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 Universitys 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 companys 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 1600s. 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 regulationsrequire 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 actuallywas for these assets. Auditors did not agree with these unobservable means and

Case Study Week 1 eventually 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. PWCs 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/ifrsreporting/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.