#cfa-level-1 #fra-introduction #reading-22-financial-statement-analysis-intro #study-session-7

The role of financial reporting by companies is to provide information about a company’s performance, financial position, and changes in financial position that is useful to a wide range of users in making economic decisions.1 The role of financial statement analysis is to use financial reports prepared by companies, combined with other information, to evaluate the past, current, and potential performance and financial position of a company for the purpose of making investment, credit, and other economic decisions. (Managers within a company perform financial analysis to make operating, investing, and financing decisions but do not necessarily rely on analysis of related financial statements. They have access to additional financial information that can be reported in whatever format is most useful to their decision.)

In evaluating financial reports, analysts typically have a specific economic decision in mind. Examples of these decisions include the following:

  • Evaluating an equity investment for inclusion in a portfolio.

  • Evaluating a merger or acquisition candidate.

  • Evaluating a subsidiary or operating division of a parent company.

  • Deciding whether to make a venture capital or other private equity investment.

  • Determining the creditworthiness of a company in order to decide whether to extend a loan to the company and if so, what terms to offer.

  • Extending credit to a customer.

  • Examining compliance with debt covenants or other contractual arrangements.

  • Assigning a debt rating to a company or bond issue.

  • Valuing a security for making an investment recommendation to others.

  • Forecasting future net income and cash flow.

These decisions demonstrate certain themes in financial analysis. In general, analysts seek to examine the past and current performance and financial position of a company in order to form expectations about its future performance and financial position. Analysts are also concerned about factors that affect risks to a company’s future performance and financial position. An examination of performance can include an assessment of a company’s profitability (the ability to earn a profit from delivering goods and services) and its ability to generate positive cash flows (cash receipts in excess of cash disbursements). Profit and cash flow are not equivalent. Profit (or loss) represents the difference between the prices at which goods or services are provided to customers and the expenses incurred to provide those goods and services. In addition, profit (or loss) includes other income (such as investing income or income from the sale of items other than goods and services) minus the expenses incurred to earn that income. Overall, profit (or loss) equals income minus expenses, and its recognition is mostly independent from when cash is received or paid. Example 1 illustrates the distinction between profit and cash flow.


Profit versus Cash Flow

Sennett Designs (SD) sells furniture on a retail basis. SD began operations during December 2009 and sold furniture for €250,000 in cash. The furniture sold by SD was purchased on credit for €150,000 and delivered by the supplier during December. The credit terms granted by the supplier required SD to pay the €150,000 in January for the furniture it received during December. In addition to the purchase and sale of furniture, in December, SD paid €20,000 in cash for rent and salaries.

  1. How much is SD’s profit for December 2009 if no other transactions occurred?

  2. How much is SD’s cash flow for December 2009?

  3. If SD purchases and sells exactly the same amount in January 2010 as it did in December and under the same terms (receiving cash for the sales and making purchases on credit that will be due in February), how much will the company’s profit and cash flow be for the month of January?

Solution to 1:

SD’s profit for December 2009 is the excess of the sales price (€250,000) over the cost of the goods that were sold (€150,000) and rent and salaries (€20,000), or €80,000.

Solution to 2:

The December 2009 cash flow is €230,000, the amount of cash received from the customer (€250,000) less the cash paid for rent and salaries (€20,000).

Solution to 3:

SD’s profit for January 2010 will be identical to its profit in December: €80,000, calculated as the sales price (€250,000) minus the cost of the goods that were sold (€150,000) and minus rent and salaries (€20,000). SD’s cash flow in January 2010 will also equal €80,000, calculated as the amount of cash received from the customer (€250,000) minus the cash paid for rent and salaries (€20,000) and minus the €150,000 that SD owes for the goods it had purchased on credit in the prior month.

Although profitability is important, so is a company’s ability to generate positive cash flow. Cash flow is important because, ultimately, the company needs cash to pay employees, suppliers, and others in order to continue as a going concern. A company that generates positive cash flow from operations has more flexibility in funding needed for investments and taking advantage of attractive business opportunities than an otherwise comparable company without positive operating cash flow. Additionally, a company needs cash to pay returns (interest and dividends) to providers of debt and equity capital. Therefore, the expected magnitude of future cash flows is important in valuing corporate securities and in determining the company’s ability to meet its obligations. The ability to meet short-term obligations is generally referred to as liquidity, and the ability to meet long-term obligations is generally referred to as solvency. Cash flow in any given period is not, however, a complete measure of performance for that period because, as shown in Example 1, a company may be obligated to make future cash payments as a result of a transaction that generates positive cash flow in the current period.

Profits may provide useful information about cash flows, past and future. If the transaction of Example 1 were repeated month after month, the long-term average monthly cash flow of SD would equal €80,000, its monthly profit. Analysts typically not only evaluate past profitability but also forecast future profitability.

Exhibit 1 shows how news coverage of corporate earnings announcements places corporate results in the context of analysts’ expectations. Panel A shows the earnings announcement, and Panel B shows a sample of the news coverage of the announcement. Earnings are also frequently used by analysts in valuation. For example, an analyst may value shares of a company by comparing its price-to-earnings ratio (P/E) to the P/Es of peer companies and/or may use forecasted future earnings as direct or indirect inputs into discounted cash flow models of valuation.

Exhibit 1. An Earnings Release and News Media Comparison with Analysts’ Expectations

Panel A: Excerpt from Apple Earnings Release

Apple Reports Second Quarter Results

Record March Quarter Revenue and Profit

iPhone Sales More Than Double

CUPERTINO, California—April 20, 2010—Apple® today announced financial results for its fiscal 2010 second quarter ended March 27, 2010. The Company posted revenue of $13.50 billion and net quarterly profit of $3.07 billion, or $3.33 per diluted share. These results compare to revenue of $9.08 billion and net quarterly profit of $1.62 billion, or $1.79 per diluted share, in the year-ago quarter. Gross margin was 41.7 percent, up from 39.9 percent in the year-ago quarter. International sales accounted for 58 percent of the quarter’s revenue.

Apple sold 2.94 million Macintosh® computers during the quarter, representing a 33 percent unit increase over the year-ago quarter. The Company sold 8.75 million iPhones in the quarter, representing 131 percent unit growth over the year-ago quarter. Apple sold 10.89 million iPods during the quarter, representing a one percent unit decline from the year-ago quarter.

“We’re thrilled to report our best non-holiday quarter ever, with revenues up 49 percent and profits up 90 percent,” said Steve Jobs, Apple’s CEO. “We’ve launched our revolutionary new iPad and users are loving it, and we have several more extraordinary products in the pipeline for this year.”

“Looking ahead to the third fiscal quarter of 2010, we expect revenue in the range of about $13.0 billion to $13.4 billion and we expect diluted earnings per share in the range of about $2.28 to $2.39,” said Peter Oppenheimer, Apple’s CFO.

Source: www.apple.com/pr/library/2010/04/20results.html

Panel B: Excerpt Downloaded from FOXBusiness.com Report: Tuesday, 20 April 2010

“Apple Earnings Surge By 90% in Second Quarter” by Kathryn Glass

In what’s beginning to become its trademark, Apple Inc. (AAPL: 238.7911, –9.5489, –3.85%) delivered much better-than-expected second-quarter earnings, but gave third-quarter guidance below expectations.

The personal-technology behemoth said it expects third-quarter earnings in the range of $2.28 to $2.39 per share on revenue between $13 billion and $13.4 billion. Analysts were expecting third-quarter earnings of $2.70 a share on revenue of $12.97 billion, according to a poll by Thomson Reuters.

Apple reported second quarter profit of $3.07 billion, or $3.33 per share, compared with year-ago profit of $1.62 billion, or $1.79 per share. Revenue rose to $13.5 billion, compared with revenue of $9.08 billion, one year ago. The tech giant said 58% of revenue came from international sales.

The results soared above expectations; analysts’ second-quarter profit estimates were for $2.45 per share on revenue of $12.04 billion.

Analysts are also interested in the current financial position of a company. The financial position can be measured by comparing the resources controlled by the company (assets) in relation to the claims against those resources (liabilitiesand equity). An example of a resource is cash. In Example 1, if no other transactions occur, the company should have €230,000 more in cash at 31 December 2009 than at the start of the period. The cash can be used by the company to pay its obligation to the supplier (a claim against the company) and may also be used to make distributions to the owner (who has a residual claim against the company’s assets, net of liabilities). Financial position is particularly important in credit analysis, as depicted in Exhibit 2. Panel A of the exhibit is an excerpt from an April 2010 announcement by a credit rating agency of an upgrade in the credit ratings of Teck Resources Ltd., a Canadian mining company. The rating agency explained that it upgraded the credit rating of the company (its “corporate credit rating”) and the credit rating of the company’s debt securities (the “issue-level rating”) because the company had repaid its debt quickly (“accelerated debt repayment”). Panel B of the exhibit is an excerpt from the company’s second quarter 2010 earnings announcement in which the company’s CEO describes the company’s repayment of debt. Panel C of the exhibit is an excerpt from the company’s financial report illustrating the change in the company’s financial position in June 2010 compared with December 2009. As shown, the amount of the company’s debt liabilities relative to the amount of its equity declined substantially over the period.

Exhibit 2

Panel A: Excerpt from Announcement by Standard & Poor’s Ratings Services: 16 April 2010

Teck Resources Ltd. Upgraded To ‘BBB’ From ‘BB+’ On Improved Financial Risk Profile; Removed From CreditWatch

We are raising our long-term corporate credit rating on Vancouver-based mining company Teck Resources Ltd. to ‘BBB’ from ‘BB+’.… We are also raising the issue-level rating on the company’s notes outstanding to ‘BBB’ from ‘BB+’…. We base the upgrade on Teck’s materially improved financial risk profile following the accelerated debt repayment in the past year. The stable outlook reflects our opinion that Teck will maintain relatively stable credit metrics in the medium term, despite inherent volatility in the commodities market.

Source: Market News Publishing.

Panel B: Excerpt from Earnings Announcement by Teck Resources Limited: 28 July 2010

Teck Reports Second Quarter Results for 2010

Vancouver, BC—Teck Resources Limited (TSX: TCK.A and TCK.B, NYSE: TCK) announced quarterly earnings of $260 million, or $0.44 per share, for the second quarter of 2010. Our operating profit before depreciation was approximately $1.0 billion and EBITDA was $844 million in the second quarter.

Don Lindsay, President and CEO said, “During the quarter we eliminated the outstanding balance of our term bank loan and have now repaid the US$9.8 billion bank debt related to the Fording acquisition in less than 18 months, just over two years ahead of schedule. In addition, all of our operations performed well, and we met or exceeded the guidance given in our previous quarterly report. Our second quarter benefitted from a substantial increase in coal sales to 6.4 million tonnes and the higher benchmark prices negotiated for the second quarter. In addition, in the quarter we re-established our investment grade credit ratings from all of the major rating agencies and declared a semi-annual dividend of $0.20 per share.”

Source: Teck Resources Form 6-K, filed 11 August 2010.

Panel C: Financial Position of Teck Resources Limited: 28 July 2010 and 31 December 2009

(in millions of Canadian $)28 July 2010 31 December 2009
ASSETS$ 28,570 $ 29,873
Debt5,678 8,004
All other liabilities7,273 7,288
Total liabilities12,951 15,292
EQUITY15,619 14,581
Debt divided by equity0.36 0.55

In conducting a financial analysis of a company, the analyst will regularly refer to the company’s financial statements, financial notes, and supplementary schedules and a variety of other information sources. The next section introduces the major financial statements and some commonly used information sources.


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