Part 12. Applications of Financial Statement Analysis

Question 1

Credit rating formula items:

Answer 1

1. Scale and diversification - larger companies, with wider variety of product lines and greater geographic diversity are better credit risks.
2. Operational efficiency - eg. operating ROA, operating margins and EBITDA margins; high operational efficiency is associated with better debt ratings.
3. Margin stability - stability of relevant profitability margins indicates higher probability of repayments (better debt rating, and lower interest rate); with highly variable operating results make lenders nervous.
4. Leverage - ratios of operating earnings, EBITDA, or some measure of free cash flow to interest expense or total debt; firms with greater earnings in relation to debt and interest expense are better credit risks.

Question 2

Backtesting

Answer 2

Using a specific set of criteria to screen historical data to determine how portfolios based on those criteria would have performed.

with special attention to potential effects of survivorship bias, data-mining bias, and look-ahead bias.

Question 3

Differences in depreciation methods/estimates:

Answer 3

• Aggressive firm using higher estimates of useful asset lives or asset salvage values will report lower annual depreciation expense, and higher net income than conservative firms.

so firms aggressive assumptions are:

• increase balance sheet net asset values and reported net income, with IFRS only permitting upward revaluation of fixed asset.

Question 4

Average age of firms assets:

Answer 4

To estimate the number of years worth of depreciation a firm has recognised by dividing accumulated depreciation from balance sheet by depreciation expense from income statement.

Question 5

For a company that has grown through acquisition:

Answer 5

• Tangible assets of acquired units will be recorded at fair value as of acquisition date, than historical cost net of accumulated depreciation.
• Identifiable intangible assets of acquired units will be valued at their acquisition cost, than not being included in balance sheet assets.
• Goodwill, the excess of acquisition price over fair value of acquired net assets will be shown on balance sheets.

Question 6

2 adjustments of goodwill to improve comparability:

Answer 6

1. Goodwill should be subtracted from assets when calculating financial ratios.
2. Any income statement expense from impairment of goodwill in current period should be reversed, increasing reported net income.
3. Calculating price to book value of equity per share, an analyst can remove goodwill from assets and recalculate lower adjusted book value, resulting in price to adjusted book value ratio that is greater.