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.

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Financial Statement Analysis

  1. 1. Crowdsourced Business Presentation Design ServiceFinancial Statement AnalysisFinancial Statement Analysis, FinancialRatios, Accounting InformationThis document explains the financial statement analysis process. Most slides areinstructional and covered topics include the financial statement analysis process,financial ratios analysis, accounting information (assumptions, principles, policies,procedures), and others. January 23, 2013ORIGINAL PROJECT DETAILShttp://pptlab.com/ppt/Financial-Statement-Analysis-20
  2. 2. PPT Lab (www.pptlab.com) is the only crowdsourced presentation design service. Get consulting-quality presentations at a fraction of the cost!www.PPTLab.comsupport@pptlab.com 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.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 2
  3. 3. Contents  Overview 4  Approach to Financial Statement Analysis 7  Financial Ratio Analysis 13  Accounting Information 24  Things to Know 38PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 3
  4. 4. Contents  Overview  Approach to Financial Statement Analysis  Financial Ratio Analysis  Accounting Information  Things to KnowPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 4
  5. 5. This document explains the financial statement analysis processExecutive Summary (1 of 2) 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. This document explains the financial statement analysis process, as well as related topics of accounting information, financial ratios, and things to watch out for when conducing this analysis. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. Analysis of a company’s financial statements can reveal immense information into its health, strategy, and performance—but there are also numerous misleading traps.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 5
  6. 6. Understanding how to perform and analyze financial ratios is a critical partof financial statements analysisExecutive Summary (2 of 2) Performance of a firm can be assessed by computing key ratios and analyzing: • How is the firm performing relative to the industry? • How is the firm performing relative to the leading firms in their industry? • How does the current year performance compare to the previous year(s)? • What are the variables driving the key ratios? • What are the linkages among the ratios? • What do the ratios reveal about the future prospects of the firm for various stakeholders such as shareholders, bondholders, employees, customers etc.? Merely presenting a series of graphs and figures will be a futile exercise. We need to put the information in a proper context by clearly identifying the purpose of our analysis and identifying the key data driving our analysis. Financial analysis is performed by both internal management and external groups. Firms would perform such an analysis in order to evaluate their overall current performance, identify THIS IS A PARTIAL PREVIEW problem/opportunity areas, develop budgets and implement strategies for the future. External groups (e.g. investors, regulators,full document customers) also perform financial You can download the lenders, suppliers, at http://PPTLab.com. analysis in deciding whether to invest in a particular firm, whether to extend credit, etc. There are PPT Lab is a crowdsourced presentation design service. several rating agencies (such as Moody’s, Standard & Poors) that routinely perform financial analysis of firms in order to arrive at a composite rating.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 6
  7. 7. Contents  Overview  Approach to Financial Statement Analysis  Financial Ratio Analysis  Accounting Information  Things to KnowPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 7
  8. 8. Basic financial statement analysis of a company follows a 12-step processApproach (1 of 5) 1 Acquire the company’s financial statements for several years. As a minimum, get the following statements, for at least 3 to 5 years: Acquire the company’s financial statements • Balance sheets • Income statements • Shareholder equity statements • Cash flow statements 2 Quickly scan all of the statements to look for large movements in specific items from one Scan for large movements in year to the next. E.g. specific items • Did revenues have a big jump, or a big fall, from one particular year to the next? • Did total or fixed assets grow or fall? If you find anything that looks very suspicious, research the information you have about the company to find out why. E.g. • Did the company purchase a new division, or sell off part of its operations, that year? THIS IS A PARTIAL PREVIEW 3 You can download significant to your analysis. the financial statements for additional information that may the full document at http://PPTLab.com. Review the notes accompanying Review notes accompanying the be PPT Lab is a crowdsourced presentation design service. financial statementsPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 8
  9. 9. Approach (2 of 5) 4 Look for large changes in the overall components of the companys assets, liabilities or equity. Examine the balance sheet E.g. • Have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? • Has the proportion of debt grown rapidly, to reflect a new financing strategy? If you find anything that looks very suspicious, research the information you have about the company to find out why. 5 Look for trends over time. Calculate and graph the growth of the following entries over the past several years: Examine the income statement • Revenue (sales) • Net income (profit, earnings) Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? For each of the key expense components on the income statement, calculate it as a THIS IS A PARTIAL PREVIEW percentage of sales for each year. Look for favorable or unfavorable trends. Also, determine whether the spending trends support the company’s strategies. You can download the non-recurring or non-operatinghttp://PPTLab.com. on not directly Look for full document at items. companies"unusual" expenses almost an related to ongoing operations. However, some These are have such items PPT Lab is a crowdsourceddo these reflect on the earnings quality? annual basis. How presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 9
  10. 10. Approach (3 of 5) 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 companys long- Examine the shareholder’s term strategy here? equity statement 7 This gives information about the cash inflows and outflows from operations, financing, and investing. Examine the cash flow statement 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 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 Calculate financial ratios accounting courses. A summary of some useful ratios appears at the end of this document. THISLiquidity ratios • IS A PARTIAL PREVIEW • Leverage (or debt) ratios You can download• the fullratios Profitability document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. • 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.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 10
  11. 11. Approach (4 of 5) 9 Obtain data for the company’s key competitors, and data about the industry. For competitor companies, you can get the data and calculate the ratios in the same way you Obtain competitive and industry did for the company being studied. You can also get company and industry ratios from the data Quicken.com Evaluator (http://www.quicken.com/) and Schwab Stock Evaluator (http://www.schwab.com/cdso). Compare the ratios for the competitors and the industry to the company being studied. Is the company favorable in comparison? Do you have enough information to determine why or why not? If you don’t, you may need to do further research. 10 Review the market data you have about the company’s stock price, and the price to earnings (P/E) ratio. Try to research and understand the movements in the stock price and Review market data P/E over time. Determine in your own mind whether the stock market is reacting favorably to the company’s results and its strategies for doing business in the future. Review the evaluations of stock market analysts. These may be found at any brokerage site 11 Graph the payout over several years. Determine whether the company’s dividend policies are supporting their strategies. Review the dividend payout THIS IS A PARTIAL PREVIEW E.g. • If the company is attempting to grow, are they retaining and reinvesting their earnings You can download the fulldistributing them to at http://PPTLab.com. rather than document investors through dividends? PPT Lab is a crowdsourced presentation design service. company has • Based on your research into the industry, are you convinced that the sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends? • Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends?PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 11
  12. 12. Approach (5 of 5) 12 Review all of the data that you have generated. You will probably find that there is a mix of positive and negative results. Review all the data Answer the following question: “Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term?” THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 12
  13. 13. Contents  Overview  Approach to Financial Statement Analysis  Financial Ratio Analysis  Accounting Information  Things to KnowPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 13
  14. 14. Financial ratio analysis is a powerful diagnostic tool that helps identifyproblems areas and opportunities within a companyFinancial Ratio Analysis A popular way to analyze the financial statements is by computing ratios, also known as financial comparables. The most frequently used A ratio is a relationship between two numbers, e.g. ratios by Financial Analysts provide ratio of A: B = 1.5:1  A is 1.5 times B. insights into a firm’s… A ratio by itself may have no meaning—therefore, a given ratio is compared to: Liquidity • Ratios from previous years for internal trends • Ratios of other firms in the same industry for Degree of Financial Leverage external trends Ratio analysis is a diagnostic tool that helps to Profitability identify problem areas and opportunities within a company. Efficiency THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. Value PPT Lab is a crowdsourced presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 14
  15. 15. Ratio analysis follows a 5-phase approachRatio Analysis Approach 1 2 3 4 5 Calculate Key Apply Average Identify Comparable Average the Make a Valuation Ratios for Ratio to Obtain Companies Key Ratios Judgment Comparables Indicative Value • Criteria such as • The ratio can be • Discard outliers and • Apply average ratios • Based on the values growth, technology, expressed as V/x, average the ratios of obtained in Step 3 to calculated in Step 4, clientele, size, and where V=value of the other comparables to the absolute data of make a judgment on leverage are used to firm of firm’s equity calculate the average the company being the value of the identify comparables and x is some financial ratio that should be valued, to arrive at the business • Comparables should, variable, such as applied to the indicative value based • The value may be earnings, cash flow, company being valued on each financial calculated as a simple as far as possible, have financial rations book value, sales, or • Such average ratios parameter average of the values similar to each other even a physical should be calculated • Determine the based no the different and to the company characteristic for each financial valuation range based parameters being valued • Calculate V/x across variable that is used on these indicative • Alternatively, THIS IS A PARTIAL PREVIEW the comparables for for valuation values methodologies several choices of x producing outliers may You can download the full document at http://PPTLab.com. be discarded in computing the average PPT Lab is a crowdsourced presentation design service.Source: Financial Modeling GuidePPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 15
  16. 16. Liquidity ratios indicate a company’s ability to pay off Liquidity Degree of Financial Leverageshort-term financial obligations Profitability EfficiencyLiquidity Ratios Value OVERVIEW RATIOS 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 Current (Total Current Assets) / (Total Current higher ratio (#1 and #2) would indicate a greater Ratio Liabilities) liquidity and lower risk for short-term lenders. The Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1). (Total Current Assets – Inventories) / While high liquidity means that the company will not (Total Current Liabilities) default on its short-term obligations, one should keep Quick in mind that by retaining assets as cash, valuable Ratio In the quick ratio, we subtract inventories from total investment opportunities may be lost. Obviously, current assets, since they are the least liquid among the current assets cash by itself does not generate any return. Only if it is invested will we get future return. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 16
  17. 17. Debt ratios show the extent to which a firm is relying on Liquidity Degree of Financial Leveragedebt to finance its operations Profitability EfficiencyFinancial Leverage (or Debt) Ratios Value OVERVIEW RATIOS Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, Debt to and how well it can manage the debt obligation, i.e. Equity (Total Debt) / (Total Equity) repayment of principal and periodic interest. If the Ratio company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and Debt to (Total Debt) / (Total Equity) allows it to exploit business opportunities and grow. Asset Ratio Note that total debt includes short-term debt (bank advances + the current portion of long-term debt) Interest (Earnings before Interest and Taxes) / and long-term debt (bonds, leases, notes payable). Coverage (Annual Interest Expense) (or Times This shows the firm’s ability to cover fixed interest Interest charges (on both short-term and long-term debt) with current earnings. The margin of safety that is Earned) acceptable varies within and across industries, and Ratio also depends on the earnings history of a firm. THIS IS A PARTIAL PREVIEW (Net Cash Flow) / (Annual Interest You can download the full document at http://PPTLab.com. Expense) Cash Flow PPT Lab is a crowdsourced presentation design service. assessing a Cash flow is a “critical variable” in Coverage company. If a company is showing strong profits but has poor cash flow, you should investigate further before passing a favorable opinion on the company.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 17
  18. 18. Profitability ratios provide color around the company’s Liquidity Degree of Financial Leverageprofits and should be compared with other like companies Profitability EfficiencyProfitability Ratios Value OVERVIEW RATIOS Profitability is a relative term. It is hard to say what Net Profit percentage of profits represents a profitable firm, as (Profit after Taxes) / Sales profits depend on such factors as the position of the Margin company and its products on the competitive life cycle (for example profits will be lower in the initial Return on years when investment is high), on competitive Assets (Profit after Taxes) / (Total Assets) conditions in the industry, and on borrowing costs. (ROA) For decision-making, we are concerned only with the present value of expected future profits. Past or Return on (Profit after Taxes) / (Shareholder’s current profits are important only as they help us to Equity Equity) identify likely future profits, by identifying historical and forecasted trends of profits and sales. (ROE) Shareholder’s equity is measured as the book value. We want to know whether profits are generally on the rise; whether sales stable or rising; how the Earnings profits compare to the industry average; whether per (Profits after Taxes – Preferred the market share of the company is rising, stable or Common Dividend) / (# of Common Shares THIS IS A falling; and other things that indicate the likely future PARTIAL PREVIEW Share profitability of the firm. Outstanding) (EPS) You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. Payout (Cash Dividends) / (Net Income) RatioPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 18
  19. 19. Efficiency ratios indicate how well the company’s assets Liquidity Degree of Financial Leverageare being managed Profitability EfficiencyEfficiency Ratios Value OVERVIEW RATIOS These ratios reflect how well the firm’s assets are being managed. (Cost of Goods Sold) / (Average The inventory ratios shows how fast the inventory is Inventory) being produced and sold. Inventory This ratio shows how quickly the inventory is being Turnover 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. Total Sales / (Average Total Assets) Assets This ratio shows how much sales the firm is generating for every dollar of investment in assets. Turnover The higher the ratio, the better the firm is performing. Accounts (Annual Credit Sales) / (Average Receivable Receivables) THIS IS A PARTIAL PREVIEW Turnover Average You can download the full document at http://PPTLab.com.(Total Sales / Collection (Average Receivables) / Days in a Year) PPT Lab is a crowdsourced presentation design service. Period Days in (Days in a Year) / (Inventory Turnover) Inventory Also referred to as “shelf life.”PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 19
  20. 20. Value ratios reflect the “embedded value” in the Liquidity Degree of Financial Leveragecompany’s stocks Profitability EfficiencyValue Ratios Value OVERVIEW RATIOS Value ratios show the “embedded value” in stocks, and are used by investors as a screening device before making investments. Price to (Current Market Price per Share) / For example, a high P/E ratio may be regarded by Earnings (After-tax Earnings per Share) some as being a sign of “over pricing”. When the Ratio (P/E) markets are bullish (optimistic) or if investor sentiment is optimistic about a particular stock, the P/E ratio will tend to be high. For example, in the late 1990s Internet stocks tended to have extremely high P/E ratios, despite their lack of profits, reflecting Dividend (Annual Dividends per Share) / investors optimism about the future prospects of Yield (Current Market Price per Share) these companies. Of course, the burst of the bubble showed that such confidence was misplaced. On the other hand, a low P/E ratio may show that the company has a poor track record. On the other hand, it may simply be priced too low based on its THIS IS A PARTIAL PREVIEW potential earnings. Further investigation is required to determine whether the company would then You can download the full document at http://PPTLab.com. provide a good investment opportunity. PPT Lab is a crowdsourced presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 20
  21. 21. Ratios analysis provides insights into the company’s performance—bothwith respect to itself year or year and against that of competitorsUses of Ratio Analysis  To evaluate performance, compared to previous years and to competitors and the industry  To set benchmarks or standards for performance To highlight areas that need to be improved, or areas that offer the most promising future  potential To enable external parties, such as investors or lenders, to assess the creditworthiness  and profitability of the firm THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 21
  22. 22. However, there are many limitations to ratio analysis—from the subjectivityof the analyst…Limitations of Ratio Analysis (1 of 2) 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. 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. 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. THIS IS A PARTIAL PREVIEW Financial can download the assessment of the costs and not value. For example, You statements provide an full document at http://PPTLab.com. fixed assetsLabusually shown on the balance sheet as thedesignthe assets less their PPT are is a crowdsourced presentation cost of service.  accumulated depreciation, which may not reflect the actual current market value of those assets.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 22
  23. 23. … to the variation of accounting practices among different countriesLimitations of Ratio Analysis (2 of 2) Financial statements do not include all items. For example, it is hard to put a value on  human capital (such as management expertise). And recent accounting scandals have brought light to the extent of financing that may occur off the balance sheet. Accounting standards and practices vary among countries, and thus hamper meaningful  global comparisons. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 23
  24. 24. Contents  Overview  Approach to Financial Statement Analysis  Financial Ratio Analysis  Accounting Information  Things to KnowPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 24
  25. 25. This diagram illustrates the hierarchy of accounting qualitiesHierarchy of Accounting Qualities Users of Accounting Decision Makers and their Characteristics Information Constraints Costs < Benefits Materiality (Pervasive Constraint) (Threshold for Recognition) User-Specific Qualities Understandability Pervasive Criterion Decision Usefulness Primary Qualities Relevance Reliability Ingredients of THIS IS A PARTIAL PREVIEW Representa- Predictive Feedback Primary Qualities Timeliness Verifiability tional Neutrality You can download the full document at http://PPTLab.com. Value Value Faithfulness PPT Lab is a crowdsourced presentation design service. Secondary Qualities Comparability ConsistencySource: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 25
  26. 26. Below we have tabulated key definitions of qualitative characteristics ofaccounting informationQualitative Characteristics of Accounting Information (1 of 2) TERM DEFINITION Bias in measurement is the tendency of a measure to fall more often on one side than the other of what it Bias represents instead of being equally likely to fall on either side. Bias in accounting measures means a tendency to be consistently too high or too low. The quality of information that enables users to identify similarities in and differences between two sets of Comparability economic phenomena The inclusion in reported information of everything material that is necessary for faithful representation of the Completeness relevant phenomena. A prudent reaction to uncertainty to try to insure that uncertainty and risks inherent in business situations are Conservatism adequately considered. Consistency Conformity from period to period with unchanging policies and procedures THIS IS A PARTIAL PREVIEW Feedback Value YouThe quality of information that enables users to confirm or correct prior expectations. can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. The magnitude of an omission or misstatement of accounting information that, in the light of surrounding Materiality circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 26
  27. 27. Qualitative Characteristics of Accounting Information (2 of 2) TERM DEFINITION Absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of Neutrality behavior. The quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or Predictive Value present events. The capacity of information to make a difference in a decision by helping users to form predictions about the Relevance outcomes of past, present, and future events or to confirm or correct prior expectations. The quality of information that assures that information is reasonably free from error and bias and faithfully Reliability represents what it purports to represent. Representational Correspondence or agreement between a measure or description and the phenomenon that it purports to Faithfulness represent (sometimes called validity). Timeliness Having information available to a decision maker before it loses its capacity to influence decisions. THIS IS A PARTIAL PREVIEW Understandability The quality of information that enables users to perceive itsat http://PPTLab.com. You can download the full document significance. PPT Lab is a crowdsourced presentation design service. The ability through consensus among measures to ensure that information represents what it purports to represent Verifiability or that the chosen method of measurement has been used without error or bias.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 27
  28. 28. An understanding of accounting assumptions, principles, procedures, andpolicies is important to financial statement analysisAccounting Understanding 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. Accounting Accounting Assumptions Principles Accounting Accounting Procedures Policies THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 28
  29. 29. Accounting Accounting Assumptions PrinciplesThere are 4 foundational accounting assumptions Accounting Procedures Accounting PoliciesAccounting Assumptions (1 of 2) There are 4 basic assumptions that underlie all companies that provide financial statements—economic entity, going concern, time period, and monetary unit assumptions. ASSUMPTIONS  The most basic accounting assumption is that economic activity can be identified with a particular unit or entity of accountability. The unit or entity to be accounted for can be defined as an area of Economic Entity economic interest to a particular individual or group. Corporations, sole proprietorships, and Assumption partnerships are example of accounting entities.  The Economic Entity Assumption determines the nature and scope of the reporting that is required for the unit or entity. Accounting information pertains to an entity, the boundaries of which are not necessarily those of the legal entity.  Accounting is based on the assumption that the accounting unit or entity is engaged in continuous and ongoing activities. The accounting unit or entity is assumed to remain in operation Going Concern into the foreseeable future to achieve its goals and objectives. Assumption THIS IS A PARTIAL PREVIEW  This assumption is referred to as the Going Concern (or Continuity) Assumption. If evidence indicates that the unit or entity has a limited life, modifications in accounting principles, methods, You can download the full document at http://PPTLab.com. and reporting practices would ordinarily be required; for example, in cases where corporate reorganization or liquidation under bankruptcy is involved. PPT Lab is a crowdsourced presentation design service.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 29
  30. 30. Accounting Accounting Assumptions Principles Accounting Accounting Procedures PoliciesAccounting Assumptions (2 of 2) ASSUMPTIONS  The continuous operations of a business or other economic unit or entity over an extended period of time can be meaningfully segmented into equal time periods, such as a year, quarter, or month. Time Period Assumption  The Time Period Assumption requires that the economic life of a business can be divided into artificial time periods. Accounting time periods are generally a month, a quarter, or a year. A fiscal year is an accounting time period that is one year long.  The Monetary Unit Assumption requires that financial information be measured and accounted for in the basic monetary unit of the country in which the enterprise is located. Monetary Unit Assumption  The monetary value of an economic event or transaction, determined at the time it is recorded, is not adjusted for subsequent changes in the purchasing power of the monetary unit. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 30
  31. 31. Accounting AccountingThere are 7 key accounting principles to know and Assumptions Principlesunderstand Accounting Procedures Accounting PoliciesAccounting Principles (1 of 5) 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. PRINCIPLES  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. Cost Principle 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 requires that information provided in financial statements be sufficiently complete to avoid misleading users of the reports by omitting significant facts of information. Full Disclosure Principle  This principle also refers to revealing information that would be useful in the decision-making THIS IS A PARTIAL PREVIEW 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 You can download the full document at http://PPTLab.com. (footnotes), schedules, and supplementary reports, and in a summary of significant policies PPT Lab is a crowdsourced presentation design service. preceding the first note to financial statements.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 31
  32. 32. Accounting Accounting Assumptions Principles Accounting Accounting Procedures PoliciesAccounting Principles (2 of 5) PRINCIPLES  This principle determines when revenue is to be considered realized—realization refers to the process of converting non-cash resources and rights into money; the term is used in accounting Revenue Realization and financial reporting to refer to sales of assets for cash or claims to cash. Principle  According to the realization principle, revenue is realized when the sale takes place because the earning process is substantially completed and an exchange has taken place. It is also assumed that (1) the amount of revenue is determinable and its collection’s reasonably assured, and (2) reasonable estimates can be made of related future costs.  Revenue from services rendered is recognized when services have been performed and are billable. Revenue from permitting others to use enterprise resources, such as interest, rent and royalties is recognized as time passes or as the resources are used. Recognition dictates that revenue should be recognized in the accounting period in which it is earned.  Exceptions to the basic revenue principle provide for the recognition of revenue under the following conditions:  Recognition when the sale price is collected, i.e., the cash method and the installment method.  Recognition when the production process is completed, but before the sale, i.e., the THIS IS A PARTIAL PREVIEW production method.  Recognition proportionally over the performance of a long-term contract, i.e., the percentage You can download the full document at http://PPTLab.com. of completion method. PPT Lab is a crowdsourced presentation design service.  Recognition at the completion of a long-term contract, i.e., the completed contract method.  Recognition of profit from the sale only after the payments received equal the cost of the item sold, i.e., the cost recovery method.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 32
  33. 33. Accounting Accounting Assumptions Principles Accounting Accounting Procedures PoliciesAccounting Principles (3 of 5) PRINCIPLES  The matching principle requires that revenues generated and expenses incurred in earning those revenues be reported in the same income statement. In this way, sacrifices (expenses) are Matching Principle matched against benefits or accomplishments (revenues).  It is through the matching process hat net income is determined.  General guidelines for applying the matching principle include the following:  Associating cause and effect. Some costs are recognized as expenses on the basis of a presumed direct association with specific revenues. For example, sales commission expense can be associated with eh sales revenue of the period and should be reported on the income statement when the sales revenue is reported.  Systematic and rational allocation. Where there is no cause and effect relationship between revenue and expenses, and attempt is made to associate costs in a systematic and rational manner with the products of the period affected. For example, depreciation expense for office equipment has no cause and effect relationship to revenue of the period; the cost of the equipment should be depreciated in a systematic and rational manner over the life of the asset.  Immediate recognition. Costs that cannot be related to revenues by either of the two THIS IS A PARTIAL PREVIEW preceding processes are recognized as expenses of the current period. For example, the salary of the company’s president should be given immediate recognition as an expense in You can download the full document at http://PPTLab.com. the period it is incurred. PPT Lab is a crowdsourced presentation design service.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 33
  34. 34. Accounting Accounting Assumptions Principles Accounting Accounting Procedures PoliciesAccounting Principles (4 of 5) 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. Materiality Principle  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 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 Conservatism Principle 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 THIS IS A PARTIAL PREVIEW 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). You can download the at the lower of cost or market http://PPTLab.com.  Valuing inventory full document at is an application of this principle. PPT Lab is a crowdsourced presentation design service.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 34
  35. 35. Accounting Accounting Assumptions Principles Accounting Accounting Procedures PoliciesAccounting Principles (5 of 5) PRINCIPLES  This refers to the reporting from year to year within an entity.  It requires that a particular accounting principle, method, or procedure, once adopted, not be Consistency Principle changed from period to period.  Should management determine that a particular accounting treatment is not appropriate and should be changed, generally accepted accounting principles requires that the facts related to the change and its dollars effects be reported. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 35
  36. 36. Accounting AccountingAccounting procedures are those rules that determine Assumptions Principlesthe how financial statements are developed Accounting Procedures Accounting PoliciesAccounting Procedures • Accounting procedures are those rules and practices that are associated with the operations of an accounting system and that lead to the development of financial statements. • Accounting procedures include the methods, practices, and techniques used to carry out accounting objectives and to implement accounting principles. Last-in, first out (LIFO) and straight-line depreciation are examples of accounting for inventory and buildings. • Accounting procedures can vary from company to company and from industry to industry. • An accounting procedure should be selected in a given circumstance if its use reflects generally accepted accounting principles and if it is appropriate to record, process, and report the event o transaction. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. Accounting procedures can vary across industries—and among organizations in any given industry.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 36
  37. 37. Accounting AccountingIt its critical to collect and understand all accounting Assumptions Principlespolicies Accounting Procedures Accounting PoliciesAccounting Policies • 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: 1• A selection from existing alternatives (for example, inventory methods such as LIFO, FIFO, and average methods) 2• Areas those are peculiar to a particular industry in which the company operates 3• Unusual and innovative applications of generally accepted accounting principles 4• 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. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. Different organizations may apply the same accounting principles differently—as reflected by their policies.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 37
  38. 38. Contents  Overview  Approach to Financial Statement Analysis  Financial Ratio Analysis  Accounting Information  Things to KnowPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 38
  39. 39. Here are some more accounting considerations—understanding accrualbasis and cash basis accountingOther Accounting Considerations Major bases of accounting include the accrual basis and cash basis:  In accrual accounting, revenue and gains are recognized in the period when they are earned. Expenses and losses are recognized in the period they are incurred. Accrual Basis  Accrual accounting is concerned with the economic consequences of events and transactions Accounting instead of merely with cash receipts and cash payments. Under accrual accounting, net income does not necessarily reflect cash receipts and cash payments for a time period.  Accrual accounting generally provides the best measure of earnings, earning power, managerial performance, and stewardship.  Cash-basis accounting recognizes only transactions involving actual cash receipts and disbursements occurring I a given period. Cash Basis  Cash-basis accounting recognizes revenues and gains when cash is received and expenses and Accounting losses when cash is paid. No attempt is made to record unpaid bills or amounts owed to or by the THIS IS A PARTIAL PREVIEW entity. No attempt is made to match revenues and expenses to determine income.  Cash-basis accounting is widely used by small businesses and for income tax purposes You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service. The economic substance of a transaction is sometimes considered more significant then the legal form of the transaction for reporting purposes.Source: Analysis and Uses of Financial Statements, Delta PublishingPPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 39
  40. 40. Here are some things you need to know about financial statementsThings to Know (1 of 3) 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 Wall Street Is Not your motives of so-called experts. As of yet, there are no rules ensuring that they disclose their conflicts of Friend interest. 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 Proforma Earnings trouble is that there are no standards for reporting Proforma Statements, leaving the door open to Announcements 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. 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 Frequent Restructuring large company, they will be routine. If charges and write downs for restructurings occur regularly, the Charges and Write-Downs company may be classifying normal business expenses as extraordinary to create the illusion that the THIS IS A PARTIAL PREVIEW core business is more profitable than it really is. You can downloadgenerally establish reserves to cover the costs of restructuring. Reserves allow Companies the full document at http://PPTLab.com. management to "store profits" for later use if the reserves are unusually large. At a later time, they PPT Lab is areverse the reserve for the amount that was not spent and it flows directly to the bottom line. Reserve Reversals can crowdsourced presentation design service.Source: Prentice Hall Publishers, 2003PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 40
  41. 41. Things to Know (2 of 3) Pension Funds are great sources of earnings manipulation. Boost earnings by under funding them or by overestimating the investment return of the fund so that current payments will be lower and profits Pension Funds higher. If the fund does particularly well, pull the excess back into the income statement to boost profits. Statements can mislead and evade but they must come clean in the footnotes or face criminal charges. That’s why the pros look here first. You will learn about risk exposure, debt that changes Footnotes to Financial character under certain conditions, the use of aggressive accounting practices and all sorts of other Statements details that management would like to avoid telling you. Look at the revenue and receivable numbers over several years. Is the ratio of receivables to sales increasing? If yes, then the company is shipping goods faster than customers are paying for them. Sales/Non-Sales Are deferred revenues dropping? If so, the company is living off last year’s sales. In the current slowdown, customers look to change sales terms to use the supplier’s money as much as possible by acknowledging the sale as late as possible. THIS IS A PARTIAL PREVIEW The pros know that it is too easy to manipulate earnings numbers. So they focus on cash flow as being a more reliable indicator of performance because the cash is either there or it isn’t. One expert, Cash Flow Is King can You download the full document at http://PPTLab.com. thinks a comparison of cash flow vs. non-cash revenue could have been an early tip of to Enron investors. PPT Lab is a crowdsourced presentation design service.Source: Prentice Hall Publishers, 2003PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 41
  42. 42. Things to Know (3 of 3) Companies account for the premium over book value that they pay for an acquired company as goodwill. Under the older accounting rules, companies could write down the payment for goodwill with Goodwill a charge against earnings spread out over decades. First Call estimates that, because of the goodwill accounting change, analyst forecasts for 2002 are about three percentage points too high. As companies restate prior year earnings to account for the change, earnings will shrink. 78% of companies with sales over $10 billion compensate management with stock options. Yet accounting rules do not require the issuing of the option to be accounted for with an expense. In the Employee Stock Options wake of Enron, this controversial and questionable rule may be changed. If so, one expert estimates that many large tech companies may see an annual reduction in earnings of 1/3. THIS IS A PARTIAL PREVIEW You can download the full document at http://PPTLab.com. PPT Lab is a crowdsourced presentation design service.Source: Prentice Hall Publishers, 2003PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 42
  43. 43. PPT Lab (www.pptlab.com) is the only crowdsourced presentation design service. Get consulting-quality presentations at a fraction of the cost!www.PPTLab.comsupport@pptlab.com 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.PPT Lab (www.PPTLab.com) – Crowdsourced Business Presentation Design Service 43

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