Overview of Financial Statement Analysis

1
Overview of Financial Statement Analysis

• Chapter 1
• Robinson, Munter, Grant

2
Learning Objectives

• Nature and purpose of Financial Analysis
• Accounting standards and processes underlying
  financial reports
• Role of professional financial analysts

3
Analysis for Decision Making

• Financial statement analysis is a tool for making
  complex investment and credit decisions.
  Specifically, it is used to
• Evaluate historical performance
• Predict future cash flows
• Establish the value of an enterprise
• Evaluate management

4
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 attributable to value growth from
  stock sale

5
Estimating cash flows requires

• Current and relevant information
• An evaluation of the firms profit and growth
  potential
• An assessment of the firms survival likelihood

6
Cash Flows and Prices

• Investors would like to pay an amount for an
  investment such that its annual future cash flows
  will provide a rate of return (r) greater than or
  equal to the return other potential uses of the
  money would provide.

7
Cash Flows and Prices

• In cases of identical payouts, return equals

8
Cash Flows and Prices

• Given a desired rate of return and an estimate of
  future cash flows, purchase price can be
  estimated as

9
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

10
Analysis Techniques

• Use publicly available data from financial
  statements including
• Income Statement
• Statement of Owners Equity
• Balance Sheet
• Statement of Cash Flows
• Notes to Financial Statements

11
Analysis Techniques Time series analysis

• Compare a firm to itself over time
• Firms provide at least two periods of comparable
  data in each set of financial statements

12
Analysis Techniques Cross-sectional Analysis

• Compare several firms over the same time period
• Designed to hold economic effects constant
• Enables analyst to determine how a firm is doing
  given the prevailing macroeconomic conditions
• Comparison of large, diverse, multinational firms
  is complex (and covered in detail in chapters 9
  and 18)

13
Financial Statements and Performance

• Financial statements are prepared in a consistent
  manner (enabling cross-sectional and time series
  comparisons)
• Accounting rules are designed to reflect firm
  performance

14
Basic Financial Statements

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

15
Accounting and Reporting Standards

• 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

16
Development of US Accounting Standards

• 1900
• No mandated reporting requirements even though
  the professions of accounting and auditing
  existed.
• 1933/34
• Securities Acts give the SEC authority to
  regulate financial reporting.
• The accounting profession worked to develop and
  refine accounting principles and auditing
  procedures.
• 1970s
• Financial Accounting Standards Board is created
  as the authority on financial reporting for
  publicly traded US firms.

17
Development of International Accounting Standards

• International Accounting Standards (IASB)
• 14 member committee of auditors, accountants,
  academics and financial statement users
• Developed International Accounting Standards
  (IAS) to help investors cope with financial
  analysis in global capital markets
• Rules are not used worldwide, but a number of
  countries do use the framework

18
Regulatory Requirements

• SEC filing requirements
• Form 10-K audited annual report
• Form 10-Q quarterly report
• Form 8-K periodic informational reports

19
Transactions and the Accounting Process

• Remember, Assets Claims
• Original owners put 1,000 in corporate checking
  account

20
Transactions and the Accounting Process

• Maintain the Assets Claims equality
• Build on previous transaction
• Corporation spends 50 on inventory

21
Transactions and the Accounting Process

• Change the previous transaction
• Corporation purchases 50 of inventory on credit

22
Transactions and the Accounting ProcessExpanded
Transaction Model

• Original owners put 1,000 in corporate checking
  account
• Corporation purchases 50 of inventory on credit
• Purchase a 5,000 building for 500 cash and
  4,500 mortgage

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Expanded Transaction Model
Assets Assets Assets Claims Claims Claims
Cash Inventory Building Accounts Payable Mortgage Payable Common Stock
1,000 1,000
50 50
(500) 5,000 4,500
500 50 5,000 50 4,500 1,000
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Transactions and the Accounting ProcessExpanded
Transaction Model

• The company pays rent of 2,000 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

25
Expanded Transaction Model
Assets Assets Assets Claims Claims Claims
Cash A/R Inventory Accounts Payable Common Stock Retained Earnings
(2,000) (2,000)
30,000 30,000
(15,000) (15,000)
(2,000) 30,000 (15,000) 13,000
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Basic Financial StatementsUsing recorded
information the

• Balance Sheet
• Reports totals of assets and claims on the date
  ending the reporting period
• Statement of Cash Flows
• Reports all cash inflows and outflows (more in
  chapter 4)
• The cash column of the transaction model
• Statement of Shareholders Equity
• Reports changes in the owners claim accounts
  during the period

27
The Professional AnalystBuy-Side and Sell-Side
Analysts

• Buy-side
• Provide information within the investment firm
• Information is rarely available to outsiders
• Sell-side
• Provide information to brokers who work with
  external clients
• Reports are created with external clients in mind

28
The Professional AnalystProfessional Designation

• Association for Investment Management and
  Research (AIMR)
• Established professional standards and ethics for
  financial analysts
• Sets disciplinary procedures in the event that
  unethical behavior is suspected or detected
• Manages the Chartered Financial Analyst (CFA)
  exam
• A series of three examinations covering
  economics, finance, statistics and financial
  statement analysis

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The Professional AnalystRole of the Analyst

• Incorporate incrementally informative data into
  recommendations
• Analysis is an ongoing process utilizing many
  types of resources
• Financial statement analysis is the starting
  point of this process

30
Summary

• Objectives of financial analysis
• Forecasting future cash flows
• Evaluating past performance
• Role of accounting information
• Importance of accounting standards
• Primary financial statements
• Market efficiency (role of analysts)