Prep ch1


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Prep ch1

  1. 1. Overview of Financial Statement Analysis Chapter 1 UWYO COB ACCT2000
  2. 2. Learning Objectives <ul><li>Understand purpose and nature of financial analysis </li></ul><ul><li>Understand financial reports and accounting processes </li></ul>
  3. 3. Analysis for Decision Making <ul><li>Investment and credit decisions </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 equity or debt </li></ul></ul><ul><li>Evaluate management </li></ul>
  4. 4. Cash Flows and Prices <ul><li>In cases of identical payouts (annuity), purchase price can be estimated as: </li></ul><ul><li>Given expected cash flows and current price, required rate of return equals </li></ul>
  5. 5. 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 from stock sale (due to growth) </li></ul></ul>
  6. 6. 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 (abandonment option) </li></ul><ul><li>See P1-3, P1-9, & P1-11 </li></ul>
  7. 7. 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>
  8. 8. Analysis Techniques Public data from 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 the assets (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><ul><li>Notes to Financial Statements </li></ul>
  9. 9. Analysis Techniques Time series analysis <ul><li>Compare a firm to itself over time </li></ul><ul><li>Pros: Highly comparable </li></ul><ul><li>Cons: Economic shocks may affect firm performance </li></ul>
  10. 10. Analysis Techniques Cross-sectional Analysis <ul><li>Compare several firms over the same time period </li></ul><ul><li>Pros: Enables analyst to determine how a firm is doing given the prevailing macroeconomic conditions </li></ul><ul><li>Cons: Comparison of large, diverse, multinational firms is complex and many firms are not comparable </li></ul><ul><li>See P1-2 </li></ul>
  11. 11. Accounting and Reporting Standards <ul><li>Accounting rules are designed to reflect firm performance, enabling predicting future cash flows and evaluating management performance </li></ul><ul><li>Financial statements are prepared in a consistent manner, enabling cross-sectional and time series comparisons </li></ul><ul><li>However… </li></ul>
  12. 12. Accounting and Reporting Standards <ul><li>Accounting standards allow management to have options on financial reporting because management generally has better information about a firm. </li></ul><ul><li>Management has incentives to manipulate reported numbers. </li></ul><ul><li>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 </li></ul><ul><li>See P1-8, P1-10, & P1-13 </li></ul>
  13. 13. Accounting Standards <ul><li>US Generally Accepted Accounting Principles (GAAP) developed by Financial Accounting Standards Board (FASB) </li></ul><ul><li>International Accounting Standards (IAS) developed by International Accounting Standards Board (IASB) </li></ul>
  14. 14. Transactions and the Accounting Process <ul><li>Original owners put $10,000 in corporate checking account </li></ul><ul><li>Corporation purchases $20,000 of inventory on credit </li></ul><ul><li>Purchase a $500,000 building for $5,000 cash and $495,000 mortgage </li></ul><ul><li>The company pays salary of $4,000 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>
  15. 15. Expanded Transaction Model Accounts Receivable Common Stock Mortgage Payable Accounts Payable Building Inventory Cash Claims = Assets
  16. 16. Use recorded information to prepare basic financial statements <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>Income statement </li></ul><ul><ul><li>Reports revenues and expenses that change the owners’ claim accounts during the period </li></ul></ul><ul><li>Statement of Cash Flows </li></ul><ul><ul><li>Reports all cash inflows and outflows during the period </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><ul><li>See P1-5, P1-12, P1-6, & P1-7 </li></ul>
  17. 17. Summary <ul><li>Purpose and nature of Financial Analysis </li></ul><ul><li>Financial reports and accounting processes </li></ul>
  18. 18. Problems <ul><li>Purpose and nature of Financial Analysis </li></ul><ul><ul><li>Information to use: P1-3 (C), P1-9, & P1-11 (Not value-added because ROE<r) </li></ul></ul><ul><ul><li>Techniques: P1-2 (C) </li></ul></ul><ul><li>Financial reports and accounting processes </li></ul><ul><ul><li>Accounting methods: P1-8 (4,000,000 under straight-line method), P1-10 (800,000 under US GAAP), & P1-13 </li></ul></ul><ul><ul><li>Accounting process: P1-5 (A) & P1-12 (0, 10 million, and 0.3 million) </li></ul></ul><ul><ul><li>Financial statements: P1-6 (43,250,000) & P1-7 (A) </li></ul></ul>