Module 1 Flashcards
what is financial statement analysis
The process of extracting information from financial statements to better understand a company’s current and future performance and financial conditions
who are the different people that have objectives for using financial statements
- management
- investors and analysts
- creditors, lenders, and rating agencies
- regulatory agencies
- legal institutions
- other decision makers
what does management use financial statements for
to raise financing for the company, meet disclosure requirements, and as a benchmark for executive bonuses
what does investors and analysts use financial statements for
to help decide to buy or sell a stock or not
what does creditors and rating agencies use financial statements for
to determine the creditworthiness of a company’s debt and lending terms
what does regulatory agencies use financial statements for
to encourage the enactment of social and economic policies, and to monitor compliance with the laws
what does legal institutions use financial statements for
to assess fines and reparations in litigation
what do other decision makers use financial statements for
for things like determining demands in labour union negotiations and assessing damages for environmental abuses
who are the users that demand financial accounting information
- Managers and employees
- Investment analysts and information intermediaries
- Creditors and suppliers
- Stockholders and directors
- Customers and strategic partners
- Regulators and tax agencies
- Voters and their representatives
who and how are financial information supplied
- If benefits > costs of disclosing accounting information, managers will give out the information
- They can determine the quality and quantity of information to give
- Regulation and bargaining power affects the disclosure costs and benefits
what are the required reports that public companies in the US must file
- form 10-k
- form 10-q
what is the form 10-k
- Audited annual report
- Includes the 4 financial statements with explanatory notes, and the management’s discussion and analysis (MD&A) of financial results
- Must be filed within 60 days of the year-end for larger companies & 90 for smaller companies
what is the form 10-Q
- Unaudited quarterly report
- Includes summary versions of the 4 financial statements and limited additional disclosures
- Must be filed within 40 days of the quarter-end for larger companies & 45 days for smaller companies, except for the 4th quarter, which is in the 10-K
what are other useful information beyond financial statements
- financial statement footnotes
- management discussion and analysis (MD&A)
- independent auditor report
- regulatory filings, including proxy statements (DEF 14A) and other SEC filings (8K)
- prospectus (S1)
- Analyst Research Reports
- ESG reporting
what are financial statement footnotes
Explanation of the numbers in the financial statements
what is an MD&A
What management think about the numbers in the financial statements
what is an independent auditor report
Whether the auditor thinks the statements follows the standards
what is a proxy statement (DEF 14A)
- Filed before shareholder conference
- About important events and structure that shareholders need to approve
- Proposal required to vote
- Details of ownership
- Biographic information on directors
- Disclosure of executive compensation
what is a form 8K
- Important things that shareholders should know
- Wide range of corporate events, reported within 4 days
- Entry into or termination of a material definitive agreement (including petition for bankruptcy)
- Exit from a line of business or impairment of assets
- Change in the company’s certified public accounting firm
- Change in control of the company
- Departure of the company’s executive officers
- Changes in the company’s articles of incorporation or bylaws
what is a prospectus S1
- Needs to be filed when companies sell their shares on the market
- written document that informs potential investors all about the company
what are the benefits of disclosure
- access to capital
- good reputation
- valuation and analysis
- risk assessment
how is access to capital a benefit of disclosure
- capital markets have debt and equity financing
- Lets say the company shares their accounting information
- The better their prospects are, the cheaper it would be for them to get more capital (money)
- This can be from lower interest rates or higher stock prices
how is good reputation a benefit of disclosure
- can also help with recruiting efforts in labour markets -> company looks good = more people want to work there
- can also help with having good supplier-customer relations in the input and output markets
how is valuation and analysis a benefit of disclosure
- How well a company does in these markets depends on their success and if the market knows of that success
- So disclosing audited good news about the company’s products, processes, management, etc. is good for a company, and its why companies would want to do it
how is risk assessment a benefit of disclosure
- Companies can’t disclose false or misleading good news because their information needs to follow audit requirements and there are legal repercussions if they provide inaccurate information
- It can also damage the reputation of the company
what are the costs of disclosure
- Preparation and dissemination costs (Compliance and Audit costs)
- Competitive disadvantages (Proprietary costs)
- Litigation costs
- Political costs
- Monitoring costs
what is Preparation and dissemination costs (Compliance and Audit costs)
Even though company’s have the information for internal use, it costs more and takes up more time for them to audit the information and comply with SEC rules
what are Competitive disadvantages (Proprietary costs) of disclosure
Revealing information such as:
- Product or segment successes
- Strategic alliances or pursuits
- Technological or system innovations
- Product or process quality improvements
Can reduce or eliminate a company’s competitive advantage
what is the litigation cost of disclosure
- By disclosing information, the company may create expectations for others
- If those expectations are not met, people could end up taking legal action against the company
- It would then be costly to defend against customer or investor lawsuits
- Even if a case is dismissed, it would still be costly
what is the political costs of disclosure
- Highly visible companies can face political and public pressure
- Ex. government defence contractors, large software conglomerates, and oil companies face a lot of public scrutiny
- Disclosing more = more public scrutiny
what is SEC’s Regulation Fair Disclosure (FD)/Reg FD
- to stop public companies from only disclosing certain information to certain stakeholders, and instead make it fair for everyone
- The goal is to curve the practice of selective disclosure by public companies
- Reg FD basically says that if an issuer wants to disclose any non-public information to certain stakeholders, they have to disclose that same information to everyone
what are the different assurance of financial reports
- notice to reader (compilation)
- review engagement
- audit engagement
what is a notice to reader
compilation of financial statements made without assurance or opinions
what is a review engagement
- a type of engagement that provides limited level of assurance
- just enough so they meet reporting requirements
what is an audit engagement
when an auditor agrees to provide an objective on financial statements
what is the assurance level of a notice to reader
none
what is the cost of a notice to reader
low
what is the complexity of a notice to reader
simple
what is the scope of a notice to reader
organizing information from management without verification
what is the use of a notice to reader
internal use or small companies
what is the assurance level of a review engagement
limited
what is the cost of a review engagement
moderate
what is the complexity of a review engagement
intermediate
what is the scope of a review engagement
inquiry and analytical procedure to provide limited assurance
what is the use of a review engagement
small companies seeking loans or private companies with external investors
what is the assurance level of an audit engagement
reasonable
what is the cost of an audit engagement
high
what is the complexity of an audit engagement
complex
what is the scope of an audit engagement
inquiry and analytical procedure to provide reasonable assurance
what is the use of an audit engagement
- public companies
- large private companies issuing bonds or requiring loans
what is the 4 steps in framework for analysis and valuation
- industry analysis
- business analysis
- financial statement analysis
- forecasting and valuation/credit analysis
what is done in the industry analysis & what is the purpose
- porter’s 5 forces
- economic cycle
- what is the profitability of a company
- can they achieve or maintain its normal profitability in the future?
- its determining this by analyzing the competition
what is done in the business analysis & what is the purpose
- business model
- competitive advantage
- business cycle
- what is the position of the firm
what is done in the financial statement analysis & what is the purpose
- accounting adjustment
- ratio analysis
- common size
- determining if the numbers are what we want
what is done in the forecasting and valuation/credit rating analysis & what is the purpose
- financial modeling
- DCF/Multiple
- collateral
- what is the value of the firm to others??
what is an industry
- a group of companies and organizations that produce similar products or provide similar services
- they are classified based on the primary business activities of the companies within them
what are the commonly used industry code systems
- NAICS
- SIC
- GICS
what is NAICS
- north american industry classification system
- mostly used by north american countries to classify business establishments by type of economic activity
what is SIC
- standard industrial classification
- older system that is used for historical data comparison and for some specific industries
what is GICS
- global industry classification standard
- developed to be used by the global financial community
- mostly for investment research and portfolio management
what are the 2 ways a company can finance its assets
- owner financing
- non-owner financing
what is owner financing
- money raised from stockholders
- they have claim on equity assets
- they are resources contributed to the company by its owners (cash or non-cash assets)
- profits retained by the company
what is non owner financing
- money raised from banks or other creditors and suppliers
- they have claims on debt assets
- money needs to be repaid or else there are severe consequences
what kind of companies usually have more debt than equity
- Companies with relatively stable cash flows
- like those in the consumer staples industry
what kind of companies usually have more equity than debt
- tech companies
- those that have larger business risk
- They reduce the level of financial risk by having more debt than equity
what types of companies have low profit levels
Retailers that operate in mature, highly competitive industries have difficulty differentiating their products so operating income as a % of sales is low
what kind of companies have high profitability
Companies that have higher levels of operating profit from patent protection and well established brands and command higher market prices and yield higher levels of profitability
how can a company determine their level of profitability
Being able to create barriers to competitive pressure from patent protection, effective marketing, etc.
what do companies need to do if they operate in highly competitive markets
If competing in highly competitive markets with little product differentiation, need to concentrate on controlling operating expenses to offset lower gross profits
what is porters value chain framework
- The model assesses a company’s value chain to understand the activities that create a company’s profit margin
- It assess primary and support activities
- The results of these activities show up on financial statements and other reports on performance and financial condition
- Can use the value chain analysis to interpret the financial reports
what are the primary activities on porters value chain
- Inbound logistics
- Operations
- Outbound logistics
- Marketing and sales
- servicing
what are the support activities in porters value chain framework
- Firm infrastructure
- Human resource management
- technology/product development (R&D)
- Procurement
what is commonly used framework for industry analysis
porters five forces
what is porters five forces
- The primary and support activities from the value chain are influenced by the 5 forces that determine the competitive intensity of the company
- industry competition
- bargaining power of buyers
- bargaining power of suppliers
- threat of substitutes
- threat of entry
what is industry competition
- Competition and rivalry raise the cost of doing business
- Companies need to hire and train workers, advertise their products, research and develop new products and engage in other related activities
- Higher the competition = higher the costs
what does looking at existing competition include
- number of companies
- slow industry growth
- low switching cost
- high fixed costs and/or high storage costs
- high exit barrier
whats the impact of high fixed costs and/or high storage costs in an industry
when industries with high fixed costs (like airlines) need to get maximum capacity to get lower per unit cost, leading to fight in market share
whats the impact of the number of companies in an industry
- more companies = higher competition for the same buyers and resources
- when companies have similar market share, they fight for market leadership
- look at the herfindahl-hirschman index which measures industry concentration based on market capitalization
- if index is high, there is high concentration
whats the impact of slow industry growth in an industry
- causes companies to fight for increased market share
- in a growing market, companies can improve revenues by accessing the expanding market, and can get more and more market share
whats the impact of low switching cost in an industry
- when buyers can easily switch to similar competitors products, competition is high
- can’t increase prices otherwise customers go to competitors
what is the bargaining power of buyers
- Buyers with strong power can extract price concessions and demand a higher level of service or even delay payment terms
- This reduces profits from sales and the operating flows that sellers can collect
when do buyers have high bargaining power
if
- they purchase large volumes relative to supplier sales (they make up most of your sales)
- the product is standard or undifferentiated (makes switching costs for buyers low)
- they can produce the product themselves
- supplier has high fixed costs
- the product is not strategic importance to buyers
what is the bargaining power of suppliers
- Suppliers with strong power can demand higher prices and earlier payments
- Could have adverse effects on profits and cash flows to the buyers
when do suppliers have high bargaining power
if
- the supply market is dominated by a few companies
- the buyers are neither large nor concentrated
- they do not have to contend with substitute products
- their products are differentiated, or suppliers have build up switching costs
- they pose a credible threat of forward integration
what is the threat of substitutes
- The more product substitutes there are, the less power sellers have to raise the prices or pass the costs to their buyers
- It places pressure on the profits of sellers
- they are substitute products in other industries or in individual products
what does ROA calculate
- how efficient a company’s management is at in generating profit from their total assets
- a %
- higher the better
whats the impact of high exit barrier in an industry
- companies have to stay in competition although they may be earning little or even negative returns
- ex. specialized assets that may be difficult to sell
when is entry easy
if there are
- a low scale threshold
- access to distribution channels
- common/accessible technology
- low switching costs
when is entry difficult
- high scale threshold
- restriction on distribution channels
- patented or proprietary knowledge
- high brand switching costs
when is exit easy
- marketable assets
- low exit costs
- independent business
when is exit difficult
- specialized assets
- high exit costs
- interrelated business
from the threat of substitute products, when is competition high
- buyers have no brand loyalty and/or there is no established brands
- changing to another product saves money without sacrificing features or performance
- simple and inexpensive to change to another product
- the producers of substitute product have very high margins and can easily attract buyers through price reductions
what framework is used for business analysis
SWOT
what is swot analysis
- Can be applied to almost any organization
- Internal factors = Strengths and weaknesses
- External factors = Opportunities and threats
- Strengths
- Weaknesses
- Opportunities
- Threats
- When used as an overall strategic analysis, it can provide a good review of the options
- Sometimes it can be too subjective because it is intuitive and allows varying opinions on relevant factors when trying to understand the company
what questions do you ask when analyzing the competitive advantage of a company
- Does the company actually have a competitive advantage, and if so, what factors explain it?
- Is the competitive advantage sustainable?
- If the company has no competitive advantage, does its management have a plan to develop one that can be implemented in an acceptable period of time with a reasonable amount of investment?
what is the threat of entry
- New market entrants
- If there are a lot of entrants, competition increases
- To reduce competition/threat, companies spend money on activities like new technologies, promotion and human development
- Creating barriers to entry = creating economies of scale
- low barrier = easy to enter = hard to maintain profitability
what are examples of barriers to entry (into a business)
- organizational economic of scale - minimum efficient scale (when its cheap to produce a lot of existing companies)
- patents and proprietary knowledge
- copyrights, and other legal protections
- regulatory/government (like needing approval from government to sell, etc. a license)
- asset specificity (specific assets used in the business that isn’t common for every business)
- having access to scarce resources (can control prices)
what are the different ways for a company to achieve competitive advantage
- barriers to entry
- product/service differentiation
- cost leader
how can companies have product/service differentiation
- Technological innovation
- Product design
- Marketing, distribution, and after-sale customer support
how can a company become a cost leader
- Access to low-cost raw materials or labour
- Manufacturing or service efficiency
- Manufacturing scale efficiencies
- Greater bargaining power with suppliers
- Sophisticated IT systems
what competitive advantages allows companies to charge higher prices
- barriers to entry
- product/service differentiation
what is the formula for ROA
net income / average assets
OR
profit margin (profitability) x asset turnover (productivity)
(%)
what is the formula for profit margin
net income / sales
what is PM
- profit margin
- Net income earned from each sales dollar
- %
- Want this number to be high
what is the formula for asset turnover
Sales / average assets
what is AT
- asset turnover
- sales generated from each dollar of assets
- Want this number to be high
what are companies that have high profitability and low productivity
- Tech companies
- High profit margins can be from patent protection which increases barriers to entry, reducing competition
- Also have a lot of assets on their balance sheet (marketable securities and intangible assets) that they don’t really generate sales on, reducing the asset turnover
what are companies with low profitability and high productivity
- Retailers
- Hard for them to differentiate products, which causes them to keep prices low
- Low prices = low profit margins
- They focus on increasing asset turnover to keep a good ROA
- They rarely have A/R
what needs to be done to have high ROA
- need high PM and AT
- managers need to manage both income statement (profit) and balance sheet (asset turnover)
what is the basic ROE formula and what is it
net income / average stockholder’s equity
- return to stockholders
- a percent
what is forecasting
Forecasting involves formalizing our predictions and stating them as financial projections
what does the quality of forecast depend on
- Quality of prior analysis
- Realistic and achievable assumptions
what is the quality of prior analysis
- How well we understand the company’s business
- How thoroughly we examined and adjusted the company’s financial statements
what is the Realistic and achievable assumptions
Objectively examine what evidence supports, or challenges, the forecast assumptions
what is the forecasting order
- Income statement
- Balance sheet
- Statement of cash flows
This is the order because each statement uses information from preceding statements
what are the different stages of the economic/business cycle
- expansion
- peak
- recession
- depression
- trough
- recovery
- different industries experience the different stages differently
- Ex. utilities don’t really experience much differences during a recession because they are a necessity vs luxury stores
what are the 4 life cycle stages of an industry, business, and product
- introduction (take off)
- growth (shake out)
- maturity (saturation)
- decline
what happens at the introduction stage
- low sales
- high cost per customer
- financial losses
- innovative customers
- few (if any) competitors
what happens at the growth stage
- increasing sales
- cost per customer falls
- profits rise
- increasing number of customers
- more competitors
what happens at the maturity stage
- peak sales
- cost per customer lowest
- profits high
- mass market
- stable number of competitors
what happens at the decline stage
- falling sales
- cost per customer low
- profits fall
- customer base contracts
- number of competitors fall
what are external factors
- another type of industry analysis
- factors that are beyond the control of the company that may affect a company’s future results from what they desire or expect
what are examples of external factors
- economic environment
- international
- political environment
- social environment
- technology
what are examples of economic environment factors
- recession
- interest rate
- taxes
what are examples of international factors
- local economic and labour conditions
- political instability
- tax laws
- local and national government regulation
what are examples of political environment factors
- regulations
- president election
- trade agreement
- any government policies affecting supply and demand
what are examples of social environment factors
- customs and conventions
- cultural
- fashion trend
- ethical issues
what are examples of technology factors
- new process
- new products
