R.19 Integration of financial statement techniques

Question 1

Steps in framework for financial statement analysis

Answer 1

1. Define objectives. What’s purpose and context of analysis? This includes the questions to answer, nature of report, timetable, and budgeted resources.

2. Collect input data. This includes financial statements, discussions with management, and company site visits.

3. Process the input data into analytically useful data. This could involve adjusting the financial statements, calculating ratios, and making forecasts.

4. Analyze and interpret the data

5. Develop/communicate conclusions and recommendations

6. Follow-up. Repeat the steps above to update reports and recommendations.

Question 2

Other Items in the Analysis

Answer 2

Asset Base Composition

• The asset mix in the balance sheet can be analyzed over historical time periods.
• Look for large amounts and growth in intangible assets, which could indicate a reliance on acquisitions.

Capital Structure Analysis

• The capital structure can be analyzed by studying common-sized statements over time.
• Growth in financial liabilities points to increased leverage.
• Current & quick ratios → changes in the working capital accounts, which sheds light on how the company is managing liquidity.

Segment Analysis and Capital Allocation

• Internal capital allocation is important to the long-term growth in a company.
• Analyze operating segments by:
  
  • Sales & EBIT
  • Asset and capital expenditures
  • Generally, a segment’s proportion of capital expenditures should be the same as its proportion of total assets. Ideally, the more profitable segments will be getting a larger proportion of the capital.

Accruals and Earnings Quality

• Balance-sheet-based accruals and cash-flow-based accruals can be compared over time.
• Balance-sheet-based accruals are the year-to-year changes in net operating assets.
  
  • B/S accruals ratio is accruals as % of avg net operating assets.
• Cash-flow-based aggregate accruals are the profit from continuing operations less operating and investing cash flow.
  
  • CF accruals ratio is CF aggregate accruals divided by avg net operating assets.
• Analysts should be concerned about high levels in the accruals ratio and levels that are trending up over time.

Cash Flow Relationships

• Determine if operating earnings are backed by cash flow.
  
  • Compare operating cash flow to operating income.
    
    • If the operating cash flow is consistently less than operating profit, the quality of the operating profit may be low.​
  • Operating cash flow and total assets relationship can also be examined.
    
    • Declining ratio of operating cash flow to total assets is a concern.

Question 3

Accruals Ratios

• Accruals Balance sheet method
• Accruals Cash Flow Method

Answer 3

Question 4

ROE comprehensive breakout of components

Answer 4

Question 5

Integration of FRA techniques: high level framework

Answer 5

Question 6

(1 of 2)

Integrating FRA Techniques Case Study: Nestle’s investment in associates of L’Oreal

What analysis tools/methods can be used to better understand the impact/implications of the investment in associates on Nestle’s financials in the following areas:

1. ROE
2. Asset Base Composition
3. Capital Structure
4. Segment Analysis and Capital Allocation
5. Accruals and Earnings Quality

Answer 6

Question 7

(2 of 2)

Integrating FRA Techniques Case Study: Nestle’s investment in associates of L’Oreal

Cash Flow Relationships

1. CF-to-Operating Profit
2. CF-to-Assets
3. CF-to-…

Reinvestment

Debt

Interest Paid

Answer 7