Level I CFA: Financial Statement Analysis: Applications-Lecture 1

financial statement analysis applications in this reading we will talk about the application of financial statement analysis we will understand how to evaluate past financial performance we will then look at how to project future financial performance and then we will get into the two major reasons why analysts evaluate financial statements one is to assess credit risk and the other is related to equity investments and finally we will talk about adjustments to reported financials evaluating past financial performance these points are taken straight from the curriculum and they highlight what we need to consider when we evaluate past financial performance i will simply read this for you as an analyst you need to consider how a company's measures of profitability efficiency liquidity and solvency change over the period being analyzed and why is this happening as the industry matures a company might try to improve its efficiency if you are a credit analyst you might be particularly concerned with the liquidity and solvency of a company these are items that we will see in more detail later 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 or more specifically you can look at the peer group and then 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 and then what is the company's business strategy what is the company's business model and do the financials reflect the strategy the curriculum gives several examples in this reading most of the examples are fairly long-winded you can read the examples if they have time i think they are very interesting but from a testability perspective they are just a few core points that you need to recognize and what i'll try to do in this lecture is highlight those important points the first example is a case study on apple and it showcases how apple's change in strategy is reflected in its financial performance in the early to mid 2000s apple primarily was a personal computer company its sales came mostly from the apple macintosh or the mac but then apple changed its strategy and the focus moved away from being purely a pc company to a company that provides several integrated products and if you look at apple in 2010 it had the iphone apple sold ipads ipods music was downloadable through itunes so the product mix changed substantially and if we look at apple's revenue and the mix of revenue coming from different sources we will see that that product mix and the corresponding revenue changed substantially between 2007 and 2010 so what that tells us is that the financial performance is reflecting apple's stated strategy apple strategy involved selling differentiated products so apple is a major innovator in its field and when a company sells differentiated products it can charge higher prices which is what apple does and that should be reflected in higher gross margins if you look at apple's gross margins between 2007 and 2010 as the strategy was being implemented the gross margins are actually becoming better so that again reflects the fact that the financial numbers do point out that the strategy was working the impact on operating profit margins is weaker the reason is that for a company that is providing differentiated products innovative products there still needs to be a substantial amount of investment in r d in marketing and so on these relatively high costs will have a impact on profit margins so just because the company has differentiated products and higher gross margins doesn't necessarily mean that the operating profit margins will also be very high the example also showcases apple's liquidity if we look at the liquidity ratios they are quite high in the two to three range this says that apple had a lot of extra cash or at least a lot of current assets relative to liabilities there are several reasons why this might happen and there are several ways in which a company can use that extra cash one interpretation might be that this would be a inefficient usage of funds but another explanation would be that this is like apple's war chest where the extra liquidity could be used to make acquisitions example two highlights the effect of differences in accounting standards on return on equity comparisons return on equity is net income over equity we are looking at three telecom companies one is verizon in the u.s which uses u.s gaap then we have a telecom company in mexico using mexican gap and a company in brazil using brazilian gaap it is a long example but the main point is that differences in accounting standards can have a substantial impact on financial ratios in other words it does not make sense to take the unadjusted numbers for say return on equity and simply compare them if we do want to compare these three telecom companies which are using different accounting standards we need to first make sure that all the numbers are presented in a particular standard u.s gaap for example and then it makes more sense to compare ratios this example shows that after we make adjustments the change in ratios are quite significant next we talk about projecting future financial performance the first thing we need to do is forecast sales for a company and what is presented here is a simplistic way of forecasting sales we first forecast the expected gdp growth then we forecast the expected industry sales based on historical relationship with gdp so if historical data tells us that a three percent increase in gdp corresponds to a three percent increase in sales then we use that in some industries a three percent increase in gdp might have a much higher increase in sales numbers this relationship between increase in gdp and the company sales or the industry sales is available by looking at historical data and doing regression analysis we should then consider the market share of the company that we are evaluating and whether that market share is going to change or not if the market share is not going to change then we can simply say that the increase in sales will correspond to the increase in the size of the industry based on this information we then forecast company sales then to come up with the estimated net income we have to forecast expenses we can use historical margins such as gross profit margin and operating margins for stable companies and this works for companies such as jnj which are large and diversified and stable for companies which are not stable they might be new companies a company like facebook for example here we need to estimate each expense item we should also remove any non-recurring items because with our forecast we are concerned about revenue items and expense items that will recur those that will not recur should not be considered in our forecasts generally we estimate interest expense and tax expense separately the reason is with interest expense the amount depends on the level of debt and the rate so we have to estimate the debt that we expect in the future and we need to estimate the interest rate and it is the combination of these two which will define interest expense with tax expense we need to have an estimate for the tax rate and obviously the earnings before tax which will be calculated based on the forecasted sales and the forecasted expenses once we have the ebt and the tax rate we can come up with the tax expense to come up with cash flows we also need to estimate changes in working capital if our working capital such as inventory is going up that is not reflected in the income statement but obviously it has a impact on cash flow so an estimate of changes in working capital is important we should also estimate investment expenditures because these will not be reflected in the income statement but they also impact cash flow we need to estimate dividend payments and so on again these are just high level points with this information we can then project the cash flow for a given company the level of analysis presented here is simplistic but from a exam perspective this should be reasonable the curriculum presents several examples examples 2 3 and 4 are fairly long if you have time you can read them but what i'll do here is give you the most important point related to each example example two deals with using historical operating profit margin to forecast operating profits we are given the example of a stable diversified firm like jnj for a company like gnj it makes sense to use historical margins to project future operating profits whereas we are given another company which is a chinese search engine company that is relatively new there it would not make sense to use historical operating profit margins because of the uncertainties involved there it would make more sense to project each expense item separately example three deals with issues in forecasting the most important point in this example is that we need to recognize which expenses and which items are non-recurring so these items are not included in a forecasting model example four is a basic financial model or a basic financial forecast this is a spreadsheet model and i don't think this is overly testable the example here is based on the discussion from the previous slide so if you know all the items from the previous slide you are reasonably well prepared from a exam perspective example 5 is a multiple choice question it tests your knowledge of ratios i would strongly encourage you to do this example from the curriculum assessing credit risk imagine you are considering the purchase of a bond that has been issued by a company one of your major concerns will be whether the company will make its coupon payments and whether the company will make its principal payment at the end the process whereby you assess whether or not the company will make its payments is called assessing credit risk you can also call this credit analysis the high level items that you will be concerned with are the ability of the issuer to meet interest and principal payments on schedule to do this one of the most important things you will look at is cash flow forecasts this will look at the amount of cash flows and also the variability of cash flows if the cash flow is very volatile then obviously that will be a concern because if the cash flow is low then there will be a question as to whether coupon payments will be made you also need to consider the business risk and the financial risk of a company when we say business risk what we are talking about is the risk of the company not having sufficient revenues or the risk of expenses being too high financial risk arises when the level of debt is high which means that interest payments are high if the operating profits are low and debt is high then the company is in a very risky situation because all the operating income might get used in paying interest the curriculum gives some specific examples on assessing credit risk and i will again highlight the most important points you need to look at the size and scale of the company that has issued the bond or issued debt you need to look at total revenue you need to look at operating profit you need to look at the business profile revenue sustainability and efficiency if a company has relatively high revenue which is sustainable and the company is operating efficiently all these are indicators that the credit risk is good good credit risk means that the company will make its payments on time you should also consider financial leverage and flexibility with leverage ratios we are talking about ratios such as debt to equity low ratios are good because for a given amount of equity if a company has low debt that means that it will easily be able to make its debt related payments coverage ratios such as ebit over interest you want these ratios to be high high ratio means that the operating profit is relatively high compared to the interest payments debt over ebitda you want debt to be relatively low and ebitda which is a proxy for cash flows should ideally be high if this ratio is low that's a good thing free cash flow to debt you want free cash flow to be relatively high and debt to be relatively low so if this ratio is high that is good by good we mean low credit risk we should also be concerned about the liquidity of a company the classic liquidity ratio is the current ratio which is current assets over current liabilities if this ratio is high that means the company will easily meet its short-term obligations

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