Financial Statement Analysis 1

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Financial analysis encompasses:

- Financial Statement Analysis: process of extracting information from financial statements (FS) to better
understand the wealth creation and the financial structure;
- Valuation: process of drawing in the results of FSA to estimate a company’s worth.

Session 1.X : THE BASICS

Session 1.1: Introduction to the course and Overview of FSA

Objectives of FSA - Helps users to make better decisions: reduction of uncertainty, application of analytical
tools..
4 buildings blocks for a good analysis: (1) Profitability (2) Solvency (3) Liquidity/Efficiency (4) Market data.

Business analysis - evaluation of a company’s economic prospects and risks for business decision.
E.g: Equity and debt valuation, credit risk assessment, earnings predictions.
FSA is an integral part of Business analysis because FS are the most comprehensive source of information
about a company.

Types of Business analysis: Credit analysis, Equity analysis, Labor negotiations, Director oversight,
external auditing, management and control, regulation, M&A, financial management….

Credit value Equity value

Company’s creditworthiness Optimal portfolio of stocks for wealth

maximization. Determination of the intrinsic value
of the firm.

Analysis = Ability to meet financial obligations over a Analysis = equity decision of investment whether buy or
given horizon , main focus risk on liquidity - ST debt - sell stock. Main focus on upside potential
and solvency - LT debt

Process of prospective analysis (forecast future payoffs):

First step: STRATEGY ANALYSIS

Purpose of identifying key drivers of profitability (margin) and of growth (activity), key risks and how
sustainable is the firm competitive advantage.
This analysis is good because:
- Avoid not seeing the forest for the trees
- Facilitates interpretation of data and results
- Provide a framework for presenting a coherent communication
= Strategic choices such as industry, competitive positioning and corporate strategy.

Second step: ACCOUNTING ANALYSIS

Process to evaluate and adjust FS to better reflect economic reality. 2 types of problems: comparability and
distorsion problems.

Third step: FINANCIAL ANALYSIS

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Process to evaluate financial position and performance using FS: Profitability analysis (evaluation of
return of investment), Risk analysis (evaluation of liquidity and solvency) and Cash Flow analysis
(evaluation of source and deployment of funds)

3 types of business activities - planning activities:

- Financing activities
- Investing activities
- Operating activities

4 Financial Statements to reflect business activities:

The FS lists the amounts associated with financing and investing activities and summaries operating
activities for the most recent period.

(1) Balance Sheet: at a point in a period.

ASSETS = LIABILITIES + EQUITY
(2) Income Statement: over a period of time.
(3) Statement of Stockholder’s equity
(4) Statement of Cash Flow: over a period of time
3 dimensions: operating, financing, investing

The difference statements are linked within and across the periods.
- IS and BS = retained earnings
- BS and Statement of Shareholders’equity = retained earnings, contributed capital
- CFS and IS = net income
- CFS and BS = change in BS cash account reflects the net cash inflows and outflows of the period.

Notes/Footnotes that follow these statements: really important, reminder of accounting rules or key points about
regulations.

Session 1.2: Analysis Preview

International Financial Reporting Standards (IFRS) - International accounting standards stating how
particular types of transactions and other event should be reported in FS = Common accounting standards.
Different standards but identical basis
GAAP - generally accepted accounting standards.

A. Important accounting principles:

(1) Historical Cost = fair and objectives values from arm’s length bargaining.

(2) Accrual Accounting = recognize revenues when earned, expenses when incurred.

(3) Materiality = threshold when information impacts making decision

(4) Conservatism = reporting and disclosing the least optimistic information about uncertain events
and transactions.
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B. Accruals: Cornerstone of accounting:

Net income = Operating Cash Flow + Accruals

Two important concepts: Revenue recognition and Expense matching.

Accrual Accounting has a superiority over cash accounting because:

- more appropriate timing of revenue recognition and more precise matching costs
- BS more precise indication of the current financial position
- more relevant for assessing a company’s present and future cash generating ablity.

Fair value accounting - value determined on the basis of their fair values on the measurement date.
VS
Historical cost model - values determined on the basis of prices obtained from actual transactions that
occurred in the past.

= Move toward Fair value accounting because more homogenous and historical cost model doesn’t
enable to have up to date value.

Session 1.3: Steps in accounting analysis

Accounting analysis - process of evaluating the extent that a company’s accounting reflects the economic
reality.
Sometimes there are some distorsions and it’s really important to correct it. It’s important for Financial
analysis because it makes datas and results comparable and adjustments are made in order to eliminate any
bias.

In FS, information has to be:

- Relevant: capacity of information to affect a decision
- Reliable: verifiable, representably faithful and neutral

Limits of FS: (1)Timeliness = periodic disclosure, no real time basis (2) Frequency = quarterly and annually
(3) Forward looking = limited prospective info (4) Environnemental factors (eg: bias of managers..)

2 types of tools for analysis:

1. Comparative analysis: Year 1 - Year 2 - Year 3

• Trend analysis (horizontal analysis): comparison over time of the evolution. All the figures
are expressed with reference to a base year. Useful to understand dynamics of an
evolution.
How? Calculate line item by line item : absolute or % of change or the % of change
approach: base year item amount used as an index with a base value of 100 (trend index)

• Common size analysis (vertical analysis): evaluation of internal markup of FS and

evaluation of FS accounts across companies.
Up-down evaluation of accounts. Output = proportionate size of assets, liabilities, equity,
revenues and expenses. E.g: trade receivables expressed in a % of assets.

2. Ratio analysis: x/y

Evaluate the relation between two or more economically important items. 

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Session 2.X : Financial Statements - Balance Sheet

Session 2.1: Balance Sheet

Assets are listed in order of liquidity while liabilities are listed in order of maturity.
= GAAP orders them in a decreasing way (from the most liquid to the least, from the most mature to the
least) and IFRS orders them in a increasing way.

ASSETS

Assets are divided into :

• Current (short-term assets): ressources or claims to ressources that are expected to be sold, collected, or
used within one year or the operating cycle, whichever is longer.
E.g: Cash & Equivalents, Accounts receivables, Inventory, Prepaid expense…

• Non-current (long-term assets): ressources or claims to ressources that are expected to yield benefits that
extend beyond one year or the operating cycle, whichever is longer.
E.g: Fixed Assets, Intangible, Deferred charges…

Operating cycle : amount of time from commitment of cash for purchases until the collection of cash from
sales.

• CURRENT ASSETS:
(1) Cash: currency, coins and amounts on deposit in bank accounts, checking accounts, and some
savings accounts.

(2) Cash equivalent : short-term, highly liquid investments that are readily convertible to a known cash
amount, close to maturity date and which are not sensitive to interest rate changes.

Liquidity - amount of cash and cash equivalents that the company has on hand (ability to react to strategic
opportunities) or can raise on a short period of time (ability to meet its obligations as they mature).

Sometimes, cash and cash equivalents are required to be maintained as compensating balances to support
existing borrowing arrangements or as collateral for indebtedness.

(3) Receivables : amounts due from others that arise from the sale of goods and services, or the loaning
of money.
Accounts receivable - refer to oral promises of indebtedness due from customers.
Notes receivable - refer to formal written promises of indebtedness due from others.
Always reported at their net realizable value.
Net realizable value = total amount of receivables - allowance for uncollectible amounts.

When it comes to analyzing receivable, two things must be taken into consideration : collection risk and
authenticity of receivables.
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Note 1:
Bad debts result from credit customers who will not pay the business the amount they owe, regardless of
collection efforts. Most businesses record an estimate of the bad debt expense by an adjusting entry at the
end of the accounting period.
= That is why there is an allowance for doubtful accounts. Once subtracted from accounts
receivable, you have the net realizable value of accounts receivable (=amount the business expects to collect).

(4) Inventories: goods held for sale or acquired for sale, as a part of a company’s normal operations.

- Expensing treats inventory costs like period costs. Costs are reported in the period when
incurred.
- Capitalizing treats inventory costs like product costs. Costs are capitalized as an asset and
subsequently charged against future period revenues benefiting from their sale.

FIFO GAAP&IFRS Oldest costs = costs of goods sold & recent costs = ending inventory
- FIFO: less cost of goods sold so a higher income
Average cost GAAP&IFRS The average cost of each unit in inventory is assigned to cost of goods sold

LIFO GAAP Inverse of FIFO (first in first out)

Note 2:
• Capitalization: process of deferring a cost that is incurred in the current period and whose benefits are
expected to extend to one or more future periods.
3 criteria: (1) it must arise from a past transaction (2) yield identifiable and reasonably probable
future benefits (3) allow owner control over future benefits

• Allocation: process of periodically expensing a deferred cost to one or more future expected benefits
periods.
- Depreciation for tangible assets
- Amortization for intangible assets
- Depletion for natural resources

• Impairment: —process of writing down asset value when its expected cash flows are less than its
carrying (book) value.

• NON-CURRENT (LONG-LIVED) ASSETS :

(1) Tangible assets: Property, plant and equipment (PPE).
Rule - Acquisition cost = purchase price + all expenditures needed to prepare the asset for its intended use.
Be careful, acquisition cost excludes financing charges and cash discounts.

Valuation emphasizes objectivity of historical costs, the conservatism principle and accounting for the
money invested.

Limitations of historical costs :

- Balance sheets do not purport to reflect market values
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- Not especially relevant in assessing replacement values

- Not comparable across companies
- Not particularly useful in measuring opportunity costs
- Collection of expenditures reflecting different purchasing power

(2) Intangible assets : patents, trademarks, copyrights and goodwill

They are recorded at cost, including purchase price, legal fees and filing fees.

(3) Deferred charges : research and development (R&D), expenditures and natural ressources

Note 3:
• Depreciation - process of allocating the cost of an asset to expense in the accounting periods benefiting
from its use.

It cannot be used in the balance sheet which records the acquisition cost but can be used in the income
statement which records an expense.

For tangible assets, the calculation of depreciation requires three amounts for each asset :
- Cost
- Salvage value
- Useful life and depreciation method => Rate of depreciation

3 methods to calculate depreciation:

- Straight-line method:

- Units-of-production method:

First step - Calculation of the depreciation rate:

Second step - Calculation of the depreciation expense:

- Accelerated method: Double Declining method

First step - Calculation of the straight line depreciation rate:

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Second step - Calculation of the double-declining balance rate:

Y=2xX

Third step - Calculation of the depreciation expense:

Depreciation expense = Y x Beginning period book value

Other calculations to know:

* Average total life span = Gross plant and equipment assets / Current year depreciation expense
* Average age = Accumulated depreciation / current year depreciation expense
* Average remaining life = Net plant and equipment assets / Current year depreciation expense
* Average total life span = Average age + Average remaining life

LIABILITIES

Liabilities are divided into :

• Operating liabilities: obligations that arise from operating activities.

E.g: Accounts payable, unearned revenue, advance payments, taxes payable, post-retirement liabilities and
other accruals of operating expenses…

• Financing liabilities: obligations that arise from financing activities.

E.g: Short and long-term debt, bonds, notes, leases and the current portion of long-term debt…

Important features in analyzing liabilities :

- Terms of indebtedness (maturity, interest rate, payment pattern, amount)
- Restrictions on deploying ressources and pursuing business activities
- Ability and flexibility in pursing further financing
- Obligations for working capital, debt to equity and other financial figures
- Dilutive conversion features that liabilities are subject to
- Prohibitions on disbursements such as dividends

Same differentiation as for assets:

• Current (short-term) liabilities : obligations whose settlement requires use of current assets or the
incurrence of another liability within one year or the operating cycle, whichever is longer.

• Non-current (long-term) liabilities : obligations not payable within one year or the operating cycle,
whichever is longer.
 • Classifying and distinguishing different equity sources
• Examining rights for equity classes and priorities in liquidation
• Evaluating legal restrictions for equity distribution
• Reviewing restrictions on retained earnings distribution
• Assessing terms and provisions of potential equity issuances
Financial Statement Analysis
Equity Classes : two basic components: 8
• Share capital Fiches Midterms S1
• Retained Earnings

SHAREHOLDER’S EQUITY 39

Equity : refers to owner (shareholder) financing. It reflects claims of owners on net assets and is exposed to
maximum risk and return.
2 basics components : share capital and retained earnings.

Shareholders’ equity
S’E reporting requirements differ
under US Gaap and IFRS
US Gaap IFRS
allows latitude in reporting S’E
5 major elements 5 current categories

• Paid-in capital* • Share capital

Preferred stock • Retained earnings
Common Stock • Reserves**
• Retained earnings • Minority interests***
• Treasury stock ** include accumulated other
*= contributed capital comprehensive income, share premium,
Option compensation
***Non controlling interests
40

* Paid-in capital : total financing received from shareholders for capital shares.
Two types :
- Preferred stock - stock with features not possessed by common stock. 20
- Common stock - stock with ownership interest and bearing ultimate risks and rewards of
company performance thanks to residual interests.

** Treasury stock : shares of a company’s stock reacquired after having been previously issued and fully
paid for. It reduces both assets and shareholder’s equity and is typically recorded at cost.
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Session 2.2: Simplified Balance Sheet and Working Captal

The balance sheet can be structured :

- By distinguishing two separate « time horizons » : current or short-term and non-current or long-term.
- By separating infrastructure related ressource and operation-cycle related ressource from cash

CASH EQUATION

Working Capital (WC) = LTC - FA

* WC > 0 = Investment cycle creates a financing ressource.

* WC < 0 = Investment cycle creates a financing need.

Working Capital Need (CN) = CA - CL

* WCN > 0 = Operating cycle creates a financing need.

* WCN < 0 = Operating cycle creates a financing ressource.

Net Cash (NC) = PC - BO

Net Cash = Working Capital – Working Capital Need

It is useful in managing and evaluating the firm’s income growth potential and the firm’s risks.
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WORKING CAPITAL NEED AND NET CASH

Working capital need : metric that allows manager to anticipate how much additional cash (if any)
might be needed to support the growth of the firm and thus anticipate a need of long-term or short-term
capital.

It highlights what the manager could do if the unavailability of current liabilities was to obtain : this
approach assumes that the manager’s job is to maintain a viable operating cycle (cash pump). Here, we
have a dynamic approach where the manager has to be proactive

Working capital : a measure of security and survival ability to the firm (creditworthiness).
= Working capital would keep the business afloat if all short-term financial supports were removed.
Indeed, it measures the likelihood the business would still be viable under extreme circonstances.

This is a defensive approach. The larger the working capital, the more security the firm has in weathering
storms. It is regarded as a static measure.
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Note 4:

Some formulas to know:

- Inventory turnover = COGS / Inventories
- Receivable collection turnover = Sales / Accounts receivable

These ratios assess effectiveness and intensity of assets in generating sales.

We can also present it in days :

- Receivable collection turnover (days) = (Accounts receivable x 360) / Sales

Session 2.1/Session 2.2: Appendices

INTEREST CALCULATION

The interest formula includes three variables that must be considered when computing interest :

Interest = Principal x Interest rate x Time

When computing interest for one year, « Time » equals 1. When the computation period is less than one year,
then « Time » is a fraction.

PREPAID EXPENSE

Prepaid expenses : advance payments for services or goods not yet received that extend beyond the current
accounting period.
Examples are advance payments for rent, insurance, utilities and property taxes.

For reasons of expediency, non-current prepaids sometimes are included among prepaid expenses
classified as current. When their magnitude is large, they warrant scrutiny. Any substantial changes in
prepaid expenses warrant scrutiny.

SPIN-OFFS AND SPLIT-OFFS

Spin-off : the distribution of subsidiary stock to shareholders as a dividend.

Assets (investment in subsidiary) are reduced as is retained earnings.

Split-off : the exchange of subsidiary stock owned by the company for shares in the company owned by the
shareholders.
Assets (investment in subsidiary) are reduced and the stock received from the
shareholders is treated as treasury stock.

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Session 3.X: Financial Statement - Income Statement

Session 3.1: The Income Statement

The IS enables to evaluate company performance, assess risk exposures and predict amounts, timing and
uncertainty of future cash flows.

INCOME

Income - residual revenues (inflows from operations - recurring) and gains (inflows from non-operations -
non-recurring) less expenses (outflows from operations) and losses (outflows from non-operations).

Reminder:
Accrual Accounting recognizes revenues and gains when earned, expenses and losses when incurred.

2 majors income dimensions:

Operating income Non-operating income

Depends whether the revenue/expense arises from ongoing operation or financing activities.

-> From operating activities -> From non-operating activities, others

3 importants aspects: Important aspect:

- Pertains only to income generated from operations
- Fosses on income for the company, not simply for
equity holders (financing revenues and expenses are
excluded)
- Pertains only to ongoing business activities.
- Includes all components of net income excluded from
operating income.
E.g : gains and losses from a company’s peripheral activities,
impairment losses from write-down, unusual or infrequent
items…

Recurring income Non-recurring income

Motivated by need to separate permanent and transitory components. It depends on the behavior of the revenue.

Accounting standards require 3 alternative income measures to identify recurring and non-recurring
income:
(1) Net income
(2) Comprehensive income: reflects all changes to shareholder equity other than from owner
activities. Measures the net change of wealth. Net income is adjusted for some unrealized gains (or
losses), called Other comprehensive income.
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(3) Continuing income: excludes extraordinary items, cumulative effects of accounting changes,
and the effects of discounted operations from net income.

Note 5:
➔ EBIT = Earnings before interest and tax.
➔ NOPAT = Net operating profit after taxes (= EBIT after tax which requires adjustments)

DECOMPOSITION OF NET PROFIT MARGINS

NON-RECURRING ITEMS

• Extraordinary items
Unusual in nature, infrequent in occurence
E.g: uninsured losses from major casualty, losses from expropriation

• Discontinued segments
Gain and loss from discounted operations are reported separately, net of tax.

• Accounting changes

• Restructuring charges
• Special items
E.g: Asset impairment, restructuring charges…
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REVENUE RECOGNITION

Revenue recognition criteria:

- Earning activities complete (no significant added effort necessary)
- Risk of ownership effectively passed to the buyer
- Revenue and its related expense measured and estimated with accuracy
- Increase in cash
- No subject to revocation

Special revenue recognition situations: revenue when right of return exists, franchise revenues, product financing
arrangement, revenue under contracts, unearned revenue..

DEFERRED CHARGES

Deferred charges - Cost incurred but deferred because they are expected to benefit future periods.
4 categories:

- R&D (IFRS allows firms to capitalize R&D that are incurred in the later stage of their activities)

- Computer software costs: Prior to technological feasibility, costs are expensed when incurred. After
technological feasibility, costs are capitalized as an intangible asset.

- Costs in extractive industries: “full cost view” (= all capitalized and amortized) vs. successful
efforts” (= all costs that do not result directly in discovery of resources have no future benefit and
should be expensed as incurred).

- Miscellaneous

INTEREST COSTS

Interest costs - compensation for use of money.

- Analysts view interest as a period cost—not capitalizable
- Changes in a company borrowing rate, not explained by market trends, reveal changes in risk

ANALYZING PROFIT MARGINS

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Analyzing profit margins - Profitability analysis helps address questions such as:
* What is a company’s relevant income measure?
* What is the quality of income?
* What income items are important for forecasting?
* How persistent are income and its components?
* What is a company’s earnings power?

To analyze gross profit - steps that explain the net change in sales:
* Step 1: Focus on year-to-year change in volume
* Step 2: Focus on year-to-year change in selling price
* Step 3: Focus on Joint in volume and unit price

Note 6:
Some ratios:
➔ ROSales: Net income BIT / sales
➔ ROAssets: Net income / total assets
➔ ROEquity: Net income / Shareholder’s equity
➔ Asset turnover: Sales / total assets = 1,8. For 1 dollar invested, it generates 1,8 dollar of sales

Some ratios:

- ROSales: Net income BIT / sales

- ROAssets: Net income / total assets
- ROEquity: Net income / Shareholder’s equity
- Asset turnover: Sales / total assets = 1,8. For 1 dollar invested, it generates 1,8 dollar of sales