Financial Statement Analysis

1. Financial Statement Analysis Chapter 01- Introduction By A.S.P.G. Manawaduge B.Y.G. Rathnasekara

2. Financial Statement Analysis FSA is the application of analytical tools and techniques to general purpose financial statement and related data to derive estimates and inference useful in business analysis. It is part of business analysis.

3. Business Analysis Evaluation of the company’s prospects and risks for the purpose of making business decision. These decisions extend to equity and debt valuation, credit risk assessment, earnings predictions, audit testing, compensation negotiations ect.

4. Initial step in BA is to evaluate company’s business environment and strategies to determine • Future business prospects • Expected growth • Competitive strength & weakness • Earning potential • Earning performance • Sustainability • Financial condition

5. Type of Business Analysis 1. Credit analysis - Trade creditors - Nontrade creditors Evaluation of the creditworthiness i.e ability to honor its credit obligation This include analysis of liquidity and solvency Short term credit- Financial conditions cash flows and liquidity of current assets Long term credit – Projection of cash flows, evaluation of extended profitability

6. 2. Equity analysis • Technical analysis Searches for pattern in the price or volume history of a stock to predict future price movements • Fundamental analysis Analyzing and interpreting key factors for economy the industry and the company. The main part of fundamental analysis is evaluation of a company’s financial position and performance.

7. Use of Business Analysis • Creditors • Equity holders • Managers • Mergers, acquisitions and divestitures • Directors • Regulators • Labor unions • Customers

8. Components of Business Analysis BA encompasses interrelated processes These processes are to estimate company value Company value is estimated using a valuation model. Input to the valuation model include estimate of future payoffs and the cost of capital. The process of forecasting future payoff is called prospective analysis.

9. Cont. To accurately forecast future payoff it is necessary to evaluate company’s business prospects and its financial statement Evaluation of business prospects is a goal of business environment and strategy analysis. Company’s financial status is assessed from its financial statements using financial analysis. Quality of financial analysis depends on the reliability and economic content of the FS. This require accounting analysis.

10. Component Processes of Business Analysis Business environment and Strategy Analysis Industry Analysis Strategy Analysis Financial Statement Analysis Financial Analysis Accounting Analysis Prospective Analysis Cash Flows risk Profitability Cost of Capital Estimate Intrinsic Value

11. 1. Business Environment and Strategy Analysis Analysis of company’s future prospect is to identify and assess a company’s economic and industry circumstances. This include analysis of its product labor and capital market. analysis of business strategy seeks to identify and assess company’s competitive strengths and weaknesses along with its opportunities and threats.

12. Business Environment Analysis It consists of two parts • Industry analysis • Strategy analysis

13. Industry Analysis Industry is viewed as a collection of competitors that jockey for bargaining power with consumers and suppliers and that actively compete among themselves and face threats from new entrants and substitute product Industry Analysis must assess both industry prospect and actual and potential competition

14. Strategy analysis Evaluation of both company’s business decisions and its success at establishing a competitive advantage. It includes, Expected strategic responses to its business environment Impact of these responses on its future success and growth

15. 2. Accounting Analysis Process of evaluating the extend to which a company’s accounting reflects economic reality. Financial statements are the sources of information for accounting analysis. Accounting analysis is important for comparative analysis.

16. Limitations in Accounting Analysis • Impossible to adopt uniform rules. • Problem of setting standards. • Failure of standard to meet needs. • Error in accounting estimate These limitations lead to, - Comparability problems - Accounting distortions

17. Accounting distortions are deviations of accounting information from the underline economics. Forms of distortions - Managerial estimate subject to error or omissions. - Managers use their discretion in accounting to manipulate or window dress - Accounting standards fail to capture economic reality.

18. Accounting Risk Uncertainty in financial statement analysis due to accounting distortions. A major goal of accounting analysis is to evaluate and reduce accounting risk and to improve the economic content of FS including the comparability. This requires restatement and reclassification of FS

19. Accounting analysis includes evaluation of a company’s earning quality /accounting quality. Evaluation of earning quality requires analysis of factors such as - company business - its accounting policies - the quantity and quality of information disclosed - performance and reputation of management - Opportunity and incentives for earning management - evaluation of sustainable earning power

20. 3. Financial Analysis Use of FS to analysis a company’s financial position and performance and to assess future financial performance.

21. Financial Analysis It consist of three areas • Profitability analysis • Risk analysis • Analysis of sources and uses of funds

22. Profitability Analysis Evaluation of company’s ROI • Company’s sources and levels of profits • Identifying and measuring the impact of various profitability drivers • evaluation of two major source of profitability –margins and turnover • Reasons for changes in profitability and the sustainability of earnings.

23. Risk Analysis Evaluation of a company’s ability to meet its commitments. Assessing the solvency and liquidity along with its earning variability

24. Analysis of sources and uses of funds Evaluation of how company obtaining and developing its funds

25. 4. Prospective analysis Forecasting of future profits – cash flows or both

26. 5. Valuation This is the main objective of many type of business analysis If refers to the process of converting forecast of future profit into an estimate of company value This need a valuation model and estimation of company costs of capital.

27. Financial Statements Basis of Analysis Business Activities

28. Planning Activities A company exists to implement specific goals and objectives. Company’s goals and objectives are captured in a business plan, that describes the company’s purpose strategy and tactics for its objectives.

29. Planning activity cont. Planning help to identify expected opportunities and obstacles. Following information are important for planning • Objectives and tactics • Market demand • Competitive analysis • Sales strategies (Pricing, promotion, distribution) • Management performance • Financial projections

30. Financing Activities Methods that company use to raise the money to pay for the need. There are two main sources of financing • Equity investors • Creditors These activities depend on conditions in financial market. i.e. Sources of financing

31. In looking to financing market company should consider • amount of financing necessary • sources of financing • timing of repayment • structure of financing agreements

32. Financing activities are also involve • Return: Equity investor’s share of earning Earning distribution: Dividend payout Earning reinvestment: Retention Ratio • Public placement or private placement • Financing from creditors Debt creditors Operating creditors

33. Investing Activities Acquisition and maintenance of investment Investing funds in different assets. - Operating assets and Financial assets or - Current assets and non current assets Investing decisions involve - types of investments necessary - amount require for each type - acquisition timing - assets location

34. Operating activities Carrying out of the business plan given its financing and investing activities • R & D • Procument • Production • Marketing • Administration

35. Financial Statement Reflect Business activities Balance sheet :reflect Financing activities,& Investing activities Income statement: reflect Operating activities. Cash flow statement: reflect financing, investing and operating activities Statement of changes in equity: reflect Financing activities

36. Additional information In addition to the major components of FS following information is presented with FS • Management’s discussion and analysis • Management report • Auditor report • Explanatory notes • Supplementary information

37. Analysis Tools • Comparative analysis • Common-size analysis • Ratio analysis • Cash flow analysis • Valuation

38. Comparative Analysis This is done by requiring consecutive balance sheets, income statement from period to period. The most important information often revealed from comparative FS analysis is trend. Two techniques of comparative analysis. • Year to year change analysis • Index number trend analysis

39. Year-to year change analysis Comparing financial statements over relatively short time periods two to three years is performed with analysis of year to year changes in individual accounts. Changes in absolute dollar amounts as well as percentages can be presented.

40. Index Number Trend Analysis Useful tool for long term trend comparison. A base period should be selected with a preselected index number usually set to 100. Base year should be a normal year with regard to business condition. Only the significant items are analyzed. Current year balance Current year index No = -------------------------- x 100 Base year balance

41. Common Size FS Analysis FS analysis can benefit form knowing what proportion of a group or subgroup is made up of a particular account. Values of the items are brought to a common size. e.g. Balance sheet items are expressed as a % of total assets. This analysis is specially useful for inter company comparison.

42. Ratio Analysis A ratio expresses a mathematical relation between two quantities. If the two quantities are 1000 and 500 ratios can be presented as follow. i. 50% ii. 2:1 iii. ½ iv. 2 To be a meaningful, a ratio must refer to an economically important relation.

43. Factors Affecting Ratios • Effect of economic events • Industry factors • Management policies • Accounting methods

44. Ratio interpretation Simply computation is not useful. Ratios should be interpreted with care. They are interpreted in comparison with • Prior ratios • Predetermined standard • Ratios of competitors

45. Major areas for which RA can be applied. 1. Credit analysis i. Liquidity – Ability to meet short term obligation ii. Capital structure and solvency - ability to meet long term obligation

46. 2. Profitability i. ROI – to asses the rewards to the suppliers of funds ii. Operating performance. To evaluate profit margin from operating activities. iii. Asset utilization – To evaluate effectiveness and intensity of assets in generating sales. 3. Valuation To estimate the intrinsic value of a company (stock)

47. Types of ratios 1. Liquidity • Current ratio • Acid-test ratio • Collection period • Days to sell inventory 2. Capital structure & solvency • Total debt to equity • Long term debt to equity • Interest coverage (Times interest earned )

48. 3. ROI • Return on assets • Return on equity 4. Operating performance • Gross profit margin • Operating profit margin • Pretax margin • Net profit margin

49. 5. Asset utilization • Cash turnover • Accounts receivable turnover • Inventory turnover • Working Capital turnover • PPE turnover • Total assets turnover

50. Market Measures • Price earning ratio • Earning yield • Dividend yield • Dividend pay out • Price to book value