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Chapter 1. What is Financial Analysis?. Defining Financial Analysis. Financial analysis is the process of evaluating financial and other information for decision-making. A six-step approach is suggested for systematic financial analysis. Six-step Process.

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chapter 1

Chapter 1

What is Financial Analysis?

defining financial analysis
Defining Financial Analysis
  • Financial analysis is the process of evaluating financial and other information for decision-making.
  • A six-step approach is suggested for systematic financial analysis.
six step process
Six-step Process
  • Identify purpose of financial analysis
  • Corporate overview
  • Financial analysis techniques
  • Detailed accounting analysis
  • Comprehensive analysis
  • Decision or recommendation
corporate overview
Corporate Overview
  • Industry analysis--key economic characteristics, historical context, profit drivers, business risks
  • Firm’s business strategy--competitive strategy given the industry characteristics
industry analysis
Industry Analysis
  • Competition--growth rates, concentration ratios, degree of product differentiation, economies of scale (& relative fixed & variable costs), substitute products
  • Legal barriers--patent & copyrights, licensing, regulation
  • bargaining power of buyers (& suppliers) & price sensitivity
industry analysis criteria
Industry Analysis Criteria
  • What is the industry?
  • Relative size & significance
  • Largest companies
  • Geographic presence
  • Business cycle effects, current situation
  • Future potential
business strategy
Business Strategy
  • Cost leadership: low cost producer, economies of scale, efficient production, low input prices
  • Product differentiation: specific attributes that customers value (e.g., quality, variety, service, delivery time), brand name
  • Importance of core competencies
business strategy criteria
Business Strategy Criteria
  • Historical perspective
  • Primary focus of operations
  • Most important strategy
  • Major operating segments
  • Corporate outlook/ forecast
qualitative analysis dell computer
Qualitative Analysis--Dell Computer
  • Industry—primarily PCs: high tech, competitive (e.g., Gateway, IBM, Apple, others), changing products, high growth rates, low barriers of entry
  • Business strategy--(1) cost leadership strategy: direct selling, made-to-order manufacturing, early on the internet, low receivables; (2) product differentiation?? [IBM clones, Intel & Microsoft components]
  • Current situation—market share; what is the impact of the business cycle (e.g., PCs are durable goods)?
quantitative financial analysis
Quantitative Financial Analysis
  • Systematic analysis of key elements based on analysis context
  • Ratios, cash flows, common-size, time series, comparative (e.g., specific firms, industry, all firms), models (e.g., DuPont, Altman’s)
  • In-depth analysis for “red flag” items
quantitative financial analysis11
Quantitative Financial Analysis
  • Financial Statements
  • Common-size Analysis
  • Financial Ratios
  • Growth/trend Analysis
  • Quarterly analysis
  • DuPont Model
  • Market Analysis
detailed accounting analysis
Detailed Accounting Analysis
  • Does accounting information capture the underlying business reality?
  • Identify areas of “accounting flexibility” & evaluate accounting policies (choices) & disclosures; especially notes & MD&A
  • Evaluate earnings management potential
  • Recast accounting numbers when necessary
comprehensive analysis
Comprehensive Analysis
  • Summarize key points: what is particularly important for decision making?
  • “Red flags” are particularly important
  • Consider a written executive summary
  • Consider a rating scale, such as 1-10
  • What is the recommendation or decision?
  • What is the key rationale for this decision? [This is based on the specific decision: for a credit decision the key factors relate to credit risk, with particular focus on leverage and liquidity.]
  • Be prepared to defend this decision.
chapter 2

Chapter 2

The Financial Environment

credit decisions
Credit Decisions
  • Commercial banks provide short-term commercial loans
  • The major concern: will the company pay interest & principal when due?
  • Loan terms: interest rate, collateral, debt covenants
equity investment decisions
Equity Investment Decisions
  • Public securities trade on formal market exchanges (these are secondary markets)
  • Buying & selling are now relatively cheap transactions
  • Mutual funds are a useful alternatives to individual securities
  • Stock investing has high short-term risks
sec regulation
SEC Regulation
  • Mission: Protect investors & maintain integrity of the securities markets
  • Established following the Great Market Crash (SEC Act of 1934)
  • SEC requires public registration, proxy statements & annual (10-K) and quarterly (10-Q) reports, 8-K for specific events
  • Update: Sarbanes-Oxley Act of 2002 & Public Company Accounting Oversight Board; Dodd-Frank, 2010
goals of financial accounting in a market economy
Goals of Financial Accounting in a Market Economy?
  • Capture business economics of the firm (e.g., relationship to industry, competitive strategy, business model). How does firm create value?
  • Reduce management discretion on financial reporting (what is reality? Vs. misleading information--analysts sort this out). Note management incentives for earnings management
accounting regulators
Accounting Regulators
  • Securities & Exchange Commission (SEC)--regulates securities markets and financial reporting (10-K, 10-Q, 8-K)
  • Financial Accounting Standards Board (FASB)--promulgates GAAP
  • International Accounting Standards Board (IASB)—issuing International Financial Reporting Standards (IFRS)
u s standard setters 1938 present
U.S. Standard Setters: 1938-Present
  • Committee on Accounting Procedures (CAP) issued 51 Accounting Research Bulletins (ARBs)--1938-59
  • Accounting Principles Board (APB) issued 31 Opinions--1959-73
  • Financial Accounting Standards Board (FASB) has issued 168 Statements through 2009 (SFASs) plus other standards—now Standards Codification in 4 volumes, by topic
the fasb
  • Seven member board, full time, appointed by FAF, presumed independent
  • Extensive due process: agenda items, discussion memoranda (DM), exposure drafts (ED), pronouncements, public exposure with written & oral comments
  • Super-majority (5-2 vote) [simple majority used 1977-90]
  • Standard setting a political process
annual report information
Annual Report Information
  • Corporate Overview
  • MD&A
  • Financial Statements: Balance Sheet, Income Statement, Statement of Cash Flows, Statement of Equity
  • Notes to financial statements
  • Auditor’s Opinion
management incentives
Management Incentives
  • Managers have incentives to present information in the most favorable light (e.g., bonuses, stock options, promotions)
  • Accounting choice: accounting polities, estimates, additional disclosures
  • Standardize vs. estimates: what is reality?
  • Management have best information, but communications to investors may not be completely credible
financial statement considerations
Financial Statement Considerations
  • Managers’ information on economic reality
  • Estimation errors
  • Distortion from managers’ accounting choices & disclosure
  • Question: Can investor perceptions be manipulated?
finance theory perspectives
Finance Theory Perspectives
  • Efficient Markets
  • Random Walk
  • Portfolio Theory
  • Beta Analysis
  • Economic Behavior & Agency Theory
  • Earnings Management & Accounting Choice
efficient markets
Efficient Markets
  • Markets are efficient if information is impounded immediately in capital prices in an unbiased fashion
  • Research supports market efficiency in the semi-strong form, for short windows
  • Why?—Analyst following
  • Note long-term anomalies & other challenges (e.g., behavioral economics)
random walk
Random Walk
  • The concept that a professional portfolio cannot outperform a randomly selected stock portfolio
  • Research generally confirms this result
  • Consistent with efficient markets; that is, all information has been impounded in stock price
portfolio theory
Portfolio Theory
  • Harry Markowitz introduced the concept of portfolio diversification with his 1952 dissertation
  • Portfolio theory insists that investment portfolios should be diversified to reduce the risk relative to return
  • Capital asset pricing model: E(Ri) = Rf + [E(Rm) – Rf)
beta analysis
Beta Analysis
  • Beta () comes directly from the slope of the market model: Rit = i + iRmt + eit
  • Beta measures the relationship between price movements of the individual stock to market averages
  • Beta is a measure of systematic risk, where a =1 stock should move with the market; a >1 stock has greater market risk
economic behavior
Economic Behavior
  • Rationality: assume bounded rationality—people are intendedly rationale but limited
  • Self-interest behavior: Obedience Simple self interest Opportunism (self interest with guile-- that is, willing to violate normal ethical boundaries for personal benefit)
agency theory
Agency Theory
  • Contracts have a principal (e.g., owners) and agent (e.g., managers). The principal will attempt to maximize wealth, contract to avoid conflict, and minimize transaction and agency costs.
  • Agency costs: information asymmetries (limited information by one side), adverse selection, moral hazard (e.g., shirking).
how to reduce agency costs
How to Reduce Agency Costs
  • Better acquisition decisions
  • Monitoring--including audits and financial reporting
  • Align preferences of agents with principals (e.g., debt covenants, management compensation)--a reason for stock options
  • Control devises such as budgets
earnings management
Earnings Management
  • Operations and discretionary accounting methods to adjust earnings to a desired outcome, often income smoothing
  • Underlying theory: agency theory, transaction cost economics
  • Importance of efficient contracting: corporations are a network of contracts and exist because they write contracts efficiently
accounting choice
Accounting Choice
  • Discretionary choices to optimize behavior, using techniques such as: 1. Select alternative accounting methods (e.g., inventory) & level of disclosure (e.g., contingencies) 2. Lobbying (e.g., on proposed standards) 3. Financial, production & investment activities
discretion under gaap
Discretion Under GAAP
  • Taking a bath
  • Creating hidden reserves
  • Off-balance-sheet financing
  • Overstating performance (e.g., aggressive revenue recognition)
  • Not reporting obligations (contingencies, commitments, other liabilities)
earnings manipulation
Earnings Manipulation
  • Because alternatives are allowed, financial accounting has many discretionary aspects.
  • Managers can manipulate income by timing (e.g., recognition this year v next year) and classification (e.g., ordinary v extraordinary)
  • Accruals can be mandatory (e.g., other post employment benefits) or voluntary (e.g., depreciation)
earnings quality
Earnings Quality
  • Importance of full disclosure
  • Look for “conservative” reporting
  • Review indicators of high quality
  • Relationship of risk to earnings quality
  • Be aware of earnings management incentives and evidence of earnings manipulation
normalizing income
Normalizing Income
  • Attempt to determine earning power--related to normal operating earnings
  • Remove the “noise”--usually associated with nonrecurring items
  • Separate analysis of nonrecurring items--reorganization, “big bath” write-offs, changing GAAP
  • Evidence of earnings manipulation may require substantial adjustments to arrive at “normal earnings”
financial analysis decision
Financial Analysis Decision
  • Based on Elliott’s “value chain of information”: this is the $1,000 per hour stage
  • The purpose of financial analysis is to arrive at an informed recommendation or decision
chapter 3

Chapter 3

The Financial Statements

financial statements
Financial Statements
  • Balance Sheet
  • Income Statement
  • Statement of Cash Flows
  • Statement of Stockholders’ Equity
balance sheet
Balance Sheet
  • Assets: probable future economic benefits
  • Liabilities: probable future economic sacrifices
  • Stockholders’ Equity: residual interest, representing ownership interest (also called net assets)
  • Current Assets (cash & cash equivalents, short-term marketable securities), accounts receivable, inventory, other)
  • Property, plant & equipment
  • Long-term investments
  • Other assets
  • Current Liabilities (accounts payable, accrued & other current liabilities)
  • Long-term debt
  • Commitments & contingencies
  • Other liabilities
  • Potential off-balance sheet debt
stockholders equity
Stockholders’ Equity
  • Preferred stock
  • Common stock
  • Other paid-in capital
  • Retained earnings
  • Treasury stock
  • Other comprehensive income
  • Other equity items
income statement
Income Statement
  • Revenues: inflows from major operations
  • Expenses: outflows from major operations
  • Gains & Losses: changes in equity from peripheral activities
  • Net income: bottom line all operating activities recorded on the income statement
  • Comprehensive income: Changes in equity from all non-owner sources
  • Sales
  • Services
  • Other revenue items
  • Importance of revenue recognition criteria
operating expenses
Operating Expenses
  • Cost of goods sold (manufacturing)
  • Cost of sales (services or services included)
  • Operating expenses (selling, general & administrative, research & development, other)
  • Interest income & expenses & related
  • Provision for tax
non recurring items
Non-recurring Items
  • Extraordinary items
  • Discontinued operations
  • Accounting changes
  • Other non-recurring items
  • Other gains & losses
earnings measures
Earnings Measures
  • Gross profit
  • Operating income
  • Income before tax
  • Income from continuing operations
  • Net income
  • Comprehensive income
cash flow statement
Cash Flow Statement
  • Cash Flows from Operations
  • Cash Flows from Investing Activities
  • Cash Flows from Financial Activities
  • Statement of Stockholders’ Equity
cash from operations
Cash From Operations
  • Net income
  • Depreciation & amortization
  • Other operating adjustments
  • Changes in non-cash working capital items
cash from investing financing
Cash From Investing & Financing
  • Cash from investing Investment purchases Investment maturities & sales

Capital expenditures

  • Cash from financing Issuance of equity Purchase/acquisition of equity New debt Debt maturities or retirement


Treasury Stock

statement of stockholders equity
Statement of Stockholders’ Equity
  • Reconciliation of stockholders’ equity, alternative formats used
  • Key categories (changes) Common stock, other paid-in capital Retained earnings Treasury stock Other comprehensive income
chapter 4

Chapter 4

Quantitative Financial Analysis Using Financial Statement Information

quantitative financial analysis59
Quantitative Financial Analysis
  • Systematic analysis of key elements based on analysis context
  • Quantitative techniques to standardize financial information for relevant comparisons
  • In-depth analysis for key factors, including “red flags”
quantitative financial analysis60
Quantitative Financial Analysis
  • Financial Statements
  • Common-size Analysis
  • Financial Ratios
  • Growth Analysis
  • Du Pont Model
  • Earnings Quality/Normalizing Earnings
useful financial comparisons
Useful Financial Comparisons
  • Benchmarks: rules of thumb or averages
  • Common Sense
  • Trend Analysis (analysis over time)
  • Near Competitors
  • Industry Averages
  • Market Averages
common size analysis
Common-size Analysis
  • Overview vs. detail
  • Balance sheet: total assets = 100%
  • Income Statement: sales (or total revenues) = 100%
  • Comparisons over time & across firms (or industry averages)
  • Useful starting point for financial overview
ratio analysis
Ratio Analysis
  • A ratio converts financial information to a percentage, one approach to standardization
  • Each ratios provides a somewhat different analysis
  • Ratios overlap—a problem in one area should show up as problems in other areas
  • The importance of specific ratios differs, based on the purpose of the financial analysis
  • Ratios for the most recent period are usually the most important
ratio categories
Ratio Categories
  • Liquidity—cash, working capital & cash flow related
  • Activity—turnover ratios as possible efficiency measures
  • Leverage—debt & solvency analysis
  • Performance (or profitability)—bottom line or earnings related
liquidity ratios
Liquidity Ratios
  • Current ratio: current assets/current liabilities
  • Quick (acid test) ratio: (cash+marketable securities+net receivables)/current liabilities
  • Cash ratio: (cash+marketable securities)/current liabilities
  • Operating ratio: cash flows from operations/current liabilities
leverage ratios
Leverage Ratios
  • Debt to equity ratio: total liabilities/total stockholders’ equity
  • Debt ratio: total liabilities/total assets
  • Interest coverage: (income before tax +interest expense)/interest expense [note that the numerator is earnings before interest and taxes or EBIT]*
  • Long-term debt to equity: long-term liabilities/total stockholders’ equity
  • Debt to market equity: total liabilities at book value/total equity at market value

*alternatively: (income from continuing operations + interest expense + tax expense)/interest expense

activity ratios
Activity Ratios
  • Inventory turnover: cost of sales [or COGS]/average inventory
  • Receivables turnover: sales/average accounts receivable
  • Payables turnover: sales/average accounts payable
  • Working capital turnover: sales/average working capital
  • Fixed asset turnover: sales/average property, plant & equipment
  • Total asset turnover: sales/average total assets
activity ratios in days
Activity Ratios in Days
  • Average days inventory in stock: 365/inventory turnover
  • Average days receivables outstanding: 365/receivables turnover
  • Average days payable outstanding: 365/payables turnover
  • Length of operating cycle: average days inventory + average days receivables
  • Gross margin: (Sales-cost of sales)/sales
  • Return on sales: net income/sales
  • Return on assets: net income/average total assets
  • Pretax return on assets: earnings before interest & taxes/average total assets
  • Return on total equity: net income/average stockholders’ equity
  • Dividend payout: common dividends/net income [per share basis: dividends per share / EPS]
du pont model
Du Pont Model
  • ROE = Profitability x Activity x Solvency
  • Net Income / Average Common Equity = (Net Income / Sales) x (Sales / Average Total Assets) x (Average Total Assets / Average Common Equity)
  • ROA = Profitability x Activity
decomposition using du pont
Decomposition using Du Pont
  • Start with Return on Sales
  • Activity is avg. total asset ratio—this is a measure of asset turnover or efficiency
  • ROS x ATAR is Return on Assets (calculate as net income / average total assets)
  • Solvency is ATA / Avgas. Common Equity—this is a standard leverage ratio
  • ROA x Solvency is Return on Equity (calculate as net income / average common equity)
  • In summary, the differences between ROS, ROA & ROE depend on activity & solvency
du pont model72

Profit (Return on Sales)

Activity (Asset Turnover)

Return on Assets

Solvency (Common Equity Leverage)

Return on Equity


Net Income/Sales

Sales/Avg. Total Assets (ATA)

Net Income/ATA

ATA/Average Common Equity (ACE)

Net Income/ ACE

Du Pont Model
ratio analysis limitations
Ratio Analysis Limitations
  • Ratios are presented on a percentage basis
  • Relative size is ignored (e.g., both large & small firms can be compared)
  • It is assumed that all numbers used are correct (consider both possible errors and earnings management)
  • If the numbers are not reliable, ratios are not particularly useful
chapter 5

Chapter 5

Multiperiod Quantitative Financial Analysis

growth analysis period by period change
Growth Analysis (period-by-period change)
  • Long-term trends over time can be significant. Are current year performance measures consistent with earlier years (e.g., maintaining consistent ratios while sales are rising smoothly)?
  • As a first step, present growth rates (including % increases) for the last 5-10 years
  • Declining or negative growth rates might be obvious red flags; Red flags and other indicators of poor growth performance require further analysis
base year analysis also called trend analysis
Base-Year Analysis(also called Trend Analysis)
  • Set the earliest year, evaluated as the base year, at 100. [Note: this assumes that earliest year is “normal.”] Calculate growth by dividing the more current year numbers by the base year number.
  • This is an alternative presentation to growth rate percentages over 5-10 years (or more)
quarterly analysis
Quarterly Analysis
  • The most recent financial data is presented quarterly (e.g., 10-Q). [The one exception is at year end, with annual information is presented]
  • Financial analysts focus on quarterly data and the quarterly earnings announcement is the most important (& earliest) information
  • Common-size and ratios analysis is conducted, and compared over earlier quarters: particularly important are current quarter data to (1) the previous quarter and (2) the same quarter one year ago
chapter 6

Chapter 6

Quantitative Financial Analysis Techniques: Incorporating Market Information

quantitative market analysis
Quantitative Market Analysis
  • Stock prices & stock charts
  • Earnings per share—actual & forecast
  • Price earnings ratios (PE)
  • Dividend yield
  • Market value & market-to-book
  • Price earnings to growth ratios (PEG)
  • Valuation models
stock prices
Stock Prices
  • Prices change continuously
  • Using daily closing price
  • Stock charts, various periods
  • Industry & market comparisons
  • Internet sites
earnings per share eps
Earnings Per Share (EPS)
  • Performance measure on per share basis
  • Basic vs. diluted
  • Forecasted EPS (Analysts’ Estimates on Yahoo)
  • Annual vs. quarterly EPS
  • Annual—last 4 quarters
  • 5 year forecasts (relevance vs. reliability)
pe ratios
PE Ratios
  • Stock price as a market premium for earnings
  • Which price? (most current, historic…)
  • Which EPS? (current year actual--usually last 4 quarters, future forecast, basic vs. diluted)
  • Closing prices
  • Alternatives & how to evaluate them
market based ratios
Market-based Ratios
  • Price earnings ratio (PE): Stock price / EPS
  • Dividend Yield: Dividend per share / Stock price
  • Market value: stock price x shares outstanding
  • Market-to-book: market value / stockholders’ equity
  • Dividends given on a per share basis; focus on dividends per share, last 4 quarters. [Note—equivalent to dividends/shares outstanding.]
  • Dividend yield: dividends per share/stock price—income focus; average yield is about 2% for the S&P 500.
  • Dividend payout: dividends per share/earnings per share.
market related ratios
Market-related Ratios
  • Market-to-book: market value / stockholders’ equity [or measure on a per share basis—stock price / book value per share]—why is a “market premium to book” common?
  • Sales to market value: annual sales to outstanding shares x (1) year-end closing market price or (2) most recent closing market price.
price earnings to growth peg
Price Earnings to Growth (PEG)
  • High PE is usually associated with the expectation of high earnings growth, which can be evaluated with PEG
  • “Historic PEG” = PE based on actual EPS / 5-year historic earnings growth
  • “Forecast PEG” = PE based on forecast EPS / 5-year earnings forecast
  • PEG is useful to evaluate growth stocks, less useful for income stocks
earnings based growth model
Earnings-based Growth Model
  • P = kE / (r – g) where P is “expected” stock price, k is dividend payout rate (actual or predicted), E is EPS, r is the discount rate, and g the projected earnings growth rate
  • This model requires dividends, the discount rate is arbitrary (it could be the actual cost of capital—or based something else), and the growth rate is a forecast; results can change substantially using different assumptions
stock screening
Stock Screening
  • The purpose of stock screening is the determine which firms meet specific criteria (such as minimum ROE or dividend yield)
  • Several internet sites have stock screeners, such as Yahoo
  • The technique is useful to limit the number of companies on which to conduct a complete financial analysis
chapter 11

Chapter 11

Capital Structure & Credit Risk

corporate liabilities
Corporate Liabilities
  • Accounts Payable
  • Commercial Paper & other short-term market liabilities
  • Other current liabilities
  • Corporate Bonds
  • Other long-term market debt
  • Other liabilities (including off-balance-sheet)
credit risk
Credit Risk
  • Credit risk: probability that a corporation will either default on debt or declare bankruptcy. Default risk: probability that a corporation will not pay interest & principal when they come due Bankruptcy risk: probability that a corporation will file for bankruptcy
default risk
Default Risk
  • What is the chance (probability) that the corporation will fail to make interest or principal payments when due?
  • Because of high collection costs, creditors evaluate credit risk carefully
  • Failure events: restructurings, especially troubled debt restructuring; default; bond rating down-grading; going-concern qualifications; bankruptcy
bankruptcy risk
Bankruptcy Risk
  • Probability that a firm will file for Chapter 11 bankruptcy.
  • Importance of failure events: losses, defaults, troubled debt restructuring, going concern qualified audit opinion
  • Altman’s Z-score can be used as a prediction model for credit risk
financial leverage
Financial Leverage
  • Financial leverage is the relative mix of debt (especially long-term debt) & equity
  • Long-term debt increases credit risk & has interest charges
  • The financial leverage index (FLI) is ROE/ROA
  • A high FLI indicates the increasing use of leverage to raise ROE relative to ROA
  • The financial structure leverage ratio (FSLR) is average total assets/average common equity. This is the same ratio used in the DuPont Model for solvency. A higher ratio means higher leverage, but also a higher ROE. The ratio is identical to FL1 if there is no preferred stock. When preferred stock is present, the FSLR is higher than FLI.
altman s z score 1983 model
Altman’s Z-score, 1983 Model
  • 6.56 x (working capital / total assets)
  • + 3.26 x (retained earnings / total assets)
  • + 6.72 x (EBIT / total assets)
  • + 1.05 x (book value of equity / book value of debt)
  • = Altman’s Z-score
altman s z score
Altman’s Z-score
  • Indicator of overall financial health
  • Cutoffs: les than 1.1 bankrupt 1.1 – 2.6 gray area greater than 2.6 healthy
  • A Z-score of 1.1 or less does not mean the company is bankrupt, but does suggest that financial problems may exist
bond ratings
Bond Ratings
  • Bond rating agencies include Standard & Poor’s & Moody’s
  • Corporations are expected to have investment grade ratings, Baa and above (for Moody’s)
  • Bond ratings below investment grade are junk bonds, which is usually recognized as a red flag
chapter 12

Chapter 12

Credit Analysis

credit analysis process
Credit Analysis Process
  • Loan Purpose
  • Corporate Overview
  • Financial Analysis
  • Accounting Analysis
  • Comprehensive Analysis
  • Loan Decision
loan purpose
Loan Purpose
  • Commercial Bank Loan: term loan revolving line of credit other
  • Commercial Paper
  • Corporate Bonds
corporate overview103
Corporate Overview
  • Wide variety of firms need bank loans
  • Size characteristics—local or regional to national & global
  • Industry specializations, including impact on bank credit risk
  • Large companies have more credit options
quantitative financial analysis104
Quantitative Financial Analysis
  • Primary focus is on financial report analysis, with less emphasis on market information
  • Particular interest in liquidity & leverage
  • Evidence of financial health (as measured by credit risk) rather than earnings performance & forecasts
accounting analysis
Accounting Analysis
  • Emphasis on liquidity & cash flow information
  • Analysis of unrecorded obligations & potential overstated assets
  • Forecasts of sales & operations plus future cash flows
comprehensive analysis106
Comprehensive Analysis
  • Summary of key information (executive summary recommended)
  • Importance of credit risk
  • Adequate information to make informed recommendations/decisions
loan decisions
Loan Decisions
  • Yes/ No on loan
  • What interest rate (prime rate +)?
  • What collateral?
  • What Debt covenants?
  • Other considerations (e.g., compensating balances)
chapter 13

Chapter 13

Equity Investment Analysis

investment portfolio
Investment Portfolio
  • Importance of Portfolio Diversification
  • Based on Investor Goals
  • Short-term, liquidity focus
  • Mid-term, return but limited risk focus
  • Long-term, return focus
mutual funds
Mutual Funds
  • Investment portfolios managed by professionals & regulated by the SEC
  • Advantages: diversification, professional management, liquidity, small investment
  • Disadvantages: Fees, average returns less than expected, lack of control over investments, taxes
mutual fund categories
Mutual Fund Categories
  • Money Market Funds
  • Bond
  • Stock: growth, income, value, asset allocation, international, sector, regional
  • Balanced
  • Real estate, usually REITs
gotrocks funds
Gotrocks Funds
  • Growth Fund: maximize long-term market appreciation using large-cap stocks (focus on earnings & earnings growth potential)
  • Income Fund: maximize intermediate- & long-term income using bonds and large-cap stock that pay high dividends (+ total return as a secondary goal)
  • Value Fund: invest in large-cap stocks that out of favor—requires evidence of substantial stock price drop & ongoing restructuring (usually low market-to-book)
investment strategies
Investment Strategies
  • Buy & hold
  • Index funds
  • Dollar-cost averaging
  • Risk measures, such as Beta analysis
  • Asset allocation decisions; e.g., % of cash, bonds & stocks
six step analysis
Six-step Analysis
  • Investment purpose
  • Corporate overview
  • Quantitative financial & market analysis
  • Detailed accounting analysis
  • Comprehensive analysis
  • Recommendation or decision
investment purpose
Investment Purpose
  • Short-term (stressing liquidity & low risk)
  • Long-term (e.g., retirement—stressing long-term return, willing to accept more risk)
  • Using market averages such as the Dow Jones Industrial Average
  • Utilities may fit income funds because of high dividend yields
  • High tech firms may fit growth funds
  • Decisions: buy, sell, hold (& how much?)
  • Different important characteristics based on investment goals: Income Investment: importance of dividend yield Growth fund: importance of profit & earnings growth forecast Values funds: importance of “bargain price”