CFA® Level I - Financial Reporting and Analysis Financial Statement Analysis: Applications 1

Contents and Introduction 1.Introduction 2.Application: Evaluating Past Financial Performance 3.Application: Projecting Future Financial Performance 4.Application: Assessing Credit Risk 5.Application: Screening for Potential Equity Investments 6.Analyst Adjustments to Reported Financials

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 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?

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!

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

3. Application: Projecting Future Financial Performance 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 6www.arifirfanullah.com Forecast Sales Use historical margins for stable firms For less stable firms estimate each expense item Remove non-recurring items Estimate interest expense and tax expense Forecast Expenses Estimate changes in working capital Estimate investment expenditures Estimate dividend payments Forecast Cash Flows

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

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 8www.arifirfanullah.com

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

5. Application: Screening for Potential Equity Investments 10www.arifirfanullah.com CriterionStocks 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?

5. Application: Screening for Potential Equity Investments 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 11 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 Types of Investors

6. Analyst Adjustments to Reported Financials 12www.arifirfanullah.com When comparing ratios, adjustments might be required. Before making adjustments, consider the following: 1.Importance 2.Body of standards 3.Methods 4.Estimates

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

Estimates Related to Property, Plant and Equipment EstimateCalculation Number of years of useful life which have passedAccumulated 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 company’s overall asset base Net PPE (net of accumulated depreciation) / Depreciation Expense Average life of the assets at installationGross PPE / Depreciation Expense What percentage of the asset base is being renewed through new capital investment Capex / Sum of Gross PPE plus Capex

Analyst Adjustments for Off-Balance Sheet Financing Operating leases (off-balance sheet financing) make ratios look relatively good An analyst might want to evaluate at the impact of capitalizing operating leases Compute PV of operating lease payments Add this number to value of assets and value of liabilities The Context The Adjustment What is the impact on solvency ratios? What is the impact on coverage ratios? The Impact

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

Conclusion Read summary Review learning objectives Examples Practice problems: good but not enough Practice questions from other sources