Chapter 1

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Chapter 1

  1. 1. 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 ?? -1-
  2. 2. Fin3321 (Moore) Chapter 1 ?? How are the expected IPO values determined ?? 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. -2-
  3. 3. Fin3321 (Moore) Chapter 1 - How would FedEx determine a “fair price” for Kinkos? - How would you value the equity of the new entity? 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 -3-
  4. 4. 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 -4-
  5. 5. Fin3321 (Moore) Chapter 1 c. Statement of Cash Flows - Operating Activities (cash equivalent to operating inc.) - Investing Activities - Financing Activities 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. -5-
  6. 6. Fin3321 (Moore) Chapter 1 a. “Aggressive” Accounting practices can materially distort representation of performance. This can lead to earnings management, income smoothing and, sometimes, fraudulent financial reports. 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”) -6-
  7. 7. Fin3321 (Moore) Chapter 1 • Adjust statements for deficiencies (make unbiased) 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. -7-
  8. 8. 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 -8-
  9. 9. Fin3321 (Moore) Chapter 1 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 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 -9-
  10. 10. Fin3321 (Moore) Chapter 1 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 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 - 10 -
  11. 11. Fin3321 (Moore) Chapter 1 c. Evaluate the actual accounting strategy d. Undo accounting distortions e. Identify key accounting policies 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 - 11 -
  12. 12. Fin3321 (Moore) Chapter 1 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 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. - 12 -
  13. 13. Fin3321 (Moore) Chapter 1 - 13 -

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