Financial Statement Analysis

Valuation • Credit analysis • Executive compensation

Christian V. Petersen
and
Thomas Plenborg

Financial Times
Prentice Hall
is an imprint of

Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Singapore • Hong Kong
Tokyo • Seoul • Taipei • New Delhi • Cape Town • Madrid • Mexico City • Amsterdam • Munich • Paris • Milan
 Contents

Preface xiii
Publisher's acknowledgements xvii

1 Introduction to financial statement analysis 1

Learning outcomes 1
Introduction to financial statement analysis 1
International Financial Reporting Standards 2
Decisions and decision models 3
Outline of the book 13
Conclusions 17
Review questions 18
Notes 18
References 18

Part 1 ACCOUNTING DATA 19

Introduction to Part 1 21

2 Introduction to financial statements and bookkeeping 22

Learning outcomes 22
Introduction to financial statements and bookkeeping 22
The income statement and statement of comprehensive income 23
Balance sheet 27
Cash flow statement 30
Statement of changes in owners' equity 32
Recording transactions and preparing financial statements 32
Transaction analysis illustrated ' 37
Financial statements 43
Conclusions 45
Review questions 46
Appendix 2.1 46

3 Accrual-based versus cash-flow-based performance measures 47

Learning outcomes 47
Accrual-based versus cash-flow-based performance measures 47

VII
ents

The distinction between accrual-based and cash-flow-based

performance measures 48
Conclusions 59
Review questions 59
References 59

Part 2 FINANCIAL ANALYSIS 61

Introduction to Part 2 . 63

4 The analytical income statement and balance sheet 68

Learning outcomes 68
The analytical income statement and balance sheet 68
Carlsberg's NOPAT and invested capital 79
Conclusions 91
Review questions 92

5 Profitability analysis 93
Learning outcomes 93
Profitability analysis 93
Measurement of operating profitability 94
Alternative interpretations of the return on invested capital 99
Decomposition of return on invested capital 107
Analysis of profit margin and turnover rate of invested capital 111
Return on equity 117
Conclusions 120
Review questions 122
Appendix 5.1 122

6 Growth analysis 127

Learning outcomes 127
Growth 127
Sustainable growth rate 128
Is growth always value creating? 131
What is the quality of growth? 134
Is growth sustainable? 137
Is growth in earnings per share (EPS) always value creating? 140
Does growth in financial ratios caused by share buy-back always add value? 141
The relationship between growth and liquidity 147
Conclusions 148
Review questions 148
Notes 149
References ~ 149

7 Liquidity risk analysis 150

Learning outcomes 150
Liquidity risk 150
 Contents

Measuring short-term liquidity risk 153

Measuring long-term liquidity risk 158
Shortcomings of financial ratios measuring the short- and long-term liquidity risk 165
Conclusions 165
Review questions 166
Appendix 7.1 166
Notes 170

Part3 DECISION MAKING 171

Introduction to Part 3 173

8 Forecasting 174
Learning outcomes 174
Forecasting 174
The design of pro forma statements 175
Designing a template for forecasting 181
The estimation of financial value drivers 187
Financial statement analysis 194
Conclusions 199
Review questions 200
Appendix 8.1 200

9 Valuation 208
Learning outcomes 208
Valuation 208
Approaches to valuation 210
The attributes of an ideal valuation approach 212
Present value approaches 212
The relative valuation approach (multiples) 226
The liquidation approach 235
Conclusions 237
Review questions 237
Appendix 9.1 238
Note 244
References 244

10 Cost of capital 245

Learning outcomes 245
Cost of capital 245
Weighted average cost of capital (WACC) 246
Alternative methods of measuring the systematic risk (fie) 254
Conclusions 266
Review questions 267
Appendix 10.1 267
Note 270
References 270

IX
Contents

11 Credit analysis 271

Learning outcomes 271
Corporate credit analysis 271
The fundamental credit analysis approach 272
Pricing credit risk 291
Prediction of corporate default using statistical models 292
Conclusions 297
Review questions 297
Note 297
References 298

12 Accounting-based bonus plans for executives 299

Learning outcomes 299
Introduction to executive compensation 299
Characteristics of an effective bonus plan 301
Components of a bonus plan 306
Choice of performance measures 307
Choice of performance standards 314
Choice of pay to performance structure 318
EVA-based bonus contract - a feasible solution
to accounting-based performance measures 322
Conclusions 327
Review questions 327
Note 327
References 328

Part 4 ASSESSMENT OF ACCOUNTING DATA 329

Introduction to Part 4 331

13 Accounting quality 333

Learning outcomes 333
Accounting quality 333
The purpose of financial statement analysis and good accounting quality 336
Assessment of accounting quality 338
Total assessment of accounting quality 370
Conclusions 371
Review questions 371
Note 372
References 372

14 Accounting flexibility in the income statement 373

Learning outcomes 373
Accounting flexibility in the income statement 373
Accounting regulation and flexibility 375
Accounting flexibility in the income statement 380
Accounting flexibility and economic consequences 394
 Contents

Accounting issues in valuation 396

Accounting issues in credit analysis 404
Accounting issues in executive compensation 406
Conclusions 408
Review questions 408
Appendix 14.1 _ 409
Appendix 14.2 409
Notes 410
Reference 410

15 Accounting flexibility in the balance sheet 411

Learning outcomes 411
Accounting flexibility in the balance sheet 411
Assets, liabilities and related expenses 411
Accounting flexibility and economic consequences 433
Accounting issues in valuation 433
Accounting issues in credit analysis 444
Accounting issues in executive compensation 450
Conclusions 454
Review questions 455
Appendix 15.1 - 455
Notes 456
References 457

Glossary 458
Index 467

XI