CHAPTER 18
Integration of Financial Statement Analysis Techniques

Learning Outcomes

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

• demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or purpose (e.g., valuing equity based on comparables, critiquing a credit rating, obtaining a comprehensive picture of financial leverage, evaluating the perspectives given in management’s discussion of financial results);
• identify financial reporting choices and biases that affect the quality and comparability of companies’ financial statements and explain how such biases may affect financial decisions;
• evaluate the quality of a company’s financial data and recommend appropriate adjustments to improve quality and comparability with similar companies, including adjustments for differences in accounting standards, methods, and assumptions;
• evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios;
• analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement related modifications affect a company’s financial statements, financial ratios, and overall financial condition.

Summary Overview

The case study demonstrates the use of a financial analysis framework in investment decision making. Although each analysis undertaken may have a different focus, purpose, and context that result in the application of different techniques and tools, the case demonstrates the use of a common financial statement analysis framework. The analyst starts with a global, summarized view of a company and its attributes and digs below the surface of the financial statements to find economic truths that are not apparent from a superficial review. In the case of Nestlé, the analyst applied disaggregation techniques to review the company’s performance in terms of ROE and then successively examined the drivers of ROE in increasing detail to evaluate management’s skills in capital allocation.

An economic decision is reached, which is consistent with the primary reason for performing financial analysis: to facilitate an economic decision.

Problems

The following information relates to Questions 1–7

Quentin Abay, CFA, is an analyst for a private equity firm interested in purchasing Bickchip Enterprises, a conglomerate. His first task is to determine the trends in ROE and the main drivers of the trends using DuPont analysis. To do so he gathers the data in Exhibit 1.

Exhibit 1 Selected Financial Data for Bickchip Enterprises (€ Thousands)

		2020		2019		2018
Revenue		72,448.79		66,487.79		55,781.79
Earnings before interest and tax		6,270.79		4,710.79		3,609.79
Earnings before tax		5,101.79		4,114.79		3,168.79
Net income		4,038.79		3,345.79		2,576.79
Asset turnover		0.79		0.76		0.68
Assets/Equity		3.09		3.38		3.43

After conducting the DuPont analysis, Abay believes that his firm could increase the ROE without operational changes. Further, Abay thinks that ROE could improve if the company divested segments that were generating the lowest returns on capital employed (total assets less non-interest-bearing liabilities). Segment EBIT margins in 2020 were 11 percent for Automation Equipment, 5 percent for Power and Industrial, and 8 percent for Medical Equipment. Other relevant segment information is presented in Exhibit 2.

Exhibit 2 Segment Data for Bickchip Enterprises (€ Thousands)

		Capital Employed						Capital Expenditures (Excluding Acquisitions)
Operating Segments		2020		2019		2018		2020		2019		2018
Automation Equipment		10,705		6,384		5,647		700		743		616
Power and Industrial		15,805		13,195		12,100		900		849		634
Medical Equipment		22,870		22,985		22,587		908		824		749
		49,380		42,564		40,334		2,508		2,416		1,999

Abay is also concerned with earnings quality, so he intends to calculate Bickchip’s cash-flow-based accruals ratio and the ratio of operating cash flow before interest and taxes to operating income. To do so, he prepares the information in Exhibit 3.

Exhibit 3 Earnings Quality Data for Bickchip Enterprises (€ Thousands)

		2020		2019		2018
Net income		4,038)		3,345)		2,576)
Net cash flow provided by (used in) operating activitya		9,822)		5,003)		3,198)
Net cash flow provided by (used in) investing activity		(10,068)		(4,315)		(5,052)
Net cash flow provided by (used in) financing activityb		(5,792)		1,540)		(2,241)
Average net operating assets		43,192)		45,373)		40,421)
a includes cash paid for taxes of:		(1,930)		(1,191)		(1,093)
b includes cash paid for interest of:		(1,169)		(596)		(441)

1. Over the three-year period presented in Exhibit 1, Bickchip’s return on equity is best described as:
   1. stable.
   2. trending lower.
   3. trending higher.
2. Based on the DuPont analysis, Abay’s belief regarding ROE is most likely based on:
   1. leverage.
   2. profit margins.
   3. asset turnover.
3. Based on Abay’s criteria, the business segment best suited for divestiture is:
   1. medical equipment.
   2. power and industrial.
   3. automation equipment.
4. Bickchip’s cash-flow-based accruals ratio in 2020 is closest to:
   1. 9.9%.
   2. 13.4%.
   3. 23.3%.
5. The cash-flow-based accruals ratios from 2018 to 2020 indicate:
   1. improving earnings quality.
   2. deteriorating earnings quality.
   3. no change in earnings quality.
6. The ratio of operating cash flow before interest and taxes to operating income for Bickchip for 2020 is closest to:
   1. 1.6.
   2. 1.9.
   3. 2.1.
7. Based on the ratios for operating cash flow before interest and taxes to operating income, Abay should conclude that:
   1. Bickchip’s earnings are backed by cash flow.
   2. Bickchip’s earnings are not backed by cash flow.
   3. Abay can draw no conclusion due to the changes in the ratios over time.