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					Fin3321 (Moore)            Chapter 1


                   Welcome to Finance 3321

                  Financial Statement Analysis

Administrative Items:
   Course Syllabus
   Valuation Projects and Group Formation
   Course Overview
      o Relation of Course to Finance and Business Program
      o Value-Added Skills Provided. Firms Pay a Premium.
   Chapter 1

Course Motivation/Intro:

     1. Wall Street Journal - IPO Announcements
                                                         Price
___Date___ _____Issuer_________    _Shares_              Range
15-Jun-07 Synthesis Energy Systems 10.0M                 8.50-9.50

11-May-07 CCS Medical Holdings            10.0M        14.00-16.00

9-Aug-07 Paragon Shipping Inc             10.3M        $16.00-$18.00

7-Aug-07 Masimo Corp                      11.92M $16.00-$18.00

2-Aug-07 Concho Resources Inc             20.89M $14.00-$16.00

??     How much are these companies worth ??
??     How are the expected IPO values determined ??




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Fin3321 (Moore)                Chapter 1


   2. Headline (Wall Street Journal)

         “Investors Fear Earnings Growth May be Slowing”

         ??       What do earnings (accounting value) have to do with
                  equity prices (market value) ??

   3. Headlines (AP and Reuters)

      U.S. Foreclosures Rise Sharply in July (AP)
      Tuesday, August 21 8:19am ET

      US financial industry job cuts soar-Challenger
      Tue Aug 21, 2007 12:22PM EDT (Reuters)


   4. Job Advertisement – Wall Street Journal

                               MorningStar
                               Equity Analyst

      Morningstar is hiring outstanding stock analysts in its Chicago
      office. We like creative thinkers who understand what separates
      great businesses from the mediocre majority.            Curiosity
      punctuated with skepticism is also a trait that we admire. Our
      analysts have industry specializations, determine fair values on
      select groups of stocks and write research reports on them. If
      you can insightfully evaluate business models, love investing &
      possess excellent writing & verbal skills, let’s talk …

   5. Federal Express successfully merged with Kinkos on 1 July 2004.
        - How would FedEx determine a “fair price” for Kinkos?
        - How would you value the equity of the new entity?



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Fin3321 (Moore)             Chapter 1




         Chapter 1 – Framework for Business Analysis and Valuation

A.    Role of Financial Reporting in Capital Markets

      Business      Information        -> Savings     -> Financial
      Ideas          Intermediaries                       Intermediaries

      Firms          Accountants          Investors      Venture Cap.
                     Analysts             Pensions       Mutual Funds
                     SEC                                 Invest. Banks
                     Media                               Insurance
                     Bond Raters


         Information Asymmetries and Agency (Incentive) Problems


         Role of Market Efficiency?


                     Market for Lemons??
                           Buy Insurance               No Insurance

Bad Driver


Good Driver




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Fin3321 (Moore)             Chapter 1


B.    Focus on Financial Statements

      1. Financial Reports are 1 major mechanism in which the firm
         “credibly” communicates financial and operating performance

         a. Linkage between Financial Reporting System and Business
            Activities well diagramed in Figure 1-2.


      2. Accrual Accounting (AA) vs. Cash Accounting (CA)

         a. Attempts to capture: Transactions, Events, Circumstances.
            Hence, measures and matches expectations. (AA)

         b. Matches Revenues and Expenses (AA)

         c. Proxies “Economic Income”     (AA).   Recognizes Economic
            Benefits and Costs.

      3. Major Financial Reports (Statements):

         a. Income Statement (Periodic Performance) – Accrual Based
            - Classified. Shows “comprehensive income”

         b. Balance Sheet (Statement of Financial Position)
              - Mixes Historical Cost and Mark-to-Market
              - Assets = Liabilities + Equity
              - Classified by Current vs. Long-Term

         c. Statement of Cash Flows
              - Operating Activities (cash equivalent to operating inc.)
              - Investing Activities
              - Financing Activities

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Fin3321 (Moore)               Chapter 1


C.    Role of FASB, IASB and Auditing Function

      1. FASB (Financial Accounting Standards Board) and IASB set
         accounting standards (financial reporting rules).

         a. Standards promote quality of financial information, assist in
            comparability (uniformity), attempt to increase substance
            over form, enhance relevance (decision usefulness and
            valuation relevance).

         b. Audit function serves to enhance confidence in financial
            information. Serves as costly control mechanism. Does not
            guarantee numbers are correct.

         c. Conservatism of financial reporting standards may reduce
            valuation relevance. (slow to adapt; goodwill; R&D; etc.)

         d. Uniformity vs. flexibility tradeoffs.

D.       Transparency & Management Reporting Strategy

      1. Transparent Financial Reporting Practices allow users to
         gain a “true and fair” picture of the firm’s financial and
         operating performance and position.

      2. Management has discretion as to the level, detail and depth of
         financial information presented in reports. “Liberal” uses of
         accruals, deferrals, and aggregation can lead to “less
         informative” financial reports.
         a. “Aggressive” Accounting practices can materially distort
            representation of performance. This can lead to earnings
            management, income smoothing and, sometimes,
            fraudulent financial reports.

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Fin3321 (Moore)              Chapter 1


E.     Financial Statements & Business Analysis Process

      This process summarizes the sequence of the course and the
       valuation project.
     
       Key Figure to Summarize section is Fig 1-3

       1. Big Picture: Know the Business and Industry (Specialists)
           Understand the Economy (domestic and international)
           Understand the Industry
               o Firm
               o Competitors, Concentration, Value Drivers
               o Past Performance and forecast trends
               o Five-Forces Analysis of Industry
               o Classify Industry and Identify Value Drivers (“Key
                 Success Factors” (KSF’s) associated with the Industry
                 Classification)
               o Determine whether Firm’s strategies are consistent
                 with identified KSF’s

       2. Accounting Analysis:
           Degree of Disclosure and Transparency
           Level of Disaggregation (Details)
           Evaluate quality of accounting reports
              o Qualitative: Degree of Disclosure and Transparency
              o Quantitative: Accounting Manipulation Diagnostics
           Analysis of “Significant Accounting Policies” (Discretionary)
            and Disclosure Related to KSF’s (“Key Accounting Policies”)
           Adjust statements for deficiencies (make unbiased)




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Fin3321 (Moore)             Chapter 1


      3. Perform Financial Analysis:
          Link financial report information to financial and operating
           performance metrics
          Ratio Analysis
              o Liquidity, Operating Efficiency, Cost Structure,
                Leverage, Debt Capacity, Cash Flow
          Evaluate past performance and trends
              o Firm over time
              o Industry over time
              o Firm relative to industry

      4. Perform Prospective Analysis (Forecast)
          Based on current relationships and forecast activities,
           estimate future financial position and operating results.

      5. Estimate Value of Firm (Equity) or other Activity
          Requires valuation model(s) and framework
          “Naïve” traditional valuation multiples (ratio-based values)
          Theory-Based Valuation Models
             o Requires Estimation of Cost of Capital
             o Different Valuation Models Require Different Inputs
             o Relies on forecast future performance associated with
                models.




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Fin3321 (Moore)                      Chapter 1


           Chapter Problems and Questions for Discussion

1. Which of the following statements is correct?
   a. The FASB has the legal authority to proscribe GAAP.
   b. Transparent financial reporting allows users to get a true and fair picture of the firm.
   c. Conservatism of financial reporting standards increases valuation relevance.
   d. Prospective analysis involves assessing the past performance of the firm.
   e. The external auditor certifies the financial statements are correct.

2. Which of the following is considered an information intermediary:
   a. Insurance Companies
   b. Bond Raters
   c. Mutual Funds
   d. Firms
   e. Venture Capitalists

3. Which of the following is considered a financial intermediary:
   a. Accountants
   b. Bond Raters
   c. Mutual Funds
   d. The SEC
   e. The Media

4. In the US, the accounting treatment (GAAP) for recognizing depreciation expense is
   determined and justified by:
   a. Accrual Accounting
   b. Matching Principle
   c. Periodicity Principle
   d. Revenue Recognition Principle
   e. The IASB

5. Which organization has the legal authority to establish US accounting standards?
   a. AICPA
   b. FASB
   c. IASB
   d. SEC

6. Which of the following is not a factor that affects managers’ accounting choices?
   a. Regulatory concerns
   b. Compensation
   c. Capital Market perceptions
   d. Conservative Accounting
   e. Debt Covenants


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Fin3321 (Moore)                      Chapter 1


7. According to classical financial theory, the objective of the firm’s management should be:
   a. Maximize the book value of assets
   b. Minimize the market value of liabilities
   c. Maximize revenues
   d. Minimize expenses
   e. Maximize shareholder wealth

8. Which of the following organizational forms of the firm results in limited liability for the
   owners of the firm?
   a. Sole Proprietorships
   b. General Partnerships
   c. Corporations
   d. Joint Ventures
   e. Special purpose entities with contractual guarantees

9. Which one of the following organizational forms facilitates the accumulation of largest
   amounts of investment capital for financing the firm and its growth opportunities?
   a. Sole Proprietorships
   b. General Partnerships
   c. Corporations
   d. Joint Ventures
   e. Sub-Chapter S Corporations

10. Which of the following is a benefit of the sole proprietorship form of business?
    a. Ease of entry and exit
    b. Unlimited liability
    c. Specialization and delegation of management skills across owners
    d. Unlimited growth and financing potential
    e. Unlimited lifespan of the organization

11. Which of the following IS NOT a basic business activity that should link business
    strategies to the business environment the firm faces? (Figure 1-2)
    a. Accounting Activities
    b. Operating Activities
    c. Investment Activities
    d. Financing Activities

12. Accounting strategies include all of the following, except:
    a. Choice of accounting policies
    b. Choice of third-party (independent) auditor
    c. Choice of accounting estimates
    d. Choice of reporting format
    e. Choice of supplementary disclosures




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Fin3321 (Moore)                      Chapter 1


13. Which one of the following business analysis tools involves the evaluation of performance
    using ratios and cash flow analysis?
    a. Business strategy analysis
    b. Prospective analysis
    c. Accounting analysis
    d. Financial analysis
    e. Valuing the firm

14. The items in question 13 represent the steps to a structured valuation analysis. Put these
    steps in sequential order below:
    a) a, b, c, d, e
    b) c, a, b, e, d
    c) a, c, d, b, e
    d) a, c, b, e, d
    e) e, d, a, b, c

15. Which of the following is correct?
    a. Conservative accounting choices are mandated by republicans
    b. Aggressive accounting policies (choices) lead to lower earnings and higher assets
    c. The independent auditor’s opinion and statement on the 10-K guarantee the
       information contained in the financial reports are correct.
    d. The information contained in financial reports reflect “people-made” numbers and
       choices that may contain material errors and biases.
    e. The information contained in audited financial reports are unquestioned facts because
       GAAP and the SEC required perfect information to be contained in 10-K’s.

16. Which of the following is correct regarding accrual accounting?
    a. Accrual accounting is the information basis of inputs for most classical finance models
    b. Accrual accounting attempts to measure the period in which cash flows occur
    c. Accrual accounting attempts to measure economic activities in the period exchange
       transactions take place, regardless of when cash flows transpire.
    d. Accrual accounting forces land acquisitions to be recorded at historical cost.

17. What is the first step of the method for a structured accounting analysis (per text)
    a. Identify potential “red flags”
    b. Assess the degree of potential accounting flexibility
    c. Evaluate the actual accounting strategy
    d. Undo accounting distortions
    e. Identify key accounting policies




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Fin3321 (Moore)                      Chapter 1


18. What is the last step of the method for a structured accounting analysis (per text)
    a. Identify potential “red flags”
    b. Assess the degree of potential accounting flexibility
    c. Evaluate the actual accounting strategy
    d. Undo accounting distortions
    e. Identify key accounting policies

19. The main purpose of a firm’s financial reports is to:
    a. Present Assets, Liabilities and Equity
    b. Present Revenues and Expenses
    c. Present Operating, Investing and Financing Cash Flows
    d. Provide equity investors a means of determining the market value of the firm
    e. Credibly communicate operating and financial performance.

20. In the US, the accounting treatment (GAAP) for recognizing warranty expense is
    determined and justified by:
    f. Accrual Accounting
    g. Matching Principle
    h. Periodicity Principle
    i. Revenue Recognition Principle
    j. The IASB

21. The last line item reported on the income statement is:
    a. Net Revenue
    b. Operating Income
    c. Comprehensive Income
    d. Income from Continuing Operations
    e. Gross Profit

22. Investors will find forward-looking information in which component of the financial report?
    a. Management Discussion and Analysis Section
    b. Balance Sheet
    c. Income Statement
    d. Footnotes to Financial Statements
    e. The Auditor’s Opinion

23. In the US, the accounting treatment (GAAP) for recognizing sales commissions in the
    period the selling activity takes place and not necessarily in the period when commissions
    are paid is determined and justified by:
    k. Accrual Accounting
    l. Matching Principle
    m. Periodicity Principle
    n. Revenue Recognition Principle
    o. The IASB


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Fin3321 (Moore)                      Chapter 1



24. Which of the following is not defined as being part of the firm’s business environment?
    a. Labor markets
    b. Capital market structure
    c. Product markets
    d. Customers
    e. Business regulations

25. Which is the first step in a structured equity security analysis and valuation?
    a. Prospective Analysis
    b. Accounting Analysis
    c. Financial Analysis
    d. Business Strategy Analysis
    e. Implementing Valuation Models

26. The last possible line item reported on the income statement is:
    a. Net Revenue
    b. Operating Income
    c. Comprehensive Income
    d. Income from Continuing Operations
    e. Gross Profit

27. Which of the following line items is reported earliest in the income statement?
    a. Extraordinary Expenses
    b. Operating Income
    c. Comprehensive Income
    d. Income from Continuing Operations
    e. Gross Profit

28. Which of the following statements is incorrect?
    a. The SEC has the legal authority to proscribe GAAP.
    b. Transparent financial reporting practices allow users to get a true and fair picture of
       the firm.
    c. Conservatism of financial reporting standards may reduce valuation relevance.
    d. Prospective analysis involves forecasting future events and outcomes.
    e. The external auditor certifies the financial statements are correct.




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