Overview of Financial
Statement Analysis
1
CHAPTER
McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Business Analysis
Evaluate Prospects Evaluate Risks
Business Decision Makers
•Equity investors
•Creditors
•Managers
•Merger and Acquisition Analysts
•External Auditors
•Directors
•Regulators
•Employees & Unions
•Lawyers
Information Sources for
Business Analysis
Quantitative Qualitative
• Financial • Management
Discussion &
Statements Analysis
• Industry Statistics • Chairperson’s Letter
• Economic • Vision/Mission
Indicators Statement
• Regulatory filings • Financial Press
• Press Releases
• Trade reports
• Web sites
Credit Analysis Equity Analysis
Management &
Control Labor Negotiations
Types of
Business Director Oversight
Regulation Analysis
Financial External Auditing
Management
Mergers, Acquisitions
& Divestitures
Credit Analysis
Creditors
Trade Creditors Non-trade Creditors
• Provide goods or • Provide major
services financing
• Most short-term • Most long-term
• Usually implicit
• Usually explicit
interest
interest
• Bear risk of
default • Bear risk of default
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 Financial • Long-term financial
conditions conditions
• Current cash flows • Long-term cash flows
• Liquidity of assets • Extended profitability
Equity Analysis
Assessment of downside risk and upside
potential
Technical Analysis Fundamental Analysis
Charting Determine value without
• Patterns in price reference to price
behavior or volume
• Analyze and interpret
history
– Economy
• Predict future price
movements – Industry
– Company
Intrinsic Value
(or Fundamental Value)
Value of Company (or stock) without
reference to market value (or stock price)
Intrinsic value > Market value Buy
Strategy
Intrinsic value < Market value Sell
Intrinsic value = Market value Hold
Business
Environment &
Strategy Analysis
Industry Strategy
Analysis Analysis
Financial
Analysis
Accounting Analysis Prospective
of Sources Analysis
Analysis &Uses of Risk
Profitability
Funds Analysis
Analysis
Cost of Capital Estimate Intrinsic Value
Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality
Comparability problems — across firms and across time
Manager estimation error
Accounting
Distortion problems Earnings management
Risk
Distortion of business
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 Ratio Cash
analysis flow
Analysis of — Evaluate source & analysis
cash flows deployment of funds
Prospective Analysis
Process to forecast future payoffs
Business Environment
& Strategy Analysis
Accounting Analysis
Financial Analysis
Intrinsic Value
Dynamics of Business Activities
Business Activities Time
Beginning of period
Investing Financing
Planning
Operating
Planning
Investing Financing
End of period
Business Activities
Competition Pricing
Market demands Tactics
Planning
Activities:
Distribution Goals Promotion
& Objectives
Projections
Managerial performance
Opportunities Obstacles
Business Activities
Financing activities
• Owner (equity)
• Nonowner (liabilities)
Financing
Business Activities
Investing activities
• Buying resources
• Selling resources
Investing Financing
Investing = Financing
Business Activities
Planning
Investing Activities Financial
Activities Activities
Operating Activities
Revenues and expenses from providing
goods and services
Financial Statements Reflect Business Activities
Planning
Investing Financing
Current: Operating Current:
• Cash
• Notes Payable
• Sales
• Accounts Receivable • Cost of Goods Sold
• Accounts Payable
• Inventories • Selling Expense
• Salaries Payable
• Marketable Securities • Administrative Expense
• Income Tax Payable
Noncurrent: • Interest Expense
Noncurrent:
• Land, Buildings, & • Income Tax Expense
• Bonds Payable
Equipment
• Common Stock
• Patents Net Income • Retained Earnings
• Investments
Liabilities & Equity
Income statement
Assets Cash Flow Balance Sheet
Balance Sheet Statement of Statement of
Cash Flows Shareholders’ Equity
Financial Statements
• Balance Sheet
• Income Statement
• Statement of
Shareholders’ Equity
• Statement of Cash Flows
Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner Financing
Dell Financing
(in $billions)
$23.215 = $16.730 + $6.485
Income Statement
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit
Dell Profitability
(in $billions)
$49,205 - $40,190 = $9,015 Gross Profit
$9,015 - $4,761 = $4,254 Operating profit
Statement of Cash Flows
Net Cash Flows from Operating Activities
Net Cash Flows from Investing Activities
Net Cash Flows from Financing Activities
Additional Information
(Beyond Financial Statements)
•Management Discussion & Analysis (MD&A)
•Management Report
•Auditor Report
•Explanatory Notes to Financial Statements
•Supplementary Information (10-K, 10-Q, 8-K, 20-F)
•Proxy Statement
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
Analysis Preview
Analysis Preview
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
Analysis Preview
Common-Size Analysis
Analysis Preview
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
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)
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 interest rate (yield to maturity)
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
Analysis Preview
Equity Valuation - Free Cash Flow 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
Analysis Preview
Equity Valuation - Residual Income Model
BV is the book value at the end of period
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
Analysis in an Efficient Market
Three assumed forms of market efficiency
Weak Form - prices reflect information in
past prices
Semi-strong Form - prices reflect all public
information
Strong Form - prices reflect all public and
private information
Analysis in an Efficient Market
Market Efficiency
• assumes competent and informed analysis
• distinguish aggregate from individual behavior
• reflects information (both reliable and unreliable)
• cross-country differences in rewards to analysis
Financial statement analysis relevant to more
than just market analysis, e.g.,
• credit and lending
• auditing
• valuation of nonpublicly traded firms
• mergers and acquisitions
• etc.
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
