Chp 1

Question 1

what’s the four step framework for analysis and valuation

Answer 1

1. understand the business environment and accounting information
2. adjust and assess financial information
3. forecast future payoffs - earnings, cash flow, dividends
4. use forecasted information to estimate firm value

Question 2

define financial statement analysis

Answer 2

process of extracting information from financial statements
to better understand a company’s current and future performance and financial condition. Financial statements serve many objectives.

Question 3

what are the objectives of financial statement analysis

Answer 3

Management uses financial statements to raise financing
for the company, to meet disclosure requirements, and to serve as a benchmark for executive bonuses.

Investors and analysts use financial statements to help decide whether to buy or sell stock.

Creditors and rating agencies use financial statements to help decide on the creditworthiness of a company’s debt and lending terms.

Regulatory agencies use financial statements to
encourage enactment of social and economic policies and to monitor compliance with laws.

Legal institutions use financial statements to assess fines and reparations in litigation.

Various other
decision makers rely on financial statements for purposes ranging from determining demands in
labor union negotiations to assessing damages for environmental abuses.

Question 4

define valuation

Answer 4

process of drawing on the results of financial statement analysis to estimate a company’s worth (enterprise value)

seeks to assess the worth of equity shares + debt shares

Question 5

how can a company’s worth be viewed as?

Answer 5

collection of assets + those assets have claims on them

Question 6

how are owner claims reflected

Answer 6

in equity shares of a company

Question 7

what are the 3 main user groups of financial statements

Answer 7

investors + equity analysis, lenders + credit analysts, Company managers

Question 8

how are nonowner claims reflected

Answer 8

in obligations + debt shares pf the company

Question 9

what are the business activities? define them

Answer 9

1. operating activities: companies hire + train employees, manufacture products, deliver services, market + sell their products + services, and manage after-sale customer support
2. investing activities: companies acquire land, buildings, and equipment; grow the business with new products and services; or acquire other companies to expand into new markets.
3. financing activities: companies rase cash to fund the operating and investing activities. includes selling stock to equity investors and borrowing from banks and other lenders

Question 10

what do business forces do

Answer 10

These
forces affect the way the company does business and shape the company’s overarching goals
and objectives along with the company’s strategy and its strategic planning process.

Question 11

what’s a business strategy

Answer 11

reflects how it plans to achieve its goals and objectives - the success depends on an effective analysis of market demand + supply

Question 12

why are past financial statement an important input into the planning process

Answer 12

they provide info about the relative success of past strategic plans- taking corrective action + making new investing, operating, and financing decisions

Question 13

why do managers + employees demand financial accounting info

Answer 13

Managers and employees are interested in the company’s current and future financial health. This
leads to a demand for accounting information on the financial condition, profitability, and prospects
of their companies as well as comparative financial information on competing companies and busi-
ness opportunities. This permits them to benchmark their company’s performance and condition.
Managers and employees also demand financial accounting information for use in compensation
and bonus contracts that are tied to such numbers.

Question 14

what questions can managers address with financial statements?

Answer 14

What product lines, geographic areas, or other segments are performing well compared with
our peer companies and our own benchmarks?
■
Should we consider expanding or contracting our business?
■
How will current profit levels impact incentive and share-based compensation?

Question 15

why do investment analysts + information intermediaries demand financial accounting information

Answer 15

re interested in predicting companies’ future performance. Expectations about
future profitability and the ability to generate cash impact stock price and a company’s ability to
borrow money at favorable terms. Financial reports reflect information about past performance
and current resources available to companies. These reports also provide information about claims
on those resources, including claims by suppliers, creditors, lenders, and stockholders. This infor-
mation allows analysts to make informed assessments about future financial performance and
condition so they can provide stock recommendations or write commentaries.

Question 16

what types of questions can financial statements answer for investment analysts and information intermediaries

Answer 16

What are expected future profits, cash flows, and dividends for input into stock-price models?
■
Is the company financially solvent and able to meet its financial obligations?
■
How do expectations about the economy, interest rates, and the competitive environment
affect the company?

Question 17

why do creditors + suppliers demand financial accounting information

Answer 17

to help determine loan terms,
loan amounts, interest rates, and required collateral. Loan agreements often include contractual requirements, called
covenants, that restrict the borrower’s behavior in some fashion

Suppliers demand financial information
to establish credit terms and to determine their long-term commitment to supply-chain relations.
Both creditors and suppliers use financial information to monitor and adjust their contracts and
commitments with a company.

Question 18

what questions do creditors + suppliers have for financial statements

Answer 18

Should we extend credit in the form of a loan or line of credit for inventory purchases?
■
What interest rate is reasonable given the company’s current debt load and overall risk profile?
■
Is the company in compliance with the existing loan covenants (loan conditions that restrict
the borrower’s behavior in some fashion, such as minimum levels of working capital, retained
earnings, and
cash flow, which safeguard lenders)?

Question 19

why do stockholders + directors demand financial accounting information

Answer 19

to assess the profitability and risks of companies
and other information useful in their investment decisions.
Fundamental analysis
uses financial
information to estimate company value and to form buy-sell stock strategies. Both directors and
stockholders use accounting information to evaluate managerial performance. Outside directors
are crucial to determining who runs the company, and these directors use accounting information
to help make leadership decisions.

Question 20

what questions do stockholders + directors have for financial statements

Answer 20

Is company management demonstrating good stewardship of the resources that have been
entrusted to it?
■
Do we have the information we need to critically evaluate strategic initiatives that manage-
ment proposes?

Question 21

why do customers + strategies partners demand accounting information

Answer 21

to assess a company’s
ability to provide products or services and to assess the company’s staying power and reliability.
Strategic partners wish to estimate the company’s profitability to assess the fairness of returns on
mutual transactions and strategic alliances.

Question 22

what questions do financial statements provide for customers + strategic partners

Answer 22

Will the company be a reliable supplier?
■
Is the strategic partnership providing reasonable returns to both parties?

Question 23

why do regulators + tax agencies demand financial accounting information

Answer 23

for antitrust
assessments, public protection, setting prices, import-export analyses, and setting tax policies.
Timely and reliable information is crucial to effective regulatory policy, and accounting information is often central to social and economic policies.

Question 24

Why do voters + their representatives demand for accounting info

Answer 24

for policy decisions. The decisions can involve economic, social, taxation, and other
initiatives. Voters and their representatives also use accounting information to monitor government spending. Contributors to nonprofit organizations also demand accounting information to assess the impact of their donations.

Question 25

define form 10-K,

Answer 25

the audited annual report that includes the four financial statements, discussed
below, with explanatory notes and the management’s discussion and analysis (MD&A) of
financial results

Question 26

define form 10-Q

Answer 26

the unaudited quarterly report that includes summary versions of the four financial statements and limited additional disclosures.

Question 27

how is the quantity and quality of accounting info supplied by companies determined by managers?

Answer 27

determined by managers’ assessment of the benefits and costs of disclosure. Managers release
information provided the benefits of disclosing that information outweigh the costs of doing so.
Both
regulation
and
bargaining power
affect disclosure costs and benefits and thus play roles in
determining the supply of accounting information.

Question 28

what are the 2 compulsory SEC filings

Answer 28

form 10-K: audited annual report - including 4 financial statements, discussed below with explanatory notes and the management’s discussion and analysis of financial results

Form 10-Q: unaudited quarterly report w/summary version of the four financial statements and limited additional disclosures

Question 29

what does a company’s performance in markets depends on

Answer 29

success with its business activities and the market’s awareness of that success

Question 30

is there real economic incentives for companies to disclose reliable accounting information

Answer 30

yes to enable them to better compete in capital, labor, input, and output market

Question 31

what are the costs of disclosure

Answer 31

preparation + dissemination costs: cost of auditing the info + complying with SEC’s rules can be time consuming and costly

competitive disadvantages: disclosing info could reduce or eliminate a company’s competitive adv

litigation: risk of litigation increases if companies disclose info that creates expectations that aren’t met - cost of defending against customer/investor

political costs: highly visible companies can face political + public pressure - extra disclosure can increase this activity

Question 32

why is comparability important in converging IFRS and US GAAP?

Answer 32

improve the quality of financial reports, benefit investors, companies and other market participants who make global investment decision, reduce costs for both users + preparers of financial statements, make worldwide capital markets more efficient

Question 33

what are some evidence of high level comparability of US GAA and IFRS

Answer 33

Since 2007, the SEC has permitted foreign companies to file IFRS financial statements
without requiring reconciliation to U.S. GAAP. Currently, more than 500 companies with
a cumulative market capitalization of trillions of dollars report to the SEC using IFRS. The
Commission staff issued its final report on the convergence in July 2012 without making a
recommendation.
■
The FASB participates actively in the development of IFRS, providing input on IASB proj-
ects through the IASB’s Accounting Standards Advisory Forum (ASAF).
■
Recent joint projects between the two boards relate to leases, financial instruments, revenue
recognition, and insurance contracts.

Question 34

balance sheet vs income statement

Answer 34

balance sheet = company’s financial position at a point in time

income statement = cashflows report on performance over a period of time.

Question 35

owner vs nonowner financing

Answer 35

owner financing: raise money from stockholders

nonowner financing: raise money from banks/creditors + suppliers

Question 36

what’s the relative proportion of short and long term assets determined by

Answer 36

a company’s industry and business model

Question 37

what’s a key factor in determining a company’s level of porfitability

Answer 37

companies’ ability to create barriers to competitive pressure - patent protection, effective marketing or otherwise

Question 38

define statement of stockholders’ equity

Answer 38

reports on year-over-year changes in the equity accounts that are reported on the balance sheet

beginning balance, a summary of the activity in the account during the year and the ending balance

Question 39

define common stock _ additional paid in capital

Answer 39

stockholders’ net contributions to the company

Question 40

define retained earnings

Answer 40

net income over the life of the company - all dividends ever paid and all stock repurchases

formula: beginning retained earnings + net income for the period - dividends and other distribution to shareholders

Question 41

define statement of cash flows

Answer 41

reports the change in a company’s cash balance over a period of time

reports cash inflows and outflows from operating

Question 42

define operating activities, investing activities, financing activities

Answer 42

operating activities: cash generated from core business activities of making + selling products + services to customers

investing activities: cash outflows for purchase of PP&E

financing activities: relate to borrowing and repayment of debt, sales and repurchase of stock and the payment of dividends

Question 43

what are some important financial info not found in the 4 financial statements and where are they found

Answer 43

MD&A, independent auditor report, financial statement footnotes, regulatory filings - proxy statements + other SEC filings, ESG reporting

Question 44

what are the primary and support activities that create a company’s profit margin

Answer 44

primary activities inbound logistics, operations, outbound logistics, marketing and sales, servicing

support; firm infrastructure, human resource management, tech/product development, procurement

Question 45

what are the five forces analysis of business environment

Answer 45

Industry competition
Competition and rivalry raise the cost of doing business because
companies must hire and train competitive workers, advertise products, research and develop
products, and engage in other related activities.
B
Bargaining power of buyers
Buyers with strong bargaining power can extract price conces-
sions and demand a higher level of service and delayed payment terms; this force reduces
both profits from sales and the operating cash flows to sellers.
C
Bargaining power of suppliers
Suppliers with strong bargaining power can demand higher
prices and earlier payments, yielding adverse effects on profits and cash flows to buyers.
D
Threat of substitution
As the number of product substitutes increases, sellers have less
power to raise prices and/or pass on costs to buyers; accordingly, threat of substitution places
downward pressure on profits of sellers.
Threat of entry
New market entrants increase competition; to mitigate that threat, compa-
nies expend monies on activities such as new technologies, promotion, and human develop-
ment to erect
barriers to entry
and to create
economies of scale.

Question 46

what are the 2 parts of a SWOT analysis

Answer 46

Looking internally, we review a company’s strengths and weaknesses, while for external
purposes, we review the opportunities of and threats to the company. SWOT analysis tries
to understand particular strengths and weaknesses that give rise to specific opportunities (to
exploit the strengths) and threats (caused by the weaknesses).

but may be too subjective

Question 47

what are the factors to competitive advantage

Answer 47

Barriers to Entry.
Patents and other protections of intellectual property create
barriers to entry
that allow a company to achieve a competitive advantage and charge higher prices for their products or services and thereby earn excess returns. These legal barriers typically have a finite life,
however, and a company must maintain a pipeline of innovations to replace intellectual property
that loses patent protection.
Product Differentiation.
Product differentiation
also allows companies to earn excess returns.
Typically, differentiation is achieved from technological innovation that produces products and
services with attributes valued by customers and not easily replicated by competitors. Differentiation along the dimensions of product design, marketing, distribution, and after-sale customer sup-
port are examples. Such differentiation has costs such as research and development, advertising,
and other marketing expenses.
Cost Leader.
Another approach to achieve excess returns is to become a
cost leader. Cost leadership can result from a number of factors, includStrategic Plans.
In the absence of a competitive advantage, our analysis focuses on the likeli-
hood that a company develops such an advantage. Management often discusses its strategies withing access to low-cost raw materials or labor
(while maintaining quality), manufacturing or service efficiency in the form of cost-efficient
processes and manufacturing scale efficiencies, greater bargaining power with suppliers, sophisticated IT systems that permit timely collection of key information, and other avenues.stockholders and equity analysts, which are recorded in conference calls that are readily available
or reported in the financial press. In the case of a turnaround situation, our focus is on viability of
the plan; that is, can it be achieved at an acceptable cost given the current state of the industry?
Moreover, our focus is long term. Companies can often achieve short-term gains at long-term
cost, such as by selling profitable segments. Such actions do not create long-term value.
Sustainability and Validity.
Creating a sustainable competitive advantage that yields excess
returns is difficult, and we are wary of forecasted excess returns for an extended period. Through
a critical and thorough investigation of financial statements, its footnotes, the MD&A, and all
publicly available information, we can identify drivers of a company’s competitive advantage.
We then test the sustainability and validity of those drivers. This is an important step in assessing
competitive advantage.

Question 48

what are the declarations signed by CEO + CFO in attesting the accuracy + completeness of financial statements

Answer 48

Both the CEO and the CFO have personally reviewed the annual report.
■
There are no untrue statements of a material fact that would make the statements misleading.
■
Financial statements fairly present in all material respects the financial condition of the
company.
■
All material facts are disclosed to the company’s auditors and board of directors.
■
No changes to its system of internal controls are made unless properly communicated.

Question 49

please describe high quality earnings

Answer 49

Sustainable
, which refers to earnings that:
* Derive from normal core operations
*
Include limited one-time charges (e.g., restructuring, impairment), transactions (e.g., realized
gains or losses), and adjustments (e.g., fair value, foreign exchange)
* Follow the matching principle
* Reflect consistent reporting choices over time
* Are predictable and exhibit low volatility
Free of error and manipulation
, which refers to earnings that:
* Present fairly the results of operations
* Accurately reflect applicable accounting standards (IFRS and GAAP)
* Keep non-cash accruals to a minimum
* Include few long-term or “soft” estimates
* Are subject to high-quality audit
* Are reported by firms with strong governance structures and credible management
Informative
, which refers to:
* Earnings that are related to stock market reactions, including price and volume
*
Larger financial reporting packages (MD&A, non-GAAP disclosures) that contain substantial
information supporting bottom-line numbers
* Numbers prepared using accounting methods consistent with those used by the firm’s peers

Question 50

describe the 2 parts of ROA

Answer 50

Profitability relates profit to sales.
This ratio is called the
profit margin
(PM), and it reflects
the net income (profit after tax) earned on each sales dollar. Management wants to earn as
much profit as possible from sales.
■
Productivity relates sales to assets.
This component, called
asset turnover
(AT), reflects
sales generated by each dollar of assets. Management wants to maximize asset productivity to
achieve the highest possible sales level for a given

Question 51

what are some general observations in regards to market, turnover and ROA?

Answer 51

High margin and Low turnover.
Technology companies
Microsoft
(MSFT),
Oracle
(ORCL),
Analog Devices
(ADI),
Apple
(AAPL), and
Alphabet
(GOOGL) have high net
profit margins resulting from patent protection that increase barriers to entry and reduce com-
petition. These companies also report substantial assets, typically in the form of marketable
securities and intangible assets that arise when these companies acquire other companies (a typical method of expansion in the high-tech industry). Because these securities and intan-
gible assets do not generate “sales,” the productivity ratio (AT) is decreased by the large total
assets in the denominator.
■
Low margin and High turnover.
At the other end, retailers like
Costco
(COST),
Best Buy
(BBY),
Walmart
(WMT),
Target
(TGT), and
TJX
(TJX) find it difficult to differentiate their
products. This open competition keeps prices down, which yields lower profit margins. These
retailing companies must focus on increasing AT to maintain an acceptable ROA. To do this,
they watch inventory and PPE assets carefully and rarely have accounts receivable because
most of their trade is cash-and-carry.
■
High performance.
Return on assets (ROA) is the product of profit margin and asset turnover
and is higher as we move further away from the origin (to the upper right). Companies like
Apple
(AAPL),
Alphabet
(GOOGL),
Amgen
(AMGN),
Microsoft
(MSFT),
Nike
(NKE),
and
Home Depot
(HD) have ROAs that are higher than the median 9.6%. Many different fac-
tors explain this higher ROA, including patent protection and iconic brand names that enable
the company to charge higher prices for their goods and services.

Question 52

why is the revenue forecast the most crucial yet most difficult estimate in the forecasting process

Answer 52

It is a crucial estimate because other income-statement
and balance-sheet accounts derive, either directly or indirectly, from the revenues forecast.

Question 53

what’s the key to a good valuation

Answer 53

accurate forecasts of future cash flows with a good understanding of where the firm is and the business environment in which it compete

Question 54

what’s the relation between earnings and stock prices

Answer 54

persistent core earnings have the highest predictive
ability for future earnings and cash flows. Rigorous financial statement analysis seeks to uncover
a company’s persistent core operating earnings and cash flows.

Question 55

what’s the relation between financial ratios + credit ratings

Answer 55

Financial markets also use
forecasts to price a company’s debt and to determine interest rates.

Question 56

why do the capital markets work well in the us

Answer 56

due to self-interested buy-side an sell-side analysts, institutional investor and others