Reading 27: Applications of financial statement analysis Flashcards
Evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance.
Trends in a company’s financial ratios and differences between its financial ratios and those of its competitors or industry average ratios can reveal important aspects of its business strategy.
Demonstrate how to forecast a company’s future net income and cash flow.
A company’s future income and cash flows can be projected by forecasting sales growth and using estimates of profit margins and the increases in working capital and fixed assets necessary to support the forecast sales growth.
Describe the role of financial statement analysis in assesing the credit quality of potential debt investment.
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage.
Describe the use of financial statement analysis in screening for potential equity investments.
Potentially attractive equity investments can be identified by screening a universe of stocks, using minimum or maximum values of one or more ratios. Which (and how many) ratios to use, what minimum or maximum values to use, and how much importance to give each ratio all present challenges to the analyst.
Explain appropriate analyst adjustments to a company’s financial statements to faciliate comparison with another company.
When companies use different accounting methods or estimates relating to areas such as inventory accounting, depreciation, capitalization, and off-balance-sheet financing, analysts must adjust the financial statements for comparability.
LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO cost of goods sold can be adjusted to a FIFO basis by subtracting the change in the LIFO reserve.
When calculating solvency ratios, analysts should estimate the present value of operating lease obligations and add it to the firm’s liabilities.
