Ifsa Chapter8-1

CHAPTER 8
FINANCIAL STATEMENT ANALYSIS:

APPLICATIONS
Presenters name
Presenters title
dd Month yyyy
EVALUATION OF A COMPANYS PAST
PERFORMANCE
Copyright 2013 CFA Institute 2
PERFORMANCE: APPLE
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
2007 2008 2009 2010
Sales
Gr. Profit
Net income
$ (millions)
PERFORMANCE: APPLE
Fiscal Year
($ millions) 2010 2009 2008 2007
Net sales $65,225 $42,905 $37,491 $24,578
Gross margin 25,684 17,222 13,197 8,152
Net income (NI) 14,013
8,235 6,119 3,495
2010 2009 2008 2007
Gross margin (% sales) 39% 40% 35% 33%
PERFORMANCE: APPLE
Panel A: Data for Apple Inc. Fiscal Year
($ millions)
2010 2009 2008 2007
Cash and marketable securities
$51,011 $33,992 $24,490 $15,386
Total current assets
41,678 31,555 30,006 21,956
Total assets
75,183 47,501 36,171 24,878
Total current liabilities
20,722 11,506 11,361 9,280
PERFORMANCE: APPLE
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2007 2008 2009 2010
Peripherals and other hardware
Software, service and other sales
Other music related
iPad & related
iPod
Total Mac
iPhone & related
FORECASTING
Sales Forecast
Expenses
Gross Profit
Operating Profit
Assets
Liabilities
Cash Flow
FORECASTING
Sales Forecast
Expenses
Gross Profit
Operating Profit
Assets
Liabilities
Cash Flow
FORECASTING
Sales Forecast
Expenses
Gross Profit
Operating Profit
Assets
Liabilities
Cash Flow
FORECASTING
Sales Forecast
Expenses
Gross Profit
Operating Profit
Assets
Liabilities
Cash Flow
ITERATIONS IN FORECASTING
Forecast
Debt
Forecast
Interest
Expense
Forecast
Income and
Taxes
Forecast
Cash Flow
Sales Forecast
Expenses
Gross Profit
Operating Profit
Assets
Liabilities
Cash Flow
Example 8-5
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS
Johnson & Johnson
(NYSE: JNJ)
U.S. health care conglomerate,
founded in 1887.
2009 sales of around $61.9
billion from its three main
businesses: pharmaceuticals,
medical devices and diagnostics,
and consumer products.
For the four years prior to 2009,
average operating profit margin
was approximately 25.0%.

Baidu (NASDAQ: BIDU)
Chinese language internet
search engine, established in
2000 and went public on
NASDAQ in 2005.
Revenues for 2009 were 4.4
billion renminbi (RMB), an
increase of 40% from 2008 and
more than 14 times greater than
revenues in 2005.

FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS
Johnson & Johnson
(NYSE: JNJ)
2009 sales were $61.9 billion.

Actual operating profit for 2009
was $15.6 billion.
Actual operating profit margin for
2009 was 25.2%.
Baidu (NASDAQ: BIDU)
2009 revenues were 4.4 billion
renminbi (RMB).

Actual operating profit for 2009
was RMB1.6 billion.
Actual operating profit margin for
2009 was 36.4%.
ASSESSING CREDIT QUALITY
Credit risk: Risk of loss caused by a debtors failure to
make a promised payment
Credit analysis: Evaluation of credit risk
- Risk in a particular transaction or for a particular security
- Obligors overall creditworthiness
TECHNIQUES FOR ASSESSING CREDIT
QUALITY
Credit scoringstatistical techniques
Period-by-period cash flow projections
Analysis of business and financial risk factors

ASSESSING CREDIT QUALITY: EXAMPLE
Bombardier
Inc.
BAE
Systems
plc
EBITDA/Average assets 7.5% 10.1%
Debt/EBITDA 3.9 3.1
Retained cash flow to debt 6.1% 13.7%
Free cash flow to net debt 7.0% 7.7%
STOCK SCREENING
Universe of Stocks
Stocks Meeting
Criteria
Selection

EXAMPLE OF STOCK SCREENS
Stocks Meeting Criterion
Criterion Number Percent of Total
P/E <15 1,471 28.36%
Total debt/Assets 0.5 880 16.97%
NI/Sales > 0 2,907 56.04%
Dividend yield > 0.5% 1,571 30.29%
Meeting all four criteria simultaneously 101 1.95%
Source for data: http://google.com/finance/
SCREENS AND BACK-TESTING
Valuation metrics + Accounting metrics
Evaluation of screen using back-testing
Caveats when back-testing:
- Survivorship bias
- Look-ahead bias
- Data-snooping bias

TWO HYPOTHETICAL SCREENING STRATEGIES
Strategy A
Invest in stocks that are
components of a global
equity index, have an ROE
above the median ROE of all
stocks in the index, and
have a P/E less than the
median P/E.
Strategy B
components of a broad-
based U.S. equity index,
have a ratio of price to
operating cash flow in the
lowest quartile of companies
in the index, and have
shown increases in sales for
at least the past three years.
TWO HYPOTHETICAL SCREENING STRATEGIES:
AVOID UNINTENTIONAL SELECTIONS
Strategy A
components of a global
equity index, have an ROE
above the median ROE of all
stocks in the index, and
have a P/E less than the
median P/E.

What if Net income was < 0
and Equity < 0?
Strategy B
components of a broad-
based U.S. equity index,
have a ratio of price to
operating cash flow in the
lowest quartile of companies
in the index, and have
shown increases in sales for
at least the past three years.

What if operating cash flow
was < 0?

ANALYST ADJUSTMENTS
Importance (materiality). Is an adjustment to this item likely to affect the
conclusions? In other words, does it matter? In an industry where
companies require minimal inventory, does it matter that two
companies use different inventory accounting methods?
Body of standards. Is there a difference in the body of standards being
used (U.S. GAAP versus IFRS)? If so, in which areas is the difference
likely to affect a comparison?
Methods. Is there a difference in accounting methods used by the
companies being compared?
Estimates. Is there a difference in important estimates used by the
companies being compared?

INVESTMENTS
Investments
- Unrealized gains and losses on the income statement
versus
- Unrealized gains and losses not on the income statement
but instead recognized in equity.
If two otherwise comparable companies have significant
differences, it may be useful to adjust.
INVENTORY: EXAMPLE

Company A
(FIFO)
Company B
(LIFO)
Current assets (includes inventory) $300,000 $80,000
LIFO reserve NA $20,000
Current liabilities $150,000 $45,000
NA = not applicable
INVENTORY: EXAMPLE

Company A
(FIFO)
Company B

Unadjusted
(LIFO basis)
Adjusted
(FIFO basis)
Current assets
(includes inventory) $300,000 $80,000 $100,000
Current liabilities $150,000 $45,000 $45,000
Current ratio 2.00 1.78 2.22
GOODWILL AND
INTANGIBLE ASSETS
SCHW AMTD
Market capitalization on January 2010 (market
price per share times the number of shares
outstanding) $21,871 $11,525
Total shareholders equity as of most recent
quarter $5,073 $3,551
Goodwill $528 $2,472
Other intangible assets $23 $1,225
The MV/BV for the companies is
SCHW $21,871/$5,073 = 4.3
AMTD $11,525/$3,551 = 3.2
Note: MV/BV equals the total market value of the stock (the market capitalization)
divided by total stockholders equity. It is also referred to as the price-to-book ratio
because it can also be calculated as price per share divided by stockholders equity per
share.
GOODWILL AND INTANGIBLE ASSETS
($ millions)
SCHW AMTD
Total stockholders equity $5,073 $3,551
Less goodwill $528 $2,472
Book value, adjusted $4,545 $1,079
Adjusted MV/BV 4.8 10.7
($ millions)
SCHW AMTD
Total stockholders equity $5,073 $3,551
Less goodwill $528 $2,472
Less other intangible assets $23 $1,225
Tangible book value $4,522 ($146)
MV/tangible book value 4.8 NM
NM = not meaningful
OFF-BALANCE-SHEET FINANCING
Use disclosures to assess a companys financial position as if off-
balance-sheet obligations (e.g., operating leases) were included in its
total liabilities.
Steps:
- Determine present value of future operating lease payments.
- Add present value of future operating lease payments to total debt
and to total assets.
- Adjust expenses to
- Include depreciation expense, interest expense.
- Exclude rent expense.
The adjustments for operating leases essentially treat the transaction
as if the asset subject to the operating lease had been purchased
rather than leased.

SUMMARY
Financial statement analysis applications discussed in this
presentation include
Evaluating a companys past performance.
Projecting a companys future performance.
Assessing the credit quality of a potential debt investment.
Screening for potential equity investments.
Adjusting a companys financial statements to facilitate
cross-sectional comparison.


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CHAPTER 8

FINANCIAL STATEMENT ANALYSIS:

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