Financial Statement Analysis Second Lecture

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FINANCIAL STATEMENT ANALYSIS

INTRODUCTION

Analysts are employed in a number of functional areas.

Generally, analysts evaluate investment in security. The

investment is either equity (representing an ownership

position) or debt (representing a lending position).Investment decisions are arrived at based on the

evaluation of:

1. Performance;

2. Financial position;

3. Value of the company issuing the securities.

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SCOPE OF FINANCIAL STATEMENT ANALYSIS

The role of financial reporting by companies is to provide:

1. Information about their performance;2. Financial position; and

3. Changes in financial position that is useful to a widerange of users in making economic decisions.

The role of financial statement analysis is to take financial

reports prepared by companies, combined with otherinformation:

1. To evaluate the past, current, and prospectiveperformance and financial position of a company forthe purpose of making investment, credit, and othereconomic decisions.

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REASONS FOR ECONOMIC DECISIONS BY

ANALYST

1. Evaluating an equity investment for inclusion in a portfolio.

2. Evaluating a merger or acquisition candidate.3. Evaluating a subsidiary or operating division of a parent

company.

4. Deciding whether to make a venture capital or other privateequity investment.

5. Determining the creditworthiness of a company that hasmade a loan request.

6. Extending credit to a customer.

7. Examining compliance with debt covenants or othercontractual arrangements.

8. Assigning a debt rating to a company or bond issue.

9. Valuing a security for making an investmentrecommendation to others.

10. Forecasting future net income and cash flow.

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An examination of performance can include:

An assessment of a company s profitability(the ability to earn a profit from delivering

goods and services),

Its cash flow generating ability (the ability to

produce cash receipts in excess of cash

disbursements).

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Distinction Between Profit and Cash Flow

Profit and cash flow are not equivalent.

Profit represents the excess of the prices at which

goods or services are sold over all the costs of

providing those goods and services (regardless ofwhen cash is received or paid).

Cash flow refers to receipts and payments. The

ability to generate positive cash flow is important

because, ultimately, cash is needed to payemployees, suppliers, and others to continue as a

going concern. Additionally, cash flow is the source

of returns to providers of capital.5


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Liquidity and Solvency

The expected magnitude of future cash flows is

important in valuing corporate securities and indetermining the companys ability to meet its

obligations.

The ability to meet short - term obligations is generally

referred to as liquidity, and the ability to meet long-

term obligations is generally referred to as solvency .

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EXAMPLE 1 Profit versus Cash FlowBed Mate (BM) sells imported furniture on a retail basis. BMbegan operations during December 2006 and sold furniture

for cash ofGH250,000. The furniture that was sold by BMwas delivered by the supplier during December, but thesupplier has

granted BM credit terms, according to which payment is notdue until January 2007. BM is obligated to pay GH 220,000in January for the furniture it sold during December.1. How much is BMs profit for December 2006 if no othertransactions occurred?

2. How much is BMs cash flow for December 2006?

Solution to 1. BMs profit for December 2006 is the excess ofthe sales price (GH250,000) over the cost of the goods thatwere sold (GH220,000), or GH30,000.

Solution to 2. The December 2006 cash flow is GH 250,000.

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Profit versus Cash Flow continuedProfits reflect the ability of a company to deliver goods

and services at prices in excess of the costs of deliveringthe goods and services. Profits also provide usefulinformation about future (and past) cash flows.

Corporate earnings announcements places corporateresults in the context of analysts expectations.Furthermore, analysts frequently use earnings invaluation, for example, when they value shares of a

company on the basis of the price - to - earnings ratio(P/E) in relation to peer companies P/Es or when theyuse a present value model of valuation that is based onforecasted future earnings.

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MAJOR FINANCIAL STATEMENTS AND OTHER

INFORMATION SOURCES

A great deal of information is collected to enableanalyst perform equity or credit analysis of a company.

The nature of the information will vary based on theindividual task but will typically include informationabout the economy, industry, and company as well asinformation about comparable peer companies. Muchof this information will come from outside thecompany, such as economic statistics, industry reports,trade publications, and databases containinginformation on competitors. The company itselfprovides some of the core information for analysis in itsfinancial reports, press releases, and conference callsand webcasts.

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INFORMATION SOURCES continued

Financial reports are prepared to report to investorsand creditors about the financial performance andthe financial strength at regular intervals (annually,semi-annually and quarterly).

The reports include:1. Financial statements and supplementary

information; i.e., income statement, balance

sheet, statement of cash flows, and statement of

changes in owners equity (provides additional

information regarding the changes in a

companys financial position).10


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INFORMATION SOURCES continued

Additional information that must be read by

analyst for assessment of financial reports

includes:

Notes to the financial statements (also known as

footnotes) and supplementary schedules.

Managements discussion and analysis (MD& A).

The external auditors report(s).

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THE MAJOR FINANCIAL STATEMENTS

1. Income Statement

The income statement presents information on the financialresults of a companys business activities over a period oftime. The income statement communicates how muchrevenue the company generated during a period and whatcosts it incurred in connection with generating that revenue.

Net income (revenue minus all costs) on the incomestatement is often referred to as the bottomline because ofits proximity to the bottom of the income statement. 2Income statements are reported on a consolidated basis,meaning that they include the revenues and expenses of

affiliated companies under the control of the parent(reporting) company. The income statement is sometimesreferred to as a statement of operations or profit and loss (P& L) statement. The basic equation underlying the incomestatement is Revenue - Expenses = Net income.

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Balance SheetThe balance sheet (also known as the statement offinancial position or statement of financial condition)presents a companys current financial position bydisclosing resources the company controls (assets) andwhat it owes (liabilities) at a specific point in time.Owners equity represents the excess of assets overliabilities. This amount is attributable to the owners orshareholders of the business; it is the residual interestin the assets of an entity after deducting its liabilities.The three parts of the balance sheet are formulated in

an accounting relationship known as the accountingequation: Assets Liabilities Owners equity (that is, thetotal amount for assets must balance to the combinedtotal amounts for liabilities and owners equity).

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Cash Flow Statement

The income statement and balance sheet provide a measure of a

companys success in terms of performance and financialposition, cash flow is also vital to a companys long-term success.Disclosing the sources and uses of cash helps creditors, investors,and other statement users evaluate the companys liquidity,solvency, and financial flexibility. Financial flexibility is the ability

to react and adapt to financial adversities and opportunities. Thecash flow statement classifies all company cash flows intooperating, investing, and financing activity cash flows. Operatingactivities involve transactions that enter into the determinationof net income and are primarily activities that comprise the day -

to day business functions of a company. Investing activities arethose activities associated with the acquisition and disposal oflong-term assets, such as equipment. Financing activities arethose activities related to obtaining or repaying capital to beused in the business.

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Statement of Changes in Owners Equity

Statement of changes in owners equity,statement

of shareholders equity, or statement of retained

earnings. This statement primarily serves to report

changes in the owners investment in the business over

time and assists the analyst in understanding thechanges in financial position reflected on the balance

sheet.

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Financial Notes and Supplementary Schedules

Financial notes and supplementary schedules are an

integral part of the financial statements. By way of example,the financial notes and supplemental schedules provideexplanatory information about the following:

Business acquisitions and disposals

Commitments and contingencies

Legal proceedings

Stock option and other employee benefit plans

Related - party transactions, i.e., associates

Significant customers

Subsequent events

Business and geographic segments

Quarterly financial data

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Managements Discussion and Analysis

Companies floated on a stock exchange are often

required to include in their financial reports a sectioncalled Managements Discussion and Analysis (MD &A).

In it, management must highlight any favorable or

unfavorable trends and identify significant events and

uncertainties that affect the companys liquidity, capitalresources, and results of operations. The MD &A must

also provide information about the effects of inflation,

changing prices, or other material events and

uncertainties that may cause the future operating

results and financial condition to materially depart

from the current reported financial information.

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Auditors Reports

Financial statements presented in company

annual financial reports are often required to beaudited (examined) by an independent

accounting firm that then expresses an opinion

on the financial statements. There are standardsfor auditing and for expressing the resulting

auditors opinion. International standards for

auditing have been developed by the

International Auditing and Assurance Standards

Board of the International Federation of

Accountants.18


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Sarbanes - Oxley Act 2002In response to the collapse of Enron, Worldcom, and othercorporations, the U.S. Congress passed the Sarbanes-OxleyActof 2002.The Sarbanes - Oxley Act specifically requires managementsreport on internal control to:

State that it is managements responsibility to establish andmaintain adequate internal control.

Identify managements framework for evaluating internalcontrol.

Include managements assessment of the effectiveness of thecompanys internal control over financial reporting as of theend of the most recent year, including a statement as towhether internal control over financial reporting is effective.

Include a statement that the companys auditors have issuedan attestation report on managements assessment.

Certify that the companys financial statements are fairlypresented.

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Other Sources of Information

Interim reports are also provided by the company

either semiannually or quarterly. Interim reports

generally present the four key financial statements and

footnotes but are not audited. These interim reportsprovide updated information on a companys

performance and financial position since the last

annual period.

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Financial Statement Analysis Second Lecture

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