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Financial Statement Analysis

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  1. Financial Statement Analysis K R Subramanyam John J Wild

  2. Overview of Financial Statement Analysis 1 CHAPTER

  3. Business Analysis Evaluate Prospects Evaluate Risks

  4. Information Sources for Business Analysis

  5. Credit Analysis Equity Analysis Management & Control Labor Negotiations Types of Business Analysis Director Oversight Regulation External Auditing Financial Management Mergers, Acquisitions & Divestitures

  6. Credit Analysis Creditors

  7. Credit Analysis Liquidity Ability to meet short-term obligations Focus: Current cash flows Make up of current assets and liabilities Liquidity of assets Solvency Ability to meet long-term obligations Focus: Long-term profitability Capital structure Credit worthiness: Ability to honor credit obligations (downside risk)

  8. Equity Analysis 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 Assessment of downside risk and upside potential

  9. Component Processes of Business Analysis Business Environment & Strategy Analysis Industry Analysis Strategy Analysis Prospective Analysis Accounting Analysis Financial Analysis Analysis of cash flows Risk Analysis Profitability Analysis Cost of Capital Estimate Intrinsic Value

  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. Financial Analysis Process to evaluate financial position and performance using financial statements Profitability analysis — Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Analysis of — Evaluate source & cash flows deployment of funds Common tools Ratio analysis Cash flow analysis

  12. Prospective Analysis Process to forecast future payoffs Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Intrinsic Value

  13. Dynamics of Business Activities Business Activities Time Beginning of period Financing Investing Planning Operating Investing Financing Planning End of period

  14. Business Activities Pricing Competition Market demands Tactics Planning Activities: Goals & Objectives Promotion Distribution Projections Managerial performance Opportunities Obstacles

  15. Business Activities • Financing activities • Owner (equity) • Nonowner (liabilities) Financing

  16. Business Activities • Investing activities • Buying resources • Selling resources Investing Financing Investing = Financing

  17. Business Activities Planning Activities Financial Activities Investing Activities Operating Activities Revenues and expenses from providing goods and services

  18. Financial Statements Reflect Business Activities Planning • Financing • Current: • Notes Payable • Accounts Payable • Salaries Payable • Income Tax Payable Noncurrent: • Bonds Payable • Common Stock • Retained Earnings • Investing • Current: • Cash • Accounts Receivable • Inventories • Marketable Securities • Noncurrent: • Land, Buildings, & Equipment • Patents • Investments Operating • Sales • Cost of Goods Sold • Selling Expense • Administrative Expense • Interest Expense • Income Tax Expense Net Income Liabilities & Equity Income statement Assets Cash Flow Balance Sheet Balance Sheet Statement of Shareholders’ Equity Statement of Cash Flows

  19. Financial Statements

  20. 1-20

  21. Balance Sheet Total Investing = Total Financing = Creditor Financing + Owner Financing Colgate Financing (in $billions) $9.138 = $7.727 + $1.410

  22. 1-22

  23. 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

  24. 1-24

  25. Statement of Cash Flows

  26. 1-26

  27. Additional Information(Beyond Financial Statements)

  28. Analysis Preview Purpose: Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types:  Year-to-year Change Analysis  Index-Number Trend Analysis Yr1 Yr2 Yr3 Comparative Analysis

  29. 1-29 Analysis Preview

  30. Analysis Preview Purpose :  Evaluation of internal makeup of financial statements  Evaluation of financial statement accounts across companies Output: Proportionate size of assets, liabilities, equity, revenues, & expenses Common-Size Analysis

  31. Analysis Preview

  32. Analysis Preview

  33. Analysis Preview Purpose : Evaluate 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 vs short term & benchmarking Ratio Analysis

  34. Analysis Preview Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) Valuation Valuation - an important goal of many types of business analysis

  35. 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)

  36. Analysis Preview Equity Valuation 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

  37. Analysis Preview Equity Valuation - Free Cash Flow to Equity Model FCFt+nis 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. Analysis Preview Equity Valuation - Residual Income Model BVt is the book value at the end of period t Rit+nis 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

  39. Analysis in an Efficient Market 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 Three assumed forms of market efficiency

  40. Book Organization Financial Statement Analysis Part II Accounting Analysis Part III Financial Analysis Part I Introduction and Overview 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