FSA Flashcards
Week 1:
Who are the information intermediaries that link savings and business ideas together?
What mechanisms help match savings with businesses required funding?
Information intermediaries = venture capitalists, banks, investment banks, managed funds, insurance companies
mechanisms = Stock exchanges, bond markets, bank loans, private equity
Week 1:
What does a good accounting system comprise of?
Accrual accounting
Accounting standards
Auditing of financial information
Managers reporting strategy
Week 1
What do business intermediaries use financial statements to accomplish (4)
What hinders the system?
Business strategy analysis
Accounting analysis
Financial analysis
Prospective analysis
Hindrances = fraud, Errors and mistakes, professional judgement
Week 2
What is economic analysis and what factors do we look at?
What is forecasting error?
Economic analysis = Understand how changes in the broader economy will influence the firm you are valuing
Factors:
GDP = market value of final goods and services produced within a country
Inflation = Revenues (price you receive for sales) and Expenses (price you pay for inputs)
Foreign Exchange = exporter or importer? how currency influences business
Interest rates = interest expense (effect on profit), Cost of capital, consumer behaviour (will it effect sales)
Commodity prices = key expenses and revenues
Forecasting error = past performance does not indicate future performance
Week 2
What is industry analysis and what factors do we look at?
Industry analysis = understanding the industry in which the firm operates so as to ascertain the likelihood of a firm creating value within the industry
Factor 1: Degree of actual and potential competition
- Threat of new entrants = barriers to entry are economies of scale, first mover advantage, access to channels of distribution and relationships with suppliers and customers, legal barriers..
- Threat of substitute products = relative price and performance + buyers willingness to switch
- Rivalry among existing firms = push prices towards marginal cost AND make non-price dimensions of products or services more important = intensity of competition depends on industry growth rate, concentration and balance of competitors, degree of differentiation in products and services and switching costs, scale/learning economies and ratio of fixed to variable costs, excess capacity and exit barriers.
Factor 2: Bargaining power in input and output markets
- Bargaining power of buyers = factors affecting bargaining power are number of buyers, volume per buyer, switching costs, differentiation, importance of product for costs and quality and buyer price sensitivity
- Bargaining power of suppliers = same factors as above
Week 2
Outline the 4 types of competition in an industry
What factors limit competition?
Perfect competition = Large amount of firms = low influence on price
Monopolistic competition = Medium amount of firms = medium influence on price
Oligopoly = a handful of firms = strong influence on price
Monopoly = one firm = full control of price (without government intervention)
Factors limiting competition = patents, geography, regulation, technology, licenses, economies of scale
Week 2
What is competitive strategy analysis and what factors are we concerned with? Why is competitive strategy analysis useful?
For each of the two factors what are some characteristic ratios?
Competitive strategy analysis = concerns an understanding of the ways in which a firm can achieve competitive advantage
Useful because = Understanding a firm’s strategy and industry helps in forecasting profit margin (PM) and asset turnover (ATO).
Factors
- Cost leadership = achieved through economies of scale and scope, efficient production, simpler product design, lower input costs, low-cost distribution, little research and development or brand advertising, tight cost control
- Differentiation = achieved through quality, variety, customer service, flexible delivery, brand image, research and development, creativity and innovation = cost must be lower than the price customer is willing to pay for differentiation
Ratios
- Cost leadership = characterised by low profit margin AND high turnover
- Differentiation = characterised by high profit margin AND low turnover
Week 2
What are 5 important questions to ask in relation to competitive strategy analysis?
- Does the firm have appropriate resources?
- Has the firm made appropriate commitments to achieving this competitive advantage?
- Are the firm’s activities structured consistent with the competitive strategy?
- Is the competitive advantage sustainable? Are there any barriers that make imitation by competitors difficult?
- Are there any potential changes to the industry that might reduce the competitive advantage?
Week 2
What is Corporate strategy analysis and what factors are we concerned with?
Corporate strategy analysis = analysis of the impact of having multiple businesses within one corporation = the impact of diversification (Acquiring entirely different companies) horizontal (acquiring similar companies) and vertical integration (acquiring companies within the production production process)
Factors
Economic theory = we look at the relative transaction costs of performing functions inside the firm versus outside the firm = it is not worthwhile to have multiple differing companies if they cannot work together due to transaction costs being higher than they would be to simply outsource the same products/services.
Week 2
What are abnormal returns owed to?
Abnormal returns
- economic factors
- industry structure
- how firms compete within and industry
- how firms develop competitive strategies
Week 3
What are three reasons for accounting distortions?
Reason 1 = GAAP does not equal economic reality
(R&D capitalisation, contingent liabilities not recorded, Land prices at cost, Brand values not recognised as asset)
Reason 2 = Forecast errors (errors in estimates (depreciation, bad debts))
Reason 3 = Managerial manipulation
why = 1) meet benchmarks 2) CEO change (ensure bad first year and follow up with excellent one) 3) Income smoothing 4) IPO
Week 3
Outline steps 1 and 2 in the Accounting analysis process
Step 1: Identify key accounting policies
- Key policies and estimates used to measure risks and critical factors for success must be identified.
1) Looking at income statement can identify key areas of revenue and key areas of expenditure.
2) Looking at balance sheet can identify key assets and expenses (notes to financial statements provide further information e.g. composition of PPE account)
Step 2: Assess Accounting Flexibility
- Accounting information is more open to distortion if managers have a higher degree of flexibility in choosing policies and estimates
Week 3
Outline step 3 in the accounting analysis process
Step 3: Evaluate accounting strategy
- flexibility in accounting choices allows managers to strategically communicate economic information or distort performance
Issues to consider include:
- norms for accounting policies with industry peers (what is normal for industry and business strategy)
- incentives for managers to manage earnings
- changes in policies and estimates and the rationale for doing so
- whether transactions are structured to achieve certain accounting objectives
Week 3
Outline step 4 in the accounting analysis process
Step 4: Evaluate the quality of disclosure (notes to financial statements and other disclosures)
Issues to consider include:
1) Whether disclosures seem adequate
2) Adequacy of footnotes to the financial statements
3) Whether notes sufficiently explain and are consistent with current performance
4) Whether GAAP reflects or restricts the appropriate measurement of key measures of success
5) Adequacy of segment disclosures
Week 3
Outline step 5 in the accounting analysis process
Step 5: identify Potential Red Flags
Issues to consider include:
1) Unexplained changes in accounting, especially when performance is poor
2) Unexplained transactions that boost profit
3) Unusual increases in inventory or receivables in relation to sales revenue
- Inventory / sales increase may indicate obsolete inventory
- Accounts receivable / sales increase may indicate selling more on credit so we should see more allowance for bad debt (if they haven’t then may indicate aggressive accounting)
4) Increases in the gap between net income and cash flows or taxable income
5) Use of R&D partnerships, SPEs or the sale of receivables to finance operations
6) unexpected large asset write-offs (or lack of write-offs if other firms have been writing off a particular type of asset)
7) Large fourth-quarter adjustments
8) Qualified audit opinions or auditor changes
9) Related-party transactions
Week 3
Outline step 6 in the accounting analysis process
Step 6: Undo Accounting Distortions
- Financial statement footnotes often provide information from which the analyst can undo accounting distortions or make the financial statements more comparable
Week 4
Is financing important to ROE, why?
What is the issue with using ROE to measure operating performance?
Discuss investing, operating, and financing activities in relation to value creation
Financing relation with ROE = Financing is indeed important. The impact of financing becomes apparent through the Equity Multiplier component of ROE. By undertaking debt instead of utilising equity we raise the value of the equity multiplier and in turn raise our ROE. However!! the impact of interest expense will lower the Profit Margin and result in a lower ROE. There is a trade off. Ideally it is important to balance the effects of leverage with the implications of interest expense to achieve an ideal ROE.
ROE in terms of measuring operating performance = As discussed above, financing influences ROE. Therefore, ROE does not provide clean analysis of operating performance, it mixes operating and financing performance.
Value creation = Operating and investing activities create value. Financing activities distribute value, they do not create value (because they occur at the cost of capital).
For example:
1. (Equity financing) Company X issues shares. The total amount of outstanding shares will increase, but share price will remain the exact same. No value is created. However, value could be destroyed if shares are issued at a lower price than market value
2. (Debt financing) Company X undertakes additional debt. Due to the interest expense the company will have assumed a negative position. The amount borrowed will be less than the amount owed over the long-run.
Week 4
Summarise Modigliani and Miller (1961)
MandM = Dividend payments are irrelevant to the value of the firm = paying dividends wont create or destroy value = they simply distribute value
Week 4
Reformatting the financial statements involves classifying every Income Statement and Balance Sheet account as either an Operating or Financing activity.
How do we determine if an account relates to Operating or Financing?
Determining Operating vs Financing:
Financing = have an interest payment associated
Operating = all other activities
Week 4
Outline step 1 of the reformatting process.
Step 1: Calculate Owners equity for the current year.
This is accomplished by deducing the following amounts
- OE (last year) = Owners Equity (last year)
- CI (current year) = Comprehensive income (current year)
- d = Net payments to shareholders
- Change in OI = Ownership Interest
Then simply follow the formula:
OE (cy) = OE (ly) + CI (cy) - d + OI change
Note: Comprehensive Income = Net income + OCI
Note: Net payments to shareholders = dividends, share-based payments, and share buy-backs
Week 4
Outline step 2 of the reformatting process
How does the formula A - L = E change?
Step 2: Calculate Net Operating Assets (NOA) and Net Financial Obligations (NFO)
- Identify which assets and liabilities are financing (generally anything interest bearing) and calculate NFO
- All other items are identified as operating activites to calculate NOA with.
- Confirm balance sheet still balances (OE = NOA - NFO)
A - L = E = This formula will change to NOA - NFO = E
Week 4
Outline step 3 of the reformatting process
Step 3: Reformat P and L statement
- Identify what is financing (interest paid or received + any others?) and calculate net interest expense
- Adjust net interest expense for tax shelter to calculate a Net Financing Expense after tax: NFEat = Net Interest x (1 - t)
- Identify other revenues and expenses as operating and calculate operating profit before tax
- Adjust reported tax expense for tax shelter on net interest to calculate NOPAT. If we calculated a positive NFEat (interest expense < interest revenue) we reduce tax expense by tax shield amount. If we calculated negative NFEat we increase tax expense by tax shield amount
- NI = NOPAT - NFEat
- If there is OCI, CI = NOPAT - NFEat + OCI
Week 4
Outline step 4 of the reformatting process
Step 4: Calculate FCF generated by operations and FCF spent on financing and ensure both equal the same amount.
- FCF generated by operations:
FCF = NOPAT - change in NOA + OCI - FCF spent on financing:
FCF = NFEat - change in NFO + d - change in Ownership Interest
Note: d refers to net payments to shareholders
Week 5
Ratio Analysis requires comparison against which four benchmarks?
What should effective ratio analysis do?
Which two factors drive firm value?
Which four levers achieve growth and profit targets?
- Ratios over time from prior periods (time series)
- Ratios of other firms in the industry (cross-sectional)
- Absolute benchmarks (cost of capital for the firm would be an example for which ROE could be compared against, because ROE needs to be higher)
- Common size analysis (e.g. each asset as percentage of total assets)
Effective ratio analysis = must attempt to relate underlying business factors to the financial numbers (e.g. why did Firm X’s profit margin increase?)
Drivers of firm value = Profitability and growth
Four levers = Operating management, investment management, financing strategy, dividend policy
Week 5
What is the simple Du Pont formula and its various component uses?
What are the issues with the simple Du Pont?
ROE = (NI / Sales) * (Sales / Avg Total Assets) * (Avg Total Assets / Avg OE) = Profit margin * Asset Turnover (ATO) * Financial Leverage (FLEV)
Therefore: ROE = NI / Avg OE
Issue 1: Interest impacts operating returns. I.e. the PM will change if we introduce debt into our capital structure. This is because we will have to pay an interest expense which will lower NI and therefore lower PM. This results in a PM which does not accurately reflect the profitability of operations alone.
Issue 2: Simple operating transactions influence ATO and FLEV. For example, paying a liability with cash will lower total assets (less cash asset). This will result in less Avg Total Assets and therefore a greater ATO as well as a greater FLEV. The ROE will remain the same, however the components of ROE will not be accurate reflections.
Issue 1 + Issue 2 = Overall problem
The overall problem is that Basic DuPont analysis doesn’t correctly attribute changes in operating and financing activities to the respective ratios… This is because Operating changes should impact PM and ATO (issue 2 shows this is not always the case) and Financing activities should impact FLEV ( issue 1 shows this is not always the case).
Week 5
What is the advanced DuPont analysis formula and what does the advanced DuPont do for us in regards to the basic DuPont?
Which ratios are Shareholders, Firms, and Debtholders interested in?
ROE = RNOA + FLEV *SPREAD
ROE = (NOPAT / Sales) * (Sales / AvgNOA) + (Avg NFO / Avg OE) * (RNOA - NBC)
ROE = Operating Profit Margin * Operating Asset Turnover + FLEV * Spread
Note: RNOA = OROA (same thing) = NOPAT/ AvgNOA
Note: Spread captures interest effects
Note: NBC = Net Borrowing Cost = NFEat / AvgNFO = reflects credit risk
Advanced DuPont ensures changes in operating and financing activities impact the correct ratios so that we have a clearer picture of how a business is performing
Shareholders = ROE Firms = RNOA Debtholders = NBC
