Financial Statement Analysis - Applications, CFA Level I

Level I - Financial Reporting and Analysis Financial Statement Analysis: Applications 1 Contents and Introduction 1. 2. 3. 4. 5. 6. Introduction Application: Evaluating Past Financial Performance Application: Projecting Future Financial Performance Application: Assessing Credit Risk Application: Screening for Potential Equity Investments Analyst Adjustments to Reported Financials 2 2. Application: Evaluating Past Financial Performance • How have corporate measures of profitability, efficiency, liquidity and solvency changed over the period being analyzed? Why? • How do the level and trend in a company’s profitability, efficiency, liquidity, and solvency compare with the corresponding results of other companies in the same industry? How can the differences be explained? C en 0 ter • What aspects of performance are critical for a company to successfully competee in its industry? How did the company perform relative to those critical performance mancce aspects? ak al 11 5 strategy? • What is the company’s business strategy? Do the financials reflect the strategy? 3 Example 1 - Apple’s change in strategy is reflected in its financial performance • Between 2007 and 2010, Apple’s product mix changed substantially • Differentiated products Æ higher prices Æ higher gross margins ƒ Impact on operating profit margins is weaker • In 2009 and 2010, Apple was very liquid as indicated by the high current ratio ƒ War chest! 4 Example 2 - Effect of differences in accounting standards on ROE comparisons • Comparison of three telecom companies each using a different accounting standard ƒ U.S. GAAP, Mexican GAAP and Brazilian GAAP • Example 2 illustrates how differences in accounting standards can have a significant impact on financial ratio comparisons • Make adjustments before calculating and comparing ratios 5 3. Application: Projecting Future Financial Performance Forecast Sales Forecast expected GDP growth Forecast expected industry sales based on historical relationship with GDP Consider expected change in company’s market share Forecast expected company sales Forecast Expenses Forecast Cash Flows Use historical margins for stable firms For less stable firms estimate each expense item Remove non-recurring items Estimate interest expense and tax expense Estimate changes in working capital Estimate investment expenditures Estimate dividend payments Special charges that are reported every year should be considered when forecasting expenses 6 Curriculum Examples • Example 2: Using historical operating profit margins to forecast operating profit ƒ Appropriate for stable diversified firms like JNJ • Example 3: Issues in forecasting ƒ Recognize what items are non-recurring • Example 4: Basic example of financial forecasting ƒ Essentially a spreadsheet model • Example 5: Consistency of forecasts (MCQ) ƒ Tests your knowledge of ratios 7 4. Application: Assessing Credit Risk • Ability of issuer to meet interest and principal repayment on schedule • Cash flow forecast • Variability of cash flows • Consider business risk and financial risk 8 Assessing Credit Risk • Size and scale ƒ Total revenue ƒ Operating profit • Business profile, revenue sustainability and efficiency • Financial leverage and flexibility ƒ ƒ ƒ ƒ Leverage ratios Coverage ratios Debt / EBITDA Free cash flow / Debt • Liquidity • See Examples 6 and 7 9 5. Application: Screening for Potential Equity Investments Criterion Stocks Meeting Criterion P/E < 15 Assets / Equity < 2 Dividends > 0 Meeting all three criteria simultaneously If analyst wants to keep risk low what criteria is he likely to use? If he wants low P/E firms which are financially strong what criteria is he likely to use? 10 5. Application: Screening for Potential Equity Investments Types of Investors Growth investors: Focused on investing in high earnings growth companies Value investors: Focused on paying a relatively low share price in relation to EPS or BVPS Market investors: Intermediate category k ok Backtesting: Evaluate how a portfolio based on a particular screen would have performed historically. When back-testing: • Survivorship bias exists if delisted companies are not considered • Look-ahead bias exists if database includes financial data updated for restatements; mismatch between what investor would have actually know at the time of the investment ent decision and the information used in backtesting • Data-snooping bias might exist if excessive analysis is applied to the same data set et Example 8 11 6. Analyst Adjustments to Reported Financials When comparing ratios, adjustments might be required. Before making adjustments, consider the following: 1. Importance 2. Body of standards 3. Methods 4. Estimates 12 Analyst Adjustments for Investments, Inventory and Goodwill • Investments ƒ Company A classifies financial assets as AFS, Company B classifies as Trading • Inventory ƒ FIFO Inventory = LIFO Inventory + LIFO Reserve ƒ Example 10: Adjustments for company using LIFO ƒ Example 11: Adjustments to inventory values before comparing current ratios • Goodwill k C 20 6 ƒ Company A and Company B are identical except that A has grown through acquisition n aand nd B has grown organically. What is the impact on goodwill and on total assets? ƒ Use tangible book value when making comparisons 13 Estimates Related to Property, Plant and Equipment Calculation Number of years of useful life which have passed Accumulated Depreciation / Gross PPE Number of years of deprecation expense which have been recognized Accumulated Depreciation / Depreciation Expense How many years of useful life remain for the company’s overall asset base Net PPE (net of accumulated depreciation) / Depreciation Expense Average life of the assets at installation Gross PPE / Depreciation Expense What percentage of the asset base is being renewed through new capital investment Capex / Sum of Gross PPE plus Capex pex o Estimate 14 Summary • Evaluate a company’s past financial performance and explaining how strategy is reflected in the financials • Project net income and cash flow • Assess credit quality • Screen equity investments • Make adjustments 15 Conclusion • Read summary • Review learning objectives • Examples • Practice problems: good but not enough • Practice questions from other sources 16