Financial Statement Analysis

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This document explains the financial statement analysis process. Most slides are instructional and covered topics include the financial statement analysis process, financial ratios analysis, accounting information (assumptions, principles, policies, procedures), and others.

Financial statement analysis involves analyzing the firm's financial statements to extract information that can facilitate decision-making. For example, an analysis of the financial statement can reveal:
* whether the firm will be able to meet its long-term debt commitment,
* whether the firm is financially distressed,
* whether the company is using its physical assets efficiently,
* whether the firm has an optimal financing mix,
* whether the firm is generating adequate return for its shareholders,
* whether the firm can sustain its competitive advantage, and so forth.

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Transcript of "Financial Statement Analysis"

  1. 1. Crowdsourced Business Presentation Design Service Financial Statement Analysis Financial Statement Analysis, Financial Ratios, Accounting Information February 25, 2014 This document explains the financial statement analysis process. Most slides are instructional and covered topics include the financial statement analysis process, financial ratios analysis, accounting information (assumptions, principles, policies, procedures), and others. ORIGINAL PROJECT DETAILS http://pptlab.com/ppt/Financial-Statement-Analysis-20
  2. 2. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 4 Contents Things to Know Financial Ratio Analysis Accounting Information Approach to Financial Statement Analysis Overview This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  3. 3. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 7 Contents Things to Know Financial Ratio Analysis Accounting Information Approach to Financial Statement Analysis Overview This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  4. 4. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 10 Approach (3 of 5) Examine the shareholder’s equity statement 6 Has the company issued new shares, or bought some back? Has the retained earnings account been growing or shrinking? Why? Are there signals about the company's long- term strategy here? Examine the cash flow statement 7 This gives information about the cash inflows and outflows from operations, financing, and investing. While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about Calculate financial ratios 8 Calculate financial ratios in each of the following categories, for each year. You may use the formulas found in your textbook, or other materials you have from your finance and accounting courses. A summary of some useful ratios appears at the end of this document. • Liquidity ratios • Leverage (or debt) ratios • Profitability ratios • Efficiency ratios • Value ratios Graph the ratios over time, to find the trends in the ratios from year to year. Are they going up or down? Is that favorable or unfavorable? This should trigger further questions in your mind, and help you to look for the underlying reasons. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  5. 5. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 13 Contents Things to Know Financial Ratio Analysis Accounting Information Approach to Financial Statement Analysis Overview This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  6. 6. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 16 Liquidity ratios indicate a company’s ability to pay off short-term financial obligations Liquidity Ratios Liquidity Degree of Financial Leverage Profitability Efficiency Value OVERVIEW Liquid assets are those that can be converted into cash quickly. The short-term liquidity ratios show the firm’s ability to meet its short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater liquidity and lower risk for short-term lenders. The Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1). While high liquidity means that the company will not default on its short-term obligations, one should keep in mind that by retaining assets as cash, valuable investment opportunities may be lost. Obviously, cash by itself does not generate any return. Only if it is invested will we get future return. RATIOS (Total Current Assets – Inventories) / (Total Current Liabilities) In the quick ratio, we subtract inventories from total current assets, since they are the least liquid among the current assets Quick Ratio (Total Current Assets) / (Total Current Liabilities) Current Ratio This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  7. 7. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 19 Efficiency ratios indicate how well the company’s assets are being managed Efficiency Ratios Liquidity Degree of Financial Leverage Profitability Efficiency Value OVERVIEW These ratios reflect how well the firm’s assets are being managed. The inventory ratios shows how fast the inventory is being produced and sold. RATIOS (Days in a Year) / (Inventory Turnover) Also referred to as “shelf life.” Days in Inventory (Average Receivables) / (Total Sales / Days in a Year) Average Collection Period (Annual Credit Sales) / (Average Receivables) Accounts Receivable Turnover Sales / (Average Total Assets) This ratio shows how much sales the firm is generating for every dollar of investment in assets. The higher the ratio, the better the firm is performing. Total Assets Turnover (Cost of Goods Sold) / (Average Inventory) This ratio shows how quickly the inventory is being turned over (or sold) to generate sales. A higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories. Inventory Turnover This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  8. 8. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 22 However, there are many limitations to ratio analysis—from the subjectivity of the analyst… Limitations of Ratio Analysis (1 of 2) Financial statements provide an assessment of the costs and not value. For example, fixed assets are usually shown on the balance sheet as the cost of the assets less their accumulated depreciation, which may not reflect the actual current market value of those assets. Ratios are based on financial statements that reflect the past and not the future. Unless the ratios are stable, it may be difficult to make reasonable projections about future trends. Furthermore, financial statements such as the balance sheet indicate the picture at “one point” in time, and thus may not be representative of longer periods. Ratios may not be strictly comparable for different firms due to a variety of factors such as different accounting practices or different fiscal year periods. Furthermore, if a firm is engaged in diverse product lines, it may be difficult to identify the industry category to which the firm belongs. Also, just because a specific ratio is better than the average does not necessarily mean that the company is doing well; it is quite possible rest of the industry is doing very poorly. There is considerable subjectivity involved, as there is no “correct” number for the various ratios. Further, it is hard to reach a definite conclusion when some of the ratios are favorable and some are unfavorable. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  9. 9. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 25 This diagram illustrates the hierarchy of accounting qualities Hierarchy of Accounting Qualities Source: Analysis and Uses of Financial Statements, Delta Publishing Secondary Qualities Ingredients of Primary Qualities Primary Qualities Pervasive Criterion User-Specific Qualities Constraints Users of Accounting Information Decision Makers and their Characteristics Understandability Decision Usefulness Costs < Benefits (Pervasive Constraint) Materiality (Threshold for Recognition) Relevance Reliability Predictive Value Feedback Value Timeliness Verifiability Representa- tional Faithfulness Neutrality Comparability Consistency This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  10. 10. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 28 An understanding of the key Accounting Assumptions, Accounting Principles, Accounting Procedures, and Accounting Policies underlying financial statements is helpful in understanding the nature and scope of financial statement analysis. An understanding of accounting assumptions, principles, procedures, and policies is important to financial statement analysis Accounting Understanding Source: Analysis and Uses of Financial Statements, Delta Publishing Accounting Assumptions Accounting Principles Accounting Procedures Accounting Policies This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  11. 11. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 31 There are 7 key accounting principles to know and understand Accounting Principles (1 of 5) Source: Analysis and Uses of Financial Statements, Delta Publishing Cost Principle This principle states that the acquisition cost is the proper amount at which transactions and events involving assets, liabilities, and owners’ equity should be initially recorded in the accounting system. Transactions and event are measured by the exchange price at which the transfer takes place. Cost is the exchange price in an arm’s-length transaction, that is, a transaction in which each of the parties involved is seeking to serve his own best interest. Full Disclosure Principle Full Disclosure Principle requires that information provided in financial statements be sufficiently complete to avoid misleading users of the reports by omitting significant facts of information. This principle also refers to revealing information that would be useful in the decision-making processes of informed users. Full disclosure is required for the fair presentation of financial statements. Many disclosures are made in the body of the financial statements and in notes (footnotes), schedules, and supplementary reports, and in a summary of significant policies preceding the first note to financial statements. PRINCIPLES Accounting principles are the guidelines, laws, or rules which are adopted by the accounting profession and which serve as guides to accounting practice. A major objective of accounting principles is to reduce the difference and inconsistencies in accounting practice, thereby improving the comparability and credibility of financial reports. Accounting Assumptions Accounting Principles Accounting Procedures Accounting Policies This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  12. 12. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 34 Accounting Principles (4 of 5) Source: Analysis and Uses of Financial Statements, Delta Publishing Materiality Principle PRINCIPLES This refers to the magnitude or significance of something that would be of interest to an informed investor or creditor in making evaluations and decisions. The Materiality Principle requires that anything that is material to financial statements must be disclosed—an item is material for accounting purposes if the omission or misstatement of it, in light of surrounding circumstances, make it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. Immaterial items which have little or no consequences to statement users can be handled as expediency, fairness, and professional judgment require. Conservatism Principle Conservatism is basic accounting principle that requires the reasonable anticipation of potential losses in recorded assets or in the settlement of liabilities at the time when financial statements are prepared. The principle of conservatism is sometimes expressed as follows: “Recognize all losses and anticipate no gains.” A major purpose of the principle of conservatism is to assure that assets will not be overstated or liabilities understated. Conservatism is a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered (SFAC 2). Valuing inventory at the lower of cost or market is an application of this principle. Accounting Assumptions Accounting Principles Accounting Procedures Accounting Policies This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  13. 13. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 37 It its critical to collect and understand all accounting policies Accounting Policies Source: Analysis and Uses of Financial Statements, Delta Publishing • Information about the accounting policies adopted by a reporting enterprise is essential for financial statement users and should be disclosed. Accounting principles and their method of application in the following areas are considered particularly important: • A selection from existing alternatives (for example, inventory methods such as LIFO, FIFO, and average methods) • Areas those are peculiar to a particular industry in which the company operates • Unusual and innovative applications of generally accepted accounting principles • Significant accounting policies are usually disclosed as the initial note or as a summary preceding the notes to the financial statements • APB 22 (Disclosure of Accounting Policies) explicitly lists certain items as commonly required disclosures in a summary of significant accounting policies. These items include the basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. Different organizations may apply the same accounting principles differently—as reflected by their policies. 1 2 3 4 Accounting Assumptions Accounting Principles Accounting Procedures Accounting Policies This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  14. 14. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 40 Here are some things you need to know about financial statements Things to Know (1 of 3) Wall Street Is Not your Friend Making money in a stock market that is trading flat is a zero sum game. For you to profit, someone else must lose. Be skeptical and very careful where you get your investment advice. Question the motives of so-called experts. As of yet, there are no rules ensuring that they disclose their conflicts of interest. Proforma Earnings Announcements Many companies now issue Proforma Earnings Statements that exclude certain expense items as being "extraordinary". It is now a normal part of business for many firms, particularly tech firms. The trouble is that there are no standards for reporting Proforma Statements, leaving the door open to manipulating earnings and misleading investors. Outgoing SEC Chief Economist Lynn Turner says pro forma earnings are effectively "EBS" earnings--"Everything but the Bad Stuff." A study that compares the unaudited Proforma Earnings Statements to the NASDAQ 100 companies with the audited statements they filed with the SEC shows a huge $101 billion difference for the first three quarters of 2001. Frequent Restructuring Charges and Write- Downs As businesses adjust their internal structure, they incur costs for shutting down one activity and starting another. In a small company, charges for these activities would occur infrequently, but in a large company, they will be routine. If charges and write downs for restructurings occur regularly, the company may be classifying normal business expenses as extraordinary to create the illusion that the core business is more profitable than it really is. Reserve Reversals Companies generally establish reserves to cover the costs of restructuring. Reserves allow management to "store profits" for later use if the reserves are unusually large. At a later time, they can reverse the reserve for the amount that was not spent and it flows directly to the bottom line. Source: Prentice Hall Publishers, 2003 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
  15. 15. PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 43 PPT Lab (www.pptlab.com) is the only crowdsourced presentation design service. Get consulting-quality presentations at a fraction of the cost! Each month, we will create well over 50 slides of for our members. As a member, you will drive what business slides we create by submitting your own presentation projects to our team. All presentations will be created by a team of management consultants and follow the Consulting Presentation Framework. www.PPTLab.com support@pptlab.com This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-statement-analysis-141
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