Overview of Financial Statement Analysis

1. Overview of Financial Statement Analysis Chapter 1

2. Learning Objectives • Nature and purpose of Financial Analysis • Accounting standards and processes underlying financial reports • Role of professional financial analysts • No need to read appendix 1A, 1B, and p12-17. Chap 1

3. Goal Financial statement analysis is a tool for making complex investment and credit decisions. Specifically, its basic goal is to value a firm by estimating its future cash flows and determining its financial health. Chap 1

4. Estimating cash flows requires • Current and relevant information • An evaluation of the firm’s profit and growth potential • An assessment of the firm’s survival likelihood Chap 1

5. Analysis Techniques • Starting point is to use publicly available data from financial statements including • Income Statement • Statement of Owners’ Equity • Balance Sheet • Statement of Cash Flows • Notes to Financial Statements Chap 1

6. Analysis TechniquesTime series analysis • Compare a firm to itself over time • Firms provide at least two periods of comparable data in each set of financial statements Chap 1

7. Analysis TechniquesCross-sectional Analysis • Compare several firms over the same time period • Designed to hold economic effects constant • Enables analyst to determine how a firm is doing given the prevailing macroeconomic conditions Chap 1

8. Financial Statements and Performance • Financial statements are prepared in a consistent manner (enabling cross-sectional and time series comparisons) • Accounting rules are designed to reflect firm performance Chap 1

9. Development of US Accounting Standards • 1900 • No mandated reporting requirements even though the professions of accounting and auditing existed. • 1933/34 • Securities Acts give the SEC authority to regulate financial reporting. • 1970s • Financial Accounting Standards Board is created as the authority on financial reporting for publicly traded US firms. Chap 1

10. Unions AICPA Lenders Securities and Exchange Commission Investors Politicians Accountants Others Provide input to Financial Accounting Standards Board Help set Generally Accepted Accounting Principles Environmental Factors Chap 1

11. Regulatory Requirements • SEC filing requirements • Form 10-K audited annual report • Form 10-Q quarterly report • Form 8-K special informational reports Chap 1

12. Financial Reporting Environment Industry Practices Alternative Information Sources Regulators Economy and Industry Information FASB AICPA GAAP Managers Voluntary Disclosure Users Analysts Statutory Financial Reports (Financial Statements) Investors and Creditors Enforcement and Monitoring Mechanisms SEC Litigation Corporate Governance Auditors Other Users Chap 1

13. Form 10-K (Annual Report) 10-Q (Quarterly Report) 20-F (Registration Statement/ Annual Report [Foreign]) 8-K (Current Report) Statutory Financial Reports 14-A (Proxy Statement/ Prospectus) Other SEC Filings Chap 1

14. Development of International Accounting Standards • International Accounting Standards Board(IASB) • 14 member committee of auditors, accountants, academics and financial statement users • Developed International Accounting Standards (IAS) to help investors cope with financial analysis in global capital markets • Rules are not used worldwide, but a number of countries do use the framework Chap 1

15. Basic Financial Statements • Income Statement • provides results of business activities • Balance Sheet • states assets and claims against them (liabilities and owner’s equity) • Statement of Cash Flows • provides prior cash flow information • helps analyst assess the firm’s ability to pay interested parties Chap 1

16. Transactions and the Accounting Process • Remember, Assets = Claims • Original owners put $1,000 in corporate checking account Chap 1

17. Transactions and the Accounting Process • Change the previous transaction: • Corporation purchases $50 of inventory on credit Chap 1

18. Transactions and the Accounting ProcessExpanded Transaction Model • Purchase a $5,000 building for $500 cash and $4,500 mortgage Chap 1

19. Expanded Transaction Model Chap 1

20. Transactions and the Accounting ProcessExpanded Transaction Model • The company pays rent of $2,000 for the current month • The company sells inventory to a customer on account (receivable) at a retail price of $30,000 • The portion of the inventory which was sold cost $15,000 to purchase Chap 1

21. Expanded Transaction Model Chap 1

22. Using recorded information the… • Balance Sheet • Reports totals of assets and claims on the date ending the reporting period • Statement of Cash Flows • Reports all cash inflows and outflows (more in chapter 4) • The cash column of the transaction model • Statement of Shareholders’ Equity • Reports changes in the owners’ claim accounts during the period Chap 1

23. The Professional AnalystBuy-Side and Sell-Side Analysts • Buy-side • Provide information within the investment firm • Information is rarely available to outsiders • Sell-side • Provide information to brokers who work with external clients • Reports are created with external clients in mind Chap 1

24. Role of the Analysts • Financial analysts do not believe in semi-strong form of market efficiency. • However, their job makes the market price more efficient. • If interested in becoming a CFA, visit http://cfainstitute.org/cfaprogram/ Chap 1