Assignment
On
Financial Statement Analysis and Valuation
Course code: (F-401)
Submitted to:
Md. Sajib Hossain, CFA
Assistant Professor
Department of Finance
University of Dhaka
Submitted by:
Sifat Zahan Mim
Roll: 23-188
Section:B
Batch-23rd
Department of Finance
University of Dhaka
Date of submission: 7th July, 2020
Reading 26
Long-Lived Asset
Long lived assets, also referred to as non-current assets are that are expected to provide
economic benefits over a future period of time.Long lived assets include tangible assets,
intangible assets and financial assets. The objective of this chapter is to understand the effects
and issues concerning capitalization versus immediate expensing of various costs including
construction interest, research and development and software costs. An expenditure that is
capitalized is initially recorded as an asset on the balance sheet at cost. Capitalized interest is
not reported in income statement as interest expense. The interest cost is allocated to the
income statement through depreciation expense. IFRS permit the use of either cost model or
revaluation model. The US GAAP require the use of cost model.
Reading 28
Non- Current Liabilities
Non-current liabilities refers to financial obligations in a company’s balance sheet that are not
expected to be paid within one year. Non- Current liabilities are compared to cash flow, to
see if a company will be able to meet its financial obligations in the long term. Investors and
creditors use various financial ratios to assess liquidity risk and leverage. The debt ratio
compares a company’s total debt to total asset. The lower the percentage , the less leverage a
company is using. Non-current liabilities help assess solvency.
Firms that follow U.S. GAAP must report cash interest paid in the cash flow statement as an
operating cash flow. Firms that follow IFRS report cash interest paid as an operating cash
flow or financing cash flow. When bonds mature, no gain or loss is recognized by the issuer.
At maturity the original discount or premium has been fully amortized .Thus the book value
of a bond or face value are same.
Redeeming debt is not a part of day to day operations. Thus analysts often eliminate the gain
or loss from the income statement for analysis and forecasting.
While lenders are primarily concerned with short-term liquidity and the amount of current
liabilities, long-term investors use noncurrent liabilities to gauge whether a company is using
excessive leverage. The more stable a company’s cash flows, the more debt it can support
without increasing its default risk. While current liabilities assess liquidity, noncurrent
liabilities help assess solvency.
Investors and creditors use numerous financial ratios to assess liquidity risk and leverage. The
debt ratio compares a company's total debt to total assets, to provide a general idea of how
leveraged it is. The lower the percentage, the less leverage a company is using and the
stronger its equity position. The higher the ratio, the more financial risk a company is taking
on. Other variants are the long term debt to total assets ratio and the long-term debt to
capitalization ratio, which divides noncurrent liabilities by the amount of capital available.
Reading 24
Financial Analysis Techniques (self-study)
Financial analysis tools can be useful in assessing a company’s performance and trends in
that performance .Financial analysis techniques, including common-size financial statements
and ratio analysis, are useful in summarizing financial reporting data and evaluating the
performance and financial position of a company. The results of financial analysis techniques
provide important inputs into security valuation.
Simple representation of financial statements cannot always meet the investor’s and analyst’s
requirements. For making the information useful, several techniques are implemented. The
statements are analyzed in various ways; common-size analyses, financial ratio analysis,
technical analysis and regression analysis. The main objectives of the techniques are to
analyze the present worth of entity and to build forecasts and formulate predictions about
future performance. Ratios are used for measuring activity, liquidity, solvency and
profitability. Besides financial performance, entity worth and sustainability are also crucial
for the users. Thus, the equity valuation and credit ratings are conducted. Different business
segments are analyzed separately. Though the investors are interested in the previous
analyses, the company analysts provide information for measuring entity worth. The most
vital activity was model building and forecasting. However financial statements do contain
about past performance of a company well as current financial condition.
Reading 29
Financial Reporting Quality
Ideally ,analysts would always have access to financial reports that are based on sound
financial reporting standards such as IASB and FASB. A good quality financial reporting
leads to higher reliance of the stakeholders as well as sufficient grounds for building forecast
models to the analysts. If the financial reporting is GAAP oriented and sustainable
performance-focused, the users can avail information about the return probability and make
investment decisions. Basing on three dimensions; decisional usefulness, GAAP orientation
and sustainability, financial reporting quality is segmented into six basic frameworks. In
certain cases, financial reporting quality is threatened for two basic aspects; motivation and
context. Motivation arises due to performance pressure, career involvement and other
personal factors. Besides, context arises from opportunities, motivations and rationalization.
For minimizing these aspects and to maintain a stable quality of reporting some regulations
are formed and strongly implemented to deal with motivation and opportunities. The most
important fact is that quality of reporting isn’t hampered only by departing from GAAPs,
rather following GAAPs often lead to biased accounting and intentional quality issues, which
are discussed as the key warning signs for the auditors. In practice, the quality of reports vary
greatly. High quality financial reporting provides information useful to analysts in assessing a
company’s performance. Low quality financial reporting contains inaccurate, misleading or
incomplete information.
Reading 30
Financial statement analysis:Applications
Financial statement analysis is the process of reviewing and analysing company’s financial
statement to make better economic decisions to earn income in future. Applications of
Financial statement analysis includes 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 reading 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.
Financial analysis is the process of examining a company’s performance in the context of
industry and economic environment in order to arrive at a decision or recommendation.
Industry Analysis
Industry analysis is the analysis of a specific brunch of manufacturing. Service or trade.
Before making any investment decision from the organization or investor perspective, it is
required to extract the industry information first according to the top-down approach. But, in
a bottom-down approach, this is extracted at the last. The objective is to find out a potential
industry providing aspiring company entities with well-performing stocks. Porter’s five
forces model is very useful to derive the industry profitability and risk level. For valuation,
the financial forecasting models are prepared. The models require versatile assumptions;
interest rate, return value, inflation, selling price, production unit, demand and supply chain.
All these values are quite uncertain for the future period. But, through industry analysis, the
grounds for the assumptions are formulated through regression models and correlation
equations. Two basic aspects are considered here as correlation equations; the predictions
about the economy and the condition of the industry. As the final analysis, the industry and
economic correlation are extracted. Industry analysis are important for
1 .understanding a company’s business and business environment
2. Identifying active investment opportunities.
3. Portfolio performance attribution
4. Formulating an industry or sector rotation strategy.
Company Analysis
Company analysis will involve an examination of the company’s financial position , product/
service, competitive strategy.
Elements of a Thorough Company Analysis
1. Provide an overview of the company
2. Explain relevant industry characteristics
3. Analyse demand for products or services
4. Analyse supply for products or services
5. Explaining pricing environment
6. Present and interpret different financial ratios.
Analysts can use a top-down, bottom-up or a hybrid approach to forcasting income and
expense. Top down approaches are usually begin at the level of overall economy, bottom-up
approaches are usually begin at individual company or unit.
Reading 28
Free cash flow valuation
FCFF and FCFE
Analysts likes to follow free cash flow as the return( either FCFE or FCFF) whenever one or
more following conditions are available.
1. The company doesn’t pay dividends
2. The companys pay dividend but the dividend paid differ significantly from the
companys capacity to pay dividends.
3. Free ash flow align with profitability within a reasonable forecast period with
which the analysts is comfortable.
Commonly equity can be valued directly by using FCFE or indirectly by first using a FCFF
model to estimate the value of the firm and then subtracting the value of debt from FCFF to
arrive at an estimate to the value of equity. In another perspective, the equity carries worth of
present value of future streams of cash flows. While FCFF streams evaluate the entire firm
value, the FCFE streams are concerned about the equity portion, which is the major
difference between the two. The relationship between FCFE and FCFF can be described as
follows; FCFE = FCFF – Interest (1-tax rate) + Net Borrowing. Four distinct financial
metrics can be used as inputs to derive the FCFF and FCFE. Estimating FCFF or FCFE
requires a complete understanding of the company and financial statements.
Forecasting free cash flow
1. Net income FCFF FCFE
=Net income + non-cash =Net income + non-cash
costs+ interest (1-tax rate)- costs-investment in fixed
investment in fixed capital – capital – investment in
investment in working capital working capital+ net
borrowing
2. Operating cash flow FCFF FCFE
=Operating cash flow + =Operating cash flow –
interest (1-tax rate)- investment in fixed capital +
investment in fixed capital net borrowing
3. EBIT FCFF
=EBIT (1-tax rate) +
depreciation – fixed
investment – working capital
investment
4. EBITDA FCFF
=EBITDA(1-tax rate) +
depreciation tax shield –
fixed capital investment –
working capital investment
For most of this section we assume that the company has two sources of capital debt and
common stock. Once the concepts of FCFF and FCFE are understood for a company by using
only debt and common stock. Discounted cash flow (DCF) valuation views the intrinsic value
of a security as the present value of its expected future cash flows. When applied to
dividends, the DCF model is the discounted dividend approach or dividend discount model
(DDM). This reading extends DCF analysis to value a company and its equity securities by
valuing free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Whereas
dividends are the cash flows actually paid to stockholders, free cash flows are the cash flows
available for distribution to shareholders. Unlike dividends, FCFF and FCFE are not readily
available data. Analysts need to compute these quantities from available financial
information, which requires a clear understanding of free cash flows and the ability to
interpret and use the information correctly. Forecasting future free cash flows is also a rich
and demanding exercise. The analyst’s understanding of a company’s financial statements, its
operations, its financing, and its industry can pay real “dividends” as he or she addresses that
task. Many analysts consider free cash flow models to be more useful than DDMs in practice.
Free cash flows provide an economically sound basis for valuation.
