Financial Reporting PDF

1 Week 1 ====== Chapter 1 --------- ### Introduction - Financial reporting entails the disclosure of financial information about a company's financial performance in a certain period. - **Capital markets** play an important role in channeling financial resources from savers to business enterprises. 1. ### The role of ﬁnancial reporting in capital markets - In any economy savings need to be allocated to investment opportunities. This is a critical challenge as matching savings to business opportunities through the use of capital markets is complicated for three reasons: 1. Information asymmetry between savers and entrepreneurs \> entrepreneurs have better information than savers on the value of opportunities. 2. Conﬂicting interests -- credibility problems \> entrepreneurs have an incentive to inﬂate the value of their ideas. 3. Expertise asymmetry \> savers lack the financial sophistication needed to analyze and diﬀerentiate between projects. - The emergence of intermediaries can prevent such a break down. Intermediaries are: 1. **Financial intermediaries** \> focus on aggregating funds from individual investors and analyze diﬀerent investment alternatives to make decisions. They rely on the information in the financial statements to analyze the investment opportunities and supplement the information with more sources. 2. **Information intermediaries** \> focus on providing or assuring information to investors on the quality of various business investment opportunities. They add value by enhancing the credibility of financial reports or by analyzing information in financial statements. - Ideally, the various intermediaries ensure the efficient functioning of the capital markets system. However, the intermediaries can mutually reinforce rather than counterbalance each other which can cause several problems. 2. ### From business activities to ﬁnancial statements. - Physical and financial resources create value when the firm earns a return on its investment more than the return required by capital suppliers. - The business activities of a firm are inﬂuenced by: 4. The economic environment \> industry, input and output markets, and the regulations a firm deals with. 5. Business strategy determines how the firm positions itself in the environment to achieve competitive advantage. - **Financial statements** measure and summarize the economic consequences of its business activities. The accounting system provides a mechanism through which business activities are selected, measured, and aggregated into financial statement data. - Firms produce five financial reports: 1. Income statement \> operating performance. 2. Balance sheet \> assets and how they are financed. 3. Cash ﬂow statement \> cash ﬂows. 4. Statement of other comprehensive income \> sources of changes in equity that are not the result of transactions with owners and not included in the income statement. 5. A statement of changes in equity \> all sources of changes in equity \> sum of profit/loss, other comprehensive income, and transactions with owners. - Statements are accompanied by: 1. Notes \> details 2. Management's narrative discussion \> business model, environment, strategy, performance, and risks. 3. ### Inﬂuences of the accounting system on information quality - Financial reports are inﬂuenced by: 6. The firm's business activities 7. Accounting system. - The extent of the inﬂuence of the accounting system on the quality of financial statements is critical is determined by the following institutional features of accounting systems: 1. **Accrual accounting** \> distinguishes between costs or benefits associated with economic activities and the actual payment or cash receipt. The eﬀects of economic transactions are recorded on the basis of expected cash receipts. The following conceptual building blocks form the foundation of accrual accounting: 1. **Assets** \> economic resources of a firm that have the potential to produce economic benefits and are measurable with a reasonable degree of certainty. 2. **Liabilities** \> economic obligations of a firm that arise from benefits received, have the potential of being required to be met, and cannot be feasibly avoided by the firm. 3. **Equity** \> the diﬀerence between a firm's assets and liabilities. 2. The income statement, which summarizes a firm's income and expenses, where 𝑃𝑟𝑜𝑓i𝑡 𝑜𝑟 𝐿𝑜𝑠𝑠 = i𝑛𝑐𝑜𝑚𝑒 − 1. **Income or revenue** \> economic resources earned, and performance obligations settled. The realization principle governs revenue recognition \> revenues should be recognized when the firm has provided goods or services, and the customer has paid or is expected to pay. 2. **Expenses** \> economic resources used up and economic obligations created. In sum: costs directly associated with revenues in the same period, costs associated with benefits consumed in the same period, or resources whose future benefits are not reasonably certain. 3. **Proﬁt or loss** \> the diﬀerence between a firm's income and expenses in a period. 2. Accounting conventions and standards. Several accounting conventions ensure that managers use their accounting ﬂexibility to summarize their knowledge of the firm's business activities, and not disguise reality for self-serving purposes. Accounting standards and rules also limit management's ability to misuse accounting judgements by regulating how firms record types of transactions. They create a uniform accounting language, improve the comparability of financial statements, and increase the credibility of financial statements by limiting a firm's ability to distort them. 3. Manager's **reporting strategy** \> how managers use their discretion. 4. Auditing, legal liability, and public enforcement. 4. **Auditing** \> ensures that managers use accounting rules and conventions consistently over time and that their accounting estimates are reasonable. Auditors issue an opinion, but the primary responsibility for the statements rests with corporate managers. Third-party auditing may reduce the quality of the reports because it constrains the kind of accounting rules and conventions that evolve over time. 5. **Legal liability** \> The legal environment can significantly aﬀect the quality of the reported numbers. 6. **Public enforcement** \> public enforcement bodies either proactively or on a complaint basis initiate reviews of companies' compliance with accounting standards and take actions to correct noncompliance. Proactive enforcement bodies conduct their investigations on a sampling basis. - Accrual accounting means that there is a trade-oﬀ due to: 1. Accounting estimates \> what is the 'right' number? 2. Flexibility in standards \> how much discretion to 'choose' a number? 3. 'imperfect rules' \> do the rules reﬂect the current environment? 4. Managers' incentives \> Do they want to present the 'right' number? There are incentives to 'distort' accounting numbers. 4. ### Alternative mechanisms to communicate with investors - Firms often use alternative media or forms of reporting because of the limitations of accounting standards, auditing, and enforcement. Three alternative ways are: 8. **Analyst meetings** \> meetings with financial analysts that follow the firm. Questions will be answered about the firm's financial performance and future business plans will be discussed. Some rules aﬀect the nature of these interaction and can therefore reduce the information that managers are willing to share in meetings, making it a less eﬀective forum. 9. **Non-ﬁnancial reporting** \> happens when financial statements do not sufficiently reﬂect the actions' costs or benefits. Commonly referred to as **environmental, social, and governance disclosures (ESG) disclosures**. What is relevant to report depends strongly on the industry and the environment in which a firm operates. Currently disclosed ESG reports have a low degree of standardizations. There are various frameworks and standards that companies can adhere to when preparing their non-financial reports. Two major reporting frameworks and regulation have emerged: 1. EU's **Corporate Sustainability Reporting Directive (CSRD)** \> requires large listed firms to report in line with 2. **International Sustainability Standards Board (ISSB)** \> seeks to establish disclosure standards using concepts from IFRS. Investor oriented. 1. All direct emissions within an organization's control. 2. Indirect emissions from purchased electricity, heat, steam, or cooling. 3. Other indirect emissions in entire value chain. 3. **Voluntary disclosure** \> expanded disclosure. This type of communication has three constraints: 1. Competitive dynamics in product markets. 2. Management's legal liability \> civil actions by dissatisfied investors for providing misleading information. 3. Management credibility can limit a firm's incentives to provide voluntary disclosures. 5. ### From ﬁnancial statements to business analysis - It is difficult for outside users of financial statements to separate accurate information from distortion and noise. Eﬀective financial statement analysis has value because it attempts to get at managers' inside information from public financial statement data. It is needed because the information that is conveyed needs to be understood as there is no clear right or wrong. Intermediaries rely on their knowledge of the firm's industry and its competitive strategies to interpret financial statements. Outside analysts are more objective. - Business intermediaries use financial statements to accomplish four key steps: 10. **Business strategy analysis** \> identify key profit drivers and business risks and assess the company's profit potential at a qualitative level by analyzing a firm's strategy and industry. Enables the analyst to better frame the subsequent accounting and financial analysis, and to make sound assumptions in forecasting future performance. 11. **Accounting analysis** \> evaluating the degree to which a firm's accounting captures underlying business reality by identifying places where there is accounting ﬂexibility and evaluating the firm's accounting policies and 12. **Financial analysis** \> using financial data to evaluate a firm's current and past performance and assessing sustainability. Two important skills: 3. The analysis should be systematic and efficient. 4. It should allow analysts to use the financial data to explore business issues. Commonly used tools: 1. Ratio analysis \> evaluates a firm's product market performance and financial policies. 2. Cash ﬂow analysis \> evaluates a firm's liquidity and financial ﬂexibility. 13. **Prospective analysis** \> focuses on forecasting a firm's future. Commonly used techniques allow the synthesis of the insights from the three previous steps to forecast the future: 5. Financial statement forecasting. 6. Valuation. - The first three steps provide an excellent foundation for estimating a firm's intrinsic value: 1. Strategy analysis provides sound accounting and financial analysis, and helps assessing potential changes in the competitive advantage of a firm. 2. Accounting analysis provides an unbiased estimate of a firm's current book value and ROE. 3. Financial analysis facilitates an in-depth understanding of what drives the firm's current ROE. 1. Many applications of financial statement analysis whose focus is outside the capital market context. 2. Markets become efficient precisely because some participants rely on analytical tools to analyze information and make investment decisions. Chapter 2 --------- ### Introduction - Strategy analysis allows the analyst to probe the economics of a firm at a qualitative level so that the subsequent accounting and financial analysis is grounded in business reality. The value of a firm depends on its ability to earn a return on its capital above the cost of capital. Strategic choices: 1. **Industry analysis** \> the choice of an industry or a set of industries in which the firm operates. 2. **Competitive strategy** \> how the firm intends to compete with other firms in its chosen industry or industries. 3. **Corporate strategy analysis** \> how the firm expects to create and exploit synergies across the range of businesses it operates. 1. ### Industry analysis - There are five forces that inﬂuence the average profitability of an industry, divided in two categories: 1. The intensity of competition, which determines the potential to create abnormal profits. It is the degree of actual and potential competition. **Industry competition** \> the degree to which there is competition among suppliers of the same or similar products. There are **competitive forces** in an industry: 1. Rivalry between existing firms. Several factors determine the intensity of competition between existing players in an industry: - Industry growth rate. A rapidly growing industry has a less intense rivalry among firms than a stagnant industry. - Concentration and balance of competitors. The degree of concentration inﬂuences whether firms in an industry can coordinate their pricing and other competitive moves. - Excess capacity and exit barriers. If capacity in an industry is larger than customer demand \> excess capacity, which is exacerbated if there are significant exit barriers, such as specialized assets or costly regulations. - Degree of diﬀerentiation and switching costs. - Scale/learning economies and the ratio of fixed to variable costs. A steep learning curve \> aggressive competition for market share. A high ratio of fixed to variable costs \> reduce prices to utilize capacity. 2. Threat of entry of new firms. The potential for earning abnormal profits will attract new entrants to an industry. The ease with which new firms can enter an industry is a key determinant of its profitability. The height of barriers to entry in an industry is determined by: 1. Scale. High economies of scale \> cost disadvantage new entrants. 2. First mover advantage \> early entrants may have an advantage. 3. Access to channels of distribution and relationships. 4. Legal barriers \> patents, copyrights, licensing regulations, import quotas, tariﬀs, or government subsidies. 2. The relative **bargaining power** which determines whether the industry keeps the potential profits. Actual profits are inﬂuenced on this. 1. Bargaining power of buyers is determined by two factors: - Price sensitivity \> the extent to which buyers care to bargain on price. Buyers are more price-sensitive when the product is undiﬀerentiated. - Relative bargaining power \> the extent to which they will succeed in forcing the price down. Relative bargaining power in a transaction depends on the cost to each party of not doing business with the other party. It is a measure of the ability of each party involved in a transaction to inﬂuence and shape the terms of the deal, including pricing. 2. Bargaining power of suppliers. Suppliers are powerful when there are only a few companies, and few substitutes are available to their customers. Suppliers also have a lot of power over buyers when the suppliers' product or service is critical to buyers' business. Suppliers also tend to be powerful when they pose a credible threat of forward integration. - A potential limit of the industry analysis is the assumption that industries have clear boundaries. 2. ### Competitive strategy analysis - There are two generic competitive strategies: 2. **Cost leadership \>** enables a firm to supply the same product or service oﬀered by its competitors at a lower cost. It is often the clearest way to achieve competitive advantage. Advantage: earn above-average profitability by merely charging the same price as its rivals. Focus on cost control. 3. **Diﬀerentiation** \> providing a product or service that is distinct in some important respect valued by the customer. For diﬀerentiation to be successful, three things should be accomplished: 3. It needs to identify one or more attributes of a product the customer values. 4. It has to position itself to meet the chosen customer in a unique matter. 5. Lower costs than the price the customer is willing to pay for the diﬀerentiated product. - The choice of competitive strategy does not automatically lead to the achievement of competitive advantage. A competitive strategy is unique and successful in achieving a sustainable competitive advantage when: 1. **Unique core competencies** \> it is important that the resources supporting the core competencies cannot be acquired easily by competitors or substituted by other resources. 2. **System of activities** \> the system of activities should fit the strategy and they should reinforce each other. 3. **Positioning** \> firms often identify or carve out a profitable industry subsegment. This can be based on: 1. Product or service varieties. 2. The needs of a particular customer group. 3. Access and distribution channels. 3. ### Corporate Strategy Analysis - When analyzing a multi-business organization, an analyst must evaluate the industries and strategies of the individual business units and the economic consequences of managing all the diﬀerent businesses under one corporate umbrella. - Transaction cost economics implies that the multiproduct firm is an efficient choice of organizational form when coordination among independent, focused firms is costly due to market transactions, that can arise from several sources. Emerging economies often suﬀer from these type of transaction costs because of poorly developed intermediation infrastructure. Transaction costs can arise when the production process involves human capital skills or from information and incentive problems. - Transactions inside an organization may be less costly than market-based transactions because: 4. **Information** \> communication costs inside an organization are lower because internal mechanisms can protect confidentiality and assure credibility. 5. **Enforcement** \> reducing costs of enforcing agreements between organizational subunits. 6. **Asset sharing** \> organizational subunits can share valuable non-tradable assets or non-divisible assets. - Some forces may increase transaction costs. One is the lack of expertise from top management, which reduces the possibility of realizing economies of scope. Remedy: create a decentralized organization, hire specialist managers to run each business units, and provide those managers with proper incentives. Downside remedy: it can make it more difficult to realize economies of scope because goal congruence can be decreased. - There is considerable evidence that value is created when multi-business companies increase corporate focus through divisional spin-oﬀs and asset sales and that diversified companies trade at a discount in the stock market. For this there are several explanations: 1. **Empire building** \> managers' decisions to diversify and expand frequently follow from a desire to maximize the size of their organization rather than to maximize shareholder value. 2. **Incentive misalignment** \> diversified companies suﬀer from incentive misalignment problems. 3. **Monitoring problems** \> capital markets find it difficult to monitor and value multi-business organizations because of inadequate disclosure about the performance of individual business segments. Chapter 3 --------- ### Introduction - The purpose of accounting analysis is to evaluate the degree to which a firm's accounting captures its underlying business reality. Accounting analysis includes the following components: 1. **Accounting quality analysis** \> analysts assess the degree of distortion in a firm's accounting numbers. 2. ### **Accounting adjustments** \> adjusting a firm's accounting numbers using cash ﬂow information and information from the notes to the financial statements to undo accounting distortions. 3. **Financial statement standardization** \> to remove unnecessary details and make statements more comparable across firms and over time, analysts standardize the financial statements and identify profit/loss components that will unlikely recur. 1. ### Factors Inﬂuencing Accounting Quality - When accounting distortions are large, accounting analysis can add considerable value. There are three potential sources of **noise and bias in accounting data**: 1. That introduced by rigidity in accounting rules. Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing the information content of the accounting data. The degree of distortion introduced by accounting standards depends on how well uniform accounting standards capture the nature of a firm's transactions. As a solution to the adverse eﬀects of rigid accounting rules, the IASB leaves responsibility to the managers and accountants to decide what proportion of outlays will likely generate revenue. There are important diﬀerences in the approaches of the IASB and FASB towards standard-setting. The IASB leaves much responsibility to the managers, and the FASB leaves managers much less discretion. 2. Random forecast errors as managers cannot predict future consequences of current transactions perfectly. The extent of errors in managers' accounting forecasts depends on various factors, including the complexity of the business transactions, the predictability of the firm's environment, and unforeseen economy-wide changes. 3. Systematic reporting choices made by corporate managers to achieve specific objectives. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives: 1. **Accounting-based debt covenants** \> Managers of firms close to violating covenants have an incentive to select accounting policies and estimates to reduce the profitability of covenant violation. 2. **Management compensation** \> tied to reported profits. 3. **Corporate control contests** \> competing management groups attempt to win over the firms' shareholders. Managers may make accounting decisions to inﬂuence investor perceptions in corporate control contests. 4. **Tax considerations** \> a trade-oﬀ between financial reporting and tax considerations \> reporting choices. 5. **Regulatory considerations** \> regulators use accounting numbers in various contexts, so managers of some firms may make accounting decisions to inﬂuence the outcomes. 6. **Capital market considerations** \> managers may make accounting decisions to inﬂuence the perceptions of capital markets. 7. **Stakeholder considerations** \> inﬂuence the perception of important stakeholders. 8. **Competitive considerations** \> the dynamics of competition in an industry. - The level of disclosure is also an important determinant of a firm's accounting quality. 2. ### Steps in Accounting Analysis - There are steps that an analyst can follow to evaluate a firm's accounting quality: 4. Identify key accounting policies. The analyst should identify and evaluate the policies and the estimates the firm uses to measure its critical factors and risks. 5. Assess accounting ﬂexibility. If managers have little ﬂexibility in choosing accounting policies and estimates related to their key success factors, accounting data will be less informative for understanding the firm's economics. 6. Evaluate accounting strategy. Some of the strategy questions that can be asked are: 9. **Reporting incentives** \> do managers face strong incentives to use accounting discretion to manage earnings? 10. **Deviations from the norm** \> how do the firm's accounting policies compare to the norms in the industry? 11. **Accounting changes** \> has the firm changed any of its policies or estimates, and why? 12. **Past accounting errors** \> have the company's policies and estimates been realistic in the past? 13. **Structuring of transactions** \> does the firm structure any significant business transactions so that it can achieve certain accounting objectives? 7. Evaluate the quality of disclosure. To assess a firm's disclosure quality, the following questions can be asked: 14. **Strategic choices** \> does the company provide adequate disclosures to assess the firm's business strategy and its economic consequences? 15. **Accounting choices** \> do the notes to the financial statements adequately explain the key accounting policies and assumptions and their logic? 16. **Discussion of ﬁnancial performance** \> does the firm adequately explain its current performance? 17. **Non-ﬁnancial performance information** \> if accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed? 18. **Segment information** \> if a firm is in multiple business segments, what is the quality of segment disclosure? 19. **Bad news** \> how forthcoming is management about bad news? 20. **Investor relations** \> how good is the firm's investor relations program? 8. Identify potential red ﬂags. Some common red ﬂags are: 21. unexplained changes in accounting, especially when performance is poor \> accounting discretion is used to dress up financial statements. 22. Unexplained transactions that boost profits. 23. Unusual increases in trade receivables in relation to sales increases \> company may be relaxing credit policies. 24. Unusual increases in inventories in relation to sales increases \> if the inventory build-up is due to an increase in finished goods inventory, demand for the product may be slowing down. 25. An increasing gap between a firm's reported profit and its cash ﬂow from operating activities \> any change in the relationship between reported profits and cash ﬂows might indicate subtle changes in the firm's accrual estimates. 26. An increasing gap between a firm's reported profit and its tax profit. 27. A tendency to use financing mechanisms like R&D partnerships, special purpose vehicles, and the sale of receivables with recourse \> can provide the opportunity to understate the firm's liabilities or overstate the firm's assets. 28. Unexpected large asset write-oﬀs \> management is slow to incorporate changing business circumstances into its accounting estimates. 29. Unusual risks among the Key Audit Matters or changes in independent auditors that are not well justified. 30. Poor interval governance mechanisms 31. Related-party transactions or transactions between related entities \> may lack the objectivity of the marketplace. 9. Synthesize risks and undo accounting distortions. If the analyst is unsure of the quality of the firm's accrual accounting, the cash ﬂow statement provides an alternative benchmark of its performance. 3. ### Recasting Financial Statements - Firms sometimes use diﬀerent formats to present their financial results. These diﬀerences can make it difficult to compare performance across firms, and sometimes to compare performance for the same firm over time. The task for the analyst in accounting analysis is to recast the financial statements into a common format. - One obstacle that the analyst must overcome is that the international standards allow firms to classify their operating expenses in two ways: 10. **Classiﬁcation of operating expenses by function** \> defines categories with reference to the cause of operating expenses. Provides better information about the efficiency and profitability of a firm's operating activities. 11. **Classiﬁcation of operating expenses by nature** \> defines categories with reference to the purpose of operating expenses. Income statements that are prepared under this classification include **gross proﬁt**, which is the diﬀerence between revenue and costs of goods sold. This classification is less arbitrary and requires less judgement from management. - Another obstacle may be that firms use similar terminology under diﬀerent approaches. The IFRS Standards require that when firms classify their expenses by function, they should also report a classification of expenses by nature in the notes to the financial statements. - The design of standardized statements primarily depends on how such statements will be used in the following steps of the process. Two general rules apply to most common types of business analysis: 1. Business activities versus financing activities. Business activities aﬀect the firm's value creation. Financing activities aﬀect the allocation of value among the firm's capital providers more than the value itself. The standardized financial statements must clearly separate business from financial assets or liabilities to follow such an approach. 2. Aggregation versus disaggregation. Statements must be sufficiently disaggregated to enable users to separately analyze items that have materially diﬀerent future performance consequences. - We classify balance sheet items along the following dimensions: 1. Business (operating and investment) versus financial assets or liabilities. 2. Current versus non-current assets or liabilities. 3. Assets or liabilities from continued versus discontinued operations. - In the income statement, we distinguish business items from financial items. 4. ### Accounting Analysis Pitfalls - There are several potential pitfalls and common misconceptions in accounting analysis: 12. Conservative accounting is not "good" accounting. Financial statement users want to evaluate how well a firm's accounting captures business reality in an unbiased manner. Conservative accounting can be as misleading as aggressive accounting in this perspective. Conservative accounting often provides managers with opportunities for reducing the volatility of reported earnings, which may prevent analysts from recognizing poor performance in a timely fashion. 13. Not all unusual accounting is questionable. Unusual accounting choices may be justified if the company's business is unusual. Accounting changes might be merely reﬂecting changed business circumstances. 14. Common accounting standards are not the same as common accounting practices. Lecture 1 --------- - **Financial accounting** \> framework for business analysis and valuation. - **Financial statements** \> measure and summarize economic consequences of business activities, and comprise: 1. Statement of comprehensive income. 2. Statement of financial position. 3. Cash ﬂow statement. 4. Statement of changes in equity. 5. Notes. - Business activities are inﬂuenced by the business environment and markets (the context), and by the business strategy and positioning (decisions). - The accounting system is inﬂuenced by the accounting environment and regulations, which is inﬂuenced by the environment and markets. In addition, it is inﬂuenced by the accounting strategy and policies, which is inﬂuenced by the business strategy and positioning. - Key takeaway\> accounting is not objective, there is no 'true' income. - Inﬂuences on financial reporting are: 1. Accrual accounting and discretion. 2. Managers' inﬂuence on financial statements. 3. Accounting conventions and standards. \> IFRS (international financial reporting standards. 4. Auditing and the regulatory framework. - #### The users of ﬁnancial statements: 1. Shareholders (main focus IFRS) 2. Banks/creditors (main focus IFRS) 3. Customers/suppliers 4. Employees 5. Government 6. Society 7. Etc. - Financial statements and other public information are the inputs for the analysis tools, which are: 1. Strategy analysis: 1. Industry analysis. 2. Competitive strategy analysis. 2. Strategy analysis helps in accounting analysis, financial analysis, and prospective analysis. 3. Accounting analysis \> accounting policies and distortions. 4. Financial analysis \> ratio and cash ﬂow analysis. 5. Prospective analysis \> forecasting and valuation. - The following financial statement elements: 1. Revenues and expenses belong to the income statement. 2. Assets, liabilities, and equity belong to the balance sheet. - **Accrual accounting** \> transactions are recorded when they occur, rather than at the time of a cash ﬂow. There is a trade-oﬀ due to: 1. Accounting estimates. 2. Flexibility in standards. 3. Imperfect rules. 4. Managers incentives. Management has superior knowledge of a firm's business. However, managers have incentives to 'distort' accounting numbers. - ESG reporting \> Environmental, social, and governance reporting. Consists of three pillars: 1. Environmental reporting \> greenhouse gas emissions, natural resource management, waste and pollution. 2. Social reporting \> working conditions, labor practices, product safety, data security, and the supply chain. 3. Governance reporting \> executive pay, board diversity and structure, tax strategies, bribery, corruption, transparency, accountability, and ethics. - Two major reporting frameworks and regulation have emerged: 1. **CSRD** \> Corporate Sustainability Reporting Directive, which requires listed firms to report in line with **European Sustainability Reporting Standards (ESRS)** \> stakeholder orientation. 2. **International sustainability standards board (ISSB)** \> seeks to establish disclosure standards using concepts from IFRS \> investor orientation. - Major ESG focus \> reporting greenhouse gas emissions. 1. All direct emissions within an organization's control. 2. Indirect emissions from purchased electricity, heat, steam, or cooling. 3. Other indirect emissions in entire value chain. Greatest share of a firm's carbon footprint. Lecture 2 --------- - **Strategy analysis** \> allows us to exploit the connection between business activities and financial statements. It enables analysts to: 1. Assess economic and financial outlook from a qualitative perspective. 2. Place the firm within its industry, assess its relative power and industry outlook. 3. Identify firm's profit drivers, risks, and the sustainability of its performance. 4. Evaluate management's forecasts and make own assessments. - **Industry analysis** is based on Porter's five forces, which all inﬂuence the industry profitability. The five forces can be divided into two categories: 1. Degree of actual and potential competition, which is determined by the rivalry among existing firms, the threat of new entrants, and the threat of substitute products. 2. Bargaining power in input and output markets, which is determined by the bargaining power of buyers and suppliers. - **Competitive strategy analysis** consists out of two basic competitive strategies: 1. **Cost leadership** \> optimizing operations to create cost advantage that translates into low-price products targeted at price-sensitive customers. 2. **Product/service diﬀerentiation** \> building competitive advantage based on unique, distinct, or superior products that can be sold at a price premium. - Cost leaders and diﬀerentiators diﬀer in terms of their cost control. But also, in terms of their investments in product design/quality, brand image, reputation, etc. - **Accounting analysis** is about understanding accounting, which allows analysts to eﬀectively use financial information. It helps analysts to (1) identify areas of noise and bias, and (2) make adjustments so as to estimate a firm's true performance. - There are three potential sources of **noise and bias in accounting data**: 1. Noise from accounting rules. 2. Forecast errors -- does the analyst agree with management's estimate? 3. Managers' accounting choices -- which incentives does the management have? Which adjustments are needed to 'correct' the impact of managers' biased accounting choices? - IFRS 15 \> 5-step approach to recognize revenue: 1. Identify the contract with the customer. 2. Identify the performance obligation(s) in the contract. 3. Determine the transaction price per performance obligation. 4. Allocate the transaction price to the performance obligation in the contract. 5. Recognize revenue as the entity satisfies a performance obligation. - 'golden rule' of accounting \> accruals reverse: 1. Initial positive (negative) accruals reverse into negative (positive) ones. 2. Accrual accounting is about allocating revenues and expenses to the period in which the underlying transaction occurs. At some point, cash ﬂows need to 'back up' these revenues and expenses. 3. Large accruals may be a sign for unusual accounting treatment. - Accounting analysis pitfalls: 1. Not all unusual accounting practices are dubious \> some unusual accounting phenomena can be explained by economic developments. 2. Less ﬂexibility does not mean more informative accounting. 3. Common standards are not the same as common practices. The classification of the income statement, for example, can be done by nature of expense (cause of expense), or by function of expense (purpose of expenses). - Six steps in accounting analysis: 1. Identify principal accounting policies. 2. Assess accounting ﬂexibility. 3. Evaluate accounting strategy. 4. Evaluate the quality of disclosure. 5. Identify red ﬂags. 6. Undo accounting distortions. Tutorial 1 ---------- - **Cash ﬂow** \> change in cash and cash equivalents. - Profit = change in equity \> ignoring transactions with owners. 1. Equity decreases when there is an expense or loss. 2. Equity increases when there is a revenue or gain. - Profit -- cash ﬂow = changes in other balance sheet items. - **Bookkeeping** \> technique for systematically recording the required information. - Recording a sale on credit: 1. Debittrade receivable and credit revenue 2. Debit costs of goods sold and credit inventory. When the receivables are collected: 1\. Debit cash and credit trade receivables. - Allowance for doubtful accounts is created when afraid debtors won't pay. An increase in this account consists of the following journal entries: 1\. Debit bad debt expense and credit allowance for doubtful accounts. - Cost of property, plant, and equipment is recognized as an asset if, and only if: 1. It is probable that future economic benefits associated with the item will ﬂow to the entity. 2. The cost of the item can be measured reliably. The cost includes: 1. Its purchase price including import duties, non-refundable taxes, etc. 2. Any costs directly attributed to bringing the asset to the location and condition necessary for it to be capable of operating. 3. The estimated costs of dismantling and removing the item and restoring the site on which it is located. - A provision is recognized if: 1. Present obligation 2. Outflow probable 3. Reliable estimate. Otherwise: contingent liability or no disclosure. - Journal entry for provision: 1. Debit provision expense and credit provision liability. 2. Debit provision liability and credit cash Week 2 ====== Chapter 4 --------- ### Recognition of Assets - Accountants define assets as resources that a firm owns or controls as a result of past business transactions and that can produce future economic benefits measurable with a reasonable degree of certainty. **Distortions in asset** values generally arise because there is ambiguity about whether: 1. The firm owns or controls the economic resources in question. The firm using the resource owns the asset. Some transactions, however, make it difficult to assess who owns a resource. Accounting analysis involves assessing whether a firm' reported assets adequately reﬂect the key resources under its control and whether adjustments are required. Asset ownership issues also arise from the application of rules for revenue recognition: recognition of revenue frequently coincides with "ownership" of a receivable, which is shown as an asset. In addition, accounting rules cannot capture all of the subtleties associated with ownership and control, which can create ambiguity as well. 2. The economic resources can provide future economic benefits that are measurable with reasonable certainty. it is difficult to accurately forecast future benefits associated with capital outlays. IAS 38 requires: 1. Expensing research outlays. 2. Capitalizing development outlays only if they meet stringent criteria of technical and economic feasibility. 3. The fair values of assets fall below their book values. An asset is impaired when its fair value falls below its book value. IAS 36 mandate recognizing impairment loss on a non-current asset when the asset's book value exceeds its recoverable amount, being the greater of the asset's fair value less costs of disposal. 4. Fair value estimates are accurate. Managers estimate fair values of assets for reasons other than asset impairment testing. One other reasons of fair value estimates is to adjust the book value of assets when firms use the revaluation method instead of the historical cost method. IAS 16 allows firms to record their non-current assets at fair value instead of historical cost. Fair value estimates are also needed to calculate goodwill. IFRS 3 requires testing the amount of goodwill for impairment regularly. IFRS 9 requires a firm to recognize equity investments and debt investments held for trading at their fair values. 2. ### Asset Distortions - Asset overstatements are likely to arise when managers have incentives to increase reported earnings. Thus, adjustments to assets typically require adjustments to the income statement in the form of increased expenses or reduced revenues. - Asset understatements arise when managers have incentives to deﬂate reported earnings. Accounting rules themselves can also lead to the understatement of assets or when managers have incentives to understate liabilities. - The most common items that can lead to overstatement or understatement of assets are: 3. Depreciation and amortization on non-current assets. If estimates of asset lives, salvage values, and amortization schedules are optimistic, non-current assets are likely to be overstated. 4. Impairment of non-current assets. 5. Leased assets. IFRS 16 requires that a company leasing an asset recognizes a lease asset and a lease liability on its balance sheet, reﬂecting its right to use the asset and its obligation to make rental payments \> right-of- use assets. 6. Intangible assets. The balance sheet excludes some of the most important assets, such as research and development. 7. Timing of revenue recognition. Accelerated revenue recognition is a relevant concern when analyzing statements of a company that engages in complex contracts. Because such contracts often include distinct performance obligations. Second, contracts with customers can be long term, so: 1. Cash or other considerations received for goods or services that the firm will deliver in a future period can give rise to one of two assets: trade receivable or contract asset (when right to payment is conditional on delivering future services of products). 2. Contract costs are capitalized costs that the firm has incurred to fulfill a contract such as direct labor costs. The firm amortizes these costs against the revenue it recognizes on the contract. 8. Allowances. Managers make estimates of expected customer defaults on trade receivables and loans. If managers underestimate the value of these allowances, they will overstate assets and earnings. If managers overestimate allowances for doubtful accounts or loan losses, trade receivables and loans will be understated. 9. Write-downs of current assets. Deteriorating industry or firm economic conditions can aﬀect the value of non- current assets as well as current assets. When the fair value of an asset falls below its book value, the asset is "impaired". Firms are required to recognize impairments in the values of non-current assets when they arise. 3. ### Recognition of Liabilities - Liabilities are defined as economic obligations that arise from benefits received in the past, have the potential of being required to be met, and cannot be feasibly avoided. **Distortions in liabilities** arise because there is ambiguity about: 5. An obligation has been incurred. 6. Proper measurement of the obligation. However, for some obligations it is difficult to estimate the amount of the obligation. Sometimes the amount depends on certain events. 4. ### Liability distortions - Liabilities are likely to be understated when the firm has key commitments that are difficult to value and therefore not considered liabilities for financial reporting purposes. By understating leverage, a rosy picture is presented. The most common forms of liability understatement arise when the following conditions exist: 7. Deferred revenues are understated through aggressive revenue recognition. Firms that recognize revenues prematurely, understate deferred revenue liabilities and overstate earnings. 8. Provisions are understated. Many firms have obligations that likely result in a future outflow of cash but for which the exact amount still needs to be established. A provision is recognized for such uncertain liabilities when: 10. It is probable that the obligation will lead to a future outflow of cash. 11. The firm has no or little discretion to avoid the obligation. 12. The firm can make a reliable estimate of the amount of the obligation. 9. Post-employment obligations are not fully recorded. IAS 26 requires that firms estimate the value of post- employment commitments, as the present value of future expected payouts under the plans. It is reasonable for the analyst to ask questions about these obligations, particularly in labor-intensive industries. Questions that can be asked: 13. Are the assumptions made by the firm realistic? 14. What eﬀect do the benefit assumptions play in the income statement? The post-employment benefit expense each year comprises: - Current and past service cost, plus - Interest cost on the net post-employment benefit liability. - Firms also recognize some components outside the income statement: actuarial gains and losses, and excess return on plan assets. Excess return on plan assets \> actual return -- discount rate \* fair value of plan assets. 5. ### Equity Distortions 10. Employee stock options. 11. Convertible bonds. 12. Other comprehensive income. Chapter 5 --------- ### Introduction - The goal of financial analysis is to assess a firm's performance in the context of its stated goals and strategy. There are two principal tools of financial analysis: 15. **Ratio analysis** \> assessing how various line items in a firm's financial statements relate to one another. 16. Cash ﬂow analysis \> allows the analyst to examine the firm's liquidity and how it manages its operating, investment, and financing cash ﬂows. 1. ### Ratio Analysis - Profitability and growth together determine the value of a firm. Both depend on its product market and financial market strategies. The four levers that managers can use to achieve their growth and profit targets are: 1. Operating management \> managing revenue and expenses \> product market strategy. 2. Investment management \> managing working capital and fixed assets \> product market strategy. 3. Financing strategy \> managing liabilities and equity \> financial market policy. 4. Dividend policies \> managing payout \> financial market policy. - The objective of ratio analysis is to evaluate the eﬀectiveness of the firm's policies in these areas. It involves relating the financial numbers to business factors in as much detail as possible. In ratio analysis, the analyst can: 1. **Time-series comparison** \> the analyst holds firm-specific factors constant and examines the eﬀectiveness of a firm's strategy over time. 2. **Cross-sectional comparison** \> facilitates examining the relative performance of a firm within its industry, holding industry-level factors constant. 3. Compare ratios to some absolute benchmark. For most ratios, there are no benchmarks. The exceptions are measures of rates of return. - The starting point for a systematic analysis of a firm's performance is its ROE**: [ ]**[^𝑝𝑟𝑜\$i𝑡^ ^𝑜𝑟^ ^𝑙𝑜𝑠𝑠^]. It indicates how well managers are employing the funds invested by the firm's shareholders to generate returns. In the long run, the value of the firm's equity depends on the diﬀerence between its ROE and its cost of equity capital. Cost of equity capital \> the return that equity holders require on their equity investment in the firm. We can think of the cost of equity capital as establishing a benchmark for the ROE in a long-run competitive equilibrium. Deviations from this level arise because: 1. Industry conditions and competitive strategy that cause a firm to generate economic profits. 2. Distortions due to accounting. - A company's ROE depends on: 1. How profitably it employs its assets. This can be measured by the return on assets (ROA) \> [^𝑝𝑟𝑜\$i𝑡^ ^𝑜𝑟^ ^𝑙𝑜𝑠𝑠^]. It tells us how much profit a company generates for each euro of assets invested. The ROA has two factors: 1. Net profit margin or return on sales \> ^𝑝𝑟𝑜\$i𝑡^ ^𝑜𝑟^ ^𝑙𝑜𝑠𝑠^. indicates how much the company can keep as profits for 2. Asset turnover \> [ ^𝑟𝑒𝑣𝑒𝑛𝑢𝑒^]. Indicates how many euros of revenue the firm can generate for each euro of its 2. How big the firm's asset base is relative to shareholders' investment. It indicates how many euros of assets the firm can deploy for each euro invested by its shareholders. This can be measured by the financial leverage, - It is often useful to distinguish between the sources of performance (operating, financing, investing) because: 1. Valuing operating assets requires diﬀerent tools from valuing non-operating investments. 2. Operating, investment, and financing activities contribute diﬀerently to a firm's performance and value, and their relative importance may vary significantly across time and firms. 3. The preceding financial leverage ratio does not recognize that some of the firm's liabilities are non-interest- bearing operating liabilities. - Before we decompose ROE, here is a list of definitions used in ratio analysis: - Operating and investment components are business assets. The financing component is debt and invested capital. - ROE can be decomposed by: - Return on invested capital (ROIC) measures how profitably a company can deploy its operating and nonoperating assets to generate profits. Spread is the incremental economic eﬀect from introducing debt into the capital structure. The extent to which a firm borrows relative to its equity base magnifies the ROE impact of both the positive and negative spread. The ratio of debt to equity provides a measure of this financial leverage. We can split up the ROIC into an operating (RNOA) and an investment (RNOI) component: 𝑛4𝑃𝐴𝑇 - The return on operating assets (RNOA) can be decomposed into NOPAT margin (measures how profitable a company's sales are from an operating perspective) and operating asset turnover (measures the extent to which a company succeeds in using its net operating assets to generate revenue): 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 ### Assessing Operating Management: Decomposing Proﬁt Margins - Further decomposition of a firm's NOPAT allows an analyst to assess the efficiency of the firm's operating management. The common-sized income statement can be used for this. It expresses all line items as a ratio of revenue, and it makes it possible to compare trends in income statements relationships. It allows the analyst to ask the following questions: 5. Are the company's margins consistent with its stated competitive strategy? 6. Are the company's margins changing? Why? 7. Is the company managing its overhead and administrative costs well? - The decomposition of operating expenses by function is potentially more informative as it requires management to judge whether an expense falls in the operating category or expenses incurred to manage the operations. The gross profit margin is an indication of the extent to which revenues exceed direct costs associated with sales: 1. The price premium that a firm's products or services command in the marketplace. 2. The efficiency of the firm's procurement and production process. - NOPAT margin provides a comprehensive indication of a company's operating performance because it reﬂects all operating policies and eliminates the eﬀects of debt policy \> ^𝑛4𝑃𝐴𝑇^ - EBITDA margin provides similar information but excludes depreciation and amortization \> ^𝐸𝐵𝐼𝑇D𝐴^ - **Proﬁt margin analysis** \> assess the efficiency of a firm's operating management and allows an analyst to learn about the inﬂuence of pricing choices, efficiency, currency movements, and taxes. 3. ### Evaluating Investment Management: Decomposing Asset Turnover - A detailed analysis of asset turnover allows the analyst to evaluate the eﬀectiveness of a firm's investment management. There are two areas of asset management: 8. Working capital management. Working capital is the diﬀerence between a firm's current assets and current liabilities. However, operating components and financing and investment components are not distinguished here. An alternative measure is operating working capital. The components of operating working capital that analysts focus on are trade receivables, inventories, and trade payables. The following ratios are useful in analyzing a firm's working capital management: 1. Operating working capital to sales ratio \> ^𝑜𝑝𝑒𝑟𝑎𝑡i𝑛=^ ^E𝑜𝑟𝑘i𝑛=^ ^𝑐𝑎𝑝i𝑡𝑎𝑙^ - indicates how many euros of revenue a firm i𝑛𝑣𝑒𝑛𝑡𝑜𝑟i𝑒𝑠 𝑡𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 9. Management of non-current operating assets \> PP&E, intangible assets, and derivatives. The efficiency with which a firm uses its net non-current operating assets can be measured by: - **Asset turnover analysis** \> assesses how efficiently a firm manages its core operating investments and allows an analyst to learn about the inﬂuence of store format and location, sourcing, online sales, etc. - The cash conversion cycle is the period from paying suppliers to collecting customer payment: ### Evaluating Financial Management: Financial Leverage - **Financial leverage** \> enables a firm to have an asset base larger than its equity. Financial leverage increases a firm's ROE as long as the cost of liabilities is less than the return from investing these funds. There are a number of ratios to evaluate the degree of risk arising from a firm's financial leverage: 10. Liquidity \> assesses a firm's ability to pay its current obligations: 1. Current ratio \> [ ^𝑐𝑢𝑟𝑟𝑒𝑛𝑡^ ^𝑎𝑠𝑠𝑒𝑡𝑠^]. This is a key index of a firm's short-term liquidity. A current ratio of more than one indicates that the firm can cover its current liabilities. It should be greater than or equal to 1. 2. Solvency \> a firm's ability to meet long-term obligations. Debt financing has several benefits: 1. Debt is typically cheaper than equity. 2. Interest on debt financing is tax-deductible. 3. Debt financing can impose discipline on the firm's management. 4. It is often easier for management to communicate their proprietary information on the firm's strategies to private lenders.. Measures debt as a ### Putting it all Together: Assessing Sustainable Growth - Analysts often use the concept of **sustainable growth rate,** with the following definition: 𝑅𝑂𝐸 ∗ (1 − 𝑑=𝑣=𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡=𝑜). This rate is the rate at which a firm can grow while keeping its profitability and financial policies unchanged. The rate provides a benchmark against which to evaluate a firm's growth plans. The dividend payout ratio equals: ^𝑐𝑎𝑠\*^ ^𝑑i𝑣i𝑑𝑒𝑛𝑑𝑠^ ^𝑝𝑎i𝑑^ and is a measure of its dividend policy. - Dividends are paid because: 1. It can return shareholders any cash generated in excess of operating and investment needs. 2. Dividend payments can signal management's expectations of the firm's prospects to shareholders. 3. To attract a certain type of shareholders. ### Cash Flow Analysis - Cash ﬂow analysis provides an indication of the quality of the information in the firm's income statement and balance sheet \> evaluates liquidity and the management of activities as they relate to cash ﬂows. - The cash ﬂows should be classified into three categories: 1. Cash ﬂow from operations \> cash ﬂow generated by the firm from the sale of goods and services after paying for the cost of inputs and operations. 2. Cash ﬂow from investments \> the cash paid for capital expenditures, intercorporate investments, acquisitions, and cash received from the sales of non-current assets. 3. Cash ﬂow from financing activities \> cash raised from the firm's shareholders and debt holders. - There are two cash ﬂow statement formats: 1. Direct cash ﬂow format \> cash receipts and disbursements are reported directly. It is useful to prepare an approximate indirect cash ﬂow format, by: 1. Calculating working capital from operation, profit or loss adjusted for non-current accruals, and gains from the sale of non-current assets. 2. Convert working capital from operations to cash ﬂow from operating by making relevant adjustments for current accruals related to operations: - \- increase or (+decrease) in trade receivables. - \- increase or (+decrease) in trade inventories. - \- increase or (+decrease) in other current assets excluding cash. 2. Indirect cash ﬂow format \> operating cash ﬂows is arrived by making accrual adjustments to profit or loss: 1. Current accruals \> result from changes in a firm's current assets. 2. Non-current accruals \> depreciation, deferred taxes, and equity income from unconsolidated subsidiaries. - **Free cash ﬂow** \> the cash a company generates after having maintained or expanded its asset base. It can be used for further growth or return money to debt/equity holders. 𝐹𝐶𝐹~D𝐸~ = 𝑛𝑒𝑡 =𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐=𝑎𝑡=𝑜𝑛&𝑎𝑚𝑜𝑟𝑡=𝑧𝑎𝑡=𝑜𝑛 − =𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =𝑛 𝑤𝑜𝑟𝑘=𝑛𝑔 𝑐𝑎𝑝=𝑡𝑎𝑙 − 𝑐𝑎𝑝=𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑=𝑡𝑢𝑟𝑒𝑠 = 𝐶𝐹𝑂 − 𝑐𝑎𝑝=𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑=𝑡𝑢𝑟𝑒𝑠. 1\. Young firms have a negative free cash ﬂow. Other firms need to borrow funds. It is also a key measure for firm valuation: 2\. Determine **equity value**: 𝐹𝐶𝐹~𝐸~ = 𝐹𝐶𝐹~D𝐸~ + 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤=𝑛𝑔 Lecture 3 --------- - We look at a firm's financial statements closely to determine: 1. Whether any accounting policies are unusual. 2. Whether any movement in balances are of notice. 3. Whether accounting standards show an incomplete picture of the firm. - Some companies structure transactions to dilute economic ownership, and overstated assets. This may relate to the use of 'special purpose entities': 1. Financial statements isolated from risk. 2. Shift earnings to tax havens. 3. Oﬄoad debt/risky activities. - IFRS requires the immediate expensing of some resource outflows that may have future economic benefits. Accounting for research and development leads to an understatement of assets: 1. Research expenditures \> expenses 2. Development costs \> assets. If capitalized, the useful life of the research should be calculated, to depreciate it. - Typically liabilities are understated: 1. To overstate earnings. 2. To overstate the strength of financial position. - Liabilities may be understated in case of difficulties in estimating the amount of future financial commitments. - Mid-year convention \> when research is spended evenly throughout the year. - Amortization \> how much left when capitalized. - When development costs are capitalized as assets, the following table is useful when making income statement adjustments: -- -- -- -- -- -- -- -- Then the adjustments income statement: - When development costs are capitalized as assets, the following table is useful when making balance sheet adjustments: -- -- -- -- -- -- -- -- Balance sheet adjustment table: -- -- -- -- -- -- -- -- -- -- -- -- Lecture 4 --------- Decline -- -- -- -- --------- \-- - The four-step framework helps analysts to assess a firm's performance and prospects to uncover inside information. - Strategy analysis helps understanding the underlying economics of the firm and the competition in the respective industry. Some benefits: 1. Understanding a firm's strategy provides a context for evaluating a firm's accounting policies. 2. It highlights the firm's profit drivers and major areas of risk. 3. The connection between a firm's strategy and its financial policies. - Accounting analysis helps to reverse accounting distortions. - Financial analysis uses financial data to evaluate a firm's performance. - Prospective analysis synthesizes the insights from the previous steps to make predictions about the future. - The distinction between research (expense \> income statement) and development costs (intangible assets) may be considered a discretionary decision. This discretion, however, should be limited as some companies may choose to report information falsely or inappropriately. However, when there is absent discretion, investors may have to expend resources to obtain this information from elsewhere. - The following features of accounting make it costly for managers to change accounting policies absent economic reasons: 1. Accounting policies need to be applied consistently \> only change them when they produce more relevant information. 2. Third-party certification \> the auditor will protest unless there is an economic reason. 3. Reversal eﬀect. 4. Investors' lawsuit. 5. Other stakeholders can penalize the company, if they are perceived as unreliable in dealing with external parties. - Loan covenants provide early warning signs that the borrower may be unable to repay the loan. It creates management incentives because breaching them triggers renegotiation of the loan or immediate repayment. Managers may be tempted to use their accounting discretion to avoid breaches. Week 3 ====== Chapter 6 --------- ### Introduction - **Prospective analysis** includes two tasks: 1. Forecasting \> reverse financial analysis. 2. Valuation ### The Overall Structure of the Forecast - The best way to forecast future performance is to do it comprehensively \> forecast of earnings, cash ﬂows, and balance sheet. A **comprehensive forecasting approach** guards against unrealistic implicit assumptions. In this approach all the forecasts are linked to a few key drivers. The revenue forecast is nearly always one of the key drivers, together with the profit margin. When operating asset turnover is expected to remain stable \> working capital accounts and investment should closely track revenue growth. By linking forecasts of such amounts to revenue, we avoid internal inconsistencies. - The most practical approach to forecasting a company's financial statements is to project "condensed" financial statements. Because: 1. This approach involves making a relatively small set of assumptions about the firm's future. 2. Only **condensed ﬁnancial statements** are needed for analysis and decision making for most purposes. The condensed income statement consists of: 1. Revenue 2. Net operating profit after tax. 3. Net investment profit after tax. 4. Interest expense after tax. 5. Profit or loss 1. Net operating working capital 2. Net non-current operating assets 3. Non-operating investments. 4. Debt 5. Equity. - We start the balance sheet at the beginning of the forecasting period. Assumptions about investment in working capital and non-current assets and how we finance these assets \> balance sheet end of forecasting period. Assumptions about how we use assets available during the period and run the firm's operations \> income statement for the forecasting period. - We can decompose ROE to analyze the consequences on profitability of management's: 1. Operating decisions. To do this we must start with an assumption about next period's revenue and an assumption about the NOPAT margin. To forecast the operating section of the condensed balance sheet for the end of the period, we need to make the following assumptions: 1. The ratio of operating working capital to revenue to estimate the level of working capital needed to support revenue-generating activities. 2. The ratio of net non-current operating assets to revenue \> the expected level of net non-current operating assets. 2. Non-operating investments. We make assumptions about: 3. The ratio of non-operating investments to revenue \> the expected level of non-operating investments. 4. The return on non-operating investments. 3. Financing decisions. Assumptions are made about: 5. The ratio of debt to capital to estimate the levels of debt and equity needed to finance the estimated amount of assets in the balance sheet. 6. The average interest rate that the firm will pay on its debt. - The three levels of analysis that precede prospective analysis can lead to informed decisions by analysts about expected performance. Much of the information can be used when we are going through the following steps of the forecasting process: 1. Predict changes in environmental and firm-specific factors \> assess how the firm's economic environment will change in future years and how the firm has indicated it will respond to such changes. macro-economic, industry analysis, and firm factors. 2. Assess the relationship between step 1 factors and financial performance. This step builds strongly on the financial analysis. 3. Forecast condensed financial statements \> key items. Translate expectations into forecasts. 2. ### Performance Behavior: A Starting Point - Every forecast has an initial benchmark or point of departure \> some notion about how a particular ratio would be expected to behave in the absence of detailed information. It is useful to know how key financial statistics behave on "average". - Revenue growth rates tend to be "mean-reverting": firms with above-average or below-average rates of revenue tend to revert over time to a normal level within three to ten years. One explanation for this is that as industries and companies mature, their growth rate slows down due to demand saturation and intra-industry competition. How quickly this happens depends on the characteristics of the industry and its competitive position. - Earnings have been shown on average to follow a process that can be approximated by a random walk. The prior year's earnings figure is a good starting point in considering future earnings potential. It is reasonable to adjust this simple benchmark for the earnings changes of the most recent quarter. - The behavior of ROE and other measures of return on investment is known as "mean reverting". The tendency of high ROEs to fall is a reﬂection of high profitability attracting competition. The tendency of low ROEs to rise reﬂects the mobility of capital away from unproductive ventures toward more profitable ones. The behavior of rates of ROE can be analyzed further by looking at its key components: NOPAT margin, operating asset turnover, return on non- operating investments, the proportion of capital invested in operating assets and non-operating assets, spread, and financial leverage. We have the following major conclusions: 3. Operating asset turnover tends to be relatively stable. The exception: firms with very high asset turnover, which tends to decline somewhat over time before stabilizing. 4. Financial leverage also tends to be stable \> capital structure is not often changed. 5. NOPAT margin and spread stand out as the most variable components of ROE: if the forces of competition drive abnormal ROEs toward more normal levels, the change is most likely to arrive in the form of changes in profit margins and the spread. Changes in spread is driven by changes in NOPAT because the cost of borrowing is likely to remain stable if leverage remains stable. 5. ### Sensitivity Analysis - It is wise to also generate projections based on a variety of assumptions to determine the sensitivity of the forecasts to the assumptions. Upside scenarios \> quick and successful rollout, with increased revenue, etc. Downside scenarios - no/little uptake of initiatives. Chapter 7 --------- ### Introduction - Valuation \> process of converting a forecast into an estimate of the firm's assets or equity. A wide variety of valuation approaches are employed in practice. Among those methods are: 1. Discounted dividends \> the value of the firm's equity as the present value of forecasted future dividends. 2. Discounted cash ﬂow analysis (DCF) \> the production of detailed, multiple-year forecasts of cash ﬂows. 3. Discounted abnormal profit \> the value of the firm's equity expressed as the sum of its book value and the present value of forecasted **abnormal proﬁts or losses**. 4. Discounted abnormal profit growth \> the value of the firm's equity as the sum of its capitalized next-period profit or loss forecast and the present value of forecasted **abnormal proﬁt growth**. 5. Valuation based on price multiples \> converts a current measure of performance or a single forecast of performance into a value by applying an appropriate price multiple derived from the value of comparable firms. Three commonly used multiples: price-to-book ratios, price-to-revenue ratios, and price-to-earnings ratios. - We can structure the analysis in two ways: 1. Directly value the firm's equity since this is usually the variable analysts are interested in. 2. Value the net operating assets and non-operating investments of the firm and then deduct the value of debt claims to arrive at the final equity value estimate. 1. ### Deﬁning Value for Shareholders - Shareholders receive cash payoﬀs from a company in the form of dividends, and the value of their equity is the present value of future dividends: 𝑒𝑞𝑢=𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 = ^[𝑑i𝑣i𝑑𝑒𝑛𝑑\*]^ + ^[𝑑i𝑣i𝑑𝑒𝑛𝑑+]^ + ^[𝑑i𝑣i𝑑𝑒𝑛𝑑3]^ H8𝑟𝑒 - If a firm had a constant growth rate indefinitely, its value would simplify to the following formula: ^[𝑑i𝑣i𝑑𝑒𝑛𝑑\*]^ \> Gordon 𝑒 growth model. Only used for companies with stable dividend growth rates. - This is called the dividend discount model and it forms the basis for most of the approaches for equity valuation. However, it is not very useful in practice because equity value is created through the investment and operating activities of the firm. Dividends are a by-product of such activities. ### The Discounted Cash Flow Model - The value of an asset or investment is the present value of the net cash payoﬀs that the asset generates. The discounted cash ﬂow valuation model defines the value of a firm's business assets as the present value of cash ﬂows generated by these assets (OCF) minus the investments made in new business assets. Alternatively: the sum of the free cash ﬂows to debt and equity discounted at the cost of capital: ^[4𝐶𝐹\*--i𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡]^ + ^[4𝐶𝐹+--i𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡]^ + - The cash ﬂows available to equity holders are cash ﬂows generated by the firm's business assets minus investment outlays, adjusted for cash ﬂows from and to debt holders. The free cash ﬂows to equity: (H8𝑟𝑒) (H8𝑟𝑒)+ - Cash ﬂow model with discounted perpetuity with growth: ^[𝐹𝐶𝐹𝐸]^ = ^𝐶𝐹4--𝐶𝑎𝑝𝐸𝑥8𝑛𝑒𝑡𝑏𝑜𝑟𝑟𝑜Ei𝑛=^ - Valuation under this method involves three steps: 1. Forecast free cash ﬂows available to equity holders over a finite forecast horizon using detailed information observed in the previous steps of business analysis. 2. Forecast free cash ﬂows beyond the terminal year based on simplifying assumptions. 3. Discount free cash ﬂows to equity holders at the cost of equity. The discounted amount represents the estimated value of free cash ﬂows available to equity. ### The Discounted Abnormal Proﬁt Model - The expected book value of equity for shareholders is: 𝐷=𝑣=𝑑𝑒𝑛𝑑~H~ = 𝑝𝑟𝑜G=𝑡 𝑜𝑟 𝑙𝑜𝑠𝑠~H~ + 𝐵𝑉𝐸~M~ − 𝐵𝑉𝐸~H~. By substituting this identity for dividends into the dividend discount formula and rearranging the terms, equity value becomes: 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜G 𝑒𝑞𝑢=𝑡𝑦 + 𝑃𝑉 𝑜G G𝑢𝑡𝑢𝑟𝑒 𝑎𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑝𝑟𝑜G=𝑡𝑠. - Abnormal profits are profit or loss adjusted for a capital charge, which we compute as the discount rate multiplied by the beginning book value of equity. The discounted abnormal profit valuation formula is: (H8𝑟𝑒) (H8𝑟𝑒)+ 𝑃𝑉 𝑜G 𝑎𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑝𝑟𝑜G=𝑡𝑠 𝑏𝑒𝑦𝑜𝑛𝑑 𝑦𝑒𝑎𝑟 3 The last term is the terminal value: ^(H8=)∗\$𝑟𝑒𝑒^ ^𝑐𝑎𝑠\*^ ^\$𝑙𝑜E𝑠^ - Simplified as a discounted perpetuity with growth: 𝐵𝑉 𝑜G 𝑒𝑞𝑢=𝑡𝑦 + ^𝑛𝑒𝑡^ ^𝑝𝑟𝑜\$i𝑡--(𝑟𝑒∗𝑏𝑜𝑜𝑘^ ^𝑣𝑎𝑙𝑢𝑒^ ^𝑜\$^ ^𝑒𝑞𝑢i𝑡𝑦)^. Discounting is a severe simplification and depend strongly on the perpetuity and growth rate. - If a firm can only earn a normal rate of return on its book value, investors should be willing to pay no more than book values for shares. The deviation of a firm's market value from book value depends on its ability to generate abnormal profit. The formulation also implies that a firm's equity value reﬂects the cost of its existing net assets plus the net present value of future growth options. ### Valuation Using Price Multiples - **Multiple-based valuations** do not require detailed multiyear forecasts of several parameters. Valuation using multiples involves the following three steps: 1. Select a base measure \> P/E ratio. 2. Calculate price multiples for comparable firms or compute industry variances. 3. Apply the comparable firm multiple to the performance or value measure of the analyzed firm. - The analyst relies on the market to undertake the difficult task of considering the short and long-term prospects for growth and profitability and their implications for the values of the comparable firms. Identification of "comparable firms" is often quite difficult. Price multiples used in a comparable firm analysis are those for firms with similar operating and financial characteristics. Firms within the same industry are the most obvious candidates. firms within the same industry, however, can be in other industries too, and may have diﬀerent strategies, growth opportunities, etc. one way of dealing with this is to average across all firms in the industry. Another approach is to only focus on those firms within the industry that are most similar. - A problem of choosing comparable firms from diﬀerent countries is that various factors that inﬂuence multiples may diﬀer across countries. International diﬀerences in accounting practices may lead to systematic international diﬀerences in profits or losses, which is the denominator in price-earnings ratios. The way to get around this problem is to choose comparable firms in one country or take into account the country factors that aﬀect multiples. - Price multiples can be aﬀected when the denominator variable is performing poorly. This is especially common when the denominator is a ﬂow measure, such as profits or cash ﬂows. One option is to exclude firms with large transitory eﬀects from the set of comparable firms. - The calculation of price multiples must preserve consistency between the numerator and denominator. Consistency is an issue for those ratios where the denominator reﬂects performance before servicing debt. - The abnormal profit valuation method provides insights into factors that lead to diﬀerences in value-to-book multiples across firms. The abnormal profit growth valuation helps to explain why value-to-earnings multiples vary across firms. The actual valuation formula is: (H8𝑟𝑒) - A firm's value-to-book ratio depends on the magnitude of its future abnormal ROEs, defined as ROE -- cost of equity 𝑝𝑟𝑜\$i𝑡 𝑜𝑟 𝑙𝑜𝑠𝑠 - The value-earnings multiple is aﬀected by the firm's current level of ROE performance, whereas the value-to-book multiple is not. firms with low current ROEs have very high value-earnings multiples. If a firm has a zero or negative ROE, its PE is not defined. Chapter 9 --------- ### Introduction - Investment process: 1. Establishing the objectives of the investor. 2. Forming expectations about the future returns and risks of individual securities. The foundation of this step is **equity security analysis** \> evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm's shares. 3. Combining individual securities into portfolios to maximize progress toward the investment objectives. - Analysts conduct security analysis with a focus on identifying mispriced securities to generate returns that compensate for risks, or the focus lies on gaining an appreciation for how a security would aﬀect the risk of a given portfolio. The main goal for most sell-side and buy-side analysts is identifying mispriced securities. 1. ### Investor Objectives and Investment Vehicles - The investment objectives of individual savers in the economy are highly idiosyncratic and depend on diﬀerent factors. - **Collective investment funds** \> important vehicles for savers to achieve investment objectives \> sell shares in professionally managed portfolios that invest in specific types of equity or fixed-income securities. Major classes of these funds include: 1. Money market funds. 2. Bond funds. 3. Equity funds. 4. Balanced funds. 5. Real estate funds. - **Hedge funds** are becoming an increasingly important force in the market. They employ a variety of investment strategies, such as: 1. **Market neutral funds** \> invest equal amounts of money in purchasing undervalued securities and shorting overvalued ones. 2. **Short selling funds** \> short sell the securities of companies they consider overvalued. 3. **Special situation funds** \> invest in undervalued securities in anticipation of an increase in value resulting from a favorable turn of events. 2. ### Equity Security Analysis and Market Eﬀiciency - **Efficient market hypothesis** \> information is reﬂected in security prices fully and immediately upon its release. Under this condition it would be impossible to identify mispriced securities based on public information. - The degree of market efficiency is an empirical issue. It has important implications for the role of financial statements in security analysis and for managers' approaches to communicating with their investment communities. - Evidence points that very efficient securities markets comes in several forms: 6. The market reacts very quickly. However, some studies suggest that the initial reaction is incomplete. 7. It is difficult to identify specific funds or analysts that generated abnormally high returns. However, a number of studies point to trading strategies that can be used to outperform the market. 8. Studies suggest that share prices reﬂect a sophisticated level of fundamental analysis. However, prices still do not fully reﬂect the information that could be garnered from publicly available financial statements. However, these inconsistencies do not mean that the efficient market hypothesis is not a useful benchmark for thinking about the behaviour of security prices. ### Approaches to Fund Management and Securities Analysis - **Active portfolio management** \> relies on security analysis to identify mispriced securities. Passive portfolio manager serves as a price taker and avoids the costs of security analysis. - Actively managed funds depend on security analysis. **Technical analysis** \> predicts share price movements on the basis of market indicators. **Fundamental analysis** \> primary approach that attempts to evaluate the current market price relative to projections of the firm's future profits and cash ﬂow generating potential. - Quantitative approaches, such as screening shares or implementing formal models, play a more important role in security analysis now than they did before. - Investment bankers produce formal valuations and estimate values for the purposes of bringing a private firm to the public market, or other reasons. ### The Process of a Comprehensive Security Analysis - Steps of a comprehensive security analysis are: 9. Selection of candidates for analysis. Only a small fraction of the securities should be investigated. Funds typically specialize in investing in shares with certain risk profiles or characteristics. An alternative is to screen firms based on some potential mispricing indicator. 10. Inferring market expectations. The analysis must involve a comparison of the analyst's expectations with those of the market. A number of agencies summarize analysts' forecasts of revenues and earnings. 11. Developing the analyst's expectations. Security analysts must compare their views of a share with the view embedded in the market price. Understanding the business and its industry enables the analyst to interpret new information as it arrives and infer its implications. 12. The recommendation to buy, sell, or hold the share. Reports are very detailed including income statements and balance sheets for the coming years. In making the recommendation, the analyst must consider the investment time horizon required to capitalize on the recommendation. ### Performance of Security Analysts and Fund Managers - Research shows that analysts generally add value in the capital market. Share prices tend to respond positively to upward revisions in analysts' earnings forecasts and recommendations. They also play a valuable role in improving market efficiency. - However, research shows that their forecasts and recommendations tend to be biased. Some analysts are compensated when issuing optimistic reports. - Measuring whether collective investment and pension fund managers earn superior returns is difficult because there is no agreement about how to estimate benchmark performance and many of the traditional measures of fund performance abstract from market-wide performance. In addition, statistical power is an issue for measuring fund performance and tests are likely to be highly sensitive to the period examined. There is thus little consistent evidence that pension fund managers outperform or underperform traditional benchmarks. Chapter 11 ---------- ### Introduction - Mergers and acquisitions (M&As) are a form of corporate investment. Their value to acquiring shareholders is less understood. ### Motivation for Merger or Acquisition - Some acquiring managers may want to increase power and prestige, and others realize that there is an opportunity to create new economic value for shareholders. Merger or acquisition benefits include: 1. Taking advantage of economies of scale \> when one large firm can perform a function more efficiently than two smaller ones. 2. Improving target management. 3. Combining complementary resources. 4. Capturing tax benefits \> acquisition of operating tax losses and the tax shield that comes from increasing leverage for the target firm. 5. Providing low-cost financing to a financially constrained target. 6. Creating value through restructuring and break-ups. Financial investors often pursue acquisitions to create value by breaking up the target firm because the value of such a break-up is larger than the aggregate worth of the entire firm. 7. Increasing product-market rents \> two smaller firms can merge and then collude to restrict their output and raise prices, increasing their profits. - Management may prefer to invest free cash ﬂows to buy new companies and thereby avoid paying shareholders. Another motivation for managers is to diversify. However, modern finance theorists point out that investors can diversify for themselves, and diversification leads firms to lose sight of their major competitive strengths. ### Acquisition Pricing - The acquirer should be careful to not overpay for the target as this makes the transaction highly desirable and profitable for target shareholders, but it diminished the deal's value to acquiring shareholders. **Target value analysis** is important. - one way to assess whether the acquirer is overpaying is by comparing the premium oﬀered to target shareholders to premiums in similar transactions. If the acquirer oﬀers a high acquisition premium, the analyst will conclude that the transaction is less likely to create value for acquiring shareholders. Hostile acquirers are more likely to overpay for a target. This comparison has some practical problems. It is not obvious how to define a comparable transaction- takeover premiums vary by means of payment, hostile takeovers pay higher premiums, and European takeovers diﬀer. In addition, measured premiums can be misleading if investors anticipate an oﬀer. And last, using target premiums to assess whether an acquirer overpaid ignores the value of the target to the acquirer after the acquisition. - A more reliable way to assess whether the acquirer has overpaid is to compare the oﬀer price to the estimated value of the target to the acquirer. First, the value of the target as an independent firm should be computed as this provides a useful benchmark. The most popular methods are: 8. **Earnings multiples**. To estimate the value of a target to an acquirer, the following steps are followed: 1. **Forecasting earnings** \> by forecasting next year's profit or loss assuming no acquisition. After that, we can incorporate any improvements in earnings performance that results from the acquisition, such as reduction in expenses, lower tax rates, and higher operating margins. 2. Determine the price-earnings multiple. First the target earnings forecast for the next year is multiplied by its pre-merger PE multiple. Then, the target revised earnings is multiplied by its post-merger PE multiple. 9. #### Discounted cash ﬂows, discounted abnormal proﬁt growth, or discounted abnormal proﬁt. The steps are: 3. Forecast abnormal profits, abnormal profit growth, free cash ﬂows. The abnormal profit (growth) method requires that we forecast earnings or net operating profit after tax for as long as the firm expects new 4. Compute the discount rate, which is the required return on net operating assets for the target. 5. Analyze sensitivity. ### Acquisition Financing and Form of Payment - An acquisition may destroy shareholder value if it is inappropriately financed. Forms of finance are issuing shares to target shareholders, acquiring target shares using surplus cash, or a combination of both. Acquisition financing increase or reduce the attractiveness of an acquisition from the standpoint of acquiring shareholders. - In acquisitions where debt financing or surplus cash are the forms of consideration for target shares, the acquisition increases the financial leverage of the acquirer. This increase in leverage may be part of the acquisition strategy, but can also be a side eﬀect of the method of financing. The increase in leverage may reduce shareholder value by increasing the risk of financial distress. - Information asymmetries can make managers reluctant to raise equity to finance new projects because they fear that investors will interpret the decision as an indication that the firm's equity is overvalued. Firms forced to use equity financing are likely to face a share price decline when investors learn of this method. a second information problem arises if the acquiring management does not have a good information about the target. Equity financing then provides a way to share information risks with target shareholders. - Financing the acquisition with cash allows the acquirer to retain the structure and composition of its equity ownership. An acquisition financed with shares could significantly impact the ownership and control of the firm post- acquisition. - The key payment considerations for target shareholders are the **tax and transaction cost** implications of the acquirer's oﬀer: 10. Target shareholders care about the after-tax value of any oﬀer they receive for their shares. Tax laws that allow the deferral of capital gains taxes appear to cause target shareholders to prefer a share oﬀer to a cash one. 11. Transaction costs are incurred by target shareholders when they sell any shares. They will not face these costs if the bidder oﬀers them cash. ### Acquisition Outcome - Reasons for failure are that the target receives a higher competing bid, there is opposition from **entrenched target management**, or the transaction fails to receive necessary regulatory approval. - If target managers are entrenched and fearful for their jobs, they will oppose a bidder's oﬀer. **Golden parachutes** provide top managers of a target firm with attractive compensation rewards should the firm get taken over. Defenses do not often prevent an acquisition from taking place, they rather cause delays, which increase the likelihood that there will be competing oﬀers made for the target, including by friendly parties (**white knights**). - **Takeover regulations** have the objectives of preventing management entrenchment and protecting minority shareholders during European takeovers. In 2004 the European Commission issued a Takeover Directive in which the rules of takeovers are stated. The rules of this Directive can aﬀect the analysis of a takeover oﬀer. ### Reporting on Mergers and Acquisitions: Purchase Price Allocations - The **acquisition price** that an acquiring firm pays to the target firm's shareholders compensates them for transferring a potentially widespread collection of assets and liabilities. Acquiring firms should separately identify and value assets and liabilities transferred in a merger or acquisition \> **purchase price allocation**. This helps outside investors to assess whether the acquisition price is reasonable given the identifiable assets acquired or whether the amount of goodwill arisi

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