FIN 401 Financial Statements Analysis II Notes

FIN 401 Assessment & Test Dates

Assessment:
- CA: 40%
- EXAM: 60%
Exam Breakdown:
- Test 1: 20%
- Test 2: 20%
- Final Examination: 60%
Test Dates 2025:
- Test 1: March 12th, 6-8pm, 230/G5
- Test 2: April 23rd, 6-8pm, 230/G5
- Tutorials: Day & Time/Rooms TBA
Notes Foreword:
- Notes are a summary of class discussions.
- Finer details are in lessons.
- Use prescribed textbooks, online & additional resources.
- Tutorials discuss exam/test issues.

Financial Statements Analysis II: DuPont Model

DuPont Model:
- Integrates financial ratios for investor insight.
- Guides financial statement analysis reports.
ROE (Return on Equity)
ROA (Return on Assets)
Profit Margin
- $\frac{\text{Net Profit}}{\text{Sales}}$
Assets Turnover
- $\frac{\text{Sales}}{\text{Total Assets}}$
Equity Multiplier
Net Profit
- Sales - Total Costs
- Total Costs include:
  - Depreciation
  - Taxes
  - Operating Costs
  - Interest
  - Preferred Dividends
Total Assets
- Fixed Assets
- Current Assets
  - Debtors
  - Inventories
  - Cash & Equivalents
  - Short Investments

Functions of a Financial Statement Analysis Report

End product: a financial report providing a clear, concise overview of a company's performance and potential to stakeholders.
Report recipients:
1. Company Executives:
  - Strategic decisions based on goal attainment.
  - Corrective measures for unmet goals.
  - Enhance success within limits to avoid overheating.
2. Creditors:
  - Assess creditworthiness and risks.
  - Types of credit risks:
    - Concentration risk: Single exposure causing large losses.
    - Refinancing risk: Inability to borrow to repay debt.
    - Margining risk: Smaller future cashflows due to contingencies.
    - Liquidity risk: Inability to convert assets to cash.
      - Due to asset nature or contractual obligations.
3. Shareholders:
  - Evaluate company shares for potential returns
4. Employees:
  - Assess company longevity for job security
5. Suppliers:
  - Decide whether to sell material on credit to a company
6. Rating agencies:
  - Give a credit rating to the company
7. Investment analysts:
  - Recommend company's securities to their clients
8. Governments:
  - Determine compliance with tax
9. Labor Unions:
  - Evaluate ability to pay compensation and benefits
10. Customers:
  - Assurance of business sustenance for after-sale service
11. Competitors:
  - Evaluate its financial condition

Influence of the Accounting System on Financial Analysis

Accuracy of conclusions depends on integrity of the information capturing system.
Accounting system quality directly influences analysis quality.
Influence factors:
1. Accrual system
2. Accounting conventions and standards
3. Management Reporting strategy

Accrual Accounting

Need for prompt, regular reporting prevents using cash accounting.
Affects financial records.
- Assets – Liabilities = Equity
- Revenue – Expenses = Profit
Revenues:
- Economic resources earned during a period.
- Recognized when service/goods substantially provided.
- Customer has paid or is expected to pay with certainty.
Expenses:
- Economic value of resources used in the same period (matching principle).
- Recognized when probability of incurrence is high (conservatism principle).
Profit:
- Revenue – Expenses = Profit
Assets:
- Economic resources owned, producing future benefits.
- Recorded if measurable with certainty.
Liabilities:
- Economic obligations from past benefits.
- Recognized when obligation is likely.
- Recorded when timing is reasonably determined.
Equity:
- Assets – Liabilities = Equity
Conclusion: Accrual accounting requires judgment, introducing subjectivity.

Accounting Conventions and Standards

Introduce distortion to recorded information.
Enacted by:
- FASB (Financial Accounting Standards Board) – US
- IASB (International Accounting Standards Board) – Europe, etc.
Standards govern how companies record and present accounting information.
FASB standards: GAAP (Generally Accepted Accounting Principles)
IASB standards: IFRS (International Financial Reporting Standards)
GAAP: More rules-based.
IFRS: More principle-based.
Rules:
- Curb manager discretion but can be limiting.
Managers have latitude that can be abused.
Stringent standards meant to curtail scope.
Prescriptive rules can limit applying business knowledge to capture reality.

GAAP vs IFRS

Agreement in most areas.
Differences in inventory, contingencies, intangibles.
Inventory Valuation methods
- GAAP allows LIFO, IFRS doesn’t.
- LIFO reduces profit, undervalues balance sheet. FIFO opposite.
Example:
- 10 units in inventory, 5 sold at P20.00 each
- 5 units procured for P5.00 (beginning of year)
- 5 units for P10.00 (mid-year)
- (a) FIFO
  - Sales: 5 x P20.00 = P100.00
  - Cost: 5 x P5.00 = P25.00
  - Profit: = P75.00
  - Leftover Stock: 5 x P10.00 = P50.00
- (b) LIFO
  - Sales: 5 x P20.00 = P100.00
  - Cost: 5 x P10 = P50.00
  - Profit: = P50.00
  - Leftover Stock: 5 x P5.00 = P25.00
FIFO shows better profit, stronger balance sheet than LIFO.
Same activity reports different economic values due to accounting standards.
ITEM FIFO LIFO
PROFIT P75.00 P50.00
INVENTORY P50.00 P25.00
FIFO presents a glossier picture to raise investor confidence.
FIFO leads to more tax charges due to higher profit.
Inventory reversal
- GAAP doesn’t allow write-down reversals, IFRS does.
Development costs
- GAAP expenses, IFRS can capitalize.
Intangible Goods
- GAAP values at current fair market only, IFRS at full potential with justification.
Extraordinary items
- IFRS shows in income statement, not segregated; GAAP shows, assesses separately.
Liabilities
- GAAP reports as current/non-current; IFRS has no formal requirement.
Fixed Assets
- GAAP values at historic cost less depreciation, IFRS at fair value less depreciation.
Objective: reduce manager’s ability to record similar economic transactions dissimilarly.

Local vs International Standards

IFRS has locally developed standards (A-IFRS, NZ-IFRS, BW-IFRS).
Over and above IFRS (& GAAP): sector standards and best practices.

Managers Reporting Strategy

Ranges from cliché to peak communication.
Affects public information quality.
Quality defined by breadth and depth.
- Breadth: range and materiality of topics.
- Depth: intensity and detail of discussion.
Managers have broad alternatives.
Regulations prescribe minimum disclosure, allow additional info.
Superior disclosure builds investor confidence.
Constraint: competitive dynamics in input/product markets.
Disclosure of proprietary info may hurt position.
Conclusion: Managers’ use of reporting to manipulate perception provides opportunity and challenge for analysts.

Quality of Information Recap

Accrual system – How the info is captured
Accounting conventions and standards – How the info is presented
Management Reporting strategy – How it is disseminated

External Factors of Information Quality

Auditing and legal enforcement impact info quality.
Auditing:
- Verification of financial statement integrity by an independent person.
- Required for public companies; by lenders/insurers for private.
- Assesses accuracy and compliance with standards.
Auditor Opinions:
- Unqualified opinion: Full agreement on truthfulness.
- Qualified Opinion: Minor disagreement, doesn’t materially affect fairness.
- Disclaimer: Cannot express opinion due to circumstances.
  - Reasons stated, e.g., no stock-taking presence.
- Adverse Opinion: Statements don’t reflect performance/health truthfully.
  - Materially untrue, auditor provides details.
Audit Attributes:
- Enhance investor confidence.
- Auditor should be capable and independent:
  - Qualifications: Chartered accountant supervision.
  - Multiple engagements: No non-auditing services.
  - Standards: Follow ISA (International Standards of Auditing).
  - Duration: No more than 5 consecutive years.
Auditor must face none of the 5 audit threats of independence:
- Familiarity Threat:
  - Getting too close to client employees.
- Self-Interest Threat:
  - Financial interest in company or dependence on major fee.
- Self-Review Threat:
  - Auditing own work.
- Advocacy Threat:
  - Promoting the client.
- Intimidation Threat:
  - Intimidation by management diminishes objectivity.
Meeting requirements assures quality/credibility, but ultimate responsibility remains with management.

Legal Liability

Discourages manager indiscretion.
Varying civil liability regimes (US most stringent, UK middle, Germany most accommodating).
US: Prove misleading disclosures and reliance.
UK: Prove negligent or intentionally misleading managers.
German: Prove negligence and substantive disclosure.
Public Enforcement Bodies:
- Review compliance with laws.
- Improve information quality but may stifle creativity.

Role of Financial Analysts

Information intermediaries.
Finance system: Productive use of funds.
- From surplus to those with business ideas.
- Intermediaries reduce costs, break down claims, mitigate risk.
Financial analysts intermediate information to expedite transactions

Information Intermediary Functions (Financial Analyst)

Perform economic value functions:
- Time efficiency: Gather info timeously.
- Mechanical efficiency: Transform info to knowledge.
- Liquidity creation: Increase transaction frequency, facilitate growth.
- Creation of new markets: Accurate info helps spot opportunities.
- Reduce adverse selection: Bring lender knowledge at par with borrower
- Combat moral hazard: reduce borrower's temptation to undertake agreed risky ventures
Financial advisory services:
- Risk profiling: Evaluate financial threats.
- Financial management: Plan asset acquisition, liability control.
- Investment analysis: Evaluate venture profitability and risk.
- Portfolio management: Manage wealth to ensure risk balance.
Build Investor confidence:
- Enhance investor confidence by their monitoring role

Equity Security Analysis

Evaluate company prospects from ownership perspective.
Analysis of firm’s shares for investment.
Part of overall investment process.
Process:
1. Establish investor objectives.
2. Form expectations about returns/risk of firms.
3. Combine shares into portfolios to match objectives.
Equity security analysis: Step 2 (projecting returns, assessing risks).

Purpose of Conducting the Analysis:

Identify mispriced stock.
Determine whether a particular security can be a good fit in an investor’s portfolio

Protagonists of the analysis

Systematic structure divides these financial specialists into two groups:
- Sell-side vs Buy-side Analysts
- Sell-side: includes brokers, dealers, market markers, traders, arbitrageurs, speculators, hedgers etc
  Type of Financial Analysis
  1. Brokers – mere middleman who identifies and bring together two parties withcommon interest exchanging
  2. Dealers – who trade on behalf of another person or investor. They are entrusted to act ina fiduciary on the behalf of their client
  3. Market marker – is a trader who specialises in maintaining inventory of securities of certaincompanies in order to provide liquidity for those companies.
  4. Traders – are people who take an active part in buying and selling of shares based onfundamentals for their own accord in a bid to make profit in the long run
  5. Arbitrageurs – traders who buy and sell different securities that are relatedsimultaneously in order to take advantage of price differentials
  6. Speculators – traders who attempt to anticipate what direction the a security price willtake and try to take a market position that will make them quick profit at the end of the day
  7. Hedgers – those investors that are looking to mitigate their losses by taking anoffsetting position to try and mitigate exposure to their main investment.

Equity Security Analysis Recap

Requires 3 steps:
- (i)Establish objective of analysis
- (ii)Evaluate the risk and return of the security
- (iii)Decide on the security’s goodness of fit to the wealth making plan
The main task of analysis is step 2.
- (a) Objective- could be to identify overpriced shares or to evaluate them forinvestment or wealth management purposes
- (b) By who – Sell side or buy side Analysts
- (c) Sell – Side – brokers, dealers, traders, market markers, arbitrageurs, speculators,hedgers etc

Buy-Side Financial Analysts

Include Collective investment funds, pension funds, mutual funds, insurance companies etc
Collective investment funds (CIFs) – refers to any form of a pool of funds for investment purposes.
Each fund has a specific purpose that it seeks to serve.
Initially they were distinguished from mutual funds in that they were administered bya professional in a fiduciary capacity rather than owned by a registered companyIn essence these where trust funds run by executor or a trustee
They have a defined investment strategy
Their advantages, besides being professional managed, are economies of scale andability to diversify
They also have tax and regulatory advantages
Types of CIFs
- a) Closed-ended Funds (CEFs) – these are set up with a fixed number of units of ownership or shares
  - The value of the share is not calculated from the value of the underlyingassets of the fund but is derived from the investors confidence about thefund and its management
  - CEFs can therefore sell at premium or discount of the Net Asset Value(NAV)
  - There are usually registered on the stock exchange market
  - CEFs are also referred to as investment trusts as opposed to unit trusts
- b) Open – ended Funds (OEFs) - It is a collective investment scheme in which investors buy shares directly from the investment firm itself rather than from thesecondary market
  - The price of each unit is calculated directly from the net value of the assets that the fund has invested in
  - There are also known as unit trust
  - Index funds are a form of (OEFs) which happen to be registered on exchanges
  - These are funds designed to follow certain pre-set rules so that the fund can track a specified basket of underlying investments
  - There are many of these index trackers such as :
- Exchange traded funds (ETFs) – these closely track the value of underlyingstocks or a certain Stock Market Index
  * In addition the ETFs could be targeting certain geographic areas e.g emerging markets, Asia, europe etc
  * Or specific sector or industry e.g Utility, Energy, dot.com, Biotech,exploration
  * It could be that they follow a certain investment strategy e.g value investing,growth investing or momentum investing

Investor’s objectives

In the financial mkts Equity analysis is usually undertaken for particular oridentifiable investor client
The kind of analysis undertaken, in terms of emphasis, is a function of theobjectives of the investor
Investor’s aims of investing are many and varied depending on their needs andsometimes wants
They are usually driven by the client’s personal factors such as age, wealth,education, tolerance for risk, tax status….and so on
Age: Young investors would prefer to invest in riskier shares of small but fastgrowing firms as they are more of risk-takers than the elderly. If they fail they canstill recover.
Tax status: Investors in high tax brackets would pref tax deferred capital gainsthan regular dividends or interest bearing-securities which results in them payingless tax
Income: Individuals with irregular income pref firm’s that pay regular dividendsthan those that retain profit for capital gains. This is because they need the incometo spend on their basic needs
Education: Generally, the more educated investors can tolerate more exotic/esotericinvestments to pure credit and equity ostensible because they are able tounderstand and gauge the risk level of complex transactions

Risk Tolerance

Risk-takers pref smaller fast-growing firms which are normally more risky than large dormant companies as with high risk comes high return
Family status: married people with children are more risk averse
Occupation: Professionals are more adventurous and most likely to invest in sharemarkets than in fixed income securities
Gender – Female led households used to be more conservative than male led ones

Investment vehicles (Types of Equity)

Given that investors’ needs and objectives are diverse there is need to haveequity securities that match these varied needs:
- Income funds – that invest in equities that are expected to generate regulardividend incomeGrowth funds – that specialises in equities with long-term capital gainsIndex funds – that invest in funds that track a particular set of securities/basket of assets e.g securities of Top 10 companies or
- Sector funds – which invest in a specific industries e.g Oil, Dot.com,BioTech, Software companies etc
- ETFs –Exchange traded funds which track particular indices and are tradeddirectly on the stock exchangeBonds funds – predominantly for bonds e.g. corporate, govt or high yieldbondsMortgage funds – invest in industrial, commercial or residential real estateor mortgage-backed securities. These are funds that invest in immovablepropertyThe value of security Analysis

The Value of Security Analysis

In a world of efficient markets all pertinent information will have beenincorporated in the prices of securities.
1. In this case the role of the analyst shifts from identifying mispricedsecurities for the investor to focusing on assisting the investor to maintain awell-diversified portfolio
2. Analysts also have to conduct analysis in order to correct marketinefficiencies. They help discover pertinent info and ensure it’sincorporated into the markets at their correct economic value.

Factors That Influence the Demand For Analysts’ Services in Financial Markets

a) Firm size: The larger the firm the more analysis is conducted as thereis high potential to make large amounts of profit:
- The shares of large firms are usually more liquid making it easier totrade them and take advantage of any opportunity that might havebeen identified
- The sheer size also allows block trading of shares on the marketwithout raising suspicion
- The shares are available in large numbers such that a substantialamount of profit can be made in an instant
Thus, Firm size is positively related to amount of analysts’ services required
b) Ownership structure: is in terms of the proportion of shares held by insiders versus non-insider investors
- The higher the proportion of company Insider holding, thelower demand for analysis reports.
- Insiders generally have superior info. They don’t needadditional info from an analyst
- Increase in insider holdings lowers the percentage of shares available to othernon-insider investors reducing demand for analyst’s info
- Increase in insider holding also increases secrecy and reduce transparency whichincreases the cost of providing analyst services
- Thus Ownership structure is negatively related to the demand for Analysts
c) Institutional investors: increase in the proportion of these investors’ holding andthe number of institutions involved increases the amount of analyst servicesdemanded
* This is because of both regulatory requirements, capacity and sheer size of the stakes at hand
* Thus Institutional Holding is positively related to demand for Analysis Services
d) Diversified Firms: a multidivisional firm requires an analyst to investmore effort in broadening their knowledge on the various lines ofbusinesses
* This increases the cost of providing analyst services and thus act as abarrier to the demand for of analysis
* Thus intersectionality is negatively related to analyst service demand.
e) Volatility of a firm’s stock: increases the probability of getting largedeviations from expected return
* This in turn increases the probability of making profit from trading onPrivate and presumably superior info
* This increases the demand for analysis
f) Intangible assets: analysts select firms with a large portion of intangibleassets in their balance sheet as these are not easy to evaluate by ordinarymeans and therefore high-quality private info is more valuable
* Examples of such assets are Goodwill, Brand names, Trademarks, patents,copyrights, dataTypes of equity security analysis

*These can be divided into two broad categories * Formal vs informal analysis * Formal evaluation is further divided into technical and fundamental techniques.

Formal vs Informal Evaluation

Formal analysis refers to full-scale valuation based on objectiveinformation, technical models and the use of the company’sfundamental/core metrics
It entails a systematic standardized valuation process conducted by anindependent expert who spends a great deal of time trying to understand thebehaviour patterns of the firm’s operations
Informal analyses on the other hand come in all forms, shapes and sizesand is basically amorphous.
Informal analysis is not data- driven but rather goal-driven
Its usual depends on “gut” feeling, hunch, guesswork, intuition, notion,impulse, whim, fancy, inclination, premonition, sixth sense and othermarginality approach that involves no attempt to value the firm holistically.
The analyst simply assumes that their opinion is more accurate than the restof the market
At times the investor thinks that they have unearthed some importantinformation about the firm that other investors are failing to recognise thusthey believe they could benefit.
There is therefore no specific framework to follow

Formal Evaluation

Given that informal analysis is formless and unstructured, no furtherattention can be devoted to it Formal analysis on the other hand can be categorized into technical andfundamental analysis Technical Analysis #Technical Analysis * Technical analysis is the practice of using statistics to determine trends in theshare prices * It uses metrics such as past market prices of the shares, traded volumes, pricevolatility or demand. They believe that by carefully interpreting and extrapolating this info
*These can be used on their own or regressed against other pertinent economyindicators, be there, lagging, coincident or leading indicators.

Examples of Leading Indicators are Rate of New Houses, Central BankPolicies, Crude oil Prices
Coincident Indicators are Average Earning Rates, Average Weekly hoursworked in manufacturing and the GDP
Lagging economic indicators are Unemployment rate, Interest rates andConsumer Price Index(CPI)* The technician believes that the short-term price movement are a resultof the supply and demand forces in the market for a given security thatestablishes its trend .They believe that by carefully interpreting and extrapolating this info
They believe that by carefully interpreting and extrapolating this infofuture price movements can be predicted. Technical analyst have quite a large toolbox of analytical techniquesand indicators* These models go beyond simple regression and extrapolation throughprobit analysis to artificial neural network analysis * One indicator is not enough a basis for making trading decisions . Therefore, an array of indicators are used to provide confirmation of thetechnician's hypothesis before a decision is finally made..
*There is generally no broad consensus about the best method ofidentifying future price movement * Therefore, technicians gradually develop their own set of trading rulesbased on their knowledge and experience * Technical analysis is short-term focused and is usually used by traders whobelieve in active investment strategy* Long-term investors can only use it to identify a good entry or exit pointTechnical analysis techniques* Technical analysis follow patterns of the stock price or the salesvolume through charts and technical Models.
Types of charts usedLine charts- are the most basic type of chart because itrepresents only the closing prices over a set period.
The line is formed by connecting the closing stock prices foreach day over a particular timeframe of interest: * While this type of chart doesn’t provide much insight intointraday price movements, many investors consider the closingprice to be more important than the opening, high, or low priceeach day.
These charts also make it easier to spot trends since there’s less‘noise’ the investor has to contend with compared to other charttypes (Bar charts)expand upon the line chart by adding the opening, high, lowto the closing price i.e. the daily price range to the mix.
The chart is made up of a series of vertical lines that represent the price range for each day with a horizontal dash on each side that represents theopening and closing prices * The opening price is the horizontal dash on the left side of the vertical lineand the closing price is located on the right side of the line. If the opening price is lower than the closing price, the line is often shaded black/green to represent a rising period.
The red shade represents a falling period. CANDLESTICKCHART Candlestick is a chart that displays the high, low, opening andclosing prices of a security for a specific period.
The wide part of the candlestick is called the