to generate returns to investors (inc. shareholders)
Return on assets ratio (ROA)
Return on shareholders’ equity ratio (RSE)
Return on capital employed ratio (ROCE)

Question 16

Drivers behind gross profit margin ratio

Answer 16

• Selling prices
• Product mix
• Purchase costs
• Production costs
• Inventory valuation

Question 17

Factors impacting operating profit margin ratio

Answer 17

OPM ratio: % profit left after accounting for operating expenses. Higher means more likely to cover fixed costs inc. interests comfortably<br></br>
FACTORS
* Employment policy
* Depreciation methods
* Write-off of bad debts
* Selling expenses
* Marketing expenses

Question 18

Net profit ratio

Answer 18

Like the operating profit margin ratio, net profit margin ratio evaluates the company’s ability to generate earnings after
taxes. This ratio reflects the strength of the management, since visionary management strives to improve the profitability
of a company above all its costs. It also checks how effectively the company has administered the process.
The formula for calculating net profit margin ratio is as follows.
(Net profit ÷ revenue) × 100
Where net profit = revenue – cost of goods sold – operating expenses – non-operating expenses + non-operating
income – income tax.
As an alternative, the net profit margin ratio may use profit before tax. The higher the ratio, the more favourable it is for
the company.

Question 20

LIMITATIONS OF RATIO ANALYSIS (6)

Answer 20

• Ratio analysis is only the first step towards financial statement analysis. Final conclusions cannot be drawn based
  on mere percentages shown by the ratios, as they may not reflect the holistic picture about a company’s situation.
  One needs to be vigilant while conducting research on the company.
• Mathematical calculation does not work when the base figure is zero or negative, as it may not reflect the true
  picture. For example, if bad debts for the base period and the current period are zero and £500, respectively, one
  cannot calculate the change as a percentage.
• Company projections based on trend and ratio analysis are not adequate as the trend is a reflection of historical
  actions which may or may not be applicable in the future. Moreover, ratios are purely based on accounting data.
  An accurate business forecast depends on economic and industry performance, management plans, supply and
  demand situations, competitor analysis and so on.
• Benchmarking focuses on company-to-company comparisons of how products and services perform against their
  toughest competitors, or those companies recognised as leaders in their industry. The benchmark used for financial
  ratios may not always be the most appropriate.
• A time-series analysis that makes use of historical financial information may be distorted with inflation or seasonal
  factors.
• Ratios are meaningless without a comparison against trend data or industry data and without looking at the
  causation factors.

Question 21

Examples of misappropriation of assets

Answer 21

• stealing tangible or intangible assets;
• embezzling receipts; or
• making payment for the purchase of non-existent goods and services.

Question 22

Examples of fraudulent financial reporting

Answer 22

• manipulation, falsification or alteration of accounting records or supporting documents;
• misrepresentation in, or intentional omission from, the financial statements of events, transactions or other
  significant information; or
• misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure.

Question 23

Examples of accounting errors

Answer 23

• a mistake in the processing of data (such as data entry error) from which financial statements are prepared;
• an incorrect accounting estimate arising from oversight or misinterpretation of facts; or
• a mistake in the application of accounting principles relating to measurement, recognition, classification,
  presentation or disclosure.

Question 24

Examples of creative accountnig

Answer 24

LOW GEARING IS KEY - MORE LIKELY TO ATTRACT INVESTMENT
<br></br>
* * Off balance-sheet financing
* Cut-off manipulation
* Window dressing:
* Revaluation of non-current assets
* Change of accounting policies
* Manipulation of accruals, prepayments and contingencies
ADD SUMMARY OF EACH

Question 25

What is working capital (MOVE TO CHAPTER 8 FROM, HERE DOWN)

Answer 25

Working capital = inventory + trade receivables + cash and cash equivalents – trade payables.

Question 26

Permenant vs Temporary working capital

Answer 26

For permanent working capital, the overall level of working capital remains fixed and should be financed by long-term
sources of finance. Temporary working capital fluctuates day-to-day above this level of permanent working capital:
it should be financed by short-term sources of finance. The permanent working capital is the minimum level of working
capital required to continue uninterrupted day-to-day business activities. Temporary working capital is the additional
financial requirement that arises out of events such as seasonal demand for products or business activity.

Question 27

What factors determine working capital requirements?

Answer 27

Working capital requirements change from time to time as per the size and nature of industries as well as other internal
and external factors. In general, the following factors affect requirement or working capital.
Nature of business
The investment in working capital depends on the nature of the business, product type and production techniques. For
example, retail companies have a low cash cycle with few credit customers, high supplies on credit terms and a large
inventory to cater to the demands of customers. Manufacturing companies have a long cycle with significant current
assets. The service sector does not hold any finished goods and has an insignificant amount of liabilities.
Size of business
The larger the size of business, the greater the working capital requirements to support its scale of operation. However,
a small business may also need a large amount of working capital due to high overhead charges, inefficient use of
available resources and other economic disadvantages of a smaller business.
Production policy
Some companies manufacture their products when orders are received while others manufacture products in anticipation
of future demands.
Seasonal fluctuations
If the demand for the product is seasonal, the working capital required in that season will be higher. For example, there is
greater demand for air conditioners in summer.
Credit policies
A liberal sales credit policy demands a higher level of working capital as it prolongs the debtors’ collection period and
vice versa. However, a liberal credit policy without consideration of the creditworthiness of the customers will land the
business in trouble and the requirements of working capital will also unnecessarily increase. Similarly, a tight credit
policy from suppliers shortens the creditors’ settlement period and lengthens the WCC, requiring the need for alternative
finance.
Changing technology
A firm using labour-oriented technology will require more working capital to pay labour wages.
Growth and expansion
Working capital requirements increase with the size of a firm to support larger scales of operation.
Taxation policies
Government taxation policy affects the quantum of working capital requirements. A high tax rate demands more working
capital.