CHAPTER 12
Applications of Financial Statement Analysis

Learning Outcomes

After completing this chapter, you will be able to do the following:

• evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance;
• forecast a company’s future net income and cash flow;
• describe the role of financial statement analysis in assessing the credit quality of a potential debt investment;
• describe the use of financial statement analysis in screening for potential equity investments;
• explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.

Summary Overview

This chapter described selected applications of financial statement analysis, including the evaluation of past financial performance, the projection of future financial performance, the assessment of credit risk, and the screening of potential equity investments. In addition, the chapter introduced analyst adjustments to reported financials. In all cases, the analyst needs to have a good understanding of the financial reporting standards under which the financial statements were prepared. Because standards evolve over time, analysts must stay current in order to make good investment decisions.

The main points in the chapter are as follows:

• Evaluating a company’s historical performance addresses not only what happened but also the causes behind the company’s performance and how the performance reflects the company’s strategy.
• The projection of a company’s future net income and cash flow often begins with a top-down sales forecast in which the analyst forecasts industry sales and the company’s market share. By projecting profit margins or expenses and the level of investment in working and fixed capital needed to support projected sales, the analyst can forecast net income and cash flow.
• Projections of future performance are needed for discounted cash flow valuation of equity and are often needed in credit analysis to assess a borrower’s ability to repay interest and principal of a debt obligation.
• Credit analysis uses financial statement analysis to evaluate credit-relevant factors, including tolerance for leverage, operational stability, and margin stability.
• When ratios constructed from financial statement data and market data are used to screen for potential equity investments, fundamental decisions include which metrics to use as screens, how many metrics to include, what values of those metrics to use as cutoff points, and what weighting to give each metric.
• Analyst adjustments to a company’s reported financial statements are sometimes necessary (e.g., when comparing companies that use different accounting methods or assumptions). Adjustments can include those related to investments; inventory; property, plant, and equipment; and goodwill.

Problems

1. Projecting profit margins into the future on the basis of past results would be most reliable when the company:
   1. is in the commodities business.
   2. operates in a single business segment.
   3. is a large, diversified company operating in mature industries.
2. Galambos Corporation had an average receivables collection period of 19 days in 2003. Galambos has stated that it wants to decrease its collection period in 2004 to match the industry average of 15 days. Credit sales in 2003 were $300 million, and analysts expect credit sales to increase to $400 million in 2004. To achieve the company’s goal of decreasing the collection period, the change in the average accounts receivable balance from 2003 to 2004 that must occur is closest to:
   1. –$420,000.
   2. $420,000.
   3. $836,000.
3. Credit analysts are likely to consider which of the following in making a rating recommendation?
   1. Business risk but not financial risk
   2. Financial risk but not business risk
   3. Both business risk and financial risk
4. When screening for potential equity investments based on return on equity, to control risk, an analyst would be most likely to include a criterion that requires:
   1. positive net income.
   2. negative net income.
   3. negative shareholders’ equity.
5. One concern when screening for stocks with low price-to-earnings ratios is that companies with low P/Es may be financially weak. What criterion might an analyst include to avoid inadvertently selecting weak companies?
   1. Net income less than zero
   2. Debt-to-total assets ratio below a certain cutoff point
   3. Current-year sales growth lower than prior-year sales growth
6. When a database eliminates companies that cease to exist because of a merger or bankruptcy, this can result in:
   1. look-ahead bias.
   2. back-testing bias.
   3. survivorship bias.
7. In a comprehensive financial analysis, financial statements should be:
   1. used as reported without adjustment.
   2. adjusted after completing ratio analysis.
   3. adjusted for differences in accounting standards, such as international financial reporting standards and US generally accepted accounting principles.
8. When comparing a US company that uses the last in, first out (LIFO) method of inventory with companies that prepare their financial statements under international financial reporting standards (IFRS), analysts should be aware that according to IFRS, the LIFO method of inventory:
   1. is never acceptable.
   2. is always acceptable.
   3. is acceptable when applied to finished goods inventory only.
9. An analyst is evaluating the balance sheet of a US company that uses last in, first out (LIFO) accounting for inventory. The analyst collects the following data:

   	Dec. 31, 2005	Dec. 31, 2006
   Inventory reported on balance sheet	$500,000%	$600,000%
   LIFO reserve	$50,000%	$70,000%
   Average tax rate	30%	30%

   After adjusting the amounts to convert to the first in, first out (FIFO) method, inventory at December 31, 2006 would be closest to:

   1. $600,000.
   2. $620,000.
   3. $670,000.
10. An analyst gathered the following data for a company ($ millions):

    	Dec. 31, 2000	Dec. 31, 2001
    Gross investment in fixed assets	$2.8	$2.8
    Accumulated depreciation	$1.2	$1.6

    The average age and average depreciable life of the company’s fixed assets at the end of 2001 are closest to:

    	Average Age	Average Depreciable Life
    A.	1.75 years	7 years000000
    B.	1.75 years	14 years000000
    C.	4.00 years	7 years000000

11. To compute tangible book value, an analyst would:
    1. add goodwill to stockholders’ equity.
    2. add all intangible assets to stockholders’ equity.
    3. subtract all intangible assets from stockholders’ equity.
12. Which of the following is an off-balance-sheet financing technique? The use of:
    1. capital leases.
    2. operating leases.
    3. the last in, first out inventory method.
13. To better evaluate the solvency of a company, an analyst would most likely add to total liabilities:
    1. the present value of future capital lease payments.
    2. the total amount of future operating lease payments.
    3. the present value of future operating lease payments.