FSA notes Essay example

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Lecture 1: Introduction to Financial Statement Analysis
• Look at value creation (returns) – when a firm earns returns greater than the cost of capital
• Value of firm = value of assets * Value of equity = value of firm - debt

Accounting numbers are the past, share price is the future
• Cash accounting is not good for valuations
• Accruals accounting is guessing about the future

Who does Business Valuation and FSA?
• Equity investors – investment analysis & management evaluation o Sell side analysis (public) – publish research o Buy side analysis (private) – institutions SS & DD for stock
• Debt investors – default, lending rates & covenants
• Management – strategic planning, business evaluation
• Employees/litigants/customers/government/competitors Lecture 2: Understanding the Business: Industry and Strategy Analysis (how is value generated)
1. Consider global/domestic macro economic conditions now & future (GDP, inflation, FX)
2. Analysis each of the industries the firm operates in. Look at: o Sensitivity of each industry to macro economic factors o How each industry operates and the key performance metrics of the industry o Level of competition, industry structure & profitability (lower the competition the better)
• Perfect competition: return = cost of capital
• Monopoly – growth rate > cost of capital
• Level of competition determines level of abnormal earnings
• Sources of competition:
1. Rivalry between existing firms – can compete on price or other factors
2. Threat of new entrances – usually when high abnormal profits.
3. Threat of substitutes – company price/performance + cust want to change
4. Relative bargaining power with suppliers
5. Relative bargaining power with customers and their price sensitivity
3. Detailed analysis of the operations and strategy of the firm – two main strategies: o Cost leader – high ATO, low PM (eco of scale/learning, low R&D, cost controls, efficiency) o Differentiator – low ATO, high PM (high R&D & firm seeks to be unique)
• Key success and risks of strategy?
• Does the firm have appropriate resources, structure and commitment?
• Is the competitive advantage sustainable – any potential changes to industry?
• What is the effect of the diversification, horizontal and vertical integration?

Lecture 3: Accounting Analysis
• Accounting analysis - evaluate how well accounting captures business reality. Look at: o Accounting rules & choices– introduce noise and bias o Forecast errors – conservatism and difficult to predict
• Manipulation usually involves either bringing income forward or banking it for the future
• Usually accounting manipulation done in the year end accounts. Also during: o Management change - Auditor change o Management rewards tied in with earnings - Weak governance structure o Related party transactions - Takeover target

Financial indicators that manipulation has occurred
• An earning surprise (a drop in profitability after a period of good profitability)
• Earnings growing faster than sales
• Small or zero profit and increase in profit margins
Accounting analysis – how well do the accounts reflect the economic reality?
1. Identify key accounting policies
2. Assess accounting flexibility
3. Evaluate accounting strategy
a. Against industry norms
b. Do management have an incentive to manipulate?
c. Any changes in policies/estimates – structuring of transactions e.g. leases?
d. What is history of accounting adjustments i.e. have comparatives been changed?
4. Evaluate the quality of disclosure
a. Adequate disclosure including quality of segment disclosure? Auditor responsibility
b. Does the firm explain performance? If in the notes it is audited if not marketing wrote it
c. How forth coming is management about bad news?
5. Identify red flags
a. Qualified audit report
b. Unexplained accounting standards, estimate changes or transactions increasing profit
c. Unusual increased in accruals