Far Eastern University

Financial Analysis and Research

Overview of Financial Statement Analysis

RISK (Downside RISK) = LIQUIDITY & SOLVENCY

Overview of Financial Statement Analysis1

Objective: At the end of the discussion the student should:
1. Define financial statement analysis.
2. Define business analysis.
3. Explain different types of business analysis.
4. Describe component analyses that constitute business analysis.
5. Define Valuation.

LIQUIDITY (depends on companys cash flows & the make-up of its

current assets and current liabilities) is a companys ABILITY to raise
cash in the short term to meet its obligation.
SOLVENCY (depends on companys long-term profitability and its
capital <financing> structure) is a companys LONG-TERM
VIABILITY and ABILITY to pay long-term obligation.

Financial Statement Analysis

Is an integral and important part of the broader field of business
analysis. Business Analysis is the process of EVALUATING a
companys ECONOMIC PROSPECTS and RISK includes:
a) Business environment, its strategies; and
b) Its financial position and performance

Tools and Criteria for Credit analysis EVALUATION:

a) Term (maturity);
b) Type; and
c) Purpose of the debt contract.
Short-Term credit the creditor is concerned:
a) Current financial condition;
b) Current Cash Flows; and
c) Liquidity of Current assets.

Financial statement analysis is the APPLICATION of ANALYTICAL

TOOLS and TECHNIQUE to general-purpose financial statements
and related data to derive estimate and inferences useful in business
analysis, REDUCES reliance on hunches, guesses, and intuition for
business decisions, and PROVIDE systematic and effective basis for
business analysis.

Long-term credit, including bond valuation, creditors require more

detailed and forward-looking analysis:
a) Projections of Cash flows
b) Evaluating extended Profitability (sustainable earning power) the
main source of assurance of a companys ABILITY to meet long-term
INTEREST and PRINCIPAL repayments.

Business Analysis is useful in a wide range of business decision,

a) to invest in equity or in debt securities,
b) extend credit through short or long term loans,
c) to value business in Initial Public Offering (IPO)
d) to evaluate restructuring (mergers, acquisitions, and divestitures)

Equity Analysis
Equity investors PROVIDE funds to a company in return of the RISK
and REWARD of ownership. Equity financing (equity or share capital)
meaning the equity investors are entitled to the distribution of
companys assets ONLY after the claims of ALL senior claimants
(creditors) are meet, including interest and preferred dividends. And
lastly, the equity investors are said to hold the residual interest.

Goal of Business Analysis is to improve business decisions by

evaluating available information about a companys financial
situation, its management, its plans and strategies and its business
environment.
Type of Business Analysis
Credit Analysis is the evaluation of the creditworthiness (ability of
company to pay its bill) of company. Creditors lend funds to a
company for a promise of repayment with interest. Trade creditors
(operating) deliver goods or services to a company and expect
payment within the reasonable period, often determined by industry
norms. Non-trade creditors (debt-holder) provide financing to a
company in return for a promise, usually in writing, of repayment with
interest on specific future date.

Individual who apply active investment strategies:

a) Technical Analysis
Charting, searches of pattern in the price or volume history of a stock
to predict future price movements.
b) Fundamental Analysis (widely accepted and applied)
Is the process of determining the value of the company by analyzing
and interpreting key factors for the economy, industry and the
company. A main part of the analysis is evaluating companys
financial position and performance.

Note:
Creditor Return = Credit Contract (Rate of Interest)
Creditor Profit = Goods & Service Delivered

The major goal of fundamental analysis is to determine Intrinsic value

(also called fundamental value). Intrinsic value is the value of the
company (or its stock) determined through fundamental analysis
without reference to its market value (stock price).

Creditor Bears RISK (RISK of default)

Credit Analysis = RISK and RETURN
Credit Analysis = Asymmetric Relationship (Downside RISK)
Credit Analysis = main focus RISK not PROFITABILITY

Investors strategy with the fundamental analysis is straightforward:

BUY when the stocks intrinsic value exceeds its market value, SELL
when a stocks market value exceeds its intrinsic value, and HOLD
when a stocks intrinsic value approximates its market value.

1 Financial Statement Analysis, 10 Edition,

by K. R. Subramanyan, University of
Southern California and John J. Wild,
University of Wisconsin at Madison

To determine intrinsic value an analyst must forecast a companys

earnings or cash flows and determine its risk. This is achieved

Far Eastern University

Financial Analysis and Research
through a comprehensive, in-depth analysis of companys business
prospects and its financial statements.

Overview of Financial Statement Analysis

Business Environment and Strategy Analysis
Includes attention to analysis of the Business environment (analysis
of business environment seek to identify and assess a companys
economic and industry circumstances. Analysis of its product, labor,

c) Combination of the technical and fundamental analysis

Other Uses of Business Analysis
a) Managers
Provide with clues to strategic changes in operating,
investing and financing activities.
Analyze the business and financial statement (FS) of
competing companies to evaluate a competitors
profitability and risk. (interfirm comparisons)
Both to evaluate relative strength and weaknesses.
Benchmak performance.
b) Mergers, Acquisitions, Divestitures
Business analysis is performed whenever a company
restructures its operations. (merger, acquisition,
divestitures and spin-offs.
Investment bankers need to identify potential targets and
determine their value, and
Security analysts need to determine whether or how much
additional value is created by merger for both acquirer and
acquire.
c) Financial Management
Evaluate the impact of financing decision and dividend
policy on company value.
Assess the impact of financing decisions on both future
profitability and risk.
d) Directors
Fulfilling their oversight responsibilities, responsible for
protecting the interest of the shareholders.
e) Regulator
In the case of the Philippines, BIR apply FS analysis to
audit tax return and check the reasonableness of the
reported amount.
f) Labor Union
For Collective Bargaining Agreement (CBA)
g) Customers
Determine the profitability (staying power) of supplier.

and capital market within the economic and regulatory setting called
Industry Analysis). Industry Analysis using the framework proposed
by Porters (Porters Five Forces Model) or Value Chain Analysis.
Under this framework, an industry is viewed as a collection of
competitors that jockey for bargaining power with consumers and
suppliers and that actively compete among themselves and face
threat from new entrants and substitute product. And Strategy
(analysis of Business strategy seeks to identify and assess a
companys competitive strength, and weaknesses along with
opportunity and threats called Strategy Analysis). Strategy Analysis is
the evaluation of both companys business decision and its success
at establishing a competitive advantage. This includes assessing a
companys expected strategic responses to its business environment
and impact of these responses on its future success or growth.
Accounting Analysis
Is a process of evaluating the extent to which a companys reflects
economic reality. This is done by studying a companys transaction
and events, assessing the effect of its accounting policies on financial
statements and adjusting the financial statement to both better reflect
the underlying economics and make them more amenable to
analysis. Financial statement is the primary source of information for
financial analysis.
Note:
The quality of the Financial Analysis depends on the reliability of
Financial Statements that in turn depends on the quality of
Accounting Analysis. Accounting Analysis is especially important for
comparative analysis.

Prepares
Corporation
Partnership

Components of Business Analysis

Business analysis encompasses several interrelated process.

Sole
Proprietorship

Context of estimating Company Value (Intrinsic Value)

Valuation Model (inputs to the valuation model includes estimates of
future pay0ffs Prospective Cash Flows or Earning and Cost of
Capital). The process of forecasting future payoffs is called
Prospective analysis. To accurately forecast future payoffs, it is
important to evaluate both the companys business prospects and its
financial statements. Evaluate of business prospects is the major
goal of business environment and strategy analysis. Financial status
is assessed from its financial statements using financial statement
analysis. The quality of financial analysis depends on the reliability
and the economic content of financial statements. This requires
accounting analysis of financial statements.
Guide:
Financial Statement =
Analysis

Accounting +
Analysis

Financial +
Analysis

ACCOUNTING

MADE
------------------Fundamental
Principles
Governed with
Standard
GAAP
IFRS/PFRS
IAS/PAS

FS

Users
Investors
Creditors
Analyst
Regulator
SEC
BIR

The Accounting limitations affect the usefulness of financial

statements and can yield at least two (2) problems in analysis.
a) Comparability problems arise when different companies adopt
different accounting for similar transaction or event, also when the
company changes its accounting across time, leading to difficulties
with temporary comparability.
b) Accounting distortion are deviations of accounting information from
the underlying economics. Distortions occur in at least three (3)
forms:
1) Managerial estimate (honest errors or omissions. This estimation
error is a major cause of accounting distortion)
2) Manipulates or widow-dress financial statements (earning
management)
3) Failure to capture the economic reality

Prospective
Analysis

Far Eastern University

Financial Analysis and Research

Overview of Financial Statement Analysis

2) Turnover (Capitalization utilization)

These three (3) of accounting distortion create accounting risk in

financial statement analysis. Accounting Risk is the uncertainty in
financial statement analysis due to accounting distortion.

Risk Analysis
Is the evaluation of companys ability to meet its commitments.
Involves assessing the solvency and liquidity of a company with its
earnings variability. Risk is foremost concern to creditors, risk
analysis is often discussed in the context of credit risk. Important to
equity analysis, both evaluate the reliability and sustainability of
companys performance and to estimate a companys cost of capital.

A major goal of accounting analysis is to evaluate and reduce

accounting risk and to improve the economic content of financial
statements, including comparability.
Financial Analysis
Is the use of financial statements to analyze a companys financial
position and performance, and to assess future financial
performance. Financial analysis consists of three (3) broad areas
Probability Analysis, Risk Analysis, and Analysis of sources and of
funds.

Analysis of Cash Flows

Is the evaluation of how a company obtaining and deploying its
funds. Provides insights into a companys future financing
implications.
Prospective Analysis
Is the forecasting of future payoffs typically earnings, cash flows or
both. Draws on accounting analysis, financial analysis and business
environment and strategy analysis. The output of prospective
analysis is a set of expected future payoffs used to estimate
company value.

Profitability Analysis
Is the evaluation of companys return on investment. It focuses on a
companys sources and level of profits and involves identifying and
measuring the impact of various profitability drivers. Financial
analysis is also focuses on reason for changes of profitability and the
sustainability of earning.

Valuation
Is the main objective of many types of business analysis. Valuation
refers to the process of converting forecast of future payoffs into an
estimate of company value.

Two (2) major sources of Profitability

1) Margins (The portion of sales not offset by cost)