Topic 9 - Revisiting Financial Statement Analysis (1)

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This article is a topic within the subject Accounting 1B.

Contents

Required Reading

Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 615-655.

Methodology

[1]

  1. Find Comparative Firms
  2. Understand the Business, It’s model & strategy
  3. Calculate & Interpret ratios
  4. Valuation

However, it is important to consider the limitations of FSA & the influence of market & macro factors.

Comparative Analysis

[2] It’s not always easy to find comparable firms, e.g. Woolworths has different business divisions in comparison to Coles / Wesfarmers, it doesn’t have IGA’s franchise model, it’s not the bulk buying club that Costco is & Aldi is privately owned.

What is the comparable firm for AAPL? (Apple)

Samsung, as it competes in many similar product line as apple – mobile phones, tablets, TV’s. However, Samsung is also involved in other divisions such as white goods & appliances that Apple does not compete in.

Understanding the Business Model

In competition, to thrive a firm needs an unfair/competitive advantage. Also, is the firm a fruit or tree model/strategy? [3]

Competitive Advantage

AAPL – Outstanding industrial design, seamless integration across products & services, cult following HPQ – commoditised products, customers switching to convergence devices & cloud based computing

Business Strategy/Model – Fruit or Tree

Many firms are ‘fruit businesses’. For example, the Iphone can only be sold once & AAPL has to continually innovate, upgrade & persuade consumers to buy another phone to drive profits. Others are ‘tree businesses’ whereby purchase establishes in income stream e.g. phone contract (its periodic).

Competitive Threats

AAPL – threat of android phones & tablets, product development pipeline, market saturation HPQ – commoditised markets, competing on price & not on innovation

Special Factors

This includes new product launches, acquisition/disposal of assets, e.g. Steve Jobs & AAPL Ratio Analysis: A Scale Free Relative Measure Comparable Across Firms

Turnover vs. Margins

Turnover & margins are often influenced by the industry & businesses model. It wouldn’t be good for a grocery store to have low inventory turnover but Louis Vuitton can as it is ‘timeless elegance’ but Prada shouldn’t have low turnover as fashion changes quickly. Low turnover may indicate obsolete products &/or wasted expenses on storage.

Liquidity – Current Ratio

Traditionally, above 1 is better (positive working capital), there would be enough CA’s to cover CL’s in a crisis. The modern view is that below 1 is better as it means you are using other peoples funds to run your business.

Solvency – Debt/Equity And Interest Coverage

Solvency risk refers to bankruptcy risk. Some industries/models can sustain higher leverage (tangible assets, predictable CF’s – monopoly on utilities/infrastructure) however there would be significant interest rate risk.

Valuation Analysis

We can combine comparative & valuation (pricing analysis) particularly with comparable firms. A poorly performing company may be a good buy if it is very cheap & a well performing business that is to expensive can be a bad buy.

AAPL P/E Analysis: GOOG has a 19.43 P/E; AAPL is $367 with a P/E of 13.26. If as good as GOOG AAPL price = $537.75

PEG Ratio Analysis = P.E/(Earnings Growth) - The price to earnings ratio divided by next years earnings growth. A PEG > 1 (overvalued) PEG < 1 (undervalued). We can use PEG = 1 as a benchmark.

Other valuation metrics include Price/Book, Discounted Cash Flows etc.

Market & Macro Factors

  • Secular Bull & Bear Markets – Japan has lost 2 decades of growth
  • Macroeconomic – impact of GFC on economic growth & individual company growth prospects, AUS reliance on CHN

Trend Analysis

Involves comparing performance over time for a company.

Sensitivity Analysis: What if?

What would be the effects of changes in conditions or policies on ratios & cash flows?

Limitations of Ratio Analysis

[4]

  1. Rely on past information
  2. Rely on historical cost
  3. Based on year end data
  4. Requires information that might not be disclosed
  5. Different accounting methods may not allow comparability

Financial Ratios

Ratios are a scale free, relative measure that can be compared with other companies. It is important to be consistent i.e. use the same formula.

Performance, Turnover And Liquidity Ratios

RA1.png

Financial Structure And Relationships

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End

This is the end of this topic. Click Accounting 1B to go back to the main subject page for Accounting 1B

References

Textbook refers to Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning

  1. ASB, UNSW
  2. ASB, UNSW
  3. Jeffrey Knapp, UNSW
  4. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 682
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