03

Financial Statement
Analysis
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LM01 Intercorporate Investments

Basic corporate investment categories

The table below summarizes the accounting treatment for various investment categories
under IFRS.
Financial Assets Associates Business Joint
Combinations Ventures
Influence Not significant Significant Controlling Shared
control
Typical Usually < 20% Usually 20% Usually > 50% or
percentage to 50% other indications of
interest control
Financial Classified as: Equity Consolidation IFRS:
Reporting ▪ Fair value through profit method Equity
or loss method
▪ Fair value through other
comprehensive income
▪ Amortized cost

Investments in financial assets: IFRS 9

The following flowchart will help understand the classification of financial assets under
IFRS 9.

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Reclassification under IFRS 9:

• The reclassification of equity instruments is not permitted because the initial
classification of FVPL and FVOCI is irrevocable.
• Reclassifications of debt instruments from FVPL to amortized costs (or vice versa)
are permitted only when the business model changes in a way that significantly
affects operations. Changes to the business models require judgment and are
expected to be infrequent.

Investments in associates and joint ventures

An investment is considered an “associate company” when the investor has (or can
exercise) significant influence, but not control, over the investee’s business activities.
Significant influence is presumed with 20 – 50% ownership or voting power of the
associate (investee). Significant influence may be evidenced by:
• Representation on the board of directors
• Participation in the policy-making process
• Material transactions between the investor and the investee
• Interchange of managerial personnel
• Technological dependency
Joint ventures are ventures undertaken and controlled by two or more parties. IFRS
identifies two characteristics of joint ventures as:
• A contractual arrangement exists between two or more venturers.
• The contractual arrangement establishes joint control.
The equity method is used to account for investments in associates and joint ventures.
Equity method: a one-line consolidation method.
Balance sheet:
• Investment account reflected as a single line item (non-current asset) on the balance
sheet.
• Equity investment is initially recorded on the investor’s balance sheet at cost. It has
three components:
o Reported value on investee B/S
o Fair value surplus
o Goodwill
• Subsequently, the carrying amount of the investment is adjusted to recognize the
investor’s proportionate share of the investee’s earnings or losses.
• Value of investment = beginning value + share of profits – share of dividends
• Dividends received from the investee are treated as a return of capital and reduce
the carrying amount of the investment. They are not reported on the income
statement.

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• If the investment costs exceed the book value of the investee, then we amortize the
excess purchase price attributable to plant and equipment.
• Value of investment = beginning value + share of profits – share of dividends -
amortization of excess purchase price attributable to plant and equipment
Income statement:
• The share of income (not dividends) is recorded in the investor’s income statement
Transactions with the investee:
• Because an investor company can influence the terms and timings of transactions
with associates, profits from such transactions cannot be realized until confirmed
through use of a third-party sale.
• Investor company’s share of any unrealized profit must be deferred by reducing the
amount recorded under the equity method.
• This deferred profit is added back to the equity income when confirmed.

Business combinations

Under IFRS, there is no distinction between business combinations. Under US GAAP, there
are four types: merger, acquisition, consolidation, and variable interest entity.
The acquisition method is used for business combinations.
Acquisition method
The major points related to the acquisition method are listed below:
• Identifiable tangible and intangible assets (brand names, patents, etc.) and liabilities
of the acquired company are measured at fair value on the date of the acquisition.
• Assets and liabilities that were not previously recognized by the acquiree must be
recognized by the acquirer.
• The acquirer must recognize any contingent liability if it can be reliably measured
and the obligation arises from past events.
• The acquirer must recognize an indemnification asset on the acquisition date.
• Recognition of goodwill differs between IFRS and US GAAP:
o IFRS has two options for goodwill: partial goodwill and full goodwill.
Partial goodwill = fair value of the acquisition - acquirer’s share of the fair
value of all acquiree’s assets and liabilities
Full goodwill = fair value of the entity as a whole - the fair value of all
acquiree’s assets and liabilities
o US GAAP allows only full goodwill.
• In an acquisition, when the purchase price is less than the fair value of the target’s
(acquiree’s) net assets, the acquisition is considered to be a bargain acquisition.
IFRS and US GAAP require the difference between the fair value of the acquired net
assets and the purchase price to be recognized immediately as a gain.

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Comparison of methods

The following table compares the effect of equity method and acquisition method on
financial ratios.
Equity Method Acquisition Method Acquisition Method
(Partial Goodwill) (Full Goodwill)
Profit Margin More favorable Less favorable than equity method
Leverage Most favorable Less favorable than More favorable than
equity method partial goodwill
method
ROE Most favorable Less favorable than Less favorable than
equity method partial goodwill
method
ROA Most favorable Less favorable than Less favorable than
equity method partial goodwill
method
Current Ratio More favorable Less favorable

Asset Turnover Need to calculate

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LM02 Employee Compensation: Post Employment and Share-Based

Types of employee compensation

The different types of employee compensation are:

• Short-term benefits: Compensation expected to be paid within 12 months.
• Long-term benefits: Compensation expected to be paid after 12 months.
• Termination benefits: Compensation paid in the event of employee termination.
• Share-based compensation: Compensation in the form of, or in reference to, shares
of the employer’s stock
• Post-employment benefits: Compensation expected to be paid after employee
retirement
How does share-based compensation affect financial statements

The general approach to report share-based compensation is to measure the fair value of
the share-based award at the grant date, recognize it as an expense over the vesting period
with the offsetting entry to equity. At settlement, entries are transferred from one equity
account to another.
Restricted stock refers to common stock that has been granted to employees but is subject
to selling and other restrictions.
Restricted stock units (RSU) are a similar concept. These are instruments which represent
a right to receive shares upon settlement.
The grant-date fair value for restricted stock and RSU awards is the market price of the
underlying shares.

How to forecast share-based compensation expense and shares outstanding

One approach to forecast share-based compensation is to forecast implicitly when

forecasting operating expenses. This approach is suitable if share-based component of
operating expenses has the same drivers as cash-based components. This is generally the
case for most companies, expect for companies in the early stages of their lifecycle.
For early-stage companies it is better to model share-based compensation discretely.
Under this approach, share based compensation is typically forecasted as a percentage of
revenues. To determine what percentage to apply, analysts can use a variety of methods
such as a historical average, management guidance, or assuming that the percentage will
revert to an industry average over time.
To forecast shares outstanding, analysts can use the following framework:
Basic shares outstanding, beginning of period

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Plus: RSUs vested and/or share options exercised

Plus: share issuances from secondaries, acquisitions, etc.
Less: share repurchases
Basic shares outstanding, end of period.
Valuation considerations: Share-based compensation should be considered when valuing a
company. Since share-based compensation is non-cash, discounted cash flow models used
to value companies do not account for it by default. The model needs to be modified to
account for the effect of:
• dilution from outstanding but unvested share-based awards and
• dilution from future share-based awards
How do post-employment benefits affect financial statements

Defined contribution plans: The financial reporting for DC plans is relatively straight
forward:
• Income statement: Employers’ plan contributions are recognized as an expense
• Balance Sheet: Current liability for vested but not-yet-settled contributions
• Statement of Cash Flows: Plan contributions are a cash outflow in operating activities
Defined benefit plans: Both IFRS and US GAAP require a DB plan’s ‘funded status’ to be
reported on the balance sheet.
Funded Status = Fair Value of plan assets – Pension obligation
If the funded status is negative, the plan is underfunded, and the funded status is reported
as a net pension liability on the balance sheet. If the funded status is positive, the plan is
overfunded, and the funded status is reported as a net pension asset on the balance sheet.
The periodic pension cost has to be reported on the income statement. The reporting
requirement vary for IFRS and US GAAP. Exhibit 8 from the curriculum compares the two:

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Financial modeling and valuation considerations for post-employment benefits

Financial modeling
DC Plan
• Income Statement: Expenses are forecasted implicitly with operating expenses
• Statement of Cash flows: Matched with recognized expense
• Balance Sheet: Accrued liabilities forecasted using working capital ratios
DB Plan
• General approach is to model service cost, net interest expense/income,
remeasurements, and the employer’s plan contributions in future periods
• These form basis for amounts recognized on the income statement, balance sheet
and cash flow statement
Valuation considerations:
• An underfunded plan should be treated like debt. This is because the company is
obligated to make benefit payments regardless of the underfunding.
• An overfunded plan should be ignored in valuation. This is because plan assets are
solely for paying benefits. They cannot be withdrawn and distributed to
shareholders.

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• Future service costs should be deducted from free cash flow in a discounted cash
flow model.

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LM03 Multinational Operations

Presentation currency, functional currency and local currency

Presentation (reporting) currency: The currency in which financial statement amounts

are presented. It is generally the currency of the parent company’s residence.
Local currency: The national currency of the country where the entity is located.
Functional currency: The currency of the primary economic environment in which an
entity operates. The factors that need to be considered while determining the functional
currency of subsidiary are:
1. The currency that mainly influences sales prices for goods and services.
2. The currency of the country whose competitive forces and regulations mainly
determine the sales price of its goods and services.
3. The currency that mainly influences labor, material, and other costs of providing
goods and services.
4. The currency in which funds from financing activities are generated.
5. The currency in which receipts from operating activities are usually retained.

Foreign currency transactions

Transaction exposure related to imports and exports can be summarized as follows:

Import purchase: Here the importer is required to pay in the foreign currency and the
settlement date falls after the purchase date. The importer is exposed to FX risk as the
functional currency may weaken against the foreign currency. This will increase the
amount of the functional currency that the importer is required to pay.
Export sales: Here the exporter agrees to be paid in foreign currency and the settlement
date falls sometime after the sale date. The exporter is exposed to FX risk as the functional
currency may strengthen against the foreign currency. This will decrease the amount of
functional currency that the exporter will receive.
Both U.S. GAAP and IFRS require the change in the value of foreign currency asset or
liability resulting from foreign currency transaction to be treated as a gain or loss reported
on the income statement.

Translation methods

Many companies have operations in foreign countries. Subsidiaries located in foreign

countries usually prepare their financial statements in the local currency. IFRS and US
GAAP require parent companies to prepare consolidated financial statements in which the
assets, liabilities, revenues, and expenses of both domestic and foreign subsidiaries are
added to those of the parent company. To prepare consolidated financial statements,

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parent companies must translate the foreign currency financial statements into the
parent’s presentation currency.
If the foreign subsidiary’s functional currency is different from the parent’s presentation
currency, the current rate method must be used.
If the foreign subsidiary’s functional currency is same as the parent’s presentation
currency, the temporal method must be used.
Current rate method:
Under this method, the foreign entity’s foreign currency financial statements are translated
into the parent’s presentation currency using the following procedures:
1. All assets and liabilities are translated at the current exchange rate at the balance
sheet date.
2. Stockholders’ equity accounts are translated at historical exchange rates.
3. Revenues and expenses are translated at the exchange rate that existed when the
transactions took place (For practical reasons, a rate that approximates the
exchange rates at the dates of the transactions, such as an average exchange rate,
may be used).
4. Net translation gain/loss is unrealized (will be realized when the entity is sold) and
is not shown on the income statement. Translation adjustment is reflected in equity.
Temporal method:
Under this method, the foreign entity’s foreign currency financial statements are translated
into the parent’s presentation currency using the following procedures:
1. Assets and Liabilities
a. Monetary assets and liabilities are translated at the current exchange rate.
b. Non-monetary assets and liabilities measured at historical cost are
translated at historical exchange rates.
c. Non-monetary assets and liabilities measured at current value are translated at
the exchange rate at the date when the current value was determined.
2. Stockholders’ equity accounts are translated at historical exchange rates.
3. Revenue and Expenses
a. Revenues and expenses, other than those expenses related to non-monetary
assets, are translated at the exchange rate that existed when the transactions
took place.
b. Expenses related to non-monetary assets, such as cost of goods sold
(inventory), depreciation (fixed assets), and amortization (intangible
assets), are translated at the exchange rates used to translate the related
assets.
4. The translation gain/loss is shown on the income statement.

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Instructor’s note: Items highlighted in bold indicate the differences between the temporal
method and the current rate method

Comparison of current rate and temporal methods

Current Rate Method Temporal Method

Monetary assets and liabilities Current rate Current rate

Non-monetary assets and liabilities Current rate Current rate

measured at current value
Non-monetary assets and liabilities Current rate Historical rates
measured at historical cost
Equity (other than retrained earnings) Historical rates Historical rates

Equity (retained earnings) Beginning balance plus translated net income

less dividends translated at historical rate
Revenue Average rate Average rate

Most expenses Average rate Average rate

Expenses related to assets translated Average rate Historical rates

at historical exchange rate
Treatment of the translation Accumulated as a Included as gain or loss
adjustment in the parent’s separate component of in net income
consolidated financial statements equity

Effect of currency exchange rate movement on financial statements

If value of assets to be translated is greater than value of liabilities to be translated, then we

have a net asset exposure. With the current rate there will almost always be a net asset
exposure.
The following table summarizes the effect of currency exchange rate movements on
financial statements:
Temporal Method, Net
Temporal Method Net
Monetary Liability Current Rate Method
Monetary Asset Exposure
Exposure
Foreign currency ↑Revenues ↑Revenues ↑Revenues
strengthens relative to ↑Assets ↑Assets ↑Assets
parent’s presentation ↑Liabilities ↑Liabilities ↑Liabilities
currency ↓Net income ↑Net income ↑Net income
↓Shareholder’s equity ↑Shareholder’s equity ↑Shareholder’s equity
Translation loss Translation gain

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Positive translation
adjustment
Foreign currency ↓Revenues ↓Revenues ↓Revenues
weakens relative to ↓Assets ↓Assets ↓Assets
parent’s presentation ↓Liabilities ↓Liabilities ↓Liabilities
currency ↑Net income ↓Net income ↓Net income
↑Shareholder’s equity ↓Shareholder’s equity ↓Shareholder’s equity
Translation gain Translation loss Negative translation
adjustment

Translation in a hyperinflationary economy

IFRS and US GAAP differ substantially in their approach to translating the foreign currency
financial statements of a subsidiary in a hyperinflationary economy.
US GAAP requires that the financial statements be translated using the temporal
method.
IFRS require financial statements to be first restated for inflation and then inflation
adjusted financial statements be translated at the current exchange rate.
The following procedures should be followed while adjusting the financial statements for
inflation:
• Monetary assets and liabilities are not restated.
• Nonmonetary assets and liabilities are adjusted for inflation.
o Restated costs are determined by applying the change in general price index
to the historical costs.
o If items are carried at revalued amounts (e.g. PP&E), these are restated from
the date of revaluation.
• All components of stockholders’ equity are restated by applying the change in
general price index from the beginning of the period or from the date of
contribution to the balance sheet.
• All income statement items are restated by applying the change in the general price
index from the dates when the items were originally recorded.
• Purchasing power gains/losses that arises from holding monetary assets and
monetary liabilities are included in net income. (Net monetary assets result in a
purchasing power loss; net monetary liabilities result in a purchasing power gain.)

Multinational operations and effective tax rate

Generally, multinational companies have to pay income taxes in the country in which the
profit is earned. Transfer prices (prices charged on intercompany transactions) affect the
allocation of profits between companies.

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An entity with operations in multiple countries with different tax rates could aim to set
transfer prices such that a higher portion of its profit is allocated to lower tax rate
jurisdictions. To prevent this, countries have established various laws and practices to
prevent aggressive transfer pricing practices.
Whether and when a company also pays income taxes in its home country depends on the
specific tax regime.
An analyst can obtain information about the tax impact of multinational operations from
companies’ disclosure on effective tax rates.

Sustainability of earnings

For a multinational company, sales growth is driven not only by changes in volume and
price, but also by changes in the exchange rates. Growth in sales that comes from changes
in volume or price is more sustainable than growth in sales that comes from changes in
exchange rates.

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LM04 Analysis of Financial Institutions

What makes financial institutions different from other companies?

The different types of financial institutions are:

• Banking industry – commercial banks, credit unions, etc.
• Insurance industry – property & casualty, life & health, reinsurance
• Investment management industry – mutual funds, exchange traded funds, hedge
funds, brokers & dealers.
Financial institutions have a high level of systemic risk. Their smooth functioning is crucial
to the overall economy. Due to the high level of systemic risk, the level of regulation in the
financial sector tends to be high.
The liabilities of financial institutions especially banks are made up primarily of deposits
and assets are predominantly financial assets. These assets are exposed to credit, market,
and liquidity risks.
Systematic risk: risk of disruption to financial services that is 1) caused by an impairment
of all or parts of the financial system and 2) has the potential to have serious negative
consequences for the economy as a whole.
Financial contagion: situation in which financial shocks spread from their place or sector
of origin to other locales or sectors.

Financial regulations of financial institutions

The objectives of global and regional regulatory bodies are:

• Minimize systematic risk
• Harmonize and globalize regulatory rules, standards, and oversight
• Ensure consistency of standards and regulations
• Minimize regulatory arbitrage
Some important financial regulators are: The Financial Stability Board, The International
Association of Deposit Insurers, The International Association of Insurance Supervisors,
The International Organization of Securities Commissions, Basel Committee on Banking
Supervision.
One of the most important organization focused on financial stability is the ‘Basel
Committee on Banking Supervision’. Its members include central banks from all over the
world, as well as several regulators. The key output of this committee is the international
regulatory framework for banks called – ‘Basel III’.
The objectives of this framework are to:
• Improve the banking sector’s ability to absorb shocks arising from financial and

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economic stress.
• Improve risk management and governance of banks.
• Strengthen banks’ transparency and disclosures.
The three major highlights of the Basel III framework are:
• Minimum capital requirement: A bank must have sufficient equity capital to absorb
the loss in value of assets in a financial crisis.
• Minimum liquidity: A bank must hold enough high-quality liquid assets to cover its
liquidity needs in a 30-day liquidity stress scenario.
• Stable funding: A bank should have an adequate amount of stable funding relative to
the bank’s liquidity needs over a one- year horizon.

The CAMELS approach to analyzing a bank

The ‘CAMELS’ approach has six components which addresses the following questions:
1. Capital adequacy – Does the bank have sufficient capital given its assets?
2. Asset quality – What is the quality of the bank’s financial assets?
3. Management capabilities – Is the management effective? What is its track record?
4. Earnings – What is the level of earnings? What is the quality of earnings? Are
earnings trending up or down?
5. Liquidity: How strong is the liquidity position of the bank? What are the sources of
funding? Are the sources of funding stable?
6. Sensitivity to market risk: How sensitive are the bank’s earnings to market risk?
For each component a rating is assigned on a scale of 1 to 5 (where 1 is the best rating and
5 is the worst). After the components are rated, weights are assigned, and a weighted
average is taken to calculate the overall CAMELS score.
Capital adequacy
Capital adequacy is based on the portion of assets funded by capital. It indicates whether a
bank has enough capital to absorb losses without severely damaging its financial position.
Basel III’s minimum capital requirements are:
• Common Equity Tier 1 Capital must be at least 4.5% of risk weighted assets
• Total Tier 1 Capital must be at least 6.0% of risk-weighted assets
• Total Capital must be at least 8.0% of risk-weighted assets
Common Equity Tier 1 Capital: This is the safest type of capital. It includes common stock,
issuance surplus related to common stock, retained earnings, OCI, and certain adjustments.
Other Tier 1 Capital: This includes instruments issued by bank which meet criteria such as:
• Subordinate to deposits and other debt obligations.
• No fixed maturity.
• Interest or dividend payments, if any, should be at bank’s discretion.

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• Collectively, the above two types are called ‘Total Tier 1 Capital.’
Tier 2 Capital: This is capital which meets criteria such as:
• Subordinate to deposits and to general creditors of bank.
• Minimum maturity of 5 years.
• Collectively, the three types are called ‘Total Tier 1 and Tier 2 Capital’
Risk weighted assets: Assets are weighted based on risk. For example, cash has a weight of
0%, corporate loans may be given a weight of 100% and non-performing loans may be
given a weight of 150%.
Asset quality
Asset quality is based on credit quality and diversification. The credit policies and overall
risk management processes of a bank impact its asset quality.
The three major asset categories for a bank are:
1. Loans – Generally the The quality of loans depends on:
largest component of • Creditworthiness of borrowers – High
overall assets creditworthiness implies high asset quality.
• Adequacy of adjustments for expected loan losses
– If the adjustments are not sufficient, then it
implies low asset quality.
2. Investments in securities They are measured differently depending on
issued by other entities – for categorization. The investments can be measured at:
example, a bond issued by • Amortized cost
another company. • Fair value, where unrealized gains/losses are
recorded in OCI (FVOCI)
• Fair value, where unrealized gains/losses flow
through the income statement (FVTPL)
3. Highly liquid financial They are considered the best quality assets.
instruments – for example,
T-Bills
Asset quality can be evaluated based on:
• Composition of assets
• Credit quality
Some ratios used in the analysis are:
• <Asset type>/total assets
• Allowance for loan losses / non-performing loans
• Provision for loan losses / net loan charge-offs

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Management capabilities
Management capability refers to bank management’s ability to identify and exploit profit
opportunities while managing risk.
Other factors related to management capabilities are: governance structure, compliance
with laws and regulations, internal controls, transparency of management
communications, and financial reporting quality.
Earnings
Earnings refers to a bank’s return on invested capital relative to cost of capital.
The major earnings components for banks are:
• Net interest income (the difference between the interest earned on loans and the
interest paid to its depositors)
• Service income
• Trading income
Of these sources, net interest income and service income are more stable, whereas trading
income is the most volatile.
While evaluating earnings we should consider:
• Composition of earnings
• Earnings quality
• Earnings trend
• Loan impairment allowances
• Fair value estimates
Liquidity
A bank’s failure to honor a current liability could have a systemic impact. Therefore, it is
extremely important for banks to maintain a strong liquidity position.
There are two major considerations when evaluating liquidity:
1. Liquid assets relative to near-term expected cash flows. This is measured by the LCR
ratio.
Liquidity coverage ratio (LCR) = highly liquid assets / expected cash outflows
2. Stability of the banks funding sources. This is measured by the NSFR ratio.
Net stable funding ratio (NSFR) = available stable funding / required stable funding
Basel III sets a target minimum of 100% for both ratios.
Some other factors to consider when evaluating liquidity position are:
• Concentration of funding
• Contractual maturity mismatch

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Sensitivity to market risk

Sensitivity to market risk deals with how adverse market movements impact a bank’s
earnings and financial position; measured using trading portfolio VaR and credit portfolio
VaR.
Market risk is the exposure to changes in interest rates, exchange rates, equity prices, or
commodity prices.
All entities have exposure to market risk. However, for banks the exposure to changes in
market prices arise because of mismatches in the maturity of banks’ deposits and loans.
Mismatches could be with respect to:
• Maturity
• Repricing frequency
• Reference rates
• Currency
Other factors relevant to analysis of a bank

Banking-specific analytical considerations not addressed by CAMELS include:

• Government support
• Government ownership
• Mission of banking entity
• Corporate culture
Analytical considerations not addressed by CAMELS that are also relevant for any
company:
• Competitive environment
• Off-balance-sheet items
• Segment information
• Currency exposure

Analyzing a property & casualty insurance company

Operations: Products and Distribution

Property insurance protects against loss or damage to property. Casualty insurance also
called liability insurance protects against legal liability related to a third party.
The premiums are collected at the start of the insurance contract. These premiums are then
invested during the float period. The float period represents the time difference between
receiving premiums and making insurance payouts.
In order to minimize payouts, insurance companies follow a prudent underwriting process.
They charge a sufficient price for the risks borne by them. They also try to diversify their
risks by not concentrating on one kind of policy, market, or customer type.

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Property and insurance policies are typically annual and the final cost to the company is
usually known within a year of the covered event. The policies are then renewed at the end
of the year.
The claims received by the P&C companies are unpredictable and lumpier.
Earnings characteristics
Macro view: The insurance industry is highly competitive, price-sensitive and cyclical.
Micro view: The underwriting cycle is driven by expenses. When expenses are high relative
to premiums, firms exit the market. On the other hand, when expenses are low relative to
premiums, firms enter the market.
The relevant ratio that compares the overall expenses of the insurance industry with
premiums is:
Combined ratio= (total insurance expenses)/(net premiums)
When this ratio is low, i.e. less than 100%, new entrants join the market.
Investment returns
Property and casualty insurance companies should invest in steady-return, low risk, and
highly liquid assets.
When evaluating investments, the concentration of assets needs to be considered. Most of
the investments will be in fixed income instruments, therefore concentration by type,
maturity, credit quality, industry, or geographic location, etc. should be evaluated.
The investment performance can be measured as:
total investment income
Investment income =
invested assets
Liquidity
Given the nature of the property and casualty insurance business, high liquidity is essential.
Firms should be able to satisfy the claims as they arise.
To evaluate the liquidity of a company we can look at the hierarchy of fair value reporting.
The hierarchy is based on three levels:
• Level 1: The prices for these securities are readily available. They are traded in very
liquid markets.
• Level 2: These securities are traded in less liquid conditions. Their prices are
inferred from similar securities in liquid markets.
• Level 3: No pricing is explicitly available. The reported prices are based on models
and assumptions. This level represents the least liquid investments.
Capitalization
This refers to the amount of equity capital in a company. There are no global minimum

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capital requirements. However, some local jurisdictions impose minimum requirements

based on the risk taken.
Key ratios used to analyze an insurance company are:
Ratio Formula What is Measured

Loss and loss Loss expense + loss adjustment expense Success in estimating
adjustment expense Net premiums earned risks insured
ratio
Underwriting expense Underwriting expense Efficiency of money
ratio Net premiums written spent in obtaining
new premiums
Combined ratio Loss and loss adjustment expense ratio Overall efficiency of
+ Underwriting expense ratio an underwriting
operation
Dividends to Diviends to policyholders (shareholders) Liquidity
policyholders Net premiums earned
(shareholders) ratio
Combined ratio after Combined ratio + Dividends to policyholders Efficiency of money
dividends (shareholders) ratio spent in obtaining
new premiums

Analyzing a life and health insurance company

Operations: Products and Distribution

There are three major sources of revenue for life and health insurance companies.
• Premiums
• Investment products and services
• Investment returns
L&H polices are longer term compared to P&C policies. Also, L&H claims are more
predictable compared to P&C claims. For these reasons, L&H companies can take more risk
and therefore earn a higher return on their investments.
Earnings characteristics
The major expense components for L&H companies are:
• Benefit payments
• Annuity contract payments
• Contract surrender expenses: Some insurance policies accumulate cash value and
policy holders have a right to cancel these policies before maturity. If cancelled, the
insurance company has to make a payment equal to the cash value.

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When evaluating L&H companies, we should recognize that several expense items require
significant judgment and estimates. Also, the earnings can be distorted because the
accounting treatment across different items may vary.
We can use several ratios to evaluate the profitability for L&H companies:
• ROA, ROE, growth and volatility of capital, book value per share.
• Pre-tax and post-tax operating margins.
• Total benefits paid as a percentage of net premiums written and deposits. A lower
ratio is considered better.
• Commissions and expenses incurred as a percentage of net premiums written and
deposits. A lower ratio is considered better, it implies efficiency in selling insurance
contracts.
Investment returns, liquidity and capitalization
Investment returns:
L&H companies can take on more risk relative to P&C companies. Therefore, they can
generate a higher return on their investments. Evaluation of investment returns should
address:
• Diversification
• Investment performance
• Interest rate risk
Liquidity:
Liquidity requirement is driven by liabilities. If the liabilities are short term, then the
liquidity requirement is high. On the other hand, if liabilities are long term, then the
liquidity requirement is low.
Sources of liquidity include operating cash flows and sale of investment assets.
Liquidity is measured by comparing the amount of liquid assets relative to short term
liabilities. The insurance company should have sufficient liquid assets to cover the short-
term liabilities.
Capital:
There are no global requirements for capital like the Basel III. Instead, various jurisdictions
have their own capital adequacy standards based on risk profile. L&H companies need less
of an equity cushion compared to P&C companies because the payouts are more
predictable and less volatile.
Interest rate risk is a major factor in estimation of risk-based capital due to maturity
mismatch between assets and liabilities.

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LM05 Evaluating Quality of Financial Reports

Quality of financial reports

Financial reporting quality

Low High
Low quality reports contain information High-quality reports contain information
that is pure fabrication. that is relevant, complete, neutral, and free
from error.
Low financial reporting quality impedes High financial reporting quality enables
assessment of earnings quality and assessment.
impedes valuation.

Earnings (results) quality

Low High
Low earnings quality is unsustainable. High earnings quality increases company
value.
High earnings quality is sustainable.

Quality spectrum of financial reports

From an investor’s perspective, the overall quality of financial reports, is the combination
of reporting quality and earnings quality, and it can be thought of as a continuous spectrum
ranging from highest to lowest as depicted in the diagram below:

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Potential problems that affect the quality of financial reports

Income statement: Overstatement or non-sustainability of operating income and/or net

income.
• Overstated or accelerated revenue recognition
• Understated expenses
• Misclassification of revenue, gains, expenses, or losses
Balance sheet: Misstatement of balance sheet items
• Over- or understatement of assets
• Over- or understatement of liabilities
• Misclassification of assets and/or liabilities
Cash flow statement: Overstatement of cash flow from operations.
Mergers and acquisitions provide opportunities and motivations to manage financial
results. For example, companies with declining cash flow from operations (CFO) may
acquire companies to increase CFO. This is because the acquisition may appear in CFI if
paid with cash or not appear at all if paid for with equity.

General steps to evaluate the quality of financial reports

These two questions help an analyst in evaluating the quality of financial reports:
• Are the financial reports GAAP-compliant and decision-useful?
• Are the earnings of high quality? Do they provide an adequate level of return, and
are they sustainable?
Following are the general steps to evaluate the quality of financial reports:
1. Develop an understanding of the company’s business and its industry. Understand
what accounting principles a company and its competitors follow.
2. Learn about the management. Review disclosures about compensation and insider
transactions.
3. Identify significant accounting areas, especially those in which management
judgment or an unusual accounting rule is a significant determinant of reported
financial performance.
4. Make comparisons.
• Compare the company’s financial statements and significant disclosures in the
current year’s report with the financial statements and significant disclosures in
the prior year’s report.
• Compare the company’s accounting policies with those of its closest competitors
to see if there are any unusual revenue and expense recognition.
• Using ratio analysis, compare the company’s performance with that of its closest
competitors.

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5. Check for warning signs of possible issues with the quality of the financial reports.
Examine the statement of cash flows with particular focus on differences between
net income and operating cash flows.
6. For firms operating in multiple segments by geography or product—particularly
multinational firms—consider whether inventory, sales, and expenses have been
shifted.
7. Use appropriate quantitative tools to assess the likelihood of misreporting.

Quantitative tools to assess the likelihood of misreporting

Beneish Model
The probability of manipulation is given by the M-score, which is estimated using a probit
model. The formula for calculating the M-score is given below:
M-score = –4.84 + 0.920 (DSR) + 0.528 (GMI) + 0.404 (AQI) + 0.892 (SGI) + 0.115 (DEPI) –
0.172 (SGAI) + 4.679 (Accruals) – 0.327 (LEVI)
where:
• M-score = Score indicating probability of earnings manipulation; normally
distributed random variable with a mean of 0 and a standard deviation of 1.
• DSR (days sales receivable index) = (Receivablest/Salest)/(Receivablest–1/Salest–1).
• GMI (gross margin index) = Gross margint–1/Gross margint.
• AQI (asset quality index) = [1 – (PPEt + CAt)/TAt]/[1 – (PPEt–1 + CAt–1)/TAt–1], where
PPE is property, plant, and equipment; CA is current assets; and TA is total assets.
• SGI (sales growth index) = Salest/Salest–1.
• DEPI (depreciation index) = Depreciation ratet–1/Depreciation ratet, where
Depreciation rate = Depreciation/(Depreciation + PPE).
• SGAI (sales, general, and administrative expenses index) = (SGAt /Salest)/(SGAt–
1/Salest–1).

• Accruals = (Income before extraordinary items – Cash from operations)/Total

assets.
• LEVI (leverage index) = Leveraget/Leveraget–1
How to interpret the M-score:
• The probability of earnings manipulation is calculated by using the cumulative
probabilities for a standard normal distribution.
• The probability is given by the amount on the left side of the distribution.
• Higher M-scores (less negative numbers) indicate an increased probability of
earnings manipulation.

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Indicators of earnings quality

High earnings quality are the earnings that are sustainable and represent the returns equal
to or in excess of the company’s cost of capital. Low-quality earnings are insufficient to
cover the company’s cost of capital and/or are derived from non-recurring, one-off
activities.
Indicators of earnings quality include:
1. Recurring earnings
2. Earnings persistence and related measures of accruals
3. Mean reversion in earnings
4. Beating benchmarks
5. External indicators of poor-quality earnings

Evaluating the earnings quality of a company

The objective of analyzing earnings is to understand the persistence and sustainability of

earnings. Analysts must be aware of the following accounting choices used by managers to
enhance their companies’ reported performance:
Revenue Recognition:
• Understand the revenue recognition policies as stated in the most recent annual
report.
• Study the days’ sales outstanding (DSO) trend. If it is increasing, it means
receivables were not paid on time.
• Consider cash versus accrual revenue.
• Compare the DSO and receivables turnover with those of other companies from the
industry.
• Perform trend analysis, over time and in comparison with competitors, to assess
revenue quality.
• Look for transactions with related parties.
Property and Capital Expenditure Analysis:
• Understand the cost capitalization policies as stated in the most recent annual
report. This may be used to avoid expense recognition.
• Perform trend analysis to examine the following:
o Non-current asset accounts: may indicate an unusual increase in costs.
o Gross and operating profit margins
o Turnover ratio for total assets
o Depreciation compared to asset base
o Capital expenditure relative to gross PPE

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• Look for company transactions with entities owned by senior officers or

shareholders.
Bankruptcy prediction models are used to quantify the likelihood that a company will
default on its debt and/or declare bankruptcy. One such model to assess the probability of
bankruptcy is the Altman model. Altman’s Z-score is calculated as follows:
Z-score = 1.2 (Net working capital/Total assets) + 1.4 (Retained earnings/Total assets) +
3.3 (EBIT/Total assets) + 0.6 (Market value of equity/Book value of liabilities) + 1.0
(Sales/Total assets)
The higher the Z-score, the lower the probability of bankruptcy of a company.

Evaluating cash flow quality

High quality operating cash flow means the company’s performance was good and the
company had high reporting quality.
High-quality cash flow for a mature company would typically mean that OCF:
1. is positive and derived from sustainable sources
2. is adequate to cover capital expenditures, dividends, and debt repayments, and
3. has low volatility.
Some OCF manipulating techniques used by companies are:
• Selling receivables to a third party
• Delaying payable to boost OCF
• Inappropriate classification of cash flows to overstate OCF
• Exploiting flexibility in accounting standards

Balance sheet quality

The characteristics of high financial reporting quality with regard to the balance sheet are:
• Completeness
• Unbiased measurement
• Clear presentation
The characteristics of high financial results quality with regard to a strong balance sheet
are:
• Optimal amount of leverage
• Adequate liquidity
• Economically successful asset allocation

Sources of information about risk

Some useful indicators of a company’s risk are:

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• A company’s financial statements can provide useful indicators of financial,

operating, or other risk. For example, high leverage ratios signal financial risk.
• An audit opinion(s) covering financial statements provide information about
reporting risk.
• The notes and disclosures provide information about financial, operating, reporting,
or other risks.
• Required disclosures that are specific to an event, such as capital raising, non-timely
filing of financial reports, management changes, or mergers and acquisitions.
• Financial press, including online media, can be a useful source of information about
risk.

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LM06 Integration of Financial Statement Analysis Techniques

Financial analysis framework

The financial statement analysis framework recommended by the CFA Institute consists of
the following steps:
1. Define the purpose and context of the analysis.
2. Collect input data.
3. Process input data, as required, into analytically useful data.
4. Analyze/interpret the data.
5. Develop and communicate conclusions and recommendations.
6. Follow up.

Integration of financial statement analysis techniques

DuPont analysis
• DuPont analysis decomposes ROE into its components:
1. ROE = Return on assets × Leverage
2. ROE = Net profit margin × Asset turnover × Leverage
3. ROE = EBIT margin × Tax burden × Interest burden × Asset turnover × Leverage
• Evaluating the different components of ROE allows the analyst to identify a company’s
potential strengths and weakness.
• DuPont analysis should be performed with and without the impact of ‘income from
associates’. This is because the operations and resources of associate companies are
not in the parent company’s control.
Asset base composition
Common size balance sheets are used to examine the change in asset base composition
over time.
Capital structure analysis
• An analyst can use leverage ratios and liquidity ratios to evaluate changes in the capital
structure of a company.
• However, simply looking at high-level leverage numbers is not enough. An analyst
should dive deeper to evaluate whether the capital structure is becoming riskier.
Segment analysis and capital allocation
• For large companies with multiple business segments it is important to perform a
segment analysis and understand how the company allocates funds to different
segments.
• The segment EBIT margin should be compared with the ratio of total capital
expenditure % to total assets.
• Ideally, segments with high margins should receive a relatively high capital allocation.

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• However, high EBIT margins does not necessarily mean that a segment is doing well
from a cash-flow perspective. Beyond the EBIT margin, we should also estimate the
cash return on assets across different segments.
Accruals and earnings quality
• Earnings can be separated into cash flow and accruals. The accrual ratio can be
estimated using a balance sheet approach or a cash flow approach.
Balance sheet accruals ratio for time t = (NOAt - NOAt -1) / [(NOAt + NOAt-1)/2]
Cash flow accruals ratio for time t = [NIt - (CFOt + CFIt)] / [(NOAt + NOAt-1)/2]
• In both cases, if the accrual ratio is close to zero, this means that accruals play little or
no role in the financial performance of a company and the earnings are of high quality.
Cash flow relationships
• Cash flow from operations should be compared with operating profit to determine if the
earnings are of high quality.
• Other cash flow ratios such as the cash flow interest coverage ratio can also be used in
the analysis.
Decomposition and analysis of the company’s valuation
When a company has significant investments in associates, the price-to-earnings multiple
of the “pure company” should be calculated by removing the impact of associates and using
adjusted market value and net income.

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LM07 Financial Statement Modeling

Top-down and bottom-up approaches

Top-down approach begins at the economy level, then the industry and finally to the
company level. There are two top-down approaches:
Growth relative to GDP growth: In this approach, we:
• Forecast nominal GDP growth rate (can forecast real GDP growth and inflation
separately).
• Forecast revenue growth relative to GDP depending on the company’s position in
the lifecycle and/or business cycle sensitivity. The forecasted revenue is expressed
in two ways:
o As percentage point discounts or premiums. For instance, Pfizer’s revenue is
projected to grow at 100 bps above nominal GDP growth rate.
o In relative terms: GDP is forecasted to grow at 4% and Oracle’s revenue is
forecasted to grow at a 25% faster rate.
Market growth and market share: In this approach, we:
• Forecast growth rate of relevant market
• Forecast change of company’s market share in the market. For example, assume
Tesla is expected to maintain a market share of 1% in the automobile market. If the
automobile market is expected to grow to $30 billion in annual revenue, then Tesla’s
annual revenue is forecasted to grow to 1% * $30 billion = $300 million.
Bottom-up approaches begin at the level of the individual company or unit within the
company. Examples of bottom-up approaches include:
• Time-series: Forecasts based on historical growth rates or time-series analysis.
• Return on capital: Forecasts based on balance sheet accounts and rates or ratios.
• Capacity-based measure: Forecasts (for example, in retailing) based on same-store
sales growth and sales related to new stores.
A hybrid approach combines top-down and bottom-up approaches.

Income statement modeling: Operating costs

Similar to revenue forecasting, costs may be forecasted using a top-down, bottom-up, or

hybrid approach
• Top-down approach: Consider factors such as overall level of inflation, or industry-
specific costs.
• Bottom-up approach: Consider factors such as segment-level margins, historical
cost-growth rates, historical margin levels, etc.
• Hybrid view: Incorporate elements from both top-down and bottom-up approaches.

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A positive correlation between operating margins and sales suggests economies of scale.
Forecasting income statement elements
• Forecast COGS by segment, product category, or by volume and price, to improve
forecasting accuracy. COGS is forecasted as a percentage of sales using historical
relationships.
• In SG&A, selling and distribution costs such as wages are variable and can be
estimated as a percentage of sales. General and administrative expenses are more or
less fixed and increase or decrease gradually.
• Two non-operating expenses are financing expenses and taxes.
o To forecast debt financing expenses, forecast the level of debt and the
corresponding interest rates.
o There are three types of taxes: statutory tax rate, effective tax rate, and cash
tax rate. Use effective tax rate to forecast net income and the cash tax rate to
forecast cash flows. To forecast future tax expense, often the tax rate based
on normalized operating income, adjusted for special items, is used.

Balance sheet and cash flow statement modeling

The table below summarizes the approach for forecasting balance sheet items.
Item Forecasting method Comment
Accounts receivable Use sales and DSO Top-down: project economy
to slow sales down, lower
inventory turnover.
Bottom-up: use company’s
historical ratios
Inventory Use COGS and inventory Estimate maintenance and
turnover growth capital
expenditures.
PP&E and depreciation Consider the future need for
PP&E and depreciation
disclosures.
Debt (capital structure) Use debt/equity,
debt/capital, debt/EBITDA
Retained earnings Net income and dividend
policy
Cash flow statement can be derived based on the income statement and balance sheet.

Biases that influence analyst forecasts

Five key biases that influence analyst forecasts are:

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• Overconfidence bias
• Illusion of control bias
• Conservatism bias
• Representative bias
• Confirmation bias

Impact of competitive factors in prices and costs

Competitive factors affect a company’s ability to negotiate lower input prices with
suppliers and to raise prices for products and services. Porter’s five forces framework can
be used as a basis for identifying such factors. The table below summarizes this framework.
Force Comment
Threat of substitutes Fewer substitutes or higher switching costs increase industry
profitability.
Internal rivalry Lower rivalry increases industry profitability.
Supplier power Presence of many suppliers limits their pricing power, which in
turn does not put a downward pressure on the industry’s
profitability.
Customer power Presence of many buyers limits their negotiating power, which
in turn does not put a downward pressure on the industry’s
profitability.
Threat of new entrants High barriers to entry increase industry profitability.

Sales and cost projections with inflation and deflation

Sales projections
• Higher input costs such as commodity or labor usually result in higher prices. This
relationship between price and cost, i.e. how long it takes for the price to increase, if
it’s gradual or immediate, depends on the industry structure.
• If demand is relatively price inelastic, revenue will benefit from inflation. If demand
is price elastic, revenues will decrease even if unit prices are increased because
volumes decline.
• High inflation in export market might increase sales in foreign currency terms, but
that gain might be lost if foreign currency depreciates.
Cost projections
The following factors help in forecasting costs:
• Understanding the purchasing characteristics of an industry. For example, if
companies use long-term price-fixed forward contracts and hedging instruments,
then price increases can be gradual instead of a sudden hike.
• Monitoring the underlying drivers of input prices such as weather conditions.

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• The impact of inflation or deflation on industry’s cost structure depends on the

competitive structure.
• Break down the cost structure by category and geography.
• For each cost element, assess the impact of inflation and deflation on input prices;
consider the company’s ability to use cheaper alternatives for expensive inputs
when input prices rise.

Effect of technological developments on demand, selling prices, costs and margins

Technological developments can change the economics of industries and individual

companies. When a technological development results in a new product that threatens to
cannibalize demand for an existing product, a unit forecast for the new product combined
with an expected cannibalization factor can be used to estimate the impact on future
demand for the existing product.
The table below highlights the impact of technological developments on demand, selling
prices, costs and margins.
Impact on Factors to consider
Demand Market segments; cannibalization factor per segment. These help in
determining the post cannibalization volume.
Selling prices Company strategy; response to threat of substitutes
Operating costs Understand breakdown between fixed and variable costs. If sales
and margins decrease because of cannibalization, then variable costs also decrease.
Method 1: evaluate sensitivity of costs to changes in revenue
% Δ (cost of revenue + operating expense)
% Variable Cost ≈ % Δrevenue
% Fixed Cost = 1 − % Variable cost
Method 2: assign an estimate of the percentage of fixed and variable
costs to the various components of operating expenses

Long-term forecasting

Forecast time horizon is influenced by factors such as:

• Investment strategy for which the stock is being considered
• Cyclicality of the industry
• Company specific factors
• Analyst’s employer preferences
Longer-term projections often provide a better representation of the normalized earnings
potential of a company than a short-term forecast, especially when certain temporary
factors are present. Normalized earnings are the expected level of mid-cycle earnings for a

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company in the absence of any unusual or temporary factors that impact profitability
(either positively or negatively).
“Growth relative to GDP growth” and “market growth and market share” methods can be
applied to develop longer term projections. Using revenue and cost forecasts, the income
statement, balance sheet and cash flow statement can be projected for the time horizon to
arrive a terminal value. The historical multiple-based approach is often used.

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