Overview of Financial Statement Analysis


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Overview of Financial Statement Analysis

  1. 1. Overview of Financial Statement Analysis Chapter 1
  2. 2. Learning Objectives <ul><li>Nature and purpose of Financial Analysis </li></ul><ul><li>Accounting standards and processes underlying financial reports </li></ul><ul><li>Role of professional financial analysts </li></ul><ul><li>No need to read appendix 1A, 1B, and p12-17. </li></ul>
  3. 3. Goal <ul><li>Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, its basic goal is to value a firm by estimating its future cash flows and determining its financial health. </li></ul>
  4. 4. Estimating cash flows requires <ul><li>Current and relevant information </li></ul><ul><li>An evaluation of the firm’s profit and growth potential </li></ul><ul><li>An assessment of the firm’s survival likelihood </li></ul>
  5. 5. Analysis Techniques <ul><li>Starting point is to use publicly available data from financial statements including </li></ul><ul><ul><li>Income Statement </li></ul></ul><ul><ul><li>Statement of Owners’ Equity </li></ul></ul><ul><ul><li>Balance Sheet </li></ul></ul><ul><ul><li>Statement of Cash Flows </li></ul></ul><ul><ul><li>Notes to Financial Statements </li></ul></ul>
  6. 6. Analysis Techniques Time series analysis <ul><li>Compare a firm to itself over time </li></ul><ul><li>Firms provide at least two periods of comparable data in each set of financial statements </li></ul>
  7. 7. Analysis Techniques Cross-sectional Analysis <ul><li>Compare several firms over the same time period </li></ul><ul><li>Designed to hold economic effects constant </li></ul><ul><li>Enables analyst to determine how a firm is doing given the prevailing macroeconomic conditions </li></ul>
  8. 8. Financial Statements and Performance <ul><li>Financial statements are prepared in a consistent manner (enabling cross-sectional and time series comparisons) </li></ul><ul><li>Accounting rules are designed to reflect firm performance </li></ul>
  9. 9. Development of US Accounting Standards <ul><li>1900 </li></ul><ul><ul><li>No mandated reporting requirements even though the professions of accounting and auditing existed. </li></ul></ul><ul><li>1933/34 </li></ul><ul><ul><li>Securities Acts give the SEC authority to regulate financial reporting. </li></ul></ul><ul><li>1970s </li></ul><ul><ul><li>Financial Accounting Standards Board is created as the authority on financial reporting for publicly traded US firms. </li></ul></ul>
  10. 10. Environmental Factors Financial Accounting Standards Board Generally Accepted Accounting Principles Provide input to Help set Securities and Exchange Commission Unions Investors Accountants Politicians Lenders Others AICPA
  11. 11. Regulatory Requirements <ul><li>SEC filing requirements </li></ul><ul><ul><li>Form 10-K audited annual report </li></ul></ul><ul><ul><li>Form 10-Q quarterly report </li></ul></ul><ul><ul><li>Form 8-K special informational reports </li></ul></ul>
  12. 12. Financial Reporting Environment Regulators         FASB AICPA Industry Practices GAAP Enforcement and Monitoring Mechanisms SEC Corporate Governance Managers Auditors Statutory Financial Reports (Financial Statements) Alternative Information Sources Economy and Industry Information Voluntary Disclosure Users Analysts Investors and Creditors Other Users Litigation                                                                                
  13. 13. Form 10-K (Annual Report) 10-Q (Quarterly Report) Other SEC Filings 14-A (Proxy Statement/ Prospectus) Statutory Financial Reports 8-K (Current Report) 20-F (Registration Statement/ Annual Report [Foreign])
  14. 14. Development of International Accounting Standards <ul><li>International Accounting Standards Board(IASB) </li></ul><ul><ul><li>14 member committee of auditors, accountants, academics and financial statement users </li></ul></ul><ul><ul><li>Developed International Accounting Standards (IAS) to help investors cope with financial analysis in global capital markets </li></ul></ul><ul><ul><li>Rules are not used worldwide, but a number of countries do use the framework </li></ul></ul>
  15. 15. Basic Financial Statements <ul><li>Income Statement </li></ul><ul><ul><li>provides results of business activities </li></ul></ul><ul><li>Balance Sheet </li></ul><ul><ul><li>states assets and claims against them (liabilities and owner’s equity) </li></ul></ul><ul><li>Statement of Cash Flows </li></ul><ul><ul><li>provides prior cash flow information </li></ul></ul><ul><ul><li>helps analyst assess the firm’s ability to pay interested parties </li></ul></ul>
  16. 16. Transactions and the Accounting Process <ul><li>Remember, Assets = Claims </li></ul><ul><li>Original owners put $1,000 in corporate checking account </li></ul>
  17. 17. Transactions and the Accounting Process <ul><li>Change the previous transaction: </li></ul><ul><li>Corporation purchases $50 of inventory on credit </li></ul>
  18. 18. Transactions and the Accounting Process Expanded Transaction Model <ul><li>Purchase a $5,000 building for $500 cash and $4,500 mortgage </li></ul>
  19. 19. Expanded Transaction Model $1,000 $4,500 $50 = $5,000 $50 $500 $4,500 $5,000 ($500) $50 $50 $1,000 $1,000 Common Stock Mortgage Payable Accounts Payable Building Inventory Cash Claims = Assets
  20. 20. Transactions and the Accounting Process Expanded Transaction Model <ul><li>The company pays rent of $2,000 for the current month </li></ul><ul><li>The company sells inventory to a customer on account (receivable) at a retail price of $30,000 </li></ul><ul><li>The portion of the inventory which was sold cost $15,000 to purchase </li></ul>
  21. 21. Expanded Transaction Model $13,000 = ($15,000) $30,000 ($2,000) ($15,000) ($15,000) $30,000 $30,000 ($2,000) ($2,000) Retained Earnings Common Stock Accounts Payable Inventory A/R Cash Claims = Assets
  22. 22. Using recorded information the… <ul><li>Balance Sheet </li></ul><ul><ul><li>Reports totals of assets and claims on the date ending the reporting period </li></ul></ul><ul><li>Statement of Cash Flows </li></ul><ul><ul><li>Reports all cash inflows and outflows (more in chapter 4) </li></ul></ul><ul><ul><li>The cash column of the transaction model </li></ul></ul><ul><li>Statement of Shareholders’ Equity </li></ul><ul><ul><li>Reports changes in the owners’ claim accounts during the period </li></ul></ul>
  23. 23. The Professional Analyst Buy-Side and Sell-Side Analysts <ul><li>Buy-side </li></ul><ul><ul><li>Provide information within the investment firm </li></ul></ul><ul><ul><li>Information is rarely available to outsiders </li></ul></ul><ul><li>Sell-side </li></ul><ul><ul><li>Provide information to brokers who work with external clients </li></ul></ul><ul><ul><li>Reports are created with external clients in mind </li></ul></ul>
  24. 24. Role of the Analysts <ul><li>Financial analysts do not believe in semi-strong form of market efficiency. </li></ul><ul><li>However, their job makes the market price more efficient. </li></ul><ul><li>If interested in becoming a CFA, visit http://cfainstitute.org/cfaprogram/ </li></ul>
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