Financial Statement Analysis: An Introduction

Financial Statement Analysis: An Introduction 2014 Level I Financial Reporting and Analysis IFT Notes for the CFA exam

Contents 1. Introduction... 3 2. Scope of Financial Statement Analysis... 3 3. Major Financial Statements and Other Information Sources... 4 4. Financial Statement Analysis Framework... 11 Summary... 13 Next Steps... 15 This document should be read in conjunction with the corresponding reading in the 2014 Level I CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute. Copyright Irfanullah Financial Training. All rights reserved. Page 2

1. Introduction Financial analysis is the process of examining a company s performance in the context of its industry and economic environment in order to arrive at a decision or environment. For this purpose, financial reports are one of the most important sources of information available to a financial analyst. Furthermore, the analyst also uses information contained in the notes to financial statements and supplementary information (such as management discussion). It is important that an analyst have a strong understanding of each of these sources of information. 2. Scope of Financial Statement Analysis In order to develop a basic understanding of financial analysis, we first need to understand the difference between the roles of financial reporting and financial statement analysis. The role of financial reporting is to provide information about a company s performance (Income Statement), financial position (Balance Sheet) and changes in financial position (Statement of Changes in Equity). The role of financial statement analysis is to use these financial reports prepared by companies, combined with other information, to evaluate the past, current and potential future performance and financial position of a company for the purpose of making investment, credit, and other economic decisions. Examples of such decisions include: Should an equity investment be included in a portfolio? Should credit be extended to a particular customer? What is the future net income and cash flow for a particular company? The performance of a company can include an assessment of a company s profitability, ability to generate positive cash flows, liquidity and solvency. Liquidity refers to the ability of a company to meet short-term obligations. Solvency refers to the ability of a company to meet long-term obligations. Copyright Irfanullah Financial Training. All rights reserved. Page 3

3. Major Financial Statements and Other Information Sources Companies prepare financial reports at regular intervals (annually, semiannually, and/or quarterly depending on regulatory requirements). These financial reports consist of financial statements and supplementary disclosures and notes. The financial statements summarize financial information for users outside the company such as investors, creditors and analysts. 3.1 Financial Statements and Supplementary Information A complete set of financial statements include: (i) Balance sheet (ii) Income statement (iii) Statement of changes in equity (iv) Cash flow statement These are discussed in detail in the following section. Along with these required financial statements, a company typically provides additional information in its financial reports. This can include a letter from the management discussing results (called management discussion & analysis [MD&A]), an external auditor s report providing assurances, a corporate responsibility report and so on. We now discuss each financial statement and some of the additional information included in financial reports. 3.1.1 Balance Sheet The balance sheet (also known as the statement of financial position or statement of financial condition) presents a company s current financial position by showing details of the company s assets, liabilities and owner s equity at a specific point in time. Assets are the resources the company controls while liabilities are the company s obligations to lenders and other creditors. Owner s equity represents the excess of assets over liabilities. It is the owner s residual interest in (i.e. residual claim on) the company s assets after deducting its liabilities. Copyright Irfanullah Financial Training. All rights reserved. Page 4

The relationship between these three parts of a balance sheet can be expressed in the following equation (sometimes known as the accounting equation): Assets = Liabilities + Owner s Equity. An example of a balance sheet is shown below: Assets Liabilities Current assets Current liabilities Cash $200,000 Accounts payables $75,000 Short-term investments 80,000 Salaries payable 20,000 Accounts receivable 50,000 Interest payable 20,000 Inventories 350,000 Taxes payable 6,000 Prepaid insurance 20,000 $700,000 Current portion of note 35,000 $156,000 Long-term investments Long-term liabilities Stock investments $50,000 Notes payable $100,000 Cash value of insurance 20,000 70000 Bank loan 35,000 Mortgage obligations 60,000 Property, plant & equipment Deferred income taxes 74,000 $269,000 Land $50,000 Total liabilities $425,000 Buildings and equipment $100,000 Less: Accum. Depreciation -75,000 $25,000 75000 Intangible assets Goodwill 275,000 Stockholder's equity Capital stock $450,000 Other assets Retained earnings 270,000 Receivable from employee 25,000 Total assets $1,145,000 Total stockholder's equity $720,000 Total liabilities & equity $1,145,000 On the left hand side, we see that the assets of the company have been listed. These include both tangible and intangible assets. On the right hand side, the liabilities and owner s equity have Copyright Irfanullah Financial Training. All rights reserved. Page 5

been listed. The sum of both sides must be equal, as indicated by the accounting equation. The balance sheet is always made at a specific point in time, such as on 31 December 2012. 3.1.2 Statement of Comprehensive Income The statement of comprehensive income can be presented, under IFRS, as a single statement of comprehensive income or as two statements, an income statement and a statement of comprehensive income. 3.1.2.1 Income Statement The income statement presents information on the financial results of a company s business activities over a period of time. It is also known as the statement of operations and profit and loss (P&L) statement. The income statement shows how much revenue and other income a company generated during a period and the expenses it incurred to generate that revenue and other income. Revenue refers to amounts charged for the delivery of goods or services in the ordinary activities of a business. Expenses include cost of sales, administrative expenses, and income tax expenses. An example of an income statement is shown below: Revenues Net Sales $650,000 Expenses and Losses Cost of goods sold 200,000 Selling expenses 150,000 General & administrative 165,000 Loss on sale of land 2,100 Interest expense 6,000 523,100 Income Before Tax $126,900 Income tax expense 12,000 Net Income $114,900 Copyright Irfanullah Financial Training. All rights reserved. Page 6

Net income (also called net profit) on the income statement is often referred to as the bottom line and can be calculated by using the following equation: Net income = Revenues + Other income Expenses = Income Expenses. Companies also present basic and diluted earnings per share on their income statement. Earnings per share (EPS) numbers represent net income attributable to a class of shareholders divided by the relevant number of shares of stock outstanding during the period. Basic EPS is calculated using the weighted average number of common (ordinary) shares outstanding. Diluted EPS is calculated using the number of diluted shares the number of shares that would hypothetically be outstanding if potential claims on shares (such as stock options and convertible bonds) were exercised. 3.1.2.2 Other Comprehensive Income Comprehensive income includes all items that impact owners equity but are not the result of transactions with shareowners. Under IFRS, when comprehensive income is presented in two statements, the statement of comprehensive income begins with the profit or loss from the income statement and then presents the components of other comprehensive income. Examples of these components are exchange differences on translating foreign operations, deferred taxes, and gains on available-for-sale financial assets. 3.1.3 Statement of Changes in Equity The statement of changes in equity reports changes in the owners investment in the business over time. The basic components of owners equity are paid-in capital and retained earnings. Retained earnings include the cumulative amount of the company s profits that have been retained in the company. In addition, minority interests and reserves (for accumulated other comprehensive income items) are shown in equity. 3.1.4 Cash Flow Statement The cash flow statement discloses the uses and sources of cash for a company over a period of time. This helps creditors, investors and other statement users evaluate the company s liquidity, Copyright Irfanullah Financial Training. All rights reserved. Page 7

solvency and financial flexibility. Financial flexibility is the ability of the company to react and adapt to financial adversities and opportunities. The cash flow statement organizes the cash flows of the company in three categories: operating, investing and financing. Cash flows from operating activities generally involve the cash effects of transactions that are used to determine net income and hence, comprise the day-to-day activities of the company. Cash flows from investing activities are cash flows from those activities associated with the acquisition and disposal of long-term assets, such as property and equipment. Cash flows from financing activities are cash flows from activities related to obtaining or repaying capital to be used in the business. An example of a cash flow statement is shown below: Cash flows from operating activities: Net income $2,000,000 Add (deduct) noncash effects on operating income Depreciation expense $100,000 Gain on sale of land -170,000 Increase in accounts receivable -200,000 Decrease in inventory 35,000 Increase in accounts payable 70,000 Decrease in wages payable -20,000 ($185,000) Net cash provided by operating activities $1,815,000 Cash flows from investing activities: Sale of land $850,000 Purchase of equipment -200,000 Net cash provided by investing activities $650,000 Cash flows from financing activities: Proceeds from issuing stock $80,000 Dividends on common -45,000 Repayment of long-term loans -950,000 Net Cash provided by financing activities ($915,000) Net increase in cash $1,550,000 Cash balance at January 1 100,000 Cash balance at December 31 $1,650,000 Copyright Irfanullah Financial Training. All rights reserved. Page 8

The sum of the net cash flows from operating, investing and financing activities equals the net change in cash during the fiscal year. 3.1.5 Financial Notes and Supplementary Schedules The notes (also called footnotes) that accompany the four financial statements are required and are an important part of the complete set of financial statements. They disclose information about the accounting policies, methods, and estimates used to prepare the financial statements. Both IFRS and US GAAP allow some flexibility in choosing among alternative policies and methods when accounting for certain items. This will be discussed in detail in the next reading. Examples of financial notes and supplementary schedules that the company discloses in its financial statements include: Acquisitions and Disposals Commitments and Contingencies Legal Proceedings Employee Stock Options and Other Benefits Related Party Transactions Significant Customers Business and Geographic Segments 3.1.6 Management Commentary or Management Discussion and Analysis Companies typically include a section in their annual reports where the management discusses a variety of issues such as the nature of the business, past results and future outlook. This section comprises of subjective information where management is presenting its view and interpretation of that data that it has reported. The management should establish and put in processes to ensure that the financial reports adequately reflect the economic reality of the company. This section is known as management commentary or management discussion and analysis (MD&A). Various regulators in different countries specify what should be included in the MD&A. 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. Copyright Irfanullah Financial Training. All rights reserved. Page 9

3.1.7 Auditor s Report A company s financial statements are often required to be audited (examined) by an independent accounting firm in accordance with specified auditing standards. The independent auditor then provides a written opinion on the financial statements which is known as an audit report. The purpose of an audit of financial statements is to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared in accordance with applicable regulations and laws. The auditor can express one of the three following opinions in the audit report after examination of all financial statements: Unqualified Opinion: Reasonable assurance that financial statements are fairly presented. This is the one analysts would like to see in a financial report. Qualified Opinion: Some misstatement or exception to accounting standards Adverse Opinion: Financial statements are materially misstated In some cases, auditors issue a disclaimer of opinion. This happens when the auditors are unable to issue an opinion due to some reason, such as scope limitation. 3.2 Other Information Sources Other information sources that a company can provide include interim reports and proxy statements. Interim reports are provided by the company either semiannually or quarterly, depending on applicable regulatory requirements. These include the four financial statements and condensed notes but are not audited. They are useful for obtaining updates on a company s performance and its financial position since the last annual period. Proxy statements are statements distributed to shareholders about matters that are to be put to a vote at the company s annual (or special) meeting of shareholders. They typically contain useful information regarding: Management and director compensation Copyright Irfanullah Financial Training. All rights reserved. Page 10

Stock performance Potential conflicts of interest between management, the board and shareholders Companies also provide relevant current information on their web sites, in press releases and in conference calls with analysts and investors. 4. Financial Statement Analysis Framework The CFA Institute recommends an analysis framework that analysts can use in a variety of positions within the investment management industry. The framework is summarized in the figure below. The blue boxes represent the phases of financial analysis while the white boxes represent the outputs from that phase. 4.1 Articulate the Purpose and Context of Analysis It is essential to understand the purpose of the analysis, based on the analyst s role in the organization. For example, an equity analyst analyzes the financial reports in order to decide whether to invest in the company or not. On the other hand, a credit analyst looks at the company in a very different light in order to judge whether it should be given a loan or not. Next, the analyst defines the context which includes details such as the intended audience, time frame, budget and so on. Once the purpose and the context are defined, the analyst compiles the specific Copyright Irfanullah Financial Training. All rights reserved. Page 11

questions to be answered by the analysis, decides on the content to be prepared and finalizes the timeline and the budget. 4.1 Collect Data Next, the analyst collects data required to answer the questions compiled in the previous step. In addition to the past and the current financial statements, the analyst should try to obtain industry and economic data and have discussions with the management regarding the company s operations and its future outlook. The analyst can also have discussions with the company s suppliers, customers and competitors to further obtain data for his or her analysis. 4.2 Process Data After obtaining the required data, the analyst processes this data using the appropriate analytical tools. At this stage, this will involve: Reading and evaluating financial statements for each company being analyzed Making any adjustments to the financial statements to facilitate comparison. This is useful when the unadjusted statements of the subject companies reflect differences in accounting standards, accounting choices or operating decisions. Preparing or collecting common-size financial statements (which scale data to directly reflect percentages or changes) and financial ratios. 4.3 Analyze/Interpret the Processed Data The next step is to interpret the output. The analyst uses this interpretation to support his conclusions or recommendations. For example, an equity analyst may require a buy, hold or sell decision. In support of his decision, he will cite information such as target value, relative performance, expected future performance and other information used to reach this decision. 4.4 Develop and Communicate Conclusions/Recommendations Next, the analyst communicates the conclusions or recommendations in the appropriate format. The format varies by analytical task, by institution and/or by audience. For example, an equity Copyright Irfanullah Financial Training. All rights reserved. Page 12

analyst s report typically includes summary and investment decision, earnings projections, valuation, industry & competitive analysis, and other information. 4.5 Follow-up The financial analysis process does not end with a report. If an equity investment is made or a credit rating is assigned, period review is necessary to determine if the original conclusions are still valid. In the case of a rejected investment, follow-up can be useful to determine if the financial analysis is adequate or should be refined. Follow up can include repeating all the previous steps on a periodic basis. Summary Note: This summary has been adapted from the CFA Program curriculum. The information presented in financial and other reports, including the financial statements, notes, and management s commentary, help the financial analyst to assess a company s performance and financial position. An analyst may be called on to perform a financial analysis for a variety of reasons, including the valuation of equity securities, the assessment of credit risk, the performance of due diligence in an acquisition, and the evaluation of a subsidiary s performance relative to other business units. Major considerations in both equity analysis and credit analysis are evaluating a company s financial position, its ability to generate profits and cash flow, and its ability to generate future growth in profits and cash flow. This reading has presented an overview of financial statement analysis. Among the major points covered are the following: The primary purpose of financial reports is to provide information and data about a company s financial position and performance, including profitability and cash flows. The information presented in financial reports including the financial statements and notes and other reports including management s commentary or management s discussion and analysis allows the financial analyst to assess a company s financial position and performance and trends in that performance. Copyright Irfanullah Financial Training. All rights reserved. Page 13

The basic financial statements are the statement of financial position (i.e., the balance sheet), the statement of comprehensive income (i.e., a single statement of comprehensive income or two statements consisting of an income statement and a statement of comprehensive income), the statement of changes in equity, and the statement of cash flows. The balance sheet discloses what resources a company controls (assets) and what it owes (liabilities) at a specific point in time. Owners equity represents the net assets of the company; it is the owners residual interest in or residual claim on the company s assets after deducting its liabilities. The relationship among the three parts of the balance sheet (assets, liabilities, and owners equity) may be shown in equation form as follows: Assets = Liabilities + Owners equity. The income statement presents information on the financial results of a company s business activities over a period of time. The income statement communicates how much revenue and other income the company generated during a period and what expenses, including losses, it incurred in connection with generating that revenue and other income. The basic equation underlying the income statement is Revenue + Other income Expenses = Net income. The statement of comprehensive income includes all items that change owners equity except transactions with owners. Some of these items are included as part of net income, and some are reported as other comprehensive income (OCI). The statement of changes in equity provides information about increases or decreases in the various components of owners equity. Although the income statement and balance sheet provide measures of a company s success, cash and cash flow are also vital to a company s long-term success. Disclosing the sources and uses of cash helps creditors, investors, and other statement users evaluate the company s liquidity, solvency, and financial flexibility. The notes (also referred to as footnotes) that accompany the financial statements are an integral part of those statements and provide information that is essential to understanding the statements. Analysts should evaluate note disclosures regarding the use of alternative accounting methods, estimates, and assumptions. In addition to the financial statements, a company provides other sources of information that are useful to the financial analyst. As part of his or her analysis, the financial analyst should Copyright Irfanullah Financial Training. All rights reserved. Page 14

read and assess this additional information, particularly that presented in the management commentary (also called management s discussion and analysis [MD&A]). A publicly traded company must have an independent audit performed on its annual financial statements. The auditor s report expresses an opinion on the financial statements and provides some assurance about whether the financial statements fairly present a company s financial position, performance, and cash flows. In addition, for U.S. publicly traded companies, auditors must also express an opinion on the company s internal control systems. Information on the economy, industry, and peer companies is useful in putting the company s financial performance and position in perspective and in assessing the company s future. In most cases, information from sources apart from the company are crucial to an analyst s effectiveness. The financial statement analysis framework provides steps that can be followed in any financial statement analysis project. These steps are: a) articulate the purpose and context of the analysis; b) collect input data; c) process data; d) analyze/interpret the processed data; e) develop and communicate conclusions and recommendations; and follow up. Next Steps Solve the practice problems in the curriculum. Solve the IFT Practice Questions associated with this reading. Review the learning outcomes presented in the curriculum. Make sure that you can perform the implied actions. Copyright Irfanullah Financial Training. All rights reserved. Page 15