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LM06 Integration of Financial Statement Analysis Techniques 2023 Level II Notes © IFT. All rights reserved 1 LM06 Integration of Financial Statement Analysis Techniques 1. Introduction ........................................................................................................................................................ 2 2. Case Study: Long- Term Equity Investment ........................................................................................... 3 Summary ................................................................................................................................................................12 This document should be read in conjunction with the corresponding reading in the 2023 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Ver 1.0
LM06 Integration of Financial Statement Analysis Techniques 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction This reading demonstrates how to apply financial analysis concepts from Level I and Level II. A basic financial statement analysis framework is presented in Exhibit 1 of the curriculum: Phase Sources of Information Examples of Output 1. Define the purpose and context of the analysis. • The nature of the analyst’s function, such as evaluating an equity or debt investment or issuing a credit rating • Communication with client or supervisor on needs and concerns • Institutional guidelines related to developing specific work product • Statement of the purpose or objective of the analysis • A list (written or unwritten) of specific questions to be answered by the analysis • Nature and content of report to be provided • Timetable and budgeted resources for completion 2. Collect input data. • Financial statements, other financial data, questionnaires, and industry/economic data • Discussions with management, suppliers, customers, and competitors • Company site visits (e.g., to production facilities or retail stores) • Organized financial statements • Financial data tables • Completed questionnaires, if applicable 3. Process input data, as required, into analytically useful data. • Data from the previous phase • Adjusted financial statements • Common-size statements • Ratios and graphs • Forecasts 4. Analyze/interpret the data. • Input data and processed data • Analytical results 5. Develop and communicate conclusions and recommendation s (e.g., with an analysis report). • Analytical results and previous reports • Institutional guidelines for published reports • Analytical report answering questions posed in Phase 1 • Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit
LM06 Integration of Financial Statement Analysis Techniques 2023 Level II Notes © IFT. All rights reserved 3 6. Follow-up. • Information gathered by periodically repeating above steps, as necessary, to determine whether changes to holdings or recommendations are necessary • Updated reports and recommendations In Section 2, an analyst applies this framework to evaluate a long-term equity investment in Nestlé. 2. Case Study: Long- Term Equity Investment Phase 1: Define a Purpose for the Analysis The purpose of the analysis is to determine whether to make a long-term investment in Nestlé stock. Before making this economic decision, the analyst wants to address the following questions:  What are the factors that have driven Nestlé’s financial success?  Are these factors sustainable?  What are the risks that can impact the sustainability of Nestlé’s returns? Phase 2: Collect Input Data The analyst gathers the 2011 to 2014 annual reports from Nestlé’s website. Phase 3: Process Data and Phase 4: Analyze/Interpret the Processed Data To address the questions identified in Phase 1, the analyst decides to do the following:  a DuPont analysis  an analysis of the composition of Nestlé’s asset base  an analysis of Nestlé’s capital structure  a study of the company’s segments and the allocation of capital among them  an examination of the company’s accruals in reporting as they affect earnings quality  a study of the company’s cash flows and their adequacy for the company’s continued operations and strategies  a decomposition and analysis of the company’s valuation Instructor’s Note: Candidates who are interested in the details of the Nestlé analysis should read the curriculum. In these notes we’ll highlight the key points which are important from a testability perspective. DuPont Analysis The DuPont analysis separates the components impacting return on equity (ROE). Common ways of decomposing ROE include: 1. ROE = Return on assets × Leverage 2. ROE = Net profit margin × Asset turnover × Leverage
LM06 Integration of Financial Statement Analysis Techniques 2023 Level II Notes © IFT. All rights reserved 4 3. ROE = EBIT margin × Tax burden × Interest burden × Asset turnover × Leverage Evaluating the different components of ROE allows the analyst to identify a company’s potential strengths and weakness. For example, two companies might have the same ROE but for very different reasons. The first company may have a high net profit margin, medium asset turnover and low leverage. The second company may have a low profit margin, low asset turnover but very high leverage. In this case, the ROE of the first company is likely to be more sustainable relative to the ROE of the second company. The analyst performs the DuPont analysis with and without the impact of ‘income from associates.’ This is because the operations and resources of associate companies are not in Nestlé’s control. Nestlé’s expanded DuPont analysis with and without the impact of associates is shown below: 2014 2013 2012 Tax burden (excl. associates) 67.21% 73.82% 74.30% × Interest burden 94.16% 95.17% 94.73% × EBIT margin 11.90% 14.18% 14.92% = Net profit margin (excl. associates) 7.53% 9.96% 10.50% × Associates’ effect on net profit margin 216.07% 113.76% 113.33% = Net profit margin 16.27% 11.33% 11.90% Total asset turnover (excl. associates) 0.787 0.829 0.825 Effect of associates’ investments on turnover (0.065) (0.081) (0.075) × Total asset turnover 0.722 0.748 0.750 = Return on assets 11.75% 8.47% 8.93% × Leverage 1.87 1.94 1.98 = Return on equity (ROE) 21.97% 16.44% 17.67% Traditional ROE calculation (CHF millions): Net income 14,904 10,445 10,677 ÷ Average total equity 68,012 63,402 60,503 = ROE 21.91% 16.47% 17.65% A major cause for concern is that Nestlé’s net profit margin (excluding associates) is on a downward trend. Going through the annual reports with a fine-toothed comb, the analyst noticed that Nestlé recorded several goodwill impairment losses over the period under study. A particularly large goodwill impairment loss of CFH 1,908 million was recorded in