Chapter 4 - Financial Statement Analysis

Question 1

1. What are some common SEC documents used by investment bankers?

Answer 1

Some of the common SEC documents used by investment bankers
include the 10‐K (annual report), 10‐Q (quarterly report), 8‐K (current
report), Schedule 14A (proxy statement), S‐1 and S‐4 (registration statements),
Schedule 13‐D, and Schedule 13‐F.

Question 2

2. What is some of the key information found in a 10‐K?

Answer 2

Some of the key information found in a 10‐K includes a general business
overview, which includes information on business segments, operations,
customers, suppliers, competition, recent acquisitions, risk factors,
and ongoing litigation. The 10‐K also includes the three financial
statements (income statement, balance sheet, and cash flow statement),
footnotes to those financial statements, management’s discussion, and
analysis and a list of exhibits.

Question 3

3. What are some of the differences between a 10‐K and a 10‐Q?

Answer 3

The 10‐K is typically significantly longer and contains much more
detail than the 10‐Q, in terms of business overview and footnotes to
the financial statements. The 10‐K’s financial statements are audited,
whereas the financial statements in the 10‐Q are unaudited. The 10‐K,
since it reflects an annual report, is filed once per year whereas the 10‐Q,
which reflects quarterly reports, is filed three times per year.

Question 4

4. What are some key ratios that we use to analyze financial statements?

Answer 4

Some of the key ratios used to analyze financial statements include
growth statistics, such as revenue growth; profitably ratios, such as
gross margin, EBIT margin, and net income margin; return ratios such
as ROA, ROE, and ROIC; credit ratios, such as leverage ratios and interest
coverage ratios; and activity ratios, such as days sales of inventory
and accounts receivable days.

Question 5

5. How would you calculate revenue growth from this year compared to
   last year?

Answer 5

To calculate revenue growth from this year compared to last year,
divide this period’s revenue by last period’s revenue and subtract 1.

Question 6

6. How would you calculate average revenue growth over the past five years?

Answer 6

To calculate average revenue growth over the past five years, divide
this period’s revenue by the first period’s revenue, raise that value to one
fifth and subtract 1.

Question 7

7. Why might one company have higher gross margin than another?

Answer 7

One company might have a higher gross margin than another if it has
higher sales prices or lower direct and variable costs.

Question 8

8. Why might one company have higher EBIT margin than another?

Answer 8

One company might have a higher EBIT margin than another if it has
higher gross margins or lower SG&A costs.

Question 9

9. Why might one company have higher net income margin than another?

Answer 9

One company might have higher net income margin than another if
it has higher EBIT margins, lower interest expense, or a lower effective
tax rate.

Question 10

10. What are the different return ratios used by bankers?

Answer 10

Some of the return ratios used by bankers include return on assets
(ROA), return on equity (ROE), and return on invested capital (ROIC).

Question 11

11. Which return ratio is best to use when comparing companies that have
    different capital structures?

Answer 11

Return on invested capital (ROIC) would be the best return ratio to
use when comparing companies that have different capital structures
because ROIC is neutral of capital structure.

Question 12

12. What are some important examples of credit ratios?

Answer 12

Some examples of credit ratios include debt to equity ratio, debt to
total capitalization ratio, leverage ratios, and interest coverage ratios.

Question 13

13. Would a company prefer to have a high leverage ratio or a high interest
    coverage ratio?

Answer 13

A company would prefer to have a higher interest coverage ratio because
it reflects more cash flow relative to interest expense, thus more
cash cushion. A higher leverage ratio reflects more debt relative to cash
flow.

Question 14

14. How do you calculate days sales of inventory?

Answer 14

You calculate days sales of inventory by dividing inventory by costs
of goods sold and multiplying by 360 or 365.

Question 15

15. Which is better for a company, higher days sales of inventory or lower,
    and why?

Answer 15

It is better for a company to have a lower value for days sales of
inventory because it reflects less money tied up financing inventory.
However, if the inventory levels gets too low it may introduce risk into
the company’s production.

Question 16

16. How do you calculate accounts receivable days?

Answer 16

You calculate accounts receivable days by dividing accounts receivables
by revenue and multiplying by 360 or 365.

Question 17

17. Which is better for a company, higher accounts receivable days or lower,
    and why?

Answer 17

It is better for a company to a have a lower accounts receivable days
because the company’s customers are paying the company faster and
that money can be used for other purposes.

Question 18

18. How do you calculate accounts payable days?

Answer 18

You calculate accounts payable days by dividing accounts payables
by costs of goods sold and multiplying by 360 or 365.

Question 19

19. Which is better for a company, higher accounts payable days or lower,
    and why?

Answer 19

It is better for a company to have a higher value of accounts payable
days because the company’s vendors are helping to finance the company’s
operations. However, too high a value can indicate financial distress
and can result in suppliers stopping selling to the customer.

Question 20

20. What are different time periods that we might want to use to analyze
    financial statements?

Answer 20

Some of the different time periods bankers use to analyze financial
statements include a full fiscal year period, the last twelve months
(LTM) period, and projected fiscal year periods.

Question 21

21. How do you calculate LTM?

Answer 21

You can calculate LTM (last twelve months) by adding an income
statement (or cash flow statement) value for the most recent full fiscal
year to the value for the most recent year to date (YTD) period and
subtracting the corresponding value from last year’s equivalent YTD
period.

Question 22

22. How do you calendarize financials? Why is this important?

Answer 22

You calendarize financial statements by adjusting one company’s fiscal
year to approximate another company’s fiscal year. We multiply the
financial results (e.g., revenue) for Year 1 by the percentage of the year
that overlaps with the base fiscal year. We then multiply the results for
Year 2 by the percentage of that year that overlaps with the base fiscal
year. Adding to the two figures together approximates a company having
the base fiscal year. This is important to do to have an apples‐to‐apples
comparison between companies’ operating performance especially
when economic or industry conditions have changed.

Question 23

23. What are some indications that a company might be financially distressed?

Answer 23

Some indications that a company might be financially distressed include
low interest coverage ratios or high leverage ratios, poor revenue,
cash flow or profitability, escalating accounts payable days, and declining
levels of cash on the balance sheet.

Question 24

24. Why might we make adjustments to a company’s financial statements?

Answer 24

We make adjustments to a company’s financial statements so that
we can make an apples‐to‐apples comparison between time periods or
between different companies in the same industry. Specifically we do not
want one item or unusual items to affect the various ratios and statistics
we use for comparison purposes.

Question 25

25. What are some of the sources for finding non‐recurring items?

Answer 25

Some sources for finding non‐recurring items include a company’s
income statement, the footnotes to the income statement, the MD&A
section of 10-Ks and 10‐Qs, the press release, 8‐K, and conference call
transcript corresponding to a company’s earnings announcement, and
equity research reports

Question 26

26. What are some examples of non‐recurring items?

Answer 26

Some examples of non‐recurring items include restructuring costs
such as severance, gains or losses from unusual litigation, costs stemming
from natural or man‐made disasters, gains or losses from the sale
of assets, and losses from asset write‐downs or impairments.

Question 27

27. What key questions do you need to ask yourself when adjusting for
    non‐recurring items?

Answer 27

When adjusting for non‐recurring items, you should ask yourself
what time period the non‐recurring item affected, whether the item was
a cost or income, whether the item was operating or non‐operating, and
whether the item was disclosed pre‐tax or post‐tax.