ANALYSIS OF FINANCIAL STATEMENTS

ANALYSIS OF FINANCIAL STATEMENTSOSMAN BIN SAIFWEEK: ONESESSION: 1Self IntroductionFinance Graduate;MSC. Accounting and Finance (University of Exeter, UK)MBA- Finance (SZABIST, Islamabad)Certified Financial Consultant (IFC , Canada)Certifications in Project Management, Monitoring and Evaluation and Research Policy Development.Consultant with SDPIPreviously , Senior Researcher with TP WING, MOCVisiting Faculty various universities and institutes.Permanent Faculty member at Bahria University.

IntroductionWhat is Financial Analysis?Defining Financial AnalysisFinancial analysis is the process of evaluating financial and other information for decision-making.A six-step approach is suggested for systematic financial analysis.Six-step ProcessIdentify purpose of financial analysisCorporate overviewFinancial analysis techniquesDetailed accounting analysisComprehensive analysisDecision or recommendationCorporate OverviewIndustry analysis--key economic characteristics, historical context, profit drivers, business risksFirms business strategy--competitive strategy given the industry characteristics

Industry AnalysisCompetition--growth rates, concentration ratios, degree of product differentiation, economies of scale (& relative fixed & variable costs), substitute productsLegal barriers--patent & copyrights, licensing, regulationBargaining power of buyers (& suppliers) & price sensitivityIndustry Analysis CriteriaWhat is the industry?Relative size & significanceLargest companiesGeographic presenceBusiness cycle effects, current situationFuture potentialBusiness StrategyCost leadership: low cost producer, economies of scale, efficient production, low input pricesProduct differentiation: specific attributes that customers value (e.g., quality, variety, service, delivery time), brand nameImportance of core competencies Business Strategy CriteriaHistorical perspectivePrimary focus of operationsMost important strategyMajor operating segmentsCorporate outlook/ forecastQualitative Analysis--Dell ComputerIndustryprimarily PCs: high tech, competitive (e.g., Gateway, IBM, Apple, others), changing products, high growth rates, low barriers of entryBusiness strategy--(1) cost leadership strategy: direct selling, made-to-order manufacturing, early on the internet, low receivables; (2) product differentiation?? [IBM clones, Intel & Microsoft components]Current situationmarket share; what is the impact of the business cycle (e.g., PCs are durable goods)?Quantitative Financial AnalysisSystematic analysis of key elements based on analysis contextRatios, cash flows, common-size, time series, comparative (e.g., specific firms, industry, all firms), models (e.g., DuPont, Altmans)In-depth analysis for red flag itemsQuantitative Financial AnalysisFinancial StatementsCommon-Size AnalysisFinancial RatiosGrowth/Trend AnalysisQuarterly AnalysisDuPont ModelMarket Analysis

Detailed Accounting AnalysisDoes accounting information capture the underlying business reality?Identify areas of accounting flexibility & evaluate accounting policies (choices) & disclosures; especially notes & MD&AEvaluate earnings management potentialRecast accounting numbers when necessary

Comprehensive AnalysisSummarize key points: what is particularly important for decision making?Red flags are particularly importantConsider a written executive summaryConsider a rating scale, such as 1-10 DecisionWhat is the recommendation or decision?What is the key rationale for this decision? [This is based on the specific decision: for a credit decision the key factors relate to credit risk, with particular focus on leverage and liquidity.]Be prepared to defend this decision.Examples of External Uses of Statement AnalysisTrade Creditors -- Focus on the liquidity of the firm.Bondholders -- Focus on the long-term cash flow of the firm.Shareholders -- Focus on the profitability and long-term health of the firm.Examples of Internal Uses of Statement AnalysisPlan -- Focus on assessing the current financial position and evaluating potential firm opportunities.Control -- Focus on return on investment for various assets and asset efficiency.Understand -- Focus on understanding how suppliers of funds analyze the firm.Primary Types of Financial StatementsIncome StatementA summary of a firms revenues and expenses over a specified period, ending with net income or loss for the period.Balance SheetA summary of a firms financial position on a given date that shows total assets = total liabilities + owners equity.Basket Wonders Balance Sheet (Asset Side)a. How the firm stands on a specific date.b. What BW owned.c. Amounts owed by customers.d. Future expense items already paid.e. Cash/likely convertible to cash within 1 year.f. Original amount paid.g. Acc. deductions for wear and tear. Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assetsb $2,169Basket Wonders Balance Sheet (thousands) Dec. 31, 2007aBasket Wonders Balance Sheet (Liability Side)a. Note, Assets = Liabilities + Equity.b. What BW owed and ownership position.c. Owed to suppliers for goods and services.d. Unpaid wages, salaries, etc.e. Debts payable < 1 year.f. Debts payable > 1 year.g. Original investment. h. Earnings reinvested.Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f530 Shareholders Equity Com. Stock ($1 par) g200 Add Paid in Capital g729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equitya,b $2,169Basket Wonders Balance Sheet (thousands) Dec. 31, 2007Basket Wonders Income Statementa. Measures profitability over a time period.b. Received, or receivable, from customers.c. Sales comm., adv., officers salaries, etc.d. Operating income.e. Cost of borrowed funds.f. Taxable income.g. Amount earned for shareholders. Net Sales $ 2,211 Cost of Goods Sold b 1,599Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expensee 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007aFramework for Financial AnalysisAnalytical Tools UsedSources and Uses StatementStatement of Cash FlowsCash Budgets1. Analysis of the fund needs of the firm.Trend / Seasonal ComponentHow much funding will be required in the future?Is there a seasonal component?Framework for Financial AnalysisHealth of a Firm

Financial Ratios

1. Individually2. Over time3. In combination4. In comparison1. Analysis of the funds needs of the firm.2. Analysis of the financial condition and profitability of the firm.Framework for Financial AnalysisExamples:Volatility in salesVolatility in costsProximity to break-even point1. Analysis of the funds needs of the firm.2. Analysis of the financial condition and profitability of the firm.3. Analysis of the business risk of the firm.Business risk relates to the risk inherent in the operations of the firm.

Framework for Financial AnalysisA Financial Manager must consider all three jointly when determining the financing needs of the firm.Determiningthe financingneeds of the firm.1. Analysis of the funds needs of the firm.2. Analysis of the financial condition and profitability of the firm.3. Analysis of the business risk of the firm.Framework for Financial AnalysisNegotiationswithsuppliers ofcapital.Determiningthe financingneeds of the firm.1. Analysis of the funds needs of the firm.2. Analysis of the financial condition and profitability of the firm.3. Analysis of the business risk of the firm.Use of Financial RatiosTypes of ComparisonsInternal ComparisonsExternal ComparisonsA Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.External Comparisons and Sources of Industry RatiosExamples:Risk Management AssociationDun & BradstreetAlmanac of Business and Industrial Financial RatiosThis involves comparing the ratios of one firm with those of similar firms or with industry averages.Similarity is important as one should compare apples to apples.Questions?

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