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Prep ch1


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  • 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 firm’s profit and growth potential
    • An assessment of the firm’s survival likelihood (abandonment option)
    • See P1-3, P1-9, & P1-11
  • 7. Evaluating Management
    • Financial statement analysis may be the basis for a manger’s performance appraisal
    • Managers’ compensation may be a function of the this appraisal
    • It’s 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 owner’s equity)
    • Statement of Cash Flows
      • provides prior cash flow information
      • helps analyst assess the firm’s 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 Accounts Receivable Common Stock Mortgage Payable Accounts Payable Building Inventory Cash Claims = Assets
  • 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 ROE<r)
      • 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)