Financial
Statement
Analysis
SARAH FE SHARON L. GABRIEL, MBA, CPA, CMITAP
Substitute Techer
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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BFM333 - Financial Analysis and Reporting
Course Description
• This course takes an in-depth look into company financial
statements and shows how information therein can be
analyzed and processed to aid many individuals including
creditors, investors, managers, consultants, auditors,
directors, regulators and employees in their business
decisions. It equips students with a wide array of tools and
techniques useful in many fields in finance
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Course Learning Outcomes
As a result of this course, students should be able to:
• write a background material on a company, its industry and its economic
environment
• sift and analyze important information from the Notes to the Financial
Statements portion of annual reports and adjust the statements as
needed
• evaluate a company’s sources and uses of cash using tools and techniques
in cash flow analysis
• estimate the company’s economic value using the residual income model
• synthesize the results of the various analyses above and come up with
credit and investment recommendations
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• determine if a company is a good short term credit by employing tools of
liquidity analysis
• appraise if a company is a good long term credit using capital structure
measures and tools in solvency analysis
• measure a company’s ROI from an operating standpoint as well as from
the viewpoint of shareholders
• project the company’s financial statements over both the short and long
term by applying techniques in prospective analysis
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Course Outline
Part 1 Overview of Financial Statement Analysis
• Types and Components of Business Analysis
• The Financial Statements
• Analysis Tools
Part 2 Financial Reporting and Analysis
Part 3 Special Topics in Accounting Analysis
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Part 4 Financial Statement Analysis Proper
• Comparative Financial Statement Analysis
• Common Size Financial Statement Analysis
• Cash Flow Analysis
• Credit Analysis (Liquidity & Solvency)
• ROI & Profitability Analysis
• Prospective Analysis
• Equity Valuation
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One Word Activity
Instruction
Choose one Finance related word that
best describes you or your life and explain
why
Name Spinner
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Overview of Financial
Statement Analysis
1
CHAPTER
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Business Analysis
Evaluate Prospects Evaluate Risks
Business Decision Makers
Equity investors
Creditors
Managers
Merger and Acquisition Analysts
External Auditors
Directors
Regulators
Employees & Unions
Lawyers
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Information Sources for Business
Analysis
Quantitative Qualitative
Management discussion & Analysis
Financial Statements
Chairperson’s Letter
Industry Statistics
Press Releases
Economic Indicators
Financial press
Regulatory filings
Vision/Mission Statement
Trade reports Web sites
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Credit Analysis Equity Analysis
Management &
Control Labor Negotiations
Types of
Business Director Oversight
Regulation Analysis
Financial External Auditing
Management
Mergers, Acquisitions
& Divestitures
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Credit Analysis
Trade Non-trade
Creditors Creditors
Provide Provide
Bear risk of Bear risk of
goods or major
default default
services financing
Usually Usually
Most short- Most long-
implicit explicit
term term
interest interest
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Credit Analysis
Credit worthiness: Ability to honor credit obligations
(downside risk)
Liquidity Solvency
Ability to meet short- Ability to meet long-
term obligations term obligations
Focus: Focus:
• Current cash flows • Long-term profitability
• Make up of current • Capital structure
assets and liabilities
• Liquidity of assets
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Equity Analysis
Assessment of downside risk and upside potential
Technical analysis / Fundamental Analysis
Charting
Determine Intrinsic value
• Patterns in price or without reference to
volume history of a price
stock
• Predict future price • Analyze and interpret
movements key factors
– Economy
– Industry
– Company
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Technical analysis / Charting
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Technical analysis / Charting
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Equity Analysis
Assessment of downside risk and upside potential
Technical analysis / Fundamental Analysis
Charting
Determine Intrinsic value
• Patterns in price or without reference to
volume history of a price
stock
• Predict future price • Analyze and interpret
movements key factors
– Economy
– Industry
– Company
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Component Processes of
Business Analysis
Business
Environment &
Strategy Analysis
Industry Strategy
Analysis Analysis
Financial
Analysis
Analysis
Accounting of cash Prospective
Analysis flows Risk
Analysis
Profitability
Analysis Analysis
Cost of Capital Estimate Intrinsic Value
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Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality
Comparability problems — across firms and across time
Manager estimation error
Distortion problems Earnings management Accounting
Risk
Accounting Standards
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Financial Analysis
Process to evaluate financial position and
performance using financial statements
Profitability analysis — Evaluate return
on investments Common tools
Risk analysis ——— Evaluate riskiness
& creditworthiness Cash
Ratio
flow
analysis
analysis
Analysis of — Evaluate source &
cash flows deployment of funds
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Prospective Analysis
Process to forecast future payoffs
Business Environment
& Strategy Analysis
Accounting Analysis
Financial Analysis
Intrinsic Value
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Dynamics of Business Activities
Business Activities Time
Beginning of period
Investing Financing
Planning
Operating
Planning
Investing Financing
End of period
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Business Activities
Competition Pricing
Market demands Tactics
Planning
Activities:
Distribution Goals Promotion
& Objectives
Projections
Managerial performance
Opportunities Obstacles
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Business Activities
Financing activities
• Owner (equity)
• Nonowner (liabilities)
Financing
Creditor
• Debt creditor
• Operating creditor
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Business Activities
Investing activities
• Buying resources
• Selling resources
Investing Financing
Investing activities
• Operating asset/Financial asset
• Current/Non-current asset Investing = Financing
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Business Activities
Planning
Investing Activities Financial
Activities Activities
Operating Activities
Revenues and expenses from providing
goods and services
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Financial Statements Reflect Business Activities
Planning
Investing Financing
Current: Operating Current:
• Cash • Notes Payable
• Sales • Accounts Payable
• Accounts Receivable • Cost of Goods Sold
• Inventories • Salaries Payable
• Selling Expense
• Marketable Securities • Income Tax Payable
• Administrative Expense
Noncurrent: Noncurrent:
• Interest Expense
• Land, Buildings, & • Income Tax Expense
• Bonds Payable
Equipment • Common Stock
• Patents • Retained Earnings
Net Income
• Investments
Liabilities & Equity
Income statement
Assets Cash Flow Balance Sheet
Balance Sheet Statement of Statement of
Cash Flows Shareholders’ Equity
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Financial Statements
Balance Sheet
Income Statement
Statement of Shareholders’
Equity
Statement of Cash Flows
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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)
$12.238 - $5.536 = $6.701 Gross Profit
$6.701 - $4.5411 = $2.160 Operating profit
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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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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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Analysis Preview
Yr1 Yr2 Yr3
Comparative 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
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Analysis Preview
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Analysis Preview
Common-Size Analysis
Purpose : • Evaluation of internal makeup
of financial statements
• Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses
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Analysis Preview
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Analysis Preview
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Analysis Preview
Ratio Analysis
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
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Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis
Purpose: Estimate intrinsic value of a
company (or stock)
Basis: Present value theory (time value of
money)
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Analysis Preview
Debt (Bond) Valuation
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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Analysis Preview
Equity Valuation
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 - 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 capital
E refers to an expectation
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Analysis Preview
Equity Valuation - Residual Income Model
BV is the book value at the end of period t
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)]
k is the cost of capital
E refers to an expectation
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Book Organization
Financial Statement Analysis
Part I Part II Part III
Introduction and Overview Accounting Analysis Financial Analysis
Chapter 3: Analyzing Chapter 7: Cash Flow
Chapter 1: Overview of Analysis
Financial Activities
Financial Statement Chapter 8: Return on
Chapter 4: Analyzing
Analysis Invested Capital
Investing Activities
Chapter 5: Analyzing Chapter 9: Profitability
Chapter 2: Financial Analysis
Investing Activities:
Reporting and Chapter 10: Prospective
Special topic
Analysis Analysis
Chapter 6: Analyzing
Chapter 11: Credit
Operating Activities Analysis
Chapter 12: Equity
Analysis and Valuation
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Exercise 1-1 (20 minutes)
A.
• Comparative financial statement analysis for a single year reflects a
brief period of a company's history. It is essentially an interim analysis
of a company’s business activities for that year. Moreover, the
accounting system’s allocation of costs and revenues to such short
periods of time is, to a considerable extent, based upon convention,
judgment, and estimates.
• The shorter the time period, the more difficult is the matching and
recognition process and the more it is subject to error. In addition,
single-year comparative analysis may not accurately reflect a
company's long-run performance. This is because of the possibility of
unusually favorable or unfavorable economic or other conditions
experienced in any particular year.)
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• Consequently, any comparative financial statement analysis for a single
year cannot provide information on trends and changing relations that
might occur over time. For this reason, the information generated by
comparative analysis of a set of single-year statements is of limited
interpretive value. Moreover, the financial statements themselves have
limitations for analytical and interpretive purposes by virtue of the inherent
limitations of the accounting function applied to a single year.
• Also, many factors that significantly affect the progress and success of a
firm are not of a financial character and are not, therefore, expressed
explicitly in financial statements. These include factors such as general
economic conditions, labor relations, and customer attitudes. The
preparation of comparative statements for a single year would not alleviate
these limitations.
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B.
• Changes or inconsistencies in accounting methods, policies, or
classifications for the years covered by comparative financial statement
analysis can yield misleading inferences regarding trends or changing
relations.
• For example, a change in a firm's depreciation or inventory methods, even
though the alternative procedures are acceptable or preferable, can inhibit
the comparability of corresponding items in two or more of the periods
covered.
• Further, the existence of errors (and their correction in subsequent
periods), nonrecurring gains or losses, mergers and acquisitions, and
changes in business activities can yield misleading inferences from
comparative analysis performed over several years.
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• To avoid the potential for misleading inferences from these factors, we
must carefully examine footnotes, explanations, and qualifications that are
disclosed as part of financial reporting. Our comparative analysis must be
adjusted for such possibilities. Also, changing price levels for the periods
of analysis can distort comparative financial statements.
• For example, even items on a comparative balance sheet or income
statement that pertain to a single year are not all expressed in dollars
having the same purchasing power. Namely, in an era of rising prices, a
given year's depreciation represents older dollars having greater
purchasing power compared with most other income statement items.
Further, inventory methods other than LIFO can add to the inflationary
distortion of the income statement. Similarly, balance sheet items for a
given year are expressed in dollars of varying purchasing power
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• Beyond these vertical distortions that exist within individual years covered by
comparative financial statements, are horizontal distortions in the trends and
relations of corresponding items across years. For example, an upward trend
in sales may actually reflect a constant level of, or even decline in, actual
sales volume because of increases in prices.
• Because of the potential for misleading inferences from comparative analysis
during periods of changing price levels, its usefulness as an analytical and
interpretative tool is severely restricted. This is because price level changes
can limit the comparability of the data in financial statements across time. Of
course, analysis of price-level adjusted financial statements can restore the
comparability of these statements across time and, thereby, enhance their
usefulness as tools of analysis and interpretation
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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)
