Question

1.(a) Explain the advantages of using market capitalization as a measure of equity, and then, its drawbacks.

(b)Explain how looking at the ratio of total assets to total liabilities can mislead the analyst.

2.Describe how the careful study of financial statements can help raise warning flags regarding risk in merger and acquisitions have driven stock for stock transactions, and explain some examples of the need to watch for earnings discontinuities.

3.(a)Explain some of the ways that companies downplay expenses?

(b) What do most analysts do to benefit from the insights provided by the careful scrutiny of financial statements?

Answer 1

1. (a) Advantages of using market capitalization as a measure of equity:

Market capitalization is used to arrive at the value of a company.It is calculated by multiplying the outstanding number of sharesby current market price of the share of the company.

(No. of shares outstanding * Market Price per share).

Another notable method of calculating the value of the company is to deduct all the liabilities from the Fair value of Total Assets.

Advantages of using the first method (market capitalization) are;

• Easy to use: It is easy to compute the value of the firm by market capitalization as the price of the listed common stock is readily available, whereas, it is cumbersome to arrive at the FMV of all the assets in the other method.
• Fairly dependable valuation: As the market price of the stock is tracked by lot of analysts and traders, the valuation arrived by this method is fairly dependable, whereas in the case of valuation model, arriving at the fair value of assets is subjective and prone to mis-statements.
• The valuation by this method takes into consideration the future earning potential of the company, which is the best method for evaluating a going concern.

(b) By looking at the total assets to total liabilities, the analysts figure out the financial risk of the business. It is calculated as per the below formula;

                Total Liabilities / Total Assets

It shows the extent to which the assets are financed by outside liabilities. If the above result is more than 1, and increasing year on year, it means that the company relies heavily on the borrowed fund for its operation and is not willing to repay the liabilities.

Incase if the Assets of the company include intangible assets like goodwill and other fictitious assets of no real value, then the Total assets would show at a greater value and thus may mislead the analysts.

1. In Mergers and Acquisitions, proper due diligence exercise of the acquiree company is very critical. If properly done, it may raise warning flags which help in the final decision making.

As EPS is one of the driving criteria in a acquisition decision, it is usual that the acquire company present good earning numbers.If the earnings growth looks abnormal, vis-a vis the industry trends, then flag needs to be raised, as there may be some inaccurate reporting or misstatement.

Applying financial ratios also raise redflags, if the ratios vary abnormally year on year, and also when compared to the industry trends.

Examples of the need to watch for earning discontinuities:

Managers tend to report higher earnings by not following Accounting standard guidelines and defer recognition of expenses.When this act is regularly done, it would present discontinuity in reporting of earnings vis-a vis expenses, over the periods.Some of the examples are;

Recognising revenue immediately on receipt of sales order, Billing to fictitious customers, understatement of expenses, Not creating provision for warranty claims etc.,

3) a. Some of the ways that companies downplay expenses:

a. Not accounting complete expenses

b. Not creating provisions for expected liabilities like warranty claims.

c.Not showing contract workers on roll and not paying for statutory expenses.

b. Analysts who tract businesses get to know lot of insights about the financial performance of the company, which is not known to the market or public at large. Some analysts use these information to their personal gains by “selling” these price sensitive data to news agencies.

They also share such information to their clients who, based on that advice, trade on these stocks.

The analysts may also trade by themselves in the stocks of the companies for quick gains.