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Overview of Financial Statement Analysis


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Overview of Financial Statement Analysis

  1. 1. Overview of Financial Statement Analysis Chapter 1 Robinson, Munter, Grant
  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>
  3. 3. Analysis for Decision Making <ul><li>Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, it is used to: </li></ul><ul><ul><li>Evaluate historical performance </li></ul></ul><ul><ul><li>Predict future cash flows </li></ul></ul><ul><ul><li>Establish the value of an enterprise </li></ul></ul><ul><ul><li>Evaluate management </li></ul></ul>
  4. 4. Pricing Investments <ul><li>The price an investor is willing to pay depends on predicted future cash flows </li></ul><ul><li>Future cash flows from extending credit </li></ul><ul><ul><li>Interest income </li></ul></ul><ul><ul><li>Return of principal </li></ul></ul><ul><li>Future cash flows from equity investments </li></ul><ul><ul><li>Dividends </li></ul></ul><ul><ul><li>Proceeds – attributable to value growth – from stock sale </li></ul></ul>
  5. 5. 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>
  6. 6. Cash Flows and Prices <ul><li>Investors would like to pay an amount for an investment such that its annual future cash flows will provide a rate of return (r) greater than or equal to the return other potential uses of the money would provide. </li></ul>
  7. 7. Cash Flows and Prices <ul><li>In cases of identical payouts, return equals </li></ul>
  8. 8. Cash Flows and Prices <ul><li>Given a desired rate of return and an estimate of future cash flows, purchase price can be estimated as: </li></ul>
  9. 9. Evaluating Management <ul><li>Financial statement analysis may be the basis for a manger’s performance appraisal </li></ul><ul><li>Managers’ compensation may be a function of the this appraisal </li></ul><ul><li>It’s important to understand which elements of performance are within or beyond managers’ control </li></ul>
  10. 10. Analysis Techniques <ul><li>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>
  11. 11. 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>
  12. 12. 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><ul><li>Comparison of large, diverse, multinational firms is complex (and covered in detail in chapters 9 and 18) </li></ul>
  13. 13. 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>
  14. 14. 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>
  15. 15. Accounting and Reporting Standards <ul><li>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 </li></ul>
  16. 16. 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><ul><li>The accounting profession worked to develop and refine accounting principles and auditing procedures. </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>
  17. 17. Development of International Accounting Standards <ul><li>International Accounting Standards (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>
  18. 18. 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 periodic informational reports </li></ul></ul>
  19. 19. 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>
  20. 20. Transactions and the Accounting Process <ul><li>Maintain the Assets = Claims equality </li></ul><ul><li>Build on previous transaction </li></ul><ul><li>Corporation spends $50 on inventory </li></ul>
  21. 21. Transactions and the Accounting Process <ul><li>Change the previous transaction: </li></ul><ul><li>Corporation purchases $50 of inventory on credit </li></ul>
  22. 22. Transactions and the Accounting Process Expanded Transaction Model <ul><li>Original owners put $1,000 in corporate checking account </li></ul><ul><li>Corporation purchases $50 of inventory on credit </li></ul><ul><li>Purchase a $5,000 building for $500 cash and $4,500 mortgage </li></ul>
  23. 23. 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
  24. 24. 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>
  25. 25. 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
  26. 26. Basic Financial Statements 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>
  27. 27. 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>
  28. 28. The Professional Analyst Professional Designation <ul><li>Association for Investment Management and Research (AIMR) </li></ul><ul><ul><li>Established professional standards and ethics for financial analysts </li></ul></ul><ul><ul><li>Sets disciplinary procedures in the event that unethical behavior is suspected or detected </li></ul></ul><ul><ul><li>Manages the Chartered Financial Analyst (CFA ® ) exam </li></ul></ul><ul><ul><ul><li>A series of three examinations covering economics, finance, statistics and financial statement analysis </li></ul></ul></ul>
  29. 29. The Professional Analyst Role of the Analyst <ul><li>Incorporate incrementally informative data into recommendations </li></ul><ul><li>Analysis is an ongoing process utilizing many types of resources </li></ul><ul><li>Financial statement analysis is the starting point of this process </li></ul>
  30. 30. Summary <ul><li>Objectives of financial analysis </li></ul><ul><ul><li>Forecasting future cash flows </li></ul></ul><ul><ul><li>Evaluating past performance </li></ul></ul><ul><li>Role of accounting information </li></ul><ul><li>Importance of accounting standards </li></ul><ul><li>Primary financial statements </li></ul><ul><li>Market efficiency (role of analysts) </li></ul>