Overview of Financial Statement Analysis

1
Overview of Financial Statement Analysis

• Chapter 1
• UWYO COB ACCT2000

2
Learning Objectives

• Understand purpose and nature of financial
  analysis
• Understand financial reports and accounting
  processes

3
Analysis for Decision Making

• Investment and credit decisions
• Evaluate historical performance
• Predict future cash flows
• Establish the value of equity or debt
• Evaluate management

4
Cash Flows and Prices

• In cases of identical payouts (annuity), purchase
  price can be estimated as
• Given expected cash flows and current price,
  required rate of return equals

5
Pricing Investments

• The price an investor is willing to pay depends
  on predicted future cash flows
• Future cash flows from extending credit
• Interest income
• Return of principal
• Future cash flows from equity investments
• Dividends
• Proceeds from stock sale (due to growth)

6
Estimating cash flows requires

• Current and relevant information
• An evaluation of the firms profit and growth
  potential
• An assessment of the firms survival likelihood
  (abandonment option)
• See P1-3, P1-9, P1-11

7
Evaluating Management

• Financial statement analysis may be the basis for
  a mangers performance appraisal
• Managers compensation may be a function of the
  this appraisal
• Its important to understand which elements of
  performance are within or beyond managers control

8
Analysis Techniques Public data from financial
statements

• Income Statement
• provides results of business activities
• Balance Sheet
• states assets and claims against the assets
  (liabilities and owners equity)
• Statement of Cash Flows
• provides prior cash flow information
• helps analyst assess the firms ability to pay
  interested parties
• Notes to Financial Statements

9
Analysis Techniques Time series analysis

• Compare a firm to itself over time
• Pros Highly comparable
• Cons Economic shocks may affect firm performance

10
Analysis Techniques Cross-sectional Analysis

• Compare several firms over the same time period
• Pros Enables analyst to determine how a firm is
  doing given the prevailing macroeconomic
  conditions
• Cons Comparison of large, diverse, multinational
  firms is complex and many firms are not
  comparable
• See P1-2

11
Accounting and Reporting Standards

• Accounting rules are designed to reflect firm
  performance, enabling predicting future cash
  flows and evaluating management performance
• Financial statements are prepared in a consistent
  manner, enabling cross-sectional and time series
  comparisons
• However

12
Accounting and Reporting Standards

• Accounting standards allow management to have
  options on financial reporting because management
  generally has better information about a firm.
• Management has incentives to manipulate reported
  numbers.
• Therefore, analysts must become familiar enough
  with the accounting options available to the firm
  being studied in order to understand and evaluate
  the information presented in the financial
  statements
• See P1-8, P1-10, P1-13

13
Accounting Standards

• US Generally Accepted Accounting Principles
  (GAAP) developed by Financial Accounting
  Standards Board (FASB)
• International Accounting Standards (IAS)
  developed by International Accounting Standards
  Board (IASB)

14
Transactions and the Accounting Process

• Original owners put 10,000 in corporate checking
  account
• Corporation purchases 20,000 of inventory on
  credit
• Purchase a 500,000 building for 5,000 cash and
  495,000 mortgage
• The company pays salary of 4,000 for the current
  month
• The company sells inventory to a customer on
  account (receivable) at a retail price of 30,000
• The portion of the inventory which was sold cost
  15,000 to purchase

15
Expanded Transaction Model
16
Use recorded information to prepare basic
financial statements

• Balance Sheet
• Reports totals of assets and claims on the date
  ending the reporting period
• Income statement
• Reports revenues and expenses that change the
  owners claim accounts during the period
• Statement of Cash Flows
• Reports all cash inflows and outflows during the
  period
• Statement of Shareholders Equity
• Reports changes in the owners claim accounts
  during the period
• See P1-5, P1-12, P1-6, P1-7

17
Summary

• Purpose and nature of Financial Analysis
• Financial reports and accounting processes

18
Problems

• Purpose and nature of Financial Analysis
• Information to use P1-3 (C), P1-9, P1-11 (Not
  value-added because ROEltr)
• Techniques P1-2 (C)
• Financial reports and accounting processes
• Accounting methods P1-8 (4,000,000 under
  straight-line method), P1-10 (800,000 under US
  GAAP), P1-13
• Accounting process P1-5 (A) P1-12 (0, 10
  million, and 0.3 million)
• Financial statements P1-6 (43,250,000) P1-7
  (A)