ACCT1511: AFM1B

Revisiting Financial
Statement Analysis
Topic 5.1

Week 9
 Learning Objectives

LO1. Comparative financial statement analysis

LO2. Pricing and valuation
LO3. Market and macro factors
LO4. Limitation of financial statement analysis
 Outline: Financial Statement Analysis and Accounting Policy
Choice
Financial Statement Analysis (FSA):
LO1. What is FSA? Revise ACCT1501
LO2. Which FSA tools should you choose?
LO3. Calculate and interpret a variety of ratios
LO4. Impact of a transaction on ratios, some analysis
LO1. Comparative FSA
LO2. Pricing and valuation
LO3. Market and macro factors
LO4. Limitation of FSA
3
The following ratios will be provided in the final exam

Memorising not
required…
Who uses financial statement analysis?

• Managers, for strategic and operational decision making.

• Investors and financial analysts, to evaluate
management performance and to make investment
decisions.
• Creditors, to make lending decisions.
• Auditors, to assess the reasonableness of financial
statement values.
• Suppliers, to assess opportunities and ability to repay.
What to do before you start analysing
• Learn about the company
• Consider the decision to be made (e.g. invest, lend, etc.)
• Calculate relevant ratios
• Obtain comparative data (e.g. previous period,
competitors, industry)
Sources of information about a company

• Financial statements are only one source of

information about a company.
• Other sources of information include:
– financial newspapers
– press releases
– internet
– economy-wide factors
– information about other companies.
 What is a share price?
• A share price is the price on a stock market that one
share of a company’s equity trades for.

$5.70 for 1 share

Source: Google Finance 12/9/2017
Share Price can be used as part of a profitability analysis

Source: Palepu et al. (2010) Business Analysis & Valuation, Cengage.

 What is a Earnings per share?
Earnings per share = (Operating profit after tax – Dividends on preference shares)
Weighted average number of ordinary shares outstanding

Source: Yahoo Finance 12/9/2017

Source: Yahoo Finance 12/9/2017

Price / earnings ratio = Market price per ordinary share
Earnings per share
Think about it this way: the purchaser of the stock is investing
$12.38 for every dollar of Qantas’ earnings

Source: Yahoo Finance 12/9/2017

Comparative Analysis Source: Yahoo Finance 13/9/2017

Qantas

Qantas Cathay China Singapore Virgin

China
Pacific Southern airlines Airlines
Southern
airlines
Cathay
Pacific

Cathay
Pacific
Singapore
airlines

1/1/2013 1/1/2014 1/1/2015 1/1/2016 1/1/2017

Virgin
airlines
Which company
should I invest
in?
Which company should I invest in?

Ratios can help us aid our decision making

 Source: Yahoo Finance 13/9/2017
Valuation Metrics (Unless otherwise
stated, prices are in local country Forecast EPS: FT Markets 13/9/2017.
currency)
Company Stock Price Excepted Market
exchange 13/9/2017 EPS Forecast Cap
ticker EPS (AUD)

Cathay 0293.HK HKD11.98 -0.15 0.16 7.51B

Pacific
Airways
China 1055.HK HKD6.090 0.45 0.58 14.74B
Southern
Airlines
Qantas QAN.AX AUD5.80 0.46 0.60 10.11B
Airways

Singapore C6U.SI SGD10.34 0.29 0.38 11.32B

Airlines
Virgin VAH.AX AUD0.185 -0.03 0.01 1.564B
Australia
 Performance Metrics (13/9/2017) Source: Yahoo Finance 13/9/2017

Price/ ROA Profit ROE Debt/ Current

P/E Book Margin Equity Ratio

Cathay -82.05 0.51 -1.25% -3.21% -5.15% 135.84 0.66

Pacific
Airways
China 18.25 8.80 2.2% 3.32% 8.59% 177.55 0.22
Southern
Airlines
Qantas 18.47 2.98 5.06% 5.31% 25.09% 136.67 0.44
Airways
Singapore 35.655 0.92 2.41% 2.42% 2.75% 11.98 0.91
Airlines
Virgin -6.61 1.01 0.19% -4.37% -15.03% 154.61 0.76
Australia
Currency differences
Can I compare company ratios if the company has
different currency?

Yes!
If you calculate the PE ratio from price and
earnings per share which are both in the same
$AUD $SGD currency, the currency unit cancels out and you
get a number that has no unit scale. As such,
P/E = AUD5.80 P/E = SGD10.34 you can compare the PE ratios of companies
AUD0.46 SGD0.29 from different countries.

= 18.47 = 35.655
Comparative Analysis
Which competitors would be best?

McDonalds (MCD) Owned by Restaurant Yum! Brands (YUM)

Brands (QSR)
Only one business is this company Multiple business is this company
Group includes Tim
Hortons
Sometimes a business is part of another consolidated group.
 Comparative Analysis
Putting your Ratio Analysis to work
Select Company(s)/ Industry/ Sector

Peer firm selection:

Find the closest among the comparable
companies to your firm of interest.
19
Finding a Comparable Firm
Find the closest among the comparable companies in your selection

What is the comparable firm for Woolworths?

• Coles (Wesfarmers) / business lines do not match
• IGA (Metcash) / scale – franchise format
• Aldi (privately owned) / discount
• Costco / hypermart, bulk-buying club

20
 Think about Apple
What is the comparable firm for Apple AAPL?
• Desktops /Laptops/ Tablets : computing devices
• Mobile phones: telephony devices
• Portable music: consumer electronic devices
• Music, Apple store: online retail

21
 What is the Comparable Firm for Apple ?

22
Peer comparison – past exam question (from 2011s2)

Question 1: Give One (1) reason why your choice of peer

comparison is appropriate.
Hints:
Would depend on choice of peer comparison, should be along the
lines of that the peer company is in a similar industry/ sells similar
products
Must be appropriate to the company, e.g. HPQ because they sell
computers and AAPL sells computers too
Peer comparison – past exam question (from 2011s2)

Question 2: Give One (1) reason why your choice of peer comparison
company may not be appropriate.
Hints:
Would depend on choice of peer comparison
Should be along the lines of that AAPL has a broad product/
service range that other companies do not match well
 AAPL vs HPQ: Understand the Business Model
Why is AAPL not a good choice as a competitor for HPQ?
AAPL
• Outstanding industrial design
• Proprietary operating systems locks customers in
• Seamless integration among products/ services
• Has cult following
HPQ
• Products have become commoditised
• Customers switching to convergence devices, cloud based
computing?
Analysis of the Business Model is part of a complete business analysis method

Source: Palepu et al. (2010) Business Analysis & Valuation, Cengage.

Business model/ Strategy is important

Where does the cash come from:

Fiat vs Ferrari

Both car companies, but vastly different strategies for

generating cash.

Impact on accounting ratios?

Turnover vs. Margins
Higher sales turnover means better?
Woolworths (Supermarket) vs. David Jones (Dept.
Stores) vs. Premier Brands (Specialty Retail)?
Woolworths vs. Prada (Luxury fashion / footwear;
1913.HK)
Service versus Products
Product => scalable revenue
Service => not scalable, need
more human capital
 AAPL vs HPQ: Competitive Threats
AAPL HPQ
• Threat from Android based Commoditised markets:
phones/tablets: lawsuit against competes on price not
Samsung regarding tablets innovation
• Product development pipeline
• Market saturation?

30
 AAPL vs HPQ: Special Circumstances

New product launch, “Hot” on “In” product: iPhone 8,

iPhone X

Acquisition/ disposal of assets: HPQ to consider exit

desktop/laptop business?

Steve Jobs and his influence on AAPL

31
 Past exam question: Session 2, 2011 Final (Supplementary)

Question: In financial statement analysis, it is important to consider

special situations or context that may affect your analysis. Give two
(2) reasons from the information provide or from your general
knowledge that may affect your decision. (4 marks)
Suggested Answers:
Steve Jobs was the visionary CEO of AAPL driving product
development. Now that he passed away it is uncertain whether
the current management of AAPL can continue his legacy.

While AAPL has quickly dominated areas such as smart phones

and tablets, it would seem that Android based platforms by
Google (GOOG) may seriously erode their dominance.
32
 AAPL vs HPQ: Ratio Analysis

Use the Ratios you learnt in ACCT1501:

Do they tell you that AAPL is superior to HPQ?

In this case AAPL has been doing so well in the past few years, it
would be outperforming its various peers on nearly every Ratio

33
Ratio formulas are provided in the exam, as in
workshop/tutorial questions
They are not important to memorise, because we are only
interested in application and interpretation
There are many acceptable versions of the same ratio
• For example, ROA may be EBIT/ASSETS, or
NPBT/ASSETS, or NPAT/ASSETS
• Need to be flexible in applying ratios appropriate
to the context
Ratio Analysis: Profitability Ratios

In general, a profitable company shows..

Positive return
Compare ROE & ROA against cost of capital
Ratio Analysis: Activity Turnover
Asset/Inventory turnover
Inventory Turnover – the higher, the better or worse?
Woolworths 2007 T&G p.710-711
• Turnover ratio = 31,832.8/ [(2,739.2+1,902.9)/2] = 13.714
• Days inventory = 365/13.714 = 26.6 days
AAPL 2011 from finance.yahoo.com
• Turnover ratio = 64,431/ [(776+1,051)/2] = 70.53
• Days inventory = 365/70.53 = 5.2 days
Low Inventory Turnover may indicate:
• Obsolete products
• High storage costs (affect expense)
45 days for Prada? LVMH?
Ratio Analysis: Liquidity Ratios

Ideal Current Ratio?

• Traditional view: above 1 is better
– Shows positive Working Capital (CA – CL)
– Stable cashflows situation
– Enough current assets available to fire sell to cover current liabilities in
worse case scenario
• Modern view: below 1 is better
– Negative working capital means using other suppliers’ (accounts
payable) and customers’ (unearned revenue) money to run your
business so that you don’t have to use your own
Liquidity versus Solvency
• Liquidity: short term cashflow problems
Financial structure ratios: Solvency

Debt/Equity greater than 1? TA/SE = 2

Interest coverage close to or below 1?
Solvency risk: bankruptcy
Some industries/ business models may be able to sustain higher leverage
• More tangible assets (creditors were willing to lend money!)
• Predictable cash flows
– limited competition or little threat of technological change
– Infrastructure/ utilities
• If too high? Interest rate risk
Next week’s workshop will focus on these ratios
 Valuation Analysis

Combine comparative and valuation (pricing) analysis

• Valuation using comparable firms
• Measure the market’s expected growth
• Understand the over/under valuation of a company (cheap=good?)

• A poorly performing company that is very cheap may be a good buy

• A well performing company that is very expensive may be a bad buy
 Pricing & valuation based analysis: PER
Price to earnings (PE) ratio
• Price / EPS
- Low PE: Undervalued (cheap)
- High PE: Overvalued (expensive)
- ttm means trailing twelve months
23/11/2011 AAPL GOOG HPQ RIMM Industry
Price US$ 366.99 570.11 25.78 16.20 N/A
P/E (ttm): 13.26 19.43 6.05 2.96 13.55
PEG (5 yr
0.57 0.82 0.88 0.67 1.44
expected):

Note: RIMM has changed its ticker to BBRY

40
PER
Historical
• Most recent completed financial year
• ttm: trailing 12 months

Forward
• Current financial year

Forecast
• Some financial period in future
• Usually 3 or 5 years out
 Past Exam Question - Session 2, 2011 Final (Supplementary)

Question:
You are considering the investment in Apple Inc. (AAPL). What would
be your price target for AAPL? Show your calculations and round to
nearest cent. (2 marks)
Answer:
Using price & PE ratio as at 23 November 2011:
$366.99 x 19.43 (GOOG PE) /13.26 (AAPL PE) = $537.75
Recommendation: BUY

42
 Past Exam Question - Session 2, 2011 Final Exam
(Supplementary)
(a) You are considering the investment in Apple Inc. (AAPL). What
would be your price target for AAPL? Show your calculations and
round to nearest cent. (2 marks)
Answer:
Using price & PE ratio as at 23 November 2011:
$366.99 x 6.05 (HPQ PE) /13.26 (AAPL PE) = $167.44
Recommendation: SELL

Can’t just apply valuation analysis blindly, need to think about future
43
growth prospects
 Price Earning Growth Ratio
PEG Ratio = PE / Earning’s Growth %
• PEG > 1: Overvalued (expensive)
• PEG < 1: Undervalued (cheap)
23/11/2011 AAPL GOOG HPQ RIMM Industry
Price US$ 366.99 570.11 25.78 16.20 N/A
P/E (ttm): 13.26 19.43 6.05 2.96 13.55
PEG (5 yr
0.57 0.82 0.88 0.67 1.44
expected):

Is valuation multiple supported by growth rate?

Is growth sustainable? Will be company be around in 5 years?
PEG ratios are often calculated using current (historical ttm) PER
years in future and a growth rate over relevant period (in above
example 5 years)
44
 Past Exam Question - Session 2, 2011 Final Exam
(Supplementary)
Question:
You are considering the investment in Apple Inc. (AAPL). What would be your
price target for AAPL? Show your calculations and round to nearest cent. (2
marks)
Answer:
Using price & PEG ratio as at 23 November 2011:
$366.99 x 1.00 (Normalised PEG) / 0.57 (AAPL PEG) = $643.84
Recommendation: BUY
Using price & PEG ratio as at 23 November 2011:
$366.99 x 0.88(HPQ PEG) / 0.57(AAPL PEG) = $566.58
Recommendation: BUY
45
Other Valuation Metrics

The price to book ratio

• Market value of equity / book value of equity
• E.g. Banks
• Try on finance.yahoo.com: C, JPM

Different methodologies (not examinable)

• Mining: Discounted Cash Flow (DCF)
• Infrastructure firms, DCF also
• Internet bubble – loss making (clicks, price to sales)
An additional part of analysis is to examine the
Business Environment that the company operates within

Look at this
now

Next week’s
lecture

Source: Palepu et al. (2010) Business Analysis & Valuation, Cengage.

Market and Macro Factors

Bull vs Bear secular market

• Japan’s lost 2 decades

Macroeconomics
• Impact of Global Financial Crisis on global economic growth, and as such
individual company’s growth prospects

• Australia’s reliance on China’s growth and demand for commodity minerals

 Past Exam Question - Session 2, 2011 Final (Supplementary)

Question:
In financial statement analysis, it is important to consider special
situations or context that may affect your analysis. Give two (2)
reasons from the information provide or from your general
knowledge that may affect your decision. (4 marks)
Suggested answer (at the time):
The Global Financial Crisis may make consumers more cautious
about spending discretionary income, and thus limit the demand for
AAPL’s products, and the company’s growth

49
Trend Analysis/ Sensitivity Analysis: “What if”

Compare performance over time for single company

What if?

• State assumptions & recalculate financial

figures/ ratios
Next week’s Lecture – Accounting Policy choice
Trend analysis

Thoughts on trend analysis and cross-company comparisons with ROE

and ROA:
Ideally, the trend of a company’s ROE and ROA will be stable or
increasing.
If ROE or ROA are negative, or have declined materially relative to prior
years or are lower than their direct competitors, then you should read
the narrative portions of the annual report and other sources to
determine how management are responding to this problem.
Trend analysis
ROE and ROA will naturally tend to be lower in highly
competitive industries, and higher in industries where
competition is less intense.
Cross-company comparisons of ROE and ROA are
most meaningful when the companies are direct
competitors offering similar products.
Example: Company XYZ
2016 2015
Return on shareholders’ equity 13% 12%
Return on total assets (ROA) 8% 9%
Profit margin 20% 18%
Asset turnover .40 .50
Days in inventory 72 days 55 days
Days in debtors 42 days 42 days
Current ratio 1.6:1 1.5:1
Quick ratio 0.7:1 1.1:1
Debt to equity ratio 1.4:1 1.0:1

1. Comment on the company’s profitability, asset management, liquidity and financial structure.
2. Why could ROE and ROA move in different directions?
3. What caused the fall in ROA?
4. What caused the fall in asset turnover?
5. What caused the increase in the current ratio?
Limitations of financial statement ratios
• The quality of ratios is sensitive to any lack of consistency
in the accounting methods used by a company over time.
• Ratio comparisons across companies can be misleading if
the companies use different
accounting methods.
• Ratio comparisons across companies can be misleading if
the companies operate in different industries or are
substantially different in other ways.
Limitations
• The usefulness of ratios is based upon the
belief that past relationships are useful in
forecasting future performance.
• Failure to adjust for inflation or market values
results in current dollar amounts often being
compared to past dollar amounts.
Limitations
• Year end data may not be reflective of the typical
situation of the company. Furthermore, management
may attempt to improve certain ratios by, for example,
using cash to pay off short term borrowings (improves
the current ratio).
• Ratios tell only part of the story. To understand the full
story requires a deeper understanding of a company
and its industry.
Example: Company PQZ has the following data
ROA = 10% Current ratio = 2 : 1
What is the effect of each of the following transactions on the above ratios?
Transaction Effect on ROA Effect on Current Ratio
Borrowed $200 000 from the bank, repayable Decrease Increase
in two years

Issued shares for $300 000 Decrease Increase

Purchased equipment for cash, $50 000 No effect Decrease

Credit sales of $80 000 (COGS $60 000) Increase Increase

Paid $10 000 to accounts payable Increase Increase

Received $20 000 from accounts receivable No effect No effect

Received an electricity bill for $5 000 for Decrease Decrease

electricity used in this period
Next Week’s Lecture:
Accounting Policy choice