Financial Statement Analysis
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1 Financial Statement Analysis K R Subramanyam John J Wild McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
2 Overview of Financial 1-2 Statement Analysis 1 CHAPTER
3 1-3 Business Analysis Evaluate Prospects Evaluate Risks Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers
4 Information Sources for Business Analysis 1-4 Quantitative Qualitative Financial Statements Industry Statistics Economic Indicators Regulatory filings Trade reports Management discussion & Analysis Chairperson s Letter Press Releases Financial press Vision/Mission Statement Web sites
5 1-5 Credit Analysis Equity Analysis Management & Control Regulation Types of Business Analysis Labor Negotiations Director Oversight Financial Management External Auditing Mergers, Acquisitions & Divestitures
6 1-6 Credit Analysis Trade Creditors Non-trade Creditors Provide goods or services Bear risk of default Provide major financing Bear risk of default Most shortterm Usually implicit interest Most longterm Usually explicit interest
7 1-7 Credit Analysis Credit worthiness: Ability to honor credit obligations (downside risk) Liquidity Ability to meet shortterm obligations Focus: Current cash flows Make up of current assets and liabilities Liquidity of assets Solvency Ability to meet longterm obligations Focus: Long-term profitability Capital structure
8 1-8 Equity Analysis Assessment of downside risk and upside potential 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
9 1-9 Component Processes of Business Analysis Business Environment & Strategy Analysis Industry Analysis Strategy Analysis Financial Analysis Accounting Analysis Analysis of cash flows Profitability Analysis Risk Analysis Prospective Analysis Cost of Capital Estimate Intrinsic Value
10 1-10 Accounting Analysis Process to evaluate and adjust financial statements to better reflect economic reality Comparability problems across firms and across time Manager estimation error Distortion problems Earnings management Accounting Standards Accounting Risk
11 1-11 Financial Analysis Process to evaluate financial position and performance using financial statements Profitability analysis Evaluate return on investments Common tools Risk analysis Evaluate riskiness & creditworthiness Analysis of cash flows Evaluate source & deployment of funds Ratio analysis Cash flow analysis
12 1-12 Prospective Analysis Process to forecast future payoffs Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Intrinsic Value
13 1-13 Dynamics of Business Activities Business Activities Time Investing Planning Financing Beginning of period Operating Investing Planning Financing End of period
14 1-14 Business Activities Competition Market demands Distribution Managerial performance Planning Activities: Goals & Objectives Pricing Tactics Promotion Projections Opportunities Obstacles
15 1-15 Business Activities Financing activities Owner (equity) Nonowner (liabilities) Financing
16 1-16 Business Activities Investing activities Buying resources Selling resources Investing Financing Investing = Financing
17 1-17 Business Activities Investing Activities Planning Activities Financial Activities Operating Activities Revenues and expenses from providing goods and services
18 1-18 Financial Statements Reflect Business Activities Investing Current: Cash Accounts Receivable Inventories Marketable Securities Noncurrent: Land, Buildings, & Equipment Patents Investments Assets Balance Sheet Sales Planning Operating Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax Expense Net Income Income statement Cash Flow Statement of Cash Flows Financing Current: Notes Payable Accounts Payable Salaries Payable Income Tax Payable Noncurrent: Bonds Payable Common Stock Retained Earnings Liabilities & Equity Balance Sheet Statement of Shareholders Equity
19 1-19 Financial Statements Balance Sheet Income Statement Statement of Shareholders Equity Statement of Cash Flows
20 1-20
21 1-21 Balance Sheet Total Investing = Total Financing = Creditor Financing + Owner Financing Colgate Financing (in $billions) $9.138 = $ $1.410
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) $ $5.536 = $6.701 Gross Profit $ $ = $2.160 Operating profit
24 1-24
25 1-25 Statement of Cash Flows Net Cash Flows from Operating Activities Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities
26 1-26
27 1-27 Additional Information (Beyond Financial Statements) Management s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information Proxy Statement
28 1-28 Analysis Preview Comparative Analysis Yr1 Yr2 Yr3 Purpose: Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types: Year-to-year Change Analysis Index-Number Trend Analysis
29 Analysis Preview 1-29
30 1-30 Analysis Preview Purpose : Evaluation of internal makeup Output: Common-Size Analysis of financial statements Evaluation of financial statement accounts across companies Proportionate size of assets, liabilities, equity, revenues, & expenses
31 Analysis Preview 1-31
32 Analysis Preview 1-32
33 1-33 Analysis Preview Purpose : Output: Ratio Analysis Evaluate relation between two or more economically important items (one starting point for further analysis) Mathematical expression of relation between two or more items Cautions: Prior Accounting analysis is important Interpretation is key - long vs short term & benchmarking
34 1-34 Analysis Preview Purpose: Estimate intrinsic value of a Basis: company (or stock) 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 B t is the value of the bond at time t I t +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 V t is the value of an equity security at time t D t +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 FCF t+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 Ri t+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RI t = NI t - (k x BV t-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
40 1-40 Book Organization Financial Statement Analysis Part I Introduction and Overview Part II Accounting Analysis Part III Financial Analysis Chapter 1: Overview of Financial Statement Analysis Chapter 2: Financial Reporting and Analysis Chapter 3: Analyzing Financial Activities Chapter 4: Analyzing Investing Activities Chapter 5: Analyzing Investing Activities: Special topic Chapter 6: Analyzing Operating Activities Chapter 7: Cash Flow Analysis Chapter 8: Return on Invested Capital Chapter 9: Profitability Analysis Chapter 10: Prospective Analysis Chapter 11: Credit Analysis Chapter 12: Equity Analysis and Valuation
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