L2-3: Financial Statement Analysis

Question 1

What are two approaches to financial statement analysis?

Answer 1

• Common-size analysis
• Ratio analysis

Question 2

What is common-size analysis?

Answer 2

Normalize balance sheets and income statements and allow the analyst to more easily compare performance across firms and for a single firm over time.

Question 3

What is a vertical common-size balance sheet?

Answer 3

Expresses all BS accounts as a percentage of total assets.

Question 4

What is a vertical common-size income statement?

Answer 4

Expresses all IS items as a percentage of sales.

Question 5

When are ratios informative/useful?

Answer 5

Not in isolation, but when compared to:
1. Other firms (peer benchmarking, cross-sectional analysis): between variations.
2. The company’s historical performance (time series analysis): within variation.
3. Other benchmarks: e.g. to the company’s required rate of return.

View ratios relative to each other, don’t only look at one.

Question 6

Is calculation of ratios equal to financial analysis?

Answer 6

No, analysis goes beyond collecting data and computing numbers, it encompasses computations and interpretations.
- credit analysis
- equity analysis
- strategic planning

Question 7

What are the five groups/classifications of financial key ratios?

Answer 7

1. Activity: How efficient are the firm’s operations and the firm’s management of assets?
2. Liquidity: How well is the firm positioned to meet short-term obligations?
3. Solvency: How well is the firm positioned to meet long-term obligations?
4. Profitability: How and how much is the firm achieving returns on its investments? Ability to generate profits from its resources.
5. Valuation: How does the firm’s performance or financial position relate to its market value?

Question 8

What are some drawbacks of accounting based comparison to aware of?

Answer 8

• Different growth strategies (e.g. growing by acquisition → goodwill).
• Different value added strategies (e.g. competing in prices
  → Sales/Total assets)
• Financed in different ways (e.g. debt intensive industries
  → Equity/Assets)
• Use different accounting methods (analyze accounting principles).
• Active in different countries, vulnerable to multiple sources of shocks that ripple through their financial statements and then ratios.

Question 9

How can the problems with accounting based comparison be reduced?

Answer 9

• Choose companies that are as similar as possible.
• Make use of techniques like clustering analysis to choose similar companies within industries.
• Matching algorithms can also be used to find comparable companies.
• Adjust accounting.
• Choose key ratios that are not affected by the problem.

Question 10

What 4 concepts are connected to growth financials?

Answer 10

1. Growth: how does growth in sales/assets/employees translate into growth in equity?
2. Financial position: has a clear impact (how do we finance that growth?).
3. Dividend policy (new issues): the payout policy impacts growth in equity (clean identity surplus).
4. Profitability: ROE tells us how profitable shareholders investment has been, taking into account how the growth has been financed.

Question 11

What is the formula for the growth relationship for equity?

Answer 11

∆E / E = ROE - DIV/E + NewIssue/E

Question 12

What is financially balanced growth?

Answer 12

When the growth rate of equity is the same as the growth rate of assets

Question 13

What does the gross margin measure?

Answer 13

Gross profit / Sales

Measures the ability to translate sales into profit after consideration of cost of products sold.

Question 14

What does the operating margin measure?

Answer 14

EBIT / Sales

Measures the ability to translate sales into profit after consideration of operating expenses.

Question 15

What does the net margin (return on sales) measure?

Answer 15

Net profit / Sales

Measures the ability to translate sales into profit after consideration of all expenses and revenues, including
interest, taxes, and non-operating items.

Question 16

What question does ROE answer?

Answer 16

What rate of return has the firm earned on the shareholders’ equity it had available during the year?

Question 17

What question does ROA answer?

Answer 17

What rate of return has the firm earned on the assets it had available to use during the year?

Question 18

How do we calculate EBIE?

Answer 18

EBIT + interest income

Question 19

What signifies cost leadership?

Answer 19

Low margins, high turnover.

• Stable technology
• Standard products
• High efficiency
• Cost management

Question 20

What signifies differentiation?

Answer 20

High margins, low turnover

• Innovative technology
• Mix of products
• High quality
• Brand

Question 21

What does a firm’s position in a DuPont chart indicate?

Answer 21

• Industry membership.
• Strategy.
• Performance.

Question 22

What may movement over time in a DuPont graph indicate?

Answer 22

• Changed level of efficiency (cost reduction scheme, capital efficiency scheme, etc).
• Change of strategy (outsourcing production, disposal of capital intensive parts of business, etc).
• Change in the competitive landscape (import tariffs, patent expiry, etc).
• Shift in the economic climate (some industries are more exposed to macro-level shocks).

Question 23

What is an industry and how can they be classified?

Answer 23

A group of firms.

• Fama & French: US firms divided into 12/48 industries (groups). Different level of specificity (narrowness of industry).
• US SIC: We use 4 digits, but it can be up to 8. The digits provide a specific code/grouping, the more numbers, the more specific. Like a tree, it branches out into more specific categorizations.

Question 24

What is a horizontal common-size balance sheet?

Answer 24

Prepared by dividing the quantity of each item by a base year quantity of the item. Highlights structural changes and can be used for trend analysis. Expresses everything as a percentage of the base year

Question 25

What are some questions that can be asked in common-size analysis?

Answer 25

- What are the important components of the company’s balance sheet? - Have any notable changes occurred? - What caused the changes? - What conclusions can we draw from comparing two companies? Dependent on judgment and interpretation

Question 26

What is the clean surplus relationship equation?

Answer 26

∆E = NetIncome - Div + NewIssue

Question 27

What are typical characteristics in a DuPont chart?

Answer 27

- Far left: capital intensive energy companies - Middle: manufacturing industrial companies - Far right: organically growing consulting companies.

Question 28

What is needed for ratio analysis to make sense?

Answer 28

Setting up benchmarks, for comparative purposes. Like industry average. If the distribution is not standard, the reference is not the mean but either the median or the percentile intervals.

Question 29

Why do we need to include a measure of dispersion in ratio analysis?

Answer 29

The adequacy (quality) of benchmarks will depend on factors such as the company size and the deviation from a settled standard. Even if we deflate items for comparison, ratio comparison is not optimal when comparing very large to very small firms.

Question 30

What are some potential solutions when there is a lot of dispersion among firms in the same industry?

Answer 30

- Within comparison: using the past information of the firm to make comparisons. - Comparison with a peer firm, i.e., a direct competitor subjected to similar shocks and characteristics, such as size, capital structure, etc. - Use cluster analysis to find a group of peer firms within an industry.

Question 31

What is cluster analysis?

Answer 31

- Want to see if possible to group companies, in a certain sector, that have similar characteristics. - Similarity defined in statistical terms. - Afterwards, we try to interpret the results in an economically meaningful way. - Clustering is an iterative procedure. In our case, we have a number of key ratios (s) for a sample of companies (n). Each observation (company) is a vector (point) in a s-dimensional space. The more ratios we use to calculate the similarity between forms, the more dimensions we use.

Question 32

What is the curse of dimensionality and how can we minimise it?

Answer 32

A problem in cluster analysis. Want to include many dimensions, but that makes it harder to find a match. Alleviate the issue by not including strongly correlated ratios (strong correlation = 20-30% in social sciences).

Question 33

What are some ratios that we have seen strong correlation between?

Answer 33

- ROE and ROA - Current ratio and Cash ratio - Debt-to-equity and solvency ratio (negative corr) - Receivables turnover and asset turnover

Question 34

What are redundant ratios?

Answer 34

Ratios that provide very similar information within the same category.

Question 35

What are diagnostic ratios?

Answer 35

Ratios that cannot easily be substituted by other ratios. For instance, the interest coverage ratio in the solvency category.

Question 36

What can factor analysis do?

Answer 36

Help us reduce the number of variables without sacrificing variability. After generating the factors for profitability, liquidity, solvency and efficiency, we can perform cluster analysis.

Question 37

How can we approach distress prediction?

Answer 37

Using ratio analysis to help us predict future bankruptcy (legal procedure, not liquidation)

Question 38

What is the idea behind distress prediction and what techniques are there?

Answer 38

Idea: using a sample of bankrupt and non-bankrupt firms, we can try to isolate and put into a model those factors (ratios) that single out the types of firms. 1. Discriminant analysis: - Uni-variate (one ratio): Beaver 1966 - Multi-variate (array of dimensions): Altman 1968 2. Logit Model: Ohlson 1980

Question 39

What is the idea behind discriminant analysis?

Answer 39

To find one or more variables with a distribution that is (statistically) significantly different between: - sub-sample of bankrupt companies - sub-sample of non-bankrupt companies This analysis uses binary classification.

Question 40

How does uni-variate discriminant analysis work?

Answer 40

- Work out ratios for each company. - Work out the mean for each ratio in each of the two sub-samples (bankrupt vs. non-bankrupt). - Run a test to check whether the means are significantly different between the two sub-samples. - Select one ratio. - Select the discriminant level.

Question 41

What can you say about Beaver's (1966) uni-variate discriminant analysis?

Answer 41

79 bankrupt firms and 79 (matched) non-bankrupt firms. Selection process based upon a paired-sample design, i.e. for each bankrupt firm in the sample, a non-bankrupt firm of the same industry and asset size was selected. Ratios seem to be significantly different between the two subsamples: - Cash flow to total debt - net income to total assets - total debt to total assets - WC to total assets - Current ratio - no-credit interval Some difference is seen already 5 years before distress, but the closer we get the more predictive power we have (larger gap).

Question 42

How does multivariate discriminant analysis work?

Answer 42

Use a linear combination of ratios, which determines a value Z. Select cut-off values for Z to classify firms according to certain categories. Steps: 1. Three subsamples. Two subsamples of firms (bankrupt/non-bankrupt) and another random subsample of firms to test how good our model classifies these firms into bankrupt/non-bankrupt categories. 2. Build a linear discriminant function (Z) that minimizes Type I and II errors. 3. Study the prediction power of the model.

Question 43

What can you say about Alman's (1968) multivariate discriminant analysis?

Answer 43

66 firms from manufacturing sector. Different weights are assigned to different ratios to find Alman's Z-score. Depending on cutoff values for Z, we predict high or low risk of bankruptcy in the next 2 years. Dependent variable Y=0 if the firm goes bankrupt in the following two years; 1 otherwise.

Question 44

What is the idea of Logit Model analysis and what advantage does it have?

Answer 44

Method similar to multi-variate discriminant analysis: choose a discriminant value for the probability of bankruptcy. Advantage: it does not need to assume normality (independent variables). - Allows to calculate a probability of bankruptcy.

Question 45

What can you say about Ohlson's (1980) logit model analysis?

Answer 45

2000 firms. Dependent variable Y=1 if the firm goes bankrupt in the following year; 0 otherwise. 1. Calculate the ratios. 2. Obtain Y^ by plugging the ratios into the model. 3. Use the Logit function to retrieve the probability of bankruptcy/non-bankruptcy.