Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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Overview of Financial
Statement Analysis

1
CHAPTER
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Business Analysis

Evaluate Prospects Evaluate Risks

Business Decision Makers

Equity investors

Creditors

Managers

Merger and Acquisition Analysts

External Auditors

Directors

Regulators

Employees & Unions

Lawyers
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Information Sources for Business

Analysis
Quantitative Qualitative

Management discussion & Analysis

Financial Statements

Chairperson’s Letter
Industry Statistics
Press Releases
Economic Indicators
Financial press

Regulatory filings
Vision/Mission Statement

Trade reports Web sites

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Credit Analysis Equity Analysis

Management &
Control Labor Negotiations

Types of
Business Director Oversight
Regulation Analysis

Financial External Auditing

Management

Mergers, Acquisitions
& Divestitures
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Credit Analysis

Trade Non-trade
Creditors Creditors

Provide Provide
Bear risk of Bear risk of
goods or major
default default
services financing

Usually Usually
Most short- Most long-
implicit explicit
term term
interest interest
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Credit Analysis
Credit worthiness: Ability to honor credit obligations
(downside risk)

Liquidity Solvency
Ability to meet short- Ability to meet long-
term obligations term obligations
Focus: Focus:
• Current cash flows • Long-term profitability
• Make up of current • Capital structure
assets and liabilities
• Liquidity of assets
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Equity Analysis
Assessment of downside risk and upside potential

Technical analysis / Fundamental Analysis

Charting
Determine Intrinsic value
• Patterns in price or without reference to
volume history of a price
stock
• Predict future price • Analyze and interpret
movements key factors
– Economy
– Industry
– Company
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Component Processes of
Business Analysis

Business
Environment &
Strategy Analysis

Industry Strategy
Analysis Analysis

Financial
Analysis

Analysis
Accounting of cash Prospective
Analysis flows Risk
Analysis
Profitability
Analysis Analysis

Cost of Capital Estimate Intrinsic Value

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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

Risk
Accounting Standards
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Financial Analysis

Process to evaluate financial position and

performance using financial statements

Profitability analysis — Evaluate return

on investments Common tools

Risk analysis ——— Evaluate riskiness

& creditworthiness Cash
Ratio
flow
analysis
analysis
Analysis of — Evaluate source &
cash flows deployment of funds
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Prospective Analysis

Process to forecast future payoffs

Business Environment
& Strategy Analysis

Accounting Analysis

Financial Analysis

Intrinsic Value
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Dynamics of Business Activities

Business Activities Time
Beginning of period
Investing Financing
Planning

Operating

Planning
Investing Financing
End of period
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Business Activities
Competition Pricing

Market demands Tactics

Planning
Activities:
Distribution Goals Promotion
& Objectives
Projections
Managerial performance

Opportunities Obstacles
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Business Activities

Financing activities
• Owner (equity)
• Nonowner (liabilities)

Financing
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Business Activities

Investing activities
• Buying resources
• Selling resources

Investing Financing

Investing = Financing
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Business Activities
Planning
Investing Activities Financial
Activities Activities

Operating Activities
Revenues and expenses from providing
goods and services
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Financial Statements Reflect Business Activities

Planning
Investing Financing
Current: Operating Current:
• Cash • Notes Payable
• Sales • Accounts Payable
• Accounts Receivable • Cost of Goods Sold
• Inventories • Salaries Payable
• Selling Expense
• Marketable Securities • Income Tax Payable
• Administrative Expense
Noncurrent: Noncurrent:
• Interest Expense

• Land, Buildings, & • Income Tax Expense

• Bonds Payable
Equipment • Common Stock
• Patents • Retained Earnings
Net Income
• Investments

Liabilities & Equity

Income statement
Assets Cash Flow Balance Sheet

Balance Sheet Statement of Statement of

Cash Flows Shareholders’ Equity
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Financial Statements

Balance Sheet

Income Statement

Statement of Shareholders’
Equity

Statement of Cash Flows

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Balance Sheet

Total Investing = Total Financing

= Creditor Financing + Owner Financing

Colgate Financing
(in $billions)
$9.138 = $7.727 + $1.410
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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
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Statement of Cash Flows

Net Cash Flows from

Operating Activities
Net Cash Flows from
Investing Activities
Net Cash Flows from
Financing Activities
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Additional Information
(Beyond Financial Statements)

Management’s Discussion & Analysis (MD&A)

Management Report
Auditor Report
Explanatory Notes to Financial Statements
Supplementary Information
Proxy Statement
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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
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Analysis Preview
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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
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Analysis Preview
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Analysis Preview
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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
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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)
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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)
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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
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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
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Analysis Preview
Equity Valuation - Residual Income Model

BV is the book value at the end of period t

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
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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
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Book Organization
Financial Statement Analysis

Part I Part II Part III

Introduction and Overview Accounting Analysis Financial Analysis

Chapter 3: Analyzing Chapter 7: Cash Flow

Chapter 1: Overview of Analysis
Financial Activities
Financial Statement Chapter 8: Return on
Chapter 4: Analyzing
Analysis Invested Capital
Investing Activities
Chapter 5: Analyzing Chapter 9: Profitability
Chapter 2: Financial Analysis
Investing Activities:
Reporting and Chapter 10: Prospective
Special topic
Analysis Analysis
Chapter 6: Analyzing
Chapter 11: Credit
Operating Activities Analysis
Chapter 12: Equity
Analysis and Valuation