Chapter 4: Introduction to Financial Statement Analysis

The content
1. Introduction
2. Roles of Financial Reporting and Financial statement Analysis
3. Primary Financial Statement and Other Information Sources
4. Financial Statement Analysis Framework
1. Introduction
What is financial analysis?
- Financial analysis is the process of examining a company’s
performance. For this purpose, financial reports are one of the most
important sources of information available to a financial analyst.
- A financial analyst must have a strong understanding of the
information provided in a company’s financial reports, notes, and
supplementary information.
2. Roles of Financial Reporting and Financial Statement Analysis
What is role of financial reporting?
The role of financial reporting is to provide information about a
company’s performance (income statement and cash flow statement),
financial position (balance sheet) and changes in financial position
(statement of changes in equity).
What is role of financial statement analysis?
The role of financial statement analysis is to use the financial reports
prepared by firms and combine them with other sources of information
to decide whether or not you can invest in the equity of the firm or
lend money to the firm.
3. Primary Financial Statements and Other Information Sources

The primary financial statements are the balance sheet, the income
statement, the cash flow statement, and the statement of changes in
owners’ equity.
Balance Sheet (Statement of Financial Position)

• The balance sheet reports the firm’s financial position at a specific

point in time. It has the following elements:
• Assets – What the company owns.
• Liabilities – What the company owes.
• Owners’ equity – What the shareholders of the company own.
Depending on the form of the organization, owners’ equity may be
referred to as “partners’ capital” or “shareholders’ equity” or
“shareholders’ funds”, or “net assets”.
• The relationship between the elements can be shown as:
Assets = Liabilities + Owners’ equity

• The capital structure of a company represents the combination of

liabilities and equity used to finance its assets. Both financial position
and capital structure are useful in credit analysis.
Income statement

The income statement reports the financial performance of the firm

over a period of time. It has the following elements:
• Revenues – Income generated by selling goods and services.
• Expenses – Costs incurred for producing goods and services.
• Net income – Resulting profit or loss.

The relationship between the elements can be shown as:

Net income = Revenues - Expenses
Cash flow statement

The cash flow statement reports the sources and uses of cash for the
firm over a period of time. It has the following elements:
• Operating cash flows – Cash flows from day-to-day activities.
• Investing cash flows - Cash flows associated with the acquisition and
disposal of long-term assets, such as property and equipment.
• Financing cash flows - Cash flows from activities related to obtaining
or repaying capital.
Statement of changes in owner’s equity

It reports the changes in the owners’ investment in the firm over time.
It has the following elements:
• Paid in capital – Amount raised from owners.
• Retained earnings – Firm’s profits that have been retained (i.e., not
paid out as dividends).
Footnotes
They provide additional details about the information presented in
financial statements. This includes important information about the
accounting methods, estimates, and assumptions.

They also contain information regarding acquisitions and disposals,

commitments and contingencies, legal proceedings, employee stock
options and other benefits, related party transactions and business,
and geographic segments.
Management’s commentary
It provides an assessment of the data reported in the financial
statements from the management’s perspective.

Examples of content include trends and significant events affecting the

company’s operations, liquidity and capital resources, off-balance sheet
obligations, and planned capital expenditures.
What is auditor’s report?
An audit is an independent review of a firm’s financial statements. It
enables the auditor to express an opinion on the fairness and reliability
of the financial reports. An audit report can contain one of the
following opinions:
• Unqualified Opinion - Reasonable assurance that financial statements
are fairly presented. This is also referred to as an “unmodified” or a
“clean” opinion. (This is the opinion that you would like to see.)
• Qualified Opinion - Some misstatement or exception to accounting
standards.
• Adverse Opinion - Financial statements are not presented fairly.
Other information sources

• Interim reports – Quarterly or semiannual reports prepared by the firm.

These reports are not audited.
• Proxy statements - Statements distributed to shareholders about matters that
are to be put to a vote.
• Press releases, conference calls, and websites – Firms often provide current
information via these media.
• External sources – Information about the economy, industry, and the firm’s
competitors.
4. Financial Statement Analysis Framework
Financial Analysis Techniques
The content
• Introduction
• The Financial Analysis Process
• Analytical Tools and Techniques
• Common ratios used in financial analysis
• Equity Analysis
• Credit Analysis
• Business and Geographic Segments
• Model Building and Forecasting
1. Introduction
• Financial analysis is a useful tool in evaluating a company’s
performance and trends.
• The primary source of data is the company’s annual reports,
financial statements, and Management Discussion and
Analysis (MD&A) .
• An analyst must be capable of using a company’s financial
statements along with other information such as
economy/industry trends to make projections and reach valid
conclusions.
2. The Financial Analysis Process

• An analyst must clarify the purpose and context of why it is

needed.

• An analyst can choose the right techniques for the analysis.

• For example, the level of detail required for a substantial long-

term investment in equities will be higher than one needed for a
short- term investment in fixed income.
2.1. The Objectives of the Financial Analysis Process
2.2. Distinguishing between Computation and Analysis

• An effective analysis is not just a compilation of various pieces

of information, tables, and graphs. It includes both calculations
and interpretations.
• For analyzing past performance, an analyst computes several
ratios, compares them against benchmarks, evaluates how the
company performed, and determines the reasons behind its
good/bad performance.
• Similarly, for a forward-looking analysis, an analyst must
forecast and make recommendations after analyzing trends,
management quality, etc.
3. Analytical Tools and Techniques

- Various tools and techniques such as ratios, common size analysis,

graphs and regression analysis help in evaluating a company’s
performance.
- Evaluations require comparisons, but to make a meaningful
comparison of a company’s performance, the data needs to be
adjusted first.
- An analyst can then compare a company’s performance to other
companies at any point in time (cross-section analysis) or its own
performance over time (time-series analysis).
3.1 Ratios
• A ratio is an indicator of some aspect of a company’s performance like
profitability or inventory management that tells us what happened,
but not why it happened.
• Ratios help in analyzing the current financial health of a company,
evaluate its past performance, and provide insights for future
projections.
• Calculating ratios is straightforward, but interpreting them is
subjective.
Uses of ratio analysis

Ratios allow us to evaluate:

• operational efficiency.
• financial flexibility.
• changes in company/industry over time.
• company performance relative to industry.
Limitations of ratio analysis

Ratio analysis also has certain limitations. Some of the

factors to consider include:
• Need to use judgment: An analyst must exercise judgment
when interpreting ratios.
For example, a current ratio of 1.1 may not necessarily be
good/bad unless viewed in perspective of other
companies/industry.
• Nature of a company’s business: Companies may have
divisions operating in different industries. This can make it
difficult to find comparable ratios.
• Use of alternate accounting methods: Using alternate
methods may require adjustments before the ratios are
comparable.
For example, Company A might use the LIFO method to measure
inventory, while a comparable company might use the FIFO
method. Similarly, one company may use the straight line
method of depreciation, while another may use an accelerate
method.

• Consistency of results of ratio analysis: One set of ratios may

indicate a problem, while the other may indicate the problem is
short term making the results inconsistent.
3.2. Common-Size Analysis

• Common-size financial statements are used to compare the

performance of different companies with an industry or a company’s
performance over time.
• Common size statements are prepared by expressing every item in a
financial statement as a percentage of a base item.
 Common-Size Analysis of the Balance Sheet

There are two types of common-size balance sheets:

vertical and horizontal.
Vertical common-size balance sheet
• A vertical common-size balance sheet is prepared by dividing each
item on the balance sheet by the total assets for a period and
expressed as a percentage. This highlights the composition of the
balance sheet.
Trend analysis or time-series analysis provides information on historical performance and
growth. It indicates how a particular item is changing – whether it is improving or
deteriorating
– relative to total assets over multiple periods
Cross-Sectional Analysis
The vertical common-size balance sheet can be used in cross-sectional
analysis (also called relative analysis) to compare a specific metric of
one company with the same metric for another company or companies
for a single time period.
Horizontal Common-Size Balance Sheet
4. Common Ratios Used in Financial Analysis
A large number of ratios are used to measure various aspects of
performance. Commonly used financial ratios can be categorized
as follows:
4.1. Interpretation and Context

• As standalone numbers, the financial ratios of a company are not

meaningful. The ratios are usually industry specific. For instance, one
cannot compare the ratios of HSBC with that of Facebook.
• The financial ratios should be used to periodically evaluate a
company’s past performance (trend analysis) and its goals and
strategy; how it fares against its peers in the industry (cross-sectional
analysis); and the effect of economic conditions on its business.
4.2. Activity Ratios
• Activity ratios measure how efficiently a company manages its
assets.
4.3 Liquidity ratios
Liquidity ratios measures a company’s ability to meet short-term obligations. It
also indicates how quickly it turns assets into cash.
4.4 Solvency
Ratios
Solvency ratios measure a company’s ability to meet long-term
obligations. In simple terms, it provides information on how much
debt the company has taken and if it is profitable enough to pay
the interest on debt in the long term. It has to be analyzed within
an industry’s perspective. Certain industries such as real estate
use a higher level of leverage.
4.5. Profitability Ratios
Profitability ratio is used to evaluate the company’s ability to generate
income as compared to its expenses and other cost associated with the
generation of income during a particular period.
5. Equity
Analysis
One of the most common applications of financial analysis is that
of selecting stocks. An equity analyst uses various tools (such as
valuation ratios) before recommending a security to be included
in an equity portfolio. The valuation process consists of the
following steps:
• Understanding the company’s business and existing financial
profile.
• Forecasting the company’s performance, such as revenue
projections.
• Selecting the appropriate valuation model.
• Converting forecasts to a valuation.
5.1. Valuation
Ratios
Valuation ratios aid in making investment decisions. They
help us determine if a stock is undervalued or overvalued.
6. Credit
Analysis
Credit risk is the risk that the borrower will default on a payment when
it is due.

For example, if you are a bondholder, credit risk is the risk that the bond
issuer will not pay you the interest on time.

Credit analysis is the evaluation of this credit risk. Just as ratio analysis is
useful in valuing equity, it can also be applied to analyze the
creditworthiness of a borrower.
6. Credit
Analysis
• Credit ratings are based on a combination of qualitative and
quantitative factors.
• Qualitative factors include an industry’s growth prospects, volatility,
technological change, competitive environment, operational
effectiveness, strategy, governance, financial policies, risk
management practices, and risk tolerance.
• Quantitative factors include profitability, leverage, cash flow adequacy,
and liquidity.
7. Business and Geographic
Segments
A business or geographic segment is a portion of a company that
has risk and return characteristics distinct from the rest of the
company and accounts for more than 10% of the company’s
sales or assets. Companies are required to report some items
for significant segments separately.
8. Model Building and
Forecasting
• Analysts use several methods to forecast future performance. One
commonly used method is to project sales and to combine the
forecasted sales numbers with expected values for key ratios.

• For example, by using sales numbers and gross profit margin, one can
determine cost of goods sold and gross profit. This method is
particularly useful for mature companies with stable margins.
• Besides ratio analysis, techniques such as sensitivity analysis,
scenario analysis, and simulations are often used as part of the
forecasting process.
• Scenario analysis shows a range of possible outcomes
as specific assumptions or input variables are changed.
• With scenario analysis, a number of different scenarios
are defined and outcomes are estimated for each outcome.
• Simulations involve the use of computer models and input
variables which are based on a pre-defined probability
distribution.