Subramanyam FSA Chapter 01 - ETJ

Financial Statement Analysis
K R Subramanyam
John J Wild
Kode & Mata Kuliah Revisi 1.0

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview of Financial
Statement Analysis
1
CHAPTER
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Business Analysis
Evaluate Prospects Evaluate Risks
Analyzing business environment, strategies, and

financial position and performance
Useful for business decisions: invest in equity or

debt, extend credit through short or long term,
value IPO, evaluate restructurings
Financial Statement Analysis = application of

analytical tools and techniques to general-purpose FS
and related data >> estimates and inferences useful
in business analysis
Information Sources for Business Analysis
Quantitative Qualitative
Management discussion & Analysis

Financial Statements
Chairperson’s Letter
Industry Statistics
Press Releases
Economic Indicators
Financial press
Regulatory filings
Vision/Mission Statement
Trade reports Web sites

Credit Analysis Other Uses of
Business Analysis
- Managers
Types of - Mergers, acquisitions
Business and divestitures
Equity Analysis - Financial management
Analysis - Directors
- Regulators
- Labor unions
- Customers

Credit Analysis
Trade Creditors Non-trade

Creditors
Provide goods Bear risk of Provide major Bear risk of

or services default financing default
Mostly short- Usually implicit Mostly long- Usually explicit

term interest term interest

Credit Analysis
Credit worthiness: Ability to honor credit obligations
(downside risk)
Liquidity Solvency
Ability to meet short-term Ability to meet long-term
obligations obligations
Focus: Focus:
• Current cash flows • Long-term profitability
• Make up of current • Capital structure
assets and liabilities

Equity Analysis
Provide funds in return for risks and rewards of ownership
Assessment of downside risk and upside potential
Technical analysis / Charting Fundamental Analysis

• Patterns in price or volume Determine Intrinsic value
history of a stock without reference to price
• Predict future price
movements • Analyze and interpret key
factors
– Economy
– Industry
– Company

Components of
Business
Business
Analysis
Environment &
Strategy Analysis
Industry Strategy
Analysis Analysis
Financial
Analysis
Analysis
Accounting of cash Prospective
Analysis flows Risk
Analysis
Profitability
Analysis Analysis
Cost of Capital Estimate Intrinsic Value

Business Environment and Strategy Analysis
Identify and assess company’s economic and

industry circumstances
Includes analysis of
- Product, labor, and capital markets within economic and regulatory setting
- Company’s competitive strengths and weaknesses, opportunities and threats
Industry Analysis >> Porter framework (value chain analysis: competitors,

bargaining power of consumers and suppliers, threats of new entrants and
substitute products)
Strategy Analysis >> evaluation of both company’s business decision and its
success at establishing competitive advantage
Accounting Analysis
Process to evaluate and adjust financial

statements to better reflect economic reality
Accounting limitations could yield 2 problems in analysis:
Comparability problems — across firms and across time
Manager estimation error

Accounting
Distortion problems Earnings management
Risk
Accounting Standards

Financial Analysis
Process to evaluate financial position and

performance using financial statements
Consists of 3 broad areas:
Profitability analysis — Evaluate return

on investments (margins and turnover) Common tools
Risk analysis — Evaluate ability to meet

commitments (solvency and liquidity) Cash
Ratio
flow
analysis
analysis
Analysis of cash flows — Evaluate source &
deployment of funds

Prospective Analysis
Process to forecast future payoffs
Business Environment
& Strategy Analysis
Accounting Analysis
Financial Analysis
Expected Future Payoffs

Valuation
Process to convert forecasts of future payoffs >>

estimate of company value
Select:
- Valuation model
- Estimate cost of capital

Financial Statements – Basis of Analysis
Business Activities Time
Beginning of period
Investing Financing
Planning
Operating
Planning
Investing Financing
End of period

Planning Activities
• Business Plan = company’s purpose, strategy, and tactics for

its activities
• Insight into business plan  analysis of current and future

prospects = part of analysis for business environment and
strategy (e.g. Company objectives and tactics, market
demands, competitive analysis, sales strategies, management
performance, financial projections)
• Source of information : financial statements, press releases,

industry publications, analysts’ newsletter, financial press,
Letter to Shareholders, MD&A

Financing Activities
• Financing Activities = methods that companies use to raise

money to pay for carrying out its business plan; Two main
sources = Equity Investors and Creditors
• Equity investors provide financing in a desire for return on

their investment, in form of Earnings Distribution (dividend)
or Earnings Reinvestment (retained earnings = internal
financing)
• Creditors consists of Debt Creditors (directly lend money) and

Operating Creditors (to whom the company owes money as
part of operation)

Investing Activities
• Investing Activities =company’s acquisition and maintenance

of investments for purposes of selling products and providing
services, and investing excess cash.
• Two types of investments: Operating Assets (PPE, legal rights,

inventories, human capital, information system, etc.) and
Financial Assets (other companies’ stock, bonds, money
market funds)

Operating Activities
Planning
Investing Activities Financial
Activities Activities
Operating Activities
Revenues and expenses from providing
goods and services; represents carrying out business plan
given its financing and investing activities.
5 Components: R&D, procurement, production,
marketing, and administration
Financial Statements Reflect Business Activities
Planning
Investing Financing
Current: Operating Current:
• Cash • Notes Payable
• Sales Accounts Payable
• Accounts Receivable • Cost of Goods Sold
•
• Inventories • Salaries Payable

• Selling Expense
• Marketable Securities • Income Tax Payable
• Administrative Expense
Noncurrent: Noncurrent:
• Interest Expense
• Land, Buildings, & • Income Tax Expense

• Bonds Payable
Equipment • Common Stock
• Patents • Retained Earnings
Net Income
• Investments
Liabilities & Equity

Income statement
Assets Cash Flow Balance Sheet
Balance Sheet Statement of Statement of

Cash Flows Shareholders’ Equity
Financial Statements
Balance Sheet
Income Statement
Statement of Shareholders’
Equity
Statement of Cash Flows

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Balance Sheet
Total Investing = Total Financing

= Creditor Financing + Owner Financing
Colgate 2011 Financing

(in $billions)
$12.724 = $10.183 + $2.541

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Income Statement
Revenues – Cost of goods sold = Gross Profit

Gross profit – Operating expenses = Operating Profit
Colgate’s 2011 Profitability

(in $billions)
$16.734 - $7.144 = $9.590 Gross Profit

$9.590 - $5.749 = $3.841 Operating profit

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26
Statement of Cash Flows
Net Cash Flows from Operating

Activities
Net Cash Flows from Investing

Activities
Net Cash Flows from Financing

Activities

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Additional Information
(Beyond Financial Statements)
Management’s Discussion & Analysis (MD&A)
Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement

Financial Statement Analysis Preview
Comparative FS Analysis
Purpose: Evaluation of consecutive

financial statements
Output: Direction, speed, & extent of any
trend(s)
Types:  Year-to-year Change Analysis
 Index-Number Trend Analysis
1-31
Analysis Preview
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Analysis Preview
Common-Size Analysis
Purpose :  Evaluation of internal makeup
of financial statements
 Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses
Analysis Preview

Analysis Preview

Analysis Preview
Ratio Analysis
Purpose : Evaluate relation between two or more
economically important items
Output: Mathematical expression of relation
between two or more items
Cautions:  Prior Accounting analysis is important
 Interpretation is key - long vs short
term & benchmarking

Analysis Preview
Ratio Analysis
1. Credit (Risk) Analysis
a. Liquidity: ability to meet short-term obligations
b. Capital structure & solvency: ability to meet long-term obligations
2. Profitability Analysis
a. Return on investment: financial rewards to suppliers of equity &
debt financing
b. Operating performance: profit margins
c. Asset utilization: effectiveness and intensity of assets in generating
sales (turnover)
3. Valuation
Estimate intrinsic value of a company (stock)

Analysis Preview
Cash Flow Analysis

Purpose : Evaluate sources and uses of funds
Output: Insights into how a company is obtaining and

deploying its resources, used in cash flow
forecasting

Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis
Purpose: Estimate intrinsic value of a

company (or stock)
Basis: Present value theory (time value of
money)

Analysis Preview
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)

Analysis Preview
Equity Valuation – Dividend Discount 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

Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model
FCFt+n is the free cash flow in the period t + n [often

defined as cash flow from operations less capital
expenditures]
E refers to an expectation

Analysis Preview
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)]
E refers to an expectation
Analysis in an Efficient Market
Efficient Market Hypothesis (EMH) =
reaction of market prices to financial
and other information
Three assumed forms of market efficiency:

Weak Form - prices reflect information in past prices
Semi-strong Form - prices reflect all public information
Strong Form - prices reflect all public and private
information

Book Organization
Financial Statement Analysis
Part I Part II Part III

Introduction and Overview Accounting Analysis Financial Analysis
Chapter 3: Analyzing Chapter 7: Cash Flow

Chapter 1: Overview of Analysis
Financial Activities
Financial Statement Chapter 8: Return on
Chapter 4: Analyzing
Analysis Invested Capital and
Investing Activities
Chapter 5: Analyzing Profitability Analysis
Chapter 2: Financial Chapter 9: Prospective
Investing Activities:
Reporting and Analysis
Intercorporate Investments
Analysis Chapter 10: Credit
Chapter 6: Analyzing
Analysis
Operating Activities Chapter 11: Equity
Analysis and Valuation

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Financial Statement Analysis

Kode & Mata Kuliah Revisi 1.0

Kode & Mata Kuliah 2 Revisi 1.0

Evaluate Prospects Evaluate Risks

Analyzing business environment, strategies, and

Useful for business decisions: invest in equity or

Financial Statement Analysis = application of

Management discussion & Analysis

Trade reports Web sites

Kode & Mata Kuliah 5 Revisi 1.0

Trade Creditors Non-trade

Provide goods Bear risk of Provide major Bear risk of

Mostly short- Usually implicit Mostly long- Usually explicit

Kode & Mata Kuliah 6 Revisi 1.0

Kode & Mata Kuliah 7 Revisi 1.0

Technical analysis / Charting Fundamental Analysis

Kode & Mata Kuliah 8 Revisi 1.0

Cost of Capital Estimate Intrinsic Value

Identify and assess company’s economic and

Industry Analysis >> Porter framework (value chain analysis: competitors,

Process to evaluate and adjust financial

Accounting limitations could yield 2 problems in analysis:

Comparability problems — across firms and across time

Manager estimation error

Kode & Mata Kuliah 11 Revisi 1.0

Process to evaluate financial position and

Profitability analysis — Evaluate return

Risk analysis — Evaluate ability to meet

Kode & Mata Kuliah 12 Revisi 1.0

Expected Future Payoffs

Process to convert forecasts of future payoffs >>

Kode & Mata Kuliah 14 Revisi 1.0

Kode & Mata Kuliah 15 Revisi 1.0

• Business Plan = company’s purpose, strategy, and tactics for

• Insight into business plan  analysis of current and future

• Source of information : financial statements, press releases,

Kode & Mata Kuliah 16 Revisi 1.0

• Financing Activities = methods that companies use to raise

• Equity investors provide financing in a desire for return on

• Creditors consists of Debt Creditors (directly lend money) and

Kode & Mata Kuliah 17 Revisi 1.0

• Investing Activities =company’s acquisition and maintenance

• Two types of investments: Operating Assets (PPE, legal rights,

Kode & Mata Kuliah 18 Revisi 1.0

• Inventories • Salaries Payable

• Land, Buildings, & • Income Tax Expense

Liabilities & Equity

Balance Sheet Statement of Statement of

Statement of Cash Flows

Kode & Mata Kuliah 21 Revisi 1.0

Total Investing = Total Financing

Colgate 2011 Financing

Kode & Mata Kuliah 23 Revisi 1.0

Kode & Mata Kuliah 24

Revenues – Cost of goods sold = Gross Profit

Colgate’s 2011 Profitability

$16.734 - $7.144 = $9.590 Gross Profit

Kode & Mata Kuliah 25 Revisi 1.0

Net Cash Flows from Operating

Net Cash Flows from Investing

Net Cash Flows from Financing

Kode & Mata Kuliah 27 Revisi 1.0

Kode & Mata Kuliah 29 Revisi 1.0