Analysis of Financial Statements Final Exam

What do investors, and others, use financial reports for?

To assess the performance of a firm and their future plans

What is the main source of information for a firm?

Their financial statements

What are the 5 main financial statements?

* Balance sheet
* Income statement
* cash flow statement
* statement of changes in equity
* notes to the accounts

Why is it difficult to match savings to business opportunities?

* information asymmetries (lemmons problem)
* manager incentives

What do financial intermediaries try to resolve? And why?

* financial intermediaries try to resolve the lemmons problem
* goal is to use financial statements and make financial statement analysis

Banks and investment companies are considered what?

Financial intermediaries

Authors, financial analysts and bond-rating agencies are considered what?

Considered information intermediaries

What two types of intermediaries help resolve the lemmons problem and allow financial statements to be used for financial statement analysis?

* financial and information intermediares

What would happen to the market if there was an absence of information?

* investors will stop allocating funds to businesses, causing markets to disappear

Financial statements should give the .... and .... view of the financial position and the results of the operations.

Fill in the blank

* true and fair

What do financial statements do?

They simplify and summarize the economic activities of a firm into accounting periods following accounting standards

The simplification of financial statements refers to?

* Making the huge set of transaction into a manageable amount of categories
* literally simplifying all the transaction into a more simple way of viewing all of them

The summarization of financial statements refers to?

* Giving info with the right amount of details

Briefly explain the manager's role for financial statements

* manager uses their judgement to make estimations (creates private info and noise)
* manager has certain discretion to prepare the FS
* manager can add voluntary information

What are the 3 reasons why an analyst has to un-do the accounts?

* Reconstruct the economic events
* appreciate the underlying activities of the firm
* evaluate its prospects for the future

Who has more information regarding a firm, the manager or a financial statement?

the manager

Noise in regard to financial statements refers to?

estimation errors and distortions

In order to separate valuable information on a firm from noise and to obtain inside information from the public requires a deep analysis. This deep analysis can be broken up into 4 smaller analysis, what are they?

1. Business strategy analysis
2. Accounting analysis
3. Financial analysis
4. Prospective analysis

Identifying key profit drivers and business risks to assess the company's profit potential at the qualitative level.

What type of analysis is this? What does it analyze?

* it's a business strategy analysis
* which analyses a firm's industry and strategy

Evaluating the degree to which the firm's accounting captures the underlying business.

What type of analysis is this?

* accounting analysis

Evaluating the current and past performance of a firm to assess its sustainability.

What type of analysis is this? What does is analyze?

* financial analysis
*analyses ratio and cash flows

Forecasts the future of the firm.

What type of analysis is this? What does it analyze?

* prospective analysis
* analyses the value of the business

Why do firms operating in multiple businesses/industries (could be 3 up to 10, or more)?

* To reduce the total risk at the firm level
* being more profitable

According to Porter (1980), the average profitability of an industry is due to 5 forces. These 5 forces can be grouped into two groups, what are the two groups?

* competition
* bargaining power

What are the two extremes about competition?

* perfect competition
* monopoly

Which type of competition, from the two extremes, creates few opportunities to earn abnormal profits?

Perfect competition

Which type of competition, from the two extremes, creates monopoly profits?

monopoly

What are Porter's Five Forces?

* Competition in the industry (existing rivalry)
* Potential of new entrants into the industry
* Power of suppliers
* Power of customers
* Threat of substitute product

From Porter's diamond, which forces are potential sources of competition?

* existing rivalry
* threat of entrants
* threat of substitution of products/services

What are 5 factors that influence rivalry between existing firms?

* industry growth rate
* degree of product differentiation
* concentration and balance of competitors
* Excess capacity and barriers to exit
* scale economies and ratio fixed/variable costs

From the factors that influence rivalry between existing firms

The higher the growth rate, the lower the price war

What factor is this referring to?

Industry growth rate

From the factors that influence rivalry between existing firms

The higher the degree of product differentiation, the lower the price war

What factor is this referring to?

Degree of product differentiation

From the factors that influence rivalry between existing firms

The higher and the more balanced (opposite to fragmented) competition is, the higher the price war

What factor is this referring to?

Concentration and balance of competitors

From the factors that influence rivalry between existing firms

The higher the excess capacity and barriers to exit are, the higher the price war

What factor is this referring to?

Excess capacity and barriers to exit

From the factors that influence rivalry between existing firms

The higher the economies obtained from the pass production and the higher the ratio fixed/variable costs, the higher the pressure to reduce prices to increase the market share

What factor is this referring to?

Scale economies and ratio fixed/variable costs

What are three factors that influence the threat of entry of new firms?

* economies of scale
* legal barriers
* access to channels of distribution and relationship

In regard to factors that influence the threat of entry of new firms, explain legal barriers?

Regards licensing regulation that limit the entry in some industries

In regard to factors that influence the threat of entry of new firms, explain economies of scale?

* Large investments are required to enter the industry
*Ex - R+D, in the pharmaceutical industry,
* Ex - plant and equipment in the telecommunications industry)

In regard to factors that influence the threat of entry of new firms, explain access to channels of distribution and relationships

There is a limited capacity in the existing distribution channels as well as high costs of developing new channels

What are 2 factors that influence the threat of substitute products or services

* Specificity of products/services which make it more difficult to substitute
* Substitutions don't necessarily need to be exactly the same, but provide the same function

What are 2 factors that influence the ability to bargain with buyers and suppliers?

* degree of product differentiation
* number of buyers relative to number of sellers

In regard to factors that influence the ability to bargain with buyers and suppliers, explain product differentiation?

the higher the degree of product differentiation, the lower (larger) the power of the buyer (seller) to negotiate

In regard to factors that influence the ability to bargain with buyers and suppliers, explain the number of buyers relative to the number of sellers

The higher the number, the lower (larger) the power of the buyer (seller) to negotiate

What is an advantage of selling a unique product or having many buyers?

You have more possibilities to fix conditions/prices and buyers cannot influence so easily

What are two competitive strategies of firms?

* cost leadership
* differentiation

The competitive strategy, cost leadership, involves?

Involves offering same product/service but at a lower price which puts an emphasis on controlling and reducing costs

The competitive strategy, product differentiation, implies?

Implies offering a distinctive product/service and implies investing in signals of value as brand image, product appearance and reputation

What two sources do equity investors look at for returns?

* dividend and capital appreciation

Equity investors and shareholders expect the firm to add what to their investments?

value

Creditors and (especially) loan officers are primarily worried about what of a firm?

on their repayments

To sell goods and services and obtain good return to the owners, what main activities must firms perform?

* financing
* investing
* operating
* BUT ALSO planning

Making decisions to achieve business strategy is about what activity?

About planning

Obtaining money to acquire assets is regarding what activity?

financing

Acquisitions and maintenance of productive investments is about what activity?

Investing

Purchasing, manufacturing, and selling of goods and services, which occur everyday and are the fundamental source of income, is regarding what activity?

operating

What does balance sheets summarize?

Summarize the financial positions of a firm at a date (A \= L + E)

What does statement of comprehensive income measure? Does this come in the form of 1 or 2 statements

* Measure performance during a time period (P \= I - Ex)
* can be either 1 or 2 statements

What does the statement of changes in equity report?

Reports changes in the components of equity

What does the cash flow statement show?

Shows the movements in cash (change in cash \= In - Out)

What information is provided in the notes to the accounts?

* Information about the accounting policies
* Explanation about what content of the financial statement
* Some additional information

T or F
Listed firms provide half-year reports (which are unaudited) and quarterly info?

T

If the statement of comprehensive incomes comes into two statements, what are they?

1. income statement (realized)
2. other comprehensive income (unrealized)

What 3 things are included in the letter to the shareholders?

* Chairman of the board tells the firm's industry conditions,
* competitive position,
* managements future plans

What is provided in the management commentary/report?

* details about current performance and changes in performance

Who prepares an auditor's report?

independent expert

What is included in an auditor's report?

* Opinion on the accounting quality of the FS
* following GAAS

An auditor's report is an opinion on the accounting quality of the FS, this opinion can come in 4 different forms, what are they?

* Unqualified (clean) opinion
* Qualified opinion
* adverse opinion
* disclaimer of opinion (insufficient evidence to give opinion)

What does accrual accounting distinguish between?

* Between the recording of costs and benefits derived from transaction and the actual payments of receipts of cash
* so difference between recording payment to recording

Net income (or profit) is based on what?

* Based on the expected cash receipts and payments
* ( I - Ex)

What is an asset?

A present ECONOMIC RESOURCE

What is a liability?

A PRESENT OBLIGATION

T or F?
Equity is the residual interest?

T

An increase in assets, or decrease in liabilities, which results in an increase in equity is what?

income

What does income increase? And what does it decrease?

* increases: assets and equity
* decreases liabilities

A decrease in assets, or increase in liabilities, that result in a decrease in equity is what?

expense

What doe expenses increase and decrease?

* increase liabilities
* decrease assets and equity

Does the cash flow statement require assumptions?

no

What complementary information do income and cash-flow statements provide?

* profitability (long run goal)
* Liquidity (short term goal)

Why do profits need to b transformed into cash?

Because if not the firm will not succeed

Why does accounting focus on accruals?

because transactions are not completed at the end of the period

Why are accounting periods so short?

because investors need information

To predict future stock, what is more useful, foreseeing future profits or foreseeing future cash flows?

Foreseeing future profits is more useful to predict stock value

What is one way managers can take manipulate information to obtain private benefits?

Through contracts which provide incentives to manipulate

The role of accounting standards and the need of comparability do what?

reduce transaction costs

Since 2005, EU listed companies use what, produced by what, to prepare consolidated accounts

They use IFRS produced by IASB to prepare consolidated accounts

IFRS?

International Financial Reporting Standards

IASB?

International Accounting Standards Board

IS the IFRS used in the US?

no

Uniform accounting standards reduce managers recording economic transactions in different ways. Thus, uniform accounting language increase the creditability of financial statements BUT?

But may discourage managers from using their own private information

Can accounting standards regulate everything?

* no they cannot, leaving room for manager's judgement

With accounting regulations and external auditing, could reports still have noise and be biased?

yes

What are some of the sources of noise and bias in accounting data?

* rigidity in the accounting rules
* random forecast errors
* Systematic reporting choices by managers to achieve their specific objectives

Briefly describe liberal and conservative in regard to managing accounts?

don't be too liberal or too conservative

What should you do is previous analysis suggests that accounts are misleading?

* you should restate the numbers
* compare income statement and cash flow statement to see the deviations
* notes to the accounts is also useful for finding deviations

Why does the conservatism principles in managing accounts arise?

Over concerns of managers' incentives to overstate the firms' performance

Do accounting rules differ between tangible and intangible assets?

* yes
* more demanding with intangible assets

What is the recoverable value?

higher of fair value (FV) less cost to sale and value in use (ViU)

What is fair value (FV)

* IFRS says its the price that would be received for selling an assets or paid to transfer a liability

What is value in use (ViU)

* IAS what the present value would be of a future cash flow that came about from an asset

What happens to earnings and perceived financial risks when liabilities are understated

* earnings appear to be overstated
* financial risks appear to be lower