Overview of Financial Statement

Analysis

Topic 1
Where are we?
Part I
Introduction and Overview
To understand the business &
the financial statements
Topic 1
– Overview of Financial
Statement Analysis
Topic 2
– Financial Reporting & Analysis
Part II
Accounting Analysis
To understand the numbers
(and adjust them, if any)
Topic 3
– Analyzing Financing Activities
Topic 4
– Analyzing Investing Activities
Topic 5
– Analyzing Operating Activities
Part III
Financial Analysis
To analyze the past
performance
Topic 6
– Profitability Analysis
Topic 7
– Credit Risk Analysis
Topic 8
– Cash Flow Analysis
To forecast the future
performance & make decision
Topic 9
– Forecasting and Valuation
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Lesson Plan
• Overview of Financial Statement Analysis
• Decision-to-Make

• Processes of Financial Statement Analysis

• Business Environment & Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Prospective Analysis & Valuation

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Overview
Financial statement analysis (FSA) is the application of
analytical tools and techniques to general-purpose financial
statements and related data to derive estimates and
inferences useful in business analysis.

FSA provides a systematic basis for, and is an integral part of, conducting
business analysis and decision-making.

For “what decision” and “by whom”?

- Equity analysis (Equity investors)
- Credit risk analysis (Creditors)
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Use of FSA: Decision-making
Equity investors Creditors
Nature of the debt: Equity instrument Debt instrument

For example: Ordinary shares - Account payable

- Bonds/Notes payable

Returns available to 1. Dividends 1. Interest

investors: 2. Capital gain 2. Principal

Focus of analysis: Profitability Creditworthiness

(liquidity & solvency)

Who else might also conduct FSA?

- Directors, Managers (internal)
- Regulators (tax audit?), Customers, Suppliers, M&A (external)
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Decision-to-make: Equity Analysis
Techniques in equity analysis
• Technical analysis
• Fundamental analysis* (Focus in this module)

Technical analysis ( 技術分析 ) searches for patterns in the price or

volume history of a stock to predict future price movements.

Fundamental analysis ( 基本分析 ) is a process (or, an attempt!) to

determine the intrinsic value ( 內在價值 ) of a company by analyzing and
interpreting key factors for the economy, the industry, and the company.
FSA is a major part of fundamental analysis.

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Decision-to-make: Equity Analysis
Intrinsic value is the value of a company (or its equity shares) determined
through fundamental analysis, without reference to its (current) market
price.

Briefly, a few steps:

1. To analyze a company’s business prospects and its financial
statements;

2. To estimate its future profitability and risk; and

3. To convert these estimates into a measure of intrinsic value by using a

valuation model.

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Decision-to-make: Credit Risk Analysis
Credit risk analysis is the evaluation of the creditworthiness of a company,
that is, the ability to pay debt when due.

Types of debt owed by a company:

• Trade debt
• E.g. Trade Payable / Accounts Payable
• Delivery of goods / service on account
• Short credit terms (e.g. 30 – 60 days)
• Non-interest-bearing

• Non-trade debt
• E.g. Bonds / Notes issued by the company
• Can be a short / long term source of financing
• Interest-bearing 8
Decision-to-make: Credit Risk
Analysis
Liquidity ( 短期償債能力 ) is a company’s ability to pay debt when due in
the short term. Cash flows and the makeup of its current assets and
current liabilities determine liquidity.

Solvency ( 長期償債能力 ) measures a company’s long-turn viability and

ability to settle long-term obligations. It depends on both its long-term
profitability as well as capital structure.

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Lesson Plan
• Overview of Financial Statement Analysis
• Decision-to-Make

• Processes of Financial Statement Analysis

• Business Environment & Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Prospective Analysis & Valuation

10
Business Environment & Strategy Analysis

Business Financial
Business
Environment and Statement
Analysis
Strategy Analysis Analysis*

Business environment and strategy analysis provides a qualitative

understanding on the company.

Both qualitative and quantitative understanding on the company are

required for an informed estimate and decision-making.

Where to find the information:

- Did it perform well this year? Why?
- Do you expect it to perform well next year? Again, why?
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Business Environment & Strategy Analysis
Business environment
- Product
- Labor
- Capital markets within its economy
- Political/regulatory setting … etc.

Industry and strategy

- Structure of an industry  (average) profitability of the companies
(Monopoly? Perfect Competition?)

- “Porter’s Five Forces Model” (Competitors,

Consumers, Suppliers, New Entrants, Substitutes …)

- SWOT analysis 12
Lesson Plan
• Overview of Financial Statement Analysis
• Decision-to-Make

• Processes of Financial Statement Analysis

• Business Environment & Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Prospective Analysis & Valuation

13
Accounting Analysis
Accounting analysis is a process to evaluate and adjust (if applicable) the
financial statements to better reflect economic reality.

What is a set of general-purpose financial Part II

statements? Accounting Analysis

- Statement of Profit or Loss (i.e., Income Statement) To understand the numbers

(and adjust them, if any)
- Statement of Financial Position (i.e., Balance Sheet)
- Statement of Changes in Equity Topic 3
– Analyzing Financing Activities
- Statement of Cash Flows
Topic 4
- Notes to Financial Statements – Analyzing Investing Activities
Topic 5
- Analyzing Operating Activities
In addition, the auditor’s report and management
discussion and analysis (MD&A) provide relevant
information for our analysis.
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Accounting Analysis: The Basis
General-purpose financial statements are prepared in accordance with the
requirements of “Generally Accepted Accounting Principles” (GAAP).

International Financial Reporting Standards (IFRSs) are the GAAP that are
being directly or indirectly adopted in many financial markets.

Hong Kong Financial Reporting Standards (HKFRSs), being fully converged

with the IFRSs since 2005, are the applicable GAAP in Hong Kong. These
are issued by the Hong Kong Institute of Certified Public Accountants
(HKICPA)*

https://www.hkicpa.org.hk/en/Standards-and-regulation/Standards/Members-Handbook-and-Due-Pro
cess/Due-Process/Financial-reporting

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Accounting Analysis: The Basis
What did the company have at the period-end date?

An asset ( 資產 ) is a present economic resource controlled by the entity as

a result of past events. An economic resource is a right with the potential
to produce economic benefits.

A liability ( 負債 ) is a present obligation of the entity to transfer an

economic resource as a result of past events.

Equity ( 股東權益 ) is the residual interest in the assets of the entity after
deducting all its liabilities.

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Accounting Analysis: The Basis
Why did the company’s net assets change during a period?

Net profit ( 當期純利 ) = Income ( 收入 ) – Expenses ( 費用 )

Changes in net assets (i.e. net equity) during a period, for example
= Net profit
+ Other Comprehensive Income ( 其他綜合收益 )
+ Cash receipt from issuing new shares
– Cash dividends to shareholders

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An example of “Income Statement” Page 22, Subramanyam (2014) 18
An example of “Balance Sheet” (part 1) Page 21, Subramanyam (2014) 19
An example of “Balance Sheet” (part 2) Page 21, Subramanyam (2014) 20
An example of “Balance Sheet” (part 3) Page 21, Subramanyam (2014) 21
Accounting Analysis: Limitation
Financial statements are supposed to reflect the economic reality of a
company. However, sometimes it may not reflect this perfectly due to
accounting distortions.

Accounting distortions
The reported accounting numbers might not (fully) reflect the economic
reality of a company. For example,
1. Estimation error
2. Earnings management (by accounting choices / real actions)
3. Economic reality not captured by accounting standards

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 Accounting Analysis: Adjustment
Given the above, accounting analysis is a process to evaluate and adjust
(if applicable) the financial statements so as to better reflect economic
reality. This involves evaluating:

(i) Financial Reporting Quality (Do the financial statements and disclosure
notes faithfully represent the economic reality?); and

(ii) Earnings Quality (Are the reported results sustainable in the long term?)

After conducting accounting analysis, a set of (adjusted) accounting numbers

is available (if any adjustment at all) for conducting financial analysis.

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Lesson Plan
• Overview of Financial Statement Analysis
• Decision-to-Make

• Processes of Financial Statement Analysis

• Business Environment & Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Prospective Analysis & Valuation

24
Financial Analysis
Financial analysis is the use of financial Part III
statements to: Financial Analysis
(i) Analyze a company’s financial To analyze the past
performance
performance and position; and Topic 6
– Profitability Analysis
(ii) Assess its future financial performance.
Topic 7
– Credit Risk Analysis
Topic 8
– Cash Flow Analysis
Profitability
To forecast the future
performance & make decision
Topic 9
– Forecasting and Valuation
Liquidity Source and
& Solvency Use of
Funding
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Financial Analysis: Tools
1. Comparative Financial Statement Analysis (Horizontal Analysis)
- Year-to-Year Change Analysis
- Index-Number Trend Analysis

2. *Common-Size Financial Statement Analysis (Vertical Analysis)

- Common-Size Statement of Profit or Loss
- Common-Size Statement of Financial Position

3. Ratio Analysis
- Profitability, Asset Utilization, Liquidity, Solvency

* To be covered in later topics

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Year-to-Year Change Analysis

Page 29, Subramanyam (2014) 27

Year-to-Year Change Analysis
What could we tell from the numbers above?
• Net sales: Up by 7.5%
• Cost of sales: Up by 12.3%  Higher cost of production?
• SG&A expenses: Up by 6.4%  Better operating efficiency?

Comparative financial statement analysis can:

(i) Reveal the trend of each item; and
(ii) Compare trends in related items

Sales vs. Freight-out costs?

Sales vs. Accounts Receivable?

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Index-Number Trend Analysis
Year-to-year analysis is useful for comparing the results for 2 years only.
For comparison for 3 years or more, index-number trend analysis might be
performed.

A few steps:
1. Select a base period (a year usually), with all numbers in this period
usually preset as “100”
2. Numbers in other periods will expressed as a percentage changes from
the base period.

This can be used for analyzing items in income statements and/or in

balance sheets. A period of normal situation shall be selected as the “base
period”.

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Index-Number Trend Analysis
For example, ACY Limited had below cash balances:
Year 1: $300 (If selected as the base period)
Year 2: $570
Year 3: $285

Index Number regarding cash for each year:

Year 1: 100 = ($300 / $300) * 100

Year 2: 190 = ($570 / $300) * 100

Year 3: 95 = ($285 / $300) * 100

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Index-Number Trend Analysis
Another example: Points to look for at your
analysis:

Did sales increase or decrease in

the 6 years from 2006?

At a constant speed? Or did it

slow down?

How about Colgate’s cost

controlling while sales were
changing?

Notice:
Same accounting policies?
Impact of inflation?

Page 31, Subramanyam (2014) 31

Index-Number Trend Analysis: Example 1
Example 1
You learn below for ACY Limited:

Year 3 Year 2 Year 1

$ $ $
Sales 13,000 11,300 10,100

Less: Cost of Goods Sold (10,200) (8,880) (8,000)

Gross Profit 2,800 2,420 2,100

“The Company is a retailer of books and stationery products, operating a retail

store in Kowloon. In recent years, more fashionable and youth-oriented
products have been introduced to the store, widening the variety of goods
available. A stable product pricing strategy was adopted to ensure a
reasonable profit for goods sold.”
Class
Exercise 32
Example 1
Required:
(a) Compute the index-number trend percents for below accounts, using
Year 1 as the base year.
i. Sales;
ii. Cost of goods sold; and
iii. Gross profit.

(b) For each of the items (i) to (ii) above, analyze the trend, the observed
results, and the likely reason(s) behind.

Round your answers to ONE decimal place in amount / dollar / percentage

(if applicable). (e.g. 1.1 / $2.2 / 3.3%)
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Example 1
Your Try:

Index-Number
Year 3 Year 2 Year 1
Sales 128.7 111.9 100
Cost of goods sold 127.5 111 100
Gross profit 133.3 115.2 100

For example, the index number of sales in Year 2

= ($11,300 / $10,100) * 100
= 111.881
= 111.9 (ONE decimal place as required in this question) 34
Example 1
Your Try:

Analyze the trend, the observed results, and the likely reason(s)
behind:

Sales
Sales grew from $10,100 in Year 1 to $13,000 in Year 3. Observed
results
/ Indexes for sales increased consistently from 100 in Year 1 to
128.7 in Year 3.

The trend
Trend in sales is positive / growing.

Likely
The sales growth might reflect the company’s success in widening reason(s)
its product range. 35
Example 1
Your Try:

Analyze the trend, the observed results, and the likely reason(s)
behind:

Cost of goods sold

Indexes for cost of goods sold increased, but by a lesser percentage Observed
than sales (In Year 3: Sales 128.7; COGS: 127.5. Similar results in results
Year 2).

The trend
Cost of goods sold increased at a slower rate than sales growth /
remained stable as a percentage of the sales revenue.

Likely
This reflects the stable product pricing strategy adopted by the reason(s)
company. 36
Ratio Analysis
Profitability Liquidity and Solvency
1. Operating Performance 4. Liquidity
- Gross profit margin - Current ratio
- Net profit margin - Acid-test ratio
- Average receivable collection period
- Average days to sell inventory

2. Asset Utilization 5. Solvency

- PPE turnover - Total debt to equity (D/E ratio)
- Total asset turnover - Times interest earned

3. Return on Investment … and more

- Return on assets (ROA)
- Return on net operating assets (RNOA)
- Return on common equity (ROCE)
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Ratio Analysis: Profitability
Gross profit margin = Gross profit / Sales * 100%

(During a period)
IF Sales = $500
COGS = $200

THEN
Gross profit margin = ( $500 - $200 ) / $500 * 100%
= 60%

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Ratio Analysis: Liquidity
Cash ratio = Cash / Current Liabilities
Current ratio = Current assets / Current liabilities

(At the period-end date)

IF Cash = $100
Inventory = $30
Current liabilities = $120

THEN
Cash ratio = $100 / $120
= 0.833…

Current ratio = ($100 + $30) / $120

= 1.0833… 39
Ratio Analysis and its Limitations
Some points to note:
• Ratios are not defined by the accounting standards. The formulas
adopted in different textbooks might have minor variations.

• Usefulness of ratios depends on the reliability of the numbers

(accounting analysis) and on the representativeness of the period-end
figures (impact of seasonality in business cycle?)

• A ratio is only meaningful when referring to an economically important

relation. Ratios cannot be interpreted in isolation. (Lead or lag
indicators?) (typical range in the given industry?)

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Lesson Plan
• Overview of Financial Statement Analysis
• Decision-to-Make

• Processes of Financial Statement Analysis

• Business Environment & Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Prospective Analysis & Valuation

41
Prospective Analysis & Valuation
A firm’s value (and thus your investment) ultimately depends on its payoffs
to investors in the future. Techniques like discounted cash flows models
shall be familiar to you.

Two steps:
(i) To forecast a company’s future earnings

(ii) To convert such (estimated) future earnings into today’s value

- Dividend discount model
- Free cash flow to equity model, etc.

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Textbook Reading & Exercise
Textbook Reading
• Chapter 1. Financial Statement Analysis. International Edition
(11th edition). Subramanyam (2014). McGraw-Hill.

Textbook Exercise
• Exercise 1-11
• Problem 1-2

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