Reading 12 - Intergration of Financial Statement Analysis Techniques

Question 1

What are the 6 steps in the framework for analysis of financial statements?

Answer 1

1. Establish the objectives
2. Collect data
3. Process data
4. Analyze data
5. Develop and communicate conclusions
6. Follow up

Question 2

What is the input and output from the Establish the objectives of the Framework for Analysis?

Answer 2

Input

• Analyst’s perspective (evaluate a debt or equity investment)
• Needs communicated by client or supervisor
• Institutional guidelines

Output

• Purpose statement and specific questions to be answered
• Nature and content of final report
• Timetable and budget

Question 3

What is the input and output from the Data Collection portion from the objectives of the Framework for Analysis?

Answer 3

Input:

• Financial Statements
• Communication with management, suppliers, customers and competitors

Output:

• Organized financial information

Question 4

What is the input and output from the Processing the Data portion from the objectives of the Framework for Analysis?

Answer 4

**Just output**

Output:

• Adjusted financial statements
• Common-size statements
• Ratios
• Forecasts

Question 5

What is the input and output from the Analyzing the Data portion from the objectives of the Framework for Analysis?

Answer 5

**Just output**

Output:

• Results of analysis

Question 6

What is the input and output from the Develop and communicate conclusions portion from the objectives of the Framework for Analysis?

Answer 6

Input:

• Results from analysis using report guidelines

Output:

• Recommendations

Question 7

What is the input and output from the Follow-Up portion from the objectives of the Framework for Analysis?

Answer 7

Input:

• Periodically update information

Output:

• Update analysis and recommendations

Question 8

What is the formula for the DuPont ROE?

Answer 8

Question 9

What is the formula for the DuPont total asset turnover?

Answer 9

Question 10

What is the formula for the DuPont financial asset leverage?

Answer 10

Question 11

What is the formula for the DuPont tax burden?

Answer 11

Question 12

What is the formula for the DuPont interest burden?

Answer 12

Question 13

What is the formula for the DuPont EBIT margin?

Answer 13

Question 14

What is the formula for the Accruals Ratio using the balance sheet approach?

Answer 14

Question 15

What is the formula for the Accruals Ratio using the cash flow statement approach?

Answer 15

Question 16

What is the formula for cash generated from operations (CGO)?

Answer 16

Question 17

If a firm’s earnings are partially from Intercorporate Investments, what adjustment needs to be made to eliminate this bias?

Answer 17

**For influential investments (>20% but less than 50%) the equity method is used in which the investor recognizes its pro-rata shares of the investee’s earnings on the income statement

• This equity income should be removed from the DuPont analysis
• The balance sheet should also be updated by reducing the total assets by the carrying value of the investment

**effect on ratios

1. Will decrease the investor firm’s earning and net profit margin
2. Will increase total asset turner (since you have fewer assets)

Question 18

What are some techiniques for analyzing a companies Asset Base?

Answer 18

Examine the composition of the balance sheet over time

• Common-size analysis is helpful
• Useful in identifying acquisitions and goodwill

Analyzing a company’s asset base involves assessing its resources, efficiency, and strategic use of assets to generate revenue and sustain operations. Here are some effective techniques:

1. Asset Composition Analysis
   
   • Categorize assets into short-term (current) and long-term (non-current) to understand liquidity and capital allocation.
   • Evaluate the proportion of tangible assets (like property and equipment) versus intangible assets (like patents and goodwill). Companies with high intangible assets may rely heavily on intellectual property or brand value.
2. Efficiency Ratios
   
   • Asset Turnover Ratio: Measures how efficiently assets are used to generate revenue. Formula:\text{Asset Turnover} = \frac{\text{Revenue}}{\text{Total Assets}}

• Fixed Asset Turnover Ratio: Specifically assesses how effectively fixed assets like equipment contribute to sales.

3. Liquidity Assessment
   
   • Analyze current assets like cash, inventory, and receivables to evaluate short-term financial health.
   • Use liquidity ratios, such as the current ratio and quick ratio, to determine whether the company can meet its short-term obligations.
4. Depreciation and Impairment Analysis
   
   • Review how fixed assets are depreciated and check for impairment charges. Significant impairments may signal declining value or poor asset management.
5. Asset Quality Review
   
   • Assess the condition and reliability of physical assets, especially in capital-intensive industries.
   • For intangible assets, examine valuation methods and potential risks, such as regulatory changes affecting patents.
6. Growth Trends
   
   • Analyze changes in asset base over time to identify growth areas or inefficiencies.
   • Look at capital expenditures (CapEx) to gauge reinvestment in fixed assets and long-term strategies.
7. Industry Comparisons
   
   • Benchmark the company’s asset base against competitors to spot competitive advantages or inefficiencies.
   • Consider sector-specific metrics, as the asset structure varies by industry. For instance, tech firms may prioritize intangible assets, while manufacturing relies heavily on physical assets.
8. Debt-Asset Relationship
   
   • Examine the ratio of assets funded by debt (e.g., debt-to-assets ratio) to understand financial leverage and risks associated with the asset base.

• Recall that goodwill is no longer amortized but subject to impairment

Question 19

Why is a firm’s capital structure important to consider when reviewing a firm?

Answer 19

A firm’s capital structure—the mix of debt, equity, and other financing sources—is critical to understanding its financial health, risk profile, and ability to generate value for stakeholders.

1. Financial Risk and Stability:
   
   • A firm heavily reliant on debt might face higher financial risk due to interest obligations, especially during economic downturns. However, debt can be advantageous when managed well, as it often costs less than equity due to tax-deductible interest.
2. Cost of Capital:
   
   • Capital structure influences the firm’s weighted average cost of capital (WACC), which is used to evaluate investment decisions. The right balance between debt and equity helps minimize the cost of financing and maximize shareholder returns.
3. Flexibility and Growth Potential:
   
   • A firm with excessive debt might have limited flexibility to raise funds for new projects. Conversely, a firm with high equity may have room to take on more debt to fuel growth.
4. Shareholder Value:
   
   • The proportion of equity impacts ownership dilution and the firm’s ability to distribute dividends. Investors evaluate whether the firm’s capital structure aligns with their risk tolerance and desired returns.
5. Signal to Market:
   
   • Capital structure choices send signals to the market about the firm’s strategy and confidence in its future. For instance, increasing debt could indicate aggressive growth plans, while issuing equity might suggest caution.

• Examine long term debt to capital
• Some liabilities are less onerous than others and may not necessarily require an outflow of cash
  
  • employee benefit obligations
  • deferred taxes
  • retructuring provisions

Question 20

How do you calculate the Defensive Interval Ratio?

Answer 20

Question 21

How do you calculate the Days’ Sales Outstanding?

Answer 21

Question 22

How do you calculate the Days Inventory on Hand?

Answer 22

Question 23

How do you calculate an Adjusted Profit Margin when you have to back out the effect of a Investment in Associates?

Answer 23

Question 24

How do you calculate an Adjusted Total Asset Turnover ratio when you have to back out the effect of a Investment in Associates?

Answer 24