Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview of Financial
1-2

Statement Analysis

1
CHAPTER
 1-3

Business Analysis

Evaluate
EvaluateProspects
Prospects Evaluate
EvaluateRisks
Risks
 1-4

Information Sources for Business

Analysis
1-5
 1-6

Credit Analysis
 1-7

Credit Analysis
Credit
Creditworthiness:
worthiness:Ability
Abilityto
tohonor
honorcredit
creditobligations
obligations
(downside
(downsiderisk)
risk)

Liquidity
Liquidity Solvency
Solvency
Ability
Abilityto
tomeet
meetshort-
short- Ability
Abilityto
tomeet
meetlong-
long-
term
termobligations
obligations term
termobligations
obligations
Focus:
Focus: Focus:
Focus:
••Current
Currentcash
cashflows ••Long-term
flows Long-termprofitability
profitability
••Make
Makeupupofofcurrent ••Capital
current Capitalstructure
structure
assets
assetsand
andliabilities
liabilities
••Liquidity
Liquidityof
ofassets
assets
 1-8

Equity Analysis
Assessment
Assessmentof
ofdownside
downsiderisk
riskand
andupside
upsidepotential
potential

Technical
Technicalanalysis
analysis/ / Fundamental
FundamentalAnalysis
Analysis
Charting
Charting Determine
DetermineIntrinsic
Intrinsicvalue
value
••Patterns
Patternsin
inprice
priceor
or without
volume withoutreference
referenceto to
volumehistory
historyof
ofaa price
price
stock
stock
••Predict ••Analyze
Analyzeand
andinterpret
Predictfuture
futureprice
price interpret
movements key
keyfactors
factors
movements
–– Economy
Economy
–– Industry
Industry
–– Company
Company
1-9
 1-10

Accounting Analysis

Process to evaluate and adjust financial

statements to better reflect economic reality

Accounting
Risk
 1-11

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
 1-12

Prospective Analysis
Process
Processto
toforecast
forecastfuture
futurepayoffs
payoffs

Business
BusinessEnvironment
Environment
&&Strategy
StrategyAnalysis
Analysis

Accounting
AccountingAnalysis
Analysis

Financial
FinancialAnalysis
Analysis

Intrinsic
IntrinsicValue
Value
 1-13

Dynamics of Business Activities

Business
BusinessActivities
Activities Time
Time
 1-14

Business Activities
 1-15

Business Activities

Financing
Financingactivities
activities
• •Owner
Owner(equity)
(equity)
• •Nonowner
Nonowner(liabilities)
(liabilities)

Financing
 1-16

Business Activities

Investing
Investingactivities
activities
• •Buying
Buyingresources
resources
• •Selling
Sellingresources
resources

Investing Financing

Investing
Investing==Financing
Financing
 1-17

Business Activities

Operating
OperatingActivities
Activities
Revenues
Revenuesand
andexpenses
expensesfrom
fromproviding
providing
goods
goodsand
andservices
services
 1-18

Financial Statements Reflect Business Activities

 1-19

Financial Statements
1-20
 1-21

Balance Sheet

Total Investing = Total Financing

= Creditor Financing + Owner Financing
1-22
 1-23

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
1-24
 1-25

Statement of Cash Flows

1-26
 1-27

Additional Information
(Beyond Financial Statements)
 1-28

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
 1-29

Analysis Preview
 1-30

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
 1-31

Analysis Preview
 1-32

Analysis Preview
 1-33

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
 1-34

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)
 1-35

Analysis Preview
Debt (Bond) Valuation

Btt is the value of the bond at time t

Itt +n
+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)
 1-36

Analysis Preview
Equity Valuation

Vtt is the value of an equity security at time t

Dtt +n
+n
is the dividend in period t+n
k is the cost of capital
E refers to expected dividends
 1-37

Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model

FCFt+n
t+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
 1-38

Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period t

tt

Rit+n
t+n
is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning
book value, BV, or RItt = NItt - (k x BVt-1
t-1
)]
k is the cost of capital
E refers to an expectation
 1-39

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
 1-40

Book Organization