Financial Analysis Level II CFA PDF

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Financial Analysis Level II CFA...

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SS 6: Evaluating Quality of Financial Report 2 dimensions: Earnings Quality & Reporting Quality Reporting Quality  Assessment of the information disclosed in the financial reports. High quality reporting provides decision useful information High Quality Earnings  High level of earnings & sustainability of earnings. Good economic performance & sustainable earnings are considered higher quality. Low Quality Earnings  Bad performance or Misrepresentation of economic performance. One cannot have both low-quality reporting & high quality earnings; High quality earnings assume High quality reporting. However, one could have a situation in which the company has high quality reporting but low quality earnings. The Conceptual Framework for assessing the quality of a company’s reports entails answering 2 questions: - Are the underlying financial reports GAAP compliant & decision useful? - Are the earnings high quality? Financial report quality: -

GAAP compliant & decision-useful, high quality earnings. GAAP compliant & decision-useful, low quality earnings. GAAP compliant but not decision useful Non-compliant accounting Fraudulent accounting

Potential problems that affect the Quality of financial reportings may arise from: - Measurement & Timing issues ( for Multiple Elements) - Classification issues ( For a Specific Element) Measurement & Timing issues  Errors in measurement and/or timing typically affect multiple financial statement elements. (Aggressive or conservative revenue recognition). Classification issues  How an individual financial statement element is categorized within a particular financial statement. Classification issues typically affect a Specific element. Classification shifting will never result in a higher Reported income.

Biased Accounting Biased accounting choices seek to further a specific agenda – to sell a story. Some examples of biased accounting choices and their related warning signs are shown below. Mechanisms to misstate profitability: - Aggressive revenue recognition, including channel stuffing, bill and hold sales, and outright fake sales. - Lessor use of finance lease classification. - Classifying non-operating revenue/income as operating, and operating expenses as nonoperating. Warnings signs of Misstated profitability: - Revenue growth > than peers - Receivables growth > than revenue growth - Higher rate of customer returns - High proportion of revenue is received in final quarter - Unexplained boost to Operating margin - Operating CF < than Operating income - Aggressive Accounting assumptions Mechanisms to misstate Assets & Liabilities: - Choosing inappropriate models or models inputs and thus affecting estimated values of financial statement elements. - Reclassification from current to non-current. - Over or understating allowances and reserves. - Understating identifiable assets in acquisition method accounting for business combinations.

Warnings signs of misstated Assets & Liabilities: - Inconsistency in model inputs for valuation of assets versus valuation of liabilities. - Typical current assets being classified as Non-current - Allowances & reserves differ from those of peers & fluctuate over time. - High Goodwill to Total assets. - Use of SPE - Large fluctuations in DTA & DTL Mechanisms to overstate operating cash flows: - Managing activities to affect CFO - Misclassifying CFI as CFO Warnings signs of Overstated Operating cash flows: - Increase in payables combined with decrease in inventory & receivables - Capitalized Expenditures - Increases in bank overdraft Business combination – Acquisition method accounting M&A often provide opportunities & motivations to manage financial results. Cash acquisitions are reflected in CFI activities. If acquisitions are paid for using stock, such payment would bypass the cash flow statement altogether. Stock acquisition provides an incentive to the acquiring & the acquired company to inflate their stock price prior to acquisition. In some cases, misreporting is actually the impetus for acquisitions: acquiring company managers may pursue acquisitions to hide pre-acquisition accounting irregularities. Acquiring companies often underestimate the value of identifiable net assets – thereby overestimating goodwill on acquisition. The effect of overestimating goodwill, since goodwill is not amortized, is to increase future reported profits. Such overestimated goodwill will eventually have to be written down. GAAP accounting but not Economic reality Results in financial reporting do not always faithfully represent Economic reality (no SPE consolidation before the Enron Case). Restructuring provisions & impairment losses provide opportunities to time the recognition of losses. Provisions are non-cash expenses charged in the current period, future expenses from such provisions bypass the IS. In such cases, losses recognized in the current period will boost income in the future when reversed. Evaluate the Quality of a firm’s financial report Step 1: Understand the company, its industry & the accounting principles it uses Step 2: Understand management including the terms of their compensation Step 3: Identify material areas of accounting that are vulnerable to subjectivity Step 4: Make Cross sectional & Time series comparisons of financial statement Step 5: Check for warning signs Step 6: Check for shifting of profits or revenues to a specific part of the business Step 7: Use Quantitative tools to evaluate the likelihood of misreporting

The Beneish Model Probit Regression Model that estimates the probability of earnings manipulation using 8 dependent variables. The M-score determines the probability of earnings manipulation.

Limitations of the Beneish model: -

Relies on Accounting data which may not reflect Economic reality Deeper analysis of underlying relationships may be warranted to get a clearer picture As managers become aware of the use of specific Quantitative tools, they may begin to game the measures used

Altman Model Not directly related to Earnings quality, Altman’s Z-score model was developed to assess the probability that a firm will file for bankruptcy. It relies on discriminate analysis to generate a Z-score using 5 variables: -

Net WC as a proportion of total assets Retained Earnings as a proportion of total assets Operating profit as a proportion of total assets MV of Equity relative to BV of liabilities Sales relative to assets

Interpreting Altman’s Results : - X > 3  Low probability of Bankruptcy - X < 1.81  High prob. Of Bankruptcy - 1.81 < X < 3  Uncertain

Each variable is positively related to the Z-score & a higher Z-score is better (less likelihood of bankruptcy). Limitation: Single period static model which does not capture the change in key variables over time. Accounting data Indicators of Earnings quality High Quality Earnings are characterized by 2 Elements: - Sustainable (High-quality earnings tend to persist in the future) - Adequate (High quality earnings cover the company’s cost of capital) As stated previously high quality earnings assume high-quality reporting. Sustainable or Persistent Earnings  Earnings that are expected to recur in the future Earnings comprised of a high proportion of non-recurring items are considered to be nonsustainable. Classification of items as non-recurring is highly subjective & hence, is open for gaming. Classification shifting does not affect the total NI but rather is an attempt to mislead the user of the financial statement into believing that the core or recurring portion of earnings is higher than it actually is. Conservative Recognition  Higher the sustainability of earnings

Accruals: Under the Accrual basis of Accounting, revenues are recognized when earned and expenses are recognized when incurred, regardless of the timing of CF. More use of Discretion. Unfortunately, accrual accounting requires considerably subjectivity because of the many estimates & judgments involved with assigning revenues and expenses to appropriate periods. More Timely information about future CF compared to the Cash Basis accounting . Due to this subjectivity in revenue & expense recognition, disaggregating income into its 2 major components: Cash & Accruals

The accrual component of income is less persistent than the cash component. In the following regression model B1 > B2:

It is important to recognize that some accruals occur as part as normal business, nondiscretionary accruals. Discretionary accruals result from non-normal transaction or nonnormal accounting choices, & are sometimes used to manipulate earnings One mechanism to separate discretionary & non-discretionary accruals is to model total accruals as a function of a set of factors that typically give rise to normal accruals. The residuals from such a model would be an indicator of discretionary accruals. Finally, a Major Red flag is raised about earnings quality when a company reported Positive NI while reporting Negative CFO. Other indicators One metric used to identify potential low quality earnings is to look for those companies that repeatedly meet or barely beat consensus estimates. When examining NI, analysts should be aware that earnings at Extreme levels (+/-) tend to revert back to normal levels over time. This phenomenon is known as Mean Reversion. Because of mean reversion, analysts should not expect extreme earnings to continue indefinitely. When earnings are largely comprised of accruals, mean reversion will occur faster, and even more so when the accruals are largely discretionary. Evaluate the Earnings Quality of a company Accounting systems require many estimates & rely on many subjective choices. These estimates & choices can be misused by managers to present misleading performance. 2 Major contributors to earnings manipulation are: - Revenue recognition issues - Expense recognition issues (capitalization). Subjectivity in revenue recognition practices makes revenue highly vulnerable to manipulation. Revenues generated by Channel Stuffing or Bill-and-hold Arrangements should be considered spurious & inferior. A higher growth rate of receivables relative to the growth rate of revenues is a red flag. Similarly, an increasing days’ sales outstanding (DSO) over time is an indication of poor revenue quality. Channel Stuffing  Inducing customers to order products just before year-end by offering them generous terms, such as favorable pricing. Contingent Sales  Induce customers to buy by offering the right to return.

Expense Capitalization One way to boost reported performance is to under-report an Operating expense by Capitalizing it. Capitalizing & expense does however show up one the BS as an asset and an analyst should be wary of unsupported changes in major asset categories. When the proportion of PP&E increases over time in common size balance sheets, analyst should question whether there is a systematic capitalization of expenses underway. Indicators of CF quality High Quality CF means the reported CF was high & the underlying reporting quality was also high. Because operating CF has the most direct impact on the valuation of a company, we will focus on CFO while evaluating CF. (Red Flag: Positive NI & Negative CFO) High quality CF is characterized by Positive CFO that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments. High quality CFO is characterized by Lower volatility than, that of the firm’s peers. Significant differences between CFO & earnings, or differences that widen over time can be an indicator of earnings manipulation. Management can affect CF by Strategic decisions ( Timing) Evaluate the BS Quality of a company Completeness  Could be compromised by the existence of Off-balance-sheet liabilities such as incorrect use of the operating lease classification or purchase agreements structured as take or pay contracts. The Equity Method of accounting would result in certain profitability ratios being higher than under the Acquisition Method. Firms consolidating several subsidiaries with close to a 50% ownership stake by using the Equity method would be a cause of concern  Low Quality if investments are voluntarily kept under 50% to use the equity method. Unbiased Measurement  The BS reflects subjectivity in the measurement of several assets & liabilities Clear Presentation  Companies have discretion regarding the presentation, clarity of presentation is very important for an analyst. Source of information about risk Financial Statements  Contain information regarding the leverage & the variability of cash flows and earnings over time Auditor’s report  Audit report provides only Historical information. However, involuntary changes in auditors, a small sized audit firm relative to the size of the company being audited, and a lack of auditor independence are red flags that an analyst should pay attention to.

Notes to Financial statements  Companies are required to make certain risk related disclosures in the Notes to financial statements. Both GAAP & IFRS require companies to disclose risks related to Pension benefits, Contingent obligations & Financial instruments. Management Discussion & Analysis (MD&A) Firms should include principal risks that are unique to the business in their MD&A. SEC form NT  In the US, SEC form ‘NT’ is filed when a firm is unable to file required reports in a timely manner. Because such an occurrence is usually due to breakdown in accounting system or internal controls, or the discovery of misrepresentation that needs to be investigated Financial Press  Often the initial information about accounting irregularities at a company is obtained from the financial press.

AQI variable  Measures the change in proportions of assets, other than PPE & current assets, overtime. (cf. Beneish Model); A value greater than 1 for AQI indicates an increase in proportion of assets other than PPE and CA and may indicate excessive expenditure capitalization. Integration of Financial Statement Analysis Techniques

DuPont decomposition:

It allows us to identify the firm’s performance drivers, allowing us to expose effects of weaker areas of business that are being marked by the effects of other, stronger areas. The Equity method is used to account for influential investment. Under the equity method, the investor recognizes its pro-rata share of the investee’s earnings on the IS. Eliminating the equity income from the investor’s earnings permits analysis of the investor’s performance resulting exclusively from its own asset base. Assuming the investee is profitable, this adjustment will decrease both the investor firm’s earnings and net profit margin. Since under the equity method, the firm’s investment is reported as a BS asset, total asset should be reduced by the carrying value of investment. This will increase total asset turnover. We can use the overall DuPont Equation to estimate the overall effect on ROE. Capital Allocation decisions Consolidated financial statements can hide the individual characteristics of dissimilar subsidiaries. Firms are required to disaggregate financial information by segment to assist users. Recall that a Business Segment is a portion of a larger company that accounts for more than 10% of the company’s revenues or assets, & is distinguishable from the company’s other line of business in terms of risk and return characteristics. Geographic Segment are also identified based on the same criteria. Although required disclosure under US GAAP & IFRS is limited, the disclosures are valuable in identifying each segment’s contribution to revenue & profit, the relationship between capital expenditures and rates of return, and which segments should be de-emphasized or eliminated. Earning quality & CF analysis Earning quality  Persistence & Sustainability of a firm’s earnings. Earnings that are closer to CFO are considered higher quality. Earnings are subject to accrual accounting events that require numerous judgments & estimates. As a result, earnings are more easily manipulated than CF. We can disaggregate earnings into their CF & accruals components using either a BS approach or a CF statement approach. With either approach, the ratio accruals to average net operating asset can be used to measure earnings quality.

Accruals ratio Balance sheet approach, we can measure accruals as the change in Net Operating Asset over a period. Net Operating Assets (NOA) = Operating Assets - Operating Liabilities Operating assets are equal to total assets minus cash, equivalent to cash and marketable securities. Operating liabilities are equal to total liabilities minus total debt.

Just like ROA & ROE the measure can be distorted if a firm is growing or contracting quickly. Scaling the measure allows for comparisons with other firms. Scaling is done by dividing the accrual measure by the average NOA for the period. The result is the Accrual Ratio:

Cash flow statement approach we can also derive the aggregate accruals by subtracting CFO & CFI from reported earnings:

Recall that IFRS allows some flexibility in the classification of certain CF, Primarily interest and Dividends paid. For US GAAP it may be necessary to reclassify these CFO to CFF activities for comparisons purposes. Wide fluctuations of this ratio may indicate earnings manipulation. The accrual ratio based on the CF statement is:

Market value decomposition

Agressive Revenue Recognition : - + Account Receivable - + Revenues - + Expenses - + Income - + Equity

When a parent company has an ownership interest in an associate it may be beneficial to determine the standalone value of the parent. Standalone Value of the Parent  Implied value of the parent without regard to the value of the associate. The implied value is equal to the parent’s market value less the parent’s pro-rata shares of the associate’s market value.

Off-balance-sheet financing There are a number of Financing arrangements that are not reported on the BS. One of the most common forms of Off-balance-sheet financing is Operating lease. Operating lease  Rental arrangement: the lessee report neither an asset nor a liability related to the lease on its BS, even though the lessee may have a contractual obligation under the lease agreement. The lessee only report Rental expense, equal to the periodic lease payment, on the IS. Finance lease  Treated as a purchase an asset financed with debt. Thus, the lessee reports an asset and a liability on its BS. On the IS the lessee reports depreciation expense and interest expense instead of rental expense. For Analytical purposes an Operating lease should be treated as a Finance lease, increasing asset and liability by the PV of the remaining lease payments. Stockholder’s equity is not affected by this adjustment. Capitalizing an Operating lease will increase Financial Leverage because of the increase of liability. In the IS it is necessary to replace the rental expense for the operating lease with depreciation expense and interest expense. In the early year depreciation & interest expense will exceed the lease payment. As a result, NI will be lower in the early years for a Finance lease compared to operating lease & the interest coverage ratio will likely decline. Other examples of Off-BS Financing techniques are: - Debt guarantees - Sales of receivables with recourse - Take or Pay agreements In each case the analytical adjustment is similar to the operating lease adjustment; that is, increase assets & liabilities by the amount of the transaction that is off-BS. ROE = tax burden * interest burden * EBIT margin * asset turnover * financial lev. Tax burden = NI / earnings before tax = 1-tax rate Asset turnover = revenue / total assets (mean) Percentage of big value due to ownership of small = Pro rata shares of small market capitalization / Big’s market capitalization.  An adjustment of devise could have to be made. When adjusting from operating lease  operating profit would increase....