Corporate Rating Methodology - FSA

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Understanding Industry Dynamics and Financial Statements
Industry Classification External Factors Demand and Supply Analysis Size and Growth trends Profitability
1- Cost factors 2- Pricing Competitive Strategies
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General classification by product or service type Segmentation by the Industrial Life Cycle:
Life Cycle Phase Pioneer

Growth Mature Decline
Description Product is new, acceptance is questionable, high risk Product acceptance is established, accelerating growth in sales and earnings Growth in line with the economy, competition for market share Demand for product steadily decreasing
Classification by Business Cycle Reaction

Behaviour Pattern Description Growth above-normal expansion in sales and profits independent of the business cycle Stable performance during ups and downs Profitability tracks the business cycle, often in an exaggerated manner
Defensive Cyclical
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External factors
Technology survival with new products Government and regulatory - policies can kill or serve an industry Demographics young or aging population affect demand Social Changes changes in Lifestyles Foreign influences low cost production of textiles overseas decimated the US textile industry
Demand and Supply Analysis

Demand What derives an industrys revenue Economic expansion or changing consumption patterns Segmentation by users home, commercial, industrial Segmentation by geographic region Supply Existing suppliers and market shares Attractiveness of industry to newcomers Demand/Supply gap
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Industry Profitability
Cost structure and pricing flexibility Demand/supply balance as indicator of future profitability Relationship between sales growth and profits Product segmentation helps in pricing High degree of concentration inhibits price movements Local and international competition High/low entry barriers affect pricing power in the long
run Ability to pass on increases in key raw material costs
Corporate Strategies
Cost leadership the firm sets out to become the lowcost producer in the industry Differentiation unique positioning based on product, the delivery system or the marketing approach Market share paradigm relative market share is a necessity because it drives relative cost Rule of 3 and 4 a stable competitive market has no more than 3 competitors and no more than 4 times the share of the smallest player
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Five competitive forces that determine industry profitability

Potential Entrants
Bargaining power of suppliers
Industry Competitors
Bargaining power of customers
Suppliers Rivalry among existing firms

Threat of substitute products or services
Customers
Substitutes
Source: Competitive Advantage by Michael E. Porter (New York; The Free Press, 1085)
Management horizon:
Problems and Challenges
Russian Banking Sector Overview Capital Adequacy Yields Going Down Size of Assets Narrowing Margins Corporate Governance Growing Risk Inefficient Processes Competition Technological sophistication Central Bank Regulations Market Volatility Alfa Bank Overview Legislation Control
Management Concerns
Alfa Bank Business Strategy
Banking System
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Financial Statement Analysis

Financial Statements- Income Statement, Balance sheet and Cash flow statement Miscellaneous supporting calculations and adjustments Ratios and trend analysis Key value drivers
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Financial Statements comprise

Balance Sheet Provides a snapshoot of a firms financial position Reports on the performance of the firm Reports the cash receipts and cash outflows classified according to operating, investing and financing activities Reports the amounts and source of changes in equity from transactions with owners Allow us to understand the amount, timing and uncertainty of the estimates reported in the financial statements
Income Statement
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Statement of Cash Flows Statement of Stockholders Equity Notes to Financial Statements
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Financial Statements interactions
Income Statement Sales - Expenses Net Income
Balance Sheet Assets - Liabilities Equity
Cash Flow Statement Inflows - Outflows Net Cash
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Balance Sheet and its classification

Assets are the economic resources controlled by the firm Liabilities are the financial obligations that the firm must fulfill in the future. Liabilities are often fulfilled by payment of cash. They represent source of financing provided to the firm by the creditors Equity Ownership is the owners investment and the earnings retained from the commencement of the firm. Equity represents source of financing provided to the firm by the owners.
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Analysis and Adjustments to the Balance Sheet

The balance sheet shows the recorded assets, liabilities and equity of the firm. The reported balance sheet usually suffer from two defects:
Some assets and liabilities are not recorded. These are called off-balance sheet items The amounts at which assets and liabilities are measured may differ significantly from their economic value
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Income Statement and its significance

The income statement measures the success of business for a given period of time.
it recognizes a separation of operating transaction from non-operating transaction; it matches costs and expenses with related revenues; and it highlights certain intermediate components of income that are used for the computation of ratios used to assess the performance of enterprises
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Quality of earnings
The quality of earnings refers to substance and sustainability of earnings. It refers to the use of accounting methods and assumptions that tend not to overstate reported revenues and earnings. It may be affected by two factors:
The accounting methods and estimates chosen by the firms management The nature of non-operating items on the income statement
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Adjustments to Reported Income

Reported net income should also be examined for possible adjustments. There are two objectives:
Remove non-operating items from operating income to obtain a better measure of operating results for the period, and better inter-period comparisons Obtain a measure of the earning power of the firm. The concept of earning power represent the (permanent) net income of the firm, ignoring temporary, nonrecurring, or unusual factors.
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Normalized Net Income

Normalization is a process of estimating normal operating earnings for each period by removing nonrecurring items from reported income. Such items may include:
Accounting changes Realized capital gains and losses Catastrophes such as natural disasters, accidents Impairments or restructuring charges Litigations or government actions Discontinued operations
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Statement of shareholders equity and its adjustments

Original capital used to start the firm, plus proceeds from any additional shares issued, less the cost of shares repurchased Retained earnings accumulated over the firms life Accounting adjustments. Certain accounting standards result in entries directly to equity, without flowing through the income statement. Examples include changes in market value of long term marketable securities and foreign exchange effects
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Statement of cash flows and its significance

The beginning and ending cash balances on the statement of cash flows tie directly to the cash and cash equivalent accounts listed on the balance sheets at the beginning and end of the period. Cash receipts and payments during a period are classified in the statement of cash flows in three different activities: Operating activities Investing activities Financing activities
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Analysis of Cash Flow Statement

Analysis of cash flow statement should lead to insights into a firms financial position and performance. Analysis should focus on both the level and trends in cash flow components. Our primary objective should be:
Determine the firms ability to generate cash flows to meet operating needs Evaluate the role of different sources of financing for current operations and growth Analyze to the extent to which cash flow classification are affected by reporting choices
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Key ratios for a Corporate
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Other important variables

Size of production lines and capacity utilization rate Proximity to feedstock and consumption markets Realization per ton, which, in turn, is a function of the first two variables Cost of electricity Closeness to ports and sea channels Venturing into other areas such as blocks and readymix concrete manufacturing Enterprise value (EV)* per ton * EV = Market Cap + Debt-Cash & Equivalents
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Integrated Profitability Analysis: Du Pont Framework

Profitability of asset use ROE = EBIT / Average Shareholder Equity ROE = EBIT Ave. Shareholder Equity Asset/Equity Ratio = Ave. Total Assets Ave. Shareholder Equity Impact of Debt in Capital Structure
Profitability of sales/ Value retention
Profit Margin = EBIT Sales
Asset Turnover Ratio = Sales Ave. Total Assets
Productivity/ Efficiency of Asset Use
BUSINESS DRIVERS
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What are some potential problems and limitations of financial ratio analysis?
Comparison with industry averages is difficult if the firm operates many different divisions. Average performance not necessarily good. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different operating and accounting practices distort comparisons. Sometimes hard to tell if a ratio is good or bad. Difficult to tell whether company is, on balance, in strong or weak position.
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2/28/2012

Understanding Industry Dynamics and Financial Statements

1- Cost factors 2- Pricing Competitive Strategies

Life Cycle Phase Pioneer

Classification by Business Cycle Reaction

Demand and Supply Analysis

run Ability to pass on increases in key raw material costs

Five competitive forces that determine industry profitability

Bargaining power of suppliers

Bargaining power of customers

Suppliers Rivalry among existing firms

Alfa Bank Business Strategy

Financial Statement Analysis

Financial Statements comprise

Statement of Cash Flows Statement of Stockholders Equity Notes to Financial Statements

Financial Statements interactions

Income Statement Sales - Expenses Net Income

Balance Sheet Assets - Liabilities Equity

Cash Flow Statement Inflows - Outflows Net Cash

Balance Sheet and its classification

Analysis and Adjustments to the Balance Sheet

Income Statement and its significance

Adjustments to Reported Income

Normalized Net Income

Statement of shareholders equity and its adjustments

Statement of cash flows and its significance

Analysis of Cash Flow Statement

Key ratios for a Corporate

Other important variables

Integrated Profitability Analysis: Du Pont Framework

Profitability of sales/ Value retention

Profit Margin = EBIT Sales

Asset Turnover Ratio = Sales Ave. Total Assets

Productivity/ Efficiency of Asset Use

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