Comprehensive summary of the course Advanced Financial Statement Analysis based on the relevant chapters in the book, the information from the slides and extensive notes taken during all lectures. This summary contains all the information you need to complete your exam successfully and is ideal for...
Extensive but clear summary - Business Analysis and Valuation, ISBN: 9781473722651 Business Analysis and Valuation (BKBMIN053)
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Advanced Financial Statement Analysis
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Advanced Financial Statement
Analysis
CH.1: A framework for business analysis and valuation
1.1. Framework for business analysis and valuation
Business intermediaries use financial statements to accomplish 4 KEY STEPS:
1. Business strategy analysis : analyse a firm’s industry + its strategy to survive in that
industry.
If you do an industry analysis and look at what strategy the company is going to use to survive in that
industry then you know what to look for in the financial statement.
• If the firm uses a low cost strategy they need to keep their costs low in order to create
margins. So in this strategy you have low profit margins (you offer your products at low
profit
prices) and high asset turnovers (de netto rendabilitieit van de totale activa)
revenue
revenue
TA
profit revenue
ROA = x
revenue TA
• You can also use a differentiation strategy where you differentiate yourself by offering high
quality for example. Therefore these companies can charge higher prices. If they use a
product differentiation strategy, then they have a very high profit margin because the price
you pay is way above the costs and the (asset) turnover is lower, the amount of cars sold is
not so high.
So you need to know what industry the company is working in, who are the competitors and what
strategy it is using to survive. This gives you a benchmark to assess whether a company is doing good
or not.
2. Accounting analysis: evaluating whether the financial statements of a firm reflect the
underlying business reality. It is possible that a firm’s accounting doesn’t reflex the reality
because there are distortions. Another important step is to undo these distortions by
recasting the firm’s accounting numbers.
1
, Distortions Something that prevents a financial statement from reflecting the
underlying business reality.
Example of distortions: depreciations. A company that bought a machine and is going to use it mostly
in the first years must use accelerating depreciation. A firm that plans on using the machine equally
over its lifetime need to use constant depreciations. Etc.
From the moment you give the company flexibility in the way they do their accounting,
managers can use this to report in their own best interest. To make it seem that the earnings
are higher because then they will get a bonus. This makes that the statements don’t reflect
the reality.
SO what you need to do in this step is:
• Analyse if there are distortions
• Undo these distortions: if you start working on numbers that don’t represent the reality, how can
you ever come up with the right valuation of a company? You need to start with numbers that reflect
the reality.
• After adjustments you come up with a new set of financial statements, and these
statements you are going to analyse.
3. Financial analysis: is the company successful in pursuing its strategy? Evaluate the current
and past performance of a firm and assess its sustainability.
4. Prospective analysis: focuses on predicting the future performance of the company to
estimate the value of the company. So you are going to forecast a firm’s future by analysing
its past. We analyse the financial statements of 2017 and predict the financial statements of
2018, 2019, etc.
• First component: forecasting financial analysis
• Second component: valuating the company
Credit analysis: if I give money to a company, will I ever see my money back. So you need to
assess the creditworthiness of a company.
Consolidated vs. Statutory financial statements
• Consolidated financial statements: the combined financial statements of the parents company
and its various subsidiaries that the parent company controls . The parent company owns
more than half of the voting stock of these other companies. If a parent owns less than 50% of
the voting stock then this subsidiary is not in the consolidation.
You simply add the numbers of the subsidiaries to the numbers of the parent company. You will have to
make some corrections but we are not going to look at that (e.g. the intra-group transactions will be
subtracted but as said, we are not going to look at that).
2
,Normally the company indicates that it is a consolidated financial statement but if they don’t
mention it then you can see it on the non-controlling interests, you only have this in a consolidated
balance sheet.
NON-CONTROLLING INTERESTS: This reflects that the company adds everything from its subsidiaries
to its own financial statements as if it would own 100% of the subsidiary while that is often not true.
This post reflects that a part of the assets belongs to other (minority) shareholders of the
subsidiaries.
You have the same in the income statement: non-controlling interests: you add 100% of the
turnover of the subsidiaries to the turnover of the parent (also for the profit 100%), but part of this
profit is not owned by the parent because it is owned by minority shareholders so this profit needs to
be split up in two parts.
One part that belongs to the owners of Lotus bakeries
One part that belongs to the minority shareholders (=net-controlling interests).
IF WE PERFORM ANALYSIS WE ALWAYS WORK WITH RESULT AFTER TAXES, we always take the
complete and don’t subtract the non-controlling interests.
Turnover = sales turnover
Profit or loss after taxes = net income = earnings of the company = results after taxes
• Statutory financial statements: the financial statements of one single company on its own,
this can be a parent company or one of its subsidiaries.
Is FSA useful given the theory of efficient markets?
Efficient markets Market prices react completely and quickly to available accounting
information and to all information that is available on the market.
If markets were truly efficient, the share prices today should already reflect all the information in the
financial statements of 2017. If that is true, than it would not be useful to perform a FSA on the FS of
2017 because these are historical and the information should already be implemented in the stock
prices.
The abnormal returns (difference between the actual return and the expected return) drift in the direction of
the earnings surprise (difference between reported earnings and expected earnings). If firms report good news
in (quarterly) earnings their abnormal returns tend to drift up. Idem when firms report bad news, their
abnormal returns tend to drift down.
NOW markets are highly but NOT completely efficient because there is a post-earnings
announcement drift: after the financial statements have been released there are still abnormal
returns.
The day the announcement was made, the market reacts quickly but it doesn’t react
completely because it keeps reacting even after the day of the announcement. If the market
would act completely it should stop reacting on the day of the announcement since all
available information would then be incorporated in the stock prices.
3
, So a particular company on a certain moment in time can still be over- or undervalued. It is not
because the market is highly efficient on average that every share in the market is correctly valued
on every moment in time and that is why FSA is still useful.
If a companies is undervalued in the market today then you’ll want to buy its shares because you believe the
value of the shares now is lower than what you actually think they are worth, so you expect the value of the
shares to increase and therefore you buy them now, to make a profit in the future.
You take the earnings that the company announces – expected earnings = unexpected earnings.
The expected earnings are made up by analysts and are put together in a consensus analysis forecast.
You have positive unexpected earnings and negative unexpected earnings. The researchers went 60 days back
before the earnings were announced and computed the cummulative abnormal returns (returns on a normal
trading day – expected returns), these can also be positive or negative.
On day 0 you have 0 abnormal returns, but then they go up for the companies that report positive unexpected
earnings, it is as if the market already knows that the company is doing very good and this is already reflected
in the stock prices before the company announces it. The abnormal returns go down for companies that have
negative unexpected earnings, the return of these companies is negative and goes lower and lower than the
benchmark (the market index) it is as if the market already foresees that the companies is going to announce
bad news.
This is evidence of efficient markets, because we see now that the market reacts quickly and it even
foresees. So it is in line with that part of the definition of efficient markets. But does it react
completely?
No, because the companies that had an announcement of bad news continues to perform
worse than the benchmark in terms of returns. The market can foresee it but the market
keeps reacting after the announcement. And because of the reacting after the day of the
announcements, it doesn’t react completely.
1.2. International Financial Reporting Standards
(IFRS)
4
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