Financial statements Flashcards
Describe the range of executive compensation methods and evaluate their advantages and drawbacks.
Link pay to stock price performance Most major companies around the world now link part of their executive pay to the stock-price performance. This compensation is generally in one of three forms:
stock options
restricted stock (stock that must be retained for several years)
performance shares (shares awarded only if the company meets an earnings or other target).
Sometimes these incentive schemes constitute the major part of the manager’s compensation pay.
There are clearly many advantages of tying compensation to stock price. When a manager works hard to maximise firm value, he helps both the stockholders and himself.
-Encourgaes excessive risk taking
-Reflects performance relative to expectations Because a company’s stock price depends on investors’ expectations of future earnings, rates of return depend on how well the company performs relative to expectations.
Link bonus to accounting measures compensation also includes a bonus that depends on increases in earnings or on other accounting measures of performance.
+They measure absolute performance rather than relative to investors expectations
+They can be applicable to junior employees
Critically evaluate the coincidence or divergence of managerial and firm interests in terms of agents and principles.
Coincidence of interests:
Incentive Structures:
Many organizations establish incentive systems, such as performance-based bonuses or stock options, designed to align managerial rewards with shareholder returns. When managed correctly, these structures can motivate managers to work towards the firm’s success
Reputation and Career Concerns:**
Managers’ reputations and future career opportunities often depend on the firm’s performance. A successful company enhances their standing in the industry, which aligns their interests with those of shareholders.
Divergence of managerial and firm interests
Risk Aversion:
Managers often exhibit risk-averse behavior, preferring safer strategies that protect their positions. This can conflict with shareholders’ willingness to embrace risk for higher potential returns, resulting in divergent strategic choices.
Information Asymmetry:
Managers typically have more information about the firm’s operations than shareholders. This information imbalance can lead to situations where managers prioritize personal interests over those of the shareholders, exacerbating the agency problem.
Identify the signs of good and poor governance.
What is the reason top management (CEOs) pay too much attention to earnings and earnings targets?
A more pressing problem is that CEOs and CFOs seem to pay too much attention to earnings and earnings targets, at least in the short run, to maintain smooth growth and to meet earnings targets.They may be tempted to manage earnings, not with improper accounting, but by tweaking operating and investment plans. For example, they may defer a positive-NPV project for a few months to move the project’s up-front expenses into the next fiscal year
How can we align the interests of the manager and the shareholder?
Incentivies The agency problem can be tackled to some extent by trying to design reward packages that motivate the directors to act in the shareholders’ interests. This approach can be seen in practice because many companies pay their directors bonuses that are linked to profits, or they give them a stake in the company. You will want to ensure that managers and employees are rewarded appropriately when they add value to the firm.
**Performance measuremnt ** You cannot really reward the value added unless this value can be measured. Since you receive what you reward and reward what you measure, you will receive what you measure.
Accounting statements allow monitoring of the behaviour of directors. If the shareholders have access to credible and informative financial statements, then they can review the directors’ performance. If the directors are not performing adequately then they risk replacement.
In turn, the top management (the CEO and the CFO) should ensure that middle managers and employees have the right incentives to seek and invest in positive-NPV projects.
What do Moody’s long-term and short-term ratings reflect?
Any rating agency talks about two aspects. Each of these rating you know categories umbrella within the rating has a very clear definition about what is the likelihood of default because it talks about the credit risk assessment, right.
So what is the likelihood of default and if it defaults, what would be the recovery rate. So, any asset which goes into that particular category can have those similar characteristics. That’s what at least we expect, yeah.
The long-term issues are for anything above one year.
Short term will be only four less than one year.
For long term we look at life really of default on any contracts, promise payments and expected financial losses suffered in the event of default. That’s what the Modi’s rating would look at. Modi’s ratings start from AAA all the way down to CA-20. Different categories, right? Some of half of it, or less than half of this, is considered investment worthy and the others are high. Risky so what we call junk bonds, right, are riskier as well.
What are Credit Ratings and what are the risks they do not incorporate?
hey are an expression of relative opinions about the creditor worthiness of an issue or a issuer from strongest to weakest in an umbrella of all the credit risks assessments that the company has done for various products and companies et cetera. So, they rank each companies issue, etcetera into this umbrella of different credit risk levels and then each risk level is defined with its own characteristics or what is the probability of default versus you know what would be the expected recovery rate. They provide an opinion about the issue, or the issuer, based on the current market conditions.
Credit ratings should be factored in when you make investment decisions. They are not investment advice and do not provide any guarantee about, you know, what to buy, hold or sell. It doesn’t provide recommendations. It should not be the only factor you should consider while you make investment decisions.
They’re not any indicators of market liquidity or credit quality. It doesn’t say anything about the price of those assets in the secondary financial markets. It doesn’t say anything about the future credit risk.
They should not be the only thing that we should know when you make investment decisions or when you measure exactly what is going to happen to the company.
They’re not a guarantee about credit quality or the exact measure of probability that a particular issue or will or will not default accept, so you need to be careful about that.
They also provide a lot of insight. They provide the standardization of how this information can be translated into the wider capture market. Anybody sitting anywhere in the world can access this information, understand it affectionately, so it provides investors access to a wider capital market. It provides an opportunity to issue the markets more frequently, more economically. And sell very large offerings at with very long maturities as well. So it in a overall enables you know cost reduction, especially when you’re talking about highly rated securities, the cost of borrowing would be much lower compared to another asset which doesnt have a rating. Or compared to a lower rating as the would be higher risky as the default probability will be higher so.They will charge.Higher credit risk premium on those as well. So if you have a higher rating for a particular you know company or listing that you know issuing. Then naturally that would be.They would only face a much lower cost associated with that issue.
So credit agencies play a crucial role. That doesn’t mean that it wasn’t without criticism. Of course they have got things wrong as well. Many people of Quest 10, you know, the method they use for coming up with these ratings, and there is sometimes also a conflict of interest because firms hire rating agencies to provide the rating right. And the scrutiny of rating agencies wasn’t par, at least from the regulator’s point of view. At least a decade or so ago. Since the 2008 crisis, there has been a lot more scrutiny about what the rating agencies do as well. So, I think they have. There’s a lot more due diligence on you knows what they do, the kind of work they do, what are the processes in place, how do they come up with the statistical modelling, which comes up with a certain rating, et cetera. There is a lot more accountability related to that now.
What is Altman’s Z score?
The Altman C score, so this is one of the risk management internal financial ratio-based risk management tool to predict the probability of default.
It was developed by Altman for the manufacturing industry.
It looks at five financial ratios combined to identify the predictive power of what might happen to that particular industry or the particular company.
Based on the values of these individual factors. So here he identified a lot of predictability on these five different factors and see based on this individual financial factors, you can say that OK, you know the form is in either financial distress or to say that whether the cash flow is but the credit is good, bad or it’s in the grey area et cetera.
Each one has a certain coefficient associated with it, which corresponds to the size and the impact of that particular financial issue on the overall predictability of default. Yeah. And then we standardize the Z score to three different, you know, range of values. Anything above 3 consider to be extremely.
Low probability of bankruptcy or default, which means that it’s very good credit. Any score between 1.81 to 2.99 is Grey area, where uncertainty in uncertainty which means there is a difficulty in distinguishing whether it’s good or bad credit and anything below 1.81 we clearly know that you know there is a high probability of default which is highly risky, so it would be you know the credit risk premium on that would be very high as well.
This is a risk management-based tool using finance ratio analysis using internal financial ratio analysis. The combination of this can be used to predict the probability of default of a cash flow into the future. This is specifically for the manufacturing industry.
What is Credit Risk?
Credit risk arises when one of the parties failed to meet its obligations, and that causes a financial loss for the other party. Credit risk need not necessarily come purely from default. Default is a worst-case scenario. You could also have a credit risk or a financial loss due to either we are deferral, rescheduling or any adjustment that might happen to the original agreement. This failure may come a failure to meet the agreement that happens due to either inability not able to or not be willing to pay. There are two areas, right. One is not able or not willing, the majority of the counterparty risks comes used to not being able to right the firm is not generating enough cash flow so they don’t have enough capital to meet or money to meet the financial obligations. In the worst-case scenario, unwillingness usually happens when you have, you know highly levered transactions where probably the whole thing is finance. Using that, the firm is kindly leveraged, and they they think that OK maybe the terms and conditions of the original agreement was extremely severe, but they think that you know there’s a dispute over validity, the terms and conditions of how they agreed the financial contract. So they want to renegotiate the contract. So to be a bit fairer for et cetera, right. But in all of these cases, the creditor would have a financial loss due to the counterparty non meeting its obligations.
Why do we need to assess credit risk?
When you’re looking at credit or, you know, fixed income assets, the cash flows are very standard, right for fixed income assets. So, we know exactly when the cash flows will be, how much and it also has an end date. So, forecasting this capital is extremely easy when it comes to fixed income assets. But what happens to those cash flows in the real term when you sell these assets on the secondary market, et cetera, there are light adjustments that take place.
Why the adjustments? Because even though we know what the cash flow projections are, there is a possibility that there will be a credit risk associated with these cash flows as well. What do I mean by that? Maybe there is a potential for default, right? You know there is a credit risk associated with each of these cash flows and then you might not get the exact cash flow as projected or forecasted by the contractual obligation.
In these cases, because of those risks associated with it; we must discount the future cash flows at an appropriate rate to get the current market value of the fixed income, cash flows.
To do the discounting we need to assess the credit risk and then apply that credit risk premium on the cash flow to identify what is the correct discount rate we should use to discount the future cash flows from the fixed income assets.
The appropriate discount rate would be the interest rate, the risk-free rate plus the credit risk premium.
So, we need to quantify the credit risk first and then assess what the credit risk premium is. Then we apply that on top of the risk-free rate to discount the future cash flows to get the current market value of this credit instruments or the cash flows from the fixed income assets that we are assessing in the financial markets,
yeah, so we do need the credit risk assessment to identify the credit risk premium and the credit risk premium that is faced by different assets would vary based on the various factors that we are observing, whether it’s about the time to maturity, the coupons, the interest rate fluctuation that might happen in the market, the demand for those assets in the market.
Explain the importance of inventory accounting and describe the principle methods.
The method a company uses affects the inventory amount it can charge as an expense, and subsequently its taxable income.
A companys financial results and comparisons between two companies one using fifo and the other LIFO can be greatly distorted for example SLIDE 34
Analyse corporate credit, giving examples of how debt reporting varies according to accounting methods.
Corporate credit analysis focuses on various factors, such as country risk, industry features and company-specific factors.
Credit risk assessment of corporates involves financial analysis.
Corporate credit assessment is influenced by how debt is reported, which varies between GAAP and IFRS. Understanding the accounting principles and framework is necessary in order to establish whether the information in the statements reflects a company’s performance.
Measurement of Debt
GAAP: Generally uses amortized cost for measuring most financial liabilities, except for those designated at fair value.
iFRS: Allows for both amortized cost and fair value measurement, depending on the classification of the financial liability (e.g., fair value through profit or loss or amortized cost).
Explain why financial statements may need to be reformulated or annotated for accurate comparison.
For credit analysis, it is useful when the analyst works on the financial statements, that they are in a form to uncover what is important to creditors, effectively to be fully and timely repaid. Reformulation of financial statements involves reclassifying items in the financial statements and bringing more detail into the financial statements from the footnotes.
Hidden Liabilities: Some liabilities may not be fully reflected on the balance sheet, such as operating leases or contingent liabilities. Reformulating statements to include these items provides a more comprehensive view of a company’s financial obligations.
https://keats.kcl.ac.uk/mod/book/view.php?id=8367097
Describe credit ratings, show how they are used and explain what they mean.
- Credit ratings are assessments of the creditworthiness of a borrower.
These ratings indicate the likelihood that the borrower will default on its debt obligations.
They are used for
* Investment Decisions:
Risk Assessment: Investors use credit ratings to assess the risk associated with bonds or other debt instruments.
* Lending Decisions:
Loan Terms: Lenders assess credit ratings to determine the terms of a loan, including interest rates and collateral requirements.
Credit ratings are typically assigned using a letter-based system, with each rating reflecting the issuer’s creditworthiness:
Investment-Grade Ratings:
AAA/Aaa: all the way to Non-Investment Grade Ratings (Speculative): Junk bonds
Define credit risk and calculate default probability using the Z-score.
Credit risk refers to the possibility that a borrower will default on their obligations, leading to a financial loss for the lender or investor. This risk is particularly relevant in lending, bond investing, and any financial transactions involving credit.
The Z-score **can indicate the likelihood of default **based on its value,
