Reading 34 LOS's

Question 1

LOS 34a: Evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance

Answer 1

Analysis should focus on :

• Important changes that have occurred in corporate measures of profitability, efficiency, liquidity, and solvency and the reasons behind these changes
• Comparisons of the company’s financial ratios with others from the same industry and the reasons behind any differences
• Examination of performance aspects that are critical for a company to successfully compete in the industry and an evaluation of the company’s performance on these fronts relative to its competitors
  
  • The company’s business model and strategy and how they influence its operating performance

Question 2

LOS 34b: Forecast a company’s future net income and cash flow

Answer 2

The top-down approach that is typically used to forecast sales invloves the following steps:

• Attain forecasts for the economy’s expected GDP growth rate
• Use regression models to determine the historical relationship between the economy’s growth rate and the industry’s growth rate
• Undertake market share analysis to evaluate whether the firm being analyzed is expected to gain, lose, or retain market share over the forecasting horizon

Once a forecaste for sales has been established, income and cash flow can be estiamte by using the following methods:

Estimate gross or operating profit margins over the forecasting horizon and apply them to revenue forecasts. Net profit margins are affected by leverage ratios and tax rates, so historical data provides a more reliable measure for gross profit margins

Make separate forecasts for individual expense items, aggregate them, and subtract the total from sales to calculate net income. This is a very subjective exercise, as each expense item must be projected based on some relationship with sales or another relevant variable

To forecaset cash flows,analysts must make assumptions about future sources and uses of cash. The most important things that an analyst must consider when forecasting cash flows are:

• Required increase in working capital
• Capital expenditures on new fixed assets
• Repayment and issuance of debt
• Repurchase and issuance of stock

Question 3

LOS 34c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment

Answer 3

Credit analysis involves evaluation of the 4 “C’s” of a company

• Character refers to quality of management
• Capacity refers to the ability of the issuer to fulfill its obligations
• Collateral refers to the assets pledged to secure a loan
• Covenants are limitations and restrictions on the activities of issuers

Financial statements are used to calculate several type of ratios that are used to evaluate the credit risk of a company. The four general categories of items considered are:

1. Scale and diversification of the business Larger companies enjoy significant leverage in negotiations with suppliers and lenders. Those with more product lines and a wider geographical reach offer more diversification and have lower credit risks
2. Operational efficiency- Firms that earn a higher return on their assets and have better operating and EBITDA margins have lower credit risk
3. Stability and sustainability of profit margins - Consistently high profit margins indicate a higher probability of repayment and reflect low credit risk
4. _Degree of financial leverage -_Comfortable levels of cash flow compared to interest payment requirements indicate that a firm is adequately cushioned and should be able to meet debt-servicing requirements comfortably. High ratios of free cash flow to total debt and to interest expense indicate low credit risk

Question 4

LOS 34d: describe the use of financial statement analysis in screening for potential equity investments

Answer 4

Screening is the process of filtering a set of potential investments into a smaller set by applying a set of criteria. These criteria include financial ratios and other characteristics like market cap

Growth Investors invest in those companies that are expected to see higher earnings growth in the future. A growth investor would set earnings growth and/or momentum screens like a high price-to-cash flow ratio and sales growth exceeding 20% over the last three years

Value Investors try to pay a low price relative to a company’s net asset value or earning prowess. A value investor might set screens like a higher-than-average return on equity (ROE) and a lower-than-average P/E ratio to shortlist equity investments that suit her style

Market-oriented investors are an intermediate group of investors who cannot be categorized as growth or value investors

Analysts evaluate how a portfolio based on particular screens would have performed historically through the process of back-testing. This method applies the portfolio selection rules to historical data and calculates returns that would have been realized had particular screens been used

Question 5

LOS 34e: Explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company

Answer 5

Adjustments are described below:

Adjustments related to investments - Investments in securities issued by other companies can be classified under different categories. Unrealized gains and losses on securities classified as “ financial assets measured at fair value through other comprehensive income” are not recorded on the income statement, while other gains and losses are included on income statement. If an analyst is comparing two firms with significant differences in classification of investments, adjustements for the different financial statement impact of the two classifications would be necessary

Adjustements related to inventory- A LIFO company’s financial statements must be adjusted to FIFO terms before comparisons with FIFO companies can be undertaken. Important accounts affected by conversion from LIFO to FIFO are net income, retained earnings, inventory, COGS, and deferred taxes

US GAAP requires firms that use the LIFO inventory cost flow assumption to disclose the beginning and ending balances for the LIFO reserve in the footnotes of the financial statements. The LIFO reserve equals the difference between the value of inventory under LIFO and its value under FIFO. In periods of rising prices and stable inventory levels, LIFO EI is lower than FIFO EI. Therefore,

• EI_FIFO = EI_LIFO + LR
• where LR = LIFO reserve
• COGS_FIFO=COGS_LIFO - (Change in LR during the year)

Since COGS(FIFO) is lower than COGS(LIFO) during periods of rising prices, FIFO gross profits and net income before taxes are greater than their values under LIFO by an amount equal to the change in LIFO reserve. However, net income after tax and under FIFO will be greater than LIFO net income after tax by:

• Change in LIFO reserve x (1- Tax Rate)

The year-end balance of the LIFO reserve represents the cumulative dfference in COGS between the FIFO and LIFO cost flow assumptions over the years. Cumulative COGS_FIFO will be less than cumulative COGS_LIFO, and consequently, cumulative FIFO gross profits will be higher. However, the entire LIFO reserve will not be added to retained earnings when converting from LIFO to FIFO. The LIFO reserve will be divided between retained earnings and taxes that have been avoided and delayed by recording lower profits under LIFO

When converting from LIFO to FIFO assuming rising prices:

Equity increase by : LIFO reserve x (1 - Tax Rate)

Liabilities increase by : LIFO reserve x Tax rate

Adjustments related to PP&E

Depreciation and net fixed asset values must be assessed and necessary adjustments made to bring sets of financial statements on the same footing before making comparisons.

• Gross fixed assets = Accumulated depreciation + Net Fixed assets

If we divided both sides of this equation we get the following:

• Gross investment in fixed assets/ Annual Depreciation = Estimated Useful life or Depreciable life- the historical cost of an asset divided by its useful life equals equals annual depreciation expense under the straight-line method. Therefore this equation equals the estimated useful life
• Accumulated Depreciation / Annual Depreciation = Average Age of Asset - Annual depreciation expense times the number of years that the asset has been in use equals accumulated depreciation. Therefore, accumulated depreciation divided by annual depreciation equals the average age of the asset
• Net investment in fixed asset / Annual Depreciation = Remaining Useful Life = the number of years the asset has remaining in its useful life

These calculations are important beacause :

• They help identify older, obsolete assets that might make the firm’s operations less efficient
• They help forecast future cash flows from investing activities and identify major capital expenditures that the company might need to raise cash for in the future

Adjustments related to Goodwill - Goodwill is recognized when the price paid for the target company in an acquisition exceeds the fair value of the target’s net assets. When a company that grows via acquisitions is compared to a firm that grows internally, the former will have higher reported assets and a greater book value even if the real economic values of the two companies are identical. Analysts must remove the inflating effect of goodwill on book value and rely on the price to tangible book value ratio to make comparisons

Adjustments related to off-balance sheet financing If classified as an operating lease, the lease is treated as a rental contract, with rent expense recorded on the income statement and no asset or liability recognized on the balance sheet). In contrast, if classified as a capital lease, the lessee records the asset and associated liability on its balance sheet. When a lease confers all the risks and benefits of ownership on the lessee but is still accounted for as an operating lease by the lessee, the arrangement gives rise to off-balance sheet financing

Analysts must also perfrom the following adjustments to the income statement when reclassifying an operating lease as a capital lease:

• Rent Expense (recognized under an operating lease) must be eliminated. Typically, rent expense when performing this adjustment is estimated as the average of two years of rent expense
• Interest expense is added. Interest expense is estimated as the interest rate times the present value of operating lease payments
• Depreciation is added. Depreciation is estimated on a straight-line basis for the number of years of future lease payments