Overview of Financial Statement Analysis
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1 Overview of Financial Statement 17 November 2007 FN FN 421 Financial Statement Statement and Reporting and Reporting Business Evaluate Prospects Evaluate Risks Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Directors Regulators Employees & Unions Lawyers 2 Information Sources for Business Quantitative Financial Statements Industry Statistics Economic Indicators Regulatory filings Trade reports Qualitative Management Discussion & Chairperson s Letter Vision/Mission Statement Financial Press Press Releases Web sites 3
2 Types of Business Credit Equity Management & Control Regulation Types of Business Labor Negotiations Director Oversight Financial Management Mergers, Acquisitions & Divestitures External Auditing 4 Types of Business Credit Equity Management & Control Regulation Types of Business Labor Negotiations Director Oversight Financial Management Mergers, Acquisitions & Divestitures External Auditing 5 Creditors Trade Creditors Provide goods or services Most short-term Usually implicit interest Bear risk of default Non-trade Creditors Provide major financing Most long-term Usually explicit interest Bear risk of default 6
3 Credit Credit Worthiness Ability to honor credit obligations (downside risk) Liquidity Ability to meet short-term obligations Focus: Current financial conditions Current cash flows Liquidity of assets Solvency Ability to meet long-term obligations Focus: Long-term financial conditions Long-term cash flows Extended profitability 7 Types of Business Credit Equity Management & Control Regulation Types of Business Labor Negotiations Director Oversight Financial Management Mergers, Acquisitions & Divestitures External Auditing 8 Equity Assessment of downside risk and upside potential Technical Determine value with reference to price Charting: Patterns in price behavior or volume history Predit future price movements Fundamental Determine value without reference to price Analyze and interpret: Economy Industry Company 9
4 Intrinsic Value (or Fundamental Value) Value of Company (or stock) without reference to market value (or stock price) Intrinsic value Strategy Buy Market value Hold Sell 10 Business and Financial Statements Business Environment & Strategy Industry Strategy Accounting Profitability Financial of Sources & Uses of Funds Risk Prospective Cost of Capital Estimate Intrinsic Value 11 Accounting Process to evaluate and adjust financial statements to better reflect economic reality Comparability Problems across firms and across time Distortion Problems Manager estimation error Accounting Earnings management Risk Distortion of business 12
5 Financial Process to evaluate financial position and performance using financial statements Profitability Risk of Cash Flows Evaluate return on investment Evaluate riskiness & creditworthiness Evaluate sources & uses of funds Common Tools Ratio Cash Flows 13 Prospective Process to forecast future payoffs Business Environment & Strategy Accounting Financial Intrinsic Value 14 Dynamics of Business Activities Business Activities Time Beginning of Period Investing Planning Financing Operating Investing Planning Financing End of Period 15
6 Business Activities Competition Pricing Market Demands Distribution Planning Activities : Goals & Objectives Tactics Promotion Managerial Performance Projections Opportunities Obstacles 16 Business Activities Financing Activities Owner (equity) Non-owner (debts) Financing 17 Business Activities Investing activities Buying resources Selling resources Investing Financing Investing = Financing 18
7 Business Activities Investing Activities Planning Activities Financial Activities Operating Activities Revenues and expenses from providing goods and services 19 Financial Statements Reflect Business Activities Investing Current: Cash Accounts Receivable Inventories Marketable Securities Noncurrent: Land, Buildings, & Equipment Patents Investments Assets Sales Planning Operating Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax Expense Net Income Income statement Cash Flow Financing Current: Notes Payable Accounts Payable Salaries Payable Income Tax Payable Noncurrent: Bonds Payable Common Stock Retained Earnings Liabilities & Equity Balance Sheet Balance Sheet Statement of Cash Flows Statement of Shareholders Equity 20 Financial Statements Balance Sheet Income Statement Statement of Shareholders Equity Statement of Cash Flows 21
8 Balance Sheet Total Investing = Total Financing (Creditor + Owner) Income Statement Gross Profit = Revenues - COGS Operating Profit = Gross Profit - OPEX
9 Statement of Shareholders Equity Statement of Cash Flows Net cash flows from: Operating activities Investing activities Financing activities
10 Financial Statement Links Additional Information (Beyond Financial Statements) Management Discussion & (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information (Annual Reports, Form 56-1, Prospectus) Proxy Statement 27
11 Preview Comparative (Across Time) Yr 1 Yr 2 Yr 3 Purpose: Evaluation of consecutive financial statements Output: Direction, speed and extent of any trend(s) Types: Year-to-year change analysis Index-number trend analysis 29
12 Common Size Yr 1 Yr 2 Yr 3 Purpose: Evaluation of internal makeup of financial statements Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues and expenses 30 Ratio Purpose: Evaluation of 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 v.s. short term and benchmarking) 31
13 Ratio (Cont d) 32 Valuation (Goal of Business ) Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) Bond valuation Equity valuation: Dividend discount model Free cash flows model Residual income model 33
14 in an Efficient Market Weak form Price reflect information in past prices Semi-strong form Prices reflect all public information Strong form Prices reflect all public and private information 34 in an Efficient Market Market Efficiency assumes competent and informed analysis distinguish aggregate from individual behavior reflects information (both reliable and unreliable) cross-country differences in rewards to analysis Financial statement analysis relevant to more than just market analysis, e.g. credit and lending auditing valuation of nonpublicly traded firms mergers and acquisitions etc. 35
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