Financial Statement Analysis (9788245034240)

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Copyright © 2021 by Vigmostad & Bjørke AS All Rights Reserved First edition 2017 Second edition 2021 / Printing 1 2021 Graphic production: John Grieg, Bergen ISBN: 978-82-450-3424-0 Cover design by Fagbokforlaget Supplementary resources are available online at www.fagbokforlaget.no/fsa Inquiries about this text can be directed to: Fagbokforlaget Kanalveien 51 5068 Bergen Tel.: 55 38 88 00 e-mail: fagbokforlaget@fagbokforlaget.no www.fagbokforlaget.no All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photo-copying, recording, or otherwise, without the prior written permission of the publisher.

This book is dedicated to our families Thomas: my wife, Susanne, and children: Peter, Frederikke and Karl Emil Finn: my wife, Christine, and children: Simen and Karla Marie We love you!

Contents overview Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Chapter 1 Introduction to financial statement analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Part 1

Accounting data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Introduction to Part 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Chapter 2 Introduction to financial statements and bookkeeping

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47

Chapter 3 Accrual-based versus cash-flow-based performance measures . . . . . 85

Part 2

Financial analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

101

Introduction to Part 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Chapter 4 The analytical income statement and balance sheet . . . . . . . . . . . . . . . . . . . . . 109 Chapter 5 Profitability analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Chapter 6 Growth analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Chapter 7 Liquidity risk analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

Part 3

Decision-making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

249

Introduction to Part 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 Chapter 8 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Chapter 9 Cost of capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Chapter 10 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331

Financial Statement Analysis

Chapter 11 Credit analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375

8

Chapter 12 Evaluating and rewarding management’s performance . . . . . . . . . . . . . . 419

Part 4

Accounting flexibility and adjustments for decision-making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

461

Introduction to Part 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463 Chapter 13 Accounting quality and flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467 Chapter 14 Specific topics in accounting flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 Chapter 15 Management misuse of accounting flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569 Chapter 16 Accounting flexibility and consequences for users . . . . . . . . . . . . . . . . . . . . . . . 595 Chapter 17 Adjustments to improve accounting quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681 Glossary

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685

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 693

Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Vision of the book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Target group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Prerequisites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Digital resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17 18 19 19 20

Chapter 1 Introduction to financial statement analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Introduction to financial statement analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

International Financial Reporting Standards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Decisions and decision models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Equity-oriented stakeholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debt-capital-oriented stakeholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Compensation-oriented stakeholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Outline of the book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21 23 24 25 30 32 35

Part 1

Accounting data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Introduction to Part 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Chapter 2 Introduction to financial statements and bookkeeping

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47

Sources of financial information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Content of the annual report. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The income statement and statement of comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . .

Balance sheet (statement of financial position) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash flow statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Statement of changes in owners’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Notes (Disclosures) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Recording transactions and preparing financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Recording transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Transaction analysis illustrated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Preparing financial statements from recorded transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47 49 54 59 63 65 67 67 69 72 79

Appendix 2.1 Accounting terms where there might be differences in practice between IFRS, UK and USA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Chapter 3 Accrual-based versus cash-flow-based performance measures . . . . . 85 Introduction to accrual- versus cash-flow-based performance measures . . . . . . . . . . . . . . . . . . . .

The distinction between accrual- and cash-flow-based performance measures . . . . . . . . . . . . .

The distinction between short and long-term earnings capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Shortcomings of accrual and cash-flow-based performance concepts . . . . . . . . . . . . . . . . . . . . . . . .

The ability of accrual and cash-flow-based performance measures to gauge a firm’s earnings capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Approximations to cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85 86 91 92 95 98

Part 2 Financial Statement Analysis

Financial analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

101

Introduction to Part 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Introduction to financial ratio analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Pitfalls in financial ratio analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Requirements for financial ratio analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Chapter 4 The analytical income statement and balance sheet . . . . . . . . . . . . . . . . . . . . . 109 The analytical income statement and balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The analytical income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The analytical balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Carlsberg’s NOPAT and invested capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Carlsberg’s own definition of invested capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

109 113 116 123 138

Chapter 5 Profitability analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 What is a satisfactory profit? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Profitability analysis of the operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The trends in ROIC over time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Assessment of ROIC vs the recquired rate of return (WAAC) . . . . . . . . . . . . . . . . . . . . . . . . . .

Assessment of ROIC vs peers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Assessment of stock market's implicit (forward looking) ROIC . . . . . . . . . . . . . . . . . . . . . . . .

Pitfalls in the interpretations of the return on invested capital . . . . . . . . . . . . . . . . . . . . . . . . .

Decomposition of return on invested capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Indexing and common size analysis of operating profit margin and turnover rate. . . . . . . .

Days on hand (for each item): 365/turnover rate (for each item) . . . . . . . . . . . . . . . . . . . . . . .

Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Effect of minority interests on return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 5.1 Heineken original and analytical financial statements . . . . . . . . . . . . . . . . . . . . . .

141 143 145 145 147 148 149 157 163 168 170 172 179

Chapter 6 Growth analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Growth in sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The relationship between growth, liquidity and invested capital . . . . . . . . . . . . . . . . . . . . . . .

Limits to growth; the sustainable growth rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Different types of growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

What is the quality of growth? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Is growth sustainable in the future? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Is growth in earnings per share (EPS) always value creating? . . . . . . . . . . . . . . . . . . . . . . . . . . .

Is growth in EPS from share buybacks always value creating? . . . . . . . . . . . . . . . . . . . . . . . . . .

185 186 188 192 193 196 199 201

Introduction to liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Rörvik Timber as a case to analyse liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Measuring long-term liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Does the firm have a sound financing structure? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Are funds from operations sufficient to pay interests and instalments? . . . . . . . . . . . . . . .

Does the firm have liquidity reserves for a rainy day? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Is the firm liquidity efficient? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Short-term liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Summary of liquidity risk analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Shortcomings of financial ratios measuring the short- and long-term liquidity risk. . . . . .

Appendix 7.1 Liquidity risk analysis of Rörvik Timber . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 7.2 Rörvik Timber’s financial ratios and liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . .

209 211 214 214 223 227 228 231 236 239 241 246

Contents

Chapter 7 Liquidity risk analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

Part 3

Decision-making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

249

Introduction to Part 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 Chapter 8 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The technical design of pro forma statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Issues when designing a template for forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Do financial value drivers in the template reflect the underlying economic relations of a firm? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Is the level of aggregation in the template appropriate? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The estimation related aspects of forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Identification of key financial value drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Analysing trends in the financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Strategic analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An evaluation of the estimates supporting the pro forma statements . . . . . . . . . . . . . . . . .

The challenges of forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 8.1 Carlsberg case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

253 256 262 263 265 268 268 269 270 280 283 286

11

Chapter 9 Cost of capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Introduction to cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Weighted average cost of capital (WACC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Estimation of owners’ required rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Estimation of the required rate of return on debt (NIBL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Corporation tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pulling it all together: WACC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 9.1 Carlsberg case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Required rate of return on assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Required rate of return on equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

WACC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

297 299 299 303 323 324 325 327 327 328 330

Financial Statement Analysis

Chapter 10 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331

12

Introduction to valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Approaches to valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The attributes of an ideal valuation approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Present value approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The dividend discount approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The discounted cash flow approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Excess return approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Adjusted present value approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An evaluation of the present value approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The relative valuation approach (multiples) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

How are multiples applied for valuation purposes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The relationship between present value approaches and multiples . . . . . . . . . . . . . . . . . . . .

What drives multiples? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Other things to remember when using multiples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Asset-based value approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Net Asset Value (NAV) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Sum-of-the-parts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Liquidation value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An evaluation of the asset-based approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 10.1 Carlsberg case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

331 333 335 336 338 341 345 351 353 354 354 356 359 362 365 365 365 365 366 367

Chapter 11 Credit analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 Introduction to credit analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Structure of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Use and type of loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 1: An understanding of the intended use of the loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 2: An understanding of the type of financing (loan). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Estimating probability of default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 3: Business risk analysis: An analysis of the industry, firm and management. .

Step 4: Assessment of a firm’s financial health based on historical financial data . . .

Assessment of a firm’s financial health based on credit ratings . . . . . . . . . . . . . . . . . . . . . . . . .

Step 5: A simulation of future cash flows to evaluate the firm’s ability to service debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Estimating loss given default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

375 378 379 379 379 381 382 384 391 397 403

Step 6: Exposure at default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 7: Estimating the recovery at default and the recovery rate . . . . . . . . . . . . . . . . . . . . . . .

Estimating the expected loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 8: Summarising the results of the credit analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 9: Some caveats when estimating the expected loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Terms of a loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 10: Pricing credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Step 11: Covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

403 404 409 409 412 414 414 415

Chapter 12 Evaluating and rewarding management’s performance . . . . . . . . . . . . . . 419 419 420 422 425 425 426 427 427 431 433 442 448 453 454 456

13

Part 4

Accounting flexibility and adjustments for decision-making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

461

Introduction to Part 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463 Different accounting regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464 Flexibility inherent due to increasing number of estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464 Bias or misuse of accounting flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464 Chapter 13 Accounting quality and flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467 Accounting quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Defining accounting quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accounting regulation and flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Conceptual Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Inconsistencies under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Mixed measurement bases under IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Relevance of financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Contents

Performance evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

How to evaluate management’s performance under perfect and complete market conditions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The principal-agent relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Characteristics of a well-designed accounting-based incentive plan . . . . . . . . . . . . . . . . . . . . . . . .

Congruence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Controllability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Simplicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accounting issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Components of an incentive plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Choice of performance measures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Choice of performance standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Choice of pay-to-performance structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Illustration of an EVA-based incentive plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A two-component EVA-based incentive plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An advanced EVA-based incentive plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

467 467 468 469 472 478 481 484

Chapter 14 Specific topics in accounting flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489

Financial Statement Analysis

Structure of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Inventory accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Intangible and tangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accounting for leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Deferred tax liabilities and deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Off-balance sheet financing; factoring and reverse factoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Foreign exchange and hedge accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Purchase price allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The level of information in disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 14.1 Check-list of accounting flexibility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14

489 490 502 506 525 531 539 545 549 551 556 558 560 568

Chapter 15 Management misuse of accounting flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569 Misuse of accounting flexibility; does it happen?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Does earnings management happen frequently? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Definition of earnings management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Motives for accounting manipulation and situations to look for . . . . . . . . . . . . . . . . . . . . . . .

The major accounting fraud cases and methods used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Recognising revenue too early . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Related party transactions to increase gains, avoid impairments and hide debt . . . . .

Capitalising instead of expensing costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Overstating assets by delaying impairments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accruing fake assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Not accruing for claims or liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

What has been done to avoid accounting fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

More detailed accounting rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Improved enforcement and oversight boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Stricter regulation of auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Increased requirements for corporate governance, some hard law and some soft law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

569 570 572 573 576 577 581 584 584 585 587 588 589 590 590 591

Chapter 16 Accounting flexibility and consequences for users . . . . . . . . . . . . . . . . . . . . . . . 595 Structure of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Conservative versus aggressive accounting: How does it affect users? . . . . . . . . . . . . . . . . . . . . . .

Conservative versus aggressive accounting: How does it affect investors? . . . . . . . . . . . .

Conservative versus aggressive accounting: How does it affect creditors? . . . . . . . . . . . .

Conservative versus aggressive accounting: How does it affect the assessment of management’s performance . . . . . . . . . . . . . . . . . .

Conclusion of aggressive versus conservative accounting policies . . . . . . . . . . . . . . . . . . . . .

The impact of accounting flexibility item-by-item on users of financial statements . . . . . .

The impact of accounting flexibility on investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The impact of accounting flexibility on creditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The impact of accounting flexibility when assessing management’s performance . . .

595 596 598 600 601 602 602 603 618 626

Chapter 17 Adjustments to improve accounting quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Assessment of faithful representation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Adjustments to improve faithful representation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Adjusting profit for unusual items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Unusual or extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Impairment losses on non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Changes in accounting estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Value changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Changes in accounting policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Discontinued operations and assets held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Alternative Performance Measures (APM) / Non-GAAP measures . . . . . . . . . . . . . . . . . . . . . . . . .

A case of assessing unusual items in operating profit: Carlsberg 2016–2019 . . . . . . . . . . . . . .

Identification of “red and green flags” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Quality of a firm’s business model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Unsatisfactory development in accounting numbers and financial ratios . . . . . . . . . . . . .

The firm’s ability to convert accounting earnings to cash flows . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 17.1 Checklist for items that should be reviewed when identifying unusual items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

631 632 635 640 641 649 651 652 653 654 655 657 667 668 671 674 679

Glossary

............................................................................................

685

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 693

Contents

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681

15

Preface

Financial statement analysis has proven to be useful in a wide range of business decisions. Equity analysts use it as a foundation for their projection of the earnings potential of a firm. Credit analysts use it as a tool to analyse operating and financial risks and to determine whether loans should be extended. Consultants apply it as part of their strategic analysis. Management uses it in monitoring competitors and in establishing a “best practice” in an/their industry. Investment bankers and private equity funds apply financial statement analysis as basis for analysing potential mergers and acquisitions.

The course “financial statement analysis” is therefore in demand at business schools worldwide. It provides business students with a framework for analysing financial statements for different analytical purposes. It is our ambition that the framework laid out in this book will provide business students and practitioners with a unique insight into financial statement analysis.

Vision of the book Most textbooks on financial statement analysis primarily focus on investors.

This implies that the analysis aims at supporting a valuation perspective. This book differs from other books by introducing and developing a framework for financial statement analysis that takes a wider user perspective. In addition to valuation, we also focus on credit analysis and performance evaluation and bonus plans for management. This implies that the book takes the view point of an equity analyst, credit analyst and performance analyst, respectively. This book recognises that these three users make decisions in different contexts using different aspects of financial statements. So, to make optimum decisions, we focus on each of these contexts separately using different accounting information and applying different sets of ratios.

Overview

Financial Statement Analysis

An important premise when reading this textbook is that although a firm’s financial statement serves as an important source of information, it is crucial that additional information is collected and analysed. This includes an understanding of the firm’s strategy and its competitors and the markets which it serves. Thereby it is possible to analyse the financials much more intelligently and generate more powerful analyses.

The book is divided into four parts which, when combined, give you an excellent insight into financial statement analysis. Each part represents a theme that includes information on:

18

• • • •

Part 1 – Accounting data Part 2 – Financial analysis Part 3 – Decision-making Part 4 – Accounting flexibility and adjustments for decision-making.

In Part 1 – Accounting data, we present the different financial statements in the annual report. Needless to say, familiarity with the components of the annual report is an essential prerequisite for understanding the other parts of this book.

Based on our experience, many students as well as practitioners have only limited knowledge of how firms record (double-entry bookkeeping) transactions and enter them into different financial statements. We therefore also revisit the double-entry bookkeeping system.

In Part 2 – Financial analysis, we discuss in detail how to measure and analyse a firm’s profitability, growth and risk. Good profitability is important for a firm’s future survival and to ensure a satisfactory return to shareholders.

The historical profitability is also an important element in defining the future expectations for a firm. Growth is seen by many as the driving force for future progress in firms. It is therefore essential to measure growth and ensure that it is profitable. The monitoring of the liquidity risk is central to any business.

Without liquidity a firm cannot pay its bills or carry out profitable investments and in extreme cases lack of liquidity leads to bankruptcy. An analysis of short and long-term liquidity risk is therefore crucial.

In Part 3 – Decision-making, we apply the financial analysis on different decision contexts: • • • • •

Forecasting Cost of capital Valuation Credit analysis Evaluating and rewarding management’s performance.

Target group This book is intended for people interested in financial statement analysis. Many of the techniques discussed in this book can be used in relation to valuation of firms, assessment of creditworthiness and performance evaluation, and the design of accounting-based bonus plans for executives. However, people interested in related matters such as financial management and risk management may also find inspiration in this book. The book is designed so that it can be used in financial statement analysis for a variety of settings including MBA, Master in Accounting and Finance, executive courses, and undergraduate courses in Accounting and Finance. Furthermore, the book is suitable for practitioners with an interest in financial statement analysis.

Prerequisites Since financial statements typically serve as the primary source of data in financial statement analysis, it is important that students and practitioners have a basic knowledge of financial accounting. Although the book can be read with

Preface

Forecasting (pro forma statements) serves as the foundation for many business decisions. An understanding of how to build pro forma statements and ensuring that they are based on reasonable assumptions is therefore essential. Cost of capital is a concept used across different decision contexts. For example, cost of capital serves as the discount factor in valuation and as a performance standard (threshold) in compensation schemes. Consequently, we discuss how to estimate the cost of capital. The chapter on valuation gives an overview of the valuation techniques available and we discuss in detail how to apply the most popular valuation techniques including the present value approaches such as the discounted cash flow model and the economic value added model, multiples such as the P/E ratio and EV/EBIT ratio and asset based approaches. The chapter on credit analysis aims at assessing a firm’s ability and willingness to pay its financial obligations in a timely manner. It also examines the probability that a firm would default and the potential loss in case of such a default. Finally, the chapter on evaluating and rewarding management’s performance addresses how to use the financial statements to assess performance, and how to design bonus plans.

In the first three parts we have taken reported financial data at face value. In the final part, Part 4 – Accounting flexibility and adjustments for decision-making, we challenge the accounting data used in the financial analysis. The concept of “accounting quality” is defined, and we document that management has some flexibility and discretion in producing financial statements. Management even misuses accounting flexibility. We therefore discuss accounting policies and flexibility and how they have an impact on firm valuation, credit analysis and the design of accounting-based bonus plans for executives.

19

little or with no prior knowledge of financial accounting and reporting, to gain full benefit from reading the text, we do recommend that students as well as practitioners have a basic understanding of financial accounting. Furthermore, knowledge of financial and strategic issues is also useful as we draw on both disciplines throughout our book.

Digital resources

Financial Statement Analysis

In addition to this book digital resources will be provided for instructors and students.

20

• On request instructors can have access to a set of PowerPoint presentations for support and use in lectures, and an instructors manual containing extended and additional case studies.

• For students the book’s website provides several supporting learning features, as glossary, flash cards and multiple choice questions for each chapter.

Chapter 1

Introduction to financial statement analysis Learning outcomes After reading this chapter you should be able to:

· Understand the three user perspectives applied in this book · Identify the different decision models available for valuation and credit · · ·

analysis Understand how to evaluate management’s performance, and how to design a bonus plan based on accounting data Recognise that accounting information is treated differently in different decision contexts Understand the structure of this book.

Introduction to financial statement analysis Consider this scenario: A firm’s inventory is destroyed in a fire and the firm recognises a substantial loss on its income statement because it was under-insured. How should this loss influence a financial statement analysis? Would you deduct this loss when determining the income of the firm? Why or why not?

These sorts of decisions are at the heart of financial statement analysis. In fact, the purpose for financial statement analysis is to help people make better decisions. But it is not always as straightforward as it initially appears.

1

Financial Statement Analysis

For instance, if we continue with the above scenario and add a bit of context, your decision about how the loss should influence a financial statement analysis might change:

22

First, assume that the purpose of the analysis is to determine the market value of equity based on estimated future profits. If management corrects the underinsurance problem, then, for equity valuation purposes, the loss can be considered non-recurring “noise” and should be excluded when extrapolating from past income in order to forecast future income.

Similarly, if you are a creditor, the focus would be on the firm’s ability to generate future profits and cash flows to pay interests and instalments. If, however you are the creditor with collateral in the inventory, the focus should be on repayment from the insurance and other available sources.

On the other hand, if the objective is to determine the amount that management will receive in bonus income, then it probably makes sense to include the loss when determining the income. This is because management has failed adequately to insure inventory and this failure caused a loss to the owners as a consequence of the fire.

The case above demonstrates that the decision – the reason for doing the analysis – drives the information needed and used in the analysis.

There are many different decision contexts and types of decision makers, but this book focuses on three important groups: equity-oriented stakeholders, debt-capital-oriented stakeholders and compensation-oriented stakeholders. To get a sense of who might be in each group, take a look at Table 1.1.

Table 1.1 Equity-oriented stakeholders

· · · · · ·

Investors Firms Corporate finance analysts Pension funds Venture capital providers Private equity providers

Debt-capital-oriented stakeholders

· · · ·

Banks Mortgage-credit institutes Firms Bond holders

Performance-oriented stakeholders

· · ·

Management The board Investors

These groups receive guidance from analysts. Equity analysts value the residual return in a firm after all other claims have been satisfied, with the goal of determining the level of investment in the firm. Credit analysts assess a firm’s ability to repay its existing or new debts, with goals pertaining to the amount and terms of credit to be extended to the firm. Performance analysts, including firm board

International Financial Reporting Standards This book is written for users of financial statements prepared under different sets of accounting standards. However, we primarily rely on International Financial Reporting Standards (IFRS) (where the old, still existing standards are named International Accounting Standards (IAS)) and only to a minor extent on the US accounting standards (US GAAP) issued by the Financial Accounting Standards Board (FASB). As we consider specific topics, we mainly discuss definitions, recognition issues, measurement criteria and classification issues as set forth under IFRS as developed by the International Accounting Standards Board (IASB). IFRS (which then also includes IAS) are used in many parts of the world, including the European Union, Hong Kong, Norway, Australia, Malaysia, Pakistan, GCC countries, Russia, South Africa, Singapore and Turkey. More than 150 countries around the world, including all of Europe, currently require or permit IFRS reporting for all or most publicly accountable entities.

More recently, the US Securities and Exchange Commission (SEC) has begun to accept the IFRS financial statements of non-US firms, thus allowing these firms to issue shares and bonds in American capital markets. American firms are not yet required to apply IFRS. In fact, initially, non-US firms may apply either IFRS or US accounting standards, whereas American firms are allowed to report under US standards only.

It has become increasingly challenging to analyse financial statements because of the trend toward measuring assets and liabilities at fair value.

Clearly, the objective of fair value financial statements is admirable: to measure firm assets and liabilities at their current market value. But with fair value, both the producer (i.e. management of the firm) and the user of the information take on additional responsibilities. With fair value, managers must look beyond simplistic historical cost accounting methods and choose among the measurement techniques allowed by IFRS (and other standard setters). Users, on the other hand, read the financial disclosures with an eye toward discerning the “truth”. The truth, it turns out, depends on the context of the question being asked. For instance:

Chapter 1 Introduction to financial statement analysis

members, use a firm’s financial statements to determine performance-based management compensation.

These three groups make decisions in different contexts using different aspects of financial statements. Therefore, we treat these analytical contexts separately. We will introduce different decision models for each group and show what accounting information is required in each instance.

23

Financial Statement Analysis

1 What is the value of the residual equity in the business?

2 Can the firm repay new or existing debt?

3 What is the firm’s performance for management compensation purposes?

24

IFRS standards require both producers and users to exercise considerable judgement. Consider, for example, the IFRS standard that requires assets to be tested for impairment. An impairment test essentially requires that management estimate the value of an asset or group of assets (a cash generating unit, or CGU).

If the value of an asset or group of assets is below the carrying value, they need to be written down. The result of the impairment test can have a large impact on the firm’s earnings and financial ratios. However, there is plenty of room for management discretion in this decision, since outsiders cannot see all inputs that management uses. Both management and the user know that the quality of accounting information depends on management faithfully conveying useful information. Because of this, the user will ask key questions like: “To what extent do I trust the information provided by management?” and “Is there any need to make adjustment to the reported accounting data?”

Facing this situation, management’s reporting decision is likely to depend on the relative importance of existing and future contracts based on financial statement information. Managers of firms with stringent contracts, such as debt covenants, are likely to choose measurements that avoid breach of such covenants. On the other hand, managers are more likely to be truthful if the financial information is being provided to informed users who are not bound by existing long-term contracts based on financial information. Ultimately, whether the financial statements faithfully reflect the firm’s economics depends on these contractual incentives, management’s innate integrity, and the firm’s internal and external control systems.

Decisions and decision models Users should keep focused on the reason for the financial analysis – the decision at hand. In the midst of information overload, users can lose sight of the purpose of their analysis, and this often results in a well-informed answer to the wrong question. For this reason, we encourage analysts to specify, and write down, the decision at hand before digging into the data and analysis. Here are a few examples of business decisions: 1 Should our bank lend a firm EUR 10 million at 5% per annum for three years?

2 Determine comparable returns on equity in a recent accounting period for two firms in the same industry in order to allocate EUR 5 million in equity capital.

By clearly defining the decision from the outset, the analyst will be able to stay focused on the relevant information and will be more likely to make the right choice.

Now let’s explore in more depth the three sets of decision makers mentioned earlier: equity-oriented stakeholders, debt-capital-oriented stakeholders and compensation-oriented stakeholders.

Equity-oriented stakeholders

In general, equity-oriented stakeholders use financial information to assess the intrinsic value of a firm. Investors decide whether to buy, hold or sell residual equity (e.g. shares of stock). Stock analysts tend to work within specific industry segments in order to gain superior knowledge of an industry and therefore a competitive advantage. For instance, analysts often specialise in segments such as biotech, information technology or food and beverages. A stock analyst typically gathers information based on an industry’s history and expected performance prior to focusing on a specific firm. Once an industry’s outlook has been assessed, the analyst will assess a firm’s historical performance and form an opinion of the expected earnings potential of the firm. Conversely, an analyst in a corporate finance department advises the firm – concerning financial matters such as merger and acquisitions, issues concerning initial public offerings (IPOs), choice of capital structure and the achievement of debt capital. From both sides of the coin, there are similarities between the work carried out by a stock analyst and an analyst in a corporate finance department – both aim to assess the value of the firm.

Investors who buy the analyses from the stock analysts often invest according to some predefined criteria. For instance, they may invest in certain industries such as biotech or information technology or within a specific country or region (e.g. Russia, South America or Asia). Investors may also self-select into clienteles based on the desire for “value” or “growth” investing. Though investors and their analysts work in different ways and spend different amounts of time on valuation, they all try to assess the future earnings potential of a firm.

The techniques used to value equity are increasingly being employed outside of traditional stock analysis. In the mid-1980s, Professor Alfred Rappaport popularised the concept of value-based management. The concept was soon followed by a large number of consultancy firms including Stern Stewart (the EVA concept), McKinsey & Co., Boston Consulting Group and PA Consulting. The basic principle of the concept of value-based management is to systematise, quantify and evaluate strategic action plans. The concept is therefore an extension of the strategy literature since it quantifies the economic values of different strategic plans of action.

Chapter 1 Introduction to financial statement analysis

3 In the most recent quarter, how much profit was generated from operations under the authority of the executive responsible for Asian operations?

25

Financial Statement Analysis

Stock-based compensation schemes are popular throughout the world as a means of aligning the interests of management and shareholders, while conserving cash available for managers to invest. In addition, a large number of unlisted firms, especially within the biotech and information technology industries, compensate key employees with promises of “a share of the action”, or equity. In deciding whether to enter into these contracts, both employees and management need to assess the value of the compensation contract.

Impairment test of goodwill is one of the latest examples of an area in which the techniques of valuation are applicable. The accountant has to reassess the value of goodwill in order to identify a possible impairment loss. This requires knowledge of the market value of the cash generating unit being assessed.

As the above examples illustrate, valuation of firms are used in a number of contexts.

26

Valuation models

Equity-oriented stakeholders focus on determining the “true” value of firms’ equity since investors who correctly value a firm’s stock can make money if the market value is different. Underpriced shares can be purchased to return a profit when the market value corrects. Conversely, overpriced shares can be sold short, and the investor will make money as long as the market value reflects the true potential of the firm during the period in which the investor holds the position.1 There are a number of different valuation models. Figure 1.1 categorises valuation models into four distinct groups. We will now briefly elaborate on each approach, in order to show that the different valuation approaches require different inputs, which affect how we design our financial statement analysis. In Chapter 10, we will explain in more detail how to use each approach for valuation purposes.

Present value models

The first group of valuation models is named present value approaches. These models share the same characteristics: the value of a firm (or asset) is estimated as the present value of future cash flows. The estimated market value of equity is found by discounting expected cash flows by the owners’ required rate of return taking into account the time value of money and the underlying risk of the income streams.

With the dividend models as the point of departure, the market value of the equity of a firm can be calculated as: ∞

P0 = ∑

t =1

1

di v t

(1 + re ) t

“Sold short” refers to the practice of borrowing shares, selling them, and subsequently repurchasing the shares and returning the repurchased shares to the lender.

where

In order to apply the present value models, information about future profitability, growth rates and risk is needed. It is therefore necessary to estimate the future economic potential of a firm to be able to apply a present value model. In this context, the financial statement analysis is an important element since it gives an insight into the historical profitability, growth rates and risk. The financial statement analysis thus establishes (historical) levels and trends in the economic performance of the firm, which is a good starting point for making forecasts.

Valuation approaches

Enterprise value (EV)

The asset based approach

Relative valuation (Multiples)

Present value

Equity value

Enterprise value (EV)

Equity value

Net Asset Value (NAV) Approach

Contingent claim valuation

Chapter 1 Introduction to financial statement analysis

P0 = Estimated market price of equity at time 0 div t = Dividends at time t re = Investors’ required rate of return

27 Discounted cash flow (to firm) model

Discounted cash flow (to equity) model

EV/IC

P/B

Sum-ofthe-parts approach

Economic value added model

Residual income model

EV/NOPAT

P/E

Liquidation approach

Adjusted present value model

Dividend discount model

EV/EBIT

EV/EBITDA

EV/Revenue

Figure 1.1

Overview of valuation approaches

As part of an historical financial statement analysis, the analysts will consider the quality of the reported accounting data. For example, the analysts need to distinguish between recurring and unusual accounting items. Unusual items, for example gains or losses on the sale of non-current assets, are those that are not likely to recur – or only with large time intervals. Therefore, when predicting the future earnings potential of a firm, analysts will typically exclude unusual items from the historical data and analyses. Furthermore, it is important to check that historical data is based on unchanged accounting policies. This ensures that any observed trend is caused by underlying changes in operations rather than by changes in 537.

Financial Statement Analysis

Relative valuation models

Relative valuation models are often referred to as multiples. In these models, the value of a firm is estimated by comparing with the price of comparable (peer group) firms based on reported or expected accounting earnings, equity, turnover or cash flows. Example 1.1 illustrates the application of multiples.

Example 1.1 Assume that a pharmaceutical firm located in Europe is planning to buy an Australian competitor, which is doing research into pharmaceuticals for the central nervous system (CNS). The Australian competitor, which is not listed, has announced that the outlook for the coming fiscal year is favourable. Thus, a 20% increase in earnings is expected. As a result, net earnings increase to EUR 200 million. Currently, most

28

pharmaceutical firms specialising in CNS are traded at a P/E multiple2 around 17.

Assuming that it is fair to pay EUR 17 per every euro of net income for a firm within the CNS industry, the value of the Australian competitor can be estimated to be EUR 3.4 billion (EUR 200 million x 17).

The example demonstrates that the use of multiples assumes that accounting data can be compared across firms. Thus, the use of multiples makes significant constraints on the data. First, the accounting policies for the firms that are compared have to be identical. Second, earnings of the firms which are compared have to have the same “quality”. This implies that a distinction between recurring or unusual earnings has to be made. Finally, applying the same multiple across different firms implies that they have the same expectation about future profitability, growth and risk.

2

The multiple P/E expresses the current share price (P) as a number of times of its earnings (E) per share. That is how many euro investors are willing to pay for one euro in earnings.

In addition to this book digital resources will be provided for instructors and students.

Focusing on three user groups — equity, credit and compensation analysts — the authors present a variety of targeted tools and techniques for analysis and interpretation of financial statements. Along with updates of the most recent IFRS-accounting standards, this edition also contains new and updated real life examples — many from the Nordic countries – helping the readers understand complex issues when analyzing financial statements.

Thomas Plenborg, PhD, is Professor at Copenhagen Business School. His research is widely published in academic and professional journals and he is a board member for several international companies. He has also consulted multiple international companies on financial issues.

Student tools such as quizzes and multiple choice questions have been updated, which improve the learning.

The second edition is filled with expert guidance that students and managers at all levels have to come to trust.

Features:

•

An integrated case study that runs throughout the text

•

Mini-case studies throughout the text to show real world applications

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Clear and comprehensive figures, featuring actual financial data

Supplementary resources are available online at www.fagbokforlaget.no/fsa

From the authors: «It is our ambition that the framework laid out in this book will provide business students and practitioners with a unique insight into financial statement analysis.»

ISBN 978-82-450-3424-0

is ys al n An tio it lua ed va Cr e E – n nc io a at m lu for Va Per

A four-part themed approach: accounting data, financial analysis, decision-making, and assessment of accounting data

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Financial Statement Analysis

• On request instructors can have access to a set of PowerPoint presentations for support and use in lectures, and an instructor’s manual containing extended and additional case studies and worked Excel solutions • For students the book’s website provides several supporting learning features, as glossary, flash cards and multiple choice questions for each chapter • Supplementary resources are available online at www.fagbokforlaget.no/fsa

This well-structured and thoughtful book is ideal for master and bachelor students in accounting and finance, and MBA students wishing to gain insight into financial statement analysis. The second edition provides up-to-date insights and practical advises on how to apply companies’ financial statements for decision making.

Thomas Plenborg Finn Kinserdal

Digital resources:

Finn Kinserdal, PhD, is Associate Professor at Norwegian School of Economics. He has previously been at McKinsey and been partner at EY, where he held positions as Head of Assurance in Norway and Head of Nordic Oil & Gas and Energy Sector. He has been auditor for some of Norway’s largest firms.