Financial
Statement
Analysis
K R Subramanyam
John J Wild
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview of Financial
Statement Analysis
1
CHAPTER
1-2
1-3
Business Analysis
Evaluate Prospects
Evaluate Risks
Business Decision Makers
Equity investors
Creditors
Managers
Merger and Acquisition Analysts
External Auditors
Directors
Regulators
Employees & Unions
Lawyers
1-4
Information Sources for Business
Analysis
Quantitative
Financial Statements
Qualitative
Management discussion & Analysis
Chairperson’s Letter
Industry Statistics
Press Releases
Economic Indicators
Financial press
Regulatory filings
Vision/Mission Statement
Trade reports
Web sites
1-5
Credit Analysis
Equity Analysis
Management &
Control
Regulation
Financial
Management
Labor Negotiations
Types of
Business
Analysis
Director Oversight
External Auditing
Mergers, Acquisitions
& Divestitures
1-6
Credit Analysis
Trade
Creditors
Non-trade
Creditors
Provide
goods or
services
Bear risk of
default
Provide
major
financing
Bear risk of
default
Most shortterm
Usually
implicit
interest
Most longterm
Usually
explicit
interest
1-7
Credit Analysis
Credit worthiness: Ability to honor credit obligations
(downside risk)
Liquidity
Ability to meet shortterm obligations
Focus:
• Current cash flows
• Make up of current
assets and liabilities
• Liquidity of assets
Solvency
Ability to meet longterm obligations
Focus:
• Long-term profitability
• Capital structure
1-8
Equity Analysis
Assessment of downside risk and upside potential
Technical analysis /
Charting
• Patterns in price or
volume history of a
stock
• Predict future price
movements
Fundamental Analysis
Determine Intrinsic value
without reference to
price
• Analyze and interpret
key factors
– Economy
– Industry
– Company
1-9
Component Processes of
Business Analysis
Business
Environment &
Strategy Analysis
Industry
Analysis
Strategy
Analysis
Financial
Analysis
Accounting
Analysis
Analysis
of cash
flows
Risk
Profitability
Analysis
Analysis
Cost of Capital Estimate
Prospective
Analysis
Intrinsic Value
1-10
Accounting Analysis
Process to evaluate and adjust financial
statements to better reflect economic reality
Comparability problems — across firms and across time
Manager estimation error
Distortion problems
Earnings management
Accounting Standards
Accounting
Risk
1-11
Financial Analysis
Process to evaluate financial position and
performance using financial statements
Profitability analysis — Evaluate return
on investments
Risk analysis ——— Evaluate riskiness
& creditworthiness
Analysis of —
cash flows
Evaluate source &
deployment of funds
Common tools
Ratio
analysis
Cash
flow
analysis
1-12
Prospective Analysis
Process to forecast future payoffs
Business Environment
& Strategy Analysis
Accounting Analysis
Financial Analysis
Intrinsic Value
1-13
Dynamics of Business Activities
Business Activities
Time
Beginning of period
Investing
Financing
Planning
Operating
Planning
Investing
Financing
End of period
1-14
Business Activities
Pricing
Competition
Market demands
Distribution
Tactics
Planning
Activities:
Goals
& Objectives
Promotion
Projections
Managerial performance
Opportunities
Obstacles
1-15
Business Activities
Financing activities
• Owner (equity)
• Nonowner (liabilities)
Financing
1-16
Business Activities
Investing activities
• Buying resources
• Selling resources
Investing
Financing
Investing = Financing
1-17
Business Activities
Investing
Activities
Planning
Activities
Financial
Activities
Operating Activities
Revenues and expenses from providing
goods and services
1-18
Financial Statements Reflect Business Activities
Planning
Investing
Operating
Current:
•
•
•
•
Cash
Accounts Receivable
Inventories
Marketable Securities
Noncurrent:
•
•
•
Land, Buildings, &
Equipment
Patents
Investments
Sales
• Cost of Goods Sold
• Selling Expense
• Administrative Expense
• Interest Expense
• Income Tax Expense
•
Balance Sheet
Current:
•
•
•
•
•
•
Net Income
Cash Flow
Statement of
Cash Flows
Notes Payable
Accounts Payable
Salaries Payable
Income Tax Payable
Noncurrent:
•
Income statement
Assets
Financing
Bonds Payable
Common Stock
Retained Earnings
Liabilities & Equity
Balance Sheet
Statement of
Shareholders’ Equity
1-19
Financial Statements
Balance Sheet
Income Statement
Statement of Shareholders’
Equity
Statement of Cash Flows
1-20
1-21
Balance Sheet
Total Investing = Total Financing
= Creditor Financing + Owner Financing
Colgate Financing
(in $billions)
$9.138 = $7.727 + $1.410
1-22
1-23
Income Statement
Revenues – Cost of goods sold = Gross Profit
Gross profit – Operating expenses = Operating Profit
Colgate’s Profitability
(in $billions)
$12.238 - $5.536 = $6.701 Gross Profit
$6.701 - $4.5411 = $2.160 Operating profit
1-24
1-25
Statement of Cash Flows
Net Cash Flows from
Operating Activities
Net Cash Flows from
Investing Activities
Net Cash Flows from
Financing Activities
1-26
1-27
Additional Information
(Beyond Financial Statements)
Management’s Discussion & Analysis (MD&A)
Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement
1-28
Analysis Preview
Yr1
Yr2
Yr3
Comparative Analysis
Purpose: Evaluation of consecutive
financial statements
Output: Direction, speed, & extent of any
trend(s)
Types:  Year-to-year Change Analysis
 Index-Number Trend Analysis
1-29
Analysis Preview
1-30
Analysis Preview
Common-Size Analysis
Purpose :  Evaluation of internal makeup
of financial statements
 Evaluation of financial statement
accounts across companies
Output:
Proportionate size of assets,
liabilities, equity, revenues, &
expenses
1-31
Analysis Preview
1-32
Analysis Preview
1-33
Analysis Preview
Ratio Analysis
Purpose :
Evaluate relation between two or more
economically important items (one
starting point for further analysis)
Output:
Mathematical expression of relation
between two or more items
Cautions:  Prior Accounting analysis is important
 Interpretation is key - long vs short
term & benchmarking
1-34
Analysis Preview
Valuation
Valuation - an important goal of many types
of business analysis
Purpose: Estimate intrinsic value of a
company (or stock)
Basis:
Present value theory (time value of
money)
1-35
Analysis Preview
Debt (Bond) Valuation
Bt is the value of the bond at time t
It +n is the interest payment in period t+n
F is the principal payment (usually the debt’s face value)
r is the investor’s required interest rate (yield to maturity)
1-36
Analysis Preview
Equity Valuation
Vt is the value of an equity security at time t
Dt +n is the dividend in period t+n
k is the cost of capital
E refers to expected dividends
1-37
Analysis Preview
Equity Valuation - Free Cash Flow to Equity
Model
FCFt+n is the free cash flow in the period t + n [often
defined as cash flow from operations less capital
expenditures]
k is the cost of capital
E refers to an expectation
1-38
Analysis Preview
Equity Valuation - Residual Income Model
BV is the book value at the end of period t
Rit+n is the residual income in period t + n [defined as
net income, NI, minus a charge on beginning
book value, BV, or RIt = NIt - (k x BVt-1)]
k is the cost of capital
E refers to an expectation
t
1-39
Analysis in an Efficient Market
Three assumed forms of market efficiency
Weak Form - prices reflect information in
past prices
Semi-strong - prices reflect all public
Form
information
Strong Form - prices reflect all public and
private information
1-40
Book Organization
Financial Statement Analysis
Part I
Introduction and Overview
Chapter 1: Overview of
Financial Statement
Analysis
Chapter 2: Financial
Reporting and
Analysis
Part II
Accounting Analysis
Chapter 3: Analyzing
Financial Activities
Chapter 4: Analyzing
Investing Activities
Chapter 5: Analyzing
Investing Activities:
Special topic
Chapter 6: Analyzing
Operating Activities
Part III
Financial Analysis
Chapter 7: Cash Flow
Analysis
Chapter 8: Return on
Invested Capital
Chapter 9: Profitability
Analysis
Chapter 10: Prospective
Analysis
Chapter 11: Credit
Analysis
Chapter 12: Equity
Analysis and Valuation