Financial Statement Analysis
Introduction & Overview
FIN 3513-001: Financial Statement Analysis
Week (1) January 16 & 18, 2024
Course Overview
 Understand

What are the available sources of information
 Use

of financial statements to evaluate past & present performance
Tools & metrics used to analyze financial performance & solvency
 How

well financial performance aligns with a company’s strategy
What are the economic/business factors impacting strategic objectives
 Extent

& analyze financial statement information
historical trends can be used to project future performance
Impact of economic/business environment on future performance
2
Course Overview
 Understand

& analyze financial statement information
What are the available sources of information:

SEC Filings for Public Companies: 10-K, 10-Q, 8-K

Independent Auditor Reports

Management Discussion & Analysis (MD&A) - Form 10-K

Equity Research Reports

Company Website: Annual Reports, Investor Relations, News &
Announcements

Other Sources: Press Releases, Trade Publications, Industry Surveys
3
Course Overview
 Use

of financial statements to evaluate past & present performance
Tools & metrics used to analyze financial performance & solvency:

Liquidity Ratios

Leverage/Solvency Ratios

Return on Equity (ROE)/Return on Assets (ROA) Ratios

Productivity/Activity Ratios

Profitability Ratios
4
Course Overview
 How

well financial performance aligns with a company’s strategy
What are the economic/business factors impacting strategic objectives:

Competitive Environment

Leverage/Bargaining Power with Customers & Suppliers

Threat of Product Substitutes

New Market Entrants
5
Course Overview
 Extent

historical trends can be used to project future performance
Impact of economic/business environment on future performance:

GDP (Gross Domestic Product)

Inflation

Projected Output/Production

Interest Rates

Disposable Income
6
Focus of Course Content

Application of Accounting Principles/Assumptions:
 Does the application of accounting principles/assumptions make economic
sense
 Consistency of accounting principles/assumptions across companies within an
industry sector

Analyzing financial performance and what it reveals:
 Underlying business strategy, competitive dynamics, management capabilities
 Changes or differences in accounting estimates, assumptions, policies
 Changes in company strategies, management actions

Quality of earnings & earnings management:
 Persistent earnings central to a company’s core operations vs non-core earnings
 How executive and senior management incentives can impact earnings quality
7
Financial Reporting
Overview
Purpose of Financial Reporting
Primary objective of financial reporting is the dissemination of financial statements
that accurately measure the profitability and financial condition of a company

Firm’s objective of financial reporting:

Reflects both high-quality reporting and high-quality earnings

Conformity with financial reporting requirements: U.S. GAAP, IFRS

Compliance with SEC reporting requirements for public companies: 10-K, 10-Q,
8-K fillings

Transparency of information available to shareholders/debt holders

Ability to access capital and compliance with debt covenants

Maintaining company’s credit rating

Compliance with SEC certification requirements (Sarbanes-Oxley): CEO/CFO must
certify financial results
9
Primary Users of Financial Statement

Objective of Financial Reporting - provide users with information that supports investment
and management decisions - Three Main Groups:

Investors & Equity Analysts - formulate expectations regarding future profitability and
financial strength to estimate a company’s equity value
-

Lenders & Credit Analysts - assess a company’s ability to repay its debts and manage credit
risk associated with debt securities
-

Expected future profits, cash flows and dividends
Solvency of the company in meeting future financial obligations
Expectations about the economy, interest rates, competitive environment
Extend credit in the form of short-term loans, line of credits, or long-term debt
Determine interest rates based on the company’s risk profile and current debt load
Compliance with loan covenants requiring minimum working capital, retained earnings,
interest coverage
Company Managers - review financial performance, formulate profit maximizing strategies,
and access capital
-
Performance assessment of product lines and market segments
Investment in new product/service lines and financing sources
Impact of projected profits on share-based and other compensation incentives
10
Financial Reporting - Regulatory Oversight

Securities and Exchange Commission (SEC)
 Authority to enforce generally accepted accounting standards
 Protect investors - maintain fair, orderly, and efficient markets
 Facilitate capital formation

Financial Accounting Standards Board (FASB)
 FASB is recognized by the SEC as the designated accounting standard setter for
public companies
 The official pronouncements of the FASB are designated “Accounting Standards
Codification (ASC)”

International Accounting Standards (IFRS)
 Operates as an independent standard-setting body similar to FASB
 Both U.S. GAAP and IFRS prescribe the same set of financial statements
 No formal plan for the U.S. to transition to IFRS, or for IASB and FASB to converge
11
Financial Reporting - SEC Filing Requirements
Publicly traded firms must file financial accounting information with the SEC

Audited Annual Report (10-K):
 Audited annual report that includes the four financial statements, with explanatory
notes and Management’s Discussion and Analysis (MD&A) of financial results

Unaudited Quarterly Reports (10-Q):
 Unaudited summary versions of the four financial statements filed for each of the
first three fiscal quarters including limited additional disclosures

Current Reports (8-K):
 Required to file an 8-K within 4 business days of a significant event - major asset
sales, acquisitions/divestitures, changes in ownership, bankruptcy, change in
independent audit firm

Foreign Companies (20-F):
 Submitted by all "foreign private issuers" with listed equity shares on exchanges in
the U.S.
12
Financial Reporting - International Accounting Standards (IFRS)
Companies in more than 120 countries, including the European Union, the United Kingdom,
Canada, and Japan use International Financial Reporting Standards (IFRS) for their financial
reports

Movement toward the adoption of International Financial Reporting Standards (IFRS)
issued by the International Accounting Standards Board (IASB) beginning in 2002

Examples of jurisdictions requiring the use of IFRS:
 European Union
 Australia and New Zealand
 Hong Kong, Malaysia, and Republic of Korea
 Israel and Turkey
 Brazil and Chile
 Canada and Mexico

SEC permits foreign companies whose stock is traded in the United States to file IFRS
financial statements without requiring reconciliation to U.S. GAAP
13
Reporting Transparency - Benefits & Costs



Regulatory bodies (SEC, FASB, IASB), prescribe minimum level standards of accounting
disclosures and financial statement filing dates
Managers’ weigh the costs against benefits in deciding the quantity and quality of accounting
information disclosed
Benefits of Disclosure - economic incentives to disclose reliable/audited financial information
extend to a company’s access to capital, labor, input and output markets:




Company’s ability to secure debt & equity financing
Company’s recruiting efforts in labor markets
Company’s ability to maintain superior supplier-customer relations
Costs of Disclosure - costs of disclosing financial information includes:




Preparation/Dissemination - cost of auditing & compliance with SEC filing requirements
Competitive Disadvantages - reduce or eliminate a company’s competitive advantage by
disclosing product/segment success, strategic alliances, technological innovations, process
improvements
Litigation Risk - potential customer or investor lawsuits arising from unmet expectations
Political Risk - highly visible companies are subject to political & public scrutiny - defense
contractors, software conglomerates, oil companies
14
Fair Disclosure - Regulation Fair Disclosure (Reg FD)

Regulation Fair Disclosure (Reg FD): Adopted by the SEC to curb selective disclosure of
information by publicly traded companies to financial analysts and certain stockholders

Implemented in October 2000 to stop companies from selectively disclosing important
information to market professionals and certain shareholders while withholding other
pertinent information

When an issuer discloses material nonpublic information to certain individuals or
entities - securities market professionals such as stock analysts or shareholders of the
issuer who may trade on the basis of the information - the issuer must also make public
disclosure of that information

Objective is to level the playing field for all investors and prevent a loss of confidence in
the markets

Companies that conduct earnings and forecast calls to update stock analysts must
simultaneously issue a press release to make that information available to the general
public
15
Financial Reporting
Accounting Standards/Assumptions
Financial Reporting - Accounting Assumptions
Definition: set of rules that ensures an organization’s business operations are
conducted efficiently as mandated by FASB accounting standards
Purpose: provide a basis of consistency to evaluate the genuineness of the company’s
financial statements and determine the company’s financial wellbeing
17
Financial Reporting - Accounting Assumptions

Reliability: record only those accounting transactions that can be verified - invoices,
billing statements, receipts, bank statements

Consistency: consistent accounting methods used across all accounting periods ensure comparison of financial results for different accounting periods

Time Period: accounting practices and methods must be maintained and reported
for a particular period - accounting periods remain consistent from year-to-year

Going Concern: company will continue operating for the foreseeable future continuity assumption

Economic Entity: financial records of the organization must be maintained separate
from the personal accounting records of the company’s owners

Money Measurement: transactions must be recorded and expressed in monetary
terms - quantify financial state of affairs
Accounting assumptions ensure that businesses operate smoothly, efficiently,
and according to standards set by FASB
18
Financial Reporting - Managerial Choices

GAAP allows companies latitude in choosing accounting methods/assumptions used
to prepare financial statements

Choice of accounting methods/assumptions may yield differences in reported
income, assets, liabilities and equity amounts across companies/industries

Accrual accounting requires management’s formulation of estimates/assumptions:

Revenue earned on long-term contracts

Collections from accounts receivable

Useful life of PP&E and degree fixed assets have been used

Value impairments of assets and goodwill

Future cost of warranty claims
19
Financial Reporting - Potential Flaws

Accounting assumptions subject to manipulation may include revenue/expense
recognition, write-off of receivables, inventory, leases, etc.

Corporate executives may be influenced by compensation structures tied to earnings
targets - is management’s intent to present accurate and fair financial statements,
maximize shareholder wealth, or maximize their own personal wealth?

Evidence of “managed” earnings in GAAP compliant financials may include:
 Accelerated revenue recognition
 Overstatement of asset values
 Deferral of expenses
 Understatement of liabilities
20
Financial Reporting - Adopted Standards
Reporting standards adopted by management may vary, based on the
following:

Management Self-Interests

Revenue/Expense Recognition

Minimizing/Maximizing Setbacks

Projecting Growth Expectations

Downplaying Significant Contingencies
21
Financial Reporting - Adopted Standards (cont’d)
Management Self-Interests:

Corporations can exercise wide latitude in reporting financial results before
violating GAAP principles
 “Smoothing” of earnings to create the illusion that profits are rising at a constant
rate year-over-year
 Borrowing sales and profits from subsequent quarters by offering discounts or
more favorable payment terms to customers
 Increasing discretionary expenses (training and plant maintenance) to reduce
volatility in quarterly profits

CEOs motivated by self-interest may result in less transparent and straight forward
financial reporting
 Executive bonuses tied to operating results - growth in earnings per share
 Altering accounting practices - extending the life of depreciable assets or delaying
the cost of replacing assets
22
Financial Reporting - Adopted Standards (cont’d)
Minimizing/Maximizing Reporting Setbacks:

Corporations may exercise different standards in divulging negative results that
materially impact share price


Post small increases in quarterly profits more frequently than small declines by
utilizing discretionary items, thus improving quarterly profit margins
“Big Bath” hypothesis: Corporations tend to report large declines in earnings more
commonly than large increases

Incentive to maximize and report setbacks by accelerating future expenses into
the current quarter, thus ensuring positive future earnings

Recognize a larger write-offs of long-life assets over and above the loss in value
- obsolescence of production facilities, goodwill, etc.
23
Financial Reporting - Adopted Standards (cont’d)
Projecting Growth Expectations:

Management tends to downplay the deceleration of growth trends to normalized
or historical levels
 Sales of new products will eventually reach saturation due to competition or
market share limitations
 Growth in excess of annual GDP is unsustainable over extended periods

Companies may rationalize declining growth to persuade investors that profit
trends will continue
 Impact of unusual weather conditions causing declining growth trends
 Delays in shipments resulting in temporary reductions in production capacity
 Introduction of new products intended to restore accelerated growth trends

Adopting diversification strategies as a means of maintaining high earnings growth
 Multi-industry corporations are faced with the same earnings growth limits as
industry focused companies
24
Financial Reporting - Adopted Standards (cont’d)
Downplaying Significant Contingencies:

Litigation in the form of class action/personal injury suits that threaten
corporations - environmental hazards, product liability, etc.


Bankruptcies connected with asbestos exposure and other environmental hazards
have heightened the need to account for major legal contingencies
Senior executives are motivated to downplay risks that threaten stock values and
compensation incentives in the form of stock options

Corporate executives may downplay the magnitude of a major legal contingency as
being less dire than economic reality

Executives are conflicted between testifying in the company’s defense and
acknowledging investor’s concerns regarding contentious lawsuits
25
Example: Under Armour, Inc. - May 3, 2021
Sports equipment company that manufactures footwear, sports and casual apparel
with $5.27 billion in annual revenue
Case Summary:
 Second half of 2015, Under Armour failed to meet sales projections for North America,
indicating shortfalls from analysts’ revenue projections
 Warm winter weather negatively impacting sales of Under Armour's higher-priced cold
weather apparel
 Beginning in 2015 Q3, company accelerated or “pulled forward” $408 million in existing
orders that customers requested to be shipped in future quarters
 Company mislead investors - not disclose the use of pull forward practices to meet
analysts' revenue targets
SEC Findings:
 Under Armour violated antifraud provisions of the Securities Act of 1933
 $9.0 million settlement related to the company’s accounting practices and
misleading financial results
26
Example: Wells Fargo & Co. - Feb 21, 2020
Multinational financial services company with corporate headquarters in San Francisco,
with operating income of $20.6 billion for 2022
Case Summary:
 From 2002 to 2016, Wells Fargo opened millions of unauthorized or fraudulent accounts
and pressured customers into buying financial products they did not need
 Repeatedly misled investors regarding “cross-sell” strategy - selling additional financial
products to existing customers - characterized as a key component of its financial success

Sought to induce investors’ continued reliance on the cross-sell performance metric inflated by accounts and services that were unused

SEC Findings:
 Violated the antifraud provisions of the Securities Exchange Act of 1934
 $500 million settlement as part of a $3.0 billion settlement with the SEC and
Department of Justice
27
Financial Reporting - Importance of Being Skeptical

Financial statements may be GAAP compliant - financial performance may be
misleading in terms of generated earnings:

Compensation of corporate executives directly tied to financial performance

Latitude afforded by the Generally Accepted Accounting Principles (GAAP)

Conflict of interest between independent auditor and corporate client
KEY TAKEAWAYS

Manipulation of financial statements with the intent to commit fraud is a real and
ongoing problem, costing billions of dollars each year

GAAP standards provide significant latitude and interpretation in accounting methods
used to convey a company’s financial condition

Compensation incentives may motivate management to enhance the company's
financial condition to meet performance expectations
28
Financial Statements
Analysis Process
Financial Statements - Four Basic Financial Statements
Contain primarily historical Information

Balance Sheet
 Assets, Liabilities & Owners’ Equity

Income Statement
 Revenue less Expenses = Net Income

Statement of Shareholders’ Equity
 Changes in Equity plus cumulative sum of undistributed profits

Statement of Cash Flows
 Operating, Investing and Financing activities

Footnotes to Financial Statements
 Significant accounting policies, estimates, etc.
30
Financial Statements - Balance Sheet

Company’s financial position at a point in time

Company’s resources (Assets) or what the company owns

Company’s assets are financed from owner (Equity) and nonowner (Liabilities)
financing:

Owner Financing - financing raised from Stockholders - Equity

Non-Owner Financing - financing from Banks, Creditors & Suppliers Liabilities or Debt

Short-term or Current assets - generate cash within one year of the balance
sheet date

Long-term assets or PP&E - generate cash over extended periods of time
31
Financial Statements - Balance Sheet (cont’d)
Balance Sheet - Statement of the financial position as of a certain date

Assets
 Resources owned by a corporation, e.g., cash, accounts receivable, equipment,
land - presented in the order of liquidity

Liabilities
 Amounts/services owed by the company, e.g., loans payable, accounts
payable, accrued salaries, customer advances, etc.

Stockholders’ Equity
 Initial investment by the owners (Capital Stock - common & preferred stock)
plus the cumulative sum of undistributed profits (Retained Earnings)
32
Financial Statements - Balance Sheet (cont’d)

Relative proportion of current and long-term assets vary widely across industries
and companies within the same industry

Example: How a company’s industry and business model reflect the relative
proportion of current and long-term assets

Retail/Department Stores

Consumer Products

Technology/Storage/Peripherals

Restaurants

Airlines
33
Financial Statements - Balance Sheet (cont’d)
Retail/Dept Stores
Consumer Products
Technology
Restaurants
Airlines
34
Financial Statements - Balance Sheet (cont’d)
Retail/Dept Stores
Consumer Products
Technology
Restaurants
Airlines
35
Financial Statements - Balance Sheet (cont’d)
Retail/Dept Stores
Consumer Products
Technology
Restaurants
Airlines
36
Financial Statements - Balance Sheet (cont’d)

Company’s industry and business model reflect the relative proportion of
current and long-term assets

Retail/Department Stores - High levels of inventory - Best Buy, Macy’s,
Nordstrom

Consumer Products - High levels of Long-Term Assets - Goodwill resulting from
M&A activity, and Patents/Trademarks related to products and processes Johnson & Johnson, Colgate-Palmolive, Procter & Gamble

Technology - High levels of cash/investments in marketable securities and longterm securities - Alphabet, Apple, Intel Corp

Restaurants - High levels of equipment and leasehold improvements - Starbuck,
Darden Restaurants

Airlines - High levels of equipment and leased assets - Delta Airlines, American
Airlines
37
Financial Statements - Balance Sheet (cont’d)

Relative proportion of owner (equity) and nonowner (debt/liabilities) financing
vary widely across industries and companies within the same industry

Example: How a company’s industry and business model reflect the
relative proportion of owner and nonowner financing

Retail/Department Stores

Consumer Products

Technology/Storage/Peripherals

Restaurants

Airlines
38
Financial Statements - Balance Sheet (cont’d)
Retail/Dept Stores
Consumer Products
Technology
Restaurants
Airlines
39
Financial Statements - Balance Sheet (cont’d)

Company’s industry and business model reflect the relative proportion of
owner and nonowner financing

Retail/Department Stores - Increase in LT debt, long-term lease obligations &
declining retained earnings - Best Buy, Macy’s, Nordstrom

Consumer Products - Repurchased significant amount of common stock to boost
shareholder returns - Johnson & Johnson, Colgate-Palmolive, Procter & Gamble

Technology - Higher levels of business risk with a higher proportion of equity
capital financing vs debt financing - Alphabet, Apple, Intel Corp

Restaurants - Heavily leveraged with higher debt and lease obligations - Starbuck,
Darden Restaurants

Airlines - Higher debt and long-term leases required to finance fixed assets - Delta
Airlines, American Airlines
40
Financial Statements - Income Statement


Companies use resources to produce, promote and sell products and services
to generate operating income

Input Markets - suppliers of materials & labor - generate expenses including
inventory, salaries, materials and logistics

Output Markets - customers of products and services - generate revenue and
some expenses related to marketing, distribution and services to customers
Operating/Net income arises when revenues exceed expenses and net loss
occurs when expenses exceed revenues
41
Financial Statements - Income Statement (cont’d)
Income Statement - Performance of a company over a period of time

Revenues
 Measure of economic benefits generated by the sale of products or providing of
services over a period of time

Expenses
 Measure of economic sacrifices incurred to “earn” the revenues of a given period


Examples: cost of inventory sold, employee salaries, rent expense, utilities,
advertising, etc.
Net income
 Net Revenue less Operating Expenses equals Operating Income (EBIT) less Interest
Expense and Taxes equals Net Income
42
Financial Statements - Income Statement (cont’d)

Relative profitability (operating income as a percent of sales or revenue) varies
widely across industries and companies within the same industry

Example: How a company’s industry and business model determine
profitability levels

Retail/Department Stores

Consumer Products

Technology/Storage/Peripherals

Restaurants

Airlines
43
Financial Statements - Income Statement (cont’d)
Retail/Dept Stores
Consumer Products
Technology
Restaurants
Airlines
44
Financial Statements - Income Statement (cont’d)


Company’s industry and business model determine profitability levels

Retail/Department Stores - Best Buy, Macy’s, Nordstrom - operate in a mature
industry with low product differentiation - operating income as a percent of sales
is low

Consumer Products - Johnson & Johnson, Colgate-Palmolive, Procter & Gamble generate higher levels of profitability given brands are well established and
command higher market prices

Technology - Alphabet, Apple, Intel Corp - generate higher levels of profitability
from patent protection for intellectual property
Key factors in determining profitability:

Ability to create barriers to competition through patent protection & effective
marketing - higher profitability levels

Highly competitive markets with little product differentiation - focus more on
controlling operating expenses to offset lower operating profits
45
Financial Statements - Statement of Cash Flows
Cash Flow Statement - Separates changes in cash into three categories:


Reports cash inflows & outflows from operations, investing and financing
activities over a period of time

Operating cash flow - net cash generated from core business activities of
producing and selling products and services

Investing cash flow - cash inflows/outflows for the purchase of PP&E and
sale/purchase of marketable securities

Financing cash flow - cash inflows/outflows related to borrowing/repayment of
debt, sale/repurchase of stock and payment of dividends
Cash Flow Statement sums to the actual change in cash during the year:

Actual change refers to the difference between the beginning and ending cash
balances reported on the balance sheet
46
Financial Statements - Statement of Cash Flows

Operating Activities section indicates the company’s ability to generate cash
from its core business activities to meet the company’s current cash needs

Analyze cash flow from operations to check the following:
Ability to repay creditors
Opportunity for expansion
Ability to distribute cash dividends
47
Financial Statements - Shareholders’ Equity
Change in stockholders’ equity including change in retained earnings over a period
of time
Shareholders’ Equity - Contributed capital received from issuing stock to
shareholders




Beginning balance in capital stock
(+) Common Shares issued
(–) Treasury Stock purchased
Ending Balance in capital stock
Retained Earnings - Earned capital or reinvested capital - cumulative total amount
of earned income retained in the business




Beginning balance in retained earnings
(+) Net Income earned for the period
(–) Dividends distributed for the period
Ending balance in retained earnings
48
Financial Statements - Interconnectivity
49
Financial Statements - Accounting Considerations
1. Using Generalized Financial Statements

Financial data and software companies (Bloomberg, FactSet, Capital IQ) modify financial
statements to fit a pre-created templates

Generalization of financial statements may obscure relevant items or the frequency these
items occur - compressing “one-time” events into a single line item

Frequent “one-time” items per year may signal poor accounting standards or abuses of
accounting standards by management

Combining line items may also hide relevant trends - combined “net revenues” line item
versus a breakout of “customer sales”

Unmodified financial statements are preferred - are the amounts reported in these
statements consistent with the business narrative reported in the management’s discussion
and analysis (MDA) section
50
Financial Statements - Accounting Considerations
2. Understanding the Interactivity of the Financial Statements

Relate changes in the balance sheet accounts to the cash-flow statement - identify
inconsistencies in amounts or categorizations

Understand how changes in accrued liabilities, income taxes payable, short-term and longterm notes payable affect operating expenses in the income statement, and how it affects
cash flows from operations
3. Adjusting Statements for “One-Time” Items

Modifying financial statements to adjust for one-time items - write-offs, sale of a division,
accounting revision

If reported write-off amounts are rounded ($75 million), the amount most likely represents
management’s estimate and will likely be revised in the future
51
Financial Statements - Accounting Considerations
4. Creating Comparative Financials in Time

Temporal or time dimension for the income statement, balance sheet, and cash-flow vary:
-

The three statements are aligned for the first quarter only - Important to put all three
statements on the same time dimension to detect any intentional mismatches or
irregularities
-

Income statement is reported quarterly for first three quarters and then annually
Balance sheet is reported as a quarterly snapshot
Cash-flow statement is reported cumulative for each quarter and year end
Create the fourth quarter income statement by subtracting the first three quarters
Subtract the first quarter cash-flow statement from the second quarter, the first two quarters
from the third quarter, and the first three quarters from the annual cash flow statement
Creating quarterly cash-flow statements may detect accounting irregularities:
−
−
Delaying a capital lease payment from one quarter to the next, reflecting a flattening or decline in
cash flows for the subsequent quarter
May contradicts positive cash-flow trends generated quarterly by the company
52
Financial Statements - Accounting Considerations
5. Reading the Financial Statement Footnotes

Pay attention to the information contained in the footnotes

If the footnotes provide detailed numbers or amounts, compare these to what is presented
on a consolidated basis in the financial statements:
−
Incorporate the detailed property, plant, and equipment amounts reported in the footnotes into
the balance sheet to detect any differences or distortion in expected useful lives
−
If the common-size ratios of PP&E items to total assets do not reflect the projected useful lives,
this may distort reported depreciation, net income, and operating cash flows
53
Financial Statements
Analysis Approach
Financial Statements - Analysis Approach
Process of extracting information from financial statements to better understand a
company’s current & future performance and financial condition
Objective - Develop the framework and tools for analyzing financial statements through
a four-step approach:
I.
Understand the business environment and reported accounting information

 What is the nature of the environment in which the company operates?
II.
Adjust financial statement information to better reflect performance and financial
condition
 What is the company’s current financial performance and condition?
III.
Formulate predictions about future financial performance
 Where is the company heading in terms of projected earnings, cash flows and dividends?
IV. Estimate the company’s value based on projected financial performance
 What is the company worth in relation to enterprise and/or equity values?
55
Financial Statements - Analysis Approach (cont’d)
 State
the Objective and Context
 Gather
Relevant Data
 Process
Data
 Analyze
& Interpret Data
 Report
Conclusions or Recommendations
 Update
Analysis as Conditions Change
56
Financial Statements - Analysis Approach (cont’d)

State the Objective and Context
 Determine what questions the analysis seeks to answer
 Determine the form in which to present the information
 Determine what resources and time are needed

Gather Relevant Data
 Acquire firm’s financial statements and relevant industry and economic data
 Question the firm’s management, suppliers and customers
 Visit company sites

Process the Data
 Make any appropriate adjustments to financial statements
 Calculate ratios
 Prepare exhibits - common size financial statements and graphs/charts
57
Financial Statements - Analysis Approach (cont’d)


Analyze and Interpret the Data

Use data to answer questions in Step 1

Determine what conclusions or recommendations the analysis supports
Report the Conclusions or Recommendations


Prepare report and communicate to intended audience
Update the Analysis as Required

Update the analysis periodically to ensure most recent information is included

Update conclusions or recommendations when necessary
58
Financial Statements - Analysis Framework
Framework for Financial Analysis & Valuation
Business Environment &
Accounting Information
• Reporting on Business
Activities
• Demand for & Supply of
Accounting Information
• Review of Financial
Statements
• Analyzing the Business
Environment
Adjusting & Assessing
Financial Information
Forecasting Financial
Statements
• Accounting Methods
used in Financial
Reporting
• Forecasting Process Projected Revenue,
Earnings & Cash Flows
• Analysis of Financial
Statements
• Forecasting Mechanics
• Analysis of Profitability &
Productivity
Estimate Value using
Forecasted Information
• Valuation Process &
Models
• Valuation for Business
Decisions - Financing,
Acquisitions, Organic
Growth
59
Financial Statements - Analysis of Business Environment

Companies engage in the following business activities for which financial statements
provide useful information:
Operating Activities - hiring and training of employees, manufacturing products, delivering
services, managing after-sale customer support
Investing Activities - acquiring land, buildings and equipment, introducing new products
and services, acquiring companies to expand market share
Financing Activities - raising capital to finance operating and investing activities, issuing
share of stock or accessing debt from banks and other lenders

Environmental forces impacting a company’s business activities include:
 Market conditions impacting current demand & supply
 Business threats or competitive pressures
 Regulatory oversight of the industry
Environmental forces shape the goals and objectives of the company’s strategic planning
process - demand for products/services, supply of inputs (labor & capital), competitive
environment, business threats
60
Financial Statements - Evaluating Past Performance
Purpose: Evaluate a Company’s past financial performance - does it reflect the company’s
strategy?

Adjustments to financial statements - comparing to other industry sector companies
using different accounting methods, estimates, or assumptions

Investment (debt & equity securities) measured at Fair Value:
 “Trading Securities” - unrealized gains/loss reported in Income Statement
 “Available for Sale” - unrealized gains/loss reported in Other Comprehensive Income

Inventory Valuation - LIFO versus FIFO

Property Plant & Equipment (PP&E) - estimates of salvage value, useful life,
depreciation methodology, and capital expenditures

Intangible Assets & Goodwill - difference in accounting for assets, impact on
profitability & productivity ratios

Off-Balance Sheet Financing - impact on profitability & leverage ratios
61
Financial Statements - Forward Looking Analysis
Purpose: Project a Company’s future net income and cash flows - formulate assumptions
to project future performance

Adjustments to projected revenues, earnings and cash flows:

Non-operating Income - include only persistent core earnings & cash flows

Impairment of Goodwill/Fixed Assets - one-time events not included in day-to-day
operations

Discontinued Operations - adjust for income/loss from discontinued operations
including gain/loss on sale

Non-controlling Interest - include only net income attributable to stockholders

Acquisitions - recognize full-year revenue, expenses, and operating synergies
Quality of adjustments to the company’s financial information drives the quality of
the forecast
62
Forecasting Financial Performance - Projecting Company Sales
“Top-Down” Approach to forecasting sales at the individual company level
Macro Economy
Indicators
Industry & Sector
Analysis
Company
Analysis
63