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 Statement Analysis

1-2

1
CHAPTER

1-3

Business Analysis
Evaluate Prospects
Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers

Evaluate Risks

1-4

Information Sources for Business Analysis
Quantitative Financial Statements Industry Statistics
Press Releases Qualitative Management discussion & Analysis Chairperson’s Letter

Economic Indicators
Financial press

Regulatory filings
Vision/Mission Statement

Trade reports

Web sites

1-5

Credit Analysis

Equity Analysis

Management & Control
Types of Business Analysis

Labor Negotiations

Regulation

Director Oversight

Financial Management

External Auditing
Mergers, Acquisitions & Divestitures

1-6

Credit Analysis

Trade Creditors

Non-trade Creditors Provide major financing

Provide goods or services

Bear risk of default

Bear risk of default

Most shortterm

Usually implicit interest

Most longterm

Usually explicit interest

1-7

Credit Analysis
Credit worthiness: Ability to honor credit obligations (downside risk)

Liquidity Ability to meet shortterm obligations Focus: • Current cash flows • Make up of current assets and liabilities • Liquidity of assets

Solvency Ability to meet longterm obligations Focus: • Long-term profitability • Capital structure

1-8

Equity Analysis
Assessment of downside risk and upside potential

Technical analysis / Charting • Patterns in price or volume history of a stock • Predict future price movements

Fundamental Analysis Determine Intrinsic value without reference to price • Analyze and interpret key factors
– Economy – Industry – Company

1-9

Component Processes of Business Analysis

Business Environment & Strategy Analysis Industry Analysis Strategy Analysis

Financial Analysis Analysis of cash flows Risk Profitability Analysis Analysis

Accounting Analysis

Prospective Analysis

Cost of Capital Estimate

Intrinsic Value

1-10

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 Standards

Accounting Risk

1-11

Financial Analysis
Process to evaluate financial position and performance using financial statements
Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Analysis of — cash flows Evaluate source & deployment of funds

Common tools
Cash flow analysis

Ratio analysis

1-12

Prospective Analysis
Process to forecast future payoffs
Business Environment & Strategy Analysis Accounting Analysis

Financial Analysis

Intrinsic Value

1-13

Dynamics of Business Activities
Business Activities
Investing Financing
Planning

Time
Beginning of period

Operating

Planning Investing Financing End of period

1-14

Business Activities
Competition Pricing Tactics Planning Activities: Goals & Objectives

Market demands

Distribution

Promotion Projections

Managerial performance Opportunities Obstacles

1-15

Business Activities

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

Financing

1-16

Business Activities

Investing activities • Buying resources • Selling resources

Investing

Financing

Investing = Financing

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Business Activities
Investing Activities Planning Activities Financial Activities

Operating Activities
Revenues and expenses from providing goods and services

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Financial Statements Reflect Business Activities
Planning
Investing
Current:

• • •

Financing
Current:

• • •

Operating
Sales • Cost of Goods Sold • Selling Expense • Administrative Expense • Interest Expense • Income Tax Expense

Cash Accounts Receivable Inventories Marketable Securities Land, Buildings, & Equipment Patents Investments

Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings

Noncurrent:

Noncurrent:

• •

• •

Net Income

Income statement
Assets

Liabilities & Equity

Cash Flow

Balance Sheet

Balance Sheet

Statement of Cash Flows

Statement of Shareholders’ Equity

1-19

Financial Statements
Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows

1-20

1-21

Balance Sheet
Total Investing = Total Financing = Creditor Financing + Owner Financing

Colgate Financing (in $billions) $9.138 = $7.727 + $1.410

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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
Net Cash Flows from Operating Activities
Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities

1-26

1-27

Additional Information
(Beyond Financial Statements)
Management’s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information Proxy Statement

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

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)

1-36

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

1-37

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

1-38

Analysis Preview
Equity Valuation - Residual Income Model

BV 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)] k is the cost of capital E refers to an expectation
t

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
Financial Statement Analysis
Part I Introduction and Overview Part II Accounting Analysis Chapter 3: Analyzing Financial Activities Chapter 4: Analyzing Investing Activities Chapter 5: Analyzing Investing Activities: Special topic Chapter 6: Analyzing Operating Activities Part III Financial Analysis
Chapter 7: Cash Flow Analysis Chapter 8: Return on Invested Capital Chapter 9: Profitability Analysis Chapter 10: Prospective Analysis Chapter 11: Credit Analysis Chapter 12: Equity Analysis and Valuation

Chapter 1: Overview of Financial Statement Analysis
Chapter 2: Financial Reporting and Analysis

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