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)