This document provides an overview of financial statement analysis. It discusses evaluating business prospects and risks through credit analysis, equity analysis, accounting analysis and financial analysis. These analyses focus on liquidity, solvency, profitability, risk and intrinsic value. Various tools for analysis are discussed like ratio analysis, cash flow analysis and valuation. The purpose, outputs and cautions of different analysis techniques are outlined. Finally, the efficient market hypothesis and book organization are briefly covered.

1. McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial
Statement
Analysis
K R Subramanyam
John J Wild

2. 1-2
1CHAPTER
Overview of Financial
Statement Analysis

3. 1-3
Business Analysis
Evaluate ProspectsEvaluate Prospects Evaluate RisksEvaluate Risks

4. 1-4
Information Sources for Business
Analysis

5. 1-5

6. 1-6
Credit Analysis

7. 1-7
Credit Analysis
Liquidity
Ability to meet short-
term obligations
Focus:
• Current cash flows
• Make up of current
assets and liabilities
• Liquidity of assets
Liquidity
Ability to meet short-
term obligations
Focus:
• Current cash flows
• Make up of current
assets and liabilities
• Liquidity of assets
Solvency
Ability to meet long-
term obligations
Focus:
• Long-term profitability
• Capital structure
Solvency
Ability to meet long-
term obligations
Focus:
• Long-term profitability
• Capital structure
Credit worthiness: Ability to honor credit obligations
(downside risk)
Credit worthiness: Ability to honor credit obligations
(downside risk)

8. 1-8
Equity Analysis
Technical analysis /
Charting
• Patterns in price or
volume history of a
stock
• Predict future price
movements
Technical analysis /
Charting
• Patterns in price or
volume history of a
stock
• Predict future price
movements
Fundamental Analysis
Determine Intrinsic value
without reference to
price
• Analyze and interpret
key factors
– Economy
– Industry
– Company
Fundamental Analysis
Determine Intrinsic value
without reference to
price
• Analyze and interpret
key factors
– Economy
– Industry
– Company
Assessment of downside risk and upside potentialAssessment of downside risk and upside potential

9. 1-9

10. 1-10
Accounting Analysis
Accounting
Risk
Process to evaluate and adjust financial
statements to better reflect economic reality
Process to evaluate and adjust financial
statements to better reflect economic reality

11. 1-11
Financial Analysis
Profitability analysis — Evaluate return
on investments
Risk analysis ——— Evaluate riskiness
& creditworthiness
Analysis of — Evaluate source &
cash flows deployment of funds
Common toolsCommon tools
Ratio
analysis
Cash
flow
analysis
Process to evaluate financial position and
performance using financial statements
Process to evaluate financial position and
performance using financial statements

12. 1-12
Prospective Analysis
Intrinsic ValueIntrinsic Value
Business Environment
& Strategy Analysis
Business Environment
& Strategy Analysis
Accounting AnalysisAccounting Analysis
Financial AnalysisFinancial Analysis
Process to forecast future payoffsProcess to forecast future payoffs

13. 1-13
Dynamics of Business Activities
Business ActivitiesBusiness Activities TimeTime

14. 1-14
Business Activities

15. 1-15
Business Activities
Financing
Financing activities
• Owner (equity)
• Nonowner (liabilities)
Financing activities
• Owner (equity)
• Nonowner (liabilities)

16. 1-16
Investing activities
• Buying resources
• Selling resources
Investing activities
• Buying resources
• Selling resources
Investing = FinancingInvesting = Financing
Business Activities
FinancingInvesting

17. 1-17
Operating Activities
Revenues and expenses from providing
goods and services
Operating Activities
Revenues and expenses from providing
goods and services
Business Activities

18. 1-18
Financial Statements Reflect Business Activities

19. 1-19
Financial Statements

20. 1-20

21. 1-21
Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner Financing

22. 1-22

23. 1-23
Income Statement
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit
Colgate’s Profitability
(in $billions)
$12.238 - $5.536 = $6.701 Gross Profit
$6.701 - $4.5411 = $2.160 Operating profit

24. 1-24

25. 1-25
Statement of Cash Flows

26. 1-26

27. 1-27
Additional Information
(Beyond Financial Statements)

28. 1-28
Analysis Preview
Purpose: Evaluation of consecutive
financial statements
Output: Direction, speed, & extent of any
trend(s)
Types: • Year-to-year Change
Analysis
• Index-Number Trend
Purpose: Evaluation of consecutive
financial statements
Output: Direction, speed, & extent of any
trend(s)
Types: • Year-to-year Change
Analysis
• Index-Number Trend
Comparative Analysis
Yr2Yr1 Yr3

29. Analysis Preview
1-29

30. 1-30
Analysis Preview
Purpose : • Evaluation of internal makeup
of financial statements
• Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses
Purpose : • Evaluation of internal makeup
of financial statements
• Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses
Common-Size Analysis

31. 1-31
Analysis Preview

32. 1-32
Analysis Preview

33. 1-33
Analysis Preview
Purpose : Evaluate relation between two or more
economically important items (one
starting point for further analysis)
Output: Mathematical expression of relation
between two or more items
Cautions: • Prior Accounting analysis is important
• Interpretation is key - long vs short
term & benchmarking
Purpose : Evaluate relation between two or more
economically important items (one
starting point for further analysis)
Output: Mathematical expression of relation
between two or more items
Cautions: • Prior Accounting analysis is important
• Interpretation is key - long vs short
term & benchmarking
Ratio Analysis

34. 1-34
Analysis Preview
Purpose: Estimate intrinsic value of a
company (or stock)
Basis: Present value theory (time value of
money)
Purpose: Estimate intrinsic value of a
company (or stock)
Basis: Present value theory (time value of
money)
Valuation
Valuation - an important goal of many types
of business analysis

35. 1-35
Analysis Preview
Debt (Bond) Valuation
Bt is the value of the bond at time t
It +n is the interest payment in period t+n
F is the principal payment (usually the debt’s face value)
r is the investor’s required interest rate (yield to maturity)

36. 1-36
Analysis Preview
Equity Valuation
Vt is the value of an equity security at time t
Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends

37. 1-37
Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model
FCFt+n is the free cash flow in the period t + n [often
defined as cash flow from operations less capital
expenditures]
k is the cost of capital
E refers to an expectation

38. 1-38
Analysis Preview
Equity Valuation - Residual Income Model
BVt is the book value at the end of period t
Rit+n is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning
book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital
E refers to an expectation

39. 1-39
Analysis in an Efficient Market
Three assumed forms of market efficiency
Weak Form - prices reflect information in
past prices
Semi-strong - prices reflect all public
Form information
Strong Form - prices reflect all public and
private information
Weak Form - prices reflect information in
past prices
Semi-strong - prices reflect all public
Form information
Strong Form - prices reflect all public and
private information

40. 1-40
Book Organization