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Reading 30: Financial Statement Analysis: Application (Assess credit…
Reading 30: Financial Statement Analysis: Application
Past financial performance analysis
Trends in financial ratios
How have key ratios changed and why?
How do key ratios and trends compare with competitors/ industry?
What aspects of performance are critical for a competitive advantage?
How did the company perform in these areas?
What is the company's business model and strategy? are they reflected in key measures?
Forecast future net income and cash flow
Projecting performance
Top-down forecasting
good for stable industry
2) forecast expected industry sales based on historical relationship with GDP
3) consider expected change of firm's market share
1) forecast expected GDP growth
Forecast expected firm sales
5) Use historical margins for stable firms (gross, operating, net) or individual forecast for each expense item
Remove nonrecurring items
Historical margins are not relevant to new, volatile, or high fixed cost industries
Forecasting Net Income and Cash Flow
1) develop spreadsheet based on estimated growth rate of sales
2) make assumptions about working capital, fixed assets, CoGS and SG&A as proportions of sales
3) estimate interest rates for saving/borrowing, tax rate, and dividends
4) project net income and cash flow based on assumptions
Assess credit quality
Ability of issuer to meet interest and principal repayment of schedule (capacity)
Cash flow forecast focus
Variability of cash flows
4Cs
Character
Capacity
Collateral
Covenants
Credit Scoring
Credit rating agencies employ formulas that are weighted averages of several specific accounting ratios and business characteristics
1) Scale and diversification: Size, product diversification, geographical diversification
2) Operational efficiency: Operating ROA, operating margins, EBITDA margins, degree of vertical integration
3) Margin stability: Stability of profitability margins indicates a higher probability of repayment (leads to a better debt rating and a lower cost of debt capital)
4) Leverage: Coverage ratios of operating earnings, EBITDA, or some measure of free cash flow to interest expense or total debt make up the most important part of the credit rating formula
Screen for potential equity investment
Screening: Applying a set of criteria to reduce a set of investments to a smaller subset having desired characteristics
Involves comparing ratios to min/max values
Growth investors: Focus on earnings growth
Value investors: Focus on low share price in relation to earnings or assets
Market oriented: Neither value nor growth focused
Peer comparison
Analyst must adjust the financial statement for comparability
Adjustments for differences in accounting choices (e.g., revenue recognition criteria)
Adjustments for differences in accounting standards (e.g., IFRS vs GAAP)
Required to ensure accounts are comparable for ratio comparison
Examples
Investments
If comparable companies have significant differences in classifications of investment securities, adjustment may be useful
Goodwill
Internally generated vs. purchased
Can subtract goodwill and other intangible assets to get market value/ tangible book value
Inventory
FIFO vs. (GAAP only) LIFO vs. WAC
PP&E
Differences in depreciation methods and estimates
Information to adjust may not be available; consider a qualitative difference
When calculating solvency ratios, analyst should estimate the present value of operating lease obligation and add it tot the firm liability
Companies may use different accounting methods or estimates.