Assignment

on

Summary of the Course

Course Name: Financial Statement Analysis and Valuation

Course code: F-401

Submitted to:

Md. Sajib Hossain, CFA

Assistant Professor

Department of Finance

University of Dhaka

Submitted by:

Meherun Haque Erani

Section: B

ID No: 23-416

Department of Finance

University of Dhaka

Date of Submission: 7th July, 2020

Long Lived Assets:
Long-lived assets include tangible assets, intangible assets, and financial assets. When an
asset is expected to provide benefits for only the current period, its cost is expensed on the
income statement for the period. If an asset is expected to provide benefits over multiple
periods, it is capitalized rather than expensed. The cost of a purchased finite-lived intangible
asset is amortized over its useful life. Under IFRS, research costs are expensed but
development costs may be capitalized. Under U.S. GAAP, both research and development
costs are expensed as incurred, except in the case of software created for sale to others. With
capitalization, the asset value is put on the balance sheet and the cost is expensed through the
income statement over the asset’s useful life through either depreciation or amortization.
Understanding the reporting of long-lived assets at inception requires distinguishing between
expenditures that are capitalized and those that are expensed. Once a long-lived asset is
recognized, it is reported under the cost model at its historical cost less accumulated
depreciation (amortization) and less any impairment or under the revaluation model at its fair
value. IFRS permit the use of either the cost model or the revaluation model, whereas US
GAAP requires the use of the cost model. Key points include the following:
■ Expenditures related to long-lived assets are capitalized as part of the cost of assets if they
are expected to provide future benefits, typically beyond one year. Otherwise, expenditures
related to long-lived assets are expensed as incurred.

■ Although capitalizing expenditures, rather than expensing them, results in higher reported
profitability in the initial year, it results in lower profitability in subsequent years; however, if
a company continues to purchase similar or increasing amounts of assets each year, the
profitability-enhancing effect of capitalization continues.

■ Companies must capitalize interest costs associated with acquiring or constructing an asset
that requires a long period of time to prepare for its intended use.

■ IFRS require research costs be expensed but allow all development costs (not only software
development costs) to be capitalized under certain conditions. Generally, US accounting
standards require that research and development costs be expensed; however, certain costs
related to software development are required to be capitalized.

■ When one company acquires another company, the transaction is accounted for using the
acquisition method of accounting in which the company identified as the acquirer allocates
the purchase price to each asset acquired (and each liability assumed) on the basis of its fair
value. Under acquisition accounting, if the purchase price of an acquisition exceeds the sum
of the amounts that can be allocated to individual identifiable assets and liabilities, the excess
is recorded as goodwill.

■ Capitalized costs of long-lived tangible assets and of intangible assets with finite useful
lives are allocated to expense in subsequent periods over their useful lives. For tangible
assets, this process is referred to as depreciation, and for intangible assets, it is referred to as
amortization.
■ Companies are required to disclose the fair value of financial liabilities, including debt.
Although permitted to do so, few companies opt to report debt at fair values on the balance
sheet. Summary 521

■ Two types of pension plans are defined contribution plans and defined benefits plans. In a
defined contribution plan, the amount of contribution into the plan is specified (i.e., defined)
and the amount of pension that is ultimately paid by the plan (received by the retiree) depends
on the performance of the plan’s assets. In a defined benefit plan, the amount of pension that
is ultimately paid by the plan (received by the retiree) is defined, usually according to a
benefit formula.

■ Under a defined contribution pension plan, the cash payment made into the plan is
recognized as pension expense.

■ Under both IFRS and US GAAP, companies must report the difference between the
defined benefit pension obligation and the pension assets as an asset or liability on the
balance sheet. An underfunded defined benefit pension plan is shown as a non-current
liability.

■ Under IFRS, the change in the defined benefit plan net asset or liability is recognized as a
cost of the period, with two components of the change (service cost and net interest expense
or income) recognized in profit and loss and one component (measurements) of the change
recognized in other comprehensive income.

■ Under US GAAP, the change in the defined benefit plan net asset or liability is also
recognized as a cost of the period with three components of the change (current service costs,
interest expense on the beginning pension obligation, and expected return on plan assets)
recognized in profit and loss and two components (past service costs and actuarial gains and
losses) typically recognized in other comprehensive income.
Financial Reporting Quality:
Financial reporting quality varies across companies. The ability to assess the quality of a
company’s financial reporting is an important skill for analysts. Indications of low-quality
financial reporting can prompt an analyst to maintain heightened skepticism when reading a
company’s reports, to review disclosures critically when undertaking financial statement
analysis, and to incorporate appropriate adjustments in assessments of past performance and
forecasts of future performance.

■ Financial reporting quality can be thought of as spanning a continuum from the highest
(containing information that is relevant, correct, complete, and unbiased) to the lowest
(containing information that is not just biased or incomplete but possibly pure fabrication).

■ Reporting quality, the focus of this reading, pertains to the information disclosed. High-
quality reporting represents the economic reality of the company’s activities during reporting
period and the company’s financial condition at the end of the period.

■ Results quality (commonly referred to as earnings quality) pertains to the earnings and cash
generated by the company’s actual economic activities and the resulting financial condition,
relative to expectations of current and future financial performance. Quality earnings are
regarded as being sustainable, providing a sound platform for forecasts.

■ An aspect of financial reporting quality is the degree to which accounting choices are
conservative or aggressive. “Aggressive” typically refers to choices that aim to enhance the
company’s reported performance and financial position by inflating the amount of revenues,
earnings, and/or operating cash flow reported in the period; or by decreasing expenses for the
period and/or the amount of debt reported on the balance sheet.

■ Conservatism in financial reports can result from either (1) accounting standards that
specifically require a conservative treatment of a transaction or an event or (2) judgments
made by managers when applying accounting standards that result in conservative results.

■ Managers may be motivated to issue less-than-high-quality financial reports in order to

mask poor performance, to boost the stock price, to increase personal compensation, and/or to
avoid violation of debt covenants.

■ Conditions that are conducive to the issuance of low-quality financial reports include a
cultural environment that result in fewer or less transparent financial disclosures, book/tax
conformity that shifts emphasis toward legal compliance and away from fair presentation,
and limited capital markets regulation.

■ Managers’ considerable flexibility in choosing their companies’ accounting policies and in

formulating estimates provides opportunities for aggressive accounting.

■ Examples of accounting choices that affect earnings and balance sheets include inventory
cost flow assumptions, estimates of uncollectible accounts receivable, estimated realizability
of deferred tax assets, depreciation method, estimated salvage value of depreciable assets,
and estimated useful life of depreciable assets.

■ Cash from operations is a metric of interest to investors that can be enhanced by operating
choices, such as stretching accounts payable, and potentially by classification choices.

Applications of Financial Statement Analysis:

Evaluating a company’s historical performance addresses not only what happened but also
the causes behind the company’s performance and how the performance reflects the
company’s strategy. The projection of a company’s future net income and cash flow often
begins with a top-down sales forecast in which the analyst forecasts industry sales and the
company’s market share. 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. Analyst adjustments to
a company’s reported financial statements are sometimes necessary (e.g., when comparing
companies that use different accounting methods or assumptions). Adjustments can include
those related to investments; inventory; property, plant, and equipment; and goodwill. 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.
The main points in the reading are as follows:

■ Evaluating a company’s historical performance addresses not only what happened but also
the causes behind the company’s performance and how the performance reflects the
company’s strategy.

■ The projection of a company’s future net income and cash flow often begins with a top-
down sales forecast in which the analyst forecasts industry sales and the company’s market
share. By projecting profit margins or expenses and the level of investment in working and
fixed capital needed to support projected sales, the analyst can forecast net income and cash
flow.

■ Projections of future performance are needed for discounted cash flow valuation of equity
and are often needed in credit analysis to assess a borrower’s ability to repay interest and
principal of a debt obligation.

■ Credit analysis uses financial statement analysis to evaluate credit-relevant factors,

including tolerance for leverage, operational stability, and margin stability.
■ When ratios constructed from financial statement data and market data are used to screen
for potential equity investments, fundamental decisions include which metrics to use as
screens, how many metrics to include, what values of those metrics to use as cutoff points,
and what weighting to give each metric.

■ Analyst adjustments to a company’s reported financial statements are sometimes necessary

(e.g., when comparing companies that use different accounting methods or assumptions).
Adjustments can include those related to investments; inventory; property, plant, and
equipment; and goodwill.

Free Cash Flow Valuation:

Discounted cash flow models are widely used by analysts to value companies.

■ Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows
available to, respectively, all of the investors in the company and to common stockholders.

■ Analysts like to use free cash flow (either FCFF or FCFE) as the return:

● If the company is not paying dividends;

● If the company pays dividends but the dividends paid differ significantly from the
company’s capacity to pay dividends;

● If free cash flows align with profitability within a reasonable forecast period with which the
analyst is comfortable; or

● If the investor takes a control perspective.

■ The FCFF valuation approach estimates the value of the firm as the present value of future
FCFF discounted at the weighted average cost of capital

The value of equity is the value of the firm minus the value of the firm’s debt:

Equity Value = Firm value – Market value of debt

Dividing the total value of equity by the number of outstanding shares gives the value per
share.

■ FCFF and FCFE are frequently calculated by starting with net income:

FCFF = NI + NCC + Int (1 – Tax rate) – FC Inv – WC Inv

FCFE = NI + NCC – FC Inv – WC Inv + Net borrowing

■ FCFF and FCFE are related to each other as follows:

FCFE = FCFF – Int (1 – Tax rate) + Net borrowing

■ FCFF and FCFE can be calculated by starting from cash flow from operations:

FCFF = CFO + Int(1 – Tax rate) – FCInv

FCFE = CFO – FCInv + Net borrowing

■ FCFF can also be calculated from EBIT or EBITDA:

FCFF = EBIT (1 – Tax rate) + Dep – FC Inv – WC Inv

FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – FC Inv – WC Inv

FCFE can then be found by using FCFE = FCFF – Int (1 – Tax rate) + Net borrowing.

■ Finding CFO, FCFF, and FCFE may require careful interpretation of corporate financial
statements. In some cases, the needed information may not be transparent.

■ Earnings components such as net income, EBIT, EBITDA, and CFO should not be used as
cash flow measures to value a firm. These earnings components either double- count or
ignore parts of the cash flow stream.

■ FCFF or FCFE valuation expressions can be easily adapted to accommodate complicated

capital structures, such as those that include preferred stock.

■ One common two- stage model assumes a constant growth rate in each stage, and a second
common model assumes declining growth in Stage 1 followed by a long- run sustainable
growth rate in Stage 2.

■ To forecast FCFF and FCFE, analysts build a variety of models of varying complexity. A
common approach is to forecast sales, with profitability, investments, and financing derived
from changes in sales.

■ Three- stage models are often considered to be good approximations for cash flow streams
that, in reality, fluctuate from year to year.