Integration of FSA Techniques
Integration of Financial Statement Analysis Techniques
Exam focus
This topic covers the integration of financial statement analysis techniques to adjust and interpret balance sheets and income statements within a common framework. You should be able to identify and explain how management's accounting choices and assumptions affect reported results and ratios, and make appropriate adjustments to improve comparability for decisions such as valuing equity, evaluating creditworthiness, and assessing financial leverage.
Framework for analysis
Learning outcome (LOS 13.a): Demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or purpose (for example, valuing equity based on comparables, critiquing a credit rating, obtaining a comprehensive picture of financial leverage, or evaluating the perspective given in management's discussion of financial results).
The primary purpose of financial statement analysis is to identify potential outcomes, positive or negative, that could affect an investment or credit decision. A basic analytical framework organises the analyst's work according to the objective and guides which data to collect and process and how to report conclusions.
Typical objectives include assessing an investment in a company, evaluating credit risk, analysing capital allocation decisions, or anticipating the impact of proposed accounting changes. The data selected and how it is processed depend on the chosen objective.
Common steps in the financial analysis framework are:
- Establish the objective(s) of the analysis.
- Collect relevant data (financial statements, management commentary, industry data, supplier/customer information).
- Process the data into comparable formats (for example, common-size statements or ratio series).
- Analyse the processed data to identify drivers of performance and risk.
- Develop and communicate conclusions and recommendations.
- Follow up (monitor results and update analysis as new information arrives).
Module quiz 13.1
1. When applying the financial analysis framework, which of the following is the best example of output from processing data?
- A. A written list of questions to be answered by management.
- B. Audited financial statements.
- C. Common-size financial statements.
2. When applying the financial analysis framework to the valuation of an equity security, communicating with company suppliers, customers, and competitors is an input that occurs while:
- A. establishing the objective of the analysis.
- B. processing data.
- C. collecting data.
Sources of earnings and performance
Learning outcomes (LOS 13.b and 13.c): Identify financial reporting choices and biases that affect quality and comparability of financial statements; evaluate and recommend adjustments to improve comparability, including adjustments for differences in accounting standards, methods, and assumptions.
Return on equity and DuPont decomposition
To identify the drivers of a firm's return on equity (ROE) and to highlight areas of strength or weakness, use the extended DuPont decomposition. The extended DuPont breaks ROE into components such as tax and interest burdens, operating margin, asset turnover and financial leverage, thereby exposing how changes in operations, efficiency and financing interact to produce ROE.
Analysts must also consider whether income sources are generated internally (from the firm's own operations) or externally (for example, equity income from associates). When equity income from associates or joint ventures is material, remove equity income and the corresponding investment from the analysis to avoid bias. Under the equity method (generally for ownership of 20-50%), an investor recognises its share of the investee's earnings on the investor's income statement and reports the investment as a balance-sheet asset. Eliminating equity income reduces earnings and removes the investment asset from total assets; depending on amounts, this reduces ROE and affects ratios such as asset turnover.
Professor's note: When removing an equity investment, do not arbitrarily adjust shareholders' equity unless information on how the investment was financed is provided. In the absence of financing details, assume the investment used the company's average capital structure and do not change the financial leverage ratio.
An extended example follows based on selected financial data for Thunderbird Corporation. Thunderbird owns a 30% equity interest in a supplier, Eagle Corporation. Selected data appear in the figures referenced below.
Observed ROE increased slightly from 19.51% to 21.26%, driven by an improving EBIT margin and lower effective taxes and interest burden, partly offset by a reduction in financial leverage. After excluding Eagle's equity income and the investment asset, Thunderbird's adjusted ROE declines because equity income boosted reported earnings; EBIT margin is unchanged if equity income is not included in reported EBIT. The adjusted extended DuPont illustrates the standalone performance excluding associate effects.
Module quiz 13.2
1. Lorenzo Company recently reported an EBIT margin of 11%, total asset turnover of 1.2, a financial leverage ratio of 1.5, and interest burden of 70%. Assuming an income tax rate of 35%, Lorenzo's return on equity is closest to:
- A. 9%.
- B. 10%.
- C. 11%.
2. McAdoo Corporation recently reported the following:
Tax burden, without regard to investments in associates, is closest to:
- A. 57.6%.
- B. 60.0%.
- C. 67.1%.
3. Selected financial information from Westcreek Corporation follows:
At the end of 2023, Westcreek's total asset turnover, without regard to the investment in Creston, is closest to:
- A. 2.0.
- B. 2.3.
- C. 2.5.
4. Rainbow Corporation recently reported the following financial information for its two separate divisions:
Rainbow is most likely overallocating resources to:
- A. Red only.
- B. Green only.
- C. Red and Green.
Asset base and capital structure
Analysing the asset base requires examination of the composition of balance sheet items over time. Presenting balance sheet items in common-size format (as a proportion of total assets) is a useful starting point to detect shifts in asset mix.
For a manufacturing firm, current assets (receivables and inventory) and fixed assets (plant, property and equipment) are typically significant. Goodwill may also be material when a firm has made acquisitions; for example, goodwill represented 29.1% of total assets for Thunderbird at the end of 2023, and goodwill increased since 2021-evidence of several acquisitions. Because goodwill is not amortised under current accounting standards, impairment risk from acquisitions is an important analyst concern.
Capital structure
A firm's capital structure must support its strategic objectives and meet obligations. Simple leverage ratios (for example, financial leverage) can mask differences in the quality of liabilities: some obligations (bank loans, bonds) create contractual cash outflows and can lead to default or covenant breaches, while other liabilities (deferred tax, certain provisions, employee benefit obligations) may not require immediate cash payments.
Thunderbird's financial leverage decreased from 2.2 in 2021 to 2.0 in 2023. Long-term debt as a percentage of long-term capital fell from 12.4% in 2021 to 8.6% in 2023. However, working capital trends show mixed signals: the current and quick ratios declined due to higher notes payable and decreased marketable securities, and the defensive interval ratio declined with higher daily expenditures and fewer marketable securities. At the same time, the cash conversion cycle shortened from 31.0 days to 15.5 days via faster receivables collection (lower days sales outstanding), higher inventory turnover (lower days on hand) and slower supplier payments (higher days payable).
Capital allocation
Consolidated financial statements can mask the differences among dissimilar subsidiaries. Segment disclosures (by business line or geography) help users identify each segment's contribution to revenue and profit, the relationship between capital expenditures and returns, and which segments might warrant more or less investment.
Thunderbird operates four divisions: aircraft, automotive, marine and specialty products. Revenue and EBIT by segment are presented below.
In Thunderbird's case, the automotive division is the largest contributor to revenue and EBIT, while the specialty products division is the smallest and its contribution to EBIT declined from 5.8% in 2021 to 5.1% in 2023.
Assets and capital expenditures by segment show that the automotive division requires the most assets and capital expenditure; the aircraft division has required the least capital expenditure; and the specialty products division has the least assets but rising capital expenditure. Using segment percentages, compute the ratio of proportional capital expenditures to proportional assets for each segment. A ratio greater than one means the firm is allocating a greater share of capex to the segment than the segment's share of assets (growth investment). A ratio below one indicates relatively less investment.
Compare each segment's EBIT margin to its capital-expenditure-to-assets ratio to evaluate whether the firm is investing in its most profitable segments. For Thunderbird, the specialty products division has the lowest EBIT margin but the highest capex-to-assets proportion ratio-evidence of potentially poor capital allocation that could depress overall returns if continued.
Accrual measures such as EBIT are imperfect proxies for cash generation. Where segment cash flows are not reported, approximate cash generation as EBIT + depreciation and amortisation. Use this to compute cash operating return on average total assets (average of beginning and ending assets for the period) to assess segment cash returns.
For example, average assets for the aircraft division in 2023 = ($14,777 + $6,861) / 2 = $10,819. If estimated cash flow for the aircraft division is $2,612, the cash-flow-to-average-assets ratio is 2,612 / 10,819 = 24.1%.
Earnings quality and cash flow analysis
Learning outcomes (LOS 13.d and 13.e): Evaluate how changes in accounting standards, methods or assumptions affect financial statements and ratios; analyse effects of balance-sheet modifications, earnings normalisation and cash-flow statement adjustments on a company's financial condition and ratios.
Earnings quality
Earnings quality refers to persistence and sustainability of earnings; earnings closer to operating cash flow are higher quality. Because accounting earnings are affected by estimates and accrual choices, they can be manipulated more easily than cash flow. Analysts disaggregate earnings into cash and accrual components using either a balance-sheet approach or a cash-flow statement approach. The accruals ratio (accruals scaled by average net operating assets) measures the extent of accruals: lower accruals ratios indicate higher earnings quality.
Accruals ratio - balance sheet approach
Net operating assets (NOA) = operating assets - operating liabilities, where operating assets = total assets - cash and marketable securities, and operating liabilities = total liabilities - total debt (short-term and long-term debt).
Balance-sheet aggregate accruals:
accrualsBS = NOAEND - NOABEG
Accruals ratio (balance sheet) = accrualsBS / average NOA
Accruals ratio - cash flow statement approach
Aggregate accruals can also be derived from the cash flow statement by subtracting cash flows from reported earnings:
accrualsCF = NI - CFO - CFI
Accruals ratio (cash flow) = accrualsCF / average NOA
Professor's note: CFO is cash flow from operating activities and CFI is cash flow from investing activities; financing cash flow (CFF) is excluded because it relates to financing decisions, not operating and investing performance. When comparing firms under different GAAPs, reclassification of interest and dividends may be required because IFRS allows some flexibility in classification.
Using Thunderbird's selected data, the balance-sheet accruals ratio fluctuated widely (for example, 17.3% → 8.2% → 16.6%), a pattern that can suggest earnings management. The cash-flow accruals ratio, however, rose steadily from 5.6% in 2021 to 19.7% in 2023, increasing concerns. Given these mixed signals, compare operating income to cash generated from operations to see if earnings are supported by cash.
Cash generated from operations (CGO) adjusts operating cash flow by adding back cash paid for interest and taxes (since operating income excludes these cash outflows). CGO can be computed as:
CGO = EBIT + non-cash charges - increase in working capital
Compute the ratio CGO / operating income. For Thunderbird, CGO exceeded operating income over the three years, which mitigates the accruals-based concerns and indicates that operating earnings are supported by cash flow.
Cash-flow ratios and reinvestment
Evaluate acquisitions and capital requirements using cash-flow-based metrics: cash return on total assets, cash flow to reinvestment (CFO / capital expenditures), cash flow to total debt, and cash-flow interest coverage (CFO / cash interest paid). For Thunderbird, cash return on total assets increased, cash flow covered capital expenditure by 3.6× in 2023, cash flow to total debt was 56.4% in 2023, and cash-flow interest coverage was about 21.9×-all supportive of financial flexibility despite higher accruals.
Module quiz 13.3, 13.4, 13.5
1. Suppose that we are provided the following financial data for MegaCo Industries:
MegaCo's cash flow accruals ratio is closest to:
- A. 5.0%.
- B. 7.5%.
- C. 10.0%.
Market value decomposition
When a parent holds an ownership interest in an associate, the parent's standalone implied value (excluding the associate) is its market value less its pro rata share of the associate's market value. For associates traded in foreign currencies, convert the associate's market value into the parent's reporting currency at the relevant exchange rate (year-end market capitalisation uses the period-end rate; earnings are converted at the average rate over the period when needed).
Example: Thunderbird's market capitalisation = $137 billion. Eagle's market capitalisation = €60 billion. Exchange rate $/€ = 1.40 at year-end. Thunderbird's pro rata share of Eagle = €60 billion × 30% × $1.40 = $25.2 billion. Thunderbird's implied value excluding Eagle = $137 billion - $25.2 billion = $111.8 billion, or 81.6% of Thunderbird's market capitalisation ($111.8 billion / $137 billion).
If Thunderbird's total net income = $8 billion and reported P/E = 17.1 (137 / 8), and equity income from Eagle = $0.896 billion, then stand-alone net income excluding Eagle = $8.0 billion - $0.896 billion = $7.104 billion. Implied P/E without Eagle = $111.8 billion / $7.104 billion ≈ 15.7, which may be a larger discount to a benchmark (for example, S&P 500 multiple of 20.1).
Professor's note: When converting investee earnings denominated in a foreign currency, use the average exchange rate for the period because earnings are assumed to accrue evenly throughout the year.
Summary of findings (example: Thunderbird)
Support for investment:
- Earnings growth generated internally, via acquisitions, and via investment income from Eagle.
- ROE positive and trending upward; equity income from Eagle increased ROE.
- Earnings quality appears acceptable because operating earnings are confirmed by operating cash flow.
- Cash flow sufficient to support capital expenditure and to allow for increased debt if needed.
- Firm growing through acquisitions and cash return on assets has increased.
- After removing pro rata share of Eagle, Thunderbird appears undervalued relative to the market on an implied P/E basis.
Concerns:
- Potential earnings manipulation signalled by increasing accrual ratios, though mitigated by strong cash flow.
- Possible overallocation of capital to the specialty products division, which has low and declining EBIT margin.
- Risk of future goodwill impairment from recent acquisitions.
Module quiz 13.6
Use the following information to answer Questions 1 and 2. Big Company owns 25% of Small Company. Selected recent financial data for both firms follows:
1. The percentage of Big's value explained by its ownership of Small is closest to:
- A. 10.9%.
- B. 11.6%.
- C. 13.6%.
2. The implied P/E multiple of Big, without regard to Small, is closest to:
- A. 16.1.
- B. 16.4.
- C. 17.2.
Key concepts
LOS 13.a
- Basic framework for financial analysis: 1) establishing objectives, 2) collecting data, 3) processing data, 4) analysing data, 5) developing and communicating conclusions, and 6) following up.
LOS 13.b
- Use the extended DuPont equation to examine sources of earnings and performance. Remove equity income from associates and the associated investment asset to eliminate bias when assessing standalone performance.
- Examine balance sheet composition over time and determine whether capital structure supports future obligations. Recognise that some liabilities may not require immediate cash outflows.
- Segment disclosures help identify revenue and profit contributions, the relation between capital expenditure and returns, and segments to emphasise or de-emphasise.
LOS 13.c
- Adjust the balance sheet for off-balance-sheet liabilities where appropriate (for example, recognise present value of take-or-pay commitments).
LOS 13.d
- Be aware of proposed accounting changes and their effects on financial statements and valuations.
LOS 13.e
- Disaggregate earnings into cash flow and accruals with balance-sheet and cash-flow approaches. A lower accruals ratio indicates higher earnings quality.
- Compare earnings to cash flow: add back cash interest and taxes to operating cash flow to compute cash generated from operations (CGO) and compare CGO with operating profit.
- Compute a firm's standalone market value by eliminating the pro rata market value of investments in associates; compute an implied P/E by dividing standalone market value by earnings excluding equity income from associates.
Answer key for module quizzes
Module Quiz 13.1
1. C. Common-size financial statements are created in the data processing step of the framework for financial analysis. (LOS 13.a)
2. C. Communication with management, suppliers, customers, and competitors is an input during the data collection step. (LOS 13.a)
Module Quiz 13.2
1. A. ROE = tax burden × interest burden × EBIT margin × asset turnover × financial leverage = (1 - 0.35) × 0.70 × 0.11 × 1.2 × 1.5 = 0.09 (9%).
2. B. (158,650 net income - 16,750 equity income) / 236,500 EBT = 60.0%. (LOS 13.b)
3. B. 848,000 revenue / [ (2023 total assets of 468,000 - 2023 Creston investment of 56,400 + 2022 total assets of 363,600 - 2022 Creston investment of 42,100) / 2 ] = 848,000 / 366,550 = 2.31. (LOS 13.b)
4. A. Rainbow may be overallocating resources to Red because Red has the lowest EBIT margin and a proportional capex:assets ratio greater than 1 (70% / 40% = 1.75). Green has the highest EBIT margin and a capex:assets ratio less than 1 (30% / 60% = 0.50). (LOS 13.b)
Module Quiz 13.3, 13.4, 13.5
1. A. Cash flow accruals ratio = (NI - CFO - CFI) ÷ average NOA = [12,000 - 33,000 - (-30,000)] / 180,000 = 5%. (Module 13.5, LOS 13.e)
Module Quiz 13.6
1. B. Pro rata share of Small's market cap / Big's market cap = (€150,000 × 25% × 0.85) / £275,000 = 11.6%. (LOS 13.e)
2. B. Big's implied value without Small is £243,125, or £275,000 Big market cap - £31,875 pro rata share of Small market cap (€150,000 × 25% × 0.85 current exchange rate). Big's net income without Small is £14,800, or £16,000 Big net income - £1,200 pro rata share of Small net income (€6,000 × 25% × 0.80 average exchange rate). Implied P/E = 16.4 (£243,125 / £14,800). (LOS 13.e)
