Financial Statement Analysis

Semester 2, 2022/2023

Course Outline

Li Wen
 Course Instructions
Before the class
• Join the Wechat course group, and be alert to reminders and
announcements there.

• https://www.learnin.com.cn (where I’ll upload course materials)

 Course Instructions
During the class
• Please attend classes on time.
• Actively participate in the class discussions.

After the class

• Review the lecture notes.
• Finish assignment and submit it online before the deadline.
 Introduction
▪ Course requirement

 Prerequisites
--- Accounting, Intermediate Accounting

 Keep yourself updated of the business news

(e.g. Wall Street Journal, Bloomberg, and other local
APPs such as 雪球，华尔街见闻，财新网，FT中文网、商业
周刊中文版)
 Introduction

▪ Learning objectives

To provide students a sound understanding of the concepts and

tools essential for financial statement analysis
To enhance the students’ understanding of the role of financial
reporting in providing economic decision makers with useful
information
To develop the students’ self-learning abilities, analytical skills,
attitudes towards active learning and the ability to use
accounting information for problem solving and decision making
in business scenarios.
 Introduction

▪ Textbook
Financial Statement Analysis (11th edition), by K.R.
Subramanyam, China Remin University Press
▪ English version!

▪ Reference book
Financial Statement Analysis and Security Valuation (5th
edition), by Stephen Penman, China Machine Press
 Introduction

▪ Assessment criteria

Assessment %
Class Participation & 20
Assignment
Mid-term exam 30
Final exam 50
Total 100
 Introduction

▪ Communication

Office hour:
 14:00-17:00, Monday, Room 210, Faculty of Finance and
Accoutancy (综合楼), Fengxian Campus

Email: wenli@sbs.edu.cn

Wechat Group
 Course Overview

▪ Why do we need to take this course?

Financial Statement
Analysis
 Course Overview

▪ Why is it important that capital markets can accurately

determine firm value?

Financial
Market
Information

Capital

Firm 1 Firm 2 Firm 3 …… Firm N

 Course Overview

Q1: Is accounting information useful?

--- Yes, useful!
Ball and Brown (1968) --- An empirical evaluation of
accounting income numbers

Q2: Voluntary accounting information? Mandatory

accounting information?
--- Mandatory! (Financial statements)
Lemon market --- George Akerlof (1970)
 Course Overview

▪ Decision --- Buy or Sell or Hold?

▪ Stock price v.s. Intrinsic value of stock

▪ Accounting provides the information to make decisions!

Course Overview
Financial Statement Analysis

Semester 2, 2022/2023

Chapter 1
Overview of Financial Statement Analysis
 Preview of Chapter 1

Business Analysis

Financial Statements --- Basis of Analysis

Financial Statement Analysis Preview

 Learning objectives

Explain business analysis and its relation to financial statement

analysis

Identify and discuss different types of business analysis

Describe the component analyses that constitute business

analysis

Explain business activities and their relation to financial

statements
 Learning objectives

Identify relevant analysis information beyond financial

statements

Analyze and interpret financial statements as a preview to more

detailed analyses

Apply several basic financial statement analysis techniques

Define and formulate some fundamental valuation models

Explain the purpose of financial statement analysis in an

efficient market
Introduction to Business Analysis
Types of Business Analysis
 Types of Business Analysis

Credit Analysis
 Types of Business Analysis

Credit Analysis
 Types of Business Analysis

Equity Analysis

Technical Fundamental
Analysis Analysis
 Components of Business Analysis

Business
Environment and
Strategy Analysis

Financial
Industry Analysis Strategy Analysis
Statement
Analysis

Accounting Financial
Prospective
Analysis Analysis Analysis
Profitability Analysis of Risk
Analysis Cash Flows Analysis

Cost of Capital Intrinsic Value

Estimate
 Business Environment and
Strategy Analysis
Porter (1980, 1985)

Industry analysis
Firm’s profitability is largely driven by industry structure.

Strategy analysis
Competitive strategy and competitive advantage
Industry Analysis
Industry Analysis
 Industry Analysis

Value Chain Analysis

 Industry Analysis

Competitive Advantage --- “Five forces” by Michael Porter

(1980, 1985)
Strategy Analysis
 Strategy Analysis

 Does the firm have competitive advantage?

 How durable is the firm’s competitive advantage?

 How would a business decision affect the firm’s

competitive advantage?
 Class Discussion

 Can you give some examples of firms that adopt different

generic strategies?
Accounting Analysis
Financial Analysis
Prospective Analysis
 Financial Statements
– Basis of Analysis
Business Activities
 Business Activities
- Planning Activities
 Business Activities
- Financing Activities
 Business Activities
- Investing Activities
 Business Activities
- Operating Activities

Research &
Development

Procurement

Production

Marketing

Administration
 Information Sources
for Business Analysis
Financial Statements
Balance Sheets
Balance Sheets
 Balance Sheets

Assets = Liabilities + Shareholders’ Equity

Shareholders’ Equity = Assets – Liabilities

Value of Equity = Value of Firm – Value of Debt

Income Statement
 Income Statement
 Net Revenue – Cost of Goods Sold = Gross Margin

 Gross Margin – Operating Expenses = Operating Income (Earnings before

interest and taxes --- EBIT)

 Operating Income – Interest Expense + Interest Income = Income before Taxes

 Income before Taxes – Income Taxes = Income before Extraordinary Items

 Income before Extraordinary Items + Extraordinary Items = Net Income

 Net income + Other comprehensive income = Comprehensive income

Statement of Cash Flows
Statement of Cash Flows
Statement of Cash Flows
 Retained Earnings, Comprehensive
Income, and Changes in Capital Accounts
 Additional Information
(Beyond Financial Statements)
 Financial Statement Analysis Preview
Analysis Tools

 Comparative financial statements analysis

--- Year-to-year change analysis
--- Index-number trend analysis
 Common-size financial statement analysis
 Ratio analysis
 Cash flow analysis
Comparative Analysis
 Comparative Analysis

Comparative Income Statements

Year-to-Year Change Analysis
 Comparative Analysis

Comparative Income Statements

Index-Number Trend Analysis
Item 2011 2010 2009 2008 2007
Revenues $400,000 $355,000 $320,000 $290,000 $275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2011 2010 2009 2008 2007

Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%

(290,000 ÷ 275,000) × 100% = 105%

(198,000 ÷ 190,000) × 100% = 104%
(92,000 ÷ 85,000) × 100% = 108%
Common Size Analysis
 Common Size Analysis
Common Size Balance Sheets
 Common Size Analysis
Common Size Income Statements
Ratio Analysis
 Ratio Analysis

Credit (Risk) Analysis

 Liquidity
 Capital structure and solvency

Profitability Analysis
 Return on investment
 Operating performance
 Asset utilization

Valuation
 Class discussion

 What are the commonly used ratios to measure

Liquidity / solvency

profitability

efficiency
 Liquidity

Working Cash Ratio

Capital

Current Quick Ratio

Ratio
 A Classified Balance Sheet

Matrix, Inc.
Asset Section: Classified Balance Sheet
December 31, 2022
Current assets:
Cash $ 30,000
Notes receivable 16,000
Accounts receivable 60,000
Inventory 70,000
Prepaid expenses 4,000
Total current assets 180,000
Plant and equipment:
Land $ 150,000
Building $ 121,000
Less: Accumulated depreciation (10,000) 111,000
Equipment and Fixtures 46,000
Less: Accumulated depreciation (27,000) 19,000
Total plant and equipment 280,000
Other assets:
Patents 170,000
Total assets $ 630,000
Use this information to calculate the
liquidity ratios for Babson Builders.
Babson Builders, Inc.
2022
Cash $ 30,000
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 15,000
Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000
 Working Capital

Working capital is the excess of current assets over

current liabilities.

Current Assets represent liquid resources, including

cash, marketable securities, receivables,
inventories, and prepaid expenses.

Current liabilities are existing obligations that are

expected to be paid by current assets, such as
payables, and unearned revenue.
 Working Capital

Working capital is the excess of current

assets over current liabilities.

12/31/22
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
 Current Ratio

This ratio measures the

short-term debt-paying
ability of the company.

Current Current Assets

=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000
 Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick assets are cash, marketable securities, and

receivables.

This ratio is like the current

ratio but excludes current assets such as
inventories that may be difficult to quickly
convert into cash.
 Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick $50,000
= = 1.19 : 1
Ratio $42,000
 Solvency

Times Equity
Interest Ratio
Earned

Debt Ratio
 Long-Term Credit risk

Use this information to calculate ratios to measure the

well-being of the long-term creditors for Babson Builders.

Babson Builders, Inc.

2022
Earnings before interest
expense and income taxes $ 84,000
This is often Interest expense 7,300
referred to as Total assets 346,390
EBIT Total stockholders' equity 234,390
Total liabilities 112,000
 Interest Coverage Ratio

Times Operating income before Interest

Interest = and Income Taxes
Earned Annual Interest Expense
Times
$84,000
Interest = = 11.5 times
7,300
Earned

This is the most common measure of

the ability of a firm’s operations to
provide protection to the long-term
creditor.
 Debt Ratio

A measure of creditor’s long-term risk.

The smaller the percentage of assets that are
financed by debt, the smaller the risk for
creditors.

Debt Total
= ÷ Total Assets
Ratio Liabilities
= $112,000 ÷ $346,390
= 32.33%
 Profitability

Gross Earnings per

Margin Share

Return on Return on
Assets Equity

Market prospects of investment

Price-Earnings Dividend
Ratio Yield
 Profitability
Use this information to calculate the profitability ratios for
Babson Builders, Inc.
Babson Builders, Inc.
2022
Ending market price per share $ 15.25
Number of common shares
outstanding all of 2007 27,400
Net income $ 53,690
Total shareholders' equity
Beginning of year 180,000
End of year 234,390
Revenues 494,000
Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390
 Earning Per Share

Net Income
= EPS
Average Shares of Capital Stock Outstanding

Look back at the information from Babson and get the

values we need to calculate earning per share.

$53,690
= $1.96
27,400
 Return On Assets (ROA)

This ratio is generally considered

the best overall measure of a
company’s profitability.

Operating
ROA = ÷ Average total assets
Income
= $ 53,690 ÷ [($300,000 + $346,390) ÷ 2]
= 16.61%
 Return On Equity (ROE)

This measure indicates how well the

company employed the owners’
investments to earn income.

ROE = Net income ÷ Average total equity

= $ 53,690 ÷ [($180,000 + $234,390) ÷ 2]

= 25.91%
 Price-Earnings Ratio

Current Market Price of one Share of Stock

= P/E
Earnings Per Share

$15.25
$1.96 = 7.78

The measure shows us the relationship between earning of the

company and the market price of its stock. It reflects investors’
expectations concerning the firm’s future performance.
 Dividend Yield

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Babson Builders pays an annual dividend of $1.50 per

share of capital stock. The market price of the
company’s capital stock was $15.25 at the end of 2011.

This ratio identifies the return, in terms of

cash dividends, on the current market
price of the stock.
 Dividend Yield

Dividend = Dividends Per Share

Yield Ratio Market Price Per Share

Dividend $1.50
= = 9.84%
Yield Ratio $15.25

if you are an investor who required current income

you will want to look for common shares with a
high dividend yield. If you are willing to accept a
less current income with a possibility of growth in
the market price per share, you may look at
companies with a lower dividend yield.
 Efficiency

Accounts Inventory
Receivable Turnover
Turnover

Average Average
Days to Days to sell
collect AR inventory
 Measures of efficiency

Babson Builders, Inc.

2022
Use this
Cash $ 30,000
information to
Accounts receivable, net
calculate ratios to Beginning of year 17,000
measure the End of year 20,000
efficiency for Inventory
Babson Builders, Beginning of year 10,000
Inc. End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 500,000
Cost of goods sold 140,000
 Operating Cycle

Cash

Accounts
Receivable Inventory

2. Sale of merchandise on account

 Inventory Turnover Rate

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

This ratio measures the number

of times merchandise inventory
is sold and replaced during the
year.
 Avg. Number of Days to sell inventory

Avg. Number of Days to sell inventory

This ratio calculates the average number of
days it takes to sell the inventory.

Average Days to 365

=
Sell Inventory Inventory Turnover
 Accounts Receivable Turnover Rate

Accounts
Net Sales
Receivable =
Average Accounts Receivable
Turnover

Accounts
$500,000
Receivable = = 27.03 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many times a

company converts its receivables into
cash each year.
 Avg. Number of Days to Collect A/R

Avg. Number of Days to Collect A/R

This ratio calculates the average number of
days it takes to collect AR.

365
Accounts Receivable Turnover Ratio
 Ratio Analysis

Chart Title

Uses Limitations

Ratios help users Management may enter

understand into transactions merely
financial relationships. to improve the ratios.

Ratios provide for Ratios do not help with

quick comparison analysis of the company's
of companies. progress toward
nonfinancial goals.
 Cash Flow Analysis

Cash flow from operating

activities

Cash flow from investing

activities

Cash flow from financing

activities
Valuation Models
 Valuation Models

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)
 Valuation Models

Equity Valuation --- Dividend Model

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
 Valuation Models

Equity Valuation --- Free Cash Flow to Equity Model

FCFEt+n is the free cash flow to equity in the period t + n

[often defined as cash flow from operations less capital
expenditures plus increases (minus decreases) in debt]
k is the cost of capital
E refers to an expectation
 Valuation Models

Equity Valuation --- Residual Income Model

BV is the book value at the end of period t

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
 Valuation Models
Class exercise

 Requirement: Compute the intrinsic value of the remaining 49% of

Labrador’s shares using the alternative valuation models (assume a
cost of capital of 10%).
• Dividend Discount Model

• FCFE Model
• Residual Model
Analysis in an Efficient Market
 Analysis in an Efficient Market
Question --- Is the market really efficient?
 Post earnings announcement drift (PEAD) anomaly
End of Chapter 1