Case Study – Week 1

Week 1 Case Study – Financial Statement Analysis

Chapter 1 – with focus on Ratio Analysis

Case Study – Week 1

The first chapter discusses various methods of performing financial analysis. Financial

statement analysis provides a means of ascertaining that financial health. Standards around

financial statements also allow markets to be more efficient: People are more willing to invest

(providing more liquidity to markets) when they believe their investments are sound. Ratios

offer a tool for comparing similar companies in similar industries. The ability to analyze ratios

and make sound investment decisions is a major contributor to market fluidity and therefore

market efficiency.

As noted on page 12 of Cal University’s Financial Statement Analysis document (2006), A

ratio must refer to an economically important relation. Analysis of a ratio can reveal important

relations and bases of comparison in uncovering conditions and trends difficult to detect by

inspecting the individual components that make up the ratio.”

Let us look at some important ratios:

1) Price to cash flow ratio: Current share price divided by the total cash flow from

operations (noted on the cash flow statement). It provides a good estimation of the

money available to the company for growth, marketing, debt reduction etc. Many

prefer this ratio to the popular “price to earnings” ratio when the company has capital

intensive product development cycles. The Investopedia website notes that this ratio

removes the effects of depreciation and non-cash factors which often result in low

earnings in early years and inflated profits at the end of the product cycle. Companies

involved in capital-intensive projects typically have lower cash flows because the

cash is being invested back into materials, facilities and equipment. High-tech

companies typically have higher cash flows since less capital is required.

Case Study – Week 1

2) Debt to equity ratio: Total liabilities / shareholders’ equity. The ratio represents the

proportion of debt to equity and is typically compared to industry benchmarks. A

ratio of greater than one means that the company is being financed by debt. A high

number relative to its industry counterparts can be an early indicator of problems on

the horizon.

3) Price-to-Book ratio: Price per Share / Book value of Equity (which in turn are the

assets – liabilities). A low P/B ratio of 3 or less - means something is fundamentally

wrong. Either the stock is undervalued (a good buying opportunity) or the company

is underperforming (and correctly valued). It can be used with the Return on Equity

ratio (noted below) to make a more informed decision.

4) Return on Equity: Net Income / Shareholders’ Equity. Investors should take notice

if the P/B ratio remains low while the ROE is high or on the rise. It indicates that

despite the relatively low stock price, the company is earning money. You may have

found a good deal before the rest of the market - before investors have bid up the

price. An ROE of say, 50% indicates that for each $1 of equity investment, the

company earns $.50. That is quite a large percentage. According to Subramanyam

(2009) the average is 12% for publically traded companies.

I would rather develop an understanding of ratio analysis than look only at charts and read

investment guidance from dubious sources. While it is true that one can look at “candlesticks”

and attempt to predict where the stock price is going in the near future, utilization of ratio

analysis gives the investor a better understanding of the company’s financial health.

Chapter 2

Case Study – Week 1

Chapter Two – with focus on Fair Value Accounting

Chapter two covers financial reports. Fair Value Accounting (FVA) is an item that has

sparked a lot of debate. Subramanyam (2009) maintains that historical-cost has been the basis of

financial accounting since the 1600’s. However markets are much more fluid and dynamic than

they were in past centuries. A company may own assets which appreciate or depreciate

significantly in value in the span of a year. Fair Value Accounting attempts to determine asset

and liability values by assessing the market.

Sybramanyan (2009) describes a “hierarchy of inputs” which are used to determine the

market price of an asset (or liability), even when prices cannot be directly determined by market

observation.

1. Quoted prices in active markets

2. Observable prices in active markets for similar assets may be used when a directly

quoted price for that particular asset is unavailable.

3. Unobservable inputs reflect assumptions about the valuation that market

participants would assign to that asset – if there was a market for it.

I can directly apply an understanding of this hierarchy to my work in Enterprise Risk

Management. Subramanyan (2009) notes that financial regulations require that the third level

(unobservable inputs) in the “hierarchy of inputs” be used sparingly after the first and second

methods have been exhausted. When I worked as a consultant at AIG (pre-bailout), we began

having difficulty using the first and second type of inputs to “mark to market” because the

normal purchasers of our assets stopped buying them. Management attempted to look at

hypothetical scenarios and historical market prices to determine what the market value actually

was for these assets. Auditors did not agree with these “unobservable” means and eventually

Case Study – Week 1

AIG was forced to conclude that the market value for some of the assets was essentially zero.

The assets were “toxic” and there were no signs that they would be worth more in the

foreseeable future.

Writing down assets to their current market value (even if they have zero value) is a great

benefit for readers of financial reports: Readers are better able to determine the financial health

of the company when the current market values of assets are reflected. FVA prevents companies

from essentially pretending that its assets on the books are worth more than the market is willing

to pay for them.

Subramanyan (2009) notes that FVA emphasizes neutrality because it is without any bias:

Income is simply the net change in value of assets (and liabilities). A disadvantage of FVA is

that companies may appear to have wild swings in profitability during periods of high market

volatility and the value of assets changes rapidly.

International Financial Reporting Standards (IFRS) are standards being adopted by an

increasing number of companies around the world. In the U.S., US-GAAP (generally accepted

accounting principles) are converging with IFRS. PWC’s IFRS convergence website notes that

IFRS standards are based on FVA. This means that FVA is increasingly becoming a

predominant standard around the world. It will allow readers of financial reports to compare

“apples to apples” when looking at IFRS-standard reports. It will allow for greater transparency

and is a major development in the history of financial statement analysis.

Case Study – Week 1

References

Subramanyam, K.R. (2009). Financial Statement Analysis.

PWC IFRS Convergence Guideline. Retrieved from

www.pwc.com/us/en/issues/ifrs-reporting/publications/IFRS-convergence-joint-projects.jhtml .

Investopedia Dictionary. Price to Cash Flow definition. Retrieved from

http://www.investopedia.com/terms/p/price-to-cash-flowratio.asp.