Financial Statement Analysis
Forecasts about future business performance start with the analysis of trends in past performance. Generally, trends continue unless external
exogenous events (such as War, governmental policy decisions, major government legislation, or global events such as commodity supply disruptions, natural disasters, political and national cultural changes), and/or internal endogenous firm events (such as management changes, strategic business decision changes, product innovations, mergers and acquisitions, product line additions or deletions, or the failure to anticipate or offset vigorous competition), are accounted for or implemented and combined with other forces that cause material change. Financial analysis begins with the study of the quantitative and qualitative data reported in publications that include review of the reported financial statements, generally, the most recent quarters and the most recent three to five year period. Financial analysis includes the computations of various categories of ratios and financial measures. The historical trend in these ratios are studied and compared to industry performance and competitor performance. Forecasts and projections of those trends are then used to make predictions about future performance, usually using a selected valuation model containing underlying assumptions that are ‘best fit’ to solve the particular problem.
Ratios are useful because they standardize numbers and facilitate comparisons. They are used to assess and highlight strengths and weaknesses. In the finance literature they are classified into five major categories to answer the following questions:
Liquidity: Can we make required payments as they become due?
Asset Management: Do we have the right amount of assets for a given quantity of sales?
Debt Management: Do we have the right mix of debt and equity?
Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in the profit margins, return assets and return on the equity?
Market Value: Do investors like what they see as reflected in the Price earnings ratios and Market to Book value ratios?
FINANCIAL STATEMENT ANALYSIS
Accounting Textbooks tend to classify the ratios into three categories:
I. LIQUIDITY RATIOS
II. SOLVENCY RATIOS
III. PROFITABILITY RATIOS
SUGGESTED SUPPLEMENTARY MATERIALS
1) Bragg, S.M., Business Ratios and Formulas A Comprehensive Guide 3rd Edition ISBN: 978-1-118-16996-4 John Wiley NJ © 2012
2) Fridson and Alvarez, Financial Statement Analysis; A Practitioner’s Guide 4th Ed. ISBN: 978-0-470-63560-5
400 pages John Wiley NJ © 2011
3) Lundholm and Sloan, MP Equity Analysis and Valuation with E- VAL 3rd Edition, ISBN 978-0073526898 McGraw-Hill NY © 2012
4) K.R. Subramanyam Financial Statement Analysis 11th Ed. ISBN-13: 978-0078110962 McGraw-Hill N.Y. © 2011
5) Koller, Goedhart, and Wessels Valuation: Measuring and Managing the value of Companies 5th Edition, McKinsey & Co. John Wiley & Sons, Inc., Hoboken, New Jersey © 2010.
6) Stickney, Bradshaw, Baginski and Whalen, Financial Reporting and Statement Analysis A Strategic Perspective 7th Edition, Mason, OH: South-Western Cengage Learning, ©2011.
Google Books: http://www.worldcat.org/title/financial-reporting-
7) Easton, McAnally, Sommers and Zhang, Financial Statement Analysis & Valuation 5th Edition ISBN 978-1-61853-233-6, Cambridge Business Publishers, LLC © 2018
8) Palepu, Healy and Bernard, Business Analysis & Valuation, Using Financial Statements – Texts and Cases 3rd Edition Thomson South-Western © 2004
9) Gibson, C.H., Financial Reporting and Analysis 9th Edition, Thomson, South-Western © 2004
10) White, Sondhi and Fried, The Analysis and Use of Financial
Statements 3rd Edition John Wiley © 2003
1) DEFINITIONS: Financial analysis is the use of financial statements to analyze a company’s financial position and performance, and to assess future financial performance. Profitability analysis is the evaluation of a company’s return on investment. It emphasizes profitability drivers such as margins and turnover. Risk Analysis is the evaluation of a company’s ability to meet its commitments and involves assessing its solvency and liquidity in addition to its earnings variability. It is important to evaluate the reliability and sustainability of company performance and to estimate a company’s cost of capital. Analysis of sources and Uses of Funds is the evaluation of how a company is obtaining and deploying its cash resour- ces. Prospective Analysis is the forecasting of future payoffs – typically earnings and cash flows. This analysis draws on accounting analysis, financial analysis, and business environment and strategy analysis to produce a set of expected future payoffs used to estimate company value. Valuation is the process of converting forecasts of future payoffs into an estimate of company value. To determine company value, a valuation model must be selected to estimate the company’s cost of capital.
2) USE OF FINANCIAL STATEMENTS: Financial statement analysis is a collection of analytical processes that are part of business analysis, which includes analyzing a company’s business environment and strategy. A company’s financial statements provide information about planning, financing, investing and operating activities. Business plans, material events, prospective information may be observed in letters to shareholders and the Management Discussion and Analysis (MDA) portions of financial statements. Policies and Procedures on internal operating and financial controls may be found in the Management Report, which may be combined with the auditor’s report to ascertain the degree of responsibilities shared among the directors, senior management and the independent CPA auditors. Explanatory footnotes, supplementary schedules and proxy statements include all kinds of relevant financial data such as business segment data, valuation accounts, business combinations or disposals, related party transactions, commitments and contingencies, legal proceedings, significant customers, stock option, deferred compensation or pension plans, export sales, marketable securities, quarterly financial data, short-term and long-term borrowings, effective tax rate, tax credits and fiscal obligations, and the classes of equity ownership (5% to 50%) that may exercise significant influence over the company’s operating, financing, investing and planning activities.
3)TOOLS: Five important sets of tools include the use of i) comparative financial statement analysis; ii) common-size financial statement analysis; iii) ratio analysis; iv) cash flow analysis and v) valuation. Financial statement analysis utilizes year-to-year change analysis and index-number trend analysis. Common size financial statements focus on the internal components of a business through vertical analysis of its financial statements. Ratio analysis includes credit risk analysis [liquidity, capital structure and solvency], profitability analysis [Return on investment, Operating performance and asset utilization] and valuation [P/E, earnings yield, dividend yield, dividend payout ratio, price to book value}. Cash flow analysis is used to evaluate the sources and uses of funds.
4) VALUATION: Financial statement analysis includes estimating the intrinsic value of a company or its stock. Present Value theory is the basic underlying theme under any valuation model and states that the value of a debt or equity security is equal to the sum of all expected future payoffs from the security discounted to the present at an appropriate discount rate. Future payoffs from stocks are dividends and capital appreciation. The discount rate in the case of a bond is the prevailing interest rate (yield to maturity) whereas, in the case of a stock, it is the risk adjusted cost of capital or the expected rate of return. Debt valuation is the present value of interest payments plus the present value of principal payments. Equity valuation models may include the dividend discount model, free cash flow to equity model, the residual income model.
STEP ONE (1):
All project / case assignments require gathering recent financial statements and current investment research data in which public information is available. Obviously, the fiscal or calendar year-ends may determine the time periods in which certified audited financial statements were publicly filed. It is also recommended that students investigate other financial reports filed with the Securities and Exchange Commission such as 10-Q and 8-K reports, and other filings such as Insider Trading dis- closures, reports and data. The project/ case assignment should incorpor- ate trend analysis employing different financial measures and comparing them against the industry standards and major competitor(s) in addition to the results for the selected companies. Lastly, it is recommended that you look at independent research reports (e.g. Value Line Investment Research) to gather other financial information, qualitative and/or quantitative, includ- ing reports that utilize other financial valuation models, such as beta rik measures, smart beta and/or EVA analysis. The project / case Assignment should also incorporate qualitative analysis of the management of these companies. For example, what is the company’s score on business ethics, stakeholder and community issues, environmental protection, and other corporate governance matters?
STEP TWO (2):
The Project Case Assignment requires an analytical decisional perspective of committing independent capital investment resources in the context of lenders/bankers (debt) and shareholders/ common stockholders (equity). The analysis may include risk-reward trade-off analysis based upon the data gathered and analyzed in step 1).
STEP THREE (3):
DATA ANALYSIS AND COMPARISON:
Meaningful presentation of the data in graphs and charts and the interpretation of the data should be carefully explained with commentary and analysis.
STEP FOUR (4)
The choice of the valuation model(s) should be explained and supported. Why was the model selected for the particular report or case?
STEP FIVE (5)
What are the quantitative results from each forecasted model and what do we learn from the results? What are the conclusions and predictions and how do we accomplish them.
STEP SIX (6)
How do actual results compare with the predictions and can we explain the errors or differences?
MODELS: In addition to the Financial Statement Analytical tools presented in the Textbook, the referenced websites and the data listed above, it is recommended that you peruse the models presented in the books selected above.
i) To get managers to start thinking like investors, we typically ask the following two questions: As an investor, would you buy the stock in your own company? As a manager, what are you doing to increase the value of your (shareholder’s) investment in your company?
ii) What do financial statements tell about a borrower’s ability and willingness to repay a loan? What is the most immediate danger faced by a lender and how can this condition arise? What is the ultimate objective of the credit analyst? iii) Quality of Earnings “…In the long-run, net income should be about equal to cash flows because a company is normally in business in order to earn cash. The timing may be slightly different. That is, a company may get cash and subsequently do something to earn it or the company may earn revenues by delivering services or products and then later receive the cash. The closer the amount of net earnings is to the amount of cash flow in the short-run, the higher the perception of the quality of the earnings…..Another issue is the sustainability of earnings. Earnings are higher quality if they will be ongoing rather than just a blip on the screen…” iv) Earnings before interest, taxes, depreciation and amortization EBITDA “…The interchangeability of EBITDA and operating cash flow (OCF), is extremely significant in light of a long tradition of empirical research linking cash flow and bankruptcy risk. Beaver tested cash flow defined as Net Income + Depreciation +Depletion + Amortization, and found that of all of the ratios tested, the best single predictor of bankruptcy was a declining trend in the ratio of cash flow to total debt….The empirical evidence indicated that by adding depreciation to the numerator, analysts improved their ability to predict which companies would go bust, relative to comparing total debt with net income alone….” v) Market/Book Ratio “… The M/B ratio expresses the relationship between the market value of a firm’s common stock and the shareholder’s equity section of the balance sheet. The M/B ratio equals the market value of the firm’s common stock divided by the shareholders’ equity reported in the balance sheet (the firm’s book value). Since shareholders’ equity equals the cumulative amount of common stock, retained earnings, and translation adjustments, the M/B ratio is typically much lower than the P/E ratio. The M/B ratio is another way of looking at the relationship between management’s performance and the market’s assessment of that performance.
CONCEPTS AND TECHNIQUES
A technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount.
A technique for evaluating a series of financial statement data over a period of time to determine the increase (decrease) that has taken place, expressed as either an amount or a percentage, relative to ma base year.
Free Cash Flow
The amount of cash from operations after adjusting for cash dividends paid and capital expenditures. (Statement of Cash). A very significant ratio used by Board of Directors and Compensation Committees to set Executive and Management compensation performance targets and standards.
Includes all changes in stockholder’s equity during a period except those relating to or resulting from investments by stockholders and distributions to stockholders.
CRITERIA FOR GRADING:
Data Compilation and research
Calculations, ratio analysis and presentation of results
Charts, Graphs and Tables of data analysis
Industry and sector data and use of benchmarks and standards
Vertical and Horizontal analysis – Financial trend analysis
Financial Statements and Footnote analysis: accounting policies
M D & A summaries, forecasts and analysis (forward looking
Valuation studies, EVA analysis, Expected growth rate analysis
Recent News articles, events and EMH (efficient markets hypothesis)
Rating agencies and analysis (Moody’s, S&P and Fitch debt ratings)
Analysis of special SEC Filings: Restrictive covenants, ESOPs,
Stock Options, Pension Plans, other Executive Compensation
Incentive plans, deferred tax matters, effective tax rates
Corporate Governance Announcements, Policies (e.g. stakeholder
Business ethics, social responsibility and stakeholder matters
Board of Director Policies, M&A issues etc.
Stock risk assessment, beta and institutional ratings
Qualitative assessments of management such as business ethics
and social responsibility, litigation etc.
Intangibles and non-quantitative management assessments
Precise, coherent, well-organized substantive analytical narratives
applying and discussing the financial statement tools
Conclusions and summaries relating to insider trading activity
You need not have all 20 criteria but your paper submissions should cover many of the listed topics. Also, this is not an exhaustive list.
SUMMARY AND CONCLUSION