The Cash Flow Statement represents the pivotal concept of our class: our focus will be on how to prepare it and interpret its contents.
Other related topics are:
• Accounting data quality and earnings management
• Balance sheet statement and income statement "reengineering"
• Profitability analysis
• Solvency analysis
The main topics the class deals with are analyzed in very good international handbooks. These books are particularly fitting:
• P. M. Bergevin, Financial Statement Analysis: An Integrated Approach, Upper Saddle River (N.J.), Prentice Hall, 2002
• P. Easton ? M.L. McAnally ? G. Sommers ? Xiao?Jun Zhang, Financial Statement Analysis and Valua? tion, 4th edition, Cambridge Business Publishers, 2015
• S.H. Penman, Financial Statement Analysis and Securities Valuation, McGraw Hill International Edi? tion, 2010
• C.P. Stickney – P. R. Brown – J. M. Wahlen, Financial Reporting, Financial Statement Analysis, and Valuation, Thomson South?Western, 2007
• R. Subramanyam – J. J. Wild, Financial Statement Analysis, McGraw Hill?Irwin, 2009
• G. I. White – A. C. Sondhi – D. Fried, The Analysis and Use of Financial Statements, John Wiley, 2003
Students are free to choose the source to draw from. Once your choice is made, only a few selected chapters should be studied. The chapters of each book that are the most related to the class contents are:
• Bergevin, 1?6, 8?14
• Easton et al., 1?4, Appendix B
• Penman, 3, 7?11, 15, 17?19
• Stickney et al., 1, 3?6
• White et al., 2?4, 17?18
• Subramanyam et al., chapters: 1, 2, 6?8, 10
A student is also free to shape his/her personal handouts, by gathering chapters selected from the recommended handbooks.
A good handbook to have a look at to know something more about financial ratios is:
• Bragg S.B., Business Ratios and Formulas. A Comprehensive Guide, J. Wiley and sons Inc., 2002
This course would like to equip you with the knowledge to read, interpret and analyze financial statement data in order to make informed business decisions regarding investment, credit, or resource allocation. Such skills are required for equity and credit analysts, executives, bankers, auditors, consultants and other users of financial information.
The course assumes you have a solid grasp of financial accounting concepts and principles. You should also have some notions in finance.
Theoretical lectures will systematically treat concepts and analytical tools you are requested to use. Coherently with an international master class approach, lectures aim at offering you a conceptual framework to manage the different phases of your analysis and draw your attention to some significant issues.
Each tutorial is designed to give students a practical application of previously studied theoretical notions; thus, we will apply analytical tools to conduct an extensive fundamental analysis of a real company using its current financial statements. We will spend a third of our class time working on tutorials.
A mix of lectures, cases, and discussions provides an interactive learning environment, allowing you to achieve a better understanding of the economic meaning of the financial statements contents.
Type of Assessment
At the end of our class, we will assess your preparation by means of an individual test. Students are also encouraged to write a financial analysis report. In this case, the course grade will take into account both students' results, in this proportion:
• Individual test 60%
• report 40%
In any case, to pass your exam you must get a passing grade in your individual test and report. For students who will take part in class meetings on a regular basis (and only for them), the course grade will also factor in class participation. The grade for class participation only works in your favor: if you actively attend class meetings, you could earn up to three points to add to your individual test and report average grade.
The individual test is a written test. If you have prepared a financial analysis report, you are requested to do three intertwined exercises, working on some financial statements that you will be given. One exercise focuses on the financial statement reengineering; one deals with a cash flow statement preparation; the last exercise is a brief ratio analysis concerning a company's profitability and solvency conditions. After calculating some ratios that are considered the most fitting, you have to comment on the accounting results. You will have two hours to carry out your work. To take their test, students will use a spreadsheet (for calculation) and a Word file (for comments). For this reason, the test will be held in building D15.
For students who do not present a financial analysis report, the final exam consists of an analysis of a listed company's financial statements. Students have to work out a report where they present an essay structured in four sections:
1. analysis of the business background of the company
2. comment on the financial statements' quality
3. analysis of profitability
4. analysis of solvency
All the statements in the report have to be justified and supported with the analysis of specific accounting data. Analyzing solvency, students are requested to present a" reengineered" cash flow statement. The test lasts 3 hours. To prepare the business background analysis, a week before the exam, students will be informed, by email, on the branch of industry which the company to be analyzed works in. To draw up their reports, students are allow to use a spreadsheet and a Word file. For this reason, the test will be held in building D15.
At the beginning of our course, individuals or groups choose a company out of a list that will be made available to students.
You have to prepare a report on the selected company, which analyzes the main strands we will focus our attention on in our lectures and tutorials. In the first section of your report, you should depict the environment your target company competes in and the main strategies it adopts. In the second section, you should zero in on financial statements reengineering and cash flow presentation. In the third section, you should delve into your company's profitability and solvency situation. Students can work on the consolidated financial statements or the separate financial statements of the aforementioned companies. Your report will be valid for the 2017-2018 academic year. Students are allowed to work individually, but they are encouraged to work as a team of no more than four people. The allocation of companies among groups will follow a first-come-first-serve policy. No more than two groups should have the same company.
The grade for class participation will depend on the quality of your interaction and participation in class discussions. In particular, students should actively participate in tutorials. This implies the preparation of specific assignments related to each tutorial before class and sharing of your insights during class. Assignments will be communicated by means of a weekly newsletter. I will randomly call on study teams to deal with some problems the tutorial is concerned with. This practice is not intended to put you on the spot, but to encourage everyone to participate in the class discussion. In particular, your contribution will be appreciated, by making comments to move the discussion toward a better understanding of the concepts covered in class. In evaluating your contribution, the quantity of comments is not important per se or offering the "right" solution. Typically, no single "right" solution exists. Many of the financial statement analysis problems you will address through tutorials will not have clear-cut or "correct" solutions. Therefore, there is much to be gained if we examine a wide variety of viewpoints. You can provide valuable contribution by posing intelligent questions, raising alternative viewpoints, and providing well-reasoned challenges to expressed views.
For term projects, I will look at two strands of your work:
o 1. Presentation (40%) Organization, use of visuals and highlights, typeset, tables, use of an appendix, professional appearance
o 2. Contents (60%) Readability, synthesis, focus on key issues only, development of an economic reasoning with personal interpretations, conclusions and forecasts
The same rationale will be used to assess your individual test. Thus, I will take into account presentation and contents. I will focus my attention on cash flow statement, ratio selection, and comments. I appreciate comments that are not didactic (i.e. you explain what a ratio means in general) or descriptive (i.e. you translate numbers into words), but comments that are consistent with the strategic background of the company.
WHAT HAS IT GOT TO DO WITH ME?
The financial statement analysis (FSA) is presented in a broad framework that helps understand what it is useful
for and what it has to do with a financial professional's preparation. In this respect, the FSA is part of the fundamental
analysis process, which aims at assessing a company's intrinsic (or fundamental) value. This value is the
basis for determining stocks' target price, which is an estimate of a stock's future price based upon an earnings
or cash flow forecast. Looking at the practice, a company's fundamental value is generally measured by using the discounted cash flow method (DCF). In light of this, the FSA contributes to figure out the main drivers of a company's cash flows and risk conditions that affect a company's cost of capital.
LET'S DO AS HARRY DID
We analyze the financial statements to understand how a company works. Therefore, an analyst needs to refer
to a clear and simple model that represents the main features of a business, i.e. the elements of corporate performance that are the most revealing. Without referring to such a model, an analyst cannot properly use the
several tools of analysis at his/her disposal.
The typical valuation practice of investors shows that this model should be based on a conceptual distinction
between operating and financing activities. We will use this model to reconfigure (reengineer) the financial statements and identify statistics that effectively illuminate the relevant aspects of an entity.
THE GRASS IS ALWAYS GREENER ON THE OTHER SIDE OF THE FENCE
As stated on good authority, accounting indicators are only informative when they are related to a valid point of
comparison. Thus, an analyst has to compare a company's accounting data over time and with accounting data
of other companies. Cross sectional comparisons, in particular, are crucial to assess the competitive positioning
of a company, its business efficiency, and its strategic choices. For these purposes, a few techniques and tools
can be used and different terms of comparison selected.
FROM LAG TO LEAD
The financial statement analysis results depend on the information the analyst is able to gather. The informational
basis consists of financial and non-financial information. The latter is critical to depict the background that
is necessary to interpret the accounting or financial data. The lecture's aim is twofold:
• To give a general picture of both kinds of information, with a specific attention to non-financial information
• To show where an analyst can find this information
I WON'T GET FOOLED AGAIN
Once we have gathered information, we have to assess its quality. In particular, we have to evaluate the accounting
data quality, because if the data quality is poor, the analysis' results will also be poor. In this respect, our
lecture focuses its attention on the effects of accounting policies on the accounting system. Then, we will move
to the potential actions of earnings management, pointing out the diagnostics to detect the presence of such
WHERE MONEY COMES FROM AND WHERE IT GOES
The above-mentioned model, which sketches the main aspects of a business, is applied to the balance sheet. In
this way, we obtain a new statement that shows the main investments and financial resources of a company.
Thanks to this statement, an analyst can correctly assess financial needs and profitability levels of a company.
Through the reformulation of the balance sheet, an analyst pinpoints a company's net working capital (NWC).
This indicator is an approximate but useful measure of the current financial requirement caused by the current
operative activities. The cash flow of a company depends on changes in NWC over time. As a company's value
depends on its cash flows, NWC is a terrific value driver, which an analyst should zero in on. Thus, we will pick
the NWC apart to understand the main factors that impinge on it.
NOT ONLY A FLASH IN THE PAN
The model that represents the main features of a business has also to be applied to the profit and loss statement.
However, before reengineering this prospectus, an analyst should pick apart those costs and revenues that are
abnormal with respect to what the company usually does. By segregating these values from the others, we obtain
a normalized or adjusted (or current) measure of earnings that can be used to anticipate the future earnings, all things being equal. Analysts talk about "earnings power" to mean a company's long-term capacity to produce
EVEN TONY SOPRANO KNOWS THAT!
The adjusted earnings signals the basic profitability of a company. They are determined by operating and financial
activities run by a company. The operating activities are at the core of profitability as they represent what a
company should do for a living. Operating profit is influenced by a few accounting components that are based
on managers' estimates, like depreciation, amortization, and impairment of PP&E and intangible assets. These
components make it difficult to compare a company's profit over time and cross-sectionally. In order to overcome
this limitation, analysts calculate a specific operating margin, which is called EBITDA. This margin makes
operating performance comparison easier and, in addition to this, roughly signals a company's capacity to produce
cash flow from its current activities.
WHO IS THE KING?
As IASB incisively states: "Users of an entity's financial statements are interested in how the entity generates and uses cash and cash equivalents. This is the case regardless of the nature of the entity's activities and irrespective of whether cash can be viewed as the product of the entity, as may be the case with a financial institution. Entities need cash for essentially the same reasons however different their principal revenue-producing activities might be.They need cash to conduct their operations, to pay their obligations, and to provide returns to their investors."
That is the reason why, as an analyst, we have to accurately assess a company's capacity to produce cash flow.
For this purpose, we will outline a cash flow statement's structure, which is coherent with the model that represents
the main features of a business. This structure will be used to reformulate the cash flow statement, if a
company presents this prospectus, or to prepare a new statement starting from scratch, if the prospectus is not
encompassed in a company's annual report.
THE FUEL AND THE FIRE OF CASH FLOW
Cash flow should be rooted in the operating activities of a company. Thus, an analyst must pay very close attention
to measure the amount of cash flow that comes from the core business of a company. The nitty-gritty stuff
is to spot the main drivers the operating cash flow depends on. Moving along this track, EBITDA and net working
capital stand out as pivotal determinants of the operating cash flow.
WHEN THE CASH IS FREE
The operating cash flow depends not only on the current operating activities run by a company, but also on the
amount of investments a company makes to be competitive in its industry. An analyst is interested in measuring
this amount, which is called, in the financial jargon, capex, i.e. capital expenditure. By adding capex to the current
operating cash flow, we obtain the free cash flow from operation (FCFO). FCFO represents the available cash flow
to reward a company's creditors and stockholders. For this reason, to assess a company's intrinsic value, the
discount cash flow model, applied in asset side logic, takes into account free cash flow.
THE DO-OR-DIE STRUGGLE FOR GROWTH
Once they are reengineered, the financial statements must be interpreted to understand what the main features
of a business are and how they do perform. In addition to this, they contain numbers in the form of absolute
values. Absolute values are deceiving and cannot help you run time and cross-sectional comparisons. Therefore,
we use reengineered accounting data to build some ratios. In light of this, the question is: where should we start
from to run our ratio analysis?
Tons of pieces of research have shown that a company has to grow if it wants to survive and gain a competitive
advantage in its business arena. Growth affects profitability and solvency, the two main strands of a company's
management. Therefore, before focusing our attention on those strands, we have to gauge if and how intensely
a company is growing, looking at its revenues and production capacity.
GET THE BANG FOR YOUR BUCK
Free cash flow determines a company's fundamental value. The main driver of the free cash flow is operating
profitability. Thus, an analyst must measure profitability very carefully, by using the right ratios. Among them,
ROI (or RONA) is of paramount importance. Free cash flow can be roughly predicted by connecting ROI to a
company's growth rate. However, calculating ROI is not enough: it is necessary to assess how the strategic
choices directly influence the ROI amount. A widely adopted approach to ROI analysis shows that it mainly depends
on capital productivity and return on sales. Both these determinants can be further analyzed, until we
uncover the key «every day activities» of a company's business.
WHEN DOES A COMPANY GO BUST?
A company can prosper and create value for its stakeholders only if its profitability goes with solvency. Solvency
allows a company to pay its debt and distribute dividends. It can be assessed on two different but intertwined
perspective: in the long-term, as financial solidity; in the short-term, as liquidity. The balance sheet and the cash
flow statement offer an analyst precious hints to get his teeth into both these strands of a business, in particular,
liquidity. In this respect, the different sections of these statements will be explored by using a selected number
LET'S PUT THE JIGSAW PUZZLE TOGETHER
As a company is a system, operating profitability and solvency are two sides of the same coin. To draw his conclusions,
an analyst needs to lump together all the jigsaw pieces of the puzzle. The net profitability analysis offers
the whole picture of a company and shows the relationships between operating profitability and solvency. The
Return on Equity (ROE) ratio synthesizes the net profitability performance. Its level depends on three main factors:
operating profitability, financial structure, cost of debt. When the latter one is lower than operating profitability,
a company can increase its ROE by levering debt. This effect is usually called "financial leverage" or "trading
Net profitability levels are also consequential for a company's growth. In fact, net profit distribution to shareholders,
in the form of dividends, affects a company's capability of growing without collecting new debt, with all
the consequences on solvency.
In each tutorial, the topics presented in a lecture (or in a few lectures) are put into practice. While a lecture deals
with some selected features of a topic, the tutorial offers the opportunity to cover other strands of the same
topic, gaining a broader view of it.