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FRAMEWORK
The primary reason for performing financial statement analysis is to
facilitate an economic decision.
The framework for the analysis contains six phases:
1. Define the purpose for the analysis
2. Collect input data
3. Process data
4. Analyze/interpret the processed data
5. Develop and communicate conclusions
6. Follow-up
DUPONT ANALYSIS
Nestls ROE:
2007
2006
2005
10.58%
10.00%
9.44%
Assets turnover
0.994
0.963
0.955
Leverage
2.02
2.01
2.16
21.25%
19.36%
19.48%
ROE
Deleveraging
*Does not add to 100% because of rounding
SEGMENT ANALYSIS
Business Segment: A portion of a larger company that accounts for
more than 10% of the companys revenues or assets and is
distinguishable from the companys other lines of business in terms of
risk and return characteristics.
Conducting segment analysis helps analysts understand any
geopolitical investment risks.
Ratio of capital expenditures proportion to total asset proportion ranked
by EBIT margin:
- A ratio < 1 indicates that the segment is being allocated a lesser
proportion of capital expenditures than its proportion of total assets.
- A ratio > 1 indicates that the company is growing the segment.
- Comparing the ratio with the EBIT margin gives an analyst an idea of
whether the company is investing its capital in the most profitable
segments.
Copyright 2013 CFA Institute
EARNINGS QUALITY
Earnings quality: The persistence and sustainability of a firms earnings.
Ways to evaluate earnings quality:
Analyze the accruals: Accrual ratio fluctuations indicate the use of accruals
to time earnings.
where NOA = Net operating Assets, CFO = Cash flow from operating, and CFI
= Cash flow from investing.
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EARNINGS QUALITY
Nestl example:
Fluctuated significantly.
Much higher in the most recent
year than in the earlier years.
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EARNINGS QUALITY
Study the companys cash flow and its relationship to net income. Are
operating earnings backed by cash flow, or are the operating earnings
more of an accounting result?
- Appropriate adjustments to keep the comparisons between cash
flow and earnings symmetrical:
a) Add the cash paid for interest and taxes to the operating cash
flow. The resulting operating cash flow before interest and taxes
is the relevant operating cash flow for comparison with the
operating income.
b) Add goodwill amortization to the period prior to 31 March 2004.
IFRS 3, Business Combinations, suspended the amortization
of goodwill after 31 March 2004. To amortize goodwill in some
but not other years of operating earnings would produce a
misleading trend in the ratios.
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EARNINGS QUALITY
Examine the relationship between operating cash flow and total assets.
Total assets reflect the sum of managements resource allocations.
Compare cash flow with reinvestment, debt, and debt-servicing
capacity.
Results indicate
-
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VALUATION: EXAMPLE
To determine the value that the market is placing solely on the
companys operations, analysts need to remove the value of the
companys holdings of other companies from the market value.
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OFF-BALANCE-SHEET LEVERAGE
Off-balance-sheet leverage refers to operating leases.
Capital lease
- Is reported as an asset and liability on lessees balance sheet.
- Results in interest expense and depreciation expense (instead of rental
expense) on lessees income statement.
When capitalizing an operating lease, the lessees
- Financial leverage increases.
- Interest coverage ratio decreases.
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$1,075 is added to total assets and total longterm debt when calculating ratios in the pro forma
column if operating leases are capitalized.
Copyright 2013 CFA Institute
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What is the financial leverage if the company (1) treats them as sold and
(2) holds securitized financial receivables on the balance sheet?
1) 3,610,600/976,500 = 3.70
2) (3,610,000 + 267,500)/976,500 = 3.97
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SUMMARY
The framework of financial statement analysis contains six steps:
define a purpose for the analysis, collect input data, process data,
analyze the processed data, communicate conclusions, and follow-up.
Earnings are more easily manipulated than cash flows. An effective
way to examine earnings quality is to examine the pattern between
operating income and operating cash flows.
To make a logical comparison, adjustments need to be made prior to
conducting financial statement analysis. For example, adjustments
may include removing assets owned and return earned by affiliates
that are not under control of the company.
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