Assignment

On
Syllabus Summary
Course: Financial Statement Analysis and Valuation (F-401)

Submitted to:
Md. Sajib Hossain
Assistant Professor
Department of Finance
University of Dhaka

Submitted by:
Anika Rahman
ID No: 23-212
Section: B
Department of Finance
University of Dhaka

Date of Submission: 7th July, 2020

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 Table of Content

Reading 26: Long-Lived Assets

Reading 28: Non- Current (Long-Term) Liabilities

Reading 29: Financial Reporting Quality

Reading 30: Applications of Financial Statement Analysis

Reading 28: Free Cash Flow Valuation

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 READING 26: LONG LIVED ASSETS
• Long-lived assets (noncurrent assets or long-term assets)
- Assets that are expected to provide economic benefits over a future period of
time, typically greater than one year.
- May be tangible (plant, property, and equipment, or PP&E), intangible, or
financial assets.
• Intangible assets:
- Assets lacking physical substance.
- Include items that involve exclusive rights, such as patents, copyrights,
trademarks, and franchises.
• Amortization: Allocation of the cost of an intangible asset over its useful life.
• An intangible asset with an indefinite useful life is not amortized.
• An intangible asset with a finite useful life is amortized using the same methods as
depreciation. Calculating amortization requires
- The original amount at which the intangible asset is recognized,
- The estimated length of its useful life, and
- The estimated residual value at the end of its useful life.
 Revaluation model:
-Alternative to historical cost model permitted under IFRS.
-Long-lived assets measured at fair value.
-May be used only if the fair values of the assets can be measured reliably.
-Unlike historical cost, may result in increases or decreases in value of long-lived assets.
-Impairment charges reflect an unanticipated decline in the value of an asset.
-In general, when an asset’s carrying amount is not recoverable:
-The carrying amount of the impaired asset is written down.
 Lease: Contract between the owner of an asset—the lessor—and another party seeking
use of the asset—the lessee.

READING 28: NONCURRENT (LONG TERM) LIABILITIES

 Bond: Pricing of debt based on present value of future cash payments.

 Payment of bonds: May be redeemed at maturity or before maturity

- A firm may decide to retire bonds early
- To reduce interest costs or to remove debt from balance sheet
- But only if it has sufficient cash
- To account for retiring bonds early
- Eliminate carrying value of bonds at redemption date
- Record cash paid

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 - Recognize gain or loss on redemption
 Gain or loss on bond repurchase = Net bonds payable
− Repurchase payment .

• Debt covenants: Covenants protect creditors by restricting activities of the borrower.

- Affirmative covenants
- Negative covenants
• If a borrower violates a debt covenant, depending on the severity of the breach and the
terms of the contract, lenders may
- choose to waive the covenant,
- be entitled to a penalty payment or higher interest rate,
- renegotiate, or
- call for immediate repayment of the debt.
• Leases: Leasing an asset is an alternative to purchasing.
• Rather than borrowing and buying the asset, a company arranges to lease the asset.
• Advantages to leasing an asset compared with purchasing it:
-Leases can provide less costly financing; usually require little, if any, down payment;
and are often at fixed interest rates.
-The negotiated lease contract may contain less restrictive provisions than other forms of
borrowing.
-Leasing can reduce the risks of obsolescence, residual value, and disposition to the
lessee.
• Solvency: Company’s ability to meet its long-term debt obligations.
• Two types of commonly used solvency ratios:
- Leverage ratios
- Focus on the balance sheet
- Measure relative amount of debt in the company’s capital structure
- Coverage ratios
- Focus on the income statement and cash flows
- Measure the ability of a company to cover its debt-related payments.

READING 29: FINANCIAL REPORTING QUALITY

Financial reporting quality refers to the characteristics of a firm’s financial statements. The
primary criterion for judging financial reporting quality is adherence to generally accepted
accounting principles (GAAP) in the jurisdiction in which the firm operates.
High quality financial reporting must be decision useful. Two characteristics of decision useful
financial reporting are relevance and faithful representation. Relevance refers to the fact that
information presented in the financial statements is useful to users of financial statements in
making decisions. Faithful representation encompasses the qualities of completeness, neutrality,
and the absence of errors.
Quality Spectrum of Financial Reports

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 • Reporting is compliant with GAAP and decision useful; earnings are sustainable and
adequate.
• Reporting is compliant with GAAP and decision useful, but earnings quality is low
(earnings are not sustainable or not adequate).
• Reporting is compliant with GAAP, but earnings quality is low and reporting choices and
estimates are biased.
• Reporting is compliant with GAAP, but the amount of earnings is actively managed to
increase, decrease, or smooth reported earnings.
• Reporting is not compliant with GAAP, although the numbers presented are based on the
company’s actual economic activities.
• Reporting is not compliant and includes numbers that are essentially fictitious or
fraudulent.
Conditions conducive to issuing low-quality financial reports
Three factors that typically exist in cases where management provides low-quality financial
reporting are motivation, opportunity, and a rationalization of the behavior. So to the sources of
motivation previously listed, we can add conditions that increase the opportunity to present low-
quality financial reports. Circumstances in which low quality, or even fraudulent, financial
reporting is more probable are:
The company has weak internal controls.
The board of directors provides inadequate oversight.
Applicable accounting standards provide a large range of acceptable accounting treatments,
provide for inconsequential penalties in the case of accounting fraud, or both.
The third likely element of low-quality financial reporting is rationalization by management for
less-than-ethical actions. Most people who do something they know is wrong tell themselves a
story that seems (at least to them) to justify breaking the rules.

Accounting Choices and Recognizition:

 Revenue Recognition:One example of how a firm’s choices affect the timing of revenue
recognition is the choice of where in the shipping process the customer actually takes title
to the goods. A firm may choose terms with their customer of free-on-board (FOB) at
the shipping point (the firm’s loading dock) or FOB at the destination (the customer’s
location). Choosing terms of FOB at the shipping point will mean that revenue is
recognized earlier compared to FOB at the destination.
In a bill-and-hold transaction, the customer buys the goods and receives an invoice but
requests that the firm keep the goods at their location for a period of time. The use of
fictitious bill-and-hold transactions can increase earnings in the current period by
recognizing revenue for goods that are actually still in inventory. Revenue for future
periods will be decreased as real customer orders for these bill-and-hold items are filled
but not recognized in revenue, offsetting the previous overstatement of revenue.
 Estimates of Credit Losses:One example of accounting choices that affect financial
reports is the estimation of losses from uncollectable customer credit accounts. On the
balance sheet, the reserve uncollectible debt is an offset to accounts receivable. If
management determines the probability that accounts receivable will be uncollectible is
lower than their current estimate, a decrease in the reserve for uncollectible accounts will

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 increase net receivables reported on the balance sheet, reduce expenses on the income
statement, and increase net income.
 Valuation Allowance:Similar to the effects of an allowance for bad debt, increasing a
valuation allowance will decrease the net deferred tax asset on the balance sheet and
reduce net income for the period, while a decrease in the valuation allowance will
increase the net deferred tax asset and increase net income for the period.
 Depreciation Methods and Estimates:Compared to straight-line depreciation, using an
accelerated method of depreciation increases expenses, and decreases net income, in the
early years of an asset’s life. In the later years of an asset’s life, expenses are lower and
net income higher when an accelerated depreciation method is used.
 Amortization and Impairment: The intangible asset goodwill is not amortized but is
subject to a test for impairment. By ignoring or delaying recognition of an impairment
charge for goodwill, management can increase earnings in the current periods. Related
 Party Transactions:If a public firm does business with a supplier that is private and
controlled by management, adjusting the price of goods supplied can shift profits either to
or from the private company to manage the earnings reported by the public company.
 Capitalization:Capitalization also affects cash flow classifications. If an expense is
capitalized, the entire amount is classified as an investing cash outflow so that operating
cash flow is increased by that amount.
 Other Cash Flow Effects: Taking longer to pay suppliers increases operating cash flows
and is referred to as stretching payables. Delaying payments that would normally be
made near the end of a reporting period until the beginning of the next accounting period
will increase operating cash flow in the current period and reduce it in the subsequent
period. There is no effect on reported earnings in the current period from stretching
payables.

READING 30: FINANCIAL STATEMENTS ANALYSIS

Trends in financial ratios and differences between a firm’s financial ratios and those of its
competitors or industry averages can indicate important aspects of a firm’s business strategy.
• In general, it is important for an analyst to understand a subject firm’s business strategy.
If the firm claims it is going to improve earnings per share by cutting costs, examination
of operating ratios and gross margins over time will reveal whether the firm has actually
been able to implement such a strategy and whether sales have suffered as a result.
Role of financial statement analysis in assessing the credit quality
• Traditionally, credit analysts have spoken of the “three Cs,” “four Cs,” or even the “five
Cs” of credit analysis. One version of the three Cs includes: Character, Collateral, and
Capacity to repay. Character refers to the firm management’s professional reputation and
the firm’s history of debt repayment. The ability to pledge specific collateral reduces
lender risk. It is the third C, the capacity to repay, that requires close examination of a
firm’s financial statements and ratios.

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 • Credit rating agencies such as Moody’s and Standard and Poor’s employ formulas that
are essentially weighted averages of several specific accounting ratios and business
characteristics. The specific items used in the formula and their weights vary from
industry to industry, but the types of items considered can be separated into four general
categories:
1. Scale and diversification. Larger companies and those with a wider variety of product lines
and greater geographic diversification are better credit risks.
2. Operational efficiency. Such items as operating ROA, operating margins, and EBITDA
margins fall into this category. Along with greater vertical diversification, high operating
efficiency is associated with better debt ratings.
3. Margin stability. Stability of the relevant profitability margins indicates a higher probability
of repayment (leads to a better debt rating and a lower interest rate). Highly variable operating
results make lenders nervous.
4. Leverage. 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. Firms
with greater earnings in relation to their debt and in relation to their interest expense are better
credit risks.
use of financial statement analysis in screening for potential equity investments.
• In many cases, an analyst must select portfolio stocks from the large universe of potential
equity investments. Whether the object is to select growth stocks, income stocks, or value
stocks, accounting items and ratios can be used to identify a manageable subset of
available stocks for further analysis.
• Some investment strategies even have financial ratios in their names, such as low
price/earnings and low price/sales investing. Multiple criteria are used because a screen
based on a single factor can include firms with other undesirable characteristics. For
example, a company with a low price/earnings ratio may also have operating losses,
declining sales prospects, or very high leverage.
• Analysts should be aware that their equity screens will likely include and exclude many
or all of the firms in particular industries. A screen to identify firms with low P/E ratios
will likely exclude growth companies from the sample. A low price-to-book or high
dividend screen will likely include an inordinate proportion of financial services
companies.
• Back testing refers to using a specific set of criteria to screen historical data to determine
how portfolios based on those criteria would have performed. There is, of course, no
guarantee that screening criteria that have identified stocks that outperformed in the past
will continue to do so. Analysts must also pay special attention to the potential effects of
survivorship bias, data-mining bias, and look-ahead bias.
Investments in Securities
• Because the classification of a firm’s investment securities affects how changes in their
values are recorded, it can significantly affect reported earnings and assets.
• Recall that unrealized gains and losses on held-for-trading securities are recorded in
income, while those on available-for-sale or held-to-maturity securities are not.
• Additionally, while unrealized gains and losses on held-for-trading and available-for-sale
securities are reflected in balance sheet asset values, for held-to-maturity securities they
are not.

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 READING 28: FREE CASH FLOW
The value of a company depends on its ability to generate future cash flows. We find the value
by finding the present value of its relevant future cash flow. The most important question is how
we define the relevant cash flow ? The most common approach to define the cash flow is
• 1. Dividend 2. Free Cash Flow to Firm 3. Residual Income Valuation
• When we find the value of a company by discounting the expected future dividend, we
call this process Dividend Discount Model.
When we find the value of a company by discounting the expected Free Cash Flow to Firm, we
call this process Free Cash Flow Model
The name that Free Cash Flow is intended to signify that firm is free to use this cash flow or firm
has discretion on how to use the free cash flow because this is the cash flow that firm has after
meeting all operating expenses and necessary capital expenditure in fixed assets and investment
in working capital ( current asset minus current liability)
• In order to maximize the ultimate objective of the corporation-wealth maximization- first
does everything –operating , financing and long term investment policy decision. After
doing everything , if firm has still cash flow left , that cash flow is free and firm has full
discretion on how to use that cash flow .
Use of Free Cash Flow
- Pay Dividend
- Share Repurchase
- Advance Payment of Debts
- Engage in additional M&A activities ( don’t be confused with corporate goal
Finding FCFF:
FCFF = (Sales – COGS-Operatng Expense including non cash expense like Dep)*(1-tax
rate)+ Dep- Capex – change in WC
- FCFF can be found from Net Income
- FCFF = NI + NCC + Int(1 – Tax rate) – Inv(FC) – Inv(WC) or
- Adjustment ; Net noncash charges represent an adjustment for noncash decreases and
increases in net income. The most common noncash charge is depreciation and
amortization expense
- After-tax interest expense must be added back to net income to arrive at FCFF. This step
is required because interest expense net of the related tax savings was deducted in
arriving at net income and because interest is a cash flow available to one of the
company’s capital providers
- Similar to after-tax interest expense, if a company has preferred stock, dividends on that
preferred stock are deducted in arriving at net income available to common shareholders
Finding FCFE
FCFF can be found from EBIT
- FCFF = EBIT(1-tax rate) + depreciation – Cap. Expend. – change in working capital
FCFF can be found from EBITDA
- FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv