Financial Statement Analysis

ELEVENTH E D I T I O N

K.R. Subramanyam  John J. Wild

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Overview of Financial
Statement Analysis

1
CHAPTER
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Business Analysis:

Business
Analysis

Accounting Financial Prospective

Analysis Analysis Analysis

– Aids in making informed decisions by structuring the

decision task through evaluation of firm’s (e.g., Colgate)
- Environment - Strategies
- Financial Position - Financial Performance
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Business Analysis

Evaluate Prospects Evaluate Risks

Business Decision Makers

Equity investors

Creditors

Managers

Merger and Acquisition Analysts

External Auditors

Directors

Regulators

Employees & Unions

Lawyers
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Financial Statement Analysis

• It is the application of analytical tools and
techniques to general-purpose financial
statements and related data to derive estimate
and inferences which are useful in business
analysis.
– It reduces reliance or
hunches, guesses or
intuition for business
decisions.
– It decreases uncertainty of
business analysis.
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Reason for use of

Financial Statements
• They provide rich and reliable source of
information about:
Financing:
How company obtained its resources.
Investing:
Where those resources are deployed.
Operating Profitability:
How effectively resources are deployed.
Is it sufficient to use Financial statements
as basis of business decision?
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Other Information
• What are firm’s future business prospects?
• What is firm’s earnings potential?
• What is firms current financial condition?
• How does firm compare
with its competitors?
• What is a reasonable price
for firm’s stock?
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Information Sources for

Business Analysis
Quantitative Qualitative

Management discussion & Analysis

Financial Statements

Chairperson’s Letter
Industry Statistics
Press Releases
Economic Indicators
Financial press

Regulatory filings
Vision/Mission Statement

Trade reports Web sites

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Credit Analysis Equity Analysis

Management &
Control Labor Negotiations

Types of
Business Director Oversight
Regulation Analysis

Financial External Auditing

Management

Mergers, Acquisitions
& Divestitures
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Credit Analysis
Credit Analysis is the evaluation of the credit worthiness
of the company.

Trade Non-trade
Creditors Creditors

Provide Provide
Bear risk of Bear risk of
goods or major
default default
services financing

Most short- Usually Usually

term implicit Most long-
explicit
(30-60 Days) interest term
interest
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Credit Analysis
Credit worthiness: Ability to honor credit obligations.
- It focuses on the downside risk instead of upside potential.

Liquidity Solvency
Ability to meet short- Ability to meet long-
term obligations. term obligations.
- Focus: -Focus:
• Current cash flows. • Long-term profitability
• Make up of current assets • Capital structure
and liabilities
-Tools:
- Tools:
• Projections of cashflow.
• Liquidity of current assets
• Current Financial Condition • Evaluation of extended
• Cash flows profitability.
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Equity Analysis
• Equity Investors:
– They provide funds to a company in return for risk
and rewards of ownership.
• Residual interest:
– Entitled to the distribution of company’s assets only
after the claims of all other senior claimants are met.
• Intrinsic value / fundamental value:
– Value of a company (or its stock) determined through
fundamental analysis without reference to its market
value.
– Buy and Sell Strategy based on intrinsic value.
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Equity Analysis
Assessment of downside risk and upside potential

Technical analysis / Fundamental Analysis

Charting
Determine Intrinsic value
• Patterns in price or without reference to
volume history of a price
stock
• Predict future price • Analyze and interpret
movements key factors
– Economy
– Industry
– Company
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Equity Analysis
• Technical Analysis:
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Business Analysis:
Business
Environment &
Strategy Analysis

Industry Strategy
Analysis Analysis

Financial
Analysis

Analysis
Accounting of cash Prospective
Analysis flows Risk
Analysis
Profitability
Analysis Analysis

Cost of Capital Estimate Intrinsic Value

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Business Analysis:
Business
Environment &
Strategy Analysis

Industry Strategy
Analysis Analysis

 Industry is viewed as  Evaluation of both

collection of competitors company’s business
which are actively decisions and its success
competing among at establishing a
themselves and face competitive advantage.
threats from new
entrants and substitutes.  Understanding firms
 Value chain analysis. product mix and cost
structure.
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Accounting Analysis

Accounting:
Accounting is the language of the business which
is used to record, classify, summarize, report and
analyze the financial information of an enterprise.
 It involves judgement guided by fundamental
accounting principles.
 Accounting principles are governed by
standards i.e.,
 IFRS
 GAAP
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Accounting Analysis
Rules of Debit & Credit:
 Debit and Credit are called tools of the accounting
language which may also be termed as the alphabets
of the accounting language.

Debit Group Credit Group

Assets Owners Equity
Expenses Liability Heads of
Account
Income

Dr. Cr. Cr. Dr.

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Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality.
 By understanding company’s transactions and events.
 Assessing the effects of its accounting policies on financial statements.
 Adjusting statements and making them more amenable to analysis.

Limitations
Comparability problems — across firms and across time

Manager estimation error

Distortion problems Earnings management

(Window-dress Fin. Statement)
Accounting
Risk
Accounting Standards
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Accounting Analysis
Evaluation of company’s accounting quality involves:
 Evaluation of accounting policies.
 Quality and quantity of information disclosed.
 Performance and reputation of management; and
 The opportunities and incentives for earnings
management.

Major Goal of accounting analysis is to evaluate and

reduce accounting risk and to improve the economic
content of financial statement.
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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 Cash
Ratio
flow
analysis
analysis
Analysis of — Evaluate source &
cash flows deployment of funds
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Types of Financial Analysis

• Profitability Analysis:
 Focuses on firm’s sources & levels of profits
 It includes evaluation of two major sources:
 Margins (portion of sales not offset by costs)
 Turnover or capital utilization

• Risk Analysis:
 It involves assessing the solvency and liquidity of
company along with its earning variability.
• Cashflow Analysis:
 Evaluation of how company is obtaining and deploying
its funds.
 Use of retained earnings or external financing for future projects.
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Prospective Analysis
Process / Art to
forecast future payoffs

Business Environment
& Strategy Analysis

Accounting Analysis

Financial Analysis

Intrinsic Value
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Dynamics of Business Activities

Business Activities Time
Beginning of period
Investing Financing
Planning

Operating

Planning
Investing Financing
End of period
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Planning Activities
Competition Pricing

Market demands Tactics

Planning
Activities
Distribution Goals & Promotion
Objectives
Projections
Managerial performance

Opportunities Obstacles
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Financing Activities
Refer to methods that companies use to raise the
money to pay for
 Raw material
 Salaries to employees
 Utility payments
 Research and Development

Sources of Financing:
1) Owner (equity)
2) Non-owner (liabilities)
Financing
a) Trade Creditors
b) Non-Trade Creditors
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Financing Activities
Return: Equity investors share of company’s earnings.
Earning distribution: Payment of dividends to
shareholders.

Dividend Payout: refers to the proportion of earnings

distributed.

Earnings reinvestment: Retaining earnings within the

company for use in its business.

Earning retention ratio: The proportion of earnings

retained or one less the dividend payout ratio.
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Investing Activities
Refer to company’s acquisition and maintenance of
investment for purposes of selling products and
providing services and for the purpose of investing
excess cash.
 Real Assets
 Financial Assets
 Operating Assets
 Current Assets
Investing Financing
 Non-Current Assets

Investing activities
• Buying resources
• Selling resources Investing = Financing
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Operating Activities
Planning
Investing Activities Financial
Activities Activities

Operating Activities
Revenues and expenses from providing
goods and services
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Operating Activities
Operating activities involve at least five possible
components:

Research and Development

Procurement
Production
Marketing
Administration
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Financial Statements Reflect Business Activities

Planning
Investing Financing
Current: Operating Current:
• Cash • Notes Payable
• Sales • Accounts Payable
• Accounts Receivable • Cost of Goods Sold
• Inventories • Salaries Payable
• Selling Expense
• Marketable Securities • Income Tax Payable
• Administrative Expense
Noncurrent: Noncurrent:
• Interest Expense

• Land, Buildings, & • Income Tax Expense

• Bonds Payable
Equipment • Common Stock
• Patents • Retained Earnings
Net Income
• Investments

Liabilities & Equity

Income statement
Assets Cash Flow Balance Sheet

Balance Sheet Statement of Statement of

Cash Flows Shareholders’ Equity
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Overview of Financial
Statement Analysis

1
CHAPTER
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Financial Statements

Balance Sheet

Income Statement

Statement of Shareholders’
Equity

Statement of Cash Flows

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Balance Sheet

Assets = Liabilities + Owner’s Equity

= Creditor Financing + Owner Financing

Total Investing = Total Financing

Activities Activities

Colgate Financing
(in $billions)
$9.138 = $7.727 + $1.410
$9.138 = $9.138
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Income Statement
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit

Colgate’s Profitability
(in $billions)

$12.238 - $5.536 = $6.701 Gross Profit

$6.701 - $4.5411 = $2.160 Operating profit
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Statement of Cash Flows

Net Cash Flows from

Operating Activities
Net Cash Flows from
Investing Activities
Net Cash Flows from
Financing Activities
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Additional Information (Pg 26)

(Beyond Financial Statements)

Management’s Discussion & Analysis (MD&A)

Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement
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Analysis Tools
The five important sets of tools for financial
analysis are:

1) Comparative Financial statement analysis

2) Common-size financial statement analysis
3) Ratio analysis
4) Cash flow analysis
5) Valuation
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Comparative / Horizontal 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
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Comparative Analysis
Year-to-year Change Analysis
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Comparative Analysis
• Limitations:
Example:
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Comparative Analysis
Index-Number Trend Analysis

Illustration 1.2
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Comparative Analysis
Index-Number Trend Analysis
Exercise:
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Comparative Analysis
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Comparative Analysis
Solution:
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Analysis Preview
Common-Size Analysis

Purpose :  Evaluation of internal makeup

of financial statements
 Evaluation of financial statement
accounts across companies
Output: Proportionate size of assets,
liabilities, equity, revenues, &
expenses
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Common-Size Analysis
Example:
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Common-Size Analysis
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Common-Size Analysis
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Overview of Financial
Statement Analysis

1
CHAPTER
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Analysis Preview
Ratio Analysis

Purpose : Evaluate relation between two or more

economically important items, starting point for
further analysis, Identify areas requiring further
investigation, trends and bases of comparison.
Output: Mathematical expression of relation
between two or more items
Cautions:  Prior Accounting analysis is important
 Interpretation is key - long vs short
term & benchmarking
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Ratio Analysis
1) Credit (Risk) Analysis
a) Liquidity
b) Capital Structure and Solvency
2) Profitability Analysis
a) Return on investment
b) Operating performance
c) Asset Utilization
3) Market Measures
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Credit (Risk) Analysis

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Credit (Risk) Analysis

• Current Ratio:
 Measures current assets available to satisfy current
liabilities.
 Higher current ratio is good for creditors but may not be
good for stock holders or owners.
 Low current ratio may not be good for creditors but can
indicate efficiency in using short term assets.
 Limitations:
 High current ratio may give false sense of security to
creditors by treating all current assets/ liabilities equally.
 Low current ratio may give false sense of danger.
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Credit (Risk) Analysis

• Quick Ratio or Acid-Test Ratio:
 Stringent test of short-term liquidity, uses only the most
liquid current assets, cash, short-term investment and
accounts receivable.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
 Higher acid-test ratio is good for creditors but may not be
good for stock holders or owners.
 Low acid-test ratio may not be good for creditors but can
indicate efficiency in using short term assets.
 Limitations: High acid-test ratio may give false sense of
security to creditors by treating all current assets/ liabilities
equally. Low current ratio may give false sense of danger.
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Credit (Risk) Analysis

Collection Period:
 Length of time needed for conversion
of receivables to cash.

Days to sell inventory:

 Length of time needed for conversion
of inventory to cash.
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Credit (Risk) Analysis

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Exercise
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Exercise
(Solution)
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Profitability Analysis

1 $ of assets generate
16.51 Cents
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Profitability Analysis
Return On Assets (ROA):
• Higher ROA is considered better as it indicates company
is efficient in using assets to generate profits & vice versa.
Limitations:
• Higher ROA does not necessarily mean higher cash flows.
• Assets value based on book value not market value.
Return on Equity (ROE):
 Higher ROE is better as it indicates company is efficient in
giving more profit to company’s owners & vice versa.
Limitations:
 Higher ROE does not necessarily mean higher cash flows.
 Owners investment based on stock value not book value.
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Profitability Analysis
Operating Performance Analysis:
1) Gross Profit Margin
2) Operating Profit Margin (pretax)
3) Net profit margin (after tax)
Higher is considered better.
Limitations:
 High profit margins might not be good as it reduces
volume so, Low profit margins might be better as it
increases volume e.g., walmart.
 High profit margin does not necessarily mean high
cashflows.
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Profitability Analysis
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Market Measures
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Market Measures
• Price to earning:
– Interpretation: An investor is willing to pay $25.39 for
$1 of current earnings.
– Generally a high P/E ratio means that investors are
anticipating higher growth in the future.
– Companies that are losing money do not have a P/E
ratio.
• Earning Yield:
– Interpretation: The percentage of each dollar invested
in the stock that was earned by the company.
– Earnings yield is used by many investment managers
to determine optimal asset allocations
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Market Measures
• Dividend Yield:
– A financial ratio that shows how much a company pays
out in dividends each year relative to its share price.
• Dividend payout rate:
– The percentage of earnings paid to shareholders in
dividends.
– Companies tend to have a higher payout ratio.
– A reduction in dividends paid is looked poorly upon by
investors, and the stock price usually depreciates as
investors seek other dividend-paying stocks.
• P/B Ratio: The price-to-book ratio measures a
company's market price in relation to its book value.
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Exercise
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Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis

Purpose: Estimate intrinsic value of a

company (or stock)
Basis: Present value theory (time value of
money)
Info Req: - Expected future payoffs
- Discount rate
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Analysis Preview
Debt (Bond) Valuation

Bt is the value of the bond at time t

It +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)
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Analysis Preview
Equity Valuation
Dividend discount Model

Vt is the value of an equity security at time t

Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends
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Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model

FCFt+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
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Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period t

t

Rit+n is the residual income in period t + n [defined as

net income, NI, minus a charge on beginning
book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital
E refers to an expectation
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Efficient Markets

Market in which security prices are

current and fair to all traders.
Transactions costs are minimal.

There are two forms of efficiency:

1. Operational efficiency and
2. Informational efficiency
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Operational Efficiency
Speed and accuracy with which
trades are processed.
Ease with which the investing public
can access the best available prices.
 The NYSE’s SuperDOT computer
system,
NASDAQ’s SOES

Match buyers and sellers very efficiently and

at the best available price.
Therefore definitely very operationally
efficient markets.
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Informational Efficiency
Speed and accuracy with which
information is reflected in the available
prices for trading.
Securities would always trade at their fair
or equilibrium value.
• These three forms make up what is known as the
efficient market hypothesis (EMH).

Weak-form efficient markets :

Current prices reflect past prices and trading
volume.
Technical analysis –not useful.
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Informational Efficiency
 Semi-strong-form efficient markets:
 Current prices reflect price and volume
information and all available relevant public
information as well.
 Publicly available news or financial statement
information not very useful.
 Strong-form efficient markets:
 Current prices reflect price and volume history of
the stock, all publicly available information, and
even all private information.
 All information is already embedded in the price--
no advantage to using insider information to
routinely outperform the market.
 Most academic research supports semi-strong form
of efficient markets. Public information is fully
reflected in markets within minutes.
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Book Organization
Financial Statement Analysis

Part I Part II Part III

Introduction and Overview Accounting Analysis Financial Analysis

Chapter 3: Analyzing Chapter 7: Cash Flow

Chapter 1: Overview of Analysis
Financial Activities
Financial Statement Chapter 8: Return on
Chapter 4: Analyzing
Analysis Invested Capital
Investing Activities
Chapter 5: Analyzing Chapter 9: Profitability
Chapter 2: Financial Analysis
Investing Activities:
Reporting and Chapter 10: Prospective
Special topic
Analysis Analysis
Chapter 6: Analyzing
Chapter 11: Credit
Operating Activities Analysis
Chapter 12: Equity
Analysis and Valuation