LM12 Applications of Financial Statement Analysis

Level I - Financial Statement Analysis
Financial Statement Analysis: Applications
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Contents and Introduction
• 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
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1.1 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?
• What aspects of performance are critical for a company to successfully compete in

its industry? How did the company perform relative to those critical performance
aspects?
• What is the company’s business strategy? Do the financials reflect the strategy?
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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  higher prices  higher gross margins

 Impact on operating profit margins is weaker
• In 2009 and 2010, Apple was very liquid as indicated by the high
current ratio
 War chest!
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Example 2 - Effect of differences in accounting standards on ROE
comparisons
• Comparison of three telecom companies each using a different

accounting standard
 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
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2. 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 Estimate changes in working capital
For less stable firms estimate each expense item Estimate investment expenditures
Remove non-recurring items Estimate dividend payments
Estimate interest expense and tax expense
Special charges that are reported every year should be considered when forecasting expenses
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Curriculum Examples
• Example 2: Using historical operating profit margins to forecast operating profit
 Appropriate for stable diversified firms like JNJ
• Example 3: Issues in forecasting

 Recognize what items are non-recurring
• Example 4: Basic example of financial forecasting

 Essentially a spreadsheet model
• Example 5: Consistency of forecasts (MCQ)

 Tests your knowledge of ratios
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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
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Assessing Credit Risk
• Size and scale
 Total revenue
 Operating profit
• Business profile, revenue sustainability and efficiency
• Financial leverage and flexibility
 Leverage ratios
 Coverage ratios
 Debt / EBITDA
 Free cash flow / Debt
• Liquidity
• See Examples 6 and 7
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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?
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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
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
decision and the information used in backtesting
• Data-snooping bias might exist if excessive analysis is applied to the same data set
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6 - 8. 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
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Analyst Adjustments for Investments, Inventory and Goodwill
• Investments
 Company A classifies financial assets as AFS, Company B classifies as Trading
• Inventory
 FIFO Inventory = LIFO Inventory + LIFO Reserve
 Example 10: Adjustments for company using LIFO
 Example 11: Adjustments to inventory values before comparing current ratios
• Goodwill
 Company A and Company B are identical except that A has grown through acquisition and B has
grown organically. What is the impact on goodwill and on total assets?
 Use tangible book value when making comparisons
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Estimates Related to Property, Plant and Equipment
Estimate Calculation
Number of years of useful life which have passed Accumulated Depreciation / Gross PPE
Number of years of deprecation expense which Accumulated Depreciation / Depreciation Expense

have been recognized
How many years of useful life remain for the Net PPE (net of accumulated depreciation) /
company’s overall asset base Depreciation Expense
Average life of the assets at installation Gross PPE / Depreciation Expense
What percentage of the asset base is being Capex / Sum of Gross PPE plus Capex
renewed through new capital investment
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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
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Conclusion
• Read summary
• Review learning objectives
• Examples
• Practice problems: good but not enough
• Practice questions from other sources
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Level I - Financial Statement Analysis

Financial Statement Analysis: Applications

• How have corporate measures of profitability, efficiency, liquidity and solvency

• What aspects of performance are critical for a company to successfully compete in

• Between 2007 and 2010, Apple’s product mix changed substantially

• Differentiated products  higher prices  higher gross margins

• Comparison of three telecom companies each using a different

• Example 2 illustrates how differences in accounting standards can have

• Make adjustments before calculating and comparing ratios

Forecast Expenses Forecast Cash Flows

• Example 3: Issues in forecasting

• Example 4: Basic example of financial forecasting

• Example 5: Consistency of forecasts (MCQ)

• Cash flow forecast

• Variability of cash flows

• Consider business risk and financial risk

If analyst wants to keep risk low what criteria is he likely to use?

Number of years of deprecation expense which Accumulated Depreciation / Depreciation Expense

Average life of the assets at installation Gross PPE / Depreciation Expense

• Project net income and cash flow

• Assess credit quality

• Screen equity investments

• Review learning objectives

• Practice problems: good but not enough

• Practice questions from other sources

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