week 1 (mod 1)

Question 1

what is financial statement analysis?

Answer 1

process of extracting info from financial statements to better understand a comp’s current and future performance and financial condition

Question 2

what objectives do financial statements serve?

Answer 2

• management; raise financing for the comp, meet disclosure agreements, benchmark for exec bonuses
• investors and analysts; decide whether to buy/sell stock
• creditors and rating agencies; decide on creditworthiness of comp’s debt and lending terms
• regulatory agencies; encourage enactment of social and econ policies, monitor compliance with laws
• legal institutions; assess fines and reparations in litigation

Question 3

what is common size, aka vertical analysis or right sizing?

Answer 3

• expresses the balance sheet in % terms
• every line item on the balance sheet (A, L & Eq) divided by total assets

Question 4

why is common size used?

Answer 4

• to compare:
  
  • a comp across 2+ years
  • 2+ comps, adjusts for size and currency differences
  • a comp to industry or other benchmark

Question 5

what is vertical analysis or right sizing?

Answer 5

• every line item on the income statement divided by total rev
• express income statement in % terms

Question 6

why is vertical analysis/right sizing used

Answer 6

• to compare
  
  • a comp across 2+ years
  • 2+ comps, adjusts for size and currency differences
  • a comp to industry or other benchmark

Question 7

what are 2 primary reports that companies must supply?

Answer 7

• form 10-k: audited annual report
  
  • 4 financial statements
  • explanatory notes
  • mgmt’s discussion and analysis (md&a)
• form 10-q: unaudited quarterly report
  
  • summary versions of the 4 financial statements
  • limited additional disclosures

Question 8

what do managers consider when deciding on the quantity and quality of accounting info to supply?

Answer 8

benefits and costs of disclosure

Question 9

what are costs of disclosure?

Answer 9

• preparation and dissemination (compliance and audit) costs
  - even if comp has already gathered info for internal use, the cost of auditing info and complying with the sec’s rules can be time consuming and costly
  
  • competitive disadvantages (monitoring costs)
    
    • disclosing product/segment successes, strategic alliances or pursuits, technological or system innovations, and product or process quality improvement can reduce/eliminate comp’s competitive advantage
  • litigation
    
    • chances increase if comps disclose info that creates expectations that are not met, cost of defending against customer/investor lawsuits is consequential
  • political costs
    
    • highly visible comps can face political and public pressure
    • ex. gov defence contractors, large software conglomerates, oil comps
  • proprietary costs
  • monitoring costs

Question 10

what are benefits to disclosure?

Answer 10

• access to capital
  
  • comps provide debt and equity financing; the better a comp’s prospects, the lower the cost of capital (lower interest rates, higher stock prices)
• good reputation
  
  • recruiting efforts in labour markets and ability to establish supplier-customer relations in input/output markets
• valuation and analysis
• risk assessment

Question 11

what is important info about a company that is communicated to various decision makers through means other than the 4 financial statements?

Answer 11

• mgmt discussion and analysis (md&a)
• independent auditor report
• financial statement footnotes
• regulatory filings, proxy statements and other sec filings
• environmental, social and governance (esg) reporting

Question 12

what is sec’s regulation fair disclosure (fd)?

Answer 12

to curb the practice of selective disclosure by public companies

Question 13

what are the different assurance of financial reports?

Answer 13

• • notice to reader (compilation)
    
    • assurance level: none
    • cost: low
    • complexity: simple
    • scope: organizing info from mgmt
    • use: internal use or small comps
  • review engagement
    
    • assurance level: limited
    • cost: moderate
    • complexity: intermediate
    • scope: inquiry and analytical procedure to provide limited assurance
    • use: small comps seeking loans/private comps with external investors
  • audit engagement
    
    • assurance level: reasonable
    • cost: high
    • complexity: complex
    • scope: inquiry and analytical procedure to provide limited assurance
    • use: public comps, large private comps issuing bonds or requiring loans

Question 14

what is the framework for analysis and valuation?

Answer 14

1. industry: porter’s 5 forces, economic cycle
2. business: business model, competitive advantage, business cycle
3. financial statement: ratio analysis, common size statement analysis
4. forecasting and valuation/credit: financial modelling, dcf/multiple, collateral

Question 15

what is an industry

Answer 15

group of comps and organizations that produce similar products/services

Question 16

how are industries classified?

Answer 16

based on the primary business activities of the comps within them

Question 17

what are commonly used industry code systems?

Answer 17

1. naics (north american industry classification system),
   - used primarily in us, canada, mexico
   - classifies businesses by type of economic activity
2. sic (standard industrial classification)
   
   • older system
   • used for historical data comparison and some specific industries
3. • gics (global industry classification standard)
   • developed by msci and s&p
   • used by global financial community, particularly for investment research and portfolio mgmt

Question 18

• what are porter’s 5 forces?

Answer 18

• barriers to entry
  
  • unique industry characteristics reduce the rate of entry of competitors, maintaining profit level of existing comps in the industry
  • may result from:
    
    • organizational econ of scale - minimum efficient scale
    • patents and proprietary knowledge
    • regulatory/government
    • asset specificity
• existing competition
  
  • number of comps
    
    • more comps means comps must compete for the same buyers and resources
    • when comps have similar market share, comps fight for market leadership
    • herfindahl-hirschman index
  • slow industry growth
    
    • causes comps to fight for increased market share
  • low switching cost
    
    • when buyers can easily switch to comp’s products
    • competition is high
  • high fixed costs and/or high storage costs
    
    • industry with it must max their capacity to attain lower per unit cost, leading to a high for market share
  • high exit barrier
    
    • comps have to stay in competition although they may be earning little/even negative returns on investment
• entry and exit| ENTRY is EASY if there are: | ENTRY is DIFFICULT if there are: |
  | — | — |
  | low scale threshold | high scale threshold |
  | access to distribution channels | restriction distribution channels |
  | common/accessible tech | patented or proprietary knowledge |
  | low switching costs | high brand switching costs || EXIT is EASY if there are: | EXIT is DIFFICULT if there are: |
  | — | — |
  | marketable assets | specialized assets |
  | low exit costs | high exit costs |
  | independent business | interrelated business |
• threat of substitute products
  
  • according to porter’s 5 forces: substitute products refer to products in other industries
  • but can be used for individual products
  • competition is high when:
    
    • buyers have no brand loyalties and/or there are no established brands
    • changing to another product saves money w/o sacrificing features/performance
    • simple/inexpensive to change to another product
    • producers of sub products have very high margins and can easily attract buyers thru price reductions
• bargaining power of buyers
  
  • buyers are powerful when:
    
    • they purchase large volumes relative to supplier sales
    • product is standard/undifferentiated
    • they can produce the product themselves
    • supplier have high fixed costs
    • product is not of strategic importance to the buyers
• bargaining power of suppliers
  
  • suppliers are powerful when:
    
    • supply market is dominated by a few comps
    • buyers are neither large/concentrated
    • they do not have to contend with sub products
    • products are differentiated or the suppliers have build up switching costs
    • they pose a credible threat of forward integration

Question 19

• what are external factors that affect industries?

Answer 19

• beyond control of comp
  
  • may cause comp’s future results to differ significantly from those expected/desired
    external factors:
    economic environment
    (ex recession, interest rate, taxes)
    international
    (ex. local economic and labour conditions, political instability, tax laws, local and national gov regulation)
    political environment
    (ex regulations, presidential election, trade agreement, any gov policies affecting supply and demand)
    social environment
    (ex. customs and conventions, cultural, fashion trend, ethic/issues)
    technology
    (ex. new process, new product)