03 - Financial Statement Analysis

03 Financial Statement Analysis Financial Statement Analysis 2024 Level II High Yield Notes LM01 Intercorporate Investments Basic corporate investment categories The table below summarizes the accounting treatment for various investment categories under IFRS. Financial Assets Associates Business Combinations Joint Ventures Influence Not significant Significant Controlling Shared control Typical percentage interest Usually < 20% Usually 20% to 50% Usually > 50% or other indications of control Financial Reporting Classified as: ▪ Fair value through profit or loss ▪ Fair value through other comprehensive income ▪ Amortized cost Equity method Consolidation IFRS: Equity method Investments in financial assets: IFRS 9 The following flowchart will help understand the classification of financial assets under IFRS 9. © IFT. All rights reserved 1 Financial Statement Analysis 2024 Level II High Yield Notes Reclassification under IFRS 9: • The reclassification of equity instruments is not permitted because the initial classification of FVPL and FVOCI is irrevocable. • Reclassifications of debt instruments from FVPL to amortized costs (or vice versa) are permitted only when the business model changes in a way that significantly affects operations. Changes to the business models require judgment and are expected to be infrequent. Investments in associates and joint ventures An investment is considered an “associate company” when the investor has (or can exercise) significant influence, but not control, over the investee’s business activities. Significant influence is presumed with 20 – 50% ownership or voting power of the associate (investee). Significant influence may be evidenced by: • Representation on the board of directors • Participation in the policy-making process • Material transactions between the investor and the investee • Interchange of managerial personnel • Technological dependency Joint ventures are ventures undertaken and controlled by two or more parties. IFRS identifies two characteristics of joint ventures as: • A contractual arrangement exists between two or more venturers. • The contractual arrangement establishes joint control. The equity method is used to account for investments in associates and joint ventures. Equity method: a one-line consolidation method. Balance sheet: • Investment account reflected as a single line item (non-current asset) on the balance sheet. • Equity investment is initially recorded on the investor’s balance sheet at cost. It has three components: o Reported value on investee B/S o Fair value surplus o Goodwill • Subsequently, the carrying amount of the investment is adjusted to recognize the investor’s proportionate share of the investee’s earnings or losses. • Value of investment = beginning value + share of profits – share of dividends • Dividends received from the investee are treated as a return of capital and reduce the carrying amount of the investment. They are not reported on the income statement. © IFT. All rights reserved 2 Financial Statement Analysis 2024 Level II High Yield Notes • If the investment costs exceed the book value of the investee, then we amortize the excess purchase price attributable to plant and equipment. • Value of investment = beginning value + share of profits – share of dividends amortization of excess purchase price attributable to plant and equipment Income statement: • The share of income (not dividends) is recorded in the investor’s income statement Transactions with the investee: • Because an investor company can influence the terms and timings of transactions with associates, profits from such transactions cannot be realized until confirmed through use of a third-party sale. • Investor company’s share of any unrealized profit must be deferred by reducing the amount recorded under the equity method. • This deferred profit is added back to the equity income when confirmed. Business combinations Under IFRS, there is no distinction between business combinations. Under US GAAP, there are four types: merger, acquisition, consolidation, and variable interest entity. The acquisition method is used for business combinations. Acquisition method The major points related to the acquisition method are listed below: • Identifiable tangible and intangible assets (brand names, patents, etc.) and liabilities of the acquired company are measured at fair value on the date of the acquisition. • Assets and liabilities that were not previously recognized by the acquiree must be recognized by the acquirer. • The acquirer must recognize any contingent liability if it can be reliably measured and the obligation arises from past events. • The acquirer must recognize an indemnification asset on the acquisition date. • Recognition of goodwill differs between IFRS and US GAAP: o IFRS has two options for goodwill: partial goodwill and full goodwill. Partial goodwill = fair value of the acquisition - acquirer’s share of the fair value of all acquiree’s assets and liabilities Full goodwill = fair value of the entity as a whole - the fair value of all acquiree’s assets and liabilities o US GAAP allows only full goodwill. • In an acquisition, when the purchase price is less than the fair value of the target’s (acquiree’s) net assets, the acquisition is considered to be a bargain acquisition. IFRS and US GAAP require the difference between the fair value of the acquired net assets and the purchase price to be recognized immediately as a gain. © IFT. All rights reserved 3 Financial Statement Analysis 2024 Level II High Yield Notes Comparison of methods The following table compares the effect of equity method and acquisition method on financial ratios. Equity Method Acquisition Method Acquisition Method (Partial Goodwill) (Full Goodwill) Less favorable than equity method Profit Margin More favorable Leverage Most favorable Less favorable than equity method ROE Most favorable Less favorable than equity method ROA Most favorable Less favorable than equity method Current Ratio More favorable Less favorable Asset Turnover Need to calculate © IFT. All rights reserved 4 More favorable than partial goodwill method Less favorable than partial goodwill method Less favorable than partial goodwill method Financial Statement Analysis 2024 Level II High Yield Notes LM02 Employee Compensation: Post Employment and Share-Based Types of employee compensation The different types of employee compensation are: • • • • Short-term benefits: Compensation expected to be paid within 12 months. Long-term benefits: Compensation expected to be paid after 12 months. Termination benefits: Compensation paid in the event of employee termination. Share-based compensation: Compensation in the form of, or in reference to, shares of the employer’s stock • Post-employment benefits: Compensation expected to be paid after employee retirement How does share-based compensation affect financial statements The general approach to report share-based compensation is to measure the fair value of the share-based award at the grant date, recognize it as an expense over the vesting period with the offsetting entry to equity. At settlement, entries are transferred from one equity account to another. Restricted stock refers to common stock that has been granted to employees but is subject to selling and other restrictions. Restricted stock units (RSU) are a similar concept. These are instruments which represent a right to receive shares upon settlement. The grant-date fair value for restricted stock and RSU awards is the market price of the underlying shares. How to forecast share-based compensation expense and shares outstanding One approach to forecast share-based compensation is to forecast implicitly when forecasting operating expenses. This approach is suitable if share-based component of operating expenses has the same drivers as cash-based components. This is generally the case for most companies, expect for companies in the early stages of their lifecycle. For early-stage companies it is better to model share-based compensation discretely. Under this approach, share based compensation is typically forecasted as a percentage of revenues. To determine what percentage to apply, analysts can use a variety of methods such as a historical average, management guidance, or assuming that the percentage will revert to an industry average over time. To forecast shares outstanding, analysts can use the following framework: Basic shares outstanding, beginning of period © IFT. All rights reserved 1 Financial Statement Analysis 2024 Level II High Yield Notes Plus: RSUs vested and/or share options exercised Plus: share issuances from secondaries, acquisitions, etc. Less: share repurchases Basic shares outstanding, end of period. Valuation considerations: Share-based compensation should be considered when valuing a company. Since share-based compensation is non-cash, discounted cash flow models used to value companies do not account for it by default. The model needs to be modified to account for the effect of: • • dilution from outstanding but unvested share-based awards and dilution from future share-based awards How do post-employment benefits affect financial statements Defined contribution plans: The financial reporting for DC plans is relatively straight forward: • • • Income statement: Employers’ plan contributions are recognized as an expense Balance Sheet: Current liability for vested but not-yet-settled contributions Statement of Cash Flows: Plan contributions are a cash outflow in operating activities Defined benefit plans: Both IFRS and US GAAP require a DB plan’s ‘funded status’ to be reported on the balance sheet. Funded Status = Fair Value of plan assets – Pension obligation If the funded status is negative, the plan is underfunded, and the funded status is reported as a net pension liability on the balance sheet. If the funded status is positive, the plan is overfunded, and the funded status is reported as a net pension asset on the balance sheet. The periodic pension cost has to be reported on the income statement. The reporting requirement vary for IFRS and US GAAP. Exhibit 8 from the curriculum compares the two: © IFT. All rights reserved 2 Financial Statement Analysis 2024 Level II High Yield Notes Financial modeling and valuation considerations for post-employment benefits Financial modeling DC Plan • • • Income Statement: Expenses are forecasted implicitly with operating expenses Statement of Cash flows: Matched with recognized expense Balance Sheet: Accrued liabilities forecasted using working capital ratios DB Plan • • General approach is to model service cost, net interest expense/income, remeasurements, and the employer’s plan contributions in future periods These form basis for amounts recognized on the income statement, balance sheet and cash flow statement Valuation considerations: • • An underfunded plan should be treated like debt. This is because the company is obligated to make benefit payments regardless of the underfunding. An overfunded plan should be ignored in valuation. This is because plan assets are solely for paying benefits. They cannot be withdrawn and distributed to shareholders. © IFT. All rights reserved 3 Financial Statement Analysis • 2024 Level II High Yield Notes Future service costs should be deducted from free cash flow in a discounted cash flow model. © IFT. All rights reserved 4 Financial Statement Analysis 2024 Level II High Yield Notes LM03 Multinational Operations Presentation currency, functional currency and local currency Presentation (reporting) currency: The currency in which financial statement amounts are presented. It is generally the currency of the parent company’s residence. Local currency: The national currency of the country where the entity is located. Functional currency: The currency of the primary economic environment in which an entity operates. The factors that need to be considered while determining the functional currency of subsidiary are: 1. The currency that mainly influences sales prices for goods and services. 2. The currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services. 3. The currency that mainly influences labor, material, and other costs of providing goods and services. 4. The currency in which funds from financing activities are generated. 5. The currency in which receipts from operating activities are usually retained. Foreign currency transactions Transaction exposure related to imports and exports can be summarized as follows: Import purchase: Here the importer is required to pay in the foreign currency and the settlement date falls after the purchase date. The importer is exposed to FX risk as the functional currency may weaken against the foreign currency. This will increase the amount of the functional currency that the importer is required to pay. Export sales: Here the exporter agrees to be paid in foreign currency and the settlement date falls sometime after the sale date. The exporter is exposed to FX risk as the functional currency may strengthen against the foreign currency. This will decrease the amount of functional currency that the exporter will receive. Both U.S. GAAP and IFRS require the change in the value of foreign currency asset or liability resulting from foreign currency transaction to be treated as a gain or loss reported on the income statement. Translation methods Many companies have operations in foreign countries. Subsidiaries located in foreign countries usually prepare their financial statements in the local currency. IFRS and US GAAP require parent companies to prepare consolidated financial statements in which the assets, liabilities, revenues, and expenses of both domestic and foreign subsidiaries are added to those of the parent company. To prepare consolidated financial statements, © IFT. All rights reserved 1 Financial Statement Analysis 2024 Level II High Yield Notes parent companies must translate the foreign currency financial statements into the parent’s presentation currency. If the foreign subsidiary’s functional currency is different from the parent’s presentation currency, the current rate method must be used. If the foreign subsidiary’s functional currency is same as the parent’s presentation currency, the temporal method must be used. Current rate method: Under this method, the foreign entity’s foreign currency financial statements are translated into the parent’s presentation currency using the following procedures: 1. All assets and liabilities are translated at the current exchange rate at the balance sheet date. 2. Stockholders’ equity accounts are translated at historical exchange rates. 3. Revenues and expenses are translated at the exchange rate that existed when the transactions took place (For practical reasons, a rate that approximates the exchange rates at the dates of the transactions, such as an average exchange rate, may be used). 4. Net translation gain/loss is unrealized (will be realized when the entity is sold) and is not shown on the income statement. Translation adjustment is reflected in equity. Temporal method: Under this method, the foreign entity’s foreign currency financial statements are translated into the parent’s presentation currency using the following procedures: 1. Assets and Liabilities a. Monetary assets and liabilities are translated at the current exchange rate. b. Non-monetary assets and liabilities measured at historical cost are translated at historical exchange rates. c. Non-monetary assets and liabilities measured at current value are translated at the exchange rate at the date when the current value was determined. 2. Stockholders’ equity accounts are translated at historical exchange rates. 3. Revenue and Expenses a. Revenues and expenses, other than those expenses related to non-monetary assets, are translated at the exchange rate that existed when the transactions took place. b. Expenses related to non-monetary assets, such as cost of goods sold (inventory), depreciation (fixed assets), and amortization (intangible assets), are translated at the exchange rates used to translate the related assets. 4. The translation gain/loss is shown on the income statement. © IFT. All rights reserved 2 Financial Statement Analysis 2024 Level II High Yield Notes Instructor’s note: Items highlighted in bold indicate the differences between the temporal method and the current rate method Comparison of current rate and temporal methods Current Rate Method Temporal Method Monetary assets and liabilities Current rate Current rate Non-monetary assets and liabilities measured at current value Current rate Current rate Non-monetary assets and liabilities measured at historical cost Equity (other than retrained earnings) Current rate Historical rates Historical rates Historical rates Equity (retained earnings) Revenue Beginning balance plus translated net income less dividends translated at historical rate Average rate Average rate Most expenses Average rate Average rate Expenses related to assets translated at historical exchange rate Treatment of the translation adjustment in the parent’s consolidated financial statements Average rate Historical rates Accumulated as a separate component of equity Included as gain or loss in net income Effect of currency exchange rate movement on financial statements If value of assets to be translated is greater than value of liabilities to be translated, then we have a net asset exposure. With the current rate there will almost always be a net asset exposure. The following table summarizes the effect of currency exchange rate movements on financial statements: Foreign currency strengthens relative to parent’s presentation currency © IFT. All rights reserved Temporal Method, Net Monetary Liability Exposure ↑Revenues ↑Assets ↑Liabilities ↓Net income ↓Shareholder’s equity Translation loss Temporal Method Net Monetary Asset Exposure ↑Revenues ↑Assets ↑Liabilities ↑Net income ↑Shareholder’s equity Translation gain 3 Current Rate Method ↑Revenues ↑Assets ↑Liabilities ↑Net income ↑Shareholder’s equity Financial Statement Analysis Foreign currency weakens relative to parent’s presentation currency ↓Revenues ↓Assets ↓Liabilities ↑Net income ↑Shareholder’s equity Translation gain 2024 Level II High Yield Notes ↓Revenues ↓Assets ↓Liabilities ↓Net income ↓Shareholder’s equity Translation loss Positive translation adjustment ↓Revenues ↓Assets ↓Liabilities ↓Net income ↓Shareholder’s equity Negative translation adjustment Translation in a hyperinflationary economy IFRS and US GAAP differ substantially in their approach to translating the foreign currency financial statements of a subsidiary in a hyperinflationary economy. US GAAP requires that the financial statements be translated using the temporal method. IFRS require financial statements to be first restated for inflation and then inflation adjusted financial statements be translated at the current exchange rate. The following procedures should be followed while adjusting the financial statements for inflation: • Monetary assets and liabilities are not restated. • Nonmonetary assets and liabilities are adjusted for inflation. o Restated costs are determined by applying the change in general price index to the historical costs. o If items are carried at revalued amounts (e.g. PP&E), these are restated from the date of revaluation. • All components of stockholders’ equity are restated by applying the change in general price index from the beginning of the period or from the date of contribution to the balance sheet. • All income statement items are restated by applying the change in the general price index from the dates when the items were originally recorded. • Purchasing power gains/losses that arises from holding monetary assets and monetary liabilities are included in net income. (Net monetary assets result in a purchasing power loss; net monetary liabilities result in a purchasing power gain.) Multinational operations and effective tax rate Generally, multinational companies have to pay income taxes in the country in which the profit is earned. Transfer prices (prices charged on intercompany transactions) affect the allocation of profits between companies. © IFT. All rights reserved 4 Financial Statement Analysis 2024 Level II High Yield Notes An entity with operations in multiple countries with different tax rates could aim to set transfer prices such that a higher portion of its profit is allocated to lower tax rate jurisdictions. To prevent this, countries have established various laws and practices to prevent aggressive transfer pricing practices. Whether and when a company also pays income taxes in its home country depends on the specific tax regime. An analyst can obtain information about the tax impact of multinational operations from companies’ disclosure on effective tax rates. Sustainability of earnings For a multinational company, sales growth is driven not only by changes in volume and price, but also by changes in the exchange rates. Growth in sales that comes from changes in volume or price is more sustainable than growth in sales that comes from changes in exchange rates. © IFT. All rights reserved 5 Financial Statement Analysis 2024 Level II High Yield Notes LM04 Analysis of Financial Institutions What makes financial institutions different from other companies? The different types of financial institutions are: • Banking industry – commercial banks, credit unions, etc. • Insurance industry – property & casualty, life & health, reinsurance • Investment management industry – mutual funds, exchange traded funds, hedge funds, brokers & dealers. Financial institutions have a high level of systemic risk. Their smooth functioning is crucial to the overall economy. Due to the high level of systemic risk, the level of regulation in the financial sector tends to be high. The liabilities of financial institutions especially banks are made up primarily of deposits and assets are predominantly financial assets. These assets are exposed to credit, market, and liquidity risks. Systematic risk: risk of disruption to financial services that is 1) caused by an impairment of all or parts of the financial system and 2) has the potential to have serious negative consequences for the economy as a whole. Financial contagion: situation in which financial shocks spread from their place or sector of origin to other locales or sectors. Financial regulations of financial institutions The objectives of global and regional regulatory bodies are: • Minimize systematic risk • Harmonize and globalize regulatory rules, standards, and oversight • Ensure consistency of standards and regulations • Minimize regulatory arbitrage Some important financial regulators are: The Financial Stability Board, The International Association of Deposit Insurers, The International Association of Insurance Supervisors, The International Organization of Securities Commissions, Basel Committee on Banking Supervision. One of the most important organization focused on financial stability is the ‘Basel Committee on Banking Supervision’. Its members include central banks from all over the world, as well as several regulators. The key output of this committee is the international regulatory framework for banks called – ‘Basel III’. The objectives of this framework are to: • Improve the banking sector’s ability to absorb shocks arising from financial and © IFT. All rights reserved 1 Financial Statement Analysis • • 2024 Level II High Yield Notes economic stress. Improve risk management and governance of banks. Strengthen banks’ transparency and disclosures. The three major highlights of the Basel III framework are: • Minimum capital requirement: A bank must have sufficient equity capital to absorb the loss in value of assets in a financial crisis. • Minimum liquidity: A bank must hold enough high-quality liquid assets to cover its liquidity needs in a 30-day liquidity stress scenario. • Stable funding: A bank should have an adequate amount of stable funding relative to the bank’s liquidity needs over a one- year horizon. The CAMELS approach to analyzing a bank The ‘CAMELS’ approach has six components which addresses the following questions: 1. Capital adequacy – Does the bank have sufficient capital given its assets? 2. Asset quality – What is the quality of the bank’s financial assets? 3. Management capabilities – Is the management effective? What is its track record? 4. Earnings – What is the level of earnings? What is the quality of earnings? Are earnings trending up or down? 5. Liquidity: How strong is the liquidity position of the bank? What are the sources of funding? Are the sources of funding stable? 6. Sensitivity to market risk: How sensitive are the bank’s earnings to market risk? For each component a rating is assigned on a scale of 1 to 5 (where 1 is the best rating and 5 is the worst). After the components are rated, weights are assigned, and a weighted average is taken to calculate the overall CAMELS score. Capital adequacy Capital adequacy is based on the portion of assets funded by capital. It indicates whether a bank has enough capital to absorb losses without severely damaging its financial position. Basel III’s minimum capital requirements are: • Common Equity Tier 1 Capital must be at least 4.5% of risk weighted assets • Total Tier 1 Capital must be at least 6.0% of risk-weighted assets • Total Capital must be at least 8.0% of risk-weighted assets Common Equity Tier 1 Capital: This is the safest type of capital. It includes common stock, issuance surplus related to common stock, retained earnings, OCI, and certain adjustments. Other Tier 1 Capital: This includes instruments issued by bank which meet criteria such as: • Subordinate to deposits and other debt obligations. • No fixed maturity. • Interest or dividend payments, if any, should be at bank’s discretion. © IFT. All rights reserved 2 Financial Statement Analysis • 2024 Level II High Yield Notes Collectively, the above two types are called ‘Total Tier 1 Capital.’ Tier 2 Capital: This is capital which meets criteria such as: • Subordinate to deposits and to general creditors of bank. • Minimum maturity of 5 years. • Collectively, the three types are called ‘Total Tier 1 and Tier 2 Capital’ Risk weighted assets: Assets are weighted based on risk. For example, cash has a weight of 0%, corporate loans may be given a weight of 100% and non-performing loans may be given a weight of 150%. Asset quality Asset quality is based on credit quality and diversification. The credit policies and overall risk management processes of a bank impact its asset quality. The three major asset categories for a bank are: 1. Loans – Generally the The quality of loans depends on: largest component of • Creditworthiness of borrowers – High overall assets creditworthiness implies high asset quality. • Adequacy of adjustments for expected loan losses – If the adjustments are not sufficient, then it implies low asset quality. 2. Investments in securities They are measured differently depending on issued by other entities – for categorization. The investments can be measured at: example, a bond issued by • Amortized cost another company. • Fair value, where unrealized gains/losses are recorded in OCI (FVOCI) • Fair value, where unrealized gains/losses flow through the income statement (FVTPL) 3. Highly liquid financial They are considered the best quality assets. instruments – for example, T-Bills Asset quality can be evaluated based on: • Composition of assets • Credit quality Some ratios used in the analysis are: • /total assets • Allowance for loan losses / non-performing loans • Provision for loan losses / net loan charge-offs © IFT. All rights reserved 3 Financial Statement Analysis 2024 Level II High Yield Notes Management capabilities Management capability refers to bank management’s ability to identify and exploit profit opportunities while managing risk. Other factors related to management capabilities are: governance structure, compliance with laws and regulations, internal controls, transparency of management communications, and financial reporting quality. Earnings Earnings refers to a bank’s return on invested capital relative to cost of capital. The major earnings components for banks are: • Net interest income (the difference between the interest earned on loans and the interest paid to its depositors) • Service income • Trading income Of these sources, net interest income and service income are more stable, whereas trading income is the most volatile. While evaluating earnings we should consider: • Composition of earnings • Earnings quality • Earnings trend • Loan impairment allowances • Fair value estimates Liquidity A bank’s failure to honor a current liability could have a systemic impact. Therefore, it is extremely important for banks to maintain a strong liquidity position. There are two major considerations when evaluating liquidity: 1. Liquid assets relative to near-term expected cash flows. This is measured by the LCR ratio. Liquidity coverage ratio (LCR) = highly liquid assets / expected cash outflows 2. Stability of the banks funding sources. This is measured by the NSFR ratio. Net stable funding ratio (NSFR) = available stable funding / required stable funding Basel III sets a target minimum of 100% for both ratios. Some other factors to consider when evaluating liquidity position are: • Concentration of funding • Contractual maturity mismatch © IFT. All rights reserved 4 Financial Statement Analysis 2024 Level II High Yield Notes Sensitivity to market risk Sensitivity to market risk deals with how adverse market movements impact a bank’s earnings and financial position; measured using trading portfolio VaR and credit portfolio VaR. Market risk is the exposure to changes in interest rates, exchange rates, equity prices, or commodity prices. All entities have exposure to market risk. However, for banks the exposure to changes in market prices arise because of mismatches in the maturity of banks’ deposits and loans. Mismatches could be with respect to: • Maturity • Repricing frequency • Reference rates • Currency Other factors relevant to analysis of a bank Banking-specific analytical considerations not addressed by CAMELS include: • Government support • Government ownership • Mission of banking entity • Corporate culture Analytical considerations not addressed by CAMELS that are also relevant for any company: • Competitive environment • Off-balance-sheet items • Segment information • Currency exposure Analyzing a property & casualty insurance company Operations: Products and Distribution Property insurance protects against loss or damage to property. Casualty insurance also called liability insurance protects against legal liability related to a third party. The premiums are collected at the start of the insurance contract. These premiums are then invested during the float period. The float period represents the time difference between receiving premiums and making insurance payouts. In order to minimize payouts, insurance companies follow a prudent underwriting process. They charge a sufficient price for the risks borne by them. They also try to diversify their risks by not concentrating on one kind of policy, market, or customer type. © IFT. All rights reserved 5 Financial Statement Analysis 2024 Level II High Yield Notes Property and insurance policies are typically annual and the final cost to the company is usually known within a year of the covered event. The policies are then renewed at the end of the year. The claims received by the P&C companies are unpredictable and lumpier. Earnings characteristics Macro view: The insurance industry is highly competitive, price-sensitive and cyclical. Micro view: The underwriting cycle is driven by expenses. When expenses are high relative to premiums, firms exit the market. On the other hand, when expenses are low relative to premiums, firms enter the market. The relevant ratio that compares the overall expenses of the insurance industry with premiums is: Combined ratio= (total insurance expenses)/(net premiums) When this ratio is low, i.e. less than 100%, new entrants join the market. Investment returns Property and casualty insurance companies should invest in steady-return, low risk, and highly liquid assets. When evaluating investments, the concentration of assets needs to be considered. Most of the investments will be in fixed income instruments, therefore concentration by type, maturity, credit quality, industry, or geographic location, etc. should be evaluated. The investment performance can be measured as: total investment income Investment income = invested assets Liquidity Given the nature of the property and casualty insurance business, high liquidity is essential. Firms should be able to satisfy the claims as they arise. To evaluate the liquidity of a company we can look at the hierarchy of fair value reporting. The hierarchy is based on three levels: • Level 1: The prices for these securities are readily available. They are traded in very liquid markets. • Level 2: These securities are traded in less liquid conditions. Their prices are inferred from similar securities in liquid markets. • Level 3: No pricing is explicitly available. The reported prices are based on models and assumptions. This level represents the least liquid investments. Capitalization This refers to the amount of equity capital in a company. There are no global minimum © IFT. All rights reserved 6 Financial Statement Analysis 2024 Level II High Yield Notes capital requirements. However, some local jurisdictions impose minimum requirements based on the risk taken. Key ratios used to analyze an insurance company are: Ratio Formula Loss expense + loss adjustment expense Loss and loss Net premiums earned adjustment expense ratio Underwriting expense Underwriting expense Net premiums written ratio Combined ratio Loss and loss adjustment expense ratio + Underwriting expense ratio Dividends to policyholders (shareholders) ratio Combined ratio after dividends Diviends to policyholders (shareholders) Net premiums earned Combined ratio + Dividends to policyholders (shareholders) ratio What is Measured Success in estimating risks insured Efficiency of money spent in obtaining new premiums Overall efficiency of an underwriting operation Liquidity Efficiency of money spent in obtaining new premiums Analyzing a life and health insurance company Operations: Products and Distribution There are three major sources of revenue for life and health insurance companies. • Premiums • Investment products and services • Investment returns L&H polices are longer term compared to P&C policies. Also, L&H claims are more predictable compared to P&C claims. For these reasons, L&H companies can take more risk and therefore earn a higher return on their investments. Earnings characteristics The major expense components for L&H companies are: • Benefit payments • Annuity contract payments • Contract surrender expenses: Some insurance policies accumulate cash value and policy holders have a right to cancel these policies before maturity. If cancelled, the insurance company has to make a payment equal to the cash value. © IFT. All rights reserved 7 Financial Statement Analysis 2024 Level II High Yield Notes When evaluating L&H companies, we should recognize that several expense items require significant judgment and estimates. Also, the earnings can be distorted because the accounting treatment across different items may vary. We can use several ratios to evaluate the profitability for L&H companies: • ROA, ROE, growth and volatility of capital, book value per share. • Pre-tax and post-tax operating margins. • Total benefits paid as a percentage of net premiums written and deposits. A lower ratio is considered better. • Commissions and expenses incurred as a percentage of net premiums written and deposits. A lower ratio is considered better, it implies efficiency in selling insurance contracts. Investment returns, liquidity and capitalization Investment returns: L&H companies can take on more risk relative to P&C companies. Therefore, they can generate a higher return on their investments. Evaluation of investment returns should address: • Diversification • Investment performance • Interest rate risk Liquidity: Liquidity requirement is driven by liabilities. If the liabilities are short term, then the liquidity requirement is high. On the other hand, if liabilities are long term, then the liquidity requirement is low. Sources of liquidity include operating cash flows and sale of investment assets. Liquidity is measured by comparing the amount of liquid assets relative to short term liabilities. The insurance company should have sufficient liquid assets to cover the shortterm liabilities. Capital: There are no global requirements for capital like the Basel III. Instead, various jurisdictions have their own capital adequacy standards based on risk profile. L&H companies need less of an equity cushion compared to P&C companies because the payouts are more predictable and less volatile. Interest rate risk is a major factor in estimation of risk-based capital due to maturity mismatch between assets and liabilities. © IFT. All rights reserved 8 Financial Statement Analysis 2024 Level II High Yield Notes LM05 Evaluating Quality of Financial Reports Quality of financial reports Financial reporting quality Low Low quality reports contain information that is pure fabrication. High High-quality reports contain information that is relevant, complete, neutral, and free from error. High financial reporting quality enables assessment. Low financial reporting quality impedes assessment of earnings quality and impedes valuation. Earnings (results) quality Low Low earnings quality is unsustainable. High High earnings quality increases company value. High earnings quality is sustainable. Quality spectrum of financial reports From an investor’s perspective, the overall quality of financial reports, is the combination of reporting quality and earnings quality, and it can be thought of as a continuous spectrum ranging from highest to lowest as depicted in the diagram below: © IFT. All rights reserved 1 Financial Statement Analysis 2024 Level II High Yield Notes Potential problems that affect the quality of financial reports Income statement: Overstatement or non-sustainability of operating income and/or net income. • Overstated or accelerated revenue recognition • Understated expenses • Misclassification of revenue, gains, expenses, or losses Balance sheet: Misstatement of balance sheet items • Over- or understatement of assets • Over- or understatement of liabilities • Misclassification of assets and/or liabilities Cash flow statement: Overstatement of cash flow from operations. Mergers and acquisitions provide opportunities and motivations to manage financial results. For example, companies with declining cash flow from operations (CFO) may acquire companies to increase CFO. This is because the acquisition may appear in CFI if paid with cash or not appear at all if paid for with equity. General steps to evaluate the quality of financial reports These two questions help an analyst in evaluating the quality of financial reports: • Are the financial reports GAAP-compliant and decision-useful? • Are the earnings of high quality? Do they provide an adequate level of return, and are they sustainable? Following are the general steps to evaluate the quality of financial reports: 1. Develop an understanding of the company’s business and its industry. Understand what accounting principles a company and its competitors follow. 2. Learn about the management. Review disclosures about compensation and insider transactions. 3. Identify significant accounting areas, especially those in which management judgment or an unusual accounting rule is a significant determinant of reported financial performance. 4. Make comparisons. • Compare the company’s financial statements and significant disclosures in the current year’s report with the financial statements and significant disclosures in the prior year’s report. • Compare the company’s accounting policies with those of its closest competitors to see if there are any unusual revenue and expense recognition. • Using ratio analysis, compare the company’s performance with that of its closest competitors. © IFT. All rights reserved 2 Financial Statement Analysis 2024 Level II High Yield Notes 5. Check for warning signs of possible issues with the quality of the financial reports. Examine the statement of cash flows with particular focus on differences between net income and operating cash flows. 6. For firms operating in multiple segments by geography or product—particularly multinational firms—consider whether inventory, sales, and expenses have been shifted. 7. Use appropriate quantitative tools to assess the likelihood of misreporting. Quantitative tools to assess the likelihood of misreporting Beneish Model The probability of manipulation is given by the M-score, which is estimated using a probit model. The formula for calculating the M-score is given below: M-score = –4.84 + 0.920 (DSR) + 0.528 (GMI) + 0.404 (AQI) + 0.892 (SGI) + 0.115 (DEPI) – 0.172 (SGAI) + 4.679 (Accruals) – 0.327 (LEVI) where: • M-score = Score indicating probability of earnings manipulation; normally distributed random variable with a mean of 0 and a standard deviation of 1. • DSR (days sales receivable index) = (Receivablest/Salest)/(Receivablest–1/Salest–1). • GMI (gross margin index) = Gross margint–1/Gross margint. • AQI (asset quality index) = [1 – (PPEt + CAt)/TAt]/[1 – (PPEt–1 + CAt–1)/TAt–1], where PPE is property, plant, and equipment; CA is current assets; and TA is total assets. • SGI (sales growth index) = Salest/Salest–1. • DEPI (depreciation index) = Depreciation ratet–1/Depreciation ratet, where Depreciation rate = Depreciation/(Depreciation + PPE). • SGAI (sales, general, and administrative expenses index) = (SGAt /Salest)/(SGAt– 1/Salest–1). • Accruals = (Income before extraordinary items – Cash from operations)/Total assets. • LEVI (leverage index) = Leveraget/Leveraget–1 How to interpret the M-score: • The probability of earnings manipulation is calculated by using the cumulative probabilities for a standard normal distribution. • The probability is given by the amount on the left side of the distribution. • Higher M-scores (less negative numbers) indicate an increased probability of earnings manipulation. © IFT. All rights reserved 3 Financial Statement Analysis 2024 Level II High Yield Notes Indicators of earnings quality High earnings quality are the earnings that are sustainable and represent the returns equal to or in excess of the company’s cost of capital. Low-quality earnings are insufficient to cover the company’s cost of capital and/or are derived from non-recurring, one-off activities. Indicators of earnings quality include: 1. Recurring earnings 2. Earnings persistence and related measures of accruals 3. Mean reversion in earnings 4. Beating benchmarks 5. External indicators of poor-quality earnings Evaluating the earnings quality of a company The objective of analyzing earnings is to understand the persistence and sustainability of earnings. Analysts must be aware of the following accounting choices used by managers to enhance their companies’ reported performance: Revenue Recognition: • Understand the revenue recognition policies as stated in the most recent annual report. • Study the days’ sales outstanding (DSO) trend. If it is increasing, it means receivables were not paid on time. • Consider cash versus accrual revenue. • Compare the DSO and receivables turnover with those of other companies from the industry. • Perform trend analysis, over time and in comparison with competitors, to assess revenue quality. • Look for transactions with related parties. Property and Capital Expenditure Analysis: • Understand the cost capitalization policies as stated in the most recent annual report. This may be used to avoid expense recognition. • Perform trend analysis to examine the following: o Non-current asset accounts: may indicate an unusual increase in costs. o Gross and operating profit margins o Turnover ratio for total assets o Depreciation compared to asset base o Capital expenditure relative to gross PPE © IFT. All rights reserved 4 Financial Statement Analysis • 2024 Level II High Yield Notes Look for company transactions with entities owned by senior officers or shareholders. Bankruptcy prediction models are used to quantify the likelihood that a company will default on its debt and/or declare bankruptcy. One such model to assess the probability of bankruptcy is the Altman model. Altman’s Z-score is calculated as follows: Z-score = 1.2 (Net working capital/Total assets) + 1.4 (Retained earnings/Total assets) + 3.3 (EBIT/Total assets) + 0.6 (Market value of equity/Book value of liabilities) + 1.0 (Sales/Total assets) The higher the Z-score, the lower the probability of bankruptcy of a company. Evaluating cash flow quality High quality operating cash flow means the company’s performance was good and the company had high reporting quality. High-quality cash flow for a mature company would typically mean that OCF: 1. is positive and derived from sustainable sources 2. is adequate to cover capital expenditures, dividends, and debt repayments, and 3. has low volatility. Some OCF manipulating techniques used by companies are: • Selling receivables to a third party • Delaying payable to boost OCF • Inappropriate classification of cash flows to overstate OCF • Exploiting flexibility in accounting standards Balance sheet quality The characteristics of high financial reporting quality with regard to the balance sheet are: • Completeness • Unbiased measurement • Clear presentation The characteristics of high financial results quality with regard to a strong balance sheet are: • Optimal amount of leverage • Adequate liquidity • Economically successful asset allocation Sources of information about risk Some useful indicators of a company’s risk are: © IFT. All rights reserved 5 Financial Statement Analysis • • • • • 2024 Level II High Yield Notes A company’s financial statements can provide useful indicators of financial, operating, or other risk. For example, high leverage ratios signal financial risk. An audit opinion(s) covering financial statements provide information about reporting risk. The notes and disclosures provide information about financial, operating, reporting, or other risks. Required disclosures that are specific to an event, such as capital raising, non-timely filing of financial reports, management changes, or mergers and acquisitions. Financial press, including online media, can be a useful source of information about risk. © IFT. All rights reserved 6 Financial Statement Analysis 2024 Level II High Yield Notes LM06 Integration of Financial Statement Analysis Techniques Financial analysis framework The financial statement analysis framework recommended by the CFA Institute consists of the following steps: 1. Define the purpose and context of the analysis. 2. Collect input data. 3. Process input data, as required, into analytically useful data. 4. Analyze/interpret the data. 5. Develop and communicate conclusions and recommendations. 6. Follow up. Integration of financial statement analysis techniques DuPont analysis • DuPont analysis decomposes ROE into its components: 1. ROE = Return on assets × Leverage 2. ROE = Net profit margin × Asset turnover × Leverage 3. ROE = EBIT margin × Tax burden × Interest burden × Asset turnover × Leverage • Evaluating the different components of ROE allows the analyst to identify a company’s potential strengths and weakness. • DuPont analysis should be performed with and without the impact of ‘income from associates’. This is because the operations and resources of associate companies are not in the parent company’s control. Asset base composition Common size balance sheets are used to examine the change in asset base composition over time. Capital structure analysis • An analyst can use leverage ratios and liquidity ratios to evaluate changes in the capital structure of a company. • However, simply looking at high-level leverage numbers is not enough. An analyst should dive deeper to evaluate whether the capital structure is becoming riskier. Segment analysis and capital allocation • For large companies with multiple business segments it is important to perform a segment analysis and understand how the company allocates funds to different segments. • The segment EBIT margin should be compared with the ratio of total capital expenditure % to total assets. • Ideally, segments with high margins should receive a relatively high capital allocation. © IFT. All rights reserved 1 Financial Statement Analysis • 2024 Level II High Yield Notes However, high EBIT margins does not necessarily mean that a segment is doing well from a cash-flow perspective. Beyond the EBIT margin, we should also estimate the cash return on assets across different segments. Accruals and earnings quality • Earnings can be separated into cash flow and accruals. The accrual ratio can be estimated using a balance sheet approach or a cash flow approach. Balance sheet accruals ratio for time t = (NOAt - NOAt -1) / [(NOAt + NOAt-1)/2] Cash flow accruals ratio for time t = [NIt - (CFOt + CFIt)] / [(NOAt + NOAt-1)/2] • In both cases, if the accrual ratio is close to zero, this means that accruals play little or no role in the financial performance of a company and the earnings are of high quality. Cash flow relationships • Cash flow from operations should be compared with operating profit to determine if the earnings are of high quality. • Other cash flow ratios such as the cash flow interest coverage ratio can also be used in the analysis. Decomposition and analysis of the company’s valuation When a company has significant investments in associates, the price-to-earnings multiple of the “pure company” should be calculated by removing the impact of associates and using adjusted market value and net income. © IFT. All rights reserved 2 Financial Statement Analysis 2024 Level II High Yield Notes LM07 Financial Statement Modeling Top-down and bottom-up approaches Top-down approach begins at the economy level, then the industry and finally to the company level. There are two top-down approaches: Growth relative to GDP growth: In this approach, we: • Forecast nominal GDP growth rate (can forecast real GDP growth and inflation separately). • Forecast revenue growth relative to GDP depending on the company’s position in the lifecycle and/or business cycle sensitivity. The forecasted revenue is expressed in two ways: o As percentage point discounts or premiums. For instance, Pfizer’s revenue is projected to grow at 100 bps above nominal GDP growth rate. o In relative terms: GDP is forecasted to grow at 4% and Oracle’s revenue is forecasted to grow at a 25% faster rate. Market growth and market share: In this approach, we: • Forecast growth rate of relevant market • Forecast change of company’s market share in the market. For example, assume Tesla is expected to maintain a market share of 1% in the automobile market. If the automobile market is expected to grow to $30 billion in annual revenue, then Tesla’s annual revenue is forecasted to grow to 1% * $30 billion = $300 million. Bottom-up approaches begin at the level of the individual company or unit within the company. Examples of bottom-up approaches include: • Time-series: Forecasts based on historical growth rates or time-series analysis. • Return on capital: Forecasts based on balance sheet accounts and rates or ratios. • Capacity-based measure: Forecasts (for example, in retailing) based on same-store sales growth and sales related to new stores. A hybrid approach combines top-down and bottom-up approaches. Income statement modeling: Operating costs Similar to revenue forecasting, costs may be forecasted using a top-down, bottom-up, or hybrid approach • Top-down approach: Consider factors such as overall level of inflation, or industryspecific costs. • Bottom-up approach: Consider factors such as segment-level margins, historical cost-growth rates, historical margin levels, etc. • Hybrid view: Incorporate elements from both top-down and bottom-up approaches. © IFT. All rights reserved 1 Financial Statement Analysis 2024 Level II High Yield Notes A positive correlation between operating margins and sales suggests economies of scale. Forecasting income statement elements • Forecast COGS by segment, product category, or by volume and price, to improve forecasting accuracy. COGS is forecasted as a percentage of sales using historical relationships. • In SG&A, selling and distribution costs such as wages are variable and can be estimated as a percentage of sales. General and administrative expenses are more or less fixed and increase or decrease gradually. • Two non-operating expenses are financing expenses and taxes. o To forecast debt financing expenses, forecast the level of debt and the corresponding interest rates. o There are three types of taxes: statutory tax rate, effective tax rate, and cash tax rate. Use effective tax rate to forecast net income and the cash tax rate to forecast cash flows. To forecast future tax expense, often the tax rate based on normalized operating income, adjusted for special items, is used. Balance sheet and cash flow statement modeling The table below summarizes the approach for forecasting balance sheet items. Item Forecasting method Comment Accounts receivable Use sales and DSO Top-down: project economy to slow sales down, lower inventory turnover. Bottom-up: use company’s historical ratios Inventory Use COGS and inventory Estimate maintenance and turnover growth capital expenditures. PP&E and depreciation Consider the future need for PP&E and depreciation disclosures. Debt (capital structure) Use debt/equity, debt/capital, debt/EBITDA Retained earnings Net income and dividend policy Cash flow statement can be derived based on the income statement and balance sheet. Biases that influence analyst forecasts Five key biases that influence analyst forecasts are: © IFT. All rights reserved 2 Financial Statement Analysis • • • • • 2024 Level II High Yield Notes Overconfidence bias Illusion of control bias Conservatism bias Representative bias Confirmation bias Impact of competitive factors in prices and costs Competitive factors affect a company’s ability to negotiate lower input prices with suppliers and to raise prices for products and services. Porter’s five forces framework can be used as a basis for identifying such factors. The table below summarizes this framework. Force Threat of substitutes Internal rivalry Supplier power Customer power Threat of new entrants Comment Fewer substitutes or higher switching costs increase industry profitability. Lower rivalry increases industry profitability. Presence of many suppliers limits their pricing power, which in turn does not put a downward pressure on the industry’s profitability. Presence of many buyers limits their negotiating power, which in turn does not put a downward pressure on the industry’s profitability. High barriers to entry increase industry profitability. Sales and cost projections with inflation and deflation Sales projections • Higher input costs such as commodity or labor usually result in higher prices. This relationship between price and cost, i.e. how long it takes for the price to increase, if it’s gradual or immediate, depends on the industry structure. • If demand is relatively price inelastic, revenue will benefit from inflation. If demand is price elastic, revenues will decrease even if unit prices are increased because volumes decline. • High inflation in export market might increase sales in foreign currency terms, but that gain might be lost if foreign currency depreciates. Cost projections The following factors help in forecasting costs: • Understanding the purchasing characteristics of an industry. For example, if companies use long-term price-fixed forward contracts and hedging instruments, then price increases can be gradual instead of a sudden hike. • Monitoring the underlying drivers of input prices such as weather conditions. © IFT. All rights reserved 3 Financial Statement Analysis • • • 2024 Level II High Yield Notes The impact of inflation or deflation on industry’s cost structure depends on the competitive structure. Break down the cost structure by category and geography. For each cost element, assess the impact of inflation and deflation on input prices; consider the company’s ability to use cheaper alternatives for expensive inputs when input prices rise. Effect of technological developments on demand, selling prices, costs and margins Technological developments can change the economics of industries and individual companies. When a technological development results in a new product that threatens to cannibalize demand for an existing product, a unit forecast for the new product combined with an expected cannibalization factor can be used to estimate the impact on future demand for the existing product. The table below highlights the impact of technological developments on demand, selling prices, costs and margins. Impact on Factors to consider Demand Market segments; cannibalization factor per segment. These help in determining the post cannibalization volume. Selling prices Company strategy; response to threat of substitutes Operating costs Understand breakdown between fixed and variable costs. If sales and margins decrease because of cannibalization, then variable costs also decrease. Method 1: evaluate sensitivity of costs to changes in revenue % Variable Cost ≈ % Δ (cost of revenue + operating expense) % Δrevenue % Fixed Cost = 1 − % Variable cost Method 2: assign an estimate of the percentage of fixed and variable costs to the various components of operating expenses Long-term forecasting Forecast time horizon is influenced by factors such as: • Investment strategy for which the stock is being considered • Cyclicality of the industry • Company specific factors • Analyst’s employer preferences Longer-term projections often provide a better representation of the normalized earnings potential of a company than a short-term forecast, especially when certain temporary factors are present. Normalized earnings are the expected level of mid-cycle earnings for a © IFT. All rights reserved 4 Financial Statement Analysis 2024 Level II High Yield Notes company in the absence of any unusual or temporary factors that impact profitability (either positively or negatively). “Growth relative to GDP growth” and “market growth and market share” methods can be applied to develop longer term projections. Using revenue and cost forecasts, the income statement, balance sheet and cash flow statement can be projected for the time horizon to arrive a terminal value. The historical multiple-based approach is often used. © IFT. All rights reserved 5