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C FA ® E x a m P r e p a r a t o r y P r o g r a m
Level 1 Batch 44 | 2023
Financial Reporting Analysis 10B
Financial Reporting
Quality Application
B I N U S F I N A N C I A L A N A LY S T A C A D E M Y P R O G R A M
A d a p t e d f r o m C FA ® In s t i t u t e C u r r i c u l u m L e v e l 1
a. Evaluate a company’s past financial performance and
explain how a company’s strategy is reflected in past financial
performance;
• Trends in financial ratios and differences between a firm’s financial ratios and those of its
competitors or industry averages can indicate important aspects of a firm’s business
strategy
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• It is important for an analyst to understand a subject firm’s business strategy and then to
interpret that into the financial ratios.
Activity Ratio → Turnover
Liquidity Ratio → Current ratio, quick ratio
Solvency Ratio → D/E, D/A
Profitability Ratio → GP Margin, ROA, ROE
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b. Forecast a company’s future net income and cash flow;
Forecasting Net Income:
• Start with estimating future sales.
• Used Top Down approach beginning from GDP growth and the growth of industry sales.
• If the market share is expected to be the same, then company growth is the same as industry
growth. If analyst expects market share to increase or decrease in the next period, market share
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can be adjusted for this change and then multiplied by estimated industry sales
Forecasting Cash flow:
• Make assumption about future sources and uses of cash. Most important will be Working Capital,
Capital Expenditures, issuance or repayment of debt, and issuance or repurchase of stock
• Typical assumption is that noncash working capital as a percentage of sales remain constant.
Historical avg of profitability → constant % of GP margin, EBT%
b. Forecast a company’s future net income and cash flow;
Income and Cash Flow Projection
20X0 20X1 20X2 20X3 20X4
Sales @ +5% per year 86,145 90,452 94,975 99,724 104,710
COGS @ 35% of sales 30,151 31,658 33,241 34,903 36,648
Opex @ 55% of sales 47,380 49,749 52,236 54,848 57,590
Pretax income 8,614 9,045 9,497 9,972 10,471
Taxes @ 35% 3,015 3,166 3,324 3,490 3,665
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Net income 5,599 5,879 6,173 6,482 6,806
Cash (Borrowing) 8,615 6,311 3,892 1,350 (1,318)
Noncash working capital @ 85% sales 73,223 76,884 80,729 84,765 89,003
Current assets 81,838 83,195 84,620 86,116 87,685
Net income 5,599 5,879 6,173 6,482 6,806
- Investment in Working Cap 3,478 3,661 3,844 4,036 4,238
- Investment in Fixed Cap @ 5% of sales 4,307 4,523 4,749 4,986 5,235
Change in cash (2,186) (2,304) (2,419) (2,540) (2,667)
Beginning cash 10,801 8,615 6,311 3,892 1,350
Ending cash 8,615 6,311 3,892 1,350 (1,318)
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c. Describe the role of financial statement analysis in
assessing the credit quality of a potential debt investment;
Capacity to repay requires close examination of a firm’s financial statements and ratios.
Items to be considered are:
1. Scale and Diversification larger companies and those with a wider variety of product lines
and greater geographic diversification are better credit risks.
2. Operational efficiency high operating efficiency is associated with better debt ratings.
3. Margin stability stable margin indicates higher probability of repayment. Highly variable
operating results make lenders nervous.
4. Leverage firms with greater earnings in relation to their debt and in relation to their
interest expense are better credit risks.
d. Describe the use of financial statement analysis in
screening for potential equity investments;
• Financial ratios could help to select portfolio of stocks from the large universe of potential
equity investments.
• However, screening investment based on single ratios (i.e low P/E and low Price/sales)
can include firms with other undesirable characteristics. For example, company with low
P/E may also have operating losses, declining sales prospects, or very high leverage.
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e. Explain appropriate analyst adjustments to a company’s
financial statements to facilitate comparison with another
company;
Because different companies choose different accounting methods, an analyst must be
prepared to adjust the financial statements of one company to make them comparable.
1. Investment in Securities
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Classification of investment as held for trading, available for sale or held to maturity securities could
affect the reported
Gain/loss, fair earnings and assets.
value measurement
2. Inventory Accounting Differences (LIFO vs FIFO)
Differences in COGS and Inventory due to LIFO and FIFO method should be adjusted accordingly
to make it comparable.
LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO COGS
can be adjusted to a FIFO basis by subtracting the change in the LIFO reserve.
e. Explain appropriate analyst adjustments to a company’s
financial statements to facilitate comparison with another
company;
1. Differences in Depreciation Methods and Estimates.
Over and asset’s life, difference between depreciation methods, estimates of useful lives, and
estimate of salvage values used by otherwise comparable firms can lead to significant differences
in reported income and balance sheet asset values.
A firm that is aggressive might report lower annual depreciation expense and higher net income.
Comparing average ages and useful lives of assets within an industry may reveal differences in
firms’ future capital spending needs.
4. Off Balance Sheet Financing
Debt ratios should include liabilities for both finance lease and operating leases.
Pre and post acquisition lack of comparability when acquisition
method is used
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e. Explain appropriate analyst adjustments to a company’s
financial statements to facilitate comparison with another
company;
6. Goodwill
Two companies with identical assets, but where one has grown through acquisition of some
business units while the other has grown internally by creating such business units, will show
different balance sheet values for the same assets. Hence, necessary adjustment are:
Goodwill need to be subtracted from assets when calculating financial ratios.
Any impairment of goodwill in current period should be reversed, increasing reported net income.
7. Other Intangible Assets
IFRS permit upwards revaluation of intangible assets while US GAAP does not. Hence, reducing
intangible asset values (thereby equity) by the cumulative amount of any such upward revaluations
References
• Ciesielski, Jack T., CPA, CFA, Elaine Henry, PhD, CFA, and Thomas I. Selling, PhD, CPA, “Financial Reporting Quality”,
CFA Program Curriculum 2020 Level 1. CFA Institute, 2019.
• Robinson, Thomas., PhD, CFA, Jan Hendrik van Greuning, DCom, CFA, Elaine Henry, PhD, CFA, and Michael A. Broihahn,
CPA, CIA, CFA, “Applications of Financial Statement Analysis”, CFA Program Curriculum 2020 Level 1. CFA Institute, 2019.
• SchweserNotes for the CFA Exam Level 1: CFA Program Exam Prep. Kaplan, Inc., 2018.
This presentation material is strictly for class discussion purpose only, and can not be used, copied and
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@binus_executive_education BINUS Executive Education bbs.binus.ac.id/exed
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