Overview of Financial Statement Analysis

Chapter 1

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Learning Objectives

• Nature and purpose of Financial Analysis

• Accounting standards and processes underlying financial reports

• Role of professional financial analysts

• No need to read appendix 1A, 1B, and p12-17.

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Goal

Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, its basic goal is to value a firm by estimating its future cash flows and determining its financial health.

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Estimating cash flows requires

• Current and relevant information

• An evaluation of the firm’s profit and growth potential

• An assessment of the firm’s survival likelihood

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Analysis Techniques

• Starting point is to use publicly available data from financial statements including– Income Statement– Statement of Owners’ Equity– Balance Sheet– Statement of Cash Flows– Notes to Financial Statements

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Analysis Techniques Time series analysis

• Compare a firm to itself over time

• Firms provide at least two periods of comparable data in each set of financial statements

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Analysis Techniques Cross-sectional Analysis

• Compare several firms over the same time period

• Designed to hold economic effects constant

• Enables analyst to determine how a firm is doing given the prevailing macroeconomic conditions

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Financial Statements and Performance

• Financial statements are prepared in a consistent manner (enabling cross-sectional and time series comparisons)

• Accounting rules are designed to reflect firm performance

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Development of US Accounting Standards

• 1900– No mandated reporting requirements even though the

professions of accounting and auditing existed.

• 1933/34– Securities Acts give the SEC authority to regulate

financial reporting.

• 1970s– Financial Accounting Standards Board is created as the

authority on financial reporting for publicly traded US firms.

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Environmental Factors

Financial Accounting Standards Board

Generally Accepted Accounting Principles

Provide input to

Help set

Securities and

Exchange Commission

Unions

Investors

Accountants

Politicians

Lenders

Others

AICPA

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Regulatory Requirements

• SEC filing requirements– Form 10-K audited annual report– Form 10-Q quarterly report– Form 8-K special informational reports

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Financial Reporting Environment

Regulators   

 

FASB

AICPA

Industry Practices

GAAP

Enforcement and Monitoring Mechanisms

SECCorporate

Governance

Managers

Auditors

Statutory Financial Reports(Financial Statements)

Alternative Information Sources

Economy and Industry Information

Voluntary Disclosure

Users

Analysts

Investors and

CreditorsOther Users

Litigation

                        

    

           

 

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Form 10-K (Annual Report)

10-Q(Quarterly Report)

OtherSEC Filings

14-A(Proxy Statement/

Prospectus)

Statutory Financial Reports

8-K(Current Report)

20-F (Registration Statement/Annual Report [Foreign])

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Development of International Accounting Standards

• International Accounting Standards Board(IASB)– 14 member committee of auditors, accountants,

academics and financial statement users– Developed International Accounting Standards

(IAS) to help investors cope with financial analysis in global capital markets

– Rules are not used worldwide, but a number of countries do use the framework

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Basic Financial Statements

• Income Statement– provides results of business activities

• Balance Sheet– states assets and claims against them (liabilities and

owner’s equity)

• Statement of Cash Flows– provides prior cash flow information

– helps analyst assess the firm’s ability to pay interested parties

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Transactions and the Accounting Process

• Remember, Assets = Claims

• Original owners put $1,000 in corporate checking account

Assets = ClaimsCash Common Stock

$1,000 = $1,000

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Transactions and the Accounting Process

• Change the previous transaction:• Corporation purchases $50 of inventory on credit

=Cash Inventory Accts. Payable Common Stock

$1,000 = $1,000 $50 $50

$1,000 $50 = $50 $1,000

ClaimsAssets

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Transactions and the Accounting ProcessExpanded Transaction Model

• Purchase a $5,000 building for $500 cash and $4,500 mortgage

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Expanded Transaction Model

Assets = Claims

Cash Inventory Building Accounts Payable

Mortgage

Payable

Common Stock

$1,000 $1,000

$50 $50

($500) $5,000 $4,500

$500 $50 $5,000 = $50 $4,500 $1,000

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Transactions and the Accounting ProcessExpanded Transaction Model

• The company pays rent of $2,000 for the current month

• The company sells inventory to a customer on account (receivable) at a retail price of $30,000

• The portion of the inventory which was sold cost $15,000 to purchase

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Expanded Transaction Model

Assets = Claims

Cash A/R Inventory Accounts Payable

Common

Stock

Retained

Earnings

($2,000) ($2,000)

$30,000 $30,000

($15,000) ($15,000)

($2,000) $30,000 ($15,000) = $13,000

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Using recorded information the…

• Balance Sheet– Reports totals of assets and claims on the date ending

the reporting period

• Statement of Cash Flows– Reports all cash inflows and outflows (more in chapter

4)– The cash column of the transaction model

• Statement of Shareholders’ Equity– Reports changes in the owners’ claim accounts during

the period

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The Professional AnalystBuy-Side and Sell-Side Analysts

• Buy-side– Provide information within the investment firm– Information is rarely available to outsiders

• Sell-side– Provide information to brokers who work with

external clients– Reports are created with external clients in

mind

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Role of the Analysts• Financial analysts do not believe in semi-

strong form of market efficiency.

• However, their job makes the market price more efficient.

• If interested in becoming a CFA, visit http://cfainstitute.org/cfaprogram/