Financial Analysis - integral part of analyzing the long-term success of every business.

-linked to doing and completing a business analysis which is the process of evaluating a company’s

Business Analysis is the process of evaluating and assessing the company’s prospects and risks

Business Decisions include:

-Equity and debt valuation
-Credit risk assessment
-Earning predictions
-Audit testing
-Compensation negotiations

Types of Business Analysis

Credit Analysis: evaluation of the creditworthiness or the ability of a company to honor its credit obligations

Liquidity is ability to raise cash in the short term to meet its obligations.
Solvency is long-run viability and ability to pay long-term obligations.

Equity Analysis: assesses both the downside and upside potential of ownership of securities. This analysis primarily uses a
combination of technical and fundamental analysis.

Technical Analysis: also known as charting, searches for patterns in the price or volume history of a stock to predict
future price movements.
Fundamental Analysis: is the process of determining the value of a company by analyzing and interpreting key
factors for the economy

Other Uses of Business Analysis

Business analysis and financial statement analysis are beneficial to the following contexts:

Managers. provide managers with clues to strategic changes in operating

Mergers, acquisitions and divestitures. performed whenever a company restructures its operations through mergers
Financial Management. helps assess the impact of financing decisions
Directors. aid directors in fulfilling their oversight responsibilities.
Regulators. to audit tax returns and check reasonableness
Labor Unions. useful to labor unions in collective bargaining negotiations.
Customers. used to determine the profitability of suppliers along with estimating the suppliers’ profits

Components of Business Analysis

Business Environment and Strategy Analysis

It consists of two parts – the Industry Analysis and Strategy Analysis.

Industry Analysis: The prospects and structure of its industry largely drive a company’s profitability.

Strategy Analysis: is the evaluation of a company's decisions and success at establishing a competitive advantage.

Accounting Analysis
Is a process of evaluating the extent to which a company’s accounting reflects economic reality

Financial Analysis
to analyze a company’s financial position and performance,

Prospective Analysis
Is the forecasting of future payoffs – typically earnings, cash flows or both

Valuation
Refers to the process of converting forecasts of future payoffs into an estimate of company value.

Four Major Business Activities of a Company:

1.Planning Activities: goals and objectives are captured in a business plan that describes the company’s purpose
2.Financing Activities: methods that companies use to raise the money to pay for their needs.
2 Main Sources of External Financing:
a.)Equity Investors (owners or shareholders): provide financing to a company in a desire for a return on their
investment
b.)Creditors (lenders): provide financing to a company by lending with an agreement or contract of repayment
3.Investing Activities:
acquisition and maintenance of investments for purposes of selling products and providing services,
4.Operating Activities:
carrying out of the business plan given its financing and investing activities. It involves at least five components: research and
development, procurement, production, marketing and administration

What are the financial statements reflecting the business activities?

1.)The Balance Sheet: The accounting equation also called the balance sheet identity is the basis of accounting system:
Assets = Liabilities + Equity

2. )The Income Statement: measures a company’s financial performance between balance sheets. It is a representation of
the operating activities of a company.

3. )The Statement of Shareholders’ Equity: this report changes in the accounts that make up equity. This is useful in
identifying reasons for changes in equity holders’ claims on the assets of a company.

4. )The Statement of Cash Flows: this reports cash inflows and outflows separately for a company’s operating, investing, and
financing activities over a period of time.

This section gives preliminary exposure to five important sets of tools for financial analysis:
1.Comparative Financial Statement Analysis
2.Common-size Financial Statement Analysis
3.Ratio Analysis
4.Cash Flow Analysis
5.Valuation

Comparative Financial Statement Analysis:

This presents and reviews consecutive balance sheets, income statements, or statements of cash flows from period to period.

Common-Size Financial Statement Analysis:

understanding the internal makeup of financial statements to examine the accounts that make up specific subgroups

Common-size statements comparisons because financial statements of different companies are recast in common-size
format.

Ratio Analysis:
It is a ratio that expresses a mathematical relation between two quantities.

Factors Affecting Ratios:

-Economic events
-Industry factors
-Management policies

Accounting methods

1.Credit (Risk) Analysis

a.Liquidity. Evaluate the ability to meet short-term obligations
b.Capital Structure and Solvency. To assess the ability to meet long-term obligations
2.Profitability Analysis
a.Return on Investment. To assess financial rewards to the suppliers of equity and debt financing.
b.Operating Performance. To evaluate profit margins from operating activities.
c.Asset Utilization. To assess effectiveness and intensity of assets in generating sales, also called turnover.
3.Valuation
To estimate the intrinsic value of a company
Cash Flow Analysis
Is primarily used as a tool to evaluate the sources and uses of funds. It provides insights into how a company is obtaining its
financing and deploying its resources.
Valuation Models
This refers to estimating the intrinsic value of a company or its stock.
Debt Valuation: The value of a security is equal to the present value of its future payoffs discounted at an appropriate rate.
The future payoffs of the debt security are its interest and principal payments.
Equity Valuation: The basis of equity valuation is the present value of future payoffs discounted at an appropriate rate –
payoffs coming from dividend payments and capital appreciation

Analysis in an Efficient Market

Efficiency Market Hypothesis (EMH) deals with the reaction of market prices to financial and other information.

Three Forms of EMH:

Weak Form EMH – asserts that prices reflect fully the information contained in historical price movements.
Semi strong Form EMH – asserts that prices reflect fully all publicly available information.
Strong Form EMH – asserts that prices reflect all information including inside information

A Creditor (Banker)
ability to satisfy its loan obligations. Interest and principal payments must be paid, Is also concerned about the company’s
ability to meet its contractual debt obligations.

A Credit Analyst
gathers and reviews financial data about loan applicants, including their payment habits ,determine the creditworthiness of
loan applicants

An Investor
Its focus is to review financial statements focusing on the company’s ability to create and sustain
An Investment Analyst
a financial professional with expertise in evaluating financial and investment information
An investment analyst continuously collects and interprets data, such as company financial statements, price developments,
currency adjustments and yield fluctuations.

REPORTING ENVIRONMENT
Statutory Financial Reports: are the most important part of the financial reporting
process.
Three (3) Categories of Statutory Financial Report:
1.) Financial Statements: includes quarterly and annual reports
2.) Earnings Announcements: the key summary of information released to the
public
3.) Other Statutory Reports: include the details of board of directors, managerial
ownership, managerial remuneration, and employee stock options. As well as
audited financial statements, information about proposed project or share issue.

Factors Affecting Statutory Financial Reports:

1. Generally Accepted Accounting Principles (GAAP):
 - the rules and guidelines of financial accounting, it is a collection of standards,
- The rules that determine measurement and recognition policies such as how
assets are measured,

2. Managers:
- Primary responsible for fair and accurate financial reporting
- They have ultimate control over the integrity of the accounting system and
the financial records that make up financial statements.

3. Monitoring and Enforcement Mechanisms:

- Ensure the reliability and integrity of financial reports
- Includes the Auditors – ensure the quality and reliability of financial
statements;
- Includes the Corporate Governance – the board of directors and audit
committee; the audit committee is appointed by the board and represented by both
managers and outsiders.
- Includes Securities and Exchange Commission (SEC) – plays an
active role in monitoring and enforcing accounting standards. They check reports to
ensure compliance with statutory requirements
-
Includes the Threat of Litigation – it is the amount of damages relating to accounting
irregularities paid by companies, managers, and auditors. This threat influences managers to adopt
more responsible reporting

Desirable Qualities of Accounting Information

Relevance: the capacity of information to affect a decision. This implies that timeliness is a
desirable characteristic of accounting information.
Reliability: for information to be reliable, it must be verifiable, representationally faithful,
and neutral. Representational faithfulness means the information reflects reality

Important Principles of Accounting

1. Historical Cost: presents objectivity between determined historical values and

estimates of current values of assets and liabilities.
2. Accrual Accounting: it is a modern accounting for which revenues are recognized
when earned and expenses when incurred, regardless of the receipt or payment cash.
3. Materiality: refers to the magnitude of an omission or misstatement of accounting
information to avoid unwanted disclosures.
4. Conservatism: involves reporting the least optimistic view when faced with
uncertainty in measurement. This reduces the reliability and relevance of accounting
information. This has important implications for analysis

Limitations of Financial Statement Information

1. Timeliness: Financial statements are prepared as often as every quarter
and are released three to six weeks after quarter-end. While analysts update
forecasts and recommendations on a nearly real-time basis.
2. Frequency: closely linked to timeliness.
3. Forward-looking: financial statements contain limited forecasts, further
historical-cost-based accounting usually yields recognition lags. While analysts’
reports and forecasts, use much forward-looking information.
Accrual Accounting – An Illustration
- Accrual Accounting, like cash accounting measures the performance and
financial condition of an enterprise.
- This aims to inform users about the consequences of business activities for a
company’s future cash flows as as possible with a reasonable level of certainty.

Accruals vs Cash Flows

Accruals are the sum of accounting adjustments that make net income different from net
cash flow. The most common meaning is accounting adjustments that convert operating
cash flow to net income.

Types of Accruals:
1. Short-term accruals refer to short-term timing differences between income and cash
flow. Also called working capital accruals.
2. Long-term accruals arise from capitalization. This asset capitalization process
generates long-term assets such as plant, machinery and goodwill.

Cash Flow refers to the change in the cash account balance (notes, cash equivalents).
-Are more reliable than accruals, cannot be manipulated

Alternative Types of Cash Flows:

1. Operating Cash Flow: refers to cash from company’s ongoing activities
2. Free Cash Flow: reflects the added effects of investments and divestments in
operating assets.
Accounting Analysis

- process of evaluating the extent to which a company’s accounting numbers reflect

economic reality.
- evaluating a company’s accounting risk and earnings quality, estimating earning
power, and making necessary adjustments to financial statements
- process an analyst uses to identify and assess accounting distortions

2 Reasons for the Need for Accounting Analysis:

1.) Accrual accounting improves upon cash accounting by reflecting business activities in a
more timely manner.
2.) Financial statements are prepared for a diverse set of users and information needs.

Earnings Management

- Can be defined as the purposeful intervention by management in the earnings

determination process, usually to satisfy selfish objectives (Schipper, 1989).
- Can be cosmetic, where the managers manipulate accruals without any cash flow
consequences. It can also be real, where managers take actions with cash flow
consequences for purposes of managing earnings.

Earnings Management Strategies:

1.) Increasing Income: the strategy to increase a period’s reported income

2.) Big Bath: the strategy that involves taking as many write-offs
used in conjunction with an income-increasing strategy

3.) Income Smoothing: common form of earnings management.

Analysis Implications of Earnings Management:

1.) Incentives for earnings management.

2.) Management reputation and history.
3.) Consistent pattern.
4.) Earnings management opportunities.
Process of Accounting Analysis:

1.) Evaluating earnings quality: involves the following steps:

a. Identify and assess key accounting policies.

b. Evaluate extent of accounting flexibility.
c. Determine the reporting strategy.
d. Identify and assess red flags.

2.) Adjusting financial statements: final and most involved task in accounting analysis. It
includes the following:

a. Capitalization of long-term operating leases.

b. Recognition of ESO expense for income determination.
c. Adjustments for one-time charges such as asset impairments and
restructuring costs.
d. Recognition of the economic status of pension and other post retirement
benefit plans on the balance sheet.
e. Removal of the effects of selected deferred income tax liabilities and assets
from the balance sheet.
Debt financing refers to funds that a company has borrowed from various creditors to run the
business. The company may get funds directly from investors by issuing securities such as bonds
called public debt. The firm may also get funds from financial institutions, such as banks and
other credit institutions, in the form of loans called private debt. Debt always has borrowing
costs, typically using the payment of interest. This is why financial liabilities are also known as
interest- bearing liabilities, which differentiate them from operating liabilities such as accounts
payables, which usually do not have contracted interest tied to the borrowing. The other
important feature of debt which distinguishes it from equity is that it has a fixed term at the debt
maturity. The principal amount must be repaid at the date of maturity. Debt financing can be
categorized into two types:

1. Short Term Debt Financing. Short- term debt is primarily used for financing
working capital to fund the day to day operation of the business.

Short-term borrowing is recorded as a current liability and be seen on the balance

sheet as line items called bank borrowing, commercial paper, or short-term
notes. Short-term financing is commonly utilized by companies that usually have
temporary cash flow issues when sales revenues are insufficient to cover current
expenses.
Long Term Debt Financing. It is a debt that has terms exceeding a year. . It is
also used to meet sustained needs for capital.
A lease is a contractual agreement between a lessor, which is the owner of the asset,
and a lessee, the user of the asset. It gives a lessee the right to use an asset, owned by the
lessor, for the term of the lease. In return, the lessee makes rental payments to the lessor.

Leasing has grown in frequency and magnitude. Estimates indicate that almost one-
third of plant asset financing is in the form of leasing. Lease financing is popular for several
benefits.
1. Lessors use leasing to promote sales by providing financing to buyers. Interest
income from leasing is often a major source of revenue for those lessees. In turn,
leasing often is a convenient means for a buyer to finance its asset purchases.
2. Tax considerations also play a role in leasing. Tax payments can be reduced
when ownership of the leased asset rests with the lessor.
3. Leasing can be a source of off-balance-sheet financing. In this way, leasing is
said to window-dress financial statements.

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 Operating Lease Method

In an operating lease, the owner, or lessor, transfers only the rights to use the
property to the lessee for specified periods. At the end of the lease period, the
lessee returns the property to the lessor.
Capital Lease Method

In leasing arrangements in which the lessee assumes the risks and enjoys the
rewards of ownership, the lease contract is considered a capital lease.

Off-balance-sheet financing refers to the nonrecording of

certain financing obligations in the balance sheet. Investors and lenders
often use the proportion of debt in a company’s capital structure as a
measure of risk and, therefore, as a factor in establishing the cost of
funds. Companies prefer to obtain funds without showing a liability on
the balance sheet in the hope that future lenders or investors will
ignore the risks associated with such financing. It is used to keep debt-
to-equity and leverage ratios low.

Companys usually accomplish off-balance-sheet financing using

one or a combination of two approaches: (1) sale of an existing asset
and (2) use of another entity to obtain the financing.

Sale of an Existing Asset

A company may use accounts receivable; inventories; property, plant,

and equipment; and other assets as collateral for a loan. If the company
borrowed funds using the assets as collateral, The selling company
would increase cash and increase liability. Use of Another Entity to
Obtain Financing

The general theme of this approach to off-balance-sheet

financing is that the company obtains access to the asset that the funds’
finance, but neither the asset nor its financing appears on the
company’s balance sheet. Instead, they appear on the balance sheet of
another entity.

Three primary events lead to changes in the book value of shareholders’

equity are:

1. Investments by shareholders, usually net cash

received by the company at the equity initial
issue date.

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 2. Distributions to shareholders, usually through
periodic cash dividend payments to investors and
sometimes through share repurchases.
3. Profitable operating and investing activities. The
net income of the company is a large component of
this increase.

Profitable operating and

investing activities Analysis:

The use of capital obtained from financing activities to support profitable investing and operating
activities also leads to increases in shareholders’ equity via increases in net assets reported as net
income on the income statement.

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