FSA LECTURES (Notes)

INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis is a method of reviewing and analyzing a company‘s
accounting reports (financial statements) in order to gauge its past, present or projected
future performance. This process of reviewing the financial statements allows for better
economic decision making.
Globally, publicly listed companies are required by law to file their financial statements
with the relevant authorities. For example, publicly listed firms in Pakistan are required
to submit their financial statements to the Securities and Exchange Commission of
Pakistan (SECP). Firms are also obligated to provide their financial statements in the
annual report that they share with their stakeholders. As financial statements are
prepared in order to meet requirements, the second step in the process is to analyze
them effectively so that future profitability and cash flows can be forecasted.
Purpose of Financial Statements Analysis
The main purpose of financial statement analysis is to utilize information about the past
performance of the company in order to predict how it will fare in the future. Another
important purpose of the analysis of financial statements is to identify potential problem
areas and troubleshoot those.
Financial Statement Analysis (Meaning)
 Financial statement analysis is an analysis which highlights the important
relationships in the financial statements.
 It focuses on evaluation of past operations as revealed by the analysis of basic
statements.
 Financial statement analysis embraces the methods used in assessing and
interpreting the result of past performance and current financial position as they
relate to particular factors of interest in investment decisions.
 Financial statement analysis is an important means of assessing past
performance and in forecasting and planning future performance.
 Financial statement analysis is a systematic and specialized arrangement of
information for the purpose of its interpretation.
Definitions of Financial Statement Analysis
(a) "Financial statement analysis is an information processing system designed
to provide data for decision-making models, such as the portfolio selection
model, bank lending decision models and corporate financial management
models."
(b) "Financial statements analysis is largely a study of relationship among the
various financial factors in a business as disclosed by a single set of
 statements and a study of the trends of these factors as shown in series of
statements."

USERS OF FINANCIAL STATEMENTS ANALYSIS

There are different users of financial statement analysis. These can be classified into
internal and external users. Internal users refer to the management of the company who
analyzes financial statements in order to make decisions related to the operations of the
company. External users do not necessarily belong to the company but still hold some
sort of financial interest. These include owners, investors, creditors, government,
employees, customers, and the general public. These users are elaborated on below:
1. Management

The managers of the company use their financial statement analysis to make intelligent
decisions about their performance. For instance, they may gauge cost per distribution
channel, or how much cash they have left, from their accounting reports and make
decisions from these analysis results.

2. Owners

Boards of directors, as investor representatives, use them to monitor managers’

decisions and actions. Small business owners need financial information from their
operations to determine whether the business is profitable. It helps in making decisions
like whether to continue operating the business, whether to improve business strategies
or whether to give up on the business altogether.

3.Investors

Investors who have purchased shares in a company need financial information to

known the method which used by the company in performance evaluation process. The
investors use financial statement analysis to determine what to do by through their
investments in the company, So depending on how the company is doing, the investors
will either hold onto their shares, sell them or buy more.
4. Creditors
Creditors are interested in knowing if a company will be able to pay its debts or loans as
they become due. The creditors use cash flow analysis of the company‘s accounting
records to measure the company‘s liquidity, or its ability to make short-term payments.
5. Government
Governing and regulating bodies of the state look at financial statement analysis to
determine how the economy is performing in general so they can plan their financial and
industrial policies. Tax authorities also analyze a company‘s statements to calculate the
tax burden that the company has to pay.

6.Employees
Employees need to know if their employment is secure and if there is a possibility to
increase their salaries. The employees want to be well-informed of their company‘s
profitability and stability. Employees may also be interested in knowing the company‘s
financial position to see whether there may be plans for expansion and hence, career
prospects for them. Employees and unions use financial statements in labor
negotiations.

7.Customers

Customers need to know about the ability of the company to service its clients into the
future. The need to know about the company‘s stability of operations is heightened if the
customer (i.e. a distributor of specialized products) is dependent wholly on the company
for its supplies.

8.General Public

Anyone in the general public, like students, analysts and researchers, may be interested
in using a company‘s financial statement analysis. They may wish to evaluate the
effects of the firm on the environment, or the economy or even the local community. For
instance, if the company is running corporate social responsibility programs for
improving the community, the public may want to be aware of the future operations of
the company.
9. Suppliers
A supplier uses financial information as part of the due-diligence process, an important
step in identifying the risks associated with doing business with a client. Suppliers use
financial statements in setting credit terms.
10. Others
Investment advisors and information intermediaries use financial statements in making
buy-sell recommendations and in credit rating. Investment bankers use financial
statements in determining company value in an IPO, merger, or acquisition.

KEY FINANCIAL STATEMENTS & HOW THEY ARE ANALYZED

The main types of financial statements are the balance sheet, the income statement
and the statement of cash flows. These accounting reports are analyzed in order to aid
economic decision-making of a firm and also to predict profitability and cash flows.
BALANCE SHEET
The balance sheet shows the current financial position of the firm, at a given single
point in time. It is also called the statement of financial position. The structure of the
balance sheet is laid out such that on one side assets of the firm are listed, while on the
other side liabilities and shareholders’ equity is shown. The two sides of the balance
sheet must balance as follows:
Assets = Liabilities + Shareholders’ Equity
The main items on the balance sheet are explained below:
Current Assets
Current assets held by the firm refer to cash and cash equivalents. These cash
equivalents are assets that can be easily converted into cash within one year. Current
assets include marketable securities, inventory and accounts receivable.
Long-term Assets
Long-term assets are also called non-current assets and include fixed assets like plant,
equipment and machinery, and property, etc.
A firm records depreciation of its fixed, long-term assets every year. It is not an actual
expense of cash paid, but is only a reduction in the book value of the asset. The book
value is calculated by subtracting the accumulated depreciation of prior years from the
price of the assets.
Total Assets = Current Assets + Book Value of Long-Term Assets
Current Liabilities
Current liabilities of the firm are obligations that are due in less than one year. These
include accounts payable, deferred expenses and also notes payable.
Long-term Liabilities
Long-term liabilities of the firm are financial payments or obligations due after one year.
These include loans that the firm has to repay in more than a year, and also capital
leases which the firm has to pay for in exchange for using a fixed asset.
Shareholders’ Equity
Shareholders’ equity is also known as the book value of equity or net worth of the firm. It
is the difference between total assets owned by a firm and total liabilities outstanding. It
is different from the market value of equity (stock market capitalization) which is
calculated as follows: number of shares outstanding multiplied by the current share
price.
Balance Sheet Analysis
The balance sheet is analyzed to obtain some key ratios that help explain the health of
the firm at a given point in time. These metrics are as follows:
Debt-Equity Ratio = Total Debt / Total Equity
The debt-equity ratio is also called a leverage ratio. It is calculated to assess the
leverage, or gearing, of a firm to show how much it relies on debt to finance its activities.
This ratio has pertinent implications for the financial health of the firm and the risk and
return of its shares.
Market-to-Book Ratio = Market Value of Equity / Book Value of Equity
The market-to-book ratio is used to reflect any changes in a firm’s characteristics. The
variations in this ratio also show any value added by the management and its growth
prospects.
Enterprise Value = Market Value of Equity + Debt – Cash
The enterprise value of a firm shows the underlying value of the business. It reflects the
true value of the firm’s assets, not including any cash or cash equivalents, while
unencumbered by the debt the firm carries.
INCOME STATEMENT

The purpose of an income statement is to report the revenues and expenditures of a

firm over a specific period of time. It was previously also called a profit and loss
account. The general structure of the income statement with major components is as
follows:

Sales revenue

– Cost of goods sold (COGS)

= Gross profit

– Selling, general and administrative costs (SG&A)

– Research and development (R&D)

= Earnings before interest, taxes, depreciation and amortization (EBITDA)

– Depreciation and amortization

= Earnings before interest and taxes (EBIT)

– Interest expense

= Earnings before taxes (EBT)

– Taxes
= Net income

The net income on the income statement, if positive, shows that the company has made
a profit. If the net income is negative, it means the company incurred a loss.

Earnings per share can be derived from knowing the total number of shares outstanding
of the company:

Earnings per Share = Net Income / Shares Outstanding

Income statement Analysis

Some useful metrics based on the information provided in the income statement and the
balance sheet are as follows:

Profitability Ratios:

1. Net profit margin: This ratio calculates the amount of profit that the company has
earned after taxes and all expenses have been deducted from net sales.

Net profit Margin =Net Income / Net Sales

2. Return on Equity: This ratio is used to calculate company profit as a percentage of

total equity.

Return on Equity = Net Income / Book Value of Equity

Valuation Ratios:

Price to earnings ratios (P/E ratio)

The P/E ratio is used to evaluate whether the value of a stock is proportional to the level
of earnings it can generate for its stockholders. It assesses whether the stock is
overvalued or undervalued.

(P/E) Ratio = Market Capitalization / Net Income = Share Price / Earnings per Share

III. The Statement of Cash Flows

CASH FLOW STATEMENT

The statement of cash flows shows explicitly the sources of the firm’s cash and where
the cash is utilized. It is essentially a statement whereby the net income is adjusted for
non-cash expenses and any changes to the net working capital. It also reflects changes
in cash coming from, or being used by, investing and financing activities of the firm. The
structure and main components of the cash flow statement are as follows:

Cash from operating activities = Net income + Depreciation ± Changes in net working
capital
Cash from financing activities = New debt + New shares – Dividends – Shares
repurchased

Cash from investment activities = Capital expenditure – Proceeds from sales of long-
term assets

All three of the above determine the bottom line: changes in cash flows.

Cash Flows Statement Analysis

In order to measure how much cash is available to the company for investments without
outside financing or money diverting from operations, it is useful to conduct a simple
cash flow statement analysis. The free cash flow, as the name suggests, allows a
company to be able to pay dividends, repay its debts, buy back its stock and also make
new investments to facilitate future growth. The excess cash produced by the company,
free cash flow, is calculated as follows:

Net Income

+ Amortization/Depreciation

– Changes in Working Capital

– Capital Expenditures

= Free Cash Flow

Some analysts also study the cash flow from operating activities to see if the company
is earning “quality” income. In order for the company to be doing extremely well, the
cash from operating activities must be consistently greater than the net income earned
by the company.

METHODS OF FINANCIAL STATEMENT ANALYSIS

A variety of tools designed to fit specific needs are available to help users analyze
financial statements. Some basic tools of financial analysis are comparative financial
statement analysis, common-size financial statement analysis, ratio analysis, cash flow
analysis and valuation models.
Analysis Tools
This section gives preliminary exposure to five important sets of tools for financial
analysis:

1. Comparative financial statement analysis can be done by reviewing consecutive

balance sheets, income statements, or statements of cash flows from period to period.
This usually involves a review of changes in individual account balances on a year-to-
year or multiyear basis. The most important information often revealed from
comparative financial statement analysis is trend. A comparison of statements over
several periods can reveal the direction, speed, and extent of a trend. Comparative
analysis also compares trends in related items. For example, a year-to-year 10% sales
increase accompanied by a 20% increase in freight-out costs requires investigation and
explanation. Similarly, a 15% increase in accounts receivable along with a sales
increase of only 5% calls for investigation. In both cases we look for reasons behind
differences in these interrelated rates and any implications for our analysis.
Comparative financial statement analysis also is referred to as horizontal analysis
given the left-right (or right-left) analysis of account balances as we review comparative
statements.
Two techniques of comparative analysis are especially popular:
 Year-to-year change analysis
 Index-number trend analysis
Year- to-Year change analysis: Comparing financial statements over relatively
short time periods—two to three years—is usually performed with analysis of year-
to-year changes in individual accounts. A year-to-year change analysis for short time
periods is manageable and understandable. It has the advantage of presenting
changes in absolute dollar amounts as well as in percentages.
  Formula to Calculate Year- to year change analysis
 Year- to year change analysis can be calculated by the following formula:
 Dollar Change = Amount in the Current Year – Amount in the Base Year
 Percentage Change = (Amount in the Current Year – Amount in the Base Year) X 100
Amount in the Base Year

From the following balance sheets of ABC Ltd. Prepare Comparative statement

Limitations of Year to Year change analysis:

 Year-to-Year Change Analysis can comparing financial statements over relatively
short time periods—two to three years only.
 When a negative amount appears in the base and a positive amount in the next
period (or vice versa), we cannot compute a meaningful percentage change.
 When there is no amount for the base period, no percentage change is
computable.
 When the base period amount is small, a percentage change can be computed
but the number must be interpreted with caution. This is because it can signal a
large change merely because of the small base amount used in computing the
change.
 When an item has a value in the base period and none in the next period, the
decrease is 100%.
 These points are underscored below:

Index-number trend analysis: Analyzing data using index-number trend analysis

requires choosing a base period, for all items, with a preselected index number
usually set to 100. Because the base period is a frame of reference for all
comparisons, it is best to choose a normal year with regard to business conditions.
 Formula to Calculate Index Number
 An index number can be calculated by the following formula:
 Index number = (Index year dollar amount / Base year dollar amount) x 100
From the following Income statement of ABC Ltd. Calculate trend analysis for
year 2014 and 2015.
2. Common-size financial statement analysis Financial statement analysis can
benefit from knowing what proportion of a group or subgroup is made up of a particular
account. Specifically, in analyzing a balance sheet, it is common to express total assets
(or liabilities plus equity) as 100%. Then, accounts within these groupings are
expressed as a percentage of their respective total. In analyzing an income statement,
sales are often set at 100% with the remaining income statement accounts expressed
as a percentage of sales. Because the sum of individual accounts within groups is
100%, this analysis is said to yield common-size financial statements. This procedure
also is called vertical analysis given the up-down (or down-up) evaluation of accounts
in common-size statements. Common-size financial statement analysis is useful in
understanding the internal makeup of financial statements. For example, in analyzing a
balance sheet, a common-size analysis stresses two factors:
1. Sources of financing—including the distribution of financing across current liabilities,
noncurrent liabilities, and equity.
2. Composition of assets—including amounts for individual current and noncurrent
assets.
Common-size statements are especially useful for intercompany comparisons because
financial statements of different companies are recast in common-size format.
Comparisons of a company’s common-size statements with those of competitors, or
with industry averages, can highlight differences in account makeup and distribution.
Reasons for such differences should be explored and understood. One key limitation of
common-size statements for intercompany analysis is their failure to reflect the relative
sizes of the companies under analysis.
From the following balance sheets of ABC Ltd. Prepare common size statement.
3. Ratio analysis is a tool of financial analysis which studies the numerical or
quantitative relationship between two variables or items. Ratio analysis is an attempt to
derive quantitative measures or guides concerning the financial health and profitability
of a business enterprise. Ratio analysis involves the use of various methods for
calculating and interpreting financial ratios to assess the performance and status of the
business unit. The financial analysts always need certain yardsticks to evaluate the
efficiency and performance of any business unit. The one of the most frequently used
yardstick is "Ratio Analysis". Liquidity Ratio, Activity Ratio, Profitability Ratio, Solvency
Ratio
4.Cash flow analysis is primarily used as a tool to evaluate the sources and uses of
funds. Cash flow analysis provides insights into how a company is obtaining its
financing and deploying its resources. It also is used in cash flow forecasting and as
part of liquidity
analysis

5. Valuation Models: Valuation is an important outcome of many types of business and

financial statement analysis. Valuation normally refers to estimating the intrinsic value
of a company or its stock. The basis of valuation is present value theory. This theory
states the value of a debt or equity security (or for that matter, any asset) is equal to the
sum of all expected future payoffs from the security that are discounted to the present at
an appropriate discount rate. Present value theory uses the concept of time value of
money—it simply states an entity prefers present consumption more than future
consumption. Accordingly, to value a security an investor needs two pieces of
information: (1) expected future payoffs over the life of the security and (2) a discount
rate.
1. Debt Valuation
2.Equity Valuation