Overview of Financial 1-1. Statement Analysis

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1 Overview of Financial 1-1 Statement Analysis

2 1-2 Financial Statement Analysis Financial Statement Analysis is an integral and important part of the business analysis. Business analysis? Process of evaluating a company s economic prospects and risks. The purpose is to improve business decisions.

3 1-3 Business Analysis Evaluate Prospects Evaluate Risks Business Decision Makers Equity investors Creditors Managers Merger and Acquisition Analysts External Auditors Regulators Board of Directors Employees & Unions Lawyers

4 1-4 Business Analysis These business decisions extend to equity and debt valuation, credit risk assessment, earnings predictions, audit testing, compensation negotiations, and countless other decisions. Business analysis aids in making informed decisions by helping structure the decision task through an evaluation of a company s business environment, its strategies, and its financial position and performance.

5 Component Processes of Business Analysis 1-5

6 Industry Analysis 1-6

7 1-7 Strategic Analysis Encompass (includes) evaluation of: Business decision Success in achieving competitive advantage This includes assessing a company s expected strategic responses to its business environment and the impact of these responses on its future success and growth. Strategy analysis requires scrutiny of a company s competitive strategy for its product mix and cost structure.

8 1-8 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

9 1-9 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

10 1-10 Prospective Analysis Process to forecast future payoffs Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Intrinsic Value

11 Information Sources for Business Analysis 1-11 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

12 1-12 Financial Statement Analysis Application of Tools & Techniques Using Financial Statements Other Related Data To derive estimates & Inferences

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 Investing Activities Operating assets: Investments in land, buildings, equipment, legal rights (patents, licenses, copyrights), inventories, human capital, information systems, and similar assets are for the purpose of conducting the company s business operations. Operating activities are a company s primary source of earnings. Earnings reflect a company s success in buying from input markets and selling in output markets. Analysis of earnings figures, and their component parts, reflects a company s success in efficiently and effectively managing business activities. Financial assets: invest excess cash in securities such as other companies 'equity stock, corporate and government bonds, and money market funds. Current assets: short-term Non-current assets: long-term

18 1-18 Types of Business Analysis Credit Analysis Equity Analysis Management & Control Regulation Types of Business Analysis Labor Negotiations Director Oversight Financial Management Mergers, Acquisitions & Divestitures External Auditing

19 1-19 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

20 1-20 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

21 1-21 Credit Analysis Liquidity ratios: Current ratio: measures current assets available to satisfy current liabilities. Current ratio = Acid-test ratio: a more stringent test of short-term liquidity, uses only the most liquid current assets: cash, short-term investments, and accounts receivable. Acid-test ratio =

22 1-22

23 Analysis and Interpretation: Mixon's short-term liquidity position has weakened over this two-year period. Both the current and acid-test ratios show declining trends. Although we do not have information about the nature of the company's business, the acid-test ratio shift from 1.7 to 1 down to 0.9 to 1 and the current ratio shift from 2.9 to 1 down to 1.9 to 1 indicate a potential liquidity problem. Still, we must recognize that industry standards may show that the 2004 ratios were too high (instead of 2006 ratios as too low). 1-23

24 1-24 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 market price Analyze and interpret key factors Economy Industry Company

25 1-25 Business Activities Investing Activities Planning Activities Financial Activities Operating Activities Revenues and expenses from providing goods and services

26 1-26 Financial Statements Balance Sheet Income Statement Statement of Shareholders Equity Statement of Cash Flows

27 1-27 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

28 1-28 Balance Sheet Total Investing (Assets) = Total Financing Liabilities: Funding from creditors = Creditor Financing (Liabilities) + Owner Financing (Equity) represent obligations of a company / claims of creditors on assets Equity: 1. Funding invested by owners 2. Accumulated retained earnings Colgate Financing =? (in $billions)

29 Total Financing =? 1-29

30 1-30

31 1-31 Balance Sheet Total Investing = Total Financing = Creditor Financing + Owner Financing Colgate Financing (in $billions) $9.138 = $ $1.410

32 1-32 Income Statement Revenues Cost of goods sold = Gross Profit Gross profit Operating expenses = Operating Profit Colgate s Profitability =? (in $billions)

33 Gross Profit =? 1-33 Operating profit =?

34 1-34 Revenues Cost of goods sold = Gross Profit Gross profit Operating expenses = Operating Profit $ $5.536 = $6.701 Gross Profit $ $ = $2.160 Operating profit

35 1-35 The Three Major Profits Source:

36 Exercise 1-36

37 1-37 Exercise Sales 100.0% 100.0% Cost of goods sold Gross profit 34.0% 47.6% Operating expenses Net income 13.0% 28.2% Analysis and Interpretation: This situation appears to be unfavorable. Both cost of goods sold and operating expenses are taking a larger percent of each sales dollar in year 2006 compared to the prior year. Also, even though sales volume increased, net income both decreased in absolute terms and declined to only 13.0% of sales as compared to 28.2% in the year before.

38 1-38 Exercise Express the Mixon Company s balance sheets in common-size percents. (Round to the nearest one-tenth of a percent.)

39 1-39 Exercise Mixon Company Common-Size Comparative Balance Sheet December 31, * 2004 * Cash 5.9% 8.0% 9.9% Accounts receivable, net Merchandise inventory Prepaid expenses Plant assets, net Total assets 100.0% 100.0% 100.0% Accounts payable 24.9% 16.9% 13.2% Long-term notes payable secured by mortgages on plant assets Common stock, $10 par value Retained earnings Total liabilities and equity 100.0% 100.0% 100.0% * Column does not equal due to rounding.

40 1-40 Statement of Cash Flows Net Cash Flows from Operating Activities Net Cash Flows from Investing Activities Net Cash Flows from Financing Activities

41 1-41

42 1-42

43 1-43 Additional Information (Beyond Financial Statements) Management s Discussion & Analysis (MD&A) Management Report Auditor Report Explanatory Notes to Financial Statements Supplementary Information Proxy Statement

44 1-44 Management s Discussion & Analysis (MD&A) A portion of an organization's annual report that is written for shareholders in which management explains how the company performed the past year and projections for the coming year. The report also highlights other aspects of the organization.

45 1-45 Management Report The purposes of this report are to reinforce: 1. senior management's responsibilities for the company s financial and internal control system and 2. the shared roles of management, directors, and the auditor in preparing financial statements.

46 1-46 Auditor report An external auditor is an independent certified public accountant hired by management to provide an opinion on whether or not the company s financial statements are prepared in conformity with generally accepted accounting principles. Financial statement analysis requires a review of the auditor s report to ascertain whether the company received an unqualified opinion. Anything less than an unqualified opinion increases the risk of analysis.

47 1-47 Explanatory Notes to Financial Statements Explanatory notes that accompany financial reports play an integral part in financial statement analysis. Notes are a means of communicating additional information regarding items included or excluded from the body of the statements. Explanatory notes include information on: 1. accounting principles and methods employed, 2. detailed disclosures regarding individual financial statement items, 3. commitments and contingencies, 4. business combinations, 5. transactions with related parties, 6. stock option plans, 7. legal proceedings, 8. significant customers.

48 1-48 Supplementary Information Supplemental schedules to the financial statement notes include information on: 1. business segment data, 2. export sales, 3. marketable securities, 4. valuation accounts, 5. short-term borrowings, 6. quarterly financial data.

49 1-49 Proxy Statement Shareholder votes are solicited for the election of directors and for corporate actions such as mergers, acquisitions, and authorization of securities. A proxy is a means whereby a shareholder authorizes another person to actor him or her at a meeting of shareholders. A proxy statement contains information necessary for shareholders in voting on matters for which the proxy is solicited. Proxy statements contain a wealth of information regarding a company including the identity of shareholders owning 5% or more of outstanding shares, biographical information on the board of directors, compensation arrangements with officers and directors, employee benefit plans, and certain transactions with officers and directors. Proxy statements are not typically part of the annual report.

50 1-50 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 (Y2Y) Index-Number Trend Analysis

51 1-51 Analysis Preview Y2Y analysis is straightforward. Be attention when: 1. Negative value 2. Missing value

52 1-52 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

53 1-53 Analysis Preview Common-Size Analysis In analyzing a balance sheet: It is common to express total assets (or liabilities plus equity) as 100%. In analyzing an income statement: Sales are often set at 100% with the remaining income statement accounts expressed as a percentage of sales.

54 Analysis Preview 1-54

55 Analysis Preview 1-55

56 1-56 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

57 1-57 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

58 1-58 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)

59 1-59 Analysis Preview Annuity & its Present Value (PV) An annuity is a series of payments made at fixed intervals of time.

60 1-60 Analysis Preview PV formula for Annuity The PV of an annuity is the summation of a Geometric sequence, the discount factor is its common ratio. 1 * (1+i) 2-1 (1 + i)p P = A A(1 + i) n P(1 + i 1) = A[1 (1 + i) n ] P = A [1 (1 + i) n ] / i 1 2

61 1-61 Analysis Preview Discount rate VS discount factor Discount rate: Assuming a discount rate (i) of 10%, the $1,000 in a year's time would be equivalent to $ to you today (1,000 / [ ]). Discount factor: for the same case, the discount factor is 1/(1+i)= 1 / ( ) = 10/11 PV factor for annuity: PV factor for annuity

62 1-62 Analysis Preview Annuity & its Present Value (PV) Use the formula to compute the PV of the annuity : discount rate = 5% PV = Annuity * PV factor (of annuity) = 1000 * [ ^(-5) ] / 0.05 = 1000 * =

63 Exercise 1-63

64 Exercise 1-64

65 1-65 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

66 1-66

67 1-67 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

68 1-68

69 1-69 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

70 1-70

71 1-71 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

72 1-72 Analysis in an Efficient Market EMH assumes the existence of competent and well-informed analysts using tools of analysis like those described in this book. It also assumes analysts are continually evaluating and acting on the stream of information entering the marketplace. Extreme proponents of EMH (Efficient Market Hypothesis) claim that if all information is instantly reflected in prices, attempts to reap consistent rewards through financial statement analysis is futile. This extreme position presents a paradox. On one hand, financial statement analysts are assumed capable of keeping markets efficient, yet these same analysts are assumed as unable to earn excess returns from their efforts. Moreover, if analysts presume their efforts in this regard are futile, the efficiency of the market ceases.

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