Financial Statement Analysis
Angeline M. Lavin, Ph.D., CFA
Major Financial Statements
• Corporate shareholder annual and quarterly
reports must include
– Balance sheet
– Income statement
– Statement of cash flows
• Reports filed with Securities and Exchange
Commission (SEC)
Financial Statements
• Corporate shareholder annual and quarterly
reports must include
– Balance sheet (Exhibit 10.1)
– Income statement (Exhibit 10.2)
– Statement of cash flows (Exhibit 10.3)
• Reports filed with Securities and Exchange
Commission (SEC)
– 10-K and 10-Q
• All reports must be prepared using GAAP
Analysis of Financial Ratios
• Ratios are more informative than raw
numbers
• Ratios provide meaningful relationships
between individual values in the financial
statements
• Ratios help investors evaluate management
performance in terms of profitability,
efficiency and risk.
Relative Financial Ratios
• Enable comparison of a firm’s performance
to
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–
–
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The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)
Five Categories of Financial Ratios
1. Internal liquidity (solvency)
2. Operating efficiency and profitability
3. Business and financial risk analysis
4. Growth analysis
5. External liquidity (marketability)
Common Size Statements
• Normalize balance sheets and income
statement items to allow easier comparison
of different size firms
• Common size balance sheet: all accounts
are expressed as a percentage of total assets
• Common size income statement: all
accounts are expressed as a percentage of
sales
Financial Statement Quality
• High-quality balance sheets typically have
– Conservative use of debt
– Assets with market value greater than book
– No liabilities off the balance sheet
Financial Statement Quality
• High-quality income statements reflect
repeatable earnings
• Gains from nonrecurring items should be
ignored when examining earnings
• High-quality earnings result from the use of
conservative accounting principles that do
not overstate revenues or understate costs
The Value of Financial Statement Analysis
• Financial statements, by their nature, are
backward-looking
• An efficient market will have already
incorporated these past results into security
prices, so why analyze the statements?
• Analysis provides knowledge of a firm’s
operating and financial structure
• This aids in estimating future returns
Specific Uses of Financial Ratios
1. Stock valuation
2. Identification of corporate variables
affecting a stock’s systematic risk (beta)
3. Assigning credit quality ratings on bonds
4. Predicting insolvency (bankruptcy) of firms
Stock Valuation Models
Valuation models attempt to derive a value based
upon one of several cash flow or relative
valuation models
All valuation models are influenced by:
• Expected growth rate of earnings, cash flows, or
dividends
• Required rate of return on the stock
Financial ratios can help in estimating these critical
inputs