overview of financial statement analysis -...

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Overview of Financial

Statement Analysis

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Financial Statement Analysis

• Financial Statement Analysis is an integral

and important part of the business

analysis.

• Business analysis?

– Process of evaluating a company’s economic

prospects and risks.

– The purpose is to improve business

decisions.

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Business Analysis

Evaluate Prospects Evaluate Risks

Business Decision Makers

Equity investors

Creditors

Managers

Merger and Acquisition Analysts

External Auditors

Regulators

Board of Directors

Employees & Unions

Lawyers

Equity Analysis

Credit Analysis

Strategic Analysis: inter-firm; strength / weakness

Identify the value of target etc.

The quality of the financial reporting

The accuracy of financial report

The analysis on shareholders’ interests and responsibility

The analysis which are useful in collective bargaining negotiations.

The analysis about the humanity, legality etc.

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Business Analysis

• These business decisions extend to equity and debt

valuation, credit risk assessment, earnings predictions,

audit testing, compensation negotiations, and countless

other decisions.

• Business analysis aids in making informed decisions by

helping structure the decision task through an evaluation

of a company’s business environment, its strategies, and

its financial position and performance.

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Component Processes of Business Analysis

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Industry Analysis

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Strategic Analysis

Encompass (includes) evaluation of:

•Business decision

•Success in achieving competitive advantage

•This includes assessing a company’s expected strategic responses to

its business environment and the impact of these responses on its

future success and growth.

•Strategy analysis requires scrutiny of a company’s competitive

strategy for its product mix and cost structure.

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Accounting Analysis

Comparability problems — across firms and across time

Manager estimation error

Distortion problems Earnings management

Accounting Standards

Accounting

Risk

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

Common tools

Ratio

analysis

Cash

flow

analysis

Process to evaluate financial position and

performance using financial statements

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Prospective Analysis

Intrinsic Value

Business Environment

& Strategy Analysis

Accounting Analysis

Financial Analysis

Process to forecast future payoffs

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Information Sources for Business

Analysis

Trade reports

Regulatory filings

Economic Indicators

Industry Statistics

Financial Statements

Quantitative

Web sites

Vision/Mission Statement

Financial press

Press Releases

Chairperson’s Letter

Management discussion & Analysis

Qualitative

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Financial Statement Analysis

Application of Tools & Techniques

Using Financial Statements

To derive estimates & Inferences

Other Related Data

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Dynamics of Business Activities

End of period

Beginning of period

Business Activities Time

Investing

Operating

FinancingPlanning

Planning

FinancingInvesting

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Business Activities

Planning

Activities:

Goals

& Objectives

Competition Pricing

Market demandsTactics

Promotion

Managerial performance

Opportunities

Projections

Distribution

Obstacles

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Business Activities

Financing

Financing activities

• Owner (equity)

• Nonowner (liabilities)

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Investing activities

• Buying resources

• Selling resources

Investing = Financing

Business Activities

FinancingInvesting

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Investing Activities

• Operating assets: Investments in land, buildings, equipment,

legal rights (patents, licenses, copyrights), inventories, human capital,

information systems, and similar assets are for the purpose of conducting

the company’s business operations.– Operating activities are a company’s primary source of earnings. Earnings reflect a

company’s success in buying from input markets and selling in output markets.

– Analysis of earnings figures, and their component parts, reflects a company’s success in

efficiently and effectively managing business activities.

• Financial assets: invest excess cash in securities such as

other companies 'equity stock, corporate and government bonds, and

money market funds.

• Current assets: short-term

• Non-current assets: long-term

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Types of

Business

Analysis

Credit Analysis Equity Analysis

Management &

Control

Mergers, Acquisitions

& Divestitures

Director OversightRegulation

External Auditing

Labor Negotiations

Financial

Management

Types of Business Analysis

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Credit Analysis

Trade Creditors

Provide goods or services

Most short-term

Usually implicit interest

Bear risk of default

Non-trade Creditors

Provide major

financing

Most long-term

Usually explicit interest

Bear risk of default

payables which are

related directly to the

company's primary

operations.

payables which are not

related directly to the core

operating business of the

company

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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

Solvency

Ability to meet long-

term obligations

Focus:

• Long-term profitability

• Capital structure

Credit worthiness: Ability to honor credit obligations

(downside risk)

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Credit Analysis

• Liquidity ratios:

– Current ratio: measures current assets available to

satisfy current liabilities.

• Current ratio =

– Acid-test ratio: a more stringent test of short-term

liquidity, uses only the most liquid current assets:

cash, short-term investments, and accounts receivable.

• Acid-test ratio =

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Analysis and Interpretation: Mixon's short-term liquidity position has weakened over this

two-year period. Both the current and acid-test ratios show declining trends. Although

we do not have information about the nature of the company's business, the acid-test

ratio shift from ‘1.7 to 1’ down to ‘0.9 to 1’ and the current ratio shift from ‘2.9 to 1’ down

to ‘1.9 to 1’ indicate a potential liquidity problem. Still, we must recognize that industry

standards may show that the 2004 ratios were too high (instead of 2006 ratios as too

low).

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Equity Analysis

• Equity investors provide funds to a company in return for

the risks and rewards of ownership. Equity investors are

major providers of company financing.

• Unlike credit analysis, equity analysis is symmetric in

that it must assess both downside risks and upside

potential. Because equity investors are affected by all

aspects of a company’s financial condition and

performance, their analysis needs are among the most

demanding and comprehensive of all users.

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Equity Analysis

Technical analysis / Charting

• Patterns in price or volume history of a stock

• Predict future price movements

Fundamental Analysis

Determine Intrinsic value

without reference to

market price

• Analyze and interpret

key factors

– Economy

– Industry

– Company

Assessment of downside risk and upside potential

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Intrinsic value

• Intrinsic value (also called fundamental value) refers

to the value of a company, stock, currency or product

determined through fundamental analysis without

reference to its market value.

• It is ordinarily calculated by summing the discounted

future income generated by the asset to obtain the

present value.

• It is worthy to note that this term may have different

meanings for different assets.

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Planning

ActivitiesInvesting

Activities

Financial

Activities

Operating ActivitiesRevenues and expenses from providing

goods and services

Business Activities

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Financial Statements

Balance Sheet

Income Statement

Statement of Shareholders’ Equity

Statement of Cash Flows

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Financial Statements Reflect Business Activities

PlanningInvesting

Current:

• Cash

• Accounts Receivable

• Inventories

• Marketable Securities

Noncurrent:

• Land, Buildings, &

Equipment

• Patents

• Investments

Assets

Balance Sheet

FinancingCurrent:

• Notes Payable

• Accounts Payable

• Salaries Payable

• Income Tax Payable

Noncurrent:

• Bonds Payable

• Common Stock

• Retained Earnings

Liabilities & Equity

Balance Sheet

Statement of

Shareholders’ Equity

Operating

• Sales

• Cost of Goods Sold

• Selling Expense

• Administrative Expense

• Interest Expense

• Income Tax Expense

Net Income

Income statement

Cash Flow

Statement of

Cash Flows

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Balance Sheet

Total Investing (Assets) = Total Financing

= Creditor Financing (Liabilities)

+ Owner Financing (Equity)• Liabilities:

– Funding from creditors

– represent obligations of a company / claims of creditors on assets

• Equity:

– 1. Funding invested by owners

– 2. Accumulated retained earnings

Colgate Financing = ?

(in $billions)

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Total

Financing =?

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Balance Sheet

Total Investing = Total Financing

= Creditor Financing + Owner Financing

Colgate Financing

(in $billions)

$9.138 = $7.727 + $1.410

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Income Statement

Revenues – Cost of goods sold = Gross Profit

Gross profit – Operating expenses = Operating Profit

Colgate’s Profitability =?

(in $billions)

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Gross Profit =?

Operating profit =?

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Revenues – Cost of goods sold = Gross Profit

Gross profit – Operating expenses = Operating Profit

$12.238 - $5.536 = $6.701 Gross Profit

$6.701 - $4.5411 = $2.160 Operating profit

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The Three Major Profits

Source: http://www.investopedia.com/articles/investing/062113/understanding-profit-metrics-gross-operating-and-net-profits.asp

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Statement of Cash Flows

Net Cash Flows from Operating Activities

Net Cash Flows from Investing Activities

Net Cash Flows from Financing Activities

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Note: Additional paid-in-capital represents

the excess paid by an investor over and

above the par-value price of a stock issue

and is often included in the contributed

surplus account in the shareholders'

equity section of a company's balance sheet.

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Additional Information(Beyond Financial Statements)

Management’s Discussion & Analysis (MD&A)

Management Report

Auditor Report

Explanatory Notes to Financial Statements

Supplementary Information

Proxy Statement

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Management’s Discussion & Analysis (MD&A)

• A portion of an organization's annual report that is written

for shareholders in which management explains how

the company performed the past year and projections for the coming

year. The report also highlights other aspects of the organization.

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Management Report

• The purposes of this report are to reinforce:

1. senior management's responsibilities for the company’s

financial and internal control system and

2. the shared roles of management, directors, and the auditor in

preparing financial statements.

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Auditor report

• An external auditor is an independent

certified public accountant hired by

management to provide an opinion on

whether or not the company’s financial

statements are prepared in conformity

with generally accepted accounting

principles.

• Financial statement analysis requires a

review of the auditor’s report to

ascertain whether the company

received an unqualified opinion.

Anything less than an unqualified

opinion increases the risk of analysis.

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Explanatory Notes to Financial Statements

• Explanatory notes that accompany financial reports play an integral

part in financial statement analysis.

• Notes are a means of communicating additional information

regarding items included or excluded from the body of the

statements.

• Explanatory notes include information on:

1. accounting principles and methods employed,

2. detailed disclosures regarding individual financial statement items,

3. commitments and contingencies,

4. business combinations,

5. transactions with related parties,

6. stock option plans,

7. legal proceedings,

8. significant customers.

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Supplementary Information

• Supplemental schedules to the financial

statement notes include information on:

1. business segment data,

2. export sales,

3. marketable securities,

4. valuation accounts,

5. short-term borrowings,

6. quarterly financial data.

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Proxy Statement

• Shareholder votes are solicited for the election of directors and for

corporate actions such as mergers, acquisitions, and authorization of

securities.

• A proxy is a means whereby a shareholder authorizes another person to

actor him or her at a meeting of shareholders.

• A proxy statement contains information necessary for shareholders in

voting on matters for which the proxy is solicited.

• Proxy statements contain a wealth of information regarding a company

including the identity of shareholders owning 5% or more of outstanding

shares, biographical information on the board of directors, compensation

arrangements with officers and directors, employee benefit plans, and

certain transactions with officers and directors.

• Proxy statements are not typically part of the annual report.

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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 (Y2Y)

Index-Number Trend Analysis

Comparative Analysis

Yr2Yr1 Yr3

Analysis Preview

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Y2Y analysis is

straightforward.

Be attention when:

1. Negative value

2. Missing value

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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

Common-Size Analysis

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Analysis Preview

• In analyzing a balance sheet:– It is common to express total assets (or liabilities plus

equity) as 100%.

• In analyzing an income statement:– Sales are often set at 100% with the remaining income

statement accounts expressed as a percentage of

sales.

Common-Size Analysis

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Analysis Preview

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Analysis Preview

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Exercise

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Exercise

2006 2005

Sales 100.0% 100.0%

Cost of goods sold 66.0 52.4

Gross profit 34.0% 47.6%

Operating expenses 21.0 19.4

Net income 13.0% 28.2%

Analysis and Interpretation: This situation appears to be unfavorable.

Both cost of goods sold and operating expenses are taking a larger

percent of each sales dollar in year 2006 compared to the prior year.

Also, even though sales volume increased, net income both

decreased in absolute terms and declined to only 13.0% of sales as

compared to 28.2% in the year before.

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Exercise

• Express the Mixon Company’s balance sheets in common-size

percents. (Round to the nearest one-tenth of a percent.)

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Exercise

Mixon Company

Common-Size Comparative Balance Sheet

December 31, 2004-2006

2006 2005* 2004*

Cash 5.9% 8.0% 9.9%

Accounts receivable, net 17.1 14.0 13.2

Merchandise inventory 21.5 18.5 14.2

Prepaid expenses 1.9 2.1 1.1

Plant assets, net 53.6 57.3 61.6

Total assets 100.0% 100.0% 100.0%

Accounts payable 24.9% 16.9% 13.2%

Long-term notes payable secured by

mortgages on plant assets 18.8 23.0 22.1

Common stock, $10 par value 31.4 36.5 43.6

Retained earnings 24.9 23.5 21.0

Total liabilities and equity 100.0% 100.0% 100.0%

* Column does not equal 100.0 due to rounding.

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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

Ratio Analysis

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Analysis Preview

Purpose: Estimate intrinsic value of a

company (or stock)

Basis: Present value theory (time value of

money)

ValuationValuation - an important goal of many types

of business analysis

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Analysis Preview

Annuity & its Present Value (PV)

An annuity is a series of payments made at fixed intervals of time.

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PV formula for Annuity

Analysis Preview

① * (1+i)

②-①

(1 + i)P − P = A − A(1 + i) − n

P(1 + i − 1) = A[1 − (1 + i) − n]

P = A [1 − (1 + i) − n] / i

The PV of an annuity is the summation of a Geometric sequence, the

discount factor is its common ratio.

①

②

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Analysis Preview

Discount rate VS discount factor

• Discount rate: Assuming a discount rate (i) of 10%, the $1,000 in a

year's time would be equivalent to $909.09 to you today (1,000 /

[1.00 + 0.10]).

• Discount factor: for the same case, the discount factor is 1/(1+i)= 1

/ (1.00 + 0.10) = 10/11

PV factor for annuity

• PV factor for annuity:

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Analysis Preview

Annuity & its Present Value (PV)

Use the formula to compute the PV of the annuity :

discount rate = 5%

PV = Annuity * PV factor (of annuity)

= 1000 * [ 1- 1.05^(-5) ] / 0.05

= 1000 * 4.32948

= 4329.48

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Analysis Preview

Debt (Bond) Valuation

• A bond is a form of debt (i.e. a contractual liability;

basically just a certificate showing that a borrower

promises to repay interest and principal on specified

dates.

• Issued by both governments and corporations

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Analysis Preview


• Example: the Government of Canada issued a bond

with a face value of $1,000 in June 2002 which

matures in June 2022. The stated annual interest rate

is 8%:

• the face value (the principal or par value) is $1,000

• the annual coupon is $80

• the coupon rate is 8%

• the time to maturity is 20 years

• the maturity date is June 1, 2022

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Analysis Preview


Bt is the value of the bond at time t

It +n is the interest payment in period t+n

F 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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Exercise

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Exercise

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Exercise

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Analysis Preview

Equity Valuation

– Dividend Discount Model

Vt is the value of an equity security at time t

Dt +n is the dividend in period t+n

k is the cost of capital

E refers to expected dividends

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Analysis Preview

Equity Valuation

– Dividend Discount ModelExample:An investor plans to hold Newco's stock for 2 years. Newco expects to

pay its shareholders common equity, $0.25 per share over the next two

years. The investor anticipates Newco's stock will close the end of that

time period at $40 per share. Given a rate of return of 10%, what is the

value of Newco's common stock at the end of the two-year time

period?

Answer:Value of Newco's common stock

= $0.25/ (1.10)1 + $0.25/(1.10)2 + $40/(1.10)2

= $33.49

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Analysis Preview

Equity Analysis and Valuation

– Earnings Persistence:

Recasting and adjusting earnings;

Determinants of Persistence;

Measuring persistence

– Earnings-Based Valuation:

Stock prices and accounting data

Valuation multiples

– Earning Power and Forecasting:

Earning power

Earnings forecasting Monitoring and revising

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Intrinsic value







present value.



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Intrinsic value







present value.



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Analysis Preview

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]


E refers to an expectation

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Analysis Preview

Equity Valuation

- Residual Income Model

BVt is the book value at the end of period t

Rit+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)]


E refers to an expectation

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Analysis in an Efficient Market

Three 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

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Analysis in an Efficient Market

• EMH (Efficient Market Hypothesis) assumes the existence of

competent and well-informed analysts using tools of analysis like

those described in this book.

• It also assumes analysts are continually evaluating and acting on

the stream of information entering the marketplace.

• Extreme proponents of EMH claim that if all information is instantly

reflected in prices, attempts to reap consistent rewards through

financial statement analysis is futile.

• This extreme position presents a paradox.

– On one hand, financial statement analysts are assumed capable of keeping

markets efficient, yet these same analysts are assumed as unable to earn

excess returns from their efforts.

– Moreover, if analysts presume their efforts in this regard are futile, the efficiency

of the market ceases.

overview of financial statement analysis -...

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