Fsa Lecture Notes

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From financial statements to business analysis

- Financial and information intermediaries can add value by improving investors'
understanding of a firm's current performance and its future prospect
- Business intermediaries use financial statements to accomplish:
- Business strategy analysis: used to identify key profit drivers & business risks
and to assess the companys profit potential at a qualitative level
- Involves analysing a firm’s industry and its strategy to create a sustainable
competitive advantage
- Accounting analysis: evaluate the degree to which a firm’s accounting captures
the underlying business reality
- Analysts can assess the degree of distortion in a firms accounting numbers
- Financial analysis: using financial data to evaluate the current and past
performance of a firm and assess its sustainability.
- Ratio analysis and cash flow analysis are important tools
- Prospective analysis: focuses on forecasting a firm’s future and is the final step
in business analysis.
- Two commonly used techniques → financial statement forecasting and
valuation
- Its also possible to assess a firms value based on the firms current book
value of equity & its future return on equity (ROE) and growth
Chapter 2: Strategy analysis

- Strategy analysis allows the analyst to probe the economics of a firm at a qualitative level
so that the accounting and financial analysis is grounded in business reality
- Also allows the identification of the firms profit drivers and key risks
- Allows analysts to assess the sustainability of the firms current performance and
make realistic forecasts of future performance
Gedownload door Willem Ran (ran.willem@outlook.com)

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- A firms value is det by its ability to earn a return on its capital in excess of the cost of
capital
- Firms COC is det by the capital markets, whereas the firms profit potential is det
by its own strategic choices
- Strategy analysis involves industry analysis, competitive strategy analysis, and corporate
strategy analysis
- Industry choice → The choice of an industry or a set of industries in which the
firm operates
- Competitive strategy → The manner in which the firm intends to compete with
other firms in its chosen industry or industries
- Corporate strategy → The way in which the firm expects to create and exploit
synergies across the range of businesses in which it operates
Industry analysis
- The industry analysis is an analysis of an industry’s profit potential
- Analysts have to first assess the profit potential of each industry where the firm is
competing in bc the profitability of various industries differ systematically and
predictably over time
- The avg profitability of an industry is influenced by the five forces
- the intensity of competition determines the potential for creating abnormal profits
by the firm in an industry
- The greater the bargaining power of buyers and suppliers, the lower is the
industry’s profit potential
Degree of actual & potential competition

- Profits in an industry r a function of the max price that custs r willing to pay for the
industrys product/service
- Industry competition → One of the key determinants of price is the degree of
competition among suppliers of the same or similar products
- Perfect competition → price will be equal to marginal cost (P = MC), there will
be few opportunities to earn supernormal profits
- Perfect monopolistic competition → industry is dominated by a single firm, there
will be potential to earn monopoly profits
- In reality, degree of competition of most industries is somewhere in between
perfect competition & monopoly
3 potential sources of competition

#1 - Rivalry between existing firms
- In most industries, the avg level of profitability is influenced by the nature of rivalry
among existing firms in the industry

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- Some industries compete aggressively by pushing price close to MC

- Some industries do not compete aggressively on price. Instead, they compete on
non-price dimensions (innovation, service, brand image)
- Factors determining intensity of competition among existing firms:
- 1. Industry growth rate
- In growing industries → incumbent firms need not grab market share from
each other to grow
- In stagnant industries → existing firms can grow by taking the market
share away from other players (intense rivalry among firms can be
expected)
- 2. Concentration & balance of competitors
- the concentration is determined by the number of firms and their sizes in
the industry
- Degree of concentration influences the extent to which firms in an
industry can coordinate their pricing & other competitive moves
- When theres one dominant firm (Google) → they can set the rules of
competition (have more power in the industry)
- When theres only 2 or 3 equal-sized players (P&G, unilever, Henkel) →
they can implicitly cooperate with each other to avoid destructive price
competition
- Fragmented industry → competition is likely to be severe
- 3. Excess capacity & exit barriers
- in case of excess capacity (industry capacity > customer demand), firms
will cut prices to fill capacity
- Problem with excess capacity can be worsened if there r significant
barriers for firm to exit the industry
- Exit barriers r high when assters r specialized or if there are regulations to
make exit costly
- 4. Degree of differentiation & switching costs
- firms can avoid competition by doing differentiation
- Products r very similar → cust r ready to switch from one
competitor to another on the basis of price
- Switching cost det cysts propensity to move from one product to another
- Low switching cost → greater incentive for firms to engage in
price competition
- E.g. PC industry
- 5. Scale/learning economies & the ratio of fixed to variable cost
- If theres a steep learning curve or there r other types of scale economies in
the industry, size becomes an important factors of firms in the industry

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- There will be incentive to engage in aggressive compeititon for

market share
- If ratio of fixed to var costs r high, firms have an incentive to reduce prices
to utilize installed capacity
- Firms can compete on the dimensions of price or quality
- Price competition → likely to happen when customers switching
costs r low, if fixed costs r high, if products r subject to decay
- Industry profitability becomes under pressure when companies
compete on the same dimension (esp when they compete on price)
- When competing on diff dimension & targeting diff cust groups,
companies can succeed to segment the market & preserve industry
profitability
#2 - Threat of new entrants

- The potential of earning abnormal profits will attract new entrants to the industry
- This threat forces incumbent firms to make additional investments
- Factors determining height of barriers to enter an industry:
- 1. Scale
- With large economies of scale → new entrants face the choice of either
investing in a large capacity (which might not be utilized right away) or to
enter with less than optimum capacity
- New entrants will initially suffer from a cost advantage against existing
firms
- Scale of a firm may not only affect the cost per unit sold, but also the
customers demand for a product/service
- Scale affects demand → if the usefulness of a product/service
increases with the number of users (e.g. internet
communication/social media), or if the perceived
reliability/reputation of the company increases with size and is
valued by customers
- 2. First mover advantage
- early entrants can set standards, enter in exclusive arrangement with
suppliers, acquire scarce govt license, and have cost advantage over new
(late) entrants
- If there r learning economies, early firms will have a cost adv over new
entrants
- FMA is likely to be large when there r significant switching costs for cust
once they start using existing products
- 3. Access to channels of distribution & relationships

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- limited capacity in the existing distribution & high costs of developing

new channels are considered barriers to entry
- E.g. new entrant in the automotive industry is likely to face
barriers due to the difficulty of developing a dealer network
- Existing relationships between firms & custs also make it difficult for new
firms to enter an industry
- 4. Legal barriers
- Legal barriers such as patents & copyrights in a research-intensive
industry limit entry
- Licensing regulations also limit entry (e.g. in taxi service, medical service,
telecommunication industries, etc)
- Tariffs, import quota, and govt subsidies can also limit the entry of foreign
competitors
#3- Threat of substitute products/service

- relevant substitutes r from the products/services that perform the same function (e.g.
plastic bottles & metal cans r substitute as packaging in the beverage industry)
- In some case, threat of substitute doesnt only come from custs switching from one
product to another, but also from utilizing technologies that allow them to do without, or
use less of, the existing products (e.g. energy conserving technologies allow custs to
reduce their consumption of electircity & fossil fuel)
- Threat of subs depends on the price & performance of the competing products & on custs
willingness to substitute
- Custs perception of whether 2 products r subs depends on whether they perform
the same function for a similar price
- When 2 products perform identical function, it would be difficult for them to
differ from each other in price (e.g. designer label clothing charges price premium
even if its not superior in terms of functionality bc custs place a value on the
brand image)
Bargaining power in input and output markets

- While the degree of competition in an industry determines whether there is potential to
earn abnormal profits, the actual profits are influenced by the industry's bargaining
power with suppliers & customers
- Input side → firms enter into transactions with suppliers of labor, raw materials, finances
- Output side → firms wither sell directly to final cust, or through an intermediary in the
distribution chain
#4 - Bargaining power of buyers

- 1. Price sensitivity

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- Buyers r more price-sensitive when the product is undifferentiated & there r a few
swtiching costs
- Sensitivity of buyers also depend on the importance of the product to their own
cost structure
- When the product represents a large fraction of the buyers cost, buyer is
likely to expend the resources necessary to shop for a lower-cost
alternative
- When the product represents a small fraction of the buyers cost, they may
not expend resources to search for lower-cost alternatives
- Importance of product quality to buyer also determines whether or not price
becomes an important determinant of the buying decision
- 2. Relative bargaining power
- Refers to the extent to which they will succeed in forcing the price down
- Even if buyers r price sensitive, they may not be able to achieve low prices unless
they have a strong bargaining position relative to the firm
- Relative bargaining power depends on the cost to each party of not doing business
with the other party
- Its determined by the number of buyers relative to the number of suppliers,
volume of purchases by a buyer, number of alternative products available, buyers'
switching cost from one product to another, and threat of backward integration by
the buyers
#5 - Bargaining power of suppliers

- suppliers are powerful when there are only a few companies and substitutes, when the
product or service is critical to the buyer and when they pose a credible threat to forward
integration
- limitation of the industry analysis framework → the assumption that industries have clear
boundaries. In reality, it is often not easy to clearly demarcate industry boundaries
Competitive strategy analysis

- profitability of a firm is also influenced by the strategic choices it makes to cope with or
change the industrys compeititve forces
- A firm may aim to change the industry structure & profit potential (e.g. M&A in
the european airline industry which reduces the industrys fragmentation &
increase avg profitability),
- Or firm may take the industry structure as given & choose a set of activities that
might help them create a profitable position in the industry
- 2 competitive strategies → cost leadership & differentiation
- Both strategies allow a firm to build sustainable competitive advantage

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- Firms that utilizes both strategies r <stuck in the middle= and r expected to earn
low profitability
- They run the risk of not being able to attract price-conscious cust bc of the
high cost (from differentiation) & theyre also unable to provide adequate
differentiation to attract premium price custs
Source of competitive advantage

- Cost leadership: enables a firm to supply the same product/service offered by its
competitor at a lower cost
- In industries where basic product/service is a commodity, cost leadership might be
the only way to achieve superior performance
- Cost leadership can be achieved through economies of scale, scope & learning,
efficient production, simpler product design, lower input costs, and efficient
organizational processes
- If cost leadership is achieved, the firm is going to earn above-avg profitability by
charging the same price as its rivals
- Cost leadership can force its competitors to cut prices and accept lower returns or
exit the industry
- Firms that achieve cost leadership will focus on tight cost controls, by making
investments in efficient scale plants, minimizing overhead costs, and avoiding
serving marginal customers.
- Differentiation: providing a product/service that is distinct in some important aspect that
is highly valued by cust
- For differentiation to be successful:
- Needs to identify one or more attributes of a product that customers value
- position itself to meet the chosen customer need in a unique manner
- achieve differentiation at a cost that is lower than the price is willing to
pay for the differentiated product
- Drivers of differentiation includes providing superior intrinsic value via
- Product quality - Bundled services
- Product variety - Delivery timing
- Differentiation can be achieved by investing in signals of value
- Brand image - Reputation
- Product appearance
- The organizational structure & control system with differentiation strategies need
to foster creativity & innovation
Achieving & Sustaining competitive advantage

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- Cost leadership & differentiation strategy requires the firm to make the necessary
commitments to acquire the core competencies needed & structures its value chain in an
appropriate way
- Core competencies: economic assets that the firm possesses
- Value chain: set of activities that the firm performs to convert inputs into outputs
- The uniqueness of a firms core competencies & its value chain dets the sustainability of a
firms competitive advantage
- Unique core competencies: the economic assets that a firm possesses have to be
not easy to acquire by competitors or substitute for by other resources
- System of activities: the system of activities has to fit with the strategy and
potentially reinforce each other
- A coherent system of activities is difficult for competitors to imitate (esp
when such activities require a trade-off)
- Positioning: firms often identify or carve out a profitable sub-segment of an
industry.
- The identification of sub-segments could be based on
- particular product varieties
- the needs of particular customer group
- particular access and distribution channels.
Corporate strategy analysis

- some companies focus on only one business, but many operate in multiple businesses
- When analysing a multi-business organization, an analyst has to not only evaluate the
industries and strategies of the individual business, but also the economic consequences
of managing all the different businesses under one corporate umbrella
Sources of value creation at the corporate level

- several factors that influence an organization’s ability to create value through a broad
corporate scope includes,
- Economic theory: the optimal activity scope of a firm depends on the relative
transaction costs of performing a set of activities inside a firm versus using the
market mechanism.
- Transaction costs economics: the multiproduct firm is an efficient choice of
organizational form when coordination among independent, focused firms is
costly due to market transaction cists
- Transaction costs can arise out of several sources → if the production
process involves specialized assets (human capital skills), that is not easily
available in the marketplace or from market imperfections like
information or incentive problems

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- Transactions inside an organization may be less costly than market-based transactions for
several reasons:
- Information: communication costs inside an organization r reduced bc
confidentiality can be protected and credibility can be assured through internal
mechanisms
- Enforcement: HQ office play a critical role in reducing costs between
organizational subunits
- Asset sharing: organizational subunits can share valuable non-tradeable assets
(skill, systems, processes) and non-divisible assets (brand names, reputation) can
be shared
- Transaction costs can also increase inside organizations
- Top management may lack the specialized information and skills to manage
businesses across several industries
- Decentralization, hiring specialist managers to run each business unit & providing
these managers with proper incentives may be the solution
- Decentralization can decrease goal congruence among subunit managers,
making it difficult to realize economies of scope
Empirical evidence
- Diversified companies trade at a discount in the stock market relative to comparable
focused companies
- Acquisitions of one company by another often fail to create value for the acquiring
companies.
- Value is created when multi-business companies increase corporate focus through
divisional spin-offs and asset sales.
- Some explanations for diversification discount:
- Empire building: diversification and expanding are frequently driven by a desire
to maximize the size of the firm rather than to maximize shareholder value
- Incentive misalignment: business unit managers have incentives to make
investment decisions that benefit their own units but may be suboptimal for the
firm as a whole
- Monitoring problems: because of inadequate disclosure about the performance
of individual business segments it’s difficult to monitor and value multi-business
firms

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Lecture 2 (Chapter 3 & 4)

Role of accounting
- 2 main approaches: mark-to-market & historical cost
- Mark to market: recognizing the asset for the value it has today on the market (using the
price today as a benchmark)
- Still commonly used
- Historical cost → price paid when the asset is paid
- Used to estimate values when the market is not liquid
- Special Purpose Entities/Vehicles
- A special purpose vehicle, also called a special purpose entity (SPE), is a
subsidiary created by a parent company to isolate financial risk
- They are a separate entity from the parent company (kalo parent company goes
bankrupt, the special entity is unaffectded)
Case with Emron

- The energy business used to be regulated
- Once the sector got deregulated, the prices were fluctuating a lot
- Emron thus estimated the value of their plant by calculating how many kilowatt
the plant can produce over the lifetime of the plant times the price that it has at the
moment → however, it wasnt clear how they estimate the price (they inflated the
value of their asset, which leads to the inflation of their revenues, etc)
- Emron uses the mark to market approach very aggressively (case above)
Chapter 3: Accounting analysis

- The purpose of accounting analysis is to evaluate the degree to which a firms accounting
captures its underlying business reality & undo any accounting distortions
- By identifying places that has accounting flexibility & evaluating the
appropriateness of the firms accounting policies & estimates, analysts can assess
the degree of distortion in a firms accounting numbers
- To undo the accounting distortion, analysts can adjust the firms cash flow
information and information from the financial statement notes
Accounting quality
- Accounting quality: The degree to which a financial report (accrual accounting) reflects
the economic reality of the firm → how much can we trust the numbers?
- If all companies r truthful, it becomes easier to compare the company with other
companies
- Ideally, all assets & liabilities (balance sheet) would be measured at fair value (value of
all assets & liab at the date of the financial statement) → bc it reflects the reality better

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- This is, however, not applicable to all asset → can be tricky especially if the
market is not liquid
- If there r no liquid asset available, its better to use historical cost instead
- Using fair value would be inaccurate bc it will be based on own judgment
(v sensitive/biased to the incentive of the one making the estimate)
Noise from accounting rules

- Accounting rules introduce noise & bias bc its difficult to restrict management discretion
without reducing the information content of accounting data
- The degree of distortion introduced by accounting standards depends on how well
uniform accounting standards capture the nature of a firms transactions
- Accounting quality can vary based on 3 sources of <noise=
- Rigidity in accounting rules
- Principles-based (IFRS) vs rules-based (GAAP)
- Which financial reporting standards do we use (IFRS vs US GAAP)?
- Principles-based → gives you the general rules on how to record
transaction (provides less technical guidance)
- Has more flexibility
- Ensures that the financial statements reflect the economic situation
of firms transactions, instead of their legal form
- Rules-based → has a lot of standards that focuses on diff aspects
- Diff situations have different accounting rules/standards to follow
(more rigid)
- Increases verifiability of the information included in the financial
statements, reduces managers misuse of their reporting discretion,
and increases the comparability of financial statements across
firms
- Random forecast errors (accrual accounting)
- Accrual accounting → the manager will make predictions based on their
expectation about future cash (e.g. selling on credit → recording a
transaction in accounts receivables)
- When client defaults, the company would have to make estimates
about the probability of whether the client will default or no
- Due to this accrual accounting, there might be errors due to the lack of
knowing what will happen in the future (bc you need to make judgment
based on the current environment → e.g. covid is very unpredicatble)
- Systematic reporting choices made by managers accounting choices to achieve
specific objectives
- Managers introduce noise into accounting data through their own
accounting decisions

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Accounting choices
- Accounting choices provide flexibility in how the financial statement preparers depict the
economic reality of different firms.
- There r certain areas where there r no flexibility (i.e. R&D cost r reported
differently in US GAAP & IFRS)
- For instance (below r the name of accounts used to allocate the cost of tangible fixed
assets. These accounts have flexibilities regardless of the accounting principles used):
- Depreciation (straight line/accelerated method), amortization, depletion
- Inventories (FIFO, LIFO)
- Revenue recognition (can be a problem when we have an aggressive revenue
recognition)
- Expenditures on assets (making investments of diff types of assets)
- In a case of maintenance/repair (i.e. leaking roof in the office), repairing
the leak would be considered an expense → they will not be capitalized
(transferring the expense to asset side to increase net income)
- Managers have a variety of incentives to exercise their accounting discretion to achieve
certain objectives:
- Capital market considerations: beating earnings forecasts (expectation of the
earnings of the company)
- Companies who perform below the expectation may have the incentive to
overstate their earnings to meet the forecast
- Managers may take decisions to influence the perception of capital
markets (can be successful when there r information asymmetry)
- Debt covenants: contracts with banks
- Managers make accounting decisions to meet certain contractual
obligations in their debt covenants by selecting the policies & estimates to
reduce the probability of covenant violation
- Management compensation: depend on profits
- Managers compensation & job security r tied to profits earned, thus why
managers may choose accounting policies that maximize their expected
bonus compensation
- Mergers and take-overs: corporate control contests
- In corporate control contests (hostile takeovers), competing management
groups attempt to win over the firms shareholders
- Managers may make decisions to influence investors perceptions in
corporate control contests
- The acquiring firms may overstate its performance to boost its share price,
which in turn reduces the share exchange ratio
- Tax considerations: relations with tax reporting
- Some firms may forgo tax reduction to report higher profits

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- Some firms may also report lower profit to reduce their tax payments
- Regulatory considerations: protecting domestic industries
- Managers may choose accounting decisions to influence regulatory
outcomes
- E.g. import tariffs → protects local producer from imported goods (local
producer may want to undervalue their performance to ask for this
protection)
- Competitive considerations: proprietary information → dont want to be
disclosed that much (nanti kalo competitor know too much about our company,
we might lose our competitive advantage)
- Stakeholder considerations: demands of labor unions
- Using accounting decisions to influence the perception of important
stakeholders in the firm
- Labor unions can use healthy profit to demand wage increase (used when
firms earn high profits)
- Managers may also make decisions to decrease profit when they are facing
union contract negotiations (so firms dont have to deal with the demands
of higher profits)
Steps in accounting analysis

Step 1: Identify key accounting policies (accounting policy disclosures)
- Firms have to choose accounting choices/policies that is related to the key drivers of
success of the company & risks → it differs from industry to industry
- Have to identify what r the main areas of accounting that is considered as the key
success factor and focus on that
- Examples:
- 1. in banking industry, when they give out loans, they need to take into account
the credit risk (due to this, they have to have a risk analysis → have to expect how
much theyre going to lose by giving out the loan)
- 2. for retail industry, the way we record inventories is a key success factor
(inventory management → the key accounting policy)
Step 2: Assess accounting flexibility
- Some firms have more flexible accounting standards than others
- Little flexibility → accounting data r likely to be less informative for understanding firms
economics
- Considerable flexibility → accounting numbers have potential to be informative,
depending on how managers exercise this flexibility
- E.g. under US GAAP, R&D will always be considered as an expense (theres no other way
the firm can report this)
Step 3: Evaluate accounting strategy

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- When firms have accounting flexibility, they can use it to communicate their firms true
economic situation or hide it
- Strategies to examine how managers exercise their flexibility:
1. Reporting incentives (covenants, M&As, bonus targets etc to manage earnings)
2. Deviations from the norm (do the policy used have the same norm with the
industry?)
a. Having deviations r fine, but we have to make sure that the deviations
have a purpose in the firm
3. Accounting changes (making changes in policies or estimates)
a. Making changes r not necessarily bad, but we need to look into it and see
what causes the accounting policies
4. Past accounting errors (r the estimates realistic in the past)
5. Structuring of transactions (lease term, Enron joint-ventures) → does the firm
structure any transactions to achieve certain accounting objectives?
a. Structuring transactions → firms might make the transaction in a way that
fits the accounting method/rule
Step 4: Evaluate the quality of disclosure
- Disclosure → the details that the report include
- Factors to increase firms disclosure quality:
1. Strategic choices (does the firm provide adequate disclosure)
2. Accounting choices (do the notes adequately explain the key accounting policy &
assumptions) → notes yg ada di annual report to explain in detail the numbers in
the financial statement
3. Discussion of financial performance (does the firm adequately explain its current
performance)
4. Non-financial performance information (does the firm provide adequate
additional disclosure to manage the non-financial aspects of the firm → e.g.
customer satisfaction, environment of the firm, any aspects that r not quantified
but may affect future performance)
5. Segment information (if firm has diff segments, is the quality of each segment
being disclosed)
6. Bad news (how does the firm deal with bad news, do the firm explain why their
performance drop)
7. Investor relations (how good is the relation between investor & firm, how easy it
is for shareholders to access information from the firm)
Step 5: Identify potential <red flags=
- After performing an overall analysis of the company, we need to identify what are the
main issues on which we need to focus our future efforts on.
- Future efforts = important use of resources
- Red flag analysis is only a starting point for further investigation

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- A red flag doesnt necessarily mean that its a problem, but it needs to be investigated
- Potential red flags:
- Unusual transactions/unexplained accounting changes especially when operating
profit is poor
- managers using their discretion to make the financial statement look nice
- Selling assets may indicate that there is a problem in the commpany
- When debt (liability) is converted to equity, it may signal that the firm is
trying to reduce its obligation
- Unusual inventory/receivables increases in relation to sales increases
- Need to look at the relation between inventories and sales
- When inventory increase significantly but sales remain the same, it may
signal that in the future, the inventory might be write-off
- Increasing gap between reported profits and operating cash flow
- This might indicate changes in the firms accrual estimates (which is based
on expectations)
- Increasing gap between reported profits and tax profits
- An increasing gap between a firms reported profits & tax profits may
indicate that financial reporting to shareholders has become more
aggressive
- Sale of receivables with recourse or special purpose entities
- Qualified audit opinions, key audit matters or changes in auditors
- New year-end date → the end of the financial year
- A company can postpone the disclosing of the financial statement (i.e. yg
harusnya december jadi july next year gt)
- Large year-end adjustments (interim reporting)
- Poor internal governance mechanisms (independent directors, internal auditors,
audit committee)
- Related party transactions: potentially self-serving → transactions made between
subsidiaries from the same company
- Taking advantage of minimizing tax
Step 6: Recast financial statements and undo accounting distortions
- In case of detecting financial reporting distortions, analysts should make adjustments for
these misstatements to reduce the distortions
- Best manner to do it: standardized accounting nomenclatures and formatting using
standard templates
- Helps ensure that performance metrics used for financial analysis r calculated
using comparable definitions across companies
Standardized financial statements (cek book page 88 Table 3.1 - 3.5)

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- Recasting financial statement is useful so that firms can compare its performance with
other firms
- International standards allows firms to classify their operating expenses in 2 ways:
- By nature → defines categories with reference to the cause of operating expense
- Make distinction between cost of materials, cost of personnel, cost of
non-current asset (depreciation & amortization)
- Less arbitrary & requires less judgement from management
- By function → defines categories with the purpose of operating expense
- Make distinction between costs incurred for the purpose of producing the
products or services sold (i.e. SG&A, cost of sales, etc)
- Provides better information about the efficiency & profitability of a firms
operating activities
- Main classifications:
- Cash flow statement → Operating, investment & financing activities cash flow
statement, financial, and operating results
- Balance sheet → Current and non-current assets/liabilities
- Balance sheet → Continued and discontinued operations predicting future
earnings
- Discontinuing operation by selling them → important when we want to
forecast future earnings
- Recurring (the activity is done repetitively) and non-recurring (only done this year
→ when the activity is being write-off) activities predicting future earnings
- Conservative vs Informative accounting
- Conservative accounting is not always good accounting
- Conservatism → reporting only the worst-case scenario
- I.e. when the firm is faced with bad news, the firm records them
immediately in accounting. But when theres good news, you hold on and
wait until its 100% sure that the good news will become reality
- A more conservative country will also have a conservative accounting
policy
- Informative → including all the relevant & available information when reporting
- Unusual accounting is not always bad accounting
- Firms’ circumstances may be different
- Mind firms’ business strategy
- Does the accounting reflect the competitive strategy?
- Accounting standards are not the same as practices
- Differences in firm’s - Differences in quality of
circumstances auditors
- Differences in enforcement - Differences in culture
rules

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Chapter 4: Accounting adjustments

- Dealing with the areas where we found some errors or do not agree with in terms of the
methods used
- Adjustments is made before going further into the financial analysis (computing
ratios)
Accounting adjustments
- Identify and undo accounting distortions
- analyzing elements of the balance sheet for possible distortions allows the analyst
to better understand the economic substance of a firm’s transactions and financial
position
- The balance sheet approach has the most common types of distortions
Asset distortion
- Assets: resources owned/controlled by the firm with probable future benefits that can be
measured reliably (that will generate value for the firm)
- Distortions in assets arise from whether:
- the firm owns/controls the economic resource (e.g. leases)
- A lease is not recorded as an asset, its recorded as rent expense
- future economic benefits can be measured with reasonable certainty (e.g. R&D)
- Research will always be recorded as an expense, but development can be
capitalized under certain circumstances (if its not capitalized, we will have
less asset on the balance sheet)
- fair value estimates are accurate (e.g. impairment, revaluation method)
- Above fair value → have to record an impairment to decrease the value in
the balance sheet
- Incentives for asset distortion:
- Incentives to inflate (or deflate) reported earnings can result in overstated assets
(and vice versa) → firms can also have the incentive to undervalue their earnings
- Bonuses - Trade unions
- Stock pledging - Government policies
- Stock based M&As - Earnings targets
- Covenants (analysts)
- Income smoothing → conducted to show a persistent level of earnings in
that period
- <Taking a bath= → Incentive to decrease earnings this period to look better
in the next period
- Common forms of overstating assets (to increase value of assets):
- Understated depreciation/amortization of non-current assets

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-Delayed write-downs of current or non-current assets

-Understated allowances (provisions)
- When a company sell on credit, they have to make an estimation about the
default risk of the customer
- The allowance will decrease account receivables → if we dont record a
high enough allowance, the asset will be overstated
- Accelerated recognition of revenues (channel stuffing)
- Recording revenue when its not the time yet
- Common forms of understating assets (to decrease value of assets)
- Leased assets (lessee) or intangible assets off-balance sheet
- If we dont classify the lease as finance, it wont appear as an asset
- Non-recognition (not recording) of deferred tax assets
- Overstated allowances
- Overstated depreciation/amortization of non-current assets
- Discounted receivables off balance sheet (lessor)
- Conservatism in IFRS may also result in understated assets
- e.g. research and advertising expenditures may not be capitalized
Liability distortion
- Liabilities: Economic obligations arising from benefits received in the past, for which
the amount and timing are reasonably certain (needs to be paid back)
- Types of liabilities:
- Harsh liabilities: recognized on the balance sheet (e.g. bank loan)
- Provisions: recognized on the balance sheet (highly probable liability, e.g.
warranty liability)
- Contingent liabilities: not recognized on the balance sheet, but should be included
in the notes bc it cannot be quantified yet & we dont know when its due (possible
future liability)
- The shorter the term of the liability, the less room for manipulation
- The <softer= the liability, the more room for manipulation (estimate)
- Common liability distortion:
- liabilities may arise from
- incentives to overstate earnings or the strength of financial position
- difficulties in estimating the amount of future financial commitments
- Common forms of liability understatement
- aggressive revenue recognition (e.g. unearned revenues)
- understatement of provisions (e.g. warranty liability)
- off-balance-sheet non-current liabilities (e.g. leasing, factoring with
recourse)

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- pension and post-retirement obligation understatements (not fully

recorded)
Equity distortions
- Equity: the residual claim on a firm’s assets held by stockholders (whats left for the
shareholders if we sell all asserts & pay liabilities)
- Assets = Liabilities + Equity
- distortions in Assets and/or Liabilities may lead to distortions in Equity
- Distortions in equity can also be caused by:
- Unrealized gains and losses (OCI) → recording the share price based on the fair
value in the market but bc its not sold yet, we dont know the real price hence why
its <unrealized=
- Stock options/Convertible debentures → bonds that can be converted into equity

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Lecture 3 (Chapter 5)
- Financial analysis: The application of analytical tools & techniques to the financial
statements and data to derive some estimates & gain inferences in business analysis
- This decreases the uncertainty when making decisions and reduce the reliance on
guesses & intuition → helps us in making an informed decision
Chapter 5: Financial Analysis

- Goal of financial analysis → assess the performance of a firm in the context of its stated
goals & strategy
- 2 principal tools:
- Ratio analysis: involves assessing how various line items in a firms financial
statements relate to one another
- It provides foundation for making forecast for future performance
- Cash flow analysis: examines the firms liquidity & how the firm is managing its
operating, investment & financing cash flows
Ratio analysis
- The value of a firm is determined by its profitability and growth
- Firms growth and profitability is influenced by its product market & financial
market strategies
- Product market strategy: implemented through the firms competitive strategy,
operating policies & investment decisions
- Financial market strategy: implemented through financing & dividend policy
- The four levers managers can use to achieve their growth and profit targets are:
- Operating management
- Investment management
- Financing strategy
- Dividend policies
- The goal of ratio analyses is to evaluate the effectiveness of the firm’s policies in each of
these areas

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- Also to evluate the success of firms business choices

- Using ratio analysis, analyst can make:
- Time-series comparison: compare ratios for a firm over time
- Analyst can hold firm-specific factors constant & examine the
effectiveness of a firms strategy over time
- Cross-sectional comparison: compare ratios for the firm and other firms in the
industry (one firm compared with other firms from the same industry)
- Analyst examines the relative performance of a firm within its industry,
holding industry-level factors constant
- Compare ratios to some absolute benchmark
- There is a lack of absolute benchmark when it comes to ratio analysis →
we always have to compare between different industries & firms within
the same industry
Definition of accounting items used in ratio analysis
Income statement items

- Interest expense after-tax → related to financing activity (e.g. paying interest when the
company has debt obligations)
- Needs to be taken out (subtracted)
- Net investment profit after tax (NIPAT) → profit/loss made from investing activities
- The company earns interest when lending money on another company, invest in
treasury bond, etc
- Through investment income, the company can use it to buy shares of another
company (investment income → dividend), or selling an asset (e.g. selling an old
computer is classified as investment income)

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- Net operating profit after tax (NOPAT) → any activities that r outside of the investing
activities
- Interest expense is added back bc when calculating for profit/loss, this interest
expense is being deducted
Balance sheet items

- Operating working capital → the capital required for running the daily operations of
the company
- excess cash & cash equivalents r taken out from assets bc its related to investing
activities (excess cash can be used for investment by the company)
- Excess cash is often an estimation bc we dont know how much a cash the
company has in excess (usually estimated as 5% of revenue, or compare
with the companys prev years performance)
- Not all companies have excess cash
- Current debt & current portion of non-current debt → taken out from liability bc
its related to financing activities (anything that has interest is considered as a
financing activity)
- Current debt → short-term debt thats paid back in less than a year for
which we pay interest (e.g. interest payable, overdraft, notes payable, etc)
- Current portion of non-current debt → a long-term debt (e.g. mortgage)
that we know how much we have to pay (interest, principal) this year (for
instance we have a mortgage loan that is paid in 30 years, but we already
know how much to pay in terms of principal and interest today)
- Net non-current operating assets → non-current operating assets r all assets that will be
used for more than 1 year
- <Net= means we need to take out some liabilities
- Derivatives can come from asset & liability (makanya itung as net)
- Non-interest-bearing non-current liabilities → any liabilities that is due in more
than 1 year but we dont have to pay interest for it (e.g. net deferred tax, warranty)
- Non-operating investments → recorded in the asset part in BS, but its non-operating
(not used for the core business activity of the company)
- minority equity investment → an investment in another company but the
investment is not large enough that we can control the company (21% - 49% →
pokoknya <50%)
- If we invest large enough (we can control the company), the firm needs to
disclose it in the financial statement
- Net operating assets → assets of a business directly related to its operations
- Business assets → items of value that your business owns, creates or benefits from (also
includes asset that is not related to operating activities)

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- Debt → liabilities that have both implicit & explicit interest (includes both current &
non-current debt)
- Invested capital → investment made by both shareholders and debtholders in a company
- When a company needs capital to expand, it can obtain it either by selling stock
shares or by issuing bonds
Measuring overall profitability

- Systematic analysis of a firms performance can be done by looking at its Return on
Equity (ROE)
- ROE: an indicator of a firms performance as it provides an indication of how well

managers r employing the funds invested by the firms shareholders to generate returns
- How much profit/loss the company made for each euro of funds invested by the
shareholders
- Industry average ROE is between 8% - 10%
- The ROE is the starting point for systematic analysis of performance
- In the long run, value of the firms equity is det by the relationship between its ROE and
its cost of capital
- Cost of capital (COC): return that the firms equity holders require on their equity
investment in the firm
- Firms that r expected over the long run to generate ROE > COC, should have
market value > book value and vice versa
- A company’s ROE is affected by two factors → how profitably it employs its assets and
how big the firm’s asset base is relative to shareholders’ investment
- With this, ROE can be decomposed into return on assets (ROA) & equity
multiplier (a measure of financial leverage) → the formula below is the traditional
approach
- ROA → explains how much profit a company is able to generate for each euro of
assets invested
- Equity multiplier → indicates how many euros of assets the firm is able to
deploy for each euro invested by its shareholders
- ROA can be decomposed into (traditional approach/DuPont analysis):

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- Return on revenue (ROR) or net profit margin → indicates how much the
company is able to keep as profits for each euro of revenue it makes
- Asset turnover → indicates how many euros of revenue the firm is able to
generate for each euro of its assets
Decomposing profitability (alternative approach of ROE)

- Even though the above approach is popularly used to decompose a firm's ROE, it has
several limitations
- In the computation of ROA, the denominator includes the assets claimed by all
providers of capital to the firm, but the numerator includes only the earnings
available to equity holders (after interest payments have been deducted).
- The assets themselves include both operating assets and investment assets such as
minority equity investments and excess cash.
- The profit/loss includes profit from operating & investing activities, and interest
income & expense
- No clear distinction between operating, investment, and financing activities
- The equity multiplier is a measure of financial leverage
- increases in financial leverage may have a negative effect on the company
(padahal formula wise, a higher equity multiplier leads to higher ROE)
- Company becomes riskier, may not be able to repay creditors,
interest for loans r likely to increase
- It is often useful to distinguish between the sources of performance:
- Valuing operating assets requires different tools from valuing investment assets.
- Operating, investment, and financing activities contribute differently to a firm's
performance and value, and their relative importance may vary significantly
across time and firms.
- The traditional decomposition of ROE does not make it explicit: whereas
the equity multiplier reflects the direct effect of leverage, the net profit
margin reflects the indirect effect.
- Financial leverage ratio used above does not recognize the fact that some of a
firm's liabilities are in essence non-interest-bearing operating liabilities
- These issues r addressed by using the alternative approach to decompose ROE

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- Return on invested capital (ROIC) → measure of how profitably the company

is able to deploy its operating & non-operating assets to generate profits
- This would be the companys ROE if it were financed with all equity
(when the company has no leverage/debt)
- Spread → the incremental economic effect from introducing debt into the capital
structure (tells us how a firm utilizes its debt & whether it makes sense or not to
introduce debt)
- This economic effect of borrowing is positive as long as the ROIC > cost
of borrowing
- A negative spread will reduce the firms ROE (hence why its preferable for
it to be positive
- Firms that doesnt earn enough returns to pay for interest cost reduce their
ROE by borrowing
- Firms can increase spread by increasing the level of leverage, which can
lead to a higher ROE. However, a very high level of leverage increases
equity risk and consequently, increases its cost of equity, thus reducing the
benefits of leverage
- Essentially, the higher the leverage the better as it leads to a higher ROE
- Financial leverage → ratio of firms debt to equity
- Spread x financial leverage → measures the financial leverage gain to
shareholders
- To separate the effect on profitability of a firms non-operating investment from its
operating activities, the ROIC can be split up into operating & investment component:
- The return that a firm earns on its invested capital (ROIC) is a weighted avg of its
return on net operating assets (RNOA) & its return on non-operating
investments (RNOI)
- For the average firms, the RNOI < RNOA → otherwise the firm wont be focusing
on its core operating business activities but on investment instead
- RNOI typically decreases the ROIC relative to the RNOA
- If RNOI > RNOA, the firm is doing better on its investing activities that
on its daily operating activities (which is what theyre supposed to be
doing)
- Return on net operating assets (RNOA) can be decomposed into NOPAT margin &
operating asset turnover

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- NOPAT Margin → measures how profitable a companys sales r from an

operating perspective (how much operating profit do the company make with
every euro generated in revenue)
- Net operating profit after tax (NOPAT) is a measure that shows how well a
company performed through its core operations
- Operating asset turnover → measures the extent to which a company is able to
use its net operating assets to generate revenue
- The appropriate benchmark for evaluating ROIC is the weighted avg cost of debt &
equity capital (WACC → weighted avg cost of capital)
- In the long run, the value of the firms assets is det by where ROIC stands relative
to this norm
- Over the long run & absent of some barrier to competitive forces, ROIC will tend
to be pushed towards the WACC
- Since WACC < cost of equity capital → ROIC tends to be pushed to a level lower
than that to which ROE tends
- The average ROIC for large firms in europe over long period is between 6% - 8%
Assessing operating management: decomposing net profit margins

- A firms net profit margin (ROS or ROR) shows the profitability of the companys
operating activities
- Further decomposition of the firm’s ROS allows analyst to assess the efficiency of the
firm’s operating management
- A tool used for this is the common-sized income statement in which all the line
items are expressed as a ratio/percentage of sales revenues (vertical analysis) →
see table 5.5 page 185
- The common-sized income statement allows comparison on trends in income statement
relationships over time for the firm & trends accross different firms in the industry
- The idea is to compare the company with itself by looking at prev years, with one of the
main competitor, or with the industry avg
Decomposition by function
- Some firms classify their operating expenses according to function
- This requires the firm to use judgment in dividing total operating expenses into
expenses that are directly associated with products sold or services delivered (cost
of sales → manufacturing cost) and expenses that are incurred to manage
operations (SG&A expense → non-manufacturing cost)
- This approach is more informative than decomposition by nature

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- Gross margin → an indication of the extent to which revenues exceed direct cost
associated with sales
- Gross margin is the difference between the firms revenue & cost of sales
- Gross margin is influenced by:

- The price premium that a firms product/service command in the market place
- The price premium is influenced by the degree of competition & the extent
to which its products r unique
- The efficiency of the firms procurement & production process
- The firms cost of sales can be low when it can purchase its input at a lower cost than
competitors and or run its production process more efficiently → case for a low-cost
strategy firm
- Selling, general & administrative expenses (SG&A) → influenced by the operating
activities it has to undertake to implement its competitive strategy
- A company competing on the basis of quality & rapid introduction of new
products is likely to have a higher R&D cost relative to a company competing on
a cost basis
- A company attempting to build a brand image, distribute its products through
retailers, and provide significant customer service is likely to have a higher selling
& administration cost relative to a company that sells through warehouse and
doesnt provide much customer support
- A companys SG&A r also influenced by the efficiency in how they manage its
overhead activities
- Stickiness of SG&Aexpenses occurs bc its costly for firms to temporarily cut
capacity in down periods & bring them back when sales recover
- E.g. in countries with a strong labor regulation makes it difficult for firms
to lay off/cutting back personnel when in time of crisis
- A retailers expenditures on procurement can be as sticky as selling expenditures
Decomposition by nature
- The international accounting rules require all firms reporting under IFRS classify and
disclose their operating expenses by nature in the income statement or in the notes to the
financial statements
- 4 expense categories (also known as drivers of consumption)
- Cost of materials - Depreciation & amortization
- Personnel expense - Other operating expenses
- advantage of classifying operating expenses by nature → these expenses can more easily
be related to their main drivers (such as the number of employees).

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- The total expense obtained will be the same when using both decomposition methods
- The only difference is how the firm reports/classify them. But the value remains
unchanged
NOPAT margin & EBITDA margin

- NOPAT margin → provides an indication of the operating performance of a company as
it reflects all operating policies & eliminates the effects of debt policy
- EBITDA margin → provides similar info as NOPAT margin, but it excludes
depreciation & amortization expense (a major part of the non-cash operating expense)
- EBITDA is not strictly a cash concept bc revenue, cost of sales, SG&A expenses r
included as non-cash items
- NOPAT is influenced by any non-recurring income (expense) items included in profit/loss

- If the profit/loss is largely influenced by the non-reccuring item, then it will be
hard to accurately predict what will happen in the future (solanya kan
non-reccuring jd its only a <one time= thing → e.g. writing off an obsolete
inventory)
Tax expense
- Taxes are an important element of firms' total expenses
- Two measures to evaluate the tax expense:
- the ratio of tax expense to sales (or revenue)
- the ratio of tax expense to earnings before taxes (average tax rate)
- A firms tax note provides detailed account of why its avg tax rate differs from the
statutory tax rate
- Statutory tax rate: the tax rate set by the govt (differs between countries)
- *if a firm doesnt make any profit, then they will not be asked to pay tax

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Evaluating investment management: Decomposing asset turnover

- Asset turnover is the 2nd driver of a companys ROE
- A detailed analysis of asset turnover allows analyst to evaluate the effectiveness of a
firms investment management
- 2 primary areas:
- working capital management: difference between a firms CA & CL
- This doesnt distinguish between operating components (e.g. trade
receivables, inventories & trade payables) & financing components (e.g.
excess cash, marketable securities, notes payable)
- Formula of operaring WC can be seen in the table above
- Manegement of non-current operating assets: A non-operating asset is a class
of assets that are not essential to the ongoing operations of a business but may still
generate income or provide a return on investment (ROI)
Working capital management

- The components of working capital thats primarily being focused on r
- Trade receivables - Trade payables
- Inventories
- A certain amount of investment is necessary to run its normal operations
- Operating working capital turnover: indicates how many euros of revenue a firm is
able to generate for each euro invested in OWC
- Trade receivables turnover, inventories turnover, trade payables turnover: examines
how productively the 3 principal components of OWC is being used → the higher the
better
- Trade receivables turnover: how many times within the year that the company
collects its receivables and converted to cash → a higher turnover rate is better as
it shows that the firm converts the receivables to cash faster

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- A high receivables turnover ratio can indicate that a company's collection

of accounts receivable is efficient and that it has a high proportion of
quality customers who pay their debts quickly.
- Inventories turnover: how many times inventories r sold (converted to sales) →
the higher the ratio, the better (cost of sales r recorded when the sales r made,
meaning that the inventories r converted to sales more times → the firm has no
problem in selling their inventory)
- A high inventory turnover means that goods are sold faster and a low
turnover rate indicates weak sales and excess inventories, which may be
challenging for a business
- The use of <cost of sales/materials= differs depending on the
decomposition by function/nature
- Trade payables turnover: how many times within the year that the company
pays its payables
- A high ratio shows that the company is paying its creditors and suppliers
quickly, while a low ratio suggests the business is slower in paying its bills
- Days receivables, days inventories, days payables: another approach to evaluate the
efficiency of a firms working cap management → the lower the better
- Days receivables: how many days does it takes for the firm to collect its
receivables → the lower the value (days), the better (meaning that the firm
collects their receivables quick)
- Days inventories: how many days does it take for the company to sell its
inventory
- Days payables: how many days does it take for the company to pay its payables
- The differences in the companies working capital management becomes more visible
when considering the
- Cash conversion cycle: avg number of days it takes each company to collect cash
from its customers since the moment it has paid its suppliers → the lower the
value the better as it implies that the company needs fewer days to recover money
spent on materials.
- Number of days taken for a company to convert its resources into cash
Cash conversion cycle = Days inventories + Days receivables - Days payables
Non-current assets management

- Includes the assets used for >1 year
- E.g. net PP&E, ingantible assets (goodwill), derivatives used to hedge operating
risk
- The efficiency in which a firm uses its net non-current operating assets is measured using
- Net non-current operating assets (as % of revenue)

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- Net non-current operating assets turnover: measures the revenue generated per
unit of non-current assets used
- As PP&E is the most important non-current assets in a firms BS, the efficiency in which
a firm uses its PP&E is measured by the ratio of PP&E to revenue
- PP&E turnover: how many euros of sales the company receives for each euro
invested in property, plant, and equipment (PPE)
- The higher the PPE Turnover, the more efficient we are with our capital
investments
Evaluating financial management: Financial leverage

- Financial management: how the firm is financing its activities
- Financial leverage: Use of liabilities aimed at increasing firms performance at the cost
of increasing financial risk
- Financial leverage enables a firm to have an asset base > equity
- Firms can increase its equity through borrowing & the creation of other liabilities (e.g.
trade payables, provisions, deferred tax)
- Financial leverage increases a firms ROE as long as the cost of liab. is less than the return
from investing these funds
- Financial leverage is
- Analysis of leverage can be performed on both current & non-current liab
- Liquidity analysis → evaluating the firms ability to repay its current liabilities
(measures the ability to meet short-term obligation of a company)
- Solvency analysis → evaluating the firms ability to repay debt (firm's ability to
meet its long-term debts and obligations)
- Interest-bearing liabilities: liab that charges interest (e.g. notes payable, other forms of
current debt, non-current debt that carry an explicit interest charge, and other forms of
liabilities)
- Non-interest-bearing liabilities: liab that doesnt carry interest (e.g. trade payables,
deferred tax)
- Financial lease obligation, pension obligations, etc → carry an implicit interest charge
- While financial leverage can benefit firms shareholders, it can also increase their risk
- Liabilities have predefined payment terms, and the firm faces risk of financial
distress if it fails to meet these obligations
- Financial leverage can increase ROE when its spread is (+)
Liquidity analysis (short-term)

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Used to evaluate the risk related to a firms current liab.
- These ratios measures the firms ability to repay its current liab.
- First 3 formula compares the firms current liab with its current assets that can be
used to repay those liab
- 4th formula focuses on the ability of the firms operations to generate the resources
needed to repay its current liab
- Current ratio: measures a company's ability to pay short-term obligations or those due
within one year
- key index of a firms short-term liquidity
- A current ratio > 1 indicates that the firm can cover its current liab from the cash
realized from its current assets
- However, firm can face short-term liquidity problem even with a current ratio > 1
when some of its current assets r hard to liquidate
- The higher the current ratio, the more capable a company is of paying its
obligations because it has a larger proportion of short-term asset relative to its
short-term liabilities
- Quick ratio: measures a company's ability to meet its short-term obligations with its
most liquid assets
- assumes that the firms trade receivables r liquid
- Trade receivables r expected to convert to cash quickly (whereas inventories
might take longer time)
- Quick ratio > 1 → the company owns more quick assets than current liabilities.
As the quick ratio increases, so does the company's liquidity. More assets can be
quickly converted into cash, if necessary
- Cash ratio: measures a company's ability to cover its short-term obligations using only
cash and cash equivalents.
- considers only cash & cash equivalents, bc its a better indication of a firms ability
to cover its current liab in an emergency
- Cash ratio > 1 means that a company will be able to pay off its short-term
liabilities with cash and cash equivalents, and have funds left over.
- Operating cash flow: measures the firms ability to cover its current liab from the cash
generated from the operations of the firm

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- Operating cash flow ratio: measures how much does the cash flow in a company
generated from operating activities can cover its current liab.
Solvency analysis (long-term)
- Companys financial leverage is also influenced by the firms debt financing policy
- Includes liabilities that has interest payments implicitly or explicitly
- Benefits from debt financing:
- Debt is cheaper than equity bc firm promises predefined payment tems to
debtholders
- In most countries, interest on debt is tax deductible (dividends to shareholders r
not) → interest tax shield
- Debt financing can impose discipline on the firms management & motivate it to
reduce wasteful expenditures
- Easier for management to communicate their proprietary info on the firms
strategies & prospects to private leaders (with debt) than to public markets (with
equity)
- such communication can potentially reduce firms COC
- To much reliance on debt financing can be costly to firms shareholders (taking a debt
itself has already increased the firms credit risk)
- Firm will face financial distress if it defaults on the interest & principal payments
- Debtholders can impose covenants on the firm, which restricts the firms
operating, investment & financing decisions
- The optimal capital structure of a firm is det by its business risk
- Firms CF r highly predictable when theres little competition or theres little threat of
technological changes
- Such firms have low business risk, giving them the ability to rely heavily on debt
financing
- If firms CF r highly volatile & its CapEx needs r unpredictable, it may have to rely
primarily on equity financing
- Liabilities-to-equity ratio: indicates how much liabilities (from operating

activities) a company is using to finance its assets relative to the value of its
shareholders equity
- Debt-to-equity ratio: indicates how much debt (from financing activities) a
company is using to finance its assets relative to the value of shareholders' equity
- The D/E ratio signals the extent to which shareholder's equity can fulfill
obligations to creditors, in the event of a business decline.

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- A low D/E ratio indicates a lower amount of financing by debt via lenders,
versus funding through equity via shareholders.
- A higher D/E ratio indicates that the company is getting more of its
financing by borrowing money, which subjects the company to potential
risk if debt levels are too high.
- Debt-to-capital ratio: a measurement of a company's use of financial leverage by
comparing its total obligations (interest-bearing) against its total capital
- the higher the debt-to-capital ratio, the riskier the company → this means
that the company is funded more by debt than equity, implying a higher
liability to repay the debt and a greater risk of forfeiture on the loan if the
debt cannot be paid timely.
- The ease in which firms can meet its interest payments is an indication of the degree of
risk associated with its debt policy → can be estimated using the interest coverage ratio
- Interest coverage ratio: a debt and profitability ratio used to determine how
easily a company can pay interest on its outstanding debt.
- Earnings based: indicates the euros of earnings available for each euro of
required interest payment
- Cash flow based: indicates the euros of cash generated by operations for each
euro of required interest payment
- More informative (its based on cash so its less likely to be manipulated)
- Taxes r added back into the calculation bc taxes r computed only after interest
expense is deducted
- A coverage ratio of 1 → firm is barely covering its interest expense through its
operating activities (very risky)
- The larger the coverage ratio, the greater the cushion the firm has to meet
its interest obligations → a high ratio indicates a strong financial health as
it shows that the company is capable of meeting interest obligations
- The lower the ratio, the more the company is burdened with interest
expenses & that the company is more vulnerable to interest volatility
Sustainable growth rate

- Sustainable growth rate: measures the rate at which the company can grow while
maintaining its profitability and financial policies
- Sustainable growth is used to evaluate a firms ratio in a comprehensive manner

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- The rate provides a benchmark against which a firms growth plans can be
calculated
- The firms ROE & dividend payout policy dets the pool of funs available for growth
Sustainable growth rate = ROE x (1 - Dividend payout ratio)
- Dividend payout ratio: a measure of the firms dividend policy

- Reasons for paying dividend:
- It provides a way for the firm to return to its shareholders any cash
generated in excess of its operating and investment needs
- Dividend payment serves as a signal to shareholders about managers
expectations of the firms future prospects
- To attract a certain type of shareholders
Cash flow analysis

- Cash flow analysis can provide further insights into operating, investing, and financing
activities
- Cash flow from operation: cash generated by the firm from the sale of goods &
services after paying for the cost of inputs and operations
- Cash flow from investment: cash paid for CapEx, intercorporate investment,
acquisition, and cash received from the sales of non-current asset
- Cash flow from financing: cash raised from (or paid to) the firms shareholders &
debt holders

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- All companies using IFRS are required to include a statement of cash flows in their
financial statements
- Two methods of computing cash flow from operations: direct vs. indirect
Profit or loss = CFO + Accruals (net)

- Direct cash flow: operating cash receipts and disbursements r reported
directly
- Indirect cash flow: firms derive their operating cash flow by making
accrual adjustments to profit/loss → a more useful approach bc it links the
cash flow statement with the firms IS & BS
- Factors affecting firms ability to generate positive cash flow from operations:
- Firms in a steady state should generate more cash flows from their customers than
they spend on operating expenses
- Growing firms however, r more likely to experience negative cash floes bc theyre
making heavy investments in R&D, advertising & marketing, building a brand to
sustain future growth, etc
- Firms working capital management also affects the firms ability to generate positive cash
flow from operations
- Firms in growing stage → invest cash flow in operating working capital items
including accounts receivables, inventories, accounts payable
- Net investments in WC is a function of firms credit policies (trade receivables),
payment policies (trade payables, prepaid expense & provisions), and expected
growth in sales (inventories)
- Thus, when interpreting gitms cash flow from operations after its WC, its
important to take into account their growth strategy, industry characteristics &
credit policies
- Cash flows made on lon-term investments comprise of CapEx, intercirporate investments
and M&A
- Any positive cash flow from operation after making OWC investments allows the
firm to putsue long-term growth opp.
- If the firms operating cash flow after WC investments r not sufficient to finance
its LT investment, it has to rely on external financing to fund its growth
- Such firms have less flexibility to pursue LT investment compared to those
who fund them internally
- Any excess cash flow after making LT investment is FCF that is available for both debt
holders & shareholders
- Payment to debt holders include interest & principal payments
- Firms with neg FCF have to borrow additional funds to meet their interest & debt
repayment obligations, or cut some of their investments in WC of LT investments,
or issue equity
- Cash flows after payments to debt holders is FCF to shareholders

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- Payment to shareholders consists of dividend payments or share repurchase

- If firms pay dividend despite having neg CF, they r borrowing money to
pay these dividends
- While this is feasible in the ST, its not recommended for firms to pay
dividend unless it has a positive CF
- Firms that have large FCF after debt payment run the risk of wasting the money
on unproductive investments to pursue growth for its own sake

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- Prospective analysis → an analysis that includes both forecasting & valuation to
explicitly summarize the analysts forward looking views
- Why prospective analysis? → to make forward looking decisions by making a proper
accurate prediction about the operations of the company
- This analysis allows us to gain an understanding of the firms future changes in
economy, industry, staregy, and its future financial performance
Overall structure of the forecast

- Forecasting is an important steps in financial analysis as forecasting allows us to change
the numbers, value, and impression of the company
- Its like a <reverse financial analysis=, where we make prediction about the firms
performance
- In order to do forecasting, we need to understand the companys past performance, its key
drivers, etc that is obtained from the financial analysis
- We need to consider all the facts that we know in order to make the prediction
- The best way to forecast future performance is to do it comprehensively, by producing
earnings forecast, cash flow forecast and balance sheet forecast.
- Can be done by using the comprehensive forecasting approach
- The comprehensive forecasting approach is useful because it guards against
unrealistic implicit assumptions
- The comprehensive approach involves many forecasts, but in most cases they are all
linked to the behaviour of a few key drivers, such as sales (revenue) forecast and profit
margin
- Key drivers → the items that generate profit in a company (first thing to do when
forecasting is to determine its key drivers)
- This key drivers vary according to the type of business/industry
- By linking forecast to the revenue forecast, the firms can avoid internal
inconsistencies & unrealistic implicit assumptions
- E.g. key drivers of an airline company → the capacity of the airplane (how many
seats available in each company)

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- The airline company can sell as much tickets as they want but if they dont
have the capacity to take every customer, then it would be useless
- Whether the company is performing well in terms of its capacity (r they
able to operate under full capacity or not) needs to be accounted for when
making forecast
- E.g. key drivers of service business (e.g. food delivery) → number of ppl
subscribed to the service, the capacity (number of deliverer)
- The future of the company does not only depend on the past financial numbers, it is
highly affected from the behaviors of the management
Steps to forecasting
#1 - Determine key performance
drivers
- The first thing that we’re going to
look for is their sales revenue
- Some ppl tend to go for the
price of the products to
make the estimation (this
might not give an accurate
answer bc the price of a
product is affected by
outside factors e.g.
inflation, COGS, etc)
- Instead, the volume or products sold (capacity) should be use as the base for the
estimation as it gives a more real estimate of the company
- Until you manage to find the final item that drives the firms revenue, you have to keep on
digging into the details of the firms sales
#2 - Make expectations
- After the key driver is determined, make an assumption of the direction of the change
- Will the key driver increase or decrease sales in the future based on the
information that is already available in the current & previous year
- Next, determine how do we want to quantify the expectation (how much will the key
drivers increase/decrease the sales revenue in the future)
How to determine the direction & percentage of change? (refer to #2)

- Past performance of a firm can be used as a starting point to eunderstand the behavior of
key measures such as sales or earnings
- Studying the time series of measures such as earnings can provide insights into
trends for future performance

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- Measures from prior periods provide benchmarks to compare forecasts against

(the past performance will be used as a reference point to forecasting → ideally,
we can take the average of the data from last 2 years for the estimation)
- To determine the percentage of change, dont use horizontal analysis. Use vertical analysis
instead
- Horizontal analysis → analysis yg kek lo liat in the past years sales revenue of the
firm change nya by brp % and then u base your forecast on that
- Vertical analysis → taking the % of each item to a common based number
(usually we base it on sales → % of an item to sales)
- If we manage to determine key driver, we can forecast sales. If we can
forecast sales, we can forecast the rest
- If we dont have any further information regarding the item that we forecasted,
then we can assume that the numbers will remain constant over the years based on
the prev years
Key accounting measures

- Sales growth tend to be mean-reverting
- In a sense that whatever the performance of a firm is like (mau bagus diawal kek
mau jelek diawal kek, it will always revert back to the mean)
- We also need to observe the behavior of competitors
- On average, earnings follow a random walk (hard to estimate). Long-term trends tend to
be sustained.
- Return on Equity (ROE) depends on both earnings and the asset base. Patterns tend to be
mean-reverting
A practical framework for forecasting - How to forecast?

- The most practical approach to forecasting a companys financial statement is to focus on
projecting its condensed financial statement as opposed to a detailed financial statement
- It requires the firm to prepare a condensed balance sheet and income statement
- Steps of forecasting process:
- Step 1: Predict changes in environmental and firm-specific factors (e.g.
relationship with customer, number of employees, BOD, business units, etc)
- Any changes in the environment/firm itself, no matter how small or big,
might give an indication of the firms future performance
- Step 2: Assess the relationship between step 1 factors and financial
performance/analysis
- Step 3: Forecast condensed financial statements
Step 1: Predict changes in environmental and firm-specific factors
- Macroeconomic analysis → e.g. how does the war, pandemic, etc affect the firms
performance and what does it imply about the firms future performance)

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- Industry and business strategy analysis → the strategy used that will affect the sales of
the company
- Accounting analysis → quality of the reporting items
- Things that can be considered when predicting the direction & percentage of change:
Step 2: Assess the relationship between step 1 factors and financial performance
- Making the financial analysis based on:
- The sources of performance in previous years?
- Economic factors causing the firm’s profitability (loss) and by how much
- Are these factors and their performance effects permanent or transitory?
- The pattern (trend) in financial performance?
- Are there any reasons why this trend is likely to continue or change?
Step 3: Forecast condensed financial statements

In order to do this, estimate the following:
- Condensed Income Statement (items to forecast):
- Sales - Interest expense after tax
- Net operating profit after tax - Net Profit
(NOPAT)
- Net investment profit after
tax (NIPAT)
- Condensed Balance Sheet:
- Net operating working capital - Investment assets
- Net operating non-current - Debt to capital
assets

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- Valuation is the 2nd and final step of prospective analysis after forecastin
- Valuation: process of converting a forecast into an estimate of the value of firm’s asset or
equity
- Its useful for:
- Capital budgeting → involves consideration of how a particular project will affect
firm value
- Strategic planning → focuses on how the value of a firm is influenced by larger
sets of actions
- Security analysis → conducts valuation to support their buy/sell decisions
- Potential acquirers → estimate the value of target firms & the synergies they
might offer
- Credit analyst → implicitly consider the value of the firms equity <cushion= to
maintain a complete view of the risk associated with lending activity
- Different methods of valuation (in this course, focus is on 2nd and 3rd method):
- Discounted dividends: expresses the value of firms equity as the PV of
forecasted future dividends
- Discounted cash flow (DCF) analysis: involves the production of detailed,
multiple-year forecasets of cash flows. The forecasts r then discounted at the
firms estimated COC to obtain the PV
- Discounted abnormal profit: value of the firms equity is expressed as the sum of
its book value and the PV of forecasted abnormal profit (loss)
- Discounted abnormal profit growth: defines the value of firms equity as the
sum of its capitalised next-period profit/loss forecast and the PV of forecasted
abnormal profit growth beyond the next period
- Valuation based on price multiples: the current measure of performance or
single forecast of performance is converted into a value by applying an
appropriate price multiple derived from the value of comparable firms
- Regardless of which method is used to value the company, we should arrive at the same
result
Discounted Dividends Valuation

- The present value of future dividends to shareholders is the basis of the discounted
dividends method
- Since shareholders receive cash payoffs in the form of dividends, the value of
their equity is the PV of future dividends
- rc → cost of equity capital

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- The equation above represents the analysis over an indefinite period. In reality, firms can
go bankrupt or get taken over
- If this is the case, shareholders will receive a terminating dividend on their shares
- Terminal value: the expected value of equity at the end of the forecast horizon
Discounted Cash Flow Model

- The present value of free cash flows to equity shareholders is the basis of the discounted
cash flow model
- The value of an asset or investment is the PV of the net cash payoffs that the asset
generates
- BVA → book value of assets (changes in WC + investment expenditure -

depreciation & amortization expense)
- BVD → book value of debt (interest-bearing debt)
- Example:
Discounted Abnormal Earnings

- Abnormal earnings: Also known as unexpected earnings, which refers to the situation
when the firm earns a higher/lower than normal profit
- E.g. when investors expect a 10% ROE from the firm but it turns out that the
firms ROE is 12%, the 2% additional ROE is known as the <abnormal earnings''
- The amount that deviates from expectation
- Re * BVE → Capital charge (also known as the <normal= earnings)

- Thus, the equity value using abnormal earnings method will be:

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- Example:
Discounted Abnormal Earnings Growth

- Abnormal earnings growth: the annual change in abnormal earnings
- Example:

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NOTE: In theory, regardless of which approach used to calculate the firms value, we should
obtain the same result. But in reality, its almost impossible to arrive at the same result bc of the
terminal value assumption
Valuation Using Price Multiples

- Typically used when you have limited information about the firms financial performance
or when a financial analysis is not available
- This method does not require a detailed multiyear forecast of a number parameter (e.g.
growth, profitability & COC)
- Under this approach, analysts rely on the market as a benchmark to value their own
company
- Analysts assumes that the pricing of those other firms is applicable to the firm at
hand
- Valuation using multiples involves the following three steps:
- Step 1: Select a measure of performance or value (e.g., earnings, sales, cash
flows, book equity, book assets)
- Step 2: Calculate price multiples for comparable firms, i.e., the ratio of the market
value to the selected measure of performance or value
- Step 3: Apply the comparable firm multiple to the performance or value measure
of the firm being analyzed
- Example:
Comparing valuation methods

- No one method is superior to the others
- Using the same assumptions about the firm fundamentals should yield the same value
estimates from either of the 4 methods used
- However, the 4 method still differ in the following aspects:
- Focus on earnings or cash flow (cash & profit is different due to accrual
accounting)

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- e.g. accounts receivables (its recorded as sales when the payment is made
but the firm hasnt obtain the payment yet hence the cash doesnt change)
- Amount of analysis or structure required
- Terminal value implications
Key issues to implement valuation

- Before actually conducting the valuation, there r 3 things that needs to be considered:
1. Estimate the COC to discount the forecasts
- The COC differs for every valuation method
- The key drivers and COC (discount rate) have to match one another
2. Make forecasts of financial performance stated in terms of abnormal profits and
book values, or FCF, over the life of the firm
- Needs to arrive at a forecasted terminal value
3. Need to choose between an equity valuation or asset valuation approach
- There r cases where asset valuation is the better approach compared to
equity valuation
How to value a firm?
- Claims → Liability (debtholders) + Shareholders equity (equity holders)

- In the assets side, asset is decomposed into operating asset and investment asset
- Operating asset → all the assets used for the main operations of the company
- Investment asset → all other assets that r not connected to the main operation of
the company
- According to the table above, each performance driver has a different discount rate
- We can apply all the valuation approach by changing the performance driver and
the discount rate depending on what performance driver we want to value
How to compute Cost of Equity (re)

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- Common approach: Capital Asset Pricing Model (CAPM)

- The idea of CAPM is that investors only care about the risk that an asset
contributes to their portfolio, and thus want to be compensated for this
- Cost of equity is the sum of (i) the risk-free rate and (ii) the premium for systematic risk
- Risk-free rate (rf): Rate on intermediate-term government bonds

- Market Risk Premium [E(rm) - rf]:Excess of the expected return on the market
over the risk-free rate
- Beta (ß): (Adjusted) historical association between firm-specific and market
returns
- The CAPM model however, is not a complete method to measure COE
Adjusting cost of equity (re)

- The cost of equity can be adjusted based on the firm-specific item (it needs to consider
these effects)
- Size effect: certain firms have different beta values (smaller firms will have
higher betas as they are more riskier than bigger firms) → we need to adjust the
value of equity according to the size of the firm
- Leverage effect: the beta risk of a firms equity changes as a function of its
leverage
- As the leverage increase, the sensitivity of the firms equity performance to
economy-wide changes also increases
- The higher the leverage, the higher the beta level, the riskier the firm
- For financially healthy firms, we assume that beta investment and beta
debt is 0 (the bottom part of the formula is not relevant) bc there shouldnt
be any risk in their investment assets and debt (ß = 0 → no risk)
- Non-Operating Investments effect: more investment assets implies lower beta
(company is not as risky) bc they have the investment to finance whatever
liability they have
Computing weighted average cost of capital (WACC)

- WACC: The appropriate discount rate to value a company’s assets (debt plus equity). It
takes into account debt and equity sources of financing

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- For most firms, the WACC is not equal to the required return on business assets, which is
the return that we obtain when computing the beta of business assets on the CAPM
formula
Computing return on operating assets (rNOA)

- To value a companys net operating assets (NOA), the analysis discounts abnormal net
operating profit after tax (NOPAT), abnormal return on net operating assets (RNOA), or
FCF on operating assets
- For a financially healthy firms whose investment assets and debt consists of low risk
instruments (e.g. excess cash, fixed income securities, etc), the beta of non-operating
investment (investment asset) and debt = 0
- To check whether a company is financially healthy, we can look at the auditors
report made for the firm and see whether the auditor has a going concern on the
company or not
- For a financially healthy firm, we can assume that the firm will continue its
activities for the foreseeable future
Detailed Forecasts of Performance

- Use forecasted condensed financial statements to determine:
- Abnormal earnings = Net profitt – (re * BVEt-1)

- Abnormal NOPAT = NOPATt - (rNOA * total net operating assetst-1)
- Abnormal NIPAT = NIPATt - (rNIA * total net investment assett-1)
- FCF from operating & investment asset = FCF to debt and equity holders
- Using asset valuation method
- Itung FCF to equity gausah pake BVE lagi
- BVE cuma dipake pas itung abnormal earnings and abnormal NOPAT

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Terminal Value
- Terminal Value: the final year of the forecast and represents the PV of future abnormal
earnings or free cash flows for the remainder of the firm’s life
- Beyond the terminal value, we make an assumption of how much it will grow
based on the key drivers of the company
- In practice, the forecasting period is usually 10 years
- If we dont know how long it will take for the company to keep going, we can asume that
the company will continue their operations forever
- The green part can be adjusted depending on which performance driver you want
to calculate → remember to also adjust the discount factor accordingly
- First calculate the TV, and then discount it to find the PV
Practical issues in valuation

- Accounting distortions → Accounting choices, though self-correcting, affect both
earnings and book value
- Negative book values → Start-up firms and firms in certain industrial sectors, etc, may
have negative book equity
- if the book value of equity (BVE) is negative to begin with, dont try to make the
valuation from an equity perspective (try to use the asset approach instead)
- Excessive cash balances and cash flows → Firms with cash beyond the level required to
finance operations warrant further investigation to understand whether the excess cash
indicates corporate governance problems

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Lecture 6 (Chapter 9 & 10)

- Sources of finance: how firms raise money to finance their resources
- Claims → Liability + assets

- Liability → external claims (involves external parties such as bank, creditors, etc)
- These external parties focuses more on the downside risk of debt financing
for the firm bc they lack the access to companys complete information
- Shareholders equity → internal claims (involves internal parties such as investors)
- As a shareholder, you’re interested in the risk and also the companys
potential future (not all shareholders have equal access to companys
complete information → the larger the shares you hold, the larger the info
you can get)
Equity security analysis

- Equity security analysis: The evaluation of a firm and its prospects from the perspective
of a current or potential investor in the firms’ shares
- The process of gathering and organizing
information and then using it to determine the
intrinsic value of a firms’ equity
- Intrinsic value: The underlying or inherent value of a
share, as determined through fundamental analysis
- A prudent investor will only buy a stock if its
market price does not exceed what the investor
thinks the share is worth
- The intrinsic value can be compared to the market price to det the
over/underpriced shares on the market
- Aim of security analysis:
- Determining the (best) investment opportunities → this can be done by:
- Establishing investment objectives
- Developing expectations about future returns and risks of individual
securities

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- Combining individual securities into portfolios that meet investment

objectives
- Projecting future returns and assessing risk
- Identification of mispriced stock
- Prospective analysis is central to security analysis
Risk tolerance
- We need to understand what is the risk tolerance/profile of an investor
- Depending on the risk profile, we can make a suggestion for the investor that suits
them best (if theyre less risky, we can suggest them to take the least risky stocks)
Equity Security Analysis & Market Efficiency

- Efficient market hypothesis: The efficient markets hypothesis posits that security prices
reflect all available information fully and immediately upon its release
- In a perfectly efficient markets → impossible to identify mispriced stocks
- Role of financial statements
- If markets are extremely efficient, the few who receive newly announced financial
information could trade advantageously on it before it is fully disseminated to the
rest of the market
- Once we believe that the market is efficient, we stop doing security analysis. But once we
stop the security analysis, the market becomes inefficient causing mispriced shares.
- The ones still having security analysis will take the advantage, making the market
efficient again → its a constant cycle
- If we want the market to be efficient, we need to keep having security analysis
Who Needs Security Analysis in an Efficient Market?

- Fundamental analysis is still important because:
- All of the people doing fundamental analysis is the reason the market is efficient
- Financial markets may not be perfectly efficient

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- Pricing errors are inevitable
Security Analysis - Traditional Approach <Top Down=

1. Step 1: Economic Analysis
a. A study of general economic conditions that is used in the valuation of shares
(GDP, inflation, production level, individual income, interest rates, exchange
rates, etc.)
2. Step 2: Industry Analysis
a. Evaluate the competitive position of a particular industry in relation to other
industries (new opportunities, growth potential, etc.)
b. Identify companies within the industry that look promising (market positions,
pricing leadership, economies of scale, etc.)
3. Step 3: Fundamental Analysis
a. Financial condition of a specific company
b. Historical behavior of a specific company’s shares
Security Analysis – A Comprehensive Approach

1. Step 1: Selection of candidates to analyze
a. Since we cannot value all of the shares available in the market, we need to select
by industry, sector, etc
b. Specialization by industry sector or potential mispricing basis allows more depth
of analysis.
2. Step 2: Inferring market expectations
a. Identifying potentially mispriced securities requires a comparison of the analysts
expectations with those of the market
b. The analysis that we made ourselves needs to be compared with the information
available in the market so we can make a more accurate decision making
3. Step 3: Developing analyst’s expectations
a. Forecasts of earnings and cash flows along with an estimate of value must be
derived from the analyses performed
4. Step 4: The final product of security analysis
a. Financial analysts must ultimately recommend some action to take on a security
based on the analyses conducted
Final product of security analysis

- The strategy is straightforward
- Intrinsic value > Market value → BUY
- Intrinsic value < Market value → SELL
- Intrinsic value approximates Market value →
HOLD or REVIEW

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Credit analysis
- Credit analysis: the evaluation of the risk of a firm in terms of repayment ability from
the perspective of a current or potential holder of its debt, trade payables, loans or any
liability
- When a company gets credit from an external party, this external party want to
understand whether the company has the ability to repay them
- A key element of credit analysis is the prediction of the likelihood a firm will face
financial distress
- Numerous parties are interested in the credit-worthiness of a company → banks,
investors, suppliers, auditors, and employees, etc
- Debt is an important source of financing, though there are trade-offs in financing with
debt instead of equity capital
Why Firms Use Debt Financing

- Equity financing is relatively more expensive compared to debt financing
- Interest tax shields
- Corporations or other taxable entities are able to deduct interest paid on debt as an
ordinary business expense
- There r no corporate tax shield on dividend payments or retained earnings
- Management incentive alignment
- Leverage imposes a discipline on management to create value, reducing conflicts
of interest between managers and shareholders
- Firms with a relatively high leverage r pressured to generate cash flows to meet
the payments of interest & principal, reducing the resources available to fund
unjustifiable expenses & investments that dont maximize shareholder value
Potential Downsides of Debt Financing

- Increasing levels of debt financing may be accompanied by a higher likelihood of
financial distress → a situation where firms r unable to meet itnterest or principal
repayment obligations to creditors
- Financial distress has some of the following negative consequences:
- Legal costs (direct cost)→ restructuring the company in the event of bankruptcy
is costly as there r numerous parties involved (lawyers, bankers, accountants, etc)
and firms still need to pay additional cost if there r additional legal proceedings
- Damage to ability to raise capital → distressed firms face significant challenges
in raising capital as potential new investors & creditors will be wary of becoming
involved in the firms legal dispute
- Cost of conflicts between creditors and stockholders → in the event of
financial distress, creditors focus on the firms ability to service its debt while
shareholders worry that their equity will revert to the creditors if the firm defaults

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(soalnya debtholder pasti dibayar duluan and kalo ada sisa, baru dikasih ke equity
holder)
- Firms r likely to fall into financial distress if they have high business risks & their assets r
easily destroyed in financial distress.
- In contrast, firms with tangible assets can sell their assets if they got into financial
distress, providing additional security for lenders & lowering the cost of financial distress
- Firms with intangible assets r less likely t obe highly leveraged than firms whose
assets r more tangible
The market for credit

- Below r the list of major suppliers of
debt financing
- Commercial banks
- Non-bank financial institutions
- Public debt markets
- Sellers who provide financing
(e.g. suppliers of the company)
Country Differences in Debt Financing

- The extent to which national bankruptcy laws protects debt providers affects their debt
financing practices (the creditors attitude, intention, etc in offering credit to firms)
- In certain countries, creditors r well protected and in other, they r not well
protected
- Responses to weak protection for creditor (in countries with weak protection):
- Multiple-bank borrowing → borrowing smaller proportion of debt from
multiple banks (loan syndication) so the risk r allocated over numerous banks
- Supplier financing → when a firm buys the supplies from the supplier using
credit (accounts payable to suppliers → extending repayment to supplier)
- Off-balance sheet financing → when the liability is not seen/recorded in the
balance sheet (through factoring). This practice helps companies keep
debt-to-equity and leverage ratios low, resulting in cheaper borrowing and the
prevention of covenants from being breached.
- OBSF is commonly used by businesses that are highly leveraged,
especially when taking on more debt means a higher D/E ratio, leads to an
increase risk in default
- This practice involves omitting certain capital expenditures or assets from
the balance sheet. This means shifting ownership to other entities like

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partners or subsidiaries in which the company secures a minority claim

(e.g. through JV, R&D, partnership, operating lease).
- Public debt → companys can also resort to public debt when there r weak
protection against creditors (e.g. govt bond, the company issuing its own bonds
and ask the public to buy the bond, etc)
- Optimal mix of debt and equity
- In countries with borrower friendly and creditor unfriendly bankruptcy laws:
- Creditors extend more short-term debt because this allows them to
frequently review the borrower’s financial position and adjust the term of
the loan when necessary.
- Companies make greater use of supplier financing.
- Companies make greater use of off-balance sheet financing such as
factoring of customer receivables.
- Public debt markets tend to be more developed
Analyzing credit
- Credit analysis is more narrowly focused than estimating the value of a firm’s equity
- Business strategy, accounting, financial, and prospective analyses are still important
- The better a firm’s future business prospects, the lower the risk to the creditor
The Credit Analysis Process in Private Debt Markets

1. Consider the nature and purpose of the loan
a. This helps with structuring the terms and duration of the loan (maturity), along
with the rationale for borrowing
b. The size of the loan must be set
2. Consider the type of loan and available security
a. There are numerous types of loans are available from open lines of credit to lease
financing
b. The type and amount of security needed to collateralize a loan must be established
c. We need to know what type of loan the firm is asking for and what security does
the firm has available to repay the loan
3. Conduct financial analysis
a. Comprehensive analysis of business strategy, accounting, and financial aspects of
the firm
b. Ratio analysis is useful, particularly ratios addressing the ability to make loan
payments
i. Liquidity analysis - short term ability to pay its debt
ii. Solvency analysis - long term ability to pay its debt (firms ability to
sustain its activity into the long term)
4. Assemble loan structure and debt covenants

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a. Some covenant terms include the borrower maintaining specific financial

conditions
b. For example:
i. Maintenance of minimum net worth
ii. Minimum coverage ratio
iii. Maximum ratio of total liabilities to net worth
iv. Minimum net working capital balance to current ratio
v. Maximum ratio of capital expenditures to earnings before depreciation
Financial Statement Analysis and Public Debt

- The credit worthiness of public & private debt is different → to assess the credit
worthiness of public debt, we use credit ratings
- Debt ratings provide important information to investors
- The meaning of debt ratings
- Standard & Poor’s has a rating system from D to AAA that grades the relative
riskiness of debt
- Debt ratings influence the yield that debt instruments must pay for investors to
buy them
- Factors that drive debt ratings
- Performance measures are used to gauge the expected future health of the firm
and the ability to repay debt
Prediction of Distress
- Models for distress prediction
- One of the more popular and robust models is the Altman’s Z-score model:
- X1 = net working capital/total assets (measure of liquidity)

- X2 = retained earnings/total assets (measure of cumulative profitability)
- X3 = EBIT/total assets (measure of return on assets)

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- X4 = market value of equity/book value of total liabilities (measure of market

leverage)
- X5 = sales/total assets (measure of sales generating potential of assets)
- Z < 1.81 → Bankcruptcy
- 1.81 < Z < 2.67 → <gray area=
- Z > 2.67 → the company is financially healthy and there is no possibility of distress

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How much debt is right?
ROE Decomposition
ROE 2020 2021 Formula
Net operating profit Margin NOPAT / Revenue

(NOPAT margin)
x Operating asset turnover Revenue / Operating

asset
= Return on operating asset
Return on operating asset
x Operating asset / Invested

capital
+ Return on investment asset NIPAT / Non-operating

investment
x Investment asset / Invested

capital
= Return on invested capital

(ROIC)

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Spread ROIC - (IEAT/Debt)
x Financial Leverage Debt / Equity
= Financial leverage gain
ROE = ROIC + Financial

leverage gain
Valuation Method (Equity valuation) - Abnormal Earnings

2021E 2022E Formula
Abnormal earnings Profit/loss - (re*equity prev

year) → kalo yg dicari tahun
2021, pake equity value 2020
Discount factor 1/(1+re)n
PV abnormal earnings AE * Dis factor
Sum of PV abnormal Sum of all PV abnormal

earnings earnings
Beginnng BV equity Take the value from the

previous year (in this case,
2020)
Terminal value AE at last year *((1+Growth

beyond terminal year)/(re -
growth))*Disc factor at last
year
Equity value (2020) sum PV AE + beginning BV

equity + TV
Equity value (2021) Equity value (2020) *

(1+re)^(gap dr tanggal sebelom
and yg dicari/365)
Equity value per share (2021) Equity value (2021) / SO

- Kalo disuruh cari discounted FCF to equity, use the same table tp gausah include
Beginning BV equity (BV equity is only used when calculating AE and Abnormal
NOPAT)

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Valuation Method (Asset valuation) - FCF to equity & debt holder

2021E 2022E Formula
FCF to debt & equity Profit/loss - (re*equity prev

year) → kalo yg dicari tahun
2021, pake equity value 2020
Discount factor 1/(1+re)n
PV FCF to debt & equity AE * Dis factor
Sum of PV debt & equity Sum of all PV abnormal

earnings
Terminal value AE at last year *((1+Growth

beyond terminal year)/(re -
growth))*Disc factor at last
year
Asset value sum PV AE + TV
Book value of debt Net asset (given) - BVE (given)
Equity value Aseet value - BV debt
Equity value per share (2021) Equity value / SO

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lOMoARcPSD|30735875

From financial statements to business analysis

Chapter 2: Strategy analysis

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Degree of actual & potential competition

3 potential sources of competition

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- Some industries compete aggressively by pushing price close to MC

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- There will be incentive to engage in aggressive compeititon for

#2 - Threat of new entrants

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- limited capacity in the existing distribution & high costs of developing

#3- Threat of substitute products/service

Bargaining power in input and output markets

#4 - Bargaining power of buyers

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#5 - Bargaining power of suppliers

Competitive strategy analysis

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Source of competitive advantage

Achieving & Sustaining competitive advantage

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Corporate strategy analysis

Sources of value creation at the corporate level

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Lecture 2 (Chapter 3 & 4)

Case with Emron

Chapter 3: Accounting analysis

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Noise from accounting rules

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Steps in accounting analysis

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Gedownload door Willem Ran (ran.willem@outlook.com)

Standardized financial statements (cek book page 88 Table 3.1 - 3.5)

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Gedownload door Willem Ran (ran.willem@outlook.com)

Chapter 4: Accounting adjustments

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-Delayed write-downs of current or non-current assets

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- pension and post-retirement obligation understatements (not fully

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Chapter 5: Financial Analysis

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- Also to evluate the success of firms business choices

Definition of accounting items used in ratio analysis

Income statement items

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Balance sheet items

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Measuring overall profitability

- ROE: an indicator of a firms performance as it provides an indication of how well

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Decomposing profitability (alternative approach of ROE)

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- Return on invested capital (ROIC) → measure of how profitably the company

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- NOPAT Margin → measures how profitable a companys sales r from an

Assessing operating management: decomposing net profit margins