Financial Statement Analysis

1. Financial Statement Analysis K R Subramanyam John J Wild

2. Overview of Financial Statement Analysis 1 CHAPTER

3. Information Sources for Analysis

4. Business Activities Planning Activities Financial Activities Investing Activities Operating Activities Revenues and expenses from providing goods and services

5. Financial Statements Reflect Business Activities Planning • Financing • Current: • Notes Payable • Accounts Payable • Salaries Payable • Income Tax Payable Noncurrent: • Bonds Payable • Common Stock • Retained Earnings • Investing • Current: • Cash • Accounts Receivable • Inventories • Marketable Securities • Noncurrent: • Land, Buildings, & Equipment • Patents • Investments Operating • Sales • Cost of Goods Sold • Selling Expense • Administrative Expense • Interest Expense • Income Tax Expense Net Income Liabilities & Equity Income statement Assets Cash Flow Balance Sheet Balance Sheet Statement of Shareholders’ Equity Statement of Cash Flows

6. Major aspects of financial statement analysis Profitability analysis Credit analysis Cash flow analysis Basic analysis Market measures Financial distress and bankruptcy analysis Special analysis topics Financial forecast Equity valuation Prospective analysis

7. Analysis Process

8. Comparative analysis • Why we need to compare? • What we need to compare? • Period-to-period • Firm-to-firm • Division-to-division • Difference types: • In dollars: ∆A = A1 – A0 • In percentages: A1 x 100 (%) A0

9. Horizontal analysis To compare a company’s financial position and performance between periods. Time

10. Trend analysis Trend analysisis used for comparison of the same item over a significantly long period to detect general pattern of a relationship between associated factors and project the future direction of this pattern.

11. Trend analysis

12. Vertical analysis Technique for identifying relationship between items in the same financial statement by expressing all amounts as the percentage of the total amount taken as 100 (a common-size financial statement).

13. Common-size graph

14. Common-size Balance sheets

15. Common-size balance sheets

18. Ratio analysis • To evaluate relationships among financial statement items • Four groups: • Liquidity • Solvency • Efficiency • Profitability

19. Equity Valuation Purpose: Estimate intrinsic value of a company (or stock) Basis: Present value theory (time value of money) Valuation - an important goal of many types of business analysis

20. 1 1 P = A x x 1 - r (1 + r)n 1 P = Fn (1 + r)n Present value theory P: Present value Fn: Future value at period n A: Annual cash flows (from period 1 to period n) r: discounted rate

21. Equity valuation – Residual Income Model Expected Income = Required rate of equity x Book value of equity Residual Income = Actual Income – Expected Income Fair value of Equity = Book value of Equity + PV{Expected Residual Incomes} Investors should pay more than book value if actual income is higher than expected and less than book value if actual income is lower than expected.

22. Equity valuation – Residual Income Model BVt is the book value at the end of period t Rit+nis 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

23. Example

24. Example Fair value of equity VE =

25. Equity valuation – Dividend model 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

26. Equity Valuation – Free cash flow to equity model FCFEt+nis the free cash flow to equity 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