Financial Statement Analysis

K R Subramanyam John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview of Financial Statement Analysis

1-2

1
CHAPTER

1-3

Business Analysis
Evaluate Prospects
Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers

Evaluate Risks

1-4

Information Sources for Business Analysis

Quantitative Financial Statements Industry Statistics
Press Releases Qualitative Management discussion & Analysis Chairpersons Letter

Economic Indicators
Financial press

Regulatory filings
Vision/Mission Statement

Trade reports

Web sites

1-5

Credit Analysis

Equity Analysis

Management & Control

Types of Business Analysis

Labor Negotiations

Regulation

Director Oversight

Financial Management

External Auditing
Mergers, Acquisitions & Divestitures

1-6

Credit Analysis

Trade Creditors

Non-trade Creditors Provide major financing

Provide goods or services

Bear risk of default

Bear risk of default

Most shortterm

Usually implicit interest

Most longterm

Usually explicit interest

1-7

Credit Analysis
Credit worthiness: Ability to honor credit obligations (downside risk)

Liquidity Ability to meet shortterm obligations Focus: Current cash flows Make up of current assets and liabilities Liquidity of assets

Solvency Ability to meet longterm obligations Focus: Long-term profitability Capital structure

1-8

Equity Analysis
Assessment of downside risk and upside potential

Technical analysis / Charting Patterns in price or volume history of a stock Predict future price movements

Fundamental Analysis Determine Intrinsic value without reference to price Analyze and interpret key factors
Economy Industry Company

1-9

Component Processes of Business Analysis

Business Environment & Strategy Analysis Industry Analysis Strategy Analysis

Financial Analysis Analysis of cash flows Risk Profitability Analysis Analysis

Accounting Analysis

Prospective Analysis

Cost of Capital Estimate

Intrinsic Value

1-10

Accounting Analysis
Process to evaluate and adjust financial statements to better reflect economic reality
Comparability problems across firms and across time Manager estimation error

Distortion problems

Earnings management
Accounting Standards

Accounting Risk

1-11

Financial Analysis
Process to evaluate financial position and performance using financial statements
Profitability analysis Evaluate return on investments Risk analysis Evaluate riskiness & creditworthiness Analysis of cash flows Evaluate source & deployment of funds

Common tools
Cash flow analysis

Ratio analysis

1-12

Prospective Analysis
Process to forecast future payoffs
Business Environment & Strategy Analysis Accounting Analysis

Financial Analysis

Intrinsic Value

1-13

Dynamics of Business Activities

Business Activities
Investing Financing
Planning

Time
Beginning of period

Operating

Planning Investing Financing End of period

1-14

Business Activities
Competition Pricing Tactics Planning Activities: Goals & Objectives

Market demands

Distribution

Promotion Projections

Managerial performance Opportunities Obstacles

1-15

Business Activities

Financing activities Owner (equity) Nonowner (liabilities)

Financing

1-16

Business Activities

Investing activities Buying resources Selling resources

Investing

Financing

Investing = Financing

1-17

Business Activities
Investing Activities Planning Activities Financial Activities

Operating Activities
Revenues and expenses from providing goods and services

1-18

Financial Statements Reflect Business Activities

Planning
Investing
Current:

Financing
Current:

Operating
Sales Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax Expense

Cash Accounts Receivable Inventories Marketable Securities Land, Buildings, & Equipment Patents Investments

Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings

Noncurrent:

Noncurrent:

Net Income

Income statement
Assets

Liabilities & Equity

Cash Flow

Balance Sheet

Balance Sheet

Statement of Cash Flows

Statement of Shareholders Equity

1-19

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

1-20

1-21

Balance Sheet
Total Investing = Total Financing = Creditor Financing + Owner Financing

Colgate Financing (in $billions) $9.138 = $7.727 + $1.410

1-22

1-23

Income Statement
Revenues Cost of goods sold = Gross Profit Gross profit Operating expenses = Operating Profit

Colgates Profitability (in $billions)

$12.238 - $5.536 = $6.701 Gross Profit

$6.701 - $4.5411 = $2.160 Operating profit

1-24

1-25

Statement of Cash Flows

Net Cash Flows from Operating Activities
Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities

1-26

1-27

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

1-28

Analysis Preview
Yr1 Yr2 Yr3

Comparative 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

1-29

Analysis Preview

1-30

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

1-31

Analysis Preview

1-32

Analysis Preview

1-33

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

1-34

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)

1-35

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 debts face value) r is the investors required interest rate (yield to maturity)

1-36

Analysis Preview
Equity Valuation

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

1-37

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] k is the cost of capital E refers to an expectation

1-38

Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period 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)] k is the cost of capital E refers to an expectation
t

1-39

Analysis in an Efficient Market

Three assumed forms of market efficiency
Weak Form - prices reflect information in past prices Semi-strong - prices reflect all public Form information Strong Form - prices reflect all public and private information

1-40

Book Organization
Financial Statement Analysis
Part I Introduction and Overview Part II Accounting Analysis Chapter 3: Analyzing Financial Activities Chapter 4: Analyzing Investing Activities Chapter 5: Analyzing Investing Activities: Special topic Chapter 6: Analyzing Operating Activities Part III Financial Analysis
Chapter 7: Cash Flow Analysis Chapter 8: Return on Invested Capital Chapter 9: Profitability Analysis Chapter 10: Prospective Analysis Chapter 11: Credit Analysis Chapter 12: Equity Analysis and Valuation

Chapter 1: Overview of Financial Statement Analysis

Chapter 2: Financial Reporting and Analysis