Lvl2: Financial statement analysis

IFRS9 classification

IFRS9 reclassification

• Reclassifications of debt instruments are permitted only when the business model changes. The choice to measure equity investments at FVOCI or FVPL is irrevocable.

Consolidation - contingent liabilities

recognize any contingent liability assumed in the acquisition if 1) it is a present obligation that arises from past events, and 2) it can be measured reliably.

IFRS include contingent liabilities if their fair values can be reliably measured. US GAAP includes only those contingent liabilities that are probable and can be reasonably estimated.

“Partial goodwill” vs “Full goodwill”

• partial - fair value of consideration given) less the acquirer’s share of the fair value of all identifiable tangible and intangible assets, liabilities, and contingent liabilities acquired

• full - fair value of the entity as a whole less the fair value of all identifiable tangible and intangible assets, liabilities, and contingent liabilities

IFRS either ; US GAAP only full

NCI

IFRS either full or partial ; US GAAP only full

share based comp - tax

tax windfall from increase in share price

shares outstanding

Assumed proceeds from cash exercise + Average unrecognized share-based compensation expense

• In-the-money options (average share price > strike price) are dilutive and included in diluted shares outstanding.

• Out-of-the-money and at-the-money options are anti-dilutive and left out of diluted shares outstanding.

• RSUs are dilutive except when the average stock price is materially below the stock price at the RSU grant date. This can result in anti-dilutive RSUs because the unrecognized stock-based compensation expense is based on grant date share prices.

Funded status

Funded status = Fair value of plan assets – Pension obligation

• Pension obligation = The present value, without deducting any plan assets, of expected future payments required to settle the obligation resulting from employee service in the current and prior periods.

• different plans’ funded statuses cannot be netted

Pension expense - IFRS

• Service cost - PL operating- current (from service in current period); past

• Net interest expense/income - PL financing - pension obligation accretion

• Remeasurement - OCI - actuarial + actual vs assumed rate

Pension expense - GAAP

• Current service cost - opex

• Interest cost - int exp - gross - pension obligation unwinding

• Expected return on plan - offset in earnings - expected rate of return

• Amortization of past service cost - OCI

• Amortization of net gains or losses - PL or OCI - actuarial + actual vs assumed

valuation of DB plan

• underfunded plan is considered debt

• overfunded plan is ignored in valuation

• remove net interest expense if net pension balance is deducted from enterprise value

Basel III

• minimum capital requirement - % of risk-weighted assets funded with equity capital

• minimum liquidity - high-quality liquid assets - 30 day stress scenario

• stable funding - tenor of deposits and type of depositor

Camels

• Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk.

• 1-5 rating - 1 best

• composite rating - weighted

Capital adequacy

absorb potential losses

risk weighted assets - cash 0%; corporate loans 100%

capital tiers - tier 1 common stock retained earnings, oci tier 2 subordinate

Asset quality

existing and potential credit risk of assets

Management capabilities

governance structure, internal controls, ability to identify and control risk

Earnings

adequate return on capital to capital providers

Liquidity Position

to pay liabilities

• liquidity coverage ratio - min % of expected cash outflows that must be held in highly liquid assets

• net stable funding ratio - min % of required stable funding sourced from available stable funding - liquidity

• Concentration of funding - proportion obtained from a single source

• Contractual maturity - maturity of assets compared to funding source

Snensitivity to market risk

• interest rate, ex rate, equity prices, commodity prices

Other banking-specific considerations

• Govt support

• Govt ownership

• Mission of banking entity

• Corproate culture

Other considerations - bank

• Competitive environment

• Off-bs items

• Segment information

• currency exposure

• risk factors

• Basel III

combined ratio

• insurance expenses / net premiums earned - low=hard insurance market > attracts new entrants

• underwriting loss ratio + expense ratio

• underwriting loss ratio: claims paid / net premiums written

• expense ratio: underwriting + sales comm / net premiums earned

loss reserves

• historical with estimate of future losses

• if optimistic > priced too low

• the longer the obligation runs > more difficult to estimate

profitability measure of health insurance

• total benefits paid per net premium

• commission & exp per net premium

net interest margin

diff between int income on loans - int paid on deposits

loans - LT

deposits - ST

reporting quality vs earnings quality

• reporting - information in financial reports - decision useful; faithful rep

• earnings - financial condition; sustainable activities

Beneish Model

probability of earnings manipulation

M-Score = DSR + GMI + AQI + SGI + DEPI - SGAI + Accruals - LEVI

• DSR (days sales receivable index) = (Receivables_t/Sales_t)/(Receivables_t−1/Sales_t−1).

• GMI (gross margin index) = Gross margin_t−1/Gross margin_t.

• AQI (asset quality index) = [1 − (PPE_t + CA_t)/TA_t]/[1 − (PPE_t−1 + CA_t−1)/TA_t−1],

• SGI (sales growth index) = Sales_t/Sales_t−1.

• DEPI (depreciation index) = Depreciation rate_t−1/Depreciation rate_t, where Depreciation rate = Depreciation/(Depreciation + PPE).

• SGAI (sales, general, and administrative expenses index) = (SGA_t /Sales_t)/(SGA_t−1/Sales_t−1)

• Accruals = (Income before extraordinary items⁹ − Cash from operations)/Total assets.

• LEVI (leverage index) = Leverage_t/Leverage_t−1, where Leverage is calculated as the ratio of debt to assets.

higher M score (less neg number) > increased prob

Earnings persistence

Earnings_t+1 = α + β₁Earnings_t + ε

A higher coefficient (β₁) represents more persistent earnings.

larger component of accruals would be less persistent and thus of lower quality.

Altman model

probability of bankruptcy

• Z-score =

• 1.2 (Net working capital/Total assets) + : ST liq risk

• 1.4 (Retained earnings/Total assets) + : accum profitability & age

• 3.3 (EBIT/Total assets) + : profitability

• 0.6 (Market value of equity/Book value of liabilities) + : leverage ratio

• 1.0 (Sales/Total assets) : ability to generate sales

higher Z score better

bankruptcy <1.81 < unclear < 3 < low prob

shortcoming of Altman model

• single period

• past performance- going concern assumption

cash flow quality

• positive OCF

• OCF derived from sustainable sources

• OCF adequate to cover capital expenditures, dividends, and debt repayments

• OCF with relatively low volatility (relative to industry participants)

cash flow classification

• FRS permits companies to classify interest paid either as operating or as financing.

• IFRS also permits companies to classify interest and dividends received as operating or as investing.

• US GAAP requires that interest paid, interest received, and dividends received all be classified as operating cash flow

balance sheet quality

• completeness

• unbiased measurement

• clear presentation

balance-sheet-based and cash-flow-based accruals ratios

Balance sheet accruals ratio for time t = (NOA_t − NOA_{t −1})/[(NOA_t + NOA_t−1)/2], and

Cash flow accruals ratio for time t = [NI_t − (CFO_t + CFI_t)]/[(NOA_t + NOA_t−1)/2],

abs value - lower better

net asset balance sheet exposure

assets translated at the current exchange rate are greater than liabilities translated at the current exchange rate

Factors Considered in Determining the Functional Currency

• sales price of goods and services

• competitive forces and regulations

• labor, material, cogs

• financing

• receipts

• extension of parent or autonomy

• large or small portion of parent

• remitted to parent

• need funds from parent

hyper inflation

• cumulative 3-year inflation rate > 100%

• IFRS - restated for local inflation > translated to parent presentation currency (monetary assets not restated, only non-monetary assets from date of revaluation; equity from beg of year or historical)

• GAAP - remeasure as if functional currency is the reporting currency - temporal

current vs temporal method

• current - foreign currency is the functional currency - translation adj in equity

• temporal - parent presentation currency is functional currency - translation diff as gain/loss