INTEGRATION OF FINANCIAL STATEMENT ANALYSIS

TECHNIQUES
LOS 20.a: Demonstrate the use of a framework for the analysis of
financial statements, given a particular problem, question, or purpose
(e.g., valuing equity based on comparables, critiquing a credit rating,
obtaining a comprehensive picture of financial leverage, evaluating the
perspectives given in managements discussion of financial results).
The basic financial analysis framework involves:

Step Input Output

Perspective of the analyst (e.g.,
evaluating a debt/equity investment or Purpose statement
1. Establish the issuing a credit rating) Specific questions to be answered
objectives Needs or concerns communicated by the Nature and content of the final report
client or supervisor Timetable and resource budget
Institutional guidelines
Financial statements
2. Collect data Communication with management, Organized financial information
suppliers, customers, and competitors
Adjusted financial statements
Common-size statements
3. Process data Data from Step 2
Ratios
Forecasts
4. Analyze data Data from Steps 2 and 3 Results
5. Develop and Report answering questions posed in Step
Results from analysis
communicate 1
Published report guidelines
conclusions Recommendations
6. Follow up Periodically updated information Updated analysis and recommendations

LOS 20.b: Identify financial reporting choices and biases that affect the
quality and comparability of companies financial statements and
explain how such biases may affect financial decisions.
LOS 20.e: Analyze and interpret how balance sheet modifications,
earnings normalization, and cash flow statement related
modifications affect a companys financial statements, financial
ratios, and overall financial condition.
The analysis focuses on the following:

Sources of earnings and return on equity

Asset base
Capital structure.
Capital allocation decisions.
Earnings quality and cash flow analysis.
Market value decomposition.
Off-balance-sheet financing.
Anticipating changes in accounting standards.

Sources of earnings and return on equity

Analyze using Du Pont Equation:
When adjusting for Investment in Associate under Equity Method:
1. Tax Burden Adjust NI for Income for Investment
2. EBT/EBIT Same (as without investment in Associate)
3. EBIT/Revenue Same (as without investment in Associate)
4. Revenue/Avg. Assets Adjust Avg. Assets for Investment in Associate
5. Avg. Assets/ Avg. Equity Although it should be adjusted, but since we do
not whether investment in Associate is financed through Equity, it would not
be prudent to adjust assets and equity for investment amount. This ratio is
thus assumed the same (as without investment in Associate)

Final Ratio after adjustment for Associate in Investment will not be equal to either
(NI Income from Assc.) / (Avg. Equity) or (NI Income from Assc.) / (Avg. Equity
adjusted for Inv. In Assc.) because of #5.

Asset base
Conduct common-size Analysis
Examine the composition of the balance sheet (i) Item-wise and (ii) over
time.
For Manufacturing firms, investments in goodwill/intangible should not be too
high.
If goodwill through acquisitions consider possibility of future impairments

Capital Structure
A firms capital structure must be able to support managements strategic
objectives as well as to allow the firm to honor its future obligations.
See composition of ST Debt, LT Debt, other liabilities and Equity
Some Liabilities may not require cash outflow (employee benefits, deferred
taxes etc.)
Also conduct Ratio analysis

Capital allocation decisions (Allocation to Business Segments):

A business segment is a portion of a larger company that accounts for more
than 10% of the companys revenues or assets, and is distinguishable from
other line(s) of business
 Limited disclosure for segment-wise information required under U.S.
GAAP/IFRS but the disclosures are valuable in identifying each segments
contribution
Ratio of proportional CAPEX to proportional assets for each segment, If >1,
indicates the firm is growing the segment by allocating a greater percentage
of its CAPEX to that segment
By comparing the EBIT margin contributed by each segment to its ratio of
capital expenditure proportion to asset proportion, we can determine if the
firm is investing its capital in its most profitable segments.
Segmental cash flow data is generally not reported. We can, however,
approximate cash flow as EBIT plus depreciation and amortization to
calculate Cashflow/Avg Assets for each segment
Earnings quality and cash flow analysis.
Earnings quality refers to the persistence and sustainability of a firms
earnings.
We can disaggregate earnings into their cash flow and accruals components
using either a balance sheet approach or a cash flow statement approach.
With either approach, the ratio of accruals to average net operating assets
can be used to measure earnings quality.
Balance Sheet approach:
Accruals = Change in Net Operating Assets or ( NOA) or (NOAEND NOABEG)
NOA = Operating Assets (T.Assets cash/equivalents) Operating Liabilities
(T.Liabilites ST or LT Debt)
Accrual Ratio (for comparability in case of size differences) = NOA/Avg.
NOA
Cashflow approach:
Accruals = NI CFO CFI (CF from investing activities)
[careful for classification difference of Int/Div under IFRS (CFO or CFF)/GAAP
(CFO)]
Accrual Ratio (for comparability in case of size differences) = (NI CFO
CFI)/Avg. NOA
Interpretation of both ratios is the same: the lower the ratio, the higher the
earnings quality. Furthermore, wide variations in Accrual Ratio indicates
earnings manipulation
Earnings are considered higher quality when confirmed by cash flow. Cash
flow can be compared to operating Income by adding back cash paid for
interest and taxes to operating cash flow. (Cash generated from Operations
(CGO) = Operating Cash flow + Cash Interest paid + Cash Taxes paid = EBIT
+ NCC WCC ). Be Careful when adding back I and T in case of IFRS because
they may have been classified as Financing Activities
CGO/Operating Income close to or greater than 1 is good
Cash Return/Total Assets is useful in determining whether recent acquisition
were justified. If increasing then justified
Cash flow to reinvestment Ratio = CGO/CAPEX ( cash generated per unit
CAPEX, good)
Cash flow to Total Debt = CGO/Total Debt (at current CGO, how many years
will the company take to repay entire debt, indicates level of leverage,
good)
Cash flow interest coverage = CGO/cash interest paid (Cash-based interest
coverage ratio, good)
Market value decomposition.
In case of investment in subsidiary or affiliate, it may be beneficial to
determine the standalone value of the parent
The implied value of the parent (disregarding subsidiary) = MV Parent
Company Pro-rata share of MV Associate. (if Sub. on FCY Stock Exchange;
convert to Parents reporting currency)
Implied P/E of the parent indicates whether Parent is over/under-valued
compared to peers
Market Cap ( Parent )Prorata Market Cap ( )
Implied P/ E=
( Parent )Prorata ( )
LOS 20.c: Evaluate the quality of a companys financial data and
recommend appropriate adjustments to improve quality and
comparability with similar companies, including adjustments for
differences in accounting standards, methods, and assumptions.
The balance sheet should be adjusted for off-balance-sheet financing
activities (activities not reported on BS).
Capitalize operating leases for analytical purposes by increasing assets and
liabilities by the present value of the remaining lease payments. Also, adjust
the income statement by replacing rent expense with depreciation expense
on the lease asset and interest expense on the lease liability. (note that in
the early years of a finance lease, Dep. and Int. expense will exceed lease
payment)
Capitalizing a Finance Lease will increase leverage and Debt/Equity and
decrease interest Coverage
Befor
5-Year Operating Lease ($ Mn) e After
Term 5 Debt 21.75 30.85
Interest 10% Equity 50.19 50.19
Rental Payment
($Mn) 2.40 Assets 71.94 81.04
PV ($Mn) 9.10 EBIT 4.16 4.74*
Int 1.40 2.31
=4.16 + 2.4 (rental) - 1.82
Finance Lease (dep)
Balance Sheet
Assets (BS) +9.10 Ratios
Assets/Equ
Liabilities (BS) +9.10 ity 1.43 1.61
Debt/Equit
Income Statement y 0.43 0.61
EBIT/Intere
Dep Exp (IS) +1.82 st 2.97 2.05
Int Exp (IS) +0.91
Other examples of off-balance-sheet financing are debt guarantees, sales of
receivables with recourse, and take-or-pay agreements. In each case, the
analytical adjustment is similar i.e. increase assets and liabilities by the
amount of the transaction that is off-balance-sheet.
LOS 20.d: Evaluate how a given change in accounting standards,
methods, or assumptions affects financial statements and ratios.
Users must be aware of the proposed changes in accounting standards
because of the financial statement effects and the potential impact on a
firms valuation. (esp. in coming years as IFRS and GAAP converge)
FASB has generally eliminated operating lease. In most cases, firms are
required to capitalize leases. Effect Leverage ; compliance to debt
covenants more difficult.