Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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Overview of Financial
Statement Analysis

1
CHAPTER
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Business Analysis

Evaluate Prospects Evaluate Risks

Business Decision Makers

Equity investors

Creditors

Managers

Merger and Acquisition Analysts

External Auditors

Directors

Regulators

Employees & Unions

Lawyers
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Information Sources for Business

Analysis
Quantitative Qualitative

Management discussion & Analysis

Financial Statements

Chairpersons Letter
Industry Statistics
Press Releases
Economic Indicators
Financial press

Regulatory filings
Vision/Mission Statement

Trade reports Web sites

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Credit Analysis Equity Analysis

Management &
Control Labor Negotiations

Types of
Business Director Oversight
Regulation Analysis

Financial External Auditing

Management

Mergers, Acquisitions
& Divestitures
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Credit Analysis

Trade Non-trade
Creditors Creditors

Provide Provide
Bear risk of Bear risk of
goods or major
default default
services financing

Usually Usually
Most short- Most long-
implicit explicit
term term
interest interest
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Credit Analysis
Credit worthiness: Ability to honor credit obligations
(downside risk)

Liquidity Solvency
Ability to meet short- Ability to meet long-
term obligations term obligations
Focus: Focus:
Current cash flows Long-term profitability
Make up of current Capital structure
assets and liabilities
Liquidity of assets
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Equity Analysis
Assessment of downside risk and upside potential

Technical analysis / Fundamental Analysis

Charting
Determine Intrinsic value
Patterns in price or without reference to
volume history of a price
stock
Predict future price Analyze and interpret
movements key factors
Economy
Industry
Company
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Component Processes of
Business Analysis

Business
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

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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

Risk
Accounting Standards
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Financial Analysis

Process to evaluate financial position and

performance using financial statements

Profitability analysis Evaluate return

on investments Common tools

Risk analysis Evaluate riskiness

& creditworthiness Cash
Ratio
flow
analysis
analysis
Analysis of Evaluate source &
cash flows deployment of funds
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Prospective Analysis

Process to forecast future payoffs

Business Environment
& Strategy Analysis

Accounting Analysis

Financial Analysis

Intrinsic Value
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Dynamics of Business Activities

Business Activities Time
Beginning of period
Investing Financing
Planning

Operating

Planning
Investing Financing
End of period
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Business Activities
Competition Pricing

Market demands Tactics

Planning
Activities:
Distribution Goals Promotion
& Objectives
Projections
Managerial performance

Opportunities Obstacles
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Business Activities

Financing activities
Owner (equity)
Nonowner (liabilities)

Financing
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Business Activities

Investing activities
Buying resources
Selling resources

Investing Financing

Investing = Financing
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Business Activities
Planning
Investing Activities Financial
Activities Activities

Operating Activities
Revenues and expenses from providing
goods and services
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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
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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 Financing
(in $billions)
$9.138 = $7.727 + $1.410
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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
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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)

Managements Discussion & Analysis (MD&A)

Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement
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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
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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
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Analysis Preview
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Analysis Preview
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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
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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)
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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)
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Analysis Preview
Equity Valuation (Dividend 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
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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
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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)]
k is the cost of capital
E refers to an expectation
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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
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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
Investing Activities
Chapter 5: Analyzing Chapter 9: Profitability
Chapter 2: Financial Analysis
Investing Activities:
Reporting and Chapter 10: Prospective
Special topic
Analysis Analysis
Chapter 6: Analyzing
Chapter 11: Credit
Operating Activities Analysis
Chapter 12: Equity
Analysis and Valuation