CFA Level I - Financial Reporting and Analysis

Financial Statement Analysis: Applications

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Contents and Introduction

1.
2.
3.
4.
5.
6.

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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2. 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 companys 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 companys business strategy? Do the financials reflect the strategy?

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Example 1 - Apples change in strategy is reflected in its financial

performance
Between 2007 and 2010, Apples 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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3. 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 companys market share
Forecast expected company sales

Forecast Expenses

Forecast Cash Flows

Use historical margins for stable firms

For less stable firms estimate each expense item
Remove non-recurring items
Estimate interest expense and tax expense

Estimate changes in working capital

Estimate investment expenditures
Estimate dividend payments

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Curriculum Examples
Example 3: Using historical operating profit margins to forecast operating profit
Appropriate for stable diversified firms like JNJ

Example 4: Issues in forecasting

Recognize what items are non-recurring

Example 5: Basic example of financial forecasting

Essentially a spreadsheet model

Example 6: 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 7 and 8
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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

Example 9

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6. 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

have been recognized

Accumulated Depreciation / Depreciation Expense

How many years of useful life remain for the

companys overall asset base

Net PPE (net of accumulated depreciation) /

Depreciation Expense

Average life of the assets at installation

Gross PPE / Depreciation Expense

What percentage of the asset base is being

renewed through new capital investment

Capex / Sum of Gross PPE plus Capex

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Analyst Adjustments for Off-Balance Sheet Financing

The Context
Operating leases (off-balance sheet financing) make ratios look relatively good
An analyst might want to evaluate at the impact of capitalizing operating leases
The Adjustment

Compute PV of operating lease payments

Add this number to value of assets and value of liabilities
The Impact
What is the impact on solvency ratios?
What is the impact on coverage ratios?
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Summary
Evaluate a companys 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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