FSA

3 limitations of ratio analysis

1. measureability 2. non-capitalized costs 3. historical costs pg. 3-41

Explain what it means when a company's ROE exceeds its RNOA.

An ROE that exceeds RNOA implies a positive return on nonoperating activities. This results from borrowed funds being invested in operating assets whose return (RNOA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.

What is credit risk?

Credit risk encapsulates the chance of loss resulting from a creditor's default (either interest or principal).

What is a company's cost of capital?

The cost of capital represents the return the investor must receive in order to invest in a risky asset. The investor must recover two costs (1) the foregone interest from investing in this asset (time value of money) and (2) the risk the investor incurs for investing in this asset.

How is the Cost of Equity Capital computed using beta, the risk-free rate, and the market premium?

The market's expected return, or cost of equity capital, can be computed by adding the product of beta and the market premium to the risk-free rate.

Describe how to compute the PV of an increasing perpetuity

The present value factor of a growing perpetuity can be computed as 1/(r-g) where r represents the appropriate discount rate and g represents the growth rate. This is often called the Gordon Growth Model. The present value of a growing perpetuity can be computed as the product of the present value factor and the perpetuity payment.

Investors who buy the bonds are concerned with the issuing company's...

ability to meet semiannual interest payments (Liquidity) and to repay the principal at maturity (solvent)

Types of bank loans

pg 4-5

The overarching purpose of credit risk analysis is to...

quantify expected credit losses to inform lending decisions

Intrinsic Value of the firm

the economic value of the company assuming the actual future payoffs are known today

4 steps to determine the chance of default

1. Evaluate Nature and purpose of loan 2. Assess Macroeconomic Environment and industry Conditions 3. Analyze Financial Ratios 4. Perform Prospective Analysis pg 4-9

What is the main purpose for performing a credit analysis?

Assessing credit risk via a credit analysis allows suppliers of credit to determine 1) whether they wish to extend credit to a particular entity, and if so, 2) what the credit terms should be (e.g. interest rate, covenants, and other contractual restrictions). For example, a lender would be more likely to impose greater restrictions and a higher rate of interest for entities that posed a larger credit risk than those with lower credit risk ratings. The "junk bonds" of the 80s yielded high returns for the very reason these loans posed high credit risks.

Describe the concept of asset turnover. What does the concept mean and why is it so important to understanding and interpreting financial performance?

Asset turnover measures the amount of revenue compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Because turnover is one of the components of ROE (via RNOA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.

Expected Credit Loss

Chance of default x Loss given default

Why is it important to disaggregate RNOA into NOPM and NOAT?

Companies must manage both the income statement and the balance sheet in order to maximize RNOA. This is important, as too often managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of RNOA into its profit and turnover components focuses analysis on both of these areas.

Why do lenders impose debt covenants on borrowers?

Covenants represent terms or conditions placed on the borrower to limit the loss given default by protecting cash flows the company will have to repay the loan. Loan covenants tied to financial ratios also aid creditors by providing evidence of deteriorating conditions within the firm.

How does coverage analysis differ from measures of liquidity and solvency?

Coverage analysis differs from typical measures of liquidity and solvency because it uses flow variables (from the income statement and cash flow statement) to calculate how likely it is that the company will be able to make principal and interest payments.

Why are missing or understated liabilities especially critical for credit analysis?

Credit analysis attempts to discern whether a company will be able to pay back its obligations. Because various methods exist for companies to obtain "off-balance-sheet" financing, it is imperative to adjust the financials for any obligations not listed on the balance sheet because these are real economic obligations that must be honored and may have senior claim in certain situations. Operating leases are an example of a financing vehicle with stipulated payment terms. Understanding the implications of operating leases may not be possible from a cursory glance at the financial statements.

How is information contained in the FS useful in pricing securities?

Current and historical financial information are the primary sources of information for forecasting future financial performance. Analysts frequently eliminate transitory items from reported earnings to gain a clearer perspective of the expected future earnings of the company, that is, those earnings that are likely to persist into the future. The trend in these persistent earnings is, then, used to form an initial estimate of future earnings. Thus, transitory items are less useful in valuing equity securities. Nonfinancial information, such as order backlog, an assessment of macroeconomic activity, the industry competitive environment, and so forth, is also used in the forecasting process.

Given the potentially positive relation between financial leverage and ROE, why don't we see companies with 100% financial leverage (entirely nonowner financed)?

Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.

What are free cash flows to the firm (FCFF) and how are they used in the pricing of equity securities?

Free cash flows to the firm are equal to NOPAT minus the increase in NOA (or plus the decrease in NOA). The discounted cash flow (DCF) model defines securities prices in terms of the present value of expected free cash flows to the firm (FCFF).

Capital Expenditures are usually an important cash outflow for a company, and they figure prominently into forecasts of net operating assets. What sources of information about capital expenditures can we draw upon?

Historical capital expenditures are reported in the statement of cash flows. Forecasted capital expenditures (CAPEX) are sometimes discussed in the Management Discussion and Analysis (MD&A) section of the 10-K and also in meetings with analysts or in other public disclosures.

In addition to recent revenue trends, what other types and sources of information can we use to help us forecast revenues?

In addition to analyzing historical revenue trends, we can incorporate external (nonfinancial) information into the forecasting process. Some examples include incorporating the expected level of macroeconomic activity, the degree to which the competitive landscape is changing, recent changes in laws or regulations, any strategic initiatives that have been announced by management, and so forth.

With respect to bankruptcy prediction, what is a Type 1 error and a type 2 error? which is most costly to a creditor?

In the context of Altman's model, two errors may arise. A Type I error occurs when the Z-score from the model indicates that bankruptcy is unlikely yet the firm goes bankrupt. A Type II error occurs when the Z-score from the model indicates that bankruptcy is likely, yet the firm does not go bankrupt. Creditors would be more worried by Type I errors, as these erroneously reject the probability of bankruptcy and may result in large losses to the creditor when the company goes bankrupt.

How is After-Tax Cost of Debt Capital calculated?

The cost of debt capital is the product of two components. The first is the average borrowing rate and the second is one minus the marginal tax rate. The average borrowing rate and marginal tax rates can generally be estimated from the notes to the financial statement. One less the marginal tax rate represents the cost of debt after the tax savings from the interest expense is taken into account.

What does the concept of financial statement articulation mean in the forecasting process?

The forecasted income statement, balance sheet and statement of cash flows should articulate in the same way that historical financial statements do; that is, they should tie together as we discuss in Module 2. We also need to be sure that our forecast assumptions are internally consistent (that they articulate across the financial statements). For example, it doesn't make much sense to forecast an increase in gross profit margins if we are forecasting a recession and higher levels of (unsold) inventory.

What does the market premium represent?

The market premium is the difference between the expected return on the market and the expected risk-free rate.

Explain the three types of debt covenants

Three types of common covenants: those that require borrowers to take certain actions, those that restrict the borrower from taking certain actions, and those that require the borrower to maintain certain financial conditions.

Explain what it means when a company's RNOA exceeds its ROE.

When RNOA exceeds ROE, the company has net nonoperating assets (nonoperating assets > nonoperating liabilities). This is "negative" net nonoperating obligations in the ROE disaggregation. The net nonoperating assets earn a return, which, when scaled by the negative NNO yields a negative nonoperating return. The company is holding nonoperating assets that do not create more value than the operating activities and this reduces overall ROE

We use coverage ratios to...

assess the company's ability to generate profit and cash to cover the fixed charges from debt (interest and principal) in the short and long term

Net Working Capital

current assets - current liabilities positive working capital implies that cash generated by "liquidating" current assets would be sufficient to pay current liabilities

A company that generates higher operating margins and returns on capital has a greater ability to...

generate equity capital internally, attract capital externally and withstand business adversity

The best collateral is

high-grade property such as securities with an active market because the value is known and liquidation is straightforward

A common strategy to improve liquidity is to...

increase operating liabilities wherever possible, without damaging creditor and supplier relations, so as to improve cash flow

Market Beta reflects...

the risk that cannot be diversified away by investing in a portfolio of risky assets

How can an increase in financial leverage increase a company's ROE?

Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt.

Why do lenders distinguish between cyclical cash needs and cash needed to fund operating losses?

Lenders distinguish between cyclical cash needs and cash needed to fund operating losses because the second type of cash is riskier. It is typical for firms such as retailers to experience cyclical cash flows during the year as they gear up for busy season(October -December for many retailers). This happens in the ordinary course of business. In contrast, operating losses are not routine and can signal ongoing liquidity problems, or at worst, bankruptcy.

Liquidity vs Solvency Why is performance Crucial?

Liquidity refers to cash availability: how much cash the company has and how quickly it can generate more on short notice. Solvency refers to a company's ability to meet its financial obligations over the short and long run. Both measures provide perspective on companies' credit risks and thus measure the likelihood of default or potential bankruptcy.

What is liquidity and why is it crucial to company survival?

Liquidity refers to cash: how much cash a company has, how much cash is coming in the door, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees, and provide their shareholders a return on investment. Cash is, therefore, critical to a company's survival.

Why are discontinued operations viewed as a nonoperating activity in the analysis of the balance sheet and the income statement

Once a business segment has been sold or designated for sale, it is classified as a discontinued operation. Consequently, sales and expenses related to the business segment are reported separately. Thus, the income statement reports income from continuing operations, discontinued operations, and net income (which includes both continuing and discontinued operations). On the balance sheet, the business segment's assets and liabilities are similarly segregated. Because the business segment was or will be sold, it no longer contributes to the operating activities of the company. One of the primary uses of financial information is to project future financial results so that investors and others can properly price the company's securities and evaluate strategic plans. The discontinued operations will not affect future results (other than via investment of the proceeds from the sale), and, therefore, should not be considered as a component of operating activities.

Are there some components or earnings that are more useful than others when pricing securities? What non financial information might also be useful?

The DCF and ROPI models define the price of a security in terms of the company's expected free cash flow to the firm (FCFF) and the expected residual operating income (ROPI), respectively. These expectations are, then, discounted to the present, using the WACC as the discount rate, to calculate an estimated share price. Expectations about the future financial performance of a company, therefore, significantly influence expected market value. There is an inverse relation between securities prices and expected return, the discount rate (WACC in this case).

Intrinsic Value vs Stock Price of a company

The company's stock price represents the price utilized in the most recent trade. The intrinsic value represents the company's value estimated using insights gained from financial statement analysis and the company's fundamentals (dividends and other payoffs). The dividend discount model, using estimated future dividends and the cost of equity capital, is one means to estimate the intrinsic value of a company's stock.

Describe the circularity that occurs when beta is used to help estimate an intrinsic value for comparison to market prices

The computation of market beta relies on market prices of the firm and also the market index to estimate the discount rate for the firm. However, then we assume that the firm may be mispriced when we apply that discount rate in estimating the intrinsic value of the firm.