Understanding Financial Statements - Intermediate

Training Introduction

• The mixed-valuation model and its problems:
• Evolution from a backwards-looking exercise in stewardship towards a support tool for forward-looking economic decision-making
• Why does this make life inherently and inevitably difficult for analysts and investors?
• Core qualities of financial statements analysis and reporting. This reading financial statements course includes easily understood illustrations from real life:
• Relevance and materiality (example: why inventory valuation is more critical in low-margin businesses)
• Comparability (example: closely comparable competitors in an (apparently) homogeneous industry, but with different histories of organic growth versus external acquisition, leading to different bases of accounting for intangibles)
• Understandability (example: pharmaceuticals, hi-tech generally)
• Reliable measurement (example: intangible assets in knowledge-based support industries)
• Fair value, time value of money, and discounted present values
• Management discretion: the exercise of judgement, and the use of estimation techniques
• The three principal financial statements: their objectives, rationale and limitations
• The five elements of business financial statements: assets, liabilities, equity, income and expense
• Accounting as a record of flows and stocks, of resources (assets) and obligations (liabilities)

Focus on Earnings-Based Metrics: Unpacking EBITDA

• Revision of basic calculations and any technical problems arising
• Questions about ‘Earnings’:
• The big question: how comparable are operating earnings (i) over time and (ii) vis-a-vis the competition?
• Are the company’s financial accounting policies for revenue and expense recognition appropriately selected, clearly described, and consistently applied? (examples: Vodafone’s mobile phone pricing contracts, Upfront payments and agent v principal issues)
• How significant are figures for the capitalised expense, relative to operating profit?
• Does the company also use a non-GAAP earnings measure, and if so, what is its stated (and real) purpose? What are its merits and demerits? (Many examples, but interesting to compare the non-GAAP measures within an industry, e.g. like-for-like in food retailing)
• Are stated earnings ‘normal’ - or have they been ‘normalised’ by the exercise of management discretion? What about income/ expenses booked through OCI?
• Are ‘exceptional’ income and expenses separately identified, and are they really exceptional? (examples: Oil & Gas and environmental damage costs, financial sector and PPI settlements,)
• Do earnings include non-operating items such as gains/losses on non-current assets or discontinued operations?
• Are there financing elements in some operating items, such as in the payment terms of trade suppliers? (example: supermarkets turning over inventory in 15 days, paying suppliers in 45 days, using the permanent float to finance a whole year’s CAPEX)
• Does a relatively smooth development at the consolidated level mask significant (if mutually compensating) swings between operating segments?
• Questions about ‘Interest’:
• If this is the net figure, what are the gross figures for income and expense, and are there one-off factors in either of them, e.g. interest received on temporary reinvestment of disposal proceeds?
• What do the figures contain, other than interest on the conventional debt and financial investments, e.g. concerning the unwinding of discounts on provisions, and pension plans?
• Questions about ‘Taxes’:
• Does the overall tax charge, or the current/deferred split, vary significantly from year to year, and if so, why? What is the effective tax rate, and are there any uncertain tax positions (for example: Loss carry forward producing possible future tax savings - assets)
• Questions about ‘Depreciation and Amortisation’:
• Does the total include impairment charges (or reversals) or other indications of possible impending problems for future years’ EBITDA?
• What does EBITDA not tell us about cash generation?
• Working capital management
• Capex requirements – for maintenance and expansion

Focus on Balance Sheet Metrics (‘Return on . . .’)

• Redcliffe's Understanding Financial Statements training will revisit these key principles:
• Valuation basis: historic cost or Fair Value
• Reliable measurement
• Specific problem areas, creating very different balance sheets for economically identical businesses:
• Organic growth versus external acquisition. Does it make sense to omit assets altogether just because their value cannot be reliably measured? (example: internally developed intangibles such as footballers brought up through the academy)
• What is the basis for Fair Value? Market value or value in use? And how is it measured?
• Leased assets: how are they reported under IFRS 16 and what are the exemptions that could hide the true asset and liability position.
• Financial assets: introduction to main problem areas
• Different policies for depreciation, amortisation and impairment
• Accounting and financial statements for liabilities:
• Current and noncurrent
• Provisions and contingent liabilities: problems of classification and measurement
• Financial liabilities

Bringing It All Together in Financial Analysis

• How to use the other sections of the annual report: chairman’s and CEO’s letters, business and financial reviews
• Uses and abuses of financial ratio analysis:
• The key drivers of profitability
• The key drivers of cash generation
• Trends in profitability
• Management of working capital, liquidity and solvency
• The identification and management of financial and other risks and uncertainties
• The importance of knowing what to expect and knowing the industry

Course Wrap-up and Conclusion