McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statement

Analysis

K R SubramanyamJohn J Wild

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1CHAPTER

Overview of Financial Statement Analysis

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Business Analysis

Evaluate ProspectsEvaluate Prospects Evaluate RisksEvaluate Risks

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Information Sources for Business Analysis

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Credit Analysis

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Credit Analysis

Liquidity

Ability to meet short-term obligations Focus: • Current cash flows• Make up of current assets and liabilities• Liquidity of assets

Liquidity

Ability to meet short-term obligations Focus: • Current cash flows• Make up of current assets and liabilities• Liquidity of assets

Solvency

Ability to meet long-term obligations Focus:• Long-term profitability• Capital structure

Solvency

Ability to meet long-term obligations Focus:• Long-term profitability• Capital structure

Credit worthiness: Ability to honor credit obligations(downside risk)

Credit worthiness: Ability to honor credit obligations(downside risk)

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Equity Analysis

Technical analysis / Charting

• Patterns in price or volume history of a stock

• Predict future price movements

Technical analysis / Charting

• Patterns in price or volume history of a stock

• Predict future price movements

Fundamental Analysis

Determine Intrinsic value without reference to price

• Analyze and interpret key factors

– Economy

– Industry

– Company

Fundamental Analysis

Determine Intrinsic value without reference to price

• Analyze and interpret key factors

– Economy

– Industry

– Company

Assessment of downside risk and upside potentialAssessment of downside risk and upside potential

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Accounting Analysis

AccountingRiskAccountingRisk

Process to evaluate and adjust financial statements to better reflect economic reality

Process to evaluate and adjust financial statements to better reflect economic reality

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Financial Analysis

Profitability analysis — Evaluate return on investments

Risk analysis ——— Evaluate riskiness & creditworthiness

Analysis of — Evaluate source & cash flows deployment of funds

Profitability analysis — Evaluate return on investments

Risk analysis ——— Evaluate riskiness & creditworthiness

Analysis of — Evaluate source & cash flows deployment of funds

Common toolsCommon tools

Ratioanalysis

Ratioanalysis

Cash flow

analysis

Cash flow

analysis

Process to evaluate financial position and performance using financial statements

Process to evaluate financial position and performance using financial statements

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Prospective Analysis

Intrinsic ValueIntrinsic Value

Business Environment& Strategy Analysis

Business Environment& Strategy Analysis

Accounting AnalysisAccounting Analysis

Financial AnalysisFinancial Analysis

Process to forecast future payoffsProcess to forecast future payoffs

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Dynamics of Business Activities

Business ActivitiesBusiness Activities TimeTime

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Business Activities

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Business Activities

Financing

Financing activities

• Owner (equity)

• Nonowner (liabilities)

Financing activities

• Owner (equity)

• Nonowner (liabilities)

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Investing activities

• Buying resources

• Selling resources

Investing activities

• Buying resources

• Selling resources

Investing = Financing Investing = Financing

Business Activities

FinancingInvesting

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Operating ActivitiesRevenues and expenses from providing

goods and services

Operating ActivitiesRevenues and expenses from providing

goods and services

Business Activities

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Financial Statements Reflect Business Activities

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Financial Statements

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Balance Sheet

Total Investing = Total Financing

= Creditor Financing + Owner Financing

Total Investing = Total Financing

= Creditor Financing + Owner Financing

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Income Statement

Revenues – Cost of goods sold = Gross Profit

Gross profit – Operating expenses = Operating Profit

Revenues – Cost of goods sold = Gross Profit

Gross profit – Operating expenses = Operating Profit

Colgate’s Profitability(in $billions)

$12.238 - $5.536 = $6.701 Gross Profit

$6.701 - $4.5411 = $2.160 Operating profit

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Statement of Cash Flows

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Additional Information(Beyond Financial Statements)

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Analysis Preview

Purpose: Evaluation of consecutive financial statements

Output: Direction, speed, & extent of any trend(s)

Types: Year-to-year Change Analysis

Index-Number Trend Analysis

Purpose: Evaluation of consecutive financial statements

Output: Direction, speed, & extent of any trend(s)

Types: Year-to-year Change Analysis

Index-Number Trend Analysis

Comparative AnalysisComparative Analysis

Yr2Yr1 Yr3

Analysis Preview

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Analysis Preview

Purpose : Evaluation of internal makeup

of financial statements

Evaluation of financial statement accounts across companies

Output: Proportionate size of assets, liabilities, equity, revenues, & expenses

Purpose : Evaluation of internal makeup

of financial statements

Evaluation of financial statement accounts across companies

Output: Proportionate size of assets, liabilities, equity, revenues, & expenses

Common-Size AnalysisCommon-Size Analysis

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Analysis Preview

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Analysis Preview

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Analysis Preview

Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis)

Output: Mathematical expression of relation between two or more items

Cautions: Prior Accounting analysis is important

Interpretation is key - long vs short term & benchmarking

Purpose : Evaluate relation between two or more economically important items (one starting point for further analysis)

Output: Mathematical expression of relation between two or more items

Cautions: Prior Accounting analysis is important

Interpretation is key - long vs short term & benchmarking

Ratio AnalysisRatio Analysis

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Analysis Preview

Purpose: Estimate intrinsic value of a

company (or stock)

Basis: Present value theory (time value of

money)

Purpose: Estimate intrinsic value of a

company (or stock)

Basis: Present value theory (time value of

money)

ValuationValuationValuation - an important goal of many types

of business analysisValuation - an important goal of many types

of business analysis

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Analysis Preview

Debt (Bond) ValuationDebt (Bond) Valuation

Bt is the value of the bond at time tIt +n is the interest payment in period t+nF is the principal payment (usually the debt’s face value)r is the investor’s required interest rate (yield to maturity)

Bt is the value of the bond at time tIt +n is the interest payment in period t+nF is the principal payment (usually the debt’s face value)r is the investor’s required interest rate (yield to maturity)

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Analysis Preview

Equity ValuationEquity Valuation

Vt is the value of an equity security at time tDt +n is the dividend in period t+nk is the cost of capitalE refers to expected dividends

Vt is the value of an equity security at time tDt +n is the dividend in period t+nk is the cost of capitalE refers to expected dividends

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Analysis Preview

Equity Valuation - Free Cash Flow to Equity Model

Equity Valuation - Free Cash Flow to Equity Model

FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures]

k is the cost of capitalE refers to an expectation

FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures]

k is the cost of capitalE refers to an expectation

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Analysis Preview

Equity Valuation - Residual Income ModelEquity Valuation - Residual Income Model

BVt is the book value at the end of period tRit+n is the residual income in period t + n [defined as

net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)]

k is the cost of capital E refers to an expectation

BVt is the book value at the end of period tRit+n is the residual income in period t + n [defined as

net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)]

k is the cost of capital E refers to an expectation

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Analysis in an Efficient Market

Three assumed forms of market efficiencyThree assumed forms of market efficiency

Weak Form - prices reflect information in past prices

Semi-strong - prices reflect all public

Form information

Strong Form - prices reflect all public and private information

Weak Form - prices reflect information in past prices

Semi-strong - prices reflect all public

Form information

Strong Form - prices reflect all public and private information

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Book Organization