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BE352 - Financial Reporting/Markets > L2-3: Financial Statement Analysis > Flashcards

L2-3: Financial Statement Analysis Flashcards

1
Q

What are two approaches to financial statement analysis?

A
  • Common-size analysis
  • Ratio analysis
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2
Q

What is common-size analysis?

A

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

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3
Q

What is a vertical common-size balance sheet?

A

Expresses all BS accounts as a percentage of total assets.

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4
Q

What is a vertical common-size income statement?

A

Expresses all IS items as a percentage of sales.

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5
Q

When are ratios informative/useful?

A

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.

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6
Q

Is calculation of ratios equal to financial analysis?

A

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

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7
Q

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

A
  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?
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8
Q

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

A
  • 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.
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9
Q

How can the problems with accounting based comparison be reduced?

A
  • 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.
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10
Q

What 4 concepts are connected to growth financials?

A
  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.
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11
Q

What is the formula for the growth relationship for equity?

A

∆E / E = ROE - DIV/E + NewIssue/E

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12
Q

What is financially balanced growth?

A

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

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13
Q

What does the gross margin measure?

A

Gross profit / Sales

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

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14
Q

What does the operating margin measure?

A

EBIT / Sales

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

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15
Q

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

A

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.

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16
Q

What question does ROE answer?

A

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

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17
Q

What question does ROA answer?

A

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

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18
Q

How do we calculate EBIE?

A

EBIT + interest income

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19
Q

What signifies cost leadership?

A

Low margins, high turnover.

  • Stable technology
  • Standard products
  • High efficiency
  • Cost management
20
Q

What signifies differentiation?

A

High margins, low turnover

  • Innovative technology
  • Mix of products
  • High quality
  • Brand
21
Q

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

A
  • Industry membership.
  • Strategy.
  • Performance.
22
Q

What may movement over time in a DuPont graph indicate?

A
  • 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).
23
Q

What is an industry and how can they be classified?

A

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.
24
Q

What is a horizontal common-size balance sheet?

A

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

25
Q

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

A
  • 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

26
Q

What is the clean surplus relationship equation?

A

∆E = NetIncome - Div + NewIssue

27
Q

What are typical characteristics in a DuPont chart?

A
  • Far left: capital intensive energy companies
  • Middle: manufacturing industrial companies
  • Far right: organically growing consulting companies.
28
Q

What is needed for ratio analysis to make sense?

A

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.

29
Q

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

A

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.

30
Q

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

A
  • 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.
31
Q

What is cluster analysis?

A
  • 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.

32
Q

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

A

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).

33
Q

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

A
  • ROE and ROA
  • Current ratio and Cash ratio
  • Debt-to-equity and solvency ratio (negative corr)
  • Receivables turnover and asset turnover
34
Q

What are redundant ratios?

A

Ratios that provide very similar information within the same category.

35
Q

What are diagnostic ratios?

A

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

36
Q

What can factor analysis do?

A

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.

37
Q

How can we approach distress prediction?

A

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

38
Q

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

A

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
39
Q

What is the idea behind discriminant analysis?

A

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.

40
Q

How does uni-variate discriminant analysis work?

A
  • 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.
41
Q

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

A

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).

42
Q

How does multivariate discriminant analysis work?

A

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.

43
Q

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

A

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.

44
Q

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

A

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.

45
Q

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

A

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.

BE352 - Financial Reporting/Markets (6 decks)

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