FSA Test1 Cheat Sheet - Summary Financial Statement Analysis PDF

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Test1 Cheat Sheet...

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• What is the 6 step process in FSA?——1. Identify Economic Characteristics and Competitive Dynamics in the Industry 2. Identify Company Strategies 3. Assess the Quality of the FS 4. Analyze the profitability and risk 5. Project future financial statements 6. Value the firm • What can be done to identify Industry characteristics?——Use competitive ratios to compare across the several industries. For example: Profit Margin (Net Income/Sales). Asset Turnover: (Sales/ Total Assets). ROA: (Net Income/ Total Assets) . LTD/TA: (Long term debt/total assets) • Value Chain Analysis Views a firm as a series of business processes that each add value to the product or service • Porter's Five Forces threat of entry, threat of substitute, supplier power, buyer power, and competitive rivalry • What is "Rivalry amongst existing firms?" ——The first order of competition. It is the intensity of the competition • Determinants of the intensity of competition——Industry growth rate, degree of differentiation,switiching cost,Scale economies and ratio of fixed to variable costs (airline ind)，Excess capacity and exit barriers (Automotive + Steel Ind.) • Threat of New Entrants——Economies of Scale，First mover advantage Access to channels of distribution and relationship Legal Barriers • Concentrated vs Diffuse Rivalry——Concentrated is more profitable, diffuse is less profitable • Economics of Scale——New Entrants have two choices -Invest in large capacity or enter with less than optimum capacity (Both Suffer Cost Disadvantage) Might arise from -Large investments in R&D-Brand Advertising-PPE • First Mover Advantage——-Set industry standards-Exclusive arrangements-Cost advantage for learning economies-Acquire scarce govt. licenses-Could cause a large switching cost • Access to Channels of Redistribution and Relation——-Existing distribution has limited capacity-Developing new channels is costly-Existing relationship between firms and customers -Could enjoy cost advantage -Could be large when there are significant switching costs • Legal Barriers——Patents, copyrights, licensing regualtion • Threat of Substitutes——Existing products that have the same function but have different forms。Competition increases and profitability decreases 。Strategies: Products with few substitutes，Product quality，Brand recognition，Customer Loyalty，Marketing Strategy • Supplier Power——Powerful suppliers are price setters-Lots of buyers and few suppliers-Reduce the profit margin-Pass pressure on to the customer Strategy: More suppliers • Buyer Power——Relative Bargaining Power -A few of buyers make large purchase from many suppliers -decrease price and profitability *Price sensitivity -Undifferentiated products -Low switching costs -Cost structure -The importance of the products to buyers own product quality • Economic Attributes Framework——Demand, Supply, Manufacturing, Marketing, Investing & Financing • Limitations of Industries Analysis——It is not easy to demarcate industry lines • Step 2 of FSA——Identify the Company Strategies -Nature of product or service -Integration with the value chain -Geographical diversification -Industry diversification • Nature of Product or Service——Strategy: Cost leadership or differentiation • Vertical Integration and Horizontal Integration——Strategy:Practice where a single entity controls the entire process of a product, from the raw materials to distribution. Combining organizations at the same level of operation under one management. •Step 3 Assess the Quality of the Financial Statements •Step 4 Analyze Profitability and Risk: Common-size financial statements Changes in percentages Ratios • Step 5 Forecasted Financial Statements • What is the "Delegation of Reporting Management"? -Complex judgements that are required in order to recognize how a company makes certain decisions on where prices or costs come from (Look at notes section in Financial Report) -Flexibility allows them to signal information or disguise reality • Traits of being relevant Confirmatory value, predictive value, materiality • Traits of having faithful representation Completeness, neutrality, freedom from error • mixed attribute model different types of assets and liabilities are valued using different measurement bases (Historical v Fair Value) -Managers need discretion in making estimates relevant -Also can misuse their discretion and inject bias; decrease reliability • What are the types of historical costs? Acquisition cost: Amount initially paid to acquire the asset (Prep costs included) Adj Acquisition cost: As asset is consumed, it is expensed (Depreciation or COGS) Present Value: Used for monetary assets and monetary liabilities. (Lots of different discount rates they can use) • What does the FASB and IASB perceive Fair Value as? FASB: exit price；IASB: Exit and entry price -are mostly used for financial assets and liabilities • What are the three tiers of Fair Value? Level 1: Traded in liquid and orderly mkt, valued using latest mkt prices Level 2: Not traded in liquid mkt, can be valued using financial models whose inputs are available from liquid markets Level 3: Not traded in liquid mkt, can be valued using financial models but require managers to estimate inputs • What are the methods of fair values for non monetary assets Current Replacement Cost: Cost to pay to acquire or produce a new one；Net Realizable Value: Net amount a firm would receive if it sold an asset • Income Recognition Approach 1: Historical Approach: Recognized in BS and IS only during market transaction; Approach 3: Current Value: Recognized in BS and IS as it changes over time; Approach 2: Hybrid Changes in balance sheet as it occurs over time-Changes in Income statement when realized in a market transaction • External auditing laws and rules Sarbanes-Oxley Act; Relationship between the firm and the auditor; Public Company Accounting Oversight Board (charged with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies); All Public Accounting Firms ; Integrity of the reported financial statements • Incentive to improve accuracy of FS Legal liability; Threat of lawsuits, potential for significant legal liability might discourage accounting proposals where management and auditor judgement come into play. • Factors influencing accounting quality? Noise from accounting rules; Forecast Errors; Managers Accounting choices (Compensation, FIFO/LIFO, Competitive consideration) Steps in Performing Accounting Analysis Step1: Identify Principal Accounting Policies; Step2: Assess Accounting Flexibility; Step3:Evaluate Accounting Strategy; Step4: Evaluate the Quality of Disclosure; Step5: Identify Potential Red Flags; Step 6: Undo Accounting Distortions • Step 1 of Performing Accounting AnalysisIdentify key success factors in the business! e.g Banking... Credit risk management; Manufacturing…product quality; Equipment Leasing... Accurate residual value forecast

• Step 2 of Performing Accounting Analysis Assess Accounting Flexibility! -Not all firms have equal accounting flexibility e.g R&D is a key factor for some companies; no discretion in reporting; Marketing and branding must be expensed for goods firms; Managing credit risk is the critical success factors for banks and bank managers have freedom to estimate defaults -Managers have some flexibility; Depreciation policy+Inventory accounting policy • Step 3 of Performing Accounting Analysis Evaluate Accounting Strategy!; Compare to other firms in the industry!; Has firm changed policies or estimates... have they been realistic; Does the firm structure and significant business transactions so that it can achieve certain accounting objectives • Step 4 of Performing Accounting Analysis Evaluate the Quality of Disclosure! Whether information discloses current performance and is consistent with the current performance • Step 5 of Performing Accounting Analysis Identify Potential Red Flags! -Unexplained transactions that boost profits -Unusual increases in inventory or A/R in relation to sales -Use of R&D partnership, SPE's -Asset write-off • Step 6 of Performing Accounting Analysis Undo Accounting Distortions! CF Statement; Financial Statement footnotes ; Tax footnote • Accounting Analysis Pitfalls -Conservative accounting may also be misleading... historical cost and accounting for intangible assets -Do not attribute all changes in a firms accounting policies and accruals to earnings management • Incentives to Practice earnings management -Upwards earnings management (Increase managers compensation, avoid takeover, decrease cost of debt, increased benefits from IPO, insider selling) • Downwards Earnings Management incentives Discourage earnings management, reduce the probability of antitrust actions, tax issues and capital requirements, suppress stock prices and thus yield favorable terms when taking a company private, insider purchase • Deterrents to Earnings Management SEC, reputation, legal consequence, audits, scrutiny of analysts/investors • Accounting quality in the liability recognition -Firm knows that it will have to sacrifice economic benefits at a specified date -The firm has a present obligation and little or not discretion to avoid the transfer -The transaction or event that give rise to the obligation has already occurred • Obligations with Estimated Payment Dates and amounts -Requires estimation because the firm cannot identify the specific future recipients -Cannot compute amount of resources it will transfer in the future -Unexpected changes in this type of liabilities • Obligations with fixed payment amounts but estimated payment dates Most current op. liabilities fall into this category. Firms normally settle these obligations within a few months after incurring them Qual. Concerns The lack of an interest rate assumption in measuring the liabilities, short run nature, tendency for amounts be fixed contract • Obligations from advances or unexecuted contracts and agreements The important balance sheet and earnings quality issue is whether revenue has been recognized too early ex: when to recognize Gift card as revenue when they are not claimed. • Obligations under mutually unexecuted contracts Arise when two entities transfer agree to transfer resources but neither has made a transfer. • Contingent obligations obligations that arise conditional on something else occurring, such as a performance based bonus • Off Sheet Financing Leases Sales of receivables Product Financing Arrangements Research and Developing Financing Agreements Take-or-pay or throughput contracts • Leases- How is it off sheet? Lessors deliver a long-lived asset for the lessees non cancelable promise to pay cash -Operating lease (like renting) are considered operational expenses and is not on balance sheet -Capital lease (like loan) treated as being owner by lessee so it stays on balance sheet Problem? -Understate long term liabilities -Understate longterm solvency risk ratio(overstate return on assets) • Sale of Receivables Is it a loan or sale of assets -Yes, it is like a collateralized loan (gets money and promises to pay back) -No, it sold an asset GAAP requires that it is a transfer of receivables if it surrenders control -Can't access recievable in case of bankruptcy -Buying firm(SPE) takes the right to exchange the transferred asset -No repurchase plan or cause to repurchase • Product Financing Agreement Firms recognize product financing arrangements for two conditions -Arrangement requires firm to purchase the inventory at specific price -The payment made covers all acquisition, holding, and financing costs Form a joint venture -Because they are equally owned, neither firm recognizes consolidate joint venture FS with • R&D Financing Agreement their own FS -Report their shares as an investment -Liabilities and R&D expense appear only on FS of joint venture, -Recognize as a liability if -Requires sponsoring firm to repay any of the funds by the other parties -Sponsoring firm bears the risk of failure of the R&D work Agreement in which purchaser agrees to pay specified amounts periodically to a seller for product/service • Take or Pay Contracts -Sign agreement to joint venture, free to make certain payments to venture every month (sufficient to cover operating financing costs -the two firms have signed non cancelable purchase commitment -No benefits that obligate them to pay, as they receive benefits or obligations, liability arises. • What are the Asset Distortions? 1. Delayed asset write-downs 2. Underestimated reserves 3. Accelerated recognition of revenues • Delayed Asset Write-Downs Investors: Write downs are directly charged to earnings Creditors: Increase leverage Inventory: Growing inventory and receivables, write down of similar products by competitors PPE: Warning sighs declining longterm asset turnover, declines in return on assets to below the cost of capital for the firm, industry benchmark • Underestimated Returns Allowance for bad debts or loan losses Warning signs: -Growing receivables -Business downturns for a firms major clients Growing loan delinquencies • Accelerate Recognition of Revenues Warning Signs: Receivables growth outpacing sales growth, and increasing days receivable -"Bill and hold" : bill customers for sales and hold merchandise until later delivery • Tools in the Assessment of Accounting Quality Portioning earnings into operating cash flow and accrual components • Sloan (1996) defines accruals as... (Net income-Op. CF)/Avg Total Assets • DSRI Days' sales in receivables -Large increase may indicate an overstatement of AR • GMI Gross Margin Index -If GMI>1 , sales are deceasing and might have higher incentive to manipulate • AQI Asset Quality Index -Uncertainty in intangible assets -> firm capitalizes expenses • SGI Sales Growth Index -Growing companies, low cost external financing may cause managers to manipulate sales and earnings • DEPI Depreciation Index -Increase might show that the firm has slowed the rate of depreciation -> increasing earnings • SAI Selling and Administrative Expenses Index -When you invest more you want to increase sales -> hard to keep pace = yes-When they do not take advantage of capitalizing and it was expensed = no • LVGI Firm is likely to violate debt agreement and needs to manipulate earnings to comply • TATA Total assets to total accruals -Greater accruals can serve as means of manipulating earnings...